Interpretation of Financial Statements

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1 Interpretation of Financial Statements Author Noel O Brien, Formation 2 Accounting Framework Examiner. An important component of most introductory financial accounting programmes is the analysis and interpretation of financial statements. This is usually dealt with towards the end of the programme and may be seen and used as a test of the students comprehension of much of the material covered. It requires a knowledge of the users of financial statements and the particular requirements of each category of user. It requires the skill to select and measure various indicators of performance and offer possible explanations for trends over a period or variances from norms. A review of all recent Accounting Framework papers shows that the topic is popular. At an introductory level questions usually take the form of analyzing income statements and balance sheets. In effect students are expected to appraise the performance of a reporting entity over different reporting periods, the performances of different entities over the same period or compare the performance of an entity with the industry norm (which will be given if required to answer a question). Students will normally calculate ratios and comment on them. The particular ratios may be specified or it may be left to the student to select. This article sets out to give students guidance as to what is expected from a good answer and how to approach such questions. The normal approach to the interpretation of financial statements is to select suitable accounting ratios and to comment on them. These questions often guide the student on the ratios to be selected by specifying aspects of performance or financial position to be analysed. Sometimes the ratios themselves are specified; sometimes the student is asked to select the ratios without any indication as to which category is required. In this latter case there may be significant marks allocated for the correct selection. The following are some of the ratios most likely to be useful to the student at Formation 2 level. Profitability ratios. Return on capital employed (ROCE). ROCE measures the profit relative to the size of the business or the amount of capital it takes to run the business. It is often called the primary ratio because many consider it the most important. The ratio shows how efficiently a business is using its resources. ROCE is calculated as follows: Profit before interest and taxation X100 Shareholders equity + long term liabilities Some students calculate this ratio incorrectly by using a wrong figure either above the line or below the line. Sometimes they do not compare like with like. For instance they show profit after interest above the line but show long-term liabilities below the line. As interest is the return on the long-term liabilities it should be added back above the line. Page 1 of 6

2 Return on equity. (ROE) ROE shows the return equity shareholders receive on the book value of their investment and is calculated as follows: Profit after interest, preference dividends and tax X100 Total equity shareholders funds. This ratio may be important for examination candidates as the difference between ROCE and ROE has significant implications for how a business might raise additional capital. However, it may not be so significant for equity shareholders in large plcs as other measures such as price earnings (P/E) ratio give a better indication of return. One of the reasons for this is that the balance sheet numbers (especially for non current assets) may not reflect correct current values. Profitability of sales. The profitability of sales is clearly important for the financial health of any business. It is normally analysed under the following: Gross profit margin This ratio is calculated as follows: Gross profit X 100 Sales revenue Gross profit is the difference between sales revenue and the cost of sales. Changes in the margin are caused by changes in selling prices, changes in purchasing price or a combination of both. It is important for students to remember what does not affect the ratio. For a non-manufacturing business increases in wages, interest, depreciation or other such expenses have no effect on this ratio. Operating profit margin / net profit margin. These terms often present difficulties. Usually operating profit is taken to mean profit before deduction of interest and the term net profit is profit after deduction of interest. Often the term earnings before interest and tax (EBIT) is used for operating profit. It is important for the student to be clear which ratio is being used, especially if comparing two entities that are similar in all respects except that one is largely financed by equity and the other by borrowings. In a case such as this the EBIT number should be used. Solvency / liquidity ratios. Liquidity refers to the firm s ability to meet its short-term commitments. A business may be trading profitability but may be unable to pay its current liabilities such as wages or suppliers. This is a liquidity problem. Two common ratios are used to measure liquidity: Current ratio: Current assets : current liabilities. Acid test: Current assets less inventory : current liabilities Long-term solvency is measured by looking at the capital structure of the business and comparing long-term borrowings with owners capital (equity). This is measured in various ways the most common being: Page 2 of 6

3 Debt to Equity ratio Total long-term debt Equity and Gearing ratio: Total long-term debt Equity + long term debt In the past the treatment of preferred share capital presented problems as it was considered neither debt nor equity. Sometimes the term prior charge capital was used and preference shares were included with loans. Now, however, all capital must be classified as either debt or equity. At this level if preferred capital is stated to be redeemable it may be classified as debt. The ideal capital structure (ratio between debt and equity) is a matter that will be dealt with later in your programme of studies. At this level we consider the risks inherent in having too much debt on the one hand and the advantages of the probable lower cost of debt on the other. Also the composition of the assets of the business may indicate the preferred capital structure. Perhaps non current assets need to be financed mainly by equity whereas other assets could be financed by debt. Interest cover should also be considered. Efficiency ratios. Efficiency ratios are concerned with the control of inventories, payables and receivables. Inventory control is usually measured in terms of times turned over. This is measured as follows: Inventory turnover: Cost of sales Average inventory It may also be measured in terms of time, such as days. Payables and receivable are usually measured in terms of time outstanding and are measured as follows (Days): Receivables: Trade Receivables X 365 Sales Payables: Trade Payables X 365 Purchases Page 3 of 6

