Investors Report

Michelle_Michy

Chapter5_FMDMInterpretationofFinancialStatements1.pdf

Home >Education homework help >Investors Report

enu-fmd-bk-en-GB January 6, 2015 - 15:22 63

Chapter

Chapter 5

Interpretation of Financial Statements

5.1 Introduction 59 5.2 Ratio Analysis 60 5.3 Shareholders’ Investment Ratios 70 5.4 Limitations of Ratio Analysis 71 5.5 Summary 71

Learning Objectives

After completing the study of this unit you should be able to:

• analyse and interpret accounting information through the use of ratio analysis

• calculate and interpret key ratios to help current and potential shareholders assess investments

• recognise the limitations of ratio analysis.

5.1 Introduction

Units 1−4 have been designed to help you to appreciate the purpose and content of the main financial statements. Now we need to consider how you can make the maximum use of the information offered to best interpret the financial performance and the financial position of the reporting entity. Let’s investigate this by way of the scenario shown in the following example.

ABC plc have just reported annual profits of £5m for their last trading period, so does that mean that they have had a successful year?

Not necessarily. The figure of £5m when stated on its own is said to be an absolute measure and is fairly meaningless. For useful interpretation, you need to be able to make comparisons with other information.

The following data have been gathered.

• ABC plc had reported profits of £4m in the previous year.

• The capital employed in the company this year was £20m.

• ABC plc had forecast their profits to be £4.5m for the year.

• DEF plc, the major competitor of ABC plc, made a profit of £2m despite having a similar level of capital employed in the business.

What can you now say about ABC plc’s reported profit figure?

Assuming ABC plc had a similar level of capital employed in the business during the previous year then we can make the following deductions:

• Their profits have increased by £1m since the previous year − good

• Their profits exceeded their target by £0.5m − good

• Their return on capital employed (profit/capital employed) was higher than their main competitor. ABC plc had a return of 25% (£5m/£20m) compared with DEF plc’s return of 10% (£2m/£20m) − good.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 64

Chapter

Finance for Management Decision-Making

When you compare the financial performance of one company against its past results, its budgeted results or its competitor’s results, the measures are said to be relative and it is these relative measures that enable you to undertake useful interpretation.

With relative measures, you need to compare like with like. You cannot compare the results of a high street bank with those of a brewing company and expect to get a very meaningful analysis. The entities will have different capital structures, asset bases and perhaps profit ideals. Similarly, if a company has changed dramatically since the previous year, because it has developed new products or moved into new markets or acquired some major new subsidiaries, then again you need to be wary of making comparisons of results.

Although the figures you interpret relate to past information, you are really trying to anticipate what might happen in the future. Each user group has certain areas of analysis that they are particularly interested in. If, for instance, they plot past results, perhaps a trend will emerge which will enable them to predict the future and help to ensure that they make the correct economic decisions.

5.2 Ratio Analysis

Because of the need to compare figures between companies or to compare the results of one company over several years, much of the analysis is done using accounting ratios and percentage movements. It is customary to categorise ratios in relation to the different aspects of the business that interested parties are trying to measure. This unit focuses on five key areas of analysis:

• profitability

• short-term solvency and liquidity

• efficiency

• long-term solvency and stability

• shareholders’ investment ratios.

As you review the main ratios in each of the above categories, you need to be aware that ratio analysis is not an exact science. There is no legislation and there are no accounting standards telling users which ratios to calculate and how to interpret them. Therefore, do not be surprised if different textbooks show a different interpretation of the ratios from those used in this unit. Remember, it is the trend given by the results that is important and, as long as the ratio you choose to use is applied consistently from year to year, or between companies, you will be able to interpret results with some degree of confidence.

5.2.1 Profitability

The generally accepted primary objective for management is to maximise the wealth of the shareholders. Profitability looks at the extent to which the resources employed in the business generate returns over and above the running costs. Profit provides new wealth to the owners, firstly to cover dividend payments and secondly to finance the future expansion of the business.

Gross profit = Gross profit

Revenue × 100%

Gross profit is the difference between sales and cost of sales. Gross profit expressed as a percentage of sales is often referred to as the gross margin. This gives the user an insight into the relationship between the sales revenue and the production/purchasing costs, and the eventual percentage calculated can be translated into a gross profit margin per pound (£) of sale. For instance, if a company’s gross profit is 40% then, for every £1 sold, the company has made a profit of 40p after deducting the costs of manufacturing the product.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 65

Chapter

Interpretation of Financial Statements

The gross profit, of course, needs to be high enough to cover all the operating expenses (selling, distribution and administration) incurred in running the business as well as leaving an amount for profit. If a company’s gross margin has moved from one year to the next, then there are really only three main explanations:

• the selling price has increased or decreased

• the cost of manufacturing or buying in the product has increased or decreased.

