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CIMA F2 > E. Analysing Financial Statements > Flashcards

E. Analysing Financial Statements Flashcards

1
Q

who are the users of financial analysis?

A

shareholders, providers of finance, suppliers, customers, employees, government

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2
Q

what objective for shareholders have when using financial analysis ?

A
  • dividend
  • share price growth
  • business will continue to operate
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3
Q

what do providers of finance use financial analysis to determine?

A
  • whether they will get their money back

- should they provide finance

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4
Q

what do suppliers use financial analysis to determine?

A

whether they will get paid for supplies

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5
Q

what do customers use financial analysis to determine?

A

whether company will be able to continue to supply the customer

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6
Q

what do employees use financial analysis to determine?

A

if jobs are secure

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7
Q

what do governments use financial analysis to determine?

A

appropriate taxes were paid

special-purpose reports for certain sectors

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8
Q

what are the 3 types of ratios?

A

profitability
ST liquidity and efficiency
LT liquidity (capital structure)

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9
Q

what are the main profitability ratios?

A

GPM(GP%)
OPM(OP%)
ROCE
EBITDA

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10
Q

what is the GPM and how is it calculated?

A

gross profit margin is the % of revenue that is gross profit

gross profit / revenue x 100

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11
Q

does volume affect GPM?

A

no as revenue will rise with gross profit

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12
Q

is higher GPM or lower GPM preferred?

A

higher: less costs so more profit per sale

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13
Q

what are some common reasons for GPM movements?

A 
sales price movements
cost price movements
changes in sales mix
changes in efficiency
changes in inventory valuation policies e.g AVCO, FIFO
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14
Q

What is the OP% and how is it calculated?

A

operating profit margin is the portion of revenue that is profit after operating expenses are deducted

Op profit (PBIT)/revenue x 100

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15
Q

what are some common reasons for OP% movements?

A

if in line with GP%< reasons are the same
if not in line with GP%, changes are due to operating expenses movement:
-redundancies
-marketing costs
-exceptional write off of PPE
-salary savings due to directors leaving posts
-larger delivery networks

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16
Q

what is ROCE and how is it calculated?

A

return on capital employed outlines how effectively the entity has generated profit from its capital invested
PBIT/capital employed x 100

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17
Q

how is capital employed calculated for firms and associates?

A

equity+interest bearing borrowing (LT borrowing + overdraft)

associates:equity + LT borrowing + overdraft - NCA

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18
Q

what are some common reasons for movements in ROCE?

A

movements in OP% or asset turnover
if not in line with OP%, movement caused by asset turnover (i.e how well entity generates revenue from NCAs)
-revaluations
-investments in PPE near end of the year: not time to generate profits
-change in leases

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19
Q

What is the EBITDA and what does it show?

A

earnings before interest, tax, depreciation and amortisation

  • analyses profitability of a company
  • compares operating performance of companies without impacts of accounting policies and financing decisions
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20
Q

how is EBITDA calculated?

A 
PAT(from SPLOCI)
\+interest
\+tax
\+depreciation
\+amortisation
=EBITDA
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21
Q

how can EBITDA be used as a gimmick to improve company performance perception?

A

-commonly quoted by large companies who have significant depreciation and amortisation charges as a basis for assessing their operating performance
-commonly but inaccurately used to measure cash flows
-

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22
Q

why is EBITDA used to measure profitability but is only an approximation of operating cash flows?

A

no impacts on accruals or working capital movements have been considered when determining EBITDA

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23
Q

what are the ST liquidity ratios?

A

current ratio

quick ratio

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24
Q

what are the ST efficiency ratios?

A

inventory holding period (inventory days)
receivable payment period (receivable days)
payables payment period (payable days)

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25
Q

what is a current ratio and how is it calculated?

A

current assets/current liabilities

  • healthy level is 2:1
  • higher the better
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26
Q

what are the downsides of a very low current ratio?

A

may not be able to repay customers

liquidation risk

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27
Q

what are the downsides to a very high current ratio?

A

obsolete inventory
poor credit control
poor cash management

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28
Q

why must we consider industry averages of ratios when determining ratios?

A

retailers will have lower current ratio than manufacturers

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29
Q

what is another name for the quick ratio?

A

acid test ratio

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30
Q

what is the quick ratio and how is it calculated?

A

(current assets-inventory)/current liabilities as a ratio

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31
Q

why is the quick ratio a better indication of short-term liquidity?

