Interpretation of financial

statements
Statement of comprehensive income

Role:
● shows profitability
● tracks revenue sources
● evaluates performance

Example:

2017 example (million)

revenue 25.4

cost of sales (12.3)

gross profit 13.1

selling expenses (3.2)

admin expenses (6.4)

operating profit 3.5

finance costs (0.4)

profit for the year (net profit) 3.1

taxation (0.6)

profit for the year after taxation 2.5

Key
● revenue: the money the business receives from sales (turnover)
● cost of sales: the production costs of a business
● gross profit: the revenue minus the cost of sales
● selling expenses: sales commissions, advertising, distribution…
 ● admin expenses: indirect costs of a business (salaries, stationary supplies, telephone
bills)
● operating profit: gross profit minus selling and admin costs
● finance costs: the interest paid to the lender from borrowing
● net profit: operating profit minus cost of finance
● net profit after tax: amount of money that is left after all expenses have been
deducted.

Stakeholder interest

Shareholders:
● owners of a business are interested in the profit made by the business
Managers and directors:
● they are likely to use key information in the statement to monitor progress and set
annual targets for growth
employees:
● if they want a wage increase, having information in the statement may be useful
when presenting a claim
suppliers:
● Before accepting an order for a new customer, they would want to check whether
they can afford what they bought.
The government:
● needed by the tax authorities to help asses how much tax a business has to pay
● government statistic agencies may collect economic data for public use

Statement of financial position (balance sheet)

Role:
● provides insight into financial health and performance of a business
● shows how funds are raised and used
Example:

2017 (million)

Non-current assets 143.4

Current assets 15.1

total assets 158.5

current liabilities 13.4

non-current liabilities 36.4

total liabilities (49.8)

net assets (total assets - total liabilities) 108.7

shareholder’s equity ———

total equity (the same as net assets) 108.7

Key:

Assets: resources a business owns and uses

- non current: assets not expected to be sold within a year, long term resources
- current: liquid assets that belong to the business (cash or expected to be converted
into cash within a year)

Liabilities: the debts of the business

- current: money owed by the business expected to be repaid within 12 months
(borrowings, dividends)
- non current: amount of money owed for more than one year (retirement pensions)

Net assets: the value of all assets minus liabilities

Total equity: the amounts of money owed to shareholders (always the same as net assets)
Stakeholder interest

Shareholders
● to see if the company is performing well
● to see if the company struggles (risk of losing their investment)
Managers and directors
● to use the balance sheet for financial planning
Suppliers
● to determine whether the business can pay debts
Employees
● to assess if the business can afford to pay rises or ensure job security

Limitations of the balance sheet

● reflects a specific time, not the overall performance along the year
● doesn’t include seasonal trends
● companies may use ‘window dressing’ to manipulate financial data to appear more
favorable and attract investors

Ratio analysis
Profitability ratios

● help to show how well a business is doing by assessing the performance of a

business.
● Used to make comparisons with previous years and other businesses in the SAME
industry
● Usually focus on profit and revenue

Gross profit margin: gross profit/revenue x 100

- higher gross profits are better
- The quicker the turnover of inventory, the lower the gross margin that is needed
- gross profits are used to help make decisions (if gross margin is below the average,
action might be needed)
net profit margin: net profit/revenue x 100
- higher margins are better
- It shows the profit that is left after all deductions have been made, the final profit for
the owners

Liquidity Ratio

Used to evaluate whether a business is able to meet its short-term debts by using its liquid
resources (cash)

Aspect Current ratio acid test ratio

scope of assets includes all current assets excludes inventories and

prepaid expenses

liquidity focus broader, includes less-liquid stricter, focuses on highly

assets liquid assets

risk perspective may overestimate liquidity provides a more realistic

measure of liquidity

Current ratio: current assets/current liabilities

● If the business has the current ratio between 1.5 :1 and 2 : 1 it has enough liquid
resources.
● if the current ratio is below 1.5 then the business doesn't have enough working
capital
● however some businesses such as retailers have very low current ratios such as 1
because of their fast selling stocks
● a current ratio above 2 may suggest money is being used unproductively

Acid test ratio: current assets - inventories / current liabilities

● if the ratio is less than 1 it means its current assets minus inventories cant cover its
liabilities
 ● retailers don't have a problem if the ratio is less than 1

Gearing ratio

Non-current liabilities / capital employed x 100%

capital employed = current assets + non current assets - current liabilities

● examines how much of a company’s operations are financed by debt compared to

equity or total capital (debt + equity)
● indicates financial risk and long-term solvency of a company
● high gearing: heavy reliance on debts, higher financial risk, may improve returns
during growth periods
● low gearing: higher reliance on equity (money invested by owners/shareholders)

Advantages:
● helps businesses balance financing strategies to optimize growth and minimize risk
● helps investors evaluate risk and financial stability

Return on capital employed (ROCE)

Operating profit / capital employed x 100%

● Compares the profit with the amount of money invested (capital)

● Profit always has to be operating profit (net profit before tax) as the tax is outside
company control
● Higher ratios are better:
- shows efficiency: the company is using its capital well to make more profit
- attracts investors: it shows good performance and profitability
- indicates growth: suggests the company is reinvesting wisely for future success

example: if a company has a ROCE of 20% it earns 0,20$ profit for every $1 invested in the
business.
Limitations of Ratio Analysis

● ratios must be compared with similar companies and periods of time (company size,
time and focus can distort comparisons)
● changes in company operations or economic factors can affect ratios
● comparisons need to account for external changes
● ratios rely on accurate financial statements (inflation may distort financial results,
making them unreliable)
● ratios ignore factors like customer service and brand loyalty

Human Resources
Labour productivity

Total output (per period of time) / average number of employees (per period of time)

● measure of efficiency of a workforce

● productivity differs between processes and businesses in different efficiency
● A section that uses automatic equipment will have a higher productivity than labour-
intensive sections

Advantages of high labour productivity

● gain competitive advantage
● enhances customer satisfaction
● better workplace morale
● makes average costs lower
- This allows a business to lower its prices (and gain higher sales)
- Also allows it to keep the same prices (increase profit margins)

Why might increased labour profitability not gain competitive advantage?

