Jennifer

Type author
Maynard
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Financial Accounting, Reporting &

Analysis
Chapter 5 – Techniques for the
interpretation of financial statements

© Oxford University Press, 2017. All rights reserved.

 1. Learning objectives

After studying this chapter you will be able to:

• Interpret a set of simple financial statements using horizontal,
vertical and ratio analytical techniques for a variety of users
• Understand key limitations of the analysis performed
• Understand that an interpretation of a set of financial statements
requires more than the use of the analytical techniques included
in this chapter.

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 2. Preliminary notes before analysis

• Different users will have different reasons for examining and

analysing the financial statements.
• Background information related to the business should be noted
because they provide context for the analysis.
• Analysis is not simply calculating ratios, it is in fact a process of
finding answers to the question “why”

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 3. Overview of financial statements
3.1 Horizontal analysis:
Horizontal analysis is used to compare historical data, such as ratios,
or line items, over a number of accounting periods.

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 3. Overview of financial statements
3.2 Vertical analysis:
Vertical analysis is an analysis method in which each line item is
listed as a percentage of a base figure

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 3. Overview of financial statements
3.2 Vertical analysis: Vertical analysis is particularly useful in the
comparison of cost and profit levels, and financial structures of
companies in different industry sectors.

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 Required: What can be concluded using above vertical analysis?

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• Answer

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 3. Overview of financial statements
3.3 Ratio analysis:
To obtain meaningful information, the calculated ratios
should be compared with: ratios from past years, ratios of other
businesses in the same industry, standards required by an interested
organisation.
Ratios are normally divided into 5 following different categories:

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 Profitability ratios
• Return on capital employed (ROCE)

PBIT PBIT
ROCE= =
Capitalemployed Equity +longterm liability
• Measures overall efficiency of company in employing resources available
to it.
• There are variations in the calculation of this ratio. Other definitions of
capital employed often seen are: (1) Equity + long-term debt; (2) total
assets. Capital employed can be the figure at the start or the end of the
year, or an average figure. Net profit can also be taken to exclude
depreciation and amortization in addition to interest (EBITDA) or to
exclude one-off items or fair value changes

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 Profitability ratios
ROCE is often sub-analysis as follows.

ROCE = Net profit margin x Asset

turnover
• Profit margin shows amount of profit generated per $1 of sales
• Asset turnover is a measure of how well the assets of a business are being
used to generate sales.
• Note: There might be a trade-off between profit margin and asset turnover.
• A high profit margin means sales prices are high, there is likely that asset
turnover will be lower.
• A high asset turnover means that the company is generating a lot of
sales, but to do this it might have to keep its prices down and so accept
a low profit margin
 Profitability ratios
• Net profit margin, Gross profit margin and profit analysis

Expense over sales

• Ideally, profit margin should be similar from year to year and

comparable with other businesses in the same industry. However this
ratio can be changed due to changes in the gross profit earned and the
overheads incurred.
• Different types of businesses will have very different gross profit
margins. For example a supermarket will have a much lower gross
profit margin compared with a jewelry business.
 Profitability ratios
• Requirement: Calculate the profitability ratios for Sharples plc.
 Liquidity ratios
• Liquidity is the ability of a business to meet its short-term liabilities as
they fall due.
• Two common definitions of liquid assets:
(a) All current assets without exception
(b) All current assets with the exception of inventories
Current ratio

Currentassets
ratio
Current
Current liabilitie
s

- Current ratio in excess of 1 should be expected. A figure of 1.5:1 is

regarded as the norm
- 2:1 acceptable? 1.5:1? Depends on industry
 Liquidity ratio
Quick ratio

 Inventory
Currentassets
(acidtest)
Quickratio
Currentliabilitie
s
• Eliminates illiquid and subjectively valued inventory
• It is often theorised that an acceptable current ratio is 1.5 and an
acceptable quick ratio is 0.8, but these should only be used as a guide.
 Liquidity ratio

• Requirement: Calculate the liquidity ratios for Sharples plc.

