Interpretation/Analysis of

Financial Statements

Kampumure Joseph
Consultant-UMI
0782-863812

JKampumure-UMI 1
OBJECTIVES

By the end of the session, participants

should be able to;
Carry out financial analysis.
Identify the weaknesses of Ratio analysis.
Definition of financial analysis

This is the process of establishing the

financial strengths and weaknesses of the
firm.
Financial analysis involves the use of
various financial statements.
How is financial analysis done?

This is done by establishing the

relationship between the various items
with in the financial statements.
This is done through;
 Trend analysis
 Ratio analysis
Who carries out financial analysis?

Management of the firm.

Creditors.
Financial Institutions.
Regulatory bodies (Like BOU for Banks
in Uganda, Capital Markets Authority for
listed institutions, etc.)
Suppliers.
Shareholders, etc.
Uses of financial analysis
They show the liquidity position of the firm at
any moment.
They indicate whether the firm is generating
adequate return on investment to justify
commitment of funds in the business.
They show how management is efficiently
employing the resources entrusted to it by the
owners.
To provide information about the Survival of the
firm- ability of the firm to provide for its long
term obligations.
Different Needs of the Users
Financial analysis provides information to
different stake holders including:-
1. Trade creditors-these are interested in a
firm’s ability to meet their claims over
short term period ( liquidity).
2. Suppliers of long term debt. Are
concerned with a firm’s long term
solvency and survival.
3.Investors are interested in profitability,
liquidity and capital structure.
Different Needs of the Users-Ctd
4. Share holders are interested in the firm’s
earnings and capital structure. Capital
structure influences a firm’s earning
ability and risk.
5.Management
These are interested in every aspect of
financial analysis as their responsibility is
to ensure efficient and effective use of the
resources of the firm
Different Needs of the Users-Ctd
6. Employees
Are interested in benefits and job security –
they look at profitability and liquidity of
the firm.
7. Government and tax authorities are
interested in cash and profitability for tax
purposes.
Govt is also interested in information for
policies.
Tools for financial
analysis

Index or trend analysis

Ratio analysis
 a) Index / Trend analysis –
 Relates various items of the income
statement( SOCI) or balance sheet(SOFP) to
similar items in a given base year.
It gives trend fluctuations compared to
base year.
 Also it gives explanations for
fluctuations.
b) Financial Ratios
A ratio is the relationship between two or
more things.
Financial ratios are only useful when;
i. They are compared with ratios of the
previous years of the same entity to show
the trend.
ii. They are compared to forecasted ratios.
iii.They compared with ratios of other firms
in the same type of business (industry).
Note:
The absolute figures reported in the
financial statements do not provide a
meaningful understanding of the position
and financial performance of a firm.
Example:-
Consider two entities Mulago Hospital and
IHK.
Mulago has net income of Ugx 1,000m
IHK has net income of Ugx 360m

Using the numbers above, which company

seems to be doing better?
But consider the following additional
information:-
MULAGO IHK
Net income 1,000 m 360m
Sales 10,000m 720m
Total assets 20,000m 960m
Question
With additional information which
company is performing better?
Why?
Categories of ratios
a) Liquidity ratios
Liquidity ratios:- indicate the ability of the
firm to pay its short term obligations when
they become due.
i) Current Ratio = Current Assets
Current Liabilities
Current ratio is a measure of a company's short
term solvency.
It represents margin of safety to creditors.
A ratio of 2:1 is considered acceptable;
but it is advisable to look at average ratio
for companies in the same business
2. Quick asset ratio (also known as the acid
test ratio) is given by:
current Assets-inventory
current liabilities

A ratio of 1:1 is considered appropriate.

b) Activity/Efficiency Ratios
These ratios indicate how efficiently
management uses its resources to generate
revenues (sales).
They are called turn over ratios.
They indicate how management uses
assets to generate sales.
i) Inventory Turn Over
This measures how inventory is used to
generate revenue. There are 2 types of
turn over;-
Rate of inventory turn over
= Cost Of Sale
Average Inventory
Average Inventory = (Opening Inventory +
Closing Inventory)/2
Example

Suppose;
Cost of sales for ABC Ltd = 900M
Average inventory = 250M
Rate of inventory turn over
= 900m = 3.6 times
250m
Inventory is turned into sales 3.6 times in a
year. The more times the better.
ii) Debtor turn over
This indicates the rate of collection of
cash from debtors
Rate of debtor turn over gives the number
of times cash collections are made in a
given period.
Debtor turn over (Debtor turn Over)

