Financial Statements

Question 1

Balance Sheet Equation

Answer 1

Assets - Liabilities = Equity

Question 2

Financial Statements

Answer 2

Balance Sheets, P&L,
Cash flow

Question 3

Uses & limitations of Balance Sheet

Answer 3

Pros:
Shows hows the Business is financed and how funds are deployed
Can provide a basis for assessing the value of the business
Relationships between assets and claims can be assessed
Performance can be better assessed
Limits:
Goodwill and brands
Human resources
Monetary stability

Question 4

P&L Equation

Answer 4

Sales - Cost of sales =Gross profit
Gross profit - Operating expenses =Operating profit
Opening profit + Interest Receivables - interest Payables - Tax Expense (Percentage of EBT) =Net profit

Question 5

Equation for Cost of Sales

Answer 5

Cost of sales = Opening inventory - Closing Inventory + Purchases

Question 6

Usefulness & limits of P&L

Answer 6

Pros:
Provides Confirmatory and Predicts Values
Tracks the performance of the company
Supports and allows investor’s analyses
Provides a perspective of cash in & out flows
Cons:
Does not provide actual cost
Ignores non-revenue factors
Profit is an Opinion

Question 7

Cash Flow Cycle (operations)

Answer 7

Cash+cash equivalents –> inventories (stock) –> trade debtors –> cash+cash equivalents

Question 8

Cash Flow Equation

Answer 8

Operating activities +/- Investing activities +/- financing activities = net increase/decrease in cash or cash equivalents

Question 9

Financial ratio classification

Answer 9

Profitability
Efficiency
Liquidity
Financial gearing
Investment

Question 10

Ratio benchmark

Answer 10

Past Periods
Similar businesses during the same periods
Planned performance

Question 11

Return On Capital Employed (ROCE)

Answer 11

(PBIT (operating profit)/(Equity + long term loans OR total assets – current liabilities + bank loans and overdrafts due within 1 year)*100

Purposes/ limits:
Compares profit with the assets available to generate profit.

There is more than one definition of capital employed (e.g. short term borrowings may be included) so beware inter-company comparisons.

Use of year end figures for capital employed may distort trends and inter-company comparisons.

Question 12

Return On Ordinary Shareholders Funds (ROSF)

Answer 12

(Net profit after tax and preference dividend/Ordinary share capital (Issue Price per Share x Number of shares) + reserves) x100

Purposes/ limits:

Often the year end figure for ordinary shareholders funds is used but an average for the year would be better

Whichever is used should be consistently applied

Question 13

Profit Margin

Answer 13

Gross margin
Formula: (gross profit/sales)*100

High gross profit margin percentage is a good profitability measurement indicator in buying and selling goods, but, before any other expenses are taken into account.

Operating margin:
(PBIT(operating profit)/sales)*100

High operating profit margins relative to competitors or improving margins are usually taken as indicators of efficiency and good management.

Low margins are often due to inefficiency or poor management.

Question 14

Profitability ratios

Answer 14

Return on ordinary shareholders’ funds
Return on capital employed
Operating Profit margin
Gross profit margin

Question 15

Net Asset Turnover

Answer 15

Formula
Sales/capital employed (total assets)

Purpose:

• Shows how hard the company’s assets are being made to work and is another indication of management efficiency.
• Management should dispose of assets which cannot generate sales as well as developing the company’s products or services

Limits:
- Asset turnover will tend to be low in capital-intensive industries (e.g. manufacturing) and high in labour intensive service industries.

• Beware revaluations of property– this will reduce both asset turnover and ROCE distorting year on year comparisons

Question 16

Average Inventories Turnover Period

Answer 16

Formula: (Average inventory held(Opening inventory + closing inventory / 2)/cost of sales)*365

• Measures the average number of days for which inventory is being held.
• Usually a lower figure is preferred but what is reasonable depends on the nature of the inventory.

