Past Papers

Question 1

Gross profit margin

Answer 1

GPM = (Sales - COGS)/Sales

A metric analysts use to assess a company’s financial health by calculating the amount of money left over from product sales after subtracting the cost of goods sold.

Question 2

Gross profit margin Pros

Answer 2

• Easy to calculate and indicates the financial health of a company
• The base for calculation of other ratios
• Acts as a guideline for companies in adjusting the price to earn maximum profit.
• Useful tool to measure performance against competitors.

Question 3

Gross profit margin Cons

Answer 3

• Excludes indirect costs
• Not a good benchmark for industry comparisons as there is variance in cost structure and profit determination between industries.
• Measures only profitability and ignores other factors.
• Cost of materials may vary with industry valuation method.

Question 4

Operating profit margin

Answer 4

Operating income/Revenue x 100

Shows a company’s ability to manage its indirect costs

Question 5

Operating profit margin Pros

Answer 5

• Facilitates understanding of profit trends across periods more efficiently
• Indirect costs influence the bottom line so should not be excluded.

Question 6

Operating profit margin cons

Answer 6

• Not a measure of financial value or cash flow.
• Depreciation and other non-cash expenditures are included in profit.
• It excludes changes in working capital and capital expenditures.

Question 7

Operating income

Answer 7

• Operating income = Gross income - Operating expenses
• Operating income is the amount a company generates from its core operations, meaning it excludes any income expenses not directly tied to the core business.

Question 8

Operating income Pros

Answer 8

Helpful for investors as it doesn’t include taxes and other one off items that might skew profit or net income.

Question 9

Operating income cons

Answer 9

A company can still have high operating income and lose money - due to interest and taxes.

Question 10

EPS

Answer 10

• (Net income - Preferred Dividends)/ (End of period common shares outstanding)
• An indicator of a company’s profitability. The higher a company’s EPS, the more profitable its considered to be.
• EPS indicates how much money a company makes for each share value of its stock and is a widely used metric for estimating corporate value.
• A higher EPS indicates greater value because investors will pay more for a company’s shares if they think the company has higher profits relative to its share price.

Question 11

EPS Pros

Answer 11

Used for P/E ratio

Use it to choose stocks to purchase

Question 12

EPS Cons

Answer 12

• Can’t directly compare EPS as an investor as ordinary shareholders do not have direct access to the earnings.
• Its possible to inflate the EPS
• Changing accounting policy for reporting earnings can also change EPS.
• EPS does not take into account the price of the share, so it has little to say about whether a company’s stock is over or undervalued.

Question 13

EPS - Explain difference between diluted and basic versions

Answer 13

Basic EPS does not factor in the dilutive effect of shares that could be issued by a company. When the capital structure of a company includes stock options etc. it could increase the total number of outstanding shares.

Diluted EPS will always be equal or lower than basic EPS because it includes a more expansive definition of the company’s shares outstanding.

Question 14

Total Asset Turnover

Answer 14

• Asset Turnover = Total Sales / ((Beginning Assets + Ending Assets)/2
• Used as an indicator of the efficiency with which a company is using its assets to generate revenue.
• The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets.

Question 15

Total Asset Turnover Pros

Answer 15

Can be used to compare similar companies in the same sector or group

Question 16

Total Asset Turnover Cons

Answer 16

Different sectors have different asset turnover ratios (e.g. retail is relatively small) so its difficult to compare different sectors.

Question 17

Current ratio

Answer 17

Current Ratio = Current assets / Current liabilities

A liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

Compares current assets to current liabilities.

Question 18

Current ratio pros

Answer 18

Straightforward to calculate

Question 19

Current ratio cons

Answer 19

The current ratio at any one time is just a snapshot, and is therefore not representative of long-term.

Doesn’t factor in accounts receivable or inventory - the current ratio may look acceptable but the company may be headed for default.

Not useful when comparing between industries.

Question 20

Trade payables (days)

Answer 20

Trade payables (days) = (Accounts Payable x Number of Days) / COGS

COGS = Beginning Inventory + Purchases - Ending Inventory

The average time (in days) that a company takes to pay its bills and invoices to its trade creditors, which may include suppliers, vendors or financiers.

Calculates on a quarterly or annual basis and indicates how well the company’s cash outflows are being managed.

