Week 11 Flashcards
Financial statement analysis requires
Financial information
Standards of comparison (benchmark)
Financial information
Income statement, balance sheet, the statement of cashflow and the statement of changes in equity
Standards of comparison (benchmark)
the prior year(s) of the same company, competitors, industry standards.
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).
There are many analysis tools used to conduct a financial analysis. The three most common are:
Horizontal analysis
Vertical analysis
Ratio analysis
Horizontal analysis
Also known as trend analysis. It is a technique that calculates the change in an account balance from one period to the next and expresses that change in both dollar and percentage terms. It is a simple but powerful analysis tool. It reveals significant changes in account balances and therefore identifies items for further investigation.
Horizontal analysis examples
6/10
Vertical analysis
Vertical analysis is a technique that states each account balance on a financial statement as a percentage of a base amount on the statement.
It also allows comparisons of different companies (and the same company over time) by controlling for differences in size.
Vertical analysis examples
6/10
Ratio analysis
Profitability – Measure of success in wealth creation
Liquidity – The ability to meet short-term obligations
Solvency – The ability to satisfy its long term obligations
Profitability analysis
6/10
Return on equity
The return on equity ratio compares profits to the average balance in shareholders’ equity, showing how effectively a company uses the funds provided by shareholders during the year to generate additional equity for its owners.
6/10
Profit margin ratio
The profit margin ratio compares net income to net sales and measures the ability of a company to generate profits from sales. A higher ratio indicates a greater ability to generate profits from sales.
6/10
Return on assets
The return on assets ratio compares income to average total assets
It represents the ability to generate profits from its entire resource base (not just those resources provided by owners).
Measures overall profitability with respect to investment in assets
6/10
Price earnings ratio
The price to earnings ratio compares income to the current market price of the company’s shares, it is an investor’s perception of the company.
A price earnings ratio of 10 means that investors pay ten times current EPS share to buy one share.
A higher price to earnings ratio generally indicates that investors are more optimistic about the future prospects of a company.
Profitability ratios
Measure the profit or operating success of an entity for a given period of time. Profitability is often regarded as the ultimate test of management’s operating effectiveness.
Profitability of an entity affects its:
Ability to obtain debt and equity financing.
Liquidity position.
Ability to grow.
Relationships among profitability measures
6/10 *2
Liquidity analysis
A business’s inability to pay interest and to repay the liabilities is the reason why businesses are placed into administration.
Directors may be personally liable if they allow a company to trade while it is insolvent.
Liquidity analysis (2)
6/10
Current ratio
The current ratio is one of the most frequently used ratios in financial analysis and compares current assets to current liabilities. It compares assets that should be turned into cash within one year to liabilities that should be paid within one year. A higher ratio indicates greater liquidity.
6/10
Quick ratio
The quick ratio (the acid-test ratio) compares a company’s cash and near-cash assets, or quick assets, to its current liabilities.
It also measures the degree to which a company could pay off its current liabilities immediately, a higher quick ratio indicates greater liquidity.
6/10
Receivables turnover
Indicates the effectiveness of credit collection policies.
Measures the number of times trade receivables are converted into cash during the period
The higher the receivable turnover, the shorter the period of time between an entity making credit sales and collecting the cash for the receivable
6/10
Inventory turnover ratio
The inventory turnover ratio measures the number of times on average the inventory sold during the period. Its purpose is to measure the liquidity of the inventory
Inventory turnover is produce specific. A higher ratio is usually desirable.
Reflects the effectiveness of inventory management
6/10
Solvency analysis
Solvency refers to a company’s ability to remain in business over the long term and satisfy its long-term obligations. Solvency is related to liquidity but differs with respect to time frame.
