SESSION 07 INTERPRETATION OF FINANCIAL STATEMENTS PART 1. GDM Managing Finance

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1 SESSION 07 INTERPRETATION OF FINANCIAL STATEMENTS PART 1 GDM Managing Finance

2 Accounting Management Accounting Financial Accounting

3 Session 07 Synopsis 1. Objective of accounting 2. Users of accounting information 3. Book-keeping process 4. Introduction to the Balance Sheet 5. Introduction to the Income Statement 6. Ratio calculations

4 1. Objective of Accounting

5 Introduction to accounting The key objective of accounting is to provide financial information for decision makers and other interested parties

6 2. Users of Accounting Information

7 Users of Accounting Information The key objective of accounting is to provide financial information for decision makers and other interested parties Users of Accounting Information Investor groups ( Current and future shareholders) Lenders Employees Business analysts/advisors Pressure groups The government The Public Internal users (Strategic, tactical, operational level managers)

8 Users of Accounting Information Investor groups ( Current and future shareholders) Lenders Employees Business analysts/advisors Pressure groups The government The Public Internal users (Strategic, tactical, operational level managers)

9 3. Book-keeping Process

10 Book-keeping Process Book-keeping process is the recording of monetary transactions, appropriately classified, in the financial records of an entity, either by manual means or otherwise.

11 Book-keeping Process

12 Book-keeping Process 6. General purpose financial reports 6.1 Balance Sheet 6.2 Income Statement 6.3 Equity Statement 6.4 Cash Flows Statement Also called the final accounts / financial statements in simple.

13 Book-keeping Process These are what is handed out to the users of accounting information for them to analyse and make decisions. Analysing accounting information or analysing the GPFRs and making decisions is referred to as INTERPRETATION OF FINANCIAL STATEMENTS. In order to Analyse GPFRs/Financial Statements, first you need to understand how these financial statements are constructed and structured, what items are included; etc.

14 4. Introduction to the Balance Sheet

15 6.1- Balance Sheet The balance sheet gives you a picture of the company s financial strength at the end of the accounting period.

16 6.1- Balance Sheet ASSETS Items which the business OWNS. Resources that may be used by a business to derive revenue in the future. Exa: Land & Buildings Machinery Motor-vehicles Intangible Assets (e.g. brand name) Investments Stocks/Inventories Trade Debtors / Trade Receivables Other Receivables Cash in hand/ Bank balance Property, Plant & Equipment (PPE)

17 6.1- Balance Sheet LIABILITIES Items which the business OWES. an entity s obligations to transfer economic benefits as a result of past transactions or events. Exa: Loans /Interest bearing borrowings (Long term/ Short term) Trade Creditors / Trade Payables Other Payables Bank Overdraft

18 6.1- Balance Sheet ASSETS Non-current Assets Current Assets Assets which are not intended for sale or disposal within one year Assets which are intended to be sold or used up within one year LIABILITIES Non-current Liabilities Current Liabilities Liabilities which would be settled over one year Liabilities which would be settled/due within one year

19 6.1- Balance Sheet Equity / Capital The owners interest in the business Includes; the money which the owners first invested (Share Capital) + Profits/earnings which the business made, but owners did not take back from the business (Retained Earnings) + RESERVES

20 6.1- Balance Sheet Sample Balance Sheet PLEASE REFER THE ADDITONAL HANDOUT PROVIDED.

21 5. Introduction to the Income Statement

22 6.2- Income Statement The Income Statement (Profit & Loss Account/PnL) provides a picture of the company s trading performance over the last accounting period (usually a year). Prepared on the basis of; INCOME EXPENSES = PROFIT

23 6.2- Income Statement INCOME Generated through sales (Sales Revenue) Other general income (Other Income ) Maybe on credit and/or on cash

24 6.2- Income Statement EXPENSES Expenses incurred immediately parallel to making sales (Cost of Sales) Other general expenses Distribution Expenses Administration Expenses Other Operating Expenses Finance Expenses Maybe on credit and/or on cash Taxation (Income Tax expense / Tax Expense / Taxation)

25 6.2- Income Statement PROFITS Gross Profit = Sales Revenue Cost of Sales Operating Profit = Gross Profit + Other Income Other General Expenses Profit Before Tax = Operating Profit Finance Expenses Profit After Tax = Profit Before Tax Taxation

26 6.2- Income Statement Sample Income Statement PLEASE REFER THE ADDITONAL HANDOUT PROVIDED.

