BCOM 111

TOPIC ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

1.1 Introduction
The analysis and interpretation of financial statements is done to assess the strengths and
weaknesses about an entity’s financial position and performance to enable stakeholders
make appropriate decisions.

In the financial analysis, one compares the current financial statements with:
 Similar information for prior periods (trend analysis).
 Those of other entities in the industry or industry averages (cross-sectional analysis).
 Budgets or forecasts (management expectations).

Main objectives of the analysis are to assess:

 The profitability of the entity.
 The operational efficiency of the entity as a whole and its various
segments/departments.
 The Liquidity ratios of the entity.
 The long term solvency and financial stability of the entity.
 The developments in future by making forecasts.

Financial analysis tools include:

 Graphics i.e. pie charts and bar charts.
 Common-size analysis of the SOFP, SOPLOCI and SOCF:
- Vertical common-size in relation to a single financial statement e.g. expressing each
item of the SOFP as a percentage of total assets or of the SOPLOCI as a percentage
of total revenue.
- Horizontal common-size in relation to the same item in prior periods.
 Financial ratio analysis

Factors considered in the analysis include the following:

 Markets in which the entity operates – whether new and expanding or contracting.
 General economic conditions – whether the economy is growing or is in recession.
 Size of the business in relation to competitors e.g. is it large to benefit from economies
of scale.
 Changes in accounting policies especially affecting the valuation of non-current assets
and inventory.
 Changes in inflation and foreign currency rates.
 Different production and purchasing policies.
 Different financing policies e.g. leasing assets as opposed to outright buying.
 Different effects of government incentives

Types of ratios
Ratios used in the analysis of financial statements are grouped into these categories:
 Profitability ratios

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 Efficiency ratios
 Liquidity ratios
 Long term solvency and financial stability ratios
 Investment ratios

When interpreting ratios, consider what each ratio means, what the change in the ratio
means and what the other information that may be needed.

1.2 Profitability ratios

These measure the entity’s ability in creating wealth for the owners. The following are the
common profitability ratios:

a) Gross profit margin = Gross profit × 100

Revenue
This may be computed using total revenue, by product, area, month, quarter etc.

In analyzing the ratio, consider the following:

 Sales prices, sales volume and sales mix.
 Purchase prices and related costs like discounts and carriage.
 Production costs, both direct and indirect.
 Inventory levels and inventory valuation, including errors, cutoff and stock-out costs.

Always compare the change in this ratio with the change in revenue over the years and the
type of business, for example, supermarkets have low with high revenue.

b) Net profit margin = Profit before interest & tax × 100

Revenue
The ratio shows how well an entity is managing its operating expenses.

In analyzing the ratio, consider the following:

 Sales expenses in relation to sales levels.
 Administrative expenses as a percentage of revenue.
 Distribution costs as a percentage of revenue.
 The effect of depreciation (e.g. higher depreciation on revalued or new assets) on each
expense category.
 The change in the ratio that do not march with the movement in gross profit margin.

c) Return on capital employed (ROCE) = Profit before interest and tax X 100
Capital employed
The ratio profit earned before paying interest and taxes that may change over time.
Capital employed = Total assets less current liabilities.
The ratio shows how efficiently a business is utilizing its resources and
assesses management performance.

In analyzing the ratio, consider the following:

 How risky is the business?
 How capital intensive is the entity?
 The current borrowing rates.
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 The change year to year.
 The ROCE for similar business – in comparability, but consider the effect of :
- Revaluation surplus.
- Policies like research and development.
- Bank overdraft.
- Investments and related income
 Asset turnover that measures how efficiently an entity uses its assets to generate sales.
Asset turnover = Revenue
Total assets

There is a trade-off between profit margin and asset turnover:

 A high profit margin due to high prices (e.g. those selling luxury goods) may lead to
reduced sales and lower asset turnover.
 A high asset turnover (e.g. those selling ordinary goods) require increased sales that
may be achieved by reducing prices which leads to a lower profit margin.

