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Accounting > Semester 2 - Lecture 2 > Flashcards

Semester 2 - Lecture 2 Flashcards

1
Q

Why is ratio analysis important?

A
  • the financial statements have been constructed …… but so what?
  • interpretation of those statements is the key to in-depth understanding of performance.
  • interpretation is the commentary on the results of the ratios calculated I.e. what do you mean? How is the company performing against benchmarks?
  • ratios help to build up a picture of the position and performance of a business.
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2
Q

What is a ratio?

A
  • a mathematical expression of the relationship between 2 or more variables
  • there must be a significant relationship between the variable
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3
Q

Is the absolute value of a ratio significant?

A
  • if you calculate a ratio in isolation it will not tell you a great deal about the financial health or performance of a business
  • ratios are used for comparison
  • therefore they must be used in context
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4
Q

What are comparisons used for?

A
  • comparison of one period with another(last year)
  • comparison of performance with planned performance (budget)
  • review of trend over a number of periods
  • inter firm comparisons within industry sectors
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5
Q

What are the key steps?

A

1) identify users and their information needs (e.g. investors, employees etc)
2) select and calculate the appropriate ratios (e.g. liquidity, gearing etc)
3) interpret and evaluate the results (I.e. using relevant benchmarks)
4) identify limitations

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6
Q

The 5 types of ratios?

A
  • profitability
  • efficiency
  • liquidity
  • gearing
  • investor
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7
Q

Types of profitability ratios

A
  • return on capital employed (ROCE)

- return on shareholders funds (ROSF)

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8
Q

What is the return on capital employed (ROCE) ?

A

Fundamental measure of business performance. Expresses relationship between operating profit and average long term capital invested in the business.

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9
Q

What is the return on capital employed (ROCE) calculation?

A

Operating profit (PBIT)
………………………………… X 100
Capital employed

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10
Q

How to calculate capital employed?

A

Equity (retained profit and reserves of a business) + long term liabilities

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11
Q

What is return on shareholders funds?

A

Measure the profit attributable to ordinary shareholders relative to the amount they have invested.

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12
Q

How to calculate return on shareholders funds?

A

Profit after tax (PAT)
……………………………. X 100
Shareholders funds

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13
Q

What are the interpretation of ROCE and ROSF?

A
  • compares inputs (capital invested) with outputs (operating profit)
  • assesses the effectiveness with which funds have been deployed during accounting period.
  • could the business/shareholders be getting a better return by investing its fund’s elsewhere?
  • ideally ROCE should be higher than the rate of interest ……. otherwise why not leave the money in the bank?
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14
Q

What is gross profit margin?

A
  • relates gross profit to same period sales revenue

- measure of profitability in buying and selling goods/services before other expenses

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15
Q

How to calculate gross profit margin?

A

Gross profit
………………. X 100
Sales

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16
Q

What are the interpretation of GP margin?

A
  • how much of our sales revenue are we retaining as GP?
  • represents what a company made after paying off its cost of goods sold
  • companies with high gross profit margin are more liquid and have more money to spend on indirect expenses
  • if a company’s raw material cost start to increase, the gross profit margin will fall unless prices are increased
17
Q

What is operating profit?

A
  • Relates the operating profit for the period to the sales revenue generated in that period
  • shows not just the margins earned on sales but also the firms ability to control its operating cost
18
Q

Interpretation of OP margin?

A
  • how much of our sales revenue are we retaining as operating profit?
  • if our GP margin is remaining stable but our OP margin is falling - need to examine our operating costs
  • the higher the better - less than 5% means the company is in a vary competitive sector or is going badly
  • variations in operating profit margin over time, usually due to changes in sales mix, selling prices or indirect costs
19
Q

What is a non current asset turnover ratio?

A
  • a measure of how effectively the firm is using its long-term asset base to generate sales
  • may be of particular relevance in comparing the performance of, for example, retailers (whose major asset is usually the selling space) of high-tech manufactures.
20
Q

How to calculate non-current asset turnover ratio?

A

Sales
…………
Non-current asset

21
Q

What are the interpretations of NCA turnover?

A
  • amount of sales revenue generated per £ of non-current asset
  • it is a measure of the level of activity and productivity (the company’s ability to generate sales revenue from its asset base)
  • if the assets are not producing sales, they represent a drain on the company’s resources/efficieny
  • BUT may be distorted by failure to replace assets in
22
Q

What are average receivables collection period?

A
  • measures the average time taken to collect money from receivables
  • unless told otherwise, assume all sales are credit sales
23
Q

What is the calculation of average receivables collection period?

A

Trade receivables
………………………… X 365
Credit sales

24
Q

What is the interpretation of TR period?

A
  • businesses will usually prefer shorter settlement periods (but it could result in lower sales)
  • where the period is high compared with other businesses, this indicates inadequate credit control
  • normal average around 45-75 days
25
Q

What is inventory holding period?

A

Measures the average time taken to turn inventory into sales (or the average length of time inventory is held for) uses cost of sales and not sales

26
Q

What is the calculation of inventory holding period?

A

Inventory
………………….. X 365 days
Cost of sales

27
Q

What is the interpretation of inventory holding period?

A
  • shouldn’t be holding inventory fir too long
  • may be distorted by seasonal factors or by major upturns in sales activity
  • too long? - JIT
28
Q

What is the average payables payment period?

A
  • measure the average time taken to pay suppliers

- use cost of goods sold when credit purchases is not available

29
Q

How to calculate average payables payment period?

A

Trade payables
…………………….. X 365 days
Credit purchases

30
Q

What is the interpretation of TP period?

A
  • may be distorted by special treatment of a few large suppliers
  • this is a free source of finance (?) businesses will try to extend it for as long as possible
  • but if they leave it too long they may lose goodwill of supplier/future credit/affect credit rating/indicate financial weakness/missing prompt payment discounts
31
Q

How do you calculate the net trade (operating) cycle?

A

NTC = inventory holding period + receivables collection period - payables payment period

32
Q

What are the liquidity ratios?

A

Current ratio

Quick ratio

33
Q

How to calculate a current ratio?

A

Current asset
———————
Current liabilities

34
Q

How to calculate quick ratio?

A

Current asset less inventory
—————————————-
Current liabilities

35
Q

What are the interpretation of liquidity?

A

Current ratio
——————-
- the higher the ratio the more liquid the business
- ideal approx 2:1 (depends on industry)
- higher - too much finance tied up in CA
- lower - concern about meeting CL

Quick ratio
—————-
- ideal approx 1:1 (depending on industry)

36
Q

What is gearing?

A
  • ratio of external (burrowed) to internal (equity) long-term finance
  • should be low where demand is volatile and profits fluctuate
37
Q

How do you calculate gearing?

A

Long term debt
————————. X100
Total capital employed

38
Q

What are the limitations of ratios?

A
  • highlights change, but doesn’t explain
  • deterioration doesn’t necessarily mean bad management
  • broad picture - battery of ratios
  • comparability and choice of accounting methods
  • Window dressing
  • seasonality
  • quality of financial statements
  • restricted vision of ratios
  • ratios relating to the statement of financial position

Accounting (4 decks)

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