Financial Statement Analysis

Question 1

What is profitability

Answer 1

Profitability is the ability of a business to generate excess income to cover its expenses

Question 2

How to improve profitability with examples

Answer 2

1. Sell goods at higher selling prices.
   -Increase price of goods
2. Buy goods at lower cost price.
   -Buy I’m bulk to obtain trade discount
   -Switch to another supplier that offers lower prices, without compromising on quality
3. Increase sources of other income.
   -Sublet excess space to another business to earn rental income
   -Pay early to take advantage of cash discounts
4. Reduce operating expenses.
   -Reduce the use of electrical appliances to lower utilities expenses
   -Hire freelancers or part-timers on a needs basis
   -Negotiate for lower rental
   -Relocate to another premise that charges lower rental
   -Capitalise on technology to reduce cost of manpower

Question 3

Gross profit/loss formula

Answer 3

Gross profit/loss = Net sales revenue - Cost of sales

Question 4

Profit for the period formula

Answer 4

Gross profit/loss + Other income - Other expenses

Question 5

Profitability ratio: Gross profit margin

Answer 5

Formula:
(Gross profit / Net sales revenue) x 100%

Interpretation:
-Measures how much gross profit a business earns for every dollar of net sales revenue

-The higher the gross profit margin, the more profitable the business

Question 6

Profitability ratio: Mark-up on cost

Answer 6

Formula:
(Gross profit / Cost of sales) x 100%

Interpretation:
-Measures how much gross profit a business earns for every dollar of its cost of sales

-The higher the mark-up on cost, the mort profitable the business

Question 7

Profitability ratio: Profit margin

Answer 7

Formula:
(Profit for the period / Net sales revenue) x 100%

Interpretation:
-Measures how much profit a business earns for every dollar of Net sales revenue

-The higher the profit margin, the more profitable the business

Question 8

Profitability ratio: Return on equity

Answer 8

Formula:
(Profit for the period / Average equity) x 100%

Interpretation:
-Measures how much profit a business earns for every dollar of equity invested by the owner or shareholders in the business

-The higher the return on equity, the more efficient the business is in generating profits for its owner or shareholders

Question 9

Average equity formula

Answer 9

(Total equity at the beginning of the financial period + Total equity at the end of the financial period) / 2

Question 10

What is liquidity

Answer 10

Liquidity is the ability of a business to convert current assets into cash to pay current liabilities. It is also the ability of a business to repay its CLs when they fall due

Question 11

How to improve liquidity with examples

Answer 11

1. Increase sources of cash.
   -Obtain cash contribution from owner or shareholders
   -Obtain long-term loan
   -Sell excess non-current assets for cash
2. Manage cash outflow.
   -Reduce operating expenses
   -Negotiate for better credit terms from supplier

Question 12

Why may a profitable business not be liquid

Answer 12

The business may have difficulty in collecting payment from its credit customers or it may have used cash to buy non-current assets with an aim to generate more income in the future

Question 13

Working capital formula

Answer 13

Working capital = Current assets - Current liabilities

Question 14

Liquidity ratio: Current ratio

Answer 14

Formula:
Total current assets / Total current liabilities

Interpretation:
-Measures the ability of a business to repay its short-term debts using its current assets

-The acceptable norm varies from industry to industry. However , a general benchmark to use is 2.

-The higher the current ratio, the more liquid a business is

Question 15

Liquidity ratio: Quick/Acid test/Liquid ratio

Answer 15

Formula:
(Total current assets - Inventory - Prepayments) / Total current liabilities

Interpretation:
-Measures the ability of a business to pay its short-term debts using its quick assets, which can be converted into cash more quickly than other current assets such as inventory and prepayments

-The acceptable norm varies from industry to industry. However, a general benchmark to use is 1.

-The higher the quick ratio, the more liquid a business is.

Question 16

Efficiency ratio: Rate of inventory turnover (times)

Answer 16

Formula:
Cost of sales / Average inventory

Interpretation:
-Measures the number of times a business has sold and replaced its inventory

-The higher the rate of inventory turnover, the more efficient the business is at managing its inventory

Question 17

Efficiency ratio: Days sales in inventory (days)

Answer 17

Formula:
(Average inventory/Cost of sales) x 365 days

Interpretation:
-Measures the number of days a business takes to sell its inventory

-The fewer the days sales in inventory, the more efficient the business is at managing its inventory

Question 18

Average inventory formula

Answer 18

Average inventory = (Inventory at the beginning of the financial period + Inventory at the end of the financial period) / 2

Question 19

How to improve efficiency in inventory management with examples

Answer 19

1. Sell inventory faster.
   -Reduce selling price for slow-moving goods
   -Provide trade discounts to encourage customers to buy in bulk and regularly
   -Attract more customers through marketing campaigns
2. Keep sufficient inventory on hand.
   -Use technological tools to improve the accuracy of predictions about customer demand in order to know when and how much inventory to buy

Question 20

How does a business manage its inventory

Answer 20

The business maintains inventory at an optimal levels to meet customer demand

Question 21

How does a business manage its trade receivables

Answer 21

The business does so by granting appropriate credit terms to promote sales and collecting cash from its credit customers on a timely basis.

Question 22

Efficiency ratio: Rate of trade receivables turnover (times)

Answer 22

Formula:
Net credit sales revenue / Average net trade receivables

OR

Net credit service fee revenue / Average net trade receivables

Interpretation:
-Measures the number of times a business collects payment from its credit customers

-The higher the rate of trade receivables turnover, the more efficient the business is at managing trade receivables

Question 23

Efficiency ratio: Trade receivables collection period (days)

Answer 23

Formula:
(Average net trade receivables / Net credit sales revenue) x 365 days

OR

(Average net trade receivables / Net service fee revenue) x 365 days

Interpretation:
-Measures the number of days a business takes to collect payment from its credit customers

-The shorter the trade receivables collection period, the more efficient the business is at managing trade receivables

Question 24

Average net trade receivables formula

Answer 24

Average net trade receivables = (Net trade receivables at the beginning of the financial period + Net trade receivables at the end of the financial period) / 2

Question 25

Why does a business buy sufficient goods

Answer 25

To keep on hand to prevent a stock-out situation, which often results in a loss of sales. However, if the business buys too many goods and is unable to sell them, it will incur higher storage costs and increase the risks of the goods becoming obsolete

Question 26

What happens when a business takes longer than usual to collect payment from its credit customers

Answer 26

The business would have lesser cash, causing its liquidity position to worsen

Question 27

How to improve efficiency in trade receivables management with examples

Answer 27

1. Improve credit granting processes.
   -Monitor collection patterns closely
   -Ensure credit is granted to customers who are financially able
2. Provide monetary incentives.
   -Offer cash discounts to encourage credit customers to pay early
3. Increase debt collection efforts.
   -Send regular reminders to credit customers who delay payment or refuse to pay
   -Engage professional debt recovery agencies to collect payment from financially distressed credit customers