Financial analysis Flashcards
What are the 4 types of decisions businesses need to make?
1) Financing decisions
2) Investment Decisions
3) Operating decisions
4) Distribution (/Dividend) decisions
How can one look at financial statements in a way that considers the 4 types of decisions businesses need to make ?
> For Investment decisions the we can look at the statement of asset position (specifically the asset section)
> For financing decisions we can look at the statement of asset position (specifically the equity and liabilities sections)
> For Operating decisions we can look at the statement of comprehensive income
> For distribution (/ dividend) decisions we can look at the statement of cash flows
According to Warren Buffet, what makes a great company?
Warren Buffet mentioned the 4 filters. He said a company can be great if it has:
1) An understandable product
- Investors and customers should understand the product
2) A durable competitive advantage
- The company should have something (not necessarily its product) which sets it apart from other companies. This should be something that keeps it ahead of its competitors. i.e the company should have a niche.
3) Management with integrity
Those who run the company should manage it with integrity
4) Margin of safety
The company should have financial strength. It should be so strong it can keep afloat even during tough times
How can one determine if a company is fairly valued?
we can look at the Price-to-Earnings (P/E) ratio. If it is high, then that means stocks might be overvalued; if it is low, then that means stocks might be undervalued.
How can one determine if an industry is a good one to invest in?
We can consider the Price-to-Sales (P/S) ratio. A lower ratio may indicate a better investment opportunity
What ratios can be used to determine if management is making the right decisions?
1) For Financing decisions:
The debt to equity ratio can be used. A high ratio might mean higher risk, while a balanced ratio is often preferred.
2) For Investing decisions
The Return on Assets (ROA) can be used. A higher ROA indicates more effective use of assets to generate earnings
3) For Operating decisions
The Operating Profit Margin can be used. A higher margin suggests better control over costs.
4) For Distribution decisions
The Dividend Payout Ratio can be used. A lower ratio means the company is retaining more earnings for future growth
What is the Operating profit margin formula? and what line items are excluded from operating profit?
Operating profit margin = Operating Profit/ Revenue
The following line items are excluded from operating profit:
Interest on loans, loss on disposal of assets, and other line items that are unrelated to the company’s core business activities.
What is the objective of Financial analysis?
The objective is to examine a firm’s financial position and
returns in relation to risk, with a view to forecasting the firm’s future prospects
Breakdown:
1) Examine a firm’s financial position:
This involves analyzing the company’s balance sheet, which shows its assets, liabilities, and equity. The goal is to understand the company’s overall financial structure, including how much debt it has compared to its equity and its ability to meet obligations.
2) Returns in relation to risk:
This refers to evaluating the company’s profitability (e.g., return on assets, return on equity) in relation to the risks it faces. For example, a company might generate high returns, but if those returns come with high risk (e.g., through excessive debt), it may not be sustainable in the long term. This analysis helps to understand whether the returns justify the level of risk.
3) Forecasting future prospects:
By analyzing past and current financial performance, analysts try to predict how the company will perform in the future. They look at trends in key metrics (like revenue growth, cost management, and profitability) and use them to make informed projections about the company’s future performance and ability to grow, manage risks, and generate returns.
List the categories of analysts
Categories of analysts:
–Shareholders and potential investors
–Creditors
–Management
–Employees
–Auditors
–SARS
–Suppliers
List the categories of a Financial Analysis
Categories of Financial analysis:
1) Time series
2) Cross-sectional
analysis
What is a Time Series Financial Analysis? and what things do you need to watch out for when doing this analysis?
A Time Series is an analysis over a period of time
You need to watch for:
– Structural change
– Change in accounting policies
– Business cycle
– Effects of inflation
What is a Cross Sectional Financial Analysis? And what things do you need to watch out for when doing this analysis?
A Cross Sectional Analysis is an analysis at a point in time
You need to watch for:
–Data availability
–Lack of comparable companies
–Different financial year-ends
–Different customer base
–Different accounting policies
If Retained Earnings of a company have dropped dramatically. What are the 3 possible reasons for this?
