Revise lecture 27 1

Interpreting financial statements 2

Interpreting financial information 1. Profitability ratios 2. Liquidity and working capital ratios 3.Long term financial stability 4.Investors ratios 5. Limitations of financial statements and ratio analysis 6.Related parties 3

Profitability ratios Gross profit margin or percentage is Gross profit / Sales revenue * 100% This is the margin that the company makes on its sales, and would be expected to remain reasonably constant. 4

Operating profit margin (net profit) ratio Can be calculated as: PBIT / Sales revenue * 100% Any changes in operating profit margin should be considered further: 1.Are they in line with changes in gross profit margin? 2.Are they in line with changes in sales revenue? 5

Operating profit margin (net profit) ratio 3. As many costs are fixed they need not necessarily increase/decrease with a change in revenue. 4. Look for individual cost categories that have increased/decreased significantly. 6

ROCE ratio ROCE = Profit / capital employed * 100% Profit is measured as: Operating (trading) profit, or The profit before interest and tax (PBIT) Capital employed is measured as: Equity + interest bearing finance 7

ROCE ratio ROCE for the current year should be compared to: 1.The prior year ROCE 2.A target ROCE 3.The cost of borrowing 4.Other companies ROCE in the same industry 8

Net asset turnover Sales revenue / Capital employed (net assets) = times pa It measures management’s efficiency in generating revenue from the net assets at its disposal The higher, the more efficient 9

Liquidity and working capital ratios 10

Working capital ratios There are two ratios used to measure overall working capital: 1.The current ratio 2.The quick or acid test ratio 11

Current ratio or Working capital ratios Current ratio or working capital ratio = Current assets / current liabilities :1 The current ratio measures the adequacy of current assets to meet the liabilities as they fall due. Traditionally, a current ratio of 2:1 or higher was regarded as appropriate for most businesses to maintain creditworthiness. However, more recently a figure of 1:5 :1 is regarded as the norm. 12

Current ratio or Working capital ratios The current ratio should be looked at in the light of what is normal for the business. For example, supermarkets tend to have low current ratios because: There are few trade receivables There is a high level of trade payables There is usually very tight cash control, to fund investment in developing new sites and improving sites 13

Quick ratio 0r liquidity or acid test ratio Current assets – inventory / current liabilities :1 It provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities. Normal levels for the quick ratio range from 1:1 to 1.7:1 Like the current ratio it is relevant to consider the nature of the business (e.g. supermarkets have very low quick ratios) 14

Quick ratio 0r liquidity or acid test ratio When interpreting the quick ratio, care should be taken over the status of the bank overdraft. A company with a low quick ratio may actually have no problem in paying its amounts due if sufficient overall overdraft facilities are available. 15

Long-term financial stability The main points to consider when assessing the longer-term financial position are: 1.Gearing 2.overtrading 16

Long-term financial stability Gearing Gearing ratios indicate: The degree of risk attached to the company and The sensitivity of earnings and dividends to changes in profitability and activity level 17

Long-term financial stability High and low gearing In highly geared businesses: 1.A large proportion of fixed-return capital is used 2.There is a greater risk of insolvency 3.Returns to shareholders will grow proportionately more if profits are growing 18

Long-term financial stability High and low gearing Low-geared businesses: 1.Provide scope to increase borrowings when potentially profitable projects are available 2.Can usually borrow more easily 19

Gearing Not all companies are suitable for a highly- geared structure. A company must have two fundamental characteristics if it is to use gearing successfully 1.Relatively stable profits 2.Suitable assets for security 20

Measuring Gearing There are two methods commonly used to express gearing as follows: 1.Debt / equity ratio 2.Interest cover ratio 21

Overtrading Overtrading arises where a company expands its sales revenue fairly rapidly without securing additional long- term capital adequate for its needs. The symptoms of overtrading are: 1.Inventory increasing, possibly more than % to revenue 2.Receivables increasing, possibly more than % to revenue 3.Cash and liquid assets declining at a fairly alarming rate 4.Trade payables increasingly rapidly 22

Investors ratios 1.EPS ratio 2.P/E ratio 3.Dividend yield ratio 23

Limitations of FS and ratio analysis Ratios are tool to assist analysis They help to focus attention systematically on important areas and summarise information in an understandable form. They assist in identifying trends and relationships. 24

Limitations of FS and ratio analysis However ratios are not predictive if they are based on historical information. They ignore future action by management They can be manipulated by window dressing or creative accounting They may be distorted by difference in accounting policies 25

Limitations of FS and ratio analysis Assets values shown in the SFP at historic cost may bear no resemblance to their current value or what it may cost to replace them. This may result in a low depreciation charge and overstatement of profit in real terms. As a result of historical costs the financial statements do not show the real cost of using the non-current assets. 26

Related parties Definition Two parties are considered to be related if one part has the ability to control the other party or exercise significant influence over the other party, or the parties are under common control 27

Related parties Distortion of financial statements A related party relationship can affect the financial position and operating results of an entity in a number of ways. 1.Transactions are entered into with a related party which may not have occurred without the relationship existing 28

Related parties Distortion of financial statements 2. Transactions may be entered into on terms different to those with an unrelated party 3. Transactions with third parties may be affected by the existence of the related party relationship 29