1. Analysis of Financial Statement
Ratio analysis
Ratio analysis may highlight unusual results or clarify trends,
enabling various users of accounts to make informed
decisions relating to the company.
For ratios to be useful, comparisons must be made - on a
year to year basis, or between companies. On their own
they are useless for any sensible decision making.
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2. Analysis of Financial Statement
Categories of ratios
• Profitability
• Liquidity
• Gearing
• Investors’ ratios.

3. Analysis of Financial Statement
PROFITABILITY
Return on capital employed (ROCE) = PBIT Debt + Equity %
PBIT = Profit before interest and tax. It is often referred to internationally as IBIT (Income before interest and tax)
Debt + equity = Debt is long-term debt (generally non-
current liabilities) + equity section of SOFP, representing the capital invested in the business. It is equal to 'Total assets less current liabilities' (TALCL)
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4. Analysis of Financial Statement
Sections of the statement
Gross profit margin = Gross profit Revenue %
Operating profit margin = PBIT Revenue %
Net asset turnover = Revenue TALCL TALCL = Total assets less current liabilities representing
the net assets turned over. Can also be calculated as debt + equity
5 Return on equity = PAT and preference dividends Equity %

5. Analysis of Financial Statement
LIQUIDITY
Current ratio = Current assets Current liabilities
Quick ratio (or acid test) = Current assets - inventories Current liabilities
Inventory turnover/days = Cost of sales or Inventories × 365 days * Inventories Cost of sales
Receivables collection period = Trade receivables × 365 days * Credit turnover
Payables payment period = Trade payables × 365 days * Credit purchases

6. Analysis of Financial Statement
GEARING
1 Debt/equity = Interest bearing debt Equity %
2 Debt/ (debt + equity) = Interest bearing debt Interest bearing debt Equity %
Interest bearing debt = long-term debt on which the
company is required to pay interest. In some instances a
persistent bank overdraft is classed as long-term debt.
3 Interest cover = PBIT Interest payable

7. Analysis of Financial Statement
INVESTORS’ RATIOS
1 Dividend yield = Dividend per share Share price %
2 Dividend cover = EPS Dividend per share
3 Price/Earnings (P/E) ratio = Share price EPS

8. Analysis of Financial Statement
Limitations of financial statements
• Problems of historical information
• Creative accounting
• Related party transaction
• Unrepresentative financial statements

9. Analysis of Financial Statement
Problems of historical information：
Financial data quickly becomes out of date
There is no guarantee that trends in historical data will
Continue
A change in company strategy may have occurred since the
financial data was published. Similarly, a change in
management since the results were published can lead to
different market expectations about the future.

10. Analysis of Financial Statement
Creative accounting
Creative accounting is where management use accounting
methods to work in their favour to achieve a desired effect.
This is often borne out of a desire to give markets what they
expect to see, e.g.
• Steady growth in profits
• Stable dividends
• No key ratio changes or improvement in ratios.

11. Analysis of Financial Statement
Related party transaction (IAS 24)
A transfer of resources or obligations between related
parties, regardless of whether a price is charged.
Eg:
Other group companies (including associates and joint
ventures.
Key management personnel (and their close family)
Companies in which key management personnel or their
family have influence.
IAS 24 requires transactions with related parties to be
disclosed

12. Analysis of Financial Statement
Possible effects on the financial statements
Higher or lower revenue and profit due to artificial prices on
transactionsbwith related parties
Costs or savings due to different terms and conditions other
than prices (e.g. lost interest due to longer credit periods
given to related parties)
Revenue that would not occur without the influence of the
related party
Suppliers determined by personal relationships or financial
interests of key management personnel
Loans to related parties at preferential interest rates.

13. Analysis of Financial Statement
Unrepresentative financial statements
Trading may be seasonal within a period (or over different accounting
periods). Companies with a seasonal business often position their year
end after the busy season for practical reasons, but this may also
coincide with when the financial position is at its most solvent.
Year end figures are often not representative, because they
include year end accounting adjustments and may be subject
to 'window dressing'.
Major asset acquisitions just before the year end may have
the following effects:
– no/little sales revenue
– a low relative depreciation charge.

14. Analysis of Financial Statement
Limitations of interpretation techniques
Inflation when comparing to previous years
Different accounting policies/classifications when
comparing to different companies e.g. ROCE higher if use
cost models for assets
Lack of information/ breakdown of information
Year end figures not representative
Related party transactions make the ratios incomparable
with other companies
Different ratio definitions used by different companies

15. Analysis of Financial Statement
Limitations of interpretation techniques
Different companies in the same business may have different
risk profiles or specific factors affecting them, making
Industry comparisons less meaningful
Where financial statements are manipulated, this is often
Done to improve key ratios
A new company will have no comparatives to compare with.