Topic 3 - Financial Statements

Question 1

What 3 financial statements that summarise the current financial position of the firm are Corporations are required to release Annual Report

Answer 1

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement

Question 2

What is a Balance Sheet

Answer 2

A balance sheet provides a snapshot of the company’s financial position

Question 3

What are Assets, Current assets and Non-current assets

Answer 3

Assets - things that the firm owns
Current assets - those which have a life of less than one year
Non-current assets - those which have a life longer than one year

Question 4

What are Liabilities, Current liabilities and Non-current liabilities

Answer 4

Liabilities - things that the firm owes
Current liabilities - those which have a life of less than one year
Non-current liabilities - those which have a life longer than one year

Question 5

What is Net working capital

Answer 5

(balance sheet) The difference between a firm’s current assets and its current liabilities

Question 6

What is Shareholders Equity

Answer 6

(balance sheet) The difference between a firm’s total assets and total its liabilities

Question 7

What is the Balance sheet equation

Answer 7

(balance sheet) Assets = Liabilities + Shareholders’ Equity (the 2 sides must be equal to each other)

Question 8

What is Book Value vs Market Value

Answer 8

Book values - values shown on a balance sheet (accounting values based on International Financial Reporting Standards)
Market values - the price at which the asset or liability can be bought or sold

Question 9

Why does the Balance sheet not necessarily provide an accurate picture of a company’s value (x3)

Answer 9

1. The balance sheet reports the book value not the market value of assets and liabilities
2. Intangible assets (strong brand reputation or skilled employees) are not reported in the balance sheet
3. The accounting value of equity is not necessarily related to the market value of equity (financial managers try to maximise market value of equity)

Question 10

What is The Income Statement

Answer 10

The income statement examines a company’s performance over a given period of time
It considers the company’s revenues and expenditures

Revenues - Expenses = Income

Question 11

What does it mean when Revenues are recognised based on the ‘realisation principle’

Answer 11

Revenues are recognised at the point that their value is known (sale) rather than when the revenue is received (according to IFRS)

Question 12

What does it mean when Expenses are recognised based on the ‘matching principle’

Answer 12

Once revenue is realised, the costs associated with that revenue are recognised

Question 13

What is the Cash flow equation/Cash flow identity

Answer 13

(cash flows)

Cash flow from assets = Cash flow to creditors + Cash flow to shareholders

Question 14

What is the Total cash flow equation

Answer 14

(cash flows)

Total cash flow = Cash flow from operating activities + Cash flow from investing activities + Cash from from financing activities

Question 15

What are the 5 most commonly used Financial Ratios

Answer 15

1. Liquidity ratios
2. Financial leverage ratios
3. Turnover ratios
4. Profitability ratios
5. Market value ratios

Question 16

What is Liquidity and why is it important

Answer 16

A company’s liquidity describes how easily and quickly its assets can be converted into cash
Liquidity is important because it demonstrates the company’s ability to pay its short term bills

Question 17

What is the Current ratio

Answer 17

(liquidity ratio)
Assesses a company’s ability to meet short term obligations using all of its current assets, including inventories

Current ratio = Current assets / Current liabilities

Question 18

What does it mean when the current ratio is less than 1

Answer 18

If a company’s current liabilities are greater than their current assets

Question 19

What is the quick ratio

Answer 19

(liquidity ratio) Measures a company’s short term liquidity

Quick ratio = (Current assets - Inventories) / Current liabilities

Question 20

What are Financial Leverage Ratios

Answer 20

Financial Leverage Ratios indicate a company’s ability to meet its long-term debt obligations

Question 21

What is the Total debt ratio

Answer 21

(financial leverage ratio) Measures how much of a company’s assets are financed through debt rather than equity

Total debt ratio = Total liabilities / Total assets
OR
(Total assets - Shareholders’ equity) / Total assets

Question 22

What does a Debt ratio above 0.5 suggest

Answer 22

A debt ratio above 0.5 indicates that more of the company’s assets are financed through debt rather than equity

Question 23

What are 2 variations of the total debt ratio

Answer 23

(financial leverage ratio) Debt-Equity Ratio = Total Liabilities / Shareholders’ equity
AND
Equity multiplier = Total Assets / Shareholders’ Equity

Question 24

What are Turnover ratios

Answer 24

Turnover ratios demonstrate how efficiently a company generates sales

Question 25

What is the Inventory turnover ratio, and the Days' Sales in Inventory

Answer 25

(turnover ratio) Measures how efficiently (quickly) a company manages its inventory - Inventory Turnover = Cost of goods sold / Inventory - Days' Sales in Inventory = 365 days / Inventory turnover

Question 26

What is the Receivables turnover ratio and the Days' Sales in Receivables

Answer 26

(turnover ratio) Indicates how quickly the company collects the money it's owed in relation to its sales - Receivables Turnover = Net Sales / Trade Receivables - Days' Sales in Receivables = 365 Days / Receivables Turnover

Question 27

What is the Total Asset turnover ratio

Answer 27

(turnover ratio) A measure of how efficiently a company uses its assets to generate sales Total asset turnover ratio = Net Sales / Total assets

Question 28

What are Profitability ratios

Answer 28

Profitability measures indicate how well a company has performed relative to its sales, assets or equity

Question 29

What is the Profit Margin equation

Answer 29

(profitability ratio) Profit Margin = Net Income / Sales

Question 30

What is Return on Assets (ROA)

Answer 30

(profitability ratio) A measure of how efficiently a company uses all of its assets to generate net income Return on Assets = Net Income / Total Assets

Question 31

What is Return on Equity (ROE)

Answer 31

(profitability ratio) A measure of how effectively a company uses shareholders' equity to generate profits ROE = Net Income / Shareholders' Equity

Question 32

What are Market Value ratios

Answer 32

Market value measures examine the value of holding shares in the company

Question 33

What is Earnings per Share

Answer 33

(market value ratio) Measures the income generated from each share EPS = Net Income / Shares Outstanding

Question 34

What is the price-earnings ratio

Answer 34

(market value ratio) Shows how much investors are willing to pay per unit of a company's earnings (used to assess if a stock is overvalued, undervalued, or fairly priced) P/E Ratio = Price per Share / Earnings per Share

Question 35

What is the market-to-book ratio

Answer 35

(market value ratio) Compares a company's market value to its book value. A value 1> the market believes the company is destroying value/underperforming Market-to-Book Ratio = Market Value per Share / Book Value per Share

Question 36

What are 2 useful ways of "benchmarking" a company's performance

Answer 36

1. Time Trend Analysis - examine the same financial ratio over a period of years 2. Peer Group Analysis - compare the ratio with the same ratio from similar companies in the same industry (Aspirant analysis - comparing themselves to the leader in the industry)