Question 21

Trade payables (days) Pros

Answer 21

A company with high trade payable days can delay making payments and use the available cash for short-term investments as well as to increase their working capital and free cash flow.

Question 22

Trade payables (days) cons

Answer 22

A higher TPD could indicate an inability to pay its bills on time.

No clear cut figure of what constitutes a healthy days payable outstanding, as the DPO varies significantly by industry, competitive positioning of the company and its bargaining power. Large companies with a strong power of negotiation are able to contract for better terms with suppliers and creditors.

Question 23

Trade receivables (days)

Answer 23

Trade receivables (days) = (Trade receivables/Sales) x 365

Focuses on the time it takes for trade debtors to settle their bills.

A high figure (more than industry average) may suggest general problems with debt collection or the financial position of major customers.

Question 24

Trade receivables (days) pros

Answer 24

Straightforward to calculate

Question 25

Trade receivables (days) cons

Answer 25

Varies between industries. Can’t compare between industries.

Companies of different sizes often have very different capital structures which can greatly influence calculations.

Difficult to tell the cause. A high ratio might indicate a company’s collection of receivables is efficient, it might indicate a company operates on a cash basis or it might indicate the company is conservative when it comes to extending credit to its customers.

Can vary throughout the year

Question 26

Inventory days

Answer 26

(Average inventory / COGS) x 365

Average inventory = (Beginning Inventory + End Inventory)/2

Indicates the average time in days that a company takes to turn its inventory into sales.

Used to determine the efficiency of sales.

Question 27

Inventory days pros

Answer 27

Managing inventory levels is vital for most businesses and is especially important for retail companies or those selling physical goods. Inventory days is one of the best indicators of a company’s level of efficiency at turning over its inventory.

Question 28

Inventory days cons

Answer 28

Varies between industries - difficult to compare.

Exact recommended inventory days varies for different industries - generally considered to be between 30-60 days.

Question 29

P/E ratio

Answer 29

P/E = Share price / Earnings per share

The ratio for valuing a company that measures its current share price relative to EPS.

Question 30

P/E ratio pros

Answer 30

Can be used to compare companies but also compare the same company against its own historical record.

Helps determine whether a stock is under or over valued.

Question 31

P/E ratio cons

Answer 31

Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.

Question 32

Operating cycle

Answer 32

= (days inventory outstanding) + (days sales outstanding) - (days payable outstanding)

DIO = Average inventory / COGS per day

Average inventory = (beginning inventory + ending inventory)/2

DSO = Average AR/Revenue per day

Average AR = (begining AR + ending AR) /2

DPO = Average AP/COGS per day

The average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods.

A company with an extremely short operating cycle requires less cash to maintain its operations and so can still grow while selling at relatively small margins.

A shorter operating cycle means a company is healthier

Question 33

Operating cycle pros

Answer 33

Measures how efficiently a company’s managers are managing its working capital.

Used to see how long a company’s cash remains tied up in operations.

Question 34

Operating cycle cons

Answer 34

On its own it doesn’t mean very much - it should be used to track a company over time and to compare to competitors.

Less relevant in different industries e.g. consulting

Question 35

EBIT margin

Answer 35

EBIT/Revenue x 100

A measure of a company’s profitability by dividing EBIT by revenue.

Shows how much of each dollar of revenue was converted into profit

Question 36

EBIT margin pros

Answer 36

Tells you how profitable a company is compared to its sales

Takes into account a company’s ability to generate profits from its operations.

Useful metric for comparing different companies and industries

Question 37

EBIT margin cons

Answer 37

EBIT margin does not take into account the company’s capital structure or its cost of capital. This means that a company with a high debt-to-equity ratio could have a high EBIT margin but still be in a weak financial position.

Does not account for a company’s tax liabilities, which could be significant.

Does not necessarily reflect the company’s underlying profitability or cash flow. Important to use a variety of metrics.

Question 38

Quick ratio

Answer 38

(Cash + Marketable securities + Accounts receivable)/Current liabilities

OR

(current assets - inventory - prepaid assets)/ current liabilities

Indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets.

Also called Acid Test Ratio.

Indicates the company’s ability to instantly use its near-cash assets to pay down its current liabilities.

A result of 1 is considered to be a normal quick ratio.

Less than 1 may not be able to fully pay off its current liabilities in the short term

Higher than 1 can instantly get rid of its liabilities.

