Financial statement analysis

Question 1

Why diluted earnings per share:

Answer 1

The purpose of publishing a separate figure for diluted earnings per share is to warn shareholders of potential future changes in the earnings per share figure as a result of events that actually may have, or theoretically could have taken place.

Question 2

High growth prospects:

Answer 2

High P/E ratio, low dividend yield

Question 3

Trailing PE ratio and prospective PE ratio:

Answer 3

Trailing P/E ratio
Ignore one-off events, such as windfalls or exceptional items
Prospective P/E Ratio
Instead of using the historic EPS of the company, the prospective P/E ratio uses the current financial year’s forecast.

Question 4

Dividend cover:

Answer 4

Dividend cover gives an investor an idea of how likely it is to maintain the current level of dividend. The higher the dividend cover, the more likely a company is able to sustain that level of dividend.

Question 5

Gearing:

Answer 5

One interpretation of this ratio is the risk to shareholder dividends. As dividends are discretionary, and interest on debt is obligatory.
Another interpretation the ability of the company to borrow more. The more highly geared the company is, the less likely it will be able to borrow more.

Question 6

Interest cover

Answer 6

How easily a company can pay interest expenses on outstanding debt? The lower the ratio, the more the company is burdened by debt expense.

Question 7

Net debt to equity

Answer 7

This ratio removes cash and short-term investments from the debt figure on the debt/equity ratio.

Question 8

capital employed extra:

Answer 8

In the slide:
Capital employed = Total assets – Current liabilities
According to the accounting equation:
Total assets - Current liabilities = Equity + Non-current liabilities
The examiner can use either side of the equation to define capital employed.

Question 9

Return on assets are the same as:

Answer 9

capital employed.

Question 10

Gross profit margin:

Answer 10

The percentage of revenues the company converts to profit after considering the costs of sales

Question 11

Operating profit margin

Answer 11

The percentage of revenues the company convert to profit after considering costs of sales and other operating costs

Question 12

The limitations of ratio analysis:

Answer 12

• As financial statements contain historic data, ratios are not predictive
• Different accounting methods and practices may make it difficult to draw comparisons
  • Particularly internationally
• Significant judgement is needed when performing ratio analysis
  • Leads to divergence of opinion