SU3 - The Analysis of Financial Statements

Question 1

Explain the purpose of Profitability ratios.

Answer 1

It allows the analyst to evaluate the effectiveness and efficiency of the firm’s management and employees in generating profit by means of sales, and the productive use of assets and of the capital of the owners.

Question 2

What are the typical profitability ratios?

Answer 2

1. Gross profit margin
2. Net profit margin
3. ROI
4. ROA

Question 3

Formula for Gross Profit Margin

Answer 3

(Sales - Cost of Sales) / Sales x 100

Question 4

Purpose of the Gross Profit Margin.

Answer 4

It indicates how well a firm is able to cover its operating expenses through its core business.

Question 5

What can be done to improve the Gross Profit Margin?

Answer 5

1. Increase sales through improved marketing.
2. Procurement and material managers could lower the levels of inventory.
3. Attempt to produce at a lower cost or to buy at better prices.
4. Produce fewer quantities or by less stock during periods of declining sales.

Question 6

What is the purpose of the Net Profit Margin?

Answer 6

It measures the percentage of rand of sales remaining after all expenses, including taxes, have been deducted.

Question 7

The formula for Net Profit Margin.

Answer 7

Net profit after tax / Sales x 100

Question 8

What can be done to improve the Net profit margin?

Answer 8

1. Increase sales through more efficient and effective marketing.
2. Reduce expenses

Question 9

What is the purpose of the ROI?

Answer 9

It measures managements effectiveness in generating profits with available assets.

It can be compared with the firms Required rate of return(Cost of capital), which it needs to exceed.

Question 10

The formula for ROI?

Answer 10

Net Profit after Tax / Total Assets x 100

Question 11

What can be done to increase the ROI?

Answer 11

1. Increase revenue by increasing sales or the price of goods and services.
2. Lower operating expenses.
3. Reduce the investment in current assets, such as inventory and accounts receivable during periods of declining sales.
4. Evaluate the effectiveness and efficiency of the fixed assets with a view to improving productivity.
5. Improve the effectiveness and efficiency of employees through training.

Question 12

What is the purpose of the return on equity?

Answer 12

It measures the returned earned on the owner’s investment.

Question 13

The Formula of ROE?

Answer 13

Net profit after tax / Shareholders equity x 100

Question 14

Explain the term Leverage or Gearing.

Answer 14

it is the extent to which debt is used to finance the firm.

Question 15

What can be done to increase the ROE ratio?

Answer 15

1. Increase revenue by increasing sales or the price of goods and services.
2. Lower the operating expenses.
   Improve marketing to improve the asset turnover rate.
3. Increase the leverage by making greater use of debt to finance the firm.

Question 16

Provide the 3 Liquidity ratios.

Answer 16

1. Net working capital
2. Current ratio
3. Quick (acid-test) ratio

Question 17

The formula for Net working capital.

Answer 17

Net working capital = current assets - current liabilities

Question 18

How can Net Working Capital be improved?

Answer 18

1. Accelerate cash inflows by offering cash discounts for early settlement of debtor’s accounts.
2. Buy fewer goods on credit in order to reduce the current liabilities.
3. Decrease inventory by selling more goods - improve sales and increasing cash or accounts receivable.
4. Increase current assets by increasing the level of ending inventory, as long as the inventory can be sold soon after the commencement of the new accounting period.

Question 19

Formula for the Current Ratio.

Answer 19

Current Assets / Current Liabilities

Question 20

What does and Current ratio of 1.33 means?

Answer 20

It means that you only have R1.33 in current assets of every one rand you have in current liabilities.

Question 21

What can be done to increase the Current ratio?

Answer 21

1. Accelerate cash inflow by offering cash discounts of early settlement of debtors’ accounts.
2. Buy fewer goods on credit in order to reduce the current liabilities.
3. Decrease inventory by selling more goods.
4. Increase current assets by increasing the level of ending inventory, as long as the inventory can be sold soon after commencement of the new accounting period.

Question 22

The formula for the Quick (acid-test) ratio.

Answer 22

(Current assets - inventory) / Current Liabilities

Question 23

The formula for Asset Turnover.

Answer 23

Sales / Total Assets

Question 24

Provide the 3 Activity Ratios

Answer 24

1. Inventory turnover
2. Average Collection Period
3. Average Payment Period

Question 25

Formula for Inventory turnover

Answer 25

Cost of goods sold / Average inventory

Average inventory = Beginning inventory + Ending inventory

Question 26

Formula for ACP.

Answer 26

Accounts receivable / Average daily sales

Question 27

Formula for APP

Answer 27

Accounts payable / Average daily credit purchases

Purchases is usually a percentage of cost of goods sold, which will be given.

Question 28

Formula for Debt ratio

Answer 28

Total Liabilities / Total Assets x 100

Question 29

Formula for Debt-equity ratio

Answer 29

Long-term debt / Shareholder’s equity x 100

Question 30

Formula for EPS

Answer 30

(Earnings after tax - preference dividends) / number of ordinary shares.

Question 31

Formula for Dividend per share (DPS)

Answer 31

Dividends for ordinary shareholders / number of ordinary shares issued

Question 32

Formula for Price-earnings ratio (P/E ratio)

Answer 32

Current market price of ordinary shares / EPS

Question 33

Formula for Earnings Yield

Answer 33

EPS / current market price x 100

Indicates the current income-producing power per ordinary share

Question 34

Formula for Dividend Yield

Answer 34

DPS/ current market price x 100

Indicates the actual cash flow the the shareholders receives.