module 6 Flashcards
horizontal analysis
compares reported numbers in different reporting periods to highlight the magnitude and significance of changes.
- able to make comparisons easily
horizontal analysis (dollar change)
current period’s number - previous period’s number
horizontal analysis (percentage change)
Current period’s number – Previous period’s number/Previous period’s number
* 100
vertical analysis
- 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
anchor item
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)
ratio analysis
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
ratio analysis process (3 steps)
- Calculate a meaningful ratio by expressing $ amount of an item by $ amount of another item.
- Compare the ratio with a benchmark.
from previous years
from budget (forecast)
from comparative entities or
from industry averages. - Interpret the ratio and seek to explain why it differs to benchmark.
major categories of ratio analysis (4 categories)
- Profitability → measures success in wealth creation (return on assets & equity)
- Asset efficiency → measures the effectiveness of an entity in using its assets to generate revenue
- Liquidity → measures short term financial risk
- Capital structure → measures long term financial risk (overall debt vs. equity finances)
ROA purpose
Reflects the results of entity’s ability to:
- convert sales revenue into profit.
- generate income from its asset investments.
ROA sentence layout
for every 1$ of assets, the entity gets x cents of profit
HIGHER = BETTER
gross profit margin ratio purpose
Reflects a business’ ability to convert per sales dollar into GP
gross profit margin sentence layout
for every 1$ of sales rev, the b can get x cents of gross profit
HIGHER = BETTER
gross profit margin equation
(sales - COGS)/sales rev
profit margin ratio purpose
reflects a business’ ability to convert sales rev into profit after tax
HIGHER = BETTER
asset turnover purpose
- 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)
asset turnover sentence structure
for every 1$ of assets, can generate x times more sales rev.
HIGHER = BETTER –> leads to higher ROA ratio
breakdown of ROA into 2 ratios + why we might do it
Profit margin equation *(Asset turnover equation)
- Able to make a better assessment on what’s impacting your return on assets
breakdown of ROA into 2 ratios gives insights on:
- how a company operates
2. can suggest strategies for improvement
how can a company improve ROA?
- 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 - decreasing the investment in assets (decrease the denominator) without reducing sales volume. this will increase the asset turnover.
days inventory ratio purpose
indicates the average period of time it takes to sell inventory. Short or long?
SHORTER = BETTER
times inventory turnover purpose
indicates the number of times that inventory is sold per year
GREATER = BETTER
days debtors ratio purpose
indicates average period of time it takes to collect the money from its trade related accounts receivable.
days debtors equation
AR / sales rev *365
times debtors ratio purpose
indicates the number of times debtor (accounts receivable) is paid per year
what does the survival of an entity depend on?
its ability to pay its debts when they fall due (its liquidity)
EVALUATE:
- are their assets liquid enough?
- AR = more liquid than inventory
working capital purpose
An entity must have sufficient working capital to satisfy its short-term requirements and obligations.
CA - CL = working capital
why is excess working capital undesirable?
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
current ratio purpose
- working capital ratio
indicates $ of current assets per $ of current liabilities.
HIGHER = BETTER
quick ratio (acid-test) purpose
- 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
current ratio sentence layout
for every 1$ of CL, the b has x cents to meet every dollar of CL.
entity’s capital structure
the proportion of debt financing relative to equity financing, and reflects the entity’s financing decision.
financial flexibility
is the ability of an entity to adapt to change
analysis of capital structure
- Assess a business’ long-term flexibility
* Too much existing debt reduces flexibility. - Assess financial risk:
* long-term debts incur INTEREST
* Too much INTEREST expense → greater level of financial risk
capital structure ratio purpose
- 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%
debt to equity ratio sentence structure
For every 1$ of equity finance employed, you have employed x cents of debt
interest coverage ratio purpose
Indicates the level of comfort that a business has in meeting interest expense
(assesses a b’s financial risk –> inversely related)
HIGHER = BETTER
interest coverage ratio rule of thumb
should be GREATER than 3:1
- more EBIT = BETTER –> covers financial costs
limitations of ratio analysis
- each b has different accounting policies (such as depreciation) –> leads to different profit values
- quality of financial statements –> certain data may not be disclosed
- balance sheet is just one day of a year –> may not be representative of the entire year
net financial costs equation
total interest expense - total interest income
profitability ratios
- gross profit margin ratio
- profit margin ratio
- ROA
efficiency ratios
- asset turnover ratio
- days inventory ratio
- days debtors
liquidity ratios
- working capital ratio
- current ratio
- quick ratio
capital structure/gearing ratios
- debt ratio
2. interest cover ratio
