Analysis and interpretation of financial statements

*firms analyse and interpret their financial statements

in order to assess their performance and progress
*analysis involves detailed examination and review of
information provided in a set of financial statements
of a business
– the results of this analysis are interpreted in order to
assess performance of the business
*interpretation includes comparing results with:
(a) results of other similar businesses
(b) own targets and budgets
(c) results from previous years
Accounting ratios
*are all calculations involved in interpreting
financial statements which may include
ratios, percentages and time periods.
NB*Unless stated in the examination, show
the ratios correct to two decimal places
*the categories include:
1. liquidity ratios
2. profitability ratios
3. efficiency ratios
Important terms
Working capital – is the amount of capital available for the day-to-day
running of the business
– it is basically the difference between current assets and current
liabilities
– it can also be called net current assets
Capital owned – is the amount owed by the business to the owner(s)
of that business at a certain date.
Capital employed – is the total amount of funds used in a business and
it consists of the owner’s capital and non-current liabilities
*it can be calculated as follows:
(i) non-current assets plus working capital or,
(ii) total assets less current liabilities or,
(iii) non-current liabilities plus current liabilities less current
liabilities or,
(iv) owner’s capital plus non-current liabilities
*it can also be referred to as net assets
 Jon Bruno
Income Statement for the year ended 30 May 2014
$ $
Revenue (sales – all on credit) 50 000
Less Cost of sales
Opening inventory 12 000
Add Purchases (all on credit) 36 000
48 000
Less Closing inventory 8 000 40 000
Gross profit 10 000
Less Expenses 5 000
Profit for the year 5 000
 Statement of as at 31 May 2014
$ $
Non-current assets 12 000
Current assets
Inventory 8 000
Trade receivables 6 000
Bank 4 000 18 000
Total assets 30 000

Capital and liabilities

Capital – opening balance 17 000
Add Profit for the year 5 000
22 000
Less Drawings 2 000
20 000
Current liabilities
Trade payables 10 000
Total capital and liabilities 30 000
The ratios
1. liquidity ratios
2. profitability ratios
3. efficiency ratios
Liquidity ratios
*liquidity means the ease and speed with which
assets can be turned into cash
*it is the ability of a firm to meet its short term
debts when they fall due
The ratios are:
(a) current ratio
(b) quick (or acid-test or liquid) ratio
Current ratio (or working capital ratio)
*compares the assets which will become liquid
within one year with the liabilities due for
payment in that period i.e. it measures the ability
of a business to meet its current liabilities when
they fall due
**satisfactory ratio is 2:1 (i.e. anything between
1.5:1 and 2:1) – however, this depends on the size
and type of business
*anything above 2:1 may imply poor management of
current assets e.g. a lot of capital tied up in
inventories.
NB: sufficient working capital is needed to finance
the day-to-day activities of a business
Current ratio = current assets : current liabilities
OR = current assets__
current liabilities
= 18 000
10 000
= 1.8 : 1
Consequences of having insufficient working capital
1. problems in meeting debts (or liabilities) when they fall
due
2. inability to take advantage of cash discounts
3. difficulty in obtaining further supplies on credit
4. inability to take advantage of business opportunities
when they arise
Ways of improving working capital
1. introduction of further capital by the owner(s) – i.e. capital
injection
2. selling surplus non-current assets
3. obtaining non-current loans
4. reducing drawings by owner(s) – or reduction in dividends
5. increasing profit
6. delaying buying non-current assets
Reasons why it is important to have adequate working capital
7. to be able to meet debts when they fall due
8. to be able to take advantage of cash discounts
9. to ensure that there is no difficulty in obtaining further
supplies on credit
10. to be able to take advantage of business opportunities
when they arise
Possible reasons for a change in current ratio
A decrease
1. increase in current liabilities greater than
the increase in current assets
2. increase in bank overdraft
3. increase in trade payables
4. decrease in inventory
5. decrease in trade receivables
An increase
1. increase in current assets greater than the
increase in current liabilities
2. increase in trade receivables and no significant
change in current liabilities
3. increase in bank and no significant change in
current liabilities
4. increase in inventory and no significant change in
current liabilities
5. decrease in trade payables and no significant
change in current assets
Quick ratio (or acid test ratio or liquid ratio)
*compares the assets which are in monetary form, or which
will convert into cash quickly, with the liabilities which are
due for repayment in the near future
NB*It excludes inventory which is not regarded as a liquid
asset (or which is regarded as the least liquid asset)
* inventory takes two stages to turn into money or to become
liquid:
(i) selling the inventory
(ii) collection of money from trade receivables
**the ratio shows whether the firm would have surplus liquid
funds if all current liabilities were paid immediately from
liquid funds.
*satisfactory ratio is 1:1 – but also depends on the size and
type of business
 a ratio 1:1 indicates that the immediate liabilities can be
met out of the liquid assets without having to sell
inventory (which may have to be sold at a reduced price)
**depending on the business, a ratio more than 1:1 may
indicate poor management of liquid assets e.g. too high
bank balance – which may indicate that funds are not
being used to the best advantage of the firm
Quick ratio = current assets less inventory : current liabilities
OR = current assets – inventory
current liabilities
= 18 000 – 8000 = 10 000 =1:1
10 000 10 000
OR = liquid assets : current liabilities
Possible reasons for a change in quick / acid-test / liquid ratio

