Chapter 18

Interpretation of Financial Statements

Process of Interpretation of Financial Statements

Interpretation and analysis involve:

• ​​Identifying users
• ​​Examining financial information
• ​​Analysing (comparison, evaluation and prediction)
• ​​Reporting in a format to provide information for economic decision-making

Users of Financial Statements

• Internal Users

The ability of an organisation to analyse its financial position is essential for improving its competitive standing. Analysis of financial performance helps organisations identify opportunities to improve performance.

• External Users

The objective of general-purpose financial reporting is to provide information useful to the primary users in making decisions relating to providing resources to the entity. Users external to the entity will generally have access only to published financial statements. Whereas investors may be most interested in growth potential, lenders will be concerned with the availability of cash (to ensure they are paid on time) and the quality of assets provided as security.

Activity 1

Match the following users of financial statements to their corresponding opinions.

Ratio Analysis

Financial statements are analysed with the use of ratios.

Purpose of Ratio Analysis

The purpose of calculating and analysing the ratios for a company can assist users of financial statements by:

​​Providing a uniform measurement which will act as an indicator of:

• ​​areas for further investigation in the current period
• ​​the pattern of results over a series of periods (trend analysis)
• ​​Summarising large quantities of financial data into information that can be used to make qualitative judgments about an entity’s financial performance.

Reducing financial data to fewer expressions of variables which is useful when:

• ​​the relationship between amounts is of interest (rather than absolute monetary amounts)
• ​​the information generated will be reviewed over time (as in trend analysis).
• ​​Indicating areas where the entity may be strong or weak (rather than evaluate financial performance in “good/bad” terms).

Comparisons of Ratio Analysis

The results of the ratio analysis are typically compared between:

• ​​previous and current periods (historical comparison)
• ​​target/budgeted (or standard) and actual figures
• ​​other companies/industry averages (similar industry comparison)
• For comparisons to be meaningful, they should be based on functionally related amounts. For example, bad debt expense is a function of trade receivables rather than revenue (so a percentage of trade receivables will be preferable for analysis).

Classifications of Ratios

Ratios may be classified on several bases. For example:

• ​​Basis of financial statements ​​ Ratios are derived from the statement of financial position and the statement of profit or loss. (Position ratios)

​​By function ​​ Ratios consider the needs of users for information about:

• ​​How the business is performing (Profitability and Efficiency)
• ​​How it stands financially (Liquidity and Position)
• ​​Its potential (market standing).

Classification is subjective ​​ for example, liquidity ratios are also position ratios.

Introduction to Profitability Ratios

General profitability ratios are derived from statements of profit and loss alone. In contrast, overall profitability ratios consider the entity’s size as represented by its capital in the statement of financial position.

Profitability ratios show how a company’s income compares with its expenses. They can indicate how well the business has been keeping control of its costs.

The types of profitability ratios are illustrated in the diagram below:

Gross Profit Margin

The gross profit margin ratio shows how profitable a company’s trading has been. It indicates how much the company has been able to mark up the sales price of its goods above the costs it has incurred.

This ratio is often used to compare companies in the same business sector.

Typical gross profit margins will vary across different business sectors, making comparison less useful.

Revenue is net of discounts and customer returns

​​Gross profit = Revenue -​​ Cost of goods sold

​​

Cost of goods sold (or cost of sales):

​​For a trading company = Opening inventory + Purchases ​​ Closing inventory

​​For a manufacturing company, it includes conversion costs (labour, overheads, etc.)

The margin must cover all operational expenses and meet management’s requirements for increasing reserves (retained earnings) and shareholders’ requirements (for dividends).

Gross Profit Margin Analysis

Gross profit percentage provides insight into the relationship between purchasing costs and revenues.

A low or declining gross profit margin is usually an adverse sign.

