TOPIC 2+3: Analysing and Interpreting Financial Statements 1 Flashcards

Lecture 6+7, Chapter 7 (+ Chapter 8 on 'Investment Ratios') (50 cards)

1
Q

Define ‘Financial ratios’.

A

A representation of numbers that shows the state of a company’s finances and company health.

A tool used for summarising, analysing and interpreting financial statements.

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2
Q

Why are financial ratios useful?

A

Financial ratios are used for tracking the company’s financial performance against internal benchmarks and for comparison with competitors or industry averages.

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3
Q

What can be compared to competitors?

A

Financial ratios can be used to compare:

  • Past periods for the same business
  • Similar businesses for the same or past periods
  • Planned performance for the business
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4
Q

Which users are interested in financial ratios?

A
  • Internal users: Management team, employees, and owners.
  • External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers.

Compliance: Getting insight into a financial ratio can help external users determine whether a company’s management uses sound business practices.

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5
Q

List the five primary groups of financial ratios.

A

1. Profitability ratios: Evaluating a company’s ability to generate profit relative to revenue, assets, equity etc.

2. Efficiency ratios: Indicating how effectively a company utilises its assets and manages liabilities to generate sales and maximise profits.

3. Liquidity ratio: Assessing a company’s ability to meet its short-term financial obligations using its current assets.

4. Financial gearing ratios (or leveraging financial ratios or leverage ratios): Assessing the extent to which a company is financed by debt compared to equity, reflecting financial risk.

5. Investment ratios: Analysing the return and value of investments in the company, useful for investors assessing potential profitability.

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6
Q

Are one group of financial ratios usually used alone?

A

In practice, most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company’s financial health.

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7
Q

Define ‘Profitability ratios’.

A

Financial metrics used to evaluate a company’s ability to generate profit (income) relative to revenue, operating costs, assets, equity, or capital employed.

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8
Q

When are profitability ratios most valuable?

A

Profitability ratios are most valuable when compared to similar companies or past periods.

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9
Q

Define and give formula: Capital invested

A

Definition: The total amount of money that investors, including both shareholders and creditors, have contributed to a business.

  • It typically includes equity investments by shareholders and debt financing provided by creditors.

Formula: Invested capital (IC) = Net working capital (NWC) + Net property, plant, and equipment (PP&E)

  • Net Working Capital (NWC) = Current operating assets – Current operating liabilities

If there are intangible assets then:

  • Invested capital (IC) = Net working capital (NWC) + Net PP&E + Acquired intangibles + Goodwill

If the company operates in intangible-only industries then:

  • Invested capital (IC) = Total debt + Common equity + Preferred stock + Equity equivalents

I.e. no need for net PP&E

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10
Q

Define and give formula: Capital employed

A

Definition: The total capital used by a company to generate profits, including equity and debt.

  • It represents the total resources employed in the business operations, including fixed assets, working capital, and other long-term investments.

Formula: Capital employed = Total assets – Current liabilities

OR

Capital employed = Equity + Non-current liabilities

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11
Q

Define and give formula: Average long-term capital invested in a business

A

Definition: The total capital employed by the company over an extended period, including:

  • equity (such as common stock and retained earnings)
  • long-term debt (such as bonds or loans with maturities longer than one year)

Formula: Average long-term capital = (Total long-term debt - Total equity) ÷ 2

OR

Average long-term capital = (Beginning long-term capital + Ending long-term capital) ÷ 2

NB! Here, “capital” refers to capital employed. This could be equity or liabilities (debt capital).

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12
Q

Compare capital invested, capital employed and average long-term capital invested in a business.

A
  • Capital invested: Total money contributed to the business by both owners (equity) and lenders (debt).
  • Capital employed: Total resources used in the business.
  • Average long-term capital invested: The average amount of capital employed over a period.
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13
Q

What are the two categories of profitability ratios?

A

1. Margin ratios represent the company’s ability to convert sales into profits at various degrees of measurement.

2. Return ratios represent the company’s ability to generate returns to its shareholders.

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14
Q

What are the two primary margin ratios?

A
  1. Gross profit margin ratio
  2. Operating profit margin ratio
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15
Q

Define and give formula: Gross profit margin ratio

A

Definition: Measures the percentage of sales revenue that remains after deducting the cost of goods sold (COGS).

  • It shows how efficiently a company produces or buys its goods.
  • Higher margin = better efficiency in managing production or purchasing costs.