1.3 Efficiency ratios

These measure the efficiency with which an entity manages its working capital. They
include the following:

a) Inventory turnover period = Inventory × 365 days

Cost of sales
The ratio shows the average number of days inventory is held by an entity.
The higher the inventory turnover period the better, but consider the following:
 Lead times.
 Seasonal fluctuations in orders.
 Alternative use of warehouse space.
 Bulk buying discounts.
 Risks of inventory expiring of getting destroyed.

b) Receivables collection period = Trade receivables × 365 days

Credit sales
The ratio shows the average number of days taken by customers to pay debts and the
entity’s efficiency in debt collection to avoid cash being tied up in receivables and minimize
bad debts.

An increase in the number of days may be an indicator of:

 Poor debt collection
 Poor credit control
 Policy to increased debt collection period so as to attract more customers

The ratio should be compared with the stated credit policy.

One should be careful with intercompany comparison as the collection periods
for manufacturers are generally higher than those for retailers like supermarkets.
The inventory and receivables turnover periods affect an entity’s liquidity.

c) Payables payment period = Trade payables × 365 days

Credit purchases

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The figure for cost of sales is used if the one for credit purchases is not available.
The ratio shows how long a business takes to pay its suppliers.
An increase in the number of days may be an indicator of:
 Free finance from suppliers to the entity as payments to payables should be deferred as
long as possible.
 Inability to pay suppliers due to liquidity problems.

However, delayed payment of suppliers makes the entity miss cash discounts and may also
lead to less favourable terms of trade that may be offered by suppliers.

NB The working capital cycle = Inventory turnover period + Receivables turnover period –
Payables turnover period.

1.4 Liquidity ratios

These ratios measure the ability of the business to raise cash to meet its short term debts.
Liquidity ratios include the following:

a) Current ratio = Current assets

Current liabilities

The ratio shows the ability of an entity to pay its current liabilities using is current assets.
A ratio of 1.5:1 may be acceptable depending on the type of business.
The higher the ratio, the more liquid is the entity.
However, a very high ratio may suggest that funds are tied up in current assets and may not
be earning the highest returns possible.

b) Quick ratio = Current assets less inventory

Current liabilities
 This ratio includes only highly liquid assets like cash, short term investments with ready
market like treasury bills, fixed bank account deposits and trade receivables.
 The ratio excludes inventory that is not easily converted into cash.
 The ratio of 1:1 is considered adequate for most entities.
 Retailers have lower quick ratios than manufacturers.
 Some entities with fast moving inventory like supermarkets operate with lower liquidity
ratios without any cash flow problem as they have few receivables and finance
their inventory using high levels of payables and tight cash controls.
 Consider how quickly the business can raise more money to finance its operations e.g.
whether it can get an overdraft or if it has one, whether it can be extended or not.

1.5 Long term solvency and financial stability ratios

These ratios measure the ability of the entity to meet its long term financial commitments.
They are also called solvency ratios as they show the ability of an entity to pay its debt. An
entity highly indebted has high financial risk and may not:
 Easily borrow more money from financial institutions even when there is need.
 Be in position to pay dividends when earning small profit before interest and tax.
 Meet its debt obligations as the debt burden increases and may be liquidated.

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The following are the common long term financial stability ratios.

a) Debt ratio = Total debts

Total assets
Debt includes all payables, current and non-current.
b) Gearing
Gearing shows the entity’s long term capital structure i.e. the proportion of the interest
bearing debt to total capital employed:
Gearing ratio = Long term debt × 100%
Shareholders’ equity + Long term debt
Long term debt includes non-current loans & redeemable preference share capital.
Shareholders’ equity includes ordinary shares, reserves and irredeemable shares.
A company with a gearing ratio above 50% is considered highly geared and one below 50%
is low geared. The level of gearing depends is influenced by factors like the attitude
of owners and managers to risk, the availability of equity funds and the type of industry
in which the entity operates.

