ANALYSIS AND INTERPRETATION

OF FINANCIAL STATEMENTS

1
 LEARNING OUTCOMES

Describe ratio analysis.

Describe the types of ratios.

Discuss the objectives, formulae and

interpretations of the different categories of ratios.

Identify the relevant information from an annual

report of a public listed company for the application
of ratio analysis.

2
 ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENTS

What? Definition

Evaluation or assessment of financial

statements on the financial performance,
financial position and
cash flows of an entity.
 OVERVIEW OF ANALYSIS AND
INTERPRETATION OF FINANCIAL
STATEMENTS (Cont’d)

Why? Purpose

To assist the users of the financial statements

in making informed judgments and
decisions.
 ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENTS
Sources Technique
 Annual report How?
 Components of
financial statements;
 Chairman’s Statement;
 Financial Review; Ratios analysis
 Statement of Corporate
Governance;
 Directors’ Report;
 Etc.
 Press release
 Others – company
website, etc.
 RATIO ANALYSIS
• An analytical technique to assess an entity’s
1 financial strengths and weaknesses.

• Understand users information needs.

2

• Compute financial ratios (or accounting ratios).

3

• Analyse and interpret the financial ratios.

4
What’s an accounting ratio?
Financial/accounting ratio is the relationship
between two (or more) numerical values taken from
a company's financial statements.

Ratio Analysis is the analysis of a range of ratios and

the relationships between them with the aim of
building a picture of a company’s financial
performance and position.
 RATIO ANALYSIS

Ratio analysis can provide insight into

an entity’s health and its competitive
position if they are put into perspective.

 It provides a QUICK and SIMPLE means

of examining the financial health of a business.
 It is only the starting point for further
analysis and some care is required when making
conclusions
 The Need for comparision
A ratio on its own is not significant

Need to compare it with something else.

Can compare ratio with:

1.Ratio of previous period

2.Forecast Ratios
3.Ratio of a similar business
 TYPES OF RATIOS
Profitability
……………….
1
Ratios
…………..…
Investment Liquidity
……………
5 2
Ratios Types of Ratios
Ratios

Financial
…………..…gearing Efficiency
…………..…
4 3
Ratios Ratios
 Types of ratio
Category of ratio What it reveals

Profitability How successfully is the

business trading?

Liquidity How easy is it for the

business to pay its way?

Efficiency How effectively are the

short-term assets and
liabilities of the business
being managed?
Demonstration Exercise 8.1

Who might be particularly interested in each type of

ratio?

Profitability

Liquidity

Efficiency
 TYPES OF RATIOS (Cont’d)
 Now let us start to conduct a ratio analysis on
the financial statements of NEXT Plc (2019)

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 Next Plc
Next plc is a British multinational clothing, footwear and
home products retailer headquartered in Leicestershire,
United Kingdom. It has around 700 stores, of which circa
500 are in the United Kingdom, and circa 200 across
Europe, Asia and the Middle East. Next is the largest
clothing retailer by sales in the United Kingdom, having
overtaken Marks & Spencer in early 2012 and 2014. It is
listed on the London Stock Exchange and is a constituent of
the FTSE 100 Index.

1
 Profitability ratios
Measure the degree of an entity’s success in
achieving desired ……………
profit levels.
e s Examples of profitability
tiv ratios: -
e c 1
j
Ob 1 Gross profit margin
5 2 2
Operating profit
Profitability margin
Ratios 3 Net profit margin

4 3 4 Return on Capital Employed

5 Etc..
 Profit Margin Ratios
We compare the profits made with the sales level:

Gross Profit Net Profit

Margin Margin (before
Taxation)

Operating Profit Net Profit

Margin Margin (after
Taxation)
 PROFITABILITY RATIOS (Cont’d)
Fo
rm
ula
e
£1,474.2 millions
Gross profit ? Gross profit
X 100%
margin ?
Sales revenue
2019: 35.4% £4,167.4 millions

£762.0 millions
Operating profit Operating profit
?

X 100%
margin Sales revenue
17
?

