Interpreting Financial Statements

The chapter begins with an overview of a company’s Annual Report and shows how ratio analysis
can be used to interpret financial statements. This interpretation covers profitability, liquidity (cash
flow), gearing (borrowings), activity/efficiency and shareholder return. We also look at working
capital management in detail.

Annual Reports

For all companies, the Companies Act requires the preparation of financial statements. Financial
statements are an important part of a company’s Annual Report, which must be available to all
shareholders for all companies listed on the Stock Exchange.

The Annual Report for a listed company typically contains:

• A financial summary - the key financial information.

• A list of the main advisers to the company: legal advisers, bankers, auditors and so on.
• The chairman’s, directors’ and/or chief financial officer’s report(s). These reports provide a
useful summary of the key factors affecting the company’s performance over the past year
and its prospects for the future. It is important to read this information as it provides a
background to the financial statements, and the company’s products and major market
segments (much of this information may be contained in an Operating and Financial Review).
The readers must 'read between the lines' in this report, since an intention of the Annual
Report is to paint a realistic yet often 'glossy' picture of the business. However, as
competitors will also read the Annual Report, the company takes care not to disclose more
than is necessary.
• The statutory reports (i.e. those required by the Companies Act) by the directors and
auditors. These will contain a summary of financial performance, major policies, strategies
and activities, details about the board of directors, and statements about corporate
governance and internal control and the responsibility of the board for the financial
statements.

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 • The audit report which will define the auditors’ responsibilities, an opinion as to whether the
financial statements give a true and fair view and are compliant with the Companies Act and
IFRS and the basis upon which that opinion has been formed.
• The financial statements: Income Statement and/or Statement of Comprehensive Income,
Statement of Changes in Equity, Statement of Financial Position and Statement of Cash
Flows. Where consolidated figures are provided, these should be used, as they are the total
figures for the group of companies that comprise the whole business. Prior year figures must
be shown for comparative purposes.
• Notes to the financial statements, which provide detailed explanations to the figures in the
financial statements, and usually run to many pages. As well as a breakdown of many of the
figures contained in the Income Statement, Statement of Financial Position and Statement
of Cash Flows, the Notes will include details such as: the major accounting policies adopted;
staff numbers and staff costs; directors’ remuneration; depreciation of assets; investments;
taxation; share capital; capital expenditure contracted for; pension liabilities; lease liabilities;
subsidiaries; events occurring after the end of the financial year.
• A five-year summary of key financial information (a Stock Exchange listing requirement).
• Operating and Financial Review (OFR).

The Accounting Standards Board published a Reporting Statement: Operating and Financial Review
(OFR) in 2006. The statutory requirement for all companies to produce an OFR was subsequently
removed and the reporting statement is now a voluntary statement according with 'best practice'
principles for listed companies. The OFR (different companies may use different terminology) is
intended to be forward-looking, providing details of strategy for shareholders and a broader group
of stakeholders, to complement and supplement financial statements, including key performance
indicators.

The OFR should provide information to enable shareholders 'to assess the strategies adopted by the
entity and the potential for those strategies to succeed', including:

• The nature of the business, description of the market, the competitive and regulatory
environment and the organization’s objectives and strategies.
• The development and performance of the business in the last year and in the future.
• The resources, principal risks, uncertainties and relationships that may affect long-term
value.

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 • Description of the capital structure, treasury policies and objectives and liquidity of the
business in the last year and in the future.

The context of financial statements

Before we commence analysing the financial statements themselves, it is particularly important to

understand the context in which the business operates. While much information can be obtained
from the Annual Report and the company’s website, it must be remembered that these are at least
in part produced for public relations purposes, hence it is important to seek out broader information
about the company which will then provide the context in which the financial statements can be
interpreted and understood.

Access to past newspaper articles using library databases can provide a more rounded picture of a
company, including criticisms of its operations. A good example is the press coverage given to BP's
Deepwater Horizons drilling rig explosion and oil spill in the Gulf of Mexico in 2010, where press
reports (and government enquiries) provided a much different picture of the company than that
found in BP’s Annual Report. However, it is important to remember that press reports themselves
can be inaccurate and biased. Nevertheless, making enquiries into a company through newspaper
articles can help to understand the 'bigger picture'.

This bigger picture can also be obtained from industry publications, trade associations and
exhibitions, where information extends not just to individual companies but to a whole industry.
Market research and consulting firms also produce detailed analyses of industries but can be
expensive, while credit rating agencies provide independent information about companies’ financial
position including litigation and credit reputations. Stock market analysts undertake their own
analysis and use that to support the buy or sell recommendations they give to their investment
clients.

