Module 6 – Interpretation of Financial Statements
Introductory Points:
 Absolute Figures in financial statements do not tell the reader very much
 Percentages or ratios permit easy comparison between different corporate entities
 Ratios can be used to suppress poor absolute figures
 Using year end figures may not reflect the typical financial situation during the year
 There’s wide diversity in approaches to financial analysis – e.g. companies define ‘profits’ differently.
What’s important is that there is consistency in how companies apply their definitions
 Its important to use trends rather than just take one year’s ratios
 Group financial statement should be used where possible for ratio analysis
6.3 Liquidity Ratios
These ratios are designed to measure a company’s ability to meet its maturing short term obligations.
Name
Current Ratio
Ratio
Current Assets
Current Liabilities
What ratio means
A company is in a good position
to meet its current obligation if
the Current Ration > 1. Rule of
thumb: Current Ratio >2 means
a sound financial situation
Quick Ratio
(Acid Test)
Current Assets – Inventory
Current Liabilities
Removing inventory from the
Current Analysis provides a
more rigorous test. Rule of
thumb: >1 means it can meet its
short term obligations. This ratio
does not include the company’s
ability to raise cash from other
sources.
Comments
Since nothing is
known about the
marketability of
inventory, this ratio
can give misleading
results.
If less than 1 and
current ratio > 1 then
company should look
at its stock control.
Inventory means the
value of closing
inventory in Balance
Sheet.
6.4 Profitability Ratios
These ratios are designed to measure management’s overall effectiveness: does the company control
expenses and earn a reasonable return on funds committed.
Name
Gross Profit
Margin
Ratio
Gross Profit x 100%
Sales
Profit Margin
Profit before Interest and Taxes x 100%
Sales
What ratio means
First critical measure
of profit
Comments
sometimes difficult
to get a satisfactory
measure of gross
profit from
published accounts
Note that profit is
defined as net profit
before interest and
taxes and before
financing charges.
Also, add in profit
(loss) from
associated
companies
Return on
Total Assets
Profit before Interest and Taxes x 100%
Total Assets
Profit is not the only
function of sales, it
is also closely
related to assets
employed by the
company to product
the profit.
A company with a
higher return is
working its assets
more. Lower figures
may require the
shedding of
unproductive
assets. Total
Assets= Fixed
+Current
Return on
Specific
Assets
Profit before Interest and Taxes x 100%
Inventory
Inventory here is
closing stock from
balance sheet. This
could include
finished goods, raw
materials and
stocks in progress.
Return on
Capital
Employed
Profit before Interest and Taxes x 100%
Capital Employed
A company can
relate profit to any
individual asset – in
this case Inventory
Also, add in profit
(loss) from
associated
companies
Capital employed is
the total assets of a
company minus the
current liabilities.
Return on
Owners Equity
Profit Attributable to Shareholders x 100%
Owners Equity
Relates profit
earned to the capital
(contributed and
accumulated) of the
ordinary
shareholders of the
company
Note that profit is
defined as net profit
before interest and
taxes and before
financing charges.
Also, add in profit
(loss) from
associated
companies
Profit attributable to
shareholders
means net profit
after interest and
tax and after
removing the profits
attributable to
minority interests
but before
dividends
6.5 Capital Structure Ratios
Capital Structure Ratios are divided into two groups:
 those that examine the asset structure of the company
Name
Fixed to
Current Asset
Ratio
Fixed Assets
Current Assets
What ratio means
For every $1
invested in current
assets, how much
was invested in
fixed?
Comments
Fixed Assets =
Tangible + Non –
Tangible Assets.
Non Tangible would
be long term
investments etc.
 those that analyze the financing arrangements of the company’s total assets, in particular the amount
the company relies on debt – gearing ratios.
Gearing ratios (sometimes known as leverage) measure the contribution of shareholders against that
provided by creditors and providers of loan capital. If the owners have provided only a small proportion of
capital then the risks are borne mainly by creditors. In this situation if the earns more on the borrowed
funds then it pays in interest, the return to the shareholders is magnified. So assets earning 13% and with
an interest rate of 11%, the 2% differential accrues to the shareholders.
