1. Chapter 3 Analysing and interpreting financial statements
LEARNING OUTCOMES
You should be able to:
Calculate key ratios for assessing 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
Discuss the use of ratios in helping to predict financial failure

2. The key aspects of financial health
Profitability
Investment
Liquidity
Efficiency
Financial gearing
Financial ratios

3. 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:

4. 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

5. BA’s operating profit margin5 10
2006
2009
2008
2007
2010
– 5
Operating profit margin %
Target

6. 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 × Credit sales revenue
Average trade payables × Credit purchases
Sales revenue Number of employees
Sales revenue________________ Share capital + Reserves + Non-current liabilities

7. The main elements of the ROCE ratio
multiplied by
equals
Return on capital employed
Sales revenue Long-term capital employed
Operating profit Sales revenue
Source: P. Atrill and E. McLaney, Accounting and Finance for Non-Specialists, 7th edn, Financial Times Prentice Hall, 2010, p. 206.

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

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

10. Investment ratios Formula Dividend payout ratio 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

11. 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

12. Average dividend yield ratios for businesses in a range of industries1 2 6 5 4 3
Oil and gas
Construction and materials
Chemicals
Industrial engineering
Pharmaceuticals and biotechnology
Tobacco
Food and Drug Retailers
Electricity
Life insurance/ Assurance
Media
Travel and leisure
Beverages
4.30
4.25
2.18
2.81
4.45
4.14
2.19
2.65
2.96
5.22
2.62
4.23
3.12
Average for all SE listed businesses %
Source: Constructed from data appearing in the Financial Times, 3/4 April 2010

13. Average price/earnings ratios for businesses in a range of industries
5.0
25.0
20.0
15.0
10.0
Oil and gas
Construction and materials
Chemicals
Industrial engineering
Pharmaceuticals and Biotechnology
Tobacco
Food and Drug Retailers
Electricity
Life insurance/ Assurance
Media
Travel and leisure
Beverages
14.10
12.77
28. 79
15.58
12.31
19.07
15.11
17.34
17.17
17.20
21.78
11.31
30.0
17.73
Average for all SE listed businesses
times
Source: Constructed from data appearing in the Financial Times, 3/4 April 2010

14. Graph plotting current ratio against time
0.9
J. Sainsbury plc
0.8
Current ratio
0.7
Tesco plc
0.6
0.5
William Morrison plc
0.4
0.3
0.2
0.1
2002
2003
2004
2005
2006
2007
2008
2009
2010

15. Average (mean) ratios of failed and non-failed businesses

16. Scatter diagram showing the distribution of failed and non-failed businesses
Current ratio
ROCE ratio
Failed businesses
Non-failed businesses
Source: P. Atrill and E. McLaney, Accounting: An Introduction, 7th edn, Financial Times Prentice Hall, 2009.

17. Z = The Z score model 0.717a + 0.847b + 3.107c + 0.420d + 0.998e
where:
a = Working capital/Total assets
b = Accumulated retained profits/Total assets
c = Operating profit/Total assets
d = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value
e = Sales revenue/Total assets
0.717a b c d e
Z =

18. Limitations of ratio analysis
Over-reliance on ratios
The basis for comparison
Quality of financial statements
Statement of financial position ratios
Inflation
Creative accounting