Financial accounting and reporting I

7 FINANCIAL STATEMENTS ANALYSIS

Section overview

„ Overview
„ Horizontal analysis
„ Vertical analysis
„ Impact of specific transactions on ratios

7.1 Overview
Financial statement analysis is the process of analysing a company's past, current and projected
performance for decision-making purposes
Financial statement analysis allows analysts to identify trends by comparing ratios across multiple
periods and statement types to allow analysts to measure liquidity, profitability, company-wide
efficiency, and cash flow.
Financial statement analysis is of the following types:
‰ Horizontal analysis
‰ Vertical analysis
‰ Ratio analysis (already explained in above sections)

7.2 Horizontal analysis

Horizontal analysis is used to compare historical data, such as ratios, or line items, over a number
of accounting periods.
Financial analysts and investors need to identify trends and growth patterns in the company’s
performance over a number of years, a year-end balance sheet or income statement is not enough
to evaluate whether the company is operating efficiently and profitably.
Horizontal analysis also makes it easier to compare growth rates and profitability among different
companies.
The following is the formula for horizontal analysis:
Amount in comparison year – Amount in base year x 100
Base year
The following figure is an example of how to prepare a horizontal analysis for two years.
Carnations Ltd
Profit & Loss Account
For the year ended December 31, 2018

%age change
2018 2017
from 2017 to 2018
Rs. in millions
Sales 86,320 75,200 14.79
Cost of Sales (44,618) (40,900) 9.09
Gross Profit 41,702 34,300 21.58
Distribution costs (19,597) (15,380) 27.42
Administrative expenses (2,339) (2,053) 13.93

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 Chapter 10: Interpretation of financial statements

%age change
2018 2017
from 2017 to 2018
Rs. in millions
Other operating expenses (1,322) (1,052) 25.67
Other income 1,488 1,000 48.80
Profit before interest 19,932 16,815 18.54
Finance cost (343) (300) 14.33
Profit before taxation 19,589 16,515 18.61

7.3 Vertical analysis

In vertical analysis each category of accounts on the balance sheet is shown as a percentage of
the total account.
Line items on an income statement can be stated as a percentage of gross sales, while line items
on a balance sheet can be stated as a percentage of total assets or liabilities. This analysis of
income statements gives the company a heads up if cost of goods sold or any other expense
appears to be too high when compared to sales and allows the management to identify the reasons
and take action to fix the problem(s).
Carnations Ltd
Statement of Financial Position
For the year ended December 31, 2018

2018 2017
------------------ Rs. in millions ------------------
Assets
Non-Current Assets
Property, plant & equipment 15,000 42.33% 12,000 32.71%
Intangibles 500 1.41% 600 1.64%
Long term investments 120 0.34% 100 0.27%
Long term loans 200 0.56% 150 0.41%
Long term deposits and
prepayments 70 0.20% 180 0.49%
15,890 44.84% 13,030 35.51%
Current Assets
Stores and spares 650 1.83% 585 1.59%
Stock in trade 6,000 16.93% 5,500 14.99%
Trade debts 2500 7.05% 1200 3.27%
Loans and advances 800 2.26% 300 0.82%
Short term deposits and 750 900
2.12%
prepayments 2.45%
Other receivables 350 0.99% 175 0.48%
Cash and bank balances 8,500 23.98% 15,000 40.88%
19,550 55.16% 23,660 64.49%
Total assets 35,440 36,690

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Financial accounting and reporting I

