Analysis and Interpretation of Financial Statements

International Accounting and Analysis
Analysis and Interpretation of Financial Statements

Unit Structure 1.0 1.1 1.2 General overview of the unit Learning Objectives Framework for financial analysis 1.2.1 1.2.2 1.2.3 1.2.4 1.3 Economic analysis Industry analysis Tools for conducting industry analysis Preliminary statement analysis
1.2.5 Ratio computations to interpret financial statements Ratio computations 1.3.1 1.3.2 1.3.3 1.3.4 1.3.5 1.4 1.5 1.6 Profitability ratios Liquidity ratios Working capital or efficiency ratios Gearing ratios Shareholders investment ratios
Illustrative question Summary/key points Activity
Unit 1
1.0
GENERAL OVERVIEW OF THE UNIT
The key to understanding and interpreting financial statements is above all to possess an inquisitive and analytical frame of mind. This means that when one examines a set of accounts, one must try to understand where the figures come from and what they mean. This module will build on what has been covered in your undergraduate studies by providing a framework for analyzing and interpreting financial statements. Indeed, ratios help to direct the users attention on areas of good and bad performance and areas of significant change but do little to explain the reasons for the change. This is why ratios should be interpreted in context, by looking at the industry in which the firm operates, by comparing ratios of the firm with those of previous years, by comparing ratios of the firm with those of other similar companies and also by assessing the reliability of the figures in the financial statements.
Unit 1
1.1
LEARNING OBJECTIVES
By the end of this Unit, you will be able to do the following: 1. Calculate relevant profitability, efficiency, liquidity and gearing ratios. 2. Conduct a preliminary analysis by setting consecutive balance sheets, income statements or other tabulated financial information side by side and reviewing changes in individual categories on a year-to-year or multiyear basis. 3. Analyse and interpret ratios of the firm by comparing them with: the firms previous set of financial statements, another similar firm for the same period and industry average ratios. 4. Understand and explain simple ways to artificially boost accounting profits 5. Discuss the limitations of ratios.
Unit 1
1.2
FRAMEWORK FOR FINANCIAL ANALYSIS
1.2.1 Economic analysis

In analysisng a firms prospects , it often makes sense to start with the broad economic environment, i.e. one must conduct an economic analysis followed by an industry analysis. Because the prospects of the firm are tied to the broader economy, one must undertake an economic review to assess those macroeconomic factors inflation, interest rates, exchange rates, taxation rates, sentiment, government spending, business cycle position (boom or recession or peaks or trough) that will have an impact on the firm. In other words, we must assess the revenue sensitivity of the firm to macroeconomic variables. The latter would consist of political factors, economic factors, social factors and technological factors.
1.2.2 Industry analysis

Industry analysis is important for the same reason that macroeconomic analysis is. Just as it is difficult for an industry to perform well when the macroeconomy is ailing, it is unusual for a firm to operate well when the industry itself is facing difficulties (e.g. textile industry in Mauritius)
1.2.3 Tools for conducting industry analysis:

Industry life cycle: start-up stage (new product or technology; difficult to predict which firm will emerge as industry leaders), Consolidation stage (as the new product becomes established, the survivors of the start-up stage are more stable and performance of surviving forms closely track the industry), Maturity Stage (product has become standardized and producers are forced to compete to a greater extent on price thereby leading to smaller industry profit margins), Decline stage (here the industry grows at less than the overall economy or it might even shrink).
Porters five forces: assessing industry structure and performance.

Unit 1
Threat of new entrants This will depend on the barriers to entry. The lower are the barriers the easier it is for new players to enter the market and erode the profits of existing firms. The barriers will be higher if existing firms (i) enjoy economies of scale (ii) have brand loyalty (iii) have high set-up costs (iv) absolute cost advantages.
ii
Threat of substitutes The greater the availability of substitute products, the lesser are suppliers able to increase the price and the lower the profit potential of the industry. This threat will be greater when: (i) buyers have full information and are price conscious (ii) the substitiute offers similar performance and is lower priced (iii) Switching costs for customers are low.
iii
Bargaining power of suppliers Suppliers can exert power in two main ways: (a) increase price and (b) refuse to supply. Their power will be higher when: (i) suppliers are in monopoly position (ii) their product is of superior quality (differentiated) (iii) little or no substitues (iv) switching costs for the buyer would be high
iv
Bargaining power of customers Customers (consumers, retailers, industrial buyers) generally want better quality at lower prices. Their power will be higher when (i) lots of competitors (ii) lots of subtitutes (iii) the customer accounts for a substantial proportion of customers sales (iv) low switching cots (v) high product quality is not important to the customer
Competitive rivalry
The higher the intensity of rivalry, the lesser the possibility for competitors as a whole to make higher profits. Competition will be strong when: (i) Industry is no longer growing: the only way to increase sales is to take market share from competitors (ii) there is High fixed operating cost implying high cost sensitivity Unit 1 5
(i.e. Degree of Operating leverage is high); failure to maintain sales will cause a dramatic fall in profitability (iii) there are low switching costs (iv) lack of product differentiation.
1.2.4 Preliminary statement analysis

