Past Papers Flashcards

Question

Trade receivables (days) cons

Answer 1

Varies between industries. Can’t compare between industries. Companies of different sizes often have very different capital structures which can greatly influence calculations. Difficult to tell the cause. A high ratio might indicate a company’s collection of receivables is efficient, it might indicate a company operates on a cash basis or it might indicate the company is conservative when it comes to extending credit to its customers. Can vary throughout the year

Answer 2

(Average inventory / COGS) x 365 Average inventory = (Beginning Inventory + End Inventory)/2 Indicates the average time in days that a company takes to turn its inventory into sales. Used to determine the efficiency of sales.

Answer 3

Managing inventory levels is vital for most businesses and is especially important for retail companies or those selling physical goods. Inventory days is one of the best indicators of a company’s level of efficiency at turning over its inventory.

Answer 4

Varies between industries - difficult to compare. Exact recommended inventory days varies for different industries - generally considered to be between 30-60 days.

Answer 5

P/E = Share price / Earnings per share The ratio for valuing a company that measures its current share price relative to EPS.

Answer 6

Can be used to compare companies but also compare the same company against its own historical record. Helps determine whether a stock is under or over valued.

Answer 7

Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.

Answer 8

= (days inventory outstanding) + (days sales outstanding) - (days payable outstanding) DIO = Average inventory / COGS per day Average inventory = (beginning inventory + ending inventory)/2 DSO = Average AR/Revenue per day Average AR = (begining AR + ending AR) /2 DPO = Average AP/COGS per day The average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. A company with an extremely short operating cycle requires less cash to maintain its operations and so can still grow while selling at relatively small margins. A shorter operating cycle means a company is healthier

Answer 9

Measures how efficiently a company’s managers are managing its working capital. Used to see how long a company’s cash remains tied up in operations.

Answer 10

On its own it doesn't mean very much - it should be used to track a company over time and to compare to competitors. Less relevant in different industries e.g. consulting

Answer 11

EBIT/Revenue x 100 A measure of a company’s profitability by dividing EBIT by revenue. Shows how much of each dollar of revenue was converted into profit

Answer 12

Tells you how profitable a company is compared to its sales Takes into account a company’s ability to generate profits from its operations. Useful metric for comparing different companies and industries

Answer 13

EBIT margin does not take into account the company’s capital structure or its cost of capital. This means that a company with a high debt-to-equity ratio could have a high EBIT margin but still be in a weak financial position. Does not account for a company’s tax liabilities, which could be significant. Does not necessarily reflect the company’s underlying profitability or cash flow. Important to use a variety of metrics.

Answer 14

(Cash + Marketable securities + Accounts receivable)/Current liabilities OR (current assets - inventory - prepaid assets)/ current liabilities Indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets. Also called Acid Test Ratio. Indicates the company’s ability to instantly use its near-cash assets to pay down its current liabilities. A result of 1 is considered to be a normal quick ratio. Less than 1 may not be able to fully pay off its current liabilities in the short term Higher than 1 can instantly get rid of its liabilities.

Answer 15

More conservative measure than current ratio (which includes all current assets as coverage for current liabilities).

Answer 16

Offer insight into the viability and certain aspects of a business, but it does not provide a complete picture.

Answer 17

P/E, P/B (price to book), Price to earnings growth, dividend yield

Answer 18

A stock’s price doesn’t necessarily explain its value. Important to analyze further with ratios.

Answer 19

Any singular ratio is too narrowly focussed to stand alone, so combining these and other financial ratios gives a more complete picture.

Answer 20

Total Tax / Earnings before taxes The percent of their income that a corporation pays in taxes. The effective corporate tax rate is the rate they pay on their pre-tax profits.

Answer 21

Straightforward to calculate using income statement

Answer 22

Typically considers income taxes and doesn’t consider other taxes e.g. property tax

Answer 23

ROTA = EBIT/Average Total Assets Ratio that measures a company’s EBIT relative to its total net assets. Indicator of how effectively a company is using its assets to generate earnings.

Answer 24

Easy to calculate Easy to compare to similar organisations.

Answer 25

Over time, the value of an asset may diminish or increase. In the case of real estate, an asset may rise. Assets can also depreciate. Assets may be understated to actual market value. If debt is used to buy an asset, ROTA may look favourable whie the company may actually be struggling with its interest expense payments.