2018 2017

------------------ Rs. in millions ------------------

Equity and liabilities

Share capital and reserves

Share capital 1,000 2.82% 1,000 2.73%

Reserves 2,950 8.32% 7,095 19.34%

Liabilities

Non-current liabilities

Staff retirement benefits 290 0.82% 295 0.80%

Current liabilities

Trade and other payables 30,000 84.65% 27,500 74.95%

Provisions 1200 3.39% 800 2.18%

Total current liabilities 31,200 88.04% 28,300 77.13%

Total liabilities 31,490 88.85% 28,595 77.94%

Total equity and liabilities 35,440 36,690

Carnations Ltd
Profit & Loss Account
For the year ended December 31, 2018

2018 2017

------------------ Rs. in millions ------------------

Sales 86,320 100% 75,200 100%

Cost of Sales (44,618) 51.69% (40,900) 54.39%

Gross Profit 41,702 48.31% 34,300 45.61%

Distribution costs (19,597) 22.70% (15,380) 20.45%

Administrative expenses (2,339) 2.71% (2,053) 2.73%

Other operating expenses (1,322) 1.53% (1,052) 1.40%

Other income 1,488 1.72% 1,000 1.33%

Profit before interest 19,932 23.09% 16,815 22.36%

Finance cost (343) 0.40% (300) 0.40%

Profit before taxation 19,589 22.69% 16,515 21.96%

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 Chapter 10: Interpretation of financial statements

7.4 Impact of specific transactions on ratios

It is important to understand how certain future transactions or events might affect already
calculated ratios, for example, an entity may be required to certain current ratio of at least 1.75 as
part of its running finance agreement with the bank.
The following mathematical rules are useful in most circumstances:
‰ Increase in numerator will increase the measure of ratio
‰ Decrease in numerator will decrease the measure of ratio
‰ Increase in denominator will decrease the measure of ratio
‰ Decrease in denominator will increase the measure of ratio
‰ Increase in numerator and denominator by equal amount will increase the lower side of
fraction bar, more proportionately.
‰ Decrease in numerator and denominator by equal amount will decrease the lower side of
fraction bar, more proportionately.

Example 01: Epivac Limited

Question: Epivac Limited is considering to take some of the following measures during the last week
of the year ending 31 March 2021 in order to show better financial performance:
(i) Pay balance of a major supplier from bank overdraft facility and avail 5% discount.
(ii) Sell slow moving stock items at a price equal to cost.
(iii) Recover debtors’ balances by offering cash discounts of 10%.
(iv) Offer extended credit terms of 90 days which would increase sales at existing margins.
(v) Dispose-off some non-current assets at gain.
Required: State the effect (increase, decrease, no effect) of each of the above measure on the
following financial ratios:
(a) Gross profit %
(b) Net profit %
(c) Current ratio
(d) Stock turnover (times)
(e) Return on non-current assets
(f) Quick ratio
Answer:

S. Measures
Ratios
No.
(i) (ii) (iii) (iv) (v)
Gross profit %
(a) Increase* Decrease Decrease* No effect No effect
Gross Profit / Sales
Net profit %
(b) Increase Decrease Decrease Increase Increase
PAT / Sales
Current ratio
(c) Increase No effect Decrease Increase Increase
Current assets / Current liab.
Stock turnover (times)
(d) Decrease* Increase No effect Increase No effect
Cost of Sales / Inventory
Return on non-current assets
(e) Increase No effect Decrease Increase Increase
PBIT / Non-current assets
Quick ratio
(f) Increase Increase Decrease Increase Increase
(RA + Cash) / Current liab.
*The settlement discount is deducted from revenue or cost of purchases.

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Financial accounting and reporting I

