Analysing and interpreting financial statements OBJECTIVES You should be able to: Calculate important ratios for determining the financial performance and position of a business and explain the significance of the ratios calculated Identify the major categories of ratios that can be used for analysis purposes Discuss the limitations of ratios as a tool of financial analysis Explain the importance of gearing to a business and its owners

Financial ratio classification Categories Profitability Efficiency Liquidity Gearing Investment

Return on ordinary shareholders’ funds Return on capital employed Profitability ratios Return on ordinary shareholders’ funds Return on capital employed Net profit margin Gross profit margin Formula Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans Net profit before interest and taxation x 100 Sales Gross profit x 100 Sales

Efficiency ratios Formula Average stock turnover period Average settlement period for debtors Average settlement period for creditors Sales to capital employed Formula Average stock held x 365 Cost of sales Sales per employee Trade debtors x 365 Credit sales Trade creditors x 365 Credit purchases Sales Long-term capital employed Sales Number of employees

The main elements comprising the ROCE ratio Sales Long-term capital employed Return on capital employed multiplied by equals Net profit before interest and taxation sales

Liquidity ratios Formula Current ratio Acid test ratio Current assets Current liabilities (creditors due within one year) Current assets (excluding stock) Current liabilities

Gearing ratios Formula Interest cover ratio Formula Profit before interest and taxation Interest payable Long-term liabilities Share capital + Reserves + Long-term liabilities

The effect of financial gearing Profit before interest and tax

Investment ratios Formula Dividend payout ratio Dividend yield ratio Earnings per share Formula Dividends announced for the year x 100 Earnings for the year available for dividends Dividend per share/(1- t) x 100 Market value per share Earnings available to ordinary shareholders Number of ordinary shares in issue Price/earnings ratio (P/E) Market value per share Earnings per share

Average dividend yield ratios for businesses in a range of Industries 1 2 6 5 4 3 Oil and gas Construction and building materials Chemicals Engineering and machinery Pharmaceuticals and biotechnology Tobacco Food and drug retailers Electricity Real estate Transport Leisure and hotels Banks 3.67 4.35 4.42 5.15 2.85 4.52 3.98 4.29 3.35 6.32 3.16 4.83 Source: Constructed from data appearing in the Financial Times, 18 January 2003

Average price/earnings ratios for businesses in a range of industries 5 10 30 25 20 15 Oil and gas Construct. and building materials Chemicals Engineering and machinery Pharmaceuticals and biotechnology Tobacco Food and drug retailers Electricity Real estate Transport Leisure and hotels Banks 22.86 8.45 16.77 12.87 18.62 12.54 18.83 12.93 14.06 22.63 23.18 12.67 Source: Constructed from data appearing in the Financial Times, 18 January 2003

Graph plotting current ratio against time 2000 2003 2002 2001 2004 XYZ Ltd Industry average