Exam revision questions

Question 1

Return on assets

Answer 1

Return on assets measures the overall net profit as a percentage of average total assets invested in the firm. It represents a company’s ability to generate profits from its entire assets base, not just those resources provided by owners. It reflects its profitability from revenue and profitability from investments in assets.

For example, GASKA Ltd.Ltd ROA ratio of 32,75% shows that GASKA Ltd.Ltd generated approximately 33 cents in profit for every dollar of assets it possessed during the
year.

Question 2

Net Profit Margin

Answer 2

Net Profit margin measures the percentage of each sales dollar that represents net profit. A higher ratio indicates a greater ability to generate profits from sales.

For example, GASKA Ltd.Ltd’s net profit margin is 22.9%, which means that the company generated 22.9 cents net profit from each sales dollar.

Question 3

Asset turnover

Answer 3

Asset turnover measures how efficiently an entity uses its assets to generate sales. So, higher ratio is always favourable.

For example, the asset turnover ratio of GASKA Ltd.shows that the company generated $1.40 sales for every dollar invested in its assets.

Question 4

Relationship between ROA, NPM and AT

Answer 4

The ratios are interrelated as profit margin multiplied by asset turnover gives return on assets.

For example, for GASKA Ltd.., the profit margin of 22.9% multiplied by the asset turnover of 1.43 times = return on assets of 32.75%.

Question 5

Describe what this information indicates about the differences in each business approach

14/10

Answer 5

Companies can follow many different business strategies to success. One strategy is to sell many products at low prices and rely on high sales volume to create profits. It seems Blackjacks Ltd. follows this strategy. The other possible strategy is to keep higher profit margin to compensate for low sales turnover. It seems GASKA Ltd. follows this strategy by having lower asset turnover but higher profit margin than Blackjacks Ltd.

Question 6

14/10

Q5

Answer 6

The current ratio and the accounts receivable turnover have improved during the last three years. However, company’s quick assets ratio has declined significantly. This could cause major liquidity issues as they may not be able to settle their bills when they become due.
It appears that the slow-moving inventory brings major liquidity crisis to the business.

Question 7

You are reviewing the performance of a company that has posted its most recent year-end financial statements a rate of return of 10%

Discuss additional information and bench marks that might assist you in evaluating
whether this return is adequate

Answer 7

A single ratio by itself may not be very meaningful and is best interpreted by comparison with: (1) past ratios of the same entity, (2) ratios of other entities, or (3) industry norms or predetermined standards. In addition, other ratios of the entity such as efficiency, liquidity and gearing ratios are necessary to determine overall financial well-being.

Question 8

Explain the main difference between a provision and a contingent liability

Answer 8

Provisions satisfy the definition of a liability and are defined as liabilities for which only the amount or timing of the future sacrifice of economic resources is uncertain. Nevertheless, they are recognised as liabilities.

A contingency, on the other hand, is a liability (or indeed, an asset) whose outcome will be confirmed on the occurrence or non-occurrence of future uncertain events beyond the control of the entity. Such a contingency may or may not satisfy the recognition criteria for a liability. As such, it may or may not be reported on the balance sheet. However, contingencies have been reported in notes to annual reports. A contingent liability is a liability but is one that does not satisfy the recognition criteria for a liability because it is not yet probable that a future sacrifice of resources will be required, or the amount cannot be measured reliably.

Question 9

The accounting treatment for a provision and a contingent liability is the same. Discuss

Answer 9

The statement is not true.
A provision must be recognised as a liability and reported on the balance sheet. Provisions satisfy the definition of a liability and are defined as liabilities for which only the amount or timing of the future sacrifice of economic resources is uncertain. Nevertheless, they are recognised as liabilities.

A contingent liability is a liability but is one that does not satisfy the recognition criteria for a liability because it is not yet probable that a future sacrifice of resources will be required, or the amount cannot be measured reliably. IAS 37/AASB137 states that contingent liabilities are not to be included in the

Question 10

1B

Answer 10

15/10

Question 11

2

Answer 11

15/10

Question 12

7

Answer 12

15/10

Question 13

10

Answer 13

15/10

Question 14

9

Answer 14

15/10

Question 15

12

Answer 15

15/10

Question 16

14

Answer 16

15/10

Question 17

15

Answer 17

15/10

Question 18

16

Answer 18

15/10

Question 19

Expenditures after acquisition- Capital expenditure

Answer 19

15/10

Question 20

Cum dividend

Answer 20

Cum dividend refers to the situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when shareholders sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.

