Interpretation of Financial

Statements

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 Interpreting Financial Statements

 Concerned with the use of ratios

 Example:

Profit margin = Gross profit x 100

Sales

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 Why use ratios?
 Identify trends

 Comparison with others/ industrial average

 Business plans

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 Ratios can be specifically used to
analyse the following areas:

 Liquidity
o Solvency
o Ability of the business to pay its way

 Profitability
– Ability to generate wealth
– Long term prospects

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 .
 Activity
– Efficiency
– Use of assets
 Financial structure
– Concerned with the gearing/leverage of the
business – relative proportions of debt and
equity
– Financial risk
 Investors ratios
– Is the company a good investment? 5
 Example of Financial Accounts
Income Statement for year ending 30th April 2014

£M
Sales 7,650
Less: Cost of sales (5,800)
Gross Profit 1,850
Expenses (150)
Operating Profit 1,700
Loan interest (50)
Profit before tax 1,650
Taxation (600)
Profit after tax 1,050
Dividends 300
Retained profit 750

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Statement of Financial Position as at 30th April 2014

£M
Non-Current Assets (tangible) 10,050
Current Assets
Stock 1,500
Debtors 1,200
Cash 900
3,600

Total Assets 13,650

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 .
£M

Equity and Liabilities

Called up share capital 5,900
Profit and Loss account 5,000
10,900

Non-Current Liabilities 350

Current Liabilities 2,400

13,650

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 .
 Examples of Ratios:
1. Liquidity
a) Current Ratio
Current Assets
Current Liabilities

3600 = 1.5 : 1
2400
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 .
b) Acid Test
Current Assets – Stock
Current Liabilities

3600 – 1500 = 0.9 : 1

2400

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 .
2. Profitability
a) Gross Margin

Gross profit x 100 = 1850 x 100 = 24.2%

Sales 7650

b) Net operating margin

PBIT x 100 = 1700 x 100 = 22.2%

Sales 7650
PBIT = Profit before interest and tax

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 .
c) Return on Capital Employed
PBIT x 100
Capital Employed
Capital Employed = Ord. Share capital + Reserves +
Long Term Liabilities

1700 x 100 = 15.1%

11250

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 .
d) Return on Shareholders’ Funds

Profit after tax x 100

Shareholders’ Funds

1050 x 100 = 9.6%

10900

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3. Efficiency
a) Net Assets Turnover Ratio

Sales
Capital Employed

7650 = 0.68 times

11250

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 .
b) Stock Turnover
Cost of Goods Sold 5800 = 3.9 times
Average Stocks 1500

c) Stock days
Average Stocks x 365
Cost of Goods Sold
1500 x 365 = 94 days
5800

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 .
d) Debtors Turnover
Debtors x 365
Sales
1200 x 365 = 57 days
7650

e) Creditors Turnover
Creditors x 365
Purchases*

* Could use ‘cost of sales’ if no alternative

2,400 x 365 = 151 days

5,800

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 .
4. Financial structure
a) Gearing
Prior Charge Capital (PCC) x 100
Shareholders Funds + PCC

350 x 100 = 3.1%

10900 + 350

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 .
b) Interest Cover
PBIT
Interest Charges

1700 = 34 times
50

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5.
a) Dividend Yield
Dividend x100
Market value of shares
If it is assumed that nominal price of a share is £1.00 and
current market price is £2.20
£0.0508 x 100 = 2.3%
£2.20

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b) Earnings per share (EPS)
Profit after tax – Pref Div
No of ordinary shares

1050 = £0.178
5900

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c) Price/earnings ratio

Share Price
EPS

£2.20 = 12.4
£0.178

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 Limitations of Ratio Analysis
 Only deals with quantifiable aspects
 May be misleading as a snapshot
 Ignores special circumstances
 Indicates inefficiency but does not explain
 Basis of measurement
 Pyramid is geared to one ratio – ROCE
 Transfer Pricing
 Ratios are interrelated
 Open to manipulation
 Be wary of comparison 22