Interpretation of financial statements

Question 1

..to make decisions and provide advice but for whom? (3,4)

Answer 1

The users of financial statements

Per Conceptual Framework

• Investors (existing and potential)
• Lenders
• Other creditors

But also

• Customers,
• employees,
• general public,
• Government etc

Question 2

Needs and objectives of users

Three general areas of interest: (what are they and what questions do they raise/answer)

Answer 2

Performance

• What is the profitability?
• How well have assets been used to generate profits

Financial position

• Can immediate debts be paid? How well is working capital being managed? - Can the business survive?

Investment / Risk

• Returns for shareholders and company

Question 3

Benchmarks are needed

Comparison against (for example) (4)

Answer 3

The previous period

• Is current year better or worse

Budgeted figures

• Has current activity matched expectations?

Competitors & The industry average

• Is our business performing as well as another (or the industry?

Question 4

How do we interpret financial statements? (4 steps)

Answer 4

1. Start with information directly in the statements
2. Calculate ratio’s from figures within the statements
3. Compare and contrast to expectations, competitors, industry averages etc
4. Use the above to make sense of the story

Question 5

Financial analysis terminology

What is Vertical (3) and Horizonal (2) analysis

Answer 5

Vertical analysis

• Within one time period
• Shows relative size of an account compared to a total
• Eg. cost of sales were x% of turnover

Horizontal analysis

• Shows percentage change over time
• Eg sales revenue grew by x% in the year

Question 6

Example of what you can learn from a statement of profit or loss (4)

Answer 6

• Both companies are profitable in 20X2
• Dougal generates approximately 2.5x the revenue of Ted but less than 1.5x the operating profit
• Dougal incurs high distribution costs compared to Ted (4x)
• Dougal incurs high finance costs compared to Ted (17x)

Question 7

Example of what you can learn from a Statement of financial position (5)

Answer 7

• Dougal is better than Ted in using its PPE to generate revenue
• Both companies have positive equity
• Inventory and payables in Dougal high compared to Ted
• Ted has large cash balance. Dougal has a large bank overdraft – can expect high interest costs
• Dougal has high long term borrowings – can expect high interest costs

Question 8

Example of what you can learn from a Statement of cash flows

Answer 8

• Both generate cash inflows from operations
• Ted has decreased cash in the year but has invested in NCA and repaid borrowings. Both these should improve future profits and cash flow
• Dougal has increased cash balances but has issued more equity and debt which will decrease future retained earnings

Question 9

Use of ratios to understand a business (4)

Answer 9

• There are many ratio’s that could be calculated, and for some, different ways of calculating them.
• Each user will select ratio’s, and the method of their calculation, that would be useful to them.
• Important to know how the ratio’s are calculated and what they tell us.
• Important to note that ratio’s in isolation do not give a full picture. They should be compared to other relevant benchmarks.

Question 10

Capital Terminology

Assets?

Equity?

Total capital?

Total capital?

Capital employed?

Working capital?

Answer 10

Assets = Liabilities + Equity

Equity = total owner investment + reserves = total capital

Total capital = Total assets – Total liabilities

Total capital = NCA + CA – CL – NCL

Capital employed = NCA + CA – CL

Working capital = CA – CL

Question 11

Performance ratios - their formulas and use? (5)

Answer 11

Gross profit

• (𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕)/𝑹𝒆𝒗𝒆𝒏𝒖𝒆 x 100%
• Effectively shows the percentage of revenue that’s generated from the main trade of the organisation.
  Very industry specific.

Operating profit margin

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕)/𝑹𝒆𝒗𝒆𝒏𝒖𝒆 x 100%
• Shows a measure of profit that is generated per £1 of revenue that can contribute towards tax and finance costs. Very industry specific.

Return on capital employed (‘ROCE’)

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙 𝒂𝒏𝒅 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕)/(𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 𝒍𝒆𝒔𝒔 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)

=

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕)/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅) x 100%
• Indicates how efficiently and effectively a company has utilised its assets during a period in generating profit

Asset turnover

• 𝑹𝒆𝒗𝒆𝒏𝒖𝒆/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅)
• Expressed as a number of times per annum
• Effectively shows the sales revenue generated for every £1 of capital employed.
• Measure of the level of activity and productivity.

Non current asset turnover

• 𝑹𝒆𝒗𝒆𝒏𝒖𝒆/(𝑵𝒐𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔)
• Expressed as a number of times per annum
• Effectively shows the sales revenue generated for every £1 of non current asset.
• Measure of the level of activity and productivity.

Question 12

Financial position/ liquidity - their formulas and use? (6)

Answer 12

Inventory turnover

• (𝑪𝒐𝒔𝒕 𝒐𝒇 𝒔𝒂𝒍𝒆𝒔)/(𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)
• How many times inventory is turned over in a year

Inventory days

• (𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)/(𝑪𝒐𝒔𝒕 𝒐𝒇 𝒔𝒂𝒍𝒆𝒔) 𝑿 𝟑𝟔𝟓
• How long on average inventory is stored before it is sold

Receivables’ days

• (𝑻𝒓𝒂𝒅𝒆 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔)/(𝑪𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔) 𝒙 𝟑𝟔𝟓
• How long it takes on average to collect receivables

Payables’ days

• (𝑻𝒓𝒂𝒅𝒆 𝒑𝒂𝒚𝒂𝒃𝒍𝒆𝒔)/(𝑪𝒓𝒆𝒅𝒊𝒕 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔) 𝒙 𝟑𝟔𝟓
• How long it takes on average to pay payables

Current ratio

• (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔)/(𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)
• Measure of extent current liabilities are covered by current assets

Quick ratio

• (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔 𝒍𝒆𝒔𝒔 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)/(𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)
• Measure of ability to cover liabilities with most liquid current assets

Question 13

Investment ratio’s - their formulas and use? (5)

Answer 13

Capital Gearing

• (𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒍𝒐𝒂𝒏𝒔)/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅)
• Gearing or leverage is relationship between fixed interest capital (debt) and total capital (debt and equity).
• Measure of financial risk

Dividend Cover

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙)/(𝑬𝒒𝒖𝒊𝒕𝒚 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅)
• Measure of ability of company to pay current dividend

Interest Cover

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕)/(𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒐𝒔𝒕)
• Measure of ability of company to pay current interest

Earnings per share

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙)/(𝑵𝒐. 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔)
• Useful for shareholders to evaluate performance over time

Price Earnings Ratio

• (𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆)/𝑬𝑷𝑺
• Reflects risk – effectively number of years taken to cover the cost of buying a share

Question 14

Limitations and warnings (2/4,1)

Answer 14

Are you comparing like-with-like?

• Accounting policies
• Exact competitors
• Environments of periods compared
• Time value of money

Appropriateness of ratios used

• Industry characteristics