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ANALYSIS AND
INTERPRETATION OF

FINANCIAL STATEMENTS

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Financial Statement Analysis

Who analyzes financial statements?
Internal users (i.e., management) External users (emphasis of chapter)

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Examples? Investors, creditors, regulatory agencies & stock market analysts and auditors

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Financial Statement Analysis

What do internal users use it for?

Planning, evaluating and controlling company operations

What do external users use it for?

Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

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Financial Statement Analysis

Information is available from

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Published annual reports

(1) (2) (3) (4) (5) Financial statements Notes to financial statements Letters to shareholders Auditors report (Independent accountants) Managements discussion and analysis

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Financial Statement Analysis

Information is available from

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Other sources
(1) Newspapers (e.g., Wall Street Journal ) (2) Periodicals (e.g. Forbes, Fortune) (3) Financial information organizations such as: Moodys, Standard & Poors, Dun & Bradstreet, Inc., and Robert Morris Associates (4) Other business publications

Methods of Financial Statement Analysis

Horizontal

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Analysis Statements

Vertical

Analysis

Common-Size Trend Ratio

Percentages

Analysis

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Ratio Analysis
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

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Ratio Analysis

No universal ratio definitions, definition of the ratios used is always provided Ratios cannot be looked at in isolation, need to compare against previous year/ competitor. Interrelationships of various ratios need to be analysed Ratios need to be analysed at lowest break down level (numerator/ denominator)

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Classification of Ratios
Profitability Ratios Liquidity Ratios (Solvency Ratios) Efficiency Ratios Capital Structure Ratios Investor Ratios

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Profitability Ratios

Gross profit margin

= Gross profit X 100% Turnover = Net profit Turnover = X 100%

Net profit margin

Return on Capital employed (ROCE)

EBIT X 100% Capital Employed

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Liquidity Ratios (Solvency Ratios)

Current Ratio = Current Assets Current Liabilities

Quick ratio ( Acid test ratio )

= Current Assets - stocks Current liabilities

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Efficiency Ratios

Asset Turnover ratio

=Turnover Capital Employed

Stock turn over ratio

= Cost of goods sold Average stocks

= Average debtors X 365 days Credit sales = Average creditors X 365 days Credit purchases = Average stocks X 365 days Cost of goods sold = Inventory T/O + Debtors T/O - Creditors T/O

Debtors Days

Creditors Days

Inventory turnover days

Working capital cycle

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Capital Structure Ratios

Liability ratio = Total Liabilities (Without SC) Total Assets = Prior Charge Capital X 100% ( <50% - low geared) Debt + Equity = Prior Charge Capital X 100% Equity = EBIT Interest charge

Capital gearing

Debt to Equity ratio

Interest Cover ratio

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Investor Ratios

EPS

= Net profit after tax, pref; div. No. of ordinary shares in issue = PAT (Profit attributable to Ord. S/Hs) Ordinary dividend paid = Dividend per Share Market Price per Share = Market Price per Share (MPS) Earnings per Share (EPS)

Dividend cover

Dividend Yield

Price / Earnings Ratio

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Limitations of Ratio analysis

Diverts the attention from figures & statements Applicability vs different account policies & currencies Interpretation & industry knowledge Creative accounting vs ratios Ratios are calculated based on historic data When comparing ratios it ignores the product mix, Different objective & different set of workforce etc.. Ignore the impact of inflation

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Limitations of Ratio analysis

Ignore the fluctuations in a given time period It only highlight the problem areas not the solutions Ignore the non-quantitative elements such as goodwill, Labour relations % quality of work force etc There is no ideal benchmark figures for each ratio Manipulation of ratios via numerator / denominator Too many ratios will confuse the users & hide the true picture / deviate from the purpose Def. used by rations are rather vague since they can be calculated in several ways