Interpretation of Financial Statements

Ratio Analysis Important not just to prepare financial statements but also to analyse and interpret the information contained in financial statements. ↓ Use Ratio analysis to do this

Ratio Analysis After calculating financial ratios, the following analyses can be performed;- Historical trend analysis – using past ratios to predict future trends. There are a number of situations where historical ratios cannot be used to predict future trends – Industry/Sector Analysis – benchmarking the performance achieved by a business entity to other businesses in the same industry –

Ratio Analysis - Method of Standardisation Ratio Analysis allows is a method of standardisation in that as ratio calculations are presented in Days, Times and Percentages, a comparison can be made between small and large businesses on the same basis –

Ratio Analysis There are 4 main categories of ratios;- Profitability ratios Liquidity ratios Efficiency ratios Gearing ratios

Ratio Analysis 1.Profitability ratios – analyse the performance of the company. Most important Profitability Ratio is ROCE (Return On Capital Employed). (a) ROCE is Net profit (b/f interest and tax) *100 Capital Employed ROCE shows the profit earned per €1 of capital employed in the business. Capital Employed = Capital and reserves section + Non Current Liabilities ROCE is compared to the finance cost of capital to see if the return being generated from capital is greater than the cost of servicing the capital i.e. Profit before interest and tax

Ratio Analysis Analysing ROCE - Calculate the Operating Profit Margin PBIT * 100 Revenue - Calculate the Asset Turnover Ratio Turnover Capital Employed from the ROCE Ratio

Ratio Analysis Other Profitability Ratios include;- (b) Gross profit % or gross margin = Gross profit * 100 Revenue This ratio indicates the efficiency of the production dept as well as the pricing policy of the business. It shows the gross profit earned in the business for every €1 of sales. (c) Net profit % or net margin = Net profit * 100 This ratio indicates the efficiency of the organisation with reference to trading overheads. It shows the net profit earned in the business for every €1 of sales. Net profit = profit b/f interest, tax and dividends (However other definitions of net profit may be used depending upon the Question)

Ratio Analysis Share Capital and Reserves (d) Return on Equity = Profit Before Tax * 100 Share Capital and Reserves

Ratio Analysis 2.Liquidity Ratios - Liquidity is essential for businesses. It is a measure of whether a business has enough short-term assets to meet its short-term debts. Often very profitable company’s can suffer from poor liquidity. Liquidity ratios include;- (a) Current Ratio (Working Capital Ratio) = Current Assets Current Liabilities Ratio measures the adequacy of the company’s current assets to meet it’s short-term liabilities. Recommended ratio is 2 /1.5: 1 Excessive current ratio could indicate – high levels of inventory (overstocking), high levels of cash which could be put to better use, high receivables (may indicate bad debts).

Ratio Analysis Current ratio should be looked at in light of what is normal for business eg supermarkets tend to have low ratios because there are no trade receivables and very tight cash control. Drawback of Current Ratio as a measure of liquidity is that it includes Closing Inventories which are the least liquid of current assets

Ratio Analysis (b) Acid-test or Quick Ratio = Current Assets – closing inventory Current Liabilities Ratio provides an indication of the immediate liquid position of the business ie whether the business, excluding inventory, has enough cash and receivables to pay its current liabilities. Recommended ratio is 1:1 Like the current ratio, need to examine the nature of the business when evaluating the result eg supermarkets have very low quick ratios. Important to note that no matter how profitable a business is, unless it is adequately liquid it may fail - “CASH IS KING”

Ratio Analysis 3.Efficiency Ratios and Working Capital Cycle = Efficiency and liquidity ratios are related in that if a business enjoys good efficiency ratios, it will tend to have good liquidity. Efficiency ratios examine how many days it takes the business to sell inventories, for receivables to pay and for the business to pay payables. There are 3 efficiency ratios;- (a) Inventory Turnover Period = Inventory* 365 days COS It measures how long on average it takes a business to sell it’s inventories. Businesses want the inventory turnover period to be as low as possible. If the turnover period is high – significant amount of cash tied up in inventory, unnecessary storage costs. Assessment of inventory days however, depends on sector business operates in –.