8 LIMITATIONS OF FINANCIAL STATEMENTS AND RATIO ANALYSIS

Section overview

„ Limitations of financial statements and ratio analysis

„ Window dressing

8.1 Limitations of financial statements and ratio analysis

Financial statements are time and cost producing. Ratio analysis can be used to compare
information taken from the financial statements to gain an analytical understanding of the results,
financial position and cash flows of a business. This analysis is a useful tool, especially for an
outsider such as a supplier, lender or an investor. However, there are a number of limitations of
ratio analysis which are given below:
Historical
All of the information used in ratio analysis is derived from actual historical results. This does not
mean that the same results will carry forward into the future. However, you can use ratio analysis
on pro forma information and compare it to historical results for consistency.
Historical versus current cost
The information on the income statement is stated in current costs (or close to it), whereas many
elements of the balance sheet are stated at historical cost (which could vary substantially from
current costs). This disparity can result in unusual ratio results.
Inflationary effect
If the rate of inflation has changed in any of the periods under review, this can mean that the
numbers are not comparable across periods. For example, if the inflation rate was 100% in one
year, sales would appear to have doubled over the preceding year, when in fact sales did not
change at all.
Aggregation
The information in a financial statement line item that you are using for a ratio analysis may have
been aggregated differently in the past, so that running the ratio analysis on a trend line does not
compare the same information through the entire trend period.
Accounting policies and estimates
Different companies in a similar industry may have different policies for recording the
same accounting transaction. This means that comparing the ratio results of different companies
may be like comparing apples and oranges. For example, one company might use reducing
balance method while another company uses straight-line depreciation.
Business conditions
You need to place ratio analysis in the context of the general business environment. For example,
60 days of sales outstanding for receivables might be considered poor in a period of rapidly
growing sales, but might be excellent during an economic contraction when customers are in
severe financial condition and unable to pay their bills.
Interpretation
It can be quite difficult to ascertain the reason for the results of a ratio. For example, an acid test
ratio of 2:1 might appear to be excellent, until you realize that the company just sold a large amount
of its stock to bolster its cash position. A more detailed analysis might reveal that the acid test ratio
will only temporarily be at that level, and will probably decline in the near future.
Company strategy
It can be difficult to interpret a ratio analysis comparison between two companies that are pursuing
different strategies. For example, one company may be following a low-cost strategy, and so is
willing to accept a lower gross margin in exchange for more market share. Conversely, a company
in the same industry is focusing on a high customer service strategy where its prices are higher
and gross margins are higher, but it will never attain the revenue levels of the first company.

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 Chapter 10: Interpretation of financial statements

8.2 Window dressing

One should also be careful of unethical practices like window dressing while interpreting the
financial statements.

Window dressing is the adaptation of the rules and practices to present financial statements in a
way that business situation appears better than it actually is. This manipulates the financial
information and misleads the users of financial statements.
Examples
Some of the ways in financial statements may be manipulated include:
‰ Delay in paying suppliers, so that the period-end cash balance appears higher.
‰ Using lower estimate for allowance for doubtful debts.
‰ Capitalize smaller expenditures that would normally be charged to expense, to increase
reported profits.
‰ Offer customers an early shipment discount, thereby accelerating revenues from a future
period into the current period.
‰ Lower depreciation expense by using higher useful lives or residual values, etc.

Example 02
2: Wasim Pvt. Ltd
Question: Wasim Pvt. Ltd. is an importer and retailer of vegetable oils. Extracts from the financial
statements for this year and last are set out below:
Income statements for the years ended 30 September
Year 7 Year 6
Rs.000 Rs.000
Revenue 2,160 1,806
Cost of sales (1,755) (1,444)
----------------- -----------------
Gross profit 405 362
Distribution costs (130) (108)
Administrative expenses (260) (198)
----------------- -----------------
Profit before tax 15 56
Income tax expense (6) (3)
----------------- -----------------
Profit for the period 9 53
----------------- -----------------

Statements of financial position as of 30 September

Year 7 Year 6
Rs.‘000 Rs.‘000
Assets
Non--current assets
Property, plant and equipment 78 72

Current assets
Inventories 106 61
Trade receivables 316 198
Cash - 6
----------------- -----------------
422 265
----------------- -----------------
Total assets 500 337
----------------- -----------------

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Financial accounting and reporting I

Equity and liabilities

Equity
Ordinaryshares 110 85
Preference shares 23 11
Share premium 15 -
Revaluation reserve 20 20
Retained earnings 78 74
----------------- -----------------
246 190
Current liabilities
Bank overdraft 49 -
Trade payables 198 142
Current tax payable 7 5
----------------- -----------------
254 147
----------------- -----------------
Total equity and liabilities 500 337
----------------- -----------------
Required: Calculate profitability ratios, liquidity ratios and working capital ratios for Wasim (private)
Limited for two years.
Answer:
Profitability ratios
Year 7 Year 6
Gross profit % =
Gross profit 405 362
x 100 x 100 = 19% x 100 = 20%
Sales 2,160 1,806

Net profit % =
Net profit 9 53
x 100 x 100 = 0.4% x 100 = 2.9%
Sales 2,160 1,806

Profit before interest and tax

Return on capital employed =
Share capital and reserves + Long-term debt capital
15 56
x 100 = 6% x 100 = 29%
246 190

Sales
Asset turnover = x 100
Share capital and reserves + Long- term debt capital
2,160 1,806
= 8.8 times = 9.5 times
246 190

