Interpreting Financial Statements

Contents
Interpreting Financial Statements............................................................................................... 1
Interpreting Financial Statements............................................................................................... 2
Purpose of interpretation: ....................................................................................................... 2
Ratios and calculations: ........................................................................................................... 2
Analysis of financial statements:................................................................................................. 9
Ratios ......................................................................................................................................... 10
RATIO ANALYSIS OF ABC INC.: ............................................................................................... 10
ABC Inc. Statement of Financial Position as at 31st December 20X7 .................................... 11
Profitability ratios: ................................................................................................................. 13
Liquidity ratios: ...................................................................................................................... 13
Efficiency ratios: .................................................................................................................... 14
Position ratios: ....................................................................................................................... 14
Analysis of Financial Statements ............................................................................................... 18
Interpreting the financial statements: .................................................................................. 18

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Interpreting Financial Statements
Purpose of interpretation:

Key reason for interpretation of financial statements to provide a better picture of the
efficiency and performance of a particular business.

Comparisons are necessary because a single figure or calculation on its own is meaningless. We
can compare the absolute figures in the statement of financial position and statement of profit
or loss with the figures for previous periods or we can compare the figures with other
businesses.

Ratios and calculations:

The calculations and ratios can be broken down into four areas:

1. Profitability ratios:

Profitability ratios focus on cost and revenue management, these ratios include:

a) Gross profit margin:

Meaning: Relationship between revenue and cost of sales.

Gross profit
Formula: GPM = × 100%
Sales revenue

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Increase in selling prices;  Decrease in selling prices;

 Decrease in purchase price;  Increase in costs.

 Decrease in production costs.

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 b) Operating profit margin (OPM):

Relationship between revenue and ALL operating costs (cost of sales,

Meaning:
distribution costs and admin expenses).

Gross profit − Distribution costs − Administrative costs

OPM =
Formula: Sales revenue
× 100%

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Decrease in employee costs;  Increase in employee costs;

 Decrease in admin costs;  Increase in admin costs;

 Decrease in rent/depreciation of  Increase in rent/depreciation of

admin office; admin office;

 Decrease in distribution costs.  Increase in distribution costs.

c) Return on capital employed (ROCE):

Meaning: Profit generated from capital invested in business.

Operating profit
Formula: ROCE = × 100%
Capital employed

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Decrease in operating costs;  Increase in operating costs;

 Increase in revenue;  Increase in capital;

 Lower level of capital.  Decrease in selling prices.

NOTE: Capital employed = all funds invested in the business (equity + loans).

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 d) Net asset turnover (times per year):

Meaning: How much revenue is generated for each $1 of net assets?

Sales revenue
Formula: Net asset turnover =
Capital employed

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Decrease in assets;  Increase in assets;

 Increase in liabilities.  Decrease in liabilities.

Interrelationship among profitability ratios:

Operating profit margin × Net asset turnover = Return on capital employed

Return on capital employed

Operating profit margin =
Net asset turnover

Return on capital employed

Net asset turnover =
Operating profit margin

2. Liquidity ratios:

Liquidity ratios focus on cash management, these ratios include:

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 a) Current ratio:

Meaning: Whether business’s assets can meet its liabilities?

Current assets
Formula: Current ratio =
Current liabilities

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Holding too much stock;  Cash flow problems;

 Not collecting receivables;  Low inventory levels;

 Holding too much cash;  Drop in demand;

 Paying suppliers too quickly.  Taking longer time to pay

suppliers.

Quick ratio:

Whether business’s LIQUID assets can meet its liabilities (can we settle-
Meaning:
off debts QUICKLY)?

Current assets − Inventory

Formula: Quick ratio =
Current liabilities

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Not collecting receivables;  Cash flow problems;

 Holding too much cash;  Taking longer time to pay
 Paying suppliers too quickly. suppliers.

3. Efficiency ratios:

Efficiency ratios focus on inventory, receivables and payables, these ratios include:

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a) Inventory turnover period:

Meaning: How long a business is holding inventory for?

Average inventory
Formula: Inventory turnover period = × 365
Cost of sales

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Slower sales;
 Faster sales;
 More unsold goods in stock;
 Increase in cost of sales;
 Bulk procurements;
 Smaller orders;
 Decrease in production and
 Lower inventory.
purchase costs.

b) Receivables collection period:

Meaning: How long a business takes to collect debts?

Average receivables
Formula: Receivables collection period = × 365
Credit sales

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Poor credit control;

 Customers paying earlier;
 Customers taking longer to pay;
 Higher settlement discounts;
 Offering more credit to
 Improved credit control process.
customers.

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 c) Payables payment period:

Meaning: How long a business takes to pay debts?

