CHAPTER 35
ANALYSIS AND
INTERPRETATION OF
FINANCIAL INFORMATION
Connolly – International Financial Accounting and Reporting – 4th Edition
35.1 INTRODUCTION
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•
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Financial information is prepared to satisfy the needs of different
stakeholders (Conceptual Framework for Financial Reporting
2010)
What is the significance of the figures contained in the financial
statements and how might they?
Ratio analysis is a tool used to conduct a quantitative analysis of
information in an entity’s financial statements
 Analysis of financial statements and the use of ratios (Section
35.2)
 Categories and calculation of ratios (Section 35.3)
 Financial balance and overtrading (Section 35.4)
 Accounting policies and limitations of ratio analysis (Section
35.5)
Connolly – International Financial Accounting and Reporting – 4th Edition
35.2 ANALYSIS OF FINANCIAL STATEMENTS AND USE
OF RATIOS
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•
•
•
Must compare ‘like with like’ (See Example 35.1)
Internal use – past performance, against budget
External use – other companies, industry
Don’t view in isolation
 Read the ‘whole’ annual report, including the narrative
information
 View in context of the economy, government legislation,
industry and firm’s life cycle & policies
•
Tell the story – look beyond the pure numbers
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 35.1: Comparing like with like
Company X began trading in 2006. Due to significant growth in
the first 3 years, Company X engaged in an aggressive
acquisition policy in 2012. This led to €100,000 of one-time
charges on a total net profit before tax of €50,000.
Shareholders equity amounted to €1,500,000.
In this scenario, Return on Capital Employed (ROCE), which is
calculated by dividing shareholders’ equity into profit (See
Section 35.3, efficiency ratios) before one-time charges would
be 10%, whilst after would be 3.33%. When comparing 2012
ratios to past years or to industry averages, it is therefore
important to compare ROCE before one-time charges as these
are not standard costs.
Connolly – International Financial Accounting and Reporting – 4th Edition
35.3 CATEGORIES AND CALCULATIONS OF RATIOS
1. Profitability
2. Liquidity
3. Efficiency
4. Growth
5. Investment
6. Cash flow
Connolly – International Financial Accounting and Reporting – 4th Edition
1. Profitability
i.e.
relationship between profitability and revenue
Consider in conjunction with liquidity
•
•
•
Gross Profit %
GP / R
Net Profit %
PBIT / R
Contribution %
C/R
Connolly – International Financial Accounting and Reporting – 4th Edition
2. Liquidity
i.e. how accessible the company’s cash is
Link with profitability
•
•
•
•
Current
CA / CL
(1.5 – 2)
Acid test or Quick
CA – Inv. / CL
(1 – 0.7)
Receivables Ratio
(Tr. Rec. / Cr. Sales) x 365
Tr. Payables Ratio
(Tr. Pay. / Cr. Purch) x 365
Be aware of individual components, window dressing (See
Example 35.2) and credit facilities
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 35.2: Window dressing
Before
After
Repayment of €400 trade payables
Current assets
€1,400
– €400
€1,000
Current liabilities
€1,000
– €400
€600
Current ratio
1.4
Connolly – International Financial Accounting and Reporting – 4th Edition
1.7
3. Efficiency
i.e. the effective utilisation of assets
Return is relative to the amount invested
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•
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ROCE (Primary ratio)
(See Table 35.1)
Revenue / Non-current Assets
(tangible?)
Revenue / Net-current Assets
Inventory turnover
[(Inventory / Material CoS) x 365]
Non-current Assets / TA
Connolly – International Financial Accounting and Reporting – 4th Edition
Table 35.1: ROCE definitions
Profit
Profit before tax and interest
Capital Employed
Gross assets = Non-current
assets and current assets
Profit before tax and interest
Net assets = Gross assets less
current liabilities
Profit after tax
Shareholders’ capital = Total
share capital and reserves
Profit after tax and preference
dividends
Shareholders’ equity capital =
Ordinary share capital plus
reserves
Connolly – International Financial Accounting and Reporting – 4th Edition
4. Growth
Areas to examine include:
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•
Revenue
PBT
Non-current Assets
Total capital employed
View in context of:
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•
•
Industry
Company life cycle
Market share v Profits
Connolly – International Financial Accounting and Reporting – 4th Edition
5. Investment
i.e. From an investor’s perspective
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EPS
PAT – NCI & PD / No. Ord. Shares
Earnings Yield
EPS / MPOS
Dividend Yield
DPOS / MPOS
Dividend Cover
PAT & PD / DPOS
PE Ratio
MPOS / EPS (See Example 35.3)
Gearing Ratio
TD / Equity
Debt Ratio
TD / TA
Interest Cover
PBIT / Interest
(See Example 35.4)
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 35.3: Interpreting the P/E ratio
For the year ended 31 December 20X6, X plc had:
(i)
(ii)
(iii)
(iv)
EPS = 10 cents;
Overall market P/E ratio = 10;
P/E ratio = 20 (because market expects above average growth);
Market price at 30 April 2012 (date of publication of previous
year’s accounts) = €2;
(v) During the year, X plc does even better than expected and by
29 April 2013 the share price is up to €3, therefore giving a P/E
ratio of 30 (based on EPS for year ended 31 December 2011);
(vi) Year ended 31 December 2012 EPS = 15 cents, announced on
30 April 2013.
This is in line with expectations so share price is unchanged and P/E
ratio drops again to 20 (€3/15 cents).
