Financial Statement Analysis: Accounting Study Guide

Financial Statement Analysis: Accounting Study Guide

Increasing leverage increases ROE as long as ROAR exceeds the after-tax interest rate. Financial leverage is also elated 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 (SQ-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 ore 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 or 2) product costs have increased, or 3) margin/slowly-turning products to lower-margin/higher-turning products. Declining gross profit margins are usually viewed negatively.

On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively margin/slowly-turning products to lower-margin/higher- turning products. 5-4 (SQ-5) Describe the concept of asset turnover. What does the concept mean and why is it so important to understanding the interpreting financial performance? Asset turnover measures the amount of revenue volume compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower.

Turnover measures productivity and an important company objective is to make assets as productive as possible. Since turnover is one of the components of ROE (via ROAR), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver 5-5 (SQ-1 0) Why is it important to segregate ROAR into profit margin (PM) and asset turnover (AT)? Companies must manage both the income statement and the balance sheet in order to maximize ROAR This is important, as many managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management.

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