14
interpretation of financial
statements
Examining basic ratios
Topics
Ratio analysis
Profitability ratios
Liquidity
Efficiency ratios
Capital structure ratio
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Ratio analysis
Why?
To give additional information to users of
the FS
Calculated ratios + explanation =
interpretation
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Calculation
Compare to another time period, e.g.
previous year or another company
Use % or ratio or days or a multiple, e.g.
inventories turnover
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14.4 Types of ratios
Profitability or performance
Liquidity or solvency
Efficiency – non-current assets and
working capital (employment of assets)
Capital structure (long-term liquidity)
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Profitability ratios (performance ratios)
gross profit margin
Gross profit / sales x 100
Increase could be due to, e.g. selling price
increase, cost reduction, discounted
materials
a measure of
 the effectiveness of the sales team,
 Pricing policies, purchasing methods
 (in a manufacturing organisation) the
production processes
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Profitability ratios (performance ratios)
gross profit mark-up
Gross profit / Cost of sales x 100
Gross profit mark-up = 168.6%, means
for every $1 we spent on the cost of goods, we
added $1.69 (approximately) to arrive at a selling
price of $2.69.
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Profitability ratios
operating profit margin
Operating profit/sales x 100
 Operating profit = gross profit - expenses
Increase could be due to above and/or
decrease in other expenses, e.g. bad debt
write offs, advertising spend, legal fees
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14.5.4 Return on capital ratios
Capital employed can consist of
 total capital employed (for ROCE calculation)
(equity + non-current liabilities)
 or just equity (for ROE calculation)
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Profitability ratios
return on capital employed (ROCE)
•Operating profit/(equity + debentures) x 100
•Increase could be due to higher profits (as above)
or lower capital employed, e.g. repayment of
debentures
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Profitability ratios
return on equity (ROE)
Profit for the period/equity
Decrease could be due to lower profit, or
higher equity, e.g. after issue of shares
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Study tip
Check the question carefully to see which
return on capital ratio is required
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14.6 Liquidity ratios
current ratio/working capital ratio
Current assets/current liabilities: 1
High ratio implies the future cash outlays
can easily be met with the incoming cash
but it depends on the make up of assets
and liabilities and may imply inefficient use
of working capital
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Quick ratio/liquid ratio/acid test
(current assets – inventories)/current
liabilities: 1
This has a similar interpretation to above
but excludes slow cash conversion item of
inventories
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Efficiency ratios
asset turnover
Sales/assets
High figure means high sales are
generated from the asset base and could
imply good use of resources or low assets
due to high depreciation or lack of
investment
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Efficiency ratios
inventories days
Average inventories/cost of sales x 365 =
inventories days
Cost of sales/average inventories =
turnover times per annum
Increase in inventories days may be due
to holding inventories for longer to satisfy
new customers, reduce ordering costs, a
change in buying patterns. It can lead to
higher insurance costs, risk of
obsolescence, etc.
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Efficiency ratios
receivables days
Receivables/sales x 365
Increase may be due to poor debt
collection, inaccurate invoicing, new
customers, extended credit terms
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Efficiency ratios
payables days
Trade payables/purchases x 365
Increase may be due to taking advantage
of longer credit terms etc., but could lead
to problems such as supply stoppages and
court action for recovery of cash
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Efficiency ratios
total working capital days
Inventories days + receivables days –
payables days
Reflects the cash conversion cycle
Increase may indicate a need to raise
finance
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Capital structure ratios
gearing ratios
Gearing ratio = debt/(debt + equity) x 100
Alternative gearing ratio = debt/equity x 100
Reflects the interest – bearing debt finance (e.g.
ordinary share capital + reserves)
High gearing implies greater risk to the ordinary
shareholder since profits will be used to pay
interest payments first. Loans may also be
secured on non-current assets
Management should ensure that profits cover
these fixed interest charges. High gearing
means that ordinary shareholders gain high
return when profits are high, and vice versa.
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Capital structure ratios
interest cover
Operating profit/interest payable
Reflects how comfortably the business is
able to meet its interest charges
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Proformas
income statement
Turnover
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Operating profit
Interest receivable
Interest payable
Profit before tax
Income tax
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X
(X)
X
(X)
(X)
X
X
(X)
X
(X)
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Calculations
Expenses should ideally be split into sales
and marketing (distribution) and others
(administration) but this is not essential
Taxation may include accrual for the
current year adjusted by over/under
provision for the previous year
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Statement of changes in equity
Share
capital
Balance at start of
period
X
Share
Genera Retaine Total
premium l
d
reserve earnings
X
X
Profit for the period
Dividends paid/declared
Transfer to general
reserve
X
Issue of shares
X
X
Balance at end of
period
X
X
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X
X
X
X
(X)
(X)
(X)
X
X
X
X
24
Balance sheet
Assets
Equity & liabilities
Non – current assets – tangible
X
Share capital
X
Non – current assets –
intangible
X
Share premium
X
X
Retained earnings
X
X
Non – current liability
Current assets
Inventories
X
Debenture
X
Receivables
X
Current liabilities
Bank
X
Trade payables
X
X
Income tax
X
X
Declared dividends
X
X
X
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Study tip
Take care with current liabilities as this is
the most common area for errors
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Cash flows statement
cash flows from operating
activities
Start cash flow with actual cash from
operations
Note that profit does not equal cash due to,
e.g. accruals, depreciation, raising of
finance
Indirect method = use IS profit figure and
then adjust to get the cash figure
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Reconciliation proforma
Cash flows from operating activities
Operating profit
X
Depreciation
X
Amortisation
X
Loss on disposal
X
Decrease in inventories
X
Decrease in receivables
X
Increase in payables
X
Cash generated from operations
X
Interest paid
(X)
Income tax paid
(X)
X
Cash flows from investing activities
Purchase of non-current assets
(X)
Proceeds sale of non – current assets
X
Interest received
X
Dividends received
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X
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X
Cash flow statements
Cash flows from financing activities
Proceeds from issue of shares
X
Proceeds from issue of loans
X
Repayment of loans
(X)
Dividends paid
(X)
X
Net increase/decrease in cash
X
Cash at beginning of period
X
Cash at end of period
X
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Calculations
The CFS adds back to the profit figure items not
realised in cash. The items would be deducted if
they were the opposite movements, e.g. increase
in inventories
Each figure should be the actual cash paid or
received so a working may be necessary to
adjust the IS figure by any accruals, e.g. the tax
figure in the IS would be adjusted for any
opening and closing accrual
You should check that the net increase/decrease
in cash + cash at beginning of the period = cash
at the end of period, as in the BS in the equation
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30
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JAN 2010
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37
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17 or 15
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2:1
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Practice questions
5. Which THREE of the following statements are
correct?
A. external auditors report to the directors
B. External auditors are appointed by the directors
C. External auditors are required to give a report to
shareholders
D. External auditors correct errors in financial statements
E. Internal auditors should not liaise with external auditors
F. Internal audit is part of internal control
G.Internal audit should be independent of the activities it
audits
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Answer
CFG
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