Financial Reporting and Analysis Unit 5
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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?

    <p>They usually experience rising sales and improved cash flows</p> Signup and view all the answers

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

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

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

    <p>Statement of comprehensive income and statement of financial position</p> Signup and view all the answers

    What do profitability ratios evaluate?

    <p>The effectiveness and efficiency of management and employees in generating profit</p> Signup and view all the answers

    What does the gross margin ratio indicate?

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

    What can affect the gross margin?

    <p>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</p> Signup and view all the answers

    What are the five basic groups of financial ratios?

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

    How can the gross margin ratio be improved?

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

    What is the purpose of industry comparative analysis?

    <p>To evaluate the performance of an entity in relation to its competitors</p> 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?

    <p>Benchmarking approach</p> Signup and view all the answers

    What does the profit margin ratio pertain to?

    <p>The relationship of profit after taxes to sales</p> Signup and view all the answers

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

    <p>Time-series analysis</p> Signup and view all the answers

    How can the profit margin ratio be improved?

    <p>By increasing sales through more effective and efficient marketing</p> Signup and view all the answers

    Which financial statement is used to calculate the gross profit?

    <p>Statement of Comprehensive Income</p> Signup and view all the answers

    What does the return on assets (ROA) measure?

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

    How can the return on assets be improved?

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

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

    <p>Total debt / Total assets</p> Signup and view all the answers

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

    <p>Sales, assets, or equity</p> Signup and view all the answers

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

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

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

    <p>To determine if the return is satisfactory or not</p> Signup and view all the answers

    What is the purpose of ratio analysis?

    <p>To identify areas for improvement and take corrective action</p> Signup and view all the answers

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

    <p>Ratio analysis</p> Signup and view all the answers

    What is the purpose of interpreting financial ratios?

    <p>To determine whether a ratio is favourable or unfavourable</p> Signup and view all the answers

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

    <p>They have no value at all</p> Signup and view all the answers

    What is the minimum acceptable acid test ratio?

    <p>1:1</p> Signup and view all the answers

    What does a low inventory turnover imply?

    <p>High risk of non-saleable merchandise</p> Signup and view all the answers

    What is the implication of a high inventory turnover?

    <p>Merchandise remains in inventory for a short time</p> Signup and view all the answers

    What is the purpose of the debtor collection period ratio?

    <p>To evaluate credit and collection policies</p> Signup and view all the answers

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

    <p>To evaluate the effectiveness and efficiency of fixed assets</p> Signup and view all the answers

    What does Return on Equity (ROE) measure?

    <p>The rate of return on shareholders' investment</p> Signup and view all the answers

    What does a low acid test ratio indicate?

    <p>Liquidity problems in the event of a crisis</p> Signup and view all the answers

    What is the implication of a high debtor collection period?

    <p>Debtors take a long time to pay their accounts</p> Signup and view all the answers

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

    <p>Increasing revenue by generating more sales</p> Signup and view all the answers

    What do liquidity ratios measure?

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

    How is the average inventory calculated?

    <p>By averaging the beginning and ending inventories</p> Signup and view all the answers

    What is the purpose of the acid test ratio?

    <p>To test the collectability of current liabilities under distress conditions</p> Signup and view all the answers

    What is the minimum acceptable value for the current ratio?

    <p>2:1</p> Signup and view all the answers

    What does the inventory turnover ratio measure?

    <p>The speed at which inventory is sold and replaced</p> Signup and view all the answers

    What can be done to improve a low current ratio?

    <p>Accelerating cash inflow by offering cash discounts</p> Signup and view all the answers

    What is the acid test ratio also known as?

    <p>Quick ratio</p> Signup and view all the answers

    Why is a higher current ratio not always desirable?

    <p>It may indicate idle cash</p> Signup and view all the answers

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

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

    What can be done to improve inventory management?

    <p>Purchasing goods that satisfy the needs of the target market</p> Signup and view all the answers

    What does the debt-to-asset ratio indicate?

    <p>The proportion of assets financed by creditors.</p> Signup and view all the answers

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

    <p>That the company is heavily reliant on debt financing.</p> Signup and view all the answers

    What is the primary purpose of the interest coverage ratio?

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

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

    <p>A company's profitability.</p> Signup and view all the answers

    What is the recommended value for the interest coverage ratio?

    <p>Between 3 and 5 times.</p> Signup and view all the answers

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

    <p>That the company is heavily reliant on debt financing.</p> Signup and view all the answers

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

    <p>An increase in profitability.</p> Signup and view all the answers

    Why may management consider issuing new ordinary shares?

    <p>To reduce the company's debt levels.</p> Signup and view all the answers

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

    <p>To measure a company's debt exposure.</p> Signup and view all the answers

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

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

    What does a high interest coverage ratio indicate?

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

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

    <p>Providing incentives to increase cash sales.</p> Signup and view all the answers

    What does the creditor payment period ratio evaluate?

    <p>The management of accounts payable.</p> Signup and view all the answers

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

    <p>To avoid damaging its credit record.</p> Signup and view all the answers

    What is the purpose of debt ratios?

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

    What does the debt to assets ratio indicate?

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

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

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

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

    <p>Improving the profitability of the entity by better marketing strategies.</p> Signup and view all the answers

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

    <p>To evaluate the company's earnings performance and prospects.</p> Signup and view all the answers

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

    <p>An increase in the return on equity.</p> Signup and view all the answers

    What does a low P/E ratio indicate?

    <p>The market has poor earnings expectations.</p> Signup and view all the answers

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

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

    What is the earnings yield ratio used for?

    <p>To measure the returns on investment.</p> Signup and view all the answers

    What can an entity do to accelerate its collection period?

    <p>Offer debtors discounts for early settlement.</p> Signup and view all the answers

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

    <p>Improving the profitability of the entity.</p> Signup and view all the answers

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

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

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

    <p>Earnings yield</p> Signup and view all the answers

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

    <p>Because it is an important metric for investors.</p> Signup and view all the answers

    What can be done to improve the earnings yield?

    <p>Improve the profitability of the company.</p> Signup and view all the answers

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

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

    What is the dividend yield ratio used to reflect?

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

    What does a high dividend yield may indicate?

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

    What is the formula to calculate the dividend yield?

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

    What can improve the dividend yield of a company?

    <p>Improving the profitability of the company</p> Signup and view all the answers

    What does a low dividend yield may indicate?

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

    What does the dividend yield reflect?

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

    What is the consequence of a high dividend yield?

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

    Why is a higher dividend yield desirable among many investors?

    <p>Because it indicates a higher return on investment</p> 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

    Earnings per Share (EPS) Ratio

    • 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

    Dividend per Share (DPS) Ratio

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

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