Companies that are highly geared:
Recession = high interest rates = lower returns to shareholders
vice versa in boom times
Name
Debt Ratio
(Gearing %)
Time Interest
Earned
Ratio
Total debt
Total Assets
Profit before Tax +Interest Charges
Interest Charges
What ratio means
For every $1 invested in
assets, how much was
contributed by those
other than company
shareholders
It measures the extent to
which earnings can
decline without the
company defaulting on
annual interest
payments
Comments
Total Debt = all
creditors (including
all loans) and
provision minus
minority interest
 Efficiency Ratios
Efficiency ratios give an indication of how effectively a company has been managing its assets.
Name
Ratio
What ratio means
Comments
Inventory
Sales
How often inventory turned over
The inventory figure is
Turnover
Inventory
during the year.
taken from year end –
Many companies are working with
this may lead to incorrect
suppliers to implement Just-in-Time
figures if the company
inventory management for raw
stocks up at year end.
materials. Finished goods are a guard Different industries have
against a sudden surge in demand –
different inventory
a careful review could help reduce
turnovers. e.g. for PC
this
chip makers the market
is prone to price swings
Average
Debtors
This is the average length of time that The greater the number
Collection
Sales per day
a company must wait after making a
the more the chance of
Period
sale before receiving payment
slack credit management
Fixed Asset
Turnover
Sales
Fixed Assets
Relates investment in Fixed Assets to
the level of sales generated therefrom
Only useful when
comparing to
competitors or previous
years. Differences could
be due to more efficient
working of fixed assets
or different valuations of
fixed assets
6.9 The Dupont Chart:
Name
Return on
Total Assets
Ratio
Profit x Sales
Sales Total Assets
What ratio means
How much are we making from our
investment in total assets?
The larger the figure the better.
Note: this is different from Return on
Total Assets ration because that used
Profits before interest and taxes as the
numerator rather than the more
detailed definition of profit used here.
Comments
Profit here is
defined as Sales
minus Operating
Costs.
Operating Costs
include cost of
sales, distribution,
R&D and
Administration.
In other words
Profit is defined as
trading profit.
6.10 The One Hundred Percent Statement:
This statement is where sales are set at 100% and all costs are transformed into a percentage of sales.
When all the operating costs are totaled up, the % difference between them and one hundred % is the
trading profit %.
6.11 Stock Market Ratios
These ratios deal with how the Stock Exchange views a company’s future prospects.
Name
Earnings Per
Share
Ratio
Net Profit for the financial year
Number of Ordinary Share in issue
Price/Earnings
Ratio
Market Price
Earning Per Share
Dividend Yield
Dividend per Share
x 100
Market Value per Share
What ratio means
This tells investors how
many years of profits are
being purchased by buying
a share at the current
market price
Dividend return to be
enjoyed based on the
market price of the share
Comments
The Net Profit
figure is after
everything –tax,
interest etc. but
before the dividend
In ICI’s case, the
dividend can be
found on Page 5/37
– its 30p.
Normally the
company has to be
tax on dividends –
in the UK its 20%.
