Analysis & Interpretation of Financial Statements

Basic Accounting & Financial
Management
Kurwa Guyashi
MSc. Accounting & Finance, BBA in Accounting, CPA (T), & CPB (TIOB)
Department of Accounting and Finance
Mzumbe University
Basic Accounting & Financial
Management
(ACC 281)
Analysis and Interpretation of Financial Statements
Kurwa Guyashi (MSc. Acc & Fin, BBA in Acc, CPA (T), & CPB (TIOB)) 2
Introduction
Analysis means establishing a meaningful
relationship between various items of the two
financial statements with each other in such a way
that a conclusion is drawn. By financial statements we
mean two statements :
 (i) Income statement (Trading, Profit and loss Account)
 (ii) Statement of Financial Position (Balance Sheet).
Analysis of financial statements is an attempt to assess

the efficiency and performance of an enterprise. Thus, the
analysis and interpretation of financial statements is very
essential to measure the efficiency, profitability, financial
soundness and future prospects of the business units.
Objective of Financial Statements Analysis
To use financial statements to evaluate an
organisation’s
 Financial performance
 Financial position.
To have a means of comparative analysis across time

in terms of:
 Intracompany basis (within the company itself)
 Intercompany basis (between companies)
 Industry Averages (against that particular industry’s
averages)
To apply analytical tools and techniques to financial

statements to obtain useful information to aid
decision making.
Parties (Users) Interested in Financial Statements
Analysis of financial statements has become very
significant due to widespread interest of various
parties in the financial results of a business unit. The
various parties interested in the analysis of financial
statements are :
1. Investors : Shareholders or proprietors of the
business are interested in the well being of the
business. They like to know the earning capacity of
the business and its prospects of future growth.
2. Tax authorities : Tax authorities are interested in
financial statements for determining the tax
liability.
Continues
3. Management : The management is interested in
the financial position and performance of the
enterprise as a whole and of its various divisions. It
helps them in preparing budgets and assessing the
performance of various departmental heads.
4. Trade unions : They are interested in financial

statements for negotiating the wages or salaries or
bonus agreement with the management.
5. Lenders : Lenders to the business like debenture

holders, suppliers of loans and lease are interested to
know short term as well as long term solvency position
of the entity.
Continues
6. Suppliers and trade creditors : The suppliers and
other creditors are interested to know about the
solvency of the business i.e. the ability of the company
to meet the debts as and when they fall due.
7. Researchers : They are interested in financial
statements in undertaking research work in business
affairs and practices.
8. Employees : They are interested to know the
growth of profit. As a result of which they can demand
better remuneration and congenial working
environment.
Continues
9. Government and their agencies : Government
and their agencies need financial information to
regulate the activities of the enterprises/ industries
and determine taxation policy. They suggest measures
to formulate policies and regulations.
10. Stock exchange : The stock exchange members
take interest in financial statements for the purpose of
analysis because they provide useful financial
information about companies.
Thus, we find that different parties have interest in

financial statements for different reasons.
Tools and Techniques of Financial Statement Analysis
Financial statements give complete information about
assets, liabilities, equity, reserves, expenses and
profit and loss of an enterprise.
They are not readily understandable to interested
parties like creditors, shareholders, investors etc.
Thus, various techniques are employed for analysing
and interpreting the financial statements.
Comparative financial statements
Common size statements
Ratio analysis
Industry comparison
Trend analysis
Comparative Financial Statements
In brief, comparative study of financial statements is
the comparison of the financial statements of the
business with the previous year’s financial statements.
It enables identification of weakpoints and applying
corrective measures. Practically, two financial
statements (balance sheet and income statement) are
prepared in comparative form for analysis purposes.
The comparative Financial statements has two

columns for the data of original financial statements.
A third column is used to show change
(increase/decrease) in figures. The fourth column
may be added for giving percentages of increase or
decrease.
Common Size Statements and Trend Analysis
The common size statements (Balance Sheet and
Income Statement) are shown in analytical
percentages. The figures of these statements are
shown as percentages of total assets, total liabilities
and total sales respectively.
Take the example of Balance Sheet. The total assets are
taken as 100 and different assets are expressed as a
percentage of the total. Similarly, various liabilities are
taken as a part of total liabilities.
The items in income statement can be shown as

