Introduction to Finance

WEEK 3
INTERPRETATION OF FINANCIAL
STATEMENTS

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Learning Outcomes

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Understand the uses of ratio analysis

Calculate the accounting ratios and
interpret the results
Understand the limitations of ratio
analysis

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Ratio Analysis
Purpose:

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To provide a quick and relatively simple means

of examining the financial health of a business
over a period of time
To provide a performance comparison between
company and its competitors or the industry
average
To provide a comparison of the financial health
of different business
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Types of Ratios
5 main categories:

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Liquidity ratios analyze the short-term

liquidity of the business ie., the ability of the firm
to pay its debt when they fall due.
Profitability analyze the returns made on
sales and capital invested.
Efficiency ratios - analyze how effectively and
efficiently the company uses its resources
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Types of Ratios

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Gearing analyze the longer term liquidity of

the firm that is related to its long term debts vs
equity. The ratios indicate the financial risk of
the firm.
Investor ratios provide information as to
whether the investors investments are
reasonably secure in the firm.

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LIQUIDITY RATIOS

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Current Ratio

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Sometimes called the working capital ratio or

bankers ratio.
It measures a companys ability to pay its current
liabilities.

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Current Ratio

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Current Ratio =
Current Assets : Current Liabilities
For example: A ratio of 5:1 would imply the firm has
$ 5 of a assets to cover every $1 in
liabilities.
Too high Might suggest that too much of its assets
are tied up in unproductive activities too much
stock.
Too low risk of not being able to pay the liabilities.

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Current Ratio
Current Assets
Current Ratio = Current Liabilities
2011
Current Assets
Current Liabilities
Current Ratio
$550,000
$210,000

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2010
$550,000
$210,000
2.6
2.2

$533,000
$243,000

$533,000
$243,000

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Acid Test Ratio

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Also referred to as the Quick ratio

A ratio that measures the instant debt-paying
ability of a company.

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Acid Test Ratio

Quick
QuickRatio
Ratio
Quick assets:
Cash
Marketable securities
Debtors
Total
Current liabilities
Quick ratio

2010

2009

$ 90,500
75,000
115,000
$280,500
$210,000
1.3

$ 64,700
60,000
120,000
$244,700
$243,000
1.0

Use:
Use: To
Toindicate
indicate instant
instant debt-paying
debt-paying ability.
ability.
The
The ratio
ratio excludes
excludes inventory
inventory as
as time
time isis
needed
needed to
to convert
convert inventory
inventory to
to cash
cash

Acid Test Ratio

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(Current assets stock) :Current liabilities

1:1 seen as ideal
A ratio of 3:1 therefore would suggest the firm has 3
times as much cash as it owes very healthy!
A ratio of 0.5:1 would suggest the firm has twice as many
liabilities as it has cash to pay for those liabilities. This
might put the firm under pressure.

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PROFITABILITY RATIOS

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Profitability Analysis
Profitability is the ability of an entity to earn profits.
This ability to earn profits depends on the effectiveness
and efficiency of operations as well as resources
available.
Profitability analysis focuses primarily on the
relationship between operating results reported in the
income statement and resources reported in the balance
sheet.

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Profitability Ratios

Ratios include:
- Gross profit margin
- Operating profit margin
- Net profit margin
- Return on capital employed
- Return on equity

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Gross Profit Margin

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Assess how much does the company earn from

producing a $ of sales
A gross margin of 55% means that for every $ of sales,
the firm makes 55 cents of gross margin. And this
margin goes into covering the operating costs of the firm
The larger the gross profit margin, the better for the
company.
The calculation is: Gross Profit/Net Sales = ____%.
Both terms come from the companys income statement.

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Operating Profit Margin

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Also known as earnings before interest and tax

(EBIT)and is found on the company's income statement.
The calculation is: EBIT/Net Sales = _____%.
The operating profit margin ratio is a measure of overall
operating efficiency, incorporating all of the expenses of
ordinary, daily business activity.

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Net Profit Margin

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Measures profitability after consideration of all expenses

including taxes, interest, and depreciation. For example,
if the net profit margin is 5%, that means that 5 cents of
every dollar is profit.
The calculation is: Net Profit/Net Sales = _____%.
When doing a simple profitability ratio analysis, net profit
margin is the most often margin ratio used.

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Return on Capital Employed

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Measures the returns to all suppliers of long-term finance

in the company.
The calculation is: EBIT/Capital Employed = _____%..
Capital employed is share capital + reserves + long term
loans. It is taken from the balance sheet.
EBIT is earnings before deductions for interest payable
to lenders, dividends to shareholders and tax to govt.

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Return on Equity

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Measures the return on the money the shareholders have put

into the company. This is the ratio potential investors look at
when deciding whether or not to invest in the company.
The calculation is:
Net Profit after tax and preference dividend, if any /
Ordinary Share Capital and reserves = ___%.
Shareholders equity comes from the balance sheet.
Generally, the higher the percentage, the better, with some
exceptions, as it shows that the company is doing a good job
using the investors' money.

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EFFICIENCY RATIOS

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Efficiency Ratios

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Examine the way in which various

resources of the business are managed.
Ratios include:
- Average stock turnover period
- Average debtor collection period
- Average creditors payment period

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Average Stock Turnover Period

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To assess the efficiency in the management of stocks.

Indicates the length of time it takes to acquire, sell and
replace the inventory.

The ratio is calculated as: Average stock held x365 days

Cost
of sales
where average stock is (opening + closing stock)/2

A lower stock turnover period is preferred as funds tied

up in stock cannot be used for other purposes.
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Average Debtors Collection Period

To assess the efficiency in collecting debts and in the

management of credit.

