ACCA PAPER F3 (FFA)

FINANCIAL ACCOUNTING

Interpretation
And
Ratio Analysis

Redoanul Haque Dolon

Management & Accountancy Educations Weald
42/A (3rd floor), (Beside IBN SINA)
Dhanmondi 9/A, Dhaka-1209
Cell: +8801612460066
E-mail: dolon.acca@yahoo.com

Ratio analysis
Balance Sheet/Statement of Financial Position
as at X.X.X:
Assets:
Non-current assets
X
Current assets:
Cash
X
Receivables
X
Closing Inventory
X
X
Total assets
X
of
Statement
In
Changes in Equity

Income Statement for the year ending X.X.X:

Sales/Revenue/Turnover
X
Less: Cost of Sales
(X)
Gross profit
X
Less: Expenses
(X)
Operating profit
X
Less: Finance cost/Interest expense
(X)
Profit before tax (PBT)
X
Less: Tax
(X)
Profit after tax (PAT)/Profit for the year/Net profit X
Less: Preference (irredeemable) dividend
(X)
Profit attributable to ordinary shareholders
X
Less: Ordinary dividend
(X)
Retained profit for the year
X

Shareholders capital:
Ordinary share capital
Reserves
Preference share capital*
Long-term liabilities
Current liabilities

X
X
X
X
X
X
X

*Redeemable preference share capital will be treated as a long-term liability. In that case its dividend will be treated
as interest (Finance cost in Income Statement).

LIQUIDITY RATIOS: Liquidity ratio measures a company's ability to pay short-term obligations
1. Current ratio =
o
o
o
o

o
o

Current Asset
Current Liabilities

X:1

Current ratio is mainly used to give an idea of the company's ability to pay back its short-term
liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).
The higher the current ratio, the more capable the company is of paying its obligations.
A current ratio of 1.5:1 to 2:1 can mean sufficient current asset to cover its current liabilities.
A current ratio of above 2:1 may mean over investment in working capital (i.e. in current assets).
Surplus assets can be used to
- to expand the business operation or to increase capacity which will earn additional profit,
- to repay debt which will save interest expenses,
- distribute to shareholders as dividend.
A current ratio below 1 suggests that the company would be unable to pay off all of its current
liabilities if they came due at that point.
Current ratio can be improved by
- selling of unused non-current assets,
- taking long-term loan,
- speeding up the receivables collection,
- slowing payables payment
A weak current ratio shows that the company is not in good financial health, but it does not
necessarily mean that it will go bankrupt as there are many ways to access financing; but it is
definitely not a good sign.
Companies that have trouble getting paid by its receivables or have long inventory turnover can run
into liquidity problems

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2. Quick or Quick asset or Acid test ratio =

o
o
o
o

Current Asset-Closing Inventory

Current Liabilities

=X:1

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid
assets (as it excludes inventory).
Inventory is excluded because some companies (specially manufacturing companies with high
inventory holding period) have difficulty turning their inventory into cash.
The higher the quick ratio, the better the position of the company.
A quick ratio of 1:1 is normally most appropriate. For companies with a high inventory turnover ratio
(i.e. short inventory holding period) can have a less than 1 quick ratio without suggesting that the
company could be cash flow trouble.
If quick ratio is too low than the current ratio; this could mean that high amount of working capital is
tied up in inventory. High amount of inventory means high inventory holding costs.

PROFITIBALITY RATIOS:
1. Return on capital employed (ROCE) =

o
o

o
o

o
o
o

o
o

o
o

Profit EFORE Interest and Tax

Capital Employed

X 100% = X%

Capital employed = Total asset Current liabilities = Share capital + Reserves +

Long-term liabilities
Deferred Tax Liability or Asset normally excluded from Capital Employed. In that case,
Capital employed = Total asset Current liabilities Deferred tax liability or asset =
Share capital + Reserves + Long-term liabilities Deferred tax liability or asset
Current Liability portion of Long-term liabilities; and a constant amount of Overdraft
normally also considered as Non-current liability for Capital employed calculation
(Opening + Closing
Better to use average Capital Employed
2 where possible.
If you are required to compare ratios between two different years and cannot
calculate average for both of the years, then take only the SFP value of the
year (i.e. do not average). This is for comparability purpose.
If market value of equity is taken then do not include Reserves.
There is a lot other contexts to define capital employed. This is basically the capital
required for a business to function.