Answer 26

Split into EBIT margin and Asset turnover (Sales/Total assets) SPlitting into sub-parts gives us an insight into what happened during the period. Disaggregation allows us to keep asking more detailed and specific questions until we have an understanding of the events and conditions that led to the performance that occurred.

Answer 27

ROE = Net Income / Average Shareholders Equity A measure of financial performance. A gauge of a corporation profitability and how efficient it is in generating profits. What is considered a good ROE will depend on industry and competitors.

Answer 28

Can be used to estimate sustainable growth rates and dividend growth rates.

Answer 29

Will vary based on the industry the company operates in. A high ROE might not always be positive - could indicate inconsistent profits or excessive debt.

Answer 30

(AP - SP) x AQ The cost of the difference in price from what was planned Materials purchased for less/more than the standard price.

Answer 31

(AQ - SQ) x SP ## Footnote This shows us how different our material costs were from planned given that we used a different quantity of inputs than planned. More material has been used in the production process than needed.

Answer 32

Labor efficiency variance + labor price variance The effect on cost of the difference in wages Differences in wages or hours worked

Answer 33

(AW - SW) x AH The effect on cost of the difference in wages HR negotiate lower wages

Answer 34

(AH-SH) x SW This shows us how different out labour costs were from planned given that labour hours were different from what was planned. Production department less/more efficient at utilizing the abilities of its workers.

Answer 35

In IFRS all research spending is expensed each year. However, development costs are capitalized once the “asset” being developed has met requirements to signal the investment is likely to either be brought to market or sold.

Answer 36

Successful R&D is capitalized on the balance sheet, as opposed to expensed. Without capitalizing R&D, a firm’s earnings can be materially understated because the traditional calculation of Net Income does not recognise the firm’s material investments in R&D as part of its operating investments. This violates one of the core principles of accounting - expenses should be recognized in the period when the related revenue is incurred

Answer 37

Provides more opportunity for the application of judgment, and adds to the risk of distortion of financial statements.

Answer 38

Most R&D costs are expensed in the present financial period. Whenever a company spends any funds on R&D activities, it must record those costs under the current financial period. Costs typically incurred include equipment and materials, and these must all have no other purpose in the company aside from R&D.

Answer 39

Less opportunity for judgement.

Answer 40

Can create a lot of volatility in profits/losses for many companies. Can create a difficulty in measuring their rates of return on assets and investments. A lack of R&D capitalization could mean that their total assets or their invested capital do not properly reflect the amount that has been invested into them. As a result, there can be an impact on a company’s ROA and ROIC

Answer 41

A measure of how reliable a company’s earnings are for assessing a company’s current and future performance. A company’s real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew numbers. Quality of earnings is the % of income that is due to higher sales or lower costs. Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earnings. The more closely a company sticks to GAAP, the higher its quality of earnings is likely to be. Measures of earnings quality: cash conversion ratio, accruals ratio

Answer 42

An increase in net income without a corresponding increase in cash flow from operations is a red flag. Due to numerous accounting standards it is possible to manipulate earnings to serve the company’s needs. Companies that manipulate earnings are said to have low earnings quality. Earnings quality drives expectations of future earnings and cash flows - low earnings quality will generally result in lower expectations of future earnings and cash flows relative to current earnings. Earnings quality is critical for credit analysis, deal diligence (e.g. M&A, LBO, IPO) If earnings quality assessment provides evidence that earnings are being manipulated by management this will raise corporate governance concerns.

Answer 43

(Net profit/ cost of investment) x 100 Determines gain or loss of an investment as a % of the cost Internally, for individual projects or investments

Answer 44

(Today’s value of expected cash flows) - (Today’s value of inves ## Footnote Calculate today’s value of expected future cash flows Internally, for individual projects or investments

Answer 45

NPV = 0 ## Footnote Determines the % rate of return at which the cash flow of a project will break even Internally, for individual projects or investments

Answer 46

Net income / Shareholder equity Measures the profitability of a corporation Externally, by investors to understand how much money they’re getting

Answer 47

Net income/ Average total assets Determines how profitable a company is relative to its assets Internally, by managers to measure efficiency, particularly in industrial and manufacturing industries.