A highly geared entity has greater risk of

bankruptcy.
Low gearing increases prospects for more and cheaper borrowing when needed.
Businesses with inventory that is subject to rapid changes in demand and prices
like extractive or high-tech industries have unstable profits and may not have enough
assets to mortgage for loans.

c) Interest cover = Profit before interest and tax

Interest expense
The ratio shows the ability of a business to pay interest from its profits.
An interest cover of less than 2 is usually considered unsatisfactory.
The lower the interest cover, the greater the risk of defaulting on interest payments.

Overtrading is the term used to describe a situation where an entity expands its sales
rapidly without securing additional long-term capital adequate for its needs.

The following are the symptoms of overtrading:

 Increasing inventories
 Rapid increase in sales and receivables
 Rapid decline in cash and other liquid assets
 Rapid increase in trade payables
 Increasing bank overdraft

Suppliers may withhold further supplies and bankers demand reducing the overdraft. The
overdraft cannot be reduced until sales are made, which cannot be realised until goods are
produced, which in turn cannot be done until raw materials are bought and wages paid. This
may lead to a financial crisis and closure of the business.

Where there is over trading, one should consider ways of overcoming the liquidity
crisis being taken by management like:
 Negotiating longer payment terms from suppliers
 Increasing the overdraft facility
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 Selling non essential assets
 Raising additional long term capital through the issue of shares or getting more loans

1.6 Investors’ ratios

These ratios assist investors in assessing measure the quality of investment in
ordinary shares. The following are the common investors’ ratios.
Earnings per share (EPS) = Profit after tax less preference share dividend
No. of ordinary shares
EPS shows profit earned per share in the period that is available to ordinary shareholders.
This ratio is a fundamental measure of a company’s performance as the trend over time is
used in assessing the investment potential of a company’s shares. Investors interested in
holding shares in the long term are more likely to be interested in growth in EPS.

Price/Earnings (P/E) ratio = Market price per share

Earnings per share
The ratio shows whether shares appear expensive or cheap in terms of how many years’
current earnings the investors are prepared to pay for.
A high P/E ratio indicates significant future earnings growth.
A low P/E ratio reflects poor expected future growth.

Dividend per share

Dividend per share = Dividend paid to ordinary shareholders
No. of ordinary shares
The ratio is influenced by what proportion of the net profit the directors decide to pay out as
dividends and the number of shares issued.
The more the dividends paid, the less the retained earnings for future investments.

Dividend cover
Dividend cover = Earnings per share
Dividends per ordinary share
The ratio show how vulnerable the dividends are to a fall in profits.
It shows how many times an entity can pay its current dividends from the available earnings.
The higher the dividend cover, the more profits can decline without dividends being affected.

Dividend yield
Dividend yield = Dividend per ordinary share x 100
Market price per ordinary share
The ratio compares the amount of dividend per share with the market price share and
provides a direct measure of the return on investment in the shares of a company. Investors
use this ratio to assess the relative merits of different investment opportunities. The lower
the dividend yield, the more the market is expecting future growth in the dividend, and vice
versa.

1.7 Example
Your company where you are employed as Procurement manager has obtained the
following summarized financial statements from Ndugu Ltd, a potential new major supplier,
for the years ended 31 December 2011 and 2010.
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Statements of profit or loss and other comprehensive income for the years ended 31
December

2010 2011
Shs 000 Shs 000
Revenue 1,159,850 1,391,820
Cost of sales (753,450) (1,050,825)
Gross profit 406,400 340,995
Operating expenses (170,950) (161,450)
Profit from operations 235,450 179,545
Finance costs (14,000) (10,000)
Profit before tax 221,450 169,545
Income tax (66,300) (50,800)
Profit for the year 155,150 118,745
Other comprehensive income - 50,000
Total comprehensive income 155,150 168,745

Statement of financial position as at 31 December

2010 2011
Shs 000 Shs 000
Assets
Non-current assets 341,400 509,590
Current assets
Inventory 88,760 109,400
Receivables 206,550 419,455
Bank 95,400 -
390,710 528,855
Total assets 732,110 1,038,445

