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AC105 - Financial Accounting > Week 8 - Financial Analysis > Flashcards

Week 8 - Financial Analysis Flashcards

1
Q

What do both lenders and shareholders use financial statement analysis for?

A

Tp predict their expected returns and assess the risks associated with those returns.

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2
Q

What are lenders interested in when conducting financial analysis?

A

Short term liquidity and long term solvency

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3
Q

What are shareholders interested in when conducting financial analysis?

A

Profitability and future share prices

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4
Q

What are both lenders and shareholders interested in?

A

The companies future

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5
Q

What do common size statements enable?

A

A comparison across time or businesses

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6
Q

What are the two ways common size statements can be prepared?

A

Vertically or horizontally

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7
Q

What does vertical common size analysis allow?

A

Expresses all figures in a particular
statement in terms of one of the figures in that statement.

The base figure can be for example:
-Sales or revenues in the IS
-Total assets in the BS

e.g.
Calculation of figures
Revenue 100.0 2,240 = Base figure
Cost of sales (77.9) (1,745/2,240) × 100%
Gross profit 22.1 (495 /2,240) × 100%

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8
Q

What does horizontal common size analysis allow?

A

Uses the figures in a specified year as the base, and subsequent years’ amounts are stated as a percentage
of the base value.

e.g.
Year 2018 2019 2020
Cash 100% 101.00% 102.01%
Trade
receivables 100% 102.00% 104.04%

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9
Q

What does trend analysis show?

A

Shows changes in key ratios over time and whether ratios indicate trends.

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10
Q

Why do we use financial ratios?

A

1) To compare the financial health of different businesses (without the problem of scale)

2) To identify trends, eg, to see if there is a
trend in financial performance

3) To determine the degree of efficiency in the management of assets and liabilities

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11
Q

What does ratio analysis do?

A

▪ compares two related figures
▪ is an aid to interpreting the financial statements
▪ is not an exact science, results must be interpreted with caution
▪ there are no standard formulae to calculate ratios

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12
Q

What may ratios be compared with?

A

▪ Past periods
▪ Similar businesses / industry averages
▪ Budgeted figures

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13
Q

What are examples of profitability ratios?

A
  • Return on capital employed (ROCE)
  • Return on equity (ROE)
  • Operating profit margin & Net profit margin
  • Gross profit margin
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14
Q

What are examples of efficiency ratios?

A
  • Inventory days
  • Receivables days
  • Payables days
  • Net asset turnover
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15
Q

What are examples of liquidity and solvency ratios: short term liquidity?

A
  • Current ratio
  • Quick (acid test) ratio
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16
Q

What are examples of liquidity and solvency ratios: long term liquidity?

A
  • Gearing ratio & Debt-to-equity (D/E) ratio
  • Interest cover
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17
Q

What are examples of investment ratios?

A
  • Dividend payout ratio & Dividend cover
  • Dividend yield ratio
  • Earnings per share
  • Price/earnings ratio
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18
Q

What does the ROCE show?

A
  • ROCE assesses the effectiveness of total capital employed. Capital employed
    represents the debt and equity with which the company generates profits.
  • ROCE is generally considered to be the primary profitability ratio as it shows how well
    a business has generated profit from its long-term financing.
  • An increase in ROCE is generally considered to be an improvement
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19
Q

What is the formula for the ROCE ratio?

A

ROCE= (Profit before interest and tax ÷ Average capital employed*) x 100%

*Share capital + Reserves + Non-current liabilities OR Total assets−Current liabilities

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20
Q

How can average capital employed be measured? (used for many calculations.

A

Share capital + Reserves + Non-current liabilities OR Total assets−Current liabilities

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21
Q

What do you do if you cannot find the averaging figures?

A

Averaging is preferred, but year-end figures are used when beginning of the year figures are not available

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22
Q

What does Return on Equity (ROE) or Return on Shareholders’ Funds (ROSF) show?

A

Assesses the return to shareholders.
This ratio focuses on the levels of profit achieved on the basis of the capital provided by the equity holders. Amounts provided by and dividends and interest paid to
preference shares and loan notes are excluded.

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23
Q

How is ROE or ROSF calculated?

A

ROE = (Profit for the year(less any preference dividend) ÷ (ordinary share capital + reserves)) x 100%

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24
Q

What does gross profit margin show? How can it be improved?

A

Measures directly trading performance.
An entity’s gross margin percentage can be improved in two ways:
1. Increase the price charged for goods or services.
2. Cost control and efficiency.
Gross margin percentages vary dramatically from industry to industry

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25
Q

How is gross profit margin calculated?

A

GPM = (Gross profit ÷ Sales revenue) x 100%

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26
Q

What does the operating profit margin show? How can it be assessed?

