Week 4 - Interpretation of financial statements

Question 1

What are the limitations of dollar value comparisons? (4)

Answer 1

The current year’s profits needs to be compared with the other information such as:

• Last years profit
• The current year’s sales
• The profits of other entities in the same industry
• The value of assets used to generate the profit

Question 2

What does financial statement analysis include? (3)

Answer 2

• Assesing financial health of a business
• Comparing past performance with current performance
• Comparing and benchmarking against other businesses in the market

Question 3

3 types of useful comparative analysis

Answer 3

• Intra-entity basis
• Industry averages
• Inter-entity basis

Question 4

What is intra-entity basis?

Answer 4

Is the comparison with a single entity (detects changes in financial relationships and trends)

Question 5

What is industry averages?

Answer 5

This is between entities in the same industry (determines position relative others)

Question 6

What is inter-entity basis?

Answer 6

Is between other entities (indicates competitive position)

Question 7

3 steps of financial statement analysis

Answer 7

1 - Identify users and their information needs

2 - Select and calculate appropriate ratios

3 - Interpret and evaluate the results

Question 8

Why do investors use financial statements?

Answer 8

• To predict expected returns
• To assess the risks associated with those returns

Question 9

Why do equity investors use financial statements?

Answer 9

To have an understanding of the business’ profitability and future security prices

Question 10

Why do creditors use financial statements? (2)

Answer 10

• To assess the short term liquidity - so how much cash a company has on hand to meet current payments when due
• To assess long term solvency - a company’s ability to generate cash to repay

Question 11

Types of financial statement analysis

Answer 11

• Cross-sectional analysis (inter-company analysis)
• The series analysis (intra-company analysis)
• The vertical analysis (common size statements)

Question 12

What is horizontal analysis? (3)

Answer 12

• 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
• Figures are stated as both dollar amounts and as percentages

Question 13

Horizontal analysis formula

Answer 13

Change since base period = (current year amount - base year amount) / base year amount

Question 14

What is vertical analysis? (3)

Answer 14

• It evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude
• Is useful for comparing company’s of different sizes
• Calculated percentages can also be tracked over time to determine patterns of change

Question 15

Limitations of financial statement analysis (5)

Answer 15

• Different accounting policies results in misleading comparisons
• Historical cost data distorts comparisons
• Performance criteria/yardsticks are not appropriate for all types of industries
• Comparisons using ratios need to consider some factors
• A single ratio provides limited information

Question 16

Why are estimates a limitiation of financial statements? (4)

Answer 16

• Allowance for doubtful debts
• Depreciation expense
• Costs of warranties
• If estimates are inaccurate the financial rations and percentages will also be inaccurate

Question 17

What is needed in a thorough business analysis? (4)

Answer 17

• Economic factors
• Competitive market influences
• Global events
• Trades & other relevant business operations