Week 5 - Interpretation of Accounts

Question 1

Interpretation of accounts is

Answer 1

a detailed explanation of the financial performance of an entity incorporating data and other quantitative and qualitative information extracted from both internal and external sources

Question 2

Main techniques for interpretation of accounts are

Answer 2

1. horizontal/trend analysis
2. vertical analysis
3. ratio analysis

Question 3

Horizontal/Trend Analysis involves

Answer 3

making line-by-line comparison of the company’s accounts for each accounting period

Question 4

Vertical Analysis requires

Answer 4

the figures in each financial statement to be expressed as a percentage of the total amount

Question 5

Ratio Analysis expresses

Answer 5

the relationship between two numbers expressed as percentage or other factor

Question 6

5 main areas of Ratio Analysis

Answer 6

1. Liquidity
2. Gearing/Solvency
3. Profitability
4. Operational/Activity
5. Investor

Question 7

Liquidity is

Answer 7

a company’s ability to meet its current obligation

Question 8

2 liquidity ratios

Answer 8

Current
Acid-test
(expressed as a factor = 3:1)

Question 9

Current Ratio =

Answer 9

Current Assets / Current Liabilities

Question 10

Acid-test Ratio =

Answer 10

(Current Assets - Inventory) / Current Liabilities

Question 11

Gearing/Leverage is

Answer 11

the amount the business has borrowed (debt) relative to the amount of finance provided by the owners of the business (equity). High percentage = highly geared

Question 12

Gearing =

Answer 12

Long Term Loans / Total Equity
(expressed as a percentage)

Question 13

Profitability is

Answer 13

the amount of profit that a business generates from its operations

Question 14

4 profitability ratios are

Answer 14

1. Gross Profit/margin
2. Net proft
3. Return on Capital employed
4. Return on Equity

Question 15

Gross Profit/margin Percentage =

Answer 15

Gross Profit / Sales

Question 16

Net Profit Percentage =

Answer 16

Profit Before Interest and Tax (PBIT) / Sales

Question 17

Return on Capital Employed (ROCE) =

Answer 17

Profit Before Interest and Tax (PBIT) / Capital Employed

Question 18

Return on Equity (ROE) =

Answer 18

Profit Before Tax / Equity

Question 19

Operational/Efficiency Ratios measure

Answer 19

how efficiently the firm manages its resources (fixed assets, inventory, debtors and creditors)

Question 20

4 efficiency ratios

Answer 20

1. stock turnover
2. asset turnover
3. debtors days
4. creditors days

Question 21

Stock Turnover =

Answer 21

Avg. inventory x 365 days / cost of goods sold

Question 22

Asset Turnover =

Answer 22

Sales / Fixed Assets

Question 23

Debtors Days =

Answer 23

Avg Debtors x 365 days / Credit Sales

Question 24

Creditors Days =

Answer 24

Avg. Creditors x 365 days / Credit purchases*

*or Cost of sales if credit purchases not available

Question 25

Inventory turnover is a

Answer 25

measure of how many times the average inventory level is sold each year

Question 26

Asset turnover is

Answer 26

a measure of how efficiently the Fixed Assets of the business are generating sales

Question 27

Debtors days measures

Answer 27

the average number of days it takes customers to pay the business

Question 28

Creditors days measures

Answer 28

the average number of days the business takes to pay suppliers

Question 29

Investor ratios measure

Answer 29

the profits of the business and the returns that are generated to investors in the form of dividends

Question 30

2 main investor ratios (covered on this course)

Answer 30

1. Earnings per Share (EPS) 2. Price Earning Ratio (P/E)

Question 31

Earnings per Share (EPS) =

Answer 31

Profit After Tax and Preference Dividend / Number of Ordinary Shares Issued

Question 32

Price Earning Ratio (P/E) =

Answer 32

Market Price Per Share / EPS

Question 33

Earnings per Share (EPS) measures

Answer 33

how much each share issued by the firm generated for the investor in terms of profit earned. Not all profit is returned directly to the shareholders in the form of dividends, the profit which is not distributed will be retained and will grow the business. Comparing EPS over a number of years will allow an investor to see if the company is growing

Question 34

Price Earning ratio (P/E) relates

Answer 34

the current earnings of the business to the current share price of the business. Provides a crude payback period for the time taken to repay the investment in terms of the current share price with the number of years of earnings. The higher the P/E ratio, the greater the confidence in the firm's future prospects.

Question 35

Limitations of ratios

Answer 35

- Deal with figures only, non-financial qualities of the business are often not apparent (skills and general morale of the workforce will not show up in data) - Is financial data consistent over time? - If comparison is made with other organizations, is there consistency of accounting policies? (ex. depreciation) - The reasons for changes in ratios perhaps not immediately apparent - Ratios generally use historical data and provide no real basis for future predicitions - Ideal ratios are guidelines only and vary from business to business