Interpretation of financial statements
Principles of ratio analysis
The financial statements published annually by companies are an important source of information for external users and their form and content are carefully regulated with the intention of ensuring that they provide a helpful and reliable guide to corporate progress and user groups
The amount of useful information that can be gleaned from the income statement and balance is severely limited even when a detailed breakdown of trading results is provided. For example the income statement might show that purchases amount to £500 million and the balance sheet might disclose trade creditors totalling £21 millions but it is impossible to assess whether these amounts, taken in isolation are satisfactory or unreasonable
Accounting ratios and ratio analysis have been developed to help translate the information contained in the accounts into a form that is more helpful and readily understandable to users of financial reports
The ratios do not appear in the financial statements but are calculated from the contents of these
Accounting ratios: The relationship between two or more items from the financial statements
Accounting ratios are calculated by expressing one figure as a ratio or percentage of another, with the objective or disclosing significant relationships and trends that are not immediately evident from the examination of individual balances appearing in the accounts
The ratio that results from a comparison of two figures possess real significant only if an identifiable commercial relationship exists between the numerator and the denominator. For example, one would expect there to be a positive relationship between net profit and level of sales, assuming that each item sold produces a profit, one would expect a higher sales figure to produce more profit
The significant of an accounting ratio is enhanced by comparison with some yardstick of corporate performance. There are three options available, namely comparison with
- Results achieved during previous accounting periods by the same company (trend analysis)
- Results achieved by other companies (inter-firm comparisons)
- Predetermined standards of budgets
The advantage of making comparisons is that it enables users to benchmark a company's performance as good, average or poor in certain key areas relative to one of the three options
Profit margins
The knowledge of the numerical value of the annual profit is not particularly informative, what is of greater interest is the profit expressed as a relationship of another variable, such as sales
Gross profit margin
A ratio that reflects the gross profit as a percentage of the sales for a business
= Gross Profit / Sales x100
Indicates the amount of profit that a company generates per unit of sales, for example a GPM of 25% informs the reader of the profit and loss account that for every £100 of sales, the company generates £25 of profit
The GPM measures the ability of a company to control its cost of goods in order to generate a profit
The higher the GPM, the more effective a company has been in controlling its cost of sales
Changes in the GPM between periods may result from a change in
The sales price
The cost of sales
The sales mix
The GPM varies between companies and over time as productive capacity and operations change
Company owners can learn from their GPM how the company has performed relative to previous years, relative to its own goals and targets and relative to its competitors in the same sector
The GPM does not take into account the operating costs of a company, therefore it is somewhat limited as a measure of overall company performance
Net profit margin
A ratio that reflects the net profit as a percentage of the sales for a business
Calculated in different ways for sole traders and limited companies
Sole trader: Net profit margin = Net Profit / Sales x100
For a limited company, the operating profit margin is calculated as follows = operating profit / sales x100
A measure of how well a company has used or combined its resources to generate a profit for the accounting period. The higher the net profit, the more effective the use that has been made of the company's resources
Different to the GPM because of the expenses consumption margin, which is a measure of how much of the sales revenue has been consumed by the overheads of the company
Similar to the GMP, as it is most useful when used as a comparison for a company rather than in isolation
Solvency Ratios
Solvency: The ability of a business to pay its short-term debts as they become due and payable
Concerned with the ability of a business to meet its short-term debts or liabilities
Current (working capital) ratio
A ratio that compares the current assets agains the current liabilities
Defined as the excess of current assets over current liabilities, and a surplus is normally interpreted as a reliable indication of the fact that a company is solvent
= Current assets / current liabilities :1
The purpose is to assess and measure the ability of a company to pay its current debts as they fall due
A general benchmark is 2:1, though this should not be interpreted as a set standard for al company
Any deviation from 2:1 should not be interpreted as signifying a better or worse outcome without further investigation or explanation
Suffers from one limitation: its inclusion of inventories. To be solvent, a company needs to be able to convert its current assets into cash at short notice and with minimal cost
Unfortunately, inventories are not readily convertible into cash, first they must be sold and then the debtor/customer has to pay
Acid test (Quick ratio)
A ratio that compares the current assets less stock against the current liabilities
Used to examine solvency to overcome the limitation of the current ratio
Excludes inventory from the current assets
= Current assets - inventories / current liabilities :1
A liquidity of 1:1 is desirable in that it affords a company the comfort of knowing it can meet its short term debts
A good ratio will depend upon a range of other factors, such as the sector, the company, its reputation or the economy
Working capital management
The ability to management the stock, short-term payables and receivables of a business to ensure the business remains solvent
The working capital ratios are designed to examine and assess the use of the company's resources
Inventory holding days
A ratio that indicates the length of time inventory is held by comparing the average stock level against the cost of sales
Measures how long a company holds its inventory on the shelf