Equity & liabilities

Equity
Share capital 100,000 100,000
Share premium 20,000 20,000
Revaluation reserve - 50,000
Retained earnings 287,000 376,165
407,420 546,165
Non-current liabilities 83,100 61,600
Current liabilities
Payables 179,590 345,480
Bank overdraft - 30,200
Income tax 62,000 55,000
241,590 430,680
Total equity & liabilities 732,110 1,038,445

The directors concluded that their revenue for the year ended 31 December 2010 fell below
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budget and introduced measures in the year 31 December 2011 to improve the situation.
These included:
 Reducing prices
 Extending credit facilities to customers
 Leasing additional machinery in order to be able to manufacture more products

You are required to carry out a financial evaluation on the potential supplier from the
information above.

Solution
a) Profitability ratios
2010 2011
Increase in revenue 1,159,850 1,391,820 +20%

Gross profit margin: 406,400 x 100 = 35% 340,995 x 100 = 24.5%

1,159,850 1,391,820
The revenue of the company has increased by 20% in 2011 compared to 2010.

Despite the increased revenue, the gross profit margin of the company has declined from
35% in 2010 to 24.5% in 2011. Reducing selling prices has increased sales but has
also reduced gross profit.

Net profit margin: 235,450 x100 = 20.3% 179,545 x 100 = 12.9%

1,159,850 1,391,820
The net profit margin has also declined from 20.3% to 12.95%, but not as much as the gross
profit margin. The decrease may be due to higher depreciation on new machinery and lease
payments if the machines were purchased as operating leases.

ROCE = 235,450 x100 = 48.0% 179,545 x100 = 29.5%

490,520 607,765
The ROCE has dropped significantly from 48% to 29.5% mainly due to the lower gross profit
and net profit margins and the high increase in non-current assets. This may be attributed to:
 Additional machines acquired as operating leases that may have led to lower profitability
as the lease payments increase expenses.
 Additional depreciation on the higher revalued assets.
 Machines bought at the end of the year and therefore were not fully operational in the
year.

b) Efficiency ratios
Inventory turnover period: 88,760 x 365 = 43 days 109,400 x 365 = 38 days
753,480 1,050,825
The inventory turnover days have slightly increased from 38 to 43 days. This may not be a
source of concern as the increase is probably due to the increased production level.

Receivables collection period: 206,550 x 365 = 65 days 419,455 x 365 = 110 days
1,159,850 1,391,820
The receivables days have increased from 65 days and nearly doubled to 110 days. This as
a result of the strategy to increase sales, but it has even gone beyond the three
months.
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There is need to improve debt collection.

Payables payment period: 179,590 x 365 = 87 days 345,480 x 365 = 120 days
753,480 1,050,825
There is an increase in the payables payment period to a high level of 120 days.
It is mainly attributed to poor debt collection and a long credit period extended to customers.
This is likely to have led to poor credit rating of the company by suppliers and reduced its
ability to negotiate the cash discounts as discussed above.

Liquidity ratios
Current ratio: 390,710 = 1.62 528,855 = 1.23
241,590 430,680
The liquidity of the company has worsened as the current ratio has declined from 1.62 to
1.23, due to the increased payables.

Quick ratio: 390,710 - 88,760 = 1.24 528,855 - 109,400 = 0.97

241,590 430,680
This has also declined as the current ratio due to similar factors.

Long term solvency and financial stability ratios

Debt ratio = Total debts 83,100 + 241,590 = 44.3% 61,600 + 480,680 = 52.2%
Total assets 732,110 1,038,445
The debt ratio has increased by 7.9%.

Gearing ratio: 83,100 = 16.9% 61,600 = 10.1%

407,420 + 83,100 546,165 + 61,600
The gearing ratio has fallen from 16.9% to 10.1% partly as a result of the reduction in non-
current liabilities. However, the bank overdraft has increased in 2011.
Assuming that the liabilities are loans and the company used its cash resources to repay
them, it may not have been a sensitive move given the poor liquidity position.

