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.
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
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Gross Profit
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x
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100%
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Sales
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Net Profit Margin
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Profit before income tax
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X
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100%
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Sales
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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
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Profit
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x
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100%
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Capital Employed
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ROCE = Return of Capital Employed
Profit is measured before deducting income tax
expense
Capital Employed is equity PLUS long-term loans
Net Asset Turnover
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Sales
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times pa
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Capital Employed
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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
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Current assets
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1
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Capital Ratio
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Current liabilities
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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
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Current Assets - Inventory
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1
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Current Liabilities
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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
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Inventory
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x
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365 days
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Cost of Sales
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This is expressed in days. As an alternative is to
compute the inventory period as a number of times:
Cost of Sales
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times pa
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Inventory
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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
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Trade Receivables
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x
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365 days
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Credit Sales
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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
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Trade Payables
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x
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365 days
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Credit Purchases
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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
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Loans + Preference Share Capital
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Ordinary Share Capital + Reserves +
Non-controlling interest
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Percentage of capital employed
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Loans + Preference Share Capital
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represented by borrowings:
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Ordinary Share Capital + Reserves +
Non-controlling interest
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PLUS Loans +Preference Share Capital
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Interest Cover
Interest Cover
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Profit Before Income Tax
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Interest Payable
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This indicates the ability of a Company to pay
interest out of income
4) INVESTOR RATIOS
(EPS)
Earnings Per Share
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Earnings
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Share
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This is regarded as the most important indicator of
a Company’s performance.
Profit/Equity Ratio
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Current Share Price
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Latest Earnings Per Share
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This represents the market’s view of the future
prospects of the share.
Dividend Yield
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Dividend per Share
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Current Share Price
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This can be compared to the yields available on
other investment possibilities
Dividend Cover
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Profit after tax
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Dividends
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This is the relationship between available profits
and the dividends payable out of the income