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Cash flow statement, cost-volume-profit measures risk

1. Online financial databases, such as Lexis/Nexis and the Dow Jones News Retrieval Service, provide data on thousands of companies. Suppose you want to compare some companies' recent earnings histories. You might have the computer compare companies' returns on stockholders' equity. The computer could then give you the names of the 20 companies with the highest return on equity. You can use any ratio that is relevant to a particular decision. How do financial principles affect financial statement analysis?

2. The analysis of cash flow statement is an important aspect of determining the health of a company. There are questions that need to be asked when you look at a cash flow statement that include:

a. Where is most of the company's cash coming from?
b. Do high sales and profits translate into more cash?
c. If sales and profits are low, how is the company generating cash?
d. Pick one of these questions and tell me why ask the question? What does the answer tell us?

3. Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. In performing this analysis, there are several assumptions made, including:
- Sales price per unit is constant.
- Variable costs per unit are constant.
- Total fixed costs are constant.
- Everything produced is sold.
- Costs are only affected because activity changes.
- If a company sells more than one product, they are sold in the same mix.
- How do we use CVP analysis to measure risk?

Solution Preview

1. How do financial principles affect financial statement analysis?

Financial principles can potentially change ratios a great deal. For instance, financial principles permit the election of different methods for allocating costs, such as LIFO or FIFO or Weighted Average Cost for inventory valuation. Depending on the method used, the inventory turnover ratio may differ considerably across firms. Firms can choose between two method for their allowance for bad debts, percent of sale or percent of receivables, with the method changing their allowance balances and therefore also their days in sales ratio. The classification of leases may be capital or operating based on financial principle rules. Capital leases are booked as financed purchase (an assets and matching liability) while an operating lease is treated as rent expense with no asset or liability booked. The leased asset may change return on assets by being included or excluded from the ratio. So, ...

Solution Summary

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Your discussion is 619 words and gives examples to support the influence of accounting principles on ratio analysis, how cash can vary considerably from profits and how CVP can be used to assess risk.

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