Week 9 - Analysis and interpretation of financial statements: analysing efficiency, liquidity, capital structure

Question 1

what is asset efficiency analysis

Answer 1

Entities invest in assets in anticipation that the investment will generate returns.

Asset efficiency ratios measure the ability of an entity to generate sales revenue using investments in current and non-current assets

Question 2

explain asset turn over ratio

Answer 2

Shows an entity’s overall efficiency in generating income per dollar of investments in assets

Value will depend on the efficiency with which it manages its current and non-current investments

Question 3

asset turnover formula

Answer 3

sales rev/ total assets

Question 4

explain inventory turnover

Answer 4

Measures the number of times per annum that inventory is turned over

cost of sales / average (or end of year inventory)

Question 5

explain days inventory ratio

Answer 5

Indicates the average period of time it takes to sell inventory

A lower ratio reflects better management efficiency in selling stock or carrying insufficient levels of inventory

Question 6

day inventory ratio formula

Answer 6

ends of year inventory/

cost of sales x 365

Question 7

time debtors turnover

Answer 7

measure the number of times per annum that trade debtors is turned over

sales rev/ end of year debtors

If available, use credit sales
**Accounts Receivable

Question 8

explain days debtors ratio

Answer 8

Indicates average period of time it takes to collect the money from its trade related accounts receivable

Measuring the efficiency of management in collecting credit sales from customers

year end debtors/sales rev x 365

Question 9

what is liquidity analysis

Answer 9

The survival of the entity depends on its ability to pay its debts when they fall due (its liquidity)

An entity must have sufficient working capital to satisfy its short-term requirements and obligations

But excess working capital is undesirable because the funds could be invested in other assets that would generate higher returns

Question 10

what is current ratio

Answer 10

Current ratio (or working capital ratio) indicates $ of current assets per $ of current liabilities
Measures the ability of the firm to meet its short-term obligations
An arbitrary rule of thumb ratio of 1.5:1 is considered a minimum, however it varies across different industries
A high current ratio is not necessarily good as it could be due to excess investments in unprofitable assets

current Assets/ current liabilities

Question 11

what is quick ratio

Answer 11

Quick ratio (or acid test ratio) measures $ of current assets available (excluding inventory) to service each $ of current liabilities

Measures the ability of the firm to meet its short-term commitments on short notice
An arbitrary rule of thumb ratio of 0.8:1 is considered a minimum, however it varies across different industries

CA - inventory / CL

Question 12

what is capital structure analysis

Answer 12

An entity’s capital structure is the proportion of debt financing relative to equity financing, and reflects the entity’s financing decision

Investments in assets are funded externally by liabilities, or internally by owner’s equity as shown in accounting equation:
A = L + OE

• The higher the proportion of debt, the higher the financial risk

Question 13

explain capital structure gearing

Answer 13

Only 1 of the 2 capital structure (gearing) ratios needs to be calculated as all indicate use of debt relative to equity to finance investments in assets (textbook focuses on debt ratio)
Measures the level of debt financing compared to owners’ funds
The debt (to assets) ratio indicates how many dollars of debt per dollar of assets
A ratio of more than 50% suggests greater reliance on debt relative to equity

1. debt to equity ratio

TL/TE x100

2. debt to assets ratio

TL/TA x 100

Question 14

explain interest coverage ratio

Answer 14

Measures the level of comfort that an entity has in meeting interest commitments from earnings

As a rule of thumb, a value above 3.0 is usually considered adequate

Interest coverage ratio:
Earnings before interest and tax (EBIT) / Interest charges (finance costs)

Question 15

advantages of financial ratios

Answer 15

It simplifies the financial statements
It helps in comparing companies of different size with each other
It helps in trend analysis which involves comparing a single company over a period
It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements

Question 16

limitations of financial ratios

Answer 16

Ratios could be influenced by inflation
Ratios ignore qualitative factors
Ratios are calculated based on past data
Inaccurate/manipulated accounting information would provide misleading ratios
Accounting standards allow different valuation methods, policies etc. which impairs comparability
Non-financial considerations, such as environmental performance, are also taken into consideration by users when assessing an entity’s performance