SU3 - The Analysis of Financial Statements Flashcards
Explain the purpose of Profitability ratios.
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.
What are the typical profitability ratios?
- Gross profit margin
- Net profit margin
- ROI
- ROA
Formula for Gross Profit Margin
(Sales - Cost of Sales) / Sales x 100
Purpose of the Gross Profit Margin.
It indicates how well a firm is able to cover its operating expenses through its core business.
What can be done to improve the Gross Profit Margin?
- Increase sales through improved marketing.
- Procurement and material managers could lower the levels of inventory.
- Attempt to produce at a lower cost or to buy at better prices.
- Produce fewer quantities or by less stock during periods of declining sales.
What is the purpose of the Net Profit Margin?
It measures the percentage of rand of sales remaining after all expenses, including taxes, have been deducted.
The formula for Net Profit Margin.
Net profit after tax / Sales x 100
What can be done to improve the Net profit margin?
- Increase sales through more efficient and effective marketing.
- Reduce expenses
What is the purpose of the ROI?
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.
The formula for ROI?
Net Profit after Tax / Total Assets x 100
What can be done to increase the ROI?
- Increase revenue by increasing sales or the price of goods and services.
- Lower operating expenses.
- Reduce the investment in current assets, such as inventory and accounts receivable during periods of declining sales.
- Evaluate the effectiveness and efficiency of the fixed assets with a view to improving productivity.
- Improve the effectiveness and efficiency of employees through training.
What is the purpose of the return on equity?
It measures the returned earned on the owner’s investment.
The Formula of ROE?
Net profit after tax / Shareholders equity x 100
Explain the term Leverage or Gearing.
it is the extent to which debt is used to finance the firm.
What can be done to increase the ROE ratio?
- Increase revenue by increasing sales or the price of goods and services.
- Lower the operating expenses.
Improve marketing to improve the asset turnover rate. - Increase the leverage by making greater use of debt to finance the firm.
Provide the 3 Liquidity ratios.
- Net working capital
- Current ratio
- Quick (acid-test) ratio
The formula for Net working capital.
Net working capital = current assets - current liabilities
How can Net Working Capital be improved?
- Accelerate cash inflows by offering cash discounts for early settlement of debtor’s accounts.
- Buy fewer goods on credit in order to reduce the current liabilities.
- Decrease inventory by selling more goods - improve sales and increasing cash or accounts receivable.
- 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.
Formula for the Current Ratio.
Current Assets / Current Liabilities
What does and Current ratio of 1.33 means?
It means that you only have R1.33 in current assets of every one rand you have in current liabilities.
What can be done to increase the Current ratio?
- Accelerate cash inflow by offering cash discounts of early settlement of debtors’ accounts.
- Buy fewer goods on credit in order to reduce the current liabilities.
- Decrease inventory by selling more goods.
- 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.
The formula for the Quick (acid-test) ratio.
(Current assets - inventory) / Current Liabilities
The formula for Asset Turnover.
Sales / Total Assets
Provide the 3 Activity Ratios
- Inventory turnover
- Average Collection Period
- Average Payment Period
Formula for Inventory turnover
Cost of goods sold / Average inventory
Average inventory = Beginning inventory + Ending inventory
Formula for ACP.
Accounts receivable / Average daily sales
Formula for APP
Accounts payable / Average daily credit purchases
Purchases is usually a percentage of cost of goods sold, which will be given.
Formula for Debt ratio
Total Liabilities / Total Assets x 100
Formula for Debt-equity ratio
Long-term debt / Shareholder’s equity x 100
Formula for EPS
(Earnings after tax - preference dividends) / number of ordinary shares.
Formula for Dividend per share (DPS)
Dividends for ordinary shareholders / number of ordinary shares issued
Formula for Price-earnings ratio (P/E ratio)
Current market price of ordinary shares / EPS
Formula for Earnings Yield
EPS / current market price x 100
Indicates the current income-producing power per ordinary share
Formula for Dividend Yield
DPS/ current market price x 100
Indicates the actual cash flow the the shareholders receives.
