M2: Financial Statement Analysis & Intro to Management Accounting

Question 1

What is the Purpose of Financial Statement Analysis?

Answer 1

1. To compare a company to it’s competitors or to the industry in general
2. To understand the overall health of the company
3. To evaluate company performance over time
4. To estimate the value of the business

In general, financial statement analysis helps with users decision making.

Question 2

What kind of analysis can we perform on financial statements?

Answer 2

1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
4. Trend analysis

Question 3

What is horizontal analysis?

Answer 3

Involves comparisons of historical data to compare company data from one period to the next. Ex: did the sales increase or decrease over the past years.

Question 4

What is vertical analysis?

Answer 4

Involves comparing items on financial statements in relation to each other to analyze the makeup of a company’s assets/liabilities or expenses/income for one year.

Question 5

What is ratio analysis?

Answer 5

Involves calculating key financial metrics to assess performance over time or performance in comparison to competitors.

Question 6

What is trend analysis?

Answer 6

Similar to horizontal analysis, the goal is to use historical data from multiple years to make predictions about the future and the company’s future stock price.

Question 7

How do you measure items on a financial statement using horizontal analysis?

Answer 7

Horizontal analysis compares one line of the financial statement from one year to the next. These amounts can be expressed as an amount or percentage and include the following measures:

1. Percentage of base period amount: calculated as the analysis period amount ÷ base period amount.
2. Percentage change for the period: calculated as (analysis period amount – prior period amount) ÷ prior period amount.
   (how much did my expenses increase or decrease as a percentage as of last period?)

Both of these can be calculated for multiple periods to show a trend.

Question 8

How do you measure items on a financial statement using vertical analysis?

Answer 8

Vertical analysis is a technique that expresses each item as a percentage of a base amount. The base amount depends on the financial statement in question:

1. Balance sheet: base amount could be total assets or total liabilities plus shareholders equity (to figure out which assets make up the biggest % of total).
2. Income statement: base amount could be total sales
3. Vertical percentage of base amount is calculated as the analysis amount ÷ base amount.

Question 9

What are the types of ratio analysis? Describe them,.

Answer 9

1. Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Will a company be able to pay debts due in coming months? Ex: paying suppliers
2. Solvency Ratios: Measure the ability of the company to survive over a long period of time. Will a company be able to pay long term obligations? Ex: paying back loans.
3. Profitability Ratios: Measure the operating success of a company for a specific period of time. Is a company more profitable than in the past or more profitable than their competitors?

Question 10

What type of ratio is a “current ratio”? Describe it.

Answer 10

1. It is a liquidity ratio.
2. Current ratio: measures the relationship between current assets and liabilities and is calculated as follows:
   Current ratio = current assets/current liabilities

A higher current ratio will generally indicate a more liquid company or company more able to pay short term debt.

Question 11

What type of ratio is a “quick ratio”? Describe it.

Answer 11

1. It is a liquidity ratio.
2. Quick ratio: measures the relationship between the most liquid assets (below 90 days) and current liabilities and is calculated as follows:
   Quick ratio = (current assets – inventory)/ current liabilities.
   ( first term= How much current assets do i have without having to sell inventory)

A higher quick ratio will generally indicate a more liquid company or company more able to pay short term debt. Here inventory is excluded because for a company to sell all inventory in less than 90 days they would have to compromise on their price.

Question 12

What type of ratio is a “debt to total assets ratio”? Describe it.

Answer 12

1. It is a solvency ratio
2. Debt to total assets ratio : used to measure the percentage of total assets that have been financed by a company’s creditors, calculated as follows:
   Debt to total assets = Total liabilities/ Total assets
   A higher ratio is generally not a good sign, it means the company has a high level of debt.
   A higher ratio also means there is a higher risk of not being able to pay debts/interest.

Question 13

What type of ratio is a “debt to equity ratio”? Describe it.

