Ahraf

Chapter 16

“How Well Am I Doing?”

Financial Statement Analysis

Solutions to Questions

16-1 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.

16-2 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.

16-3 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.

16-4 A company in a rapidly growing technological industry would probably have many opportunities to make investments at a rate of return higher than stockholders could earn in other investments. From the stockholders’ perspective, it would be better for the company to invest in such opportunities than to pay out dividends. Thus, one would expect the company to have a low dividend payout ratio.

16-5 The dividend yield is the return on an investment in shares of stock from simply collecting dividends. The other source of return on an investment in stock is increases in market value. The dividend yield is computed by dividing the dividend per share by the current market...