Comparative financial analysis implies setting consecutive balance sheets, income statements or other tabulated financial information side by side and reviewing changes in individual categories on a year-to-year or multiyear basis. The objective here is to assess (i) whether there is a particular trend positive or negative in the figures, and (ii) the extent to which changes in one account item are consistent or inconsistent with changes in another account item. Where there are inconsistencies, this signals a caution flag. Illustrative figures from Enrons 1996 Annual Report Income statement figures $ millions Revenues Operating income Net income Cash flow statement figures $ millions Cash flow from operating activities 1996 13,289 690 584 1996 1,040 1995 9,189 618 520 1995 (15) 1996 13,289 1994 8,984 716 453 1994 460 1995 9,189
Balance sheet figures $ millions Trade receivables(net of allowance for bad debts of $6 and $12) Observations:
1) Revenues are increasing over the period by 48% between 1994 and 1996 but operating income has actually declined and net income has grown 29%, a much slower pace than revenues. This combination signals at least a caution flag because:
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Company may be growing too fast (over trading) Operating costs may be getting out of control Revenue recognition may be overly aggressive 6
Between 1994 and 1995, operating income has fallen but net income has risen. (this should be investigated as it is possible that the company may have adopted an accounting policy of capitalizing certain borrowing costs (permitted by IAS 23 subject to certain conditions being satisfied) instead of expensing them to the income statement.
2) A caution flag is warranted when it is observed that net income and cash flow are moving in opposite directions or when net income is growing faster than cash flow. Enrons net income grew smoothly and steadily between 1994 and 1996 but cash flow from operating activities underwent a roller coaster ride dipping to minus $15m in 1995 and rising to a massive $1,040m in 1996. Although the discrepancy between earnings and operating cash flow might not per se indicate trouble, it does at least put the user on enquiry and begs the need for further analysis. (Ask yourself for one second if operating cash flows can be manipulated? To answer this question, you must understand how to prepare a cash flow statement!) 3) Again another caution flag is raised since it does not make much sense that debtors increases by 65% from 1995 to 1996 but provision for bad debts actually undergoes a decrease of 50%. Again, this may indicate that either the company is overstating earnings by applying dubious revenue recognition policies or it is not making adequate provision for prospective bad debts. In fact by managing provision for bad debts the company can manipulate earnings figures and give users the impression perhaps false - that earnings have grown smoothly and steadily.
4) On a general note, it is relatively easy to adopt accounting policies that artificially boost accounting profits. The following are some examples:

Lengthening the estimated useful life of an asset. Using FIFO to measure inventories and cost of goods sold.
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Prematurely recognsing revenue before revenue is earned e.g. recognizing revenue at the time of production or at the time an unconfirmed order is received.
Capitalising normal operating costs. Understating provisions Discretionary expenses (advertising, R & D, Maintenance) are purposely timed so as to smooth the earnings trend.
1.2.5 Ratio computations to interpret financial statements

