Topic 3 - Financial Statement Analysis Flashcards
Why do we need comparative analysis?
- to assess the financial health of a business.
- to compare current performance with past performance.
- to compare and benchmark against industry competitors and even across other industries.
What are the three basic comparative analysis techniques?
- Horizontal analysis
- Vertical analysis
- Ratio analysis
Explain horizontal analysis.
- Used to evaluate a series of financial statement data over a period of time.
- Analyses increases or decreases that have occurred from a particular base year.
- Percentages removes the effect of size, so relative magnitude of change is revealed.
Explain vertical analysis.
- Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude.
- Useful for comparing companies of different sizes.
What is the purpose of ratio analysis?
To evaluate the financial performance and health of a business
What are the limitations of financial statement analysis?
- Estimates
- Atypical data
- Diversification within entities
- Retrospective focus
- Lack of disclosure
- Calculation differences
- Lack of comparability
What are the three types of useful comparative information?
- Intra-entity basis:
Comparisons within a single entity (detects changes in financial relationships and trends). - Industry averages:
Between entities in same industry (determines position relative to others). - Inter-entity basis:
Between other entities (indicates competitive position).
What are the three types of ratios?
Liquidity, Solvency and Profitability
What is the purpose of Liquidity ratios?
Measures the short-term ability of an entity to pay its debts and meet unexpected needs for cash.
What is the purpose of Solvency ratios?
Measures the ability of an entity to survive over a long period of time.
- A business will fund (gear) it’s operations through either debt or equity. The term highly geared means the business has a high level of debt funding compared to its equity funding.
What is the purpose of Profitability ratios?
Measures the profit or operating success of an entity for a given period of time.
What does the current ratio measure? (liquidity)
A measure that expresses the relationship of current assets to current liabilities
What does the quick ratio measure? (liquidity)
A measure of an entity’s immediate short-term debt paying ability.
What does the inventory turnover ratio measure? (liquidity)
Measures the number of times a company sells its average level of inventory during a year
What does the average days in inventory ratio measure? (liquidity)
A measure of the average number of days it takes to sell the inventory
What does the debt to total assets ratio measure? (solvency)
A measure of the percentage of total assets provided by creditors.
- Indicates degree of leverage (percentage of total assets funded through debt).
What does the times interest earned ratio measure? (solvency)
A measure on an entity’s ability to meet interest payments as they come due
What does the free cash flow ratio measure? (solvency)
Indicates entity’s ability to pay dividends or expand operations.
What does the return on ordinary shareholders’ equity ratio measure? (profitability)
Indicates earnings per dollar invested by the owners.
What does the return on assets ratio measure? (profitability)
Measures overall profitability with respect to investment in assets.
What does the profit margin ratio measure? (profitability)
Measures percentage of each dollar of sales that results in profit.
What does the earnings per share (EPS) ratio measure? (profitability)
Measures profit earned on each ordinary share.
What does the price-earnings ratio ratio measure? (profitability)
Measures ratio of market price of each ordinary share to earnings per share.
Reflects investors’ assessments of an entity’s future earnings.
What other issues would you need to consider when looking at a companies’ financial statements?
Economic factors, competitive market influences, global events and trends and other information on business operations.