Liquidity Ratios
Current ratio =
Current assets 422 265
Current liabilities = 1.7 times = 1.8 times
254 147
Quick ratio =
Current assets excluding inventory 422 - 106 265 - 61
Current liabilities 1.2 times 1.4 times
254 147

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 Chapter 10: Interpretation of financial statements

Working capital ratios

Average time to collect =

Trade receivables 316 x 365 198 x 365
x 365 53 day s 40 day s
Sales 2,160 1,806

Average time to pay =

Trade payables 198 x 365 142 x 365
x 365 = 41 day s = 36 day s
Cost of purchases 1,755 1, 444

Inventory turnover =
Inventory 106 x 365 61 x 365
x 365 22 day s = 15 day s
Cost of sales 1,755 1, 444

Example 03: AMIR & MO Limited

Question: The income statements and statements of financial position of two manufacturing
companies in the same sector are set out below.

Amir Mo
Rs. Rs.
Revenue 150,000 700,000
Cost of sales (60,000) (210,000)
------------------- -------------------
Gross profit 90,000 490,000
Interest payable (500) (12,000)
Distribution costs (13,000) (72,000)
Administrative expenses (15,000) (35,000)
------------------- -------------------
Profit before tax 61,500 371,000
Income tax expense (16,605) (100,170)
------------------- -------------------
Profit for the period 44,895 270,830
------------------- -------------------
Assets
Non--current assets
Property - 500,000
Plant and equipment 190,000 280,000
------------------- -------------------
190,000 780,000

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Financial accounting and reporting I

Current assets
Inventories 12,000 26,250
Trade receivables 37,500 105,000
Cash at bank 500 22,000
------------------- -------------------
50,000 153,250
------------------- -------------------
Total assets 240,000 933,250
------------------- -------------------
Required:
Calculate profitability ratios, liquidity ratios and working capital ratios for Amir and Mo to make
comparison.
Answer:
Profitability ratios

Amir Mo
Gross profit % =
Gross profit 90,000 490,000
x 100 x 100 = 60% x 100 = 70%
Sales 150,000 700,000

Net profit % =
Net profit 44,895 270,830
x 100 x 100 = 30% x 100 = 39%
Sales 150,000 700,000

Profit before interest and tax

Return on capital employed =
Share capital and reserves + Long - term debt capital

Amir 61,500 + 500

x 100 = 28.5%
207, 395 +10,000

Mo 371,000 +12,000
x 100 = 47%
565,580 + 250,000
Sales
Asset turnover = x 100
Share capital and reserves + Long - term debt capital
Amir 150,000
= 0.7 times
207,395 + 10,000

Mo 700,000
= 0.85 times
565,580 + 250,000

Liquidity Ratios

Amir Mo
Current ratio =
Current assets 50,000 153,250
Current liabilities = 2.2 times = 1.3 times
22,605 117,670

Quick ratio =
Current assets excluding inventory 50,000 - 12,000 153,250 - 26,250
Current liabilities = 1.7 times = 1.1 times
22,605 117,670

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 Chapter 10: Interpretation of financial statements

Working capital ratios

Average time to collect =

Trade receivables 37,500 105,000
x 365 x 365 = 91 day s x 365 = 55 day s
Sales 150,000 700,000

Average time to pay =

Trade payables 22,605 117,670
x 365 x 365 = 137 day s x 365 = 204 day s
Cost of purchases 60,000 210,000

Inventory turnover =
Inventory 12,000 26,250
x 365 x 365 = 73 day s x 365 = 46 day s
Cost of sales 60,000 210,000

Example 04: Alpha Limited and Omega Limited

Question: Alpha Limited and Omega Limited are in the same trade, but operate in different areas.
Their accounts for the year ended 31 December, 2016 are as follows:

Profit and loss account Alpha Limited Omega Limited

Rs.’000 Rs.’000 Rs.’000 Rs.’000
Sales 1,440 1,720
Less: Cost of sales 1,120 1,342
Gross profit 320 378
Less: Overheads 220 300
Profit before tax 100 78
Taxation 40 30
Dividends 20 24
60 54
Retained earnings 40 24
Statement of financial position
Share capital of Rs. 1 each 600 200
Reserves 240 104
840 304
8% Debentures - 120
840 424
Represented by:
Non-current assets at cost 660 520
Less: Depreciation 200 160
460 360
Current assets:
Inventory 280 172
Receivables 310 300
Cash 30 32
620 504

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Financial accounting and reporting I

Current liabilities:
Taxation 40 30
Creditors 180 344
Bank overdraft - 42
Dividends 20 24
240 440
Net Current assets 380 64
840 424
Required:
Compute the current ratio, acid test ratio, creditors ratio and collection period for each of the
companies and carry out the comparative analysis of the companies based on the computed ratios.