• there has been in change in the sales’ mix.

Operating expenses = Operating expenses

Revenue × 100%

This ratio tells the user how much, from each £1 of sale, the company is spending on the non-manufacturing costs of running the business. An operating expenses ratio of 25% means that from each £1 generated in sales, the company is spending 25p on the selling, distribution and administration costs incurred in running the business.

Operating profit = Operating profit before interest

Revenue × 100%

This ratio shows the profitability of the business before incurring financing costs. It effectively tells you how much is left from each £1 of sale before the company has to account for interest charges on borrowings. The operating profit percentage should equal gross profit percentage minus operating expenses percentage.

When analysing performance between companies, it is often worth looking at these three ratios together.

Company A Company B

£000 % £000 %

Revenue 100 100 100 100

Cost of sales 60 60 50 50

Gross profit 40 40 50 50

Operating expenses 20 20 40 40

Operating profit 20 20 10 10

Company B generated a higher gross profit percentage than Company A, perhaps because of a cheaper source of raw material or more efficient shop floor operations. But Company A appear to have much better control of their operating costs than Company B and end up with a resultant 20% operating profit compared with Company B’s 10%.

Return on capital employed = Operating profit before interest

Capital employed × 100%

Arguably, the greatest measure of management efficiency, and the fairest way to assess per- formance, is to calculate the return on capital employed (ROCE) percentage. This ratio judges the profit generated in comparison with the amount of capital the organisation had available to invest in the business.

The numerator is taken as profit before interest because this figure represents the genuine return from the capital invested in the business. Interest is merely an expense incurred because companies have chosen to finance their operations with borrowed monies. It does not affect the company’s earnings potential.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 66

Chapter

Finance for Management Decision-Making

The denominator is a total of the finance input by the shareholders (capital), the finance retained in the business by the shareholders (reserves and retained earnings) and the finance provided by external lenders (non-current liabilities).

The ratio shows the investor, or potential investor, the return the company generated from the funds they had available to use in the business and can be compared with returns from other investments. Instead of putting funds into the business, those funds could have been invested in a building society account offering a return of perhaps 5%. Given the near certainty of achieving the 5% return from the building society, it is likely that the return expected from investing in a business would need to exceed this by a fair amount in order to compensate for the much higher risk involved.

5.2.2 Short-term Solvency and Liquidity

Liquidity refers to the availability of cash in the near future after taking account of immediate financial commitments. In other words, is the company generating sufficient surplus funds to meet short-term debts as they become due?

Current ratio = Current assets

Current liabilities

This ratio is expressed as a ratio of x : 1 rather than as a percentage.

Conventional wisdom suggests that current assets should exceed current liabilities but, in reality, the answer really depends on the type of business they relate to. The important point is whether the ratio is comparable with that of other businesses in the same sector and whether the trend over the years is satisfactory.

Activities vary enormously in their need for working capital and companies should maintain the elements of working capital at the lowest possible level. If a company’s liquidity ratios are too high, it means that resources are being used in the wrong part of the business. Instead of being invested in income-generating assets, resources are in fact tied up in non-productive assets like stock and debtors.

Acid test = Current assets − stock

Current liabilities

A more rigorous ratio used to assess the potential solvency of a business is the acid test ratio, sometimes referred to as the quick ratio. It is calculated on the same basis as the current ratio except it excludes inventories from current assets, focusing attention on the ability of the business to meet its short-term commitments from the more liquid assets of trade receivables and cash.

5.2.3 Efficiency

If a company is experiencing liquidity problems, you can determine the working capital areas that are causing the problems by analysing the efficiency of the organisation and its management.

Receivables collection period = Trade receivables

Revenue × 365 days

The ratio ought to be trade receivables/credit sales but, as it is unlikely that companies will segregate cash sales from credit sales, total revenue is usually used.

This ratio tells us how efficiently a company collects cash from its credit customers. Clearly, it is in the interests of a company to try and collect the cash as quickly as possible because, after all, it does belong to them. However, consideration needs to be given to the actions of the competition. If two firms have identical products in terms of selling price and quality, the company offering the longer credit period may attract more custom because there is less

enu-fmd-bk-en-GB January 6, 2015 - 15:22 67

Chapter

Interpretation of Financial Statements

pressure on customers to pay their debts quickly, therefore enabling them to use the cash within their own organisation.