Formula: Gross profit margin = (Gross profit ÷ Sales revenue) x 100%

  • Gross profit = Revenue − Cost of Goods Sold (COGS)
  • Sales revenue = net sales
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16
Q

Define and give formula: Operating profit margin ratio

A

Definition: Measures the percentage of sales revenue that remains after covering all operating expenses (excluding interest and taxes).

  • It shows how efficiently a company runs its core operations.
  • Higher margin = stronger operational efficiency.

Formula: Operating profit margin = (Operating profit ÷ Sales revenue) x 100%

  • Operating profit = Gross profit – Operating expenses
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17
Q

What are the two primary return ratios?

A
  1. The ordinary shareholders’ funds ratio (ROSF)
  2. The return on capital employed ratio (ROCE)
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18
Q

Define and give formula: The ordinary shareholders’ funds ratio (ROSF)

A

Definition: Measures the return earned on the average equity invested by ordinary shareholders during a period.

  • It shows how effectively the company uses shareholder capital to generate profit.
  • Higher ratio = the company is generating more profit for each pound of ordinary shareholders’ investment, indicating better returns and stronger performance from the shareholders’ perspective.

Formula: ROSF = ((Profit for the year - Preference dividends) ÷ (Ordinary share capital + Reserves)) × 100

  • Preference dividends: Fixed dividends paid to preference shareholders before ordinary shareholders receive any.
  • Ordinary share capital: The total value of issued ordinary shares representing ownership in the company.
  • Reserves: Profits or gains retained in the business instead of being paid out as dividends.

Ordinary shareholders’ equity = Ordinary share capital + Reserves

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19
Q

Define and give formula: The return on capital employed ratio (ROCE)

A

Definition: Measures how efficiently a company is using its long-term capital (equity and debt) to generate operating profit.

  • It shows the relationship between the operating profit generated during a period and the average long-term capital invested in the business.
  • Compare ROCE to cost of capital.
  • Higher ratio = better use of capital to generate profit.

Formula: ROCE = (Operating profit ÷ Capital employed) × 100

OR

ROCE = (Operating profit ÷ ((Total share capital + Reserves + Total non-current liabilities) ÷ 2)) × 100

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20
Q

Define ‘Efficiency ratios’.

A

Financial metrics used for indicating how effectively a company utilises its assets and manages liabilities to generate sales and maximise profits.

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21
Q

What is the relationship between profitability and efficiency?

A

Profitability and efficiency are closely linked, as operational efficiency directly affects a company’s ability to generate profit.

  • Efficiency ratios assess how well a company uses its resources (like inventory, receivables, and assets).
  • Profitability ratios measure the ability to generate profit from those resources.

Efficiency ratios provide insights into how profits are achieved, not just how much.

Analysing both together gives a full view of a company’s financial performance and operational health. So, after calculating profitability ratios, you compare them with efficiency ratios to see if they “match.”

ROCE ratio highlights that the overall return on funds employed within the business will be determined both by the profitability of sales and by efficiency in the use of capital.

22
Q

What are the five primary efficiency ratios?

A
  1. Average inventories turnover period
  2. Average settlement period for trade receivables
  3. Average settlement period for trade payable
  4. Sales revenue to capital employed
  5. Sales revenue per employee
23
Q

Define and give formula: Average inventories turnover period

A

Definition: Measures the average number of days a business takes to sell its inventory.

  • It shows inventory efficiency.
  • Shorter period = inventory is sold quickly, which is usually better for cash flow and efficiency.

Formula: Average inventories turnover period = (Average inventories held / Cost of sales) × 365

  • Average inventories held = (Opening inventory + Closing inventory) ÷ 2
  • Cost of sales = COGS
24
Q

Define and give formula: Average settlement period for trade receivables

A

Definition: Measures the average number of days it takes customers to pay what they owe after a credit sale.

  • It shows customer payment efficiency.
  • Shorter period = quicker collection of payments, which improves cash flow.

Formula: Average settlement period for trade receivables = (Average trade receivables ÷ Credit sales revenue) × 365

