Topic 2 - Interpreting and Analysing Financial Information Flashcards
What is the accrual based approach?
Revenues are recorded at the point of sale and costs are when they are incurred. Not necessarily when a firm receives or pays out cash.
What is the cash flow approach?
Used by financial professionals to focus attention on current and prospective inflows and outflows of cash.
What does a balance sheet do?
Provides a snapshot of the firm’s assets and liabiltiies.
A = L + E
Define Net Working Capital
NWC = CA - CL
Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out. Usually positive for a healthy firm.
Balance Sheet Issues - Liquidity
Ability to convert to cash quickly without significant loss in value; liquid firms are less likely to experience financial distress; liquid firms earn a lower return; trade of is to find balance between liquid and illiquid assets
Balance Sheet Issues - Market Vs Book Value
The balance sheet provides the book value of assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can be actually bought or sold.
Cash Flow Statement (Indirect Method)
Operating activities
+ net profit + depreciation + any increase in current assets except cash + increase in accounts payable - decrease in accounts payable
Investment Activities
+ ending non current assets - beginning non current assets + depreciation
Financing Activities
- decrease in notes payable + increase in notes payable - decrease in long term debt + increase in long term debt + increase in ordinary shares - dividends paid
Name the 5 types of ratios
Liquidity - companys ability to satisfy its short term obligations
Activity - the speed at which a company converts accounts into sales or cash
Debt - the proportion of total assets financed by a company’s creditors
Profitability - relate a company’s earnings to its sales, assets or equity
Market - relate a company’s market value to certain accounting values
Current Ratio
current assets / current liabilities
Quick Ratio
current assets - inventory / current liabilities
What are the primary and secondary sources of liquidity?
primary - ready cash, short term funds (trade credit bank loans), cash flow management (getting customers to pay)
secondary - renegotiating debt contracts, selling assets, filing for bankruptcy
Activity Ratio - Inventory Turnover
COGS / inventory
Average age of inve = 365 / inventory turnover
Efficiency Ratios
Average Daily Sales = annual sales / 365
Average collection period = AR / ADS
Average daily purchases = annual purchases / 365
Average payment period = accounts payable / average purchases per day
Fixed asset turnover = sales / net fixed assets
Total asset turnover = sales / total assets
Discuss operating and conversion cycles
The operating cycle = average age of inventory + average collection period
The length of time it takes a company’s investment in inventory to be collected in cash from customers
The net operating cycle (or the cash conversion cycle)
The length of time it takes for a company’s investment in inventory to generate cash, considering that some or all of the inventory is purchased using credit
The longer the cycle, the greater the company’s need for liquidity
Debt ratios
Debt Ratio = total liabilities / total assets
Debt to Equity = long term debt / total shareholder equity
Asset to Equity = total assets / ordinary shareholder equity
Times Interest Earned = earnings before interest and taxes / interest expense
Profitability Ratios
ROA = earnings available for ordinary shareholders / total assets
ROE = earnings available for ordinary shareholders / ordinary share equity
gross profit margin
gross profit / sales
operating profit margin
operating profit / sales
net profit margin
earnings available for ordinary shareholders / sales
EPS
earnings available for ordinary shareholders / number of shares outstanding
DuPont System
EPS
earnings available for ordinary shareholders /
# of ordinary shares outstanding
P/E ratio
market price per ordinary share /
earnings per share
Book Value per share
ordinary share equity / number of ordinary shares outstanding
Market to book value
market value per ordinary share / book value per ordinary share
What are the limitations of using financial ratios?
Ratios are not very helpful by themselves; they need to be compared to something.
Time-Trend Analysis
Used to see how the firm’s performance is changing through time.
Peer Group Analysis
Compare to similar companies or with the industry.
Potential Problems
Benchmarking is difficult for diversified firms.
Globalisation and international competition makes comparison more difficult because of differences in accounting regulations.
Varying accounting procedures, i.e., FIFO vs. LIFO
Different fiscal years
Extraordinary events