percentages of sales to show the relations of each item
to sales.
Continues
Trend percentage analysis (TPA)
The trend analysis is a technique of studying several
financial statements over a series of years. In this
analysis the trend percentages are calculated for each
item by taking the figure of that item for the base year
taken as 100. Generally the first year is taken as a base
year. The analyst is able to see the trend of figures,
whether moving upward or downward.
In brief, the procedure for calculating trends is as :
One year is taken as a base year which generally is the
first year or last year.
Trend percentages are calculated in relation to base year
Ratio Analysis
A financial ratio is a relationship between two
accounting numbers. Ratios help to make a
qualitative judgment about the firm’s financial
performance.
Generally ratios facilitate comparison of:
One company over time (Time Series Analysis)
One company versus other companies (Inter- firms
Analysis
One company versus industry averages (Industry
Analysis)
Types of Ratios and their Interpretations
Generally there are five types of financial ratios.
 Liquidity ratios
 Profitability Ratios
 Working Capital Efficiency Ratios
 Investor Performance Ratios
 Financial Risk Ratios
Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its
current liabilities. It shows how solvent is a business. It
involves current ratio and Quick ratio.
 Current Ratio
Current ratio helps decide whether the current assets
will be able to generate sufficient cash to pay of the
current liabilities as and when they fall due. Looks at the
ratio between Current Assets and Current Liabilities
Current Ratio = (Current Assets / Current Liabilities)
Liquidity Ratios
Ideal level? – 2 : 1
A ratio of 5 : 1 would imply the firm has Tsh.5 of
assets to cover every Tsh.1 in liabilities.
A ratio of 0.75 : 1 would suggest the firm has only 75
cents in assets available to cover every Tsh. 1 it owes
Too high – Might suggest that too much of its assets
are tied up in unproductive activities – too much
stock, for example?
Too low - risk of not being able to pay liabilities.
Continues
Quick Ratio
Also referred to as the ‘Acid Test ratio’
Acid test ratio = Quick Assets / Current liabilities
Quick Assets = (Current assets – stock)
1.5:1 seen as ideal
The omission of stock gives an indication of the cash the firm has in
relation to its liabilities (what it owes)
A ratio of 3:1 therefore would suggest the firm has 3 times as much
cash as it owes – very healthy!
A ratio of 0.5:1 would suggest the firm has twice as many liabilities
as it has cash to pay for those liabilities. This might put the firm
under pressure but is not in itself the end of the world!
Profitability Ratios
Profitability measures look at how much profit the
firm generates from sales or from its capital assets.
These ratios analyze the profitability of the company.
Ratios in this category include the following:-

 Gross Profit Margin
 Operating Profit Margin
 Net Profit Margin
 Return on Capital Employed (ROCE)
 Return on Assets (ROA)
Continues
Gross Profit Margin
This ratio reflects the gross margin that a company
makes on its sales and is calculated as:
Gross Profit Margin = (Gross profit / turnover )x 100

 The higher the better
The higher this ratio
 The more efficient is the performance of the company
 The more efficient it is in controlling direct costs
 Turnover means Sales
Continues
Operating Profit Margin
This ratio reflects the operating margin that a
company makes on its sales.
Operating profit is the net profit before interest and
tax.
Operating Profit Margin = (Operating profit/Sales )x 100
 The higher this ratio:
the more efficient is the performance of the company
 The more efficient it is in controlling selling and

administration costs.
Continues
Net Profit Margin
This ratio reflect the net margin (before tax) that a
company makes on its sales and is calculated as:
Net Profit Margin = (Net profit (PBT)/Sales )x 100
 The higher this ratio the more efficient is the
performance of the company and the more efficient it is
in controlling its borrowings and borrowing costs.
Continues
Return on Capital Employed (ROCE)
This is the most important ratio as it measures the overall
performance of the company. It reflects the relationship
between the profits earned by a company and the size of
the company. i.e. the capital employed by the company, it is
calculated as:
ROCE = (Operating Profit/ Capital employed) x 100

The higher the better
 Shows how effective the firm is in using its capital to generate
profit.
 A ROCE of 25% means that it uses every Tsh. 1 of capital to

generate 25cents in profit.
Continues
Capital employed = Total Assets –Current liabilities
or
=Shareholders’ equity + all long term liabilities
Return on Assets (ROA)
This reflects the relationship between the profits
earned by a company and its total assets. It is
calculated as:
ROA = (Operating profit/ Total assets) x 100
The higher the ratio the more efficiently the assets are
managed.
Working Capital Efficiency Ratios
This set of ratios help us analyze how efficiently the
assets of a company are being used in generating
revenue. These ratios include the following:-
 Asset Turnover
 Inventory Turnover
 Receivable Days
 Payable Days
Continues
Asset Turnover
Asset turnover shows how much revenue is
generated by each Tsh. Worth of assets and is
calculated as:
Asset Turnover = (Sales Revenue/ Total assets)
(Times p.a)
Using assets to generate profit.

