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    Interpretation of Financial Information (Financial Statement Analysis)

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    Interpretation of Financial Information (Financial Statement Analysis)

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    ibrahimukabwe64
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    Based on the interpretation of financial accounting

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    INTERPRETATION OF FINANCIAL INFORMATION (FINANCIAL STATEMENT ANALYSIS)

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    Based on the interpretation of financial accounting

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    1 views7 pages

    Interpretation of Financial Information (Financial Statement Analysis)

    Uploaded by

    ibrahimukabwe64
    Based on the interpretation of financial accounting

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 7

    1

    INSTITUTE OF ACCOUNTANCY ARUSHA (IAA)


    (BAF II 2024/2025)

    CORPORATE FINANCE (CF)

    TOPIC: INTERPRETATION OF FINANCIAL INFORMATION (FINANCIAL


    STATEMENTS ANALYSIS)

    Learning objectives

    ➢ Meaning of financial statement analysis


    ➢ Objectives of financial statements analysis
    ➢ Tools of financial statement analysis
    a) Vertical ratio analysis
    b) Horizontal ratio analysis
    c) Trend analysis
    d) Benchmarking
    e) Ratio analysis
    ➢ Computation and analysis of various accounting ratios
    (i) Profitability ratios
    (ii) Liquidity ratios
    (iii) Working capital efficiency ratios (Activity or Performance ratios)
    (iv) Financial risk ratios (Gearing ratios)
    (v) Investor performance ratios (Valuation and growth ratios)
    ➢ Advantages of ratio analysis
    ➢ Limitations of ratio analysis
    ➢ Q&A’s
    2

    Introduction of financial statement analysis


    Financial statements analysis is the process of understanding the risk and profitability of a
    business by analyzing the financial information reported in the financial statements. The primary
    objective of financial statements is to provide information to all users of these accounts to help
    them in decision making. Financial statements by themselves reveal only partial information about
    the performance, financial position, liquidity, gearing of an entity. They provide all the basic
    required financial data of an entity for a period or as at the end of the reporting period.
    Objectives of financial statement analysis
    i. Aid in decision making
    ii. Assessing the past and present (current) performance
    iii. Evaluating the overall financial position
    iv. Analyzing and predicting profitability and growth prospects
    v. Prediction of bankruptcy and failure
    vi. Assessing operational efficiency
    vii. Facilitating investment decisions
    viii. Comparing with Industry Peers
    Common tools of financial statement analysis
    Vertical Analysis: Involves expressing each line item in a financial statement as a percentage of
    a base figure. For example, in an income statement, each item is typically expressed as a percentage
    of total revenue, while in a statement of financial position, items are expressed as a percentage of
    total assets.
    Horizontal Analysis: Involves comparing financial ratios or line items in a financial statement
    over a period of time. This technique is also referred to as comparative analysis.
    Trend Analysis: Involves comparison of a firm’s present ratio with its past and expected future
    ratios to determine whether the company’s performance and financial position is improving or
    deteriorating over time. Horizontal analysis is an example of trend analysis.
    Benchmarking: Comparing a company’s financial ratios and performance metrics with industry
    standards or competitors. Helps to assess whether a company is underperforming or outperforming
    industry peers.
    Ratio Analysis: This is a financial analysis tool that involves calculating and interpreting various
    financial ratios to evaluate a company's performance, financial health, and efficiency.
    3

    Ratio analysis
    Financial ratio is the result of dividing one financial statement item by another.
    Classification of financial ratios
    (i) Profitability ratios
    (ii) Liquidity ratios
    (iii) Working capital efficiency ratios (Activity or Performance ratios)
    (iv) Financial risk ratios (Gearing ratios)
    (v) Investor performance ratios (Valuation and growth ratios)
    Profitability ratios
    Gross Profit Margin = 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 × 100%
    𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

    Reflects gross margin made on sales. The higher the ratio the better

    Operating Profit Margin = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 (𝑷𝑩𝑰𝑻) × 100%


    𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

    Reflects operating margin made on sales. The higher the ratio the better
    Net Profit Margin = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 × 100%
    𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

    Reflects net margin made on sales. The higher the ratio the better
    Return on Capital Employed = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 (𝑷𝑩𝑰𝑻) × 100%
    𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

    *Operating Profit (Profit Before Interest and Tax)


    *Capital employed = (i) Equity + Long-term liabilities or (ii) Total Assets – Current Liabilities

    Reflects relationship between profits earned and size of company (measures the overall
    performance of the company). The higher the ratio the better

    Return on Assets = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 (𝑷𝑩𝑰𝑻) × 100%


    𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

    Reflects relationship between profits earned and total assets. The higher the ratio the better
    4

    Liquidity ratios
    Current ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 times
    𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

    Measures the ability to pay current liabilities from the current assets.

