Financial Statement Analysis Methods Flashcards

Question 1

What are the three primary financial statements that companies publish?

Accepted Answer

The three primary financial statements are the income statement, the balance sheet, and the statement of cash flows. The income statement reports revenues and expenses over a reporting period. The balance sheet shows assets, liabilities, and equity at a single point in time. Together they give a complete picture.

Question 2

What basic accounting equation must always hold true on the balance sheet?

Accepted Answer

Assets equal liabilities plus shareholders' equity. This equation must hold because every resource a company controls is financed either by creditors or by owners. Any transaction that changes one side must be offset by an equal change on the other side, which keeps the statement in balance.

Question 3

What is the difference between accrual accounting and cash accounting?

Accepted Answer

Accrual accounting records revenues when they are earned and expenses when they are incurred, regardless of when cash changes hands. Cash accounting records transactions only when money actually moves. Most public companies use accrual accounting because it matches income with the activity that produced it, though cash flow still matters for solvency.

Question 4

Why do analysts read the notes that accompany financial statements?

Accepted Answer

The notes explain the accounting policies, estimates, and assumptions behind the reported numbers. They disclose details such as debt terms, lease obligations, contingent liabilities, and revenue recognition methods that the face of the statements may not show clearly. Analysts rely on them to judge how much confidence to place in the headline figures.

Question 5

What does the auditor's report add to a set of financial statements?

Accepted Answer

The auditor's report gives an independent opinion on whether the statements are presented fairly in all material respects under the applicable accounting framework. It is issued by an external accountant after examining evidence supporting the figures. An unqualified opinion is the standard result, while a qualified or adverse opinion signals problems.

Question 6

What is the difference between gross profit and operating income?

Accepted Answer

Gross profit equals revenue minus the cost of goods sold, showing what remains after direct product costs. Operating income subtracts operating expenses such as selling, general, and administrative costs and depreciation from gross profit. Operating income therefore reflects the profitability of core business activities before interest and taxes.

Question 7

Why is it important to use consistent accounting methods when comparing companies?

Accepted Answer

Consistent methods make differences in reported results reflect real business performance rather than differences in bookkeeping choices. Companies may differ in how they value inventory, depreciate assets, or recognize revenue, and those choices can shift reported profit substantially. Analysts therefore adjust figures or read the notes before drawing conclusions.

Question 8

What is depreciation and why does it matter to analysts?

Accepted Answer

Depreciation is the systematic allocation of a tangible asset's cost over the periods it is expected to be used, recorded as an expense. It is a noncash charge, so it reduces reported net income without reducing cash. Analysts add it back when measuring cash generation and watch depreciation policies because they affect reported profit.

Question 9

What is horizontal analysis and how is it performed?

Accepted Answer

Horizontal analysis compares line items across several reporting periods to reveal trends and growth rates. Analysts choose a base period, then express each later amount as a percentage change from that base. For example, if revenue grows from 100 to 120 over the base period, that is a 20 percent increase.

Question 10

What is vertical analysis and what base does it use?

Accepted Answer

Vertical analysis expresses each line item as a percentage of a single base figure within the same statement. On the income statement the base is usually total revenue, while on the balance sheet it is usually total assets. This shows the internal structure of a company's results and helps compare firms of different sizes.

Question 11

Why might horizontal and vertical analysis produce different insights about a company?

Accepted Answer

They answer different questions. Horizontal analysis tracks how an item changes over time, so rising sales may look impressive. Vertical analysis shows each item's share of a base figure in one period, which can reveal costs consuming a growing portion of revenue. Using both gives a fuller picture of trends and structure.

Question 12

How do you calculate a percentage change between two periods?

Accepted Answer

Subtract the base period amount from the current period amount, divide the difference by the base amount, and multiply by 100. For example, moving from 200 to 250 gives a difference of 50, which divided by 200 is 0.25, or a 25 percent increase.

Question 13

What is a common error when reading a percentage change from a very small base amount?

Accepted Answer

The percentage can look dramatic even when the absolute change is trivial. A jump from 2 to 6 is a 200 percent increase, yet it may be only four dollars. Analysts should check the dollar amounts alongside percentages and be cautious when a base figure is near zero, since percentage changes become unstable.

Question 14

How does a common size income statement help compare two companies of very different sizes?

Accepted Answer

It helps by restating each line as a percentage of revenue, so cost structure is visible regardless of total size. A company with revenue of 10 million and one with 1 billion can be compared directly on gross margin, selling expense ratio, and tax expense.

Question 15

What does a trend analysis over several periods reveal that two periods cannot?

