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Questions and Answers
Questions and Answers
Which of the following is NOT considered a basic financial statement?
Which of the following is NOT considered a basic financial statement?
- Statement of Financial Position
- Statement of Retained Earnings (correct)
- Statement of Comprehensive Income
- Statement of Cash Flows
Horizontal analysis involves evaluating financial statements from a single period in time.
Horizontal analysis involves evaluating financial statements from a single period in time.
False (B)
What is the base used in the income statement for vertical or common-size analysis?
What is the base used in the income statement for vertical or common-size analysis?
Net sales
In financial statement analysis, comparing a company's data with that of another enterprise is known as ______ analysis.
In financial statement analysis, comparing a company's data with that of another enterprise is known as ______ analysis.
Which analysis extends beyond two years to track past performance and predict future trends?
Which analysis extends beyond two years to track past performance and predict future trends?
An increase in accounts receivable is always viewed as a favorable sign for a company's financial health.
An increase in accounts receivable is always viewed as a favorable sign for a company's financial health.
What does a decrease in inventories generally indicate in financial statement analysis?
What does a decrease in inventories generally indicate in financial statement analysis?
The financial statement analysis technique that expresses each item in a financial statement as a percentage of a base amount is known as ______ analysis.
The financial statement analysis technique that expresses each item in a financial statement as a percentage of a base amount is known as ______ analysis.
What does Return on Sales (ROS) measure?
What does Return on Sales (ROS) measure?
A higher Price-to-Earnings (P/E) ratio always indicates a better investment opportunity.
A higher Price-to-Earnings (P/E) ratio always indicates a better investment opportunity.
What does liquidity refer to in the context of financial ratios?
What does liquidity refer to in the context of financial ratios?
The ______ cycle measures the number of days it takes for a company to buy and sell its inventory base.
The ______ cycle measures the number of days it takes for a company to buy and sell its inventory base.
Which of the following ratios measures the effectiveness of a business in using its investment in receivables to generate net credit sales?
Which of the following ratios measures the effectiveness of a business in using its investment in receivables to generate net credit sales?
A higher payable turnover always indicates better financial health for a company.
A higher payable turnover always indicates better financial health for a company.
What does the working capital turnover measure?
What does the working capital turnover measure?
______ refers to the use of debt to increase shareholder's equity.
______ refers to the use of debt to increase shareholder's equity.
Match the following ratios with their descriptions:
Match the following ratios with their descriptions:
Which of the following is the correct formula for calculating the Current Ratio?
Which of the following is the correct formula for calculating the Current Ratio?
A low Debt-to-Equity ratio generally indicates a higher risk of insolvency.
A low Debt-to-Equity ratio generally indicates a higher risk of insolvency.
What does the 'Times Interest Earned' ratio measure?
What does the 'Times Interest Earned' ratio measure?
Questions and Answers
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Flashcards
Flashcards
Horizontal Analysis
Horizontal Analysis
Presents differences in absolute amount and percentage between two periods.
Vertical Analysis
Vertical Analysis
Expressing financial data in percentage using a particular base.
Profitability
Profitability
The ability of a business to generate profit.
Liquidity
Liquidity
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Working capital turnover
Working capital turnover
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Financial leverage
Financial leverage
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Debt-to-assets Ratio
Debt-to-assets Ratio
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Price-Earnings Ratio (P/E)
Price-Earnings Ratio (P/E)
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Trend Analysis
Trend Analysis
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Gross Profit Rate
Gross Profit Rate
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Return on Sales
Return on Sales
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Return on Assets
Return on Assets
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Earnings Per Share (EPS)
Earnings Per Share (EPS)
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Current Ratio
Current Ratio
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Quick Ratio
Quick Ratio
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Book Value per Share
Book Value per Share
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EBIT
EBIT
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Inventory turnover
Inventory turnover
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Collection Period
Collection Period
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Study Notes
Study Notes
Financial Statement Analysis
- Basic financial statements include the statement of financial position (or balance sheet), statement of comprehensive income (or income statement), statement of cash flows, statement of owner's equity, and related notes.
- There are at least 4 traditional techniques of interpreting financial statements: Horizontal or comparative analysis, Trend analysis, Vertical or common-size analysis, and Financial mix ratio.
Horizontal Analysis
- This presents the differences in absolute amount and in percentage between two periods.
- Applicable to years, quarters etc
- Examines two companies, actual and budgeted data, and other bases of analyses.
- The difference can be either an increase or decrease in amount and percentage.
- To compute percentage change, divide the change in amount by the base as the formula shows: Percentage of Change = (Amount of Change) / Base.
- The base may be the last year's data, budgeted data, average industry data, or competitor's data.
- Comparing an enterprise's data with another enterprise's data is cross-sectional analysis.
Trend Analysis
- Extends beyond two years
- Track down the past and provide a pattern on what may happen in the coming years.
- Uses indexes and ratios to simplify complications and annoying presentations of numbers in the financial reports.
- Financial data expressed in indexes and ratios are easily readable compared to pesos in millions.