The decline in the gross profit margin may be due to any of the following:

• ​​Fall in selling prices (For example, due to increased competition)
• ​​a change in sales mix (For example, to remain relevant and competitive)
• ​​an increase in purchase costs (For example, due to a fall in discounts received if management is unable to buy sufficient bulk)
• ​​an increase in production costs such as materials, labour, or overheads
• ​​an overstatement of opening inventories (For example, due to an error in counting or valuing inventory or inventory losses)
• ​​an understatement of closing inventories.
• A decline may not always reflect a problem. For example, a drop may be due to the launch of a new product at a low (penetration) price or an attempt to increase market share.
• An increasein the gross profit margin may be due to the following:
• ​​an increase in selling price without a corresponding increase in cost
• ​​a decrease in costs which has not been passed on proportionately to customers​​
• ​​an understatement of opening inventory or overstatement of closing inventory.

Operating Profit Margin

The operating profit margin indicates how much revenues exceed the costs of operating the company, which includes the cost of goods sold, selling, and general and administrative expenses. It considers all operating overheads.

Operating profit margin shows the overall profitability of the business after deducting all operating expenses.

It measures how well the business has managed to control indirect costs.

Operating Profit Margin Analysis

The operating profit margin is an indicator of the control of operating expenses.

Therefore, the movement in operating profit margin should be compared to the movement in gross profit margin:

The operating profit margin would be expected to improve/deteriorate in line with the gross profit margin.

​​A relative improvement in operating profit margin could be due to good indirect cost control or a significant one-off gain (For example, profit on disposal of an asset)

​​A relative deterioration in operating profit margin could be due to a weakening cost control or high one-off costs.

This ratio may be investigated further by calculating specific expense items as a percentage of sales, for example:

Fixed costs (such as rent) may not change in line with revenue (as they may be stepped costs) which can cause the operating profit percentage to fluctuate when revenues are unstable.

The operating profit percentage would not be expected to fluctuate much if the main costs were variable.

Return on Capital Employed (ROCE)

The return on capital employed (ROCE) is the primary profitability ratio. It shows how productively (efficiently and effectively) a business has deployed its available resources, irrespective of how they have been financed. It relates the overall profit performance to the amount of capital employed in the business.

The return on capital employed ratio shows how effectively a company generates profit from its capital.

or

​​Profit before financing and income taxes = the profit before interest and dividends have been paid to finance providers, such as banks and shareholders.

​​Capital employed = the funds that belong to shareholders plus loans not repayable within one year. It can be calculated as:

​​Total Assets less Current Liabilities or

​​Shareholder’s Equity plus Long-term Liabilities

Return on Capital Employed Analysis

An increase in the ROCE percentage is generally an improvement.

If the ROCE margin falls or is low, this may indicate the following:

• ​​The entity is not using its resources efficiently. A low return may result in a loss if the economy deteriorates.
• ​​Management will need to investigate further as there may be a need to increase operating profit or sell some assets and invest the proceeds elsewhere to earn a higher return.

However, any trend that emerges by making comparisons with the previous years’ ROCE may be distorted by:

• ​​assets which are written down to low carrying amounts (overstating ROCE)
• ​​revaluations which will depress ROCE (higher capital → higher depreciation → lower profit)
• ​​timing of share/debt issues
• ​​changes in accounting policies
• If a part of the business does not meet the entity’s target ROCE (i.e. budget), management may dispose of it.

The business’s return on capital employed should exceed its cost of capital for long-term sustainability.

 Interrelationship with other Ratios

The return on capital employed can be further analysed into operating profit margin and asset turnover as follows:

​​Profit margin is often seen as a measure of the quality of profits. A high profit margin indicates a high profit on each unit sold.

​​Asset turnover is often seen as a quantitative measure, indicating how efficiently management uses the assets.

The interrelationship between profitability and efficiency can be used to provide insights into the ROCE for a particular business. For example, if a company experiences a decline in ROCE, it could be due to a fall in profitability or a drop in efficiency (or both).

Note that the calculation of ROCE shown above (operating profit margin x asset turnover) only works if profit before financing and income taxes is the same as operating profit.

Asset Turnover

Asset turnover shows the number of times the carrying amount of assets is turned over in generating revenue. For businesses in the same industry, the higher the ratio, the more efficiently the assets appear to be used.

Asset turnover shows how efficiently an entity uses its capital to generate sales.

Asset turnover is affected by the business’s accounting policy regarding depreciation and amortisation.

For example, two companies are of equivalent size and generate the same revenue. The one with the lower asset value will have a higher asset turnover. The lower carrying amount of assets may be due to tangible assets being written off over shorter estimated useful lives.

