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Introduction
Financial accounting is about providing information of general nature on a firm's performance to
users of such information. Published financial statements usually will be made available to a
whole range of interested persons. This ranges from individuals with relatively limited resources
to large investing companies. These users have diverse interests and therefore, each group of
users may place a different emphasis on particular information provided by financial statements.
Analysis and interpretation of financial statements include all measures and techniques employed
by users and financial analysts in order to obtain more useful information out of financial
statements.
Ratio analysis is the expression of logical relationship between certain items in the financial
statements.
If one needs to compare financial statements of two firms that are of different sizes, absolute
figures are not very helpful and can sometimes be misleading. In order to aid such comparison
both firms' financial statements are translated into percentage figures, thus reducing them to a
"common size”. In order to obtain a common-size Statement of Comprehensive Income, all items
in this statement will be expressed as a percentage of total revenues. As for the Statement of
Financial Position, every item will be expressed as a percentage of total assets (i.e. liabilities plus
equity).
Illustration
Following are condensed Statements of Comprehensive Income of two companies Barobaro Ltd
424Introductory Financial Accounting
If one looked at the performance of the two companies in absolute values, Barobaro Ltd seems to
perform better because it has higher profit figures. However, when absolute values are reduced to
percentages, Kijeba Ltd is a better performing company.
When such a statement as above is presented without the shilling value figures, that is, in
percentages only, it is known as a common-size statement. When such a statement as above is
presented with both shilling values and percentages but for only one company it is expressed as a
vertical analysis. Vertical analysis can be done for one year or over a number of years.
B) Horizontal Analysis
This technique makes use of comparative financial statements. Comparative financial statements
present the same firm's financial statements for two or more successive years alongside each
other. It is possible then to compute percentage changes (increases or decreases) in items in
financial statements over time. This is known as horizontal analysis. It helps detection of changes
in a firm's performance and highlights trends.
Illustration
The following comparative Statements of Comprehensive Income are given for Chungu
Company.
Chungu Company
Comparative Statement of Comprehensive Incomes
For years ended 31 Dec 20X2 and 20X1
Increase/
20X2 20X1 Percent
(Decrease)
Sales 1,530,500 1,234,000 296,500 24.0%
Sales returns 32,500 34,000 (1,500) -4.4%
Net sales 1,498,000 1,200,000 298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit 455,000 380,000 75,000 19.7%
Analysis and Interpretation of Financial Statements 425
Increase/
20X2 20X1 Percent
(Decrease)
Selling expenses 191,000 147,000 44,000 29.9%
General expenses 104,000 97,400 6,600 6.8%
Total operating exp. 295,000 244,400 50,600 20.7%
Operating income 160,000 135,600 24,400 18.0%
Other income 8,500 11,000 (2,500) -22.7%
168,500 146,600 21,900 14.9%
Other expenses 6,000 12,000 (6,000) -50.0%
Profit before tax 162,500 134,600 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net Profit after tax 91,000 76,500 14,500 19.0%
Note:20X1 is the base year in computing the change percentages
Ratio Analysis
Ratio analysis utilizes logical relationships between items in a firm's financial statements. The
object is to establish a pattern of key variables which are otherwise concealed in the information
provided in the Statement of Comprehensive Income or Statement of Financial Position.
Ratio analysis can be made for current year results or for results of the previous years as well. It
can also be employed in analysis of results of different comparable firms in the same year. One
main advantage of ratio analysis is that it allows for integrated analysis of items in both the
Statement of Comprehensive Income and the Statement of Financial Position. This provides a
broader dimension to analysis of results.
Financial ratios focus on several aspects of a firm's financial performance and financial position.
These ratios can be computed using only information disclosed in financial statements or they can
also incorporate information from stock exchange. Ratios that utilize market-based data are
known as market ratios. A company will have to be listed and quoted on the stock exchange for
such ratios to be computed.
Categories of Accounting Ratios
Accounting ratios are normally classified according to the aspects of business they are designed
to highlight. These aspects fall under the following categories:
a) Financial soundness and stability, short term and long term. During the short term the
interest is liquidity and during the long term it is solvency.
b) Profitability and return on equity or assets
c) Activity or efficiency measures and
426Introductory Financial Accounting
These ratios measure the ability of the firm to meet its maturing obligations as they fall due, both
immediately and in the long run.
