INTERPRETATION OF FINANCIAL STATEMENTS/RATION ANALYSIS

Performance indicators/ratios (e.g. percentage returns) are used to interpret

financial statements rather than raw/absolute amounts. This is because
different circumstances (e.g. different operating environments) will influence
those amounts to such an extent that comparing them or trying to draw
conclusions from them will most likely lead to misleading interpretations. For
instance if business A and business B are in the same industry and in one
financial year A makes revenues of R1m and B makes revenues of R3m, it
would appear that B is doing better than A. However to be absolutely certain
of this, the revenue has to be interpreted relative to all the factors which
affect it, such as expenses and assets used in earning that revenue. After
such relationships have been analysed, a final decision can then be made on
which business did better between the two.
Purpose of ratio analysis
Intercompany comparison ( between different businesses in the same
industry)
Intracompany comparison ( within the business over different periods
of time)
Ratios (please refer to lecture example 1 page 332, course notes)
The comparisons cited above can be achieved using ratios that basically
branch into 3 broad categories, viz,
1. Profitability ratios
These measure how well the company managed to earn returns on the
resources (revenue, assets, equity) used to earn those profits. The main
ones under this category include;
a. net profit margin/percentage (profit as a percentage of revenue)
2009
2008

net profit before interesttax

revenue
790
7180

x 100

462
5435
=11%

8.5%

b. Gross profit margin

gross profit
revenue
1795
7180

x 100

1223
5435

=28%
=23%
Both gross profit and net profit ratios have improved over the
2 years under comparison, indicating that the profitability of the
business has improved. Naturally, when gross profit margin
increases, youd expect net profit margin to increase as well as
observed in the above example. If, however GP margin increases and
NP margin declines, it could indicate management failure manage
expenses and therefore needs to be investigated.

c.

Return on capital employed/ROCE ( return on capital used to

generate revenue)

capital +reserves+non current liabilities

total assets less current liabilities
net profit before interestax

2009
2008

790
2190+ 500

462
1401+ 400
d. Return on equity (indication to ordinary shareholders on the
performance of their investment. NB- equity = ordinary share capital +
reserves)

profit after tax preference dividend

x 100
equity

2009

2008

478
2190
266
1401
=22%
=19%
Preference dividends are deducted from profit because preference
share do not form
part of equity and the dividends paid on them
can there not be used to determine return on equity.
e. Asset turnover ( revenue generated for each R1 of assets used)

revenue
total assets less current liabilities
7190
5435
2190+ 500 1401+ 400

=2.67 =
3.01
This means for every R1 of assets used, the company earned
R2.67 in 2009
2. Liquidity ratios
Used to measure a companys ability to meet its short term obligations.
Main ratios are;
a. Current ratio

current assets
:1
current liabilities

2009

2008

2314 1679
:1
:1
965
704
=2.4:1 =
2.38:1
Thus, in 2009 for example, for every R1 of current liabilities, the
company

had R2.40 of assets and therefore have enough short term assets to
cover
short term liabilities.
NB- a current ratio of at least 2:1 is generally considered safe.
b. Quick/acid test ratio

current assetsinventories
:1
current liabilies

1308 808
965 704
=1.4:1
=1.1:1
Inventories are deducted to remain with the companys most liquid
assets.
NB- a quick ratio of at least 1:1 is considered safe
c. Inventory turnover ( number of times inventory is sold/used and
replaced)

cost of sales
inventories

5385 4212
1006 871
= 5.35
4.84
Thus, in 2009 the company managed to clear inventory and
replace it 5.35
times. An increasing turnover ratio most likely indicates
improving business
d. Inventory days ( how long inventory is held before sale)

inventories
x 365
cost of sales

1006
871
x 365 ;
x 365
5385
4212
=68

= 75

Thus, the company held inventory, in 2009, for an average

68 days before selling it. If the number of days decrease
Over the years, it indicates improved business. Naturally,
When inventory turnover increases, inventory days should
decrease.
e. Trade receivables period( how long before debtors settle their
accounts)

trade receivables
credit salestotal sales( if cr sales cannot be calculated)

2009

x 365

2008

948
708
x 365 ;
x 365
7180
5435
= 48.2

47.8

Thus, in 2008, debtors paid off their debts after an average 47.8
days, while in 2009 it increased to 48.2. Even though the increase
is not significant, it must be controlled so that debtors dont
hang on to the companys money for prolonged periods
f.

Trade payables days ( how long before the company pays off debts)

trade payables
x 365
credit purchasesor cost of sales(only if cr purchases cannot be found)

653
876
x 365 ;
x 365
5385
4212
=44.3
=44.7

Thus, the number of days the company took to pay of its debts
stayed pretty much the same over the 2 years. An ideal situation
would be to have the creditors days increasing which would
increase the amount of capital available to the company in the
short term.

NB* i. Debtors and creditors periods can also be calculated based

on
weeks or months instead of days, just multiply the ratio by 52
or
12 respectively instead of 365
ii. inventory days, debtors days and creditors days put
together can be used to
calculate what is called the cash operating cycle, ( the
average amount
of time during which the business is deprived of cash). It is
calculated as
follows;
inventory days + debtors days creditors days
thus, in our example, the cash operating cycle( 2009) would be;
68 + 48.2 44.3 = 71.2
This means the company will be out cash every other 71.2 days and
should
therefore make arrangements in advance for alternative sources of
funds.
3. Gearing ratios( how much long term capital is funded by debt )

longterm loans+ preference share capital

debt

2009

2008

500
400
;
2190+ 500 1401+ 400
=19%
=22%
Thus in 2009, e.g, the companys long term capital was financed by
19% borrowed

money. The higher the ratio, the less profit will be available for
shareholders
since most of it will go to pay off interest on borrowed money.