= Inventory at the end of the period / cost of goods sold x365
The holding days of inventory is inversely related to the rate of inventory turnover
The longer a company holds its inventories, the slower its turnover rate
The shorter a company holds its inventories, the faster its inventory turnover rate
The inventory turnover rate results form dividing 365 by the inventory holding days
Holding inventory has associated costs attached, such as the costs of storage, insurance and security and the risk of obsolescence
The longer a company holds its inventories, the more costly the process is
A company will seek to minimise its inventory holding days or at least to achieve an optimal holding period
If the holding days are too long, a company risks obsolesce along with the other direct costs of insurance, security and storage
If inventories are held for too short a period, a company may experience shortages as their inventory levels maybe insufficient to meet consumer demand
Collection of trade receivables
A ratio that measures how long a business takes to receive payment from its debtors
The period of credit taken by customers varies between industries
Measure the time a company takes it collect its debts from debtors and is calculated in days
= Trade receivables / credit sales x365
The denominator is confined to credit sales as only these give rise to debts outstanding
Where the split between cash and credit sales is not given the total sales figure may be used to calculate the ratio
The ability of a company to collect its trade receivables on time has a direct impact upon its solvency and solvency ratios
As a benchmark, the trade receivables should the average credit terms of a company
Changes in the collection of trade receivables may arise from
Changes in the credit management policies
Discounts granted and taken
The fear of penalties for late payment
Changes may be responsible for an improvement or deterioration in the collection of trade receivables
Payment of trade payables
A ratio that measures how long a business takes to pay its creditors
Measures the average period of time taken by companies to pay their suppliers
=Trade payables / credit purchases x365
Where the credit purchases are not identifiable in the financial statements, the cost of sales may be used instead
A change in the rate of payment of suppliers may well reflect an improvement or decline in the solvency position of a company, for example if a company is short of cash, it is likely that suppliers will have to wait longer for the payment of amounts due to them
Changes in payments is similar to collection of trade receivables and has a direct relationship with the solvency of a company
A delay in the payment of suppliers may be a policy to improve cash holdings or may results from a worsening in cash balances
Early payment of suppliers may arise form surplus cash balances or from a desire to maintain a good credit rating
Gearing
A company may be financed from two sources: equity (shares and reserves, including profit) and debt (loans). The relationship between these two sources combine to provide a level of gearing of a company (ie how dependent a company is for finance from debt)
There are associated costs of the combination of the two financial sources that need to be examined
Gearing ratio
The relationship between internal (equity) and external (debt) finance in a company's capital structure
= Long-term debt / total capita; employed x100
Capital employed: The total of the long-term debt and shareholders' funds that is employed in a company to conduct its operational activities
A measure of how much of the company's finance comes from external sources
The higher the level of gearing, the greater the risk of a company to the external environment. For example, a company will be more susceptible to changes in interest rates, as interest charges are the cost of the external finance that a company will have to meet annually from its operating profit
Companies may classified as low or highly geared. A gearing level over 50% is regarded as the determinant of a highly geared company. A highly geared company is more exposed to external factors and the risk of insolvency from adverse changes in the external factors, the principal factor is the inability to meet its fixed interest payments
Complemented by the interest cover
Interest cover ratio
A ratio that measures the ability of a company to finance its interest charges. It is measured by the profit before interest and taxation against the interest payable
Measures the ability of a company to meet its interest charges out of its revenue
=Profit before interest and taxation / Interest payable
Measures the extent to which the company can cover its fixed interest charges from its operating profit
The ratio is expressed as the number of time and is denoted with 'x' after the numerical result
The higher the interest cover ratio, the greater a company's ability to meet its interest payment obligations and the less likely its exposure to the risk of insolvency
Limitations of the accounting ratios
The various accounting ratios seek to provide users of financial statements with a greater understanding of a company's performance.However they suffer from a number of limitations that should be borne in mind by anyone attempting to interpret their significance
The ratios do not provide explanation for observed changes, and the external user's ability to obtain further information varies considerably
A deterioration in an accounting ratio cannot necessarily be interpreted as poor management
Too much significance should not be attached to individual ratios. For example a gross profit margin of 60% might indicate that all is well, but this conclusion might be unjustified if further analysis revealed a solvency ratio of 0.4:1
Company financial statements are usually based on historic events, therefore ratios provide a further understanding of past events.They are not always useful for a forward-looking or planning tool
Accounting policies such as deprecation of non-current assets may affect the annual financial statements and as such the resulting accounting ratios
Consideration must be given to variations in commercial trading patterns when assessing the significance of accounting ratios computed for particular ratios. For example a retail chain of supermarkets would be expected to have a much lower liquidity ratio and a much higher rate of inventory turnover than a construction engineering firm. In this context accepted 'norms' such as a working capital ratio of 2:1 must be used with care