Question

1. The income statement captures a company’s performance over time, while the balance sheet captures its status at a point in time. What does this mean?

2. How does depreciation create a difference between earnings and cash flows? Are there any other ways/reasons in which accounting earnings can be different from cash flows?

3. Company A has a ROA of 8% and a ROE of 12%. Company b has a ROA of 7% and a ROE of 15%. What does this tell about the relative levels of debt financing between these two companies? Which company’s approach is better? Why?

4. What do we mean by trend analysis and comparative analysis? Why are these tools more useful than looking at the ratios for a single period in isolation?

Answer 1

(1): The income statement is for a period of time. Usually an income statement is prepared on a quarterly basis and on an annual basis. In case of quarterly income statement it shows the company’s revenue and expenses for that quarter only and in case of annual statement for that year only. Balance sheet, on the other hand, is prepared as on a particular date. So if a balance sheet was prepared on 18^th September then it will show the assets owned by the company and liabilities owed by it as on that day.

(2): In case of earnings depreciation is treated as an operating expense and hence is a deductible expense. Note that EBITDA – depreciation = EBIT. In case of cash flows depreciation is added back simply because of the fact that depreciation is a non-cash expense. Other reasons for difference in accounting earnings and cash flows can be the difference in timing of expenses and revenues. Suppose that a company has not paid its salary bill for the last 6 months. The amount will be included as an expense in the income statement but as it has not been paid yet it will not be reflected in the cash flow statement.

(3): We can say that company B is making use of higher debt financing. This is because its ROE is higher and this could be either due to efficient utilization of its equity or due to higher levels of debt being used by it. I think that approach of company A is better because it is using lower debt financing and has lower levels of risk exposure that comes with debt financing.

(4): Trend analysis looks for trends while comparative analysis simply looks at changes from one period to another. For instance trend analysis will look whether the sales of a company are showing an increasing trend or a decreasing trend. Comparative analysis will look at changes in sales this year when compared to last year’s sales. These tools are more useful than looking at the ratios for a single period in isolation because it helps to determine whether the financial position of a company is improving or deteriorating. Such an analysis is not possible when looking at the ratios for a single period in isolation as no comparisons are being made.