ratios prep

Question 1

advantages of using cash flow as a measure of company performance

Answer 1

• it cannot be hidden - like air in a balloon, one can see if it is going in or out
• generation of long-term cash flow is the real value of a company
• use of the discounted cash flow (DCF) method shows the value added to a company

Question 2

disadvantages of using cash flow as a measure of company performance

Answer 2

• there is a number of different methods of analysing cash flow
• cash flow analysis is not straightforward - it can sometimes be extremely complex
• it is sometimes difficult to obtain cash flow information
• it is difficult to compare the cash flows of different companies

Question 3

advantages of using earnings per share (cps) as a measure of company performance ( it should be noted that eps can be manipulated by companies.

Answer 3

• a simple method of use
• easy to compare companies
• possible to see the company relative to the market
• profit is easily identifiable

Question 4

disadvantages of using earnings per share (cps) as a measure of company performance ( it should be noted that eps can be manipulated by companies.

Answer 4

• the 1980s boom led to some creative accounting, e.g. Coloroll, polly peck, Maxwell, all based on accounting conventions
• different bases are used from one company to another
• use of the historical cost concept means that there is no accounting taken of expected growth or inflation
• there is no account taken of market risk
  the numbers are too easy to manipulate
• the imprecise area of the treatment of extraordinary items and provisions has now been resolved but there still remains dubious areas such as derivatives, depreciation rates, and provisioning.

Question 5

value of ratios

Answer 5

• ratios facilitate comparisons:
• the company’s prior expectations of the outcome
• external observers’ prior expectations of the outcome
• ratios based on previous years’ figures for this company
• ratios calculated from this year’s figures for other companies
• ratios calculated from previous years figures for the companies
• industry averages published by commercial organisations BUT……

Question 6

limitations of ratios

Answer 6

• companies are not very similar
• companies operate in many industries
• accounting numbers are subject to creativity.