A

removes illiquid inventory balance

-compare the 2 to see effect of current vs quick ratio

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32
Q

what is a healthy quick ratio?

A

1:1

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33
Q

what is the risk of a low quick ratio and high current ratio?

A

risk of obsolete inventory as inventory is a significant amount of current assets

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34
Q

what is inventory days and how is it calculated?

A

IHP: days inventory is held before selling

inv/COS x 365 = n days

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35
Q

what is receivable days and how is it calculated?

A

RCP: average days taken to receive payment

TR/Rev x 365 = n days

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36
Q

what is payable days and how is it calculated?

A

PPP: average days taken to make payment

TP / COS x 365 = n days

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37
Q

how is the working capital cycle calculated?

A

inv days + TR days - TP days

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38
Q

is a higher or lower WCC better?

A

lower the better

  • lower inv and receivable days
  • higher payable days
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39
Q

what are the long term liquidity (capital structure) ratios?

A

gearing
interest cover
dividend

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40
Q

what are the 2 types of gearing ratios and how are they calculated?

A

gearing ratio:debt/equity = n:n

gearing %: debt / (debt+equity) x 100

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41
Q

how is debt calculated for gearing ratios?

A

NCL + overdraft

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42
Q

what is the gearing ratio used for?

A

to determine risk associated with entity i.e how much is fuelled by debt

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43
Q

what is the risk of higher gearing ratios?

A

failing to service the entity’s debt finance (pay interest)
having finance withdrawn
failing to obtain further finance from new financiers

=>default risk

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44
Q

what is interest cover and how is it calculated?

A

outlines how many times entity can pay interest out of its profit

operating profit/finance cost = n times

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45
Q

what is the ideal interest cover?

A

higher the better

-at least 2 times is good

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46
Q

what is the risk of a lower interest cover?

A

high risk of failing to service finance going concern issue

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47
Q

how is dividend cover calculated?

A

EPS/ dividend per share = n times

profit for the year/dividend paid = n times

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48
Q

what does dividend cover outline?

A

how many times out of earnings the entity can pay dividends

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49
Q

what are the limitations of financial reporting information?

A
  • only provides historical data
  • only provides financial information
  • filed at least 3 months after reporting date so reducing relevance
  • limited information for trend analysis over time
  • lack of detailed information (aggregation)
  • historic accounting doesn’t account for inflation
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50
Q

what are the limitations of comparing different entities?

A
  • different accounting policies used between entities
  • different accounting practiced between entities e.g revenue measuring
  • non-coterminous accounting periods i.e different YEs
  • entities in same industry can have different market sectors
  • incomparability due to size
  • different regulatory systems in different countries
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51
Q

what are the limitations of ratio analysis?

A
  • acceptable variants of certain ratios exists (gearing, ROCE)
  • distortion of results e.g seasonality
  • absence of additional information to establish a conclusion
  • can be affected by creative accounting/fraudulent financial reporting (profit smoothing, off-B/S finance, teeming and lading)
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52
Q

what is teeming and lading?

A

fraudulent bookkeeping to make accounts balance

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53
Q

what does Profit after dividends / profit before dividends calculate?

A

profit retention ratio

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54
Q

what is asset turnover?

A

how much revenue is being generated from the overall capital invested

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55
Q

what are the 4 stages of the GM model?

A

Descriptive: what happened
Diagnostic: why it happened
Predictive: what is going to happen
Prescriptive: what do we do now

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56
Q

what are the 4 stages of the GM model?

A

Descriptive: what happened
Diagnostic: why it happened
Predictive: what is going to happen
Prescriptive: what do we do now

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57
Q

What is big data?

A

storage of vast amounts of data

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58
Q

what is data analytics?

A

interpretation of big data

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59
Q

Which stages of the GM model mature from conclusions created with hindsight?

A

descriptive and diagnostic

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60
Q

which stage of the GM model provide insight about the potential future effects of data?

A

predictive stage

61
Q

which stage of the GM model cumulate in proactive decisions which focus upon applying foresight?

A

prescriptive stage

62
Q

what are the key areas to consider when performing an analysis of the FS?

A
  • identify user of analysis
  • understand nature of the business, industry and organisation
  • identification of relevant sources of data for analysis
  • numerical analysis of the data available
  • interpretation of the results of the analysis
63
Q

historically, who were financial statements prepared for?

A

investors

64
Q

what type of ratios would present and potential investors look at?

