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Financial Reporting & Analysis 2 > Ratio Analysis > Flashcards

Ratio Analysis Flashcards

1
Q

what are some examples of benchmarks ratios can be compared to

A

prior year results
peers results
industry averages

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2
Q

how much can the ratios alone tell you about a company

A

about financial health

but indicates where needs further investigatioj

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3
Q

who are the users of ratios

A

users of financial statement same set

but certain ratios more useful for certain users

e.g. managers look at profitability ratios
lenders/borrowers look at liquidity ratios
investment analysts focus on investment ratios

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4
Q

what are the 3 categories of ratios

A

profitability ratios

liquidity and gearing ratios

investors ratios

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5
Q

what companies do investment ratios apply to

A

publicly listed companies

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6
Q

what do profitability ratios measure

A

how a company uses its assets to generate profitability

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7
Q

what is formula for gross profit margin

A

gross profit / revenue * 100 %

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8
Q

what does gross profit margin measure

A

how well our core operations are running

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9
Q

what could cause fluctuations in gross profit margin

A

change in what you charge

change in what you sell

possible incorrect inventory

change in costs

change in efficiency

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10
Q

what is the formula for operating profit margin

A

operating profit / revenue * 100%

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11
Q

what does operating profit margin measure

A

how we have controlled our overheads

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12
Q

what could cause fluctuations in operating profit margin

A

same as for gross profit margins, these effects will flow down

diminished control over operating costs

once off expenses e.g advertising campaigns, launching into new geographical area

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13
Q

what is the formula for return on capital employed

A

PBIT / (long term debt + equity) * 100%

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14
Q

what does return on capital employed measure

A

compares profit against the capital that was invested to make that profit

i.e. how efficiently they have been with their capital

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15
Q

why might there be fluctuations in ROCE

A

new assets not running at full capacity yet

older machines now have a reduced activity

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16
Q

what is the formula for return on equity

A

profit after tax and preference dividend / total equity * 100%

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17
Q

what does return on equity measure

A

potential return for ordinary shareholders

more relevant for shareholders as after tax and preference dividends = what they are entitled to

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18
Q

what could cause fluctuations in ROE

A

same as ROCE

gearing levels

tax impacts

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19
Q

what is the formula for asset turnover

A

revenue / capital employed

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20
Q

what does asset turnover measure

A

how well assets have worked to generate salesw

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21
Q

what is capital employed

A

equity and interest bearing debt

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22
Q

is it better to have a higher or lower asset turnover

A

higher

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23
Q

what could cause fluctuations in asset turnover

A

new assets bought late in year and no time for assets to generate any enhancement to profits

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24
Q

what is the difference between liquidity and gearing ratios

A

liquidity = ability to meet short term debts

gearing = ability to meet long term debts

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25
Q

what is the formula for current ratio

A

current assets / current liabilities

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26
Q

what does the current ratio measure

A

ability to pay current liabilities out of our current assets

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27
Q

what is the formula for quick ratio

A

(current assets - inventory) / current liabilities

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28
Q

why does quick ratio exclude inventories

A

inventories are the least liquid current asset

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29
Q

what could cause fluctuations in current or quick ratio

A

change in receivables or payables

seasonality

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30
Q

what is the target for current ratio

A

1.5 to 2 : 1

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31
Q

what is the problem with too low of a current ratio

A

cannot pay obligations

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32
Q

what is the problem with too high of a current ratio

A

storage and insurance cost for inventory, risk of it running obsolete

money could be invested and put to better use elsewhere

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33
Q

if a company has no inventories what will the quick and current ratio be

A

the same

34
Q

what is the target for the quick ratio

A

1:1

35
Q

what is the formula for inventory turnover period

A

inventories / cost of sales * 365 days

36
Q

what does inventory turnover period measure

A

number of days inventory held on average before being sold

37
Q

is a higher or lower inventory days better

A

lower

to minimise storage and security costs and risk of inventory running obsolete

as long as it meets customer demand

depends on the industry also

38
Q

what could fluctuations in inventory days indicate

A

poor inventory control
buying too much inventory and not selling enough
low demand

bought in bulk to avail of discount
buffer stock due to unpredictable demand

39
Q

what is the formula for receivables collection period

A

trade receivables / revenue * 365 days

40
Q

what does receivables days measure

A

how long it takes to be paid by our trade receivables

should bear in mind the credit term granted to customers

41
Q

what could fluctuations in receivables days indicate

A

lower is better meaning money comes in quicker

increased/decreased credit terms offered to customers

don’t want credit period to be too low as it will irritate customers to be constantly demanding them for money

could indicate worse/better credit control

42
Q

what is the formula for payables payment period

A

trade payables / purchases * 365 days

43
Q

what does payables days measure

A

how long it takes to pay suppliers

trade payables offer free short term finance but delaying payment risky

44
Q

if there is no purchases figure on the accounts, what figure can be used instead to calculate payables days

