15-1 Distinguish between horizontal and vertical analysis of financial statement
ID: 2481094 • Letter: 1
Question
15-1 Distinguish between horizontal and vertical analysis of financial statement data.
15-2 What is the basic purpose for examining trends in a company's financial ratios and other data? What other kinds of comparisons might an analyst make?
15-3 Assume that two companies in the same industry have equal earnings. Why might these companies have different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of $4, at what price would you expect to find the stock selling on the market?
15-4 Would you expect a company in a rapidly growing technological industry to have a high or low dividend payout ratio?
15-5 What is meant by the dividend yield on a common stock investment?
15-6 What is meant by the term financial leverage?
15-7 The president of a plastics company was quoted in a business journal as stating, “We haven't had a dollar of interest-paying debt in over 10 years. Not many companies can say that.” As a stockholder in this company, how would you feel about its policy of not taking on debt?
15-8 If a stock's market value exceeds its book value, then the stock is overpriced. Do you agree? Explain.
15-9 A company seeking a line of credit at a bank was turned down. Among other things, the bank stated that the company's 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current ratio might not be adequate.
Explanation / Answer
15-1 Horizontal analysis examines how a particular item on a financial statement such as sales or cost of goods sold behaves over time. Vertical analysis involves analysis of items on an income statement or balance sheet for a single period. In vertical analysis of the income statement, all items are typically stated as a percentage of sales. In vertical analysis of the balance sheet, all items are typically stated as a percentage of total assets.
15-2 By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements.
15-3 Price-earnings ratios reflect investors’ expectations concerning future earnings. The higher the price-earnings ratio, the greater the growth in earnings investors expect. For this reason, two companies might have the same current earnings and yet have quite different price-earnings ratios. By definition, a stock with current earnings of $4 and a price-earnings ratio of 20 would be selling for $80 per share.
15-4 A rapidly growing tech company would probably have many opportunities to make investments at a rate of return higher than stockholders could earn in other investments. It would be better for the company to invest in such opportunities than to pay out dividends and thus one would expect the company to have a low dividend payout ratio.
15-5 The dividend yield is the dividend per share divided by the market price per share. The other source of return on an investment in stock is increases in market value.
15-6 Financial leverage results from borrowing funds at an interest rate that differs from the rate of return on assets acquired using those funds. If the rate of return on the assets is higher than the interest rate at which the funds were borrowed, financial leverage is positive and stockholders gain. If the return on the assets I s lower than the interest rate, financial leverage is negative and the stockholders lose.
15-7 If the company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt. In hard times, interest payments might be very difficult to meet.
On the other hand, if investments within the company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt.
15-8 The market value of a share of common stock often exceeds the book value per share. Book value represents the cumulative effects on the balance sheet of past activities, evaluated using historical prices. The market value of the stock reflects investors’ expectations about the company’s future earnings. For most companies, market value exceeds book value because investors anticipate future earnings growth.
15-9 A 2 to 1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow-turning and difficult-to-liquidate inventory, or the inventory may contain large amounts of obsolete goods. Second, the receivables may be low quality, including large amounts of accounts that may be difficult to collect.
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