Week 9: Interpretation of Financial Statements

An attempt by users to evaluate the financial information of an organisation in order to measure the performance of those organisations This evaluation is usually done through ratio analysis

Users Yardsticks of comparison Areas of analysis Ratio analysis Interpret results Write report

Shareholders Loan creditors Employees Analysts & advisers Business contacts

Government
Public

Past performance Budgeted Performance

Industrial Sector Performance

Before carrying out any ratio analysis, review the financial statements for any major movements. Where relevant, calculate the major % movements.

Revenue

Operating profit
Finance costs

Profit for the year

Non-current assets

Long-term liabilities
Net assets

Profitability ratios
Short-term solvency ratios

Efficiency ratios
Long-term solvency ratios

Investment ratios

Company A results:
Sales revenue Profit for the year 100,000 5,000

What does this tell you? Is it good or bad? Is it to be expected? Is it comparable to other organisations? Can a user of the financial statements make decisions on the basis of this information?

Company B: Sales revenue 200,000; profit 6,000 Company C: Sales revenue 300,000; profit 4,500
Which of the 3 organisations is best? That depends on what the user is looking for. Looking for: Highest revenue?....................... = company C Highest profit?............................ = company B Most successful in terms of profit?......= company A (half level of sales of B, but only 1,000 less profit) We are now starting comparison we are comparing profit with sales revenue, and we are comparing one firm with another.

Company
A B C

Sales revenue
100,000 200,000 300,000

Profit
5,000 6,000 4,500

Profit ratio = Profit/Sales A..........5.0% B..........3.0% C..........1.5% So, company C looks poor but, that is only taking 1 year as information. It would be useful to look at last years results and see if any of the companies have improved their profits

It might also be useful to compare the profit with other figures, apart from sales. Suppose that the capital employed in company A is 50,000. A profit of 5,000 is a 10% return on that capital. Suppose that company Cs capital employed is only 30,000. Its return on that capital is 15% So, an investor might prefer to choose company C while a lender might prefer company B.

http://www.majestic2.co.uk/results2011.pdf
http://www.mulberry.com/about/PDF/Investor/Mulb erryGroupPLC_AnnualReport_2011.pdf http://www2.accaglobal.com/pubs/students/publica tions/student_accountant/archive/pyke0207.pdf

PROFITABILITY RATIOS

How much profit per of sales the business makes after deducting the direct production costs from the selling price? Gross Profit / Revenue

2010 Gr. Profit 60 ----Revenue 180

2009 Gr. Profit 64 -----Revenue 160

= 33.3%

= 40.0%

How much, per of sales, the

business spends on selling,

distribution and administration

expenses?
Operating expenses / Revenue

2010 Op Exp 40 -----Revenue 180

2009 Op Exp 30 -----Revenue 160

= 22.2%

= 18.75%

How much profit per of sales the business makes after all expenses (other than finance costs) have been deducted?
Profit before interest and tax / Revenue

2010 Op Profit 20 -----180

2009 Op Profit 34 -----160

Revenue

Revenue

= 11.1%

= 21.25%

How much return per on the long term capital invested in the business?
Profit before interest and tax / Capital employed
(CAPITAL EMPLOYED = Share capital + Reserves + Long term (non-current) liabilities)

2010 OP 20 ---98

2009 OP 34 ---92

Cap Emp

Cap Emp

= 20.4%

= 36.9%

SHORT-TERM SOLVENCY RATIOS

How many times do the entitys current assets cover its current liabilities?

Current assets / Current liabilities (times)

2010 CA 85 ---73

2009 CA 37 ----33

CL

CL

= 1.16 times

= 1.12 times

How many times do the entitys current assets (with the exception of inventories) cover its current liabilities? Current assets inventory / current liabilities (times)

2010 CA - inventories 61 ---73

2009 CA inventories 23 ----CL 33

CL

= 0.84 times

= 0.7 times

EFFICIENCY RATIOS

How many days does it take the company to collect the cash from its credit sales?
Trade receivables / Revenue X 365 (days)

2010
Trade recbles 60 365 ----- X -----

2009
Trade recbles 20 365 ----- X ----160 1

Revenue

180

Revenue

= 122 days

= 46 days

How many days does it take the

company to pay its short-term

suppliers for credit purchases?

Trade payables / Cost of sales X 365 (days)

2010
Trade Paybles 62 365 ----- x ----Cost of sales 120 1

2009
Trade Paybles 10 365 ----- X ----Cost of sales 96 1

= 189 days

= 38 days

How many days is inventory

lying around a warehouse?
Inventory / cost of sales X 365 (days)

2010
Inventory 24 365 ----- X ----120 1

2009
Inventory 14 365 ----- X ----96 1

Cost of Sales

Cost of sales

= 73 days

= 53 days

LONG-TERM SOLVENCY RATIOS

What % of the long-term capital invested in the business is borrowed monies?

(Gearing ratio = Long-term (non-current) liabilities

-----------------------------------Share capital + Reserves + Long-term (non-current) liabilities)

2010
Non-current liabilities 20 ----Capital Employed 98

2009
Non-current liabilities Capital Employed 20
-----

92

= 20.4%

= 21.7%

How many times does the operating profit cover the net finance costs?
Profit before interest and tax / interest charges (times)

2010
Oper Profit Finance costs 20
--------

2009
Oper Profit Finance costs 34
-------

= 20 times

= 34 times

What % of our assets would we need to cash in to settle all our liabilities?
Total Debt / Total Assets (%)

2010 Total Liabs 93 ----171

2009 Total Liabs 53 ----125

Total Assets

Total Assets

= 54.4%

= 42.4%

INVESTMENT RATIOS
Additional information required: Dividend per share: 2010: 7,000,000 / 60,000,000 = 11.67p 2009: 10,000,000 / 60,000,000 = 16.67p

Dividend per share ------------------------------- X 100 Market value per share

2010: 11.67p / 1.50 = 7.78%

2009:

16.67p / 2.50

6.67%

Total ordinary dividend ---------------------------------------------------- X 100 Profit after tax and preference dividends
2010: 7,000,000 / 13,000,000 = 53.84%

2009:

10,000,000 / 18,000,000 = 55.55%

Profit attributable to ordinary shareholders -------------------------------------------------------- pence Number of ordinary shares 2010: 13,000,000 / 60,000,000 = 21.67p

2009:

18,000,000 / 60,000,000 = 30p

Market value per share ------------------------------- times Earnings per share 2010: 2009: 1.50 / 21.67p 2.50 / 30p = = 6.92 times 8.33 times

Need 3 to 4 years of figures to establish trends.

Valid comparisons can only be made between firms of similar size and activity. Ratios relate to a particular point in time. Seasonal factors can distort them. When comparing with other companies, ensure that the bases upon which the ratios have been calculated are the same.