Payables payment period = Trade payables Cost of sales

× 365 days

In a similar way to the ratio we have just discussed, this ratio calculates how long it takes a company to pay its trade suppliers the outstanding monies owed to them. Companies have a slight dilemma here. They would like to pay their suppliers promptly in order to maintain goodwill, but early settlement of invoices does have an adverse impact on the cash flow. Perhaps the most significant thing here is the relationship between the trade payables payment period and the trade receivables collection period. As long as the cash is coming in from the customer more quickly than it is being paid out to the suppliers, the overall impact on the company’s cash position should be favourable.

Inventory turnover = Inventory

Cost of sales × 365 days

This ratio checks how quickly the organisation turns its inventory into cash, or at least trade receivables. All businesses would like to turn over their inventory as quickly as possible because the more inventory held the greater the costs will be, not only in terms of the capital tied up in inventory but also in related areas, such as:

• rent, rates and the other overhead expenses involved in running the warehouse

• payment of more material handlers (the more inventory you hold, the more material handlers you need)

• increased risk of inventory obsolescence

• increased risk of inventory being damaged in the warehouse.

5.2.4 Long-term Solvency and Stability

This section considers how a business has chosen to finance itself and what potential risks are involved. There are really only two ways of financing a business, either the shareholders put the money in themselves or they borrow money from external sources. There is no right or wrong answer as to how a business should finance itself, but worked example 5.1 should prove to you that the more money that is borrowed to run the business, the greater the risk that the company is taking.

Worked example 5.1

The capital structures of two companies operating in the same industrial sector are as follows:

Melville plc Morris plc

£ £

Share capital and reserves 900,000 100,000

Loan capital (10%) 100,000 900,000

1,000,000 1,000,000

Scenario 1 − if both companies earn a profit before interest of £100,000 then whose shareholders will be the happiest?

enu-fmd-bk-en-GB January 6, 2015 - 15:22 68

Chapter

Finance for Management Decision-Making

Melville plc Morris plc

£ £

Profit before interest 100,000 100,000

Interest payable 10,000 90,000

Profit for the shareholders 90,000 10,000

In this scenario, the capital is producing a return of 10% for the shareholders of both com- panies. Melville plc has generated a £90,000 profit from their shareholders’ investment of £900,000 while Morris plc has generated a return of £10,000 from their shareholders’ investment of £100,000.

Scenario 2 − what happens if the profit before interest is £200,000?

Melville plc Morris plc

£ £

Profit before interest 200,000 200,000

Interest payable 10,000 90,000

Profit for the shareholders 190,000 110,000

Although profit has doubled, the interest charges remain the same. Melville plc’s return to their shareholders is now over 21% (£190,000/£900,000) but look at the return generated by the shareholders of Morris plc. The interest charge remained the same while profits doubled, and the company used the borrowed money to generate a return well in excess of what it was costing them to borrow. This excess goes back to the ordinary shareholders who now have a return on investment of 110% (£110,000/£100,000).

Scenario 3 − what happens if the profit before interest is £50,000?

Melville plc Morris plc

£ £

Profit before interest 50,000 50,000

Interest payable 10,000 90,000

Profit for the shareholders 40,000 (40,000)

This time profit has halved, but again the interest charges remain the same. Melville plc, being primarily financed from shareholders’ funds, still shows a small profit and, therefore, a small return of 4.4% (£40,000/£900,000) for the shareholders. However, Morris plc, heavily reliant on borrowed money to finance the business, has made a loss and a negative return for their shareholders because the ROCE of 5% (£50,000/£1,000,000) was primarily generated from capital that was costing the company 10% per annum.

This confirms that the higher the amount of borrowed monies used to finance a business, the greater the risk that, having serviced that finance, there will be little return for the ordinary shareholder.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 69

Chapter

Interpretation of Financial Statements

The idea of having an optimum capital structure, which maximises company value and provides the most efficient and effective balance between sources of debt and equity finance, has been a subject of great debate in the academic literature in this area. Any textbook will offer you some history of how this has developed since the mid 1950s, and at the end of this unit you will find full details of a recent paper that offers a concise summary of the literature to date by Brounen, de Jong and Koedijk (2005).