27 Interpretation of Financial Statements TESTED IN TWO WAYS... RATIO CALCULATIONS WRITING A REPORT (INTERPRETING)

28 6. Ratio Calculations

29 Interpretation of Financial Statements The key objective of accounting is to provide financial information for decision makers and other interested parties. So, DIALOG and SLT have done the same and they have provided you with the financial information (financial statements income statement and balance sheet) to you. BUT...now can you really make decisions looking at the financial information in your hands???? Do those numbers make sense????

30 Interpretation of Financial Statements Take a look at the financial statements given to you... (Dialog) Now ask these questions from yourself...! Is it really useful as it is...???? Can you make comments by just seeing those stand-alone numbers???? Can you say that the company has done well this year?? orrr not?? Can you say that this company is better than their competitors???? Better than SLT?? Can you compare or make sense of these numbers themselves stand-alone????

31 Interpretation of Financial Statements The answer should be NO!! WHY???? You don t know the size of the company... Is Dialog bigger or smaller than SLT?? You don t know whether the profit figure is reasonable in comparison to the expenses they have made... You don t know whether the numbers they have achieved (profits/revenues/expenses/assets) are reasonable when considering their industry averages... The numbers may look good... BUT...You don t know whether there are hidden problems...

32 Interpretation of Financial Statements Then your job is to bring those numbers down to a comparable level and THEN YOU CAN MAKE COMMENTS ABOUT THE COMPANY...! COMPARABLE LEVEL???? % times days x : y RATIOS (9)

33 Interpretation of Financial Statements This process of converting the financial information in the income statement and the balance sheet into sensible and comparable figures is called RATIO ANALYSIS (calculating ratios). RATIOS help us to interpret the financial statements in a more sensible and useful manner.

34 Interpretation of Financial Statements Financial Info (Income Statement & Balance Sheet) Bring the financial info down to comparable levels (Ratios) Now the info are more sensible, comparable and therefore, USEFUL!!!! Gross Profit ratio - % Net Profit ratio - % ROCE - % Stock Turnover times Debtors Collection Period Creditors Settlement Period - days Current ratio x : y Acid Test ratio - x : y Gearing ratio - %

35 Interpretation of Financial Statements RATIO CALCULATIONS 9 Ratios Gross Profit ratio Net Profit ratio ROCE Stock Turnover Debtors Collection Period Creditors Settlement Period Current ratio Acid Test ratio Gearing ratio 9 different formulas for each of the ratios (which would be provided to you at the exam) A X 100 = x % A X 365 = x days A = x times or x:y B B B

36 Interpretation of Financial Statements RATIO CALCULATIONS FOUR STEPS TO FOLLOW 1 Look at the relevant ratio formula. 2 1st item will be either an INCOME, EXPENSE, PROFIT, ASEET, LIABILITY or CAPITAL item. if it is >> INCOME / EXPENSE / PROFIT >> INCOME STATEMENT if it is >> ASSET / LIABILITY/ CAPITAL >> BALANCE SHEET 3 2nd item will be either an INCOME, EXPENSE, PROFIT, ASEET, LIABILITY or CAPITAL item. if it is >> INCOME / EXPENSE / PROFIT >> INCOME STATEMENT if it is >> ASSET / LIABILITY/ CAPITAL >> BALANCE SHEET 4 Put the two items into the relevant formula, get the answer and present it in the correct form (% / times / days / x : y)

37 Interpretation of Financial Statements RATIO CALCULATIONS Gross Profit Ratio Gross Profit X 100 Total Sales Revenue = xy % Meaning?

38 Interpretation of Financial Statements RATIO CALCULATIONS Net Profit Ratio Profit Before Taxation X 100 Total Sales Revenue = xy % Meaning?

39 Interpretation of Financial Statements RATIO CALCULATIONS ROCE Net Profit After Taxation X 100 Shareholders Funds = xy % CAPITAL EQUITY Meaning?

40 Interpretation of Financial Statements RATIO CALCULATIONS Stock Turnover Cost of Sales Inventories = xy TIMES Meaning?

41 Interpretation of Financial Statements RATIO CALCULATIONS Trade Debtors Collection Period Trade Debtors X 365 Total Credit Sales = xy DAYS Meaning?

42 Interpretation of Financial Statements RATIO CALCULATIONS Trade Creditors Settlement Period Trade Creditors X 365 Total Credit Purchases = xy DAYS Meaning?

43 Interpretation of Financial Statements RATIO CALCULATIONS Current Ratio Current Assets Current Liabilities = x : y Meaning?

44 Interpretation of Financial Statements RATIO CALCULATIONS Acid Test Ratio Current Assets Inventories Current Liabilities = x : y Meaning?

45 Interpretation of Financial Statements RATIO CALCULATIONS Gearing Ratio Long term Loans X 100 Shareholders Funds + Long term Loans = xy % Meaning?

46

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