Interpretation of Financial Statements
Ratios turn the figures in the financial statements into measures that can be compared — with the previous year or with similar businesses. BA3 groups them under three headings: profitability (how well the business uses its capital to make profit), liquidity (whether it can pay its bills in the short term, including how long it takes to sell inventory, collect from customers and pay suppliers) and risk, or gearing (how much of its long-term finance is borrowed). A ratio on its own means little: what matters is how it compares and why it has changed.
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:
Area | The question it answers |
Profitability | Is the business making a good return on the money invested in it, and on its sales? Are margins and the use of assets improving? |
Liquidity | Can the business pay its bills as they fall due? How quickly does it turn inventory and receivables into cash, and how long does it take to pay its suppliers? |
Gearing (risk) | How much of the long-term finance comes from borrowing rather than from shareholders, and how easily can the business pay the interest? |
Users read the ratios to judge the business: shareholders and potential investors look first at profitability; lenders and suppliers look at liquidity and at gearing and interest cover, because these show whether they will be paid.
The lectures for this chapter work through the figures in Example 1 (section 4), so you may want to have that example open as you watch.
3 The ratios
Learn each formula, but also what it tells the user. In the formulae below, ‘÷’ means divided by. Percentages are the result × 100%.
3.1 Profitability
Ratio | Formula | What it tells the user |
Return on capital employed (ROCE) | Profit before interest and tax ÷ total long-term capital × 100%. Total long-term capital = share capital + reserves + long-term (non-current) liabilities | The profit made on all the long-term money invested in the business, whoever provided it. The key measure of how well management runs the business. |
Operating profit margin (often called the net profit margin) | Profit before interest and tax ÷ revenue × 100% | The profit made on each $1 of sales, after all operating expenses but before interest and tax. |
Gross profit margin | Gross profit ÷ revenue × 100% | The profit on each $1 of sales after cost of sales only: it reflects selling prices and the cost of the goods sold. |
Asset turnover | Revenue ÷ total long-term capital | How many dollars of sales each $1 of long-term capital generates (a number, not a percentage). |
Non-current asset turnover | Revenue ÷ non-current assets | How hard the non-current assets are working: sales generated by each $1 of non-current assets. |
Return on equity | Profit after tax and preference dividend ÷ equity shareholders’ funds (share capital and reserves) × 100% | The return earned for the ordinary shareholders. |
Profit before interest and tax is the same figure as profit from operations (operating profit). Interest and tax are left out because they do not reflect how well the business is being run: interest depends on how the business is financed, and tax on the tax rate.
When accountants analyse ratios, ‘net profit margin’ usually means the operating profit margin above. If a question asks for a margin on the final profit for the year (after interest and tax), use that figure instead — read the question.
ROCE = asset turnover × operating profit margin
So ROCE can rise in two ways: by making more profit on each sale (a higher margin), or by selling more for the same size of business (a higher asset turnover).
3.2 Liquidity
Ratio | Formula | What it tells the user |
Current ratio | Current assets ÷ current liabilities | Whether short-term assets cover short-term debts. Below 1 is a warning sign; very high may mean too much inventory or slow-paying customers. |
Quick ratio (or acid test) | (Current assets − inventory) ÷ current liabilities | The same test without inventory, which takes longest to turn into cash. Always lower than the current ratio. |
Inventory days | Inventory ÷ cost of sales × 365 days | How many days’ worth of inventory is held. Inventory is valued at cost, so it is compared with cost of sales. |
Inventory turnover | Cost of sales ÷ inventory | The same idea as a number of times a year: how often the inventory is sold and replaced. |
Average collection period (receivables days) | Trade receivables ÷ credit sales × 365 days | How long customers take to pay. If credit sales are not given, use revenue and assume all sales are on credit. |
Average payment period (payables days) | Trade payables ÷ credit purchases × 365 days | How long the business takes to pay its suppliers. If only total purchases are given, use them; if purchases are not given at all, use cost of sales. |
Some books call the three ‘days’ ratios efficiency or working-capital ratios. The BA3 syllabus lists them, with inventory turnover, under liquidity, because they show how quickly cash comes in and goes out.
A business wants to collect from customers at least as quickly as it pays its suppliers. Paying suppliers later keeps cash in the business, but delaying too long risks losing the supplier.
3.3 Gearing
The syllabus calls these the risk ratios: they all concern borrowing. The second lecture (section 3.2) covers them after the liquidity ratios.
Near the end of the second lecture the tutor mentions that the theory of gearing comes in a later exam, using an older paper name. That theory is not part of BA3; you need only calculate and explain the ratios in this chapter.
