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Chapter 24:
Interpretation of financial
statements
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What you will learn?

 Information required by users

 Ratio analysis

 Profitability ratio

 Liquidity ratio

 Efficiency ratio

 Financial position ratio

 Limitations of ratio analysis

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Information required by users

User groups

Use comparisons to ensure the business is

Management
performing efficiently and according to plan

Need information to be able to assess the

Employees employer’s ability to provide remuneration and
benefits

Need information to assess taxation and regulate

Governments
industries and for statistical purposes

Need information on risk and return on

Investors investment, the ability of the entity to pays
dividends

Lenders and Information to assess whether loans, related

suppliers interest and invoices will be paid when due

Information to judge whether the company will in

Customers existance (long-term contract of products
supplies...)
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Ratio analysis
Overview

Ratios provide information through comparison

Key accounting ratios

Financial
Profitability Liquidity Efficiency
Position

Gross profit Inventory

Current ratio Debt ratio
margin turnover
Operating Receivables
Quick ratio Gearing
profit margin day
Return on Payables
Leverage
capital days
employed Interest
Return on cover
equity
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Profitability
Gross profit margin

Gross profit
𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = × 100%
Revenue

𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 = Revenue − Cost of goods sold

Gross profit indicates the ability to control production costs or to

manage the margins

Changes in this ratio may be attributable to:

Change in product mix produced different profit margins

Change in marketing strategy to boost sales by lowering price

Change in price of raw materials

Change in production costs

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Profitability
Operating profit margin (net profit margin)

Profit before interest and tax

𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = × 100%
Revenue

Operating profit margin is a measure of how effectively the business

manages/administers the process of producing and selling its products

If gross margin remained static but operating margin has changed,

consider the following possibilities:

 changes in employment patterns

 changes to depreciation due to large acquisitions or disposals
 significant write-offs of irrecoverable debt
 changes in rental agreements
 significant investments in advertising
 .....
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Profitability
Example: Profit analysis

Year 1 Year 2
$ $
Revenue 70,000 100,000
Cost of sales 42,000 55,000
Gross profit 28,000 45,000
Expenses 21,000 35,000
Profit for the year 7,000 10,000

Year 1 Year 2
7,000 10,000
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 % = = 10% 𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 % = = 10%
70,000 100,000
28,000 45,000
𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 % = = 40% 𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 % = = 45%
70,000 100,000

 Net profit margin for both year at 10%, the gross margin not.
 The improved gross profit margin not lead to improvement in net profit
margin due to expenses as a percentage of sales rises (30% in Year 1 to
35% in Year 2)
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Profitability
Return on capital employed (ROCE)

Profit before interest and taxation (PBIT)

𝐑𝐎𝐂𝐄 = × 100%
Capital employed

𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝 = Shareholders ′ equity + longterm liabilities

(or total assets - current liabilities)

ROCE ratio shows how much profit the business generates from capital
invested in it

ROCE should be compared with:

 Previous years’ figures

 The company’s target ROCE
 Other companies in the same industry
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Profitability
Return on capital employed (ROCE)

ROCE can be subdivided into operating profit margin and asset turnover

Asset turnover is ratio to measure efficiency of use of assets

𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐦𝐚𝐫𝐠𝐢𝐧 × 𝐚𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = 𝐑𝐎𝐂𝐄

PBIT Revenue PBIT

× =
Revenue Capital employed Capital employed

A trade-off often exists between margin and asset turnover that means
different businesses can actually achieve the same ROCE

High profit margin – high profit High asset turnover – company

per $1 of sales generate lots of sales
 sales prices are high  prices kept down
 sales turnover may be low  Low profit margin
 Low asset turnover
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Profitability
Example: Return on capital employed (ROCE)

Company A Company B

Sale revenue $1,000,000 $4,000,000

Capital employed $1,000,000 $1,000,000

PBIT $200,000 $200,000

Company A Company B
$200,000 $200,000
𝐑𝐎𝐂𝐄 = = 20% 𝐑𝐎𝐂𝐄 = = 20%
$1,000,000 $1,000,000