Accepted Answer

Several periods reveal whether a change is a one-time event or a sustained pattern, and whether growth is accelerating or fading. Comparing only two periods can mislead because a single unusual result might distort the apparent direction. Longer series also show cyclical behavior and help analysts judge the reliability of management's forecasts.

Question 16

Why should analysts examine the base period chosen for horizontal analysis?

Accepted Answer

Because every later change is measured against the base, an unusually weak or strong base period can make growth look artificially high or low. Analysts check whether the base reflects normal operations, such as a period affected by a one-time gain, a plant shutdown, or a major acquisition.

Question 17

What is the current ratio and how is it calculated?

Accepted Answer

The current ratio equals current assets divided by current liabilities. It indicates whether short-term resources are sufficient to meet obligations due within the next twelve months. A result above 1 means current assets exceed current liabilities, though acceptable levels vary considerably by industry.

Question 18

How does the quick ratio differ from the current ratio?

Accepted Answer

The quick ratio, also called the acid test, removes inventory and prepaid expenses from current assets before dividing by current liabilities. Inventory is excluded because it may be slow to convert into cash, so the quick ratio gives a stricter view of immediate liquidity.

Question 19

What does the debt to equity ratio reveal about a company's financing structure?

Accepted Answer

The debt to equity ratio compares total debt with shareholders' equity, showing how much a company relies on borrowed money relative to owner funding. A higher ratio means more financial leverage and greater risk if earnings fall, while a lower ratio suggests a more conservative capital structure. Definitions vary, so check which liabilities are included.

Question 20

Why do analysts calculate the interest coverage ratio when assessing a borrower's risk?

Accepted Answer

The interest coverage ratio divides earnings before interest and taxes by interest expense, showing how many times operating earnings can pay the interest bill. A ratio of 1 means earnings just cover interest, leaving little margin. Lenders watch this figure because a falling ratio warns that debt service may be difficult.

Question 21

How does the operating cash flow ratio assess a company's ability to meet short-term obligations?

Accepted Answer

The operating cash flow ratio divides cash generated from operations by current liabilities. It uses actual cash rather than accounting balances, so it tests whether day-to-day business activity produces enough money to pay debts coming due. It complements the current ratio by focusing on cash rather than balances.

Question 22

What is working capital and why do analysts monitor it closely?

Accepted Answer

Working capital equals current assets minus current liabilities, measuring the short-term cushion available for daily operations. A positive balance suggests the company can fund near-term obligations, while a persistently negative balance may signal liquidity strain. Analysts track its changes, since a large build in receivables or inventory can absorb cash even when profit looks healthy.

Question 23

Why can a company with a strong current ratio still face a liquidity crisis?

Accepted Answer

The current ratio counts all current assets equally, yet some may be illiquid, such as slow-moving inventory or receivables from customers who pay late. A firm can also face a timing mismatch, where large payments fall due before cash from sales arrives. Credit lines, covenant breaches, or sudden market disruptions can compound the problem.

Question 24

How should analysts judge whether a given solvency ratio is acceptable?

Accepted Answer

Analysts compare the ratio with the company's own history, close competitors, and industry norms, since no universal threshold exists. Capital-intensive sectors such as utilities often carry more debt than software firms, so the same figure can signal very different risk. Cash flow stability and debt maturity matter as much as the number.

Question 25

What are gross margin and net profit margin, and how are they calculated?

Accepted Answer

Gross margin equals gross profit divided by revenue, showing the share of each sales dollar left after production costs. Net profit margin equals net income divided by revenue, showing the share of each sales dollar that remains after all expenses, interest, and taxes. These help compare pricing power and cost control across firms.

Question 26

What does return on equity measure, and what is a common concern with a very high figure?

Accepted Answer

Return on equity divides net income by shareholders' equity, measuring how much profit the company generates for each dollar owners have invested. A very high figure may reflect heavy borrowing rather than operating excellence, because debt financing and buybacks shrink the equity base and raise the ratio. Analysts therefore examine leverage alongside it.

Question 27

How does return on assets differ from return on equity?

Accepted Answer

Return on assets divides net income by total assets, measuring profit generated from all resources regardless of how they are financed. Return on equity uses only shareholders' equity as the denominator, so it reflects the owners' perspective and includes the effect of borrowing. Comparing the two reveals how much leverage is amplifying returns.

Question 28

What does the asset turnover ratio tell analysts about a company?

