lecture 9 interpretation of accounts

8/19/2019 Lecture 9 Interpretation of Accounts

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(1)Use ratios in the interpretation and analysis of accounts.

(2)Calculate the ratios for interpretation.

INTERPRETATION OF ACCOUNTS

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To understand what is ratio analysis

To identify different types of ratiosTo explain the importance of ratioanalysis and the application ofdifferent ratios in financial decision

making.To identify the limitations of ratios

Learning

objectives

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Financial analysis is the selection, evaluation, and interpretation offinancial data, along with other pertinent information, to assist ininvestment and financial decision-making.

Financial analysis may be used internally to evaluate issues such asemployee performance, the efficiency of operations, and creditpolicies, and externally to evaluate potential investments and thecredit-worthiness of borrowers, among other things.

A financial ratio is a relationship that indicates something about a

company's activities, such as the ratio between the company's currentassets and current liabilities or between its accounts receivable and itsannual sales.

The basic source for these ratios is the company's financial statements

that contain figures on assets, liabilities, profits, and losses.

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ANALYSIS AND INTERPRETATION

OF FINANCIAL STATEMENTS


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1) To evaluate performance, compared to previous years and tocompetitors and the industry

2) To set benchmarks or standards for performance

3) To highlight areas that need to be improved, or areas that offerthe most promising future potential

4) To enable external parties, such as investors or lenders, to assessthe creditworthiness and profitability of a firm.

5)

To appraise the financial strength of a company indicating thecompanies future financial performance.

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USES OF RATIOS


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i. Liquidity ratios

ii.Profitability ratios

iii.Efficiency ratios (activity ratios)

iv.Capital structure ratios

v.Investment ratios5

TYPES OF RATIOS


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Liquidity ratios demonstrate a company's

ability to pay its current obligations.

In other words, they relate to the

availability of cash and other liquid assetsto cover accounts payable, short-termdebt, and other liabilities.6

LIQUIDITY RATIOS


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i) Current Ratio = Current assets

Current Liabilities

It measures the ability of an entity to pay its near-termobligations. "Current" usually is defined as within oneyear.

A lower current ratio means that the company may not be

able to pay its bills on time, while a higher ratio means thatthe company has an excess level of current assets ( cashand stocks) that could be put to better use in the business.

The ideal current ratio depends on the types of the

business and the industry trend.

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LIQUIDITY RATIOS:


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ii) Quick Ratio = Quick assets

Current Liabilities

Quick Assets = Current Assets – Inventories

It provides a stricter definition of the company's ability to make payments oncurrent obligations.

Stock is excluded as it is considered slow in converting to cash than othercurrent assets.

If Quick Ratio is higher, the company may be keeping too much cash on handor have a poor collection program for accounts receivable.

If Quick Ratio is lower, despite having a good Current Ratio it may indicatethat the company relies too heavily on inventory to meet its obligations.

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LIQUIDITY RATIOS:


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This is the type of ratios investors are most interested in.

Profitability ratios provide information about management'sperformance in using the resources effectively.

Profitability ratios are very common performance indicators.

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PROFITABILITY RATIOS


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Gross profit margin =Gross Profits x 100

Sales

It measures the gross margin on sales a company is achieving.

It can be an indication of manufacturing efficiency andmanagement of production costs.

Higher the Gross Profit margin better the operational

efficiency of the business.

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Gross profit margi


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Net Profit Margin = PBIT x 100Sales

(PBIT = Profit before Interest and Taxes)

It measures the overall profitability of the company. It calculates how much pound you earn as profit for every £100 of sales made.

In general terms, net profitability shows the effectiveness ofmanagement in using its resources.

Though the optimal level depends on the type of business, theratios can be compared for firms in the same industry.

Higher the margin, it is better for the business.

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N!t Profit Margi


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Return Capital Employed (ROCE) = PBIT x 100

Capital employed

PBIT= Profit Before Interest & Taxes Capital= All equity + Long Term Debts.

ROCE states the profit as a percentage of the amount of capitalinvested. It indicates how effectively the company is using its financialresources

A very low ROCE usually indicates ineffective use of thecapital in recording profit in the business.

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R!t"r O Capita# Emp#o$!%


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By assessing a company's use of credit, inventory, and assets,efficiency ratios can help conduct business better.

These ratios can show how quickly the company is collectingmoney for its credit sales or how many times inventory turnsover in a given time period.

This information can help management decide whether the

company's credit terms are appropriate and whether itspurchasing efforts are handled in an efficient manner.

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EFFICIENCY RATIOS


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Assets Turnover Ratio = Sales

Net Assets

It indicates how effective assets are utilised to generatesales.

This is the effective utilisation of assets

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EFFICIENCY RATIOS

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Receivable(Debtors) Days= Average Receivables(Debtors) X 365

Sales (Credit)

It is a measure of the average length of time it takes for a company’s

debtors to pay what they owe. gives a measure of how quickly credit sales are turned into cash. If average figures are not available , there is practice of taking actualfigures.

High debtors days suggest a collection problem of its receivables. Low debtors days should be analyzed for if a company is losing out onsales by not extending credits to customers.

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EFFICIENCY RATIOS

&'ot%()*


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iii) Stock Days Ratio = Average Inventory X 365 days

Cost goods sold

It indicates the average number of days that stock are held before sold

out. It calculates the number of days, on average, that elapse betweenfinished goods production and sale of product.

