ACCA F7 (INT) Financial Reporting - Study text - 2010

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Paper F7 (INT)

Financial reporting

CHAPTER

Analysing and interpreting

financial statements

Contents

1 Purpose of financial ratio analysis

2 Return on capital, profitability and asset turnover

3 Working capital efficiency ratios

4 Liquidity ratios

5 Debt ratios

6 Investor ratios

7 Limitations of interpretation techniques

8 Specialised, not-for-profit and public sector entities

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Purpose of financial ratio analysis

 Obtaining information from the financial statements: financial ratios

 Using ratios: comparisons

 Categories of financial ratios

 Users of the financial statements and their information needs

1 Purpose of financial ratio analysis

A requirement of the examination is that you should be able to analyse the financial

statements of either a single company or a group, calculate suitable financial ratios

and comment on them. You will be required not only to calculate the ratios, but also

to interpret them and suggest what they might indicate about the financial position

and financial performance of the company or group.

1.1 Obtaining information from the financial statements: financial ratios

Financial statements are used to make decisions. They are used by shareholders and

investors, and also by lenders, as well as by management. The financial statements

contain a large number of figures, but the figures themselves do not necessarily

have much meaning to a user of the financial statements. However, the figures can

be analysed and interpreted by calculating financial ratios.

Financial ratios can help the user of the financial statements to assess:

 the financial position of the entity, and

 its financial performance

1.2 Using ratios: comparisons

Financial ratios can be used to make comparisons:

 Comparisons over a number of years. By looking at the ratios of a company over

a number of years, it might be possible to detect improvements or a

deterioration in the financial performance or financial position of the entity.

Ratios can therefore be used to make comparisons over time, and to identify

changes or trends

 Comparisons with the similar ratios of other, similar companies for the same

period.

 In some cases, perhaps, comparisons with ‘industry average’ ratios.

Chapter 21: Analysing and interpreting financial accounts

1.3 Categories of financial ratios

The main financial ratios can be classified as:

 financial performance: return on capital, profitability and use of assets

 working capital ‘turnover’ ratios

 liquidity ratios

 debt ratios

 investor ratios.

1.4 Users of the financial statements and their information needs

The IASB Framework identifies several groups of people who may use financial

statements:

 investors and potential investors

 lenders

 employees

 suppliers

 customers

 government and government agencies

 the general public.

All these groups are interested in financial performance, financial position and cash

flows, but some users are mainly interested in performance and profitability, while

others may be more interested in liquidity and gearing or other matters.

For example:

 A private investor needs to know whether to continue to hold shares or to sell

them. He or she will tend to be most interested in profitability ratios (such as

gross and net profit margin and return on capital employed) and investor ratios

(such as earnings per share, dividend cover and price earnings ratio).

 A potential acquirer needs information about an entity’s profitability and

probably also information about whether or not the entity is managed efficiently.

The acquirer’s management is likely to focus on profit margins, return on capital

employed, asset turnover and working capital ratios.

 A bank that has been approached to lend money to an entity needs to know

whether it will receive interest payments when these are due and whether the

money that it lends will eventually be repaid. A bank manager will normally be

most interested in cash flows and liquidity ratios (current ratio, acid test ratio)

gearing and interest cover. A potential lender will also be interested in

predicting future performance as without sales there will be no cash.

An examination question might ask you to interpret an entity’s financial statements

for the benefit of specific people or groups of people. Therefore your analysis should

focus on the needs of the user. What do they need to know? What are they

interested in? What decision do they need to make?

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Return on capital, profitability and asset turnover

 Return on capital employed

 Return on shareholder capital

 Analysing return: profitability and asset utilisation

 Profit/sales ratio (and cost/sales ratios)

 Sales/capital employed ratio

 Percentage annual growth in sales

2 Return on capital, profitability and asset turnover

The aim of ‘profitability ratios’ is to assess the financial performance of a profit-

making entity and the return that it makes on the capital invested.

2.1 Return on capital employed

Profit-making companies should try to make a profit that is large enough in relation

to the amount of money or capital invested in the business. The most important

profitability ratio is probably return on capital employed or ROCE.

For a single company:

100%

capital debt term-Long +reserves and capital Share

taxation and interest before Profit

= ROCE ×

The capital employed is the share capital and reserves, plus long-term debt capital

such as bank loans, bonds and loan stock.

Where possible, use the average capital employed during the year. This is usually

the average of the capital employed at the beginning of the year and end of the year.

Example

Sting Company achieved the following results in Year 1.