Question 17

Average Settlement Period for debtors (debtors days)

Answer 17

Formula: (Average Trade receivables (debtors)(Opening trade receivables + closing trade receivables / 2)/Credit sales)*365

Calculates how long on average a business takes to collect debts from credit customers. Usually the lower the better

Often a year end trade receivables figure is used but an average for the year may be preferable.

Usually the lower the better but note that this is an average which may conceal some problematic bad payers

Question 18

Average settlement period for creditors (creditor days)

Answer 18

Formula: (Average trade payables(Opening trade payables + closing trade payables / 2)/Credit purchases)*365

• This tells us how long on average a business takes to pay its creditors
• Trade creditors are a free source of finance for a business so usually the longer taken to pay the better.

Question 19

Sales Revenue per Employee

Answer 19

• It provides a measure of the productivity of the workforce.

Formula: Sales revenue/No. of employees

Question 20

Efficiency ratios

Answer 20

Net Asset Turnover
Average Inventories Turnover Period
Average Settlement Period for debtors (debtors days)
Average settlement period for creditors (creditor days)
Sales Revenue per Employee

Question 21

Working Capital

Answer 21

Working Capital = Current Assets – Current Liabilities

Is an indication of the short-run solvency of the business.

Question 22

Current ratio

Answer 22

Formula: Current assets/Current liabilities

The current ratio puts current assets over current liabilities and indicates whether assets which should convert into cash within 1 year are sufficient to pay liabilities which must be paid within the same period

In the absence of a good reason we would normally expect current assets to exceed current liabilities.

Question 23

Quick Ratio (Acid Test)

Answer 23

Formula: (Current assets – inventory)/Current liabilities

This ratio excludes inventory (inventory) from current assets. inventory is the least liquid current asset.
Measures the immediate liquidity of the firm

Question 24

Cash generated from operations to maturing obligations

Answer 24

Formula: Cash generated from operations/Current liabilities

This ratio compares the cash generated from operations ( taken from cash flow statement ) with current liabilities

It provides a further indication of the ability of the business to meet its maturing obligations.

Question 25

Financial Gearing

Answer 25

Financial gearing is concerned with the proportion of capital employed that is borrowed compared with the proportion that is provided by shareholders

Gearing ratios are from the point of view of the ordinary shareholder and are concerned with the impact on the ordinary shareholder of borrowing money

Companies must pay interest on any loans they can pay a dividend to shareholders

Formula: Long-term liabilities/Equity + Long-term liabilities

Question 26

Current and Quick Ratios
Interpretation

Answer 26

A current or quick ratio of more than 1 indicates that a company has sufficient short term assets to meet short term liabilities.

A company with a quick ratio of less than 1 may need to raise new finance.

The appropriate level of current ratio will depend on the nature of the business e.g. food retailers often have low liquidity ratios

Question 27

Interest cover ratio

Answer 27

Interest cover is a guide to the impact of gearing. it tells us what proportion of profits must be allocated to meeting interest payments

EBIT(Operating profit)/interest payable

High interest cover can improve a company’s credit rating on bond issues

cash flow is a better guide than profit as to the ability of a business to meet its interest and capital repayments

Question 28

Gearing ratio’s

Answer 28

Gearing ratio
Interest cover ratio

Question 29

Liquidity ratios

Answer 29

Working Capital
Current ratio
Quick Ratio (Acid Test)
Cash generated from operations to maturing obligations

Question 30

Dividend payout ratio

Answer 30

(Dividends announced for the year/Earnings for the year available for dividends)*100

Question 31

Dividend cover ratio

Answer 31

Earnings for the year available for dividends/Dividends announced for the year

Question 32

Dividend yield ratio

Answer 32

(Dividend per share/Market value per share )*100

it relates the cash return from a shore to its current market value

Low yields may indicate a high growth company. Yield is inversely related to share price

Dividend yield is important to investors looking for a high income rather than capital growth

Question 33

Dividend yield ratio (including tax)