A
  • profits
  • liquidity
  • dividend payouts
65
Q

what type of ratios would suppliers and other creditors look at?

A
  • liquidity

- WCC and ratios

66
Q

what type of ratios would employees look at?

A
  • liquidity
  • profitability
  • disclosures about retirement benefits and remuneration
67
Q

why is it important to understand entity?

A
  • look at industry benchmarks
  • look into management
  • quality and quantity of service
68
Q

what can financial statements be used to analyse?

A

performance: profitability, SPL
position: ownership of assets and obligations, SFP
adaptability: responding to change, SCF, WCC and SPL
prospects: future holds?

69
Q

what are the main efficiency/activity ratios?

A
  • working capital ratios

- asset turnover ratios

70
Q

how is the effective tax rate calulated?

A

tax expense/ profit before tax x 100

-should exclude share of profit of associate from profit

71
Q

what is the difference between GP% and OP%?

A

operating costs such as admin costs, telephone costs and advertising costs

72
Q

how could expense classification distort analysis in non current assets?

A

depreciation may be categorised as a cost of sale or an operating expense

73
Q

how should exceptional items be treated?

A

one-off/irregular events would distort the picture so should be removed from analysis

74
Q

what does the effective tax rate show?

A

assess the extent of the impact that tax has on the entity’s profit

75
Q

why might timing of new NCA affect ROCE?

A

if purchased at the end of reporting period, won’t have an opportunity to make returns thus negatively affecting ROCE

76
Q

how can problems arise in making valid interpretations of movements in revenue?

A
  • accounting policies vary between entities
  • inflation may account for some of the price increase
  • detailed breakdown of revenue may not be available
77
Q

why is GP% expected to be more or less constant?

A

even an increase in direct costs could be expected to pass on the increases in the form of increased sales price but this is not always realistic

78
Q

what further information would be required to evaluate GP% fully that is not available in annual reports?

A
  • breakdown by product, geographical area or other segment
  • inventory valuation policies
  • overhead allocation methods
  • purchasing details such as bulk discounts, purchasing errors, wastage or theft
  • selling prices of different products over the period
79
Q

does IAS 1 revised encourage reporting OP% as a separate line item?

A

no, although there is nothing to prevent entities providing additional information

80
Q

why could coronavirus cause distortion in operating margins?

A

operational costs caused by lockdown working conditions and cost savings through salary reductions and furlough schemes

81
Q

what adjustments should be taken into account when calculating profit after tax margin?

A

-any large adjustments of under/provided tax provisions

82
Q

even thought tax is outside the control of the entity, when should it be considered?

A

when making investment decisions

83
Q

For ROCE, should the numerator include profit before or after deductions for finance costs?

A

before

84
Q

For ROCE, if capital employed includes a bank overdraft, what should the profit figure used in the calculation exclude?

A

interest paid and payable on the overdraft

85
Q

why should the carrying amount of a NCA that doesn’t contribute to operating profit be removed from the capital employed figure of ROCE?

A

to provide consistency e.g an investment in associate

-profit share is presented outside operating profit so value of investment should be deducted from capital employed

86
Q

what is EBBB?

A

earnings before the bad bits

-use of EBITDA to publicise a higher measure of earnings than profit from operations

87
Q

why is the EBITDA sometimes misunderstood as being a cash flow measurement?

A

eliminated 2 cash adjustments but earnings are still prepared on an accruals basis
-EBITDA makes no adjustments of other aspects of accrual accounting e.g accruals or WCC so is not a cash flow measurement

88
Q

how should one begins the analysis of liquidity?

A

review the actual bank balances in absolute terms in the SFP under current assets

89
Q

what could a decrease in liquidity position suggest?

A

-going concern

90
Q

what could an increase in liquidity position suggest?

A
  • NCA disposal?

- good takeover prospect so look for indications that owner wants to sell

91
Q

why is the quick ratio more applicable to industries were inventory has long production times and cash is difficult to realise?

A

inventory can be difficult to sell so it is the least liquid current asset and removing it gives a more conservative view

92
Q

what must an entity balance with inventory holding period?

A

balance need to supply goods on time vs risk of obsolensce

93
Q

what should the ideal RCP be based on?

A

credit agreements with customers

94
Q

what is the non-current asset turnover?

A

measured efficiency of non-current assets only against revenue

95
Q

what is over-trading?

A

expanding the equity without adequate long term or short term finance

96
Q

what are the signs of over-trading?

