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Lecture 6 & 7

Interpretation of
Financial Statement

1
Lecture Objectives

This lecture will consider the:


 Importance and use of ratios
 Different categories of ratios and their
users
 Application of financial ratio analysis as a
tool in decision making
 Limitations of ratio analysis
2
Lecture Outcomes
At the end of the lecture, you should be able to:
 Explain the purposes of financial ratio analysis
 Identify the ratio categories and their respective
users
 Compute various ratios as measures of a
company’s performance
 Interpret the ratios and apply them in decision
making
 Discuss the limitations of ratio analysis

3
READING

Frank Wood, et al, Business Accounting 1,


13th Edition, Ch 47

Andrew Thomas, Introduction to Financial


Accounting, 6th Edition

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

Types of ratio categories


 Profitability
 Solvency (Liquidity)
 Efficiency
 Investment
 Capital Structure

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

Which company has the best profit?


- Absolute figures are not meaningful
8
THE NEED FOR RATIOS
(CONT’D)
Company Gross margin %
= Gross profit / Sales
A 23.6

B 24.0

C 23.5

D 23.8

Which company is most profitable? – ratios are


more useful. 9
USES OF RATIOS
RATIO MEASUREMENT
Profitability How much profit a business has
made in relation to size / capital
Liquidity How quickly the assets can be turned
into cash in short term
Efficiency How efficiently an entity has been
managed
Investment Return on investment and risk

Capital Mix of financing between share


structure capital and borrowings; gearing risk
10
Ratios & interest groups

Shareholders, mgmt, employees,


 Profitability creditors, potential investors

 Liquidity Shareholders, suppliers, competitors

Shareholders, purchasers,
 Efficiency competitors

 Shareholder Shareholders, potential


investors

 Capital Structure Shareholders, lenders,


creditors, potential
investors

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

Net profit Margin % (Profit before interest and tax / Sales)

• Depends on the type of industry a company is


operating in, company’s pricing policy, sales volume
and cost structure
• A higher margin generally suggests good performance
but should not be taken at face value. Too high may
suggest that the product is being overpriced, resulting
in decrease in quantity sold 13
Profitability (cont’d)
Return on capital employed % Profit before interest and tax
Total assets – Current Liabilities
 Popular indicator of management efficiency as it contrast
the net profit generated by company with the total value of
assets under management control
 Demonstrates how well management has utilised total
assets
ROCE = Asset turnover x Net profit margin
 Be careful when comparing across industry as there is no
exact definition of capital employed
 Some factors impact ROCE e.g. asset valuation process,
depreciation policies, revaluation policies, pricing policies,
treatment of expenses -> affects comparison with other
entities
14
Liquidity
Assess the credit risk of an entity and measure the entity’s ability
to pay its debts as and when they become due
Current Ratio ( Current Assets / Current Liabilities)
 Sufficiency of short term assets to meet short term liability
 Compared with industry norm
 If current ratio increased beyond normal range of
company/sector?
 Good/Beneficial reasons:
1. A build up of inventory to support a recent advertising
campaign
2. Permanent expansion of business which require
continuing higher level of inventories
 Unwelcome reasons:
1. Inefficient control over working capital
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2. Adverse trading condition i.e. over trading
Liquidity (cont’d)
 Acid test / Quick ratio
 Exclude stocks due to inability to convert to cash at
short span of time
 Trade Debtor days (Trade debtors/ credit sales
x 365 days)
 Indicates how efficient the company is at controlling
its debtors
 Comparison with industry norm
 Also need to compare with company’s credit policy
 Trade Creditor days (Trade creditors / credit
purchases * x 365 days) * or cost of sales
 Indicates credit facilities extended to a company by
its supplier
16
Liquidity (cont’d)
 Changes in debtors days might be misleading, so should look
at the root cause during the analysis.
 Reduction in debtor days
1. Company is successfully reducing bad debts & eliminating
poor risks, or
2. Liquidity position might be so poor that the company is
extending discounts & incentives
 Increase in debtor days
1. Company has poor credit control and besieged with bad debts
2. May be strategy to attract new customers