$200,000 $200,000
𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = = 20% 𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = = 5%
$1,000,000 $4,000,000

$1,000,000 $4,000,000
𝐀𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = =1 𝐀𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = =4
$1,000,000 $1,000,000

 Could be at luxury end of the  Could be at popular end of the

market market
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Profitability
Return on equity (ROE)

Profit after taxation and preference dividend

𝐑𝐎𝐄 =
Equity shareholders funds

ROE give an indication of the return to shareholders, such as earnings

per share, dividend per share...
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Liquidity
Key definitions

Liquidity is the amount of cash as company can put its hand on

quickly to settle its debt/or unforeseen demands for cash payments

Liquid funds/liquid assets are current assets that will or could soon
be converted into cash, and cash itself.
Two common definitions of liquid assets:

All current assets without

exception:

 Cash
All current assets with
 Short term investments for
which there is a ready exception of inventories
market
 Fixed-term deposits
 Trade receivables
 Inventories
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Liquidity
Current ratio

Current assets
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐫𝐚𝐭𝐢𝐨 =
Current liabilities

The current ratio measures whether the business can pay debts due
within one year from assets that it expects to turn into cash within that
year

 The current ratio >= 1 should be expected, ideally between 1.5 and 2
 Vary depending upon the market sector
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Liquidity
Quick ratio

Current assets − Inventories

𝐐𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨 =
Current liabilities

The quick ratio indicates the extent to which the company could pay
current liabilities without relying on the sale of inventory

A ratio of 1 is good and indicates the company do not have to rely on the
sale of inventory to pay the bills

A company with a fast inventory turnover, a quick ratio can be

comfortably less than 1 without suggesting that company should be in
cash flow trouble
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Efficiency
Inventory turnover period

Inventory
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝 = × 365
Cost of sales

The inventory turnover period indicates the average length of time that
stock spends in business before it is sold

The increase in inventory holding could be due to:

Lack of demand or poor inventory control

Buying bulk to take advantage of trade discounts

An expected increase in orders

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Efficiency
Receivables collection period

Trade receivables
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 𝐜𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝 = × 365
Credit sales

The receivables collection period shows how long it takes to collect cash
from credit customers once they have purchased goods

 Increasing accounts receivables collection period is usually a bad sign

(credit control function is poorly managed, some bad debts have not
been provided for...)

 Falling receivables days is usually a good sign, though it could indicate

that the company is suffering a cash shortage
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Efficiency
Payables collection period

Trade account payable

𝐏𝐚𝐲𝐚𝐛𝐥𝐞𝐬 𝐜𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝 = × 365
Purchases

The payables collection period shows the average length of time of the
credit period taken by the company from its suppliers

 A long credit period may be good as it represents a source of free

finance

 A long credit period may indicate that the company is unable to pay
more quickly because of liquidity problems
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Liquidity and working capital ratios

Example
Calculate liquidity and working capital ratios from the accounts of TEB Co,
a business provides service support for customers worldwide:
20X7
($m)
Revenue 2,176.2
Cost of sales 1,659.0
Gross profit 517.2
Current assets
Inventories 42.7
Receivables (Note 1) 378.9
Short-term deposits and cash 205.2
626.8
Current liabilities
Loans and overdrafts 32.4
Tax on profits 67.8
Dividend 11.7
Payables (Note 2) 487.2
599.1
Net current assets 27.7
Notes
1. Trade receivables 295.2
2. Trade payables 190.8
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Liquidity and working capital ratios

Example

20X7 Calculation

Current ratio 1.05 = 626.8/599.1

Quick ratio 0.97 = 584.1/599.1

Receivables collection period 49.5 days = (295.2/2,176.2) x 365

Inventory turnover period 9.4 days = (42.7/1,659.0) x 365

Payables payment period 42.0 days = (190.8/1,659.0) x 365

 The company is a service company and therefore it would be expected

to have very low inventory and a very short inventory turnover period.