1) A large dividend was paid
2) The company recognised a loss
3) There was a share buy-back at a premium
NOTE:
1) A profit that has decreased from the prior year will still be a profit, and therefore increase retained earnings.
2) A re-investment in assets will not affect equity – assets are being converted from one type to another.
Management are seeking to expand operations by investing in Plant, Property and Equipment. They have been advised to wait until the start of the new financial year. Discuss why this advice is good from a financial ratio analysis point of view
By waiting until the new financial year, the full impact of the PPE expansion will also be seen in the income statement numbers and the ratios will be more favourable.
The PPE would increase the asset balance but there would not have been enough time for revenue or profits to improve.
What differences would be expected in terms of the Du Pont analysis if a company changed from the cost model to the revaluation model for Plant, Property and Equipment?
The assets and equity would be expected to increase.
The efficiency will be reduced, and the leverage is likely to be reduced, because of the change to both, but the equity increases by a proportionately bigger amount.
The overall effect on RoE is a decrease
Explain why managers are sometimes resistant to preparing segmental reports.
Managers don’t like to give away information about where they are making their margins and their strategies.
Jamo Ltd has a PE ratio of 6. It then announces that headline earnings per share has dropped by 30% compared to the previous year. What is the new PE ratio of Jamo Ltd? (Assume that the share price hasn’t changed)
6/0.7 = 8.57
Why would a company have both a current tax asset and a current tax liability in its Integrated Financial Report? Why would these two amounts not be netted off from one another?
1) For groups:
There may be a current tax asset and a current tax liability because different entities within the group may have varying tax positions. Some subsidiaries may have overpaid their taxes or have refundable tax credits (resulting in a tax asset), while others may have outstanding tax obligations (resulting in a tax liability).
These amounts are not netted off because tax assets and liabilities are recorded separately for each legal entity within the group. According to IFRS, specifically IAS 12 (Income Taxes), tax assets and liabilities can only be offset if there is both:
1) A legally enforceable right to offset them, and
2) The intent to settle on a net basis or to realize the asset and settle the liability simultaneously.
Since Curro operates multiple entities, each subject to different tax treatments, these amounts must be reported separately in the financial statements.
2) For a single company
A single company can have both a current tax asset and a current tax liability due to timing differences in tax payments and obligations. This can happen for several reasons:
Overpayment vs. Outstanding Tax – The company may have overpaid its provisional tax (creating a tax asset) while still owing tax for a different period or jurisdiction (creating a tax liability).
Different Tax Authorities or Jurisdictions – If the company operates in multiple tax jurisdictions, it may have a tax refund due in one jurisdiction (asset) while owing tax in another (liability).
Timing Differences in Tax Recognition – Some tax expenses may be recognized but not yet paid, while certain tax prepayments or credits may still be pending recognition.
Why Aren’t They Netted Off?
Even within a single company, IFRS (IAS 12: Income Taxes) requires that tax assets and liabilities can only be offset if:
1) The amounts relate to the same tax authority and the same taxable entity
2) There is a legally enforceable right to offset them
If these conditions aren’t met—such as when a company has separate tax accounts for different jurisdictions or different tax periods—the tax asset and liability must be presented separately in the financial statements.
A company has a current ratio of 0.6 in 2013 and 0.19 in 2012. Comment on these ratios
1) 2013 Current Ratio (0.60): This indicates that Curro had R0.60 in current assets for every R1.00 of current liabilities, meaning it did not have sufficient short-term assets to cover its short-term obligations. A current ratio of less than 1 typically signals potential liquidity concerns, suggesting Curro may have faced challenges in meeting its short-term liabilities with its available assets.
2) 2012 Current Ratio (0.19): The very low current ratio in 2012 (0.19) reflects a more significant liquidity problem, as Curro had only R0.19 in current assets for every R1.00 of current liabilities. This would indicate severe difficulties in covering its short-term obligations without external financing or adjustments.
Conclusion: Although the current ratio improved from 0.19 in 2012 to 0.60 in 2013, Curro still faced liquidity challenges in 2013, as a ratio below 1 generally indicates the company might not be able to meet its short-term obligations without taking additional measures.