Interest cover: 235,450 = 16.8 times 179,545 =18 times

14,000 10,000
This is very adequate and has slightly increased.

1.8 Writing a report

When required to write a report on financial analysis and interpretation of
financial statements, the report should focus on the readers’ information needs and
should include the following:
 Your address, date, the addressee, the subject matter
 An introduction – a brief introductory paragraph setting out the purpose of the
report and terms of reference and the structure of the report.
 The report body – includes a discussion on the ratios
- It should be structured with headings like profitability, efficiency, liquidity,
financial stability and investment ratios.
- Should refer to calculations (including ratios) in the appendix.
- Interpret the information and any performance measures calculated e.g. possible

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 reasons for a feature or a change.
- Link the analysis between different areas.
- State other information that might be needed or would be useful (if appropriate
or required by the question.
 The conclusion
Summarise findings and make a recommendation (if required)
 The author and signature
 The appendix – showing the computation of the ratios

Prepare a report to the directors of Ndugu Ltd assessing the financial performance and
position of the company in the year ended 31 December 2011 compared to the previous
year and advise them whether or not you believe that their strategies have been successful.

Report on Ndugu Ltd

To: The Board of directors of Ndugu Ltd

From: Business Cunsultant
Date: 10 February 2012
Subject: Report on the comparative financial performance and position of Ndugu Ltd for the
years ended 31 December 2010 and 2011

Introduction
In accordance with my terms of reference, I forward to you a report on the comparative
financial performance and position of Ndugu Ltd in 2011 and 2010 based on the analysis of
the financial statements for the two periods, highlighting whether the strategies
implemented in 2011 have been successful. The ratios used in the analysis are in the
appendix at the end of the report.

Profitability
The revenue of the company has increased by 20% in 2011 compared to 2010. It therefore
appears that the strategy of reducing prices and extending credit facilities has attracted to
customers and increased revenue. However, the revenue achieved in 2011 should be
compared with the budget for the year to establish whether the target was met.

Despite the increased revenue, the profitability of the company has worsened in 2011
compared to the previous year. The gross profit margin has declined from 35% to 24.5% and
the net profit margin from 20.3% to 12.95%. The deterioration of both ratios may be
attributed to the following factors some of which are related to the strategies pursued in
2011.

The reduction in selling prices should have led to the worsening gross profit. This
problem may be overcome by the company getting quantity discounts from suppliers
as they purchase larger quantities due to the increased sales.

The leasing of additional machinery as operating leases may also have led to lower
profitability as the lease payments increase expenses. Since the non-current liabilities have
decreased in 2011, it appears that the leases are treated as operating and not as finance
leases.
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The return on capital employed (ROCE) has dropped significantly from 48% to 29.5%
mainly due to the lower gross profit and net profit margins and the reasons discussed
above. The fall in this ratio is likely not to be due to the inefficient use of assets
because the asset turnover ratio has had only a slight fall.

The decline in the ROCE may also be attributed to the revaluation of non-current assets as
there was additional depreciation on the higher asset values.

However, the lower profitability may also be due to the purchase of more new assets, in
addition to the leased ones in order to meet the increased production needs. This may have
been the case if the assets were bought at the end of the year and were not fully operational
in the year.

Efficiency
The receivables days have increased from 65 days and nearly doubled to 110
days. Although the strategy of extending credit facilities has led to increased revenue, it
has also led to an increased credit period to customers. It is recommended that the
company should improve the debt collection so that the credit period is reduced closer to 90
days.

The increase in the receivables collection period has led to the increase in the payables
payment period to unacceptably high level of 120 days. This is likely to have led to poor
credit rating of the company by suppliers and reduced its ability to negotiate the trade
discounts as discussed above.

The inventory turnover days have slightly increased from 38 to 43 days. This may not be a
source of concern as the increase is probably due to the increased production level.