A

cost of sales

BUT REMEMBER TO BE CONSISTANT WITH THIS FIGURE WITH THE COMPARATIVE FIGURES

45
Q

what causes fluctuations in payables days

A

changed credit terms

if too low = bad reputation and losing out on potential discounts for paying early

46
Q

what is the formula for debt equity ratio

A

interest bearing debt / equity * 100%

47
Q

what does debt/equity ratio measure

A

long term financial stability and solvency

48
Q

what are the benefits of a high debt equity ratio

A

tax shield of debt

could be increasing to invest in positive NPV projects

48
Q

what are the benefits of a low debt equity ratio

A

wriggle room to borrow more
static

49
Q

what are the risks of a high debt equity ratio

A

solvency risk
could come into difficulty to repay debt

50
Q

why can not every company use debt in their capital structure

A
  1. need a stable history of profits, may be harder for newer companies
  2. to borrow must have tangible assets for collatoral
51
Q

what could cause fluctuations in debt equity ratio

A

share issue/share buyback

repaying or drawing down new debt financing

52
Q

what is the formula for interest cover

A

profit before interest and tax / finance costs

53
Q

what does interest cost cover

A

how many times does our profit cover our interest payments

54
Q

what is the target for interest cover

A

2 +

55
Q

what could cause fluctuations in interest cover

A

factors that influence PBIT

change in interest bearing debt

56
Q

what is the formula for dividend yield

A

dividend per share / share price * 100%

57
Q

what does dividend yield measure

A

what you get back compared to what you put in

i.e. dividend you get compared to price you paid for share

58
Q

what would cause fluctuations in dividend yield

A

changes in dividend paid

changes in share price

some stocks are growth stocks so don’t pay dividends

59
Q

what is the formula for dividend cover

A

profit after tax / dividends

60
Q

what does dividend cover measure

A

compares profit available to be distributed among shareholders vs what was actually paid to shareholders

61
Q

what could cause fluctuations in dividend cover

A

changing profit

pressure to keep dividends year on year to keep shareholders happy

62
Q

what is the formula for earnings per share

A

net profit per year / number of issued shareholders

63
Q

what is the formula for price earnings ratio

A

share price / earnings per share

64
Q

what does price earnings ratio measure

A

shareholders confidence in the company’s future

65
Q

what could cause fluctuations in price earnings ratio

A

change in profits

change in sentiment from shareholders

66
Q

what does an analytical income statement aim to do

A

seeks to work out NOPAT (net operating profit after tax)

focus on operating activities, as these are critical and are hard to replicate compared to investing and financing activities

67
Q

are analytical income statements published

A

no

done by analysts

68
Q

what is operating tax

A

tax with the tax shield of debt added back

69
Q

what does an analytical balance sheet seek to find

A

invested capital

70
Q

how is investment capital (investment perspective) calculated

A

operating assets - operating liabilities

71
Q

how is investment capital (financing perspective) calculated

A

book value equity + Net interest bearing debt

72
Q

why is cash excluded from net interest bearing debt

A

it is seen as surplus

if it were needed for operations, it would have been spent already

73
Q

what is the formula for return on invested capital

A

NOPAT / Invested Capital

74
Q

what does return on invested capital measure

A

profitability of operations, disregarding how a firm is financed

75
Q

what can ROIC be compared to

A

WACC of company (cost of capital)

with competitors (benchmarking)

76
Q

what type of growth for a business is the most attractive

A

recurring growth i.e. growing core business

e.g. through efficiency, changing marketing approach, optimising invested capital, more profitable pricing

77
Q

what type of growth is not that attractive for business

A

transitory growth

i.e. once off so cannot rely on these going forward

e.g. gains and losses on disposal, restructuring costs, change in tax rates, change in accounting policies

78
Q

what are some limitations of ratio analysis

A
  1. relies on historical info, changes may have occurred and no guarantee these results will continue into the future
  2. accounts can be manipulated for desired effects
  3. effects of related parties
  4. seasonal trading can distort results due to levels of inventories, cash or receivables
  5. asset acquisitions - some have not had the time to generate revenue
  6. differences in accounting policies across companies makes comparisons difficult
79
Q

what are some examples of ‘creative accounting’

A

making provisions which are reversed post year end

paying back loans just before year end and taking it back out again at beginning of year

80
Q

what is the effect on the ratio analysis if the accounts were prepared just at the end of the entity’s busy season

A

likely to have:
- less inventory
- more cash
- more receivables

not representative of the SOFP ratios for the whole year

Financial Reporting & Analysis 2 (8 decks)

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