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=Operating ProfitShare Capital+Reserves+Non−current Liabilities×100%ROCE = \frac{Operating\ Profit}{Share\ Capital + Reserves + Non-current\ Liabilities} \times 100\%
    • Example:
      • For 2020: $$ROCE = \frac{£