PROFESSIONAL DEVELOPMENT & LEARNING ACADEMY

Financial Accounting and

Reporting
Module 6: Analysis of Financial
Statements

This module represents 10% of the exam weighting

Introduction
This Module covers the interpretation of financial
statements. It explains how to calculate the key ratios
and how they can be analysed and interpreted.

Module 6: Analysis of Financial Statements

Learning objectives
After completing this module, you should be able to:
• calculate, analyse and interpret financial ratios and their
interrelationship in the financial statements; and
• explain the limitations of financial statement analysis.

Module 6: Analysis of Financial Statements

Ratios

• Ratio analysis is a technique used to assess

the financial performance and position of a
company, based on its financial statements.

• There are four main groups of ratios:

– Profitability
– Liquidity
– Gearing
– Investors' ratios

Module 6: Analysis of Financial Statements

Profitability ratios 1
Return on Investment (ROI)

Module 6: Analysis of Financial Statements

Profitability ratios 2
Profit margin

Asset turnover

Module 6: Analysis of Financial Statements

Question Practice 1

Dell Co has sales of $120m and a profit before interest and

tax of $42m. Capital invested is $168m.

Required:
Calculate ROI, net profit margin and asset turnover.

Module 6: Analysis of Financial Statements

Question Practice 1 – Solution

ROI: 42/168 = 25%

Net profit margin: 42/120 = 35%

Asset turnover: 120/168 = 0.71

Module 6: Analysis of Financial Statements

Profitability ratios 3
Return on assets

Return on equity

Module 6: Analysis of Financial Statements

Question Practice 2
Walton Co has sales of $200m and a profit after interest and tax of $50m.
Shareholders' equity is $300m and interest bearing debt is $200. There are no
preference shares in issue.

Required:
Calculate ROE, net profit margin, asset turnover (based on total assets less
current liabilities) and assets to equity.

Module 6: Analysis of Financial Statements

Question Practice 2 – Solution

ROE: 50/300 = 17%

Net profit margin: 50/200 = 25%

Asset turnover: 200/500 = 0.4

Assets to equity: 500/300 = 1.7

Module 6: Analysis of Financial Statements

Liquidity ratios 1
Current ratio

Quick (acid test) ratio

Module 6: Analysis of Financial Statements

Liquidity ratios 2
Accounts receivable collection period

Inventory turnover/days

Module 6: Analysis of Financial Statements

Liquidity ratios 3
Accounts payable payment period

Module 6: Analysis of Financial Statements

Question Practice 3

Module 6: Analysis of Financial Statements

Question Practice 3 – Solution

Current ratio: 365/180 = 2.03

Quick ratio: (365 – 140)/180 = 1.25

Receivables collection period: 175/2 500 × 365 = 25.6 days

Payables payment period: 180/1 850 × 365 = 35.6 days

Inventory turnover (days): 140/1 850 × 365 = 27.6 days

Module 6: Analysis of Financial Statements

Working capital cycle

Buy Inventory days Receivables days Receive

Sell
inventories cash from
inventories
customers

Pay
suppliers
Payables
days Working capital
cycle

Module 6: Analysis of Financial Statements

Gearing 1
Gearing ratio

Interest cover

Module 6: Analysis of Financial Statements

Gearing 2
Equity to assets ratio

Assets to equity

Debt to total assets

Module 6: Analysis of Financial Statements

Question Practice 4

Fisher Co has profit before interest and tax of $65m.

The interest charge for the year was $45m onloans of
$450m. Capital invested (total assets less current
liabilities) was $600m.

Required:
Calculate the gearing ratio and the interest cover ratio.

Module 6: Analysis of Financial Statements

Question Practice 4 – Solution

Gearing: 450/600 = 75%. Fisher Co would be deemed

to be highly geared and lenders may be unwilling to lend
further monies in case the company could not repay the
debt.

Interest cover is: 65/45 = 1.4 times. This is very low, the
interest charge can only just be covered from the current
year profits and this ratio would be likely to cause
concern. If profits fell by approximately 30 per cent, all
of the profit for the year would be used to pay interest.

Module 6: Analysis of Financial Statements

Investors’ ratios 1
Earnings per share

Dividend yield

Module 6: Analysis of Financial Statements

Investors’ ratios 2
Price-earnings (P/E) ratio

Dividend cover

Module 6: Analysis of Financial Statements

Question Practice 5

Rain Co made a profit after tax of $150 000 and

declared a dividend of 5 cents per share for the year
ended 31 December 20X8. The company had 1 million
ordinary shares on issue throughout the year and the
market price of a share was $1.20.

Required:
Calculate earnings per share, the dividend yield,
dividend cover and price/earnings ratio.

Module 6: Analysis of Financial Statements

Question Practice 5 – Solution

Earnings per share: 150/1 000 = 15 cents

Dividend yield: 5/120 = 4.2%

Dividend cover: 15/5 = 3 times

Price/earnings: 120/15 = 8

Module 6: Analysis of Financial Statements

Limitations of financial statements

A number of factors may make financial statements

less reliable than they appear:
• Problems of historical cost information – especially
in periods of inflation
• Creative accounting – often aimed at reducing
gearing
• The effect of related parties, in particular involving
group companies
• Seasonal trading – timing of year end may affect
asset and liability amounts (such as inventories,
cash, trade payables)

Module 6: Analysis of Financial Statements

Accounting policies

• Choice of accounting policy can affect the financial

statements – for example, choice of inventory
valuation method.
• Change of accounting policy can only be justified if
it results in the financial statements providing
reliable and more relevant information or if required
by accounting standards.

Module 6: Analysis of Financial Statements

Limitations of ratio analysis

• Comparison against industry averages may not be

very relevant (some businesses may not be expected
to follow the industry average).
• If based on historical cost, undervalued assets may
distort ROI and gearing.
• Ratios are influenced by choice of accounting policy.
• Ratios may be distorted by creative accounting
measures (but all financial information is distorted
by creative accounting).
• Results may be distorted by inflation.
• No two companies have the same risk profile,
therefore comparison is difficult.

Module 6: Analysis of Financial Statements

 PROFESSIONAL DEVELOPMENT & LEARNING ACADEMY

QUESTIONS

Module 6: Analysis of Financial Statements