Liquidity
The liquidity of the company has worsened as the current and quick ratios have declined
from 1.62 to 1.23 and 1.24 and 0.97 respectively, partly due to the extension of credit
facilities to customers as explained by the efficiency ratios below and the
increased payables.

Long term solvency and financial stability

The gearing ratio has fallen from 16.9% to 10.1% partly as a result of the reduction in non-
current liabilities. Assuming that the liabilities are loans and the company used its cash
resources to repay them, it may not have been a sensitive move given the poor liquidity
position. The reduction in this ratio may also be attributed to the revaluation of non-current
assets.

The debt to equity ratio has substantially decreased by 9.1%. However, when we include the
bank overdraft of Shs 30,200,000 acquired in 2011, the ratio for 2011 is 16.8%, which is only
a decline of 3.6%. The gearing ratio in 2010 appears not to be high, although there is need to
compare it with the industry average before concluding that it was at a safe level, given that
the company had significant level of profits that adequately covered the finance costs.
However, it would have been more appropriate if the company had used long term debt to
finance the growth, including the acquisition of additional machinery mentioned earlier,
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instead of current liabilities.

If the company had acquired the additional machinery under finance leases, it is likely that
less expenses would be charged to the income statement and this would improve
its profitability and yet the subsequent increase in the gearing would not have
caused significant concern.

Conclusion
Although the measures taken by the directors led to an increase in revenue, the strategies
appear not to have been a complete success. The reduction in prices, the additional lease
expenses and the depreciation have worsened the profitability of the company.

The extension of the credit periods was partly successful as it increased revenue, although
it led to the deterioration of the liquidity position and the company appears to be overtrading.
In order to improve the situation, it would be appropriate to fund business expansion by
increasing long-term debt.

Signed
Appendix (in Shs 000)
2010 2011
Profitability
Increase in revenue 1,159,850 1,391,820 +20%
Gross profit margin 406,400 = 35% 340,995 = 24.5%
1,159,850 1,391,820

Net profit margin 235,450 = 20.3% 179,545 = 12.9%

1,159,850 1,391,820
ROCE 235,450 = 48.0% 179,545 = 29.5%
490,520 607,765
Efficiency
Inventory turnover period 88,760 x 365 = 43 days 109,400 x 365 = 38 days
753,480 1,050,825

Receivables collection period 206,550 x 365 = 65 days 419,455 x 365 = 110 days
1,159,850 1,391,820

Payables payment period 179,590 x 365 = 87 days 345,480 x 365 = 120 days
753,480 1,050,825
Liquidity
Current ratio 390,710 = 1.62 528,855 = 1.23
241,590 430,680

Quick ratio 390,710 - 88,760 = 1.24 528,855 - 109,400 = 0.97

241,590 430,680

Long term solvency and financial stability

Debt ratio 83,100 + 241,590 = 44.3% 61,600 + 480,680 = 2.2%
732,110 1,038,445
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Gearing ratio 83,100 = 1.9% 61,600 = 10.1%
407,420 + 83,100 546,165 + 61,600

Interest cover 235,450 = 16.8 times 179,545 =18 times

14,000 10,000

1.9 Limitations of ratio analysis

 Different accounting policies result in different figures that limit the importance of ratio
analysis. For example, different methods used in valuing inventory result in different
figures for inventory that lead to different profit figures. Different depreciation methods
result in depreciation expenses that lead to different profit figures.
 Some entities like ice cream makers, travel agents and maize millers are affected by
seasonal fluctuations that may lead to financial statements being unrepresentative of
the normal trading conditions.
 Ratios are based on financial statements that may be manipulated by window dressing.
For example, several cheques may be prepared for various supplier inorder to
reduce trade payables at the end of the financial period and are cancelled at the
beginning of the new period.
 The effects of price changes make comparison of different entities or one entity over
different accounting periods difficult unless adjustments are made for the effects of
inflation figures
 Ratios are based on historical cost information that may be outdated and not relevant
for decision making.
 Inter-firm comparison may be limited by the different non-financial factors like size.