Answer:
Liquidity Ratios

Alpha Limited Omega Limited

Current ratio=
Current assets 620,000 504,000
Current liabilities 240,000 440,000
=2.58 times =1.15 times
Quick ratios=
Current assets – inventory 620,000-280,000 504,000-172,000
Current liabilities 240,000 440,000
=1.42 times =.75 times

Working capital ratios

Average time to collect =

Trade receivables x 365 310,000 x365 300,000 x 365
Sale 1440,000 1720,000
x365= 79 days = 64 days
Average time to pay=
Trade payables x 365 180,000 x 365 344,000 x 365
Credit purchases 1120,000 1342,000
= 59 days =94days

The comments on comparative analysis of both companies based on the ratios computed above
are as under:
(i) In terms of working capital and liquidity, Alpha Limited is in a better position to honor its
obligations as they fall due because its current ratio and acid test ratio are higher than those
of Omega Limited.
(ii) Omega Limited’s payment period is better than that of Alpha Limited’s because Omega
Limited uses supplier’s funds to finance its operation.

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 Chapter 10: Interpretation of financial statements

(iii) Omega Limited’s collection period is also better than that of Alpha Limited. It extends shorter
credit period to its customers than Alpha Limited.
(iv) Omega Limited’s credit policy is better than that of Alpha Limited. This is because there is 30
days difference between its payments period and collection periods compared with Alpha
Limited that had a longer collection period than its payment period.

Example 05
5: Boom Limited (BL)
Question: Boom Limited (BL) is a manufacturer of sports goods. Following financial statements for
the year ended 31 December 2017 have been submitted to the Chief Executive Officer (CEO)
Statement of profit or loss
Rs. in ‘000
Revenues 21,000
Cost of sales (17,500)
Gross profit 3,500
Operating expenses (1,900)
Finance cost (450)
Profit before tax 1,150
Taxation (345)
Profit after tax 805

Statement of financial position

Rs. in ‘000
Property, plant and equipment 7,500
Current assets 1,500
9,000
Share capital 4,000
Reserves 1,000
Non-current liabilities 3,000
Current liabilities 1,000
9,000

Although performance of BL has improved from the last year, CEO wants to compare the results
with other companies operating in sports manufacturing industry. In this respect, following industry
data has been gathered:

Gross profit margin 23.5%

Net profit margin 7.7%
Current ratio 2.75
Gearing ratio 50:50
Return on non-current asset 32.9%
Return on capital employed 27.4%
Return on equity 31.3%
Required:
(a) Compute BL’s ratios for comparison with the industry.
(b) For each ratio, give one possible reason for variation from the industry.

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Financial accounting and reporting I

Answer:
Ratios (a) BL's ratios Industry's (b) Reasons for variation from industry
ratios
Gross profit 16.67% 23.50% Lower than industry
margin ƒ Purchase of raw material at higher prices
as compared to its competitors
ƒ Inability to obtain economies of scale in
production as compared to its competitors
ƒ Higher production costs due to
inefficiencies
ƒ Deliberately keeping selling prices
lower to gain the market share
Net profit 3.83% 7.70% Lower than industry
margin 805 ƒ BL’s gross profit margin is 6.8% lower than
x 100
21,000 industry (16.6% Vs 23.5%) whereas net
profit margin is only 3.9% lower which
indicates that BL’s operating expenses as
a percentage of sales are approximately
2.9% lower than the industry

Current ratio 1.50 2.75 Lower than industry

1,500 Since gearing ratio is lower than the
1,000 industry so BL might have:
ƒ obtained running finances as compared to
long-term financing by the industry availed
extended credit terms from suppliers
ƒ Low inventory levels are maintained by BL
ƒ Shorter credit terms are given to debtors

