M2: Financial Statement Analysis & Intro to Management Accounting Flashcards
What is the Purpose of Financial Statement Analysis?
- To compare a company to it’s competitors or to the industry in general
- To understand the overall health of the company
- To evaluate company performance over time
- To estimate the value of the business
In general, financial statement analysis helps with users decision making.
What kind of analysis can we perform on financial statements?
- Horizontal analysis
- Vertical analysis
- Ratio analysis
- Trend analysis
What is horizontal analysis?
Involves comparisons of historical data to compare company data from one period to the next. Ex: did the sales increase or decrease over the past years.
What is vertical analysis?
Involves comparing items on financial statements in relation to each other to analyze the makeup of a company’s assets/liabilities or expenses/income for one year.
What is ratio analysis?
Involves calculating key financial metrics to assess performance over time or performance in comparison to competitors.
What is trend analysis?
Similar to horizontal analysis, the goal is to use historical data from multiple years to make predictions about the future and the company’s future stock price.
How do you measure items on a financial statement using horizontal analysis?
Horizontal analysis compares one line of the financial statement from one year to the next. These amounts can be expressed as an amount or percentage and include the following measures:
- Percentage of base period amount: calculated as the analysis period amount ÷ base period amount.
- Percentage change for the period: calculated as (analysis period amount – prior period amount) ÷ prior period amount.
(how much did my expenses increase or decrease as a percentage as of last period?)
Both of these can be calculated for multiple periods to show a trend.
How do you measure items on a financial statement using vertical analysis?
Vertical analysis is a technique that expresses each item as a percentage of a base amount. The base amount depends on the financial statement in question:
- Balance sheet: base amount could be total assets or total liabilities plus shareholders equity (to figure out which assets make up the biggest % of total).
- Income statement: base amount could be total sales
- Vertical percentage of base amount is calculated as the analysis amount ÷ base amount.
What are the types of ratio analysis? Describe them,.
- Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Will a company be able to pay debts due in coming months? Ex: paying suppliers
- Solvency Ratios: Measure the ability of the company to survive over a long period of time. Will a company be able to pay long term obligations? Ex: paying back loans.
- Profitability Ratios: Measure the operating success of a company for a specific period of time. Is a company more profitable than in the past or more profitable than their competitors?
What type of ratio is a “current ratio”? Describe it.
- It is a liquidity ratio.
- Current ratio: measures the relationship between current assets and liabilities and is calculated as follows:
Current ratio = current assets/current liabilities
A higher current ratio will generally indicate a more liquid company or company more able to pay short term debt.
What type of ratio is a “quick ratio”? Describe it.
- It is a liquidity ratio.
- Quick ratio: measures the relationship between the most liquid assets (below 90 days) and current liabilities and is calculated as follows:
Quick ratio = (current assets – inventory)/ current liabilities.
( first term= How much current assets do i have without having to sell inventory)
A higher quick ratio will generally indicate a more liquid company or company more able to pay short term debt. Here inventory is excluded because for a company to sell all inventory in less than 90 days they would have to compromise on their price.
What type of ratio is a “debt to total assets ratio”? Describe it.
- It is a solvency ratio
- Debt to total assets ratio : used to measure the percentage of total assets that have been financed by a company’s creditors, calculated as follows:
Debt to total assets = Total liabilities/ Total assets
A higher ratio is generally not a good sign, it means the company has a high level of debt.
A higher ratio also means there is a higher risk of not being able to pay debts/interest.
What type of ratio is a “debt to equity ratio”? Describe it.
- It is a solvency ratio
- Debt to equity ratio: used to measure the proportion of the company’s financing that has come from debt, calculated as follows:
Debt to equity = Total liabilities/ Shareholders equity
A higher ratio will mean that a company has used more debt than equity to finance themselves.
However, a higher ratio could mean there is a higher risk of not being able to pay debts/interest.
What type of ratio is a “gross profit margin”? Describe it.
- It is a profitability ratio
- Gross profit margin: indicates a company’s ability to maintain a good selling price above cost of good sold as percentage, calculated as follows:
Gross profit margin = Gross profit/Net sales
Also referred to as % gross margin.
Generally higher is better here.
What type of ratio is a “profit margin”? Describe it.
- It is a profitability ratio
- Profit margin: indicates how profitable a company is as a percentage, so how effective they are at controlling expenses, calculated as follows:
Profit margin = Net income/Net sales
Also referred to as net margin ratio.
Generally higher is better here.
What type of ratio is a “return on assets ratio”? Describe it.
- It is a profitability ratio
- Return on assets ratio: tells you how much net income is earned for every dollar of assets, calculated as follows:
Return on assets = Net income/ Average total assets
Generally higher is better here.Means you are better at using your assets to return income.
What type of ratio is a “return on equity ratio”? Describe it.
- It is a profitability ratio
- Return on equity ratio: Measures the company’s profitability from the shareholders’ viewpoint, it shows how much income was earned for each dollar invested by the shareholders, calculated as follows:
Return on equity = Net income/ Average shareholders equity
Generally higher is better here. Means you are earning more income than what the shareholders invested in the company.
What types of decisions does “management accounting” include?
- How much should I charge for my products?
- Is my product profitable?
- How many products do I need to sell?
- Which costs are important to consider when deciding how much to charge?
In general. They help make decisions within the company.
What is a product cost? What title is it included in in the income statement?
Title in income statement: cost of goods sold
Product costs: these are all the costs required to manufacture or purchase goods to be sold by the company. When incurred, these costs represent inventory on the balance sheet and are then transferred to cost of goods sold on the income statement when sold.
What is a period cost? What title is it included in in the income statement?
Title in income statement: everything that falls under operating expenses (depreciation expense, selling and administrative expenses, employee expenses, other operating expenses).
Period costs: Costs that cannot be linked directly to the production of inventory, these are all other costs that make up the operating expenses section.
What are the 2 types of product costs? What falls into each category?
DIRECT
- Direct materials: the cost of buying and shipping raw materials or the cost of purchasing inventory if the company is a distributor.
- Direct labour: wages and benefits paid to staff for manufacturing the goods.
INDIRECT
1. Manufacturing overhead: these are costs that relate to the manufacturing process but are difficult to link to a specific product/service, so referred to as indirect costs. See next slide.
What costs makes up manufacturing overhead?
Made up of:
- Indirect materials: materials used in production not related to a specific product, such as various supplies.
- Indirect labour: wages and benefits paid to staff involved in production but not working on a specific product, such as a supervisor (“touch test”).
- Other indirect costs: costs other than those above, such as depreciation of machinery, utilities/insurance related to production, etc.
These costs are then allocated to different products based on cost drivers (an area of focus for managerial accounting courses).
What is a cost driver?
Cost driver tells us how we’re going to allocate our manufacturing over head ton our specific product line. Ex: company that sells coffee cups and wine glasses. Company has overhead for insurance of factory. How do i decide how much of that insurance goes to the coffee cups vs wine glasses. A cost driver helps allocate the insurance cost to each of the products for example how much space each production line takes up in the factory or how many hours does it thanks the machines to manufacture the coffee cup vs the wine glass.
Describe the timeline of costs on a balance sheet and an income statement.
Balance sheet:
1. Raw materials purchased
2. Work in process: Raw materials are transformed into work in progress. Direct labour and manufacturing overhead are accumulated throughout the production process.
3. Finished goods: The production process is finished, goods are stored in the warehouse until sold to customers.
Income statement:
4. Cost of good sold: Goods are sold to customers. Revenue is recognized and related inventory is now moved to cost of goods sold on the income statement.