Question 39

Quick ratio pros

Answer 39

More conservative measure than current ratio (which includes all current assets as coverage for current liabilities).

Question 40

Quick ratio cons

Answer 40

Offer insight into the viability and certain aspects of a business, but it does not provide a complete picture.

Question 41

Share price

Answer 41

P/E, P/B (price to book), Price to earnings growth, dividend yield

Question 42

Share price pros

Answer 42

A stock’s price doesn’t necessarily explain its value. Important to analyze further with ratios.

Question 43

Share price cons

Answer 43

Any singular ratio is too narrowly focussed to stand alone, so combining these and other financial ratios gives a more complete picture.

Question 44

Effective tax rate

Answer 44

Total Tax / Earnings before taxes

The percent of their income that a corporation pays in taxes.

The effective corporate tax rate is the rate they pay on their pre-tax profits.

Question 45

Effective tax rate pros

Answer 45

Straightforward to calculate using income statement

Question 46

Effective tax rate cons

Answer 46

Typically considers income taxes and doesn’t consider other taxes e.g. property tax

Question 47

Return on total assets (ROTA)

Answer 47

ROTA = EBIT/Average Total Assets

Ratio that measures a company’s EBIT relative to its total net assets.

Indicator of how effectively a company is using its assets to generate earnings.

Question 48

Return on total assets (ROTA) pros

Answer 48

Easy to calculate

Easy to compare to similar organisations.

Question 49

Return on total assets (ROTA) cons

Answer 49

Over time, the value of an asset may diminish or increase. In the case of real estate, an asset may rise. Assets can also depreciate.

Assets may be understated to actual market value.

If debt is used to buy an asset, ROTA may look favourable whie the company may actually be struggling with its interest expense payments.

Question 50

How to disaggregate ROTA

Answer 50

Split into EBIT margin and Asset turnover (Sales/Total assets)

SPlitting into sub-parts gives us an insight into what happened during the period.

Disaggregation allows us to keep asking more detailed and specific questions until we have an understanding of the events and conditions that led to the performance that occurred.

Question 51

Return on equity (ROE)

Answer 51

ROE = Net Income / Average Shareholders Equity

A measure of financial performance. A gauge of a corporation profitability and how efficient it is in generating profits.

What is considered a good ROE will depend on industry and competitors.

Question 52

Return on equity (ROE) pros

Answer 52

Can be used to estimate sustainable growth rates and dividend growth rates.

Question 53

Return on equity (ROE) cons

Answer 53

Will vary based on the industry the company operates in.

A high ROE might not always be positive - could indicate inconsistent profits or excessive debt.

Question 54

Direct material price variance

Answer 54

(AP - SP) x AQ

The cost of the difference in price from what was planned

Materials purchased for less/more than the standard price.

Question 55

Direct material quantity variance

Answer 55

(AQ - SQ) x SP

This shows us how different our material costs were from planned given that we used a different quantity of inputs than planned.

More material has been used in the production process than needed.

Question 56

Total direct labour cost variance

Answer 56

Labor efficiency variance + labor price variance

The effect on cost of the difference in wages

Differences in wages or hours worked

Question 57

Direct labour rate variance

Answer 57

(AW - SW) x AH

The effect on cost of the difference in wages

HR negotiate lower wages

Question 58

Direct labour efficiency variance

Answer 58

(AH-SH) x SW

This shows us how different out labour costs were from planned given that labour hours were different from what was planned.

Production department less/more efficient at utilizing the abilities of its workers.

Question 59

Accounting treatment of research and development expenditure under IFRS

Answer 59

In IFRS all research spending is expensed each year. However, development costs are capitalized once the “asset” being developed has met requirements to signal the investment is likely to either be brought to market or sold.

Question 60

Accounting treatment of research and development expenditure under IFRS - Positives

Answer 60

Successful R&D is capitalized on the balance sheet, as opposed to expensed. Without capitalizing R&D, a firm’s earnings can be materially understated because the traditional calculation of Net Income does not recognise the firm’s material investments in R&D as part of its operating investments. This violates one of the core principles of accounting - expenses should be recognized in the period when the related revenue is incurred

Question 61

Accounting treatment of research and development expenditure under IFRS - Negatives

Answer 61

Provides more opportunity for the application of judgment, and adds to the risk of distortion of financial statements.

