Financial Reporting and Analysis Unit 5

Questions and Answers

What is the primary purpose of financial analysis?

To calculate taxes

To prepare financial statements

To evaluate the financial performance and financial position of an entity (correct)

To identify accounting errors

What are financial ratios used for?

To calculate tax liabilities

To extract more meaningful conclusions from financial statements (correct)

To prepare financial statements

To identify accounting standards

What influences the financial performance of a company?

Only accounting principles

Economic conditions and competitive forces within the industry (correct)

Only economic conditions

Only management decisions

What typically happens to firms during periods of economic expansion?

They usually experience rising sales and improved cash flows Signup and view all the answers

What is the relationship between the number of competitors and profitability?

Entities with no or few competitors usually achieve superior profitability Signup and view all the answers

From which financial statements is the information for financial analysis obtained?

Statement of comprehensive income and statement of financial position Signup and view all the answers

What do profitability ratios evaluate?

The effectiveness and efficiency of management and employees in generating profit Signup and view all the answers

What does the gross margin ratio indicate?

The profit of the firm relative to sales after deducting the cost of sales Signup and view all the answers

What can affect the gross margin?

A combination of changes in the price charged for products sold, the price paid for products purchased, and any variation in the product mix of the business Signup and view all the answers

What are the five basic groups of financial ratios?

Profitability, Liquidity, Activity, Debt/Solvency, and Securities market Signup and view all the answers

How can the gross margin ratio be improved?

By selling a greater proportion of goods that have a higher mark-up Signup and view all the answers

What is the purpose of industry comparative analysis?

To evaluate the performance of an entity in relation to its competitors Signup and view all the answers

What is the term used to describe the approach of comparing an entity's performance with that of the industry leader or industry average?

Benchmarking approach Signup and view all the answers

What does the profit margin ratio pertain to?

The relationship of profit after taxes to sales Signup and view all the answers

What type of analysis involves evaluating an entity's performance over time?

Time-series analysis Signup and view all the answers

How can the profit margin ratio be improved?

By increasing sales through more effective and efficient marketing Signup and view all the answers

Which financial statement is used to calculate the gross profit?

Statement of Comprehensive Income Signup and view all the answers

What does the return on assets (ROA) measure?

The efficiency of management in generating profits with its available assets Signup and view all the answers

How can the return on assets be improved?

By reducing investment in current assets such as inventories and accounts receivable during periods of declining sales Signup and view all the answers

What is the formula for calculating the debt-to-assets ratio?

Total debt / Total assets Signup and view all the answers

According to Marx and Swardt, what are the measures of profitability related to?

Sales, assets, or equity Signup and view all the answers

What is the main difference between return on assets and return on equity?

Return on assets measures profit as a percentage of total assets, while return on equity measures profit as a percentage of total equity Signup and view all the answers

Why is it important to compare the return on assets with other rates?

To determine if the return is satisfactory or not Signup and view all the answers

What is the purpose of ratio analysis?

To identify areas for improvement and take corrective action Signup and view all the answers

What is the name of the approach that combines industry comparative and time-series analyses?

Ratio analysis Signup and view all the answers

What is the purpose of interpreting financial ratios?

To determine whether a ratio is favourable or unfavourable Signup and view all the answers

What is the assumption made about inventories in the acid test ratio?

They have no value at all Signup and view all the answers

What is the minimum acceptable acid test ratio?

1:1 Signup and view all the answers

What does a low inventory turnover imply?

High risk of non-saleable merchandise Signup and view all the answers

What is the implication of a high inventory turnover?

Merchandise remains in inventory for a short time Signup and view all the answers

What is the purpose of the debtor collection period ratio?

To evaluate credit and collection policies Signup and view all the answers

What is the purpose of unbundling business assets that achieve low or no profitability?

To evaluate the effectiveness and efficiency of fixed assets Signup and view all the answers

What does Return on Equity (ROE) measure?

The rate of return on shareholders' investment Signup and view all the answers

What does a low acid test ratio indicate?

Liquidity problems in the event of a crisis Signup and view all the answers

What is the implication of a high debtor collection period?

Debtors take a long time to pay their accounts Signup and view all the answers

What can be done to improve the Return on Equity (ROE)?

Increasing revenue by generating more sales Signup and view all the answers

What do liquidity ratios measure?

A company's ability to meet its short-term obligations Signup and view all the answers

How is the average inventory calculated?

By averaging the beginning and ending inventories Signup and view all the answers

What is the purpose of the acid test ratio?

To test the collectability of current liabilities under distress conditions Signup and view all the answers

What is the minimum acceptable value for the current ratio?