What ratios to calculate? 1. Profitability ratios: ratios which indicate (i) the profit margin in sales and (ii) the long term efficiency of the company in generating profits from the finds at the firms disposal. 2. Liquidity ratios: ratios which assess the ability of the company to meet its short term debts as and when they fall due. 3. Efficiency or working capital ratios: ratios which examine the extent to which management is efficient at reducing the need for working capital. 4. Gearing ratios: ratios which highlight the extent of the financial risk borne by the owners or shareholders of a business. The greater the proportion of debt capital, the greater will be the financial risk. 5. Shareholders investment ratios: these are ratios which help equity shareholders and investors to assess the worth and viability of an investment ijn ordinary shares.
1.3
1.3.1
RATIO COMPUTATIONS
PROFITABILITY RATIOS
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The business must be profitable if it is to survive in the long term i.e. for the foreseeable future. Profitability is the result of many managerial policies and decisions. Profitability ratios measure the efficiency of the business in generating profits. 1. Return on total assets (ROTA): Profits Before Interest and Tax (PBIT) Total assets
Total assets = FA + CA = Long term capital + short term capital [ Owner's equity + Long term loans] Current liabilities
ROTA reflects the profits earned before interest and tax (i.e. before remunerating providers of capital) on all the assets employed, irrespective of how they are financed. ROTA therefore measures the efficiency with which profits are generated from total capital at the disposal of the business, irrespective of the source of the capital. PBIT Sales x Sales Total assets Asset utilisation
2. ROTA =
Operating profit margin
The operating profit margin shows the amount of operating profit per Rs1 of sales. A high operating profit margin could indicate: Sales - cost of sales x 100 ) A high gross profit margin ( sales Good control over operating expenses. The difference between gross profit and operating profit before tax shows the impact of operating expenses on the business. Asset utilisation indicates the efficiency with which total assets are used to generate sales i.e. how many Rs of sales are generated with Rs1 of total assets.
1.3.2 LIQUIDITY RATIOS

Managers must ensure the short-term survival of the business. In so doing, their attention is inevitably drawn to liquidity. Is the company able to meet its short term maturing obligations?
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1.
Current ratio (or liquidity ratio) =
Current assets Current liabilitie s
Since current assets are cash or assets expected to be turned into cash within the next 12 months, and current liabilities are those that should be paid within the next 12 months, a business should presumably be in a good position to meet its current obligations if current assets exceed current liabilities by a reasonable margin having regard to the nature of the business. Traditionally the satisfactory norm was 2:1. However, a reasonable norm depends on the nature of the business. If the business carries lots of stocks and debtors, it is normal that the business will REQUIRE more working capital so that its current ratio may be 2:1 or even 3:1. However, if a business has rapid stock turnover and few debtors because it sells mainly for cash (e.g. a supermarket), then it can afford to have a lower liquidity ratio (say 1:1) because its REQUIREMENT for working capital is much less. Therefore, the level of working capital, indicated by the current ratio, must be compared with the working capital requirement. An abnormally high liquid ratio could mean that the need for working capital is high because stock is remaining in store a long time before being sold and/or because debtors are taking too much time to settle their accounts. This is why the currant ratio must be assessed in relation to working capital or efficiency ratios. 2. Quick or Acid test ratio = Current assets - stocks Current liabilitie s
Analysts recognise that current assets include inventory which is sometimes slow moving and not so readily realisable into cash as implied by the current ratio. The quick ratio therefore removes inventory from the calculation, thus providing a more rigourous (hence the term acid test) test of the company's ability to pay its short-term obligations. 3. Cash ratio = cash and cash equivalent Current liabilitie s
This is the ultimate test of liquidity as it tests whether the firm currently has enough cash to meet its current liabilities.
Interpretation: Always compare liquidity ratios with industry averages. The trend in liquidity ratios should always be monitored. 10
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If liquidity ratios are too low, this may indicate liquidity problems and the need to raise further finance. If the ratios are too high, this could indicate poor working capital management with stock and debtor levels too high.
1.3.3 WORKING CAPITAL OR EFFICIENCY RATIOS