Question 62

Accounting treatment of research and development expenditure under US GAAP

Answer 62

Most R&D costs are expensed in the present financial period. Whenever a company spends any funds on R&D activities, it must record those costs under the current financial period. Costs typically incurred include equipment and materials, and these must all have no other purpose in the company aside from R&D.

Question 63

Accounting treatment of research and development expenditure under US GAAP - Positive

Answer 63

Less opportunity for judgement.

Question 64

Accounting treatment of research and development expenditure under US GAAP - Negative

Answer 64

Can create a lot of volatility in profits/losses for many companies.

Can create a difficulty in measuring their rates of return on assets and investments. A lack of R&D capitalization could mean that their total assets or their invested capital do not properly reflect the amount that has been invested into them. As a result, there can be an impact on a company’s ROA and ROIC

Question 65

Earnings Quality

Answer 65

A measure of how reliable a company’s earnings are for assessing a company’s current and future performance.

A company’s real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew numbers.

Quality of earnings is the % of income that is due to higher sales or lower costs.

Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earnings.

The more closely a company sticks to GAAP, the higher its quality of earnings is likely to be.

Measures of earnings quality: cash conversion ratio, accruals ratio

Question 66

Earnings Quality - Why is it important

Answer 66

An increase in net income without a corresponding increase in cash flow from operations is a red flag.

Due to numerous accounting standards it is possible to manipulate earnings to serve the company’s needs. Companies that manipulate earnings are said to have low earnings quality.

Earnings quality drives expectations of future earnings and cash flows - low earnings quality will generally result in lower expectations

of future earnings and cash flows relative to current earnings.

Earnings quality is critical for credit analysis, deal diligence (e.g. M&A, LBO, IPO)

If earnings quality assessment provides evidence that earnings are being manipulated by management this will raise corporate governance concerns.

Question 67

ROI

Answer 67

(Net profit/ cost of investment) x 100

Determines gain or loss of an investment as a % of the cost

Internally, for individual projects or investments

Question 68

Net Present Value

Answer 68

(Today’s value of expected cash flows) - (Today’s value of inves

Calculate today’s value of expected future cash flows

Internally, for individual projects or investments

Question 69

Internal Rate of return

Answer 69

NPV = 0

Determines the % rate of return at which the cash flow of a project will break even

Internally, for individual projects or investments

Question 70

Return on Equity (ROE)

Answer 70

Net income / Shareholder equity

Measures the profitability of a corporation

Externally, by investors to understand how much money they’re getting

Question 71

Return on Assets (ROA)

Answer 71

Net income/ Average total assets

Determines how profitable a company is relative to its assets

Internally, by managers to measure efficiency, particularly in industrial and manufacturing industries.

Question 72

Return on Capital Invested (ROIC)

Answer 72

NOPAT/Invested Capital

Measures the % return that a company earns on invested capital

Externally, by investors to evaluate what they’re likely to get as dividends, since it is based on after-tax figures

Question 73

Return on Capital Employed (ROCE)

Answer 73

EBIT/ Capital Employed

Determines how well a company is generating profits from its capital employed

Internally by the company, since it is based on pre-tax figures and can be used to assess the ability of managers to efficiently use capital.

Question 74

Why are return measures important?

Answer 74

Evaluating potential investments

Gauging the success of existing projects

Monitoring business performance as a whole

Ensure viability and effectiveness

Question 75

EBIT

Answer 75

Earnings before interest and taxes

Net Income + Interest + Taxes

OR
Revenue - COGS - Operating Expenses

Question 76

EBIT

Adv

Answer 76

Indicates a company’s profitability.

By ignoring taxes and interest expenses, EBIT focuses on a company’s ability to generate earnings from operations

Question 77

EBIT

Disadv

Answer 77

Depreciation is included in the EBIT calculation and can lead to varying results when comparing companies in different industries.

EBIT removes interest expense and thus inflates a company’s earnings potential, particulalry if the company has substantial debt.

Question 78

EBITDA

Answer 78

Earnings Before Interest, Taxes, Depreciation and Amortization.

EBIT + Depreciation + Amortization

Or

Net Income + Interest + Dep + Amor

Question 79

EBITDA Adv

Answer 79

Measure of a company’s overall financial performance.

Can be used to compare companies against each other and industry averages.