  • The average trade receivables = (Trade receivables at opening period + Trade receivables at closing period) ÷ 2
  • Credit sales are not just sales revenue, as this does not separate cash and credit. But this might be the only information given in the income statement, unless there are notes to accounts.
25
Define and give formula: Average settlement period for trade payable
**Definition:** Measures the average number of days a business takes to pay its suppliers after making credit purchases. * It shows the efficiency of payment to suppliers. * Longer period = business takes more time to pay suppliers, which may help cash flow but could affect supplier relationships. **Formula: Average settlement period for trade payables = (Average trade payables ÷ Credit purchases) × 365** * The average trade payables = (Trade payable at opening period + Trade payable at closing period) ÷ 2 * Credit purchases are not directly shown in the income statement, but may be estimated like: Credit purchases = Cost of sales + Closing inventory - Opening inventory
26
Define and give formula: Sales revenue to capital employed
**Definition:** (also called Net Asset Turnover) measures how efficiently a business uses its capital to generate sales revenue. * It shows capital to revenue efficiency. * Higher ratio = business is using its capital more effectively to generate sales. However, a very high ratio may suggest overtrading (insufficient assets to sustain the level of sales revenue achieved). **Formula: Sales revenue to capital employed ratio = Sales revenue ÷ Capital employed** * Capital employed = Share capital + Reserves + Non-current liabilities
27
Define and give formula: Sales revenue per employee
**Definition:** Measures the average amount of sales generated by each employee. * It shows (indicates) labour productivity. * Higher ratio = better use of human resources to generate revenue. **Formula: Sales revenue per employee = Sales revenue ÷ Number of employees**
28
Define 'Liquidity ratios'.
Financial metrics used for assessing a company's ability to meet its short-term financial obligations using its current assets.
29
What are the three primary liquidity ratios?
1. Current ratio 2. Quick ratio (acid test ratio) 3. Operating cash flows to maturing obligations ratio 4. Also: Operating cash cycles
30
Define and give formula: Current ratio
**Definition:** Measures a company's ability to pay its short-term liabilities using its short-term (current) assets. * It focuses on current assets. * A ratio too low may indicate liquidity problems; too high may suggest inefficient use of resources. * A ratio of around 2:1 is often considered healthy, meaning the company has twice as many current assets as current liabilities. **Formula: Current ratio = Current assets ÷ Current liabilities**
31
Define and give formula: Quick ratio (acid test ratio)
**Definition:** (also called the Acid Test Ratio) measures a company’s ability to meet its short-term liabilities using its most liquid assets, excluding inventory. * It focuses on assets that can be quickly converted to cash (e.g. cash). * Inventory is excluded because inventories cannot be converted to cash quickly. In part due to trade receivables. * A ratio of 1:1 is generally considered acceptable. **Formula: Quick ratio = (Current assets − Inventory) ÷ Current liabilities**
32
Define and give formula: Operating cash flows to maturing obligations ratio
**Definition:** Measures a company’s ability to pay its short-term liabilities using cash generated from its core operating activities. * Unlike the current and quick ratios, this one uses actual cash flow, not just balance sheet figures, making it a more realistic measure of liquidity. * Higher ratio = stronger liquidity and better short-term financial health. **Formula: Operating cash flows to maturing obligations ratio = Cash generated from operations ÷ Current liabilities**
33
Define and give formula: Operating Cash Cycle (OCC)
**Definition:** A financial metric that measures the time it takes for a company to convert its investment in inventory and other resources into cash flow from sales. * The OCC is the time period between paying for goods and receiving the cash from selling those goods. * The same as 'The Cash Conversion Cycle (CCC)'. **Formula: OCC = Average inventory holding period + Average settlement period for trade receivables - Average settlement period for trade payables** * Average inventories turnover period = (Average inventories held ÷ Cost of sales) × 365 * Average settlement period for trade receivables = (Average trade receivables ÷ Credit sales revenue) × 365 * Average settlement period for trade payables = (Average trade payables ÷ Credit purchases) × 365
34
What happens if the assets are tied up in inventory or trade receivables?
Inventories and trade receivables are not fully liquid assets because they cannot be immediately converted into cash without some delay or potential loss in value. In that scenario, they may not be easily converted to cash. However, if a company quickly converts inventory into cash and collects payments from customers efficiently, it has more cash available to pay short-term liabilities. This results in a stronger liquidity position, reducing the reliance on external financing.
35
How does a longer vs. shorter OCC affect liquidity?
* A shorter OCC will result in higher liquidity. * A longer OCC will result in lower liquidity. Explanation: A shorter OCC results in higher liquidity, indicating more efficient cash flow management. A longer OCC means cash is tied up longer, which can lead to liquidity risks and difficulty paying suppliers or short-term debts on time.
36
Define 'Financial gearing ratios'.
