Interpretation of financial statements

Purpose

Financial statements are prepared to assist users in making decisions. They therefore need interpreting,
and the calculation of various ratios makes it easier to compare the state of a company with previous
years and with other companies.

The main areas

When attempting to analyze the financial statements of a company, there are several main areas
that should be looked at:

Profitability ratios

1)

Return on capital employed = Profit before interest and tax (Operating profit) x 100
Capital employed

2)

Net profit margin = Profit before interest and tax x 100

Revenue

3)

Gross profit margin = Gross profit x 100

Revenue

4)

Net asset turnover = Sales revenue = times

Capital employed

Liquidity ratios

1)

Current ratio = Current assets

Current liabilities
2)

Quick ratio (or acid test) = Current assets – Inventory

Current liabilities

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 3)

Inventory days = Inventory × 365 days

Cost of sales

4)

Average collection period (receivables days) = Trade receivables × 365 days

Credit sales

5)

Average payment period (payables days) = Trade payables × 365 days

Credit Purchases/COS
6)

Cash conversion cycle = inventory holding period + receivables collection period – creditors payment
period

Gearing ratios

1)

a)

Gearing = long term debt x 100

Equity

b)

Gearing = long term debt x 100

long term debt + Equity

2)

Interest cover = Profit before interest and tax

Interest charges

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