4 Shareholders investment ratios. These ratios help equity shareholders assess their investment or potential investment. Earnings per share (EPS) is possibly the most important number to appear in the accounts of a quoted plc. In the past it was particularly open to manipulation so its computation is now strictly regulated (IAS 33). It is the amount of net profit for the period that is attributable to each ordinary (equity) share which is a) outstanding during all or part of the period and b) that ranks for dividend. Directly related to the EPS is the P/E ratio in that the E in the formula is the earnings as calculated in the EPS. The P is the actual price (cost) of the share as quoted on the stock exchange. It is likely that potential and current investors are likely to be more influenced by this number than the ROE for reasons already outlined. Dividend cover is a measure of how secure the dividend payment is and is calculated as follows: Dividend cover: EPS Dividend per share Dividend yield is the return a shareholder receives on investment measured at current price. If the selection of ratios is left to the student then it is important to select wisely. A common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. On the other hand ratios should be selected from the various categories such as return on investment, profitability of sales, solvency (preferably both short term and long term), use of assets and shareholder investment ratios where these are relevant. However, no more than two from each category should be necessary. In recent examinations some candidates failed to calculate profit. This meant that it was very difficult for them to achieve a pass mark. Candidates should ensure that they are capable of using the information given to reconcile opening and closing balances in retained earnings so deriving the profit. Interpretation Having calculated the appropriate ratios most questions will request the student to comment on them. A review of the examiner s reports will show that the most common shortcoming has been the lack of analysis. In particular candidates do not offer possible reasons for movement or differences in the ratios. A typical comment may be that the stock turnover has improved from 3.4 times to 5.8 times. This adds little value to the user s understanding of the entity s performance earns no marks. Candidates are expected to show some commercial understanding. The possible reasons as to why the ratio has changed must be offered. While the student cannot be sure of the reasons plausible explanations are expected. Even if they are not the actual cause, marks will be awarded. Page 4 of 6

5 Examples of comments expected might be as follows. ROCE has improved from 15% to 17%. The gross margin improved slightly from 12% to 12.5% but this was more than offset by a significant increase in expenses which left the net profit down from 6% to 5%. Despite this, greater utilization of assets resulted in the overall increase to 17%. This greater utilization arose from tighter control of working capital with stock turnover increasing from 3 times to 5.5 times, days debtors being reduced from 46 to 28 and creditors being slightly extended from 26 to 30. The increase in gross margin is probably due to new purchasing controls introduced early in the year. The increase in expenses is due to a significant increase in rent payable and wages. Examination approach. As always read the question carefully. If you are asked for a report, give it, perhaps appending the ratios. Allocate your time between calculation of ratios and the report appropriately i.e. roughly in proportion to the marks available. Limit ratios to important areas bearing in mind the scenario. Avoid duplication in your ratios. If you are analyzing a single entity over time establish if there are changes to the capital structure. The introduction of fresh capital may impact many of the ratios and so explain changes. Structure. It may be useful to have a standard structure to your answer even though questions may vary slightly. In the case of a single entity question one may start with the change in the level of activity (sales). Compare this change with the change in profitability (absolute) and in percentage profitability of sales, distinguishing between gross, operating and net profit if relevant. If there is a significant change in the gross profit percentage try and offer plausible explanations. Were selling prices reduced to stimulate increased sales? Was the sales mix altered? If the change was at operating profit level what gave rise to it. If change was between operating and net profit then this may be explained by changes in the capital structure of the entity. Having dealt with profitability of sales examine use of assets. Were new assets purchased? If the sales to non current assets ratio has deteriorated might this be due to acquiring new assets late in the period? Comment on the ROCE and its composition. Was use of assets a factor in the change or was it entirely due to changes in the profitability of sales. Changes in working capital should then be commented on. If considering making comparisons between two entities establish that it is fair to compare them. For example are they are in the same or similar business? Are accounting policies similar? One might then address profitability, asset utilization, capital structure and liquidity using the same approach as mentioned for the single entity question above. Candidates should be aware that there may be justifiable reasons for what appears to be a deterioration in a ratio. An offer of longer credit terms in order to increase sales will result in an increase in trade receivables. Increase in stock levels may be to avoid stock outs or earn quantity discounts from suppliers. Overtrading arising from fast expansion may cause liquidity problems. Page 5 of 6

6 Finally students may be asked a general question such as Discuss the limitations of ratio analysis? or What additional information would you like?. For the former the following should be listed: The comparison of the ratios a large capital intensive business such as CRH with a supermarket in rented premises would not be useful. Entities may adopt different accounting policies such as valuation of non current assets. The position at the balance sheet date may not be typical. For example a milling company s stock holding just before harvest will be low whereas one month later it may hold inventory for a full years activity. Many entities choose their end of financial when stock levels are low. Some entities may engage in window dressing. Examination questions will never give candidates all the information they need. However the question must be answered with the available information. Additional information that would be useful might include: The future plans of the entity. Is its plant and equipment obsolete or likely to be? Has the business got good suppliers, customers and staff? Page 6 of 6

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