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Financial Reporting (FR) > Interpretation of financial statements > Flashcards

Interpretation of financial statements Flashcards

1
Q

Users of financial statements what information needed?

A

Shareholders and potential investors:
- primarily concerned with receiving an adequate return on their investment, but it must at least provide security and liquidity
Suppliers and lenders:
- concerned with security of their debt or loan
Management:
- concerned with the trend and level of profits, since this is the main measure of their success

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2
Q

What are the other potential users include:

A
  • bank managers
  • financial institutions
  • employees
  • professional advisors to investors
  • financial journalists and commentators
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3
Q

What we analyse if we want to know the performance?

A
  • this looks largely at the statement of profit or loss and associated ratios
  • profit margins, return on capital employed, net asset turnover
  • looks at the results that the business has generated in the year
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4
Q

What we analyse if we to know the position?

A
  • this looks at the statement of financial position and the associated ratios
  • short-term liquidity, looking at working capital, long-term solvency, looking at levels of debt
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5
Q

What we analyse if we to know the investor?

A
  • items that would specifically matter to investors
  • share price, dividends and earnings
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6
Q

Gross profit margin

A

Gross profit/Sales revenue x 100%

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7
Q

What changes can influence gross profit margin?

A
  • selling prices: increased competitions, entry into a new market
  • sales mix: often deliberate (discontinuing some products
  • purchase cost: including carriage inwards or discounts
  • production cost - materials, labour or production overheads
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8
Q

What is the good way to analyse gross profit margin is to ask yourself?

A

Are there any reasons why the selling price has changed?
Are there any significant changes to the costs in the year?
Has there been any indication of a change in sales mix?

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9
Q

If gross profit has not increased in line with sales revenue what are the factors to make this discrepancies?

A
  • increased ‘purchase’ costs
  • inventory write offs
  • other costs being allocated to cost of sales
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10
Q

Operating profit margin calculation?

A

Profit from operations/Sales revenue x 100%

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11
Q

What we need to consider if there are any changes in operating profit?

A
  • changes in line with changes in gross profit margin?
  • changes in line with changes in sales revenue?
  • as many costs are fixed they need not necessarily increase/decrease proportionately with a change in revenue
  • look at individual categories
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12
Q

What is important to consider when there are significant changes within operating expenses?

A
  • are these due to one-off items such as redundancies
  • are there likely to be ongoing future consequences
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13
Q

Calculation of ROCE?

A

Profit/Capital employed x 100%

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14
Q

How is the profit measured in ROCE?

A
  • operating profit or
  • the profit before interest and taxation
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15
Q

How is capital employed measured in ROCE?

A
  • equity plus interest-bearing finance, i.e. the long term finance
  • total assets less current liabilities
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16
Q

What ROCE for the current year should be compared to?

A
  • the previous year ROCE
  • the cost of borrowing
  • other entities’ ROCE in the same industry
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17
Q

In comparison with a company that revalues their non-current assets how it will influence ROCE?

A
  • it will make their ROCE lower than a company that does not revalue their assets
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18
Q

Calculation of ROE? Return on equity

A

Profit after tax/Equity x 100%

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19
Q

ROCE should be compared with?

A
  • previous year figures - no changes in policies, if replacing non-current assets is that their value will decrease and ROCE will increase
  • the company’s target ROCE
  • the cost of borrowings
  • other companies in same industry
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20
Q

Calculation for the net asset turnover

A

Sales revenue/ Capital employed
=times pa

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21
Q

What is the measure of management’s efficiency in generating revenue from the net assets at its disposal?

A
  • the higher the asset turnover, the greater the efficiency
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22
Q

Other calculation for ROCE including ratios

A

Profit margin x Asset turnover

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23
Q

A trade-off may exist between margin and asset turnover

A
  • low margin businesses (e.g. food retailers) usually have a high asset turnover
  • capital-intensive manufacturing industries (e.g. electrical equipment manufacturers) usually have relatively low asset turnover but higher margins
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24
Q

Achieving same ROCE

A
  • sell goods at a high profit margin with sales volume remaining low (designer shop)
  • sell goods at a low profit margin with very high sales volume (e.g. discount clothes store)
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25
Q

What we using to analyse the position?

A
  • short term liquidity
  • long-term solvency
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26
Q

What are two ratios used to measure overall working capital?

A
  • the current ratio
  • the quick or acid test ratio
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27
Q

Current ratio calculation

A

Current assets/current liabilities : 1

28
Q

What could cause higher or increasing figure of current ratio?

A
  • high levels of inventory and receivables
  • high cash levels which could be put to better use (e.g. investing in non-current assets)
29
Q

What measures the current ratio?

A
  • the adequacy of current assets to meet the company’s short-term liabilities
  • it reflects whether the company is in a position to meet its liabilities as they fall due
30
Q

Quick ratio/liquidity or acid ratio calculation

A

Current assets - Inventory/ Current liabilities : 1

31
Q

Why is the quick ratio also known as the acid test ratio?

A
  • because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.
32
Q

Looking at working capital what we need to have a look regarding cash?

A
  • identify where any major cash inflows have come from in the year
  • identify where the cash has been used in the year
33
Q

Inventory turnover period calculation?

A

Inventory/ COS x365 days

34
Q

Inventory turnover period calculation as a number of times per annum?

