Financial Statement Analysis Flashcards
What is profitability
Profitability is the ability of a business to generate excess income to cover its expenses
How to improve profitability with examples
- Sell goods at higher selling prices.
-Increase price of goods - 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 - Increase sources of other income.
-Sublet excess space to another business to earn rental income
-Pay early to take advantage of cash discounts - 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
Gross profit/loss formula
Gross profit/loss = Net sales revenue - Cost of sales
Profit for the period formula
Gross profit/loss + Other income - Other expenses
Profitability ratio: Gross profit margin
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
Profitability ratio: Mark-up on cost
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
Profitability ratio: Profit margin
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
Profitability ratio: Return on equity
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
Average equity formula
(Total equity at the beginning of the financial period + Total equity at the end of the financial period) / 2
What is liquidity
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
How to improve liquidity with examples
- Increase sources of cash.
-Obtain cash contribution from owner or shareholders
-Obtain long-term loan
-Sell excess non-current assets for cash - Manage cash outflow.
-Reduce operating expenses
-Negotiate for better credit terms from supplier
Why may a profitable business not be liquid
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
Working capital formula
Working capital = Current assets - Current liabilities
Liquidity ratio: Current ratio
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
Liquidity ratio: Quick/Acid test/Liquid ratio
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.
Efficiency ratio: Rate of inventory turnover (times)
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
Efficiency ratio: Days sales in inventory (days)
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
Average inventory formula
Average inventory = (Inventory at the beginning of the financial period + Inventory at the end of the financial period) / 2
How to improve efficiency in inventory management with examples
- 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 - 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
How does a business manage its inventory
The business maintains inventory at an optimal levels to meet customer demand
How does a business manage its trade receivables
The business does so by granting appropriate credit terms to promote sales and collecting cash from its credit customers on a timely basis.
Efficiency ratio: Rate of trade receivables turnover (times)
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
Efficiency ratio: Trade receivables collection period (days)
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
Average net trade receivables formula
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
Why does a business buy sufficient goods
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
What happens when a business takes longer than usual to collect payment from its credit customers
The business would have lesser cash, causing its liquidity position to worsen
How to improve efficiency in trade receivables management with examples
- Improve credit granting processes.
-Monitor collection patterns closely
-Ensure credit is granted to customers who are financially able - Provide monetary incentives.
-Offer cash discounts to encourage credit customers to pay early - 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