A

Measures operational performance.
Whether the operating profit margin level is satisfactory may only be assessed in comparison with norms, eg, industry norms.
The normal operating profit margin in a manufacturing industry is between 8 and 10%.
The normal operating profit margin in food retailing is around 3%.

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27
Q

How is operating profit calculated?

A

OPM = (operating profit ÷ sales revenue) x 100%

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28
Q

How is gross profit margin calculated?

A

Margin = Gross profit ÷ Sales

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29
Q

How is gross profit mark up calculated?

A

Mark up = Gross profit ÷ cost of sales

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30
Q

What does inventory days show? What can decreasing inventory days show?

A

How long it takes on average for inventories to be sold.

Decreasing inventory days could be due to the following:
A sudden increase in demand for the company’s products

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31
Q

How are inventory days calculated?

A

Inventory days = (average inventories held ÷ cost of sales) x 365 days

32
Q

What do receivable days show? What can increasing receivable days be because of?

A

Shows how long on average credit customers take to pay the amounts they owe to the business.

It could be bc of the company extending the credit period to attract more customers.

33
Q

What do payable days show? What can a long credit period show?

A

Shows how long the entity takes to pay its creditors.

▪ a long credit period may be good as it represents a source of free finance; or
▪ a long credit period may indicate that the company is unable to pay more quickly because of liquidity problems.

34
Q

How are payable days calculated?

A

Payable days = (average trade payables ÷ credit purchases) x 365

35
Q

When calculating payable days what should you use when credit purchases are not known?

A

Use cost of sales

36
Q

What does net asset turnover ratio show? How do you compare it between companies?

A

Net asset turnover ratio shows how effectively the entity uses its resources [capital employed] to generate sales.

It should only be compared with companies operating in the same industry. This is because industries vary in capital intensiveness.

37
Q

What is a high asset turnover often accompanied by?

A

With a low operating profit margin and vice versa

38
Q

How is net asset turnover ratio calculated?

A

Net asset turnover ratio = Sales revenue ÷ average capital employed*

39
Q

What is it if the net asset turnover ratio is too high?

A

If the ratio is very high, we say that the firm has an “overtrading” problem that is it has insufficient assets to sustain the level of sales revenue achieved (i.e. trying to do too much business with too little capital).

40
Q

What is overtrading?

A

A firm has insufficient assets to sustain the level of sales revenue achieved (i.e. trying to do too much business with too little capital).

41
Q

When can overtrading occur?

A

Occurs when a company expands its sales fairly rapidly without securing additional long term capital adequate for its needs.

42
Q

What are the symptoms of overtrading?

A

The symptoms of overtrading are:
* inventory increasing, possibly more than proportionately to sales
* receivables increasing, possibly more than proportionately to sales
* cash and liquid assets declining at a fairly alarming rate
* payables increasing rapidly

43
Q

What are the remedies for overtrading?

A

Remedies:
* Cut back trading
* Raise further capital
* Improve working capital management

44
Q

What is the link between efficiency and profitability?

A

Operating profit margin x net asset turnover ratio = ROCE

45
Q

What does the link between efficiency and profitability allow us to identify?

A

ROCE is the product of profit margin and asset turnover. By decomposing ROCE in this way, it
is possible to identify the sources of an entity’s performance problems:

  • a company with a low-profit margin might focus on product pricing (it might try to increase its
    prices) or find ways of controlling or reducing costs
  • a company with a low asset turnover ratio might look for unproductive or idle assets that
    could be sold, or for assets that could be managed more efficiently and effectively
    (inventory or receivables levels that could be lowered).
46
Q

What is working capital?

A

The difference between total current assets and total current liabilities.

Working capital = total current assets - total current liabilities

47
Q

What should the aim of working capital be for a company?

A
  • avoid excessive working capital, which creates unnecessary cost:
    inventories, receivables and payables should therefore be well-managed
  • avoid having insufficient amounts of working capital, because inadequate working capital can lead to difficulties with cash flow and liquidity
48
Q

How is operating cash cycle calculated?

A

Operating cash cycle = Inventory days + receivable days - payable days

49
Q

What does liquidity mean?

A

The ability to generate cash for working capital needs and immediate debt repayments

50
Q

What does solvency mean?

A

Long term ability to generate cash internally or externally to satisfy capacity needs, fuel growth and repay debts.

51
Q

What does current ratio show?

A

It compares the liquid assets of the company with its current liabilities.
* As a rule of thumb a ratio of two or more has been customarily regarded as
satisfactory.
* A low ratio does not necessarily indicate a problem. The current ratio should be interpreted in the light of what is normal for the type of business.
* E.g. Manufacturing businesses are expected to have a relatively higher current ratio compared to supermarket businesses.