Gearing ratio 37.5: 62.5 50 : 50 Lower than industry

3,000 ƒ Difficulty in raising long-term
4,000 + 1,000 finance from banks due to low
+ 3,000 profits
ƒ Running finance or extended
credit terms from suppliers are
available for BL

Return on 21.33% 32.90% Lower than industry

non- current 1,150 + ƒ Lower profit margins
assets 450 x
100 ƒ Relatively newer non-current
7,500 assets have higher carrying
value
Return 20.00% 27.40% Lower than industry
on 1,150 + 450 ƒ Lower profit margins
capital 4,000 + x ƒ High shareholder’s equity
employed 1,000 + 100
3,000

Return 16.10% 31.30% Lower than industry

on 805 ƒ Lower profit margins
equity x
4,000 + 100 ƒ Higher shareholder’s equity/low
1,000 gearing ratio

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 Chapter 10: Interpretation of financial statements

Example 06
6: Progressive Steel Limited
Question: Progressive Steel Limited (PSL) commenced business in 2015. The following
comparative data pertains to the year ended 30 June 2017:

PSL Industry
Description
2017 2016 2017
Gross profit margin 13% 13% 16%
Net profit margin 8% 7% 10%
Return on shareholders’ equity 22% 18% 25%
Current ratio 1.2 1.6 1.5
Debt to equity ratio 40:60 30:70 50:50
Cash operating cycle in days 119 135 118

Required:
For each ratio/data give possible reasons for variation from comparative and industry data.

Answer:
Reasons for fluctuation with
Ratios Reason for fluctuation with Industry
previous year
Gross profit In line with previous year. Lower than industry
margin No variation. ƒ The company is in initial phase and may
have kept the selling prices lower than
the industry to gain the market share.
ƒ The company may not have been able
to purchase raw material at prices
which is available to its competitors.
ƒ The company may not have been able
to obtain economies of scale in its
production which may have been
obtained by its competitors.
ƒ Possibility of higher production costs.
Net profit Higher than previous year: Lower than industry however, the difference
margin ƒ Tight control over is mainly attributed to lower gross profit
operating costs. margin.
ƒ Increase in other income.
Decrease in fixed cost per
unit due to increase in sale.
Return on Higher than previous year: Lower than industry
shareholder's ƒ Reduction in tax rates. ƒ Lower gross profit and net profit
equity margins.
ƒ Reduction in interest
rates. ƒ Lower leverage.
ƒ Decrease in equity ƒ Higher net assets resulting in higher
might be due to equity.
buyback of shares.
ƒ Distribution of profits
from previous year
which resulted in
decrease in equity.

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Financial accounting and reporting I

Current ratio Lower than previous year: Lower than industry

ƒ The company might
have obtained running
finance facility to fund
its operations in the
current year.
ƒ Long term loan
payments might have
become due in the next
12 month, which
decreases the current
ratio.
ƒ Decrease in current
assets due to better
inventory management/
reduction in credit period
of debtors.
Debt to equity Higher than previous year Lower than industry
ratio ƒ Decrease in reserves ƒ Being a new entrant the company may
due to dividend pay- out. be in the phase of expansion thereby
ƒ Further debt obtained raising debt accordingly.
during the period.
ƒ Decrease in equity might
be due to buyback of
shares.
Cash operating Lower than previous year In line with industry.
cycle ƒ Increase in current
liabilities might be due
to increase in credit
period.
ƒ Decrease in current
assets which might be
due to greater stock
turnover or better
inventory management.
ƒ By giving lower credit
days to debtors.
.

Example 07: Dairy Foods Limited

Question: The following information has been gathered by an analyst, in respect of Dairy Foods
Limited (DFL) which specializes in various dairy products.

Industry
Ratio 2016 2015 2014
average
Profit margin % 11% 10% 8% 10.45%
Quick ratio 1.38 1.40 1.42 1.52
Current ratio 1.84 1.67 1.59 1.73
Days purchases in payables 80 91 89 82

In the latest annual report to the shareholders, Directors of DFL have claimed that liquidity position
of the Company has improved significantly.
Required: Critically analyse and discuss whether you agree with the claim.

