Topic 4- Analysis of financial statements

Question 1

What are the performance/profitability ratios

Answer 1

Gross profit margin
operating profit margin
ROCE
Net asset turnover

Question 2

what is Gross profit margin

Answer 2

gross profit margin shows the amount of profit after cost of sales/goods sold

Gross profit
÷
Sales rev

Question 3

what is Operating profit margin

Answer 3

measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.

Operating profit
÷
Sales rev

Question 4

What is return on capital employed? ROCE

Answer 4

Return to all providers of capital

ROCE gives a measure of how efficiently a business is using the funds available. It measures how much is earned per $1 invested.

Operating profit / (PBIT)
÷
Capital employed

Operating profit= Profit BEFORE interest and tax
CE= Total Assets - Current liabilities (leaves N/C Liabilities and Equity)
CE= Share capital + Reserves + Long term loans

Question 5

What is net asset turnover (what does it indicate)

and the general formula

Answer 5

The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets.

Sales Rev
÷
Capital employed (Equity and Non Current liabilities)

CE= Share capital + Reserves + Long term loans

Question 6

show the two ways capital employed can be represented

Answer 6

CE= Share capital + Reserves + Long term loans

Or

CE= Total Assets - Current liabilities (leaves N/C Liabilities and Equity)

Question 7

what are the liquidity ratios

Answer 7

current ratio
quick ratio
inventory turnover period
receivables collection period
payables payment period

Question 8

What is the current ratio and the formula

Answer 8

The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations.

The current ratio measures a company’s ability to pay current, or short-term, liabilities (debt and payables) with its current, or short-term, assets (cash, inventory, and receivables).

The higher the ratio, the better as it is more liquid

Current ratio= Current Assets ÷ Current Liabilities

A measure of 2:1 means that current liabilities can be paid twice over out of existing current assets.

Question 9

What is the quick ratio/ Acid test and the formula

Answer 9

The quick or acid test ratio:
measures how well current liabilities are covered by liquid assets
 is particularly useful where inventory holding periods are long and therefore distort the current ratio. e.g. car manufacturing companies

Acid test = (CA- Inventory)÷ CL

A measure of 1:1 means that the company is able to meet existing liabilities if they all fall due at once.

Question 10

What is the inventory holding period/days?

Answer 10

The length of time inventory is held between purchase and sale.

Inventory
___÷___ x 365
Cost of Sales

Question 11

what is receivables collection period

Answer 11

Trade Receivables
÷ x 365
Credit sales / Revenue

Question 12

what is payables payment period

Answer 12

Trade payables
÷ x 365
Credit purchases (or COS)

Question 13

what are the gearing ratios/long term solvency

Answer 13

Gearing 1 & 2 formula

Interest cover

Question 14

what is gearing formula one

i.e the ratio that shows us a degree of risk attached to the ocmpany

Answer 14

Debt/Equity

loans + Pref share capital
_________________________________

Ordinary share cap + Reserves + Non Controlling Interest

Question 15

what is gearing formula two

% of capital employed represented as borrowings

Answer 15

Debt/(Debt + Equity)

loans + Pref share capital
_________________________________

Ordinary share cap + Reserves + Non Controlling Interest + Preference share capital

Question 16

what is interest cover formula

Answer 16

Looks at the POV of P/L- How many times do we cover the interest that is payable in the P/L

Operating profit/ (PBIT)
÷
Interest payable

OP=Operating profits before debt interest and tax

Question 17

what are the investor ratios

Answer 17

EPS
PE Ratio
Dividend yield
Dividend cover

Question 18

What is earnings per share show and the formula

Answer 18

This is the basic measure of a company’s performance from an ordinary shareholder’s point of view. It is the amount of profit, in cents, attributable to each ordinary share.

Earnings available to ordinary shareholders
÷
No of ordinary shares in issue

Earnings available to OS= profit after interest and tax- Preference dividend

Question 19

What is PE ratio meaning/show?

Answer 19

This is the basic measure of a company’s performance from the market’s point of view. Investors estimate a share’s value as the amount they are willing to pay for each unit of earnings. It expresses the current share price as a multiple of the most recent EPS/Current earnings.

If a PE ratio is high, investors expect profits to rise. This does not necessarily mean that all companies on high PE ratios are expected to perform to a high standard, merely that they are expected to do significantly better than in the past. They may have greater growth potential because they are coming from a low base.

Question 20

what is PE formula

Answer 20

Share Price
÷
EPS

Question 21

What is dividend yield and formula

Answer 21

The dividend yield, expressed as a percentage, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.

This provides a direct measure of the wealth received by the (ordinary) shareholder. It is the annual dividend per share expressed as an annual rate of return on the share price.

It means that if you buy a shares, the dividend ÷ by the amount you pay for the share is 5% return. You’re getting a 5% return in the form of a dividend when you buy that share

DPS
÷ ……………………. x100%
Share price

Question 22

what is dividend cover?

