Lecture 2 + 3

Question 1

What is a Balance Sheet?

Answer 1

• Presents a snapshot view of the company.

* Attempts to show what the company is worth at a specific moment in time.

Question 2

What are the 3 main differences between profit and loss sheets and balance sheets?

Answer 2

• Profit and loss looks back in time whereas a Balance sheets gives snapshot in time.
• Profit and loss looks at how much money has been made over a period of time.

• Balance sheet attempts to state what the company is
worth at a point in time.

Question 3

What are Profit and Loss accounts?

Answer 3

• review of income and expenditure over the past year.
• gross sales income (i.e. turnover).
• cost of sales (i.e. wages, material costs etc.)
• Income less cost of sales gives a profit figure - but then you need to deduct overheads (indirect costs) and tax etc. to give the true net profit (surplus) figure.

Question 4

What are Cash Flow Statements ?

Answer 4

• shows where money comes from and how it is spent.
• Cash flow is the difference between inflows and outflows – (i.e. the difference between cash receipts from the business operations and the total cash outlays incurred in carrying out these operations).

Question 5

Why would you analyse a companies finances ?

How is this analyses done ? (4 points)

Answer 5

To gain a good understanding of the ‘financial health’:

• Balance sheet – to assess value (net worth) at any given time.
• Profit and loss account – to assess profit making capacity (past performance).
• Cash flow statement – to assess availability of funds to run the business (not subject to loads).
• Business plan and financial forecast – to assess future capability for generating profit and staying competitive

Question 6

2 Main uses for financial ratios ?

Answer 6

• Analyse performance using more than one set of accounts.

* Convenient way to summarise large quantities of data and to compare performance across firms.

Question 7

List and describe the 5 financial ratios typically used ?

Answer 7

• Liquidity ratios - how easily the firm can lay its hands on cash (short term financial position).
• Efficiency/ turnover ratios - measure how productively the firm is using its assets. high ratio = firm working close to capacity.
• Profitability ratios - measure the firms return on its investments.
• Leverage ratios - how heavily the company is in debt.
• Shareholders’ return ratios - return on shareholders equity.

Question 8

What are the 3 types of manipulation ?

Answer 8

• Earnings manipulation: Share prices decline when earnings drop. To drive share prices (and executive bonuses) higher, a variety of techniques are used to manipulate earning.
• Cash flow manipulation: Manipulating the perception of a companies ability to generate cash flow from its operations.
• Key metrics manipulation: Manipulating non generally accepted accounting principle (GAAP) metrics.

Question 9

2 Methods of Earning Manipulation?

3 warning signs?

Answer 9

• Recording revenue too soon
• Recording non-existent revenue

Warning signs:
• Recording revenue before completing obligations.
• Up front revenue recognition on long-term contracts.
• Seller offering extremely generous extended payment terms.

Question 10

1 method of Cash flow manipulation?

3 warning signs?

Answer 10

• Sending all the desirable cash flows to the operating
section and all the unwanted cash flows to the other
sections (finance and investing).

Warning signs:
• Recording bogus Cash Flow From Operations (CFFO) from normal bank borrowing.
• Boosting CFFO by selling receivables before the collection date.
• Disclosures about selling receivables with recourse.

Question 11

2 Methods of Key Metric Manipulations?

3 warning signs?

Answer 11

• Showing misleading metrics to overstate performance.
• Distorting balance sheet metrics to avoid showing deterioration.

Warning signs:
• Changing the definition of a key metric.
• Highlighting a misleading metric as a surrogate for revenue.
• Divergence of trend between Same Store Sales and revenue. Revenue growth fuelled by opening additional stores. Gives little insight into how stores have actually been performing. Same Store Sales is the management metric to address this.

Question 12

What is double entry accounting?

Answer 12

When you make a change to one side, you should change the other. (Balance)

Question 13

With regards to liquidity ratios: describe a current ratio.

Answer 13

Current assets/Current Liabilities

Should be at least 1.5 and not over 3, unless the business is saving resources to launch specific investments or payments in the near future.

Question 14

With regards to liquidity ratios: describe a quick ratio (acid test).

Answer 14

Current assets-Inventory/Current Liabilities

Measures immediate resources of a company against current liabilities.

Question 15

With regards to liquidity ratios: describe a cash ratio

Answer 15

Monitors the company’s most liquid assets. A low cash ratio may not matter if the firm can borrow on short notice

Question 16

What are the 2 shareholder return ratios? (Investment ratios)

Answer 16

Price earnings ratio = market value per share/ return on equity

Dividend yield = dividends per share/ market value per share

Question 17

What are three different types of manipulation?

Answer 17

Earnings - Share prices decline when earnings drop.

Cash flow manipulation - manipulating the perception of a companies ability to generate cash flow from its operations

Key metrics manipulation - manipulating non GAAP metrics

Question 18

Name the 5 ratio analysis types ?

Answer 18

1. Liquidity – the ability of the firm to pay its way
2. Investment/shareholders – information to enable decisions to be made on the extent of the risk and the earning potential of a business investment
3. Gearing – information on the relationship between the exposure of the business to loans as opposed to share capital
4. Profitability – how effective the firm is at generating profits given sales and or its capital assets
5. Financial – the rate at which the company sells its stock and the efficiency with which it uses its assets

Question 19

What is the Acid Test?

Ideal acid test score?

Discuss high and low test scores ?

Answer 19

• Also referred to as the ‘Quick ratio’
• (Current assets – stock) : liabilities
• 1:1 seen as ideal
• The omission of stock gives an indication of the cash the firm has in relation to its liabilities (what it owes)
• A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very healthy!
• A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

Question 20

Define Gearing Ratio ?

What can be said about a high gearing ratio ?

Answer 20

Long term loans/capital employed x 100

The higher, the more exposure to interest rate fluctuations and to interest/loan repayments before being able to reinvest earnings.

Question 21

5 Limitations of Ratio Analysis ?

Answer 21

1. Firm’s industry category is often difficult to identify.
2. Published industry averages are only guidelines.
3. Accounting practises differ across firms.
4. Sometimes difficult to interpret deviations in ratios.
5. Seasonality affects ratios.

Question 22

3 steps in the Financial Framework , Briefly Describe ?

Who is responsible for using the framework and why?

Answer 22

1. Funds needs of the firm:
   - Funding required ? Is there a seasonal component ?
   - Analysed using ‘Sources and Uses Statement’, Statement of Cash Flows, Cash Budgets.

2. Health of a Firm 
Financial Ratios - 
Individually
Over Time 
In combination
In comparison

3. Business Risk of the Firm:
   Risks inherent in the operations of the firm -
   Volatility in sales and costs, Proximity to break-even point.

Financial Manager. They must determine financial needs of the firm.

Question 23

What are the 3 profitability ratios?

Answer 23

Gross profit margin = (Gross profit/ revenue) x 100

Net profit margin = (net profit/ revenue) x 100

Return on Capital Employed (ROCE) = (Profit / capital employed) x 100

Question 24

What are 2 safety ratios ?

Answer 24

Stock turnover = Cost of good sold / average stock

Debtor Days = accounts receivable/ (annual sales/365)