INTERPRETING FINANCIAL STATEMENTS Chapter 6 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS

Discuss the limitations of ratios as a tool of financial analysis LEARNING OUTCOMES You should be able to: Calculate key ratios for assessing the financial performance and position of a business Identify the major categories of ratios that can be used for analysing financial statements Discuss the limitations of ratios as a tool of financial analysis Explain the significance of the ratios calculated

The key aspects of financial health Profitability Investment Liquidity Efficiency Financial gearing Financial ratios Figure 6.1 The key aspects of financial health

Similar businesses for the same period Ratios may be compared with: Ratios benchmarks Similar businesses for the same period Planned performance Past periods Ratios may be compared with:

Profitability ratios Return on ordinary shareholders’ funds (ROSF) Profit for the year (less any preference dividend) × 100 Ordinary share capital + Reserves Return on ordinary shareholders’ funds (ROSF) Operating profit × 100 Share capital + Reserves + Non-current liabilities Return on capital employed (ROCE) Operating profit × 100 Sales revenue Operating profit margin Gross profit × 100 Sales revenue Gross profit margin

The ROCE for UK companies 3 6 9 12 15 18 2008 2010 2009 2011 All non-financial companies Service companies Manufacturing companies 2012 Figure 6.2 The ROCE of UK companies Source: Figure compiled from information taken from ‘Profitability of UK companies Q2 2013’, Office of National Statistics ( www.statistics.gov.uk/ ), 9 October 2013.

Efficiency ratios Formula Average inventories turnover period Average settlement period for receivables Average settlement period for payables Sales revenue to capital employed Sales revenue per employee Average inventories held × 365 Cost of sales Average trade receivables × 365 Credit sales revenue Average trade payables × 365 Credit purchases Sales revenue Number of employees Sales revenue________________ Share capital + Reserves + Non-current liabilities

The main elements of the ROCE ratio multiplied by equals Return on capital employed Sales revenue Long-term capital employed Operating profit Sales revenue Figure 6.3 The main elements of the ROCE ratio

Liquidity ratios Formula Current assets Current liabilities Current ratio Acid test ratio Formula Current assets Current liabilities Current assets (excluding inventories) Current liabilities

Operating profit Interest payable Gearing ratios Long-term (non-current) liabilities Share capital + Reserves + Long-term (non-current) liabilities Gearing ratio Formula Interest cover ratio Operating profit Interest payable × 100

Investment ratios Formula Dividend payout ratio × 100 Dividend cover ratio Dividend yield ratio Dividends announced for the year Earnings for the year available for dividends Earnings for the year available for dividend Dividends announced for the year Dividend per share/(1 − t ) Market value per share × 100 × 100

Investment ratios (Continued) Formula Price/earnings ratio (P/E) Earnings per share Earnings available to ordinary shareholders Number of ordinary shares in issue 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 producers Construction and materials Chemicals Pharmaceuticals and biotechnology Tobacco Food and drug retailers Life assurance Media Travel and leisure Beverages 4.14 3.56 2.22 2.14 4.25 4.35 2.38 2.63 3.94 5.72 2.21 3.33 3.34 Average for all SE listed businesses % Industrial engineering Electricity Figure 6.5 Average dividend yield ratios for businesses in a range of industries Source: Constructed from data appearing in the Financial Times, 30 November 2013.

Average price/earnings ratios for businesses in a range of industries 10.0 30.0 25.0 20.0 15.0 13.20 21.70 39.60 21.85 19.70 15.26 19.61 21.81 12.99 10.73 22.02 21.56 35.0 14.59 Oil and gas Construction and materials Chemicals Industrial engineering Pharmaceuticals and Biotechnology Tobacco Food and drug retailers Electricity Life assurance Media Travel and leisure Beverages Average for all SE listed businesses times Figure 6.6 Average price/earnings ratios for businesses in a range of industries Source: Constructed from data appearing in the Financial Times, 30 November 2013.

Graph plotting current ratio against time 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2005 2008 2007 2006 2009 2010 2011 2012 2013 Tesco plc J. Sainsbury plc William Morrison Figure 6.7 Graph plotting current ratio against time Source: Annual reports of the three businesses 2005 to 2013.

Limitations of ratio analysis The restricted view given by ratios The basis for comparison Quality of financial statements Statement of financial position ratios Inflation