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Interpretation of Financial Statements

Ratios are used to interpret financial statements rather than raw numbers, as ratios account for different operating environments. There are three main categories of ratios: profitability ratios measure returns on resources used to earn profits, liquidity ratios measure ability to meet short-term obligations, and gearing ratios measure how much long-term capital is funded by debt. Examples of important ratios in each category are provided, such as net profit margin, current ratio, and debt-to-equity ratio. Ratios allow for intercompany and intracompany comparisons over time to analyze financial performance and identify areas needing improvement.

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Tinashe Mashoyoya
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80 views

Interpretation of Financial Statements

Ratios are used to interpret financial statements rather than raw numbers, as ratios account for different operating environments. There are three main categories of ratios: profitability ratios measure returns on resources used to earn profits, liquidity ratios measure ability to meet short-term obligations, and gearing ratios measure how much long-term capital is funded by debt. Examples of important ratios in each category are provided, such as net profit margin, current ratio, and debt-to-equity ratio. Ratios allow for intercompany and intracompany comparisons over time to analyze financial performance and identify areas needing improvement.

Uploaded by

Tinashe Mashoyoya
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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INTERPRETATION OF FINANCIAL STATEMENTS/RATION ANALYSIS

Performance indicators/ratios (e.g percentage returns ) are used to interpret financial


statements rather than raw/absolute amounts. This is because different circumstances ( e.g
different operating environments ) will influence those amounts to such an extent that
comparing them or trying to draw conclusions from them will most likely lead to misleading
conclusions. For instance if business A and business B are in the same industry and in one
financial year A makes revenues of R1m and B makes revenues of R3m, it would appear that B is
doing better than A. However to be absolutely certain of this, the revenue has to be interpreted
relative to all the factors which affect it, such as expenses and assets used in earning that
revenue. After such relationships have been analysed, a final decision can then be made on
which business did better between the two.
Purpose of ratio analysis
Intercompany comparison ( between different businesses in the same industry)
Intracompany comparison ( within the business over different periods of time)
Ratios (please refer to lecture example 1 page 332, course notes)
The comparisons cited above can be achieved using ratios that basically branch into 3 broad
categories, viz,
1. Profitability ratios
These measure how well the company managed to earn returns on the resources(revenue,
assets, equity) used to earn those profits. The main ones under this category include;
a. net profit margin/percentage (profit as a percentage of revenue)
2009
2008
x 100
=11%

= 8.5%

b. Gross profit margin


x 100
=28%
=23%
Both gross profit and net profit ratios have improved over the 2 years under
comparison, indicating that the profitability of the business has improved. Naturally, when
gross profit margin increases, youd expect net profit margin to increase as well as observed in
the above example. If, however GP margin increases and NP margin declines, it could indicate
management failure manage expenses and therefore needs to be investigated.

c. Return on capital employed/ROCE ( return on capital used to generate revenue)

2009

2008

d. Return on equity (indication to shareholders on the performance of their investment.


NB- equity = ordinary share capital + reserves)
2009

2008

=22%

=19%

Preference dividends are deducted from profit because preference share do not form
part of equity and the dividends paid on them can there not be used to determine return on equity.
e. Asset turnover ( revenue generated for each R1 of assets used)

=2.67 = 3.01
This means for every R1 of assets used, the company earned R2.67 in 2009
2. Liquidity ratios
Used to measure a companys ability to meet its short term obligations. Main ratios are;
a. Current ratio
2009

2008

=2.4:1 = 2.38:1
Thus, in 2009 for example, for every R1 of current liabilities, the company
has R2.40 of assets and therefore have enough short term assets to cover
sort term liabilities.
NB- a current ratio of at least 2:1 is generally considered safe.
b. Quick/acid test ratio
=1.4:1
Inventories are deducted to remain with the companys most liquid assets.

=1.1:1

NB- a quick ratio of at least 1:1 is considered safe


c. Inventory turnover ( number of times inventory is sold/used and replaced)

= 5.35

= 4.84

Thus, in 2009 the company managed to clear inventory and replace it 5.35
times. An increasing turnover ratio most likely indicates improving business
d. Inventory days ( how long inventory is held before sale)
=68

= 75

Thus, the company held inventory, in 2009, for an average


68 days before selling it. If the number of days decrease
Over the years, it indicates improved business. Naturally,
When inventory turnover increases, inventory days should
decrease.
e. Trade receivables period( how long before debtors settle their accounts)
x 365

2009

= 48.2

2008

= 47.8

Thus, in 2008, debtors paid off their debts after an average 47.8
days, while in 2009 it increased to 48.2. even though the increase
is not significant, it must be controlled so that debtors dont
hang on to the companys money for prolonged periods
f.

Trade payables days ( how long before the company pays off debts)

=44.3

Thus, the number of days the company took to pay of its debts
stayed pretty much the same over the 2 years. An ideal situation
would be to have the creditors days increasing which would
increase the amount of capital available to the company ion the
short term.

=44.7

NB* i. Debtors and creditors periods can also be calculated based on


weeks or months instead of days, just multiply the ratio by 52 or
12 respectively instead of 365
ii. inventory days, debtors days and creditors days put together can be used to
calculate what is called the cash operating cycle,which is the average amount
of time during which the business is deprived of cash. It is calculated as
follows;
inventory days + debtors days creditors days
thus, in our example, the cash operating cycle( 2009) would be;
68 + 48.2 44.3 = 71.2
This means the company will be out cash every other 71.2 days and should
therefore make arrangements in advance for alternative sources of funds.
3. Gearing ratios( how much long term capital is funded by debt )
2009

=19%

2008

=22%

Thus in 2009, e.g, the companys long term capital was financed by 19% borrowed
money. The higher the ratio, the less profit will be available for shareholders
since most of it will go to pay off interest on borrowed money.

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