17. Interpretation of Financial Statements

Question 1

What comparatives might we use when assessing company performance?

Answer 1

Prior periods, budgets, competitors and industry averages

Question 2

What are the 5 ratios of profitability?

Answer 2

1. Gross Profit Margin
2. Operating Profit Margin
3. Net Profit Margi
4. Return on Capital Employed
5. Asset Turnover

Question 3

Who is interested in profitability ratios?

Answer 3

Investors (shareholders) and management

Question 4

What are the 5 ratios of liquidity?

Answer 4

1. Current ratio
2. Quick ratio (acid test)
3. Receivables collection period
4. Payables collection period
5. Inventory turnover

Question 5

Who is interested in liquidity ratios?

Answer 5

Creditors and investors

Question 6

What are the 2 risk ratios?

Answer 6

1. Gearing

2. Interest cover

Question 7

Who is interested in risk ratios?

Answer 7

Creditors and investors

Question 8

What is a companies working capital?

Answer 8

Net current assets –> Inventories + receivables - payables

Question 9

What is the formula for gross profit margin?

Answer 9

Gross Profit / Revenue

Question 10

What is gross profit margin used for?

Answer 10

To make pricing decisions

Question 11

What might cause fall in gross profit margin?

Answer 11

Increased costs or reduced prices to buy market share

Question 12

Is gross profit margin affected by volume of sales?

Answer 12

No

Question 13

What is the formula for operating profit margin?

Answer 13

(Operating Profit (Before Interest and Tax))/Revenue

Question 14

What is the formula for net profit margin?

Answer 14

(Net Profit (Before Tax))/Revenue

Question 15

What do the profit margin ratios help to show?

Answer 15

How efficiently the business is being run

Question 16

What is the formula for asset turnover?

Answer 16

Revenue/(Total assets - current liabilities)
OR
Revenue/(Share capital + Reserves + NCL)

Question 17

What does asset turnover measure?

Answer 17

How much sales revenue is generated for every £ of net assets employed - are they working efficiently and have they improved performance

Question 18

What is the formula for non current asset turnover?

Answer 18

Revenue/NCA

Question 19

What is the formula for Return on Capital Employed?

Answer 19

(Profit before interest and tax)/(Total assets - current liabilities)
OR
(Profit before interest and tax)/(Share capital + Reserves + NCL)

Question 20

Why is ROCE called the primary ratio?

Answer 20

It is the only ratio which compares profits to the overall size of the business

Question 21

What is an alternative equation for ROCE?

Answer 21

Operating Profit Margin x Net Asset Turnover

Question 22

Order current assets from most to least liquid:

Answer 22

Cash, Receivables, Inventory

Question 23

What is the calculation for Working Capital?

Answer 23

Current Assets - Current Liabilities

Question 24

What is the current ratio?

Answer 24

Current Assets/Current Liabilities

Question 25

What does the current ratio measure?

Answer 25

How easily a company can meet its current obligations

Question 26

What value of the current ratio would be a cause for concern?

Answer 26

Less than one - CL > CA, cannot meet obligations as they fall due

Question 27

What is the quick ratio?

Answer 27

(Current Assets - Inventory)/Current liabilities

Question 28

What is the formula for receivables collection period?

Answer 28

(Average trade receivables)/Credit Sales x 365

Question 29

What is the formula for payables payment period?

Answer 29

(Average trade payables)/(Credit Purchases or COS) x 365

Question 30

What is the formula for inventory days?

Answer 30

Inventory/COS x 365

Question 31

What is the formula for inventory turnover?

Answer 31

COS/Inventories

Question 32

What is the formula for the operating (or cash) cycle?

Answer 32

Inventory days + Receivables days - Payables Days

Question 33

What is high gearing?

Answer 33

A company has a high proportion of borrowing (loans) compared to equity

Question 34

What is low gearing?

Answer 34

A company has a high proportion of equity compared to borrowing?

Question 35

What is the gearing ratio?

Answer 35

(Interest bearing debt (excl. overdrafts but inc preference shares)) / (Share Capital + Reserves - NCL)

Question 36

What is the advantage of high gearing?

Answer 36

Debt is cheaper than equity (interest is fixed and tax deductible)

Question 37

What is the disadvantage of high gearing?

Answer 37

Harder to raise extra finance (from lenders or new shareholders)

Question 38

What is the formula for interest cover?

Answer 38

(Profit before interest and tax)/(Interest/finance Costs)