Introduction to Liquidity Ratios

Short-term liquidity ratios concern financial stability. If they indicate that an entity cannot meet short-term liabilities from available assets, there will be going concern implications. The two most common measures are the current ratio and the quick ratio.

Current Ratio

The current ratio measures the adequacy of current assets to meet short-term liabilities (without raising additional finance). This ratio is an overall measure of liquidity and the state of trading.

Current assets and liabilities include all items classified as such on the statement of financial position. Current liabilities will therefore include dividends and taxation payable.

However, where a bank overdraft is permanent (maintained from year to year), it may be excluded from current liabilities even though it is legally repayable on demand.

 Current Ratio Analysis

• The higher the current ratio, the more liquid the business is. As liquidity is essential to business survival, a higher ratio usually is preferable to a lower one.
• ​​If low/declining, the entity may not meet its short-term obligations as they become due.
• ​​A high/increasing ratio might suggest over-investment in current assets (inventories, trade receivables or cash).
• A current ratio of 1.5:1 is usually acceptable (to maintain creditworthiness).
• ​​A lowratio may indicate overtrading or under-capitalisation
• ​​A highratio may indicate under-trading or overcapitalisation

The current ratio treats all assets alike though they are not equally or readily realisable. In particular, the nature of inventories should be considered. For example, if inventories are slow-moving, the quick ratio is a better indicator of more immediate solvency.

 Quick Test Ratio

The quick test (or acid test) ratio measures immediate liquidity by eliminating from current assets the least liquid assets (inventories). This reflects the possibility that the company finds it challenging to convert inventory into cash compared to other current assets.

The quick ratio is a stricter test of liquidity:

The quick ratio indicates the sufficiency of resources (trade receivables and cash) to settle short-term liabilities (trade payables in particular).

Quick Ratio Analysis

• A ratio of 1:1 is usually considered the typical acceptable quick ratio. However:
• ​​Industries with high cash sales and high inventory holding period (for example, supermarkets) have very low quick ratios.
• ​​A manufacturing entity with seasonal sales but steady production is likely to have a lower ratio when sales volume is low (lower trade receivables and cash) and a higher ratio when sales are high.
• When analysing the quick ratio, an entity’s operating overdraft and facilities available should be considered. For example, an entity with a low quick ratio may have no problem settling current liabilities if it has adequate overdraft facilities.

Window Dressing

Window dressing may be used to present financial statements in a more favourable light to gain benefits such as:

• ​​obtain funding/borrow money
• ​​reduce tax payments
• ​​smooth profits
• ​​hide liquidity/profitability problems that might reflect poor management decisions.
• Various actions may be taken to create the desired effect.

For example, to improve liquidity, trade payables may be treated as paid at the reporting date, although they are not settled until a later date.

However, accounting for items incorrectly has ethical implications and such practices contravene ACCA’s Code of Ethics and Conduct.

Introduction to Efficiency Ratios

The efficiency ratios analyse how well a company manages its assets and liabilities internally.

The efficiency ratios calculate inventory holding, receivables collection, and payables payment periods.

Inventory Holding Period

Inventory holding period measures the average time a company holds unsold goods. The ratio measures operational and marketing efficiency.

The ratio above has used the closing inventory, but for a more accurate figure, the average inventory value for the year should be used, if the information is available. In a SFP there should be two years’ figures (the current year and the previous year), which would show the opening and closing inventory figures for the current year. If these two figures are added together then divided by two, it will give the average inventory figure for the current year. Which can be used as follows:

Average inventory holding period in days = (Average inventory  ÷ Cost of Sales) x 365.

 Inventory Holding Period Analysis

A low inventory holding period ratio generally indicates efficiency in selling goods quickly. If increasing, inventories are turning over less quickly.

