Ratios & Financial Analysis
What is common size analysis in financial analysis?
It’s a method where each item in the financial statement is expressed as a percentage of a base figure (e.g., revenue in P&L, total assets in the balance sheet) to allow comparability.
What does PESTEL analysis stand for?
Political, Economic, Social, Technological, Environmental, and Legal factors — used to analyze the macro-environment of a business.
What does the accrual principle mean in accounting?
Revenues and expenses are recorded when they are earned or incurred, not when cash is received or paid.
What is the DuPont analysis used for in financial performance evaluation?
It breaks Return on Equity (ROE) into three components: Net Profit Margin, Asset Turnover, and Financial Leverage to analyze how a company generates its ROE.
What are Porter’s Five Competitive Forces?
Industry Rivalry, Threat of New Entrants, Threat of Substitutes, Bargaining Power of Suppliers, and Bargaining Power of Buyers.
What does the allocation principle refer to in accounting?
It refers to systematically distributing the cost of long-term assets over their useful life (e.g., depreciation and amortization).
Why is industry context important when interpreting financial ratios?
Because acceptable or optimal ratio values can vary widely across industries due to different business models, risks, and capital requirements.
What do IFRS and GAAP stand for?
IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles.
Depreciation applies to tangible assets (e.g., machinery), while amortization applies to intangible assets (e.g., patents).
What are some limitations of ratio analysis?
Ratios can be misleading if taken out of context or derived from very small base values, which can exaggerate changes and lead to misinterpretation. Additionally, they don’t reflect the scale of the company and must be supported by broader financial and strategic analysis.
How can you identify a cyclical company?
It shows large fluctuations in revenue and profit aligned with economic cycles, often due to high fixed costs or demand sensitivity (e.g., construction, automotive).
How does the income statement differ from the balance sheet?
The income statement shows a company’s financial performance over a period (revenues, expenses, profit), while the balance sheet shows its financial position at a specific point in time (assets, liabilities, equity).
How can two companies have the same ROE but different financial strategies?
One might achieve high ROE through strong margins and low leverage, while another might rely heavily on debt; the underlying risk and sustainability differ.
Why can benchmarking between companies in the same industry sometimes be misleading?
Because companies may differ in strategy, scale, geographic exposure, life cycle stage, or accounting practices, even within the same sector.
Give an example of a transaction that impacts both the balance sheet and the income statement.
Recording depreciation reduces the asset value on the balance sheet and increases expenses on the income statement, lowering net income.