- Indexes are expressed in hundreds, while ratios are expressed in normal decimal places.
Vertical or Common-Size Analysis
- The analysis gets the proportional component of variables in the financial statements in relation to a chosen base (i.e., 100%).
- Like horizontal analysis, the financial statements are treated individually.
- The base in the income statement is net sales, and in the balance sheet, it is total assets.
- Expressing financial data in percentage using a base brings the size of different companies to a common format.
Financial Mix Ratios
- Differs from horizontal, trend, and vertical analyses, where each financial statement is considered a stand-alone report.
- The financial statements are interrelated and interlocked, where information in one statement is directly related to information in another.
- Since the financial statements are fundamentally-related, the information contained in one statement could be related to another.
- Four main classifications: profitability, growth, liquidity, and leverage ratios.
Profitability Ratios
- Assess a business's ability to generate profit relative to sales, investments, assets, equities, or outstanding shares.
- Examples include gross profit rate (gross profit/net sales) and operating profit ratio (operating profit/net sales).
- Other ratios are the return on sales, investments, equity, and earnings per share.
- Return on Sales (ROS) = Profit / Net Sales; measures ability to produce return for owners for every peso of net sales.
- Return on Investment (ROI) = Profit / Average Investments; measures the ability to generate return on resources used in operating the business.
- Return on Assets = [Profit + Interest Expense (net of tax)] / Total Assets; identifies profit generated by the enterprise using assets and management of facilities.
- Return on Equity = Profit / Average Shareholder's Equity, which can be expanded to (Net Sales / Net Sales) * (Inventories / Inevntories) * (Investment / Shareholder's Equity) or Return on Sales x Asset Turnover x Equity Multiplier.
- Earnings Per Share (EPS) = (Profit - Preference Dividends Requirement) / Average Ordinary Shares Outstanding; a vital financial ratio.
Growth Ratios
- Used to indicate the organization's potential and attractiveness as an investment option.
- One example is price-earnings.
- Price-Earnings (P/E) Ratio or the Earnings Multiple calculated by Market Price per Share / Earnings per Share
- The P/E ratio demonstrates an organization's ability to recover investments from earnings.
Liquidity Ratios
- Refer to the business’s ability to pay its obligations in cash when they mature.
- Liquidity analysis focal point is cash, including the management’s ability to convert its current assets in a quick, stable, and regular manner.
- Also, includes the ability of management to use trade credits and stretch the payments to trade credits in financing operating activities.
- Inventory and Receivable Conversion Cycle is a common measurement.
- Inventory-conversion cycle: Measure the number of days it takes for a company to buy and sell its inventory base.
- Receivable-conversion cycle: Measures the number of days it takes for a company to collect its receivable base.
- The total days it takes for a company to sell its inventories and collect its receivable is the operating cycle.
- Key liquidity formulas:
- Inventory turnover = Cost of Sales / Average Inventories
- Days to Sell Inventories = 365 Days / Inventory Turnover
- Receivable Turnover = Net CreditSales / Average Trade Receivables
- Collection Period = 365 Days / Receivable Turnover
- Payable Turnover = Net Credit Purchases / Average Trade Payables
- Payment Period = 365 Days / Payable Turnover
- These are sometimes known as activity or effectiveness ratios.
- Inventory turnover indicates the effectiveness of the business in selling its inventories.
- It determines the number of times the entire inventory base is sold in a given period.
- The receivable turnover measures the effectiveness of using the investment in receivables to generate net credit sales. It measure the number of times the receivable base is used in a given period.
- Payable turnover: Reflects how effective the business uses their trade credit line offered by merchandise creditors in financing its purchases.
- In times of tight cash position and unfavorable economic conditions, businesses find ways on how to lengthen the payment period to merchandise suppliers.
Primary and Secondary Liquidity and Activity Ratios
- Formulas include:
- Current Ratio = Current Assets / Current Liabilities
- Quick Assets Ratio = Quick Assets / Current Liabilities
- Working capital turnover: measure of management's effectiveness in using working capital to generate sales.
- Assets turnover: relates the operating revenues to the total investment portfolio of the business.
Financial Leverage Ratios
- Leverage is an instrument used in moving larger object.
- To gain leverage as in financing, the bigger object to be moved is the shareholder's equity and the more wealth the organization has.
- Financial leverage refers to the use of debt to increase shareholder's equity, business activities with greater exposure to financial risk.
- The more leveraged the business, the higher the financial risk is.
- Leverage Formulas:
- Debt-to-Assets Ratio = Debt / Total Assets
- Debt-to-equity Ratio = Debt / Total Equity
- Times-Interest-Earned = EBIT / Interest Expense
- The higher the debt ratio or debt-to-equity ratio, the more leveraged the business is.
- Furthermore, the more debt is used to finance investing and operating activities, the higher the risk of insolvency, the higher the financial risk, the higher the return on equity.
- The number of times interest is earned measures the long-term ability of the business to meet the interest payments.
- The higher the times interest is earned, the more profitable the business is and at the same time the more capable it is meeting interest payments.
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