1JanuaryYear1 31December Year1



$ $

Sharecapital 200,000 200,000

Sharepremium 100,000 100,000

Retainedearnings 500,000 600,000

Bankloans 200,000 500,000

Chapter 21: Analysing and interpreting financial accounts

Profitbeforetax 210,000

Incometaxexpense 65,000



–

––––––

Profitaftertax 145,000



–

––––––

Interest charges on bank loans were $30,000. Dividend payments to shareholders

were $45,000. Sales during the year were $5,800,000.

Required

Calculate the return on capital employed for Year 1.

Answer

Capital employed at the beginning of the year = $1,000,000.

Capital employed at the end of the year = $1,400,000.

Average capital employed = [$1,000,000 + $1,400,000]/2 = $1,200,000.

Profit before interest and taxation = $210,000 + $30,000 = $240,000.

20%=100%

1,200,000

240,000

= ROCE ×

This ROCE figure can be compared with the ROCE achieved by the company in

previous years, and with the ROCE achieved by other companies, particularly

competitors.

Groups of companies and ROCE

To calculate the ROCE for a group of companies, it is necessary to decide what to do

with any non-controlling interest (minority interest). Since capital employed

includes all the debt capital in the group, it makes sense to include the non-

controlling interest (minority interest) in the capital employed.

ROCE should therefore be measured as profit before interest and tax as a proportion

of total capital employed,

including the non-controlling interest (minority

interest)

2.2 Return on shareholder capital

Return on shareholder capital (ROSC) measures the return on investment that the

shareholders of the company have made. This ratio normally uses the values of the

shareholders’ investment as shown in the statement of financial position (rather

than market values of the shares).

100%

reservesandcapitalShare

taxationafterProfit

=ROSC ×

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The average value of shareholder capital should be used if possible. This is the

average of the shareholder capital at the beginning and the end of the year.

Profit after tax is used as the most suitable measure of return for the shareholders,

since this is a measure of earnings (available for payment as dividends or for

reinvestment in the business).

Example

Using the figures in the previous example:

Shareholders’ capital at the beginning of the year = $200,000 + $100,000 + $500,000

= $800,000.

Shareholders’ capital at the end of the year= $200,000 + $100,000 + $600,000

= $900,000.

Average shareholders’ capital employed = [$800,000 + $900,000]/2 = $850,000.

17.06% = 100%

850,000

145,000

= ROSC ×

Groups of companies and ROSC

When calculating the ROSC for a group of companies, the main focus of attention is

normally the return on the investment of the shareholders in the parent company.

The ROSC should therefore be calculated as:

100%

company parent the of holders equity to leattributab Equity

interest minority andtaxation after Profit

The share capital and reserves should not include the non-controlling interest

(minority interest) in the equity reserves.

2.3 Analysing return: profitability and asset utilisation

The size of the return on capital employed, or the size of the return on shareholders’

capital, depends on two factors:

 the profitability of the goods or services that the entity has sold

 the volume of sales that the entity has achieved with the capital and assets it has

employed: this is known as asset utilisation or asset turnover.

2.4 Profit/sales ratio (and cost/sales ratios)

The profit/sales ratio is the ratio of the profit that has been achieved for every $1 of

sales.

100%

Sales

Profit

= ratio esProfit/sal ×

Chapter 21: Analysing and interpreting financial accounts

Profit/sales ratios are commonly used by management to assess financial

performance, and a variety of different figures for profit might be used.

The definition of profit can be any of the following:

 Profit before interest and tax

 Gross profit (= Sales minus the Cost of sales) = ‘gross profit ratio’

 Net profit (= Profit after tax) = ‘net profit ratio’.

It is important to be consistent in the definition of profit, when comparing

performance from one year to the next.

The gross profit ratio is often useful for comparisons between companies in the

same industry, or for comparison with an industry average.

It is also useful to compare the net profit ratio with the gross profit ratio. A high

gross profit ratio and a low net profit ratio indicate high overhead costs for

administrative expenses and selling and distribution costs.

Example

Using the figures in the previous example, profit/sales ratios can be calculated as

follows:

 If profit is defined as profit before interest and tax, the profit/sales ratio =

$240,000/$5,800,000 = 0.0414 = 4.14%

 If profit is defined as profit after interest and tax, the profit/sales ratio =

$145,000/$5,800,000 = 0.025 = 2.5%

It is also useful to monitor the ratio of costs to sales:

 Ratio of (Cost of sales/Sales) × 100%

 Ratio of (Administration costs/Sales) × 100%

 Ratio of (Selling and distribution costs/Sales) × 100%

2.5 Sales/capital employed ratio

The sales/capital employed ratio is also called the ‘asset turnover ratio’. It measures

the amount of sales achieved during the period for each $1 of investment in assets.

capital debt term-Long+reserves and capital Share

Sales

=ratio turnover Asset

It is measured as ‘x times a year’.

