FINANCIAL STATEMENT ANALYSIS IMPORTANT SHORT QUESTIONS with Answers
Q. 1: Why
are notes to statements necessary?
ANS: Footnotes (notes) increase the full
disclosure of the statements by providing information on inventory and depreciation
methods, subsequent events, contingent liabilities, etc.
Q. 2: What
are contingent liabilities? Are lawsuits against the firm contingent
ANS: Contingent liabilities are dependent on
an occurrence to determine if payment will be necessary. Liabilities from lawsuits are dependent on
the outcome of the cases; they, therefore, represent contingent liabilities.
Q. 3: Describe
a proxy statement.
ANS: A proxy is a solicitation sent to
stockholders for the election of directors and for the approval of other corporate
actions. The proxy represents the shareholder
authorization regarding the casting of that shareholder’s vote.
Q. 4: Why
are adjusting entries necessary?
ANS: Most of the accounts are not up to date
at the end of the accounting period.
These accounts need to be adjusted so that all revenues and expenses are
recognized and the balance sheet accounts have a correct ending balance.
Q. 5: Usually,
current assets are listed in a specific order, starting with cash. What is the
objective of this order of listing?
ANS: They are
listed in order of liquidity, which is the ease with which they can be
converted to cash.
Q. 6: Differentiate
between marketable securities and long-term investments. What is the purpose of
ANS: Marketable securities are held as
temporary investments or idle cash. They
are short-term, low risk, highly liquid, and low yield. Examples are treasury bills and commercial
paper. Investments are long-term, held
for control or future use in operations.
They are usually less liquid and expected to earn a higher return.
Q. 7: What
is depreciation? Which tangible assets are depreciated, and which are not? Why?
ANS: Depreciation measures the wearing away of
the usefulness of the asset. Tools,
machinery, and buildings are depreciated because they wear out. The land is not depreciated, since its value
typically does not decline. If the land
has minerals or natural resources, it may be subject to depletion.
Q. 8: What is redeemable preferred stock?
Why should it be included with debt for purposes of financial statement analysis?
ANS: Redeemable preferred stock is subject to
mandatory redemption requirements or has a redemption feature that is outside
the control of the issuer. Coupled with
the typical characteristics of no vote and fixed return, this security is more
like debt than equity for the issuing firm.
Q. 9: Describe
fair value as it relates to assets and liabilities.
capital results from donations to the company by stockholders, creditors, or
Q. 10: Describe
depreciation, amortization, and depletion. How do they differ?
ANS: Depreciation is the process of allocating
the cost of building and machinery over periods of benefit. Spreading the
cost of an intangible asset is called amortization while spreading the cost of
a natural resource is called depletion.
Q. 11: What
are extraordinary items? How are they shown on the income statement? Why are
they shown in that manner?
items are events or transactions that are distinguished
by their unusual nature and infrequency of occurrence. They might include casualty losses or losses from
expropriation or prohibition. They must
be shown separately, net of tax, in order that trend analysis can be made of
income before extraordinary items.
Q. 12: What is the difference in the
impact on financial statements of a stock dividend versus a stock split?
ANS: First, a stock split is usually for a
larger number of shares. Secondly, a stock
dividend reduces retained earnings and increases paid-in capital. A stock split merely increases the shares and
reduces the par value, leaving the capital stock account intact. Both require a restatement of any per share
the income statement and the reconciliation of retained earnings.
ANS: The statement of retained earnings
summarizes the changes to retained earnings.
Retained earnings represent the undistributed earnings of the
corporation. The income statement net
income is added to retained earnings. A loss
is deducted from retained earnings.
Q. 14: What is the reason for separating
current assets from the rest of the assets found on the balance sheet?
ANS: Current assets are assets that are in the
form of cash or that will be realized in cash or that conserve the use of cash
within an operating cycle of a business, or one year, whichever is the longer
period of time.
The other assets are not expected to be
realized in cash in the near future and should, therefore, be segregated from current
Q. 15: Define
the operating cycle.
ANS: The operating cycle is the period of time
elapsing between the acquisition of goods and the final cash realization
resulting from sales and subsequent collections.
Q. 16: Discuss
how to use working capital in analysis.
ANS: The current working capital amount should
be compared with past working capital amounts to determine if working capital
is reasonable. Caution must be exercised
because the relative size of the firm may be expanding or contracting. Comparing the working capital of one firm with the working capital of another firm will usually be meaningless because of the
different sizes of the firms.
liquidity position of the firm may be better than that indicated by the
(1) Unused bank credit lines.
(2) Long-term assets that have the
potential to be converted to cash quickly.
(3) Capability to issue debt or stock.
Q. 18: List three situations in which the
liquidity position of the firm may not be as good as that indicated by the
ANS: There are many situations where the
liquidity position of the firm may not be as good as that indicated by the liquidity
ratios. Some of the situations are the
(1) Notes discounted in which the other
party has full recourse against the firm.
(2) Guarantee of a bank note for another
(3) Major pending lawsuits against the
(4) A major portion of the inventory is
(5) A major portion of the receivables are
Q. 19: Indicate the objective of the sales
to working capital ratio. ANS: The sales to working capital ratio give
an indication of whether working capital is used unprofitably or is possibly overworked.
Q. 20: A relatively low sales to working
capital ratio is a tentative indication of efficient use of working capital.
Comment. A relatively high sales to working capital ratio is a tentative
indication that the firm is undercapitalized. Comment.
ANS: No, a low sale to working capital ratio
is an indication of an unprofitable use of working capital. It indicates that low amounts of sales are
being generated for each dollar of working capital.
Yes, a high ratio is a tentative
indication that the firm is undercapitalized.
This firm will likely have a high inventory turnover and a low current
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