Unit 6 Chapter 3

ANALYSIS AND INTERPRETATION OF FINANCIAL

STATEMENTS
Chapter Overview

The Annual Report

Ratio Analysis

Using Financial Statement Information

The Annual Report
The Annual Report

Statement of Financial Position

The Income Statement

Statement of Cash Flows

 The Annual Report

The Statement of Financial Position

Assets =
Also known as
Liabilities +
The Balance Sheet
Shareholders’ equity

Liabilities and Equity

Assets represent
represent how
investments made
investments are
by company
financed
 The Annual Report

Figure 3.1: The statement of financial position.

Left side: total value of assets. Right side: total value of liabilities and shareholders’ equity
 The Annual Report

The Balance Sheet Equation

Liabilities

Assets
Equity
The Annual Report

Net Working Capital =

Current Assets - Current Liabilities

Positive net working

It is important to ensure capital means that
that net working capital enough cash will be
is positive available to pay off
liabilities arising
 The Annual Report

The Income Statement

Measures performance over a specific period
The Annual Report

Revenues

Income
Expenses
The Annual Report

Cash Flow
Cash Flow is the most
Cash Flow is NOT the
important item to take
same as Net Working
from financial
Capital
statements

Total Cash Flow comes

Cash Flows from Assets
from operating
= Cash Flows to
activities, investing
Creditors and Equity
activities and financing
Investors
activities
Ratio Analysis
Ratio Analysis

It is important to be able to analyse a

Company’s financial statements and
compare them to those of other
Companies
 TIPS on Ratio analysis
1. Comparatively is the increase or decrease on the ratio (
when comparing it to last year or to industry)
2. Why is there an increase or decrease – any thing on
background of the question
3. If there situation has deteriorated or is generally not
looking good compared to industry – what are your
suggestions to improve the situation
Ratio Analysis

Financial
Liquidity Turnover
Leverage
Ratios Ratios
Ratios

Profitability Market Value

Ratios Ratios
 Ratio Analysis: Solvency & Liquidity Ration

Current Ratio = Current Assets

Current Liabilities
• Indicates entities ability to use current assets to repay current liabilities
• If ratio is too low- then there’s concerns on our liquidity

Quick Ratio = Current Assets – Inventory

Current Liabilities

• Indicates whether entity will be able to repay its current assets out of quick assets (i.e
cash and debtors excluding inventory as it takes longer to convert to cash

• If ratio is too low may be an indication that entity relies too much on inventory to pay
creditors

• Also if ratio is too high it might be that there’s too much cash on hand or debtors are
too high
 Ratio Analysis: Long term Solvency Ratios
Total Debt Ratio = Total Assets – Total Equity or Total Debt
Total Assets Total Assets
• Indicates what % of assets are financed by debt
• The higher the ratio the more concerning as it means there’s higher financial risk ( i.e the
numerator being debt is high)
ng term Solvency Ratios
Debt-Equity Ratio = Total Debt
Total Equity
• Also referred to as the gearing ratio
• Indicates the degree to which company's activities are financed by debt
• The higher the debt funding the higher the financial risk and the higher the related finance
costs
• Remember you want your business to be financed by more equity providers than debtors,
therefore you want the numerator to be high)

Times Interest Earned Ratio = EBIT

Interest
• Indicates the likelihood of the company defaulting on their interest payment.
• The lower the ratio, the higher the risk of default
• Remember you want the numerator, being interest to be low as it means the lest debt as less
financial risk)
 Ratio Analysis: asset Management / Turnover
measures
Inventory Turnover = Cost of Goods Sold
Inventory
• Indicates number of times inventory is sold and replaced during period under review, we want the ratio to
be high
• The lower the ratio, it means there’s too much inventory on hand, therefore higher holding costs,
company should aim to hold just enough inventory to meet sales demand
Days’ Sales in Inventory = Cos of Sales X 365 Days
Inventory Turnover
• Indicates the number of days it takes to turn inventory from purchases to sales, the shorter the period the
more efficient the inventory management process
Receivables Turnover = Sales X 365 Days
Trade Receivables
• Indicates how long it take company's debtors to settle their accounts
• The longer the period the more challenging as it implies debtors may be irrecoverable and higher risk of
having bad debt
Payables Turnover= Credit Purchases X 365 Days
Trade Payables
• Indicates how long it take company’s takes to settle its creditors
• The longer the period the more challenging as in the future suppliers may be reluctant to extend the
company's credit terms or may offer credit at more expensive terms
 Ratio Analysis

Profit Margin

Return on Assets

Return on Equity
 Ratio Analysis: Profitability ratios

Profit Margin = Net Income

Sales

• We would obviously want a high ratio here as it indicates that we have a high
profit

Return on Assets = Net Income

Total Assets

• Measures the profit per unit cash on Assets

• How well are we sweating ( using our assets) to generate profit

Return on Equity = Net Income

Total Equity

• Measures how shareholders fared during the year.

• How well are we using equity funding to generate income
 Ratio Analysis : Market Value Measures
Earnings per Share = Net Income
Shares Outstanding

Price-Earnings Ratio = Price per Share

Earnings per Share
• The PE Ratio measures how much investors are willing to pay per unit of
current earnings
• The higher the ration the better

Market-to-Book Ratio= Market Value per Share

Book Value per Share

This ratio compare the current market value of a company to its cost.
This means if the value derived from this calculation is 1. Then
Using Financial Statement
Information
 Using Financial Statement Information

Time Trend • Looks at the same ratio over

Analysis a number of years

• Compares ratio with similar

Peer Group firms
Analysis • Companies in same industry
(Check SIC Code)
 Using Financial Statement Information

Inappropriate • Some companies operate in several industries

Peers • Different Accounting Standards

Aspirant • You may want to compare your firm with the

best in the industry
Analysis • Choose similar firms at the top of the industry

Sources of • Financial websites: Yahoo! Finance, Reuters,

FT.Com, ADVFN.com, Motley Fool
Information • Company accounts: download from website
Using Financial Statement Information

Financial
The Percentage of
Statements can be
Sales approach to
used to plan over
Financial Planning
the long term

External Financing
Needed (EFN)
 Problems with financial statement analysis (
NB!!!!)
• No underlying theory exists to help us identify which quantities
to look at and to use in establishing benchmarks
• Many firms are conglomerates, owning unrelated lines of
business, and consolidated financial statements for such firms
do not fit any neat industry category
• Major competitors and natural peer group members in an
industry may be scattered around the globe
– Financial statements from outside the U.S. do not necessarily
conform to all GAAP principles
• Even companies that are clearly in the same line of business
may not be comparable
• Different firms use different accounting procedures
• Different firms end their fiscal years at different times
• Unusual or transient Education.
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