Question 21

Ex dividend

Answer 21

Ex-dividend date is the date on which the legal right to the next dividend payment no longer accompanies a share. In Australia, the ex-dividend date occurs 4 business days prior to the record date when the company finalises the list of shareholders that will receive the next dividend payment. Accordingly, shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment on the payment date, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.

Question 22

Dividend reinvestment

Answer 22

A dividend reinvestment scheme is when instead of paying a cash dividend, the company issues more shares to the shareholder.

The advantage to the business is they do not need to find the cash to pay the dividend.

The advantage to the shareholder is an increase in the number of shares they hold, without any effort or fees.

Because the business simply issues more shares and does not (re)purchase its own shares, this is a share dividend. If all shareholders participated in the dividend reinvestment scheme, each shareholder would hold more shares but the same proportion of ownership in the company.

Question 23

Dividend policy related theories

Answer 23

Dividend irrelevance

Signalling

Residual dividend

Constant payout ratio divided policy

Question 24

Modigliani-Miller’s dividend irrelevance theory

Answer 24

Dividend Irrelevance Theory states that a company’s dividend policy is irrelevant and has no effect on the overall cost of capital nor the market value of the company. It argues that the market value of a company is determined by the basic earning power and the business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders.

Question 25

Signalling theory

Answer 25

The company management’s choice between debt financing versus equity financing is viewed by investors as a signal about the company management’s perception of the future financial prospects for the company. Since external investors expect that companies with bright financial prospects will prefer debt financing over equity financing, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright. Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor.

Question 26

Tax deductions:

Answer 26

Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible, with the government effectively subsidising part of the cost of debt capital.

Question 27

Constant payout ratio dividend policy

Answer 27

Constant payout ratio dividend policy refers to the policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments (for example, if the board of directors declare a constant payout ratio of 30%, then, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends). Although the dividend payout ratio remains constant over time, the dollar value of dividend payments will necessarily fluctuate as earnings change over time. Again, this fluctuation in dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.

Question 28

• The importance of integrate financial, environmental and social performance evaluate of a company

Answer 28

Traditionally it is believed that the sole objective of a company is to maximise shareholder wealth. However, now it is becoming accepted that companies also have responsibilities to a broader group of stakeholders Good financial performance is important but not the sole objective. Companies now being held responsible for their social and environmental as well as their financial performance Financial accounting measures ignores many of the externalities caused by reporting entities Focus on the information needs of stakeholders with a financial interest.

Question 29

Need for collateral:

Answer 29

With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debt holder against possible default. There is, however, no such requirement for collateral with equity financing.

Question 30

What are investors concerned with under dividend irrelevance theory

Answer 30

As a result, Dividend Irrelevance Theory contends that investors are only concerned with the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.

Question 31

Implication of dividend irrelevance theory

Answer 31

Since Dividend Irrelevance Theory argues that shareholders are not concerned with a company’s dividend policy, this implies that company managers can set any dividend policy without affecting the company’s share price.

Question 32

Implication of signalling theory

Answer 32

Accordingly, the implication of Signalling Theory is that companies should always maintain a reserve borrowing capacity by using less debt than the ‘optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.

Question 33

Residual dividend policy implication

Answer 33

Although the residual dividend policy minimises the cost of capital for the company by reducing the need to raise funds through the issuance of new equity or shares, the residual dividend policy will result in the variation of dividend payments to shareholders due to fluctuations in both the amount of retained earnings and the cost of pursuing profitable investment opportunities over time. Since investors value economic certainty, this variation or instability of dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.

Question 34

Debt financing

Answer 34

Debt providers have a contractual right to the cashflows generated by the assets of the company. e.g. term loans (long-term bank loans); debentures, bonds (government bonds and/or corporate bonds)

Question 35

Equity financing

Answer 35

Equity holders have a residual claim to the cashflows generated by the assets of the company. e.g. ordinary shares; preference shares

Question 36

Residual dividend policy

Answer 36

A policy in which the company only makes dividend payments when there is retained earnings left over after having financed all profitable investment opportunities. The residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.