​​Increase in holding period may be caused by:

• ​​fall in demand for goods
• ​​poor inventory control (storage and insurance cost increases)
• ​​over-investment in inventory exceeding immediate requirements
• ​​carrying obsolete inventory (possibly resulting in write-offs)
• ​​Falls in inventory holding period may be due to:
• ​​bulk buying to take advantage of trade (bulk) discounts
• ​​increasing inventory levels to avoid stockouts (For example, due to erratic demand or where supply is unreliable).
• Inventory holding period can vary considerably, for example:
• ​​A fishmonger ​​1 or 2 days.
• ​​A building contractor ​​200 days
• Generally, higher turnover may not mean higher profits, as increased volume may be achieved through reduced profit margins.
• For manufacturing companies, inventory holding period:
• ​​should closely relate to production time
• ​​can be further investigated by looking at a breakdown of raw materials, work-in-progress and finished goods.

Receivables Collection Period

The receivables collection period shows the average time it takes to receive payment from credit customers (the number of calendar days over which receivables are uncollected).

Receivables Collection Period Analysis

As a measure of the liquidity of trade receivables, the receivables collection period should not exceed a reasonable proportion of sales. The longer the period, the greater the expense of collecting slow-paying or uncollectible accounts.

​​An increasing ratio may be due to the following:

• ​​weak credit control (For example, lack of adequate collection procedures)
• ​​a deliberate policy to extend credit to attract more trade
• ​​major customers being allowed different credit terms (For example, three months of interest-free credit).
• ​​Although a decrease in this ratio over time is generally a positive move, occasionally, it could signal a cash shortage.
• The receivables collection period should be compared with the stated credit policy set out in terms and conditions (on invoices).
• ​​It may be negligible (For example, supermarkets, retailers and other cash-based businesses do not have credit sales).
• ​​It may be distorted for comparative purposes by:
• ​​VAT or other sales taxes
• ​​debt-factoring arrangements (where debts are sold)
• ​​seasonal trading (For example, a company with a year-end of December may have lower trade receivables due to falling trade in the holiday period)

Payables Payment Period

The payables payment period represents (average) the time (i.e. number of days) it takes to pay for supplies received on credit. Note that trade payables is presented as ‘Payables for goods or services received’ in the statement of financial position of a company.

 Payables Payment Period Analysis

• ​​An increasing ratio may be due to liquidity problems, resulting in:
• ​​poor reputation as a slow payer (may not be able to find new suppliers);
• ​​existing suppliers withdrawing supplies (or demanding “cash on delivery”); and
• ​​inability to take advantage of cash discounts (an expensive finance means).
• ​​a deliberate policy to take advantage of interest-free credit (management must not incur late-payment penalties).
• The payables payment period should be compared with average suppliers’ credit terms (on the invoice) or the credit terms of significant suppliers. Distortion may arise if amounts due to suppliers include capital acquisitions.

Operating and Working Capital Cycles

The operating cycle is how long it takes an entity to convert inventory into cash:

Operating cycle = Inventory holding period + Receivables collection period

The working capital cycle shows the amount of time (in days) that an entity takes to convert resource inputs (inventory) to cash receipts. It is the period from when cash is spent on purchases to when money is collected from customers.

The working capital cycle for a trading company is:

For a manufacturing business, the inventory holding period includes the average time raw materials are held and the time taken to produce goods.

The operating cycle looks at the entire period from purchase of inventory to cash collection, whereas the working capital cycle looks at the net time the entity’s money is tied up.

 Working Capital Cycle Analysis

Working capital is the difference between current assets and current liabilities. If the cycle is increasing, it may be due to the following:

• ​​Poor working capital control
• ​​a deliberate policy to build up finished goods inventory or attract more customers by giving a more extended credit period.
• Working capital requirements are very dependent on the type of business. For example, a supermarket may have a negative cycle as the supermarket receives cash before paying suppliers.
• Working capital indicates whether a business can generate cash as quickly as it uses it and the cash level required to maintain operating capacity. For example, the shorter the cycle, the less reliance on external finance.
• Excessive working capital represents excessive interest paid (or loss of interest income) and lost opportunities (in investing funds for a higher return).

Activity 3

The following information is taken from the financial statements of Xincai Co for the year ended 31 December 20X5.

1. Calculate the operating profit margin of Xincai Co to the nearest 0.1%.
2. Calculate the return on capital employed of Xincai Co to the nearest 0.1%.
3. Calculate the receivables collection period of Xincai Co to the nearest day.
4. Calculate the payables payment period of Xincai Co to the nearest day.
5. Calculate the inventory holding period period of Xincai Co to the nearest day.
6. Calculate the working capital cycle of Xincai Co to the nearest day.

