module 6

Question 1

horizontal analysis

Answer 1

compares reported numbers in different reporting periods to highlight the magnitude and significance of changes.
- able to make comparisons easily

Question 2

horizontal analysis (dollar change)

Answer 2

current period’s number - previous period’s number

Question 3

horizontal analysis (percentage change)

Answer 3

Current period’s number – Previous period’s number/Previous period’s number
* 100

Question 4

vertical analysis

Answer 4

• involves comparing the items in a financial statement to an anchor or base item in the same financial statement
• identifies the importance of an item relative to the anchor or base item

Question 5

anchor item

Answer 5

Anything can be the anchor item (typically sales revenue for profitable businesses ← the number you’re trying to reflect of why the company is in business)

Question 6

ratio analysis

Answer 6

an expression of one item in the financial statements in relation to another item in the financial statements
- can be a comparison between two DIFFERENT statements

Question 7

ratio analysis process (3 steps)

Answer 7

1. Calculate a meaningful ratio by expressing $ amount of an item by $ amount of another item.
2. Compare the ratio with a benchmark.
   from previous years
   from budget (forecast)
   from comparative entities or
   from industry averages.
3. Interpret the ratio and seek to explain why it differs to benchmark.

Question 8

major categories of ratio analysis (4 categories)

Answer 8

1. Profitability → measures success in wealth creation (return on assets & equity)
2. Asset efficiency → measures the effectiveness of an entity in using its assets to generate revenue
3. Liquidity → measures short term financial risk
4. Capital structure → measures long term financial risk (overall debt vs. equity finances)

Question 9

ROA purpose

Answer 9

Reflects the results of entity’s ability to:

1. convert sales revenue into profit.
2. generate income from its asset investments.

Question 10

ROA sentence layout

Answer 10

for every 1$ of assets, the entity gets x cents of profit

HIGHER = BETTER

Question 11

gross profit margin ratio purpose

Answer 11

Reflects a business’ ability to convert per sales dollar into GP

Question 12

gross profit margin sentence layout

Answer 12

for every 1$ of sales rev, the b can get x cents of gross profit
HIGHER = BETTER

Question 13

gross profit margin equation

Answer 13

(sales - COGS)/sales rev

Question 14

profit margin ratio purpose

Answer 14

reflects a business’ ability to convert sales rev into profit after tax
HIGHER = BETTER

Question 15

asset turnover purpose

Answer 15

• Shows an entity’s overall efficiency in generating income per dollar of investments in assets.
• How efficient the business uses its total assets (how b manages NC and C assets)

Question 16

asset turnover sentence structure

Answer 16

for every 1$ of assets, can generate x times more sales rev.

HIGHER = BETTER –> leads to higher ROA ratio

Question 17

breakdown of ROA into 2 ratios + why we might do it

Answer 17

Profit margin equation *(Asset turnover equation)

- Able to make a better assessment on what’s impacting your return on assets

Question 18

breakdown of ROA into 2 ratios gives insights on:

Answer 18

1. how a company operates

2. can suggest strategies for improvement

Question 19

how can a company improve ROA?

Answer 19

1. working on the profit margin
   - increasing sales revenue (which should increase profit, so long as the increase in gross profit exceeds the increase in operating expenses), while maintaining the existing asset base;
   increasing the GP% either by increasing selling price or decreasing the cost of inventory, while maintaining sales volume and the existing asset base, or
   controlling operating expenses other than COGS, while maintaining the sales revenue and the existing asset base
2. decreasing the investment in assets (decrease the denominator) without reducing sales volume. this will increase the asset turnover.

Question 20

days inventory ratio purpose

Answer 20

indicates the average period of time it takes to sell inventory. Short or long?
SHORTER = BETTER

Question 21

times inventory turnover purpose

Answer 21

indicates the number of times that inventory is sold per year
GREATER = BETTER

Question 22

days debtors ratio purpose

Answer 22

indicates average period of time it takes to collect the money from its trade related accounts receivable.

Question 23

days debtors equation

Answer 23

AR / sales rev *365

Question 24

times debtors ratio purpose

Answer 24

indicates the number of times debtor (accounts receivable) is paid per year

Question 25

what does the survival of an entity depend on?

Answer 25

its ability to pay its debts when they fall due (its liquidity)
EVALUATE:
- are their assets liquid enough?
- AR = more liquid than inventory

Question 26

working capital purpose

Answer 26

An entity must have sufficient working capital to satisfy its short-term requirements and obligations.
CA - CL = working capital

Question 27

why is excess working capital undesirable?

Answer 27

the funds could be invested in other assets that would generate higher returns (inefficient).

• Not allocating + spending cash efficiently
• Not earning interest in working capital

Question 28

current ratio purpose

Answer 28

• working capital ratio
  indicates $ of current assets per $ of current liabilities.
  HIGHER = BETTER

Question 29

quick ratio (acid-test) purpose

Answer 29

• measures $ of current assets available (excluding inventory) to service each $ of current liabilities.
• Indicates the extent to which a business could pay current liabilities without relying on the sale of inventory

Question 30

current ratio sentence layout

Answer 30

for every 1$ of CL, the b has x cents to meet every dollar of CL.

Question 31

entity’s capital structure

Answer 31

the proportion of debt financing relative to equity financing, and reflects the entity’s financing decision.

Question 32

financial flexibility

Answer 32

is the ability of an entity to adapt to change

Question 33

analysis of capital structure

Answer 33

1. Assess a business’ long-term flexibility
   * Too much existing debt reduces flexibility.
2. Assess financial risk:
   * long-term debts incur INTEREST
   * Too much INTEREST expense → greater level of financial risk

Question 34

capital structure ratio purpose

Answer 34

• Lets you see how extensively a b uses debt
• Shows the % of assets that are financed by liabilities (debt).
• DO NOT WANT RATIO TO EXCEED 60%

Question 35

debt to equity ratio sentence structure

Answer 35

For every 1$ of equity finance employed, you have employed x cents of debt

Question 36

interest coverage ratio purpose

Answer 36

Indicates the level of comfort that a business has in meeting interest expense
(assesses a b’s financial risk –> inversely related)
HIGHER = BETTER

Question 37

interest coverage ratio rule of thumb

Answer 37

should be GREATER than 3:1

- more EBIT = BETTER –> covers financial costs

Question 38

limitations of ratio analysis

Answer 38

1. each b has different accounting policies (such as depreciation) –> leads to different profit values
2. quality of financial statements –> certain data may not be disclosed
3. balance sheet is just one day of a year –> may not be representative of the entire year

Question 39

net financial costs equation

Answer 39

total interest expense - total interest income

Question 40

profitability ratios

Answer 40

1. gross profit margin ratio
2. profit margin ratio
3. ROA

Question 41

efficiency ratios

Answer 41

1. asset turnover ratio
2. days inventory ratio
3. days debtors

Question 42

liquidity ratios

Answer 42

1. working capital ratio
2. current ratio
3. quick ratio

Question 43

capital structure/gearing ratios

Answer 43

1. debt ratio

2. interest cover ratio