Current Ratio
This gives an indication of the ability of a firm to meet its current liabilities. It assumes that
current assets will be converted into cash to meet current liabilities. It is calculated as:
Current Assets
Current Ratio =
Current Liabilities
A number greater than one indicates a firm has the ability to meet its current liabilities while a
number less than one indicates potential problems in meeting current liabilities. This however, is
not conclusive, additional information may need to be obtained on nature of business and industry
environment.
Current ratio assumed that current assets could be converted into cash immediately. However, not
all current assets can be readily converted into cash. The acid test ratio recognizes this limitation
and excludes stocks, for example, in its computation. It is calculated as:
Other current assets like prepayments are also not readily available for meeting maturing
obligations. Therefore, in computing this ratio such items have to be considered if material.
This is also known as interest coverage ratio. It measures the ability of a firm to service from
operations interest payments that are due to loan financiers. Inability to pay interest on loans may
force financiers to put a firm under receivership and finally liquidation.
Borrowed money should eventually be used to generate profits. Repayment of borrowing then
will be made out of profits after interest charges and income tax. Debt repayment coverage ratio
gives an indication of the length of time it will take to repay borrowings out of profits of the
business.
It is calculated as:
Analysis and Interpretation of Financial Statements 427
Ratios associated with this aspect measure the ability of a firm to generate profits, that is,
revenues in excess of expenses. That ability can be measured according to volume of sales or
resources employed in generation of the profits. These ratios therefore measure the rate of
profitability per a shilling value of sales or an asset value. For profitability ratios, profit is taken to
be Net Profit before interest and taxes (PBIT).This is because performance resulting from
operating decisions needs to be separated from that which is influenced by financing decisions.
By using PBIT, distortions arising out of differences in capital structures and application of
taxation rules in computation of income tax for different companies are avoided.
Gross Profit
Gross Margin = × 100
Sales
Unless there is a change in the relationship between Sales and Cost of Sales the Gross Margin
Ratio should show little change from one year to the next.
It shows net profit before interest and taxes as a percentage of sales. It gives some indication on
structure and changes in operating expenses. It is calculated as:
This ratio measures profit per value of net assets. The net assets figure is arrived at by assuming
the value of fixed assets and current assets and deducting current liabilities. Alternatively, Capital
Employed is Total Assets minus Current liabilities.
ROCE is given by:
This ratio measures the ability of a firm in utilizing its total assets in generating profits.
It is given by:
428Introductory Financial Accounting
Where there is a significant change in total assets during a year, it is advisable to use an average
total assets figure in the above formula.
Various aspects of the efficiency with which assets are utilized can be gauged from turnover
ratios.
a) Inventory turnover
b) Collection period for Accounts Receivable
c) Collection period for Accounts Payable.
d) Total assets turnover.
Inventory Turnover
This measures the rate at which a business translates stocks into sales. If the rate is too slow or
decreasing this may indicate overstocking or presence of obsolete merchandise. If this rate is too
high it may indicate under stocking and other problems. Depending on the nature of the business
and industry, a certain range of rates is acceptable.
Where the figure of cost of goods sold is not available it can be substituted by a sales figure. This
should not make a significant interpretative problem as long as the formula is consistently
adhered to. It is also possible to use Closing Stock instead of Average Stock. This is especially
the case when stock levels remain more or less unchanged.
Good credit control is an important aspect of sound financial management. The average length of
time Accounts Receivable take to pay the firm is an important indicator of management
efficiency.
To put the Accounts Receivable' average collection period in perspective, credit period granted to
customers should not be out of line with the credit period granted by suppliers. Good financial
management should ensure a proper balance. Accounts Payable' average payment period is
calculated as follows:
This indicates the ability of assets to generate revenues. How much does a shilling of asset
generate in terms of sales value?
Sales
Total Assets Turnover =
Total Assets
The proportion of debt capital to total capital is an important variable to both equity holders and
financiers. It reflects riskiness of the business. Excessive debt has an inherent bankruptcy risk.