Answer 13

1. It is a solvency ratio
2. Debt to equity ratio: used to measure the proportion of the company’s financing that has come from debt, calculated as follows:
   Debt to equity = Total liabilities/ Shareholders equity
   A higher ratio will mean that a company has used more debt than equity to finance themselves.
   However, a higher ratio could mean there is a higher risk of not being able to pay debts/interest.

Question 14

What type of ratio is a “gross profit margin”? Describe it.

Answer 14

1. It is a profitability ratio
2. Gross profit margin: indicates a company’s ability to maintain a good selling price above cost of good sold as percentage, calculated as follows:
   Gross profit margin = Gross profit/Net sales
   Also referred to as % gross margin.
   Generally higher is better here.

Question 15

What type of ratio is a “profit margin”? Describe it.

Answer 15

1. It is a profitability ratio
2. Profit margin: indicates how profitable a company is as a percentage, so how effective they are at controlling expenses, calculated as follows:
   Profit margin = Net income/Net sales
   Also referred to as net margin ratio.
   Generally higher is better here.

Question 16

What type of ratio is a “return on assets ratio”? Describe it.

Answer 16

1. It is a profitability ratio
2. Return on assets ratio: tells you how much net income is earned for every dollar of assets, calculated as follows:
   Return on assets = Net income/ Average total assets
   Generally higher is better here.Means you are better at using your assets to return income.

Question 17

What type of ratio is a “return on equity ratio”? Describe it.

Answer 17

1. It is a profitability ratio
2. Return on equity ratio: Measures the company’s profitability from the shareholders’ viewpoint, it shows how much income was earned for each dollar invested by the shareholders, calculated as follows:
   Return on equity = Net income/ Average shareholders equity
   Generally higher is better here. Means you are earning more income than what the shareholders invested in the company.

Question 18

What types of decisions does “management accounting” include?

Answer 18

1. How much should I charge for my products?
2. Is my product profitable?
3. How many products do I need to sell?
4. Which costs are important to consider when deciding how much to charge?
   In general. They help make decisions within the company.

Question 19

What is a product cost? What title is it included in in the income statement?

Answer 19

Title in income statement: cost of goods sold
Product costs: these are all the costs required to manufacture or purchase goods to be sold by the company. When incurred, these costs represent inventory on the balance sheet and are then transferred to cost of goods sold on the income statement when sold.

Question 20

What is a period cost? What title is it included in in the income statement?

Answer 20

Title in income statement: everything that falls under operating expenses (depreciation expense, selling and administrative expenses, employee expenses, other operating expenses).
Period costs: Costs that cannot be linked directly to the production of inventory, these are all other costs that make up the operating expenses section.

Question 21

What are the 2 types of product costs? What falls into each category?

Answer 21

DIRECT

1. Direct materials: the cost of buying and shipping raw materials or the cost of purchasing inventory if the company is a distributor.
2. Direct labour: wages and benefits paid to staff for manufacturing the goods.

INDIRECT
1. Manufacturing overhead: these are costs that relate to the manufacturing process but are difficult to link to a specific product/service, so referred to as indirect costs. See next slide.

Question 22

What costs makes up manufacturing overhead?

Answer 22

Made up of:

1. Indirect materials: materials used in production not related to a specific product, such as various supplies.
2. Indirect labour: wages and benefits paid to staff involved in production but not working on a specific product, such as a supervisor (“touch test”).
3. Other indirect costs: costs other than those above, such as depreciation of machinery, utilities/insurance related to production, etc.

These costs are then allocated to different products based on cost drivers (an area of focus for managerial accounting courses).

Question 23

What is a cost driver?

Answer 23

Cost driver tells us how we’re going to allocate our manufacturing over head ton our specific product line. Ex: company that sells coffee cups and wine glasses. Company has overhead for insurance of factory. How do i decide how much of that insurance goes to the coffee cups vs wine glasses. A cost driver helps allocate the insurance cost to each of the products for example how much space each production line takes up in the factory or how many hours does it thanks the machines to manufacture the coffee cup vs the wine glass.

Question 24

Describe the timeline of costs on a balance sheet and an income statement.