Introduction to Position Ratios

Position ratios focus on how a company is financed. They indicate whether its current financing mix will likely cause problems over the longer term. The two main position ratios are the debt/gearing ratio and interest cover.

Gearing Ratio (Leverage)

The gearing ratio measures the proportion of borrowed funds (which earn a fixed return) to equity capital (shareholders’ funds) or total capital. This ratio provides information about the financial risk of a company.

Borrowings incur commitments to pay future interest and capital repayments, which can be a financial burden and increase the risk of insolvency.

​​​​or

​Debt includes long-term loans, bonds and preferred shares, and bank overdrafts maintained yearly (of permanent nature).

​​Equity is the residual (ordinary share capital, share premium, retained earnings, revaluation surplus and other reserves).

Gearing Ratio Analysis

The level of gearing reflects the main benefit and risks of debt finance:

• ​​Debt finance is cheaper than equity (as interest is tax deductible)
• ​​Debt finance increases the risk to shareholders (as interest must be paid regardless of profits earned).
• For the analysis of debt and equity:
• ​​Preferred shares are generally treated as debt if redeemable; otherwise, they are classified as equity.
• ​​Bank borrowings (loans and operating overdrafts) are usually considered debt.
• Financial balance means having long-term capital for long-term investments. Short-term borrowings should not finance a permanent expansion. High gearing suits entities with relatively stable profits (to meet interest payments) and suitable assets for security (For example, those in the hotel/leisure service industry).

Interest Cover

Interest cover measures the ability to pay interest on outstanding debt from profits generated during the period. It is an indicator of the protection available to loan providers and is often used by lenders when making loan approval decisions.

In the calculation of interest cover, profit must be before financing and income taxes because this is the profit figure from which interest is deducted.

The interest amount must be the interest expense reported in profit or loss:

 Interest Cover Analysis

• If profit is adequate to cover interest expense, interest cover will be greater than 1.0.
• ​​Interest cover below 1.0 indicates that interest obligations cannot be met.
• ​​A ratio of less than 2.0 is generally considered unsatisfactory.
• Interest must be paid even if profits fall. Low or falling interest cover may indicate:
• ​​potential difficulty financing debts if profits fall
• ​​doubts about going concern
• ​​increased risk to shareholders of falling dividends

Overtrading

Overtrading arises when trade increases rapidly without securing additional long-term capital (it is under-capitalised). Symptoms include:

• ​​fast sales growth
• ​​inventories, receivables, and payables increasing
• ​​cash and cash equivalents decreasing
• A short-term solution is to manage working capital better (for example, speed up the collection from customers and maintain lower inventory levels).
• Increasing capital (by a share issue) or raising long-term financing is a long-term solution.

Activity 4

You are given the following annual financial statements of two incorporated entities in similar business areas for the year ended 31 March.

Calculate EIGHT financial ratios for each of the two companies.

*Please use the notes feature in the toolbar to help formulate your answer.

Activity 5

1. Which of the following is most likely to lead to an increase in a company’s financial gearing ratio?

A bonus issue of shares

Converting a bank loan into an overdraft

An increase in the cash operating cycle

A payment of dividends to shareholders

Converting debt into share capital

2. Drivor Co’s gross profit margin for the year ended 31 December 20X3 fell from 21% to 18%.

Which of the following is MOST likely to have caused the fall?

Understatement of opening inventory at 1 January 20X3

Overstatement of closing inventory at 31 December 20X3

A purchase in January 20X4 being wrongly recorded as happening in December 20X3

A fall in the quantity of sales

Bulk discounts being negotiated with suppliers

3. Dexcan Co had the following working capital ratios in the last two years:

Which of the following statements is FALSE?

Dexcan Co’s operating cycle was lower in 20X1

Dexcan Co is receiving money from customers quicker in 20X1

Dexcan Co is paying suppliers quicker in 20X1

The risk of inventory obsolescence for Dexcan Co has increased

The increase in inventory holding period days has resulted in Dexcan Co’s quick ratio increasing