2:1 Signup and view all the answers

What does the inventory turnover ratio measure?

The speed at which inventory is sold and replaced Signup and view all the answers

What can be done to improve a low current ratio?

Accelerating cash inflow by offering cash discounts Signup and view all the answers

What is the acid test ratio also known as?

Quick ratio Signup and view all the answers

Why is a higher current ratio not always desirable?

It may indicate idle cash Signup and view all the answers

What is the formula to calculate the Return on Equity (ROE)?

Profit after tax x 100 / Equity Signup and view all the answers

What can be done to improve inventory management?

Purchasing goods that satisfy the needs of the target market Signup and view all the answers

What does the debt-to-asset ratio indicate?

The proportion of assets financed by creditors. Signup and view all the answers

What does a high debt-to-equity ratio suggest?

That the company is heavily reliant on debt financing. Signup and view all the answers

What is the primary purpose of the interest coverage ratio?

To assess a company's ability to pay off its debt. Signup and view all the answers

What does the earnings per share (EPS) ratio indicate?

A company's profitability. Signup and view all the answers

What is the recommended value for the interest coverage ratio?

Between 3 and 5 times. Signup and view all the answers

What is the implication of a high debt-to-asset ratio?

That the company is heavily reliant on debt financing. Signup and view all the answers

What does the increase in earnings per share (EPS) suggest?

An increase in profitability. Signup and view all the answers

Why may management consider issuing new ordinary shares?

To reduce the company's debt levels. Signup and view all the answers

What is the primary purpose of the debt-to-equity ratio?

To measure a company's debt exposure. Signup and view all the answers

What does the collection period of 63,10 days indicate about Spire Limited's accounts receivable?

The average time lag between sale and receipt of cash from the sale is 63,10 days. Signup and view all the answers

What does a high interest coverage ratio indicate?

That the company has sufficient earnings to cover its interest expenses. Signup and view all the answers

What can an entity with an unfavourable debtor collection period consider doing?

Providing incentives to increase cash sales. Signup and view all the answers

What does the creditor payment period ratio evaluate?

The management of accounts payable. Signup and view all the answers

Why is it important for an entity to make payment within the stated credit terms?

To avoid damaging its credit record. Signup and view all the answers

What is the purpose of debt ratios?

To evaluate an entity's degree of indebtedness and ability to service debts. Signup and view all the answers

What does the debt to assets ratio indicate?

The proportion of debt to total claims against the assets of the enterprise. Signup and view all the answers

Why do lenders care about an entity's debt to assets ratio?

Because it affects the entity's ability to service debts. Signup and view all the answers

What should management consider doing if the EPS is too low?

Improving the profitability of the entity by better marketing strategies. Signup and view all the answers

What is the purpose of calculating the Dividend per Share (DPS)?

To evaluate the company's earnings performance and prospects. Signup and view all the answers

What is the result of increasing an entity's financial leverage?

An increase in the return on equity. Signup and view all the answers

What does a low P/E ratio indicate?

The market has poor earnings expectations. Signup and view all the answers

Why might an entity's creditor payment period be longer than the credit terms?

Because some customers had difficulty paying or were abusing their credit privileges. Signup and view all the answers

What is the earnings yield ratio used for?

To measure the returns on investment. Signup and view all the answers

What can an entity do to accelerate its collection period?

Offer debtors discounts for early settlement. Signup and view all the answers

What should management focus on if the P/E ratio is too low?

Improving the profitability of the entity. Signup and view all the answers

What is the formula for calculating the Price/Earnings (P/E) ratio?

Market price per share / Earnings per share Signup and view all the answers

What is the opposite of the Price/Earnings (P/E) ratio?

Earnings yield Signup and view all the answers

Why is the EPS reported prominently on the face of the income statement?

Because it is an important metric for investors. Signup and view all the answers

What can be done to improve the earnings yield?

Improve the profitability of the company. Signup and view all the answers

What is the purpose of calculating the Dividend per Share (DPS) and Earnings per Share (EPS)?

To evaluate the company's profitability and returns on investment. Signup and view all the answers

What is the dividend yield ratio used to reflect?

The percentage return on investment in terms of market value of shares Signup and view all the answers

What does a high dividend yield may indicate?

That the company has fallen on hard times and future dividends may not be as high as previous ones Signup and view all the answers

What is the formula to calculate the dividend yield?

Dividend per share / Market price per share x 100 Signup and view all the answers

What can improve the dividend yield of a company?

Improving the profitability of the company Signup and view all the answers

What does a low dividend yield may indicate?

