Topic 4- Analysis of financial statements Flashcards

Question

what are the advantages of ratio analysis

Answer 1

Ratios are a tool to assist analysis. They help to focus attention systematically on important areas and summarise information in an understandable form. They assist in identifying trends and relationships.

Answer 2

They ignore future action by management. They can be manipulated by window dressing or creative accounting. They may be distorted by differences in accounting policies. Asset values shown in the statement of financial position at historical cost may bear no resemblance to their current value or what it may cost to replace them. This may result in a low depreciation charge and an overstatement of profit in real terms. As a result of historical costs the financial statements do not show the real cost of using the non-current assets.

Answer 3

If an entity trades with related parties, such as other entities within the same group or other entities run by the same directors, then these transactions may not be at market price. This can involve items such as purchase or sale transactions at rates other than market value or loans carrying interest rates not at market value. The impact of these transactions on the entity must be assessed to give a fair comparison with other entities, and to show the position if the entity was removed from the group and no longer enjoyed the benefit of such transactions.

Answer 4

Ratio analysis can be distorted when a company has seasonal trading. For example, a company may position their year-end to be after a particularly busy period so that inventory levels are lower than usual making the inventory count a less time-consuming process. This in turn will generally mean that current asset levels are higher from a bank/receivables point of view and that trade payables are lower (where suppliers have been paid for the supply of the inventory to meet demand for the busy period). The timing of such financial reporting would improve the appearance of the ratios and make the company seem more solvent. In comparison if the financial statements had been drawn up at a different period in time then the results could appear quite different.

Answer 5

Not for profit organisations are usually government or charity organisations within the public sector. Unlike the private sector, the NFPs are non profit driven organisations. This means that there may be profit on their statement of profit or loss, however making a profit is not one of their main objectives – however, for private business’ this is one of their main objectives. Therefore, the profitability ratios may not be as useful to NFPs as they are to private companies.

Answer 6

Effectiveness – success in achieving its objectives/providing its service. Efficiency – how well its resources are used. Economy – keeping cost of inputs low.

Answer 7

Income and expenses should increase due to the new subsidiary being included in the year This will not have a full year's results from the subsidiary, as the results will only be consolidated from the date of acquisition Acquisition costs may be included, which affect the performance of the group in the current period Margins will be affected as the newly acquired subsidiary is likely to have different margins to the rest of the group

Answer 8

100% of the assets and liabilities of the subsidiary will be consolidated at the reporting date This will mean that there could be significant increases in assets or liabilities depending on the position of the newly-acquired subsidiary Working capital ratios, such as receivables collection period, are likely to change due to the new subsidiary having different credit terms to the rest of the group Working capital ratios may also be affected adversely as the ratio uses the year-end assets or liabilities, but the income/expenses included may be time-apportioned in the statement of profit or loss. For example, a subsidiary with revenue for the year of $1,000,000 and closing receivables of $90,000 would have a receivables collection period of 33 days in its individual financial statements (90,000/1,000,000 × 365). If this had been acquired exactly halfway through the year, only $500,000 revenue would be included within the consolidated statement of profit or loss, with the full $90,000 of receivables included in the consolidated statement of financial position. This would effectively give a receivables collection period of 66 days (90,000/500,000 × 365), giving a distorted picture. Return on capital employed and net asset turnover may decrease as the subsidiary's profit will be time apportioned, but any debt held by the subsidiary will be included in full at the reporting date (see the statement of financial position below)

Answer 9

The previous year's statement of profit or loss would include a full year's results from the disposed subsidiary The results for the current year may have the subsidiary shown as a discontinued operation (shown as one line below the profit for the year from the continuing operations) or have the results consolidated into income and expenses for the period up to the date of disposal The consolidated results may also include any gain/loss on disposal, which should be stripped out for comparative purposes Any costs associated with the disposal, such as professional fees or redundancies, may be included in the current period which would not be recognised in future periods Margins are likely to be incomparable, as the prior year will include the disposed subsidiary but the current year may only include the companies remaining in the group

Answer 10

The previous year's statement of financial position would contain 100% of the assets and liabilities of the disposed subsidiary The current year's statement of financial position would contain none of these as the subsidiary will not be controlled at the reporting date Cash may be increased by the sales proceeds of the subsidiary Ratios such as working capital ratios, return on capital employed and net asset turnover may be distorted if some of the subsidiary's results are included in the statement of profit or loss, as no assets or liabilities from the subsidiary will be included in this calculation (especially if it was disposed of during mid year and so the PL would include the fiugres

Answer 11

comparing the financial statements of similar businesses can be misleading because: the businesses may use different accounting policies ratios may not be calculated according to the same formulae. For example, there are several possible definitions of gearing and ROCE. large organisations can achieve economies of scale, e.g. by negotiating extended credit periods, or discounts for bulk buying with suppliers, whereas these measures may not be available to smaller businesses, and may distort comparison. entities within the same industry can serve completely different markets and there may be differences in sales mix and product range. These can affect profitability and activity ratios such as profit margin and ratios of expenses to sales. Sector comparisons- it must also be noted that the sector will incorporate companies of different sizes so it may not be a like for like comparison.

Answer 12

Ratios based on historical cost accounts do not give a true picture of trends from year to year. An apparent increase in profit may not be a true increase, and may simply reflect the effects of inflation. Financial statements only reflect those activities which can be expressed in money terms. They do not give a complete picture of the activities of a business. For example, the size of the order book is normally ignored in financial statements. The application of accounting policies in the preparation of financial statements must be understood when attempting to interpret financial ratios. Ratios must not be used as the sole test of efficiency. Concentration on achievement of target ratios by managers may inhibit the incentive to grow and expand, to the detriment of the long-term interests of the company. A few simple ratios do not provide an automatic means of running a company. Business problems usually involve complex patterns which cannot be solved solely by the use of ratios.

Answer 13

```  budgeted figures  Cash flow statement  other management information  industry averages figures for a similar business figures for the business over a period of time.  Share price ```

Answer 14

```  market share key employee information sales mix information product range information the size of the order book the long-term plans of management.  Recent news report Board minutes Staff turnover Internal memos Future plans CEO= Reports/statements Audit reports Company objectives- if they are meeting them ```

Answer 15

* USE The key words: Improved/Better/Deteriorated/worsen/ 1) Organise ratios into groups and deal with them in logical sequence - > Profitability is usually more important that liquidity or gearing so start with this. ROCE is the most important profitability ratio (goes well with Net asset turnover and OProftiMargin) 2) Rounding- round to full digits the % and the liquidity ratios can be up to 1 decimal places 3) Make sure the numbers are realistic- if they aren't it means they are wrong e.g. e.g. if receivables days are 3 days- unrealistic 4) Justify your assertions- explain why the higher ratio is beneficial 5) Look for relationships between ratios- demonstrate commercial awareness 6) Perspective- bank manager may be interested in liquidity more than profitability which SH might be more interested in

Answer 16

The working capital formula tells us the short-term liquid assets available after short-term liabilities have been paid off. Working Capital = Current Assets – Current Liabilities

Answer 17

The working capital cycle shows the average length of time between paying production costs and receiving cash returns from the inventory.

Answer 18

Working capital cycle = Inventory turnover period (days) + receivables collection period – payables payment period