Financial Statement Analysis Mid-Semester Exam Flashcards
What is accrual accounting?
Economic transactions are recorded on the basis of expected payment and not actual cash recipts and payments.
What are the 4 key objectives that financial statements are used for?
- Business strategy analysis
- Accounting analysis
- Financial analysis
- Prospective analysis
Describe business strategy analysis?
Generate a performance perspective of the business through industry and competitive analysis.
Describe financial analysis?
Evaluate financial performance using ratios and cash flow analysis.
Describe accounting analysis?
Evaluate the quality of accounting through policies and estimates used.
Describe prospective analysis?
Make forecasts and value business.
Why is the importance of industry level analysis?
Understanding the environment and competitive forces of the industry that the organisation operates in helps to evaluate a firm’s strategy and its profitability, also a firms strategy is influenced by the industry is belongs to.
What are Porter’s 5 Forces?
- Rivalry amongst existing firms
- Threat of new entrants
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
Describe competitive force 1: Rivalry among existing firms
. Pushes prices towards the marginal cost of production
. Increases the importance of non-price dimensions of products and services
. Industry growth rate
. Concentration and balance of competitors
. Switching costs
Describe Threat of New Entrants
The ease of access for a new firm into a particular industry and affecting the profitability of other firms within the industry.
What are the factors that affect the barriers to entry?
. Economies of scale
. 1st mover advantage
. Access to distribution channels and relationships with suppliers
. Legal barriers
Describe Threat of New Substitutes
The degree to which sub products or services exists which affect an industry’s bargaining power with suppliers and customers thus affecting profitability.
The degree to which substitutes exist depends upon the price and performance of competing products or services as well as the willingness of customers to accept the substitutes.
Describe bargaining power of buyers?
Buyer bargaining power can force a decrease in price due to buyer price sensitive and the relative bargaining power of buyers.
Describe bargaining power of suppliers?
Suppliers have bargaining power when there are few substitutes or suppliers relative to the number of customers demanding a product.
What are the two basic competitive strategies?
- Cost leadership
- Product/Service differentiation
Both affect competitive advantage
Describe cost leadership?
Supply the same product or service at a lower cost. Achieved through efficient production practises, lower costs, lower R&D and marketing costs.
Describe differentiation?
Supply a unique product or service at a cost that is lower than the price premium customers are willing to pay. Achieved through superior quality, increased marketing and R&D costs.
How is competitive advantage evaluated?
. Resources and capabilities to implement strategies
. If a firm’s activities, infrastructure and other operating elements are consistent with its competitive strategy.
What is the purpose of accounting analysis?
The analyst is trying to determine the quality of accounting in the financial statements, accounting analysis helps to improve the reliability of the accounting information in order to make effective accounting solutions
Name the types of financial statements
- Statement of cash flows
- Income statement
- Balance sheet
Describe the formula for assets of the balance sheet?
Assets = Liabilities + Equity
Describe the formula for profit in context of the income statement?
Profit = Revenue – Expenditures
What is the formula for comprehensive income?
Comprehensive income = Profit for the period + Items recognised directly in equity
What is the International Standards setting that financial statements are prepared to?
Multiple countries around the world now prepare financial statements according to the International Financial Reporting Standards (IFRS). The IFRS are more principles based rather than rules based.
What is the purpose of an audit?
An audit provides a third party opinion of the quality of financial statements for organisations.
Name potential sources of noise and bias in accounting data?
Managers are allowed some level of discretion in the application of accounting standards, as a result, potential sources of noise and bias include:
- Random estimation errors
- Rigidity in accounting rules
- Manager’s accounting choices
Describe the concept of rigidity of accounting rules and random forecast errors?
Accounting standards do not reflect the true economics of the firm’s transactions, hence why some flexibility in accounting is required.
Management’s estimates can result in accounting forecasting errors, also, accrual accounting requires forecasting estimates which can be incorrect
Why does management have a number of incentives to disclose biased accounting information?
Managers are influenced to disclose biased accounting information due to tax considerations, stakeholder and capital market consideration, competitive considerations and managerial compensation.
What are the steps in performing accounting analysis?
- Identify the key accounting policies
- Assess accounting flexibility
- Evaluate accounting strategy
- Evaluate the quality of disclosure
- Indentify potential red flags
- Undo accounting distortions
Describe the key accounting policies?
Refers to the key policies and estimates used to measure risks and critical factors for success
Describe the concept of assessing accounting flexibility
Accounting information that is highly flexible is more susceptible to information distortion from managers who choose policies and estimates
Describe evaluating accounting strategy
Flexibility in accounting allows managers to strategically communicate economic information that distorts performance. The reasons for managers to disclose this type of information may include incentives, accounting policy with industry peers.
Describe the evaluation of quality of disclosure?
It must be considered whether or not the disclosure seem adequate, as well as the efficiency in quantity of footnotes and whether or not they are consistent with the current performance.
Describe the identification of potential red flags?
Factors that warrant the identification of potential red flags include unexplained changes such as transactions or the overstating or understating of information such as inventory.
