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Review questions

  • Profitability analysis
  • Growth analysis
  • Liquidity (risk) analysis
  • Biased estimates and misuse of accounting flexibility
  • Different accounting policies across time
  • Different definitions of financial items and ratios over time
  • The impact of unusual items
  • The impact of acquisitions and divestments of businesses (different risk profile)
  • The impact of new products/markets (different risk profiles)
  • Change in capital structure across time
  • Differences in estimates and use of accounting flexibility over time
  • Different accounting policies across firms
  • The impact of unusual items
  • Different definitions of financial items and ratios over time
  • A comparison with firms that are not truly comparable (different products/markets/risk profile)
  • Differences in growth strategies – organic versus acquisition related growth
  • Differences in capital structure across firms

The purpose of dividing accounting items into operating and financing related activities is to obtain a better knowledge of the different sources of value creation in a firm. For example, investors consider operating profit as the primary source of value creation and in most cases they value operations separately from financing activities. Lenders consider operating profit as the primary source of debt servicing. Therefore, analysts spend time on reformulating the income statement and balance sheet so that these statements clearly distinct between operating and financing activities.

Net Operating Profit After Tax and is measured as earnings before interests and tax (EBIT) less tax (on EBIT).

Invested capital represents the amount a firm has invested in its operations and which requires a return.

A number of items need to be carefully considered before it can be decided if they belong to operations or financing. Examples include:

  • Tax on ordinary activities
  • Investment in associates and related income and expenses from associates
  • Receivables and payables to group enterprises and associated firms
  • Cash and cash equivalents
  • Exchange rate differences
  • Derivative financial instruments
  • Retirement benefits
  • Tax payables and tax receiables