A decrease
1.greater proportion of current
assets in the form of inventory
2.increase in bank overdraft
3.increase in trade payables
4.decrease in trade receivables
An increase
1. reduced proportion of current
assets in the form of inventory
2. decrease in bank overdraft
3. decrease in trade payables
4. increase in trade receivables
How to improve actual cash position
1. increase the proportion of cash sales
2. reduce collection period for trade receivables
3. take longer to pay trade payables
4. debt factoring and invoice discounting
Negative effect of the above
1. may lead to fewer customers (1 and 2), as customers
move to other suppliers where longer credit is allowed
2. suppliers may refuse further supplies in the future until
outstanding amount is paid
3. customers may not want to work with the factoring
company and take their business to other suppliers
Summary
**quick ratio is regarded as a better indicator of liquidity
because:
– it does not include inventory in its calculation
– inventory is not regarded as a liquid asset
– a buyer has to be found
– and then the money collected
– some inventory may prove to be unsaleable
*quick ratio shows whether the business would have any
surplus liquid funds if all the current liabilities were paid
from the liquid assets
Profitability ratios
*relate profit figures to other figures within the
same set of financial statements
The ratios are:
(a) Gross profit as a percentage of sales/revenue
or gross profit/sales ratio
or gross profit margin
or gross margin
(b) Profit as a percentage of sales/revenue
or profit/sales ratio
or profit margin
(c) Return On Capital Employed (ROCE)
Gross profit margin
*can be termed gross profit as a percentage of
turnover or simply, gross margin
NB*Turnover (net sales) equals sales less sales
returns
*the ratio measures the gross profit earned for every
$100 of sales and indicates how profitable the
sales were
*it may be similar from year to year and it varies
with different industries
*generally, the higher the return, the more
profitable is the business
Gross profit margin = Gross profit_ x 100
Sales(revenue) 1
= 10 000 x 100 = 20%
50 000 1
Reasons for an increase in gross profit margin
1. buying goods from cheaper suppliers
2. increasing the selling price (*may lead to loss of customers)
3. increasing advertising and promotion
4. stricter control of cost of goods sold
5. reducing the trade discounts to customers
6. buying in large quantities and obtaining huge discounts
(hence, lower cost per unit)
7. changing the proportions of different types of goods
8. passing on increased costs to customers
Reasons for a decrease in gross profit margin
1. selling goods at cut prices (reduction in selling
price)
2. offering trade discounts to customers buying in bulk
– or increasing the rate of trade discount
3. not passing on increased costs to customers
4. holding seasonal goods
5. a difference in how much has been sold of each sort
of goods (sales mix) between different years with
different kinds of goods carrying different rates of
gross profit per $100 of sales
6. increase in cost of supplies
How to improve gross profit percentage
1. increasing selling price
2. increase advertising and sales promotion
3. obtaining cheaper supplies
4. changing the proportions of different types of goods
5. passing on increased costs to customers
Importance of gross profit ratio (e.g. to Jon Bruno)
6. it measures the success in selling goods
7. the ratio shows the gross profit earned per $100 of sales
(i.e. $20)
8. the ratio can be compared with previous years
9. the ratio can be compared against other businesses
10. Jon Bruno has spent 80% of the sales income on the cost of
goods sold
Profit to sales ratio or profit margin
*measures the profit earned for every $100 of sales
*it indicates how well a business is able to control
its operating expenses – if the profit margin
increases it indicates that the expenses are being
controlled
*the higher the return, the more profitable the
business is.
Profit margin = Profit for the year x 100
Revenue 1
= 5 000 x 100
50 000 1
= 10%
Reasons for an increase in profit margin
1. increase in gross profit margin
2. reduction in expenses (better control of expenses),
e.g. reduced staffing levels, reduced advertising etc
3. difference in types of expenses (fixed and variable)
4. increase in other income – rent received, discount
received etc
Reasons for a decrease in profit margin
1. decrease in gross profit
2. increase in expenses (worse control of expenses),
e.g. increased staffing levels, increased
advertising etc
3. a change in the type of expenses (fixed and
variable)
4. decrease in other income – rent received,
discount received etc
Importance of profit margin
1. it measures the overall success of the business
2. the ratio shows the profit earned per $100 of
sales
3. the ratio can be compared with previous years
4. the ratio can be compared against other
businesses
5. Jon Bruno has spent 10% of the sales income on
expenses
Return on capital employed (ROCE)
*is a measure of the profit as a percentage of
the amount invested in the business in order
to earn profit
*shows profit earned for every $100 of capital
employed
*the higher the return, the more efficiently the
capital is being employed within the business
*therefore, it also measures primary efficiency.
ROCE = Profit for the year) x 100
Capital employed 1
= 5 000_ x 100
20 000 1
= 25%
Reasons for an increase
1. increase in profit margin
2. decrease in capital employed
Reasons for a decrease
3. decrease in profit margin
4. increase in capital employed
Importance of ROCE
1. it shows the profit earned per $100 of the
capital employed in the business
2. the ratio can be compared with previous
years
3. the ratio can be compared against other
businesses
4. the ratio measures the overall profitability
of the investment in the business
5. the ratio shows how efficiently the capital is
being employed
Efficiency ratios
*measure the efficiency of a business and the ratios are:
(a) Rate of inventory turnover
(b) Trade receivables turnover or collection period for trade
receivables
(c) Trade payables turnover or payment period for trade payables
NB* These ratios can also be categorised under liquidity ratios