Answer 24

Balance sheet:
1. Raw materials purchased
2. Work in process: Raw materials are transformed into work in progress. Direct labour and manufacturing overhead are accumulated throughout the production process.
3. Finished goods: The production process is finished, goods are stored in the warehouse until sold to customers.
Income statement:
4. Cost of good sold: Goods are sold to customers. Revenue is recognized and related inventory is now moved to cost of goods sold on the income statement.

Question 25

What are the 2 types of cost behaviour?

Answer 25

1. Variable costs

2. Fixed costs

Question 26

What is variable costs?

Answer 26

These are costs that change in proportion to changes in output, so higher volume will equal higher variable costs.
Includes raw materials, direct labour, sales commissions, etc. (can be either product costs or period costs).
Will be constant on a per unit basis. The more units sold the higher the cost.

Question 27

What is fixed costs? What is the formula for total unit cost? What is the formula for Unit profit?

Answer 27

These are costs that remain constant regardless of the number of units sold/services provided.
Includes rent, insurance, management salaries, etc. (can be either product costs or period costs).
While fixed costs remain the same in total, as more units are produced, the fixed cost per unit will decrease. The fixed cost gets spread out over all the extra units being produced.

Total unit cost = variable cost/unit + fixed cost/unit.

The Unit profit = Sales price/unit – variable costs/unit – fixed costs/unit.

Question 28

What is the contribution margin? How do you calculate contribution margin per unit and contribution margin ratio?

Answer 28

Contribution margin is defined as the amount of money that each unit sold contributes to paying for fixed costs.
Contribution margin per unit = Revenues per unit – Variable cost per unit
Contribution margin ratio (%) = Contribution margin per unit/Selling price per unit. Tells us the % of sales price that can be used to pay for fixed costs.

Question 29

What is the breakeven point? How do you calculate breakeven volumes and breakeven revenues?

Answer 29

The number of units a company needs to sell or revenues they need to generate to cover their fixed costs.
Breakeven volume = Fixed costs/Unit contribution margin

Breakeven revenues = Fixed costs/Contribution Margin Ratio

Question 30

What happens when contribution margin is negative?

Answer 30

Businesses lose money!
More sales = more losses and no chance at profits because breakeven is impossible.
It means it’s costing more in variable costs to make a product than what I’m selling it for. The more product you sell, the more money you lose.

Question 31

What is operating leverage? Describe a high and low operating leverage.

Answer 31

The relationship between fixed and variable costs is referred to as operational leverage.
If a company has more fixed costs than variable costs, they will have a higher operating leverage.
If a company has more variable costs than fixed costs, they will have a lower operating leverage.

Question 32

What is the advantage and disadvantage of a high operating leverage? give an example.

Answer 32

Having a high operational leverage may be profitable but can be risky if the firm is not able to scale and reach the breakeven point due to high fixed costs.
Ex: Microsoft, a software company, will have high operating leverage because the variable costs of selling an additional software license will be very low compared to the initial investment of developing the software.
This can be powerful bc once i pass the point of breaking even, every sale is extremely profitable. BUT you have to make the break even point.

Question 33

What is an example of a low operating leverage?

Answer 33

A law firm will have low operating leverage as they have high variable costs from hiring experienced staff compared to the low fixed costs of rent and computers. Harder for them to earn a lot of profit once they break even because they have a high variable cost that increases.

Question 34

What is the difference between financial accounting and managerial accounting?

Answer 34

It is important to keep in mind that there are different rules that apply when preparing financial statements (IFRS & ASPE) and when doing management accounting. Management accounting is focused on internal decision making so uses different definitions/analysis.

• This means that contribution margin and gross margin will not be equal as contribution margin includes both product and period costs, which are split up on the income statement for financial reporting purposes.
• Financial accounting focuses on grouping expenses by nature whereas management accounting groups expenses as fixed vs variable.
• At the end of the day, net income is the same, just a different grouping of costs to better facilitate decision making.