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Interpretation of
Financial Statement
1
Lecture Objectives
3
READING
4
The purposes of financial
statement analysis
To evaluate the performance of a firm given the
strategy, economic and industrial environment
of the firm
To help direct the user’s focus of attention by
identifying and highlighting areas of good and
bad performance, and areas of significant
change
For comparison between time periods and
entities
To identify irregularities, anomalies and
surprises that require further investigation
5
Two common types of
comparison
Time series analysis (Trend analysis)
Comparison of current year’s information with
comparable prior periods’ information of a firm
to detect significant improvements or
deterioration in the firm’s financial or
competitive position.
Cross-sectional analysis
Comparison of a firm’s financial information
with industry data, which serves as a
benchmark for assessing the firm’s financial
performance and position with competitors in
the same industry.
6
What are ratios?
Ratios describe the relationship between
different items in the financial statements
7
THE NEED FOR RATIOS
Company Gross profit Sales
RM’000 RM’000
A 200 848
B 300 1,252
C 500 2,127.5
D 350 1,468.4
B 24.0
C 23.5
D 23.8
Shareholders, purchasers,
Efficiency competitors
1111
Profitability
Measure the performance of management
To identify whether a company maybe a
worthwhile investment opportunity
To determine a company’s performance
relative to its competitors
12
Profitability (cont’d)
Gross profit margin % (Gross Profit / Sales)
Shows the ability to generate GP from sales, the ability
to control direct expenses with regards to sales
22
Capital Structure
Measures the way a company finances
its activities in the long term
Measures a company’s ability to handle
its debts -> gearing risk
Measures the contributions of owners’
financing (equity) compared with
creditors’ financing (debt)
Typical ratios are debt ratio, capital
gearing ratio, debt to equity ratio and
interest cover
23
Capital Structure (cont’d)
Debt ratio Total liabilities
Total assets
26
Capital Structure (cont’d)
Interest cover Profit before interest and tax
Interest expense
Indicates whether enough profit is earned to pay
the interest
Gives creditors an indication of how secure the
interest payments are
Beware profit is not equal to cash
Alternative measure is to compare the actual
cash flow to interest payments to give an
indication of the availability of cash to cover the
interest charges. Use EBDITA (earnings before
depreciation, interest, tax and amortisation) 27
Investment Returns/ or
Shareholders’ ratio
29
Investment Returns/ or
Shareholders’ ratio (cont’d)
Dividend cover
Net profit after tax and preference dividend
Ordinary dividends paid and proposed
Shows the proportion of profit distributed to
ordinary shareholders
High dividend cover indicates that the
company is able to maintain its current level
of ordinary dividends
30
Investment Returns/ or
Shareholders’ ratio (cont’d)
Price earnings (P/E) ratio Market price / EPS
Shows how the market assesses the performance of the
company; a measure of market confidence
A high P/E ratio may indicate that the market thinks that
the company’s future is good. The shares are in
demand, hence the high share price.
Must consider P/E for industry or similar company
P/E ratio is sometimes used to check if shares are
over/under priced
A share is overpriced if P/E ratio is higher than industry
norm or similar companies
31
ROCE (DUPONT ANALYSIS)
32
Limitations of Financial Ratio
Analysis
Ratios analysis provides a starting point for further
investigation and should be used in conjunction with other
sources of information and other analytical techniques
Seasonal factors can distort ratio analysis
Reliability of financial statements may be impaired by fraud
or window-dressing or creative accounting
Problems in cross sectional analysis (inter-company
comparison)
Use of different accounting policies
Application of judgment, using different degree of
optimism and pessimism e.g. provision for doubtful debts
Use of different definitions for financial ratios
Difficulty in finding the appropriate benchmark
33
Limitations of Financial Ratio
Analysis (cont’d)
40
35
30
25
percentage
G
H
20
15
10
0
yr 1 yr 2 yr 3 yr 4 yr 5
14
12
10
percentage
G
8
0
yr 1 yr 2 yr 3 yr 4 yr 5
12
10
8
percentage
0
yr 1 yr 2 yr 3 yr 4 yr 5
2.5
2
G
ratio
1.5
0.5
0
yr 1 yr 2 yr 3 yr 4 yr 5
Cost of sales
Cost of sales
Gross profit
Gross profit
Other operating
Other operating income
income
Operating expenses:
Operating selling & distribution
expenses: selling &
distribution
administrative &
administrative & other s
other s
Profit from
operations