M B A

F I N A N C I A L
A C C O U N T I N G
DR. HADY OMAR
 CHAPTER 6

ANALYSING AND
INTERPRETING
FINANCIAL
STATEMENTS
 LEARNING OUTCOMES

You should be able to:

Identify the major categories of ratios that can be used for analysing
financial statements

Calculate key ratios for assessing the financial performance and position of a
business

Explain the significance of the ratios calculated

Discuss the limitations of ratios as a tool of financial analysis

 The key aspects of financial health

Profitability
Financial Investment
ratios

Financial
Efficiency Liquidity gearing
Ratios benchmarks

Ratios may be compared with:

Past periods

Similar businesses for the

same period

Planned performance
Ratio Analysis

The calculation and

interpretation of financial
ratios in order to draw
conclusions or raise
questions about the financial
position and performance of
a business
Basics of Analysis
Application of Involves
Reduces
analytical transforming
uncertainty
tools data

Financial statement analysis helps users

make better decisions.

Internal Users External Users

Managers Shareholders
Officers Lenders
Internal Auditors Customers
Information for Analysis
1. Income Statement
2. Statement of Financial Position
Published financial 3. Statement of changes in Equity
statements often 4. Statement of Cash Flows
contain a lot of detail 5. Notes to the Financial Statements
that is hard to
understand; it is
important to be clear
about key questions, to
select the most
appropriate figures and
to focus on those.
 Directors Report
• Principal activities
• Business review
• Future developments
• Research and development
• Post balance sheet events
• Statement about employee involvement
• Donations to charities
• Purchase of won shares
• Information about directors
• Creditor payment
• Directors remuneration
 Auditor’s Report

• True and fair view opinion

• Unqualified report is a “clean report”
• Qualified report shows reservation
• Statement of Directors responsibilities
• Financial statements are the responsibilities of the directors
 Annual Report

• Financial statements
• Statement of financial position
• Income statement
• Statement of changes in equity
• Cash flow statement
• Notes to the accounts
• Five-year summary
Ratio Analysis

Profitability and Gearing

Efficiency

Investment
Liquidity and
Performance
Working Capital
(Shareholders’
Control
Ratios
Three main groups
• Financial strength/solvency –
• Is the business likely to survive? Can it pay its liabilities as they fall due?
• Profitability –
• Is the business sufficiently profitable? Is it making the best use of the
resources available to it?
• Stock market –
• How are the company’s shares performing on the stock market? Are they
likely to be a good investment?
Financial Strength/Solvency

• Short term
• Can short term liabilities be met as they fall due?
• Relationship between current assets and current
liabilities
• Long term
• Can company service the long term loans?
• Interest cover
• Capital gearing
Profitability and efficiency
These ratios tell us about Return on Net profit
the financial performance of capital Margin
employed
the business. Profitability
ratios tell us about how
much profit the business
Return on Gross profit
makes in relation to its ordinary Margin
sales, or asset base. shareholders’
Efficiency ratios tell us how funds
good the business is at
using its assets to generate
sales.
Return on Capital Employed

Profit before
Return on Capital interest and Tax X 100
Employed (ROCE)=
Capital Employed
Where capital employed = Non-current Liabilities + total
Equity
This ratio describes a company’s ability to earn net
income from each capital employed dollar.
Net Profit Margin Ratio

Profit Before Interest and

Net Profit margin = Tax X 100
Sales revenue

The Net Profit Margin tells you how much profit the
business makes on each of its sales, on average. This is a
profitability ratio.
Gross Profit Margin
Gross Profit X 100
Gross Profit margin =
sales

This ratio describes a business’ ability to earn gross profit from

each sales dollar.
Return on shareholders’ Funds

Net profit after taxation and

Return on ordinary shareholders’
preference dividend (if any) X 100
funds=
Ordinary share capital + Reserves

This ratio describes a business’ ability to earn profits for each

dollar of shareholder’s funds
 The ROCE of UK companies
18

ROCE
15 Service companies

All non-financial companies

12

9
Manufacturing companies

2008 2009 2010 2011 2012 2013 2014

The main elements of the ROCE ratio

Operating profit
Sales revenue
multiplied
by

Sales revenue
Long-term capital employed

equals

Return on capital employed

Liquidity and working capital control
Liquidity and Efficiency Ratios

Average
Current
Inventories’
Ratio
Turnover Ratio

Quick Ratio
Inventory
(Acid-test
Holding Period
Ratio)

Sales revenues to
Capital Employed Average settlement
ratio period for Receivables
(Receivables Days)
Average settlement
period for trade
Sales revenue per
Payables (Payables
employee
Days)
Liquidity

