Interpretation of Financial Statements

Question 1

What are the 4 types of ratios that you might need to calculate in your exam?

Answer 1

Profitability, liquidity, long term financial stability or investor

Question 2

Profitability: How do you calculate the gross profit margin?

Answer 2

Gross profit/Revenue x 100%

Question 3

Profitability: What are the 4 reasons for a movement in the gross profit margin?

Answer 3

• selling prices
• sales mix
• purchase cost
• production cost

Question 4

Profitability: How do you calculate the operating profit margin?

Answer 4

Operating profit/Revenue x 100%

Question 5

Profitability: What are the 2 reasons for a movement in the operating profit margin?

Answer 5

• gross profit

- expenses:administration/distribution

Question 6

Profitability: How do you calculate the asset turnover?

Answer 6

revenue/*capital employed

*can use net assets as proxy

Question 7

What is capital employed?

Answer 7

equity + debt (e.g. bank loan - anything that comes with interest!)

Question 8

Profitability: What are the 3 reasons for a movement in the asset turnover?

Answer 8

• increase/decrease in revenue
• increase/decrease in NCA (non current assets)
• increase/decrease in working capital (when do significant movements happen? e.g. share issue on the last day of the year)

Question 9

Profitability: How do you calculate the ROCE (return on capital employed)?

Answer 9

operating profit/capital employed x 100%

op prof/rev (op prof margin) x rev/cap emp (asset turnover)

Question 10

Profitability: What are the 3 reasons for a movement in the ROCE?

Answer 10

• efficiency : movement in asset turnover
• profitability : movement in operating profit margin
• combination of both

Question 11

Profitability: How do you calculate EBITDA?

Answer 11

Earnings
(Profit less exceptionals)
Before
Interest
Tax (up to here would be operating profit)
Depreciation
Amortisation

(approx to operating profit cashflows)

Question 12

Profitability: What is the profitability ratio relationship?

Answer 12

Op prof margin x asset turnover = ROCE

Profitability x efficiency = return

Question 13

Liquidity: How do you calculate the current ratio? And what does it represent?

Answer 13

Current assets/current liabilities

Ability to service short tern liabilities with our short term assets

Question 14

Liquidity: How do you calculate the quick ratio (acid test)?

Answer 14

Current assets (excluding inventory)/current liabilities

Question 15

Liquidity: Why do we exclude inventory from the quick ratio?

Answer 15

Inventory is not always very liquid - how quickly can it be turned into cash

Question 16

Liquidity: What are the 4 reasons for a movement in the current/quick ratio?

Answer 16

• increase/decrease in cash balance
• increase/decrease in inventory (current ratio only)
• increase/decrease in receivables
• increase/decrease in payables

Question 17

Liquidity: What number are we ideally looking for when looking at the current/quick ratio?

Answer 17

> 1 typically BUT depends on the industry

ALSO if it’s too HIGH (exp cash) = inefficient

Question 18

Liquidity: How do you calculate the inventory turnover? And what does it represent?

Answer 18

Cost of sales/inventory
Number of times inventory is turned over in the period
Higher turnover = higher efficiency

Question 19

Liquidity: How do you calculate the inventory holding period? And what does it represent?

Answer 19

Inventory/cost of sales x 365 days
Average number of days for which the inventory is held
Lower days = higher efficiency

Question 20

Liquidity: What are the 3 reasons for a movement in the inventory ratios?

Answer 20

• improved/worse inventory control
• obsolete inventory (days go up)
• increased level of inventory to stimulate sales

Question 21

Liquidity: How do you calculate the receivables collection period? And what does it represent?

Answer 21

receivables/revenue (ideally credit sales) x 365 days
Average number of days to collect receivables balances
Lower days = higher efficiency

Question 22

Liquidity: What are the 3 reasons for a movement in the receivables collection period?

Answer 22

• improved/worse credit control
• irrecoverable debts (days go up)
• increased credit terms to stimulate sales

KEY is to compare to credit terms

Question 23

Liquidity: How do you calculate the payables collection period? And what does it represent?

Answer 23

payables/credit purchases (or cost of sales) x 365 days
Average number of days taken to pay suppliers
Higher days = greater benefits

free financing BUT don’t want angry suppliers

Question 24

Liquidity: What are the 3 reasons for a movement in the payables collection period?

Answer 24

• new credit arrangement
• new supplier
• higher days may indicate inability to pay

increasing payment period may give company reputation as poor payer

Question 25

Liquidity: How do you calculate the working capital cycle? And what does it represent?

Answer 25

Inventory days + receivable days - payable days

Shorter working capital cycle indicates higher level of efficiency

Question 26

Liquidity: How could you shorten the working capital cycle?

Answer 26

• reduce inventory
• reduce receivables
• increase payables