Lesson 10 Understanding and Using Financial Statements Exercise Short answer questions 1. What are the possible decisions that can be made with the use of financial analysis? Answer: Share investment decisions. This includes whether to invest in shares and the type of share (common, preferred). Lending decisions. This includes whether to purchase retractable preferred shares, issue mortgages, buy corporate bonds on the open market, operating line of credit Contractual decisions. This includes accepting employment, negotiating collective agreements, entering into join ventures, agreeing to act as a major supplier or distributor. Regulatory decisions. This includes need for rate or price increases, withstanding competition, impact of past regulatory decisions. 2. Indicate which company characteristic is reflected best by the company indicators listed below. The characteristics are as follows: Characteristic: A. Profitability B. Short-term solvency C. Management efficiency Company Indicators: ___ 1. Current ratio ___ 2. Sales to total assets ___ 3. Earnings per share ___ 4. Return on investment (on total assets) ___ 5. Inventory turnover ___ 6. Price earnings ratio 3. The summarized and partial balance sheet of XYZ showed the following: Item 20x3 20x4 Current assets $50,000 $58,000 Operational assets 140,000 101,000 Other assets 20,000 23,400 (a) Prepare a horizontal analysis. (b) Prepare a vertical analysis for 20x1: Change from 20x1 to 20x2 20x1 20x2 Increase (Decrease) Current assets $50,000 $ 58,000 $8,000 16% Operational assets 140,000 101,000 (39,000) (28%) Other assets 20,000 23,400 3,400 17% Total assets $210,000 $182,400 ($27,600) (13%) ======== ======== ======== ==== (b) Vertical analysis Assets Amount Percentage Current assets $50,000 24% Operational assets 140,000 67% Other assets 20,000 9% Total assets $210,000 100% ======== ==== 4. What are some advantages to using ratio analysis? What are some of its limitations? 5. Ratios, like the accounts receivable turnover ratio, can be difficult to interpret. Explain some of the problems associated with this ratio. Answer: Under normal circumstances, a short period is better than a long one as it shows that cash is being collected. However, in some situations, there may be valuable customers that take more time to pay but collectibility is assured. In addition, the amount of receivables on the balance sheet at year-end may not be typical of its normal balance.