Part 3 FINANCIAL REPORTING

Chapter 10

The annual account

Andrianantenaina Hajanirina, B.A., B.Sc., M.M., Cand Dr.

Learning objectives
By the end of this chapter you should be able to:
• Define what is meant by the ‘interpretation of accounts’;
• Outline why it is needed;
• Explain where and how one can get copies of company accounts;
• Summarise the procedure involved in interpreting a set of
accounts;
• Explain the usefulness, importance and limitations of ratio
analysis;
• Calculate seven key accounting ratios that say a lot about the
health of a business;
• Explore the relationship between those ratios;
• Explore other ratios that may be useful for non-accountants
(ratios of interest to HR Managers, bankers, marketing managers,
production managers and others).
Nature and purpose
• Definition
• The verb ‘to interpret’ has several different
meanings.
• Perhaps the most common is ‘to convert’ or ‘to
translate’ the spoken word of one language into
another, but it also has other meanings such as ‘to
construe’, ‘to define’ or ‘to explain’.
• We will use the latter meaning.
• Our definition of what we mean by the
interpretation of accounts may then be expressed as
follows:
• a detailed explanation of the financial performance
of an entity incorporating data and other
quantitative and qualitative information extracted
from both internal and external sources.
Activity 10.1

Find the latest annual report and financial statements of

Jsainsbury plc on the Internet (it would be available on the
company corporate site under ‘Investors-centre 7 reports’, rather
than its customers-facing online shopping site).
• (a) How many pages is the length of the document?
• (b) What is included in it?
Contents of financial report

Ordinarily an annual report and financial statements for a listed

business like Sainsbury’s will have:
• the statement of the directors’ responsibilities on 1 page,
• an independent auditors report on 1–3 pages,
• the primary financial statements on 6 or 7 pages,
• the notes to the financial statements on 50–60 pages and
• about 50–100 pages of other material (such as strategy and
outlook, corporate social responsibility and environmental
reports and information about the board of directors and their
pay).
Contents of financial report (cont’)
• There are three main reasons why not all information are
available because:
• Structural. Financial accounts are prepared on the basis of a
series of accounting rules.
• Even financial accounts prepared for internal purposes
contain a restricted amount of information and this is
especially the case with published accounts.
• Only information that can be translated easily into
quantitative financial terms is usually included, and also
some highly arbitrary assessments have to be made about the
treatment of certain matters such as valuation of assets such
as inventory or investments, depreciation of non-current
assets such as property or equipment, accruals for director
bonuses and allowance for bad debts.
• Furthermore, financial accounts are also usually prepared on
a historical basis so they may be out-of-date by the time that
they become available, the details may relate at best to one or
two accounting periods and probably no allowance will have
been made for inflation.
Contents of financial report (cont’)

• Absolute. The monetary figures are presented almost solely in

absolute terms.
• For example, Sainsbury’s reported a loss rather than a profit
for 2014 (a loss of £166 million to be precise), yet it still paid a
£330 million in dividend to its shareholders.
• So how, you might ask, can that be? Exactly. This is a good
example of why we need to dig behind the figures; it’s why
we need to interpret them.
• Contextual. Even if you could grasp the size and significance
of what a loss of £166 million meant, in isolation it does not
tell us very much.
• In order to make them more meaningful they need to be put
in context perhaps by comparing them with the previous
years’ results or with companies in the same industry.
User
• A question that a user in each particular group may well ask
and which it hopes to find the answer to in the accounts:

• The questions in Table 10.1 cannot always be answered

directly from the financial statements.
• For example, investors asking the question ‘What’s the
dividend like?’ will find that the annual report and accounts
gives them the dividend paid by the company in total as well
as dividend per share for the current and the previous year in
absolute amounts
Activity 10.2

Taking the seven user groups listed in table 10.1 , what other
questions do you think that each user group would ask? List
each user group and all the questions that you think each would
ask. Then insert:
• (a) where the basic information could be found in the annual
report and accounts to answer each question and
• (b) what additional information would be required to answer
each question fully.
Procedure
• Outline the basic procedure involved in interpreting a set of
accounts which is composed of four main stages:
1. collecting the information;
2. analysing it;
3. interpreting it and
4. reporting the findings.
Collecting the information

• This stage involves you first conducting a fairly general

review of the international economic, financial, political and
social climate and a more specific one of the country in which
the entity operates.
• =to see whether it is politically and socially stable with
excellent prospects for sound and continuing economic
growth.
• Ask questions:
• Is the government supportive of the industry?
• Is there an expanding market for its products?
• Is there sufficient land and space available for development?
• Is there a reliable infrastructure, e.g. utility supplies and a
transport network?
• Are there grants and loans available for developing
enterprises?
• Is there an available and trained labour force nearby?
• Try to obtain as much information about the entity as you can
get.
• This will involve finding out about its history, structure,
management, operations, products, markets, labour record
and financial performance.
• Try to obtain much of this information from the Internet,
including press releases, trade circulars and analysts’ reviews,
and the financial statements.
Analysing the information

• There are four main techniques that you can use in

interpreting a set of financial statements:
1. horizontal analysis,
2. trend analysis,
3. vertical analysis and
4. Ratio analysis.
• Figure 10.1 depicts a diagrammatic representation of these
different types of analyses. A brief description of each one is
outlined below.