ROCE is the prime measure of operating performance. This ratio indicates how efficiently a business
(i.e. managers) is using the funds invested (equity and long-term debt).
It is the ratio over which operations management has most control.
ROCE increase from previous year or above industry average means a good sign and reflects the
fact that the company (by managers) has managed to increase the sales without a proportionate
increase in costs.
ROCE decrease from previous year or below industry average shows problem with controlling of
costs. Level of dividend may also fall as a consequence.
The value of capital employed is lower where company mainly uses rented assets (i.e. thorough
operating lease) rather owning or finance lease. This is also possible where assets carrying value is
lot less than the cost (remember in that case assets will need replacement). These may result a
higher ROCE.
Asset revaluation (especially land) will result a higher amount of Capital employed, which will give a
lower ROCE without indicating company performance became poorer.
ROCE should always be higher than the rate at which the company borrows; otherwise any increase
in borrowing will reduce shareholders' earnings.

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2. Return on equity (ROE), or Return on Shareholders Capital (ROSC)

Profit AFTER Tax and Preference Dividend
Ordinary Share Capital and Reserve

o
o
o

o
o
o
o
o

Profit after tax and preference dividend is the Profit attributable to ordinary shareholders
It is common to use book values rather market value of shares (if market value used then
remember to exclude Reserves)
Better to use average of Shareholders Capital
(Opening + Closing Ordinary Share Capital and Reserves
2 where possible; specially,
when closing balance significantly differs from opening balance.
- If you are required to compare ratios between two different years and cannot calculate
average for both of the years, then take only the SFP value of the year (i.e. do not
average). This is for comparability purpose.

Return on equity (ROE) indicates to ordinary shareholders how well their investments have
performed measuring how much profit the company has generated for them with their money.
A good figure results in a high share price and makes it easy to attract new funds.
With a similar level of ROCE, a fall in ROE may mean increased finance cost because of new loans.
An improved ROE with a similar ROCE may mean some of the loans are repaid which resulted a
lower finance cost and, so, improved profit attributable to ordinary shareholders.
If new share issued sometime at period end, this may result a declined ROE without indicating poor
performance of the company because company really did not get time to utilise the new capital.

3. Gross profit margin =

o

Gross Profit
Sales

o
o

X 100% = X%

High gross profit margin may indicate effective purchasing strategy which results a lower material &/
production cost (i.e. lower cost of sales). A high gross profit margin may also indicate concentration
on low volume-high margin sales.
Low gross profit margin may be an indication of selling products cheaply (i.e. at discount) in order to
generate high volume of sales. This may also indicate increased production cost (including material
and labour cost) without a proportionate increase in selling price.

4. Operating profit margin =

o

X 100% = X%

Profit efore Interest and Tax

Sales

X 100% = X%

Operating profit margin gives analysts an idea of how much profit (before interest and tax) the
company is making from each dollar of sales.
Typically operational management has full control over operating costs (the amount of loan capital
and, so, interest expense normally depends on more higher level of management and the amount of
tax payable depends on government policy). So, operating profit margin effectively measures
performance of operational management.
A poor or declining Operating profit margin may indicate business is struggling in controlling the
costs. This may also happen because of decrease in selling price.
A healthy operating profit margin is required for a company to be able to pay interest on loans.

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5. Net profit margin =

o
o
o

o
o

Profit After Tax

Sales

X 100% = X%

Net profit margin sometimes calculated based on Profit before tax (after interest). Check
question for indication.
A higher percentage than last year or industry average indicates costs are being controlled better.
This may also indicate products are sold at higher price.
A weaken Net profit margin may indicate management is struggling in controlling the costs.
Company can sell at a discount to retain market share during economic downturn (and/or because of
intense competition). If costs remain at similar level this will result a lower Net Profit Margin.
Companies trading cheaper products can gain during economic downturn when customers generally
stop buying luxury products and turn to cheaper ones.
In large companies, where higher level of economies of scale can be achieved (i.e. lower level of per
unit cost) the net profit margin can be higher as a result.
Multinational companies can gain or loss from favourable or adverse exchange rate movements.