Describe the undo of accounting distortions?
The footnotes in the accounting often provide information that can be for correction by the analyst.
Why are financial statement adjusted by analysts?
- The accounting standards may not reflect the true economics of the business
- Removing management bias
- Increase the comparability of financial statements
Describe and define the two tools used in financial statement analysis?
- Ratio analysis: compares various line items to each to assess and address specific performance.
- Cash flow analysis:
What are the four levers manager’s can apply in order to achieve growth and profit targets?
- Operating management
- Financing management
- Investing management
- Dividend policy
What are the qualities of good ratios?
- The ratio has a specific goal or principal
- The consistency of measurement units: stock vs flow
- The consistency of measurements scope: Adjustments
What is a common size analysis for the income statement and balance sheet?
- States all income statement items as a percentage of sales
- States all balance sheet items as a percentage of total assets
Define Return on Equity?
ROE is the amount of net income returned as a percentage of shareholder’s equity. Return on equity highlights an organisation’s profitability by the amount of profit generated by the equity invested by shareholders.
What is the formula for Return on Equity?
ROE = Net Income/Average Shareholder’s Equity
Define Gross Profit Margin? and show the formula
. The profitability of sales after the cost of sales has been deducted. It describes the price premium of an organisation’s products in the marketplace as well as how efficient the production and supply chain line is.
. Gross Profit Margin = (Sales - Cost of Sales)/Sales
. Define EBIT?
. How do you calculate EBIT?
. Earnings before interest and taxes highlights an organisation’s revenue after deducting operating expenditures. EBIT is used when the need to NOT consider an organisation’s capital structure and liability obligations such as taxes are not required.
. EBIT = (Net Income - Operating Expenses) or (Net Income + Interest + Taxes)
. Define EBITA?
. How do you calculate EBITA
. EBIT refers to Interest, taxes, depreciation and ammortization added back to revenue after other expenditures has been deducted from revenue, it is used to analyse the profitbaility of organisations without considering accounting and finance decision making input.
What is asset turnover and what does it consist of?
. Is used an indicator as to the effectiveness of an organisation’s management.
. It consists of working capital management and long-term asset management.
Describe working capital and the various analysing working capital?
. Working capital is the difference between current assets and current liabilities
. Ratios include analysing working capital to sales, working capital to turnover
Describe the difference between liquidity and solvency
. Liquidity refers to an organisation’s or person’s ability to meet short-term debt obligations.
. Solvency refers to an organisation’s or person’s ability to meet long-term debt obligations.
What are some of the ratios used to measure a firm’s liquidity and what are their formulas?
- Current ratio = (current assets - current liabilities) /current liabilities
- Quick ratio = (Cash+ short-term investments+accounts receivable)/current liabilities
- Cash ratio = (cash+marketable securities)/current liabilities
- Operating ratio = cash flow from operations/current liabilities
What are ratios that are used to measure a firm’s solvency using shareholder equity?
. Liabilities to equity ratio = Total liabilities/shareholder’s equity
. Debt to equity ratio = (short + long term debt)/shareholder’s equity
. Net debt to equity ratio = (shot + long term debt - cash and markertable securities)/shareholder’s equity
What are some ratio used to highlights an organisation’s ability to pay interest on debt?
. Interest coverage ratio (earnings basis) = (Net income + interest expense + tax expense)/interest expense
. Interest coverage ratio (cash flow basis) = (cash flow from operations + interest expense + taxes paid)/interest expense
Define sustainable growth ratios and show formula?
. Measures the ability of a firm to maintain its profitability and financial policies
. ROE*(1-Dividend Payout Ratio) where dividend Payout Ratio = (cash dividends paid/net income)
What are the components of a cash flow analysis?
. Cash flow from operating activities:
- strength of organisation’s internal cash flow generation
- how well is working capital being managed
. Cash flow from investing activities
- Amount of cash invested in growth assets
. Cash flow from financing activities
- What type of external financing did the organisation rely on
- Did the organisation use internally generated funds for investing or dividend payouts
Define and describe credit analysis? Who would be interested in credit analysis?
Credit analysis refers to the analysing of an organisation’s financial statements in order to determine the ability of that organisation to pay back debt.
Investors, banks, auditors and suppliers would be interested in a firm’s liability coverage capabilities in order to invest in (extend credit to) or go into business with.
What is a loan covenant? Provide an example?
Is a promise in any formal debt agreement that certain activities will or will not be carried out, covenant agreements are maintained in the form of financial ratios such as debt-to-equity or the number of employees working at the firm.
What is the Altman Z-Score?
Refers to a decimal unit measurement of a firm’s likelihood of going bankrupt. The scores range between 1.8-3.0, a firm that scores lower than 1.8 is likely to go bankrupt whilst a firm that scores higher than 3.0 will not likely go bankrupt.
Describe the Standard & Poors credit rating system
The ratings rate from D to AAA, the lower the rating the higher the riskiness of the organisation paying back debt whilst the higher the rating the lower the riskiness of the organisation paying back debt.
