Chapter 47 An introduction to the analysis and interpretation of accounting statements

Learning objectives After you have studied this chapter, you should be able to: Explain how the use of ratios can help in analysing the profitability, liquidity, efficiency and capital structure of businesses Calculate the main accounting ratios Interpret the results of calculating accounting ratios

Learning objectives (Continued) Explain the advantages and disadvantages of the gearing of an organisation being high or low Explain how the proportion of costs that are fixed and variable impacts profit at different levels of activity Explain the relevance of IAS 1 and IAS 8, and accounting standards in general, to the preparation of financial statements

Using ratios Without ratios, financial statements are largely uninformative to all but the very skilled. Ratios enable financial statements to be interpreted if you compare like with like. Parties interested in analysis include: shareholders, lenders, customers, suppliers, employees, government agencies and competitors.

For example, let’s take the performance of four companies, all dealing in the same type of goods: Gross profit Sales £ £ Company A 200,000 848,000 Company B 300,000 1,252,000 Company C 500,000 1,927,500 Company D 350,000 1,468,400

You can only sensibly compare like with like. There is not much point, for example, in comparing the gross profit percentage of a wholesale chemist with that of a restaurant. Similarly, figures are only comparable if they have been built up on a similar basis. The sales figures of Company X, which treats items as sales only when cash is received, cannot be properly compared with those of Company Z, which treats items as sales as soon as they are invoiced.

Profitability ratios The return on capital employed ratio (ROCE) shows whether the people who invested money in the business are getting an adequate return on their investment.

Profitability ratios (Continued) The gross profit percentage shows the amount of gross profit for every £100 of sales revenue.

Profitability ratios (Continued) The net profit percentage shows the amount of net profit for every £100 of sales revenue.

Liquidity ratios The current ratio compares assets which will become liquid within approximately 12 months with liabilities which will be due for payment in the same period and indicates whether there are sufficient short-term assets to meet the short-term liabilities.

Liquidity ratios (Continued) The acid test ratio shows whether the business has sufficient liquid resources to meet its current liabilities.

Efficiency ratios The inventory turnover ratios measure how efficient a business is at maintaining an appropriate level of inventory.

Efficiency ratios (Continued) The accounts receivable/sales ratio measures the length of time a debtor takes to pay their debt.

Efficiency ratios (Continued) The accounts payable/ purchases ratio measures the length of time we take to pay our creditors.

Shareholder ratios The earnings per share ratio (EPS) gives the shareholder a chance to compare one year’s earnings with another in terms that are easily understood.

Shareholder ratios (Continued) The price/earnings ratio (P/E) puts the price of the company’s shares into context as a multiple of the earnings.

Shareholder ratios (Continued) The dividend yield ratio measures the real rate of return by comparing the dividend paid to the market price of a share.

Shareholder ratios (Continued) The dividend cover ratio gives the shareholder some idea as to the proportion that the ordinary dividends bear to the amount available for distribution to ordinary shareholders.

Capital structure ratios The gearing ratio shows the relationship between long-term interest-bearing debt and long-term funding.

Fixed and variable costs Fixed costs remain constant whether activity increases or falls within a given range of change of activity. Variable costs will change with swings in activity.

IAS 1 – Presentation of financial statements IAS 1 governs the way in which accounting information is presented in financial statements.

IAS 8 – Accounting policies, changes in accounting estimates and errors Accounting policies are defined as the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. Therefore accounting policies define the processes whereby transactions are reflected in the financial statements. Accounting policies should be selected to ensure a true and fair view is given.

IAS 8 – Accounting policies, changes in accounting estimates and errors (Continued) When choosing an accounting policy, the four characteristics of financial information should be considered: Relevance – it produces useful information. Reliability – it reflects the substance of the transaction. Comparability – it can be compared with similar information from another period. Understandability – it is capable of being understood.

Learning outcomes You should have now learnt: That comparing the trends to see if the ratios are getting better or worse as each period passes is essential for proper control. Prompt action needs to be taken where the trend in a ratio is deteriorating. The importance of interpreting ratios in their context: that is, against those of other similar businesses or against the same ratios calculated for the same organisation using data from other time periods.

Learning outcomes (Continued) That a business must be both profitable and sufficiently liquid to be successful. One factor without the other can lead to serious trouble. That careful credit control to ensure that the accounts receivable/sales ratio is not too high is usually essential to the well-being of any business.

Learning outcomes (Continued) That gearing affects the risk factor for ordinary share investors. High gearing means greater risk whilst low gearing means lower risks. How to calculate and interpret the most commonly used ratios. The relevance of ratio analysis to an assessment of liquidity, efficiency, profitability and capital structure.

Learning outcomes (Continued) That the relative amounts of fixed and variable costs can affect profit significantly when there are swings in business activity. The importance of IAS 1 and IAS 8, and accounting standards in general, to the preparation of financial statements.