• Liquidity is the ability of the company to

meet its short-term obligations
(liabilities). There are two key ratios
which are used to assess the liquidity of
a business:
1.Current ratio
2.Quick (or ‘acid test’) ratio
Current Ratio

Current Assets
Current Ratio =
Current Liabilities

This ratio measures the short-term debt-paying

ability of the company. A higher current ratio
suggests a strong liquidity position.
Quick (Acid-Test) Ratio

Cash + Short-term investments + receivables

Acid-test ratio = (Current Assets – Inventory)
Current Liabilities

Referred to as
Quick Assets
This ratio is like the current ratio but excludes current assets
such as inventories and others that may be difficult to quickly
convert into cash.
Working Capital

Working capital represents current assets financed from long-term

capital sources that do not require near-term repayment.
It is cash tied-up in the day-to-day operations of the business.

Current assets
– Current liabilities
= Working capital

More working capital suggests a strong liquidity

position and an ability to meet current obligations.
 Working capital management

• Are current assets excessive in relation to sales?

• Are there enough liquid assets to cover liabilities?
• Are inventories left idle?
• Are customers paying on time? Should the company be chasing
them up?
• Is the company taking advantage of available credit?
Inventory Turnover

Cost of sales
Inventory turnover =
Inventory Held

This ratio measures the number of times

merchandise is sold and replaced during
the year.
INVENTORY HOLDING PERIOD

Inventory Held
× 365
Inventory Holding Period = Cost of sales

This ratio is a useful measure in evaluating

inventory liquidity. If a product is demanded by
customers, this formula estimates how long it
takes to sell the inventory.
Receivable Collection period

Receivables Trade Receivables

× 365
Collection Period = Total Credit sales

Provides insight into how frequently a company

collects its trade receivable.
Payables Payment period

Payables Trade Payables

× 365
Payment Period = Total Credit Purchases

Provides insight into how frequently a

company pays back its trade payables.
Sales revenue to capital Employed

Sales revenue to Sales revenue

× 100
capital employed= Capital Employed

Provides insight into how efficient the

company was in using up capital employed
and in terms of sales revenues
Sales revenue per employee

Sales revenue per Sales revenue

employee= Number of employees

Provides insight into how efficient we are in

using up our human capital in terms of sales
revenue generated
 The effect of financial gearing

Operating
profit

Returns
to ordinary

shareholders

Figure 6.4
Gearing and Financial risk

Debt to equity
Ratio

Debt to Capital
Employed
Ratio Interest
cover
Gearing and Financial risk

Debt to equity
Ratio

Debt to Capital
Employed
Ratio Interest
cover
Debt-to-Equity Ratio

Non-Current Liabilities X100

Debt-to-equity ratio =
Total equity

This ratio measures relative dependence on long-term

finance rather than equity
Debt-to-capital employed Ratio

Non-Current Liabilities X100

Debt-to-capital
Total equity+ Non-current
Employed Ratio =
liabilities
This ratio measures what portion of a company’s assets
are contributed by creditors. A larger debt-to-capital
Employed implies less opportunity to expand through
use of debt financing.
Interest Cover

Profit before interest expense

Interest Cover =
Interest expense

Net income
+ Interest expense
+ Income taxes
= Income before interest and taxes

This is the most common measure of the ability of a company’s operations

to provide protection to long-term creditors.
If interest cover is high, the business has plenty of profits with which to pay
its interest charge.
Investment Performance
(Shareholders’ Ratios)
Earning per Dividend
share(EPS) Yield

Price-Earnings Dividend
Ratio Cover

Dividend payout
ratio
Dividend Yield

Dividend Per share

Dividend yield = X100
Market price per share
This ratio identifies the return, in terms of cash
dividends, on the current market price per share of
the company’s ordinary stock.

Dividend yield presents an indication about

whether the shares are ‘value for money’ when they
compare these figures to other companies
Dividend Cover

Net Profit before ordinary

Dividend Cover = dividends
Ordinary Dividends Paid

It indicates whether the company has a policy of paying a large or

small proportion of its profits as a dividend.

Generally, companies with a low dividend cover are attractive

investments to shareholders who seek income from their
investments; while companies with a high dividend cover are
more attractive to those who are seeking growth in the share
price.
Dividend payout ratio

Ordinary Dividends Paid

Dividend Payout = Net Profit before ordinary x 100
dividends

It indicates whether the company has a policy of paying a large

or small proportion of its profits as a dividend.

Generally, companies with a high dividend payout are

attractive investments to shareholders who seek income from
their investments; while companies with a low dividend
payout are more attractive to those who are seeking growth in
the share price.
Earning Per share (EPS)

Net Profit before ordinary dividends

Earning Per Share (EPS)=
Number of ordinary shares in issue

EPS is an indicator of the relative performance of the company

compared to the previous year, taking into consideration any
share issues during the year. This is one ratio which cannot be
used in comparing one company with another company.
EPS: is a single performance measure, is it enough?