Average payables
Formula: Payables payment period = × 365
Credit purchases

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Longer credit terms;

 Liquidity problems;
 Cash flow difficulties;
 Use of settlement discounts.
 Trouble in paying suppliers.

4. Financial ratios:

Financial ratios focus on how we finance our business in the form of debt and equity these
ratios include:

a) Gearing ratio:

 Balance of debt to equity;

Meaning:
 Balance of fixed to variable capital costs.

Long term debt Long term debt

Formula: Gearing ratio = OR
Equity (Long term debt + Equity)

Factors that will cause ratio to Factors that will cause the ratio to
increase decrease

 Too much debt;  Not enough debt;

 Debt being cheaper than equity;  Banks not willing to lend;

 Inability to raise more equity.  Mismanagement of capital

structure.

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b) Interest cover:

How much profit is available to pay interest to debt holders (a ratio of

Meaning:
less than 2 indicates a very low interest coverage)?

Operating profit
Formula: Interest cover =
Interest payable

Factors that will cause the ratio to

Factors that will cause ratio to increase
decrease

 Improving operating profit;  Falling profits;

 Reduction in interest payable;  Inability to pay dividends;
 Reduction in interest rates;  Difficulty in covering interest
 Reduction in debt-holding. costs.

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Analysis of financial statements:
The sorts of figures to look at are:

1. Non-current assets – has there been investment that will result in a drop in the cash
figures and a change to capital employed?

2. Share capital and reserves – has there been a revaluation of non-current assets or an
issue of new share capital (impact on gearing ratio)?

3. Borrowings – has there been an increase or decrease in the loan values (impact on
gearing ratio and interest cover)?

4. Current assets - has there been a significant change in inventory, receivables or cash
(impact on inventory turnover period and receivables collection period)?

5. Revenue – has there been an increase in revenue (impact on gross profit margin and
operating profit margin)? Look at the profit figures themselves too to see how revenue
and costs changed.

6. Current liabilities – have payables increased or decreased significantly? This might

indicate that we are over-buying stock or that we are taking longer to pay our suppliers.

Note: All of these individual figures can also be analysed alongside the ratios we have
calculated.

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Ratios
NOTE: Before going through this section, go through F2 – Performance Measurement (where
the concept of ratio analysis was introduced) to revise your knowledge

RATIO ANALYSIS OF ABC INC.:

ABC Inc. Statement of Profit or Loss for the year-ended 31st December 20X7

20X7 20X6

($’000) ($’000)

Revenue 500,000 400,000

Cost of sales (200,000) (200,000)

Gross profit 300,000 200,000

Rental expense (100,000) (80,000)

Administration expenses (100,000) (90,000)

Other operating expenses (5,000) (5,000)

Net profit 95,000 25,000

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ABC Inc. Statement of Financial Position as at 31st December 20X7
20X7 20X6

($’000) ($’000)

Non-current assets

Property, plant and equipment 1,500,000 1,500,000

Accumulated depreciation (75,000) (70,000)

Total non-current assets 1,425,000 1,430,000

Current assets

Cash 15,000 10,000

Inventory 200,000 90,000

Total current assets 215,000 100,000

Total assets 1,640,000 1,530,000

Current liabilities

Trade payables 10,000 80,000

Accruals 20,000 150,000

Total current liabilities 30,000 230,000

Long-term liabilities 500,000 700,000

Capital and reserves

Ordinary shares @ €1 each 100,000 100,000

Retained earnings 1,010,000 500,000

Total liabilities and equity 1,640,000 1,530,000

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Additional information:

20X7 20X6

($) ($)

Standard labour hours calculated by engineers 23,400,000 46,800,000

Budgeted labour hours by production managers 28,080,000 56,160,000

Actual labour hours worked 30,888,000 61,776,000

Using the information provided, let’s calculate the following ratios for ABC Inc.:

 Profitability

 Liquidity

 Efficiency

 Position

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Profitability ratios:

Ratio Formula 20X7 20X6

60% 50%
Gross profit Gross profit
× 100 300,000 200,000
margin Revenue × 100 × 100
500,000 400,000

19% 6%
Net profit
Return on sales × 100 95,000 25,000
Revenue × 100 × 100
500,000 400,000

6% 2%
Net profit
Return on capital 95,000 25,000
Capital employed
employed (1,640,000 − 30,000) (1,530,000 − 230,000)
× 100
× 100 × 100

Liquidity ratios:

Ratio Formula 20X7 20X6

7.17 times 0.43 times

Current Current assets
ratio Current liabilities 215,000 100,000
30,000 230,000

Quick 0.50 times 0.04 times

ratio or (Current assets − Inventory)
acid test Current liabilities (215,000 − 200,000) (100,000 − 90,000)
ratio 30,000 230,000