So sometimes the
company will add
this tax to the
dividend per share
figure before
calculating Dividend
Yield
Dividend
Cover
Net Profit of the year
Dividend Payout
This ratio is designed to
calculate and draw
attention to over-generous
management decisions to
pay out too much. The
larger the ratio the more
cover it has for dividend
payout
Usually, net profit
includes
exceptional items
Review Questions:
1. c
2. d
3. d
4. d
5. a
6. a
7. b
8. c
9. c
10. d
11. Note 14 Page 5/78 – 1994: Current Assets – Stocks (HK$) = 7500 – 834= 6666; Current Assets +
Other Liquid Funds = 6666+13202 = 19868; Quick Ratio = 19868/12317 = b
12. Profit here means net profit before interest and taxes, add back ‘Net finance charges’ (Interest)
3172 + 597 = 3769. You also should include profit from associated companies: 3769+379=4148
Profit/Sales x100% = 4148/30454 x 100% = 10.41%, Ans: b
13. 1994: Total Assets = Fixed +Current Assets + Long Term Investments + Other Liquid Funds= 24434
+ 7500 + 1894 + 13202 = 47030. Profit = 2600+557+381=3538. Ratio = 7.52 = c
14. 1995: Profit Attributable to Owners = 2978. Owners Equity = 17064. Ratio = 17.45% = c
15. 1994: Fixed Assets = Tangible + Non Tangible = 24434 + 1894 = 26328. Ratio =
26328/(7500+13202) = 26328/20702 = 1.27 x100% = 127% = d
16. Total Debt = Current Liabilities + Provisions for liabilities + Long term Liabilities – Minority Interest
For 1994: 12371 + (3006-2264) + 18517 - 88 = 31542
For 1995: 12062 + (3954-981) + 19755 – 99 = 34691
Total Assets = Fixed Assets +Long Term Investments + Current Assets + Other Liquid Funds
For 1994: 24434 +1894 + 7500 + 13202 = 47030
For 1995: 29528 + 2082 + 7557 + 12687 = 51854
Ratio for 1994 = 31542/47030 = 67.06%
Ratio for 1995 = 34691/51854 = 66.9%
An decrease of 0.16%
He includes minority interests as a debt – this is incorrect!
17. b
18. 1994: Profit before taxes and Interest = 2600 + 557 = 3157. Now add in profit from associated
companies = 3157+ 381 = 3538. Ratio = 3538/557 = 6.35 = c
19. 1994: 27215/834 = 32.63 = a
20. d
21. 1995: 5323/(30454/365) = 5323/83.43= 63.8 days = c
22. 1994: 27215/(24434+1894) = 1.03 = c
23. 1995: 6376/30454 x 100% = 20.94% = b
24. a
25. Presume all figures in question are in thousands. Dividend per share = .14, Dividend Yield Ratio =
.14/3.5 = 4% = a
26. EPS = 367,500/700,000 = 0.525 = c
27. 3.5/.525 = 6.7
28. 397500/98000 = 4.05 = d
29. 1995: from Page 5/81, the total amount of authorized shares is 3.9M. The revised EPS would be
2978/3900 = 0.76 = b
30. 1994: 2388/1203 = 1.98 = b
31. 1994: Dividend per share = Dividend in millions/ number of share in issue in millions = 1203/2864 =
0.42. Dividend yield = 0.42/6.25 = 6.72% = d
32. 1995: EPS = $1.04. PE Ratio = $7/$1.04 = 6.73 = a
Case Study 6.1
First thing to say – because both firms are in the same industry and approximately the same size, ratio
analysis is particularly useful in analyzing their relative strengths and weaknesses
(i)
Liquidity
Ratio
Current
Quick
Crail Binding
46000/31000 = 1.48
(46000 – 18000)/31000 = 0.9
Tayport Publishing
20000/6000 = 3.33
(20000 – 8000)/6000 = 2
The Current ratio shows both companies are able to meet their short term obligations from their current
assets but the quick ratio shows that when the inventory is removed from current assets Crail will no
longer be able to do so. Since both are in the publishing inventory, the inventory that Crail have on hand
at the end of the year must be marketable and sellable. Tayport look good from these figures.
(ii)
Profitability
Ratio
Gross Margin
Profit Margin
Return on Total
Assets
Return on
Inventory
Crail Binding
38000/68000 = 56%
12000/68000 = 18%
12000/56600 = 21%
Tayport Publishing
38000/61000 = 62%
7000/61500 = 11%
7000/28300 = 24%
12000/18000 = 66%
7000/8000 = 87%
Return on Capital
Employed
Return on Equity
12000/25600 = 47%
7000/22300 = 31%
9000/10000 = 90%
5250/12000 = 44%
Although Tayport has a larger Gross Margin, it’s Net Profit margin becomes less than Crail’s – this could
is due to the higher cost of sales that Tayport. This may be because of higher wages or higher cost of raw
materials – perhaps Tayport is producing a better quality good for the higher end of the market.