 Efficiency ratios
• One important issue arising from the earlier discussion on liquidity is the
ability of a business to convert its current assets to cash to pay its
liabilities. The efficiency ratios are useful in assessing firm’s
management of these conversion times.
• Inventory turnover period
Inventory
Inventory period
turnover  365
Costofsales

• Shows the number of days inventories are held on average

• The nature of the inventories is crucial in interpreting this ratio, for
example a greengrocer will have an inventory turnover of a few days,
while a furniture shop’s ratio may be 60–90 days.
• The ratio can, alternatively, be stated as the number of times
inventories are turned over, on average, each year
• Inventory turnover = COS/Inventory
 Efficiency ratios
Receivable collection period

Tradereceivable
s
 365
Creditsales
• Revenues is often used instead of credit sales
• Measure the average length of time credit customers take to pay what
they owe
• The ratio calculated can be compared with the credit period the
business allows to its customers—often 30 days
 Efficiency ratios
Payable payment period
Tradeaccounts
payable
 365
Purchases
• Use cost of sales if purchases not disclosed
• Shows how long, on average, it takes for a business to pay its credit
suppliers.
Working capital cycle (Cash cycle)
• The cash cycle describes the flow of cash out of a business and back
into it again as a result of normal trading operations
Cash cycle= Inventories turnover period + Receivable collection
period – Payable payment period
 Efficiency ratios
• Requirement: Calculate the efficiency ratios for Sharples plc.
 Gearing/long-term solvency
Gearing
Two basic gearing ratios:

• Debt finance may be replaced by net debt, which reduces debt

balances by positive cash and cash equivalent balances.
• A business that is highly geared is perceived as a riskier investment for
the equity investor.
Leverage
• An alternative way of viewing gearing is to consider how net assets are
financed.

Leverage =
 Gearing/long-term solvency
Interest cover

• The interest cover ratio shows whether a company is earning enough

PBIT to pay its interest costs
• Company must generate enough profit to cover interest.
• An interest cover of 3 times or above is considered within acceptable
limits.
• Requirement: Calculate the gearing ratios for Sharples plc.
 Investors ratio
Return on Equity (ROE) =

• Profit attributable to equity shareholders is profit after tax and after preference
dividends.
• This ratio shows the return percentage to the equity shareholders on their
investment
Earnings per share (EPS) =

• The ratio measures earnings available to the equity shareholder per share
P/E ratio =

• This ratio is a measure of market confidence in a company. It shows the number

of times the market value of a share exceeds the earnings per share and
indicates the number of years an investor would have to wait to recover his/her
investment sum.
 Investors ratio
Dividend per share =

• Obviously, investors would wish to see the ratio rise year on year, however
companies have to balance this with retaining profits for future growth.
Dividend cover =

• The ratio shows the number of times the funds available from a year’s
profits exceed the size of the equity dividend and is an indicator of the
riskiness of the dividend.
Dividend yield =

• This ratio gives the actual dividend return for an investment in equity shares
Total shareholder returns =
Investors ratio
 3.4 Statement of cash flows and their interpretation
• Many businesses fail through lack of cash rather than lack of profits.
• SOCF is not influenced by accounting policies or accruals-based
accounting methods
=> SOCF can be used to assist in the interpretation of business
performance and liquidity.
Analysis of operating activities:
• Operating cash flows should be compared with profit from operations
• The fact that operating profit is met strongly with operating cash flows,
suggest the high quality of profit from operations.
• If operating cash flows are significantly lower than profit from
operations, this may indicate that the company is in danger of running
out of cash => pay attention to firm’s liquidity and efficiency.
• The ability of the business to cover its interest payments with its
operating cash flows is important.
 3.4 Statement of cash flows and their interpretation

Analysis of investing activities:

• These cash flows are at the discretion of a business, since the business
will normally survive even if PPE expenditure is delayed for some
months, or even years.
• Significant cash outflows indicate PPE additions => suggest the
maintenance or enhancement of operating cash flows in the long term.
• A significant shortfall of capital spend compared to depreciation =>
indicate that the company is not replacing its PPE as they wear out or
the depreciation rates are wrongly estimated
 3.4 Statement of cash flows and their interpretation