45% 117%
Capital
Debt 700,000
gearing × 100 500,000
Equity (100,000 + 1,010,000) (100,000 + 500,000)
ratio
× 100 × 100

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Efficiency ratios:

Ratio Formula 20X7 20X6

76% 76%
Standard hours
Efficiency ratio × 100 23,400,000 46,800,000
Actual hours × 100 × 100
30,888,000 61,776,000

110% 110%
Actual hours
Capacity ratio × 100 30,888,000 61,776,000
Budgeted hours
× 100 × 100
28,080,000 56,160,000

83% 83%
Standard hours
Activity ratio × 100 23,400,000 46,800,000
Budgeted hours
× 100 × 100
28,080,000 56,160,000

Position ratios:

Ratio Formula 20X7 20X6

31% 31%
Asset Revenue
turnover Capital employed 500,000 400,000
ratio × 100 (1,640,000 − 30,000) (1,530,000 − 230,000)
× 100 × 100

19 days 146 days

Accounts payable
Payables
Cost of sales 10,000 80,000
days
× 365 × 365 × 365
200,000 200,000

365 days 165 days

Inventory Inventory
× 365 200,000 90,000
days Cost of sales × 365 × 365
200,000 200,000

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Interrelationship between ratios:

Ratio 20X7 20X6

Gross profit margin 60% 50%

Return on sales 19% 6%

Return on capital employed 6% 2%

Current ratio 7.17 times 0.43 times

Quick ratio or acid test ratio 0.50 times 0.04 times

Capital gearing ratio 45% 117%

Efficiency ratio 76% 76%

Capacity ratio 110% 110%

Activity ratio 83% 83%

Asset turnover ratio 31% 31%

Payable days 19 days 146 days

Inventory days 365 days 165 days

Interpretation and analysis:

Let’s discuss the relationship that we can see from the calculated ratios:

Profitability analysis:

Starting with the gross profit margin, it is growing, and a good sign. The net profit margin is also
growing (also a good sign), which in 20X6 is only at 6%, it is very low! However, without
knowing the industry average, we do not know how the company is performing against its
competitors.

What about the relationship between these two ratios? The gross profit margin just reflects the
costs of sales, whereas the net profit is everything after that. Both have grown, the net profit
more so, indicating greater efficiencies, cost reduction and sourcing cheaper materials. As both

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these ratios have improved we can see that these cost savings have been applied to the
production costs as well as the operational costs.

Moving on we have the return on capital employed, which has increased greatly from 20X6 to
20X7, however, it is quite low (if matched with the returns offered by financial institutions for
example). As pointed out earlier, it is improving and looking at the position and efficiency ratios
you can see why.

Position analysis:

The asset turnover rate has stayed approximately the same. We see payable days reducing
significantly in 20X7, reaching a point which is quite low, indicating the company did take more
advantage of the credit terms offered by suppliers.

By identifying the relationships between the ratios, we are getting more information about the
company than looking at the ratio in isolation.

Another performance ratio to be negatively trending is inventory days, which has significantly
increased. Looking at this ratio on its own we can make recommendations to reduce it, so
increasing inventory turnover and reducing the associated costs such as storage etc., however,
if we look at the other ratios we see relationships.

In ABC Inc. you know already that the gross and net profit margins have increased due to
sourcing cheaper materials. Could this be due to ABC’s bulk buying its materials to avail
discounts? We also saw the payable days have reduced, indicating that this inventory could
have been bought on little credit. Now you are beginning to see the bigger picture instead of
the inventory days alone, questions that should further be analysed include:

How much was saved by buying in bulk?

How much does it cost ABC to store this inventory?

Efficiency analysis:

Looking at the efficiency ratios we know that workers worked over the budgeted hours, over
capacity which indicates that the budgets set by managers were not accurate. We also know
that the gross and net profit margins improved, showing that the company did not incur a
significant cost for the extra labour. These ratios are interrelated, and normally it would be
expected for the costs to increase significantly if workers work over capacity, as overtime pay
tends to be higher. This prompts the question about the budgets set by the managers, they do
seem to be unrealistic!

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NOTE: By looking at how these ratios interrelate, we tend to analyse the performance of the
entire company. When looking at exam questions look at the relationships and connections
between the different ratios.

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Analysis of Financial Statements
Financial statements are of no use if they are not interpreted. An accountant must be able to
interpret the financial statements and inform the users of their conclusions, this enables better
decision making.

Interpreting the financial statements:

Compare the current financial period’s result:

 With the prior years.

 With the budgeted results.

 With the forecasted results.

 With the results of their competitors.

These comparisons will indicate the company’s position in relation to the previous year, its
budgeted and expected results as well as its competitors. Ratios are a powerful tool to compare
financial data and interpret the financial statements because they show the impact different
elements of the financial statements have on each other, however, we cannot interpret the
financial statements with ratios alone.

