IPK COLLEGE

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TEL: 012-5203212 / 0125113212 / 04-5512588
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CHAPTER 8: ANALYSING AND INTERPRETING THE FINANCIAL STATEMENT OF

SINGLE ENTITIES

1. Limitations of financial statements

i. indicate the problems of using historic information to predict future performance
ii. discuss how financial statements may be manipulated to produce a desired effect

Financial statements are affected by the obvious shortcomings of historical cost information and
are also subject to manipulation.

1.1 Historical cost information

Historical cost information is reliable and can be verified, but it becomes less relevant as time goes
by.
This is particularly misleading when attempting to predict future performance.
In a period of inflation, financial statements based on historical cost are subject to an additional
distortion.

1.2 Creative accounting

Listed companies produce their financial statements with one eye on the stock market and, where
possible, they like to produce financial statements which show analysts what they are expecting to
see.

1.3 The effect of related parties

Related parties are a normal feature of business. It is common for entities to carry on activities
with or through subsidiaries and associates, or occasionally to engage in transactions with directors
or their families.

The point is that such transactions cannot be assumed to have been engaged in „at arm‟s length‟
or in the best interests of the entity itself, which is why investors and potential investors need to
be made aware of them.

Transfer pricing can be used to transfer profit form one company to another, and inter-company
loans and transfer of non-current assets can also be used in the same way

1.4 Seasonal trading

Many companies whose trade is seasonal position their year-end after their busy period, to
minimize time spent on the inventory count.

At this point in time, the statement of financial position will show a healthy level of cash and/or
receivables and a low level of trade payables, assuming most of them have been paid.

Subject: Financial Accounting and Reporting (BBAA 2033) Page 1 of 10

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Thus, the position is reported now when the company is at its most solvent.

A statement of financial position drawn up a few months earlier, or even perhaps a few months
later, when trade is still slack but fixed costs still have to be paid, may give a very different picture

The consideration of how accounting policies may be used to manipulate company results leads
us to some of the other limitations of ratio analysis.

The most important ones are:

• In a company’s first year of trading there will be no comparative figures. So, there will be
no indication of whether a ratio is improving.
• Comparison against industry averages may not be that revealing. A business may be
subject to factors which are not common in the industry.
• Ratios based on historical cost accounts are subject to the distortions described in 1.1
above.
• Ratios are influenced by the choice of accounting policy.
• Financial statements are subject to manipulation and so are the ratios based on them.
Creative accounting is undertaken with key ratios in mind.
• Inflation over period will distort results and ratios.
• No two companies, even operating in the same industry, will have the same financial and
business risk profile. For instance, one may have better access to cheap borrowing than
the other so may be able to sustain a higher level of gearing

2. Calculation and interpretation of accounting ratios and trends

i. define and compute relevant financial ratio
ii. analyse and interpret ratios to give an assessment of an entity performance and
financial position in previous periods of financial statements and to give advice of
different stakeholders

Financial performance (profitability)

Gross profit margin

An increase in gross profit margin indicates that variable costs, raw materials, labour, power etc
are not rising as quickly as selling prices, whilst a decrease will indicate the opposite.
Changes in the gross profit margin over time should be analysed further to identify the cause:

Subject: Financial Accounting and Reporting (BBAA 2033) Page 2 of 10

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Email: [email protected]
 IPK COLLEGE
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TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

Has the company introduced new products?

Is it cutting prices to increase market share?
Was it unable to pass on inflationary price increases?

Operating profit margin

This will differ from the gross profit margin in that selling, general and administrative expenses
and depreciation are deducted. An analysis of the causes of changes in this percentage might
reveal that the company's other costs are increasing/decreasing at a greater rate than sales.

Return on capital employed

This measures the level of returns a business has made using the capital it has within it. It allows
for comparison of overall performance year on year as well as allowing comparison to an entity
in a similar industry of different size.

Net asset turnover

Non-current asset turnover

This is the overall measure of the efficiency of a company in generating sales from its investment
in non-current assets. The minimum investment in assets to generate the maximum revenue is an
indication of efficiency. However, it may in fact deteriorate in the short term if a company is
replacing heavily depreciated assets with new equipment.

Subject: Financial Accounting and Reporting (BBAA 2033) Page 3 of 10

Prepared by N.Thacharyane (Ms.Yane)
Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

Example 1 – ROCE
The following extracts are from Hassan’s financial statements:
$
Profit before interest and tax 10,200
Interest (1,600)
Tax (3,300)
Profit after tax 5,300

Share capital 20,000

Reserves 15,600
35,600
Loan liability 6,900
42,500

What is Hassan’s return on capital employed?

A 15%
B 29%
C 24%
D 12%

Example 2 – Financial performance

Archer Co is a retailer and trades through its stores on the high street, selling high quality goods.
The company has recently been suffering from rising costs, that it has been unable to pass on to its
customers. In response to the number of people shopping via the Internet, Archer Co has
implemented a cost cutting strategy in the prior year, and in the current year asked shareholders
for funds to help reduce it debt burden. The following financial information for the current year is
available:

Statement of profit and loss for the year ended 31 March 2019

Subject: Financial Accounting and Reporting (BBAA 2033) Page 4 of 10

Prepared by N.Thacharyane (Ms.Yane)
Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

a. Calculate the following ratios for the years ending 31 May 2019 and 31 May 2018:
i. Gross margin
ii. Operating margin

b. Using the information provided and the ratios calculated above, comment on the
comparative performance for the two years ended 31 May 2019 and 2018.

