Analysing and Interpreting Financial Statements

Analysing and Interpreting Financial Statements

• Ratio Analysis Overview
  • Tool for evaluating financial health of businesses
  • Helps in comparing the financial condition of a business over time or between different businesses
  • Used by both external users (shareholders, lenders) and internal users (managers)

Types of Ratios

• Profitability Ratios

  • Measure the ability of a business to generate profit relative to revenues, assets, or owners' equity.
  • Key measures include:
  • Return on Capital Employed (ROCE)
  • Return on Equity (ROE)
  • Operating Profit Margin
  • Gross Profit Margin
  • Net Profit Margin

• Liquidity Ratios

  • Assess the ability of a business to meet its short-term obligations.
  • Common ratios include:
  • Current Ratio
  • Quick Ratio (Acid Test)

• Efficiency Ratios

  • Indicate how well a company uses its assets and liabilities.
  • Examples include:
  • Inventory Holding Period
  • Accounts Receivables Collection Period
  • Accounts Payables Payment Period
  • Sales Revenue per Employee

• Gearing Ratios

  • Measure the degree to which a firm’s operations are funded by debt versus equity.
  • Important ratios include:
  • Gearing Ratio
  • Debt to Equity Ratio
  • Interest Cover Ratio

• Investment Ratios

  • Focus on shareholders' perspectives on returns and share performance.
  • Includes:
  • Earnings per Share (EPS)
  • Price to Earnings Ratio (P/E)
  • Dividend Cover

Benefits of Ratio Analysis

• Provides summary statistics for quick assessments.
• Aids in decision making across different scales of businesses.
• Enables comparison across various metrics (same period, different sizes, planned performance).

Limitations of Ratio Analysis

• Lack of uniformity in definitions (can lead to inconsistencies).
• Figures may not be representative due to accounting policies.
• Financial position is a snapshot, not a full dynamic view.
• Interpretation can be subjective, depending on context and comparison basis.

Key Examples and Calculations

1. Return on Capital Employed (ROCE): ROCE = \frac{Operating\ Profit}{Share\ Capital + Reserves + Non-current\ Liabilities} \times 100\%
   • Example:
     • For 2020: $$ROCE = \frac{£