Chapter 7 - Interpretation of Financial Statements Flashcards
- Profitability Ratios)
Gross/Operating Profit = Gross Profit/OPP x 100
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Revenue
Expenses over Revenue = Specified Expense x 100
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Revenue
Return on Capital Employed = Operating Profit x 100
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Equity + Non current liabilities
Return on Equity = Profit after Tax x 100
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Total Equity
- Finance Ratios
Interest Cover = Profit from Operations x 100
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Finance Costs
Gearing = Non-Current Liabilities x 100
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Total Equity + Non-Current Liabilities
- Liquidity Ratios
Current Ratio = Current Assets = X:1
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Current Liabilities
- ENSURE THAT THE RATIO HAS A 1 AFTER IT. E.G - 3.3:1.
Acid Ratio = Current Assets - Inventory = X:1
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Current Liabilities
- Use of Resources Ratios
Inventory Holding Period = Inventory x 365 days
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Cost of Sales
Inventory Turnover = Cost of Sales = x times
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Inventory
TR Collection Period = Trade Receivables x 365 Days
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Revenue
TP Collection Period = Trade Payables x 365
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Cost of Sales
Working Capital Cycle = Inv Days + TR Days - TP Days
- Use of Assets Ratios
Asset Turnover (NCA) = Revenue = x Times
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NCA
Asset Turnover (Net Assets) = Revenue = x Times
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Total Assets - Current Liabilities
- Profitability Ratio Definitions
GROSS PROFIT = Expresses as a percentage the gross profit in relation to revenue. (Should stay the same or be rising)
OPERATING PROFIT = Expresses profit before FC & Tax as a percentage of Revenue. (Should stay the same or be rising)
EXPENSE OVER REVENUE = Expresses as a percentage how much the expense related to revenue
RETURN ON CAPITAL EMPLOYED = Expresses the percentage of profit the company made in relation to capital employed
RETURN ON EQUITY = Expresses as a percentage what return the shareholders are getting on the total equity
- Liquidity Ratio Definitions
CURRENT RATIO = Measures how much liquid assets there are to cover current liabilities.
An acceptable ratio is 2:1. However, this may differ for different industries such as companies who deal in cash with low trade receivables.
ACID TEST RATIO = Omits inventories because it is the least liquid current asset, so shows the short term liquidity of the company.
An acceptable ratio would be 1:1 as the company would have enough liquid assets to cover liabilities. This however will vary from industry to industry.
WORKING CAPITAL = Current Assets - Current Liabilities. Net current assets - The cash available to fund day to day activities.
- Reasons for comment for changes in Current Assets
INVENTORIES = - Selling Inventory too quick/slow
- Good or bad Inventory management
- Higher/Lower Selling prices
- Too much obsolete stock
TRADE RECEIVABLES = - Fast/Slow at chasing debts
- Good/Bad for cash flow
- Better/Worse efficiency of CC
Ways to improve TR = - Credit References
- Improve Credit Control
- Shorter payment terms
- Prompt payment discounts
- Debt Factoring
- Reasons for comment on Asset Turnover
NET ASSET TURNOVER:
- Higher/Lower Turnover determines efficiency in the use of assets
- Higher figure could indicate higher turnover or lower assets / Too much current liabilities
- Lower figure could indicate too much current assets. E.g- cash in bank, too much inventory. Or; too few current liabilities. E.g - Paying suppliers too quickly
NON-CURRENT ASSET TURNOVER:
- Will be lower if new assets have been purchased
- New assets may not have started producing yet
- Will be lower if Turnover has dropped
- Assets may have been revalued up/down
- Reasons for comment on changes in Liabilities
TRADE PAYABLES:
- Slow paying is good for cash flow but not for goodwill with suppliers, and could decrease available supply.
- Paying too quickly is bad for cash flow
- Slower payments means no access to prompt payment discounts
GEARING:
* Shows the long term financial stability of the company
- 50% is a generally accepted level
- Increases in debt will increase the gearing %
- The higher the gearing, the more debt and less secure the company is
INTEREST COVER:
* Shows the safety margin with the amount of profit the company has to cover debt repayments
- Higher the better
- Worse with more debt
- Worse with lower turnover/higher costs
- Less cover may make it difficult to re-finance
- Use of Resources Definitions
INVENTORY HOLDING PERIOD = The amount of days inventory is held on average.
- Should be as short as possible
- Dependent on type of business - E.g a market trader will be days, a high value item business will be months
INVENTORY TURNOVER = The amount of times in a year inventory is turned over in relation to COS
- It can only be used by companies who buy and sell goods
TRADE RECEIVABLES COLLECTION PERIOD = Shows how many days on average TR pay for goods.
- Measures the companies efficiency of credit control
- Should compare with previous years or industry
- Looking for reduction over time
- Should ideally be below TP days
TRADE PAYABLES PAYMENT PERIOD = Measures how many days on average payment is made to suppliers.
- Slow payment good for cash flow but bad for goodwill
- Cannot be used for companies who provide a service
- TP days should remain consistent
- How to Format Written Answers:
* COMMENT AND ADVISE
ENSURE RATIO FULL WORKINGS ARE SHOWN SHOWN IF ASKED - WORDS AND FIGURES.
1 - State in a sentence whether the Ratio is better/worse than the industry standard or previous year
2 - Support the statement with reasons why this is the case with short bullet points.
3 - ADVISE - Give an opinion on what you think the right conclusion is based on the findings with reasoning in a paragraph or two.
ADVISE only:
E.g - Advise the directors which of the two companies targeted for takeover is more profitable.
CALCULATION OF RATIOS = Show the figures and the resulting percentage to ONE decimal place. Put comparison immediately by the side of the current.
Advise which company is more profitable based on the ratios.
“ALSO CALCULATE AND COMMENT ON ONE FURTHER RATIO”
This requires slightly more explanation and as to why it supports or doesn’t support your advice of which company is a better proposition for takeover.
- How to Format Written Answers:
* REPORT WRITING
INTRODUCTION = A short sentence/paragraph about what the report is about
CALCULATION OF RATIOS = Show the figures and the resulting percentage to ONE decimal place. Put comparison immediately by the side of the current. ENSURE FULL WORKING IS SHOWN IF ASKED - WORDS AND FIGURES.
EXPLANATION = A brief sentence explaining what the ratio means
COMMENT = A brief sentence saying whether the performance was better/worse than the comparison.
CONCLUSION = Bring together all the information discovered and give opinion or advise.
- How to Format Written Answers:
* ANALYSE FINANCIAL STATEMENTS IN REPORT FORMAT
INTRODUCTION = A Short paragraph explaining the purpose of the report
CALCULATION OF RATIOS = Show the figures and the resulting percentage to ONE decimal place. Put comparison immediately by the side of the current. ENSURE RATIO FULL WORKINGS ARE SHOWN SHOWN IF ASKED - WORDS AND FIGURES.
COMMENT AND ANALYSIS = Comment on how the company has performed in each ratio.
Analyse each ratio explaining what this means. E.g - ROCE has improved from X to X meaning the company is generating more profit on its capital employed. *THIS CAN BE BULLET POINTED.
All in paragraph format
CONCLUSION = Bring together all the information discovered and give opinion or advise.
