(Unit 57, Page 394)

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Purpose of Publishing Financial
Statements
To provide information about the
financial;
•position,
•performance
of an entity that is useful to a
wide range of users
in making economic decisions.
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Users of Financial Information
• Present and potential investors
• Lenders and potential lenders
• Suppliers
• Employees
• Government
• General public

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 Steps in Investigating Process
Information in the financial statements can be interpreted
by using ratio analysis.

Identify
Presentation
Interpret

Compare
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 Identify – Figures that are relevant must be identified
and suitable data must be used.

 Presentation – Figures can be compiled and

presented into a useful form. Ex; Percentages

 Interpretation – Ratios can be used to find the firm’s

financial position, assess performance, analyze capital
structure.

 Comparison – Comparison might include

comparisons over time, inter-firm comparisons and
inter-firm comparisons over time.

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 Seven-point Approach
 Reason – Reason for interpreting financial accounts
 Identification – Identify relevant figures
 Process – Decide what method will provide the most
useful and meaningful results
 Calculation – Calculating one figure as a ratio of another
 Comparison
 Interpretation – Interpret results in relation to values that
would be considered poor, average or good.
 Action – If certain results are worrying take corrective
action.
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Ratio Analysis

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 RATIOS

Profitability Efficiency Liquidity Investment

Ratio Ratio Ratio Ratio

Wealth generation Resource Usage Ability to meet liabilities Share performance

Performance Position based

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Liquidity Ratios

Whether the business

in a position to repay
its short-term debts..

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 Current Ratio
Current Asset = Current Assets
Ratio Current Liabilities

 Ideal level = 1.5 : 1 – 2 : 1

 This means that, for every £1 of short-term debts
owed, the business has £2 of assets to pay them.
 Too high – suggest that too much of its assets are tied
up in unproductive activities; these could be invested
more profitably.
 Too low - risk of not being able to pay debts 10
 Altering the Ratio
If the ratio is low that is becoming hard to pay the
short-term debts. The company will have to bring
more cash into the balance sheet. This could be done
by;

 Selling under used fixed assets

 Raising more share capital
 Increasing long-term borrowings
 Postponing planned investments

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 Acid Test (Quick) Ratio
Current Asset = Current Assets - Inventories
Ratio Current Liabilities

 Inventories are omitted because it takes a long time to

convert stock into cash.
 Ideal level = 1 : 1
 This shows business has £1 of short-term assets for every
£1 of short-term debt.
 A ratio of 0.5 : 1 would suggest the firm has twice as many
liabilities as it has cash to pay for those liabilities. This
might put the firm under pressure.
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Profitability Ratios

How well the

business is doing

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Return On Capital Employed (ROCE)
ROCE = Profit before tax and interest X 100
Total Capital Employed

 Capital employed = Debt + Equity

 The higher the value is better
 Shows how effective the firm is in using its capital (funds
invested) to generate profit
 There is no right level of ROCE. Most companies would regard a
20% ROCE as satisfactory.
 A ROCE of 20% means that it uses every £1 of capital to generate
20p in profit
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Altering the Ratio
 ROCE can be improved by;

 Increasing the level of profit generated by the same

level of capital invested

 Maintaining the level of profits generated but

decreasing the amount of capital it takes to do so.

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Gross Profit Margin
Gross Profit = Gross Profit X 100
Margin Sales Revenue

 Sales Revenue is the total value of sales income generated

from sale of goods or services.

 GPM - higher the better

 Shows the gross profit made on sales turnover.

 A gross profit margin of 45% means that for every £1 of sales,

the firm makes 45p in gross profit
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Altering the Ratio
 The gross profit margin can be improved by;

 Raising sales revenue while keeping the cost of sales

the same

 Reducing the cost of sales made while maintaining the

same level of sales revenue

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 Profit for the Year Margin
Profit for the year = Profit before tax and interest X 100
Margin Turnover

 A measure of business performance/profitability based on the

ratio of profit to sales value

 Profit for the year margin measures how well a business

controls its overheads.

 The difference between gross and net margin is small, it

suggests that overheads are low.

 The higher the value is better 18

Gearing Ratios
Shows long-
term financial
stability of the
business

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 Gearing Ratio
Gearing = Non-Current Liabilities X 100
Ratio Capital Employed

 Shows how reliant the business is upon borrowed

money.

 The higher the ratio the more the business is exposed

to interest rate fluctuations and to having to pay back
interest and loans before being able to re-invest
earnings

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Altering the Ratio

•Raising Gearing •Reducing Gearing

•Buy back ordinary •Issue more ordinary
shares shares
•Issue more •Buy back debentures
preference shares •Retain more profits
•Issue more •Repay loans
debentures
•Obtain more loans

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Advantages of Ratio Analysis
 Simplicity – Easy to calculate

 Speed – can be carried out very quickly

 Comparisons – Ideal for making comparisons.

 Decision making – Can help to identify

strength and weaknesses in the business.
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Disadvantages of Ratio Analysis
 Qualitative information is ignored
 Limitation of the balance sheet – snap shot of the business
at the end of the financial year. Therefore judgments made
on this should be kept in context.
 The quality of final accounts (accuracy)
 Firms may use different accounting practices therefore it is
important to compare “like-for-like”
 When making comparisons changes in the external
environment should be considered.
 Information about other factors such as future demand
would be useful to help judge the wider performance of the
business.
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