T HE I NTERPRETATION OF FINANCIAL STATEMENTS Profitability, liquidity, efficiency, gearing ratios

I NTERPRETATION OF F INANCIAL S TATEMENTS The Financial Statements of a company provide detailed and summarized information. The statements shows absolute figures for a particular period. They are don’t provide sufficient information to users. We have the information given: Branches Sales Revenue Profit A $ $ B $ $ C $ $4 500 From the comparison we have made B had the highest profit, but it has only 3 % of its sales revenue. Profit Sales

AJ ltd’s Profit and Loss Statement for 2009 is: Sales Cost of sales Opening inventories Purchases Less: Closing Inventories COGS (2 800)(15 700) Gross Profit Less: Expenses(6 200) Operating Profit6 100 Income tax(1 000) Profit for the period5 100 Retained earnings -opening balance7 000 Retained earnings -closing balance12 100

Balance sheet as per 31 December 2009 Assets USDLiabilitiesUSD Non-current Assets Payables3 600 Current assetsLoan payable1 650 Inventories4 800 Equity Receivables3 200Ordinary shares of 1 USD each Bank and cash 550Retained earnings Total31 550Total31 550

Using the ratios: Calculating the ratios is only one step in the analysis process. Comparison is commonly made between: - Previous accounting period - Other companies (perhaps the same type of business) - Budgets - Government statistics - Other ratios - Types of ratios: Ratios can be classified into various grouping, according to the type of information the convey. The main groupings are as follows: - Profitability (performance) ratio - Liquidity (solvency) ratio

- Efficiency (use of assets) ratio - Capital structure ratio - Security (investors) ratio Profitability ratios: - Gross profit margin - Gross profit - Sales Gross Profit mark-up Operating profit margi - Gross profit Operating profit - Cost of Sales Sales -

Return on capital ratios: The ratio is the key measure of return. There are several ways of calculating the ratio. We discuss only two of them: Return on Capital employed ROCE and Return on Equity ROE. Capital employed can consist of total capital employed (equity + non-current liability) or just Equity. In using total capital employed we include long-term loans as well as equity and this is used when calculating ROCE. In using ROE, just the Equity is used. The basic formulae for return on capital ratio ROCE is: Profit Average total Capital Employed The ROE is: Profit for the period Average Equity

Liquidity ratios: It returns the ability of business to pay its payables in the short term. There are two main liquidity ratios: The current ratio: This is also known as the working capital ratio as it is based on working capital or net current assets ratios. It is a measure of the liquidity of a business that compares its current assets with those payables within one year. Current assets Current liabilities High ratio (more than 1) means current assets are easily sufficient to cover current liabilities. It is used to be thought that a ratio of 2:1 was ideal, but this depends on type of business. A very high figure is very comforting, but may be wasteful.

The quick ratio This is known as the acid test ratio: Current assets excluding inventories Current liabilities Generally, a ratio of 1:1 is considered “ideal’ but many retail companies with very regular cash sales have very low ratios, due to their lack of receivables. Efficiency ratios The measure of efficiency of the management of assets, both non-current and current. Assets turnover ratio: These ratios compare the assets with the sales revenue (turnover), measure the value of sales revenue for each 1$ invested in those assets. The formula is: Sales Revenue Assets

Non-current assets measurement according to sales revenue: Sales revenue Non-current assets This is sales revenue generated per 1$ of non-current assets. Inventories days Inventories may be analysed calculating the ratio of inventories to cost of sales, and then multiplying the number of days in a year. The calculation is: Inventories Cost of Sales This figure gives the number of days that on average an item is in inventories before it is sold. The inventories turnover is calculated as: Cost of sales Average inventories x 365 days

Receivable days This is a measure of the average time taken by customers to settle their debts. It is calculated as: Receivables Sales X 365 days Credit sales only should be considered. If customers take longer period to pay debts, debt will have detrimental effect on cash flow, it may be necessary to take appropriate actions. Payable days This is measure of the average time taken to pay to suppliers. It is calculated by: Payables Purchases X 365 days

The purchases figure should not exclude any cash purchases, similarly, payables should include trade payables, not payable for expenses or non-current assets. The result of ratio can also be compared with the receivables days. A firm does not normally want to offer its customers more time to pay than it gets from its own suppliers, otherwise it could affect cash flow. Generally the longer period the better, as the firm holds on its cash for longer, but care must be taken not to upset suppliers by delaying payment, which could result in the loss of discounts and reliability. Total of Working Capital ratios: Number of inventory days + number of receivable days – number of payable days = Total working capital days

Capital structure ratios Different companies have different methods of financing their activities. Some may rely on the issue of share capital and the retention of profits; others rely on loan finance. The gearing ratio Gearing is the measure of the relationship between the amount and of finance and provided by external parties to the total capital employed. It is calculated by: Debt Total capital employed (ROCE ) The more highly geared ratio, the more profits that have to be earned to pay the interest cost of the borrowings. Consequently the higher ratio, the more risky is owners investment. An alternative way of calculating the gearing ratio is known as: Debt : Equity

Interest cover The ratio is the measure of the number of times that the profit is able to cover the fixed interest due on long-term loans. It provide lenders with an idea of the level of security for the payment. The formula is: Operating profit Interest payable This shows the lenders that their interest is covered how many times by the current profits.