FINANCIAL STATEMENT ANALYSIS
VALUATION 6TH EDITION FINAL PAPER
QUESTIONS WITH ANSWERS GRADED A
◉ Describe the linkage between the statement of cashflows and the
equity section of the balance sheet when a company pays dividends.
Answer: The payment of dividends is recorded in the financing activities
section of the Statement of Cash Flows as a cash outflow, reducing the
companies cash balance. The same amount paid as dividends is
subtracted from the retained earnings in the equity section of the Balance
Sheet. The decrease in cash (asset) on the Balance Sheet is matched by a
decrease in retained earnings (equity),
◉ Explain how an overstatement of revenues in the income statement
are linked to an overstatement of the balance sheet. Answer: Revenues
are an income statement item, but the overstatement of revenues
automatically leads to an overstatement of assets on the balance sheet by
the accounts receivable line.
◉ Assets are recorded at historical costs even though current market
values might be more relevant to financial statement readers. Why do we
use historical costs usage?. Answer: Valuing assets at historical cost
helps prevent overstating an asset's value by using the original purchase
price rather than fluctuating market value. As historical cost remains
constant, while market values fluctuating due to economic conditions,
,speculation, or temporary trends. This leads to the risk of subjective
adjustments that could overstate the assets value. The historical costs
approach enhances the accuracy and credibility of financial statements
◉ Explain why, as an analysts, we should keep in mind that (1) financial
statements are based on accrual accounting, and (2) managers are
responsible for financial reporting and entrusted with making key
estimates and assumptions. Answer: 1) Accrual accounting is a method
of accounting that recognizes revenues and expenses when they are
incurred, regardless of when cash transactions actually occur. This
approach provides a better picture of a company's financial position,
performance and future cashflows. It also enables to compare the
financial statements between periods and across companies. But it also
includes expectations and assumptions, which can manage earnings.
2) The discretion given to managers can be valuable, but it could also
lead to distortions.
It is important to understand the consequences and accuracy of this.
◉ Explain earnings quality. Answer: The quality of earnings is the
percentage of income that is due to higher sales or lower costs.
A company can for example have a steady increase in earnings over the
years, while a declines in operating cash flow. This means that more and
more of the net income is resulted from operating accruals. Examples
are, reduced allowance for doubtful accounts, reduced deferrals of
revenue recognition, increased capitalization of costs etc.
, ◉ Why is a company's cash flow information still useful besides the
timing and matching problems?. Answer: - It provides an important
check on earnings quality. As accruals also include expectations and
assumptions, organizations manage earnings. Because of this, it is
important to evaluate the difference between net income and operating
cash flow. If a company's high profitability is not "backed" by a
sufficient stream of cashflows, this is a red flag.
- It says something about a company's cash management: Its liquidity
and ability to pay employees, creditors and suppliers.
◉ Explain Return on equity (ROE). Answer: REO measures how
efficiently a company is using its equity to generate profit. It provides
insight into how well the company leverages its shareholders'
investments to create earnings.
REO = Net Income / Average stakeholders equity
◉ Explain how an increase in financial leverage can increase a
company's ROE. Answer: Increasing financial leverage involves using
more debt relative to equity in a company's capital structure. This can
lead to a higher Return on Equity (ROE) through the fact that with more
debt, the company's equity base (total shareholders' equity) is smaller
relative to its total assets. This increases the ROE because the same level
of net income is divided by a smaller equity base.
VALUATION 6TH EDITION FINAL PAPER
QUESTIONS WITH ANSWERS GRADED A
◉ Describe the linkage between the statement of cashflows and the
equity section of the balance sheet when a company pays dividends.
Answer: The payment of dividends is recorded in the financing activities
section of the Statement of Cash Flows as a cash outflow, reducing the
companies cash balance. The same amount paid as dividends is
subtracted from the retained earnings in the equity section of the Balance
Sheet. The decrease in cash (asset) on the Balance Sheet is matched by a
decrease in retained earnings (equity),
◉ Explain how an overstatement of revenues in the income statement
are linked to an overstatement of the balance sheet. Answer: Revenues
are an income statement item, but the overstatement of revenues
automatically leads to an overstatement of assets on the balance sheet by
the accounts receivable line.
◉ Assets are recorded at historical costs even though current market
values might be more relevant to financial statement readers. Why do we
use historical costs usage?. Answer: Valuing assets at historical cost
helps prevent overstating an asset's value by using the original purchase
price rather than fluctuating market value. As historical cost remains
constant, while market values fluctuating due to economic conditions,
,speculation, or temporary trends. This leads to the risk of subjective
adjustments that could overstate the assets value. The historical costs
approach enhances the accuracy and credibility of financial statements
◉ Explain why, as an analysts, we should keep in mind that (1) financial
statements are based on accrual accounting, and (2) managers are
responsible for financial reporting and entrusted with making key
estimates and assumptions. Answer: 1) Accrual accounting is a method
of accounting that recognizes revenues and expenses when they are
incurred, regardless of when cash transactions actually occur. This
approach provides a better picture of a company's financial position,
performance and future cashflows. It also enables to compare the
financial statements between periods and across companies. But it also
includes expectations and assumptions, which can manage earnings.
2) The discretion given to managers can be valuable, but it could also
lead to distortions.
It is important to understand the consequences and accuracy of this.
◉ Explain earnings quality. Answer: The quality of earnings is the
percentage of income that is due to higher sales or lower costs.
A company can for example have a steady increase in earnings over the
years, while a declines in operating cash flow. This means that more and
more of the net income is resulted from operating accruals. Examples
are, reduced allowance for doubtful accounts, reduced deferrals of
revenue recognition, increased capitalization of costs etc.
, ◉ Why is a company's cash flow information still useful besides the
timing and matching problems?. Answer: - It provides an important
check on earnings quality. As accruals also include expectations and
assumptions, organizations manage earnings. Because of this, it is
important to evaluate the difference between net income and operating
cash flow. If a company's high profitability is not "backed" by a
sufficient stream of cashflows, this is a red flag.
- It says something about a company's cash management: Its liquidity
and ability to pay employees, creditors and suppliers.
◉ Explain Return on equity (ROE). Answer: REO measures how
efficiently a company is using its equity to generate profit. It provides
insight into how well the company leverages its shareholders'
investments to create earnings.
REO = Net Income / Average stakeholders equity
◉ Explain how an increase in financial leverage can increase a
company's ROE. Answer: Increasing financial leverage involves using
more debt relative to equity in a company's capital structure. This can
lead to a higher Return on Equity (ROE) through the fact that with more
debt, the company's equity base (total shareholders' equity) is smaller
relative to its total assets. This increases the ROE because the same level
of net income is divided by a smaller equity base.