Answer 22

It is a measure of how many times the company’s earnings could pay the dividend. The higher the cover, the better the ability to maintain dividends if profits drop

Question 23

what is dividend cover formula

and give the alternative formula

Answer 23

Profit available for ordinary shares (PAT)
÷
Dividend for the year (interim plus)

OR

EPS
÷
DPS

Question 24

what are the limitations of financial statement and ratio analysis

i.e. main points in relation to financial statements and ratio analysis- NOT the ratio method itself

Answer 24

Difficulty of prediction when using historical cost accounts

 Creative accounting/window dressing

Problem of window dressing
effects of changes in accounting policies ((AVCO/FIFO))

 Limitations of ratio analysis
 Limited information available
many ratios not applicable to specialised 
 Not For Profit organisation
 Trading with related party
 Seasonal trading

inflation

one off costs included in the soPL

Some include dep in COS other Admin costs

manipulation in the FS

Question 25

what are the advantages of ratio analysis

Answer 25

Ratios are a tool to assist analysis.

They help to focus attention systematically on important areas and summarise
information in an understandable form.

They assist in identifying trends and relationships.

Question 26

However ratios are not predictive if they are based on historical information.

what are the 3 reasons for this

Answer 26

They ignore future action by management.

They can be manipulated by window dressing or creative accounting.

They may be distorted by differences in accounting policies.

Asset values shown in the statement of financial position at historical cost may bear no resemblance to their current value or what it may cost to replace them. This may result in a low depreciation charge and an overstatement of profit in real terms.

As a result of historical costs the financial statements do not show the real cost of using the non-current assets.

Question 27

one of the disadvantages is trading with related parties- explain

Answer 27

If an entity trades with related parties, such as other entities within the same group or other entities run by the same directors, then these transactions may not be at market price. This can involve items such as purchase or sale transactions at rates other than market value or loans carrying interest rates not at market value.

The impact of these transactions on the entity must be assessed to give a fair comparison with other entities, and to show the position if the entity was removed from the group and no longer enjoyed the benefit of such transactions.

Question 28

one of the disadvantages is seasonal trading- explain

Answer 28

Ratio analysis can be distorted when a company has seasonal trading.

For example, a company may position their year-end to be after a particularly busy period so that inventory levels are lower than usual making the inventory count a less time-consuming process. This in turn will generally mean that current asset levels are higher from a bank/receivables point of view and that trade payables are lower (where suppliers have been paid for the supply of the inventory to meet demand for the busy period).

The timing of such financial reporting would improve the appearance of the ratios and make the company seem more solvent. In comparison if the financial statements had been drawn up at a different period in time then the results could appear quite different.

Question 29

one of the disadvantages is not for profit organisations- explain

Answer 29

Not for profit organisations are usually government or charity organisations within the public sector. Unlike the
private sector, the NFPs are non profit driven organisations. This means that there may be profit on their
statement of profit or loss, however making a profit is not one of their main objectives – however, for private
business’ this is one of their main objectives.

Therefore, the profitability ratios may not be as useful to NFPs as they are to private companies.

Question 30

The main financial aim of specialised, not-for-profit and public sector organisations is not to achieve a profit or return on capital but to achieve value for money. Value for money is achieved by a combination of the three Es:

Answer 30

Effectiveness – success in achieving its objectives/providing its service.

Efficiency – how well its resources are used.

Economy – keeping cost of inputs low.

Question 31

A 20 mark interpretation question could involve transactions between a parent and a subsidiary, or an acquisition/disposal of a subsidiary.

when a subsidiary is acquired during the year, explain some of the impact you would see on statement of profit or loss

Answer 31

Income and expenses should increase due to the new subsidiary being included in the year

This will not have a full year’s results from the subsidiary, as the results will only be consolidated from the date of acquisition

Acquisition costs may be included, which affect the performance of the group in the current period

Margins will be affected as the newly acquired subsidiary is likely to have different margins to the rest of the group

Question 32

A 20 mark interpretation question could involve transactions between a parent and a subsidiary, or an acquisition/disposal of a subsidiary.

when a subsidiary is acquired during the year, explain some of the impact you would see on statement of financial position

Answer 32

100% of the assets and liabilities of the subsidiary will be consolidated at the reporting date

This will mean that there could be significant increases in assets or liabilities depending on the position of the newly-acquired subsidiary

Working capital ratios, such as receivables collection period, are likely to change due to the new subsidiary having different credit terms to the rest of the group

Working capital ratios may also be affected adversely as the ratio uses the year-end assets or liabilities, but the income/expenses included may be time-apportioned in the statement of profit or loss.
For example, a subsidiary with revenue for the year of $1,000,000 and closing receivables of $90,000 would have a receivables collection period of 33 days in its individual financial statements (90,000/1,000,000 × 365). If this had been acquired exactly halfway through the year, only $500,000 revenue would be included within the consolidated statement of profit or loss, with the full $90,000 of receivables included in the consolidated statement of financial position. This would effectively give a receivables collection period of 66 days (90,000/500,000 × 365), giving a distorted picture.

