Chapter 11 - Analysis and Interpretation Flashcards
What is meant by the analysis and interpretation of financial statements?
The financial statements and annual report contain a lot of financial and non-financial information about a company. Users of this information need to analyse and interpret it to understand it fully. Analysing both financial and non-financial information is essential for comprehensive decision-making, offering a complete picture of a company’s performance beyond just numbers.
In FAR we will consider the analysis and interpretation of financial and non-financial information from an internal perspective, with the aim of identifying inconsistencies and errors and analysing trends
What are the key ratio types we look at in this course? State what aspect of financial statements they help the auditor assess
- Perfomance ratios - helps the user assess the company’s ability to generate profit.
- Liquidity ratios - help the user assess how easily a company can meet its obligations, and how the company manages its working capital
- Long term solvency ratios - Help the user assess the company’s ability to meet its long-term debt obligations
- Efficiency ratios - Help the user assess how effectively the company uses its assets and resources to generate revenue
Outline the perfomance ratios
- Gross profit margin
- Operating profit margin
- Operating cost percentage
- Return on capital employed
Define gross profit margin, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the efficiency of a company in producing goods or services relative to its revenue.
Factors That Can Cause Changes Year to Year:
* Changes in Sales Prices – An increase or decrease in the price at which products are sold can directly impact gross profit.
* Cost of Goods Sold (COGS) Fluctuations – Variations in the cost of raw materials, labor, or manufacturing overhead can affect the margin.
* Product Mix Changes – A shift in the types of products or services sold, with different cost structures, can influence the gross margin.
* Economic Conditions– Inflation, supply chain disruptions, or changes in demand for goods can affect both revenue and COGS.
* Pricing Strategies – Discounts, promotions, or price adjustments can affect the margin.
Define operating profit margin, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to generate profit from its core business operations, excluding the impact of financing and tax expenses.
Factors That Can Cause Changes Year to Year:
* Changes in Revenue – Growth or decline in sales directly impacts operating profit margin.
* Operating Cost Fluctuations – Increases in administrative, selling, or distribution expenses reduce the margin.
* Operational Efficiency – Improvements or declines in cost control, production efficiency, or economies of scale affect the margin.
* One-Off Items – Exceptional items such as restructuring costs or gains/losses from asset sales can distort operating profit.
* Changes in Business Strategy – Shifts in focus (e.g., expansion, outsourcing) can lead to higher or lower operating expenses.
* Inflation or Wage Increases – Rising costs that aren’t matched by price increases can erode margins.
Define operating cost percentage, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the proportion of revenue that is consumed by operating costs, indicating how efficiently a business controls its operating expenses.
Factors That Can Cause Changes Year to Year:
* Changes in Operating Costs – Increases in rent, wages, utilities, or other overheads will increase the percentage.
* Revenue Fluctuations – A decrease in revenue without a corresponding drop in operating costs will raise the percentage.
* Cost Control Measures – Implementation of cost-saving strategies or automation can reduce the percentage.
* Business Expansion – New locations, product launches, or market entry may initially increase costs faster than revenue.
* Inflation or Wage Pressures – General increases in prices or staff costs will raise the operating cost base.
* Outsourcing or Restructuring – Changes in business structure may shift or reduce certain operating costs.
Define return on capital employed, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how efficiently a company is generating profit from the capital it has invested in the business. It’s a key indicator of profitability and capital efficiency.
Factors That Can Cause Changes Year to Year:
* Operating Profit Changes – Increases or decreases in profitability directly impact ROCE.
* Asset Base Fluctuations – Significant investments or disposals of assets affect capital employed.
* Financing Structure – Changes in long-term debt or equity can alter the capital employed figure.
* Depreciation Policies – Variations in depreciation methods or estimates can impact both operating profit and asset values.
* Efficiency Improvements – Better asset utilisation or cost control can boost operating profit relative to capital employed.
* Non-Recurring Items – One-off gains or losses can distort ROCE if not adjusted for.
Outline the liquidity ratios
- Current ratio
- Quick ratio (acid test)
Define current ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to meet its short-term obligations using its short-term assets. It indicates liquidity and short-term financial health.
Factors That Can Cause Changes Year to Year:
* Changes in Working Capital – Increases or decreases in receivables, inventory, or payables will affect the ratio.
* Cash Flow Management – Strong or weak cash generation impacts current assets directly.
* Debt Repayment or Refinancing – Repaying short-term debt or refinancing it into long-term liabilities can improve the ratio.
* Inventory Fluctuations – Overstocking or selling off inventory can influence current assets.
* Credit Policies – Stricter or more lenient credit terms with customers or suppliers will affect receivables and payables.
* Seasonality – For some businesses, current asset and liability levels vary significantly at different points in the year.
Define quick ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures a company’s ability to meet its short-term liabilities using its most liquid assets, excluding inventory. It’s a stricter test of liquidity than the current ratio.
Factors That Can Cause Changes Year to Year:
* Changes in Receivables or Cash Balances – Increases or decreases in liquid assets directly impact the ratio.
* Inventory Levels – A rise in inventory has no effect on the quick ratio but may signal poor liquidity if liquid assets don’t increase alongside.
* Payment Practices – Changes in how quickly customers pay or how the business manages supplier payments affect the ratio.
* Short-Term Borrowings – New short-term loans or repayments alter current liabilities and influence the ratio.
* Cash Management Strategies – Decisions around holding cash vs. reinvesting can shift liquidity.
* Economic Conditions – Slow-paying customers or rising bad debts reduce receivables, impacting the ratio.