Personal experience is also important. If you are looking at the financial statements of a large
supermarket chain such as Sainsbury’s or Tesco in the UK, personal experience of shopping can help
to understand the business operations. So for example, if you notice that food prices are lower, it
may be that supermarkets are carrying out a price war to win market share, and this may affect their
profits in the short term.

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The key issue in interpreting financial statements is to understand the context: What is happening
in the company’s market? Is customer demand changing? What technological and regulatory
changes are affecting it? Who are the major competitors? Only with this contextual awareness can
we begin to understand financial statements.

Ratio analysis

Ratio analysis is perhaps the most important tool used to analyse financial statements: the Income
Statement, Statement of Financial Position and Statement of Cash Flows. Ratios are typically two
numbers, with one being expressed as a percentage of the other. Ratio analysis can be used to help
interpret trends in performance year on year, by benchmarking to industry averages or to the
performance of individual competitors; or comparison against a predetermined target. As
companies are required to show a comparison with their prior year financial statements, ratios
should be applied, at the very least, to current and past years. However, trends can really only be
interpreted properly over a longer period, ideally five years. Trade association, market research and
consultancy reports often benchmark companies in an industry and some government statistical
data is published (e.g. on retail sales and automobile registrations). Annual Reports do not provide
comparisons against target, so this kind of ratio analysis is only possible for managers within the
company. Most financial statements provide consolidated (or group) data and data for the parent
(or holding) company. We are usually only concerned with the consolidated or group figures.
However, companies show some detailed segmental analysis of major parts of their business, which
is often very important in understanding business performance.

Ratio analysis can be used to interpret performance against five criteria:

• the rate of profitability;

• liquidity, i.e. cash flow;
• gearing, i.e. the proportion of borrowings to shareholders’ equity;
• how efficiently assets are utilized; and
• the returns to shareholders1

1 The main ratios adopted to analyse the returns to shareholders are: dividend per share (dividends paid/number of shares), dividend
payout ratio (dividends paid/profit after tax), dividend yield (dividends paid per share/market value per share), earnings per share
(EPS) (profit after tax/number of shares), and price/earnings (P/E) ratio (market value per share/earnings per share). These ratios will
not be further analysed in this chapter.

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There are different definitions that can be used for each ratio. Different text books, credit rating
agencies and stock market analysts use varying definitions. However, it is important that whatever
ratios are used, they are meaningful to the business and applied consistently. The most common
ratios follow. The calculations refer to the example Income Statement and Statement of Financial
Position reported below in Tables 1, 2 and 3. Ratios may be calculated on the end of year Statement
of Financial Position figures (as has been done in the examples that follow) or on the basis of the
average of Statement of Financial Position figures over two years.

Table 1 – Income Statement.

Table 2 – Statement of Changes in Equity.

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Table 3 – Statement of Financial Position.

Ratios are nearly always expressed as a percentage (by multiplying the answer by 100). In the
following examples, only £’000 (thousands of pounds) are shown.

Profitability

Return on (shareholders’) investment (ROI)2

net profit after tax 70

= = 7%
shareholders funds 1,000

Return on capital employed (ROCE)3

operating profit before interest and tax 100

= 1,000 + 300 = 7.7%
shareholders funds + long.term debt

Operating margin (or operating profit/sales)

operating profit before interest and tax 100

= 2,000 = 5%
sales

2 Many companies refer to this ratio as ROE (Return on Equity).

3 Many companies refer to this ratio as ROI (Return on Investment).

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Gross margin (or gross profit/sales)

gross profit 500

= 2,000 = 25%
sales

Overheads/sales

overheads 400
= 2,000 = 20%
sales

Each of the profitability ratios provides a different method of interpreting profitability. Satisfactory
business performance requires an adequate return on shareholders’ funds and total capital
employed in the business (the total of the investment by shareholders and lenders). ROI will often
be higher when shareholders’ funds are low, but this involves higher risk (see gearing, below). Profit
must also be achieved as a percentage of sales. The operating profit and gross profit margins
emphasize different elements of business performance. It is important to maximize gross margin
(the difference between selling price and the cost of sales for the volume of goods or services sold)
and to control the proportion of overhead in relation to sales.

Sales growth

A further method of interpreting performance is sales growth, which is simply

sales in year 2 − sales in year 1

sales in year 1

Hence, had the sales in the previous year been £1,800,000 (not shown in the previous tables), the
sales growth would be

2,000 − 1,800 200

= 1,800 = 11.1%
1,800

Businesses and the stock market not only like to see increasing profitability but also increasing sales,
which is an important measure of the long-term sustainability of profits.