6. Asset turnover or Asset utilisation ratio =

o
o

Sales
Capital Employed

= X:1

Use of Non-current assets instead of Capital employed is also correct. Check question for
indication. If question says nothing, then use Capital employed.
This shows the sales that is generated from each $1 worth of Capital (or asset) employed. The
higher the sales per $1 invested the more efficient use of the capital was.
If business is selling luxury products or products with higher profit margin that may result a lower
Asset turnover ratio without a weaken ROCE or Net profit margin ratio.

EFFICIENCY RATIOS:
1. Average receivables collection period =
o

o
o

o
o
o
o

Average Trade Receivables

Credit Sales

X 365 = X days

Use only CREDIT SALES. If question gives us only a Sales figure (i.e. does not split
between credit and cash sales) then use the given Sales figure.
We need only TRADE RECEIVABLES (i.e. receivables derived from credit sales). Nontrade receivables (e.g. advance, damage claim, receivables of government grant) shall not
be included. If question gives us only a Receivables figure, and does not give any other
indication about its components then assume that is the Trade receivables figure.
(Opening + Closing
Better to use average trade receivables
2 where possible; specially,
when closing balance significantly differs from opening balance.
An alternative of using Average Receivables is using year-end receivables figure where
amount of receivables did not change significantly from year-beginning to year-end.
- If you are required to compare ratios between two different years and cannot
calculate average for both of the years, then take only the SFP value of the year
(i.e. do not average). This is for comparability purpose.
Irrecoverable debts and provision for doubtful debts normally not deducted from Trade

Receivables collection period is an approximate measure of the length of time customers take to pay
what they owe.
A Receivables Collection Period similar to Payables Payment Period may be an indication of good
credit control policy.
Collection Period of less than 30 days may seem normal. Significantly in excess of 30 days
might be representative of poor management of funds of the business. However, some
businesses such as export oriented businesses normally needs to allow generous credit terms

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(may be 60 days) to win customers; whereas retailer may sell only or mainly on cash (may be
collection period of not more than 10 days).
A high or increasing collection period may mean poorly managed credit control function, and
increased risk of bad debts. This also may mean over investment in receivables.
However, increase in collection period might be a deliberate policy to increase sales by
offering better credit terms than competitors.
Decreasing or low collection period may mean tighten credit control policy; which may cause
declining customer numbers (i.e. reduction of sales).
Receivables collection days can be improved by offering discount to customers for early payment.

o
o
o
o

2. Average payables payment period =

o
o
o

Average Trade Payables

Credit Purchase

If Credit purchase or purchase amount cannot be identified from the question, use Cost of
sales as it serves as an approximation.
Use only Trade payables; i.e. payables generated from credit purchase.
Increasing or long payment period may indicate liquidity problem; and also may indicate loosing
opportunity of prompt payment discounts.
A longer payment period may also mean company has succeeded in obtaining very favourable credit
terms from its suppliers; contradictorily, this may also mean unethical business practice.
Long credit term from suppliers is a source of interest free financing. But, some suppliers may
charge interest if payment period exceeds a certain duration.
Declining or short payment period may indicate business has sufficient cash to meet payables. A
short payment period may put companys credit ratings in higher position.
If receivables collection period is longer than the payables payment period then it can cause cash
flow difficulties.

o
o
o
o

3. Inventory turnover/ holding period =

or,
o

o
o

X 365 = X days

Average Inventory
Cost of Sales

X 365 days = X days

Cost of Sales
Average Inventory

= X Times

Better to use Average Inventory figure to take into account the variation between Opening
inventory and Closing inventory. But, instead of Average Inventory the closing inventory
figure can be used where opening inventory level cannot be determined; in that case
comparable figure has to derive from same approach.

This ratio is an estimate of the average time that inventory is held before it is used or sold. If average
inventory holding period is 30 days, this means that the inventory is turned over (i.e. sold) on
average 12.16 times (= 365/30) in a year
A low turnover (i.e. high holding period) implies slow sales and, therefore, excess inventory and/ or
high level of inventory holding costs.
High inventory levels are unhealthy because they represent an investment with a zero rate of return.
It may also put company at a great loss if prices start to decline (think about technological products).

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In F9:
Average FG Inventory
X 365 days = X days
Cost of Sales
Average R Inventory
Raw materials inventory turnover period =
X 365 days = X days
Annul Purchases
Average IP
Average production (WIP) period =
X 365 days = X days
Cost of Sales

1. Finished goods inventory turnover period =

2.
3.