Answer 48

NOPAT/Invested Capital Measures the % return that a company earns on invested capital Externally, by investors to evaluate what they’re likely to get as dividends, since it is based on after-tax figures

Answer 49

EBIT/ Capital Employed Determines how well a company is generating profits from its capital employed Internally by the company, since it is based on pre-tax figures and can be used to assess the ability of managers to efficiently use capital.

Answer 50

Evaluating potential investments Gauging the success of existing projects Monitoring business performance as a whole Ensure viability and effectiveness

Answer 51

Earnings before interest and taxes Net Income + Interest + Taxes OR Revenue - COGS - Operating Expenses

Answer 52

Indicates a company’s profitability. By ignoring taxes and interest expenses, EBIT focuses on a company’s ability to generate earnings from operations

Answer 53

Depreciation is included in the EBIT calculation and can lead to varying results when comparing companies in different industries. EBIT removes interest expense and thus inflates a company’s earnings potential, particulalry if the company has substantial debt.

Answer 54

Earnings Before Interest, Taxes, Depreciation and Amortization. EBIT + Depreciation + Amortization Or Net Income + Interest + Dep + Amor

Answer 55

Measure of a company’s overall financial performance. Can be used to compare companies against each other and industry averages.

Answer 56

Can be misleading because it does not reflect the cost of capital investments like PPE. Its a non-GAAP measure Ignores costs of assets Ignores working capital.

Answer 57

Sales - COGS

Answer 58

Used to calculate EPS

Answer 59

Doesn’t include depreciation, amortization etc.

Answer 60

Assets or liabilities that do not appear on a company’s balance sheet. Prior to a change in accounting rules, operating lease was one of the most common off-balance items.

Answer 61

Can be used to keep debt-to-equity and leverage ratios low, facilitating cheaper borrowing and preventing bond covenants from being breached.

Answer 62

Difficult to identify and track within a company’s financial statements because they only appear in accompanying notes. Not intended to be deceptive, but can be misused.

Answer 63

The company leasing the asset only accounts for the monthly rental payments and other fees associated with the rental rather than listing the asset and corresponding liability on its balance sheet. At the end of the lease term, the lessee generally has the opportunity to purchase the asset as a drastically reduced price. ## Footnote Feb 2016 - FASB (issuer of GAAP) - changed the rules. Under GAAP - OBSF should be disclosed in the notes of financial statements.

Answer 64

* Transfer price is the price at which related parties transact with each other. * Transfer prices may be used between a company and its subsidiaries, or between divisions of the same company in different countries. * Transfer prices that differ from market value will be advantageous for one entity, while lowering the profits of the other entity. * A transfer price arises for accounting purposes when related parties, such as divisions within a company or a company and its subsidiary, report their own profits. When these related parties are required to transact with each other, a transfer price is used to determine costs. Transfer prices generally do not differ much from the market price. If the price does differ, then one of the entities is at a disadvantage and would ultimately start buying from the market to get a better price. * Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing among related entities. Regulations enforce an arm’s length transaction rule that states that companies must establish pricing based on similar transactions done between unrelated parties. It is closely monitored within a company’s financial reporting. * Intercompany transfers done internationally have tax advantages, which has led regulatory authorities to from upon using transfer pricing for tax avoidance. * Transfer pricing can prevent supply chain issues and result in cost savings (compared to market prices). * Market prices are based on supply-demand relationships, whereas transfer prices may be subject to other organizational forces.

Answer 65

Determine a variable cost per unit Determine fixed costs Determine unit selling price Fixed costs/(Sales price per unit - Variable cost per unit) = BE

Answer 66

* Depreciation accounts for decreases in the value of a company’s assets over time. * Depreciation allows a business to deduct the cost of an asset over time rather than all at once. * Four methods under GAAP: * Straight-line * Declining balance * Sum-of-the-years digits (not important) * Units of production (not important) * The best method for a business depends on size and industry, accounting needs and types of assets purchased. * Straight line depreciation: * (Cost of asset - salvage value)/useful life * Declining balance * Type of accelerated depreciation used to write off depreciation costs earlier in an assets life and to minimize tax exposure. * Fixed assets depreciate more so early in life rather than evenly over their entire estimated useful life. * Used if an asset is expected to lose greater value or have greater utility in earlier years. * Helps to create a larger gain when the asset is sold. * Current book value x depreciation rate

Answer 67

Accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life. The matching principle under GAAP dictates that expenses must be matched to the same accounting period in which the related revenue is generated.