Gearing ratio defines the proportion of debt capital to ordinary share/equity capital. There are
two approaches to calculate gearing ratio. One is the proportion of debt capital to total capital and
the other is given by the proportion of debt capital to ordinary share capital.
Note that debt capital plus ordinary share capital gives total capital.
Debt Capital
Debt-Equity Ratio =
Equity Capital
Debt Capital can also be expressed as a proportion of Total Capital and in this case the formula
for computing the ratio changes slightly to the following:
Debt Capital
Debt-Equity Ratio =
Debt Capital + Equity Capital
There are several advantages and disadvantages associated with gearing levels which will be
covered in an intermediate finance course.
430Introductory Financial Accounting
Market-based Ratios
These are additional ratios that can be computed when data from stock exchange are
incorporated. The most common are:
i. Dividend Yield
ii. Dividend Cover
iii. Earnings per Share and
iv. Price/Earnings Ratio.
Dividend Yield
It measures the return on the share invested using current market price of the share. If that return
is significantly lower than in alternative investment opportunities, shareholders may sell those
shares.
Dividend Cover
This ratio indicates the ability of a firm to sustain dividend payments out of its annual
distributable profits. It is calculated as follows:
This is the most commonly known and used ratio for valuing shares. It shows the amount of
profits made during the year and available to each share whether distributed as dividend or
retained for reinvestment in the business. It is calculated as follows:
This ratio is also widely used in financial press. It is usually used in establishing the market value
of a company.
It is calculated as:
Example
Freshers Ltd
Statements of Comprehensive Income
For the years ended 31 Dec 20X7 and 20X8
20X7 20X8
000’s 000’s
T.Shs T.Shs
Sales 12,700 14,800
Cost of Goods Sold 6,260 7,200
Gross Profit 6,440 7,600
Expenses 5,240 5,960
Net Profit before tax 1,200 1,640
Corporation tax 600 800
Net Profit after tax 600 840
Proposed dividends 160 400
Retained Profits for the year 440 440
Notes:
a) Percentage of credit sales 90%
b) Interest paid on the TDFL Loan was 12%
20X7 20X8
000’s 000’s 000’s 000’s
T.Shs T.Shs T.Shs T.Shs
Non Current Assets:
Freehold Property at cost 600 2,100
less: Accumulated Depreciation 0 0
600 2,100
Fixtures and Fittings at cost 2,400 3,000
less: Accumulated Depreciation 560 700
1,840 2,300
Motor Vehicles at cost 700 700
less: Accumulated Depreciation 340 400
360 300
Total Net Non Current Assets 2,800 4,700
Current Assets:
Stocks 900 1,640
Accounts Receivable 1,300 1,880
Bank balance 1,360 240
Total Current Assets 3,560 3,760
Current Liabilities:
Trade Accounts Payable 700 1,420
432Introductory Financial Accounting
20X7 20X8
000’s 000’s 000’s 000’s
T.Shs T.Shs T.Shs T.Shs
Proposed Dividends 160 400
Total Current Liabilities 860 1,820
Net Current Assets 2,700 1,940
Total Net Assets 5,500 6,640
Financed by:
Authorised Share Capital 2,000 2,000
Issued and fully paid
Ordinary Shares T.Shs 10 each 1,500 2,000
Share Premium 0 200
Retained Earnings 2,800 3,240
Shareholders' Funds 4,300 5,440
12% TDFL Loan 1,200 1,200
Total Capital 5,500 6,640
Note: Share price at the end of December, 20X8 was T.Shs 32.
Even before any ratios are computed an analysis of the figures as presented in the financial
statements provides insightful information to the keen observer. Properties have gone up from
T.Shs 600,000 in 20X7 to T.Shs 2,100,000 in the following year. Similarly Fixtures and Fittings
have increased from T.Shs 2,400,000 in 20X7 to T.Shs 3,000,000 in the following year. Clearly
there is a major expansion plan underway but the key question is how are the new acquisition
getting financed?
An analysis of the financing section of the Statement of Financial Position should be able to
provide some information on the way the non current assets are being financed. The company
raised equity capital to the tune of T.Shs 700,000, T.Shs 200,000 being share premium. There is
no change in long term borrowing. Clearly this level of financing is not enough to explain the
acquisition of the properties and fixtures and fittings. It is possible that short term financing has
been used and this information can be obtained in analysis of the relationship between Current
Assets and Current Liabilities.