That the stock is overpriced or that future dividends might be higher Signup and view all the answers

What does the dividend yield reflect?

The percentage return on investment in terms of market value of shares Signup and view all the answers

What is the consequence of a high dividend yield?

The stock may be underpriced or the company has fallen on hard times Signup and view all the answers

Why is a higher dividend yield desirable among many investors?

Because it indicates a higher return on investment Signup and view all the answers

Study Notes

Financial Statements and Analysis

Financial statements provide insight into an entity's financial performance and position.
Financial ratios are used to extract more meaningful conclusions and diagnose problems.
A ratio is a relationship between two sets of values, summarizing complex accounting information into key indicators.
Financial analysis evaluates an entity's financial performance and position, identifying risks and opportunities.

Types of Comparison

Ratio analysis involves two types of comparison:
- Industry comparative analysis: compares an entity's financial ratios to those of its industry competitors.
- Time-series analysis: evaluates an entity's performance over time, identifying trends and changes.

Profitability Ratios

Profitability ratios measure a company's ability to generate earnings compared to its sales, assets, and equity.
Types of profitability ratios:
- Gross margin (gross profit margin): profit after deducting the cost of sales, as a percentage of sales.
- Profit margin (net profit margin): profit after taxes, as a percentage of sales.
- Return on assets (ROA): operating profit, as a percentage of total assets.
- Return on equity (ROE): net profit after tax, as a percentage of shareholders' equity.

Liquidity Ratios

Liquidity ratios measure an entity's ability to meet its short-term obligations.
Types of liquidity ratios:
- Current ratio: current assets, as a percentage of current liabilities.
- Acid test ratio (quick ratio): current assets minus inventory, as a percentage of current liabilities.

Activity Ratios

Activity ratios measure the efficiency of an entity's operations.
Types of activity ratios:
- Inventory turnover: number of times inventory is sold and replaced during a period.
- Debtor collection period: average time taken by debtors to pay their accounts.
- Creditor payment period: average time taken by an entity to pay its creditors.

Debt Ratios

Debt ratios measure an entity's level of indebtedness and ability to service its debt.
Lenders use debt ratios to assess an entity's creditworthiness and ability to repay loans.### Financial Leverage
Increasing debt relative to equity to finance a business can enhance earnings for owners
However, lenders must still be repaid regardless of earnings

Debt to Assets Ratio (Debt Ratio)

Measures the proportion of debt to total claims against assets
Higher ratio indicates higher risk
Calculation: Total debt / Total assets
Example: Spire Limited's debt to assets ratio is 55.03% and 54.74% for 20.14 and 20.13 respectively

Debt to Equity Ratio

Measures the relative proportions of non-current claims to ownership claims
Used to measure debt exposure
Calculation: Non-current debt / Equity
Example: Spire Limited's debt to equity ratio is 49.56% and 60.23% for 20.14 and 20.13 respectively

Interest Coverage (Times Interest Earned) Ratio

Measures a firm's ability to cover interest payments
Calculation: Operating profit / Interest expense
Example: Spire Limited's interest coverage ratio is 27.55 times and 27.12 times for 20.14 and 20.13 respectively

Securities Market Ratios

Earnings per share (EPS), dividend per share (DPS), price/earnings (P/E) ratio, earnings yield, and dividend yield ratios are applicable only to companies listed on a stock exchange

Measures profitability
Calculation: Profit after tax / Number of ordinary shares issued
Example: Spire Limited's EPS is 37.18 cents and 36 cents for 20.14 and 20.13 respectively

Measures dividend payments
Calculation: Dividends for the year / Number of ordinary shares issued
Example: Spire Limited's DPS is 17.5 cents and 16.67 cents for 20.14 and 20.13 respectively

Price/Earnings (P/E) Ratio

Measures market price of a company's ordinary shares
Calculation: Market price per share / Earnings per share
Example: Spire Limited's P/E ratio is 3.50 times and 3.33 times for 20.14 and 20.13 respectively

Earnings Yield Ratio

Measures current profit-generating power per ordinary share
Calculation: Earnings per share / Market price per share
Example: Spire Limited's earnings yield ratio is 28.60% and 30% for 20.14 and 20.13 respectively

Dividend Yield Ratio

Measures percentage return on investment in terms of dividends
Calculation: Dividend per share / Market price per share
Example: Spire Limited's dividend yield ratio is 13.46% and 13.89% for 20.14 and 20.13 respectively

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Description

Learn about financial statements, ratio analysis, and financial performance evaluation. Identify risks and opportunities in financial data.