Ratio Analysis Receivables Days Ratio = Receivables * 365 days Net Credit Sales Ratio shows how long it takes customers to pay. Businesses want this to be as low as possible (certainly lower than the Payables Days Ratio). A very high ratio could indicate poor Credit Control in the business – Payables Days Ratio = Payables * 365 days Net Credit Purchases Ratio shows how long it takes the business to pay its suppliers. A very high ratio could indicate liquidity problems but must be assessed in the broader business environment in which the business operates –

Ratio Analysis Working Capital Operating Cycle This is the same as the Cash Cycle for a business – it examines how long it takes to generate cash from inventory and how long before cash is used to pay suppliers. When inventories are purchased, a clock starts ticking in terms of how long it takes that inventory to turn into cash. Also when inventory is purchased, another clock starts ticking in terms of how long the business can put off paying suppliers. A business can have either a surplus or a deficit in its working capital cycle – A deficit is costly – business may have to arrange a bank overdraft. Surplus can be temporarily invested and a return earned Can use efficiency ratios to work out the working capital cycle of the business

Ratio Analysis Overtrading As a general rule, the larger the business, the more capital is required. Overtrading occurs when a business expands too fast and the capital it has available to it, is too small to support the volume of business activity being undertaken. The business ultimately becomes a victim of its own success – a company that is overtrading will ultimately run out of cash. A significant number of business failures are caused by overtrading. Therefore identifying the earning signals is important and can be achieved through ratio analysis.

Ratio Analysis 4.Gearing (Leverage) Ratios A business will normally be financed through equity and debt. Gearing or leverage examines how much of the business is finance through debt i.e borrowed funds. A business that has a lot of debt relative to equity has a high gearing. A business that has low levels of debt relative to equity has a low gearing.

Ratio Analysis (a) Gearing ratio is calculated as follows;- Non Current Liabilities______ *100 OSC +PSC + Reserves +NCL OSC: Ordinary Share Capital; PSC: Preference Share Capital; NCL: Non Current Liabilities Ratio shows for every €1 invested in the company, what % comes from borrowed funds. Generally companies that have a low gearing ratio are considered safer for a number of reasons – However there are also some advantages to being highly geared

Ratio Analysis A company with a gearing ratio of more than 50% is said to be highly geared But there is no absolute limit to what a gearing ratio ought to be

Ratio Analysis (b) Interest Cover. Formula calculated as follows;- Net profit (b/f interest and tax) Interest on NCL This shows how many times the profits cover the business’ interest payments Profits must at least cover interest payments once, if not, the business will be unable to pay its interest. Banks would be very interested in this ratio and would look for a cover of in excess of three to five times.

Ratio Analysis (c) Debt Ratio Total Debts Total Assets Ratio of a company’s total debts to its total assets Assets = Non Current Assets plus Current Assets Debts = All Payables whether they are due within one year or after more than one year. *Long Term Provisions can be ignored.

Ratio Analysis (d) Leverage Ratio Shareholders Equity * 100 Shareholders Equity plus total long term debt Describes the proportion of total assets financed by equity. Also known as the “Equity to Assets Ratio”

Ratio Analysis Solvency The Ability of an Entity to Pay its debts as they fall due It is a concept that relates to the cash flow of an entity as opposed to the profitability of an entity – Therefore an entity can be profitable (Income – Expenses as recorded on the Accruals basis) but not solvent – this could occur due to overtrading (High Sales but not enough cash being collected)

Ratio Analysis Limitations of Ratio Analysis There are a number of limitations which should be borne in mind. - Information Problems: Information is out for date, historical cost information may not be the most appropriate for decision making - Comparison Problems (Trend Analysis) : Effects of price changes make comparisons difficult, potential effects of changes in accounting policies - Comparison Problems Across Companies: Different firms use different accounting policies, Differing financial and business risk profiles

Ratio Analysis Limitations of Ratio Analysis Ratios must not be used as the sole test of efficiency. Ratios indicate where controls are flawed and highlight areas for improvement. In interpreting a business’ accounts, there are many other sources of information which should be looked at including;- (a) Comments in the Chairman’s Report and Director’s Report (b) Age and nature of company’s assets (c) Current & future developments in the company’s markets including acquisitions or disposals of businesses

Interpretation of Ratios Calculated Ratio Analysis Interpretation of Ratios Calculated Do not simply tell the examiner that “ratio has gone up and/or ratio has gone down” – this is not Interpretation and is unlikely to earn marks At least state whether the situation is improving or deteriorating and Better still, suggest why the ratio might have changed