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Interpretation of Financial Statements

Author Noel OBrien, Formation 2 Accounting Framework Examiner.

An important component of most introductory financial accounting programmes is theanalysis and interpretation of financial statements. This is usually dealt with towards theend of the programme and may be seen and used as a test of the studentscomprehension of much of the material covered. It requires a knowledge of the users offinancial statements and the particular requirements of each category of user. It requiresthe skill to select and measure various indicators of performance and offer possibleexplanations for trends over a period or variances from norms. A review of all recentAccounting Framework papers shows that the topic is popular.

At an introductory level questions usually take the form of analyzing income statementsand balance sheets. In effect students are expected to appraise the performance of areporting entity over different reporting periods, the performances of different entitiesover the same period or compare the performance of an entity with the industry norm(which will be given if required to answer a question). Students will normally calculateratios and comment on them. The particular ratios may be specified or it may be left tothe student to select.This article sets out to give students guidance as to what is expected from a goodanswer and how to approach such questions.

The normal approach to the interpretation of financial statements is to select suitableaccounting ratios and to comment on them. These questions often guide the student onthe ratios to be selected by specifying aspects of performance or financial position to beanalysed. Sometimes the ratios themselves are specified; sometimes the student isasked to select the ratios without any indication as to which category is required. In thislatter case there may be significant marks allocated for the correct selection.The following are some of the ratios most likely to be useful to the student at Formation2 level.

Profitability ratios.

Return on capital employed (ROCE).ROCE measures the profit relative to the size of the business or the amount of capital ittakes to run the business. It is often called the primary ratio because many consider itthe most important. The ratio shows how efficiently a business is using its resources.ROCE is calculated as follows:

Profit before interest and taxation X100Shareholders equity + long term liabilities

Some students calculate this ratio incorrectly by using a wrong figure either above theline or below the line. Sometimes they do not compare like with like. For instance theyshow profit after interest above the line but show long-term liabilities below the line. Asinterest is the return on the long-term liabilities it should be added back above the line.

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Return on equity. (ROE)ROE shows the return equity shareholders receive on the book value of their investmentand is calculated as follows:

Profit after interest, preference dividends and tax X100

Total equity shareholders funds.

This ratio may be important for examination candidates as the difference between ROCEand ROE has significant implications for how a business might raise additional capital.However, it may not be so significant for equity shareholders in large plcs as othermeasures such as price earnings (P/E) ratio give a better indication of return. One of thereasons for this is that the balance sheet numbers (especially for non current assets)may not reflect correct current values.

Profitability of sales.The profitability of sales is clearly important for the financial health of any business. It isnormally analysed under the following:

Gross profit marginThis ratio is calculated as follows:

Gross profit X 100Sales revenue

Gross profit is the difference between sales revenue and the cost of sales. Changes inthe margin are caused by changes in selling prices, changes in purchasing price or acombination of both. It is important for students to remember what does not affect theratio. For a non-manufacturing business increases in wages, interest, depreciation orother such expenses have no effect on this ratio.

Operating profit margin / net profit margin.These terms often present difficulties. Usually operating profit is taken to mean profitbefore deduction of interest and the term net profit is profit after deduction of interest.Often the term earnings before interest and tax (EBIT) is used for operating profit. It isimportant for the student to be clear which ratio is being used, especially if comparingtwo entities that are similar in all respects except that one is largely financed by equityand the other by borrowings. In a case such as this the EBIT number should be used.

Solvency / liquidity ratios.

Liquidity refers to the firms ability to meet its short-term commitments. A business maybe trading profitability but may be unable to pay its current liabilities such as wages or

suppliers. This is a liquidity problem. Two common ratios are used to measure liquidity:

Current ratio: Current assets : current liabilities.