If average figures are not available , there is practice of taking actualfigures.

High Stock days could mean stock turnover is slow which could becostly to a business.

Low stock days could mean a fast stock turnover but it could alsosuggest a very low level of stock which have a risk of going out of

stock.

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EFFICIENCY RATIOS

&'ot%()*


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v) Account Payable( Creditors) Days Ratio

= Average Account Payable x 365 days

Cost of goods Sold

It measures how long does it take to pay the creditors.

High Creditors days could mean the poor liquidity showing theinability of a company to meet short term obligations. Low Creditors could mean a company is unable to get any credits ontheir purchase due to a poor credit rating or market reputation.

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EFFICIENCY RATIOS

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Leverage ratios look at the extent that a company has depended upon borrowing to finance its operations. It is a measure of financial leverage, demonstrating the degree to which afirm's activities are funded by owner's funds versus creditor's funds.

The higher a company's degree of leverage, the more the company isconsidered risky. As for most ratios, an acceptable level is determined by its comparison toratios of companies in the same industry.

A company with high gearing (high leverage) is more vulnerable to

downturns in the business because the company must continue to serviceits debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measureof financial strength.

When a company has high liabilities, banks or other lenders may be

unwilling to finance further to the company. As a result, these ratios arereviewed closely by bankers and investors.

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CAPITAL STRUCTURE RATIOS+

&LE,ERAGE RATIOS*


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i) Debt/ equity ratio = Debt(long-term debt)

Owners' Equity

It indicates the relative mix of the company's investor-suppliedcapital compared to debt

A company is generally considered safer if it has a low debt to equity

ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution.

In general, debt should be between 50 and 80 percent of equity.19

G!arig Ratio


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Debt ratio =Debt (total liabilities)

Total Assets

It measures how much portion of a company's Total Asset is provided

by borrowings.

A debt ratio of greater than 1 indicates that a company has more debtthan assets. Meanwhile, a debt ratio of less than 1 indicates that acompany has more assets than debt.

Used in conjunction with other measures of financial health, the debtratio can help investors determine a company's risk level.

This ratio can easily be converted to, the debt to equity ratio.20

D!-t Ratio


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Interest Cover Ratio= PBIT

Interest Expense

It indicates how comfortably the company can pay its interest.

In general, a higher interest coverage ratio means that the business isable to take on additional debt.

This ratio is closely examined by bankers and other creditors.

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It!r!st Co.!r Ratio


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Investment ratios are concerned with the return on investment forshareholders, and with the relationship between return and the valueof an investment in a company’s shares.

These are the most sought after ratios for investors.

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IN,ESTMENT RATIOS


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Earnings per share ratio (EPS)

=Profits available to ordinary shareholders

Number of ordinary shares

Earnings are profits for the year available to ordinaryshareholders, which can either be paid out as dividends to

the shareholders or retained in the business. EPS measures the profit earned per share. The higher EPS will attract more investors to acquire sharesin the company as it indicates that the business is profitable

enough to pay more dividends in time.

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Earigs p!r s/ar!


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Price Earnings (PE) Ratio = Market price per share

EPS PE ratio is the ratio of a company’s current share priceto the earnings per share.

This ratio measures the investors’ confidence in acompany. The higher PE ratio indicates strong share

holders confidence in the company and its future. The P/E ratio of a company is compared with

Specific companies in the same business sector. Other companies

The business sector as a whole.

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Pri'! Earigs &PE* Ratio


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Dividend Yield = Dividend per share X 100

Market price per share

This expresses dividend per share as a percentage of thecurrent share price.

Dividend yield is the return a shareholder is currentlyexpecting on the shares of a company.

Shareholders look for both dividend yield and the capitalgrowth.

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Di.i%!% Yi!#%


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Dividend cover ratio

=Earning Per Share

Net Dividend Per Share

It shows what proportion of profit is available to shareholders asdividends and what proportion will be retained in the business tofinance future growth.

A dividend cover of 2 would indicate that the company has paid 50%of its profits as dividends to shareholders.26

Di.i%!% Co.!r Ratio


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Large multinational conglomerates with manydifferent business segmentscan be difficult to

analyze. The difficulty is compounded by the investor's inability to identify comparable competitorsagainst which to measure the conglomerate. Qualitative factorssuch as economic and political considerations, management ability, marketingability and the human resources of the firm are not measured in the traditional financialstatements.There is always atime delay between the end of an accounting reporting period and the actualpublication of the firm's quarterly or annual financial statements. The delay can be several months.Management canmanipulate the financial statements by making accounting choices which aremore favourable to them and still remain within the acceptable accounting standards.Reporting offinancial activities will vary from company to company, making comparisons difficultfor an investor. For example, 2 identical corporations in the same industry may choose differentdepreciation rates for their equipment, or they may choose different accounting techniques forreporting inventory.

Ratios do not necessarily disclose the quality of their components. For example, a high current ratiomight mean that a company has high accounts receivable or inventories or idle cash.

Financial statements are based on historic data and thereforemay be misleading during periods ofinflation.Accounting standards and practices varyamong countries, and thus hamper meaningful globalcomparisons.

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LIMITATIONS OF RATIOS

lecture 9 interpretation of accounts

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