Atrill4eSMCh06.docx
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Atrill4eSMCh06.docx
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Atrill4eSMCh06
Chapter6–AnalysisandInterpretationofFinancialStatements
SuggestedSolutions
DiscussionQuestions
6.1Afinancialratioissimplyacomparisonbetweentwofinancialmagnitudeswithinthefinancialreportsofanentitythatprovidesvaluableinsightsintothefinancialperformanceorpositionoftheentity.
6.2Withoutastandardofcomparisonratiosprovidelittleinsight.Forexampleisa‘grossprofitmargin’of23%acceptableora‘debtorsturnover’of5timesreasonableora‘currentratio’of1.7timessecure.
Comparisonshouldbemadewith:
(a)Terms(i.e.whatcreditperiodisoffered)
(b)Budget(i.e.plan)
(c)Pastperiods/intertemporal(i.e.trend)
(d)Otherfirmsinthesameindustry(intra-industryorinterfirmcomparison)
6.3Thefactthatabusinessoperatesonalowprofitmarginindicatesthatasmallpercentageofprofitisbeingproducedforeach$1ofsalesgenerated.However,thisdoesnotnecessarilymeanthatthereturnoncapitalemployedwillbelowasaresult.Ifthefirmhasahighassetturnoverthanthiscancompensateforthelowprofitmarginandgenerateasatisfactoryreturnontheassetsemployed.
6.4(a)Acommonsizereportisonewhereallofthedollarmagnitudesarereplacedbypercentages,withthekeyfigurebecoming100(e.g.Sales=100inthestatementoffinancialperformance;TotalassetsorTotalliabilitiesandOwnersequity=100inthestatementoffinancialposition).Allothersubsidiaryfiguresareexpressedasapercentageofthekeyfigureforthatyear.
(b)Thebenefitsofcommonsizereportsarethattheyareeasilyprepared,removethedistortionofdollarmagnitudes,andreadilyhighlightpositiveornegativetrendsovertimeinfinancialmagnitudes(egthegrossmargin;thelevelofexpenses;theinventorymagnitudeetc).
(c)Twootherindexorpercentagetechniquesbeing:
(i)Horizontalanalysisorpercentagechangewhereforeachlineitemthepercentagechangefortheyeariscomputed(egsales;costofsales;expenses;currentassets;non-currentassetsetc).
(ii)Trendpercentagewhereyearonefiguresareallgivenanindexof100andsubsequentfiguresarerelatedtothatfigure(expressedasapercentageorindex).
6.5Indexorpercentageanalysisinvolvesconvertingfinancialmagnitudestoanindexorpercentagemeasure.Verticalanalysisreferstotheapplicationofthistechniquewherethekeyfigurefortheyearisexpressedasindex100(or100%),andeachsubsidiaryfigureisindexedtothatfigure(expressedasapercentageofthatfigure).Intheincomestatementthekeyfigure(#100)mightbesales,andthesubsidiaryfigureswouldbethedifferentexpenses(costofsales;selling&distributions;administrative;financial)andprofitfortheperiod.Similarlytheindexcouldbebasedonabalancesheettotal(egassets)andthesubsidiaryfigurescouldbeeachoftheassetaccounts.
Horizontalanalysisreferstotheapplicationofthistechniquewhereforeachlineiteminthereportwecomputethepercentagechangeforeachyear.Soifsalesincreasesfrom$123000to$135000,theindexorpercentagechangefortheyearis+9.8%(+12000/123000).
6.6Thecurrentratiocomparescurrentassetswithcurrentliabilities.
Thequick(acidtest)ratiocomparesthemoreliquidcurrentassetswithcurrentliabilitiesrequiringatimelycashpayment.
Thereisnouniquesetofaccountsthatareincludedinthequickratioformula,sodifferentreferenceswillprovidedifferentanswerstothisquestion.
However,itwouldbereasonabletoassumethatforcurrentassetsyouwouldexclude‘inventory’(becauseitisnotreadilyconvertedtocash)andprepayments(becausecashhasalreadybeenpaidanditisunlikelyyouwillrequestorobtainacashrefund).
Also,withcurrentliabilitiesyoumayexclude‘bankoverdraft’onthegroundsthatitisanongoingdebtthatdoesnothavetobepaidimmediately.Theproblemwiththisinterpretationisthattheoverdraftmayhavetoberepaidondemand.Additionally,youmightexcludeaccountslike‘unearnedincome’whereitisunlikelythattheywillbesatisfiedthroughafuturecashoutflow.
6.7Thepotentialadvantagesofdebtfinanceoverowner’sequityfinancefromtheviewpointofthebusiness(andowners)being:
(a)Debtfinanceisnormallyshort-termandwhenrepaidwillnotaffectthecurrentownersshareofthebusinessprofitsorassets.Itistemporaryanddoesnotdiluteownershipinterests.
(b)Interestpaidondebtfinanceistaxdeductible,whereasdividendspaidonownersequityfinance(shares)isnot.
(c)Thecostofdebt(eginterestrate)isoftenlowerthenthecostofownersequity.
(d)Debtholdersdonothavevotingrights.
(e)Wherethereturnonassetsishigherthenthecostofdebtfinance,abusinesscanimprovethereturntoownersequityholdersbytheuseofdebtfinancetoimprovereturns(calledleverageorgearing).
