Analysis and Interpretation of Financial Statements: Powerpoint To Accompany

Chapter 6
Analysis and
interpretation of
financial
statements
PowerPoint to accompany:
Learning objectives
1. Define what a ratio is
2. Identify the key aspects of financial performance and financial
position that are evaluated by the use of ratios
3. Explain the terms profitability, efficiency, liquidity, gearing and
investment
4. Summarise the alternative bases of comparison for ratio analysis
5. Present the ratio formulae for the basic ratios
6. Calculate ratios to analyse the profitability, efficiency, liquidity,
gearing and investment of a given entity’s financial statements
over several periods
2 Copyright ©2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442534803/Atrill/Accounting: An Introduction/5th edition
Learning objectives
7. Interpret basic ratios for profitability, efficiency, liquidity, gearing
and investment
8. Discuss the limitations of ratios as a tool of financial analysis
9. Understand index or percentage analysis as an alternative to ratios
Financial ratios
• Provide a quick and simple means of examining the financial health
of a business
• Simply expresses the relationship between one figure appearing in
the financial statements with another e.g. net profit in relation to
capital employed
• Are simple to calculate, and a good picture can be built up with just
a few, however ratios can be difficult to interpret
• Can be expressed in various forms e.g. percentages, fractions,
proportions depending on the need and use for the information
Financial ratios
• The key aspects of financial performance/position evaluated by the
use of ratios are:
• Profitability
• Efficiency
• Liquidity
• Gearing
Financial ratio classification
• Profitability – Measure of success in wealth creation
• Efficiency – Effectiveness of utilisation of resources
• Liquidity – The ability to meet short-term obligations
• Gearing – Measure of degree of risk to do with the amount of
leverage used to finance the business
The need for comparison
• Calculated ratios on their own do not say much about the position
or performance of a business
• Ratios need to be compared with some form of ‘benchmark’ that
the information can be interpreted and evaluated
Key steps in financial ratio analysis
Step 1:
• Identify which key indicators and relationships require examination
• Identify who needs the information and why they need it
Step 2:
• Choose the most relevant set of ratios that will accomplish the
desired purposes
• Calculate and record the results using the selected ratios
Step 3:
• Interpret and evaluate the results
The ratios calculated
Profitability
• Return on ordinary shareholders’ funds/return on equity

• Return on total assets
• Return on capital employed
• Net profit margin
• Gross profit margin
The ratios calculated – profitability ratios
Return on ordinary shareholders funds (ROSF)
• Also referred to as ‘return on equity’

• Compares the amount of profit for the period available to the owners
with the owners’ stake in the business
• Normally expressed as a percentage
Net profit after taxation and preference dividend (if any)

ROSF = Average ordinary share capital plus reserves x 100
Return on total assets (ROA)
• Compares the net profit generated by the business with the assets
owned by the business
Net profit before interest and taxation

ROA = Average total assets x 100
Return on capital employed (ROCE)
•Relationship
between the net profit generated during a period and
long-term capital invested in the business during the period
•Expressed as a percentage
Return on capital Net profit before interest and taxation

employed = Share capital + Long-term loans x 100
Net profit margin
• Relates the net profit for the period to the sales during that period
Net profit before interest and taxation

Net profit margin = Sales x 100
Gross profit margin
• Relates the gross profit of the business to the sales generated

during the same period
• Gross profit represents the difference between sales and cost of
sales
Gross profit
Gross profit margin = Sales x 100
The ratios calculated
Efficiency
• Average inventory turnover period

• Average settlement period for accounts receivable
• Average settlement period for accounts payable
• Asset turnover period
The ratios calculated – efficiency ratios
Average inventory turnover period
• Measures the average period inventory was held

• Normally expressed in terms of days
• Average inventory is the simple average of opening and closing
inventory for the period
Average inventory held

Inventory turnover period = Cost of sales x 365
Average settlement period for accounts receivable (debtors)
• Calculates how long, on average, credit customers take to pay

amounts owed
Average accounts receivable

Average settlement period = Credit sales x 365
Average settlement period for accounts payable (creditors)
• Calculates how long, on average, the business takes to pay its

creditors
Average accounts payable

Average settlement period = Credit purchases x 365
Asset turnover period
• Examines how effectively the assets of the business are being

employed in generating sales revenue
Average total assets employed

Average asset turnover period = Sales x 365
The relationship between profitability and efficiency
(p. 307)
The ratios calculated – liquidity ratios
Current ratio
• Compares the business’s liquid assets with short-term liabilities

