Interpreting Financial Statements. Notes summarising all the content from lectures and includes worked examples to better understand concepts. Grade attained: 80%
INTRODUCTION: APPRAISAL OF COMPANY FINANCIAL STATEMENTS
● Ratio analysis involves relating two numbers from an entity’s financial statements to each other
to form an easily understood measure (typically a percentage) which facilitates comparison from
previous years and across entities of different sizes.
● Most stakeholders (i.e investors and lenders) with business knowledge will use ratio analysis to
evaluate the performance of an entity, both in terms of their previous performance and relative to
competitors in the market
The Purpose of Ratio Analysis
● ‘Net assets’ is equivalent to the value of equity and long-term sources of debt that are used to
finance the company. ‘Net assets’ is also known as capital employed.
● The absolute amount of profit, or assets and liabilities, shown in the financial statements is not
usually a particularly meaningful criterion for evaluating the performance or financial position of
businesses. Thus, in order to evaluate a company’s performance and financial position over time,
or in relation to other companies, it is necessary to compute various accounting ratios and
percentages.
MEASURES OF COMPANY PERFORMANCE
Return on Capital Employed (ROCE)
● Various accounting ratios are used to measure different aspects of financial performance. Many
of these are derived from a single ratio known as the ‘return on capital employed’.
● The return on capital employed is a measure of profitability that is used to indicate how
efficiently and effectively a company has utilized its assets during a given accounting period
● Net capital employed refers to the shareholders’ interests + non-current liabilities.
Profit Margin
● The profit margin is computed thus:
● The profit margin is often described as a measure of profitability that shows what percentage of
sales revenue is profit.
, ○ Different products have different profit margins. Jewellery and greengrocery, for
example, usually have a higher profit margin than electrical goods and clothing.
● The profit margin ratio may be broken down into a number of other ratios in order to pinpoint
more precisely the reasons for changes in performance over time
Asset-turnover Ratio
● The second of the ratios making up the ROCE is referred to as the asset-turnover ratio. It is
calculated as follows:
● The asset-turnover ratio measures the level of activity and productivity.
○ Different industries have different asset turnover ratios, primarily because of differences
in technology. Labour-intensive industries usually have a high asset-turnover ratio,
whereas capital-intensive industries tend to have a lower asset-turnover ratio.
● The asset-turnover ratio can be analysed further into a number of other ratios to pinpoint more
precise reasons for changes in performance overtime
● There is an important relationship between the asset-turnover ratio
and the profit margin. In order to achieve a satisfactory return on capital employed, a company
with a low asset-turnover ratio (e.g. capital-intensive) will need a high profit margin on its
products.
○ Conversely, a company with a high asset-turnover ratio (e.g. labour-intensive) will only
require a low profit margin on its products in order to achieve a satisfactory return on
capital employed.
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