Home ADVANCED LEVEL NOTES TOPIC 7 FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION – ACCOUNTANCY

TOPIC 7 FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION – ACCOUNTANCY

What is Finance?

Finance is considered to be the foundation of the basic activities of any business. Particularly in production and marketing activities, finance functions in the same way as oil functions in the operation of machines or blood functions in the human body.

In the absence of finance, nobody can imagine either setting up a business or its operations and development. The term finance is derived from the Latin word ‘finis’ which means end/finish.

Finance can also be interpreted in many ways such as fund, money, investment, capital, amount, etc. Finance act as a medium for business which involves the acquisition and usage of funds in various departments such as the production department, purchase department, research, and development, etc.

Finance also refers to the science that describes the management, creation, and study of money, banking, credit, investments, assets, and liabilities. Finance consists of financial systems, which include public, private, and government bodies, and the study of finance and financial instruments, which can relate to countless assets and liabilities.

RATIO ANALYSIS

A ratio is one number expressed in terms of another number to show the relationship between the numbers. For example the relationship between 24 and 6 is 24/6 or 4:1 indicating that the former figure is four times as greater as the letter figure/ a variation is to use a base of 100. This is Called percentage. Using the figure at 24 and 6, the percentage become 24/6 x 100 = 400%.

Financial statements (trading profit and loss A/C and balance sheet) are produced not just for their own sake, but for the use to which they can be put by the various parties interested in different aspects of these statements.

Example

1. The DIRECTORATE – interested in overall figure which show whether the company is profitable and whether it is on a sound financial footing.

2. In a manufacturing business, foremen may be concerned with time taken to complete a job or material usage.

3. Department and general managers are concerned about measurements relating to matters falling within their individual responsibilities.

4. Shareholders (actual and prospectively are interested in their earnings (current & future) out of which dividend can be paid, the security of dividend (dividend cover) return on their investment (yield ) etc.

5. External interested parties include loan creditors, for example debenture holders who are concerned that the company is solvent and there is adequate cover for their interest trade creditors (actual and prospective)

who want to be assured that the company is both solvent and liquid, that is it has adequate cash or cash convertible resources to metal current liabilities as they fall due to financial statement analysis consists of applying any tools and techniques to financial statement (other relevant data to obtain useful information).

This information is shown as significant relationship between data and trends in those data assessing the company, past performance and current financial position.

The information shows the results or consequences of prior management decisions. In addition, the information is used to make predictions that many users of financial statements.

In financial statement analysis, it is drawn that there are certain important relationships. (expressed by means of RATIOS) between items within the trading A/C, the profit & loss A/C and balance sheet between the items of one statement and another, ratio analysis is a further helping hand to the interested parties of accounting information in marking their rational decisions.

CATEGORIES OF ACCOUNTING RATIOS

Normally classified according to the aspects of business they are designed to highlight. These aspect fall under the following categories.-

1. Financial soundness and stability, short & long terms. During the short term, the interest is liquidity and during the long term the interest is solvency.

2. Profitability and return on equity or assets.

3. Activity or efficiency measures.

4. Capital structure and gearing measures.

5. Market based ratios.

A. FINANCIAL SOUNDNESS AND STABILITY

These ratios measure the ability of the firm to meet its:

1. Current of working capital ratio

Working capital is the excess of current assets over current liabilities. The current ratio indicates the ability of a company to pay its current liability from current assets. In this may show the strength of the company’s working positions. It is calculated as:

Current ratio = (Current Assets)/(Current Liabilities).

The current ratio provides a better index of a company’s ability to pay current debts than does the absolute amount of working capital.

N.B:

A number greater than one indicates a firm has the ability ot meet its current liabilities and vice versa. But this is not conclusive evidence.

2.Acid test / Quick Asset ratio

Current ratio assumes that current assets could be turned cash immediately. However not all current assets can be readily converted into cash. The acid test ratio recognizes this limitation and excludes stocks and prepaid expenses on its computation because they might not be readily convertible into cash.

The formula is:-

Acid test ratio = (Quick assets)/(current liabilities)

OR
(current assets-stock-prepaid expenses)/(current liability)

3.Debt service coverage ratio/ time interest came / interest coverage ratio

It measures the ability of a firm to service from operations this ratio is computed as.

Interest coverage ratio = (profit before interest and tax)/(Annual interest payment).

4.Debt repayment coverage ratio.

Gives an indication of the length of time it will take to repay borrowings out of profit of the business.