Analysis of financing activities:

• Financing cash flows show how the company is raising finance (by debt
or shares) and what finance it is repaying
• It is important to understand the reason for raising finance: to finance
additions to PPE to expand the business or renew assets? To to repay
debt, thus reducing future interest costs? To keep the company afloat if
it is suffering significant operating and interest cash outflows?
• Dividend paid should also be paid attention to. If a company pays out a
significant amount of the cash dividends, it may not be retaining
sufficient funds to finance future investment or the repayment of debt.
 3.4 Statement of cash flows and their interpretation

Cash flows ratio:

• Cash return on capital employed =
Cash return is

• Cash from operations/profit from operations: This measures the quality

of the profit from operations. the higher the resulting percentage, the higher
the quality of the profits from operations

• Liquidity: this ratio gives an indication of the ability to meet current

obligations from cash that has been generated over the accounting period.
 3.4 Statement of cash flows and their interpretation

Cash flows ratio:

• Cash interest cover =

Cash interest cover tends to be slightly higher than interest cover as profit
from operations is reduced by depreciation

• Cash flows per share =

Cash flow for equity shareholders is defined as

• Cash dividend cover

 3.4 Statement of cash flows and their interpretation

Free cash flows:

• Free cash flow is a measure of the cash available to be distributed in a

discretionary way
• Requirement: Calculate the cash flow ratios for Sharples plc.
 Limitations of ratio analysis
Limitations
• Retrospective nature: ratios are based on historical information. Current
conditions might not be the same as in the past
• Inflation: the basis for many figures in the financial statements is historical cost.
Thus, due to inflation, comparison of figures from one year to the next may be
impacted
• Statement of financial position data: Figures on the SOFP may not represent
the business’s ‘normal’ position. Eg. Working capital for seasonal business might
vary throughout the year, therefore, yearend can have impact on calculated ratio.
• Business-to-business comparisons: not all companies use the same
accounting policies, thus the comparison of companies is not an easy work.
• Combined operations: Large organisations’ financial statements aggregate
financial figures from operations which differ radically in nature. It will be
impossible to draw sensible conclusions from an analysis of these figures
• Reliance on ‘norms’ :Any interpretation should not rely too heavily on suggested
norms for certain ratios or industry standards.
 Lecture example 2
TJF is a national supermarket chain selling food, clothes and household appliances
with a 31 December year end.
The finance director would like the management accountant to prepare some
financial data and analysis to present to the board. He has provided the management
accountant with extracts from the financial statements to assist him in his analysis.

STATEMENT OF PROFIT OR LOSS STATEMENT OF FINANCIAL POSITION

FOR THE YEAR ENDED 31 DECEMBER AS AT 31 DECEMBER 20X5
20X5
20X5 20X4 20X5 20X4
$m $m $m $m
Revenue 20,510 17,835 Non-current assets 9,100 8,390
Inventories 850 1,000
Cost of sales 18,970 16,835
Total current assets 1,570 1,610
Gross profit 1,540 1,000 Trade payables 2,100 2,280
Operating profit 650 530 Total current liabilities 2,920 2,650
Finance costs 200 130 Non-current liabilities 3,250 2,530
Equity 5,050 4,935
 Lecture example 2 (cont'd)
The finance director has also supplied the following information regarding
events in the year ended 31 December 20X5:
(1) Online food home delivery increased by 25%.
(2) The number of stores grew by 10% in the year. This was financed by long
term borrowings
(3) In the year ended 31 December 20X5, 40% of customers purchased at least
one clothing item during the year whereas in the year ended 31 December
20X4, only 20% of customers did.
(4) A strong marketing campaign took place during the year.
(5) The new strengthened Grocery Supplier Code of Practice came into force to
improve grocery retailers' treatment of suppliers.
 Lecture example 2 (cont'd)
Required
(a) Calculate the ratios below for the year ended 31 December 20X5, state
whether it has improved or deteriorated and provide one possible reason for
the movement in each ratio:
• Gross profit margin
• Operating profit margin
• Return on capital employed
• Current ratio
• Inventory holding period
• Payables payment period
• Interest cover
(b) Explain why it would not be relevant to calculate receivables collection
period in this example.
 Answer to lecture example 2
• Note. This answer is more comprehensive than was required. You were only
required to give one of the reasons listed for the movement in each ratio.
(a) Ratios

20X5 20X4 (given)

Gross profit margin = 1,540
= 7.5% 5.6%
Gross profit 20,510
100%
Revenue

Gross profit margin has improved.

