Lecture 7: Analysis and Interpretation of Financial Statements
Reading
Chapter 28: Review of Financial Ratio Analysis
Chapter 29: Analysis of Published Financial Statements
Objectives
 Explain the role of accounting ratios in the analysis and interpretation of the information
provided in financial statements;
 Define each of the most commonly-used accounting ratios;
 Perform a ratio analysis of a set of financial statements;
 Explain the limitations of financial ratios analysis
Introduction to ratio analysis
 The objective of financial statements is to provide users with useful information.
 Users need to analyze the financial statements and draw conclusions with regard to the
company's financial performance and financial position.
 Ratio analysis is a technique for the analysis of financial statements.
 Accounting ratios can be used to compare one period with another and one company with
another.
Accounting Ratios
 Profitability ratios
 Liquidity ratios
 Efficiency ratios
 Investment ratios
Analytical and Interpretative Approach
 Needs of the users of financial statements
- All these user groups are interested in financial performance, financial position and cash
flow, but some users are mainly interested in performance and profitability, while others
may be more interested in liquidity and gearing or other matters.
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You must make a choice:
 Choose those relevant to the situation
 Choose those relevant to the party in the question
 Make use of any additional information given in the question to help your choice.
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Still in doubt that you have anything to say?
There are some points which should serve as a useful checklist:
- What does the ratio literally mean?
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What does a change in the ratio mean?
From the information given, what is likely to have led to the changes in the ratio?
Your analysis should use the information in the scenario to produce the reason for movements in
performance and position. Your knowledge of the business will be limited to that provided within
the question, so the reasons for the movement in ratios should be linked back to this at all times.
Profitability Ratios
Gross Profit Margin and Net Profit Margin
Return on capital employed (ROCE)
Return on equity (ROE)
Return on capital employed (ROCE)
Example - ROCE
The following information has been extracted from the financial statements of two companies
for the year to 31 December 2019. the companies are of similar size and operate in the same
sector of industry.
Required: Calculate ROCE for each company and analyse each company’s ROCE figure into its
component parts.
Example – Profitability Ratios
 Archer Co is a retailer and trades through its stores on the high street, selling high quality
goods.
 The company has recently been suffering from rising costs, that it has been unable to pass on
to its customers.
 In response to the number of people shopping via the Internet, Archer Co has implemented
a cost cutting strategy in the prior year, and in the current year asked shareholders for funds
to help reduce it debt burden.
The following financial information for the current year is available:
Suggested Solution:
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The revenue has fallen by 6.7% due to more customers shopping using the Internet. If the
company does not do more to address the decline then it will run the risk of continued
falling sales in future periods. It might be a future strategy to sell its goods via the Internet
as well as from its high street stores.
Gross margin has fallen due to rising costs of production that have been unable to be
passed on directly to its customers. This will have been done in order to maintain
competitiveness with the online market, but if margins are to improve then Archer Co will
need to either increase the selling prices or look to source the same products at more
competitive prices.
Operating margin has increased because Archer Co has implemented a cost cutting
exercise that will have reduced staff numbers, and/or closed down stores that were
under-performing. This will have resulted in large costs of redundancy in the prior year
that are not present in the current year costs, and lower wages/rent in the current year.
Finance costs have reduced as the funds received from the shareholders has been used
to reduce the borrowing and lower the interest costs.
Liquidity Ratios
 Current ratio
 Quick assets ratio ("acid test")
Efficiency Ratios
 Inventory holding/turnover period
 Receivables collection period
 Payables payment period
Example – Liquidity & Working Capital Ratios
Comment on profitability
Key factors:
 Revenue has increased by 50%;
 Gross profit margin significantly decreased, maybe due to lowering of selling price in
order to increase market share and sales revenue
 Operating profit margin has decreased in line with gross profit margin;
 ROCE has increased, which must be due to the improvement in asset turnover.
Comment on liquidity:
Overall the liquidity of the company would appear to be in some doubt:
 Both the current ratio and quick ratio appear very low although they have improved since
the precious year;
 We do not know anything about the type of business, so it is difficult to comment on these
absolute levels of liquidity;
 Inventory holding period indicates that inventory is held for a considerable time and that
this period is increasing;
 Accounts receivable collection period has deteriorated rapidly although given the increase
in revenue this may be due to a conscious policy of offering extended credit terms in order
to attract new customers;
 Clearly the business is heavily dependent upon its overdraft.
Investment Ratios
 Capital gearing ratio =
Capital gearing is expressed as a percentage.
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Interest cover:
Interest cover is expressed as a ratio.
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Earnings per share:
This ratio is usually expressed in pence.
EPS is the subject of IAS 33
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Price earnings (P/E) ratio:
P/E is expressed as a ratio.
Higher P/E ratios are generally viewed more favorably than lower P/E ratios.
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Dividend cover:
Dividend cover is expressed as a ratio.
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Dividend yield:
Dividend yield is expressed as a percentage.
Example – Investor’s Ratios
Solution:
Limitations of Ratio Analysis
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Historical cost accounts
Lack of standard definitions
Figures taken from SOFP may be unrepresentative
Accounting policies may differ
Misinterpretation is possible
Other issues