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InterpretingFinStatements2017.ppt*
Interpretation of Financial Statements
Philip Wilson
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Interpreting Financial Statements
- Concerned with the use of ratios
- Example:
Profit margin = Gross profit x 100
Sales
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Why use ratios?
- Identify trends
- Comparison with others/ industrial average
- Business plans
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Ratios can be specifically used to analyse the following areas:
- Liquidity
Solvency
Ability of the business to pay its way
- Profitability
Ability to generate wealth
Long term prospects
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- Activity
Efficiency
Use of assets
- Financial structure
Concerned with the gearing/leverage of the business – relative proportions of debt and equity
Financial risk
- Investors ratios
Is the company a good investment?
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Example of Financial Accounts
Income Statement for year ending 30th April 2016
£M
Sales 7,650
Less: Cost of sales (5,800)
Gross Profit 1,850
Expenses (150)
Operating Profit 1,700
Loan interest (50)
Profit before tax 1,650
Taxation (600)
Profit after tax 1,050
Dividends 300
Retained profit 750
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Statement of Financial Position as at 30th April 2016
£M
Non-Current Assets (tangible) 10,050
Current Assets
Stock 1,500
Debtors 1,200
Cash 900
3,600
Total Assets 13,650
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£M
Equity and Liabilities
Called up share capital 5,900
Profit and Loss account 5,000
10,900
Non-Current Liabilities 350
Current Liabilities 2,400
13,650
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- Examples of Ratios:
1. Liquidity
Current Ratio
Current Assets
Current Liabilities
3600 = 1.5 : 1
2400
The organisation should have enough current assets to cover its current liabilities (i.e. can it pay immediate debts?). Seemingly, therefore, a ratio of 1:1 would be needed (although it is always important to take note of the specific industry).
Why might there be any changes in this ratio?
Think of the constituents?
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Acid Test
Current Assets – Stock
Current Liabilities
3600 – 1500 = 0.9 : 1
2400
A more strict test of liquidity – i.e. exclude stock – is it really ‘liquid’ or as valuable as the company thinks in times of financial distress?
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2. Profitability
Gross Margin
Gross profit x 100 = 1850 x 100 = 24.2%
Sales 7650
Net operating margin
PBIT x 100 = 1700 x 100 = 22.2%
Sales 7650
PBIT = Profit before interest and tax/Operating Profit
May vary greatly between business sectors – low margin/high turnover etc.
Indicates operational efficiency prior to any financing decisions
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Return on Capital Employed
PBIT x 100
Capital Employed
Capital Employed = Equity + Non-current Liabilities
(i.e. long term finance)
1700 x 100 = 15.1%
11250
Gives an indication of return on all money invested in the business.
The providers of capital could consider the ‘opportunity cost’ allowing for the risk involved
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Return on Shareholders’ Funds
Profit after tax x 100
Shareholders’ Funds
(SF includes original capital + retained profit + other reserves)
1050 x 100 = 9.6%
10900
Measures the nominal return to Shareholders specifically – i.e. it is after interest (to debt providers) and after tax (the government's share!)
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3. Efficiency
Net Assets Turnover Ratio
Sales
Capital Employed
7650 = 0.68 times
11250
How many £s of sales are being generated for each £ invested in the business?
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Stock Turnover
Cost of Goods Sold 5800 = 3.9 times
Average Stocks 1500
Stock days
Average Stocks x 365
Cost of Goods Sold
1500 x 365 = 94 days
5800
The higher stock turnover the better – i.e. more profit making opportunities.
Will lead to lower stock days – i.e. less money tied up in the business earning nothing
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Debtors Turnover
Debtors x 365
Sales
1200 x 365 = 57 days
7650
Creditors Turnover
Creditors x 365
Purchases*
* Could use ‘cost of sales’ if no alternative
2,400 x 365 = 151 days
5,800
How quickly do the company’s credit customers pay?
How quickly does the company pay suppliers?
Which measure do we want to be shorter?
What could you say about the business model of a supermarket?
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4. Financial structure
Gearing
Loans and borrowings x 100 Capital Employed
350 x 100 = 3.1%
11250
High levels of debt spell risk to the shareholders but also provide increased profit making opportunities
Can you explain the above?
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Interest Cover
PBIT
Interest Charges
1700 = 34 times
50
Measures how securely the company can pay its interest
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5.
Dividend Yield
Dividend x100
Market value of shares
If it is assumed that nominal price of a share is £1.00 and current market price is £2.20
£0.0508 x 100 = 2.3%
£2.20
The higher the yield then the better the return to shareholders – but beware this may be happening due to a falling share price.
Therefore, not straightforward
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Earnings per share (EPS)
Profit after tax
No of ordinary shares
1050 = £0.178
5900
Simply indicates the profit per share
Provides an indication of success over time but is not comparable to other companies due to differing capital structures
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Price/earnings ratio
Share Price
EPS
£2.20 = 12.4
£0.178
Generally indicates market optimism – i.e. a high number indicates that the share price has been bid to high levels and the market thinks that the future looks good
Will vary greatly between industry sectors.
Which sectors or types of companies might you think would have high ratios and which low?
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Limitations of Ratio Analysis
- Only deals with quantifiable aspects
- May be misleading as a snapshot
- Ignores special circumstances
- Indicates inefficiency but does not explain
- Basis of measurement
- Pyramid is geared to one ratio – ROCE
- Transfer Pricing
- Ratios are interrelated
- Open to manipulation
- Be wary of comparison