Question 80

EBITDA Disadv

Answer 80

Can be misleading because it does not reflect the cost of capital investments like PPE.

Its a non-GAAP measure

Ignores costs of assets

Ignores working capital.

Question 81

Net Income

Answer 81

Sales - COGS

Question 82

Net Income Adv

Answer 82

Used to calculate EPS

Question 83

Net Income disadv

Answer 83

Doesn’t include depreciation, amortization etc.

Question 84

Off balance sheet assets and liabilities

Answer 84

Assets or liabilities that do not appear on a company’s balance sheet.

Prior to a change in accounting rules, operating lease was one of the most common off-balance items.

Question 85

Off balance sheet assets and liabilities ADV

Answer 85

Can be used to keep debt-to-equity and leverage ratios low, facilitating cheaper borrowing and preventing bond covenants from being breached.

Question 86

Off balance sheet assets and liabilities DISADV

Answer 86

Difficult to identify and track within a company’s financial statements because they only appear in accompanying notes.

Not intended to be deceptive, but can be misused.

Question 87

Operating Lease (OBS)

Answer 87

The company leasing the asset only accounts for the monthly rental payments and other fees associated with the rental rather than listing the asset and corresponding liability on its balance sheet. At the end of the lease term, the lessee generally has the opportunity to purchase the asset as a drastically reduced price.

Feb 2016 - FASB (issuer of GAAP) - changed the rules.

Under GAAP - OBSF should be disclosed in the notes of financial statements.

Question 88

Market-based and negotiated transfer prices

Answer 88

• Transfer price is the price at which related parties transact with each other.
• Transfer prices may be used between a company and its subsidiaries, or between divisions of the same company in different countries.
• Transfer prices that differ from market value will be advantageous for one entity, while lowering the profits of the other entity.
• A transfer price arises for accounting purposes when related parties, such as divisions within a company or a company and its subsidiary, report their own profits. When these related parties are required to transact with each other, a transfer price is used to determine costs. Transfer prices generally do not differ much from the market price. If the price does differ, then one of the entities is at a disadvantage and would ultimately start buying from the market to get a better price.
• Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing among related entities. Regulations enforce an arm’s length transaction rule that states that companies must establish pricing based on similar transactions done between unrelated parties. It is closely monitored within a company’s financial reporting.
• Intercompany transfers done internationally have tax advantages, which has led regulatory authorities to from upon using transfer pricing for tax avoidance.
• Transfer pricing can prevent supply chain issues and result in cost savings (compared to market prices).
• Market prices are based on supply-demand relationships, whereas transfer prices may be subject to other organizational forces.

Question 89

Break even analysis

Answer 89

Determine a variable cost per unit

Determine fixed costs

Determine unit selling price

Fixed costs/(Sales price per unit - Variable cost per unit) = BE

Question 90

How to calculate depreciation

Answer 90

• Depreciation accounts for decreases in the value of a company’s assets over time.
• Depreciation allows a business to deduct the cost of an asset over time rather than all at once.
• Four methods under GAAP:
  
  • Straight-line
  • Declining balance
  • Sum-of-the-years digits (not important)
  • Units of production (not important)
• The best method for a business depends on size and industry, accounting needs and types of assets purchased.
• Straight line depreciation:
  
  • (Cost of asset - salvage value)/useful life
• Declining balance
  
  • Type of accelerated depreciation used to write off depreciation costs earlier in an assets life and to minimize tax exposure.
  • Fixed assets depreciate more so early in life rather than evenly over their entire estimated useful life.
  • Used if an asset is expected to lose greater value or have greater utility in earlier years.
  • Helps to create a larger gain when the asset is sold.
  • Current book value x depreciation rate

Question 91

Accumulated depreciation

Answer 91

Accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life.

The matching principle under GAAP dictates that expenses must be matched to the same accounting period in which the related revenue is generated.

Question 92

Effect of disposing of an asset on reported income before tax expense

Answer 92

• When an asset set for disposal is sold, depreciation expense must be computed up to the sale date to adjust the asset to its current book value.
• Compare the cash proceeds received from the sale with the asset’s book value to determine if a gain or loss on disposal has been realized. The gain or loss should be reported on the income statement..
• The asset account and its accumulated depreciation account are removed off the balance sheet when the disposal sale takes place.

Question 93

What is the accruals concept?