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Liquidity

Working capital

current assets 500

current liabilities
= 350 = 143% (or 1.43)

Acid test (or quick ratio)

current assets − inventory 500 − 200

= = 86% (or 0.86)
current liabilities 350

Working capital is explained in more detail later in this work, but is essentially the liquid funds that
circulate in and out of the bank account, comprising, in the main, receivables, inventory, payables
and bank account (or overdraft). Many businesses will aim for a working capital ratio of around
150% (or 1.5) and an acid test of around 100% (or 1). A business that has an acid test of less than
100% (or 1) may experience difficulty in paying its debts as they fall due. On the other hand, a
company with too high a working capital ratio may not be utilizing its assets effectively. However,
there are substantial variations between industries. In retail for example, a lot of inventory is held
and this is reflected in payables to suppliers, but there are no receivables from customers.
Customers pay cash as they buy goods and hence the working capital and acid test ratios will often
be less than 100% (or 1).

Gearing

Gearing ratio

long.term debt 300

=
shareholders funds + long.term debt 1,000 + 300
= 23.1%

Interest cover

profit before interest and tax 100

= = 6.25 times
interest payable 16

Gearing is the amount of borrowings relative to shareholders’ equity. The higher the gearing, the
higher the risk of repaying debt and interest. In the short term, repaying interest is more important,
so the lower the interest cover, the more pressure there is on profits to fund interest charges.
However, because borrowings are being used, the rate of profit earned by shareholders is higher

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where there are higher borrowings. The relationship between risk and return is an important feature
of interpreting business performance. Consider the example in Table 4 of risk and return for a
business under different assumptions of the mix between debt and equity in financing the total
assets of the company.

Table 4 – Risk and return – effect of different debt/equity mix

While in the example in Table 4 the return on capital employed is a constant 20% (an operating
profit of £20,000 on capital employed of £100,000), the return on shareholders’ funds increases as
debt replaces equity. This improvement to the return to shareholders shows the value of leveraging
other people’s money but it carries a risk, which increases as the proportion of profits taken by the
interest charge increases (and is reflected in the interest cover ratio). If profits turn down, there are
substantially more risks carried by the highly geared business in repaying both interest and the loan
principal. Many businesses aim for a gearing in the range of 40-60%, but there are wide variations
between industries and in the risk attitude of companies within industries.

Activity/efficiency

Asset turnover

sales 2,000
total assets
= 1,150 + 500 = 121%

Investment in assets has as its principal purpose the generation of sales. Asset turnover is a measure
of how efficiently assets are utilized to generate sales, with the goal being to work the assets as hard
as possible to generate sales.

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Working capital

The management of working capital is a crucial element of cash flow management. Working capital
is the difference between current assets and current liabilities. In practical terms, we are primarily
concerned with inventory and receivables (debtors), although prepayments are a further element
of current assets. Current liabilities comprise trade payables (creditors) and accruals. The other
element of working capital is bank, representing either surplus cash (a current asset) or short-term
borrowing through a bank overdraft facility (a current liability).

The working capital cycle is shown in Figure 1. Money tied up in receivables and inventory puts
pressure on the firm, which often results in late payments to suppliers (and potentially a higher cost
of sales). Managing working capital is essential for success, as the ability to avoid a cash crisis and
pay debts as they fall due depends on:

• managing receivables through effective credit approval, invoicing and collection activity;
• managing inventory through effective ordering, storage and identification of stock;
• managing payables by negotiation of trade terms and through taking advantage of
settlement discounts; and
• managing cash by effective forecasting, short-term borrowing and/or investment of surplus
cash where possible.

Figure 1 – The working capital cycle

Ratios to determine the efficiency of the management of working capital and methods for managing
and monitoring receivables, inventory and payables are described below.

Managing receivables

The main measure of how effectively receivables (debtors) are managed is the number of days’ sales
outstanding. Days’ sales outstanding (DSO) is:

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 receivables
average daily sales

The business has sales of £2,000,000 and receivables of £300,000. Average daily sales are £5,479
(£2,000,000/365). There are therefore 54.75 average days’ sales outstanding (£300,000/£5,479).
Management of receivables will aim to reduce days’ sales outstanding over time and minimize bad
debts. The target number of days’ sales outstanding will be a function of the industry, the credit
terms offered by the firm and its efficiency in both credit approval and collection activity.

Acceptance policies will aim to determine the creditworthiness of new customers before sales are
made. This can be achieved by checking trade and bank references, searching company accounts
and consulting a credit bureau for any adverse reports. Credit limits can be set for each customer.
Collection policies should ensure that invoices are issued quickly and accurately, that any queries
are investigated as soon as they are identified and that continual follow-up of late-paying customers
should take place. Discounts may be offered for settlement within credit terms.