Accepted Answer

Asset turnover divides revenue by average total assets, showing how many dollars of sales the company produces for each dollar of assets it holds. Higher turnover generally indicates efficient use of resources, while lower turnover may point to excess capacity or underused assets. Norms differ widely, so compare against close peers.

Question 29

What do inventory turnover and days inventory outstanding reveal about operations?

Accepted Answer

Inventory turnover divides cost of goods sold by average inventory, showing how often stock is sold and replaced. Days inventory outstanding converts that into the average number of days inventory sits before sale, calculated as the number of days in the period divided by turnover. Shorter holding periods generally signal efficiency, though very lean stock risks shortages.

Question 30

What does the receivables turnover ratio reveal about credit policy?

Accepted Answer

Receivables turnover divides net credit sales by average accounts receivable, showing how many times the company collects what customers owe. A high turnover suggests quick collection and strict credit terms, while a low turnover may indicate loose credit, slow-paying customers, or doubtful accounts. Analysts convert it into days sales outstanding to gauge collection speed.

Question 31

Why might a company's profit margin fall even while its revenue grows?

Accepted Answer

Revenue growth can come with higher costs, such as discounting to win customers, rising input prices, or expanding into lower-margin products. Heavier borrowing can also raise interest expense, lowering net margin even when operations improve. Growth investments may add depreciation or start-up expenses before generating returns.

Question 32

How can analysts combine several efficiency ratios to understand a business model?

Accepted Answer

Efficiency ratios interact, so reading them together reveals the operating model. A retailer may run thin margins but turn inventory quickly, while a manufacturer may hold more stock and rely on higher margins. Comparing turnover with margin shows whether a company competes on price, volume, or asset intensity.

Question 33

What does the price to earnings ratio show, and how is it calculated?

Accepted Answer

The price to earnings ratio divides the share price by earnings per share, showing how many dollars investors pay for each dollar of current earnings. A high multiple often reflects expectations of growth, while a low multiple may signal weaker growth or higher risk. Multiples are meaningful only against peers or the company's own history.

Question 34

What is earnings per share and why do investors track its trend?

Accepted Answer

Earnings per share equals net income available to common shareholders divided by the weighted average number of common shares outstanding. Its trend shows whether profit growth reaches each owner, since share buybacks can raise earnings per share even when total net income is flat. Analysts check whether growth comes from operations or a shrinking share count.

Question 35

What is the DuPont analysis and what are its three components?

Accepted Answer

DuPont analysis breaks return on equity into three parts: net profit margin, asset turnover, and the equity multiplier, which measures financial leverage as total assets divided by equity. Multiplying these three components reproduces return on equity. Seeing which component drives the result shows whether returns come from profitability, efficiency, or borrowing.

Question 36

How does the DuPont framework help explain a change in return on equity?

Accepted Answer

It helps by letting analysts compare each of the three components across periods to find which one moved. If return on equity rose while margin and turnover held steady, the increase came from greater leverage, which carries added risk. If margin fell but leverage rose sharply, borrowing may be compensating for weaker profitability.

Question 37

Why is operating cash flow often viewed as a check on reported net income?

Accepted Answer

Net income includes accruals and noncash items such as depreciation, so it can diverge from the cash a business actually generates. Operating cash flow shows cash from core activities, and a persistent gap where profit far exceeds operating cash flow may signal aggressive revenue recognition or rising receivables. Close alignment builds confidence in reported earnings.

Question 38

What is free cash flow and why do analysts value it?

Accepted Answer

Free cash flow is operating cash flow minus capital expenditures, representing cash left after maintaining and expanding the asset base. It indicates how much cash could be returned to lenders and owners through debt repayment, dividends, or buybacks, or kept for growth. Many analysts treat it as a demanding test of financial strength.

Question 39

How do analysts combine ratio results into an overall assessment of a company?

Accepted Answer

Analysts start with a clear question, such as whether a company can repay debt or whether its growth is sustainable, and select the ratios that address it. They compare results across periods and against peers, then check the notes and cash flows for explanations. The conclusion is a reasoned judgment, not a single number.

Question 40

What are the main limitations of ratio analysis that analysts should keep in mind?

Accepted Answer

Ratios rely on historical accounting figures, which may not reflect current market values or future prospects. Different accounting methods, estimates, and one-time items can distort comparisons between companies. Ratios also say little about nonfinancial factors such as management quality, competition, or regulation, so they work best alongside qualitative research.

Financial Statement Analysis Methods Flashcards

1Foundations of financial statements

2Horizontal and vertical analysis

3Liquidity and solvency ratios

4Profitability and efficiency ratios

5Market ratios and applied analysis

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