Topic 3 - Financial Statement Analysis

Question 1

Why do we need comparative analysis?

Answer 1

• to assess the financial health of a business.
• to compare current performance with past performance.
• to compare and benchmark against industry competitors and even across other industries.

Question 2

What are the three basic comparative analysis techniques?

Answer 2

• Horizontal analysis
• Vertical analysis
• Ratio analysis

Question 3

Explain horizontal analysis.

Answer 3

• Used to evaluate a series of financial statement data over a period of time.
• Analyses increases or decreases that have occurred from a particular base year.
• Percentages removes the effect of size, so relative magnitude of change is revealed.

Question 4

Explain vertical analysis.

Answer 4

• Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude.
• Useful for comparing companies of different sizes.

Question 5

What is the purpose of ratio analysis?

Answer 5

To evaluate the financial performance and health of a business

Question 6

What are the limitations of financial statement analysis?

Answer 6

• Estimates
• Atypical data
• Diversification within entities
• Retrospective focus
• Lack of disclosure
• Calculation differences
• Lack of comparability

Question 7

What are the three types of useful comparative information?

Answer 7

• Intra-entity basis:
  Comparisons within a single entity (detects changes in financial relationships and trends).
• Industry averages:
  Between entities in same industry (determines position relative to others).
• Inter-entity basis:
  Between other entities (indicates competitive position).

Question 8

What are the three types of ratios?

Answer 8

Liquidity, Solvency and Profitability

Question 9

What is the purpose of Liquidity ratios?

Answer 9

Measures the short-term ability of an entity to pay its debts and meet unexpected needs for cash.

Question 10

What is the purpose of Solvency ratios?

Answer 10

Measures the ability of an entity to survive over a long period of time.

• A business will fund (gear) it’s operations through either debt or equity. The term highly geared means the business has a high level of debt funding compared to its equity funding.

Question 11

What is the purpose of Profitability ratios?

Answer 11

Measures the profit or operating success of an entity for a given period of time.

Question 12

What does the current ratio measure? (liquidity)

Answer 12

A measure that expresses the relationship of current assets to current liabilities

Question 13

What does the quick ratio measure? (liquidity)

Answer 13

A measure of an entity’s immediate short-term debt paying ability.

Question 14

What does the inventory turnover ratio measure? (liquidity)

Answer 14

Measures the number of times a company sells its average level of inventory during a year

Question 15

What does the average days in inventory ratio measure? (liquidity)

Answer 15

A measure of the average number of days it takes to sell the inventory

Question 16

What does the debt to total assets ratio measure? (solvency)

Answer 16

A measure of the percentage of total assets provided by creditors.

• Indicates degree of leverage (percentage of total assets funded through debt).

Question 17

What does the times interest earned ratio measure? (solvency)

Answer 17

A measure on an entity’s ability to meet interest payments as they come due

Question 18

What does the free cash flow ratio measure? (solvency)

Answer 18

Indicates entity’s ability to pay dividends or expand operations.

Question 19

What does the return on ordinary shareholders’ equity ratio measure? (profitability)

Answer 19

Indicates earnings per dollar invested by the owners.

Question 20

What does the return on assets ratio measure? (profitability)

Answer 20

Measures overall profitability with respect to investment in assets.

Question 21

What does the profit margin ratio measure? (profitability)

Answer 21

Measures percentage of each dollar of sales that results in profit.

Question 22

What does the earnings per share (EPS) ratio measure? (profitability)

Answer 22

Measures profit earned on each ordinary share.

Question 23

What does the price-earnings ratio ratio measure? (profitability)

Answer 23

Measures ratio of market price of each ordinary share to earnings per share.
Reflects investors’ assessments of an entity’s future earnings.

Question 24

What other issues would you need to consider when looking at a companies’ financial statements?

Answer 24

Economic factors, competitive market influences, global events and trends and other information on business operations.