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Revise lecture 27

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• Interpreting financial statements

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Interpreting financial information

1. Profitability ratios2. Liquidity and working capital ratios3. Long term financial stability4. Investors ratios5. Limitations of financial statements and ratio

analysis6. Related parties

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Profitability ratios

Gross profit margin or percentage is

Gross profit / Sales revenue * 100%

• This is the margin that the company makes on its sales, and would be expected to remain reasonably constant.

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Operating profit margin (net profit) ratio

Can be calculated as: PBIT / Sales revenue * 100%

• Any changes in operating profit margin should be considered further:

1. Are they in line with changes in gross profit margin?

2. Are they in line with changes in sales revenue?

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Operating profit margin (net profit) ratio

3. As many costs are fixed they need not necessarily increase/decrease with a change in revenue.

4. Look for individual cost categories that have increased/decreased significantly.

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ROCE ratio

ROCE = Profit / capital employed * 100%

Profit is measured as:

Operating (trading) profit, orThe profit before interest and tax (PBIT)

Capital employed is measured as:

Equity + interest bearing finance

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ROCE ratio

ROCE for the current year should be compared to:

1. The prior year ROCE2. A target ROCE3. The cost of borrowing4. Other companies ROCE in the same industry

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Net asset turnover

Sales revenue / Capital employed (net assets) = times pa

• It measures management’s efficiency in generating revenue from the net assets at its disposal

• The higher, the more efficient

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• Liquidity and working capital ratios

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Working capital ratios

There are two ratios used to measure overall working capital:

1. The current ratio

2. The quick or acid test ratio

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Current ratio or Working capital ratios

Current ratio or working capital ratio = Current assets / current liabilities :1

• The current ratio measures the adequacy of current assets to meet the liabilities as they fall due.

• Traditionally, a current ratio of 2:1 or higher was regarded as appropriate for most businesses to maintain creditworthiness. However, more recently a figure of 1:5 :1 is regarded as the norm.

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Current ratio or Working capital ratios

The current ratio should be looked at in the light of what is normal for the business. For example, supermarkets tend to have low current ratios because:

• There are few trade receivables• There is a high level of trade payables• There is usually very tight cash control, to fund

investment in developing new sites and improving sites

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Quick ratio 0r liquidity or acid test ratio

Current assets – inventory / current liabilities :1

• It provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.

• Normal levels for the quick ratio range from 1:1 to 1.7:1

• Like the current ratio it is relevant to consider the nature of the business (e.g. supermarkets have very low quick ratios)

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Quick ratio 0r liquidity or acid test ratio

• When interpreting the quick ratio, care should be taken over the status of the bank overdraft. A company with a low quick ratio may actually have no problem in paying its amounts due if sufficient overall overdraft facilities are available.

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Long-term financial stability

The main points to consider when assessing the longer-term financial position are:

1. Gearing

2. overtrading

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Long-term financial stability

GearingGearing ratios indicate:

• The degree of risk attached to the company and

• The sensitivity of earnings and dividends to changes in profitability and activity level

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Long-term financial stability

High and low gearingIn highly geared businesses:

1. A large proportion of fixed-return capital is used

2. There is a greater risk of insolvency3. Returns to shareholders will grow

proportionately more if profits are growing

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Long-term financial stability

High and low gearingLow-geared businesses:

1. Provide scope to increase borrowings when potentially profitable projects are available

2. Can usually borrow more easily

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Gearing

Not all companies are suitable for a highly-geared structure. A company must have two fundamental characteristics if it is to use gearing successfully

1. Relatively stable profits

2. Suitable assets for security

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Measuring Gearing

There are two methods commonly used to express gearing as follows:

1. Debt / equity ratio

2. Interest cover ratio

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Overtrading

Overtrading arises where a company expands its sales revenue fairly rapidly without securing additional long-term capital adequate for its needs. The symptoms of overtrading are:

1. Inventory increasing, possibly more than % to revenue2. Receivables increasing, possibly more than % to revenue3. Cash and liquid assets declining at a fairly alarming rate4. Trade payables increasingly rapidly

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Investors ratios

1. EPS ratio

2. P/E ratio

3. Dividend yield ratio

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Limitations of FS and ratio analysis

Ratios are tool to assist analysis

• They help to focus attention systematically on important areas and summarise information in an understandable form.

• They assist in identifying trends and relationships.

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Limitations of FS and ratio analysis

However ratios are not predictive if they are based on historical information.

• They ignore future action by management• They can be manipulated by window dressing

or creative accounting• They may be distorted by difference in

accounting policies

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Limitations of FS and ratio analysis

• Assets values shown in the SFP at historic cost may bear no resemblance to their current value or what it may cost to replace them. This may result in a low depreciation charge and overstatement of profit in real terms. As a result of historical costs the financial statements do not show the real cost of using the non-current assets.

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Related parties

Definition

• Two parties are considered to be related if one part has the ability to control the other party or exercise significant influence over the other party, or the parties are under common control

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Related parties

Distortion of financial statements

• A related party relationship can affect the financial position and operating results of an entity in a number of ways.

1. Transactions are entered into with a related party which may not have occurred without the relationship existing

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Related parties

Distortion of financial statements

2. Transactions may be entered into on terms different to those with an unrelated party

3. Transactions with third parties may be affected by the existence of the related party relationship