Sustainable Income and Net Income

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Lupita Mora-Rubio Chapter 13 Questions September 10, 2012 #1 Sustainable income (SI): When companies look at present year net income to estimate future cash flows it must make sure it does not include “irregular items.” Irregular items can be losses, gains, revenues, or expenses. Net income (NI) adjusted for irregular item is SI. SI is the most likely level of income to be obtained in the future for the company. SI is different than NI as it does not include the irregular items in the actual year NI. What relationship does this concept have to the treatment of irregular items on the income statements? SI is of value as it contains the NI without the “noise” of irregular items. Example of irregular item is a one in a lifetime gain that needs to be adjusted and not be present in the true NI as it only occurred once. This is crucial as in determining a company’s value. #6 (a) Andrea believes that the analysis of financial statements is directed at two characteristics of a company: liquidity and profitability. Is Andrea correct? I think Andrea is partially correct depending on the underlying interest. The analysis of financial statements shows liquidity and profitability as two characteristics very important to a company. The company’s ability to pay its financial obligations and to meet unexpected cash needs is crucial to creditor, lenders, and investors. Profitability measures the income or operational success of a company for a period of time. Profitability affects the ability to obtain debt and equity financing, liquidity position, and ability to expand. (b) Are short time creditors, long-term creditors, and stockholders interested in primarily the same characteristics of a company? No, they all have their particular priorities and interests. Short time creditors (bankers, suppliers) look at liquidity. Creditors and investors look at profitability. #7 (a) Distinguish among the following bases of comparison averages: Intracompany: it is beneficial for a company to conduct comparisons within as they are helpful to catch changes in financial interactions and see for any internal trends. Comparison can be of current year cash amount with prior years and monitor for an increase or decrease. A company can also analyze proportions of a year end total assets to a year end cash amount. Intercompany: Doing comparisons with other companies allows for close view of the competitors situation and compare to yours. Total sales can be compared and reviewed. Industry: These comparisons allow you to see where you stand among industry level. Financial data can be compared across. (b) Give the principal value of using each of the three bases of comparison. The principal value is for investors to analyze the core of the company and sustainable earnings of a company. Investors can compare companies within or across an industry. Additionally, companies it self benefit from comparison opportunities to make evaluate and make changes in the business.

#8 Explain differences between the two popular methods of financial statements analysis: Horizontal analysis (trend analysis): evaluates a series of financial statement information over a period of time. Highlights the increase or decrease thorough an amount or percentage value. Financial statements include net sales, balance sheets, income statement. It is important to pay attention to both dollar and percentage changes. It is not necessarily bad if company earnings are growing at a declining rate. The amount of increase may be the same as or more than the base year, but he percentage changes may be less because the base is greater each year. -------------------------------------------------

Vertical analysis (common size analysis): used in evaluating financial statements data that each item is shown as a percent of a base amount. Example: a balance sheet current assets are 22% of total assets (total assets being the base amount). This type of analysis allows you...
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