Return on capital employed and net asset turnover may decrease as the subsidiary’s profit will be time apportioned, but any debt held by the subsidiary will be included in full at the reporting date (see the statement of financial position below)

Question 33

A 20 mark interpretation question could involve transactions between a parent and a subsidiary, or an acquisition/disposal of a subsidiary.

when a subsidiary is disposed of during the year, explain some of the impact you would see on statement of profit or loss

Answer 33

The previous year’s statement of profit or loss would include a full year’s results from the disposed subsidiary

The results for the current year may have the subsidiary shown as a discontinued operation (shown as one line below the profit for the year from the continuing operations) or have the results consolidated into income and expenses for the period up to the date of disposal

The consolidated results may also include any gain/loss on disposal, which should be stripped out for comparative purposes

Any costs associated with the disposal, such as professional fees or redundancies, may be included in the current period which would not be recognised in future periods

Margins are likely to be incomparable, as the prior year will include the disposed subsidiary but the current year may only include the companies remaining in the group

Question 34

A 20 mark interpretation question could involve transactions between a parent and a subsidiary, or an acquisition/disposal of a subsidiary.

when a subsidiary is disposed of during the year, explain some of the impact you would see on statement of financial position

Answer 34

The previous year’s statement of financial position would contain 100% of the assets and liabilities of the disposed subsidiary

The current year’s statement of financial position would contain none of these as the subsidiary will not be controlled at the reporting date

Cash may be increased by the sales proceeds of the subsidiary

Ratios such as working capital ratios, return on capital employed and net asset turnover may be distorted if some of the subsidiary’s results are included in the statement of profit or loss, as no assets or liabilities from the subsidiary will be included in this calculation (especially if it was disposed of during mid year and so the PL would include the fiugres

Question 35

what are some of the disadvantages when comparing inter-firm and sector comparison

Answer 35

comparing the financial statements of similar businesses can be misleading because:

the businesses may use different accounting policies

ratios may not be calculated according to the same formulae. For example, there are several possible definitions of gearing and ROCE.

large organisations can achieve economies of scale, e.g. by negotiating extended credit periods, or discounts for bulk buying with suppliers, whereas these measures may not be available to smaller businesses, and may distort comparison.

entities within the same industry can serve completely different markets and there may be differences in sales mix and product range. These can affect profitability and activity ratios such as profit margin and ratios of expenses to sales.

Sector comparisons- it must also be noted that the sector will incorporate companies of different sizes so it may not be a like for like comparison.

Question 36

what are some disadvantages of the ratio method (the method iteself)

Answer 36

Ratios based on historical cost accounts do not give a true picture of trends from year to year. An apparent increase in profit may not be a true increase, and may simply reflect the effects of inflation.

Financial statements only reflect those activities which can be expressed in money terms. They do not give a complete picture of the activities of a business. For example, the size of the order book is normally ignored in financial statements.

The application of accounting policies in the preparation of financial statements must be understood when attempting to interpret financial ratios.

Ratios must not be used as the sole test of efficiency. Concentration on achievement of target ratios by managers may inhibit the incentive to grow and expand, to the detriment of the long-term interests of the company.

A few simple ratios do not provide an automatic means of running a company. Business problems usually involve complex patterns which cannot be solved solely by the use of ratios.

Question 37

In practice and in examinations it is likely that the information available in the financial statements may not be enough to make a thorough analysis.

You may require additional financial information such as:

Answer 37

 budgeted figures
 Cash flow statement
 other management information
 industry averages
figures for a similar business
figures for the business over a period of time.
 Share price

Question 38

In practice and in examinations it is likely that the information available in the financial statements may not be enough to make a thorough analysis.

You may require additional NON-financial information such as:

Answer 38

 market share
key employee information
sales mix information
product range information
the size of the order book
the long-term plans of management.
 Recent news report
Board minutes
Staff turnover
Internal memos
Future plans
CEO= Reports/statements
Audit reports
Company objectives- if they are meeting them

Question 39

When answering questions, what are some important tips to remeber

Answer 39

• USE The key words: Improved/Better/Deteriorated/worsen/

1) Organise ratios into groups and deal with them in logical sequence
- > Profitability is usually more important that liquidity or gearing so start with this. ROCE is the most important profitability ratio (goes well with Net asset turnover and OProftiMargin)

2) Rounding- round to full digits the % and the liquidity ratios can be up to 1 decimal places
3) Make sure the numbers are realistic- if they aren’t it means they are wrong e.g. e.g. if receivables days are 3 days- unrealistic
4) Justify your assertions- explain why the higher ratio is beneficial
5) Look for relationships between ratios- demonstrate commercial awareness
6) Perspective- bank manager may be interested in liquidity more than profitability which SH might be more interested in

Question 40

what is working capital

Answer 40

The working capital formula tells us the short-term liquid assets available after short-term liabilities have been paid off.

Working Capital = Current Assets – Current Liabilities

Question 41

what is working capital cycle

Answer 41

The working capital cycle shows the average length of time between paying production costs and receiving cash returns from the inventory.

Question 42

what is working capital cycle formula

Answer 42

Working capital cycle = Inventory turnover period (days) + receivables collection period – payables payment period

Question 43

is deferred tax to be included under liabilities in Current ratio?

Answer 43

no