Answer 93

• Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold or expenses are recorded as incurred before the company has paid for them.
• In other words, the revenue is recognized on the company’s accounts regardless of when cash transactions have occurred.
• Alternative - cash accounting. Cash accounting only records the revenue when the cash transaction has occurred for the goods or services.
• Benefits:
• Provides a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement.

Question 94

How is depreciation an application of accruals

Answer 94

• In accrual basis accounting, when your business purchases a long-lived asset, such as a vehicle, you don’t immediately write off the full cost as an expense. Rather, you spread the cost over the expected life of the asset, an accounting procedure known as depreciation.
• You do this to adhere to accrual accounting fundamental “matching principle”, in which you match expenses to the revenue generated by those expenses.

Question 95

Why do some people ignore depreciation (e.g for EBITDA)

Answer 95

• Warren Buffett - “Does management think the tooth fairy pays for capital expenditures?”
• Depreciation and Amortization expenses are not an actual cash outflow. Therefore by not including it, it does not reduce the company’s total assets.
• EBITDA is a way to overstate the company’s earnings and thus overstate their value.
• E.g. a company that has no other assets besides PPE will lose value as the assets depreciate. Using EBITDA as a means to value this company is a way to overstate value.

Question 96

Traditional costing system

Answer 96

1. Choose a cost allocation base. Such as direct labour or direct material
2. Calculate the cost allocation rate. To do this, divide the total overhead by the total quantity of the cost allocation base.
3. Apply the overhead to each product. To do this, for each product, multiply the cost allocation rate by the product’s quantity of the cost allocation base.

Question 97

Activity-based costing system

Answer 97

1. Divide overhead cost into cost pools. Each cost pool is a group of costs incurred in the same manner. For example, shipping could be a cost pool.
2. Choose a cost driver for each cost pool A cost driver for shipping could be shipments.
3. Calculate a cost driver rate for each cost driver. To do this, divide the total dollar amount of each cost pool by the total quantity of each cost driver.
4. Apply the overhead from each cost pool to each product. To do this, for each product, multiply the cost driver rate by the quantity of the cost driver.

Question 98

Comparing Traditional and ABC (strengths and weaknesses)

Answer 98

• ABC systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement.
• Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

Question 99

Compare gross margin and EBIT margin - what does it tell us

Answer 99

Gross margin represents the % of total revenue a company has left over, above costs directly related to production and distribution The higher the %, the more financial value-add is produced on each dollar of sales made by the company. If a company’s gross margin is falling, it may look to find ways to cut labour costs, lower costs on acquiring materials or even increase prices.

EBIT margin (or operating margin) additionally subtracts overhead and operational expenses from revenues.

Similarities -

both are representations of how efficiently a company is able to generate profit by expressing it through a per-sale basis.

Higher margins are considered better than lower margins.

Both can be compared between competitiros, but not across different industries.

Differences

EBIT margin is a more significant bottom-line number for investors than gross margin. Comparisons between two companies’ operating margins with similar business models and annual sales are considered to be more telling.

Gross margin is always higher than EBIT margin because there are fewer costs to subtract from gross income.

Gross margin offers a more specific look at how well a company is managing the resources that directly contribute to the production of its goods and services.

Costs such as salaries and negotiation have more room for negotiation, therefore companies scrutinize their operating expenses as a way to increase efficiency and cut costs. Therefore, greater focus on EBIT.

Question 100

Profitability ratios

Answer 100

• Profitability ratios- provide insight into how much profit a company generates and how that profit relates to other important information about the company.
  
  • Gross margin
  • Operating margin
  • Net profit margin
  • EBITDA margin
  • Operating cash flow margin
  • ROA
  • ROE
  • ROIC
  • ROI

Question 101

Liquidity ratios

Answer 101

• Liquidity ratios - how quickly a company can repay its debts. Shows how well company assets cover expenses. Gives an idea of operational efficiency.
  
  • Current Ratio
  • Quick ratio
  • Cash conversion cycle
  • Receivables turnover
  • Inventory turnover
  • Working capital turnover

Question 102

Leverage Ratios

Answer 102

• Leverage Ratios (or Solvency ratios): used by investors ot get a picture of how well a company can deal with its long-term financial implicatiosn.
  