Stocks have increased from T.Shs 900,000 in 20X7 to T.Shs 1,640,000 in 20X8 – 82 percent
increase within a year. Accounts Receivable however, have increased as a slower rate from T.Shs
1,300,000 in 20X7 to T.Shs 1,800,000 in 20X8 – an increase of 45 percent in percentage terms.
The increase in current assets could only be financed by short term credit facilities. Consequently,
Trade Accounts Payable have doubled from T.Shs 700,000 in 20X7 to T.Shs 1,420,000 in 20X8.
It is also noticed that cash balances have severely shrunk from T.Shs 1,360,000 in 20X7 to T.Shs
240,000 the following year.
Profits have increased but only by 37 percent from T.Shs 1,200,000 in 20X7 to T.Shs 1,640,000
the following year. Surprisingly dividends have outstripped the growth in profitability – from a
dividend of T.Shs 160,000 in 20X7 to T.Shs 400,000 the following year – a growth of 150
percent. Sales have only grown by 17 percent.
From the analysis it is evident that the company needs to be more careful about the growth pattern
Analysis and Interpretation of Financial Statements 433
and the way it is financed. It appears to finance growth through its short term resources and short
term borrowing. As a result its short term liquidity suffers – something that can have serious
implications for the company.
Ratios computed from the financial statements illustrate the observations made.
20X7 20X8
Liquidity and solvency Ratios:
Current ratio 4.14 2.07
Acid Test Ratio 3.09 1.16
Debt Service Cover Ratio 9.33 12.39
Debt Repayment ratio
Profitability Ratios:
Gross Margin 50.71% 51.35%
Net Margin 9.45% 11.08%
ROCE 24.44% 26.87%
Return on Total Assets 21.13% 21.09%
Gearing Ratios:
Debt Equity Ratio 27.91% 22.06%
Debt to Total Capital Ratio 21.82% 18.07%
Detailed interpretation of the ratios will depend on the norms in businesses of similar nature.
Nevertheless, even without industry ratio comparison there are a number of useful observations
that can be made about the company and its financial health and performance.
Cross-sectional Analysis
For comparisons of one firm with another or other firms to be meaningful, those firms must have
some similar attributes. This could be based on the following groupings:
In cross-sectional comparison, there must be some benchmark or standard developed for firms
operating in the same grouping. These are known as industry standard or ratios.
Time-series Analysis
This form of analysis seeks to describe a pattern or behavior over time for some variables like
Sales, Profits or Return on Capital Employed. For such analysis to be meaningful, data in
financial statements being observed must have been prepared on the same accounting bases. Time
series analysis must also take account of any structural change that has taken place in a firm.
When dealing with private companies it can be quite difficult to obtain data and financial
statements from firms of interest to an analyst. Even in public companies there may be limited
financial disclosures which could result in non-availability of data.
Accounting figures do not fully encompass qualitative attributes of a firm. These may be
important in interpretation of financial statements, absence of which may distort the analysis.
When entities report results in different time periods, comparison of results is also limited.
Firms can choose different accounting methods and still remain within Standard Accounting
Practice. Differences in accounting estimates can result in incomparability of results of firms.
e) Inflation
Conventional financial statements do not take account of inflation. Therefore, in time series
analysis the effects of inflation on financial statements under observation need to be taken
account of.
Analysis and Interpretation of Financial Statements 435
Review Questions
1. Define analysis and interpretation of financial statements.
2. What are the two main categories of techniques employed in interpretation of financial
statements?
6. What is the advantage of ratio analysis over horizontal and vertical analysis?
7. Two types of ratios can be calculated depending on sources of their data, what are they?
8. It is helpful to categorize ratios according to aspects of business they focus on. Mention
four of those categories.
9. Show how you would compute any two ratios in each of the categories in question 8
above.
10. In profitability ratios, computation of profit is taken to be net profit before interest
expenses and income tax. Why?
11. Why would both the shareholders and loan capital providers be interested in the level of
debt in a firm?