Gearing = Long-term borrowings

Capital employed × 100%

Gearing is concerned with a company’s long-term capital structure and the gearing ratio measures the extent to which capital used to finance the business has come from a borrowed source. The denominator is the same denominator used to calculate ROCE.

There is no limit to what the ideal gearing ratio should be. A company with a gearing ratio of more than 50% is said to be highly geared, whereas one with a ratio of less than 50% is said to be lowly geared.

The risk associated with being highly geared is that, by definition, there is a lot of debt carrying a fixed rate of return which must be paid regardless of profit levels. Hence, the more highly geared the company, the greater the risk that little, if anything, will be available for distribution to the ordinary shareholders in the form of a dividend.

Alternatively, however, if the money borrowed can be invested to generate a greater return than the fixed annual charge paid, then the surplus belongs to the ordinary shareholders.

Interest cover = Operating profit before interest

Interest charges

Linked with gearing above, this ratio gives the user an insight into how easily a company is able to meet interest payments on borrowed monies. The ratio is expressed in the number of times the interest is covered and if this figure is low or has fallen from previous years, the company might have cause for concern.

Debt ratio = Total liabilities Total assets

× 100%

This ratio is another indicator of a company’s debt position because it calculates what per- centage of the assets would need to be cashed in to pay off all the liabilities. Again, if this percentage is increasing, shareholder returns might be affected, as might the willingness of banks to lend more resources. See worked example 5.2.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 70

Chapter

Finance for Management Decision-Making

Worked example 5.2

Thomson Ltd is a company that manufactures nuts and bolts which are sold on to industrial users. The abbreviated accounts for the years to June 20x5 and 20x6 are given below.

Thomson Ltd

Income statement Year ended 30 June 20x6

20x6 20x5

£000 £000

Revenue 1,200 1,180

Cost of sales 750 680

Gross profit 450 500

Operating expenses 283 266

Profit before interest 167 234

Interest payable 8 −

Profit before tax 159 234

Tax 48 80

Profit for the period 111 154

enu-fmd-bk-en-GB January 6, 2015 - 15:22 71

Chapter

Interpretation of Financial Statements

Thomson Ltd

Balance sheet as at 30 June 20x6

20x6 20x5

£000 £000 £000 £000

Non-current assets 687 702

Current assets

Inventories 276 148

Trade receivables 186 102

Cash 4 466 32 282

Total assets 1,153 984

Current liabilities

Bank overdraft 26 −

Trade payables 76 60

Accruals 16 18

Tax 48 166 80 158

Non-current liabilities

Bank loan 50 −

Total liabilities 216 158

Net assets 937 826

Equity

Ordinary £1 shares 500 500

Retained earnings 437 326

Total equity 937 826

Required

You are the management accountant of Cameron plc, a company which has been asked to supply Thomson Ltd with a substantial amount of goods. Your boss, the financial controller, has asked for a report on the financial performance and financial position of Thomson Ltd.

Solution

Before calculating any ratios, it is worth reviewing the financial statements of Thomson Ltd and comparing the percentage movements from year to year for some of the key items.

Revenue increase of 1.7% (1,200/1,180)

Cost of sales increase of 10.3% (750/680)

enu-fmd-bk-en-GB January 6, 2015 - 15:22 72

Chapter

Finance for Management Decision-Making

This tells you immediately that profitability at the gross profit level will not be good.

Operating expenses increase of 6.4% (283/266)

This tells you that the percentage increase for both categories of expense exceeded the percentage increase in sales and, therefore, the profit before interest (net margin percentage) will be poorer than the previous year.

With no interest expense last year but an £8,000 expense this year, you are aware that the company must now be using borrowed monies to finance the business.

Inventories increase of 86.5% (276/148)

Trade receivables increase of 82.4% (186/102)

From this information, you get an indication of which areas of the business have needed additional investment.

The other significant movement you can deduce from the balance sheet is in the cash/liquidity position. Positive cash from last year has been replaced by a bank over- draft and a bank loan this year. This links in to the interest payment shown on the profit and loss account.

