Financial Statement Analysis Ch. 7

Value-relevant attributes used in forecasting future amounts for a business valuation include

free cash flows.

Term lending agreements are ______ and have maturities of more than one year.

long-term loans

Earnings expected to persist into the future are called

permanent earnings.

Income from continuing operations, excluding special items, is known as

permanent earnings.

Earnings that deviate from investors' expectations are referred to as a(n) ______ ______.

Blank 1: earnings Blank 2: surprise

A measure of the relation between a firm's current earnings and its intrinsic share value is its ______/_______ ratio.

Blank 1: price Blank 2: earnings

Companies with shares that sell for a premium relative to their book value are companies with

ROCEs that consistently exceed the industry average.

Seasonal lines of credit and special purpose loans are common types of

short-term loans.

Assume the following for the Howard Saks firm: Actual earnings of $28,000, beginning book value of $250,000, ending book value of $350,000, and cost of capital of 6%. What are their abnormal earnings?

$13,000 Reason: $28,000 - (250,000 x 6%) = $13,000

Preparing comprehensive financial statement forecasts involve several steps. Which of the following is not one of these steps?

Forecast the market price per share of the company's stock.

Using the abnormal earnings approach, investors will pay a premium for those firms that

earn more than the cost of capital.

Which of the following items is an example of sustainable earnings?

earnings generated from repeat customers

The forecasted cash flow stream to be discounted after subtracting payments to debt holders and preferred shareholders is called the

flows to equity model.

The amount a firm would receive if it sold its investment is called

the exit price.

Income or loss from discontinued operations are known as

transitory earnings.

The first step in credit analysis is

understanding of the firm, its business, its key risk and success factors and dynamics of its industry.

______ ______ are considered a variation on a seasonal credit lines.

Blank 1: Revolving Blank 2: Loans

Cash flow assessment plays a central role in measuring a company's ______ ______

Blank 1: credit Blank 2: risk

An unsecured debt, meaning no specific pledge of property is made, is called a ______ bond.

Blank 1: debenture

Assume the following for the Morgan Goldman firm: Actual earnings of $14,000, beginning book value of $250,000, and cost of capital of 8%. What are their abnormal earnings?

$(6,000) Reason: $14,000 - (250,000 x 8%) = $(6,000)

The two ways to implement the discounted cash flow valuation approach include

the free cash flow model and the flows to equity model.

Before approving a loan to a company, a commercial loan officer evaluates the borrower's ability to repay the proposed loan at maturity. This evaluation typically involves

-due diligence. -analysis of credit risk.

The fundamental approach to business valuation uses

-industry and economy-wide data. -data from a firm's financial statements.

______ ______ assessment plays a central role in measuring a company's credit risk.

Blank 1: Cash Blank 2: Flow

If a company's equity cost of capital is 8% and they report current earnings of $6 per share, this implies a share price of

$75 Reason: 1/0.08 x $6 = $75

A firm can use which of the following to evaluate their prospects of generating abnormal earnings?

-Comparing the ROCE to the ROCE of other companies in the same industry. -Comparing the ROCE to the cost of equity capital.

The FASB believes that current earnings outperform current cash flows in predicting future cash flow and that belief stems from the forward-looking nature of ______ _______.

Blank 1: accrual Blank 2: accounting

Click and drag on elements in order Identify the proper order of the six steps involved in preparing comprehensive financial statement forecasts.

1. Forecast sales revenue 2. Forecast operating expenses 3. Forecast the level of operating assets and liabilities 4. Forecast depreciation and tax expense 5. Forecast the company's financial structure and dividend policy 6.Forecast cash flow statements

Most firms' P/E ratios range between

10 and 30.

Becker Corporation has the following components in its multi-step income statement: Reported EPS $15, Permanent component 60%, (earnings multiplier of 5), Transitory component 25%, (earnings multiplier of 1), and value-irrelevant component 15%, (earnings multiplier of 0). What is Becker's implied total earnings multiple?