 Creditors days changes:


1. Suppliers altering credit terms (more/less generous)
2. Company trying to gain maximum credit facilities -> increase
3. Company utilising early payment incentives -> decrease
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Liquidity- (cont’d)
 Some textbooks suggest that the current and
quick ratios must be at least 1:1; others argue
that the norm is 2:1. These are guidelines only.
 Should consider what is the norm in the industry
sector; also analyse the nature of assets and
liabilities.
 For example, current liabilities are due for
payment at varying times e.g. dividends, bank
overdraft
 Companies have some control over timing of
realization of assets e.g. trade debtors.
18
Efficiency (Asset Management)
 Measures how effectively the firm is managing its assets
 Does the total amount of each type of asset seem
reasonable, too high/low in view of current/projected sales?

Asset turnover Sales


Total assets – Current Liabilities
 Measures the amount of sales generated by the capital
employed or total assets investment
 Lower (if compared with previous year) indicates
1. Overinvestment (takeover target)
2. But could be assets are new, company prefer to purchase
rather than lease/rent
 Extremely high may indicate high selling price or
19
suppressed price in order to maximise sales volume
Efficiency (cont.)
Fixed Assets Turnover ( Sales )
Fixed Assets at NBV
 Measures how effectively the firm uses its plant and
equipment to generate sales
 Higher ratio implies greater recovery of investment in
fixed assets
 If the company’s FA turnover is lower than its
competitors, it may suggest overinvestment in fixed
assets
 Other factors to consider in comparison with other firms:
1. Depreciation rate
2. Purchase instead of lease
3. Relatively new assets i.e. start-up period
20
Efficiency (cont.)
Inventory turnover days Inventory x 365 days
Cost of goods sold
 Measure how efficient a business is at maintaining an
appropriate level of stock ; also an indicator of liquidity
 Compute average of opening and closing stock -> eliminate
seasonal effects
 Lower (-> low inventory level)
1. Greater efficiency
2. But may indicate that inventory is running out often and not
meeting demand
 Higher (-> high inventory level)
1. The business may be slowing down
2. Lower efficiency, stocks may be piling up and not being sold,
may have obsolete stocks that could lead to liquidity crisis
3. Higher inventory volumes due to purchasing in bulk to obtain
discounts
21
Efficiency (cont.)

Stock turnover ratio : Cost of sales


Stock of finished goods
 Argument for using an average of the stock at the end
of the previous year and the current year as the
denominator
 Has to be consistent
 Shows the number of times that a business ‘turns
over’/sells its average/normal level of stock during the
accounting year.
 Vary between industries, food retailers should have a
relatively high stock turnover ratio whereas jewellery
retailers normally have a much lower ratio

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

 Compares total debt with total assets


 Measures whether the company has sufficient
assets to meet all its liabilities when due
 Compare with industry norm
 Creditors prefer low debt ratios because the
lower the ratio, the greater the buffer against
creditors’ losses in the event of liquidation
24
Capital Structure (cont’d)
Capital gearing ratio Long term loans/Debt Capital
Shareholders’ funds + LT loans
 Contribution of long term lenders to long term
capital of the firm
 A company with high gearing is predominantly
financed by debt whereas company with low
gearing relies on equity finance
 The gearing of a company will affect its annual
interest payments and dividend payments.
 The higher the ratio, the higher the risk, both in
respect of expectations of future dividends to
equity investors and the threat of liquidation
LT loans = debentures, redeemable preference 25
shares or long-term borrowings
Capital Structure (cont’d)

Debt to equity Long-term loans/Debt capital


Shareholders’ funds/Equity capital
 Similar to capital gearing
 Measures the proportion of long-term loans to
equity
 The higher the ratio, the higher the risk, both in
terms of expectations of future dividends and
threat of liquidation