Closing stock (or average stock) x 365 Cost of sales
1. Stock turnover (in days) =
The stock turnover period shows the average number of days the stock stays in store before being sold. Interpretation
The lower the stock turnover period (i.e. the higher the rate of stock turn) the smaller the investment in stocks. Thus a high rate of stock turnover is desirable but the company must hold sufficient stocks to service its customers requirements. A low rate of stock turnover (i.e. stocks remain in store a long time before being sold) may indicate poor stock control or even obsolescence. Closing debtors (or average debtors) x 365 Credit sales
2.
Debtors collection (in days) =
Debtors collection represents the average time taken for debtors to settle their accounts. Interpretation The higher the collection period, the greater the investment in debtors and the greater the need for working capital. A high collection period could indicate poor credit control i.e. the credit worthiness of customers are not properly evaluated. The collection period should be compared with the past and with industry trading terms.
3.
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Creditors payment period (in days) = 365 11
Trade creditors (or average creditors) x Credit purchases
This ratio shows the average time taken by the business to pay its trade creditors. Interpretation 4. An increase in the creditors collection period could indicate that the business is finding difficulty paying its creditors or that it has obtained more favourable credit terms. An increase in the credit collection period represents a source of funds and reduces the need for working capital.
Cash cycle The cash cycle represents the length of time between paying creditors for the goods and receiving cash from debtors from the sale of goods. The cash cycle (in days) is equal to:
Stock turnover period Debtor collection period Creditor payment period
X days X days (X) days Cash cycle days X
Interpretation: A lengthening of the cash cycle will strain liquidity and will require more working capital. Compare cash cycle of business with the industry average.
1.3.4
GEARING RATIOS
Gearing is a measure of the extent to which the business is financed by debt. The higher the level of gearing, the higher the financial risk. A high financial risk implies that the business has a lot of fixed interest charges which must be paid irrespective of the level of profits earned. This means that the owners or shareholders (those who are ranked last in the pay-out queue) may end up with little or no profits as expenses and fixed interest charges must be paid first.
1.
Debt equity ratio (for a company) = Prior charge capital ( Long term loan) Ordinary share capital + Re tained profit + reserves Capital gearing = Prior charge capital Total long term Capital employed
2.
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3.
Interest cover =
PBIT Interest
Interpretation (i) An acceptable level of gearing will depend on the nature of the trade. Thus comparison with other companies and industry average is essential. As the level of gearing increases: The chance that there will be no earnings available to equity increases. Thus high gearing increases the financial risk. The owners or ordinary shareholders become more vulnerable to profit fluctuations. When profits are falling, the interest remains fixed and therefore increases as a proportion of profit. However, as profits increase, interest (which is fixed) decrease as proportion of profit. The business can be financed by debt if its profits are stable.
(ii)
1.3.5
Shareholders investment ratios