● Rival businesses may increase their productivity at a faster rate
● New rivals may set up and pay lower wages
● Rival may release a better product
Limitations of using the formula
● difficult to assess the output of service workers (doctors, research and development)
as it is not physical
● difficult to asses is there are several people involved in the production of a single unit
● limited in capital intensive businesses
● usually ignores quality of work (workers might work faster but it makes them more
vulnerable to mistakes)

Labour turnover

Number of staff leaving (over a time period) / average number of staff in post (in the time
period) x 100%

● measure of effectiveness
● the rate at which staff leave a business
● differs from department to department and business to business
● it is better if the labour turnover is low however if you want to get rid of some
workers it is better if it is high

High labour turnover

High labour turnover is caused by:
- low pays can lead to workers leaving for a higher paid jobs
- few training and promotion opportunities
- poor working conditions
- bullying and harassment
- if the workers are not suited to their jobs

Advantages Disadvantages

● new staff can bring fresh ideas and ● recruiting new staff can be costly
experiences ● it takes time for staff to become
● some workers may be ineffective and familiar with their role/business
need to be encouraged to leave ● induction programs and trainings
● Cost savings on long-term are costly
 employees (no promotions or higher
wages)
● better adaptability to change

Low labour turnover

Caused by:
● when employees receiving fair wages, bonuses, promotions and other benefits
● stability in employment
● positive workplace culture
● strong leadership and management

Advantages Disadvantages

● stability and consistency ● long-term employees may resist

● higher loyalty and morale change and become less innovative
● lower recruitment costs ● limited fresh ideas
● higher long term costs (employees
may demand higher wages and
promotions over time

Limitations of using the formula:

● part-time and full-time workers have different labour turnovers (part-time will be
higher)
● similar problems will arise for seasonal and temporary staff

Labour retention

Number of staff staying (over a time period) / average number of staff in post (in the time
period) x 100%

● looks at the rate at which employees stay with the business

BENEFITS DRAWBACKS AND CAUSES ARE THE SAME AS LABOUR TURNOVER BUT
OTHER WAY ROUND
Absenteeism

Where workers fail to turn up for work without a good reason

Rate of absenteeism = number of staff absent a day / total number of staff employed x 100%

Causes of absenteeism:
● small business tend to have lower rates as there is more commitment and teamwork
than a large business
● Businesses that have good health and safety procedures will have less illness-related
absenteeism
● Repetitive tasks lead to low job satisfaction and encourages staff to be absent
● Overworking, stressful bosses and work-related stress
● workers that feel they are not paid enough

Drawbacks:
● business has to pay sick pay
● bringing in temporary staff to cover, leads to increased costs
● profit may decrease if temporary staff are not as productive as the absent staff
● Can cause problems if the worker is important to a particular project or area
● production can be delayed = lost customers
● can demotivate the staff
● high rates of absenteeism can create a culture of absenteeism which makes this
acceptable

Annual rate of absenteeism

The rate of absenteeism for the entire year

Total number of staff absences during the year/total number of staff days that should have
been worked x 100%

Limitations of using the calculation

● if a single member of staff is off due to sickness it will raise the absenteeism rate a lot
in a small business
 ● the way absenteeism is recorded by a business will also complicate calculations (e.g.
some business will count half an absenteeism for a worker leaving to pick up their
sick child while others might ignore it)

Strategies to increase productivity and retention and reduce turnovers and absenteeism

Financial rewards
● If financial rewards are increased, employees will work harder and produce more
● Businesses can adopt piece rates: your pay depends on how much you work/produce
to motivate
● bonuses
- only paid if targets are reached (increases output)
- Loyalty bonuses (given annually and help reduce turnover)
- bonuses for good attendance

Employee share ownership

● rewarding employees with company shares
● often used to rewards senior managers and executives
sharesave scheme:
● employees saving some of their pay for years to buy shares
● The shares are at a fixed price from the beginning
● if prices had increased, employees can make capital gain
● however if the price has fallen below the fixed price employees get their cash back
(perhaps with a bonus)
● helps with turnover as if a staff has signed up for a five year scheme, they may not
want to leave and miss out on gains

Consultation strategies
● Employees are likely to be motivated and productive if they are involved in decision
making
● If staff are consulted by employers when changes are proposed they will feel valued

3 types of consultations
Pseudo-consultation: management makes a decision and informs employees. Employees
have no power to influence these decisions
Classical consultation: Involving employees through their representatives in discussions on
what affects them, allowing employees to have an influence

Integrative consultation: managers discuss with employees and agree on a decision

Empowerment strategies
Achieved by granting employees more authority

Strategies used to help empower employees:

● Training: helps employees learn new skills to prepare them for more advanced tasks
● Provide resources: Staff will need necessary resources to complete more complex
tasks
● Hand over authority: involves not questioning employees in order for them to feel
confident that they complete authority to make decisions
● Inspire confidence: involves helping staff confidence in their new role by
emphasising the strengths of an individual
● Provide feedback: feedback will help to guide them as they need to know how they
have performed

Advantages:
● They will feel more valued and loyal
● Less likely to leave
● Reduces absenteeism due to their greater sense of responsibility
● Improves motivation and productivity