Chapter 22 - Interpretation of Financial Statements Flashcards
How do we calculate gross profit margin?
gross profit / revenue x 100
What are some reasons for the movement of gross profit margin?
Selling price
Sales mix
Purchase cost
Production cost
How do we calculate the operating profit margin?
operating profit (PBIT) / Revenue x100
What are some reasons for movement of operating profit?
gross profit
expenses: admin/distribution
How do we calculate asset turnover?
Revenue / capital employed
how do we calculate capital employed?
equity + non-current liabilities (would not include deferred tax or deferred income)
What would lead to a movement in asset turnover?
- increase/decrease in revenue
- increase/decrease in NCA
- increase/decrease in working capital
How do we calculate return on capital employed?
Operating profit (PBIT) / Capital employed x100
What would lead to a movement in ROCE?
efficiency: movement in asset turnover
profitability: movement in operating profit margin
combination of both
What are the profitability ratio relationships?
operating profit margin x asset turnover = ROCE
profitability x efficiency = Return
How do we calculate the current ratio?
Current assets / current liabilities
How do we calculate the quick ratio?
(Current assets - inventories) / Current liabilities
What would cause a movement in Current/quick ratio?
increase/decrease in cash balance
increase/decrease in inventory
increase/decrease in receivables
increase/decrease in payables
How do we calculate inventory turnover?
Cost of sales / inventory
What is inventory turnover?
number of times inventory is turned over in the period. Higher turnover = higher efficiency
How do we calculate inventory holding period?
(Inventory / COS) x 365 days
What is inventory holding period?
average number of days for which inventory held. Lower days = higher efficiency
What are some reasons of movement of inventory ratios?
- improved/worse inventory control
- obsolete inventory
- increased level of inventory to stimulate sales
How do we calculate the receivables collection period?
(Trade receivables / revenue) x 365
What are reasons of movement in receivables collection period?
- improved/worse credit control
- irrecoverable debts
- increase credit terms to stimulate sales
How do we calculate payables payment period?
(Trade payables / COS) x 365 days
What are reasons of movement in payables payment period?
- new credit arrangement
- new supplier
- higher days may indicate inability to pay
What does the working capital cycle show?
the length of time between paying for inventory and receiving cash from customers for the inventory. Length of time for which we are funding our inventory
How do we calculate working capital?
inventory turnover period + receivables collection period - payables payment period
How do we calculate the gearing ratio?
Debt / equity
or
Debt / (debt +equity) x 100
What does a shorter working capital indicate?
higher level of efficiency
How may working capital be shortened?
by reducing inventory and/or receivable days and/or increasing payable days
What does debt include?
all long-term borrowings e.g., loan notes, redeemable preference shares
What does high gearing mean for a company?
- large proportion of fixed-return capital
- greater risk of insolvency
- proportionately greater returns to shareholders if profits are growing
- perceived as higher risk
What does equity include?
all elements of equity e.g., share capital, reserves, non-controlling interest
What does low gearing mean for a company?
- scope to increase borrowings for potential new projects
- borrow more easily
- perceived as lower risk
How do we calculate interest cover?
Operating profit / finance cost
What are some reasons of the movement of gearing (decreased)?
- repayment of loan notes or preference shares treated as liability
- redemption of convertbble debt instruments
- trading profits increasing retained earnings
- revaluation of non-current assets, increasing revaluation surplus
What are some reasons of the movement of gearing (increased)?
-issue of loan notes or preference shares treated as liability
- assets acquired using lease
- trading losses causing reduction in retained earnings
- excessive dividends reducing retained earnings
What is interest cover?
- indicates how many times interest costs could be paid from current profit level
- higher the better
Who would look at interest cover?
- used by lenders to assess risk of default
- lenders may insist on maintenance of minimum interest cover as part of loan agreement.
If gearing is low what would we look at next?
interest cover
How do we calculate earnings per share?
Profit available to ordinary shareholders / no. of ordinary shares
How do we calculate the Price/earnings (P/E) ratio?
current market price per share / earnings per share (EPS)
What is the P/E ratio?
- represents a measure of market confidence in company’s capacity for growth
- high P/E ratio suggests that high growth is expected
How do we calculate dividend yield?
dividend per share / market price per share
What is the dividend yield?
-potential return on investment for prospective investors
- can be compared to yields available on alternative investments
How do we calculate dividend cover?
Earnings per share / dividend per share
or
total earnings / dividends
What is dividend cover?
-similar to interest cover, indicates how many time current dividend could be paid from current profit level
- high cover indicates that current dividend level is able to be maintained
What are some limitations of financial statement analysis?
- Year-end figures not representative
- no predictive value
- ignore management action
- window dressing management
- different accounting policies
- distortion by related party transactions
What is non-financial information?
- market share
- key employee information
- long-term management plans
- governance
- environmental and social impact
How is value for money achieved?
Combination of the 3 E’s
What are the 3 E’s?
Effectiveness
Efficiency
Economy
What is effectiveness?
Success in achieving its objectives/ providing its service
What is efficiency?
how well its resources are used
what is economy?
keeping costs of input low
What is the impact on Intra-group transactions?
- distorted margins due to transfer pricing policy
- low-rate finance available from parent
