Week 24 - Limitations of Ratio Analysis, Common Size Financial Statements & Identifying Companies from Ratios Flashcards
(92 cards)
1
Q
Why can ratio analysis be unreliable when comparing across companies?
A
Because of lack of standard ratio definitions and different accounting policies or estimates.
2
Q
What does the phrase “garbage in, garbage out” refer to in ratio analysis?
A
It highlights that poor quality or incorrect data leads to misleading ratio results.
3
Q
Why might ratios based on historical data be misleading?
A
They may not reflect current or future performance, especially due to seasonality or one-off events.
4
Q
What limitation arises from missing data in ratio analysis?
A
It can lead to incomplete or distorted financial conclusions.
5
Q
What is a major non-financial limitation of ratio analysis?
A
It ignores qualitative factors, like customer satisfaction, employee morale, or brand strength.
6
Q
Why is a basis for comparison essential in ratio analysis?
A
Ratios are only meaningful when compared over time (time series analysis), across peers (cross-sectional), or against benchmarks.
7
Q
Why can it be hard to find the right comparator company?
A
Many companies operate in multiple industries, making direct comparison difficult.
Have different accounting policies/ estimates
8
Q
Do ratios tell you the full answer about a company’s performance?
A
No – they highlight areas to investigate further; they are starting points, not conclusions.
9
Q
What’s a common mistake when interpreting financial ratios?
A
Assuming a ratio is inherently “good” or “bad” without understanding the economic context.
10
Q
What is the purpose of a common size financial statement?
A
To standardize financial statements by expressing each item as a percentage of a baseline, allowing for easier comparison.
11
Q
In a common size income statement, what is each item expressed as a percentage of?
A
Revenue (Sales)
12
Q
In a common size balance sheet, what is each item expressed as a percentage of?
A
Total Assets
13
Q
Why are common size statements useful?
A
They help identify major changes and trends across time or between companies.
14
Q
How do common size statements help in cross-company comparison?
A
By removing size differences and allowing relative performance to be evaluated on a percentage basis.
15
Q
What is the significance of a decrease in net profit margin?
A
It may indicate reduced overall profitability, even if operating profit has increased.
16
Q
What financial change caused the drop in gross margin?
A
An increase in cost of sales by about 1%.
17
Q
How can a decrease in administrative expenses impact operating profit?
A
It can offset increases in other costs, potentially leading to higher operating profit.
18
Q
What question should be asked if operating profit increased but net profit decreased?
A
What happened after operating profit — e.g., were there higher taxes, lower other income, or unexpected losses?
19
Q
What are some minor contributors to the drop in net profit?
A
A slight drop in income from associates and joint ventures, and a small reduction in interest cost.
20
Q
Despite higher operating profit, why might overall profit still decline?
A
Due to higher tax expense, lower income from associates, or other non-operating costs.
21
Q
Should you only focus on changes that are visible in financial statements?
A
No – you should also consider changes that are expected but not yet visible.
22
Q
What are examples of changes that may take time to appear in financial statements?
A
Restructuring activities, strategic shifts, or new investments in operations or markets
23
Q
Why might some changes not be transparently disclosed?
A
Due to management discretion, incomplete implementation, or timing delays in reporting.
24
Q
What might a lack of change in financial results indicate?
A
Possible managerial inertia or ineffective strategy implementation.
25
What key question should analysts ask when expected changes aren’t visible?
Is management failing to act, or are changes in progress but not yet materialised?
26
Can companies be identified using financial ratios alone?
Yes, if you understand the characteristics of their industry and operations, financial ratios can help identify the company type.
27
What type of company is likely to have high inventory levels?
A retailer or manufacturer, especially in industries with physical goods (e.g., supermarkets, electronics).
28
What do large non-current assets suggest about a company?
It is likely capital intensive, such as companies in utilities, telecoms, or construction.
29
What does a high profit margin typically indicate?