• 1 Horizontal analysis.
• This technique involves making a line-by-line comparison of
the company’s accounts for each accounting period chosen for
the investigation.
2. Trend analysis
This is similar to horizontal analysis except that all the figures in
the first set of accounts in a series are given a base line of 100 and
the subsequent sets of accounts are converted to that base line.
3. Vertical analysis
This technique requires the figures in each financial statement
(usually restricted to the statement of profit or loss account and
the statement of financial position) to be expressed as a
percentage of the total amount.
4. Ratio analysis
A ratio is simply the division of one arithmetical amount by
another arithmetical amount expressed as a percentage or as a
factor.
Ratio analysis is a most useful means of comparing one figure
with another because it expresses the relationship between lots
of amounts easily and simply.
Activity 10.3

State whether the following assertions are true or false:

• (a) R atio analysis is only one form of analysis that can be
used in interpreting accounts. True/false
• (b) R atio analysis aims to put the financial results of an entity
into perspective. True/false
• (c) R atio analysis helps to establish whether or not an entity
is a going concern. True/false
Interpreting the information
• Now you have to use all the information that you have before
you to interpret or to explain what has happened.
• Some of the questions you might ask yourself include the
following:

1. What does it tell me about the company’s performance?

2. Has the company done well compared with other financial
periods?
3. How does it compare with other companies in the same
sector of the economy?
4. Are the world economic, political and social circumstances
favourable to trade generally?
5. What are they like for this company’s industry?
6. What are the prospects for the region in which this company
does its business?
Reporting the findings
• In this chapter you will probably have to write a written report.
• The format of your report will depend on its purpose but basically it
should be broken down into three main sections.
1. Your first section should be an introduction in which you outline
the nature and purpose of your report including a brief outline of
its structure.
2. The second part should contain your discussion section in which
you present your evidence and your assessment of what the
evidence means.
3. In the third concluding section summarise briefly the entire study,
list your conclusions and state your recommendations.
4. Business reports usually have a key fourth component which is
usually written at the end but placed at the start of a business
report – an executive summary.
• An executive summary is a one-page summary of all the key points
made in your report.
• In the next section we consider in much more detail one of the
analytical techniques mentioned earlier in the chapter: ratio analysis.
Ratio analysis

• There are literally hundreds of ratios that we could produce

but most accountants have just a few favourites.
• Always check the definition of a particular ratio you come
across because while the name may be familiar to you, the
definition could be different from the one that you use.
• Strictly limit the number of ratios you adopt. If you use 20
different ratios, for example, and you are covering a five-year
period, you have 100 ratios to calculate and to incorporate in
your analysis. That’s a lot to handle!
Ratios categories

• Ratios are usually grouped into five broad categories

(although there is some overlap between them):
1. liquidity (solvency) ratios;
2. profitability ratios;
3. efficiency ratios;
4. investment ratios and
5. gearing (leverage) ratios.

1. Liquidity (solvency) ratios:

measure the extent to which an entity is able to settle its
current liabilities and remain solvent.
In other words, they try to assess how much cash the entity has
available in the short term (this usually means within the next 12
months) and if assets can be turned into cash quickly in order to
settle current liabilities.
Ratios

2. Profitability ratios
measure the extent to which an entity has been able to generate
an adequate return in relation to the resources it had.
3. Efficiency ratios
tell us how an entity has been managed, i.e. how well its
resources have been looked after by those running the business.
4. Investor ratios
relate to the market value of company shares and dividends and
are of interest to investors in listed companies primarily.
5. Gearing (leverage) ratios
provide information about the funding structure of a business
and measure the extent to which an entity is able to settle its
non-current obligations, i.e. repay its debt funders.
Activity 10.4

