Analysis of Financial Statement Ratio analysis Ratio analysis may highlight unusual results or clarify trends, enabling various users of accounts to make informed decisions relating to the company. For ratios to be useful, comparisons must be made - on a year to year basis, or between companies. On their own they are useless for any sensible decision making. 5-1

Analysis of Financial Statement Categories of ratios • Profitability • Liquidity • Gearing • Investors’ ratios.

Analysis of Financial Statement PROFITABILITY Return on capital employed (ROCE) = PBIT Debt + Equity % PBIT = Profit before interest and tax. It is often referred to internationally as IBIT (Income before interest and tax) Debt + equity = Debt is long-term debt (generally non- current liabilities) + equity section of SOFP, representing the capital invested in the business. It is equal to 'Total assets less current liabilities' (TALCL) 5-3

Analysis of Financial Statement Sections of the statement Gross profit margin = Gross profit Revenue % Operating profit margin = PBIT Revenue % Net asset turnover = Revenue TALCL TALCL = Total assets less current liabilities representing the net assets turned over. Can also be calculated as debt + equity 5 Return on equity = PAT and preference dividends Equity %

Analysis of Financial Statement LIQUIDITY Current ratio = Current assets Current liabilities Quick ratio (or acid test) = Current assets - inventories Current liabilities Inventory turnover/days = Cost of sales or Inventories × 365 days * Inventories Cost of sales Receivables collection period = Trade receivables × 365 days * Credit turnover Payables payment period = Trade payables × 365 days * Credit purchases

Analysis of Financial Statement GEARING 1 Debt/equity = Interest bearing debt Equity % 2 Debt/ (debt + equity) = Interest bearing debt Interest bearing debt Equity % Interest bearing debt = long-term debt on which the company is required to pay interest. In some instances a persistent bank overdraft is classed as long-term debt. 3 Interest cover = PBIT Interest payable

Analysis of Financial Statement INVESTORS’ RATIOS 1 Dividend yield = Dividend per share Share price % 2 Dividend cover = EPS Dividend per share 3 Price/Earnings (P/E) ratio = Share price EPS

Analysis of Financial Statement Limitations of financial statements • Problems of historical information • Creative accounting • Related party transaction • Unrepresentative financial statements

Analysis of Financial Statement Problems of historical information： Financial data quickly becomes out of date There is no guarantee that trends in historical data will Continue A change in company strategy may have occurred since the financial data was published. Similarly, a change in management since the results were published can lead to different market expectations about the future.

Analysis of Financial Statement Creative accounting Creative accounting is where management use accounting methods to work in their favour to achieve a desired effect. This is often borne out of a desire to give markets what they expect to see, e.g. • Steady growth in profits • Stable dividends • No key ratio changes or improvement in ratios.

Analysis of Financial Statement Related party transaction (IAS 24) A transfer of resources or obligations between related parties, regardless of whether a price is charged. Eg: Other group companies (including associates and joint ventures. Key management personnel (and their close family) Companies in which key management personnel or their family have influence. IAS 24 requires transactions with related parties to be disclosed

Analysis of Financial Statement Possible effects on the financial statements Higher or lower revenue and profit due to artificial prices on transactionsbwith related parties Costs or savings due to different terms and conditions other than prices (e.g. lost interest due to longer credit periods given to related parties) Revenue that would not occur without the influence of the related party Suppliers determined by personal relationships or financial interests of key management personnel Loans to related parties at preferential interest rates.

Analysis of Financial Statement Unrepresentative financial statements Trading may be seasonal within a period (or over different accounting periods). Companies with a seasonal business often position their year end after the busy season for practical reasons, but this may also coincide with when the financial position is at its most solvent. Year end figures are often not representative, because they include year end accounting adjustments and may be subject to 'window dressing'. Major asset acquisitions just before the year end may have the following effects: – no/little sales revenue – a low relative depreciation charge.

Analysis of Financial Statement Limitations of interpretation techniques Inflation when comparing to previous years Different accounting policies/classifications when comparing to different companies e.g. ROCE higher if use cost models for assets Lack of information/ breakdown of information Year end figures not representative Related party transactions make the ratios incomparable with other companies Different ratio definitions used by different companies

Analysis of Financial Statement Limitations of interpretation techniques Different companies in the same business may have different risk profiles or specific factors affecting them, making Industry comparisons less meaningful Where financial statements are manipulated, this is often Done to improve key ratios A new company will have no comparatives to compare with.