The company may operate in a luxury, tech, or software industry, where value-added products/services command higher prices.
30
What might short receivables and payables periods suggest?
The company likely operates in an industry with quick cash turnover, like retail or fast food.
31
Why is industry context important when analysing ratios?
Because norms differ across sectors, so ratios must be interpreted relative to industry benchmarks.
32
In what type of industries is gearing typically higher?
In more stable industries, like utilities or infrastructure, where steady cash flows make debt more manageable.
33
Why should gearing be used cautiously in industry analysis?
Because gearing is more meaningful when comparing companies within the same industry, not across different industries.
34
What does a high gearing ratio indicate?
The company is highly reliant on debt, which may increase financial risk, especially in volatile industries.
35
What does a low gearing ratio suggest?
The company is less reliant on debt and is likely more financially conservative.
36
Typical values of:
Pharmaceutical firms
Supermarkets
Pharmaceutical Firms:
* Receivables Turnover: Low
* slow payments from customers such as governments and hospitals, which often have bureaucratic or delayed payment processes
* Profit Margin: High
* Typically charge a price premium for patented drugs, resulting in high margins relative to cost of sales
Supermarkets (Morrisons):
* Profit Margin: Low
* Operate under a cost leadership strategy with tight margins to remain competitive
* Receivables Turnover: High
* Most sales are made in cash or through cards, meaning receivables are minimal and collected quickly
37
Typical values of Real Estate Firms and Service providers
Real Estate Firms:
* Receivables Turnover: High
* Payments often come directly from banks through mortgage financing, leading to efficient collection
* Inventory Turnover: Low
* Houses, which take time to construct and sell
* Inventory Levels: High
* A large portion of current assets may be tied up in property inventory
* ∆ = Current Ratio - Quick Ratio: High
Service Providers:
* Inventory Turnover: High
* Generally, maintain minimal physical inventory—if any—leading to rapid turnover of whatever little stock is held
* Inventory Levels: Low
* As they deliver intangible services, there's little need to store inventory
* ∆ = Current Ratio - Quick Ratio: Low
38
What are the three main influences on financial reports?
Business fundamentals (economic activities and conditions) ->
GAAP (accounting rules) ->
Management discretion (judgments and estimates)
39
What do business fundamentals refer to in financial reporting?
The underlying economic activities and conditions that drive a company's performance (e.g., sales, costs, industry trends).
40
What does GAAP stand for, and what is its role?
Generally Accepted Accounting Principles – they set the rules for how financial information must be reported.
41
In what ways can management discretion influence financial statements?
Through:
Choice of accounting methods/policies
Accounting estimates (e.g., depreciation, bad debt provisions)
Transaction structure and timing
42
Why is management discretion a critical factor in financial analysis?
Because it can significantly affect reported profits and asset values, making it harder to compare companies directly.
43
What is the financial reporting process composed of?
Company’s transactions and events
Selection of accounting policies
Application of accounting policies
Estimates and judgments involved
Disclosures about transactions, events, policies, estimates, and judgments
44
What does the company’s transactions and events refer to in the financial reporting process?
It includes all the financial activities of the company, such as sales, purchases, investments, and financing.
45
What is the significance of the selection of accounting policies?
Companies must choose accounting policies that are consistent with GAAP and reflect their specific operational realities, such as revenue recognition or inventory methods.
46
What does the application of accounting policies entail?
Applying the selected accounting policies to the company's financial transactions and events consistently and accurately.
47
Why are estimates and judgments critical in financial reporting?
Companies often have to make estimates and judgments for items like bad debt provisions, asset depreciation, and inventory obsolescence, which affect financial results.
48
What should companies disclose in the financial reports?
Companies must provide disclosures about transactions, events, accounting policies, estimates, and judgments, ensuring transparency and allowing better interpretation by users.
49
What is accrual accounting?
