Chapter 8: Finacial Statement Analysis Flashcards
What does analysing financial statement involve?
Analysing financial statements involves evaluating three characteristics of an entity: its liquidity, its profitability and its solvency.
Who might need to analyse financial statements?
A short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they fall due. The liquidity of the borrower is extremely important in evaluating the safety of a loan.
A non-current creditor, such as a bondholder, however, looks to profitability and solvency measures that indicate the entity’s ability to survive over a long period of time. Non-current creditors consider such measures as the amount of debt in the entity’s capital structure and its ability to meet interest payments.
Similarly, owners are interested in the profitability and solvency of the entity. They want to assess the likelihood of future growth in profit.
What are the different bases that make comparisons between financial data?
Three are illustrated in this chapter.
1. Intra-entity basis.
2. Industry averages.
3. Inter-entity basis.
What is the intra-entity basis?
This basis compares an item or financial relationship within an entity in the current year with the same item or relationship in one or more prior years.
Eg. We can compare a company’s cash balance at the end of the current year with last year’s balance to find the amount of the increase or decrease.
Likewise, we can compare the percentage of cash to current assets at the end of the current year with the percentage in one or more prior years.
Intra-entity comparisons are useful in detecting changes in financial relationships and significant trends.
What is the industry averages basis?
This basis compares an item or financial relationship of an entity with industry averages (or norms) published by financial ratings organisations such as Dun & Bradstreet, Moody’s and Standard & Poor’s.
Eg. The profit of a major sporting goods supplier such as Rebel Sport can be compared with the average profit of all entities in the retail chain-store industry.
Comparisons with industry averages provide information as to an entity’s relative performance within the industry.
What is the inter-entity basis?
This basis compares an item or financial relationship of one entity with the same item or relationship in one or more competing entities.
The comparisons are made on the basis of the published financial statements of the individual entities.
Eg. Rebel Sport’s total sales for the year can be compared with the total sales of its major competitors such as Sports Power.
Inter-entity comparisons are useful in determining an entity’s competitive position.
What are the tools of financial statement analysis?
Various tools are used to evaluate the significance of financial statement data. Two commonly used tools are as follows:
• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Ratio analysis expresses the relationship among selected items of financial statement data.
What is horizontal analysis primarily used?
Horizontal analysis is used primarily in intra-entity comparisons. Two features in published financial statements facilitate this type of comparison.
First, each of the basic financial statements is presented on a comparative basis for a minimum of 2 years. Second, a summary of selected financial data is presented for a series of 5 to 10 years or more.
When is ratio analysis used?
Ratio analysis is used in all three types of comparisons.
What is vertical analysis?
Note that another tool used to evaluate financial statements is vertical analysis (which is not discussed in detail in this chapter).
Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount.
Eg. On a statement of financial position we might say that current assets are 22% of total assets (total assets being the base amount). Or on a statement of profit or loss we might say that selling expenses are 16% of net sales (net sales being the base amount).
What is horizontal analysis also known as and what is its purpose?
Horizontal analysis is also called trend analysis.
It is a technique for evaluating a series of financial statement data over a period of time.
Its purpose is to determine the increase or decrease that has taken place.
This change may be expressed as either an amount or a percentage.
What is the formula for horizontal analysis of changes since since period?
Change since base period = (current year amount - base year amount) ➗ base year amount
Multiply answer by 100 to get the percentage
What is the formula for horizontal analysis of current year in relation to base year?
Current results in relation to base period = current year amount ➗ base year amount
Multiply answer by 100 to get percentage.
How would a horizontal analysis of a 2-year condensed statement of financial position, showing dollar and percentage changes, be presented?
Increase (or decrease) during 2016 (above amount and percentage)
2016 2015 Amount Percentage
ASSETS
Current assets
Non-current assets
Total assets
LIABILITIES
Current liabilities
Non-current liabilities
Total liabilities
OWNER'S EQUITY Capital Retained earnings (profit) Total owner's equity Total liabilities and owner's equity
Seen in figure 8.5 (page 258)
How would a horizontal analysis of the 2-year condensed statement of profit or loss be presented?
Increase (or decrease) during 2016 (above amount and percentage)
2016 2015 Amount Percentage
Sales
(Less) Cost of sales
(=) Gross profit
(Plus) Other revenue
(Eg) Interest and dividends
(Less) Selling expenses
(Less) Administrative expenses
(Less) Financing expenses
(=) Profit before income taxes
(Less) Income tax expense
(=) Profit
Seen in figure 8.6 on page 260
Note that although the amount column is additive, the percentage column is not additive. A separate percentage is calculated for each item.
What does ratio analysis do?
Ratio analysis expresses the relationship among selected items of financial statement data.
A ratio expresses the mathematical relationship between one quantity and another.