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

 Performance of the company in relation to share


price, dividends and shares issued

Dividend yield ( Gross dividend per share / Market


price per share) x 100%
 Measure real rate of return by comparing dividend
paid to the market price
 When making inter-company comparisons, be
mindful of different risk profile of investors and
different dividend policies 28
Investment Returns/ or
Shareholders’ ratio (cont’d)
Earnings per share
Net profit after tax and preference dividend
No of ordinary shares issued during the year
 The earning power of each ordinary share of
the company
 Among the most widely used ratios to check
on the company’s performance
 Upward trend may indicate growth in
earnings

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)

Net profit sales


ROCE  x
sales capital employed
•Note: two companies, despite different
sizes of business and operating different
pricing policies, can have the same ROCE.

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)

 Historical data may cause distortions due to the


effects of inflation
 General yardsticks (e.g. a liquidity ratio of at least 1)
are not always appropriate for all types of industry
 Surrogate data used for missing data in published
accounts can cause misleading comparisons
 A single ratio may not be very informative by itself, but
a number of related ratios taken together can provide
strong indications of a company’s performance or
financial position.
34
Non- financial factors

 Factors that complement the traditional financial ratios


 Give detailed information of the operations and
business prospects
 Examples
 Production capacity and efficiency;
 Effective team of management;
 Business rivals or competitors;
 R&D capability;
 Future prospects;
 Legal and regulatory environment 35
Trend analysis
Company Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Gross profit to G 40 38 36 35 34
sales (%) H 30 32 33 33 34
Net profit to G 15 13 12 12 11
sales (%) H 10 10 10 11 11
ROCE G 13 12 11 11 10
H 8 8 9 9 10
Current ratio G 3 2.8 2.6 2.3 2.0
H 1.5 1.7 1.9 1.0 2.0
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UKAF 1083 Financial Accounting
Gross profit to sales
gross profit to sales
45

40

35

30

25
percentage

G
H
20

15

10

0
yr 1 yr 2 yr 3 yr 4 yr 5

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UKAF 1083 Financial Accounting
Net profit to sales
16

14

12

10
percentage

G
8

0
yr 1 yr 2 yr 3 yr 4 yr 5

Bachelor of Accounting (Hons) 38


UKAF 1083 Financial Accounting
ROCE
14

12

10

8
percentage

0
yr 1 yr 2 yr 3 yr 4 yr 5

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UKAF 1083 Financial Accounting
Current ratio
3.5

2.5

2
G
ratio

1.5

0.5

0
yr 1 yr 2 yr 3 yr 4 yr 5

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UKAF 1083 Financial Accounting
Trend analysis

 Co G appears to be the worst investment


for the future, as the trend is moving
downwards.
 Co H is strengthening its position all the
time.

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UKAF 1083 Financial Accounting
HORIZONTAL ANALYSIS

 A look at how sales, income, expenses,


etc increase/decrease over time and by
how much (by percentage rather than
$/c)
 A study of percentage changes in
comparative statements

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UKAF 1083 Financial Accounting
HORIZONTAL ANALYSIS: Income
Statement
2010 2009 Diff. PCT(%)
Net sales 534370 392289 142081 36.2
Cost of sales (396059) (293901) (102158) 34.8
Gross profit 138311 98388 39923 40.6
Other operating income 1755 1593 162 10.2
Operating expenses: selling (32146) (22213) (9933) 44.7
administrative (65670) (38100) (27570) 72.4
Profit from operations 42250 39668 2582 6.5
Non-operating income 1468 1536 (68) -4.4
Finance costs (1771) (1401) (370) 26.4
41947 39803 2144 5.4
Income tax (10631) (9278) (1353) 14.6
Profit after tax 31316 30525 791 2.6
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UKAF 1083 Financial Accounting
HORIZONTAL ANALYSIS: Balance
sheet
2010 2009 Diff. PCT(%)
Non-current assets
PPE 104133 100080 4053 4.0
Intangible assets 49278 51447 (2169) -4.2
Other assets 2461 1177 1284 109.1
Current assets
Inventories 33895 26963 6932 25.7
Trade receivables 67491 65729 1762 2.7
Other receivables 10341 7304 3037 41.6
Cash and bank balances 10186 34165 (23979) -70.2
Total current assets 121913 134161 (12248) -9.1
Total assets 277785 286865 (9080) -3.2

