Interpreting financial statements

Question 1

Vertical trend analysis

Answer 1

Compare prior year to current

Question 2

Horizontal analysis

Answer 2

Compare a performance of an equivalent company for the same period. Very similar sized company in same industry

Question 3

Industry average comparison

Answer 3

Companys results (ratios) compared to a compilation of the average of many other similar types of company.

Question 4

Key ratios - Profitability:

Gross profit
Operating profit
Return on capital employed (ROCE)
Asset turnover

Answer 4

Gross profit = gross profit/revenue (use to make pricing decisions may fall if lower price to sell more )

Operating profit = Profit before interest and tax / Revenue (Efficiency, controlled overheads and economies of scale)

Return on capital employed and equity = PBIT/total assets less current liabilities (how much profit is generated for every £ of assets)

Asset turnover = Revenue/TALCL (how much revenue is generated for every £ of assets, increase shows new assets working efficiently to improve performance)

Question 5

Key ratios - Liquidity:

Current ratio
Quick ratio (acid test)
Receivables collection period 
Payables payment period
Inventory turnover and days

Answer 5

Current ratio = current assets/current liabilities (how easily a company can meet its current obligations)

Quick ratio (acid test) = current assets - inventory / current liabilities (better test of liquidity as struggling businesses will have issues selling inventory)

Receivables collection period = (trade receivables / credit sales) x365 (how quickly customers pay, quality of credit control team)

Payables payment period = (trade payables / purchases or cost of sales) x365 (how quickly a business pays its suppliers, is it struggling, affect relationships)

Inventory turnover and days= Cost of sales / inventory, days = (inventory / COS) x365 days = how long it takes a business to sell its inventory. Turnover

Question 6

Key ratios - Investor ratios:

Dividend yield
Dividend cover
P/E ratio
Return on equity

Answer 6

Dividend yield = Dividend per share / market share price (as a %) indicates the return investors are receiving on their investment

Dividend cover = Profit after tax / dividends paid or EPS/dividend per share (indicates the number of times profits can cover dividends paid, higher the better)

P/E ratio = Share price / EPS (higher ratio suggests higher growth is expected)

Return on equity = Profit after tax / Equity (measures how much profit is generated for shareholders for every £ of equity)

Question 7

Key ratios - Gearing:

Gearing ratio
Debt to equity
Interest cover

Answer 7

Interest bearing debt (excl. overdraft, incl, preference shares)

Gearing ratio = interest bearing debt / TALCL

Debt to equity = interest bearing debt / total equity

Interest cover = PBIT / Interest payable expense