It is calculated as:-

= (long term liabilities+currentliabilities+current assets)/(Annual profit after interest and income tax)

5. Time preferred dividend earned ratio

This measure the ability of a company to make preferred dividend payments each year.
It given as:-

= (Net profit after interest and tax)/(Annual preferred divided)

B: PROFITABILITY AND RETURN ON EQUITY OR ASSETS

Ratios falling into this group measure the ability of a firm to generate profit’

The ability can be measured according to volume of sales or resources employed in generating the profits. These ratios measure the rate of profitability ratios. Profit is taken to be net profit prior to interest and taxes. Ratios falling under this group are:-

1. Group margin / Gross profit ratio

Specific trades / industries. The sales figure is VAT exclusive. A high gross profit percentage does not result in a large (absolute) figure of gross profit.

It is given by:-
(Gross profit )/Sales X 100

2. Operating margin / Net profit ratio/ Net profit to sales percentage reflects the percentage of each shilling of net sales that becomes net operating profit / Net profit.

The sales figure is VAT exclusive.

It is calculated as:-

Operating margin / Net profit ratio = (Profit before interest and tax)/(Net sales) x 100

Or
(Net operating income)/(Net sales) x 100

3. Return on capital employed (ROCE).

This ratio measures profit per value of net assets. The net assets figure is arrived at by using the following alternative formula:-

Capital employed –
1. Fixed assets + current assets – current liabilities

2.Total assets – current liabilities

It is given by the formula

Return on capital employed =

4. Return on total assets.

This ratio measures the ability of a firm in utilizing its total assets to generate profits

It is given by the formula, Return by total assets = x 100.

5. Return on owner’s equity

This ratio measures the return earned by the company on each shillings of shareholders equity invested.

It is given by:

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\20.png$

C. ACTIVITY OR EFFICIENCY RATIOS

Various aspects of the efficiency with which assets can be used, can be derived from turn over ratios

The most important ones are;-

1. Inventory turnover

This ratio shows the number of times a company’s average inventory / stock is sold during a period. If the rate is too low or decreasing this may indicate over – stocking or presence of obsolete merchandise.

If it is too high it may indicate under stocking or other problems, depending on the nature of the business and industry.

It is given as:

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\G4.jpg$

2. Accounts receivable turnover

This is the number of times per year that the average amount of receivable – is collected. Amount receivable – debtor. Amount A/C payable – creditor.

It is given as:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\F5.jpg$

This ratio provides an indication of how quickly the receivable (debtors) are collected.

3. Debtors average collection period/ Average collection period for accounts receivable.

Good credit control is an important aspect of sound financial management. The average length of time.

It is given by:-

Debtors average collection period=

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\D4.jpg$

Creditors average payment period.

To put the debtors average collection period in perspective credit period granted to customers should not be out of line with the credit period granted by suppliers. Good financial management should ensure a proper balance. This ratio indicates the average period measured in terms of months, weeks or days for which creditors remain unpaid.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\C5.jpg$

4. Total assets turn over / sales to total assets ratio

This ratio measures the efficiency with which a company uses its assets to generate sales.

That is it indicates how much does a shilling of an asset generate in terms of sales value. The larger the total asset turn over the larger will be the income on each shilling invested in the assets of the business.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\iimagesi\B4.jpg$ 5. Sales to capital employed ratio

It indicates the efficiency of utilization of capital employed in generating revenue.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\iimagesi\A18.jpg$ D. CAPITAL STRUCTURE AND GEARING MEASURES

Under this category the following ratios can be looked as equity or longer solvency ratios.

Show the relationship of debt and equity financing in a company. It measure the riskiness of business.

1. Equity or stock holders equity ratio

It indicates the proportion of total assets, that is provided by stock holders (owners ) on any given date.

The formula for the equity ratio is

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\298.jpg$

2. Stock holders’ equity to debt ratio.

This indicates the measure of the relative proportion of stock holders and creditors.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\309.jpg$

3. Long term debt to share holders funds

It indicates the extent of cover for fixed liabilities (loans, debentures).

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\3114.jpg$

4. Gearing

This ratio defines the proportion of debt capital and ordinary shares/equity capital. It indicates the degree of vulnerability of earnings available for ordinary shares.

Given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\329.jpg$

NB.

Some companies use ordinary share holder’s funds as denominator i.e. ordinary share capital plus reserves and some use the book value of loans and shares. Usually a gearing of greater than 1:1 is high and less than 1:1 is low.

In practice greater than 0.6:1 is regarded as high and less than 0.2:1 as low, with the range between these two extremes being regarded as relatively high or relatively low.

E. MARKET BASED RATIOS

These are additional ratios that can be computed when data from stock exchange are incorporated. The most common ones are as follows:-

1. Dividend per share

Indicates the dividend and retention policy of the company when used in line with earnings per share (below)

It is calculated as;

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\337.jpg$

2. Dividend yield (on common stock)

Indicates “current return on investment” that is it measures the real rate of return comparing the dividend paid and the market price of a share or that it measures the return on the shares invested using current market price of the shares.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\347.jpg$

It provides the investor with measure of the opportunity cost of his or her investment in terms of yield.