Ratio analysis

20x6 20x5

Profitability

Gross profit 37.5% (450/1200) 42.4% (500/1180)

Operating profit 13.9% (167/1200) 19.8% (234/1180)

ROCE 16.9% (167/987) 28.3% (234/826)

Short-term solvency

Current ratio 2.81:1 (466/166) 1.78:1 (282/158)

Acid test 1.14:1 (190/166) 0.85:1 (134/158)

Efficiency

Receivables collection 57 days (186/1200) 32 days (102/1180)

Payables payment 37 days (76/750) 32 days (60/680)

Inventory turnover 134 days (276/750) 79 days (148/680)

Long-term solvency

Gearing 5.1% (50/987) Nil

Interest cover 21 times (167/8) n/a

Debt ratio 18.7% (216/1153) 16.1% (158/984)

enu-fmd-bk-en-GB January 6, 2015 - 15:22 73

Chapter

Interpretation of Financial Statements

Report

To: Financial Controller

From: Management Accountant

Subject: Analysis of Thomson Ltd

Having been asked to supply Thomson Ltd with a substantial amount of goods, I would suggest that our main consideration has to be the ability of the company to pay for these goods on time. To judge this we need to consider two key aspects of their financial state- ments. What is their current liquidity position and what are the longer-term prospects (profitability) for the company?

It must be noted, however, that the financial data provided in the accounts relates to the past whereas these two aspects relate to the present and future. We shall have to use this past data to help to predict the future.

Liquidity

The current ratio has risen from 1.78 to 2.81, while the acid test ratio has risen from 0.85 to 1.14. This upward trend masks a potentially difficult situation because both inventories and trade receivables have increased significantly. To finance these increases, Thomson Ltd now has an overdraft and has taken on some long-term debt for the first time. This situation gives some cause for concern, though not alarm. If possible, further details are needed about why trade receivables have increased by 82%, resulting in an additional 25 days’ credit being offered to the customer. Similarly, we need to know why inventory levels have risen by nearly 86% and stock has been lying around the warehouse for an extra 55 days this year.

Profitability

The income statement shows that revenue has increased only slightly and, given the impact of inflation, it is likely that the volume of sales has in fact decreased. All three profitability ratios have dropped considerably, perhaps suggesting one of the following possibilities.

• Intense competition from overseas has caused a reduction in the selling price and, despite this, Thomson Ltd is still struggling to sell all its production because inventory levels are rising.

• Thomson Ltd’s products are past their sell-by date. Inventory is building up and customers have been offered improved payment terms in an attempt to attract business.

• A few major customers are in difficulty and they neither pay on time nor make new orders. This could be temporary or permanent.

Summary

The review of the financial statements does not reveal a thriving company but, without further information, it is hard to decide whether the situation is so bleak that we should seriously consider not supplying Thomson Ltd with their goods. Perhaps initial trading could be done on a cash basis before we felt secure enough to offer credit payment terms. Furthermore, it would be unwise of us to make any huge internal investments (for example purchase of new machinery) until we have a bit more confidence about the long-term future of Thomson Ltd.

enu-fmd-bk-en-GB January 6, 2015 - 15:22 74

Chapter

Finance for Management Decision-Making

5.3 Shareholders’ Investment Ratios

Shareholders’ investment ratios are ratios which are deemed to be significant in the context of reaching decisions about whether or not to buy, retain or sell shares in an organisation. Investors are concerned with the risk inherent in, and the return provided by, their investment. Ultimately, they are interested in the amount of cash that they will receive from their invest- ment, firstly in terms of the annual dividend paid from the company’s profits and secondly from the capital gain that might accrue should they decide, eventually, to sell their shareholding.

Earnings per share = Profit attributable to equity shareholders

Number of ordinary shares

The earnings per share (EPS) ratio shows the profit earned in relation to each ordinary share held. It is probably the most frequently quoted measure of a company’s performance, with its significance perhaps being highlighted by having an International Accounting Standard (IAS 33) totally dedicated to it. Furthermore, the disclosure in the standard requires companies to state their EPS figure on the face of the income statement. A review of the financial pages within the daily press will also tell you the current EPS figures for quoted companies. Although this ratio, with its focus on annual earnings, is sometimes criticised for causing ‘short-termism’ among investors, the EPS percentage change from year to year is a great indicator of company progress.

However, many companies have been criticised for having an ‘EPS’ fixation, i.e. focusing purely on this measure as a means of assessing overall performance. Have a look at the website www.sternstewart.comparticularly at the research section. There is a paper here titled ‘Enron Signals the End of the Earnings Management Game’ that highlights the trouble companies can get into by focusing purely on EPS.

Dividend per share = Total ordinary dividend payable

Number of ordinary shares

This ratio tells the investor the annual return that they will get for each share they purchase. The return often comprises the interim dividend paid and the final dividend proposed by the directors. The dividend policy of the company is one of the key decisions that the directors have to make. Clearly, the more profit paid out to shareholders in the form of a dividend, the less profit that can be retained in the business for future growth. However, companies are usually keen to see the annual dividend per share at least remaining the same as the previous year, if not increasing slightly.

