Lesson 12: Financial analysis I Flashcards
What is the purpose of Financial Reporting?
The objective of Financial Reporting is to provide information for decision making through its financial statements and other disclosures.
What are the types of Financial Analysis methods?
a) Horizontal analysis
b) Vertical analysis
c) Ratio analysis
What is Horizontal Analysis?
Horizontal analysis refers to examination of financial statement data across time.
What is Vertical Analysis?
This is the comparison of a company’s financial condition and performance to a base amount.
What are the 5 categories of financial ratios?
-Profitability
-Efficiency
-Liquidity
-Solvency
-Investment
What are the factors to consider in evaluating the adequacy of current and quick ratio?
-Type of Business
-Composition of Current assets
-Turnover rate of assets
What are the factors to consider in working capital management?
a) Investments in current assets
b) Investment in Inventory
c) Investment in Receivables
d) Cash and Bank balances
e) Uses of Short term finance
f) Meeting other financial commitments
What does Return on Shareholders’ Equity (ROE) ration measure?
This measures the rate of return on funds invested by ordinary shareholders.
The numerator is profit after tax less any preference dividends as ordinary shareholders are entitled to the residual profit after preference dividends are paid.
What does Profit Margin ratio measure?
It measures the efficiency of operations, i.e. the effectiveness in controlling expenses
What does the Gross Profit Margin ratio measure?
This measures the efficiency of trading operations, effectiveness of pricing policies, and the business’ ability to control manufacturing or purchasing costs.
What are the possible reasons for an increase in Gross Profit Margin?
An increase in Gross Profit Margin may be due to:
Increases in the selling price without a proportionate increases in cost price indicating the business’ ability to command higher prices for its products.
Decreases in cost price without proportionate decreases in the selling price, indicating its ability to control the cost of its products.
Promoting more profitable lines of products and dropping the unprofitable lines.
What are the possible reasons for a decrease in Gross Profit Margins?
A decrease in Gross Profit Margin may be due to:
Reduction in selling prices to generate greater sales volume or in the face of stiff competition.
Increases in the cost price without proportionate increases in selling price.
Reduction of selling prices to dispose of old, damaged or slow moving stock.
Bulk discounts given to major customers.
What does Percentage of operating expenses to net sales revenue measure?
This represents the proportion of sales which goes to covering operating expenses.
It is a measure of the business’ ability to control its operating costs.
What does Rate of Inventory turnover (times) measure?
Rate of inventory turnover measures
the number of times a company sells its average level of inventory during a year.
A faster turnover indicates ease in selling inventory, a low turnover indicates difficulty during a year.
What does the Day-sales-in-inventory (days) measure?
This measures the number of days it takes to sell the stock or the average inventory holding period.
The higher the rate of inventory turnover, the shorter the average stockholding period.
What does rate of accounts receivables turnover measure?
Receivable turnover measures the ability to collect cash from customers.
It tell us how many times during the year average receivables were turned into cash.
In other words, how long debtors take to settle their debt.
The higher the turnover,
the faster the debts are collected.
A low turnover could indicate ineffectiveness in collecting dues from customers.
What does Accounts receivable collection period (days) measure?
This indicates the average number of days it takes for debtors to pay up.
What does Rate of accounts payable turnover (times) measure?
This measures the ability of the business to pay its payables.
It indicates the number of times the company pays its average payables during the year.
A high rate of accounts payable turnover means a business pays its
suppliers very quickly and a low payable turnover means a longer time period for payments to suppliers.
A low turnover means that the
company is slow in paying its creditors due a weak liquidity position and is relying more on short term credit to finance its inventory.
In general, a lower payable turnover is better than a higher one, as the
business is making full use of the credit terms extended by its creditors.
What does the Accounts payable payment period measure?
This measures the number of days it takes to pay its accounts payables.
What does Cash Conversion Cycle / Working Capital Cycle (days) measure?
It measures how long a business takes to sell its inventory, collects payments and make its payments to suppliers.
It represents the number of days a firm’s cash remain tied up within the operations of the business.
It indicates how long a business needs to wait after payment of creditors in order to receive money from the sale of the goods.
It is thus, a measure of how well the
business is managing its working capital.
The lower the cash conversion cycle,
the more healthy a company generally is.
What does the Current Ratio / Working Capital ration measure?
It indicates the extent to which current liabilities are covered by current assets and thus, the firm’s ability to meet its current debts.
In general, the higher the
current ratio, the stronger the financial position as the business has sufficient current assets to maintain its operations.
However, too high a current ratio may mean the business is not utilising its current assets effectively.
What does the Acid test / Liquid test / Quick asset measure?
It measures the ability of the business to meet immediate liabilities with quick assets.
What is the ideal liquidity ratio?
Traditionally, the rule of thumb is that the current ratio should be at least 2:1.
This means that the firm has $2 available in the short term to settle every dollar of short term debt.
However, this rule must not be applied indiscriminately as it also
depends on other factors.
For quick ratio, the rule of thumb is that it should be at least 1:1.
This yard stick must not be rigidly applied as it depends on the nature of the business.