    Quick (Acid Test) ratio = 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 times


    𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

    Indicates the ability to pay all current liabilities if they become due for payment immediately.

    Working capital efficiency ratios (Activity or Performance ratios)


    Asset turnover = 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 times
    𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

    Shows how much revenue generated from the total assets owned by the firm. The higher the ratio
    the better

    Inventory turnover = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 times


    𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

    Indicated how many times the inventory is being turned over in a year. The higher the ratio the
    better

    Inventory turnover days = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 × 365 days


    𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠

    Reflects the number of days it takes for a company to turn over its inventories. The lower the
    number of days the better

    Trade Receivable days = 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 × 365 days


    𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

    Reflects the number of days it takes for a customer to pay. The lower the number of days the
    better
    5

    Trade Payables days = 𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 × 365 days


    𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

    Reflects the number of days it takes for a company to settle its bills. The higher the number of days
    the better, but the company should consider the payment period does not affect its reputation.

    Working capital cycle = Inventory turnover days + Trade Receivable days – Trade Payables days

    Approximate number of days it takes to purchase the inventory, sell the inventory and receive cash.
    The lower the working capital cycle the better

    Financial Risk (Gearing) Ratio


    Gearing is the level of a company’s debt related to its equity capital, usually expressed in % form.
    Gearing is a measure of a company’s financial leverage and shows the extent to which its
    operations are funded by lenders vs shareholders.
    Gearing ratios help to determine the stability of the company and the ability of the company to
    repay its long-term debts.

    Capital Gearing Ratio = 𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 × 100%


    𝐸𝑞𝑢𝑖𝑡𝑦 +𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

    It expresses the relationship between a company’s borrowings and its own fund.

    Debt to Equity = 𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 × 100%


    𝐸𝑞𝑢𝑖𝑡𝑦

    Debt ratio = 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 × 100%


    𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

    Indicates the percentage of assets financed with debt.

    Interest Cover = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 (𝑃𝐵𝐼𝑇) × 100%


    𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

    Indicates the number of times, the profit covers the interest charge. The higher the ratio the better
    6

    Investors’ Performance Ratios:


    Earnings per Share = 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 (𝑷𝑨𝑻−𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅)
    𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠

    Reflects the amount which an entity has earned per share for the given period. The higher the ratio
    the better
    Price/Earnings Ratio = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
    𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

    It helps to assess the relative risk of an investment. The higher the ratio the better

    Profit Retention Ratio = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × 100%


    𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

    Measures the proportion of retained profits to the profits earned by entity.

    Dividend Yield = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 × 100%


    𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

    Measures the return on capital investment as a percentage of market prices.

    Dividend Cover = 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥


    𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

    Measures the ability of the company to maintain its existing levels of dividends.

    Advantages of Ratio Analysis


    i. Aid in decision making.
    ii. It guides management in formulating future financial plan and policies.
    iii. It throws light on the efficiency of the business organization.
    iv. Assists in Financial Forecasting.
    v. It ensures effective cost control.
    vi. It provides greater clarity, perspective, or meaning to the data.
    vii. It measures profitability and solvency of the firm.
    viii. Facilitates Inter-Firm Comparisons
    ix. It permits monetary figures with many digits to be condensed to two or three digits.
    (Simplifies Complex Financial Statements)
    7

    Limitations of Ratio Analysis


    i. Historical Information (Data)
    ii. The use of varying accounting policies (e.g. inventory valuation methods).
    iii. Ignoring Non-Financial Factors (such as management quality, market trends, competitive
    position, or economic conditions).
    iv. Seasonal Variations (such as weather, holidays, or consumer habits).
    v. Industry-Specific Limitations (Comparison can only be within the same industry)
    vi. Lack of Uniform Definitions (Inconsistent definitions of financial ratios)
    vii. Manipulation of financial statements
    viii. Inflationary effects and effects of real prices(values)

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