12. List any four market based ratios you know and show how they are computed.
13. Dividend yield shows relative attractiveness of an investment in shares, is that true?
14. List down the limitations of analysis and interpretation of financial statements.
Exercises
1. The following data for Boni Company were available at the year-end:
Compute:
(a) Dividend yield
(b) P/E Ratio
2. The following data were available from the records of Bomani Ltd at the year end:
TAS
436Introductory Financial Accounting
3. The financial statements for a company reported the following data for the year ended 31
December 20X2:
TAS
Net profit 300,000.00
Total Assets 1,500,000.00
Total owner's equity 600,000.00
(c) .6
(d) .4
(e) cannot be determined
(f) None of the above; it was ………
(b) Zai & Co's working capital was shs. 300,000 and total current liabilities was two thirds of the
amount. Therefore current ratio was:
(a) 1:1
(b) 2:1
(c) 3:1
(d) 4:1
(e) None of the above; it was …….
(a) Leverage
(b) Profit margin
(c) Return on total assets
(d) Earnings per share
(e) None of the above.
(c) What are the limitations in producing and analysing meaningful ratios?
(d) Explain the following and give one example of each, showing how it is calculated:
Problems
1. The portion of Statement of Comprehensive Income of two companies, each for the six
months ended 30 Jan. 20-0 show:
Company X
Shs. Shs.
Sales 289,600.00
Less: Cost of Sales
Opening Stocks 19,000.00
Add: Purchases 235,100.00
Goods Available for Sale 254,100.00
Less: Closing Stocks 21,100.00 233,000.00
Gross Profit 56,600.00
Company Y
Shs. Shs.
Sales 182,500.00
Less: Cost of Sales
Opening Stocks 30,000.00
Add: Purchases 151,700.00
Goods Available for Sale 181,700.00
Less: Closing Stocks 39,700.00 142,000.00
Gross Profit 40,500.00
Required:
2. A trader in your town, Horn, has called to see you with his accountant, as he is in financial
difficulties in continuing his business and is seeking additional capital. The accountant tells
you that Horn's present position arises because his average collection period for collection of
trade debts is high, while his rate of stock turnover is low for the type of business carried on.
Required:
How would the accountant have made these two calculations? What steps should Horn take
to remedy his position before you consider advising a client of yours to lend him money?
position:
You are required to write a short report to the directors commenting on the results shown and
the comparison with the previous year.
440Introductory Financial Accounting
4. Viatu Bora Co. imports shoes from manufacturers and wholesales to retail shops. All
purchases and sales are made on credit.
The trade is not seasonal but has grown rapidly since the business was set up four years ago.
The accounts for the year ended 31 Dec. 20-1, together with the comparative figures for the
previous year, are shown below:
(a) Prepare a statement explaining the increase in the overdraft between 1 Jan. and 31 Dec.
20-1.
5. Two financial analysts are having a disagreement. One says, "I don’t know why you don't use
net income to average total assets as the measure of efficient asset usage. After all, net
income is the final result. It represents what really happened. How can you ignore taxes and
interests? They are real and they happen".
442Introductory Financial Accounting
The second analyst replies, "That isn't the point.Net income represents the combined results
of several different types of management, actions, government policies and even acts of God.
By using Profits before interest and taxes, I can somewhat pinpoint responsibility to operating
management."
6. The following details were extracted from the books of Ridhaa & Co. a grocer, whose year
end is 30th September.
20X2 20X3
Shs. Shs.
Sales 2,754,000.00 3,078,000.00
Purchases 2,254,500.00 2,640,600.00
Administration expenses 192,900.00 246,300.00
Selling & Distribution 165,300.00 138,300.00
Financial expenses 54,900.00 153,900.00
Drawings 67,500.00 87,300.00
Shs.
30 Sept. 20X1 405,000.00
30 Sept. 20X2 456,300.00
30 Sept. 20X3 788,400.00
(ii) The credit balance on Ridhaa's capital account on October 1st, 20X1 was Shs. 243,000.
Required:
(a) Show the results achieved in each year and show the gross and net profit rates.
The current market price of the ordinary shares is 200 per share, and that of the preference
shares is 80 per share.
a) the dividend yield for both the ordinary shares and the preference shares;
b) the number of times that the dividend on the ordinary shares is covered by available
profit;