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UKAF 1083 Financial Accounting
TREND ANALYSIS
 Uses trend percentages (a form of
horizontal analysis)
 Indicates the direction a business is
taking
 How have sales changed over the last 5
years?
 What is the profit trend over the last 5
years?
 Trend % = (any year $) / (base year $)
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UKAF 1083 Financial Accounting
TREND ANALYSIS

Profit after tax 2010 2009 2008 2007 2006


$ millions 30.8 29.9 27.7 22.8 18.8
% 163.8% 159% 147% 121% 100%

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UKAF 1083 Financial Accounting
VERTICAL ANALYSIS

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UKAF 1083 Financial Accounting
VERTICAL ANALYSIS – SOPL
2010 2009
Net sales 534,370 100% 392,289 100%
Cost of sales (396,059) (74.1) (293,901) (74.9)
Gross profit 138,311 25.9 98,388 25.1
Other operating income 1,755 0.3 1,593 0.4
Operating expenses:
selling and distribution (32,146) (6.0) (22,213) (5.7)
administrative and other (65,670) (12.3) (38,100) (9.7)
Profit from operations 42,250 7.9 39,668 10.1
Non-operating income 1,468 0.3 1,536 0.4
Finance costs (1,771) (0.3) (1,401) (0.3)
Profit before tax 41,947 7.9 39,803 10.2
Income tax expense (10,631) (2.0) (9,278) (2.4)
Profit after tax 31,316 5.9 30,525 7.8
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VERTICAL ANALYSIS – SOFP
2010 2009
Non-current assets RM % RM %
PPE 104,133 37.5 100,080 34.9
Intangible assets 49,278 17.7 51,447 17.9
Other assets 2,461 0.9 1,177 0.4
Current assets
Inventories 33,895 12.2 26,963 9.4
Trade receivables 67,491 24.3 65,729 22.9
Other receivables 10,341 3.7 7,304 2.6
Cash and bank balances 10,186 3.7 34,165 11.9
Total current assets 121,913 43.9 134,161 46.8
Total assets 277,785 100% 286,865 100%
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COMMON SIZE ANALYSIS

 If the SOPL and SOFP in the earlier slides


were reported based on percentage only, it is
called common-size statement.
 For the SOPL each item is expressed as a
PCT of the net sales amount. The net sales is
the common size
 For the SOFP, the common size is total assets.

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UKAF 1083 Financial Accounting
Common size PCT -
example
SOPL RM %
Net sales 150,000 100
Cost of sales (60,000) 40
Gross profit 90,000 60
Operating expenses (40,000) 27
Operating profit 50,000 33
Income tax expense (15,000) 10
Net profit 35,000 23

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BENCHMARKING

 The practice of comparing a company to


a standard set by other companies, with
a view toward improvement.
 Investors need to know how a company
compares with others in the same line of
business.
 Common size statements can be used to
compare 2 or more companies.
Bachelor of Accounting (Hons) 52
UKAF 1083 Financial Accounting
Common size comparisons
SOPL S’pore Food United Food
Ind. Hold.
Net sales 100% 100%
Cost of sales (74.1) (76.9)
Gross profit 25.9 23.1
Other operating income 0.3 0.6
Operating expenses: selling & distribution (6.0) (4.4)
administrative & other s (12.3) (1.2)
Profit from operations 7.9 18.1
Non-operating income 0.3 -
Finance costs (0.3) -
Profit before tax 7.9 18.1
Income tax (2.0) (1.7)
Profit after tax 5.9 16.4
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UKAF 1083 Financial Accounting
Common size
comparisons

United Food Hold. S’pore Food Ind.


Net sales
Net sales

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

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UKAF 1083 Financial Accounting

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