Tayport works its total assets slightly harder than Crail and in particular works its Inventory harder. This
ties in with the difference in the Quick ratio figure above. Crail could do with some better inventory
management.
Capital Employed?
Crail’s shareholders are seeing a higher return due to their higher return on equity – this is because the
company is more highly geared than Tayport and in times of high profits, the shareholders do well. This
may well change if the business environment changes and profits drop.
(iii)
Capital Structure
Ratio
Fixed to Current
Debt Ratio
Times Interest
Earned
Crail Binding
10600/46000 = 23 %
(31000 + 10000)/(10600+46000) = 72%
No Interest Figure available
Tayport Publishing
8300/20000 = 41%
(6000)/(8300+20000) = 21%
For every $1 spent on current assets, Crail spends $0.23 on fixed while Tayport spends $0.41. This
shows that Tayport is spending relatively more on Fixed Assets which may be because it’s a younger
company.
The debt ratio shows that for every $1 spent on assets, for Crail $0.72 came from sources of debt while
Tayport had $0.21 come from sources other than shareholder funds. This means that if there is a
downturn in the market (interest rates go up and profits down), then the return on equity will reduce for
Crail.
(iv)
Efficiency:
Ratio
Inventory Turnover
Avg. Collection
Time
Fixed Asset
turnover
Crail Binding
68000/18000 = 3.77
28000/(68000/365) = 150 days
Tayport Publishing
61500/8000 = 7.69
10000/(61500/365) = 59 days
68000/10600 = 6.41
615000/8300 = 7.4
Tayport seems to be closer to implementing a just in time policy in inventory control – they have a higher
turnover in inventory during the year which means that their inventory is not left sitting around in a
warehouse.
They also have a better collection time – showing better debtor management. The fixed asset turnover
really needs to be compare with the industry average to have meaning.
Rough
6.1Case Study
(i)
(ii)
(iii)
(iv)
Liquidity
Profitability
Capital Structure
Efficiency
(i)
Liquidity
Current Ratio = Current Assets/Current Liabilities
Crail = 1.48
Tayport = 3.333
Quick Ratio = Current Assets – Inventory/Current Liabilities
Crail= 0.9
Tayport = 2
(ii)
Profitability
Gross Margin = Gross Profit /Sales
Crail = 0.55
Tayport = 0.38
Profit Margin = Net profit before tax/Sales
Crail = 0.17
Tayport = 0.11
Return on Total Assets = Net profit before tax/Total Assets
Crail = 0.21
Tayport = 0.24
Return on Specific Asset= Net profit before tax/Inventory
Crail = 0.66
Tayport = 0.875
Return on Capital Employed = Net profit before tax/Capital Employed
Crail = 0.46
Tayport = 0.31
Return on Owners Equity = Net profit before tax/Owners Equity
Crail = 1.2
Tayport = 0.58
(iii)
Capital Structure
Gearing Ratio = Total Debt/Total Assets
Crail = 0.72
Tayport = 0.21
Times Interest Earned = Profit before tax + Interest/Interest , no figure for interest
Fixed to Current Asset = Fixed/Current
Crail = 0.23
Tayport = 0.415
(iv)
Efficiency
Inventory Turnover = Sales/Inventory
Crail = 3.77
Tayport = 6.15
Average collection period = Debtors/Sales per day
Crail = 150 days
Tayport = 59 days
Fixed Asset Turnover = Sales/Fixed Assets
Crail = 6.41
Tayport = 7.4
6.2
Profit before tax and interest
232
209
Current
Quick
Profit Margin
Return on Total Assets
Return on Owners Eqty
Fixed to Current Assets
Debt Ratio
Times Interest Earned
Avg Collection period
Inv Turnover
EPS
Dividend Yield
1996
0.82
0.65
15.6%
10.5%
11%
393%
39%
10.08
56.75
16.52
19.8
2.3%
1997
0.68
0.52
13.8%
8.73%
9.4%
444%
40.5%
8.03
57.14
14.69
17.8
2.77%
Extra:
Price to Earnings
Dividend Cover
0.2
2.13
0.1966
1.83