 The similarity of receivables collection period and payables payment

period means that the company is passing most of the delay in
receiving payment on to its suppliers.
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Financial position
Debt ratio

Total debts
𝐃𝐞𝐛𝐭 𝐫𝐚𝐭𝐢𝐨 =
Total assets

Debt ratio measures how much the company owes in relation to its size

When a company is heavily in debt (ie. debt ratio is >= 50%), potential
lenders may be unwilling to advance further funds.
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Financial position
Gearing ratio

Total longterm debt

𝐆𝐞𝐚𝐫𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨 = x 100%
Shareholders ′ equity + total longterm debt

Gearing ratio measures the proportion of assets invested in a business

that are financed by borrowings

The higher the level of gearing, the higher are the risks to a business
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Financial position
Leverage ratio

Shareholder′ s equity
𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐚𝐭𝐢𝐨 = x 100%
Shareholders ′ equity + total longterm debt

Leverage ratio measures the proportion of total assets financed by equity

in a business

Leverage ratio is the converse of gearing

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Financial position
Interest cover

Profit before interest and tax

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐨𝐯𝐞𝐫 =
Interest charges

Interest cover indicates the ability of a company to pay interest out of

profits generated

 Low interest cover indicates to shareholders that their dividends are

at risk (because most profits are eaten up by interest payments and
 The company may have difficulty financing its debt if its profits fall
 Interest cover less than two is usually considered unsatisfactory
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Financial position
Example: Interest cover

Company A Company B Company C

$’000 $’000 $’000

PBIT (1) 40 40 40

Interest (2) 10 25 30

Profit before tax 30 15 10

Taxation 9 5 3

Profit after tax 21 10 7

Interest cover (1)/(2) 4 times 1.6 times 1.33 times

Both B and C have a low interest cover, which is a warning to

ordinary shareholders that their profits are highly vulnerable.
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Ratio analysis
Limitations

Comparative information is not always available

The information used is sometimes out of date

Interpretation requires thought and analysis. Ratios should not

be considered in isolation

The exercise is subjective, for example not all companies use the
same accounting policies

Ratios are not defined in standard form

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Exam focus point

Exam focus point 1
A company’s gross profit as a percentage of sales increased from
24% in the year ended 31 December 20X1 to 27% in the year ended
31 December 20X2.

Which of the following events is most likely to have caused the

increase?

A. An increase in sales volume

B. A purchase in December 20X1 mistakenly being recorded as

happening in January 20X2

C. Overstatement of the closing inventory at 31 December 20X1

D. Understatement of the closing inventory at 31 December

20X1
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Exam focus point

Exam focus point 1
A company’s gross profit as a percentage of sales increased from
24% in the year ended 31 December 20X1 to 27% in the year ended
31 December 20X2.

Which of the following events is most likely to have caused the

increase?

D. Understatement of the closing inventory at 31 December

20X1
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Exam focus point

Exam focus point 2
From the following information regarding the year to 31 August 20X6,
what is the accountants payables payment period?
You should calculate the ratio using purchases as the denominator.

$
Sales 43,000
Cost of sales 32,500
Opening inventory 6,000
Closing inventory 3,800
Trade accounts payable at 31 August 20X6 4,750

A. 40 days B. 50 days

C. 53 days D. 57 days
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Exam focus point

Exam focus point 2
From the following information regarding the year to 31 August 20X6,
what is the accountants payables payment period?
You should calculate the ratio using purchases as the denominator.

$
Sales 43,000
Cost of sales 32,500
Opening inventory 6,000
Closing inventory 3,800
Trade accounts payable at 31 August 20X6 4,750

D. 57 days

Purchases = $(32,500 – 6,000 + 3,800)

= $30,300

Accounts payable payment period = (4,750/30,300) x 365 = 57 days