6.8Liquidityandsolvencyaredistinguishedbytime.Liquidityfocusesonshorttermsurvivaltomeetimmediateandshorttermcashcommitments.Solvencyislinkedtothelongertermfinancialstabilityoftheentityandthelevelofexternalversesownersorinternalfunding.
6.9Financialleveragefacilitates‘gearingup’or‘multiplying’thereturntoassetswherethereturnonassetsisgreaterthentheinterestondebt,eg:
ReturnonAssets
InterestonDebt
OwnersFunds
DebtFunds
ReturntoOwner
10%
n.a.
100%
NIL
10%
10%
8%
50%
50%
12%*1
10%
8%
10%
90%
28%*2
*1=10%+[50/50x(10%-8%)]
*2=10%+[90/10x(10%-8%)]
However,thegreatertheborrowingthehighertheinterestrate,andatthesametimethegreatertheinvestmentthelowerthereturns.Takingthelastexample
ReturnofAssets
InterestonDebt
OwnersFunds
DebtFunds
ReturntoOwners
8%
9%
10%
90%
-0.5%*3
*38.5%+[90/10x(8%-9%)]
6.10Earningsyieldisbasedonthemarketvalueoftheshares.[(Netprofitaftertaxavailabletoordinaryshareholdersaveragenumberofshares)averageshareprice].Returnonownersequityisbasedonthebookvalueoftheaverageownersequityfortheperiod.[Netprofitaftertaxandpreferencedividendsaverageownersequity]
Therefore,thebasicdifferencebetweenthetwomeasuresisthedifferencebetweenthebookvalueoftheownersequityinthestatementoffinancialpositionandthemarketcapitalisationofthefirm(themarketsassessmentoftheownershipinterest).
6.11(a)Thecashcycleistypicallytheperiodfromwhengoodsarepurchased(rawmaterialsforprocessingorfinishedgoodstosell)tillthecashisreceivedfromthesaleofthegoods(manufacturedorinitiallyacquiredasfinishedgoods).Itistheperiodthatthebusinesshastofundtheinvestmentininventories.Itcouldalsobeappliedtotheserviceindustry.
(b)Liquidityfocusesontheshort-termsurvivalofafirmandconsidersitsabilitytomeetshort-termobligations.Thisabilityisoftenexpressedintermsofhowquicklyitcanconvertnon-cashassetsintocash(turnoverratiosorperiods).Solvencyfocusesonthelonger-termsurvivaloftheentityandisgenerallyassessedonthebasisofthelevelofdebt(leverageorgearing)andinterestcoverinrelationtotherelativevolatilityofearningsinthatfirm(orindustry).
(c)Thestatementwouldappeartobetrueinlightoftheabovediscussion.
6.12Theanswertothisisspecifictotheparticipantbutoneormoreofthefollowingmaybementioned:
∙Staffturnover
∙Staffabsenteeism
∙Salestofloorspace
∙Profitperemployee
∙Salesrelatedtoadvertisingandpromotion
∙Equipmentdowntime
∙Occupancyrates
∙Salesrelatedtothetimeofday
∙Salesrelatedtocustomerprofile(age;gender;nationalityetc)
6.13(a)Profitabilityisconcernedwithfinancialperformance(absoluteorrelativereturns)whereasefficiencyisconcernedwithhowquicklyassetsorliabilitiesareturnedover.
(b)ProfitabilityRatios-GrossProfitMargin
-NetProfitMargin
-ReturnonAssets
-ReturnonOwnersEquity
EfficiencyRatios-Debtorsturnover
-CreditorsTurnover
-InventoryTurnover
-TotalAssetTurnover(salesturnover)
(c)Efficientuseofresourcescanincreasetherelativereturnonassetsorownersequity.
6.14Themeasuresusedtoassesssolvency(gearing;leverage,financialstability)couldinclude:
-Totalliabilitiestototalassets.
-Long-termliabilitiestoownersequity
-Interestcover(timesinterestearned)
However,theseratiosontheirownarerelativelymeaninglessandshouldbeconsideredwithrespectto:
(a)Inter-temporalperformance(comparisonwiththepast).
(b)Budgetorplannedperformance(comparisonwithwhatwasexpected)
(c)Intra-industryorinter-firmcomparison(comparisonwithfirmsinthesameindustry)
6.15Assetsareusedtogeneratereturns(rent;interest;sales;dividends;commission;royaltiesetc).
Thisreturnisthendistributedtothepartiesprovidingtheresourcesorinfrastructuretooperate(i.e.interesttodebtholders;taxationtothegovernment;dividendsandretainedprofitstotheowners).Interestisaddedback(ornotinitiallydeducted)sowecanassessthereturnonresourcesbeforeitisassignedorallocatedtothethreedesignatedclaimants.
6.16TheP/Eratiomayvarybetweencompanieswithinthesameindustryforthefollowingreasons:
Accountingconventions.Differencesinthemethodsusedtocomputeprofit(e.g.inventoryvaluation,depreciationetc)canleadtodifferentprofitfiguresand,therefore,differentP/Eratios.
Differentprospects.Onecompanymayberegardedashavingamuchbrighterfutureduetofactorssuchas,thequalityofmanagement,thequalityofproducts,locationetc.Thiswillaffectthemarketpriceinvestorsarepreparedtop
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