Interpretation of Financial Statements

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1 Introduction

Financial statements are prepared to assist users in making decisions. They therefore need interpreting, and the calculation of various ratios makes it easier to compare the state of a company with previous years and with other companies.

In this chapter we will look at the various ratios that you should learn for the examination.

2 The main areas

When attempting to analyse the financial statements of a company, there are several main areas that should be looked at:

• Profitability

• Liquidity

• Gearing

We will work through an example to illustrate the various ratios that you should learn under each heading.

3 Worked example

• Profitability

              (= capital + reserves + long-term liabilities)

  NB: ROCE = asset turnover × net profit margin

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• Liquidity

• Gearing

4 Limitations of ratio analysis

You must learn the various ratios. However, it is important that you are able to discuss briefly the relevance of the various ratios, and also their limitations.

Very few of the ratios mean much on their own – most are only useful when compared with the ratios for previous years or for similar companies.

Many of the ratios use figures from the Statement of Financial Position. These only represent the position at one point in time, which could be misleading. For example, the level of receivables could be unusually high at the year end, simply because a lot of invoicing was done just before the year end. Perhaps more sensible in that sort of case would be to use the average for the year. Normally in the examination you will be expected simply to use Statement of Financial Position figures at the end of the year, but do be prepared to state the problem if relevant.