Bad debts may occur because a customer’s business fails. For this reason, firms establish a provision
to cover the likelihood of customers not being able to pay their debts.

Managing inventory

The main measure of how effectively inventory (stock) is managed is the inventory turnover (or
stock turn). Inventory turnover is:

cost of sales
stock

In the example, cost of sales is £1,500,000 and inventory is £200,000. The inventory turnover is
therefore 7.5 (£1,500,000/£200,000). This means that inventory turns over (is bought or
manufactured and sold) 7.5 times per year, or on average every 49 days (365/7.5). Sound
management of inventory requires an accurate and up-to-date inventory control system.

Often in inventory control the Pareto principle (also called the 80/20 rule) applies. This recognizes
that a small proportion (often about 20%) of the number of inventory items accounts for a relatively
large proportion (say 80%) of the total value. In inventory control, ABC analysis takes the approach
that, rather than attempt to manage all stock items equally, efforts should be made to prioritize the
‘A’ items that account for most value, then ‘B’ items and only if time permits the many smaller value
‘C’ items. Increasingly manufacturing businesses adopt just-in-time (JIT) methods to minimize

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investment in inventory, treating any inventory as a wasted resource. JIT requires sophisticated
production planning, inventory control and supply chain management so that inventory is only
received as it is required for production or sale. Stock may be written off because of stock losses,
obsolescence or damage. For this reason, firms establish a provision to cover the likelihood of
writing off part of the value of stock.

Managing payables

Just as it is important to collect debts from customers, it is also essential to ensure that suppliers
are paid within their credit terms. As for receivables, the main measure of how effectively payables
(creditors) are managed is the number of days’ purchases outstanding. Days’ purchases outstanding
(DPO) are:

payables
average daily purchases

The business has cost of sales (usually its main credit purchases, as many expenses, e.g. salaries,
rent, are not on credit) of £1,500,000 and creditors of £300,000. Average daily purchases are £4,110
(£1,500,000/365). There are therefore 73 average days’ purchases outstanding (£300,000/£4,110).

The number of days’ purchases outstanding will reflect credit terms offered by the supplier, any
discounts that may be obtained for prompt payment and the collection action taken by the supplier.
Failure to pay trade payables will likely result in a higher cost of sales, and may result in the loss or
stoppage of supply, which can then affect the ability of a business to satisfy its customers’ orders.
The average payment time for trade payables has to be disclosed in a company’s Annual Report to
shareholders.

Managing working capital

Importantly, improving days’ sales outstanding or inventory turnover will not improve the working
capital ratio as there is only a shift from one type of current asset to another. Table 5 shows the
effect of changes in working capital. In the first column our working capital ratio is 150% (or 1.5) and
acid test 100% (or 1). In the second column, faster collection of receivables and faster inventory
turnover converts those current assets into money in the bank.

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Table 5 - Effects of changes in working capital

1. Original 2. Improved DSO and 4. Repayment of

3. Improved DPO
working capital Inventory turnover long term loan

Bank 10,000 15,000 9,000 6,000

Receivables 10,000 7,000 8,000 7,000
Inventory 10,000 8,000 7,000 8,000
Total current assets 30,000 30,000 24,000 21,000

Payables 20,000 20,000 14,000 14,000

Total current liabilities 20,000 20,000 14,000 14,000

Working capital ratio 150% 150% 171% 150%

Acid test ratio 100% 110% 114% 93%

While this will show improved days’ sales outstanding and inventory turnover, there is no change in
the working capital ratio, although there is an improvement in the acid test (as inventory has fallen).
In the third column, the cash funds are used to reduce payables. This improves our days’ purchases
outstanding ratio and increases our working capital ratio as there are now more current assets
relative to current liabilities. In the final column, some of the cash funds are used to repay long-term
debt (a non-current liability). This will improve the gearing ratio but results in a fall (still to an
acceptable level) in the working capital and acid test ratios, as there are now less current assets
available to meet current liabilities.

One of the issues in calculating the receivables, inventory and payables ratios is the number of days
to be used in calculating average daily sales, inventory or purchases. Provided you are consistent, it
doesn’t matter too much, but in practice it is best to try to approximate the number of days a
business is open. So a retail business operating 365 days per year could use that number while a
professional service firm operating 5 days per week tor 52 weeks may use only 260 days.