The higher the ratio, the more efficiently the assets are
being used to generate revenues.
Continues
Inventory Turnover
The rate at which a company’s stock is turned over
Inventory turnover
= (Cost of goods sold or Sales/ Average stock)
expressed as times per year
Average stock = (Opening + Closing stock) / 2
A high stock turnover might mean increased efficiency.
Continues
Receivable Days
This reflects the number of days it takes for a
customer to pay for the goods supplied on credit. It is
calculated as:
Receivable Days = (Receivable / Credit Sales) x 365
Days
Shorter the better
Continues
Payable Days
This reflects the number of days it takes for a company
to settle its bills. It is calculated as:
Payable Days = (Payables / Credit Purchases) x 365 Days
The longer the better.
Note: If a questions wants you to use 360 days a year you

need to follow that instruction but if the question is silent
then you need to use 365 days a year.

Investor Performance Ratios
Investors and potential investors primarily concerned

with knowing whether their actual or potential
investment is sound and what yield they can expect
to get from it. They would be interested in the
following ratios:
Earnings per share (EPS)
Price/ Earnings ratio (P/E)
Profit Retention Ratio
Dividend Cover
Continues
Earnings per share (EPS)
EPS is the amount of income earned during a period
per share of common stock.
It is given by the following formula:
= Profit available for distribution to ordinary

shareholders/Weighted average number of
ordinary shares outstanding
Continues
Remember: Profit available for distribution to
ordinary shareholders equal to profit after interest
and tax less preference dividend.
This ratio gives the shareholder (or prospective

shareholder) a chance to compare one year’s earnings
with another in terms easily understood.
Continues
Profit Retention Ratio
This ratio measures the extent of retained profits of
an entity. It is calculated as:
= (Profit after dividend/ Profit before dividend) x 100
The higher the ratio, the better the expected growth.
This is because shareholders expect the company to

retain more profits for further growth.
Continues
Dividend Cover
Measure the ability of the company to maintain its
existing level of dividends.
It is calculated as:
Dividend cover = Profit after tax/Dividend (Times)
The higher the ratio the more likely it will be for the
company to maintain the dividend yield and level of
dividends declared in the past.
Financial Risk Ratios
These ratios help to determine the stability of the
company and the ability of the company to repay its
long term debts. Ratios in this group include:-
 Capital Gearing Ratio
 Debt Ratio
 Interest Cover
Continues
Capital Gearing Ratio
This ratio is important measure of the company’s
risk and stability because it expresses the
relationship between a company’s borrowings and
its own funds. It is calculated as:
= (Total long term debts/ Shareholders’ fund) x 100
Total long term debts includes all items that have
to be classified as debts according to the
requirement of IAS 32 and IFRS 9. Debts include
long term borrowings, debentures, and
redeemable preference shares.
Continues
Shareholders’ fund include all items that have to be
classified as equity according to the requirements of
IAS 32 and IFRS 9. Shareholders’ funds include equity
share capital, irredeemable preference shares, and
reserves.
The higher the ratio, the more geared the company is.
This means that it relies heavily on debts for
conducting business.
Continues
The capital gearing ratio can also be calculated as a
relation between the long term debts and the total
long term funds (Equity + long term debts) of a
company. This is calculated as:
= (total long term debts/ (share holder’s funds + Long

term debts)) * 100
In this case, the capital gearing ratio shows how much
long term borrowing the company has for every Tsh.
100 of shareholders’ funds and long term debts taken
together.
Continues
Debt Ratio
It is the ratio of total liabilities (total debts) to total
assets. It is the percentage of the total funds obtained
from the trade payables.
The debt ratio can help the investors to determine

whether to invest in a particular company would be
risky. It is calculated as:
Debt ratio = (Total liabilities/ Total Assets) * 100
Continues
Interest Cover
This indicates how many times the profit covers the
interest charge. It is calculated as:
= Profit before interest and tax /Interest expenses
The higher the ratio the better, the company is in a

better position to pay the fixed charge of interest.
Corporate Evaluation using Ratio Analysis
Illustration
Guyashi Ltd is a diversified enterprise with its main
interests in the manufacture and retail of plastic products.
An investor is considering purchasing shares in the
company. The financial statements of Guyashi Ltd need to
be analysed. Relevant ratios need to be selected and
calculated and a report needs to be written for the investor.
The report should evaluate the company’s performance
and position.
In your report, you should state the possible reasons for and
significance of any changes in the ratios shown by your
calculations.
The following are its financial statements for the year

