24 Ratios

24. Interpretation of financial statementsChapter Overview ü RatiosRatiosRatio analysisRequirement in FA:p Familiar with the ratiosp Understand the change in Ratiop More Ratio analysis for real companies in markets, Pls. refer to 思考特财经（公众号） for learningImportance and purpose of interpretation of financial statements üThe financial statements of a company are designed to provideusers with information about its performance and financialposition. The figures by themselves, however, are notparticularly useful and it is only through comparisons (usuallywith ratios) that their significance can be established. This willthen enable the end user to make an informed decision.üComparisons may be made with:•Previous financial periods•Similar businesses•Industry averages.Ratio analysis I. ProfitabilityII. LiquidityIII. EfficiencyIV. PositionProfitability ratiosüPurposeProfitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return.Profitability ratiosRatiosüGross profit margin•The gross profit margin measures how well a company is running its core operations. The gross profit percentageshould be similar from year to year for the same company.A significant change may be due to:• A change is sales price• A change in product mix•An incorrect inventory valuation (will affect 2 years)• A change in cost of sales due to efficiency or price movements.Profitability ratiosüOperating profit margin•Profit before interest and taxation (PBIT) is used because it avoids distortion when comparisons are made between twodifferent companies where one is heavily financed by means of loans, and the other is financed entirely by ordinary sharecapital.•The extra consideration for the operating margin over the gross margin is how well the company is controlling itsoverheads.Profitability ratiosüOperating profit marginA significant change (especially a fall) may be due to:•The reasons for the movement in the gross profit margin as stated above•Changes in control over administration and distribution costs•One off expenses e.g. advertising.Profitability ratiosüReturn on capital employed* or total assets less current liabilities•Total equity includes share capital, share premium and reserves. Return on capital employed measures how efficientlya company uses its capital to generate profits. A potentialinvestor or lender should compare the return to a target returnor a return on other investments/ loans.Profitability ratiosüReturn on capital employedOther reasons for a significant change may include:•New assets acquired during the year which are not yet running at capacity•Assets aging•Revaluations.Profitability ratios üReturn on equityLiquidity ratiosüPurposeLiquidity measures the availability of a company’s cash to pay its short term debts.Liquidity ratiosRatiosüCurrent ratio (working capital ratio)Liquidity ratiosüQuick ratio•This is similar to the current ratio except that it omits the inventories figure from current assets. This is becauseinventories are the least liquid current asset that a company has, as it has to be sold, turned into receivables and then the cashhas to be collected.• A ratio of less than 1:1 could indicate that the company would have difficulty paying its debts as they fall due.Efficiency ratiosüPurposeEfficiency measures how well the company uses its assets to generate profit, revenue and cash.Efficiency ratios üWorking capital cycleEfficiency ratios üWorking capital cycleEfficiency ratiosüInventory turnover period (days)•This ratio measures the number of days inventories are held by a company on average.•This figure will depend on the type of goods sold by the company.• A company selling fresh fruit and vegetables should have alow inventory holding periods as these goods will quicklybecome inedible.• A manufacturer of aged wine will by default have very long inventory holding periods. It is important for a company tokeep its inventory days as low as possible, subject of courseto being able to meet its customers' demands.Efficiency ratiosüInventory turnover period (days)A significant change may be due to:• A change in type of inventory held•Improved or worsened inventory controls•Changes in the popularity of certain inventory items.Efficiency ratiosüReceivables collection period (days)•This ratio shows, on average how long it takes for the trade receivables to settle their account with the company. Theaverage credit term granted to customers should be takeninto account as well as the efficiency of the credit controlfunction within the company.A significant change may be due to:-Increased/ decreased credit terms offered to customers-Change in the mix between cash and credit transactions-Better/ worse credit