4. Working capital cycle, or, Cash operating cycle (in days) =

Inventory holding period (days) + Receivables collection period Payables payment period

In F9:
Days
X
X
X
X
(X)
X/(X)

Finished goods inventory turnover period

Raw materials inventory turnover period
Average production (WIP) period
Average receivables collection period
Average payables payment period
Operating cycle
o
o

This cycle is the length of time between cash payment to suppliers and cash received form
customers. This measured how long a firm will be deprived of cash.
A company could even achieve a negative cycle by collecting from customers before paying
suppliers. This policy of strict collections and delay payments is not always sustainable or
appreciable by customers (because they have to pay early) and suppliers (because they are being
paid late).

INVESTMENT RATIOS:
1. Earnings per share (EPS) =

Earnings (i.e. Profit) Attributable to Ordinary Shareholders

eighted Avg. Number of Ordinary Shares

or,

o
o
o
o
o
o

ar et Price per Share

Price Earnings Ratio

= $X

= $X

EPS is generally considered to be the single most important variable in determining a shares price.
This is a key measure of company performance from ordinary shareholders point of view.
EPS shows the amount of profit attributable to each ordinary share. But, it does not represent actual
income of the ordinary shareholders.
Increase in EPS generally indicates success; whereas a decrease is not welcomed by shareholders.
A constant growth in EPS may result in favourable movements (i.e. increase) in share price.
Both right issue and bonus issue of shares result in a fall of EPS. So, care must be taken while
interpreting.
EPS often ignores the amount of capital employed to generate the earnings. Two companies could
generate the same EPS, but one could do so with less investment; this could mean that this
company was more efficient at using its capital.

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2. Dividend per share (DPS) =

Ordinary Dividend Declared and Paid for The ear

eighted Avg. Number of Ordinary Shares

= X$

o DPS is the actual portion of income received by the ordinary shareholders from EPS.
o DPS is important for shareholders who are seeking income from shares rather capital gain.
o Growth in dividend per share used in share price valuation. So, companies may have a policy of
achieving steady growth in dividend pay-out per share. A steady growth normally creates
positive market reaction (i.e. increase in share price).

3. Dividend pay-out ratio =

or,
o
o

or,

o
o
o
o

X 100% = X%

Ordinary Dividend Declared and Paid for The ear

Earnings (i.e. Profit) Attributable to Ordinary Shareholders

X 100% = X%

Dividend pay-out ratio is the percentage of earnings paid to shareholders as dividends. This shows
how well earnings support the dividend payments.
High dividend pay-out ratio may mean company confidence on future earnings. But, where majority
of shares are held by a small number of shareholders, it may also mean that shareholders are taking
out as much profit as they can; and this does not necessarily serve companys long-term interest.
Low dividend pay-out ratio may mean company is expecting difficulties in the future; so now
interested in retaining earnings. But, it can also mean expansion (by reinvesting the retained
earnings) of business in the future.
Mature companies tend to have a higher pay-out ratio.

4. Dividend cover =

Dividend Per Share

Earnings Per Share

Earnings Per Share

Dividend Per Share

= X Times

Earnings (i.e. Profit) Attributable to Ordinary Shareholders

Ordinary Dividend for the ear

= X Times

Dividend cover represents how many times dividend could have paid from the profit attributable to
ordinary shareholders.
Dividend cover is a measure of the ability of a company to maintain the level of dividend paid out.
The higher the cover, the better the ability to maintain dividend pay-out if profits drop.
Typically, a ratio of 2 or higher is considered safe in the sense that the company can well afford the
dividend; but dividend cover below 1.5 may seem risky.
If the dividend cover is below 1 then the company is using its retained earnings from previous years
to pay current years dividend
A low level of dividend cover might be acceptable in a company with very stable profits, but the same
level of cover for a company with volatile profits would indicate that company may not able to
maintain the current level of dividend pay-out.