Answer 33

(Dividend per share/(1-tax))/Market value per share) x 100

The dividend tax credit rate of income tax (tax is usually 10%)

Question 34

Earning per share

Answer 34

Earnings available to ordinary shareholders/Number of ordinary shares in issue

measures the profit available to ordinary shareholders

Question 35

Cash Generated from operations per share

Answer 35

(Cash generated from operations - preference dividend)/Number of ordinary shares in issue)

It can be argued that, provides a good guide to the ability of a business to pay dividends and to undertake planned expenditures

Question 36

Price/earnings (P/E) ratio

Answer 36

Formula: Market value per share/Earnings per share

The higher the ratio the more expensive

Provides an indicator of market sentiment towards the shares

Question 37

Investment ratio

Answer 37

Dividend payout ratio
Dividend cover ratio
Dividend yield ratio
Earnings per share
Cash generated from operations per share
Price/earnings ratio

Question 38

Limitation of ratio analysis

Answer 38

Quality of financial statements: some items are excluded or manipulated

Inflation:
assets value, time lag between revenue and cost

The restricted view of ratios:
the absolute size of items should be considered

The basis for comparison:
difference in business and accounting policies

Ratios relating to the statement of financial position:
reported at financial year-end; seasonal business

Question 39

Fundamental analysis

Answer 39

Fundamental analysis is the method of analysing companies based on factors that affect their intrinsic value. It determines the underlying health and performance of a company by looking at key numbers and economic indicators. There are two sides to this method of analysis: the quantitative and the qualitative.

Question 40

Financial vs Non-financial performance indicators

Answer 40

Drawbacks of sole reliance on financial performance measures:
short-termism
Internal focus
Manipulation of results
Do not convey the whole picture
Backward looking

The optimum system for performance measurement :
Financial performance indicators (FPIs) - important to monitor financial performance.

Non-financial performance indicators (NFPIs) - reflect the long-term viability and health of the organization:
the management of human resources; product and service quality;
brand awareness and company profile

Question 41

Models for evaluating financial and non-financial performance

Answer 41

Kaplan and Norton’s balanced scorecard (BSC)
Lynch and Cross’s performance pyramid
Fitzgerald and Moon’s building block model
The performance prism

Question 42

Balance ScoreCard (BSC)

Answer 42

Explanation
Profit or Financial perspective (Lag Indicator)

Client (Customer perspective), Employees (Customer perspective) and Innovation (Innovation and Learning) (Leading Indicators);

Critical Success Factors(CSFs) and Key Performance Indicators (KPIs).

In line with the overall strategic objectives and vision of the organisation

Rank the goals and measures in order of importance.

Question 43

Implementing scorecard

Answer 43

Make the strategy explicit
Choose the measures
Define and refine
Deal with people

Question 44

Performance Pyramid

Answer 44

Level 1: to achieve long-term success and competitive advantage.

Level 2: CSFs in terms of market-related measures and financial measures.

Level 3: the achievement of customer satisfaction, increased flexibility and high productivity: the guiding forces that drive the strategic objectives of the organisation.

Level 4: monitor driving forces using the lower level departmental indicators of quality, delivery, cycle time and waste.

Question 45

Building Block Model

Answer 45

The dimensions are the goals, i.e. the CSFs for the business and suitable measures must be developed to measure each performance dimension

The standards set, i.e. the KPIs, should have the following characteristics:
Ownership:
Achievability:
Fairness:

The rewards ensure that employees are motivated to meet clear standards that are linked to controllable factors.

Question 46

The performance prism

Answer 46

Stakeholder Satisfaction: Who are our stakeholders and what do they want and need?
Strategies: What strategies do we need to satisfy these wants and needs?

Processes: What processes do we need to execute these strategies?

Capabilities: What capabilities do we need to operate our processes more effectively and efficiently?

Stakeholder Contribution: What do we want and need from our stakeholders if we are to develop and maintain these capabilities?