Interpreting financial statements using ratios

The interpretation of any ratio depends on the industry. In particular, the ratio needs to be
interpreted as a trend over time, or by comparison to industry averages or to competitor ratios or
to predetermined targets. These comparisons help determine whether performance is improving
and where further improvement may be necessary. Based on the understanding of the business
context and competitive conditions, and the information provided by ratio analysis, users of
financial statements can make judgements about the pattern of past performance, financial

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strength and future prospects. Our focus is not on how investors use financial ratios to make
investment decisions (a topic that falls more easily into corporate finance) but on how ratios are
used by boards of directors and managers in their own organization. There will be two particular
emphases: how to improve performance as measured by ratios over time; and how the company
appears to its investors when they look at the company’s financial ratios. In addition, managers will
also be concerned with the financial statements of competitors, customers and suppliers.

Broadly speaking, businesses seek:

• increasing rates of profit on shareholders’ funds, capital employed and sales, and sales
growth;
• adequate liquidity (a ratio of current assets to liabilities of not less than 100%(or 1)) to ensure
that debts can be paid as they fall due, but not an excessive rate to suggest that funds are
inefficiently used;
• a level of debt commensurate with the business risk taken;
• high efficiency as a result of maximizing sales from the business’s investments in assets; and
• a satisfactory return on the investment made by shareholders.

When considering the movement in a ratio over two or more years, it is important to look at possible
causes for the movement. This understanding can be gained by understanding that either the
numerator (top number in the ratio) or denominator (bottom number in the ratio) or both can
influence the change. Some of the possible explanations behind changes in ratios are described
below.

Profitability

Improvements in operating profitability as a proportion of sales (PBIT or EBIT) are the result of
profitability growing at a faster rate than sales growth, a result either of a higher gross margin or
lower overheads. Note that sales growth may result in a higher profit but not necessarily in a higher
rate of profit as a percentage of sales.

Improvement in the rate of gross profit may be the result of higher selling prices, lower cost of sales
or changes in the mix of product/services sold or different market segments in which they are sold,
which may reflect differential profitability. Naturally, the opposite explanations hold true for
deterioration in profitability.

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Improvements in the returns on shareholders’ funds (ROI) and capital employed (ROCE) may either
be because profits have increased and/or because the capital used to generate those profits has
altered. When businesses are taken over by others, one way of improving ROI or ROCE is to increase
profits by reducing costs (often as a result of economies of scale), but another is to maintain profits
while reducing assets and repaying debt. By shifting from debt to equity for example, the ROCE may
not alter (because capital employed is a combination of debt and equity) but the ROI will decrease
(assuming constant profits) as there is more equity.

Liquidity

Improvements in the working capital and acid test ratios are the result of changing the balance
between current assets and current liabilities. As the working capital cycle in Figure 1 showed, and
as illustrated in Table 5, money changes form between receivables, inventory, bank and payables
and results in changes to liquidity ratios. Borrowing over the long term in order to fund current
assets will improve this ratio, as will profits that generate cash flow. By contrast, using liquid funds
to repay long-term loans or incurring losses will reduce the working capital used to repay creditors.

Gearing

The gearing ratio reflects the balance between long-term debt and shareholders’ equity. It changes
as a result of changes in either shareholders’ funds (more shares may be issued, or there may be a
buyback of shares), raising new borrowings or repayments of debt. As debt increases in proportion
to shareholders’ funds, the gearing ratio will increase.

Interest cover may increase as a result of higher profits or lower borrowings (and reduce as a result
of lower profits or higher borrowings), but even with constant borrowings changes in the interest
rate paid will also influence this ratio.

Activity/efficiency

Asset turnover improves either because sales increase or the total assets used reduce, but the goal
is to make the business assets work hard to generate sales, and to sell off assets that are no longer
productive.

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Using the Statement of Cash Flows

While financial ratios do not use information from the Statement of Cash Flows, cash flow
information does provide valuable information that helps in interpreting ratios. You will recall that
the Statement of Cash Flows separates cash flows into their operating, investing and financing
components. Changes in profitability, affected by changes in working capital, are revealed in the
operating cash flows. So increasing or decreasing profits and/or improved or worsening working
capital management will be reflected here. Where capital employed has increased, you would
expect to see the purchase of new non-current assets or business acquisitions (including goodwill)
under investing activities, where you would also see proceeds of sale of any surplus non-current
assets. This kind of investment is also likely to influence the asset turnover ratio. Financing decisions
will appear under the cash flow from financing section. Here you would expect to see proceeds from
borrowings or repayments of debt, equity raised from shareholders or payments for share buybacks,
as well as the payment of dividends. In interpreting the financial ratios, check your interpretation
with the Statement of Cash Flows as this will reinforce (or challenge) your interpretation.

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