Week 9 - Analysis and Interpretation of Financial Statements

Question 1

Explain comparison in financial analysis

Answer 1

o Figures are compared with figures from previous years and other figures in the financial statements
o The process can be categorised as: horizontal (trend) analysis, vertical analysis and ratio analysis

Question 2

Explain horizontal analysis

Answer 2

o Compares the reported numbers in the current period with the equivalent numbers for a previous period
o Predicts the future direction of analysed items based on past information.

Question 3

Explain vertical analysis

Answer 3

o Comparing the items in a financial statement to a benchmark in the same financial statement.
o Allows the comparison between financial statement of different companies with different sizes

Question 4

Explain Ratio Analysis

Answer 4

o An expression of one item in the financial statements as compared to another item in the financial statements. One item is divided by another to create the ratio.
o Ratios provide clues or symptoms of underlying conditions
o Point to areas requiring further investigation

Question 5

Profitability: Profit Margin

Answer 5

Measures the net profit amount generated per dollar of sales
o Indicate how effective a company is at cost control
o Higher the net profit margin means better at using operating expenses

Question 6

Profitability: Gross Profit Margin

Answer 6

Measures the gross profit amount genrated per dollar of sales revenue. Reflects an entitiy’s pricing strategy and cost of goods management

Question 7

Profitability: Return on Assets

Answer 7

This ratio measures the rate of return earned as a result of investment in assets, which indicates the level of efficiency in using the firm’s assets to generate profits. The higher the value the more efficent a business is using assets to generate profits

Question 8

Profitability: Return on Equity

Answer 8

Measures the rate of return earned on equity provided by its owners. It is good to see an increasing trend as this will attract new investors. Higher the return on equity the more efficienct in using resources to generate profit

Question 9

Liquidity Analysis

Answer 9

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

Question 10

Liquidity: Current Ratio

Answer 10

o Measures the dollars of current assets the entity has per dollar of current liabilites, which indicates the ability to meet short term obligations

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

1.5 is minimum

Question 11

Liquidity: Quick Ratio

Answer 11

o Measure of current assets available (excluding inventory) to service each of current liabilities, this indiciates the businesses ability to meet its short term obligations on short notice.

0.8 considered minimum

Question 12

Liquidity: Asset Turnover Ratio

Answer 12

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

Question 13

Liquidity: Times Inventory Turnover Ratio

Answer 13

o Measures the number of times per annum that inventory is turned over
o The greater the inventory turnover ratio, the more times per year a company turns over its inventory

Question 14

Liquidity: Days Inventory Ratio

Answer 14

o Indicates the average period of time that it takes to sell inventory
o A lower ratio reflects better management efficient in selling stock or carrying insufficient levels of inventory.

More benefical to have a high turnover of inventory

Question 15

Liquidity: Times Debtors

Answer 15

o Measures the number of times per annum that trade debtors are turned over

Question 16

Liquidity: Days Debtors Ratio

Answer 16

o Indicates average period of times it takes to collect the money from its trade related accounts receivable
o Measuring the efficiency of management in collecting credit sales from customers

Question 17

Solvency/Capital Structure

Answer 17

o An entity’s capital structure is the proportion of debt financing relative to equity financing

Question 18

Solvency: Debt to Asset Ratio

Answer 18

o Indicates the percentage of total assrts of the entity financed from debt, hence a measure of financial risk.

greater than 50% indicates a great relaince of debt, therefore fianncial risk

Question 19

Solvency: Interest Coverage Ratio

Answer 19

Measures the number of times an entity’s earnings before interest and tax covers the interest expenses. It indicates the level of comfort that an entity has in meeting interest commitments from earnings.

Minimum of three

Question 20

Advantages of Ratios

Answer 20

o Allows for a useful comparison between companies of difference size with each other
o Helps in trend analysis which involves comparing a single company over a period
o Highlights important information in simple form quickly

Question 21

Limitations of Ratios

Answer 21

o Ratios are based on historical figures which may not accurately represent future performance
o Ratios could be influenced by inflation
o Ignore qualitative factors such as managerial quality, innovations etc.

Question 22

What Affects Profitability?

Answer 22

Return on Equity
Return on Assets
Gross Profit Margin
Profit Margin

Question 23

What Affects Liquidity?

Answer 23

Days Inventory Turnover
Inventory Turnover
Current Ratio
Quick Ratio

Question 24

What Affects Capital Structure

Answer 24

Debt to Asset Ratio
Interest coverage ratio
Times Interest Earned