1. INTERPRETING FINANCIAL STATEMENTS
Chapter 6
ANALYSING AND
INTERPRETING FINANCIAL STATEMENTS

2. 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

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

4. 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:

5. 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

6. The ROCE for UK companies3 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 ( ), 9 October 2013.

7. 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

8. 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

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

10. 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

11. 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

12. 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

13. Average dividend yield ratios for businesses in a range of industries1 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.

14. 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.

15. 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.

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