(current liabilities)
• Expressed in terms of the number of times the current assets will
cover the current liabilities
Current assets
Current ratio = Current liabilities
Acid test (also known as the quick or liquid) ratio
• Represents a more stringent test of liquidity than the current ratio

• Expressed in terms of the number of times the ‘liquid’ current
assets will cover the current liabilities
Current assets (excluding inventory and prepayments)

Acid test ratio = Current liabilities
Cash flows from operations ratio
• Compares the operating cash flows with the current liabilities of the
business
• Expressed in terms of the number of times the operating cash flows
will cover the current liabilities
Operating cash flows

Cash flows from operations ratio = Current liabilities
Financial gearing (leverage)
• The existence of fixed payment bearing securities (e.g. loans) in
the capital structure of a company
• The level of gearing, or the extent to which a business is financed
by outside parties, is an important factor in assessing risk
• Gearing may be used both to adequately finance the business, and
to increase the returns to owners – provided that the returns
generated from the borrowed funds exceed the interest cost of
borrowing
The ratios calculated – financial gearing (leverage)
Gearing ratio
• Measures the contribution of long-term lenders to the long-term

capital structure of the business
• Expressed in terms of a percentage
Long-term liabilities
Gearing ratio = Share capital + Reserves + Long-term liabilities x 100
(p. 312)
Interest cover ratio (times interest earned)
• Measures the amount of profit available to cover interest expense

of the business
• Expressed in terms of the number of times the profit generated by
the business will cover the interest expense of its gearing
Profit before interest and taxation

Interest cover ratio = Interest expense
Trend analysis
• Trends may be identified by plotting key ratios on a graph, giving a
visual representation of changes happening over time
• Intra-company trends may be compared against industry trends
• Key financial ratios are often published in companies’ annual
reports as a way to help users to identify important trends
Trend analysis (p. 323)
Ratios and prediction models
• Ratios are often used to help ‘predict the future’, however, the
choice of ratios and interpretation of results depend on the
judgement of the analyst
Limitations of ratio analysis
• The quality of the underlying financial statements determines the
usefulness of the ratios derived from them
• Ratios only offer a restricted view of ‘relative’ performance and
position – not the full picture
• No two businesses are identical and the greater their differences,
the greater the limitations of ratio analysis as a basis for
comparison
• Any ratios based upon balance sheet figures will not be
representative of the whole period because the balance sheet is a
snapshot of a moment in time
Index or percentage analysis
• Index or percentage analysis simply allows monetary figures to be
replaced with an index or a percentage
Index or percentage analysis
Income Statement
2010 2011 2012 2013

Sales 1000 112 120 118
COGS 600 110 115 113
Gross Profit 400
Expenses 250 110 97 105
Profit 150
The above is a trend percentage analysis of the income

statement of Company X over a 4 year period. 2010 is the
base year and equals to 100.
Calculate the actual results for 2011 – 2013?

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Chapter 6

• Return on ordinary shareholders’ funds/return on equity

• Also referred to as ‘return on equity’

Net profit after taxation and preference dividend (if any)

Net profit before interest and taxation

Return on capital Net profit before interest and taxation

Net profit before interest and taxation

• Relates the gross profit of the business to the sales generated

• Average inventory turnover period

• Measures the average period inventory was held

Average inventory held

• Calculates how long, on average, credit customers take to pay

Average accounts receivable

• Calculates how long, on average, the business takes to pay its

Average accounts payable

• Examines how effectively the assets of the business are being

Average total assets employed

• Compares the business’s liquid assets with short-term liabilities

Acid test (also known as the quick or liquid) ratio

• Represents a more stringent test of liquidity than the current ratio

Current assets (excluding inventory and prepayments)

Operating cash flows

• Measures the contribution of long-term lenders to the long-term

• Measures the amount of profit available to cover interest expense

Profit before interest and taxation

2010 2011 2012 2013

The above is a trend percentage analysis of the income

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