Chapter 22 - Interpretation of Financial Statements

Question 1

How do we calculate gross profit margin?

Answer 1

gross profit / revenue x 100

Question 2

What are some reasons for the movement of gross profit margin?

Answer 2

Selling price
Sales mix
Purchase cost
Production cost

Question 3

How do we calculate the operating profit margin?

Answer 3

operating profit (PBIT) / Revenue x100

Question 4

What are some reasons for movement of operating profit?

Answer 4

gross profit
expenses: admin/distribution

Question 5

How do we calculate asset turnover?

Answer 5

Revenue / capital employed

Question 6

how do we calculate capital employed?

Answer 6

equity + non-current liabilities (would not include deferred tax or deferred income)

Question 7

What would lead to a movement in asset turnover?

Answer 7

• increase/decrease in revenue
• increase/decrease in NCA
• increase/decrease in working capital

Question 8

How do we calculate return on capital employed?

Answer 8

Operating profit (PBIT) / Capital employed x100

Question 9

What would lead to a movement in ROCE?

Answer 9

efficiency: movement in asset turnover
profitability: movement in operating profit margin
combination of both

Question 10

What are the profitability ratio relationships?

Answer 10

operating profit margin x asset turnover = ROCE
profitability x efficiency = Return

Question 11

How do we calculate the current ratio?

Answer 11

Current assets / current liabilities

Question 12

How do we calculate the quick ratio?

Answer 12

(Current assets - inventories) / Current liabilities

Question 13

What would cause a movement in Current/quick ratio?

Answer 13

increase/decrease in cash balance
increase/decrease in inventory
increase/decrease in receivables
increase/decrease in payables

Question 14

How do we calculate inventory turnover?

Answer 14

Cost of sales / inventory

Question 15

What is inventory turnover?

Answer 15

number of times inventory is turned over in the period. Higher turnover = higher efficiency

Question 16

How do we calculate inventory holding period?

Answer 16

(Inventory / COS) x 365 days

Question 17

What is inventory holding period?

Answer 17

average number of days for which inventory held. Lower days = higher efficiency

Question 18

What are some reasons of movement of inventory ratios?

Answer 18

• improved/worse inventory control
• obsolete inventory
• increased level of inventory to stimulate sales

Question 19

How do we calculate the receivables collection period?

Answer 19

(Trade receivables / revenue) x 365

Question 20

What are reasons of movement in receivables collection period?

Answer 20

• improved/worse credit control
• irrecoverable debts
• increase credit terms to stimulate sales

Question 21

How do we calculate payables payment period?

Answer 21

(Trade payables / COS) x 365 days

Question 22

What are reasons of movement in payables payment period?

Answer 22

• new credit arrangement
• new supplier
• higher days may indicate inability to pay

Question 23

What does the working capital cycle show?

Answer 23

the length of time between paying for inventory and receiving cash from customers for the inventory. Length of time for which we are funding our inventory

Question 24

How do we calculate working capital?

Answer 24

inventory turnover period + receivables collection period - payables payment period

Question 24

How do we calculate the gearing ratio?

Answer 24

Debt / equity or Debt / (debt +equity) x 100

Question 25

What does a shorter working capital indicate?

Answer 25

higher level of efficiency

Question 25

How may working capital be shortened?

Answer 25

by reducing inventory and/or receivable days and/or increasing payable days

Question 26

What does debt include?

Answer 26

all long-term borrowings e.g., loan notes, redeemable preference shares

Question 26

What does high gearing mean for a company?

Answer 26

- large proportion of fixed-return capital - greater risk of insolvency - proportionately greater returns to shareholders if profits are growing - perceived as higher risk

Question 26

What does equity include?

Answer 26

all elements of equity e.g., share capital, reserves, non-controlling interest

Question 26

What does low gearing mean for a company?

Answer 26

- scope to increase borrowings for potential new projects - borrow more easily - perceived as lower risk

Question 26

How do we calculate interest cover?

Answer 26

Operating profit / finance cost

Question 26

What are some reasons of the movement of gearing (decreased)?

Answer 26

- repayment of loan notes or preference shares treated as liability - redemption of convertbble debt instruments - trading profits increasing retained earnings - revaluation of non-current assets, increasing revaluation surplus

Question 27

What are some reasons of the movement of gearing (increased)?

Answer 27

-issue of loan notes or preference shares treated as liability - assets acquired using lease - trading losses causing reduction in retained earnings - excessive dividends reducing retained earnings

Question 28

What is interest cover?

Answer 28

- indicates how many times interest costs could be paid from current profit level - higher the better

Question 29

Who would look at interest cover?

Answer 29

- used by lenders to assess risk of default - lenders may insist on maintenance of minimum interest cover as part of loan agreement.

Question 30

If gearing is low what would we look at next?

Answer 30

interest cover

Question 31

How do we calculate earnings per share?

Answer 31

Profit available to ordinary shareholders / no. of ordinary shares

Question 32

How do we calculate the Price/earnings (P/E) ratio?

Answer 32

current market price per share / earnings per share (EPS)

Question 33

What is the P/E ratio?

Answer 33

- represents a measure of market confidence in company's capacity for growth - high P/E ratio suggests that high growth is expected

Question 34

How do we calculate dividend yield?

Answer 34

dividend per share / market price per share

Question 35

What is the dividend yield?

Answer 35

-potential return on investment for prospective investors - can be compared to yields available on alternative investments

Question 36

How do we calculate dividend cover?

Answer 36

Earnings per share / dividend per share or total earnings / dividends

Question 37

What is dividend cover?

Answer 37

-similar to interest cover, indicates how many time current dividend could be paid from current profit level - high cover indicates that current dividend level is able to be maintained

Question 38

What are some limitations of financial statement analysis?

Answer 38

- Year-end figures not representative - no predictive value - ignore management action - window dressing management - different accounting policies - distortion by related party transactions

Question 39

What is non-financial information?

Answer 39

- market share - key employee information - long-term management plans - governance - environmental and social impact

Question 40

How is value for money achieved?

Answer 40

Combination of the 3 E's

Question 41

What are the 3 E's?

Answer 41

Effectiveness Efficiency Economy

Question 42

What is effectiveness?

Answer 42

Success in achieving its objectives/ providing its service

Question 43

What is efficiency?

Answer 43

how well its resources are used

Question 44

what is economy?

Answer 44

keeping costs of input low

Question 45

What is the impact on Intra-group transactions?

Answer 45

- distorted margins due to transfer pricing policy - low-rate finance available from parent