Analysis and Interpretation of Financial Statements
The income statement, the balance sheet, changes in equity and the cash flow statement provide explicit 'bottom line' indicators, however is of little significance unless provided additional context. These contexts are measured by financial ratios. Interpretation of such ratios must follow calculation.
Financial analysis techniques can be used to show:
- areas of operation where performance is deteriorating
- areas of operation where performance is below that of companies operating in the same area of business activity
- the relationship between change in various areas of operation and profitability and liquidity
There are four common techniques used to analyse financial statements; trend analysis., common-size statements., ratio analysis., and fundamental analysis.
By studying trends in single items or groups of items on financial statements, we can discern the direction in which an organisation is going. Trend analysis requires measurement at frequent intervals so that weaknesses can be detected as early as possible. Items related to investment, long-term solvency, sales and volume lend themselves to regular short-term study because of the sensitivity of these items to short-term changes.
Because trends and ratios will vary according to an organisation's environment, it is wise to compare a firm to others in the same industry. If its trends and ratios are distinctly different from the industry norm, this suggests a need for further investigation.
A financial ratio is a logical relationship between two figures or groups of figures that is expressed in one of several ways. The most common are; as a ratio, such as 2:1., as a percentage, such as 10%., as a number, such as 3 times (3x) or 30 days., in a combination, such as 3 times 10%.
|Short-term solvency or liquidity ratios||a) Current ratio b) Quick ratio c) Cash flow from operations to current liabilities|
|Efficiency ratios||a)Debtors' turnover b) Average days sales uncollected c) Inventory turnover d) Inventory turnover in days|
|Profitability ratios||a) Net profit margin before after-tax cost of interest b) Net profit margin c) Gross profit margin d) Interest cost as a percentage of sales e) Asset turnover f) Return on assets g) Return on ordinary shareholders' equity h) Earnings per share|
|Long-term solvency or financing ratios||a) Debt to equity b) Debt to total assets c) Leverage (equity) ratio d) Interest coverage e) Cash flow from operations to total liabilities|
|Market-based investment ratios||a) Price/earnings (P/E) b) Earnings yield c) Dividend per share d) Dividend yield|
|Other ratios||a) Dividend payout b) Dividend cover c) Net tangible asset backing|
Price/earnings: Share Price/Earnings Per Share
This tells us the number of times earnings per share is capitalised in share prices. A higher value indicates the market's assessment that the company is performing well and has good future prospects.
Earnings yield: Earnings per share/Share price
Dividends per share: Ordinary dividend/Number of ordinary shares
This ratio is designed to measure the income received by shareholders from each share owned. It is normally less than earnings per share because a certain amount of profit is usually retained by a company for reinvestment purposes.
Dividend Yield: Ordinary (Dividend per share/Share price)*100
This is the return to shareholders based on current share prices (as determined by the market).
Dividend Payout: Total ordinary dividend/Total profits earned for ordinary shareholders
This ratio tells us the percentage of profits distributed as dividends.
Dividend Cover: Earnings per share/Dividend per Share
This measures the number of times earnings covers the dividend payout and measures the ability of the company to meet dividend obligations. The higher the cover, the more able a company is to meet its dividend commitments.
Net tangible asset backing: Net tangible assets/Number of ordinary shares issued.
This ratio tells us the net tangible assets that are held by the firm on a per share basis. It is calculated on the presumption that if the company ceased to exist and all tangible assets yielded their book value, what amount would be available to ordinary shareholders on a per share basis after all liabilities were paid. Included in liabilities for this calculation will be preference capital and outside equity interests, both of which are not related to ordinary shareholders. Intangible assets are not included in this calculation because it is assumed that they have, in theory, no realisable value.
Fundamental analysis argues that the value of a share is derived from the underlying factors such as earnings per share and other company attributes, industry and country economic factors as well as international markets and companies can be identified which are under or over valued as a result. Those who support the efficient markets hypothesis believe the share market is accurate and would reject this view.
Five general limitations of ratio analysis can be identified.
