THE INTERPRETATION OF FINANCIAL STATEMENTS

Profitability, liquidity, efficiency, gearing ratios

INTERPRETATION OF FINANCIAL STATEMENTS The Financial Statements of a company provide detailed andsummarized information. The statements shows absolutefigures for a particular period. They are don’t provide sufficientinformation to users. We have the information given: Branches Sales Revenue Profit A $100 000 $ 5 000 B $200 000 $ 6 000 C $300 000 $4 500

From the comparison we have made B had the highest profit,but it has only 3 % of its sales revenue. Profit 6 000 Sales 200 000

AJ ltd’s Profit and Loss Statement for 2009 is:

Sales 28 000

Cost of salesOpening inventories 2 300

Purchases 16 200

18 500

Less: Closing InventoriesCOGS

(2 800) (15 700)

Gross Profit 12 300

Less: Expenses (6 200)

Operating Profit 6 100

Income tax (1 000)

Profit for the period 5 100

Retained earnings -opening balance

7 000

Retained earnings -closing balance

12 100

Balance sheet as per 31 December 2009

Assets USD Liabilities USD

Non-current Assets

23 000 Payables 3 600

Current assets

Loan payable 1 650

Inventories 4 800 Equity

Receivables 3 200 Ordinary shares of 1 USD each

14 200

Bank and cash

550 Retained earnings

12 100

Total 31 550 Total 31 550

Using the ratios: Calculating the ratios is only one step in the analysis process.

Comparison is commonly made between:- Previous accounting period- Other companies (perhaps the same type of business)- Budgets- Government statistics- Other ratios

- Types of ratios:Ratios can be classified into various grouping, according to

the

type of information the convey. The main groupings are as

follows:- Profitability (performance) ratio- Liquidity (solvency) ratio

- Efficiency (use of assets) ratio- Capital structure ratio- Security (investors) ratio

Profitability ratios:- Gross profit margin- Gross profit - Sales

Gross Profit mark-up Operating profit margi

- Gross profit Operating profit- Cost of Sales Sales-

Return on capital ratios:The ratio is the key measure of return. There are several waysof calculating the ratio. We discuss only two of them:Return on Capital employed ROCE and Return on Equity ROE.Capital employed can consist of total capital employed(equity + non-current liability) or just Equity. In using total capital employed we include long-term loans aswell as equity and this is used when calculating ROCE. In using ROE, just the Equity is used. The basic formulae for return on capital ratio ROCE is: ProfitAverage total Capital EmployedThe ROE is: Profit for the period Average Equity

Liquidity ratios:It returns the ability of business to pay its payables in the

short term. There are two main liquidity ratios:

The current ratio:This is also known as the working capital ratio as it is based

onworking capital or net current assets ratios. It is a measure ofthe liquidity of a business that compares its current assets

withthose payables within one year. Current assets Current liabilities High ratio (more than 1) means current assets are easily sufficient tocover current liabilities. It is used to be thought that a ratio of

2:1 was ideal, but this depends on type of business. A very high figure is very comforting, but may be wasteful.

The quick ratioThis is known as the acid test ratio:Current assets excluding inventories

Current liabilities

Generally, a ratio of 1:1 is considered “ideal’ but many retail companies with

very regular cash sales have very low ratios, due to their lack of receivables.

Efficiency ratiosThe measure of efficiency of the management of assets, bothnon-current and current. Assets turnover ratio:These ratios compare the assets with the sales revenue

(turnover), measure the value of sales revenue for each 1$ invested in those assets. The formula is:

Sales Revenue Assets

Non-current assets measurement according to sales revenue:Sales revenueNon-current assets This is sales revenue generated per 1$

of non-current assets.

Inventories daysInventories may be analysed calculating the ratio ofinventories to cost of sales, and then multiplying the number ofdays in a year. The calculation is: Inventories Cost of Sales This figure gives the number of days that on average an item is ininventories before it is sold. The inventories turnover is calculated as: Cost of sales Average inventories x 365 days

Receivable daysThis is a measure of the average time taken by customers tosettle their debts. It is calculated as: Receivables Sales X 365 days Credit sales only

should be considered. If

customerstake longer period to pay debts, debt will have detrimentaleffect on cash flow, it may be necessary to take appropriateactions.

Payable daysThis is measure of the average time taken to pay to

suppliers. It is calculated by: Payables Purchases X 365 days

The purchases figure should not exclude any cash purchases,similarly, payables should include trade payables, notpayable for expenses or non-current assets. The result of ratio can also be compared with the receivablesdays. A firm does not normally want to offer its customersmore time to pay than it gets from its own suppliers,otherwise it could affect cash flow. Generally the longerperiod the better, as the firm holds on its cash for longer, butcare must be taken not to upset suppliers by delayingpayment, which could result in the loss of discounts andreliability.

Total of Working Capital ratios:Number of inventory days + number of receivable days –

number of payable days = Total working capital days

Capital structure ratiosDifferent companies have different methods of financing their

activities. Some may rely on the issue of share capital and the retention of profits; others rely on loan finance.

The gearing ratioGearing is the measure of the relationship between the

amountand of finance and provided by external parties to the totalcapital employed. It is calculated by: Debt Total capital employed (ROCE)

The more highly geared ratio, the more profits that have to be earned to pay the interest cost of the borrowings.

Consequently the higher ratio, the more risky is owners investment.

An alternative way of calculating the gearing ratio is known as: Debt : Equity

Interest coverThe ratio is the measure of the number of times that the

profitis able to cover the fixed interest due on long-term loans.

Itprovide lenders with an idea of the level of security for

thepayment. The formula is: Operating profit Interest payable

This shows the lenders that their interest is covered how many

times by the current profits.