Deck 10: Analysis and Interpretation of Financial Statements

Question 1

Choose the correct explanation for the liquidity (quick)ratio.
A A measure of a business's ability to pay debts and obligations due beyond 1 year
B A measure of a business's ability to pay debts and obligations due within 2 years
C A measure of a business's ability to pay debts and obligations due within 1 year
D A measure of a business's ability to pay debts and obligations due within 1 year,excluding the value of inventory and prepaid expenses

Answer 1

D

Question 2

The following financial statements are for Sioux Appliances,a sole trader,for the years ending 31 March 20X3,20X4 and 20X5.
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Other information:
20X2 Accounts receivable were 52,000
20X2 Inventory were 19,000
20X2 Total assets were 360,000
20X2 Sales were 490,000
The bank overdraft limit is $20,000.
The mortgage is due for repayment in 20X7.
a Give a brief explanation of what each of the following ratios measure or mean: (You are not required to interpret the results from the financial statements at this point. )
i Net profit %,Return on equity %
ii Inventory turnover (days),Accounts receivable turnover (days)
iii Liquidity ratio (= Quick ratio),Debt ratio %.
b Calculate the following ratios for the 20X5 year.Show your calculations.
i Gross profit %,Net profit %,Return on equity %
ii Inventory turnover,in times per year and in days
iii Accounts receivable turnover,in times per year and in days
iv Current ratio,Liquidity ratio,Debt ratio %.
c Comment on the ratios calculated above,and the financial statement results for Sioux Appliances during the years 20X3-20X5 inclusive,in the following areas:
• profitability
• managerial performance
• financial stability.
d Recommend to Sioux what you consider to be the 6 most important things to do to correct her financial position and performance.

Answer 2

a i Net profit % measures the efficiency of net profit generation.
Return on equity % measures the rate of return on the owner's investment in the business.
ii Inventory turnover in days measures how many days on average it takes to sell stock.
Accounts receivable turnover measures how long on average it takes to collect money from customers.
iii Liquidity ratio measures the ability of a firm to pay its debts due within 1-2 months.
Debt ratio measures the % of the firm's total $ assets that are financed by borrowing.
b Ratios:
c Profitability
• Gross profit % has been constant each year,but the net profit % has decreased considerably.This means that net-profit-making efficiency has decreased considerably.
• Return on equity has dropped below bank interest rates from 20X3-20X5,actual gross profit has almost halved,and actual net profit has almost disappeared.
• A decrease in advertising has led to a decrease in sales and profitability.
• Bad debts have risen slightly,suggesting bad credit control.
• Interest expense is very high and has increased each year.
Managerial performance
• Inventory turnover has slowed down considerably.It is taking about one and a half times longer to sell inventory in 20X5 compared with 20X3.
• Although sales dropped greatly from 20X3-20X5,the inventory balance only dropped slightly.This suggests inefficiency in inventory management.
• Accounts receivable turnover has improved dramatically each year from 20X3-20X5.Accounts receivable was very good at 37 days in 20X3;now it is even better at 21 days,which is well below the expected norm of 35-40 days.
Financial stability
• The current ratio was very close to the approximate ideal of 2 : 1 in 20X3.At 1.8 : 1 in 20X5 it is still reasonably close to 2 : 1.
• The liquidity ratio was very high in 20X3.It is still above 1 : 1 in 20X5,meaning the business is solvent (able to pay its short-term debts).
• The level of debt has risen to almost 79%.At this level,the business is quite risky,as banks are unlikely to lend more money to the firm.
• The total interest expense is also very high,which adds to the risk.
• Despite the decreasing sales,Accounts payable have risen,suggesting the firm has problems paying its debts.
• Drawings have been rising and were very high in the last year.
• The business cannot afford this level of drawings to continue.
d Recommendations
• Increase advertising back up to the 20X3 level to boost sales.
• Provide discount for cash to encourage cash sales (which are currently zero).
• Have a sale with low prices on old stock to reduce inventory level.
• Check and delete any slow-moving inventory items.
• Investigate if there are any errors in accounting records.
• If possible,sell or lease part of the land and buildings to enable more debt to be repaid.
• Reduce drawings back to the 20X3 level or lower to enable more debt to be repaid.
• Investigate ways to reduce the level of debt and therefore to reduce interest payments.