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 35.4: Gearing and EPS
Two companies, A plc and B plc, both have capital of €10,000. A plc has it
all in the form of equity shares of €1 each, B plc has 5,000 €1 equity shares
and €5,000 of 10% debentures. Both companies earn profits of €5,000 in
year 1 and €2,000 in year 2. Tax is assumed at 35% and the dividend paid
is 10 cents per share.
The capital position is therefore as follows:
Shares
Debentures
A plc
€
10,000
–
10,000
Requirement
What is the EPS in each year?
Connolly – International Financial Accounting and Reporting – 4th Edition
B plc
€
5,000
5,000
10,000
Example 35.4: Gearing and EPS
Solution
Profit before tax and debenture interest
Debenture interest
Taxation (35%)
Earnings
Dividend (10%)
Retained profits
Earnings per share
A plc
B plc
Year 1 Year 2 Year 1 Year 2
€
€
€
€
5,000 2,000 5,000 2,000
–
–
500
500
4,500 1,500
1,750
700 1,575
525
3,250 1,300 2,925
975
1,000 1,000
500
500
2,250
300 2,425
475
32.5c
Connolly – International Financial Accounting and Reporting – 4th Edition
13c
58.5c
19.5c
Example 35.4: Gearing and EPS
Solution (Cont’d)
The effects of gearing can be seen to be as follows:
(a) Debenture interest is an allowable deduction before taxation, whereas dividends are paid
out of profits after taxation; company B has consistently higher retained profits than
Company A.
(b) Earnings of a highly geared company are more sensitive to profit changes. This is
illustrated as follows:
A plc
B plc
Change in profit before interest and taxation
-60%
-60%
Change in earnings
-60%
-662/3%
The reason for the fluctuation is obviously the element of debenture interest which must be paid
regardless of profit level. This more than proportionate change in earnings is important in
relation to the share price of the companies. Many investors value their shares by applying a
multiple (known as the P/E ratio) to the earnings per share. Applying a multiple of say 10 to the
EPS disclosed above would indicate share valuations as follows:
A plc
B plc
Year
1
2
1
2
Share price
€3.25
€1.30
€5.85
€1.95
Thus the share price of a highly geared company will often be more volatile than a company
with only a small amount of gearing.
Connolly – International Financial Accounting and Reporting – 4th Edition
6. Cash flows
i.e. analyses the cash inflow / outflow during the year
•
Statement of cash flows (IAS 7) (See Chapters 19 and 33)
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
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Reconciliation of operating profit
Investing activities – acquisition and disposal of non
current assets and other investments
Financing activities – equity capital and borrowings
Ratios


Funds generated by operating activities / Inventory
Net cash inflow/outflow before financing / Revenue
Connolly – International Financial Accounting and Reporting – 4th Edition
35.4 FINANCIAL BALANCE AND OVERTRADING
Financial balance:
i.e. balance between various forms of finance
 LT finance for LT investment (debt & equity)
 Use of o/d and trade credit
Connolly – International Financial Accounting and Reporting – 4th Edition
35.4 FINANCIAL BALANCE AND OVERTRADING
Overtrading:
i.e. When a company expands its turnover rapidly without
securing additional long-term capital adequate for its
needs
Symptoms
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inventory increasing > sales
receivables increasing > sales
cash and liquid assets declining rapidly
payables increasing rapidly
Connolly – International Financial Accounting and Reporting – 4th Edition
35.5 ACCOUNTING POLICIES AND LIMITATIONS OF RATIO
ANALYSIS
Accounting policies:
•
Effect of choice, and changes therein (IAS 8) (See Chapter
8)
i.e. different accounting standards allow a choice, and
involve estimates & judgement
Connolly – International Financial Accounting and Reporting – 4th Edition
35.5 ACCOUNTING POLICIES AND LIMITATIONS OF RATIO
ANALYSIS
Limitations:
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Consistency
Reporting date
Window dressing
Accounting policies – estimates and judgements
Life cycle
Age of assets
Deliberate policies
Connolly – International Financial Accounting and Reporting – 4th Edition
The following information has been extracted from the financial statements of six
companies, each of which operates in a different industry. The information is expressed
as a percentage of net assets. The industries in which the companies operate are:
A. General manufacturing;
B. Property investment and rental;
C. House building;
D. Whiskey distiller;
E. Brewer and owner of public houses; and,
F. Supermarkets.
Company
Land and buildings
Plant, machinery and vehicles
Inventory & WIP
Trade receivables
Cash at bank
Trade payables
Bank overdraft
Net assets
1
%
150
5
9
1
165
2
%
10
10
80
14
1
115
3
%
80
10
10
2
8
110
4
%
2
4
108
35
1
150
5
%
30
28
45
32
5
140
6
%
80
15
10
12
3
120
(10)
(55)
100
(10)
(5)
100
(10)
(-)
100
(33)
(17)
100
(30)
(10)
100
(20)
(-)
100
Connolly – International Financial Accounting and Reporting – 4th Edition