Accrual accounting means recording income, expenses, assets, and liabilities when they occur, not when cash is received or paid.
50
What is the benefit of using accrual accounting?
Accrual accounting provides a better representation of a company’s financial performance and position over a period, reflecting revenues and expenses as they happen.
51
What does the "matching" concept refer to in accrual accounting?
The matching concept states that revenues should be matched with the expenses incurred to generate them, reflecting the performance during the relevant period.
52
Why does accrual accounting require estimates?
Accrual accounting involves recognising rights and obligations that may not have specific cash flows yet, so estimates are needed for things like bad debts, depreciation, and provisions.
53
What is the drawback of accrual accounting?
While it provides a clearer picture of financial performance, it requires management discretion in using estimates and judgments, which could obscure or misrepresent the company's financial situation.
54
What is creative accounting often referred to as?
“Cooking the books” or “window-dressing”, meaning adjusting accounting data to report desired numbers.
55
How does creative accounting deviate from standard accounting practices?
Creative accounting follows the letter of the rules but may deviate from the spirit of those rules, often to present more favourable financial results.
56
What is Schipper's definition of creative accounting (1989)?
Creative accounting is a purposeful intervention in the financial reporting process with the intent to obtain private gain rather than just facilitating the neutral operation of the process.
57
According to Healy and Whalen (1999), what is earnings management?
Earnings management occurs when managers use judgment in financial reporting and structuring transactions to alter financial reports, either to mislead stakeholders or influence contractual outcomes.
58
What is the primary intention behind creative accounting?
The main intention is to mislead stakeholders about the company’s economic performance or to achieve certain private gains (e.g., to influence stock prices or meet performance targets).
59
What is the difference between creative accounting and earnings management?
Earnings management is a form of creative accounting where managers use judgment in reporting to influence the financial reports to achieve desired outcomes, sometimes misleading stakeholders.
60
Is creative accounting always income-increasing?
Usually, creative accounting is used to report larger profits, a healthier balance sheet, and better financial performance, but it is not always income-increasing
61
Can creative accounting be possible within GAAP (Generally Accepted Accounting Principles)?
Yes, creative accounting can occur within the bounds of GAAP if companies follow the letter of the rules but deviate from the spirit of the rules, such as through judgments or accounting estimates.
62
Is creative accounting ethical?
From a regulator's view, no, as it can mislead investors, giving some companies an unfair advantage. It matters because investors rely on accurate financial information to make decisions.
63
Why does engaging in creative accounting matter to regulators?
Regulators aim to maintain a level playing field for all investors, ensuring that financial statements are reliable and not misleading. Investors depend on these statements for accurate decision-making.
64
Can earnings management be acceptable?
Yes, if observable and if low cost for market participants to adjust for it. Investors can adjust their understanding of the reported financial results based on disclosures in financial statements and notes.
65
How can investors adjust for earnings management?
Published information, such as financial statements and notes, allows investors to identify and adjust for earnings management, improving their understanding of the company's real performance.
66
What are 8 motives for creative accounting?
◼ To get around restrictions (e.g. debt covenants)
◼ To avoid government action
◼ To hide poor management decisions
◼ To achieve sales or profit target
◼ To avoid reporting a loss
◼ To attract new share capital or loan capital
◼ To satisfy the demands of major investors
◼ To cover-up fraud
67
Why might a company use creative accounting to avoid government action?
Companies might use creative accounting to avoid government scrutiny or regulatory penalties, especially if they are trying to meet compliance requirements or minimise tax liabilities.
68
How can creative accounting be used to hide poor management decisions?
Creative accounting allows companies to mask poor decisions by adjusting reported earnings, which can make it difficult for stakeholders to see the real impact of management's choices.
69
Why might a company engage in creative accounting to achieve sales or profit targets?
Creative accounting can help companies meet sales or profit targets, which may be important for internal performance evaluations, bonuses, or external market perception.