• Watch the episode of Dragons’ Den where Sarah Lu, a young

entrepreneur, is pitching to secure some additional start up
funding to grow her business – Youdoodoll. The video is
available on the companion website or you can search for it
on YouTube. Note down any accounting or financial terms
the Dragons use in their interrogations.
• Then answer the following questions:
• (a) What are the Dragons doing while questioning the
entrepreneur?
• (b) What are they not directly asking but working out for
themselves?
Source: based on the BBC2 programme, Dragons’ Den, Series 5,
Episode 2, aired 22 October 2007.
Illustrative examples
1. Profit margin ratio (an example profitability ratio)
• The profit margin shows what percentage of every £1 of sales
is profit.
• This ratio is usually expressed as a percentage.
• The higher the margin, the better not only because there is
more profit in absolute terms but because there is more of a
buffer to absorb unfavourable economic or market events
such as reduced customer demand or increased supplier
costs.
• A business with a 1 per cent profit margin (i.e. which makes
1p profit out of every £1 of products sold) does not have
much scope to manoeuvre to remain profitable and is in a
worse-off position in comparison to a business with a 15 per
cent profit margin (i.e. one which makes 15p profit out of
every £1 of products sold).
• In capital-intensive businesses (those that require a lot of
assets such as those in the manufacturing industry), the
margins tend to be higher and in labour-intensive business
they tend to be lower.
ratios
2. Return on capital employed (ROCe) ratio (an example
efficiency ratio)
• Relating profit to funding gives the potential investors an idea
of how effective the business is in using its resources to
generate profit.
• Funding, known as capital employed, is the sum of equity
and debt funding.
• Equity funding comes from the equity investors, those who
own the business.
• Debt funding comes from banks and other creditors –
ordinary loans that may have been taken out by the business
or bonds and preference shares against which the business
has borrowed from the capital markets.
• This is how return on capital employed is calculated.
• This ratio is usually expressed as a percentage. The higher
ROCE the better. A business making £1 million in profit with
only £100,000 of funding is a much better investment
opportunity than a business that is making £1 million in profit
with £500,000 of funding.
ratios
3. Capital turn ratio (another example of an efficiency ratio)
This ratio is usually expressed as a factor, e.g. 3:1.
The capital turn ratio gives an indication of how much sales were
generated for every £1 of capital employed.
The more revenue that is generated per £1 of funding, the better.
For example, imagine that a business made £2 million in sales
with £1 million of funding provided to it from equity
and debt sources in year one.
4. ROCE revisited (an example efficiency ratio)
As we explained above, ROCE is a measure of how effective the
management has been in using the funding that was made
available to the business – higher profits for the same capital
employed representing more efficient use of resources. It turns
out that ROCE is actually capital turn multiplied by profit
margin. This relationship means that ROCE can be used for
comparison across different types of businesses – both
capitaland labour-intensive ones as capital-intensive businesses
will tend to have a low capital turn but high profit margins and
labour-intensive businesses – just the opposite.
ratios

5. Operating cash flow to operating profit ratio (an example

liquidity ratio)
The operating cash flow to operating profit ratio gives an
indication of how much cash is collected given the reported
profits.
This ratio is usually expressed as a factor, for example, 1:2 would
mean that for every £1 in profit, 50p is collected in cash.
A business can be profitable on paper but unless it has cash, it is
vulnerable.
Collecting cash from customers you have sold to is key in
keeping a healthy business.
The higher the ratio, the better, as it would mean most of the
sales were cash sales or that if they were on credit, cash was
collected from customers in a timely manner.
ratios

6. Current ratio (an example liquidity ratio)

The current ratio gives us an indication about a business’s ability
to pay its current liabilities as they fall due.
The term ‘current’ means receivable or payable within the next
12 months (the same meaning as in the financial statements).

It is usually expressed as a factor, e.g. 3 to 1, or 3:1, although you

will sometimes see it expressed as a percentage (300% in our
example, i.e. 31 * 100).
ratio

7. Debt to equity ratio (an example gearing ratio)

• The debt to equity ratio gives more information about how a
business is funded.
• A business that has borrowed a lot is said to be highly geared,
as opposed to one which is funded primarily by shareholders.
There is nothing wrong with borrowing money to expand
operations or to cover a short-term cash flow problem but
borrowing ties a company down into making fixed interest
payments, which puts pressure on results.
• Big loans may often have covenants which, if breached,
trigger the repayment of the loan in full at a time when the
company may be struggling for cash.
ratio

8. Earnings per share (EPS) ratio (an example investor ratio)

• As we mentioned the share of profits we will finish with an
example of an investor ratio.
• As referred to earlier company shareholders are entitled to
the profits a company makes and they share it in proportion
to their share of the company.
• Imagine that you and I jointly owned a company and you had
70 of the shares and I had 30 of the shares.
• Any profit the company made will be split between us in a
70:30 proportion.
• Earnings per share will tell us how much of the profit is
attributed to each individual share so that we can each
multiply that by our number of shares and work out how
much we are entitled to in total.
Limitations of ratio analysis
Ratio limit

• Ratios are an excellent way to interpret the results of

companies and understand the story behind the numbers but
they do have certain limitations. For example:
• Ratios are based on past historical information contained in
the financial statements and as such refer to past
performance.
• Past performance is not necessarily an indication of future
performance.
• We have explained in this book so far a number of accounting
adjustments and estimates that exist in the financial
statements of companies – depreciation, allowance for
doubtful debts and accruals.
• They have the potential to significantly change the numbers
reported by companies.
Conclusion
There are four main types of analyses:
1. horizontal analysis, involving a line-by-line inspection across the
various time periods;
2. trend analysis, in which all the data are indexed to a base of 100;
3. vertical analysis, where each period’s data is expressed as a
percentage of a total and
4. ratio analysis, which requires a comparison to be made of one item
with another item expressing the relationship as either a percentage
or a factor.
Ratios are usually grouped under five headings:
1. liquidity ratios, which help to decide whether an entity has enough
cash to continue as a going concern;
2. profitability ratios, which measure the profit an entity has made;
3. efficiency ratios, which show how well the entity has used its
resources;
4. investment ratios, which help to consider the investment potential
of an entity and
5. gearing ratios, which help to understand the funding structure of a
business and associated risks.
Application and assignment
• See the e-campus
End