Outline the long term solvency ratios
- Gearing ratio
- Interest cover ratio
Define gearing ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the proportion of a company’s capital that is financed through debt compared to equity. It indicates the financial risk and long-term solvency of the business.
Factors That Can Cause Changes Year to Year:
* New Borrowings or Loan Repayments – Taking on more debt increases gearing; repaying debt reduces it.
* Changes in Equity – Issuing new shares reduces gearing; buybacks or losses that reduce retained earnings increase it.
* Profitability – Strong profits increase retained earnings and equity, potentially reducing gearing.
* Dividend Policies – High dividends reduce retained earnings and equity, increasing gearing if debt remains unchanged.
* Business Expansion or Acquisition – May involve new financing that increases debt levels.
* Fair Value Adjustments – Revaluation of assets or liabilities can impact equity and thus affect the ratio.
Define interest cover ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how easily a company can pay its interest expenses from its operating profit. It indicates the company’s ability to service its debt obligations.
Factors That Can Cause Changes Year to Year:
* Changes in Operating Profit – Improved profitability increases cover; declining profits reduce the ratio.
* Fluctuations in Finance Costs – Interest rate changes or variations in debt levels directly impact the ratio.
* New Borrowings or Loan Repayments – Taking on more debt increases interest costs; repayments reduce them.
* One-Off Gains or Losses – Exceptional items affecting operating profit can distort the ratio if not adjusted.
* Foreign Exchange Movements – If debt is in foreign currency, exchange rate changes can affect interest expense.
* Capital Structure Changes – Shifts between debt and equity financing influence the ratio over time.
Outline the efficiency ratios
- Net asset turnover ratio
- Inventory period
- Inventory days
- Trade receivable period
- Trade payable period
Define net asset turnover ratio, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how efficiently a company uses its net assets to generate revenue. It indicates asset utilisation and operational efficiency.
Factors That Can Cause Changes Year to Year:
* Changes in Revenue – Increases or decreases in sales directly impact the ratio.
* Asset Base Fluctuations – Investment in or disposal of assets will change the net assets figure.
* Profit Retention or Distribution – Retained profits increase net assets; dividends reduce them, affecting the ratio.
* Asset Impairments or Revaluations – Adjustments to asset values impact net assets and therefore the ratio.
* Business Restructuring or Expansion – Acquisitions, mergers, or operational changes can significantly alter both revenue and net assets.
* Depreciation and Amortisation – These reduce the net book value of assets over time, influencing the ratio.
Define inventory period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days it takes a company to sell its inventory. It reflects inventory management efficiency and how quickly stock is converted into sales.
Factors That Can Cause Changes Year to Year:
* Inventory Management Practices – Improvements in stock control or supply chain efficiency reduce the period.
* Sales Volume Changes – Higher sales can reduce inventory levels and shorten the inventory period.
* Product Mix – A shift toward products with longer lead times or slower turnover can increase the period.
* Seasonality – Businesses may hold more stock during certain times of the year, affecting the average.
* Obsolete or Slow-Moving Stock – An accumulation of unsold or outdated items increases the inventory period.
* Changes in Cost of Sales – Rising or falling COGS without a corresponding inventory change will affect the ratio.
Define inventory turnover, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures how many times a company sells and replaces its inventory during a given period. It reflects inventory efficiency and how well stock is being managed relative to sales activity.
Factors That Can Cause Changes Year to Year:
* Sales Volume – Higher sales usually lead to more frequent inventory turnover.
* Inventory Management – Efficient procurement and demand forecasting improve turnover.
* Product Mix – Different products turn over at different rates depending on demand and shelf life.
* Stock Obsolescence – Unsellable or obsolete inventory reduces turnover.
* Seasonality – Seasonal fluctuations can cause temporary increases or decreases in turnover.
* Bulk Purchasing – Buying in large quantities may increase average inventory and reduce turnover temporarily.
Define trade payable period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days it takes a company to collect payment from its customers after a sale. It indicates the effectiveness of credit control and cash collection processes.
Factors That Can Cause Changes Year to Year:
* Credit Policy Changes – Offering longer or more flexible payment terms can increase the period.
* Collection Efficiency – Delays or improvements in collection processes directly affect the period.
* Customer Creditworthiness – A higher proportion of sales to risky or slow-paying customers can lengthen the period.
* Economic Conditions – In a downturn, customers may delay payments, increasing the receivable period.
* Sales Volume and Timing – Year-end sales spikes may temporarily inflate receivables.
* Bad Debts or Disputes – Higher levels of uncollectible debts can distort the average collection period.
Define trade receivable period, including the equation, and state what factors can cause this to change from year to year, and the audit risks it can help identify
It measures the average number of days a company takes to pay its suppliers. It reflects how the business manages its cash flow and relationships with creditors.
Factors That Can Cause Changes Year to Year:
* Supplier Payment Terms – Renegotiation of terms can lengthen or shorten the period.
* Cash Flow Constraints – Companies may delay payments when under financial pressure, increasing the period.
* Purchase Volume Fluctuations – Large one-off purchases or changes in production levels can affect average payables.
* Supplier Relationships – A strong relationship may result in more favourable terms, affecting timing.
* System or Process Changes – New accounting systems or procedures may affect when liabilities are recognised.
* Economic Conditions – In times of uncertainty, businesses may hold onto cash longer and delay payments.
What are the main types of non-financial performance measures? Give examples of each type
- Customer-related measures
- Employee-related measures
- Sustainability-related measures
- Social-relate measures