Rate of inventory turnover

*is the number of times a business sells and replaces its
inventory in a given period
*the quicker the inventory is turned, the greater the gross profit
(provided the profit margin is maintained)
*it can also be referred to as inventory turn
NB*Businesses selling luxury goods e.g. expensive
jewellery will have a low rate of inventory
turnover while businesses selling low value
‘everyday’ requirements e.g. bread/newspapers
will have a high rate of inventory turnover
* rate of inventory turnover may be the same from
year to year for a particular business
* an increase in the rate indicates improved efficiency
* a decrease may also indicate too much inventory for
the business or that the sales are slowing down
* the quicker the rate, the less time funds are tied up in
inventory which is regarded as the least liquid of the
current assets
Factors causing a lower rate of inventory turnover
1. lower sales (resulting in higher inventories)
2. too high selling prices
3. inventory over-purchased (keeping a high figure
of inventory than is really necessary)
4. falling demand
5. business activity slowing down (sales activity
slowing down)
6. business inefficiency
Rate of inventory turnover
= cost of sales___
average inventory
**This gives the number of times inventory is sold
and replaced in the given period.
OR = average inventory x 365
cost of sales 1
**This gives the number of days on average the
inventory is held before being sold
NB*Average inventory
= (opening inventory + closing inventory)
2
Rate of inventory = Cost of sales___
Average inventory
= 40 000_____
(12 000 + 8 000)/2
= 40 000
10 000
= 4 times
OR = Average inventory x 365
Cost of sales 1
= 10 000 x 365
40 000 1
= 91.25 days
= 92 days (to the nearest whole day)
How to improve rate of inventory turnover
1. reduce inventory levels
2. generate more sales activity
3. only replace inventory when needed