2006.
Guyashi Ltd
Statement of Financial Position as at 31 March
Guyashi Ltd
Statement of Financial Performance for year ended 31 March
Additional Information
Credit purchases for the year 2006 were Tsh.2,142,800.
General prospects for the major industries in which
Guyashi Co. is involved look good with a forecast glut of
oil set to reduce the cost of production and world
demand for plastic remaining strong.
Benchmarks:
There are no exact benchmarks for Guyashi Ltd because
it is a diversified company. The following are average
indicators that relate to the plastic retailing and
manufacturing industries for the year 2006.
 Gross profit margin 25%
 Net profit margin 7%
 Inventory turnover 6 times
 Capital gearing ratio 60%
 Return on Assets 12%
 Return on Capital Employed 20%
Limitations of Ratio Analysis
Ratio analysis is a widely used technique to evaluate
the financial position and performance of the firm.
But there are certain problems in using ratios.
The user should be aware of these problems. The
following are limitations of ratio analysis:
Continues
Limitations of financial statements
 Ratios are based only on the information which has
been
recorded in the financial statements.
Financial statements themselves are subject to several
limitations.
 For example, non-financial changes though
important for the business are not relevant by the
financial statements.
 Personal judgment plays a great part in determining

the figures for financial statements.
Continues
Standards of Comparisons
No fixed standard can be laid down for ideal ratios. There
are no well accepted standards or rule of thumb for all
ratios which can be accepted as norm. It renders
interpretation of the ratios difficult.
Price Level
A change in a price level can affect the validity of ratios
calculated for different time periods. In such a case the
ratio analysis may not clearly indicate the trend in solvency
and profitability of the company.
The financial statements, therefore, be adjusted keeping in
view the price level changes if a meaningful comparison is
to be made through accounting ratios.
Continues
Changing Situations
Ratios are useful in judging the efficiency of the business only
when they are compared with past results of the business.
However, such a comparison only provide glimpse of the past

performance and forecasts for future may not prove correct since
several other factors like market conditions, management
policies, etc. may affect the future operations.
Limited use of Single Ratios

A single ratio, usually, does not convey much of a sense. To make
a better interpretation, a number of ratios have to be calculated
which is likely to confuse the analyst than help him in making
any good decision.
Quality of assets is not reflected in the ratios.
Continues
Company Differences
Not only industries differ in their nature, but also the
firms of the similar business widely differ in their size
and accounting procedures etc.
It makes comparison of ratios difficult and
misleading.
Ratios alone are not Adequate
Ratios are not only indicators, they cannot be taken
as final regarding good or bad financial position of
the business. Other things have also to be seen.
Etc.
End
Thank You for Your Attention

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Basic Accounting & Financial

Analysis and Interpretation of Financial Statements

Analysis of financial statements is an attempt to assess

To have a means of comparative analysis across time

To apply analytical tools and techniques to financial

4. Trade unions : They are interested in financial

5. Lenders : Lenders to the business like debenture

Thus, we find that different parties have interest in

The comparative Financial statements has two

The items in income statement can be shown as

Current Ratio = (Current Assets / Current Liabilities)

Ratios in this category include the following:-

Gross Profit Margin = (Gross profit / turnover )x 100

 Turnover means Sales

 The more efficient it is in controlling selling and

ROCE = (Operating Profit/ Capital employed) x 100

 A ROCE of 25% means that it uses every Tsh. 1 of capital to

Using assets to generate profit.

Average stock = (Opening + Closing stock) / 2

A high stock turnover might mean increased efficiency.

Payable Days = (Payables / Credit Purchases) x 365 Days

The longer the better.

Note: If a questions wants you to use 360 days a year you

Investors and potential investors primarily concerned

= Profit available for distribution to ordinary

This ratio gives the shareholder (or prospective

This is because shareholders expect the company to

Dividend cover = Profit after tax/Dividend (Times)

= (total long term debts/ (share holder’s funds + Long

The debt ratio can help the investors to determine

Debt ratio = (Total liabilities/ Total Assets) * 100

= Profit before interest and tax /Interest expenses

The higher the ratio the better, the company is in a

The following are its financial statements for the year

 Personal judgment plays a great part in determining

However, such a comparison only provide glimpse of the past

Limited use of Single Ratios

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