Question 3

If inventory turnover is slowing down,which of the following is not likely to be a factor?
A The firm is stocking inventory that is becoming obsolete
B The firm is has not implemented proper stock rotation methods
C The firm is experiencing stock shortages for customers
D The firm is experiencing a high level of stock returns from customers

Answer 3

C

Question 4

Choose the correct definition for long-term viability.
A The ability to produce cash from the business to meet current obligations
B The ability to meet long-term obligations as they fall due for payment
C The ability of the business to continue to operate profitably
D The ability of the business to borrow further funds if needed

Question 5

Return on equity:
A measures the dividends payable to owners on their investment
B measures the net earnings payable to owners on their investment
C can be compared with bank term deposit rates to provide a guide to success
D can be compared with other investment opportunities to provide a guide to success

Question 6

The following financial statements are for Rupert's Appliances,a sole trader,for the years ending 31 March 20X3,20X4 and 20X5.
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a Calculate the following ratios for the 20X5 year only.Show your calculations.
i Gross profit %,Net profit %,Return on equity %
ii Inventory turnover (times per year),Inventory turnover (days)
iii Accounts receivable turnover (times per year),Accounts receivable turnover (days)
iv Current ratio,Liquidity ratio,Equity ratio %.
b Comment on the ratios calculated above,and the financial statement results for Rupert's Appliances during the years 20X3-20X5 inclusive,in the following areas:
• profitability
• managerial performance
• financial stability.
c Recommend to Rupert what you consider to be the 6 most important things to do to correct his financial position and performance.

Question 7

If both gross profit margin and net profit margin are increasing:
A net profit will be increasing
B net profit will be decreasing
C sales will be increasing
D it is not possible to tell

Question 8

A price/earnings ratio above the industry average indicates that:
A the market expects the firm to do well in the future in comparison with other firms
B the market expects the firm to do badly in the future in comparison with other firms
C the firm has been more profitable than other firms
D the firm has been less profitable than other firms

Question 9

Choose the correct definition for solvency.
A The ability of the business to pay debts as they fall due for payment
B The ability of the business to continue to operate profitably
C The ability of the business to borrow further funds if needed
D The ability of the business to attract new customers when needed

Question 10

If a firm drops its price to attract customers and gain a greater market share:
A net profit margin will increase
B net profit margin will decrease
C gross profit margin will increase
D gross profit margin will decrease

Question 11

Choose the correct definition for liquidity.
A The ability to produce cash from the business to meet current obligations
B The ability to meet long-term obligations as they fall due for payment
C The ability of the business to continue to operate profitably
D The ability of the business to borrow further funds if needed

Question 12

The lower the debt ratio:
A the harder it is for the business to borrow funds to carry it through a short-term cash shortage
B the easier it is for the business to borrow funds to carry it through a short-term cash shortage
C the more financially stable the business is
D the higher its interest payments are likely to be

Question 13

Choose the correct statement: the debt ratio:
A shows the percentage of assets which are funded by debt finance
B shows the percentage of assets which are funded by equity finance
C shows the percentage of liabilities which are funded by debt finance
D shows the percentage of liabilities which are funded by equity finance

Question 14

If accounts receivable (debtors)turnover is speeding up,which of the following is not likely to be a factor?
A The firm has implemented very stringent credit granting procedures for new customers
B The firm issues all its invoices promptly and accurately to clients
C The firm contacts slow-paying clients quickly and effectively concerning payment of overdue accounts
D The firm has instituted 'no-interest-for-6-months' terms for customers

Question 15

The solvency test:
A is a requirement for companies to meet before and after distributing dividends
B is a requirement for directors to verify that the company meets before and after distributing dividends
C requires the company to be able to meet its short-term debts as they fall due
D requires the company's assets to be greater than its liabilities
E all of the above

Question 16

Choose the correct explanation for the current ratio.
A A measure of a business's ability to pay debts and obligations due beyond 1 year
B A measure of a business's ability to pay debts and obligations due within 2 years
C A measure of a business's ability to pay debts and obligations due within 1 year
D A measure of a business's ability to pay debts and obligations due within 1 year,excluding the value of inventory and prepaid expenses

Question 17

Choose the correct definition for financial stability.
A The ability to produce cash from the business to meet current obligations
B The ability to meet long-term obligations as they fall due for payment
C The ability of the business to continue to operate profitably
D The ability of the business to borrow further funds if needed