Analyzing and Interpreting Financial statements
Module 4
Analyzing and Interpreting
Financial Statements
DISCUSSION QUESTIONS
Q4-1. 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.
Q4-2.A Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. 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.
Q4-3. 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 reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-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 as negatively.
Q4-4. Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits.
Q4-5. Asset turnover measures the amount of revenue compared with the investment in an
Analyzing and Interpreting
Financial Statements
DISCUSSION QUESTIONS
Q4-1. 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.
Q4-2.A Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. 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.
Q4-3. 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 reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-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 as negatively.
Q4-4. Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits.
Q4-5. Asset turnover measures the amount of revenue compared with the investment in an