Answer 68

* When an asset set for disposal is sold, depreciation expense must be computed up to the sale date to adjust the asset to its current book value. * Compare the cash proceeds received from the sale with the asset’s book value to determine if a gain or loss on disposal has been realized. The gain or loss should be reported on the income statement.. * The asset account and its accumulated depreciation account are removed off the balance sheet when the disposal sale takes place.

Answer 69

* Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold or expenses are recorded as incurred before the company has paid for them. * In other words, the revenue is recognized on the company’s accounts regardless of when cash transactions have occurred. * Alternative - cash accounting. Cash accounting only records the revenue when the cash transaction has occurred for the goods or services. * Benefits: * Provides a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement.

Answer 70

* In accrual basis accounting, when your business purchases a long-lived asset, such as a vehicle, you don’t immediately write off the full cost as an expense. Rather, you spread the cost over the expected life of the asset, an accounting procedure known as depreciation. * You do this to adhere to accrual accounting fundamental “matching principle”, in which you match expenses to the revenue generated by those expenses.

Answer 71

* Warren Buffett - “Does management think the tooth fairy pays for capital expenditures?” * Depreciation and Amortization expenses are not an actual cash outflow. Therefore by not including it, it does not reduce the company's total assets. * EBITDA is a way to overstate the company’s earnings and thus overstate their value. * E.g. a company that has no other assets besides PPE will lose value as the assets depreciate. Using EBITDA as a means to value this company is a way to overstate value.

Answer 72

1. Choose a cost allocation base. Such as direct labour or direct material 2. Calculate the cost allocation rate. To do this, divide the total overhead by the total quantity of the cost allocation base. 3. Apply the overhead to each product. To do this, for each product, multiply the cost allocation rate by the product's quantity of the cost allocation base.

Answer 73

1. Divide overhead cost into cost pools. Each cost pool is a group of costs incurred in the same manner. For example, shipping could be a cost pool. 2. Choose a cost driver for each cost pool A cost driver for shipping could be shipments. 3. Calculate a cost driver rate for each cost driver. To do this, divide the total dollar amount of each cost pool by the total quantity of each cost driver. 4. Apply the overhead from each cost pool to each product. To do this, for each product, multiply the cost driver rate by the quantity of the cost driver.

Answer 74

* ABC systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. * Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

Answer 75

Gross margin represents the % of total revenue a company has left over, above costs directly related to production and distribution The higher the %, the more financial value-add is produced on each dollar of sales made by the company. If a company’s gross margin is falling, it may look to find ways to cut labour costs, lower costs on acquiring materials or even increase prices. EBIT margin (or operating margin) additionally subtracts overhead and operational expenses from revenues. Similarities - both are representations of how efficiently a company is able to generate profit by expressing it through a per-sale basis. Higher margins are considered better than lower margins. Both can be compared between competitiros, but not across different industries. Differences EBIT margin is a more significant bottom-line number for investors than gross margin. Comparisons between two companies’ operating margins with similar business models and annual sales are considered to be more telling. Gross margin is always higher than EBIT margin because there are fewer costs to subtract from gross income. Gross margin offers a more specific look at how well a company is managing the resources that directly contribute to the production of its goods and services. Costs such as salaries and negotiation have more room for negotiation, therefore companies scrutinize their operating expenses as a way to increase efficiency and cut costs. Therefore, greater focus on EBIT.