  • Debt to total assets
  • Debt to equity
  • Interest coverage ratio
  • Net income to liabilities

Question 103

Valuation ratios

Answer 103

• Valuation ratios: used for analysing the attractiveness of an investment in a company. The lower the level of the ratio, the more attractive the investment
  
  • Price-to-earnings (P/E)
  • Price to book (P/B)
  • Price to sales (P/S)
  • Price to cash flow (P/CF)

Question 104

How to calculate capital expenditure

Answer 104

Capital expenditure is the amount spent by businesses or corporations to purchase, maintain or improve fixed, tangible assets. This is often also referred to as capital expense and is abbreviated as CAPEX for short.

∆PPE + Current Depreciation = CAPEX

Question 105

Compare return on assets and return on total equity

Answer 105

• Return on equity (ROE) and return on assets (ROA) are two key measures to determine how efficient a company is at generating profits.
• The main differentiator between the two is that ROA takes into account leverage/debt, while ROE does not.
• The way the company’s debt is taken into account is the main difference between ROE and ROA. In the absence of debt, shareholder equity and the company’s total assets will be equal.
• If the company takes on financial leverage, its ROE would be higher than its ROA. By taking on debt, a company increases its assets thanks to the cash that comes in. Assuming returns are constant, assets are now higher than equity and the denominator of the ROA calculation is higher because assets are higher. ROA will therefore fall while ROE stays at its previous level.
• Depending on the company, one may be more relevant than the other—that’s why it’s important to consider ROE and ROA in context with other financial performance metrics.

Question 106

Explain IFRS 16 Leasing

Answer 106

• 1 January 2019
• New requirements eliminate nearly all off balance sheet accounting for lessees and redefine many commonly used financial metrics such as the gearing ratio and EBITDA.
• Major impact on financial statements of lessees of property and high-value equipment.
• If a company has control over, or right to use, as asset they are renting, it is classified as a lease for accounting purposes and, under the new rules, must be recognised on the company’s balance sheet.
• No longer allows for significant financial liabilities to be held off-balance sheet, as permitted for certain types of leases under the previous rules. The objective is to ensure that companies report information for all of their leased assets in a standardised way and bring transparency on companies’ lease assets and liabilities.
• The objective of the change is to make sure that companies all return information for leased items in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities on their operating leases but keep them off the balance sheets, giving a skewed view of their overall financial status.

Question 107

Levered measures of return

Answer 107

Levered ROE is different in the way that it uses a loan to increase its overall profit for that fiscal year rather than depending on investments alone. This approach may best be used for businesses that are starting out if it has not been able to secure enough initial investments to get started, but increasing debt also runs a much greater risk to any business’s profit margin.

If a business has been losing investors due to poor performance, it may get a loan to help maintain or increase its profits; however, it’s always wise to look at the cause of fleeing investors prior to throwing more money at a problem. Rather than taking out a loan to maintain its current operations, a business may be better off downsizing, selling off assets and communicating with its remaining investors to increase overall profit and trust.

Question 108

Unlevered measures of return

Answer 108

Unlevered ROE is a straightforward metric for examining how well a business will profit its investors. Investors and shareholders expect their money to grow with the company, but as with all investments, nothing is without an element of risk.

The decisions a business makes regarding the investments will directly impact the annual ROE, and it is necessary to measure how those investments were used in order to maintain the current investments and to secure new investments for the following year. Without a positive ROE or a greater ROE than its competitors, a business runs the risk of losing investors altogether.

Question 109

Relevance

Answer 109

The values provided must be predictive in nature. Accounting information is relevant to the extent they can predict the possible future moves in business. Predictive accounting information makes it possible for stakeholders to make strategic moves to maximize profits and cut down possible losses in the future.

The values must be confirmatory. Accounting information does not stand alone. They are most times a reflection of general trends in the business. For accounting information to be considered relevant, it must be able to provide feedback on the overall state of the business or organization. It is not just enough for such information to be predictive.

Relevant accounting information must provide helpful information on what has happened in the past, what is currently happening, and what will most likely happen in the nearest future.

Question 110

Reliability

Answer 110

The Financial Accounting Standards Board (FASB) has tried to define reliable information. According to the FASB definition, accounting information is said to be reliable; the descriptions are verifiable as well as representationally faithful. The determine if accounting information is reliable, such information should have all of the following attributes:

Verifiability - similar results can be obtained using other mediums.

Faithful representations - free from error, neutral, complete.

Neutrality - unbiased