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5. Price/Earning (P/E) ratio =

or,

o
o

o
o

o
o

o
o
o

= X Times

Company s ar et Capitalisation
Earnings (i.e. Profit) Attributable to Ordinary Shareholders

= X Times

Market capitalisation is the total market value of all the issued ordinary shares of the
company.
P/E ratio also knows as Price Multiple or Earnings Multiple ratio

P/E ratio is a measure of company performance from the markets point of view.
P/E ratio shows how much money investors are currently willing to pay for each dollar of earnings. It
gives an indication of the confidence that the investors have in the future success (i.e. earnings) of
the business.
In a very basic term, a P/E ratio of 20 means investors are paying equivalent of 20 years earnings
(at current EPS level) to own a share in the company.
A P/E ratio of 1 means market is currently willing to pay $1 for each dollar of earnings currently made
by the company; this shows very little confidence on the companys future prosperity. Whereas, a
P/E ratio of 20 expresses a great deal of optimism about the future of the company since investors
are currently willing to pay $20 for each dollar of companys earnings. Investors paying 20 times of
current earnings believe that company will do significantly better in coming years, and this will not
take long to get the $20 earnings.
Market can over-value or under-value company shares depending of information available.

6. Dividend yield =
o

ar et Price Per Share

Earnings Per Share

Dividend Per Share

ar et Price Per Share

X 100% = X%

Dividend Yield is a financial ratio that shows how much a company pays out in dividends relative to
its share price.
In the absence of any capital gains, the Dividend Yield is the return on investment for a share.
Investors can secure a minimum stream of cash flow from their investment portfolio by investing in
shares which is paying relatively high and stable dividend yields.
Mature and well-established companies tend to have higher dividend yields; while young and growth
oriented companies tend to have lower yield. Many fast growing companies do not have a dividend
yield at all because they do not pay-out any dividend.

LONG-TERM SOLVENCY RATIOS:

1.

Debt ratio =

Total Debt
Total Assets

X 100% = X%

o
o

Total assets consist of non-current and current assets.

Debts consist of all current and non-current liabilities (Deferred tax liabilities can be
ignored).

o
o

This ratio represents how much money company owes compared to its Total assets.
If Debt ratio is greater than 50%, the business can be considered as a risky company. But, a high
Debt ratio may also mean companys ability to raise debt finance which shows confidence of debt
holders on the company.

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2. Gearing ratios:
a. Debt to Equity ratio =
Debt Capital
Redeemable Preference Share Capital Long-term Liabilities
X100% =
X 100% = X%
Equity Capital
Ordinary Share Capital Irredeemable Preference Share Capital Reserves

b. Debt to Total capital ratio =

Debt Capital
Total Capital

X100% =

3. Leverage ratio =

o
o
o
o

o
o
o

o
o
o

o
o

Equity Capital
Equity Capital Debt Capital

X 100% = X%
X100%

Take current liability portion as well of long-term liabilities in Debt capital calculation.
Normally do not include Deferred tax liability within Debt capital.
In F9 Preference share considered as Debt capital not Equity capital.
Also in F9, values for Gearing ratio can be either book values or market values. If using
market values remember market value of ordinary shares take account of reserves (i.e. do
not add reserve amount with total market value of ordinary shares)

A gearing level of more than 50% (where Debt Capital to Total Capital used) or more than 100%
(where Debt Capital to Equity Capital used) or Leverage ratio of less than 50% means company is
highly geared (i.e. risky).
Risk is high for investors in a high geared company because of obligation to pay the interest and
repaying capital on time.
The standard level of gearing depends on industry sector.
A relatively higher gearing may mean company adopted an aggressive strategy to expand its
operation. This has to be justified with sales and profit growth. A higher gearing may also mean
company is having financial difficulties; so may be a going concern issue.
A low or declining gearing may mean company is getting stronger financially and confident on future
earnings.
Where gearing is high, shareholders required rate of return will increase because of high level of risk
involve in the investment.
To lend money in a highly geared company, lenders may impose some covenants on the company
(example: a maximum limit of gearing, a minimum level of interest cover, pledge on some assets)

4. Interest cover =
o

Debt Capital
Equity Capital Debt Capital

Profit efore Interest and Tax

Interest Charge

= X Times

Interest cover is a measure of the adequacy of a company's profit relative to interest payment on its
debt.
A high interest cover ratio means that the business is easily able to meet its interest obligations from
profits. Similarly, a low level of interest cover ratio means that the business is potentially in danger of
not being able to meet its interest obligations.
Interest cover of more than 2 is normally considered reasonably safe. But, companies with very
volatile earnings may require an even higher level of Interest cover.
Interest cover of less than 1 means the company did not earn sufficient earning (i.e. profit) to meet
its interest charge. This means company will have to pay some of its interest from retained profit
from previous years. This may also raise question about companys going concern.

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