Ratio | Formula | What it tells the user |
Gearing | Total long-term debt ÷ (shareholders’ equity + total long-term debt) × 100% | The proportion of long-term finance that is borrowed. The higher it is, the more interest must be paid whatever the profit, so the riskier the business. |
Leverage | Shareholders’ equity ÷ (shareholders’ equity + total long-term debt) × 100% | The same idea the other way round: the proportion from shareholders. Gearing + leverage = 100%. |
Interest cover | Profit before interest and tax ÷ interest charges | How many times the profit covers the interest. The lower it is, the smaller the fall in profit that would leave the business unable to pay its interest. |
4 Worked example
Statements of Financial Position as at 30 June
2010 $ | 2010 $ | 2009 $ | 2009 $ | |
ASSETS | ||||
Non-current assets | 3,218 | 1,982 | ||
Current assets | ||||
Inventory | 2,414 | 2,090 | ||
Trade receivables | 2,275 | 1,699 | ||
Cash | 864 | 240 | ||
5,553 | 4,029 | |||
Total assets | 8,771 | 6,011 | ||
EQUITY AND LIABILITIES | ||||
Share capital and reserves | 5,255 | 3,361 | ||
Non-current liabilities | 1,200 | 960 | ||
Current liabilities | 2,316 | 1,690 | ||
Total equity and liabilities | 8,771 | 6,011 |
Statement of Profit or Loss for the year ended 30 June
2010 $ | 2009 $ | |
Revenue | 17,232 | 13,044 |
Cost of sales | (12,924) | (10,109) |
Gross profit | 4,308 | 2,935 |
Distribution costs | (804) | (610) |
Administrative expenses | (1,608) | (1,217) |
Profit from operations | 1,896 | 1,108 |
Finance costs | (120) | (125) |
Profit before taxation | 1,776 | 983 |
Income tax expense | (629) | (346) |
Profit after taxation | 1,147 | 637 |
Calculate profitability, liquidity and gearing ratios.
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5 Reasons for changes in ratios
A ratio only becomes useful when you can say why it has changed. The table lists the usual reasons; in a question, pick those that fit the information given.
Ratio moves | Possible reasons |
Gross profit margin up or down | Change in selling prices; change in the cost of purchases or production; a different mix of products with different margins; inventory lost or valued differently |
Operating profit margin moves differently from gross margin | Operating expenses (distribution, administration) growing faster or slower than sales; one-off costs |
Asset turnover or non-current asset turnover down | New assets bought during the year that have not yet produced a full year’s sales; spare capacity; falling sales. Up: assets used more intensively, or old, heavily depreciated assets |
ROCE down | Lower margins, lower asset turnover, or both (ROCE = asset turnover × margin) |
Current and quick ratios down | Cash used to buy non-current assets or repay loans; more short-term borrowing; trading losses |
Inventory days up | Slow-moving or obsolete goods; building up inventory before an expected rise in sales; buying in bulk for discounts |
Receivables days up | Longer credit given to win customers; weaker credit control; a large sale just before the year end |
Payables days up | Delaying payment to save cash (a sign of cash shortage if extreme); better credit terms negotiated |
Gearing up, interest cover down | New loans taken out; losses reducing equity; higher interest rates or lower profit |
Perera Hardware Ltd of Colombo has the following figures (all in $000). During 2019 it took out a new long-term loan and issued shares to buy and fit out a second, larger warehouse, which opened in the last months of the year. It also offered customers longer credit to win new trade.
2019 $000 | 2018 $000 | |
Revenue | 5,000 | 4,000 |
Cost of sales | (3,500) | (2,600) |
Gross profit | 1,500 | 1,400 |
Operating expenses | (900) | (800) |
Profit from operations | 600 | 600 |
Finance costs | (100) | (40) |
Purchases (all on credit) | 3,800 | 2,700 |
Non-current assets | 4,000 | 2,500 |
Inventory | 700 | 400 |
Trade receivables | 820 | 500 |
Cash | 30 | 200 |
Trade payables (the only current liabilities) | 600 | 380 |
Long-term loan | 1,250 | 500 |
Share capital and reserves | 3,700 | 2,720 |
Required:
Calculate for both years: gross profit margin, operating profit margin, ROCE, non-current asset turnover, current ratio, quick ratio, inventory days, receivables days, payables days, gearing and interest cover.
Suggest reasons for the changes, using the information given.
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6 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.
Other points to bear in mind:
Different businesses may use different accounting policies (for example, different depreciation methods), so their ratios are not strictly comparable.
There is no ‘correct’ level for most ratios: an accounting firm holds almost no inventory, while a house builder holds a great deal. Compare like with like.
Ratios point to questions rather than answers: they show that something has changed, and you then look for the reason.
7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Interpretation of Financial Statements
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