Financial Statement Analysis: Accounting Study Guide
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
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