Dividend yield = Annual dividend per ordinary share

Share price × 100%

This ratio expresses the dividend as an annual rate of return on the share price and enables potential investors to compare this return with that of other available investment opportun- ities. However, investors need to remember that the dividends they receive are not the only benefit likely to accrue from their investment. Company management often take the view that the dividend yield ought to provide an adequate investment income, but it is the wealth that can be generated from reinvesting retained profits in the business which secures a rosier future for the investor. Most shareholders will be happy to accept a low dividend yield if future returns look good.

Dividend payout = Total ordinary dividend payable

Profit attributable to equity shareholders × 100%

The dividend payout ratio shows what percentage of the annual profits that belong to the ordinary shareholders was actually paid out to them in the form of a dividend. It links in to the dividend yield ratio above because the higher the payout, the less profit the company has available to reinvest in the business. Investors should perhaps be wary if the company they have invested in is paying all of its profits back to the shareholders as dividends. It is often argued that the lower the percentage payout, the safer your dividend will be in the future.

http://www.sternstewart.com

enu-fmd-bk-en-GB January 6, 2015 - 15:22 75

Chapter

Interpretation of Financial Statements

Price earnings ratio = Share price

Earnings per share

The price earnings ratio (P/E ratio) can be interpreted as the number of years for which the currently reported profit is represented by the current share price. In other words, the P/E ratio reflects the stock market’s confidence in the future prospects of the company. It is seen as a status symbol ratio because the higher the P/E ratio within your industrial sector, the longer the market believes that the current level of earnings can be sustained.

5.4 Limitations of Ratio Analysis

There is clearly a lot of useful information that analysts can gain from calculating ratios but it is important to make clear that ratios are only the starting point in the quest for information.

• Ratios can be useful indicators of trends, but how many years of information are needed before a trend can be established? The annual report obviously gives you the current and previous year’s figures but perhaps it is necessary to use the information given in the five-year summary before being fully confident that a trend is appearing in the analysis. The problem then arises, of course, that these historical figures could well have been affected by the impact of inflation or changes in reporting requirements.

• When comparing results with other organisations, it is important to establish that the companies are involved in the same line of business. Different industrial sectors will, for example, have different expected gross profit percentages. Secondly, it is also helpful if the companies are of a similar size. If one company can afford to buy all of its non- current assets, and another company has to lease its non-current assets, this could have a significant bearing on the reported profitability of each company. Finally, we need to ensure that companies have prepared their results along similar lines. If one company depreciates its assets over 50 years and another company depreciates its assets over five years then the impact on the depreciation charge in the income statement will be considerable.

• The balance sheet is only a financial snapshot at one period of time and the impact that seasonal factors might have had on the assets and liabilities needs to be considered when evaluating ratios. A company that manufactures and sells diaries is likely to have a much larger closing inventory in November than it will have in January and this could easily distort their inventory turnover figures.

• Figures can be ‘window dressed’ to make them look slightly better than they are, for example loans can be repaid temporarily on the last day of the trading period and then re-negotiated after the publication of the financial statements. This might help a company to keep long-term debt off its balance sheet.

5.5 Summary

Whether interpreting financial information for a business colleague or interpreting financial information to please an academic examiner you should adopt exactly the same approach. You need to consider the following:

1. User groups − who is the beneficiary of the information that you are interpreting?

2. Areas of analysis − once you know who the end-user is, then you can consider which areas of analysis to focus on:

• profitability

• short-term solvency and liquidity

enu-fmd-bk-en-GB January 6, 2015 - 15:22 76

Chapter

Finance for Management Decision-Making

• efficiency

• long-term solvency and stability

• shareholder’s investment ratios.

3. Yardstick of comparison − interpretation without comparison is relatively meaning- less. We need to interpret our findings against benchmarks. The obvious benchmarks to use are:

• past performance

• budgeted performance

• industrial sector performance.

4. Ratio analysis− review the major percentage movements, where relevant, and calculate the key financial ratios for each of the areas of analysis that you are focusing on.

5. Interpret results − what do the figures that you have calculated tell you?

6. Write report − present your findings to the user in a structured manner.

Although using ratio analysis will give you some indicators of a company’s financial situation, you have to remember that ratios are only the starting points in any analysis. Information gleaned from customers, suppliers, trade journals, the financial press and the narrative content from the company’s annual report should also be considered.