Interpretation of Financial Statements Keywords and Questions

Question 1

Comparative analysis Intra-entity basis

Answer 1

Comparisons within a single entity

Question 2

Comparative analysis Industry averages

Answer 2

Between entities in the same industry

Question 3

Comparative analysis Inter-entity basis

Answer 3

Between other entities

Question 4

What is the purpose of the financial statement analysis?

Answer 4

Every item in financial reports represents important material

Its significance can be determined only in relation to something else

Most of the information contained in financial statements is expressed in monetary terms

Question 5

What are the limitations of the dollar value comparisons?

Answer 5

The current year’s profit needs to be compared with other information such as:
Last years profit
The current year’s sales
The profits of other entities in the same industry
The value of assets used to generate the profit

Question 6

Why is financial statement analysis used to overcome and why is it useful?

Answer 6

It held to overcome the dollar value comparisons limitations.

Its useful to analysts to achieve information useful for decision making including:
Assessing the financial health of a business

To compare current performance with past performance

To compare and benchmark against industry competitors and other industries

Question 7

What are the steps of financial statement analysis?

Answer 7

Identify users and their information needs

Select and calculate appropriate ratios

Interpret and evaluate the results

Question 8

What are the objectives of financial statement analysis for investors, equity investors and creditors?

Answer 8

Investors use financial analysis to:
Predict expected returns
Assess the risks associated with those returns

Equity investors are more concerned with profitability and future prices

Creditors are primarily concerned with:
Short-term liquidity - how much cash a company has on hand to meet current payments when due
Long-term solvency - a company’s ability to generate cash to repay long-term debts when due

Question 9

What are the key ratio categories?

Answer 9

Profitability
Efficiency
Liquidity
Financial gearing
Investment

Question 10

What is horizontal analysis used for and what happens in the analysis?

Answer 10

To evaluate a series of financial statement data over a period of time

Analyses increases or decreases that have occurred from a particular base year

Figures are stated as both dollar amounts and as percentages

Percentages remove the effect of size, so relative magnitude of change is revealed

One year is selected as the base year and then increases or decreases

Question 11

What is vertical analysis used for and what happens in the analysis?

Answer 11

Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude

Useful for comparing companies of different sizes

Calculated percentages can also be tracked over time to determine patterns of change

Question 12

What is ratio analysis used for?

Answer 12

Financial ratio analysis will provide warning signs that could allow a business to solves problems before the become significant

Question 13

What can ratio analysis be used to make?

Answer 13

Intra-company comparisons

Inter-entity comparisons

Question 14

What do profitability ratios measure?

Answer 14

The profit or operating success of an entity for a given period of time

Question 15

What does profit margin measure?

Answer 15

The percentage of each dollar of sales that result from in profit

Question 16

What does liquidity ratios measure?

Answer 16

The short-term ability of an entity to pay its debts and meet unexpected needs for cash

Question 17

What does a high current liquidity ratio indicate?

Answer 17

The business has sufficient current assets to maintain normal business operations and pay their current liabilities

Question 18

What does a low current liquidity ratio indicate?

Answer 18

Inability to meet short-term debts in an emergency

Question 19

What does the acid-ratio test show?

Answer 19

Whether the entity could pay its current liabilities if they came due immediately

Question 20

What are the limitations of financial statement analysis?

Answer 20

Different accounting policies results in misleading comparisons

Historical cost data distorts comparisons

Performance criteria/yardsticks are not appropriate for all types of industries

Comparisons using rations need to consider some factors

A single ratio provides limited information

Estimated such as:
Allowance for doubtful debts
Depreciation expense
Cost of warranties

Question 21

What does the return on capital employed measure?

Answer 21

The business’ ability to generate profit form operations from the total amount of capital used

Question 22

What does the operating profit margin measure?

Answer 22

The business’ ability to convert its sales revenue into profit from operations, therefore after operating expenses have been deducted

Question 23

What does the gross profit margin measure?

Answer 23

The business’ ability to convert its sales revenue into gross profit, therefore after operating expenses have been deducted

Question 24

What does operating expenses to sales measure?

Answer 24

The proportion of sales revenue consumer by operating expenses