analysing and interpreting financial statements

Question 1

external users of financial information

Answer 1

public
investors
lenders
suppliers
customers
employees
government agencies

Question 2

needs of users

Answer 2

investors:

• return
• quality of profit
• dividends

Holder of debentures

• ability to pay interest
• ability to repay debentures
• liquidity
• security

Question 3

define trend analysis

Answer 3

performed by users to help them make decisions about their interaction with the company

Question 4

define ratio analysis

Answer 4

shows the relationship between two or more figures within the same set of financial statements

ratio point of references:

• ratios from past years
• ratios of other businesses in the same industry
• specified standard ratios

Question 5

categories of ratios

Answer 5

profitability
-investors, lenders, employees, suppliers, customers, government and their agencies

liquidity
-lenders, suppliers, investors, customers

efficiency/ activity
-investors, suppliers

gearing
-investors, lenders

investor/stock market
-investors

Question 6

define key profit figure

Answer 6

tells the user about the performance of the business

Question 7

define ROCE

Answer 7

return on capital employed

- how much profit business has generated from the capital invested in it

Question 8

define net profit margin

Answer 8

the profit business has earned on its sales

Question 9

define asset turnover

Answer 9

show the levels of revenue generated per £1 of net assets employed by the business

Question 10

define liquidity

Answer 10

the ability of a business to meet its liabilities as they fall due

i. e. ability to pay bills
- ability to pay interest
- ability to repay loans/ debentures
- ability to stay within overdraft facility

Question 11

define gearing

Answer 11

the balance between equity financing and debt financing
a measure of the risk in an investment for the equity investor

e.g. companies w/ high debt financing = highly geared/ leveraged + riskier investment

Question 12

limitations of ratio analysis

Answer 12

retrospective nature
business-to-business compromises- differences in accounting policies
impact on inflation on financial data
economic climate

Question 13

what is the return on equity

Answer 13

ROE
a measure of the total return to the equity investor as a percentage of their investment- before any actual returns are given

Question 14

what are earnings per share

Answer 14

eps

earnings available to each equity shareholder

Question 15

what is the price/earnings ratio

Answer 15

the number of times the market price exceeds current earnings

an indicator of market confidence in the company

Question 16

what are dividends per share

Answer 16

total dividends for the financial year usually used i.e. current year interim and proposed

Question 17

what is dividend cover

Answer 17

the number of times earnings available for equity dividends exceeds the amount of the equity dividend

Question 18

what is dividend yield

Answer 18

the actual dividend return on an actual investment in equity shares.

Question 19

financial info required by investors

Answer 19

decisions:
Continuation of investment?
Withdrawal of investment?
Increase investment?

info needed:
Return from investment
Ability to pay amounts to investors
Value of investment
Performance of management
Risk in investment

Question 20

financial info required by lenders

Answer 20

decisions:
Lend or not?
Interest rate to be charged?
Security required?

info needed:
Ability to repay loans when due
Ability to pay interest when due
Security for loans

Question 21

financial info required by employees

Answer 21

decisions:
Continuation of employment?

info:
Long-term future and stability of business
Ability to provide appropriate level of remuneration
Retirement and other benefits
Employment opportunities

Question 22

financial info required by government

Answer 22

decisions:
HMRC – has the business paid the appropriate taxes it owes?
Other departments / agencies – has the business carried out its business properly and made appropriate information available?

info:
Business profits
Employee details
Various reports and statistics

Question 23

Limitations of Ratio Analysis

Answer 23

• Ratios do not give the whole picture of the firm’s condition
• may not be comparing like with like. The underlying accounting policies used may vary= distort comparisons
• Ratios cannot be used to interpret non-financial information
• Firms with different accounting policies will end up with different ratios making comparison meaningless
• The statement of financial position is only a ‘snapshot’ of the firm at a moment in time and may not be fully representative of a “normal” position
• Ratios do not take into account the changing business environment
• Short-term fluctuations in the market may distort the ratios
• The calculation of ratios does not take into account the change in the value of money

Question 24

advantages of ratio analysis

Answer 24

• it synthesizes the accounts into certain key ratios which can then be used to compare one set of results with another
• It is a widely used, well integrated and well used technique that is relatively inexpensive and easy to perform.
• There is some evidence of solid user understanding.

Question 25

Horizontal analysis

Answer 25

which may be just looking at changes / differences from one year to the next / one company to the other in key figures such as revenues, PBIT, non-current assets

Question 26

Vertical analysis

Answer 26

each financial statement a key figure is identified, such as revenue for the income statement and total assets for the statement of financial position, and all other figures are expressed as a percentage of this figure.