A
  • rapid growth
  • inventory, receivables and payables increase but decline in cash
  • high PBT and low cash generation
97
Q

how can entities solve overtrading?

A

raise LT finance:

  • enables improvement of inventory and credit control
  • reduces inventory and receivable days
  • improve cash flow

short-term financing:
-factoring, invoice discounting

98
Q

why might WCC ratios be unrepresentative?

A

gives on average number of days but only the closing figure is used so might not give full picture, especially of business is seasonal

99
Q

if an entity sells on both cash and credit terms, why should it split revenue into two types?

A

only credit sales are used within receivable days calculation

100
Q

what business would have very low or zero receivable days?

A

a retail or cash-based entity

101
Q

why is the asset turnover ratio likely to be high when assets are reaching the end of their useful life?

A

depreciation charges over long period decrease value

102
Q

why are entities using historic cost convention likely to have low asset productivity?

A

no revaluation so it is more intrusive as the assets age

103
Q

why does the asset turnover ratio lack significance in labour intensive entities?

A

low non-current asset base

104
Q

should the average or closing figure be used for non-current asset turnover?

A

average asset figure for denominator where possible for consistency and representative result but external users would not have access to this

105
Q

what is the average rate of borrowings?

A

typical interest rate that the entity pays on debt finance

106
Q

how can the use of debt in capital structure increate profits for shareholders?

A

cash received from lenders will be used to generate revenue and profits. as interest rates are fixed, can be relatively cheap compared to dividends and any profits generated in excess of interest costs will accrue to the shareholders

107
Q

what is the negative of debt finance to shareholder profits?

A

if debt doesn’t raise sufficient profits, fixed interest cost must be paid first and profits available to shareholders are decreased or extinguished completly

108
Q

what are some actions entities can perform based on the predictive and prescriptive solutions?

A
  • pursue acquisition
  • finance providing to a credit customer
  • look for alternative suppliers
  • deciding on a strategic approach
  • selling or retaining current investments in shares
  • agreeing to provide new financing or to withdraw existing finance from borrowers
109
Q

how can creative accounting lead to limitations in financial statements?

A
  • timing of transactions to improve results
  • profit smoothing using IFRS compliant policies e.g inv valuation
  • classification of items e.g expenses vs NCA
  • off-balance sheet financing to improve gearing and ROCE
  • revenue recognition policies
  • managing market expectations
110
Q

how do some jurisdictions combat the timeliness of FS?

A

requirement for large, listed entities to produce half0-yearly or even quarterly FS

  • less detailed than annual
  • probably not audited
111
Q

how can inflation complicate comparisons?

A

rate of inflation may not be factored into analysts calculations

112
Q

what are some limitations of accurate analysis with different accounting policies?

A
  • company which constantly revalues will have higher CV and dep than vs historical valuing company
  • classifications of similar expenses e.g part of COS or operating expenses making OP% and GP% incomparable (judgement issue)
  • varying approaches to judgements in impairment review and provisions
113
Q

why is it easier to adjust for accounting policies than judgement issues?

A

accounting standards allow comparability whereas judgement issues impossible to adjust for

114
Q

why does operational flexibility vary with size of company?

A

large company:more media coverage and regulation, harder to take risks as this can alter public perception and negatively impact shares

115
Q

what are the differences in German, France and Spanish’s approach to FS vs British and Irish?

A

more focused on tax regulation while ours are more focused on achieving true and fair view

116
Q

what is the only accounting ratio with a prescribed method of caluclation?

A

earnings per share regulated through IAS 33

117
Q

why must the calculation method of ratios be consistent?

A

usually more than one valid method of calculation so for comparisons, consistent calculation must be used

118
Q

are directors performing illegal actions with creative acocunting?

A

no, it is just unethical

119
Q

How did Tesco use altering timing as creative accounting?

A

supplier payments were recognised early thus overstating revenues of £250m

120
Q

How did Worldcom perform creative accounting via classification?

A

improperly reported $3.8B of expenses as NCA and manipulated provisions thus providing a boost to reported earnings
-scale so big they were jailed for fraud

121
Q

How did Thomas Cook perform creative accounting via classification?

A

directors excluded $1.8B of expenses over 8yr period from operating profits and continued to trade as going concern for many years

122
Q

how did Enron perform creative accounting via exclusion of liabilities?

A

set up Special Purpose Entities i.e unconsolidated structured entities to provide finance to business but excluded them from consolidation so liabilities didn’t appear on group FS

123
Q

Despite IFRS 10 consolidated FS, what type of financing remains a problem?