2019: 18.3% £4,167.4 millions

 PROFITABILITY RATIOS (Cont’d)
Fo
rm
ula
e £722.9 millions
Profit before
Net profit ? taxation
margin X 100%
(before taxation)
?Sales revenue
£4,167.4 millions
2019: 17.3%
or
£590.4 millions
Profit after
Net profit
? taxation
margin X 100%
?
(after taxation) Sales revenue
2019: 14.2% £4,167.4 millions
 Profitability Ratios: Return on Capital
Employed (ROCE)
Key profitability ratio

How effectively management uses the funds invested in the business

to generate profits

Identifies whether owners (shareholders) would be better off placing

their money in a bank deposit account rather than leaving it invested
in the company

ROCE enables comparison with alternative investments opportunities

 PROFITABILITY RATIOS (Cont’d)
Fo
rm
ula
e

Operating Profit
Return on ?

capital X 100%
employed ?

Total equity+ Non

current liabilities
 PROFITABILITY RATIOS (Cont’d)
Fo
rm
ula
e £762.0 millions
2013: 44.86%
Operating Profit
Return on ?

capital X 100%
employed ?

Total equity+ Non

current liabilities

£(553.8+1,145) millions
 PROFITABILITY RATIOS (Cont’d)
No. Ratios 2019 2018
1 Gross profit margin ?
35.4% ?
34.2%
2 Operating profit margin ? ?

3 Net profit margin 18.3% 18.6%

 Before taxation ? ?

 After taxation ?
17.3% ?
17.8%
4 Return on capital ? 14.2% ? 14.5%

employed
44.86% 46.15%
 LIQUIDITY RATIOS
Measure an entity’s ability to meet its short term financial
obligations when they are due.
…………….…
e s
tiv Examples of liquidity
c
bje 1 ratios: -
O
1 Current ratio
Liquidity
Ratios
2 Acid test (Quick) ratio

25
2
 LIQUIDITY RATIOS
(Cont’d)
Fo
rm
ula
e

?
Current assets
Current ratio
? Current liabilities

Current assets
?
(excluding inventories)
Acid test (Quick)
ratio ?
Current liabilities 26
 LIQUIDITY RATIOS
(Cont’d)
Fo
rm
ula
e
£2,032.2 millions
?
Current assets
Current ratio
? Current liabilities
2019: 1.83 times £1,112.5 millions
£(2,032.2 – 502.8) millions
2019: 1.37 times Current assets
?
(excluding inventories)
Acid test (Quick)
ratio ?
Current liabilities
£1,112.5 millions
28
 LIQUIDITY RATIOS (Cont’d)
No. Ratios 2019 2018
1 Current ratio 1.83 : 1
? ?
1.94 : 1
2 Acid test (Quick) ratio ? ?
1.37 : 1 1.45 : 1

 Current ratio (norm) = 2 times or 2:1.

 Acid test (Quick) ratio (norm) = 1 time or 1:1.

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more
 The higher the current ratio, the …………. liquid
an entity appears to be.
 EFFICIENCY RATIOS
Measure the effectiveness of an entity’s use of
……………
resources
.
e s Examples of efficiency ratios: -
tiv
c Inventory
bje 1 1
O turnover period
Efficiency Settlement
4 2 2
Ratios period for trade receivables
Settlement
3 3
period for trade payables
4 Etc.
30
 EFFICIENCY RATIOS
Fo
rm
ula
(Cont’d)
e £502.8 millions
Inventories held
Inventories ?

X 365 days
turnover period ?
Cost of sales
2019: 70 days £2,640.5 millions

3
 EFFICIENCY RATIOS
Fo
rm
ula
(Cont’d)
e £1,339.8 millions

Trade
Settlement ?
receivables
period for trade X 365 days
?
receivables Sales revenue
£4,167.4 millions
2019:118 days (Apply “Credit sales revenue” if it is available.)

3
 EFFICIENCY RATIOS
Fo
rm
ula
(Cont’d)
e £640.7millions
Average
Settlement ?
trade payables
period for trade X 365 days
? Cost of sales
payables
£2,640.5 millions
2019:89 days (Apply “Credit purchases” if it is available.)

3
 EFFICIENCY RATIOS (Cont’d)
No. Ratios 2019 2018
1 Inventory
turnover period ?
70 days
?
64 days
2 Settlement period
for trade receivables ? ?

3 Settlement period for 118 days 112 days

trade payables
89days 80 days