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Analysis and Interpretation of The Financial Statements

This document provides an overview of financial ratio analysis. It discusses the purpose of ratios in measuring business performance, key areas of financial health like profitability, liquidity, efficiency, financial gearing, and investments. Specific ratios are defined like return on shareholder funds, current ratio, inventory turnover, gearing ratio, and earnings per share. Formulas for calculating various ratios are presented. Limitations of ratio analysis are noted like quality of financial statements, impact of inflation, limited view from ratios, need for comparison benchmarks, and focus on statement of profit or loss ratios only.

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Dhiashuhada Dhia
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63 views23 pages

Analysis and Interpretation of The Financial Statements

This document provides an overview of financial ratio analysis. It discusses the purpose of ratios in measuring business performance, key areas of financial health like profitability, liquidity, efficiency, financial gearing, and investments. Specific ratios are defined like return on shareholder funds, current ratio, inventory turnover, gearing ratio, and earnings per share. Formulas for calculating various ratios are presented. Limitations of ratio analysis are noted like quality of financial statements, impact of inflation, limited view from ratios, need for comparison benchmarks, and focus on statement of profit or loss ratios only.

Uploaded by

Dhiashuhada Dhia
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 23

Lecture 1:

Analysis and Interpretation of


the Financial Statements.
Learning Outcomes

•To understand the differing techniques and methods used to assess


and analyse the performance of a business.
•To calculate key ratios that can be utilised to assess business
performance.
•To analyse and interpret the possible underlying causes that impact
upon business performance.
•To understand and assess the usefulness of ratio analysis as a tool for
measuring business performance.
Purpose of Financial Ratios

• Express the relationship of one figure to some other figures.


• Financial ratios eliminate the problem of scale enabling
comparisons across differing sized businesses.
• Ratios assist within examining a range of aspects of financial
performance and position.
• Ratios are used by internal management as a means of
planning, controlling, and assessing business performance.
• Ratios can be utilised by investors and investment analysts to
identify possible investment opportunities.
Key areas of Financial Health

Financial
Profitability Investment
ratios

Financial
Efficiency Liquidity gearing
Ratio Classifications
Type Reflect Examples
Profitability Company and managerial ROSF, ROCE, Gross and
performance operating profit margin

Liquidity Ability to meet short term Current ratio, quick ratio, and
financial obligations cash ratio

Efficiency Efficiency of resources utilised Inventory turnover period,


within a business. average settlement period for
receivables and payables

Financial Relationship between equity Gearing ratio, interest cover


Gearing and debt financing. ratio

Investment Returns on shareholders’ Earnings per Share (EPS),


investment Price / Earnings Ratio (P/E)
Ratio Benchmarks

Ratios may be compared with:

Past periods

Similar businesses for the


same period

Planned performance
Profitability Ratio Formulae

accounting accounting
provides information provides information
for managers of an to shareholders,
who suppliers and others
direct and control who are outside
its operations.
Profitability Ratios
Return on Shareholder Funds (ROSF)

• Used to compare the amount of profit for the period available to the
owners in relation to the investment in the business over the same
period.
• Depicts the amount of profit available to ordinary shareholders.

Return on Capital Employed (ROCE)

• Used to express the relationship between the size of the profit figure
relevant to the size of the business.
• Depicts how efficiently a business is utilizing its resources.
• Compares inputs (capital invested) with outputs (operating profit).
Profitability Ratios (continued)
Gross Profit Margin

• Relates gross profit of the business to the sales generated for the
same period.
• A measure of profitability in buying and selling goods or services
before other expenses are taken into account.
• Low margins may indicate poor performance and scope for
improvement.
• High margins may indicate good management but could attract other
market entities.
Profitability Ratios (continued)
Operating Profit Margin

• Relates operating profit of the business to the sales generated for the
same period.
• Provides a measure of operating profit from trading operations
before any costs of servicing long-term finance are accounted for.
• Low operating margins i.e. supermarkets. High operating margins i.e.
jewellers.
Liquidity Ratio Formulae

Formula

Current assets
Current ratio Current liabilities

Current assets (excluding inventories)


Acid test ratio
Current liabilities
Liquidity Ratios
Current Ratio

• Compares liquid assets (cash and those assets soon to be turned


into cash) with current liabilities.
• Higher the ratio the more liquid the business.
• Ideal current ratio – argued this is 2:1
• Appropriate current ratio depends upon nature of the business.
Liquidity Ratios
Acid Test Ratio

• Similar to current ratio but excludes inventory from current assets.


• A more stringent test of liquidity.
• Inventory may be difficult to convert into cash quickly.
• Ideal acid test ratio – argued this is 1:1
Efficiency Ratio Formulae
Efficiency Ratios
Average Inventories Turnover Period

• Used to measure the average period for which inventories are


held within a business.
• Holding inventory for long periods of time incurs cost. i.e.
opportunity cost, storage costs etc.
• Days increased could indicate lack of demand for goods, poor
inventory control, increased chance of obsolescence etc.
• Alternatively days increased could signify inventory increases to
avoid shortages or obtaining larger inventory levels with
discounts.
• Consideration of supplier reliability, demand for products upon
deciding optimal inventory holding period.
Efficiency Ratios
Average Settlement Period for Receivables

• Used to measure how long on average credit customers take to


pay the amount they owe the business.
• Normally prefer a shorter average settlement period as funds are
tied up that could be used elsewhere.
• Days increased could indicate lack of credit control or attempts to
attract additional customers through offering longer credit terms.
• Alternatively days increased could indicate a potential cash
shortage leading to the offer of larger discounts for prompt
payment. (negatively impacting upon profitability)
Efficiency Ratios
Average Settlement Period for Payables

• Used to measure how long on average the business takes to


pay suppliers that supply goods on credit.
• Businesses attempt to extend this period for as long as
possible.
• Free source of finance. Cash kept longer within the business.
• Could indicate a liquidity problem.
• Reputational and brand consideration.
• Possible cash discounts lost.
Financial Gearing Ratio Formulae

Formula

Gearing Long-term (non-current) liabilities


ratio Share capital + Reserves + Long-term (non-current) liabilities

Interest cover Operating profit


ratio Interest payable
Financial Gearing Ratios
Gearing Ratio

• Measures the contribution of long-term lenders to the long-term


capital structure of the business.
• Higher gearing ratio implies higher risk.
• Varies dependent upon nature of business.

Interest Cover Ratio

• Used to measure the amount of operating profit available to cover


interest payable.
• The lower the ratio the greater the risk to lenders that interest
payments will not be met.
• Consequently greater risk to shareholders that lenders will take action
against business to recover interest due.
Investor Ratio Formulae

Formula

Earnings per Earnings available to ordinary shareholders


share Number of ordinary shares in issue

Price/earnings Market value per share


ratio (P/E) Earnings per share
Investor Ratios
Earnings per Share Ratio

• Used to relate the earnings generated by the business during a period


to the number of shares in issue.
• Fundamental measure of share performance.
• EPS trends can assist within identifying investment potential of a
business.

Price / Earnings Ratio

• Relates the market value of a share to the earnings per share of a


company.
• Higher the P/E ratio, the greater the market confidence in future
business performance.
• Useful in comparing differing businesses.
Limitations of Ratio Analysis

Quality of financial statements

Inflation

The restricted view given by


ratios

The basis for comparison

Statement of financial position


ratios
End of Session

Any Questions?

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