(or leveraging financial ratios or leverage ratios) Financial metrics used for assessing the extent to which a company is financed by debt compared to equity, indicating its financial risk.
37
What are financial gearing ratios useful for?
Risk assessment
38
What are the reasons for financial gearing?
The higher the debt, the more likely an investment will end up swallowed by debt. * Insufficient operational funds * Increase in return on investment to owners
39
What are the two primary financial gearing ratios?
1. The gearing ratio 2. The interest cover ratio
40
Define and give formula: The gearing ratio
**Definition:** Measures the proportion of a company's capital that comes from long-term debt compared to equity * It indicates the business’s financial risk and reliance on borrowed funds. * Higher ratio = company is more highly geared (more debt), which can increase financial risk. * Lower ratio = company is more lowly geared (less debt), a more conservative (equity-based) capital structure, which can decrease financial risk. **Formula: Long-term (non-current) liabilities ÷ Capital employed** * Capital employed = Share capital + Reserves + Non-current liabilities
41
What is one limitation of the gearing ratio?
The gearing ratio only shows how a company is financed (debt vs equity), but it doesn’t show whether the company can actually afford its debt repayments.
42
Define and give formula: The interest cover ratio
**Definition:** Measures how easily a business can pay its interest expenses using its operating profit. * It shows how many times the company’s Earnings Before Interest and Tax (EBIT) can cover its interest payments. * Higher ratio = safer position (easier to pay interest). * Lower ratio (especially below 2) = risk of struggling to meet debt obligations. **Formula: Interest cover ratio = Operating profit ÷ Interest payable**
43
Define 'Investment ratios'.
Financial metrics used for analysing the return and value of investments in the company, useful for investors assessing potential profitability.
44
What are the five primary investment ratios?
1. Dividend payout ratio 2. Dividend yield ratio 3. Earnings per share (EPS) ratio 4. Cash generated from operations per share ratio 5. Price/earnings ratio
45
Define and give formula: Dividend payout ratio
**Definition:** Measures the proportion of earnings that a business pays out to shareholders in the form of dividends. * It shows the percentage of a company’s profit that is distributed to ordinary shareholders as dividends, rather than being retained in the business. * Higher ratio = more profits are paid out. * Lower ratio = more profits are reinvested. **Formula: Dividend payout ratio = (Dividends paid ÷ Earnings available to ordinary shareholders) × 100**
46
Define and give formula: Dividend yield ratio
**Definition:** Measures the cash return (dividend income) an investor earns from a share, relative to its current market price/value. * It can help investors to assess the cash return on their investment in the business. * Higher yield = indicates better income return, but it must be evaluated alongside share price trends and risk. **Formula: Dividend yield ratio = ((Dividend per share ÷ (1 - t)) ÷ Market price per share) × 100** Where t = tax rate.
47
Define and give formula: Earnings per share (EPS) ratio
**Definition:** Measures how much profit is earned for each ordinary share. * It indicates the company’s profitability on a per-share basis. * Higher EPS = generally signals stronger profitability and can attract investors. **Formula: EPS = Earnings available to ordinary shareholders ÷ Number of ordinary shares**
48
Define and give formula: Cash generated from operations per share
**Definition:** Measures the amount of operating cash flow earned for each ordinary share. * It provides insight into the company’s ability to fund dividends and operations using actual cash. * It focuses on cash flow rather than profit, making it useful for assessing short-term financial strength. **Formula: Cash generated from operations per share = (Cash generated from operations - Preference divided) ÷ Number of ordinary shares**
49
Define and give formula: Price/earnings (P/E) ratio
**Definition:** Measures how much investors are willing to pay for £1 of a company’s earnings, relating the market value of a share to the earnings per share. * It reflects market expectations of future growth and earnings potential. * Higher P/E ratio = often indicates higher expected future growth. * Lower P/E ratio = may suggest the stock is undervalued or has lower growth prospects. **Formula: P/E ratio = Market price (value) per share ÷ Earnings per share (EPS)**
50
In what financial statements can information for all the mentioned ratios be found?
**Income Statement (Statement of Profit or Loss)** * Gross Profit Margin * Operating Profit Margin * ROSF (Profit for the year) * ROCE (Operating profit) * Interest Cover Ratio * Earnings per Share (EPS) * Dividend Payout Ratio (if dividends are shown) * Price/Earnings Ratio (via EPS) **Statement of Financial Position (Balance Sheet)** * Capital Employed (Equity + Non-current liabilities) * Current Ratio * Quick Ratio (Acid Test) * Gearing Ratio * Trade Receivables and Payables (for settlement periods) * Inventory (for turnover period) * Reserves and Share Capital (for ROSF, gearing) * Number of shares (sometimes shown or disclosed in notes) **Cash Flow Statement** * Operating Cash Flows to Maturing Obligations Ratio * Cash Generated from Operations per Share **Notes to the Accounts** * Credit sales or credit purchases (needed for receivables/payables ratios) * Dividend per share * Number of ordinary shares * Breakdown of reserves or liabilities