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 Chapter 10: Interpretation of financial statements

Answer:
While analyzing liquidity positions of DFL, it is noted that current ratio has steadily increased over
the years and is better than industry average. However, the quick ratio has steadily declined and is
even lower than industry average. This is a clear evidence that the increase in liquidity is caused by
an increase in inventory.

Further, by considering the nature of highly perishable inventories kept by a dairy food company, it
is a possibility that DFL may bear high inventory losses due to short expiry. Based on the above, I
do not agree with the claim of DFL’s directors.

Example 08
8: Comparison
Question: Extracts from latest financial statements of two companies are as follows;
Extracts from statements of financial position
A B Assets A B
Equity & Liabilities
Rs. in millions Rs. in millions
51,690 72,114 Fixed assets 34,460 48,076
Equity & reserves
- 36,057 Stock in trade 21,700 20,000
Long term loan
35,790 45,135 Trade debtors 24,470 44,030
Trade creditors
12,000 8,500 Cash and bank 18,850 49,700
Other payables
99,480 161,806 99,480 161,806

Extract from Statement of Comprehensive Income

A B

Rs. in million

Revenue 161,600 220,150

Cost of sales (135,160) (180,520)

Gross profit 26,440 39,630

Operating expenses (9,840) (13,870)

Interest expense (720) (2,313)

Profit before tax 15,880 23,447

Income tax (333) (409)

Profit after tax 15,547 23,038

Required:
Analyze the profitability, liquidity and working capital ratios of both the companies.

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Financial accounting and reporting I

Answer:

Profitability ratios A B

Gross profit ratio (GP ÷ sales) 16.36% 18.00%

Profit to sales (Profit after tax ÷ sales) 9.62% 10.46%

Return on capital employed (Profit before interest and tax ÷

capital employed)
32.11% 23.81%

Return on asset employed (Profit before interest and tax ÷ 16.69% 15.92%
assets)

Company B's gross profit and net profit ratio is slightly higher as compared to Company A. The
difference is not significant and may be on account of higher level of sales resulting in lesser fixed
costs per unit.
Company A’s return on capital employed ratio and return on asset employed ratio are better than
Company B, because Company B has accumulated large balances of cash despite of availing long
term loan. Had Company B had used its cash balances to pay off the long term loan; it would have
both of these ratio better than Company A.

Liquidity Ratios A B

Current ratio (current assets ÷ current liabilities) 1.36 2.12

Quick ratio (current asset-inventory ÷ liabilities) 0.91 1.75

Company B has better current and quick ratio. However, it appears that these ratios are better than
Company A due to substantially high amount of trade debts in term of percentage of sales as sales
days. It also represents a risk that these trade debts may prove irrecoverable. Moreover, they may
be indicative of inefficient in debt collection as well.

Working capital turnover ratios A B

Stock turnover days (Stock ÷ Cost of goods sold × 365) [A] 58.60 40.44

Debtor turnover days (Debtor ÷ Revenue × 365) [B] 55.27 73.00

Creditor turnover days (Creditor ÷ Cost of goods sold × 365) [C] 96.65 91.26

Cash operating cycle [A+B–C] (days) 17.22 22.18

Stock turnover of Company B is better than that of Company A. Company B is turning over its stock
9 times whereas company A is doing it 6 times a year.
Company A is more effectively collecting its debtors than Company B. This could also be due to the
fact that Company B is following a lenient credit policy to attract more revenue. This fact is also
supported from higher stock turnover ratio of Company B.
Company A have availed better credit facility from its creditors but it may have forgone some
settlement discounts which might have resulted in lower gross profit ratio than that of Company B.
Overall cash operating cycle of Company A is better than Company B. Furthermore, Company B has
accumulated large balances of cash despite the fact that it has also availed long term loan. Excess
cash balance should have been used to pay off the long term loan to reduce the finance cost.