3.25 Reason: ($15 x 60% x 5) + ($15 x 25% x 1) + ($15 x 15% x 0) = $48.75 $48.75/$15 = 3.25

Match the Standard & Poor's credit rating on the left with its credit quality on the right. AAA BBB CCC D

AAA - extremely strong BBB - adequate protection CCC - currently vulnerable D - in default

______ ______ includes short-term notes sold directly to investors by large and financially sound companies.

Blank 1: Commercial Blank 2: Paper

______ _______ measure the percentage of borrowers that failed to make all promised debt payments based on the credit rating initially assigned.

Blank 1: Default Blank 2: Rates or Rate

Match the level of the hierarchy for measuring fair values on the left with its description on the right.

Level 1 - Uses quoted prices from active markets for identical assets or liabilities. Level 2 - Uses quoted prices from similar assets or liabilities. Level 3 - Uses unobservable inputs such as management's estimates of expected future cash flows.

True or false: Different levels of risk or uncertainty associated with earnings can cause the share price for firms with the same level of current and future expected earnings to sell at different prices.

True

The FASB argues that analyzing a firms'______ improves their ability to forecast future cash flows.

accounting earnings

The FASB believes that __________ provide a much better measure of long-run expected operating performance than do current cash flows.

current earnings

Research indicates that

current earnings are a better forecast of future cash flows than are current cash flows.

Riskier firms have a higher risk-adjusted cost of capital which means that the discount rate for capitalizing their earnings will be

higher, resulting in lower share prices.

If a company has an earnings rate equal to the underlying book value of net assets,

investors are willing to pay only an amount equal to the book value of net assets.

An earnings surprise

occurs when earnings deviate from investor's expectations.

The flows to equity model

subtracts payments to debt holders and preferred dividends.

High quality earnings are ______ earnings.

sustainable

The amount a firm would pay if it bought an identical investment is called

the entry price.

The interest rate on a revolving loan

will usually change as the prime rate rises or falls over the life of the credit line.

Match the ratio used for credit analysis on the left with its measurement on the right.

-EBIT interest coverage - the extent to which operating earnings exceed interest costs -Total debt/capital - financial structure -Funds from operations/total debt - cash flow capacity -Return on capital - profitability

Which of the following assess and grade the creditworthiness of companies and public entities that sell debt to investors?

-Fitch Inc. -Standard & Poor's Corp. -Moody's Investors Service

Which of the following are reasons that the free cash flow model differs from cash flow from operations under GAAP?

-Interest expense and the related income tax benefit are excluded under the free cash flow model. -Income from noncore investments and the related income tax expense are excluded under the free cash flow model.

Which of the following are true of commercial paper?

-It is usually secured by a bank credit line. -It is sold directly to investors by large and financially sound companies. -It includes an interest rate significantly below the rate a bank would charge.

Which of the following are true of long-term loans?

-They are also called term lending agreements. -They have maturities of more than one year.

Which of the following are true regarding the financial statement ratios that credit analysts at Standard & Poor's track?

-They are compared to average ratios for corporate borrowers. -They each have a precise definition so that every credit analyst is consistent with computations.

Which of the following are true about short-term loans?

-They may be secured. -They may be unsecured. -They are used primarily to finance working capital needs.

Long-term forms of public debt financing include

-bonds. -notes.

Rank the steps involved in valuing a company:

1 - Forecasting future amounts of some financial attribute. 2 - Determining the risk associated with the forecasted future amounts. 3 - Determining the discounted present value that reflects the risk.

Estimating the worth, or intrinsic value, of a company is called ______ ______

Blank 1: business Blank 2: valuation

One way that investors assess credit risk is to rely on the opinion of a ______-______ agency.

Blank 1: credit Blank 2: rating

A firm's potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return in excess of the cost of equity capital are called ______ ______.

Blank 1: growth Blank 2: opportunities

The divergence of a firm's publicly reported profit from its true operating earnings is known as of ______ ______ .

Blank 1: quality Blank 2: earnings

Earnings that are unrelated to future free cash flows and, therefore, not pertinent to assessing current share price are called ______-______ earnings.

Blank 1: value Blank 2: irrelevant

True or false: Level 2 of the GAAP hierarchy of approaches used to measure fair value uses unobservable inputs such as management's estimates of expected future cash flows.

False

True or false: The discounted cash flow valuation approach expresses what a stock is worth as the future value of present cash flows.

False

Free cash flow

is calculated as operating cash flow plus interest expense after tax minus cash outflow for capital expenditures