This appears to be because:
 Online food home delivery increased by 25% in the year and it attracts
a higher margin than sales from supermarket visits due to the delivery
charge.
 There has been a change in sales mix with higher clothes sales in the
current year probably attracting a higher margin than food sales.
 Answer to lecture example 2 (cont'd)

Operating profit margin = 20X5 20X4

650 3.0%
Profit before interest and taxation  3.2%
100% 20,510
Revenue

Operating profit margin has improved but not as much as the gross margin.
This appears to be due to:

 New, one-off marketing costs incurred in the year

 Start up costs associated with the opening of the new stores
 Answer to lecture example 2 (cont'd)

Return on capital employed = 20X5 20X4

Profit before interest and taxation 650 7.1%
100%  7.8%
Total equity  non - current liabilities * 5,050  3,250

There has only been a small improvement in ROCE despite a significant

improvement in gross margin.
This appears to be because:
 The improvements in gross margin due to the higher margin on home
delivery and clothes sales have been largely offset by one off operating costs
from marketing and new store start up costs.
 Non-current liabilities have increased due to new borrowings to open new
stores. This has largely offset the improvement in profitability.
 Any stores opened near the year end, will not yet have had a chance to
create profits.
 Answer to lecture example 2 (cont'd)

Current ratio = 20X5 20X4

Current assets 1,570 0.61
 0.54
Current liabilities 2,920
The current ratio has deteriorated, meaning that TJF is finding it harder to pay
its current liabilities as they fall due.
This appears to be because:
 TJF is holding lower levels of inventories and higher current liabilities.
Note: the current ratio is typically low for a supermarket as the receivables are
low due to cash sales, inventories are relatively low as they majority are
perishable and payables tend to be high due to the strong bargaining power of
supermarkets over their smaller suppliers.
 Answer to lecture example 2 (cont'd)

Inventory holding period = 20X5 20X4

22 days
Inventorie s 850
× 365 days  365 days  16 days
Cost of sales 18,970

Inventory days have decreased meaning that TJF is selling inventories more
quickly and holding lower levels of inventories. This is good for cash flow
providing TJF is holding sufficient inventories to meet customer demand.
The decrease appears to be due to:
 An increase in sales volume as a result of the marketing campaign, the
growth in online food home delivery, increased clothing sales and the new
stores. This increase in demand has resulted in inventory levels being
depleted more quickly.
 Answer to lecture example 2 (cont'd)

Payables payment period = 20X5 20X4

49 days
Trade payables 2,100
× 365 days × 365 days  40 days
Cost of sales 18,970

TJF are paying their suppliers more quickly. This is bad for cash flow as TJF is
not taking advantage of the free credit but good for supplier relationships.
The decrease appears to be due to:
 The new strengthened Grocery Supplier Code of Practice coming into force –
presumably TJF is paying suppliers more quickly to meet their credit terms
and to treat suppliers more fairly in the spirit of the code.
 Answer to lecture example 2 (cont'd)
Interest cover = 20X5 20X4
4.08
Profit before interest and taxation 650
 3.25
Finance costs 200

Interest cover has deteriorated. However, TJF is still easily able to pay its
finance costs out of profit.
The deterioration in interest cover appears to be due to:
 Increased borrowings to cover the financing of the new stores opened in
the year.

(b) Why not relevant to calculate receivables collection period

In a supermarket, customers have to pay for their purchases

immediately. The supermarket will not offer credit to their
customers. Therefore, the sales are cash sales rather than
credit sales resulting in few if any receivables.
Specimen paper question