70
How might creative accounting be used to avoid reporting a loss?
Companies may use creative accounting to manipulate financial results and avoid showing a loss, potentially to maintain investor confidence or to avoid negative impacts on stock prices.
71
Why would a company use creative accounting to attract new share capital or loan capital?
By adjusting financial statements, companies can present a stronger financial position, making it easier to attract new investors or secure loan financing at favourable terms.
72
What is a reason for creative accounting to satisfy the demands of major investors?
Companies may use creative accounting to meet investor expectations, ensuring that they report profits or financial stability that align with the demands of major shareholders or stakeholders.
73
How might creative accounting be used to cover up fraud?
In extreme cases, creative accounting can be a tool to conceal fraudulent activities by manipulating financial results to hide illicit or illegal transactions.
74
Why is changing estimates considered an easy form of creative accounting?
Because it’s often subjective and doesn't require formal disclosure, making it less likely to attract scrutiny (e.g. changing depreciation or warranty estimates).
75
Give 4 examples of accounting estimates that are easily changed.
1) Depreciation methods or useful life
2) Warranty provisions
3) Provision for reorganisation
4) Understate/ overstate accruals -> these reverse in the subsequent period
76
What is a drawback of manipulating accruals in creative accounting?
Accruals reverse in the next period, so any manipulation is temporary and may be exposed over time.
77
Why is changing accounting policy more difficult than changing estimates?
Because policy changes must be disclosed in the financial statement notes, attracting more scrutiny from auditors and regulators.
78
Give one example of a policy change that affects COGS and inventory.
Switching between FIFO and weighted average inventory valuation methods.
79
Why is misclassification of items in financial statements risky?
It can attract auditor scrutiny and potentially mislead stakeholders, especially if used to capitalise costs like R&D.
80
What is an example of misclassification in creative accounting?
Capitalising R&D expenses instead of recognising them as current period expenses.
81
Why is structuring transactions a harder method of creative accounting?
It often requires cooperation with external parties and can raise red flags during audits or regulatory reviews.
82
What is an example of aggressive revenue recognition?
Recognising revenue before it is earned or realisable, such as booking sales before delivery.
83
What is aggressive revenue recognition?
Also known as earnings management, involves techniques where companies manipulate financial statements to present a more favourable picture of their earnings than what is truly reflected in their actual financial performance. This can be achieved by recording revenue sooner than is appropriate or by inflating the value of assets and liabilities.
84
What aspect of depreciation can be manipulated in creative accounting?
The method (e.g. straight-line vs. reducing balance) and estimates like economic life or scrap value can be adjusted to alter the depreciation charge.
85
How can depreciation be used to manage profit levels?
By adjusting the useful life or residual value of an asset, a company can increase or decrease the annual depreciation expense, thus affecting profits.
86
What kind of estimate can be manipulated under provisions?
Provisions for warranties, reorganisation, or bad debts can be over- or understated based on subjective estimates.
87
What is meant by “conservative accounting” in the context of provisions?
Overstating provisions, such as for reorganisation, which reduces current profit but can make future profits appear stronger when released.
88
What is meant by “aggressive accounting” with bad debt provisions?
Understating provisions for bad debts, which inflates profits by not fully accounting for likely uncollectible amounts.
89
How does understating accruals (liability) or overstating prepayments (asset) affect profit?
It increases current year profit by reducing expenses, but this will reverse in the following year, reducing future profit.
90
Why is changing accruals or prepayments an "easy" method of creative accounting?
Because it's a change in estimate, which often doesn't require disclosure, making it easier to manipulate quietly.
91
How can companies manipulate inventory and COGS figures?
By changing the inventory valuation method (e.g., from FIFO to weighted-average), they can alter the cost of goods sold (COGS) and therefore affect gross profit.
92
What is required when a company changes its accounting policy for inventory?
Disclosure in the notes to the financial statements, including the reason for the change and its impact on financial results.
