Accounting Study Guide for Test # 2
Topic 5: Financial Statement Analysis
5-1 (Q5-1) Explain in general terms the concept of return on investment. Why is this concept important in the analysis of financial performance? Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet. 5-2 (Q5-2) (a) Explain how an increase in financial leverage can increase a company’s ROE. (b) Given the potentially positive relation between financial leverage and ROE, why don’t we see companies with 100% financial leverage (entirely non-owner financed)? ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt. 5-3 (Q5-3) Gross profit margin (Gross profit/Sales) is an important determinant of profit margin. Identify two factors that can cause gross profit margin to decline. Is a reduction in the gross profit margin always bad news? Explain. Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has had to reduce prices or is selling fewer units or 2) product costs have increased, or 3) margin/slowly-turning products to lower-margin/higher-turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively margin/slowly-turning products to lower-margin/higher-turning products. 5-4 (Q5-5) Describe the concept of asset turnover. What does the concept mean and why is it so important to understanding the interpreting financial performance? Asset turnover measures the amount of revenue volume compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Since turnover is one of the components of ROE (via ROA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver 5-5 (Q5-10) Why is it important to disaggregate ROA into profit margin (PM) and asset turnover (AT)? Companies must manage both the income statement and the balance sheet in order to maximize ROA. This is important, as many managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of ROA into its profit margin and turnover components facilitates analysis of these two areas of focus. 5-6 (M5-16) Common-Size Income Statements
Following is the income statement for Target Corporation. Prepare Target’s common-size income statement for the fiscal year ended January 31, 2012. ($ millions) Fiscal year ended
January 31, 2012
5-8 (M5-18) Analysis and Interpretation of Liquidity and Solvency Refer to the financial information of Target Corporation (TGT) in Problem 5-7 to answer the following. a. Compute Target’s current ratio and quick ratio for 2012 and 2011. Comment on any observed trends. b. Compute...
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