The relationship is expressed in terms of either a percentage, a ratio or a simple proportion.
To illustrate, assume a company had current assets of $94 767 000 and current liabilities of $34 836 000. The relationship is determined by dividing current assets by current liabilities. There are also alternative means of expression.
Percentage: Current assets are 272% of current liabilities.
Times: Current assets are 2.72 times current liabilities.
Proportion: The relationship of current assets to liabilities is 2.72:1.
What can ratios be used to evaluate?
Liquidity, solvency and profitability.
Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself is not very meaningful.
Such comparisons provide a benchmark against which performance is assessed. If results from ratio analysis do not meet expectations, further investigation is needed to understand the source of unexpected variation.
What are liquidity ratios?
Measures of short-term ability of the entity to pay its maturing obligations and to meet unexpected needs for cash.
What are solvency ratios?
Measures of the ability of the entity to survive over a long period of time.
What are profitability ratios?
Measures of the profit or operating success of an entity for a given period of time.
Explain liquidity ratios.
Liquidity ratios measure the short-term ability of the entity to pay its maturing obligations and to meet unexpected needs for cash.
How quickly an entity can convert its current assets into cash is a measure of liquidity. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
What are some liquidity ratios?
The ratios that can be used to determine the entity’s short-term debt-paying ability are: . the current ratio, . the acid-test ratio, . receivables turnover, . inventory turnover . and creditors turnover.
What is the current ratio? (On formula sheet)
The current ratio measures the dollars of current assets the entity has per dollar of current liabilities, which indicates the ability in meeting its short term obligations.
It is undesirable to have a ratio that is too low, as this suggests that the entity will have difficulty in meeting its short-term obligations. However, a high current ratio is not necessarily good as it could be due to excess investments in unprofitable assets (eg. Cash, inventory and receivables).
An arbitrary rule of thumb ratio of 1.5 times is considered a minimum; however, it varies across different industries.
The ratio is calculated by dividing current assets by current liabilities.
The ratio produce should indicate the amount of current assets for every dollar of current liabilities.
What does the following current ratio results mean for Hobby Galore? 2016 $1,020,000 ➗ $344,550 = 2.96:1 2015 $945,000 ➗ $303,000 = 3.11:1 Industry average 1.28:1 Competitor (Toy City) 2.19:1
The 2016 ratio of 2.96:1 means that for every dollar of current liabilities, Hobby Galore has $2.96 of current assets.
Hobby Galore’s current ratio has decreased in the current year. But, compared to the industry average of 1.28:1, and competitor Toy City’s 2.19:1 current ratio, Hobby Galore appears to be reasonably liquid.
What is the current ratio sometimes referred to?
The current ratio is sometimes referred to as the working capital ratio because working capital is the excess of current assets over current liabilities.
The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory.
A dollar of cash would be more readily available to pay the bills than a dollar of slow-moving inventory.
What is the acid-test (quick) ratio? (On formula sheet)
The quick ratio measures the dollars of current assets the entity has (excluding inventory) per dollar of current liabilities, which indicates the ability in meeting its short term obligations on short notice.
An arbitrary rule of thumb ratio of 0.8 times is considered a minimum; however, it varies across different industries.
The acid-test ratio is a measure of an entity’s immediate short-term liquidity.
Calculation:
(Current assets - Inventory) ➗ Current liabilities = Quick Ratio
Or (cash + short term investments + receivables) ➗ current liabilities
Thus, it is an important complement to the current ratio.
Cash, short-term investments and receivables are highly liquid compared with inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Therefore it is good that inventory is taken out.
Thus, the acid-test ratio measures immediate liquidity. If there are concerns about whether the entity is a going concern, such measures of liquidity become important for financial analysis
What does the following quick ratio results mean for Hobby Galore?
2016 ($100000 + $20000 + $230000) ➗ $344500 = 1.0:1
2015 ($155000 + 70000 + 180000) ➗ $303000 = 1.3:1
Industry average 0.33:1
Toy City 1.81:1
The ratio has declined in 2016. When compared with the industry average of 0.33:1 and Toy City’s of 1.81:1, Hobby Galore’s acid-test ratio seems adequate.
However, a decreasing trend indicates a deterioration in liquidity which might signal a future solvency risk.
What is receivables turnover? (Not on formula sheet)
Liquidity may be measured by how quickly certain assets can be converted to cash. How liquid, for example, are the receivables? The ratio used to assess the liquidity of the receivables is receivables turnover.
It measures the number of times, on average, receivables are collected during the period.
Receivables turnover calculation:
net credit sales (net sales less cash sales) ➗ the average net receivables = x times
Unless seasonal factors are significant, average receivables can be calculated from the beginning and ending balances of the receivables.
