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MODULE 6ANALYSIS AND INTERPRETATION
INTRODUCTIO
N
The purpose of accounting is to provide the various stakeholders with financial information about a
company to assist them in making informed decisions. For example, an investor who is considering
buying shares in a company would be advised to analyse and interpret the company’s financial
statements before committing himself to the share purchase.
STAKEHOLDERS
The following are the various people or institutions who might be interested in analysing the
financial statements of a company, as well as those aspects that they would be most interested in
analysing:
Shareholders and potential shareholders
The profit the company is making and the dividend they will likely receive.
The return on their investment.
The market price of the shares.
The success of the company’s corporate governance programme.
The performance of the directors during the year.
The security of their investment.
Directors
All aspects of the company.
The market price of the shares.
The impression the published financial statements gives the public.
Financial institutions
For a short-term loan (e.g. an overdraft facility):
The bank will assess if the company is liquid and has a good enough cash flow to service the
overdraft on a regular basis i.e. to make regular interest payments.
For a long-term loan (e.g. a mortgage loan):
The bank will assess if the company has enough security (normally the property itself) and can
maintain the monthly repayments over the period of the loan.
Creditors and suppliers
To determine if the company is liquid and has a good enough cash flow to pay them on time.
Employees and trade unions
To determine if the employees have job security and are receiving a fair salary or wage.
SARS
To determine that the net profit before tax has been calculated correctly so that income tax can
be levied on the correct taxable income.
To determine if the company has calculated its income tax, VAT and PAYE correctly and is
paying these regularly and on time.
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,Competitors
To compare their own prices and profitability.
The local community
The provision of jobs, the improvement of facilities and the impact the company has on the
environment.
Customers
The quality and prices of products and the quality of the service received from the company.
ANALYSING FINANCIAL
STATEMENTS
There are six main aspects of a company’s financial statements that stakeholders would be interested
in analysing: liquidity, profitability, returns and earnings, gearing and risk, share value and solvency.
Each aspect is covered in detail in following pages.
INTERPRETING THE
RESULTS
Once the various ratios have been calculated, the results can then be interpreted by comparing them
to one or more of the following:
Ratios in previous years.
Ratios of other similar companies.
The company’s objectives for the financial year.
LIQUIDITY
Liquidity measures the ability of a company to pay off its current liabilities without any difficulty.
Liquidity also reflects how well a company has handled its working capital.
THE CONCEPT OF WORKING
CAPITAL
When the founders start a company, they need to ensure that there is enough capital available for the
business to operate effectively. Capital is needed for the following:
To provide funds to set up the infrastructure of the company i.e. to purchase property,
vehicles, equipment and machinery.
To conduct the normal day-to-day business such as buying stock, paying creditors, paying
operating expenses, etc. The amount of capital that is allocated for this purpose is known as
working capital. The more working capital there is, the more liquid the company is, and vice
versa.
Companies prefer to buy their stock on credit rather than paying cash as this gives them time to sell
the stock before having to pay the creditor. The company should negotiate the best possible payment
terms with its suppliers. If the payment terms are 60 days or longer then this will give the company
time to sell its stock before having to pay the supplier. Payment terms of 30 days or less will place
the company under enormous pressure to sell its stock and get its debtors to pay them. Buying on
credit should reduce the amount of working capital the company will require, but only if the trading
cycle is working effectively.
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