Pr ofit after tax No of ordinary shares in issue
1. Earnings per share =
EPS indicates the amount of net profit that is attributable to each share. Since EPS shows the net profit per share, it should be easier to compare the performance of the equity of one company with that of another similar company. Earnings per share Dividend per ordinary share
2. Dividend cover =
It shows the proportion of profit for the year that is available for distribution to shareholders that has been paid (or proposed) and what proportion will be retained in the business to finance future growth.
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3. Price earnings ratio =
Market price per share Earnings per share
It is a measure of market confidence in the shares of the company. Indeed, since market price = EPS x P/E, the P/E ratio is merely a multiple of earnings. If the markets perception of the growth in the firms future earnings is strong, then the P/E ratio will be higher. The P/E ratio will be higher, when performance drivers drive market price upwards. These performance drivers are: (i) (ii) (iii) Growth in earnings and dividends (the higher the growth in dividends, the higher the P/E, other factors remaining constant) Payout ratio (the higher the payout ratio the higher the P/E ratio, other factors remaining constant) Lower business and financial risk. Dividend per ordinary share Market price per share
4. Dividend yield =
Dividend yield is that part of the shareholders total holding period return that is attributable to dividends. The total holding period return is determined as follows: The total return from holding a share over say a single period t say a year is simply the sum of dividend received (Dt) and the capital gain or loss (Pt Pt-1 ) during that period expressed as a percentage of the price of the share at the start of the period (Pt-1): + R = D t P t P t -1 P t 1 The above single period return tells us a bit of history: what HAS BEEN the return that was received on this investment.
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1.4
ILLUSTRATIVE QUESTION
Tex plc are manufacturers of an exclusive brand of cashmere products and have been in operation for the past 5 years. The company has been experiencing considerable growth as its products have captured niche markets in Hong Kong, Korea and Japan. In response to an increasing demand in its products, Tex plc has increased production levels. Because a large proportion of the companys product costs are fixed and coupled with the fact that the textile sector is very competitive, Tex plc spends heavily on advertising to increase sales volume. Profits after tax for the year ended 31 December 2003 stood at Rs700,000 and have steadily increased to Rs841,000 in 2004 achieving a record high of Rs1,200,000 in 2005. At the start of operations 5 years ago, Tex plc was initially financed by a combination of equity and debt. The debt finance consisted of a loan of Rs675,000 which was repayable in October 2005. A year ago (assume todays date is 1 April 2006) Tex plc's shares were being traded at Rs2 but over the past 6 months the share price had been trading at around Rs1.70. The accounts for the year ended 31 December 2005 have just been published and this has triggered a sharp fall in the company's share price to Rs1.35 as at 31 March 2006. Apparently analysts and investors have been very critical of the overall performance and financial position of the company for the year ended 31 December 2005. The directors are perplexed by the fact that the company has achieved record sales and profits for the current year just ended but yet analysts appear to have shifted their view of the company. The directors would like to identify the reasons behind the change in sentiment towards the business. The following information has been extracted from the published accounts of Tex plc for the year ended 31 December 2005. Income statement for the year ended 31 December 2005 2005 Sales Cost of sales Gross profit Selling and distribution expenses Administration expenses Profit from operations Net interest cost Profit before tax Income tax expense Net profit for period 9,856 4,216 5,640 1495 2,500 1,645 45 1,600 400 1,200 2004 6,374 3,268 3,106 925 1,025 1,156 65 1,091 250 841
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Cash flow statement for the year ended 31 December 2005 Cash flows from operating activities Net profit before tax Adjustments for: Depreciation Interest expense Profit on disposal of Property, plant and equipment (Increase)/ decrease in inventories (Increase)/ decrease in trade and other receivables Increase/ (decrease) in trade and other payables Cash generated from operations Interest paid Income tax paid Net cash used in operating activities Cash flows from investing activities Proceeds from sale of equipment Cash flows from investing activities Cash flows from financing activities Cash proceeds from issuing shares Interest paid Repayment of loan Dividends paid Cash flows used in financing activities Increase/ (decrease) in cash and cash equivalent Cash and cash equivalent at 31 December 2004 Cash and cash equivalent at 31 December 2005 Rs,000 1,600 210 45 (55) 1,800 (550) (840) (315) 95 (250) (155) 295 295 500 (45) (675) (85) (305) (165) 325 160 Rs,000
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Balance sheet as at 31 December 2005 2005 Rs000 ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade receivables Cash at bank Total assets EQUITY AND LIABILITIES Capital and reserves Issued share capital (Rs1) Share premium Accumulated profit Current liabilities Trade payables Loan Taxation payable Dividend payable 1,075 1,935 160 3,170 4,120 Rs000 950 525 1095 325 1,945 3,345 Rs000 2004 Rs000 1,400
800 200 2,495 3,495 125 400 100 625 4,120
500 1,395 1,895 440 675 250 85 1,450 3,345