A

Cost of sales/ Inventory
= times pa

35
Q

What indicate when an increasing number of days implies that inventory is turning over less quickly?

A
  • lack of demand for the goods
  • poor inventory control
  • an increase in costs (storage, obsolescence, insurance, damage)
36
Q

What is the calculation of receivables collection period?

A

Trade receivables/Credit sales x 365 days

37
Q

Increasing accounts receivables is bad sign what could be reasons?

A
  • lack of proper credit control
  • a deliberate policy to attract more trade
  • a major new customer being allowed different terms
38
Q

The receivables days ratio can be distorted by:

A
  • using year-end figures which do not represent average receivables
  • factoring of accounts receivables which results in very low trade receivables
  • sales on unusually long credit terms to some customers
39
Q

Payables payment period calculation

A

Trade payables/ credit purchases x 365 days

40
Q

What we compare with payables payment period?

A
  • a long credit period may be good as it represents a source o free finance
  • a long credit period may indicate that the company is unable to pay more quickly because of liquidity problems
41
Q

What if credit is long? payables payment period

A
  • the company may develop a poor reputation as a slow payer and may not be able to find new suppliers
  • existing suppliers may decide to discontinue supplies
  • the company may be losing out on worthwhile prompt payment discount
42
Q

What is the calculation for working capital cycle (cash cycle)?

A

Inventory turnover period (days) + receivables collection period - payables payment period

43
Q

What the working capital shows?

A
  • the average length of time between paying production costs and receiving cash returns from inventory
44
Q

The main point to consider when assessing the loner-term financial position are:

A
  • gearing
  • overtrading
45
Q

What gearing ratios indicate?

A
  • degree of risk attached to the company and
  • the sensitivity of earnings and dividends to changes in profitability and activity level
46
Q

What indicates highly geared businesses?

A
  • a large proportion of fixed-return capital is used
  • there is a greater risk of insolvency
  • returns to shareholders will grow proportionately more if profits are growing
47
Q

What indicates low-geared businesses?

A
  • provide scope to increase borrowings when potentially profitable projects are available
  • can usually borrow more easily
48
Q

What two fundamental characteristics must have to use gearing successfully?

A
  • relatively stable profits
  • suitable assets for security
49
Q

What are two methods commonly used to express gearings?

A
  • debt/equity ratio
  • percentage of capital employed represented by borrowings
50
Q

Calculation of deb/equity ratio

A

Loans + Preference share capital/ Ordinary share capital + Reserves + Non-controlling interest

51
Q

Calculation of capital employed represented by borrowings

A

Loans + Preference share capital/ Ordinary share capital + Reserves + Non-controlling interest + Loans + Preference share capital

52
Q

Calculation for interest cover?

A

Profit before interest and tax/ Interest payable

53
Q

Interest cover indicates the ability of a company to pay interest out of profits:

A
  • low interest cover indicates to shareholders that their dividends are at risk
  • the company may have difficulty financing its debts if its profits fall
  • interest cover of less than two is usually considered unsatisfactory
54
Q

When overtrading arises?

A
  • where a company expands its sales revenue rapidly without securing adequate long-term capital for its needs
55
Q

What are the symptoms of overtrading?

A
  • inventory increasing, possibly more than proportionately to revenue
  • receivables increasing, possibly more than proportionately to revenue
  • cash and liquid assets declining
  • trade payables increasing rapidly
56
Q

P/E ratio - Price/Earnings

A

Current share price/ Latest EPS
- represents the market’s view of the future prospects of the share
- high P/E suggests that high growth is expected

57
Q

What means higher P/E ratio and Lower P/E ratio?

A

Higher P/E ratio:
- the faster the growth the market is expecting in the company’s future EPS
Lower P/E ratio:
- the lower the expected future growth

58
Q

Calculation of Dividend yield

A

Dividend per share/ Current share price
- the lower the dividend yield, the more the market is expecting future growth in the dividend and vice versa

59
Q

Calculation of Dividend cover

A

Profit after tax/ Dividends
- this is the relationship between available profits and the dividends payable out of the profits
- the higher the dividend cover, the more likely it is that the current dividend level can be sustained in the future

60
Q

What ratios can help with?

A
  • to assist analysis
  • they help to focus attention systematically on important areas and summarise information in an understandable form
  • they assist in identifying trends and relationships
61
Q

Disadvantages of ratios?

A
  • they ignore future action by management
  • they can be manipulated by window dressing or creative accounting
  • they may be distorted by differences in accounting policies
62
Q

What is Creative accounting?

A
  • refers to the accounting practices that are designed to mislead the view that the user of financial statements has on an entity’s underlying economic performance
  • used to increase profits, inflate asset values or understate liabilities
63
Q

What is Window dressing?

A
  • is a method of carrying out transactions in order to distort the position shown by the financial statements and generally improve the position shown by them
64
Q

Examples of window dressing

A
  • a company might chase receivables more quickly at the year end to improve their bank balance
  • a company may change its depreciation estimate i.e. by increasing the expected useful life of an asset, the depreciation charge will be smaller resulting in increased profits
  • an existing loan may be repaid immediately before the year end and then taken out again in the next financial year
65
Q

How can we achieve value for money in not-for-profit and public sector organisations?

A

Effectiveness
- success in achieving its objectives
Efficiency
- how well its resources are used
Economy
- keeping cost of inputs low

66
Q
A

Financial Reporting (FR) (22 decks)

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