A

off-balance sheet financing

124
Q

what % probability makes a contingent liability?

A

probability of occurrence of less than 50% but not remote

-usually found in notes

125
Q

how should analysts treat contingent liabilities in FS?

A

calculate ratios and impact with and without them

126
Q

what are some examples of inappropriate revenue recognition?

A
  • recognising revenue from sales that are made conditionally e.g high likelihood of return
  • failing to apportion subscription revenue over appropriate accounting periods
  • recognising revenue on goods shipped to agents employed by entity
  • recognising the full amount fo revenue when only partial shipments of goods have been made
  • recognising revenue from future LT sales earlier than appropriate
127
Q

How did revenue recognition cause collapse of Carillion, the construction company?

A

aggressively recorded revenue despite delays in LT contracts with performance obligations not met so couldn’t recover cash from work carried out

  • Qatar World Cup 2022
  • building Royal Liverpool Hospital
128
Q

How can companies influence market expectations?

A

as a listed company, easier to massage expectations than improve reported results through creative accounting through bluffing

  • directors meet analysts and influence their expectations by forecasting fairly poor figures
  • when they beat these results, market view is enhanced
129
Q

what are the significant factors that motivate creative accounting?

A
  • tax avoidance
  • increasing shareholder confidence:show steady growth
  • personal gain:bonuses linked to profits
  • indirect personal gain:reputation, hiring opps, power
  • following the pack:if market wide
  • meeting covenants: lenders insist on certain criteria being met otw demand repayment
130
Q

what additional financial information can be useful to analysts that is not in financial statements?

A
  • budgeted figures
  • other management information
  • industry averages
  • figures for a similar entity
  • figures for the entity over a longer period of time
131
Q

what additional non-financial information can be useful to analysts that is not in financial statements?

A
  • market share
  • key employee information
  • sales mix information
  • product range information
  • the size of the order book
  • the LT plans of management
  • environmental policies
  • 3rd party documents e.g solicitors correspondence, contacts with customers, financiers
132
Q

How are further requests for information handled?

A

depends on user
e.g NCI would not be able to access publicly available information, lender can ask for anything and reject if not satisfied

133
Q

to perform an effective assessment of an entity’s cash flow, which areas should be reviewed in the cash flow statement?

A
  • cash generated from operations
  • dividend and interest payments
  • investing activities
  • financing activities
  • net cash flow
134
Q

what does cash generated from operations show?

A

cash movements caused by day to day activities

135
Q

how can we determine how well the entity turns profits into physical cash flow from the CFS?

A

directly compare cash generated from operations to the profit from operations

136
Q

why is it worse to have significant interest payments than dividends?

A

dividend payment is discretionary so can be reduced going forward

137
Q

what does it show if NCA investment > depreciation?

A

expansion: entity is investing at a greater rate than current assets are wearing out

138
Q

what does it show if NCA investment = depreciation?

A

stability:same rate of growth

139
Q

what does it show if NCA investment < depreciation?

A

NCA base is not being maintained which is worrying as NCAs are generators of profit

140
Q

what does financing activities in the CFS show?

A
  • changes in financing (pure cash terms)

- useful to comment on impact of changes on gearing ratio

141
Q

what does a low carried forward cash net cash flow balance indicate?

A

entity is approaching overdraft breach

142
Q

what does a large carried forward cash net cash flow balance indicate?

A

positive operational indicators or primed for takeover

143
Q

how is cash return on capital employed calculated?

A

cash generated from operation x 100

/capital employed

144
Q

what are the main cash flow ratios?

A
  • cash return on capital employed
  • cash generated from operations to total debt
  • net cash from operating activities to capital expenditure
145
Q

how is cash generated from operations to total debt ratio calculated?

A

cash generated from operations / total long-term borrowings

146
Q

what does cash generated from operations to total debt indicate?

A

entity’s ability to meet its LT obligations

147
Q

how do you calculate how many years it would take to repay LT borrowings if all cash generated from operations were to be used for this purpose?

A

total LT borrowings/cash generated from operations

148
Q

how is net cash from operating activities to capital expenditure ratio calculated?

A

net cash from operating activities x 100

/net capital expenditure

149
Q

what does net cash from operating activities to capital expenditure indicate?

A

the extent to which the entity can finance its capital expenditure out of cash flows from operating activities
-otw will need LT financing

CIMA F2 (5 decks)

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