control.Efficiency ratiosüPayables payment period (days)•This ratio is measuring the time it takes the company to settle its trade payable balances. Trade payables provide thecompany with a valuable source of short term finance, butdelaying payment for too long a period of time can causeoperational problems as suppliers may stop providing goodsand services until payment is received.A significant change may be due to:-Increased/ decreased credit terms from suppliers-Increase/ decrease in cash-Better/ worse management of the payables ledger.Efficiency ratiosüAsset turnover ratio•This ratio measures the efficiency of the use of net assets in generating revenue. Ideally the ratio should be increasing,but we need to be careful when making assessments basedon this ratio, because the company could have bought lots ofassets late in the year and they simply have not had muchtime to start generating revenue. If this is the case, the ratiowill almost certainly fall, but this is not a reflection on theability of the assets to generate revenue, it is simply a timing issue.Efficiency ratios üLink between ratios --- ROCEEfficiency ratiosüLink between ratios•Operating profit margin × Asset turnover ratio = Return on capital employedPosition ratiosüPurposePosition ratios consider the company’s long term solvency and its capital structure.Position ratiosRatiosüInterest cover•The interest cover ratio considers the number of times a company could pay its interest payments using its profitfrom operations. The main concern is that a company doesnothave so much debt finance that it risks not being able tosettle the debt as it falls due.Position ratiosüGearing•Gearing is concerned with the long-term financial stability of the company. It is looking athow much the company isfinanced by debt. Debt is cheaper than equity as interest istax deductible but the higher the gearing ratio, the lesssecure the financing of the company will be and possibly thecompany’s future.Limitations of ratio analysisüIssueThe usefulness of ratio analysis is limited by distorting factors.For example:•Inflation when comparing to previous years•Different accounting policies/classifications when comparing to different companies e.g. ROCE higher if use cost modelsfor assets•Lack of information/ breakdown of information•Trading may be seasonal within a period (or over differentaccounting periods)•Year end figures not representative because they include year end accounting adjustments and may be subject to 'windowdressing' (‘window dressing’ is the intentional manipulationof year end figures)Limitations of ratio analysisüIssueThe usefulness of ratio analysis is limited by distorting factors.For example:•Related party transactions make the ratios incomparable with other companies (i.e. selling to your friend at a discount willhave an adverse effect of your overall margin vs. acompetitor)•Different ratio definitions/formula used by differentcompanies•Different companies in the same business may have different risk profiles or specific factors affecting them, makingindustry comparisons less meaningful•Where financial statements are manipulated, this is oftendone to improve key ratios• A new company will have no comparatives to compare with.Lecture example 1Priestly has the following working capital ratios:20X220X1 Quick ratio 1.10.9 Receivables days65 days75 days Payables days50 days45 days Inventory turnover36 days41 daysLecture example 1Which of the following statements is correct?A.Priestly’s credit control has worsened in 20X2B.Priestly’s inventory is at greater risk of obsolescence in 20X2than 20X1C.Priestly is paying its suppliers more quickly in 20X2 than in20X1D.Priestly’s working capital management and liquidity haveimproved in 20X2AnswersAnswer to Lecture Example 1DA is incorrect because Priestly’s credit control has improved in20X2 (they are collecting debts from customers more quickly. B is incorrect because Priestly is selling inventory more quickly in20X2, making it at lower risk of obsolescence. C is incorrect because Priestly is taking longer to pay its suppliers in 20X2. D iscorrect because the quick ratio has improved from 0.9 to 1.1 and because the working capital cycle has decreased from 71 to 51 days.Lecture example 2The following extracts are from Mya’s financial statements:$ Profit before interest and tax 21,230 Interest on loan notes(2,000) Tax (5,200) Profit after tax 14,030Share capital 40,000 Share premium 10,000Reserves 26,50076,500 10% loan notes 20,00096,500Lecture example 2What is Mya’s return on capital employed?A.15%B.22%C.20%D.18%AnswersAnswer to Lecture Example 2You’re a Champion! Thanks for staying with us. You have finished this task.。