1.

Interpretation of financial statements

User
Investors/ potential investors
Information needs Items of interest
Risks and returns relating to Trend analysis revenue, costs
their investment and profits over the past few
Security of dividend payments years
Information to make decisions Dividend cover
about buying, selling or holding Events and announcements
shares after the reporting period
Future growth prospects Share price
Corporate governance
reports.

Employees Stability of the company (job Profitability and cash position

Lenders (banks, bondholders)
Suppliers
security and job prospects) Increases in salaries (%)
relative to increases in profit
Information about the and dividends
company’s ability to pay Directors’ remuneration
bonuses or higher salaries
Whether the entity has Total borrowing by the entity:
sufficient cash flow to repay financial gearing
loans Interest cover
The entity’s ability to pay New charges created over the
interest entity’s assets
The adequacy of collateral/ Cashflows
security for loans and bonds
The entity’s ability to settle its Net current assets
liabilities The entity’s ability to Growth record
survive and continue as a
customer

Customers The entity’s ability to survive Growth record

and continue as a supplier Cash flow

Government The entity’s contribution to Revenue and profit

the economy Market share
Regulation of activities
Taxation
Obtaining government
statistics

General public Environmental and social Environmental and social

awareness reports
Contributions to the local Directors’ report
economy Narrative business review

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 2. Criticisms of financial reporting
2.1 Historical information

Little insight into future

2.2 Unrecognized assets and liability

Goodwill, reputation, employee, skills

2.3 Clutter

Lot of general information in disclosure, financial statements become

increasingly clutter with extensive information so it’s harder to find general
information

2.4 Financial and non-financial information

Current and past profits, cashflows are not the only determinate of future
success.

Other factors like governance, management style, risk to which entity is

exposed are also important for long term success, but financial statements say
little about these factors

2.5 Estimates /professional judgement

Use of estimates are subjective which makes comparison difficult with other
entities financial statements, use of estimates gives an opportunity of window
dressing

2.6 Use of historic cost

Some standards allow historic cost and in case of inflation carrying values
become outdated in some years and users would be unable to understand the
financial position of business

2.7 Choice of accounting policy

Choice makes financial statement comparison difficult.

2.8 Scope of the audit

Audit is performed on sample basis rather than full financial statements

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3.Performance measures

1) Financial (Ratios)
Compare with
2) Non-Financial • Previous years
• Competitors
3) Alternative • Industry average
performance measures • Benchmarks
(APMs) • Forecast(budgets)

3.1 Financial Ratios

Financial performance

Profitability Efficiency

Gross profit Asset turnover Investors

Net profit margin Non-current asset turnover Earnings per share (EPS)
Return on capital employed Price/Earnings (P/E ratio)
Return on equity Profit retention ratio
Dividend payout ratio
Dividend yield
Dividend cover

Financial position

Liquidity Working capital management Financial leverage

Current ratio Inventory holding period Gearing

Acid-test ratio Receivable’s collection period Interest cover
Payable’s payment period

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Profitability ratios
Favorable Reasons

Gross Profit % = G.P/Sales x 100 Increase in Selling price

Decrease in cost/ unit

Net Profit % = PBIT/Sales x 100 Increase in GP ratio

Proper control over expenses
= Expenses / sales x 100

proper utilization of resources

Asset turnover = Sales/Capital Employed
for sales generation

Increase in NP ratio (or) Asset

ROCE = PBIT/Capital Employed*
turnover ratio

*Capital Employed = Equity + Long term liabilities (OR)

Total assets – current liabilities

ROCE is effected by:

(i) Revaluation policy

In case of revaluation gain, capital employed increases so ROCE will decrease

(ii) In early years of investment

ROCE will be lower as Capital employed will increase

Liquidity & Solvency ratios

(i) Liquidity ratios

IDEAL
Current Ratios = Current Assets / Current Liabilities 2:1

Quick/Acid test Ratio 1:1

= (C. Assets – Inventory – Prepayments) / C. Liabilities

Favorable Reasons
Inventory turnover period Increase in liquidity position
= Avg. inventory / COS x 365 Decrease in inventory obsolescence chances
Decrease in holding cost

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 Receivable Collection Period Increase in liquidity position
= Avg. receivables / credit sales (or sales) x 365 Decrease in bad debts
Less sales

Payable Payment period

= Avg. Payables/Purchases (COS) x 365 Increase in liquidity position

✓ Working Capital Cycle:

Inventory days (holding period) xxx

Receivable Collection Period xxx
Payables Payment period (xxx)
x/(x)

(ii) Solvency ratios

IDEAL
Gearing Ratio = Long term debt / Long term debt + Equity x 100 50%
(measures risk)

Debt Equity ratio = Debt / Equity x 100 100%

Interest cover = PBIT / Interest Expense Higher

Investor’s ratios
Favorable Reason
EPS = Earnings (PAT) / weighted avg. no. of shares

Price earnings ratio = MV of per share / EPS

(or)
P/E ratio = MV of total shares / PAT

Earning yield = EPS / MV of shares

Dividend yield = Dividend per share / MV of per share

Dividend cover = PAT / Dividend

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