3. Dividend cover

It indicates the ability of a firm to sustain dividend payments out of its distributable profit.

4. Earnings per share (EPS)

It indicates the amounts of the net profit after tax (but before extra ordinary items) attributable to each ordinary share in issue, and racing for dividend during the period.

It is calculated as follows:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\356.jpg$ N.B.

Earnings available to common stock holders (ordinary) share holders) is equal to Net profit after tax (net income) minus the current years preferred dividends, whether such dividends have been declared or not. And it presents the fund which supports the distribution of profit by the way of dividend to ordinary share holders.

5. Price earnings ratio(P/E) ratio

It is usually used in establishing the market value of a company. It indicates the number of years purchase of the earnings and is regarded internationally as an indicator of future performance. It acts as the index of whether a stock is relatively cheap or expensive based on ratio.

The price earnings ratio is calculated by using the following formula;-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\366.jpg$

6. Earning yield

It indicates potential return on investment. It highlights the amount earned on the ordinary share relative to their market price.

It is given by:-

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\iimagesi\377.jpg$ LIMITATIONS OF RATIO ANALYSIS

In using ratios, the analyst must keep a few general limitations in mind. The main limitations attached to it are:-

1.It lacks standard values for the ratio, therefore scientific analysis is not possible.

2.As there are no standard with to compare, it fails to throw light on the efficiency of any activity of the business.

3.It gives only the relationship between different variables and the actual magnitudes are not known through ratio.

4.Ratio are derived from the financial statement and naturally reflect their drawbacks.

5.If fails to indicate immediately where the mistake or error lies

6.It does not take into consideration the market and other changes.

7.Seasonal factors can upset ratio analysis.

8.The basis of asset valuation can be misleading.

9.A set of account never shows a complete picture of a company’s activates.

10.Ratios vary enormously between different industries.

PROBLEM

The trading stock of Joan street, retailer, has been reduced during the year ended 31^st march 2008 by Tshs 6000 from its commencing figure of Tshs 21000. A number of financial ratios and related statistics have been compiled relating to the business of Joan street for the year ended 31^st march 2008 these are shown below:-

Net profit as % net capital employed (see below)

Net profit 15

Sales 9

Sales 166 2/3

Net capital employed

Fixed assets 45%

Working capital ratios

Current assets 400%

Current liabilities

Acid test ratio

Bank + Debtors 275%

Current liabilities

Gross profit 25%

Sales

Debtor’s collection period:

Debtors x 365days 36 ½ days

Sales

Stock turn over (based on average stock for the year 10 times

Prepare the trading and profit and loss account for the year ended 31^st 2008 and balance sheet as at that date of Joan Street in as much detail as possible.

Note:

Take the closing figure at 31^st march 2008.

Solution

Opening stock 21000

Closing stock = 21000 – 6000 = 15000

$D:\PERUZI NASI NOTES\UPAMIG~1\thlb\cr\tz\__i__images__i__\Z1.jpg$

Cost of goods sold = 18000 x 10 = 180,000

Open stock + purchases – closing stock = cost of goods sold

21000 + purchases – 15000 = 180000

Purchases = 180,000 + 15000 – 21000

= 174,000/=

Gross profit = 25%

Sales = 25/100 = ¼-1 = 1/3 x 60,000

Sales = GP + Cost of goods sold

= 60,000 + 180,000

= 240,000

Net capital employed

Current assets = 400

Current liabilities 100

Current assets = 4 current liabilities

Working capital = CA – CL

But CA = 4CL

WC = 4CL – CL

WC = 3CL

Working capital = capital employed – fixed assets

WC = 144,000 – 108,000

WC = 3600

WC = 3C.L

36000 = 3C.L

3 3

C.L =12000

Debtors x 365 = 36 ½

Sales 240,000

365 debtors = 36 ½x 240000

Debtors = 24,000

	Trading and profit & loss A/C for the year ended 31/3/2008
opening stock		21000	sales	240,000
add: purchases		174000
cost of goods available or sale			195000
less: closing stock		15000
cost of goods sold		180000
gross profit c/d		60000
240,000	240,000
expenses	38400	gross profit b/d		60,000
net profit	21600
60,000	60,000


	BALANCE SHEET AS AT 31 DECEMBER 2008
Capital	122,400	fixed assets		108,000
Add; Net profit		21600	current assets
144,000	stock	15000
current liabilities		12000	debtors	24,000
	bank	9000
156,000	156,000