When interpreting the financial statements:

1. Compare the data.

2. valuate the impact of each part of the financial statements (e.g. Impact an increase in
the purchases will have on the statement of financial position and statement of
comprehensive income).

3. Analyse the differences found when comparing the financial statements by asking:

How variances impact the organisations:

 Its profitability;

 Its liquidity;

 Its efficiency of utilising resources;

 Its financial position.

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Example:

Suppose we have Wonderbar Inc. and as we can see the profitability ratios have not changed
from 20X6 to 20X7:

Profitability ratios 20X7 20X6

Gross profit margin 80% 80%

Net profit margin 20% 20%

Return on capital employed 2% 2%

If we just looked at the ratios we would say that profitability is consistent, the costs, perhaps,
should be examined with the aim to reduce them:

Income statement 20X7 ($) 20X6 ($)

Revenue 100,000 90,000

Cost of sales (20,000) (18,000)

Gross profit 80,000 72,000

Other expenses (60,000) (54,000)

Net profit/loss for the year 20,000 18,000

Looking at the actual financial statements we see that revenues and the net profits have
increased by 11%:

Increase from 20X6 to 20X7 = ($20,000 – $18,000)/$18,000 = 11%

The revenues and costs have remained the same proportionately to each other but there is
more money, in 20X6 there was 18,000 net profits and in 20X7 there was 20,000. This growth is
important to highlight and can be ignored if we just use ratios to interpret the financial
statements.

As pointed out earlier, the relationship of different parts of financial statements is very
important. We know that every debit has a credit. When interpreting the financial statements;

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we need to look at what has happened in the profit and loss and what impact it has had on the
balance sheet.

Here, the revenues and expenses have increased overall by 11%:

Revenue: ($100,000 – $90,000)/$90,000 = 11%

Cost of sales: ($20,000 – $18,000)/$18,000 = 11%

Other expenses: ($60,000 – $54,000)/$54,000 = 11%

Revenues are sales have an effect on the trade receivables. Costs could impact the trade
payables. In this situation, the revenues and costs would impact the liquidity and financial
position ratios. Taking the increase in revenues we want to see the impact the change has had
on liquidity, so let’s look at the trade receivables:

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Statement of financial
20X7 ($) 20X6 ($)
/position

Assets

Non-current assets 1,100,000 990,000

Current assets

Inventories 10,000 50,000

Trade receivables 5,000 10,000

Total assets 1,115,000 1,050,000

Liabilities and equity

Current liabilities

Trade and other payables 30,000 10,000

Non-current liabilities

Long-term borrowings 100,000 20,000

Capital and reserves

Ordinary shares @ $1 each 100,000 100,000

Retained earnings 885,000 920,000

Total liabilities and equity 1,115,000 1,050,000

The trade receivables figure has decreased from the previous year. This is a good sign as it
shows that Wonderbar managed to increase its sales revenues and reduced its bad debt risk,
so, improving its liquidity.

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What does this say about the companies’ efficiency at using its resources? Good things! The
company has reduced its debtor days or trade receivable days from 41 to 18:

Receivable days 20X6 = Trade receivables/Revenue x 365 = $10,000/$90,000 x 365 ≈ 41 days

Receivable days 20X7 = Trade receivables/Revenue x 365 = $5,000/$100,000 x 365 ≈ 18 days

This means it is getting in money (41 – 18 =) 23 days earlier from its customers. If it needed to
borrow funds to cover the period of credit they offer their customers the cost has now reduced
and Wonderbar can use its resources to grow the business rather than sustain it, therefore,
company is using its resources (i.e. debtors) more efficiently.

I already touched on the financial position, when we looked at the efficiency of use if the
company resources. The improvement of sales and the improved collection of trade debtors
has improved the cashflow of the business and, therefore, its financial position.

If Wonderbar has improved so much at collecting its trade receivables why has its current ratio
deteriorated?

Current ratio of 20X6 = Current assets/Current liabilities = $60,000/$10,000 = 6.0 times

Current ratio of 20X7 = Current assets/Current liabilities = $15,000/$30,000 = 0.5 times

This can be explained by analysing the movement of inventories and payables, the inventories
have decreased and trade payables have increased. The financial controller would interpret this
as a good thing, the company has less money tied up in stock (capital that could be used more
efficiently elsewhere) and it has increased the time to pay its suppliers (which can be a free
source of finance). However, the production manager may be worried about the supplier
relations. The conclusions you make from the financial data depends on the users.

NOTE: The conclusions made from the financial statements will enable other users to make
better decisions, but for the conclusions to be useful always remember:

 The information needs of the users.

 The best format to represent your findings to the users.

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