Additional information: 1. 2. 3. 4. 5. 6. Ordinary share capital comprises shares with a nominal value of Rs1. There were no purchases of property, plant and equipment during the year. Straight line depreciation for the year amounted to Rs210,000. The gain on disposal of an item of motor vehicle was Rs55,000. All sales are made on credit. In view of the profitable track record of the company, it was customary for directors to agree the amount of proposed dividends before the year-end.
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Following, the wave of criticism which followed the release of the 2002 accounts, the financial director has been paying closer attention to the performance of other companies in the same sector and has compiled the following industry average ratios: Operating profit margin Asset utilisation Gross profit margin Debtors collection period Non-current assets as a % of total assets Required: From the information in the financial statements above, calculate relevant ratios which would shed light on whether or not you agree with the views shared by investors and analysts. Include relevant comments. Solution: The first part of the answer calculation of ratios is quite straightforward. So, be sure to calculate all relevant ratios based on the information provided i.e. profitability, liquidity, efficiency, gearing and stock market ratios. 25% 1.5 40% 60 days 45% Earnings per share Price earnings ratio Current ratio Inventory turnover 2.2 2.5 2 6 times
Profitability 1. ROTA 2. 3. 4 5 Operating profit margin Asset turnover Gross profit margin Expenses margin
Formula PBIT/total assets PBIT/sales Sales/total assets Gross profit/sales Operating expenses/sales
2005 2004 1645 1156 x100 =39.9 % x100 = 34.6 % 4120 3345 1645 1156 x100 = 16.7 % x100 = 18.1 % 9856 6374 9856 6374 x100 = 2.4 x100 = 1.9 4120 3345 5640 3106 x100 = 57.2 % x100 = 48.7 % 9856 6374 3995 1,950 x100 = 40.53 % x100 = 30.6 % 9856 6374
Tutorial note to the calculation of profitability ratios: Profitability ratios always start off with ROTA which is measures operational performance. Since ROTA is driven by operating profit margin and asset turnover, these latter ratios
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must be computed. Operating profit margin is in turn driven by gross profit margin and expenses margin. Gross profit margin minus expenses margin will produce the operating profit margin. Calculating ratios in this very order helps to identify the drivers of operating performance. Liquidity and efficiency 1 Current ratio 2 3 4. 5. 6. 7. Quick asset ratio Cash ratio Period of inventory turnover Debtors collection period Creditors payment period Cash operating cycle Formula Current assets/current liabilities (Current assets stock) / Current liabilities Cash/current liabilities Closing stock/cost of sales *365 debtors/sales * 365 Creditors/cost of sales * 365 (4) + (5) (6) 2005 3179 = 5.07 625 2095 = 3.35 625 160 = 0.256 625 1075 x 365 = 93d # 4216 1935 x100 = 72d 9856 125 x 365 = 11d 4216 93d+72d-11d = 154 days 2004 1945 = 1.34 1450 1420 = 0.98 1450 325 = 0.22 1450 525 x 365 = 59d 3268 1095 x100 = 63d 6374 440 x 365 = 49d 3268 59d+63d-49d=73 days
# d=days
Tutorial note to the calculation of liquidity and efficiency ratios: It is always a good idea to calculate the liquidity ratios and efficiency ratios together. This is because a global picture of liquidity can only be assessed if efficiency ratios are examined together with liquidity ratios. Indeed, a current ratio well in excess of 2 (as is the case with Tex which has a current ratio of 5.07 in 2005) does not automatically imply that the firm is liquid. This is because the current ratio only looks at the working capital that is available and not the working capital requirement. This is why it is important to check how quickly the firms stock is being sold and how quickly debtors are settling their accounts. If there is a relatively significant delay in stock being sold and debtors paying up, then this will lengthen the cash operating cycle of the firm and increase its working capital requirement.
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Gearing 1 Capital gearing 2 Interest cover
Formula 2005 Long term debt/total No gearing since there long term funds is no long term debt PBIT/interest 1645 = 36.55 45
2004 675 x100 = 26.3% 2570 1156 = 17.78 65
Tutorial note: The gearing ratios show that the company is not geared at all in 2005. It has no long term debt. Stock market ratios 1 EPS 2 P/E ratio Formula Net profit/No of equity shares in issue Mkt price/EPS 2005 1200 = 1.5 800 1.35 = 0.90 (at 1.5 31/3/06) 2004 841 = 1 .7 500 2 = 1.18 (at 1.70 31/3/05)
Tutorial note: Note that the P/E ratio has halved in one year. This seems to suggest that the market does not view the company as positively as the directors!!! The point of the whole exercise is for you to calculate the ratios and then take a holistic perspective put all the bits and pieces together to see whether the ratios and also information in the financial statements (especially the cash flow statement which shows how much of the profits have converted into cash!) support the views of the directors or rather those of the analysts.
A comprehensive answer to the above question is summarized in the comments below. Try and write out your own comments before looking at the suggested solution.
