Unlocking Financial Accounting Chapter 9 Chapter 9 Interpretation of accounts Learning summary By the end of this chapter you should know: that ratio analysis is a useful technique used to assist in the interpretation of accounts there are seven main user groups that analyse financial statements there are four main categories of accounting ratios: profitability liquidity efficiency investment how to calculate and analyse the ratios.

Unlocking Financial Accounting Chapter 9 Interpretation of accounts – key points One of the first things you need to do when interpreting accounts is to calculate the relevant ratios. Ratios highlight the relationships that exist between different figures on the income statement and balance sheet. To be meaningful ratios need to be compared to previous ratios of the same business or to the ratios of other similar organisations.

Unlocking Financial Accounting Chapter 9 Users of financial statements Shareholders Loan creditors Employees Analyst advisors Business contacts The government The public.

Unlocking Financial Accounting Chapter 9 The interpretation process Identify: the users and their information needs. Review: the accounts under consideration. Select: the most relevant ratios. Calculate: the chosen ratios. Interpret: by examining, comparing and considering other information. Evaluate: the findings and form an opinion.

Unlocking Financial Accounting Chapter 9 Ratio analysis Relationships can be expressed in a variety of forms: a percentage (%) in pence (p) as times (x times) in days (x days) as a ratio (x:1). Numerous ratios can be calculated. The most common ones can be divided into groups: profitability liquidity efficiency investment.

Unlocking Financial Accounting Chapter 9 Ratio analysis – profitability ratios Gross profit % gross profit x 100 revenue Net profit % net profit x 100 revenue Return on capital employed (ROCE) profit x 100 capital employed

Unlocking Financial Accounting Chapter 9 Ratio analysis – liquidity ratios Current ratio Current assets : 1 Current liabilities Quick ratio (acid test) Current assets – closing inventory : 1 Current liabilities

Unlocking Financial Accounting Chapter 9 Interpreting published financial statements – ROCE The basics apply but there are variations due to the format of the financial statements. ROCE is a useful ratio that highlights the performance of the business: profit x 100 capital employed (CE) CE is all of the money invested in a business. It equals the share capital plus reserves plus long- term loans. The profit before interest and tax is the ‘profit’, as this is the profit before the providers of both debt and equity are paid.

Unlocking Financial Accounting Chapter 9 Interpreting published financial statements – efficiency ratios Asset turnover Sales revenue Net assets Inventory turnover Average inventory x 365 Cost of sales Trade receivables turnover Average trade receivables x 365 Credit sales Trade payables turnover Average trade payables x 365 Credit purchases

Unlocking Financial Accounting Chapter 9 Interpreting published financial statements – investment ratios Earnings per share (EPS): Earnings available to ordinary shareholders Number of ordinary shares in issue Dividend cover: Earnings available to ordinary shareholders Dividend for the year Price/earnings ratio (P/E ratio): Market value per share Earnings per share

Unlocking Financial Accounting Chapter 9 Other analytical measures Horizontal analysis: considers the difference between two figures. Trend analysis: considers the difference between figures over a number of years.

Unlocking Financial Accounting Chapter 9 Limitations of ratio analysis Ratios are only as good as the information on which they are based. Ratios are a relative measure, which ignore the actual values. The financial statements used for ratio analysis are based upon historical data. When comparisons are made, distortions may occur due to the use of different accounting policies. In times of high inflation comparisons will be distorted.