© Emile Woolf International 430 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Interpretation of financial statements

Example 09: Shispare Limited and Trivor Limited

Question: Following are the summarised financial statements of Shispare Limited (SL) and its
competitor Trivor Limited (TL) for the year ended 31 December 2019:
Statement of financial position

Assets SL TL Equity & SL TL

liabilities
Rs. in million Rs. in million
Fixed assets 5,400 7,800 Capital and 8,400 9,450
reserves
Current Long-term loan 1,900 4,600
assets:

Inventory 4,800 7,100 Current liabilities:

Debtors 2,700 3,200 Creditors 2,900 4,500

Cash 1,200 800 Accrued 900 350

expenses

8,700 11,100 3,800 4,850

14,100 18,900 14,100 18,900

Statement of profit or loss

SL TL

--- Rs. in million ---

Sales 16,700 35,400

Cost of goods sold (11,400) (27,800)

Gross profit 5,300 7,600

Operating expenses (3,500) (4,900)

Finance cost (250) (600)

Net profit 1,550 2,100

Required:
Compute relevant ratios for SL and TL to assess which company seems to:
(i) give more incentives to its customers to pay on time
(ii) avail extended credit terms from its suppliers
(iii) be more efficient in the use of capital
(iv) keep lower selling prices to gain the market share
(v) have better liquidity position
(vi) have higher ability to convert its assets into profit
(vii) control operating expenses more efficiently
(viii) have higher ability to raise bank loan in future

© Emile Woolf International 431 The Institute of Chartered Accountants of Pakistan

Financial accounting and reporting I

Answer:

Relevant ratios SL TL
Debtors collection period (i) 59.01 days 32.99 days
Debtors 2,700 3,200
= ×365 = ×365 = ×365
Sales 16,700 35,400
TL is giving more incentives to its customers to pay on time.

Creditors payment period (ii) 92.85 days 59.08 days

Creditors 2,900 4,500
ൌ ×365 = ×365 = ×365
Purchases 11,400 27,800
SL avail extended credits terms

Return on capital (iii) 17.48% 19.22%

Profit before interest 1,550+250 2,100+600
ൌ ×100 = ×100 = ×100
Capital employed 8,400+1,900 9,450+4,600
TL is more efficient in the use of capital

Gross profit margin (iv) 31.74% 21.47%

Gross profit 5,300 7,600
ൌ ×100 = ×100 = ×100
Sales 16,700 35,400
TL is deliberately keeping selling prices lower to gain the market share.

Relevant ratios SL TL
Current ratio (v) 2.29 2.29
Current assets 8,700 11,100
= = =
Current liabilities 3,800 4,850
Quick ratio 1.03 0.82
Current assets-inventory 8,700 െ 4,800 11,100 െ 7,100
= = =
Current liabilities 3,800 4,850
SL has better liquidity position

Return on assets (vi) 12.77% 14.29%

Profit before interest 1,550+250 2,100+600
ൌ ×100 = ×100 = ×100
Total assets 14,100 18,900
TL has higher ability to convert its assets into profit

Operating expenses %age (vii) 20.95% 13.84%

Operating expenses 3,500 4,900
= ×100 = ×100 = ×100
Sales 16,700 35,400
TL is efficiently controlling the operating expenses.

Gearing ratio (viii) 0.18 0.33

Debt 1,900 4,600
ൌ = =
Debt + Equity 8,400+1,900 9,450+4,600
SL is going to raise a bank loan relatively easily in future

© Emile Woolf International 432 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Interpretation of financial statements

Example 10: Limitations of ratio analysis

Question: Ratios are computed by using numerical values from financial statements to gain
meaningful information about an entity. However, due to inherent limitations of ratio analysis,
it may not reflect the correct financial situation.
Required:
Briefly explain any four limitations of ratio analysis.
Answer:
(i) Historical
All information used in ratio analysis is derived from actual historical results. This does not
mean that the same results will carry forward into the future. However, ratio analysis can be
used on pro forma information and compare it to historical results for consistency.
(ii) Historical versus current cost
The information on the income statement is stated in current costs (or close to it), whereas
many elements of the balance sheet are stated at historical cost (which could vary
substantially from current costs). This disparity can result in unusual ratio results.
(iii) Inflationary effect
If the rate of inflation has changed in any of the periods under review, this can mean that the
numbers are not comparable across periods. For example, if the inflation rate was 100% in
one year, sales would appear to have doubled over the preceding year, when in fact sales did
not change at all.
(iv) Aggregation
The information in a financial statement line item that is used for a ratio analysis may have
been aggregated differently in the past, so that running the ratio analysis on a trend line does
not compare the same information through the entire trend period.

© Emile Woolf International 433 The Institute of Chartered Accountants of Pakistan