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Suggested comments and discussion 1. 2. 3. The companys increase in ROTA from 34.6% in 2001 to 39.9% in 2002 is mainly due to the increase in asset turnover from 1.9 in 2001 to 2.4 in 2002. The increase in asset turnover has more than offset the decrease in operating margin. It seems that Tex plc achieves greater efficiency in asset utilisation since for every Rs1 invested in total assets, Tex produces Rs2.4 of sales compared only to Rs1.5 for the industry. However, the apparent increase in profitability should be mitigated by 2 key factors: (i) The increase in production levels has resulted in an increase in stocks. This implies that a greater proportion of the current years fixed product cost have not been released to the profit and loss but have been capitalised in the extra inventories inevitably leading to an increase in gross profit. This could explain why the gross profit margin has increased from 48.7% in 2001 to 57.2% in 2002. (ii) The greater asset utilisation of the company compared to the industry average is partially attributable to the fact that Tex is operating with older assets which explains why its non-current assets represent only 23.1% of total assets compared to an industry average of 45%. Sooner or later, the company will have to invest in new plant and machinery. The fact that gross profit margin has increased but operating profit margin has decreased from 18.1% in 2001 to 16.7% in 2002 implies that operating expenses as a proportion of sales has increased (from 30.6% in 2001 to 40.5% in 2002). Although the liquidity ratio is high, this does not mean that the company is liquid. Indeed, in order to assess the liquidity position of the company, one must look at the companys working capital requirement or cash operating cycle. The companys cash operating cycle has deteriorated from 73 days in 2001 to 155 days in 2002. This is mainly due to the fact that due to increasing stock levels, stock of the company stays in store an average of 93 days compared to only 60 days for the industry. Furthermore, the fact that there has also been a delay in the debtors collection period (from 63 days to 72 days) and because creditors have apparently reduced the credit period (from 49 days to 10 days) this has put a strain on the liquidity position of the company. 7. The above conclusion is confirmed by the cash flow statement. Although the income statement shows that the company has made a profit from operations amounting to Rs1.645m, the cash flow statement shows that the cash generated from operations is only Rs95,000. This may put into question the quality of the companys earnings.
4.
5.
6.
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8.
The cash flow statement also shows the issue of share which has brought in Rs500,000 has been insufficient to payback the loan of Rs675,000. The company probably had to sell a non-current asset to generate proceeds of Rs295,000 which were partly used to pay off last years tax bill and to payback the loan. Unsurprisingly, the P/E ratio of the company has fallen from 1.18 in 2001 to 0.9 in 2002 which is well below the industry average of 2.5 Indeed, the price earnings ratio depends on two factors: growth in earnings and quality of earnings. Although there has been growth in earnings, the financial analysts may not have viewed the earnings as being of good quality: (i) cash from operating activities is negative and profit for the year 2003 may have been artificially boosted by fixed product costs being capitalised in extra stocks! The above points support the views held by financial analysts and investors.
9.
10.
1.5
SUMMARY/KEY POINTS
a) Financial ratio analysis is integral to the assessment of company performance. b) Financial ratios help to direct attention to the areas of the business that need additional analysis. This implies that ratios dont provide answers or solutions to questions but rather identify possible areas of concern. It is the user or analyst who must gather enough information to provide plausible reasons for any significant changes in components of performance identified by ratio analysis. c) Financial ratios can be compared against a preceding years ratios, budgeted ratios for the current period, ratio of other companies in the same industry or industry averages. d) The above-mentioned comparison is meaningful and decision-useful only if one understands the limitations of ratios. Indeed, one important limitation of ratios is that they are calculated from figures in the financial statements. These figure are the result of accounting policies and practices, some of which may artificially place the company in a better light that is actually the case. If such creative accounting is present then ratios will be distorted.
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1.6 ACTIVITY
Heavy Goods carries on business as a manufacturer of tractors. In 2000 the company was looking for acquisitions and carrying out investigations into a number of possible targets. One of these was a competitor, Modern Tractors plc. The chief accountant of Heavy Goods plc has instructed his assistant to calculate ratios from the financial statements of Modern Tractors plc for the past three years including the compilation of industry averages. Industry average 1998 Sales growth Sales/total assets Debtors/sales (days) Gross profit/sales Profit before tax/sales Profit before interest/interest Profit after tax/total assets Profit after tax/equity Net book value of fixed assets/total assets Equity/total assets Total liabilities/total assets Total liabilities/equity Long term debt/total assets Current liabilities/total assets Current assets/current liabilities (Current assets - stock)/current liabilities Stock/total assets Cost of sales/stock Creditors/purchases (days) Debtors/total assets Cash/total assets Required: Assuming the role of the chief accountant, assess the profitability, liquidity, efficiency and gearing position of Modern Tractors plc. % % % % % % % % % % % % % 30.00 1.83 9.70 18.67 8.00 6.45 9.76 57.14 62.20 18.29 81.71 4.47 36.59 45.12 0.84 0.43 17.07 8.71 59.80 4.88 15.85 1999 40.00 2.05 5.20 22.62 17.52 26.57 27.80 75.00 57.07 37.07 62.93 1.70 18.54 44.39 0.97 0.54 18.54 8.55 58.40 2.93 21.46 2000 9.52 1.60 4 19.57 11.74 14.50 13.24 39.58 58.54 33.45 66.55 1.99 29.27 37.28 1.121 0.72 14.63 8.81 59.00 1.70 25.08 2000 8.25 2.43 22.80 23.92 4.06 4.95 8.97 28.90 19.12 32.96 69.00 2.40 19.00 50.00 1.63 0.58 41.90 4.29 28.00 18.40 9.60
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23

Analysis and Interpretation of Financial Statements

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Analysis and Interpretation of Financial Statements

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International Accounting and Analysis