Question 47

Limitation of Qualitative Analysis

Answer 47

The idea behind quantitative analysis is to measure things; the idea behind qualitative analysis is to understand them. The latter requires a holistic view and a fact-based overarching narrative.

Qualitative analysis deals with intangible and inexact information that can be difficult to collect and measure.

Machines struggle to conduct qualitative analysis as intangibles can’t be defined by numeric values: positive associations with a brand, management trustworthiness, customer satisfaction, competitive advantage, and cultural shifts are difficult, arguably impossible, to capture with numerical inputs.

A purely qualitative approach is vulnerable to distortion byblind spots and personal biases.

Qualitative analysis can consume much more time and energy than quantitative analysis.

Question 48

Porter’s 4 Competitive Strategies

Answer 48

Cost Leadership focuses on reducing the cost to deliver the products or services to a customer

Differentiation involves making your products or services different from and more attractive than those of your competitors.

Focus strategies concentrate on particular niche markets either by industry or geography and understanding the dynamics of that market and the unique needs of customers within it

Question 49

Choosing the Right Generic Strategy-
A SWOT Analysis Matrix.

Answer 49

Strength
Weakness
Opportunity
threats

Question 50

Management Strategy

Answer 50

Economies of scale
Quality (JIT &TQM)
Standardised
Customised

Question 51

Scenario Analysis

Answer 51

Managers typically start with three basic scenarios:

Base case scenario – It is the average scenario, based on management assumptions. An example – when calculating the net present value, the rates most likely to be used are the discount rate, cash flow growth rate, or tax rate.

Worst case scenario – Considers the most serious or severe outcome that may happen in a given situation. An example – when calculating the net present value, one would take the highest possible discount rate and subtract the possible cash flow growth rate or the highest expected tax rate.

Best case scenario – It is the ideal projected scenario and is almost always put into action by management to achieve their objectives. An example – when calculating the net present value, use the lowest possible discount rate, the highest possible growth rate, and the lowest possible tax rate.

Question 52

Classic Life Cycle

Answer 52

The ‘classic’ life cycle for a product has four phases, with different CSFs.

An introduction phase, when the product or service is first developed and introduced to the market. Sales demand is low whilst potential customers learn about the item. There is a learning process for both customers and the producer, and the producer might have to vary the features of the product or service, in order to meet customer requirements more successfully.

A growth phase, when the product or service becomes established and there is a large growth in sales demand. The number of competitors in the market also increases, but customers are willing to pay reasonably high prices. The product becomes profitable. Variety in the product or service increases, and customers are much more conscious of quality issues.

A maturity phase, which might be the longest stage in the product life cycle. Demand stabilises, and producers compete on price.

A decline phase, during which sales demand falls. Prices are reduced to sustain demand and to slow the decline in sales volume. Eventually the product becomes unprofitable, and producers stop making it.

Question 53

Metrics (FPI and NFPI)

Answer 53

Financial Performance

cost
profitability
liquidity
budget variance analysis
market ratios
level of bad debt
return on capital employed (ROCE)

Competitiveness

sales growth by product or service
Measures of customers base
relative market share and position

Activity

sales units
labour/machine hours
numbers of passengers carried
numbers of material requisitions serviced
number of accounts reconciled
whichever measurement is used may be compared

Productivity
efficiency measurement of resources planned against consumed
measurements of resources available against those used
productivity measurement such as production per person or per shift or per shift

Quality of service

quality measure in every unit
evaluate suppliers on the basis of quality
number of customer complaints received
number of new accounts lots of gained
rejections as a percentage of production or sales

Customer satisfaction

speed of response to customers needs
informal listening by calling a certain number of customer each week
number of customer visits to the factory or workplace
number of factory and non-factory manager visits to customers

Quality of working

days of absence
labour turnover
overtime
measure of job satisfaction

Innovations

proportion of new product and services to old ones
new products or services sales levels