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135 ChAPTER 20 – inteRpRetation oF accounts – Ratio analysis Introduction ratio analysis is a method traditionally used by people who wish to understand more fully the financial statements and performance of an entity. it may be used to identify unusual items, trends or financial problems but, to be of any use, it depends entirely on comparisons being made. these comparisons may be between the subject entity and : the industry as a whole subject entity’s prior period results management accounts forecasts other entities other related figures elsewhere in the financial statements in isolation, a calculated ratio or multiple is totally meaningless, and no useful interpretation can be drawn. 136 chApter 20: interpretAtiOn OF AccOunts – rAtiO AnAlysis Users of financial statements there is a variety of potential users of an entity’s financial statements, each of whom may have different objectives ExamplE 1 How may the following users of financial statements benefit from ratio analysis? (a) Shareholders (b) Potential investors (c) Bank and other capital providers (d) Employees (e) Management (f ) Suppliers (g) Government Paper f7 137 chApter 20: interpretAtiOn OF AccOunts – rAtiO AnAlysis categories of ratios profitability liquidity gearing investors’ ratios. ratio analysis cannot answer questions. It can only raise matters for further consideration and investigation. it must be stressed that ratio analysis on its own is not sufficient for interpreting an entity’s performance, and that there are other items of information which should be looked at, for example: the content of any accompanying commentary on the financial statements and other statements; the age and nature of the entity’s assets; current and future developments in the entity’s markets, at home and overseas, and recent acquisitions or disposals of a subsidiary by the entity; any other noticeable features of the financial statements, for example, events after the reporting period, contingent liabilities, a qualified auditors’ report, the entity’s taxation position, and involvement in research and development 138 chApter 20: interpretAtiOn OF AccOunts – rAtiO AnAlysis The key ratios Profitability Return on capital employed (or ROCE) PBIT PBIT TALCL expressed as a percentage Profit before interest and tax. It is often referred to internationally as IBIT (Income before interest and tax) Total assets less current liabilities. It is equal to the capital invested in the business (equity plus non-current liabilities) PBIT Revenue Revenue TALCL Profit available for equity Equity shareholders’ funds expressed as a percentage expressed as a multiple expressed as a percentage TALCL Profit margin Asset turnover Return on equity Liquidity Current ratio Quick ratio (or acid test) Inventory turnover Current assets : Current liabilities Current assets less inventory : Current liabilities Cost of sales Average inventory Trade receivables Credit sales Trade payables Credit purchases expressed as ratio eg 3:1 expressed as a ratio expressed as a multiple Receivables collection period × 365 expressed as a number of days Payables payment period × 365 expressed as a number of days Paper f7 139 chApter 20: interpretAtiOn OF AccOunts – rAtiO AnAlysis Gearing Debt/equity Interest bearing net debt Shareholders’ funds expressed as a percentage Debt/debt +equity Net debt Interest bearing net debt Shareholders’ funds + Interest bearing net debt expressed as a percentage long term debt net of any spare cash. In some cases, a long term bank overdraft is classed as long term debt. PBIT Interest payable expressed as a multiple Interest cover = Investors’ Ratios Dividend yield = Dividend cover = Price earnings ratio (PE Ratio) Earnings yield = Dividend per share Mid market price (MMP) Earnings per share (EPS) Dividend per share MMP EPS EPS MMP expressed as a percentage expressed as a multiple expressed as a multiple expressed as a percentage 140 chApter 20: interpretAtiOn OF AccOunts – rAtiO AnAlysis ExamplE 2 Elchin is thinking about buying a substantial interest in a competitor, Aurelija, and has a copy of Aurelija’s financial statements for the year ended 31 December, 2004. Elchin has asked you to analyse these statements and to write a report to him identifying areas which are worthy of note, and areas which will require further investigations. Aurelija’s financial statements are set out below: Statement of Comprehensive Income for the year ended 31 December, 2004 Revenue Cost of sales Gross profit Administrative expenses Distribution costs Operating profit Interest charge Profit before tax Taxation Profit after tax Proposed dividends Retained profit Statement of Financial Position as at 31 December, 2004 Tangible non-current assets Property, plant and equipment Motor vehicles Current assets Inventory Receivables Cash TOTAL ASSETS Equity share capital $1 each Retained earnings Non-current liabilities 8% Convertible bonds Current liabilities Payables Taxation Bank Proposed dividend TOTAL EQUITY AND LIABILITIES 440 49 359 24 2004 $’000 $’000 1,120 900 320 100 105 205 115 24 91 27 64 24 40 2003 $’000 $’000 1,000 760 240 74 90 164 76 76 22 54 20 34 2003 $’000 $’000 3,900 12,000 15,900 120 125 65 2004 $’000 $’000 3,600 13,000 16,600 225 280 15 520 17,120 4,000 12,048 16,048 200 310 16,210 4,000 12,008 16,008 - 872 17,120 160 22 20 202 16,210