6 Financial Statement Analysis Flashcards
Who are accounting information users?
(7)
Investors/owners, lenders, suppliers, customers, employees, government, public.
What is meant by gearing?
The relationship, or ratio, of a company’s debt-to-equity (D/E).
What are 4 sources of finance?
- Share issue
- Issuing rights to existing shareholders
- Issue shares on a different capital market
- Loans
- Financial institutions
- Public markets
- Bonds
- Issue debt directly to the capital market
- Leasing
What is trend analysis?
AKA horizontal analysis.
It compares the performance of a firm with its own performance a year before, by selecting a base year and often using a 5 year+ time frame.
What is common size analysis?
AKA vertical analysis.
It compares the performance of a firm with that of other firms (of similar size/nature).
Common size analysis and comprehensive income statements
The items in the statement of comprehensive income expressed as a percentage of revenue.
Common size analysis and consolidated balance sheets
The items in the statement of financial position expressed as a percentage of total assets.
What is ratio analysis?
The relationship between two or more figures within the same set of financial statements.
3 modes of ratio analysis
Ratios from past years
Ratios of other businesses in the same industry
Specified standard ratios
What type of ratios are used to asses performance?
- Profitability ratios
- Asset utilisation ratios
What types of ratios are used for assessing financial leverage?
- Short-term liquidity ratios
- Long-term liquidity ratios
Equation for gross profit margin
Gross profit margin = gross profit / revenue
Equation for net profit margin
Net profit margin = profit after tax / revenue
Equation for net operating profit margin
Net operating profit margin = profit before interest and tax / revenue
Equation for return on equity (ROE)
Return on equity = profit after tax / equity
Equation for return on assets (ROA)
Return on assets = profite before interest and tax / total assets
Equation for return on capital employed (ROCE)
Return on capital employed (ROCE) = profit before interest and tax / (equity + long-term debt)
Equation for earnings per share (EPS)
Earnings per share = profit after tax / number of shares outstanding
What is meant by diluted EPS?
Where a company has certain types of financial instruments - share options, share warrant, convertible securities which entitle their holder to acquire ordinary shares at some future date.
What is meant by inventory turnover?
The average length of time from purchase to sale.
(Average of opening and closing invesntories if available, or just closing inventories.)
Inventory turnover equation
Inventory turnover = cost of goods sold / inventories
Inventory turnover equation in days
Inventory turnover (in days) = (Inventories / cost of good sold) x 365
What is meant be trade receivables?
Average length of time the business takes to collect cash from credit customers.
(average of opening and closing receivables can be used)
Trade recievables equation
Trade recievable = sales / receivables
Trade receivables equation in days
Trade receivables (in days) = (receivables / sales) x 365
What is meant by trade payables?
Average length of time the business takes to pay suppliers.
(Cost of sales can be used if purchases is not given, provided opening and closing inventories are similar)
Trade payables turnover equation
Trade payables turnover = purchases / trade payables
Trade payables turnover equation in days
Trade payables turnover (in days) = (trade payables / purchases) x 365
What is the working capital cycle?
The time it takes to convert net current assets and current liabilities (e.g. bought stock) into cash.
Working capital cycle equation
Working capital cycle = inventory days + receivable days - payable days
What are short-term liquity ratios?
Examples?
The company’s ability to generate cash to meet short-term obligation, essentially working capital needs and immediate debt repayment needs.
Current ratio and quick ratio.
Current ratio equation
Current ratio = current assets / current liabilities
Quick ratio equation
Quick ratio (or Acid test) = (current assets - inventories) / current liabilities.
What are long-term solvency ratios?
Examples?
The company’s ability to generate cash internally or from external resources in order to meet long-term financial obligations.
E.g. Gearing, interest cover, dividend cover.
Gearing equation
Gearing = debt / equity or debt / (debt + equity)
Interest cover equation
Interest cover = profit before interest and tax / net interest charges
Dividend cover equation
Dividend cover = earngings per share / dividend per share
DuPont model: ROE as a function of two others.
ROE = ROA x Gearing
DePont Model: ROE as a function of three drivers
ROE = Net profit margin x asset turnover x equity multiplier
What do each of the drivers of ROE indicate?
Net profit margin indicates much the company is able to keep as profits for each unit of revenue it makes.
Asset turnover indicates how much revenue the company is able to generate for each unit of its assets.
Equity multiplier is a measure of financial leverage of the company.
6 limitations of ratio analysis
- Retrospective nature
- Impact of inflation on financial data
- Is statement of financial position a reflection of the business’s “normal” position?
- Business-to-business comparisons - different accounting policies will be used
- Combined operations of large MNCs
- Do not place too much reliance on “norms”
What is cash flow analysis?
By looking at cash flow we examines operating activities, investment management and financial risks.
Cash flow from operation allows us to analyse… (3)
Growth strategy, industry characteristics, credit policies
Cash flows related to long-term investments allow us to analyse… (2)
Long-term growth opportunities, internal/external financing
Free cash flow available to debt and equity holders indicates…
Ability to meet interest payments and principals payments, financial risk
Free cash flow available to equity holders indicates…
Ability to sustain the dividend policy, potential agency problems, etc.
5 analytical concepts we are considering
- Business environment and corporate strategy.
- Earnings management and incentives.
- Accounting discretion of top management.
- Entity analysis.
- Quality of disclosure.
What do we mean by examining ‘earnings management and incentives’?
The external and internal contracts governing a firm.
What do we mean by examining ‘accounting discretion of top management’?
(6)
- Accounting standards
- Institutional characteristics
- Company characteristics
- Board characteristics
- Audit quality
- Methods of accounting numbers management
What is meant by ‘entity analysis’?
Analysing the relationships of the company with other companies.
What is meant by examining ‘quality of disclosure’?
The accounting methods and accounting estimates.
