Summary-C2

1.What information is contained in the balance sheet, income statement, and statement

of cash flows?

Investors and other stakeholders in the firm need regular financial information to help them

monitor the firm’s progress. Accountants summarize this information in a balance sheet,

income statement, and statement of cash flows.

The balance sheet provides a snapshot of the firm’s assets and liabilities. The assets

consist of current assets that can be rapidly turned into cash and fixed assets such as plant

and machinery. The liabilities consist of current liabilities that are due for payment shortly

and long-term debts. The difference between the assets and the liabilities represents the

amount of the shareholders’ equity.

The income statement measures the profitability of the company during the year. It

shows the difference between revenues and expenses.

The statement of cash flows measures the sources and uses of cash during the year. The

change in the company’s cash balance is the difference between sources and uses.

2.What is the difference between market and book value?

It is important to distinguish between the book values that are shown in the company

accounts and the market values of the assets and liabilities. Book values are historical

measures based on the original cost of an asset. For example, the assets in the balance sheet

are shown at their historical cost less an allowance for depreciation. Similarly, the figure for

shareholders’ equity measures the cash that shareholders have contributed in the past or that

the company has contributed on their behalf.

3.Why does accounting income differ from cash flow?

Income is not the same as cash flow. There are two reasons for this: (1) investment in fixed

assets is not deducted immediately from income but is instead spread over the expected life

of the equipment, and (2) the accountant records revenues when the sale is made rather than

when the customer actually pays the bill, and at the same time deducts the production costs

even though those costs may have been incurred earlier.

4.What are the essential features of the taxation of corporate and personal income?

For large companies the marginal rate of tax on income is 35 percent. In calculating

taxable income the company deducts an allowance for depreciation and interest payments. It

cannot deduct dividend payments to the shareholders.

Individuals are also taxed on their income, which includes dividends and interest on their

investments. Capital gains are taxed, but only when the investment is sold and the gain

realized.

5.What are the standard measures of a firm’s leverage, liquidity, profitability, asset

management, and market valuation? What is the significance of these measures?

If you are analyzing a company’s financial statements, there is a danger of being

overwhelmed by the sheer volume of data contained in the income statement, balance

sheet, and statement of cash flow. Managers use a few salient ratios to summarize the

firm’s leverage, liquidity, efficiency, and profitability. They may also combine accounting

data with other data to measure the esteem in which investors hold the company or the

efficiency with which the firm uses its resources.

Table A.17 summarizes the four categories of financial ratios that we have discussed in

this material. Remember though that financial analysts define the same ratio in different

ways or use different terms to describe the same ratio.

Leverage ratios measure the indebtedness of the firm. Liquidity ratios measure how

easily the firm can obtain cash. Efficiency ratios measure how intensively the firm is using

its assets. Profitability ratios measure the firm’s return on its investments. Be selective in

your choice of these ratios. Different ratios often tell you similar things.

Financial ratios crop up repeatedly in financial discussions and arrangements. For

example, banks and bondholders commonly place limits on the borrower’s leverage ratios.

Ratings agencies also look at leverage ratios when they decide how highly to rate the firm’s

bonds.

6.How does the Du Pont formula help identify the determinants of the firm’s return

on its assets and equity?

The Du Pont system provides a useful way to link ratios to explain the firm’s return on

assets and equity. The formula states that the return on equity is the product of the firm’s

leverage ratio, asset turnover, profit margin, and debt burden. Return on assets is the

product of the firm’s asset turnover and profit margin.

7.What are some potential pitfalls of ratio analysis based on accounting data?

Financial ratio analysis will rarely be useful if practiced mechanically. lt requires a large

dose of good judgment. Financial ratios seldom provide answers but they do help you ask

the right questions. Moreover, accounting data do not necessarily reflect market values

properly, and so must be used with caution. You need a benchmark for assessing a

company’s financial position. Therefore, we typically compare financial ratios with the

company’s ratios in earlier years and with the ratios of other firms in the same business.