Acid test: Current assets less inventory : current liabilities

Long-term solvency is measured by looking at the capital structure of the business andcomparing long-term borrowings with owners capital (equity). This is measured invarious ways the most common being:

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Debt to Equity ratio

Total long-term debtEquity

and

Gearing ratio:

Total long-term debtEquity + long term debt

In the past the treatment of preferred share capital presented problems as it wasconsidered neither debt nor equity. Sometimes the term prior charge capital was used

and preference shares were included with loans. Now, however, all capital must beclassified as either debt or equity. At this level if preferred capital is stated to beredeemable it may be classified as debt.

The ideal capital structure (ratio between debt and equity) is a matter that will be dealtwith later in your programme of studies. At this level we consider the risks inherent inhaving too much debt on the one hand and the advantages of the probable lower cost ofdebt on the other. Also the composition of the assets of the business may indicate thepreferred capital structure. Perhaps non current assets need to be financed mainly byequity whereas other assets could be financed by debt. Interest cover should also beconsidered.

Efficiency ratios.

Efficiency ratios are concerned with the control of inventories, payables and receivables.Inventory control is usually measured in terms of times turned over. This is measured asfollows:

Inventory turnover: Cost of salesAverage inventory

It may also be measured in terms of time, such as days.

Payables and receivable are usually measured in terms of time outstanding and aremeasured as follows (Days):

Receivables: Trade Receivables X 365Sales

Payables: Trade Payables X 365Purchases

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Shareholders investment ratios.

These ratios help equity shareholders assess their investment or potential investment.

Earnings per share (EPS) is possibly the most important number to appear in the

accounts of a quoted plc. In the past it was particularly open to manipulation so itscomputation is now strictly regulated (IAS 33). It is the amount of net profit for the periodthat is attributable to each ordinary (equity) share which is a) outstanding during all orpart of the period and b) that ranks for dividend.

Directly related to the EPS is the P/E ratio in that the E in the formula is the earnings ascalculated in the EPS. The P is the actual price (cost) of the share as quoted on thestock exchange. It is likely that potential and current investors are likely to be moreinfluenced by this number than the ROE for reasons already outlined.

Dividend cover is a measure of how secure the dividend payment is and is calculated asfollows:

Dividend cover: EPSDividend per share

Dividend yield is the return a shareholder receives on investment measured at currentprice.

If the selection of ratios is left to the student then it is important to select wisely. Acommon complaint of markers is that when candidates are left to decide which ratios tocalculate, they calculate far too many, thus spending very little time on theirinterpretation. On the other hand ratios should be selected from the various categories

such as return on investment, profitability of sales, solvency (preferably both short termand long term), use of assets and shareholder investment ratios where these arerelevant. However, no more than two from each category should be necessary. In recentexaminations some candidates failed to calculate profit. This meant that it was verydifficult for them to achieve a pass mark. Candidates should ensure that they arecapable of using the information given to reconcile opening and closing balances inretained earnings so deriving the profit.

Interpretation

Having calculated the appropriate ratios most questions will request the student to

comment on them. A review of the examiners reports will show that the most commonshortcoming has been the lack of analysis. In particular candidates do not offer possiblereasons for movement or differences in the ratios. A typical comment may be that thestock turnover has improved from 3.4 times to 5.8 times. This adds little value to theusers understanding of the entitys performance earns no marks. Candidates areexpected to show some commercial understanding. The possible reasons as to why theratio has changed must be offered. While the student cannot be sure of the reasonsplausible explanations are expected. Even if they are not the actual cause, marks will beawarded.

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Finally students may be asked a general question such as Discuss the limitations ofratio analysis? or What additional information would you like?.For the former the following should be listed: The comparison of the ratios a large capital intensive business such as CRH with a

supermarket in rented premises would not be useful. Entities may adopt different accounting policies such as valuation of non current

assets. The position at the balance sheet date may not be typical. For example a milling

companys stock holding just before harvest will be low whereas one month later itmay hold inventory for a full years activity. Many entities choose their end of financialwhen stock levels are low.

Some entities may engage in window dressing.

Examination questions will never give candidates all the information they need. Howeverthe question must be answered with the available information.Additional information that would be useful might include: The future plans of the entity. Is its plant and equipment obsolete or likely to be? Has the business got good suppliers, customers and staff?

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