The ratio is calculated as: Trade Debtors x 365 days

Cost of sales
where trade debtor is (opening + closing debtor )/2

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Comparing this ratio with the credit terms provide

information on the efficiency in collecting receivables
as this has significant impact on cash flow of
business.
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Average Creditors Payment Period

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Assess how long on average business takes to pay

creditors
The ratio is calculated as: Trade Creditors x 365 days
Credit
Purchases
where trade creditor is (opening + closing creditor )/2
If business regularly pays late, the supplier might
withdraw credit

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GEARING RATIOS

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Gearing

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is the relationship of debt funding to equity funding in a

company
Gearing can be measured in a variety of ways, and there is no
one version that is absolutely accepted.
A commonly used measure is:
Long term liabilities
x 100
Share capital + reserves + long term liabilities
An effect of gearing is that returns to equity become more
sensitive to changes in profits. For a highly geared company,
a change in profits can lead to a proportionately greater
change in the returns to equity therefore, there is higher risk.

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Interest Cover Ratio

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Measures the amount of profit available to cover interest

payable
The calculation is: EBIT/ Interest Payable = ____ times
The lower the level of profit coverage the greater the risk
to lenders that interest payment will not be met.

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INVESTORS/ SHAREHOLDERS
RATIOS
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Shareholders Ratios

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A prime concern of shareholders is their return

on investment.
The returns from investing in shares of a
company come in two main forms:
- The payment of dividends out of profits
- The increase in the value of the shares
(share price) compared with the price that
the shareholder originally paid for the
shares
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Shareholders Ratios

Various ratios are available that are designed to

help investors assess the returns on their
investment.
Ratios include :
- Dividend per share (DPS)
- Dividend Yield
- Earnings per share (EPS)
- Price Earnings ratio(P/E)

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Dividend Per Share

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Provides an indication of the cash return an investor

receives from holding shares in the company
The calculation is:
Total dividend paid/No of ordinary shares issued =
____per share
Eg., a firm paid out the following dividends
2011: $920,000
2010: $480,000
In both years, there were 1,000,000 $1 ordinary shares
in issue which qualified to receive a dividend
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Dividend Per Share

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The dividend per share would be:

2011: $ 920,000 / 1,000,000 shares = $0.92 (or 92c)
per share
2010: $480,000 / 1,000,000 shares = $0.48 (or 48c)
per share
An ordinary shareholder would probably be pleased with
the higher dividend per share in 2011compared with
2010

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Dividend Per Share

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However, the problem with dividend per share is that the

ratio lacks a sensible context. We dont know:

How much the shareholder paid for the shares i.e.

what the dividend means in terms of a return on
investment

How much profit per share was earned which might

have been distributed as a dividend.

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Dividend Yield

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Relates the cash return from a share to its current market

value. Helps investor assess the cash return on their
investment in the company
The ratio is:
Div per share
Market value per share
A firm declared the following dividend payments: 92c (2011)
and 48c (2010)
The average share price for 1 ordinary share of the company
on the Stock Exchange during those financial years was
$14.15 (2011) and $10.67 (2010)

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Dividend Yield

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Using the formula, the dividend yield would be:

92/1415 for 2011 = 6.5%
48/1067 for 2010 = 4.5%

So the dividend yield in 2009 increased, which is good

news for shareholders since that represents an increase
in their return on investment.

What we dont know if whether the shareholders

consider it to be an acceptable return for the perceived
risk investing in the shares of the business.
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Earnings per share (EPS)

Regarded by many investment analysts as a

fundamental measure of share performance

Calculated as:
Net Profit available to ordinary shareholders
No of ordinary shares in issue

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Earnings Per Share

Net profit after tax

Less preferred dividends
Net profit avail., for Ord. SH.
Ordinary Shares
Earnings per share

2011
$ 91,000
9,000
$ 82,000
50,000
$1.64

2010
$ 76,500
9,000
$ 67,500
50,000
$1.35

Use:
Use: To
Toassess
assess the
the profitability
profitability of
of the
the
investment
investment by
by ordinary
ordinary shareholders.
shareholders.

Price Earnings ratio (P/E)

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This exhibits investors confidence on a particular share.

A high P/E Ratio indicates a high level of confidence in

the future earning power of the company and
consequently investors are willingly to pay more in
relation to the earnings stream of the company.

P/E ratio= Current share price/ EPS

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Price- Earning Ratio

Market price per share
Earnings per share
Price-earnings ratio on share

2011
$41.00
1.64
25

2010
$27.00
1.35
20

Use:
Use: To
Toindicate
indicate future
future earnings
earnings
prospects,
prospects, based
based on
on the
the relationship
relationship
between
between market
market value
value of
of ordinary
ordinary
share
share and
and earnings.
earnings.

LIMITATIONS OF RATIO
ANALYSIS
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LIMITATIONS OF RATIO ANALYSIS

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Ratios tend to raise questions rather than answer them. They

highlight the financial strengths and weaknesses of a
business but they cannot explain why these exist.

Ratios calculated depends on the quality of the financial

statement. (Garbage In Garbage Out)

Ratios says little about the size of operations. Example Co A

generates $1m profit and have a ROCE of 15% and Co B may
generate $100,000 profit and have a ROCE of 20%. Although
Co B has a higher level of profitability as measured by ROCE,
it generates lower total profit in absolute terms

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LIMITATIONS OF RATIO ANALYSIS

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Although the financial statements of most companies are

prepared in accordance with International Accounting
Standards (IAS) there is still considerable latitude in reporting
financial position eg., accounting policies, financing policies
and financial year ends, These will affect the reliability of the
comparisons between firms.

Balance sheet ratios are based on a point in time of the

company. Therefore, it may not be representative of the
financial position of the company for the year as a whole.

Any analysis of historical accounting statements are backward

looking. Decisions are about the future and therefore require
information that is forward looking
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The end

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