Interpreting Financial Statements

Question 1

Ratios can be calculated to see how…

Answer 1

Well the business is performing.

Question 2

Calculating ratios can aid in (3) …

Answer 2

1. Planning — for example, how much profit are we likely to make next year?
2. Decision making — for example, which is our most profitable product?
3. Control — for example, why have our costs increased?

Question 3

What are the different profitability ratios?

Answer 3

1. Gross profit margin
2. Net profit margin
3. Expense/Revenue percentage
4. Return on capital employed (ROCE)

Question 4

Describe gross profit margin

Answer 4

(Gross profit/revenue) x 100

• Tells a business how much profit is made for every pound of revenue received, e.g., a gross profit margin of 60% means that every 1 pound of sales provides 60 pence of gross profit after paying Cost of Sales.
• It can be used to make pricing decisions—increasing selling price relative to direct costs will result in increased gross profit margin.
• This ratio won’t generally change dramatically from one period to the next, as a company will normally decide at what gross profit margin it wishes/is able to sell its products. Gross profit margins may fall if a company lowers selling prices in an attempt to sell more goods.
• Volume of goods won’t affect this ratio.
• Falling margin may be due to increased costs, for example if a supplier increased their prices.
• When comparing different businesses, check that policies are consistent—if one company posts all of its staff costs in CoS and another posts them all in overhead costs their gross profit margins will be very different.

Question 5

Describe net profit margin

Answer 5

(Profit for the year/revenue) x 100

• The net profit margin tells a business how much net profit is made for every £1 of revenue receives, e.g., 30% profit margin means that every £1 of sales provides 30p of net profit after paying of ALL costs.
• Differences between net profit margin and gross profit margin allows you to establish if the changes are direct or caused by overheads, e.g., if GP margin has fallen by 20% but NP margin has fallen by 10% we must have made some cost savings with overhead expenses.
• Any changes to GP (e.g., pricing or direct costs) would also affect NP margin.
• One-off costs or a loss of control over indirect costs could lead to a fall in the NP margin.

Question 6

Describe expenses/revenue percentage

Answer 6

(Specified expense/revenue) x 100

• This is used to measure a specific expense as a percentage of revenue.
• For example, a company may wish to measure its marking expense as a percentage of revenue to judge the success of its marketing activity at generating sales.
• A rising expenses ratio could indicate a problem with cost control.
• Keep in mind not all expenses would be expected to rise in line with revenue, for example legal fees/depreciation.

Question 7

What is the equation for capital employed?

Answer 7

Capital employed = Capital + Non-Current liabilities

Question 8

Describe return on capital employed (ROCE)

Answer 8

(Profit for the year/capital employed) x 100

• Return on capital employed measures how much net profit is generated for every £1 of capital employed.
• Capital employed represents the funding that is available from owners and lenders.
• It indicates how effectively the business is using its funds to generate a profit.
• An increase in ROCE means the performance of a business has improved, because it is generating more profit from its funds.
• A decrease/deterioration in ROCE could be due to falling profitability or increased funds that have not yet translated into improved performance. Investing can take time to turn into profits.

Question 9

Describe the link between the SPL and SPF

Answer 9

• It is important to remember the profit for the year (or net profit) is the link between the SPL and SPF.
• Net profit is added to the capital section of the SFP.
• An increase to the net profit will also result in increase to capital, to keep the accounting equation in balance.
• Though it is useful to calculate gross profit margin and expense/revenue percentage, ultimately it is net profit that affects the capital position of the business.
• Another reason ROCE is such a key ratio is because it incorporates both the SPL and SFP figures into the ratios.

Question 10

Ratios have little meaning unless you have something to compare them to, such as…

Answer 10

• Previous year
• Target
• Another company
• Industry averages

Question 11

Is an increase to the expense/revenue percentage worse or better?

Answer 11

Indicates WORSENED performance

Question 12

What are 5 limitations of ratio analysis?

Answer 12

1. Historical information — all financial statements and hence the ratios are calculated based on past information. This limits the usefulness of the information for decision making.
2. Comparisons to other companies — be mindful that ratios calculated for other companies are based on their accounts which may use a different basis. Information may not be compared on a like for like basis. They may have a different year end and differnt accounting policies.
3. Window dressing — a company may recover lots of debts just before the year end or ensure that inventory is delivered at the start of the new year. This may mean for example cash is higher than usual and receivables are lower than usual. If year end figures are used rather than averages this can skew the ratio.
4. Non-financial information — ratios only consider the financial impacts of a business, they don’t consider qualitative aspects such as staff morale, the environment, the community etc.
5. Markets and size — businesses in the same industry may operate in different markets, therefore their ratios are not comparable. Also, larger businesses can utilise economics of scale which again will impact their ratios.