CH8 - Analysis and interpretation of financial statements

Question 1

ration analysis can be helpful in a variety of decision areas, such as

Answer 1

profit planning, pricing, working capital management and financial structure, investment decisions.

Question 2

financial ration classification

Answer 2

• profitability
• efficiency or “activity ratios”, “turnover ratios”
• liquidity
• financial gearing => important effect on the degree of risk.
• Investment

Question 3

Calculating a ratio to compare to common “benchmark”

Answer 3

past periods
similar businesses
planned performance

Question 4

The key steps in financial ratio analysis

Answer 4

Identify users and their information needs
Calculate appropriate ratios
Interpret and evaluate the results

Question 5

Who and Why they need the financial ratio analysis?

Answer 5

• Managers have an interest in all of the ratios, as they have an overall responsibility for business performance
• Shareholders: interest in their returns and the risk investment carries (profitability, investment and gearing ratios)
• Long-term lenders: are concerned with the long-term viability of the business (profitability and gearing ratios)
• Short-term lenders (suppliers): maybe interested in how readily the business can repay the amounts owing in the short term (liquidity)

Question 6

the ratios calculated

Answer 6

• b/w 2 financial positions: use year-end figures

- b/w financial position and performance: use the average of 2 figures

Question 7

which ratios may be used to evaluate the profitability of the business

Answer 7

• return on ordinary shareholders’ funds/ return on equity
• return on capital employed
• operating profit margin
• gross profit margin

Question 8

return on equity (ROE)

Answer 8

compares the amount of profit for the period available to the ordinary shareholders with the ordinary shareholders’ average stake in the business during that same period.

Question 9

ROE equation for a limited company:

Answer 9

ROE/ROSF = (Net profit after taxation and any preference dividend/average ordinary share capital plus reserves) x100

Question 10

return on capital employed (ROCE)

Answer 10

a profitability ratio that expresses the operating profit (i.e. profit before interest and taxation) as a percentage of the long-term funds (equity and borrowings) invested in the business.

Question 11

operating profit margin ratio (OPM)

Answer 11

A profitability ratio that expresses the operating profit s a percentage of the sales rev for the period.
OPM = OP/Sales x 100

Question 12

gross profit margin (GPM)

Answer 12

A profitability that expresses the gross profit as a percentage of the sales rev for a period.
GPM = GP/Sales x 100

Question 13

Liquidity ratios

Answer 13

assess how well the business can meet short-term commitments or claims against the assets when they fall due. This ratio is sometimes expressed in terms of the ability or speed with which assets can be converted to cash.

Question 14

Which ratios can be aspects of the reporting entity’s liquidity position?

Answer 14

• current ratio

- acid test (liquid or quick) ratio

Question 15

What is current ratio?

Answer 15

A liquidity ratio that relates the current assets of the business to the current liabilities.
CR= current assets/current liabilities

Question 16

An “Ideal” current ration

Answer 16

2 times (2:1)

Question 17

Which ratio is considered as a primary measure of profitability? Why?

Answer 17

Return on capital employed figure.
Because it compares inputs (capital invested) and outputs (profit). This comparison is vital in assessing how effectively funds have been deployed.