52
Q

How is current ratio calculated?

A

Current ratio = Current assets ÷ current liabilities

53
Q

What does the acid test (quick) ratio show?

A

more rigorous measure of liquidity in that it excludes inventory

54
Q

How is the acid test (quick) ratio calculated?

A

Acid test ratio = (current assets - inventories) ÷ current liabilities

55
Q

What is financial gearing and when does it occur?

A

Occurs when a business is financed, at least in part, by borrowing
instead of only equity. Why?
* to finance growth
* to exploit tax advantages (interest is tax deductible)

56
Q

What are the dangers of high financial gearing?

A

Dangers of high financial gearing:
* less control over financing decisions
* risk of bankruptcy
* high volatility in profits available to shareholders
* limited flexibility due to restrictions imposed on loan
agreements

57
Q

What does the gearing ratio show?

A

Measures the contribution of long-term debt to the capital structure of the company.
Eg, 20% gearing ratio means that the firm is 20% financed by long term debt.
To be regarded as highly geared the ratio should exceed 50%.

58
Q

How is the gearing ratio calculated?

A

Gearing ratio = Non current liabilities ÷ (share capital + reserves + non current liabilities)

59
Q

What is regarded as a highly geared ratio?

A

50%

60
Q

What does debt to equity ratio show?

A

Another measure for measuring the level of gearing.
If the debt-to-equity ratio is greater than 1, then the company is financing more assets with debt than with equity. If the ratio is less than 1, then the company is financing more assets with equity than with debt.

The higher the debt-to-equity ratio, the greater the company’s financial risk.

61
Q

How is debt to equity calculated?

A

Debt to equity = Total liabilities ÷ total equity

62
Q

What does the interest cover ratio show?

A

The amount of profit available to cover interest.
E.g. 12 times interest cover ratio means that the level of operating profit is 12 times the level of interest.

63
Q

How is interest cover ratio calculated?

A

Interest cover ratio = operating profit ÷ interest expense

64
Q

What does the dividend payout ratio show?

A

Shows the proportion of profits paid out as dividends to shareholders.
E.g. a dividend payout ratio of 20% means that 20% of profit is distributed to shareholders in the form of dividends.

65
Q

How is dividend payout ratio calculated?

A

Dividend payout ratio = (Dividend announced for the year ÷ profit after tax less any preference dividends) x 100%

66
Q

What does dividend cover ratio show?

A

The dividend cover ratio measures a company’s ability to maintain dividend payments. It shows how many times the dividends could be paid out of profits.

Eg, a dividend cover of two times means that a company can afford to pay dividends twice out of profits.

67
Q

How is dividend cover ratio calculated?

A

Dividend cover ratio = (earnings for the year available for dividend ÷ dividends announced for the year)

68
Q

What does dividend yield show?

A

Shows the cash return to a share relative to its current market value.
The ratio measures dividend policy rather than performance.

Rapidly growing companies may have low dividend yields based on historical dividends, especially if the current share price reflects anticipated future growth in
earnings and dividends.

69
Q

How is dividend yield calculated?

A

Dividend yield = (dividend per share ÷ market value per share) x 100%

70
Q

What does earnings per share (EPS) show?

A

Earnings per share (EPS) represents the earnings available to shareholders per shares issued. EPS is always expressed in pence and is calculated to one decimal place.

Eg, an EPS of 12p means that the company’s earnings allocated to each ordinary share is 12p.

71
Q

How is earnings per share (EPS) calculated?

A

EPS = (Profit (after tax) less preference dividend ÷ number of ordinary shares in issue) x 100

72
Q

What does Price/earnings (P/E) ratio show?

A

Price/earnings ratio measures market confidence in the future earnings power of a business.
It measures how much investors are willing to pay for a company relative to its current earnings, which reflects investors’ expectations of future earnings
growth.

A P/E ratio of 8 times means that the market value of the share is 8 times higher than its current level of earnings.

73
Q

How is the P/E ratio calculated?

A

P/E ratio = (Market value per share ÷ Earnings per share) x 100%

74
Q

What may be the reasons for a high P/E ratio?

A

Reasons for Tesla’s high P/E:
1. Growth potential
2. Investor sentiment
3. Maturity vs innovation
4. Profitability and Risk

75
Q

What are limitations of ratio analysis?

A
  1. Limitations of Financial Statements:
    * Historical perspective
    * Most assets at cost, not fair value (relevance?)
    * Intangibles often omitted (completeness?)
    * Subjective accounting policies (Provisions, Goodwill,
    Depreciation)
  2. Qualitative factors are ignored
  3. Lack of standard formulae
  4. Problems of price level changes
  5. Ratios alone are not adequate

AC105 - Financial Accounting (9 decks)

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