Financial Statement

1. Liquidity
The ability of a company to pay its obligations as and when they fall due (its liquidity) is a major
concern of any credit analysis. Short term liquidity can be assessed by comparing current assets
with current liabilities in a variety of forms:

Working Capital = Current Assets - Current Liabilities.

A working capital surplus represents a cushion of protection for current creditors; it indicates the
amount by which the value of current assets could decrease still leaving enough to repay current
liabilities from the sale of current assets.

Subject: Financial Accounting and Reporting (BBAA 2033) Page 5 of 10

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Email: [email protected]
 IPK COLLEGE
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TEL: 012-5203212 / 0125113212 / 04-5512588
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The optimum amount of working capital varies considerably from company to company and from
industry to industry, thus the nature of the company's business and the quality of its assets must be
considered. Companies functioning within industry sectors with short production/sales cycles (e.g.
supermarkets) can generally function satisfactorily with a much smaller amount of working capital
than those with a long production cycle (e.g. heavy engineering).

2. Current ratio

A current ratio of over one indicates that a company has a higher level of current assets than current
liabilities and should, therefore, be in a position to meet its short term obligations as and when
they fall due. However, some companies function adequately on current ratios of less than one
whilst others need a much higher ratio. Generally the more liquid the current assets are the higher
this ratio will be.

Trends are difficult to analyse but generally higher ratios indicate greater liquidity. However, an
increase may reflect a high level of unsaleable stock or overdue receivables whereas a decrease
may result from greater efficiency.

3. Quick ratio (acid test)

This quick ratio shows how easily a company can meet its current obligations using funds raised
from quick assets (those assets which can be converted quickly into cash).

A comparison of the quick ratio and current ratios which shows increases in both, but with the
current ratio increasing more, would indicate that the company has been building up stock.

4. Working capital
Inventory days

Shows how long a business is holding its inventory. A higher number of days inventory might

Subject: Financial Accounting and Reporting (BBAA 2033) Page 6 of 10

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Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

indicate holdings of obsolete or unsaleable inventory, but it might also signify a purchase of raw
materials now in anticipation of an increase in price later.

Trade receivables collection period

Providing revenue is evenly spread throughout the year the ratio will indicate how effectively debts
are being collected.

An increase in the ratio of receivables to revenue could, providing the proportion of cash sales has
not increased, indicate one of the following: -
• Receivables are being given or are taking longer to pay. What are the terms of trade?
• The total receivables figure includes long outstanding debts. Should provisions be made?

Trade payables payment period

If purchases are spread evenly throughout the year, this ratio will show the length of credit the
company is taking. An increase in the ratio may indicate that more reliance is being placed upon
the payables to finance the business. A drop in days may indicate that a company is taking cash
discounts or may indicate suppliers are cutting credit terms because of the company's decreased
creditworthiness.

5. Solvency/gearing/risk
Gearing ratio

An increase in the gearing ratio indicates that either borrowings are increasing faster than equity,
or equity is falling more quickly than borrowings. In extreme cases, borrowings may be increasing
while equity falls.

Subject: Financial Accounting and Reporting (BBAA 2033) Page 7 of 10

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Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

In the first case, this may be simply because the profit potential of any increased borrowing has
not yet been realised, or that the increase in profitability arising from the use or the increase in
borrowings is not being retained within the business.

Interest cover

Indicates the number of times profits exceed interest expense. This may indicate severe financial
difficulties or that borrowings are too high for the company to support. Is the current year's
profitability exceptional?

It is important to note that this is a ratio based on profitability not cashflow which would be a better
indicator of company’s ability to pay interest.

Example 3 – Working capital

Xena has the following working capital ratios:

Which of the following statements is correct?

A Xena’s liquidity and working capital has improved in 20X9

B Xena is receiving cash from customers more quickly in 20X9 than in 20X8
C Xena is suffering from a worsening liquidity position in 20X9
D Xena is taking longer to pay suppliers in 20X9 than in 20X8

Subject: Financial Accounting and Reporting (BBAA 2033) Page 8 of 10

Prepared by N.Thacharyane (Ms.Yane)
Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

Example 4 – Financial performance and working capital

SAF has experienced a period of rapid expansion in the last 6 months following the launch of a
new product on 1 July 20X2. The following information is available from the management
accounts of SAF:

Analyse the financial performance and working capital position of SAF, including the
calculation of five relevant ratios.

Investor Analysis

Subject: Financial Accounting and Reporting (BBAA 2033) Page 9 of 10

Prepared by N.Thacharyane (Ms.Yane)
Email: [email protected]
 IPK COLLEGE
1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG
TEL: 012-5203212 / 0125113212 / 04-5512588
www.ipk.edu.my

Example 5 – Investor ratios

Morgan Co is a listed company and has 50c equity share capital of $20m in issue. The company
paid a dividend per share of 10.5c in its most recent financial year and the share price at the
reporting date was $1.20. The additional financial information is also available to investors:
Statement of profit and loss
2019
$’000s
Profit before tax 28,350
Income tax expense (4,600)
Profit for the year 22,680

Calculate each of the following investor ratios for Morgan Co:

a. Dividend cover
b. Dividend yield
c. P/E ratio
d. EPS

Subject: Financial Accounting and Reporting (BBAA 2033) Page 10 of 10

Prepared by N.Thacharyane (Ms.Yane)
Email: [email protected]