- the use of conventional accounting information
- the variation in the classification of financial information
- the lack of detailed information
- the timing of the information provided
- the lack of 'benchmark' ratios for evaluation purposes
Under conventional accounting procedures it is possible to produce many different income statements and balance sheets for the same organisation. Yet ratio analysis uses figures from such financial statements to examine an organisation's performance over time and to compare it with that of other organisations. Thus the value of ratio analysis largely depends upon whether the organisations examined have used the same accounting procedures over the relevant period.
A second limitation concerns the classification of accounting information (into current assets, non-current assets, current liabilities, and so on). When ratios are calculated for an organisation, it is often necessary to compare one group of expenses, assets or liabilities with another. Therefore, to make valid inter-organisational ratio comparisons, the system of classification in the income statements and balance sheets must be identical.
A third general problem results from a lack of detailed accounting information. For example, the calculation of the inventory turnover of an organisation requires knowledge of its cost of goods sold and average stock, but it is difficult to obtain the amount for cost of goods sold from a typical published report. That information is generally not publicly available.
A fourth limitation arises from the timing of financial reports. Annual reports of years ended 30 June are normally published between September and the end of the calendar year. Companies that are listed on the stock exchange are required to publish half-yearly reports.
A fifth limitation of ratio analysis is that because the trading circumstances of companies differ, it is not generally possible to provide a benchmark or norm ratio to which the ratio of the company being evaluated can be compared. Industry averages are just that, an average of all firms in the industry, and this average figure may not be an optimal ratio.
The major deficiency of the current ratio is that it is based upon a liquidation concept. It assumes that if the organisation is liquidated, the current assets can be sold and the proceeds used to pay the current liabilities. Upon liquidation, current assets are not sold off to pay for current liabilities; rather, the proceeds of all assets, both current and fixed, are used to pay off creditors in the order specified by law. Assets have been valued on an ongoing concern basis, not on liquidation values. A current ratio may also be 'improved' by reducing current assets and current liabilities by the same dollar amount, assuming current assets is greater than current liabilities.
The debtors' turnover ratio is designed to give an appreciation of how quickly receivables have been collected during the period. The external analyst cannot find separate information on annual credit sales in published reports, but is forced to use total sales instead of credit sales. In this case, it is hoped that the ratio between cash and credit sales will be exactly the same in each year. Once the debtors' turnover ratio is calculated it should be compared to an organisation's established terms of credit. In other words, if an organisation has a policy that receivables should be paid in 30 days, the debtors' turnover ratio should be 12.
The calculation of the inventory or stock turnover ratio requires the use of cost of goods sold as the numerator. Cost of goods sold is not commonly available from published reports thus sales instead of cost of goods sold is often used. But sales should be greater than cost of goods sold by the amount of gross profit. Therefore an organisation's inventory turnover will obviously be higher if sales, rather than cost of goods sold, is used in its calculation.
The debt to total assets ratio measures the use made of interest-bearing outside sources of finance and is used to gauge the financial risk of the organisation. Financial leverage or gearing refers to the degree to which an organisation is dependent on debt to finance its assets. The ideal size of an organisation's leverage ratios depends upon the type of industry and the extent of the organisation's profit fluctuations.
Interest coverage is calculated by dividing earnings before interest and taxes by interest. The idea behind the ratio is that it will calculate the number of times interest is covered by the earnings. If an organisation is paying interest, it must pay it in cash. Earnings before interest and taxes are not calculated on a cash basis but on an accrual basis. This ratio is therefore comparing an item based on a cash concept to an item based on an accrual concept.
Earnings per share is calculated by dividing earnings, after tax and the payment of preference dividends, by the number of ordinary shares on issue. This ratio is widely used as a measure of a company's operating performance. As such it has a number of limitations. The ratio depends again on the definition of reported earnings. Judgment needs to be exercised in the inclusion or exclusion of extraordinary items. In any ratio analysis it is wise not to rely upon one or two ratios. It is therefore advisable to interrelate ratios to obtain a clearer picture. If there is a substantial discrepancy between the quick ratio and the current ratio, this is probably because of inventory.