Chapter 6: Financial Statement AnalysisJust click on "True" or "False" and you'll get immediate feedback.Note: Your browser must support JavaScript in order to use this quiz. Show
1. The income statement summarizes the assets, liabilities and owners' equity of a company at a moment in time.2. The current ratio is never larger than the quick ratio.3. Assets are listed in order of increasing liquidity on the balance sheet.4. A problem with a balance sheet based on historical costs is that in a period of inflation a company with old fixed assets will show a much better return on investment than a similar firm with new fixed assets.5. A short average collection period assures us that accounts receivable are being efficiently managed.6. A firm's operating cycle is equal to its inventory turnover in days (ITD) plus its receivable turnover in days (RTD).7. All companies should have at least a 1.5 to 1 current ratio.8. The shareholders' equity figure on a balance sheet represents what the firm is worth to shareholders.9. A high inventory turnover would be more important to a dairy company than to a jewelry store.10. A common-size balance sheet analysis compares the firm's performance with the consumer price index. The following item is NEW to the 13th edition. 11. The United States and a few European Union (EU) countries all adhere to US Generally Accepted Accounting Principles (US GAAP).
True/False Quiz statements/answers are Copyright © by Pearson Education Limited. Used by permission. All rights reserved. Previous Quiz |Back to Main Index | Next QuizKnowing how to work with the numbers in a company's financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of balance sheets, income statements, and cash flow statements to discern a company's investment qualities is the basis for smart investment choices. However, the diversity of financial reporting requires that we first become familiar with certain financial statement characteristics before focusing on individual corporate financials. In this article, we'll show you what the financial statements have to offer and how to use them to your advantage. 1:47 Financial StatementsKey Takeaways
1. Financial Statement = ScorecardThere are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their investing activities, many others are also investing directly in stocks. Prudent investing practices dictate that we seek out quality companies with strong balance sheets, solid earnings, and positive cash flows. Whether you're a do-it-yourself investor or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very useful. Almost 30 years ago, businessman Robert Follett wrote a book entitled How To Keep Score In Business. His principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that "a lot of people don't understand keeping score in business. They get mixed up about profits, assets, cash flow, and return on investment." The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements. But don't let this intimidate you; it can be done. 2. Financial Statements to UseThe financial statements used in investment analysis are the balance sheet, the income statement, and the cash flow statement with additional analysis of a company's shareholders' equity and retained earnings. Although the income statement and the balance sheet typically receive the majority of the attention from investors and analysts, it's important to include in your analysis the often overlooked cash flow statement. 3. What's Behind the Numbers?The numbers in a company's financial statements reflect the company's business, products, services, and macro-fundamental events. These numbers and the financial ratios or indicators derived from them are easier to understand if you can visualize the underlying realities of the fundamentals driving the quantitative information. For example, before you start crunching numbers, it's critical to develop an understanding of what the company does, its products and/or services, and the industry in which it operates. 4. Diversity of ReportingDon't expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. Less-experienced investors might get lost when they encounter a presentation of accounts that falls outside the mainstream of a so-called "typical" company. Please remember that the diverse nature of business activities results in a diverse set of financial statement presentations. This is particularly true of the balance sheet; the income statement and cash flow statement are less susceptible to this phenomenon. 5. Understanding Financial JargonThe lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circumstance can be confusing for the beginning investor. There's little hope that things will change on this issue in the foreseeable future, but a good financial dictionary can help considerably. Investopedia's Glossary of Terms provides you with thousands of definitions and detailed explanations to help you understand terms related to finance, investing, and economics. 6. Accounting: Art, Not ScienceThe presentation of a company's financial position, as portrayed in its financial statements, is influenced by management's estimates and judgments. In the best of circumstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict, and uncompromising. Whatever the case, the imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial statement analysis. 7. Key Accounting ConventionsGenerally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) are used to prepare financial statements. Both methods are legal in the United States, although GAAP is most commonly used. The main difference between the two methods is that GAAP is more "rules-based," while IFRS is more "principles-based." Both have different ways of reporting asset values, depreciation, and inventory, to name a few. 8. Non-Financial InformationInformation on the state of the economy, the industry, competitive considerations, market forces, technological change, the quality of management and the workforce are not directly reflected in a company's financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an important one, of the larger investment puzzle. 9. Financial Ratios and IndicatorsThe absolute numbers in financial statements are of little value for investment analysis unless these numbers are transformed into meaningful relationships to judge a company's financial performance and gauge its financial health. The resulting ratios and indicators must be viewed over extended periods to spot trends. Please beware that evaluative financial metrics can differ significantly by industry, company size, and stage of development. 10. Notes to Financial StatementsThe financial statement numbers don't provide all of the disclosure required by regulatory authorities. Analysts and investors alike universally agree that a thorough understanding of the notes to financial statements is essential to properly evaluate a company's financial condition and performance. As noted by auditors on financial statements "the accompanying notes are an integral part of these financial statements." Please include a thorough review of the noted comments in your investment analysis. 11. The Annual Report/10-KPrudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly-traded companies. Perhaps even before digging into a company's financials, an investor should look at the company's annual report and the 10-K. Much of the annual report is based on the 10-K, but contains less information and is presented in a marketable document intended for an audience of shareholders. The 10-K is reported directly to the U.S. Securities and Exchange Commission or SEC and tends to contain more details than other reports. Included in the annual report is the auditor's report, which gives an auditor's opinion on how the accounting principles have been applied. A "clean opinion" provides you with a green light to proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed. 12. Consolidated StatementsTypically, the word "consolidated" appears in the title of a financial statement, as in a consolidated balance sheet. A consolidation of a parent company and its majority-owned (more than 50% ownership or "effective control") subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit. The presumption is that consolidation as one entity is more meaningful than separate statements for different entities. What is included in financial data?Important forms of financial data include assets, liabilities, equity, income, expenses, and cash flow. Assets are what the company owns, liabilities are what the company owes, and equity is what is left for the owners of the company after the value of the liabilities are subtracted from the value of the assets.
What are the characteristics of financial data?The two fundamental qualitative characteristics of financial reports are relevance and faithful representation. The four enhancing qualitative characteristics are comparability, verifiability, timeliness and understandability.
What are the 5 components of financial statements?The standard requires a complete set of financial statements to comprise a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity and a statement of cash flows.
What are the three types of financial data?The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. Together the three statements give a comprehensive portrayal of the company's operating activities.
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