Answer 76

* Profitability ratios- provide insight into how much profit a company generates and how that profit relates to other important information about the company. * Gross margin * Operating margin * Net profit margin * EBITDA margin * Operating cash flow margin * ROA * ROE * ROIC * ROI

Answer 77

* Liquidity ratios - how quickly a company can repay its debts. Shows how well company assets cover expenses. Gives an idea of operational efficiency. * Current Ratio * Quick ratio * Cash conversion cycle * Receivables turnover * Inventory turnover * Working capital turnover

Answer 78

* Leverage Ratios (or Solvency ratios): used by investors ot get a picture of how well a company can deal with its long-term financial implicatiosn. * Debt to total assets * Debt to equity * Interest coverage ratio * Net income to liabilities

Answer 79

* Valuation ratios: used for analysing the attractiveness of an investment in a company. The lower the level of the ratio, the more attractive the investment * Price-to-earnings (P/E) * Price to book (P/B) * Price to sales (P/S) * Price to cash flow (P/CF)

Answer 80

Capital expenditure is the amount spent by businesses or corporations to purchase, maintain or improve fixed, tangible assets. This is often also referred to as capital expense and is abbreviated as CAPEX for short. ∆PPE + Current Depreciation = CAPEX

Answer 81

* Return on equity (ROE) and return on assets (ROA) are two key measures to determine how efficient a company is at generating profits. * The main differentiator between the two is that ROA takes into account leverage/debt, while ROE does not. * The way the company’s debt is taken into account is the main difference between ROE and ROA. In the absence of debt, shareholder equity and the company’s total assets will be equal. * If the company takes on financial leverage, its ROE would be higher than its ROA. By taking on debt, a company increases its assets thanks to the cash that comes in. Assuming returns are constant, assets are now higher than equity and the denominator of the ROA calculation is higher because assets are higher. ROA will therefore fall while ROE stays at its previous level. * Depending on the company, one may be more relevant than the other—that's why it's important to consider ROE and ROA in context with other financial performance metrics.

Answer 82

* 1 January 2019 * New requirements eliminate nearly all off balance sheet accounting for lessees and redefine many commonly used financial metrics such as the gearing ratio and EBITDA. * Major impact on financial statements of lessees of property and high-value equipment. * If a company has control over, or right to use, as asset they are renting, it is classified as a lease for accounting purposes and, under the new rules, must be recognised on the company’s balance sheet. * No longer allows for significant financial liabilities to be held off-balance sheet, as permitted for certain types of leases under the previous rules. The objective is to ensure that companies report information for all of their leased assets in a standardised way and bring transparency on companies’ lease assets and liabilities. * The objective of the change is to make sure that companies all return information for leased items in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities on their operating leases but keep them off the balance sheets, giving a skewed view of their overall financial status.

Answer 83

Levered ROE is different in the way that it uses a loan to increase its overall profit for that fiscal year rather than depending on investments alone. This approach may best be used for businesses that are starting out if it has not been able to secure enough initial investments to get started, but increasing debt also runs a much greater risk to any business’s profit margin. If a business has been losing investors due to poor performance, it may get a loan to help maintain or increase its profits; however, it’s always wise to look at the cause of fleeing investors prior to throwing more money at a problem. Rather than taking out a loan to maintain its current operations, a business may be better off downsizing, selling off assets and communicating with its remaining investors to increase overall profit and trust.

Answer 84

Unlevered ROE is a straightforward metric for examining how well a business will profit its investors. Investors and shareholders expect their money to grow with the company, but as with all investments, nothing is without an element of risk. The decisions a business makes regarding the investments will directly impact the annual ROE, and it is necessary to measure how those investments were used in order to maintain the current investments and to secure new investments for the following year. Without a positive ROE or a greater ROE than its competitors, a business runs the risk of losing investors altogether.

Answer 85

The values provided must be predictive in nature. Accounting information is relevant to the extent they can predict the possible future moves in business. Predictive accounting information makes it possible for stakeholders to make strategic moves to maximize profits and cut down possible losses in the future. The values must be confirmatory. Accounting information does not stand alone. They are most times a reflection of general trends in the business. For accounting information to be considered relevant, it must be able to provide feedback on the overall state of the business or organization. It is not just enough for such information to be predictive. Relevant accounting information must provide helpful information on what has happened in the past, what is currently happening, and what will most likely happen in the nearest future.

Answer 86

The Financial Accounting Standards Board (FASB) has tried to define reliable information. According to the FASB definition, accounting information is said to be reliable; the descriptions are verifiable as well as representationally faithful. The determine if accounting information is reliable, such information should have all of the following attributes: Verifiability - similar results can be obtained using other mediums. Faithful representations - free from error, neutral, complete. Neutrality - unbiased

Past Papers Flashcards

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