Interpretation of Financial Statements for Beginners

    Why Businesses prepare Financial Statements? My first answer is; “it is the report submitted by the Accountants to the owners of the Companies and to show the income of the cash invested by the owners.” But owners are not the only users of the financial statements.

   Who are the users of the financial statements?

-      - Shareholders– they are concerned with receiving adequate return on their investment

   - Banks –they are concerned of their loan to the business, if any

-       - Management- their main concerned is the trend and level of profits since this is the main measure of their success

     If there is a financial statements, we can compute some ratios that will be useful in interpreting the Company’s profitability, liquidity, stability and investor ratios. The ratios presented below are the basics of interpreting the financial statements.

     You should familiarise with the terminologies use in my blog for Financial Statement Beginners to use the use the different accounts; cash, receivables, etc. to use the ratios for interpretation.

http://egaykenriquez.blogspot.co.uk/2013/01/understanding-financial-statements-for.html

    For Ratio Analysis:

    There are number of ratios that can be calculated to assist interpret the financial statements namely:

  - Profitability ratios

-     - Liquidity ratios

-     - Long-term financial stability ratios

-      - Investor ratios

1) PROFITABILITY RATIOS

Gross Profit Margin		=	Gross Profit		x	100%
			Sales

 

Net Profit Margin		=	Profit before income tax				X	100%
			Sales

    Low margins may suggest poor performance but maybe due to new product launch or trying to increase its market share.

    The ratios that business makes on its Sales

ROCE	=	Profit			x	100%
		Capital Employed

    ROCE = Return of Capital Employed

    Profit is measured before deducting income tax expense

    Capital Employed is equity PLUS long-term loans

Net Asset Turnover		=	Sales			=	times pa
			Capital Employed

     This is a ratio that measures management‘s efficiency in generating revenue from the net assets at its disposal. The higher, the better

     There is a trade-off exist between asset turnover and margin

     - Low-margin businesses – e.g. Sale of detergent soaps which have a high asset turnover but low margin

-         - Capital-intensive manufacturing industries - e.g. Sale of mobile phones which have a high margins but low asset turnover

     Two completely different strategies can achieve the same ROCE

    - Selling of Expensive Perfume: sell goods at a high profit margin with sales volume remaining low

-       - Selling of Detergent Soap: sell goods at a low profit margin with very high sales volume

     2) LIQUIDITY RATIOS

Current or Working	=	Current assets	:	1
Capital Ratio		Current liabilities

     This measures the adequacy of current assets to meet the liabilities as they fall due. But if there is a high-cash level, it could be better to use if invested in non-current assets.

Quick Ratio		=	Current Assets - Inventory			:	1
			Current Liabilities

     Also known as the acid test ratio. Not to include inventory from current assets since inventory is considered not cash readily available as compared to Cash and Receivables

Inventory turnover period			=	Inventory			x	365 days
				Cost of Sales

     This is expressed in days. As an alternative is to compute the inventory period as a number of times:

Cost of Sales		=	times pa
Inventory

     An increasing number of days mean that inventory is turning over less quickly which is not a good sign which may indicate

    - not popular products

-       - poor inventory control

   - increase in storage cost

Receivable collection period			=	Trade Receivables		x	365 days
				Credit Sales

     Increasing accounts receivable collection period is not a good sign suggesting lack of proper credit control which may lead to irrecoverable debts. But sometimes in business, there is a “Bread and butter” customer who could lead to extension of credit terms which favours the said customers.

Payable payment period			=	Trade Payables	x	365 days
				Credit Purchases

     The credit period taken by the Company from its suppliers. A long credit period may be good for the Company but may develop a poor reputation as a slow payer and may lose current and incoming suppliers.

3) LONG-TERM FINANCIAL STABILITY

     Gearing ratios indicate the degree of risk attached to the company

    Measuring Gearing

Debt/equity ratio			=	Loans + Preference Share Capital
				Ordinary Share Capital + Reserves + Non-controlling interest
Percentage of capital employed			=	Loans + Preference Share Capital
represented by borrowings:				Ordinary Share Capital + Reserves + Non-controlling interest
				PLUS Loans +Preference Share Capital

   Interest Cover

Interest Cover			=	Profit Before Income Tax
				Interest Payable

    This indicates the ability of a Company to pay interest out of income

   4) INVESTOR RATIOS

(EPS) Earnings Per Share			=	Earnings
				Share

     This is regarded as the most important indicator of a Company’s performance.

Profit/Equity Ratio			=	Current Share Price
				Latest Earnings Per Share

     This represents the market’s view of the future prospects of the share.

Dividend Yield			=	Dividend per Share
				Current Share Price

     This can be compared to the yields available on other investment possibilities

Dividend Cover			=	Profit after tax
				Dividends

     This is the relationship between available profits and the dividends payable out of the income