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A2 - Intermediate Financial Accounting > Interpretation of Financial Statements > Flashcards

Interpretation of Financial Statements Flashcards

1
Q

What is efficiency defined as?
What does an efficiency ratio test?
Some examples, companies may use: (3)

A

Efficiency is defined as: work output/work input

  • An efficiency ratio tests a key output against the input that produces it.
  • Are resources are being used efficiently?
  • Some examples companies may use:
    o Profit per employee
    o Profit per unit floor area (retail business)
    o Turnover generated from assets
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2
Q

What is asset turnover?

A

Asset Turnover

The efficiency with which the company uses capital employed to generate sales

Revenue/Net Assets = £ or times

Where Net Assets = total assets – current liabilities

Or can be expressed as: Revenue/Capital Employed = £ or times

Where Capital Employed = equity + non-current liabilities

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3
Q

Non-current asset turnover

A

Measures the efficiency with which the company uses non-current assets to generate sales

Revenue/Non-current assets

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4
Q

Ratio relationships

A

ROCE = PBIT/Capital Employed

= Profit margin x Asset turnover

ROCE is influenced by

Pyramid approach – can drill down further

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5
Q

Average inventories turnover period

A

The number of days inventory is held on average

Average inventory = (opening inventory + closing inventory)

The quicker inventory is sold the better?
Depends on industry

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6
Q

Inventory turnover

A

A measure of the number of times the inventory is used up the period - e.g. in a year.
Expressed as ‘number of times’.

Average stock = (opening stock + closing inventory)
Higher the better.

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7
Q

Receivable days/ collection period

A

Measures the average number of days the company takes to collect payments from debtors.

Assumes all sales are on credit.
To express in terms of: months X 12 or weeks X 52

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8
Q

Payable days/ payment period

A

Measures the average number of days the company takes to pay creditors.

Taking longer = short-term borrowing from suppliers

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9
Q

Working Capital

A

Or net current assets
Working Capital = Current Assets – Current Liabilities
Working capital cycle:

= Inventory turnover + days receivables – days payables

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10
Q

The Working Capital Cycle (picture)

A
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11
Q

Liquidity ratios

A
  • Measure the extent to which a business can cover its short-term obligations
  • This can include short-term creditors and loan interest/ repayments
  • Can a business use its liquid assets to cover its liabilities?
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12
Q

Current (liquidity) ratio

A

Assesses exposure to the need to suddenly meet liabilities.

Current ratio = current assets/current liabilities

Expressed as a ratio, e.g. 3:1
May be dangerous if less than 1?
Depends on industry

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13
Q

Quick (acid test) ratio

A

Same as current ratio but minus inventory (because it takes longer to turn stocks into cash or near cash)

Normally greater than 1? may be negative

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14
Q

Analysis of Financing

A

How is the company financed – capital structure

Companies are financed through a mixture of:

  • Share capital
  • Retained profits
  • Loans
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15
Q
A

Gearing

  • Refers to the relationship between debt and equity
  • Indicates how the company’s capital is constituted between debt and equity (shareholders’ funds).

High gearing is OK when interest rates are low but not so good when they are high

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16
Q

Debt to Equity ratio

A

A measure of the borrowings as a proportion of shareholders’ funds
Shareholders’ funds includes:
All the share capital, share premium accounts, any reserves and profit and loss reserves.

17
Q

Financial Gearing: Example

A

use ppt

18
Q

Return on ordinary shareholders funds

A
19
Q

Gearing interpretation

A
  • Big cog : little cog effect
  • Is high gearing beneficial?

Business usually makes greater returns than interest rates on borrowings

  • Interest is tax deductible

Highly geared:

  • relatively high levels of debt funding
  • the more interest to pay before ordinary dividends paid
  • could indicate more risk
20
Q

Investment ratios

A
  • Investors BUY shares in a company in order to earn a return
  • There are a number of ratios that are useful for investors:

o Current shareholders
o Or potential investors

21
Q

Investment ratios - definitions

A
  • Dividend – proportion of profit after interest (earnings) and tax paid to shareholders.
    o The remainder of the earnings is re-invested
  • Share volume – the number of ordinary shares in circulation
  • Share price – as of today
  • Dividend cover
  • Dividend yield
  • Earnings per share
  • Price/Earnings ratio
22
Q

Dividend cover

A
  • Shows the number of times that the ordinary dividend can be paid out of current earnings
  • How many times is the dividend covered by earnings?
23
Q

Dividend Yield

A
  • Expressed as %
  • Measures the rate of return an ordinary shareholder gets by comparing the cost of their shares with the dividend payable
  • Does not take into account capital growth
  • Based on current price which may not be the price paid
24
Q

Earnings per share IAS 33

A
  • Used to estimate future growth which affects future share price.
  • Measure of growth over time – may be manipulated
  • Not all the profit has to be paid out in the form of dividends
  • Allows comparison between one year’s earnings and the next because profit is related to the tangible number of shares in issue
  • Share issue during the year
24
Q

Price/earnings ratio

A
  • Earnings per share = historical value compared with
  • Market price = forward looking value
  • The number of years earnings necessary to recover the market price of the share
  • Represents the market’s view of the growth potential of the company, dividend policy and the degree of risk involved
  • Compare to other companies in the sector
25
Q

Price/Earnings ratio discussion points

A

The price / earnings ratio that can be expected depends on:

  • Overall level of the stock market
  • The industry
  • The past record of the company
  • The view of the market
26
Q

Prediction and trend analysis

A
  • May be used to predict financial distress
  • May look at one ratio at a time or several ratios together
    o Univariate or multivariate analysis
  • Ratios can be tracked over time to detect trends
  • Plotted on a graph
27
Q

The interpretation process

A
  • Objectives of the analysis and the intended recipient
    o e.g. Investor, management, board of directors
  • General overview, wider considerations
  • Industry norms – may be hard to find
  • Horizontal analysis – over time, >2yrs
  • Vertical analysis, common sized statements
    o May aid intercompany comparisons
28
Q

Consideration of Internal and External Factors

A
  • General business environment
  • Industry specifics
  • Management – motives, policies
  • Read the narrative
29
Q

Exam approach

A
  • What format are you required to use? Be professional!
  • Be mindful of the audience – internal manager, executive director, non-executive director, investor?
  • Question – address the requirements given
  • Brief conclusion – no new information
30
Q

How to get started

A
  • Either calculate the ratios required of you or decide on the most appropriate and calculate them
  • Work your way down the statements addressing each requirement in turn:
    1. State your calculated ratios
    2. How do they differ?
    3. So what? Can you link information?
31
Q

Limitations of ratio analysis

A
  • Lack of standard definitions – not governed by IFRS (except for EPS)
  • Are two companies truly comparable?
    o Accounting policy choices
  • Timing – SOFP shows one point in time
32
Q

Explain the limitations of comparisons based on ratios

A

6 marks (out of 100)
In a 2-hour exam there are 1.2 mins per mark
Therefore 1.2 x 6 = 7.2 minutes or 7 minutes 12 seconds, in reality nearer 5 minutes.
Identification of the limitation with explanation and an example if appropriate
Marking guide:
◦ ½ mark for identification only
◦ Up to 2 marks per limitation identified, explained and illustrated with example.
◦ Max 6 marks.

A2 - Intermediate Financial Accounting (15 decks)

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