Debtor turn over = Credit Sales

Average Debtors
A high ratio implies either that a company
operates on a cash basis or that its extension of
credit and collection of accounts receivable is
efficient.
A low ratio implies the company should re-
assess its credit policies in order to ensure the
timely collection of imparted credit that is not
earning interest for the firm.
iii) Asset turn over
Fixed asset turn over
= Sales
Non current Assets
 This shows how the Non current assets
are used to generate revenue.
 If the ratio is low then there is idle
capacity
 C) Profitability ratios
 These ratios show the ability of the firm to
earn a return on the funds invested.
i) Net Profit Margin
=Earnings After Tax x 100
total Sales
Example: The profit/loss statement of BB Ltd
shows sales of Ugx 1600m and Net income after
tax Ugx 320m

NPM = 320 X 100 = 20%

1600
ii) Return on capital employed(ROCE) or
ROI is given by
profit before interest and tax
Total Assets – Current liabilities
iii) Return on total assets (ROTA)
Earnings After Tax
Total Assets

E.G EAT=160m
TA = 1.2 bn
ROTA =160m X 100 = 13.3%
1.2bn
ROE = EAT
Equity
 d) Gearing or leverage
These ratios assess whether a firm can
meet its long-term obligations .
They show the proportion of equity
financing to debt financing.
The higher the proportions of debt to
equity financing, the higher is the leverage
(Risk).
i) Debt to equity ratio
= Long-term Debt
Total Equity
E.g. Long Term Debt = 800m
Equity = 200m
debt equity ratio = 800 = 4:1
200
This means that long term debt is 4 times,
total equity.
ii) Debt : Total Assets ratio
= Long Term Debt
Total Assets

 This is the extent to which a firm’s assets

are financed by debt.
Please note that the less extent a firm’s
assets are financed by debt the better.
For example a ratio of 1:3 is better than 1:2
e) Investment ratios
These ratios show the valuation of the firm in
the capital markets .
Earning Per Share = EAT
No of outstanding shares.
Dividends per share = total dividends per year
No. of shares.
Dividend Cover = Net profit
Dividends
Price earnings ratio = Market price(per share)
Earnings per
share
 Weaknesses of ratio analysis
1. Ratios are computed from financial
statements. However, the methods used in
preparation of the statements may be different.
For example, each firm may calculate
depreciation differently. This makes
comparison of financial statements of
different companies less meaningful.
2. Ratio analysis is largely quantitative (depends
of figures). It ignores other (qualitative)
factors like quality of labor , loyalty of staff
etc.
Weaknesses of ratio analysis
3. It ignores changes in the environment like
inflation. Due to changes in economic
conditions, a firm that may have performed
well in the past period may not continue to
perform well in future.

4. Lack of reliable data

Reliable data, for example on industrial
ratio averages may not be readily available,
thus making ratio analysis impaired.
Question
a) For the following question, compute:
i.Current ratio
ii.Quick acid test
iii.Inventory turn over
iv.ROCE
v.Debt to equity ratio
vi.Earnings per share
b) What advise would you give to a potential
investor who is thinking of investing in Kati-
Kati Co Ltd?
Kati-Kati Co Ltd
Statement of Comprehensive income for the year ended
31.12.2014
Ugx’000
Revenue 104,000
COS (12,200)
Gross profit 91,800
Other income 900
Distribution costs (2,500)
Administrative Exp (24,790)
Finance costs ( 10,630)
PBT 54,780
Tax (1,000)
PAT 53,780
Dividends paid 32,268
Retained Earnings 21,512
Kati-Kati Co Ltd
Statement of financial position as at 31.12.
Assets 2014 2013
Ugx(000) Ugx(000)
Non Current Assets
Propertyplant &Equipment 116,000 106,000
Current Assets
Cash and cash equivalents 1,500 1,560
Trade receivables 200 310
Inventory 2,100 1,800
Total current assets 3,800 3,670
Total assets 119,800 109,670
Equity and liabilities
Equity
Retained earnings 21,512 56,122
Share capital 50,000 50,000
Total equity 71,512 106,122
Liabilities
Non current Liabilities
Loan 21,248 2,000
Current liabilities
Trade and other payables 11,020 548
Tax payable 16,020 1,000
Total liabilities 48,288 3,548
Total Equity and liabilities 119,800 109,670
Additional information;
Total shares are 1,200,000
It is company policy to give 60% the
earnings to share holders as dividends.

The End!!