Investors also need to consider:

1. The results of parts of the business that have since been discontinued;
2. The results of new acquisitions that have yet to come fully on stream;
3. Any exceptional items such as large, one-off profits on the sale of non-
current assets or investments.
4. Exceptional write-offs of goodwill or other assets
5. Exceptional provisions for future reorganizations and redundancies
6. Impairment of goodwill
7. Depreciation;
8. Interest;
9. Unrealized profits on revaluation of assets;
10. Exchange rate gains or losses on translating the financial statements of
overseas subsidiaries
Price-Earnings Ratio

Market price per share

Price-earnings ratio =
Earnings per share

This measure is often used by investors as a general

guideline in gauging stock values. Generally, the higher
the price-earnings ratio, the more opportunity a company
has for growth.
High PE ratio usually indicates that the company’s
prospects are expected to be very good – however, it may
also mean that the share is overvalued and not worth
buying (or, if already owned, should be sold)
 %

0
4

3
6

5
7

General industrials

3.39
Food producers

1.93
Chemicals

2.80 Industrial engineering

4.25

Pharmaceuticals
4.20

and biotechnology

Tobacco
4.03

Travel and leisure

2.14

Media
2.90

Banks
5.22

Electricity
6.25

Life assurance
4.60

Beverages
2.52
Average dividend yield ratios for
businesses in a range of industries

Average for all SE

3.95

listed businesses
 times

0
15.0
20.0

10.0
25.0

5.0
35.0

30.0
50.0

General industrials

17.72
Food producers
37.18

Chemicals

15.79
14.94 Industrial engineering

Pharmaceuticals and
biotechnology
53.28

Tobacco
19.31

Travel and leisure

25.80

Media
22.09

Banks
14.04

Electricity
11.93

Life assurance
13.69

Beverages
Average price/earnings ratios for

23.07
businesses in a range of industries

Average for all SE

21.21

listed businesses
 Graph plotting current ratio against time
0.9

Current ratio
J. Sainsbury plc
0.8
Tesco plc
0.7

0.6

0.5 William Morrison

0.4

0.3

0.2

0.1

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Presentation of ratios

• Ratios
• E.g., Current ratio is 1.8:1
• Percentages
• E.g., Return on capital employed (ROCE) is 12%
• Number of times
• E.g., Asset turnover is 3 times
• Number of days
• E.g., Inventory turnover “ratio” is 36 days
• Sum of money
• E.g., Earnings per share is 20 pence
Standards for Comparison

When we interpret our analysis, it is essential to

compare the results we obtained to other
standards or benchmarks.

 Intracompany
 Competitors
 Industry
 Guidelines
Comparisons

• Bases of comparison
• Other companies
• Other years
• Budgeted or planned results
• Other divisions
• Stock market
• Policies
Limitations of Ratio analysis
• What basis of comparison should be used?
• The effect of exceptional items
• Statement of financial position are historical and at a point in time
• Inflation not shown in financial statements
• Information in financial statements is aggregated
• Ratio analysis limited by the information companies disclose
Limitations of ratio analysis
• Comparisons with other companies are limited because
• Companies have different operating policies
• Companies have different accounting dates
• Companies have different strategies to achieve growth
• Companies have different financial policies
Predicting financial distress
• Warning signs include
• Excessive debt
• Falling profits
• Declining cash flows
• Falling share prices
• Other factors
• E.g., key executive leaving
 Z-scores

• Altman (2006) lists key data that gives warning signs

• working capital; total gross assets; retained profits; earnings before
interest and tax; market value of equity; book value of debt; sales.
• Calculate Z-score
1. Working capital/gross assets x 1.2
2. Retained profit/gross assets x1.4
3. EBIT/gross assets x 3.3
4. Market value of equity/book value of debt(total liabilities) x 0.6
5. Sales/gross assets x 1.0
• The results above are added together to arrive at the Altman Z-score
Prediction failure from Z-scores

• Statistical score
• Z-score of less than 1.81 tend to fail
• Z-score of more than 2.99 do not fail
• Altman suggests :
• the amount of working capital (in relation to total assets);
• the amount of retained profits (in relation to total assets);
• some measure of return on capital employed (ROCE);
• some measure of gearing, and the market value of equity;
• some measure of utilization of assets (or turnover of assets)

• For more information about Altman Z score, please visit

http://www.creditguru.com/index.php/bankruptcy-and-insolvency/altman-z-score-
insolvency-predictor
Limitations of ratio analysis

Quality of financial statements

Inflation

The restricted view given by

ratios

The basis for comparison

Statement of financial position

ratios
Thank
You!