Interpruting Financial Statements

Question 1

Name the 7 profitability and efficiency ratios?

Answer 1

1. Gross Profit Percentage (%)
2. Operating Profit Percentage (%)
3. Expenses/Revenue Percentage (%)
4. Asset Turnover (Net Assests)
5. Return on Capital Employed (ROCE)
6. Asset Turnover (Non-current Assets)
7. Return on Shareholders’ Funds

Question 2

Why are gross and operating profit percentages used?

Answer 2

• They are used to make pricing decisions
• Increased sales prices relative to direct costs will result in increased profit margin
• Decreasing margins may be due to increased costs or reduced sales prices - perhaps an increased market share
• Differences in both margins allow you to estalish if the changes are direct or casued by overheads.

Question 3

Why is Expenses/Revenue percentage used?

Answer 3

• Measures a specified expense as a percentage of revenue
• A rise could indicate a problem with cost control, as not all expenses are expected to rise in line with revenue.

Question 4

What does Asset Turnover (Net Assets) show?

Answer 4

• Measures the turnover generated for every £1 of Assets employed.
• Helps assess how efficiently a company utilises its assets to generate revenue.
• A higher ratio indicates better asset utilisation and operational efficiency.
• A lower ratio may suggest potential inefficiencies that require attention.

Question 5

Why is Return on Capital Employed (ROCE) used?

Answer 5

• To show how much profit is generated for every £1 of assets employed.
• Assess a company’s profitability and efficiency in generating returns relative to the capital invested/assets in the business.
• A higher ROCE indicates that the company is generating greater profits per unit of capital employed, suggesting efficient use of resources.
• A consistently high ROCE indicates a sustainable business model and effective capital allocation strategies.

Question 6

What does the Asset Turnover (Non-current Assets) show?

Answer 6

• The return generated per £1 of Non-current Assets.
• Measures a company’s efficiency in generating revenue relative to its non-current assets.
• A higher ratio indicates the company is effectively utilizing its long-term assets to generate sales
• A lower ratio suggests that the company may not be efficiently utilizing its non-current assets to generate revenue

Question 7

What does the Return on Shareholders’ Funds (ROSF) show?

Answer 7

• The return generated per £1 of shareholders’ equity.
• Measures the profitability of a company relative to the funds provided by shareholders.
• A higher ROSF indicates efficient utilisation of shareholders’ funds and effective management of the company’s resources.
• A higher ROSF indicates better returns on shareholders’ investments, which enhances shareholder value and can attract potential investors.

Question 8

What are the 2 liquidity ratios?

Answer 8

1. Current Ratio
2. Quick Ratio

Question 9

What does the Current Ratio indicate?

Answer 9

• Used to evaluate a company’s short-term liquidity and its ability to meet its short-term financial obligations.
• Short-Term Solvency: assesses the company’s ability to cover its short-term liabilities with its short-term assets.
• Stability: A healthy Current Ratio signifies that the company has a cushion of current assets to handle unexpected expenses or disruptions in cash flows.
• Inventory and Receivables Management: A high Current Ratio may indicate excessive levels of inventory or outstanding receivables, while a low ratio may suggest inventory shortages or delays in collecting receivables

Question 10

What does the Quick Ratio show?

Answer 10

• Used to evaluate a company’s short-term liquidity and its ability to meet its immediate/near-term financial obligations without relying on inventory.
• It’s a more stringent measure of liquidity compared to the Current Ratio because it excludes inventory, which may not be easily converted into cash.
• Ability to Cover Short-Term Liabilities:: measures the company’s ability to cover its short-term liabilities with its most liquid assets, such as cash or cash equivalents, and accounts receivable.
• Risk Management: A higher Quick Ratio indicates a stronger liquidity position and suggests that the company has a sufficient buffer of liquid assets to meet its short-term obligations.

Question 11

What are the 4 Use of Resources ratios?

Answer 11

1. Inventory holding period and turnover
2. Receivable’s collection period
3. Payable’s payment period
4. Working capital cycle

Question 12

What are the 2 Financial position ratios?

Answer 12

1. Gearing
2. Interest cover

Question 13

Explain Gearing?

Answer 13

• Shows the percentage of a company’s capital structure that is funded by debt compared to equity
• Indicates the reliance on borrowing to finance operations.
• Financial Risk Assessment: Gearing helps assess the company’s financial risk and solvency by evaluating its debt levels relative to equity. High Gearing means a reliance on debt financing, which can increase returns and financial risk
• Investment Decision Making: Investors, creditors, and management use gearing ratios to evaluate the company’s risk profile, financial health, and strategic decision-making.
• Capital Structure Management: Gearing influences decisions regarding capital structure, dividend policy, and investment priorities. High Gearing results in greater interest charges and less profits for shareholders.

Question 14

What does the Interest Cover show?

Answer 14

• A company’s ability to meet its interest charges from its operating profit.
• Risk of Default: A higher Interest Cover ratio signifies a lower risk of default on debt payments
• Lender Confidence: Lenders and creditors use the Interest Cover ratio to assess the company’s creditworthiness and ability to repay its debts.
• Operating Performance: The Interest Cover ratio provides insights into the company’s operating performance and profitability.

Question 15

What are the 5 limitations of ratio analysis?

Answer 15

1. Hisorical information - all financial statements are based on historical information
2. Comparison to other companies - you aren’t comaparing on a like for like basis
3. Window dressing - a comapny can acomplish things at the year end or at the start of the new year, which can skew the ratios.
4. Non financial information - no consideration of the qualitative impacts of the business.
5. Markets and Size - similar companies have different market sizes making their ratios harder to compare.

Question 16

Gross Profit Percentage

Equation

Answer 16

(Gross Profit / Revenue) X 100

Question 17

Operating Profit Percentage

Equation

Answer 17

(Operating Profit / Revenue) X 100

Question 18

Expenses/Revenue Ratio

Equation

Answer 18

(Operating Expenses / Revenue) X 100

Question 19

Asset Turnover (Net Asset)

Equation

Answer 19

Revenue / (Total Assets - Current Liabilities)

Question 20

Return on Capital employed (ROCE)

Equation

Answer 20

(Operating Profit / Total Assets - Current Liabilities) X 100

Question 21

Asset Turnover (Non-current Assets)

Equation

Answer 21

Revenue / Non-current Assets

Question 22

Return on Shareholders’ funds

Equation

Answer 22

(Profit after Tax / Total Equity) X 100

Question 23

Current Ratio

Equation

Answer 23

Current Assets / Current Liabilities

Question 24

Quick Ratio

Equation

Answer 24

Current Assets - Inventory / Current Liabilities

Question 25

Inventory Holding Period

Equation

Answer 25

(Inventories / COS) X 365

Question 26

Receivable’s Collection Period

Equation

Answer 26

(Trade Receivables / Revenue) X 365

Question 27

Payables Payment Period

Equation

Answer 27

(Trade Payables / COS) X 365

Question 28

Working Capital Cycle

Equation

Answer 28

Inventory Days + Receivable days - Payable days

Question 29

Gearing

Equation

Answer 29

(Non-current Liabilities / (Equity + Non-current Liabilities)) X 100

Question 30

Interest Cover

Equation

Answer 30

Operating Profit / Finance Costs