Interpretation of Accounts

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Chapter 9
Interpretation of Accounts
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Interpretation of Accounts
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Introduction

• Interpretation is when users evaluate financial
  information to make judgements
• Main aspects
• Profitability
• Efficiency
• Liquidity
• Gearing
• Cash flow
• Investment

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Context
Transaction occurs
Recorded in books by double entry
Preparation of accounts
Interpretation of accounts
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Overview I
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Overview II

• 1. Profitability
• i. Return on capital employed
• ii. Gross profit ratio
• iii. Net profit ratio
• 2. Efficiency
• i. Debtors collection period
• ii. Creditors collection period
• iii. Stock turnover ratio
• iv. Asset turnover ratio
• 3. Liquidity
• i. Current ratio
• ii. Quick ratio

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Overview III

• 4. Gearing
• i. Gearing ratio
• 5. Cash Flow
• i. Cash flow ratio
• 6. Investment
• i. Dividend yield
• ii. Dividend cover
• iii Earnings per share
• iv Price/earnings ratio
• v. Interest cover

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Importance of Ratios

• Quick and easy snapshot
• Aid comparisons
• Adjust for size

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John Brown Ltd
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John Brown Ltd
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(No Transcript)
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Closer Look at Main Ratios I

• Calculations based on John Brown
• 1. Profitability Ratios
• Return on Capital Employed
• measures effective use of capital
• Profit before tax and loan interest 60
  17.9
• Long term capital 335
• Gross Profit Ratio
• measures direct return on sales
• Gross profit 100 50
• Sales 200
• Net Profit Ratio
• measures bottom line return
• Net profit before taxation 50 25
• sales 200

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Closer Look at Main Ratios II

• 2. Efficiency Ratios
• 1. Debtors (Trade Receivables) Collection Period
• Measures how long it takes customers to pay
• Average debtors 40 73 days
• Credit sales per day 200/365
• 2. Creditors (Trade Payables) Collection Period
• measures how long it takes to pay suppliers
• Average creditors 50 183 days
• Credit purchases per day 100/365

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Closer Look at Main Ratios III

• 3. Stock (Inventory) Turnover
• measures how quickly stock moves through
  business
• Cost of sales 100 1.66 times
• Average stock 60
• 4. Asset Turnover Ratio
• compares sales to total assets employed
• sales
• Average total assets 200 0.51 times
• 395

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Closer Look at Main Ratios IV

• 3. Liquidity Ratios
• 1. Current Ratio
• measures short term liquidity
• Current assets 120 2
• Current liabilities 60
• 2. Quick Ratio
• measures extreme short term liquidity
• Current assets - stock 120-60 1
• Current liabilities 60

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Closer Look at Main Ratios V

• 4. Gearing
• Measures relationship between long-term
  borrowings and total capital.
• Long term borrowings 120 36
• Total long term capital 335
• Long term borrowings preference share capital
  and debentures.
• Total long-term capital share capital, long term
  borrowings and reserves.
• 5. Cash Flow
• measures cash flow
• A company with cash inflows 273,000 and outflows
  278,000.
• Total cash inflows 273 0.98
• Total cash outflows 278

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Closer Look at Main Ratios VI

• 6. Investment Ratios
• 1. Dividend yield
• Dividend related to market price
• Dividend per ordinary share (10 m- 150m) x100
  10
• Share price 67p
• 2. Dividend Cover
• How many times profit covers dividends?
• Profit after tax and preference dividends 30
  3
• Ordinary dividends 10
• 3. Earnings per Share (EPS)
• Earnings related to number of shares
• Profit after tax and preference dividends 30
  20p
• Number of ordinary shares 150

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Closer Look at Main Ratios VII

• 4. Price Earnings Ratio
• Relates EPS to market price
• Share price 67 3.35
• Earnings per share 20
• 5. Interest Cover
• How many times does profit cover interest?
• Profit before tax and loan interest 50 10 6
• Loan interest 10

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Worked Example IFigure 9.7 Illustrative Example
on Interpretation of Accounts
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Worked Example II
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Worked Example III

• 1. Vertical and Horizontal Analysis
• 2. Vertical analysis involves setting key figures
  in accounts to 100 e.g., taxation in 20X1 is 26
  of sales
• Horizontal analysis involves comparing across
  years
• e.g., sales in 20X2, 29 up on 20X1

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Worked Example IV

• 20X1 20X2
• 1. Return on Capital Employed
• 130 8 18.4 195 10 24.7
• 750 (911750) ? 2
• 2. Gross Profit Ratio
• 215 61.4 300 66.7
• 350 450
• 3. Net Profit Ratio
• 130 37.1 195 43.3
• 350 450
• Trade Receivables
• Collection Period
• 80 83 days (80 38) ? 2 48
  days
• 350 ? 365 450 ? 365

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Worked Example V

• 20X1 20X2
• 5. Trade Payables Collection Period
• 80 216 days (80 60) ? 2
  170 days
• 135 ?365 150 ?365
• 6. Inventory Turnover Ratio
• 135 5.4 times 150 4.5
  times
• 25 (2542) ?2
• 7. Asset Turnover Ratio
• 350 0.42 times 450
  
• (50500180) (3001211290) ? 2
• 0.50 times

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Worked Example VI

• 20X1 20X2
• 8. Current Ratio
• 180 2.2 110 1.8
• 80 60
• 9. Quick Ratio
• 180 - 25 1.9 110 -42 1.1
• 80 60
• 10. Gearing Ratio
• 230 30.7 250 27.4
• 750 911

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Worked Example VII

• 11. Cash Flow
• First, draw up cash flow statement and take
  cash inflows and
• outflows.
• Inflows Outflows
• 000 000
• Net cash inflow from operating activities
  210
• Returns on investment and servicing
• of finance 10
• Taxation 39
• Capital expenditure and financial investment
  211
• Equity dividends
  15
• Financing 20 ___
• 230 275
• Cash inflows 230 0.84
• Cash outflows 275

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Worked Example VIII

• 20x1
  20x2
• 12. Dividend Yield 2 2
  4 2.7
• 100
  150
• 13. Dividend Cover 101 16.8 times 153
  12.7 times
• 6 12
• 14. Earnings per Share 101 33.7p 153
  51p
• 300
  300
• 15. Price/Earnings Ratio 100 3.0 150
  2.9
• 33.7 51
• 16. Interest Cover 1308 17.2 times
  19510 20.5 times
• 8 10

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Report Format

• 1. Heading
• 2. Terms of Reference
• 3. Introduction
• 4. Major Sections
• 5. Recommendations
• 6. Appendix

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Holistic View of Ratios

• Z score model predicts failed and non-failed
  companies
• Pictics uses faces to represent a collection of
  ratios

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Performance Indicators

• Non-financial indicators
• e.g., percentage of trains late miles per
  passenger Railway Companies

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Limitations

• Context
• Absolute size
• Like for like comparisons
• International comparisons

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Conclusion

• Ratio analysis good way to overview an
  organisations activities
• Profitability, efficiency, liquidity, gearing,
  cash flow and investment ratios
• Financial ratios can be supplemented with
  performance indicators
• Need consistent and comparable calculation