Chapter 7: Interpretation of financial statements Flashcards
Profitability:
The relationship between profit and revenue, assets, equity and capital employed. Measures the relationship between income and expenses; also, the profits or losses measured against equity.
Liquidity:
The stability of the company on a short-term basis. Focuses on the relationship between assets and liabilities.
Use of resources:
The effective and efficient use of assets and liabilities. Analyses how efficiently assets and liabilities have been used by the company.
Financial position:
The way in which the company has been financed. Compares the relationship between the equity and the non-current liabilities of the company.
Profitability Ratios:
Gross profit percentage:
This expresses, as a percentage, the gross profit (revenue minus cost of sales) in relation to revenue. The gross profit percentage (or margin) should be similar from year to year for the same company. A significant change from one year to the next requires investigation into the buying and selling prices. It needs to be sufficient to cover the overheads (expenses), and then to give an acceptable return on investment.
Profitability Ratios:
Expense/revenue percentage:
A large expense or overhead item can be expressed as a percentage of revenue.
Profitability Ratios:
Operating profit percentage:
uses profit before finance costs and tax. It is often referred to as the net profit. Should be similar from year to year for the same company, and should also be comparable with other companies in the same line of business. Net profit percentage should increase from year-to-year, which indicates that the overhead costs are being kept under control. Any significant fall should be investigated to see if it has been caused by a fall in gross profit percentage, and/or an increase in one particular expense.
Profitability Ratios:
Return on capital employed (primary ratio):
expresses the profit of a company in relation to the capital employed.
Profitability Ratios:
Return on shareholders’ funds:
focuses on the return for the ordinary shareholders. It indicates the return the company is making on their funds (ordinary shares and reserves (capital and revenue)). Use the profit for the year after tax, which is the amount of profit available to the ordinary shareholders.
Liquidity Ratios:
Working capital:
is needed by all companies in order to finance day-to-day trading activities. Sufficient working capital enables a company to hold adequate inventories, allow a measure of credit to its customers (trade receivables), and to pay its suppliers (trade payables) on the due date.
Liquidity ratios:
Current ratio:
this ratio uses figures from the statement of financial position and measures the relationship between current assets and current liabilities. Although there is no ideal current ratio, an acceptable ratio is about 2:1. lt can be too high, if it is above 3:1 an investigation of the make-up of current assets and current liabilities is needed. The company may have too many inventories, too many trade receivables, or too much cash, or even too few trade payables
Liquidity ratios:
Acid test ratio (or quick ratio/liquid capital ratio):
is so called because it gives a clear indication of the health of a company’s finance. It uses the current assets and current liabilities from the statement of financial position, but inventories are omitted. This is because inventories are the least liquid current asset. Provides a direct comparison between trade receivables/cash and short-term liabilities. The balance between liquid assets, that is trade receivables and cash, and current liabilities should, ideally, be about 1:1. At this ratio a company is expected to be able to pay its current liabilities from its liquid assets. A figure below 1:1 indicates that the company would have difficulty in meeting the demands of trade payables.
Use of resources:
Inventory holding period:
is the number of days’ inventories held on average. It is important for a company to keep its inventory holding period as short as possible, subject to being able to meet the needs of most of its customers. A company which is improving in efficiency will generally have a shorter inventory holding period comparing one year with the previous one, or with the inventory holding period of similar companies.
Use of resources:
inventory turnover:
is the number of times a year that the inventory is turned over.
Use of resources:
Trade receivables’ collection period (days):
shows how many days, on average, trade receivables take to pay for goods sold to them by the company. It is a measure of the company’s efficiency at collecting the money that is due to it and we are looking for some reduction in trade receivables’ days over time. Ideally trade receivables’ days should be shorter than trade payables’ days, thus indicating that money is being received from trade receivables before it is paid out to trade payables.
Use of resources:
Trade payables’ payment period (days):
we are measuring the speed it takes to make payment to trade payables. While it can be a useful temporary source of finance, delaying payment too long may cause problems. We would expect to see the trade payables’ days period longer than the trade receivables’ days. We would also be looking for a similar figure for trade payables’ days from one year to the next: this would indicate a stable company.