Collection period for trade receivables

*can also be referred to as the trade receivables/sales
ratio or trade receivables turnover
*it measures the average time the credit customers
(trade receivables) take to pay their accounts
*the quicker they pay, the better as the money can be
used elsewhere in the business
Collection period for trade receivables/trade receivables turnover
= trade receivables x 365
credit sales 1
**This gives an answer in days

= trade receivables x 52
credit sales 1
**This gives an answer in weeks

= trade receivables x 12
credit sales 1
**This gives an answer in months
Collection period for trade receivables/trade receivables turnover
= trade receivables x 365
credit sales 1
= 6 000_ x 365
50 000 1
= 43.8 days
= 44 days (to the nearest whole day)
Comparison
* the ratio may be the same from year to year for a
particular business – which indicates consistency
*a decrease may indicate that the business has a more
efficient credit policy
*an increase may indicate an inefficient credit policy or –
that the business is having to allow longer credit terms
to maintain the quantity of credit sales
Comment
*it is used to compare the actual collection period for
trade receivables with the terms of credit when the
goods were sold
NB*the older the debt is allowed to become, the greater
the risk of having a bad debt.
How to improve collection period for trade receivables
1. offer cash discounts for early settlement of
debts
2. charge interest on overdue accounts
3. refuse further supplies until any outstanding
balance is paid
4. improve credit control policy (e.g. sending
invoices and statements of account promptly
or regularly, chasing overdue accounts etc)
5. consider invoice discounting and debt factoring
Advantages of collecting the trade receivables before due date
1. can use the money to pay the trade payables
2. can use the money within the business
3. may reduce a bank overdraft
4. may reduce the need for a bank overdraft
5. reduces the risk of bad debts
Reasons for an increase in the collection period for
trade recievables
6. less efficient credit control policy
7. allowing longer credit to maintain sales
8. not allowing cash discounts
Payment period for trade payables
* can also be referred to as the trade payables/purchases ratio
or trade payables turnover
* it measures the average time taken by a business to pay the
credit suppliers’ accounts
* may be the same from year to year in a particular business
* a decrease means that the business is paying its trade
payables more quickly
* an increase may mean that the business is in short of
immediate funds hence, it is finding it difficult to meet debts
when they fall due
* it may be influenced by the collection period for trade
receivables – if credit customers take longer to pay, the
business may not be able to pay its credit suppliers promptly
(the knock-on effect)
Payment period for trade payables / trade payables turnover
= trade payables x 365
credit purchases 1
**This gives an answer in days

= trade payables x 52
credit purchases 1
**This gives an answer in weeks

= trade payables x 12
credit purchases 1
**This gives an answer in months
Payment period for trade payables / trade payables turnover
= trade payables_ x 365
credit purchases 1
= 10 000 x 365
36 000 1
= 101.39 days
= 102 days (to the nearest whole day)