The sales/capital employed ratio is also a ratio of sales to (assets – current

liabilities). This is because capital employed = total assets minus liabilities excluding

long-term debt.

Paper F7: Financial reporting (International)

Example

Using the figures in the previous example, the asset turnover ratio =

$5,800,000/$1,200,000 = 4.83 times.

Note that:

ROCE = Profit/sales ratio × Asset turnover ratio

(where profit is defined as profit before interest and taxation).

Using the figures in the previous example:

ROCE = Profit/sales × Sales/capital

employed

  

240,000

=

240,000

×

5,800,000

1,200,000 5,800,000 1,200,000

  

20% = 4.14% × 4.83times

2.6 Percentage annual growth in sales

It can be useful to measure the annual growth (or decline) in sales, measured as a

percentage of sales in the previous year.

For example, if sales in the year just ended were $5,800,000 and sales in the previous

year were $5,500,000, the annual growth in sales has been ($300,000/$5,500,000) ×

100% = 5.45%.

Chapter 21: Analysing and interpreting financial accounts

Working capital efficiency ratios

 Purpose of working capital efficiency ratios

 Average time to collect (receivables days or days sales outstanding)

 Average time for holding inventory (inventory turnover)

 Average time to pay suppliers

 Cash operating cycle/working capital cycle

 Working capital efficiency ratios and consolidated accounts

3 Working capital efficiency ratios

3.1 Purpose of working capital efficiency ratios

Working capital efficiency ratios measure the efficiency with which the entity has

managed its receivables, inventory and trade payables. The ratios are usually

measured in terms of an average number of days.

The working capital ratios are a useful measure of whether the entity has too much

or too little invested in working capital.

Excessive investment in working capital is indicated by a long cash cycle (a long

working capital cycle) that appears to be getting even longer. When too much is

invested in working capital, the return on capital employed and ROSC will be lower

than they should be.

Under-investment in working capital is an indication of possible liquidity

difficulties. When working capital is low in comparison with the industry average,

this might indicate that current assets are being financed to an excessive extent by

current liabilities, particularly trade payables and a bank overdraft.

(The cash cycle, also called the operating cycle and the working capital cycle) is

explained later.)

3.2 Average time to collect (receivables days or days sales outstanding)

This ratio estimates the time that it takes on average to collect the payment from

customers after the sale has been made. It could be described as the average credit

period allowed to customers or the ‘average collection period’.

days 365

Sales

sreceivable Trade

= collect to days Average ×

Trade receivables should be the average value of receivables during the year. This is

the average of the receivables at the beginning of the year and the receivables at the

end of the year.

Paper F7: Financial reporting (International)

However, the value for receivables at the end of the year is also commonly used.

Sales are usually taken as total sales for the year. However, if sales are analysed into

credit sales and cash sales, it is probably more appropriate to use the figure for credit

sales only.

The average time to collect money from credit customers should not be too long. A

long average time to collect suggests inefficient collection of amounts due from

receivables.

3.3 Average time for holding inventory (inventory turnover)

This ratio is an estimate of the average time that inventory is held before it is used or

sold.

days365

salesofCost

Inventory

=turnoverInventory ×

In theory, inventory should be the average value of inventory during the year. This

is the average of the inventory at the beginning of the year and the inventory at the

end of the year.

However, the value for inventory at the end of the year is also commonly used,

particularly in examinations.

3.4 Average time to pay suppliers

The average time to pay suppliers may be calculated as follows:

days365

purchasesofCost

payablesTrade

=paytotimeAverage ×

Trade payables should be the average value of trade payables during the year. This

is the average of the trade payables at the beginning of the year and the trade

payables at the end of the year.

However, the value for trade payables at the end of the year is also commonly used

When the cost of purchases is not available, the

cost of sales should be used instead.

This figure is obtained from the profit and loss information in the statement of

comprehensive income.

Example

The following information is available for The Brush Company for Year 1.



1JanuaryYear1 31DecemberYear1

 $ $

Inventory 300,000 360,000

Tradereceivables 400,000 470,000

Tradepayables 150,000 180,000

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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