Advantages of paying trade payables after due date

1. money can be used for other things within the
business
2. may avoid bank charges/bank interest
Disadvantages of paying trade payables after due date
1. loss of cash discounts for early settlement
2. suppliers may refuse further supplies until outstanding
balance is paid
3. suppliers may insist on cash purchases in the future
(suppliers may refuse credit in the future)
4. damage to good relationship with suppliers
5. may be charged interest
Reasons for an increase in the payment period for trade
payables / trade payables turnover
6. shortage of liquid funds
7. knock-on effect of trade receivables taking longer to pay
8. suppliers not allowing cash discounts
Inter-firm comparison
*comparing ratios for the current financial year with
those of previous years helps to measure progress
and performance of a business and indicates
trends in profitability, liquidity and efficiency
*comparison can also be done with ratios of other
similar businesses
*to give meaningful results, the comparison should
be made with:
(a) a business of the same type
(b) in the same trade/industry and,
(c) approximately of the same size
Problems of inter-firm comparison
1. the accounts may be for one year only which will not show business
trend – and that year may not be a typical one
2. the businesses may use different accounting policies e.g. one using
straight line method and the other reducing balance method of
depreciation
3. the financial years may end at different dates hence, the periods
covered by the accounts are different
4. other differences may affect profitability and statement of financial
position items e.g. one business may own premises while the other
rents them
5. the accounts are based on historic cost and do not show the effects of
inflation
6. the accounts do not show non-monetary items e.g. quality of
management, goodwill, competition etc
7. it is not always possible to obtain the information about another
business which is needed to make a true comparison
Reasons why one may not compare two businesses
1. sole trader versus partnership
2. manufacturing versus service
3. run by owner versus run by a manager
4. one year old versus two or more years old
5. one sells goods on cash basis only versus credit
sales only
6. one rents premises versus one which owns and
maintains own premises (different types of
expenses)
7. different types of non-current assets
(machinery/premises/fixtures)
What to consider when comparing results with those of a similar business
1. the accounts may be for one year and do not show
trends
2. the accounts may not be for a typical year
3. the financial year may end at a different point in the
trading cycle
4. the business uses different accounting policies e.g.
depreciation
5. the accounts do not show non-monetary items but these
are important in the success of a business
6. it is not always possible to obtain all the information
about a business in order to make a true comparison
7. there may be differences that affect profitability e.g. one
rents premises and the other owns them
Users of accounting information
Owners/shareholders
1. assessment of past performance
2. basis of future planning
3. assessment of management
Managers
4. assessment of past performance
5. basis of future planning
6. control the activities of the business
7. identify areas where corrective/remedial action
is required
Workers/employees (and trade unions)
1. to decide whether the firm is secure enough to pay
adequate wages and salaries (and contribute to
pension schemes)
2. to determine whether jobs are secure
3. to find out if profits are rising, and whether a wage
increase can be afforded
Lenders
4. assessment of prospects of any loan being paid when
due
5. assessment of any interest on loan being paid when
due
6. assessment of the security available to cover any loan
Bank manager (and lenders)
1. to assess the prospects of any requested bank loan or
overdraft being paid when due
2. to assess the prospects of any interest on loan/overdraft
being paid when due
3. determine conditions and terms of lending
4. assessing of the security available to cover any
loan/overdraft
Credit suppliers of goods (trade payables)
5. identify how long the business takes to pay credit
suppliers
6. identify future prospects of the business
7. identify what credit limit is reasonable
8. assessment of liquidity position
Potential buyers
1. to assess the profitability of the business
2. to assess the market value of the assets of the
business
Customers
3. to assess whether the business is secure
4. to determine whether they will be assured of
future supplies of the goods they are purchasing
5. to establish whether there will be security of
spare parts and service facilities
Government (and tax authorities)
1. to check that the correct amount of tax is being
paid
2. to compile business statistics
3. to determine whether the business is likely to
expand and create more jobs
Local community
4. to see if the business is profitable and likely to
expand
5. to determine whether the business is making
losses and whether this could lead to closure
Limitations of accounting statements
Time factor
*accounting statements are a record of what has
happened in the past
– they are not necessarily a guide to future
performance
– because there is a gap between the end of the
financial period and the preparation of financial
statements, significant events can occur between
the end of the financial period and the time when
the accounting statements are available e.g.
changes in inventory levels or purchase of non-
current assets
Money measurement
*accounts only record information which can be
expressed in monetary terms
– this means that many factors which affect the
performance of a business will not appear in the
accounting records
– factors within the control of the business include:
– quality of management
– the skill and reliability of the workforce
– goodwill of the business
– age and condition of non-current assets
– ability to adapt in response to changing
market conditions
*factors outside the control of the business include:
– government policies
– competition
– impact of new technology
– changes in tastes and fashion
– future long-term prospects of the
particular trade or industry
Historic cost
*all transactions are recorded at the actual cost price
– it is, therefore, difficult to compare transactions
taking place at different times especially because of
inflation
Accounting policies
*all businesses should apply accounting principles of
prudence and consistency which helps in making
comparisons
*however, there are several acceptable accounting
policies which may be applied
*thus, where businesses have used different
accounting policies, it is difficult to make a
meaningful comparison of their results e.g.
depreciation
*if a business changes its policy, a comparison with
the results of previous years is difficult
Different definitions
*the profit figure for the year may be adjusted for
loan interest and sometimes preference share
dividend (not applicable at this level)
*but a comparison of results is only meaningful if
“like is compared with like” and the same
definitions are applied