CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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SOLUTIONS TO REVISION QUESTIONS C2

500

THE FINANCIAL STATEMENTS OF LIMITED COMPANIES AND THE STATEMENT OF CASH FLOWS

(b) Statement of cash ﬂ ows for the year ended 31 March 20X2

$’000

Cash ﬂ ow from operating activities

Increase in retained earnings (1,240  1,200) 40

Add: dividends declared 260

Add: depreciation 220

Less: proﬁ t on sale of non-current assets (10)

510

Less : increase in inventories (600)

Less : increase in receivables (400)

Add : increase in payables 280

(210)

Cash ﬂ ow from investing activities

Proceeds of sale of non-current assets 40

Non-current assets purchased (350)

(310)

Cash ﬂ ow from ﬁ nancing activities

Dividends declared (300)

Shares issued 500

200

Decrease in bank balance (320)

Bank at beginning of period 200

Bank at end of period (120)

Solution 9

Meltdown Ltd–Statement of comprehensive income

Revaluation

Reserve

Retained

Earnings

Total

42 100 142

Meltdown–Statement of ﬁ nancial position

Non-current assets Property 460

Equity–Revaluation reserve 42

Non-current liabilities Income tax 18

Proﬁ t for the period 100

Other comprehensive income

Revaluation of property before tax 60

Tax on revaluation (18)

Total comprehensive income 142

Meltdown Ltd–Statement of changes in equity

The Interpretation of

Financial Statements

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503

LEARNING OUTCOMES

When you have completed this chapter, you should be able to:

䉴 calculate and interpret basic ratios.

14.1 Introduction

You have now reached one of the most important areas of study in this subject – the use

and interpretation of accounting information. You now know how to prepare ﬁ nancial

statements for various organisations, from a variety of different sources of data, but now we

return to the content of Chapter 1 and the questions it posed: What is accounting, who uses

ﬁ nancial statements and for what purpose, and what makes ﬁ nancial statements useful? The

mechanics of the preparation of ﬁ nancial statements form only the start of the account-

ing process, the end result of which is to provide users with information to enable them to

make decisions. The mere presentation of a set of ﬁ nancial statements does not necessarily

achieve that objective, and this chapter looks at ways of making that information more

meaningful.

Understanding the whole of this chapter should be regarded as essential for examination

success.

14.2 What is meant by ‘ interpretation

of financial statements ’ ?

Financial statements provide a great deal of information. However, one difﬁ culty with

these statements is that they show only absolute ﬁ gures for a particular period, and at the

end of that period. To enable users to make informed decisions, the statements on their

The Interpretation of

Financial Statements

STUDY MATERIAL C2

504

THE INTERPRETATION OF FINANCIAL STATEMENTS

own do not always provide sufﬁ cient information, even though they have been prepared in

accordance with international ﬁ nancial reporting standards.

Example 14.A

Suppose that Company A has a trading account that shows sales revenue of $100,000 and the proﬁ t for

the year is $5,000. What does this tell you? It tells you that the sales revenue is $100,000 and the proﬁ t is

$5,000. Is this good or bad? Is this to be expected? Is this comparable with other organisations? Can a user of

the ﬁ nancial statements make decisions on the basis of this information?

The answer is no. That information on its own is not of use. Let us consider two other companies as well.

Company B has sales revenue of $200,000 and proﬁ t form the year of $6,000. Company C has sales rev-

enue of $300,000 and proﬁ t for the year of $4,500. Which of the three organisations is best? That depends

on what the user is looking for.

If the user is looking for the organisation with the highest revenue, that is Company C. If (s)he is looking for

the organisation with the highest proﬁ t, that is Company B. Which organisation is most successful, in terms of its

proﬁ t? You might think it is Company B, with its higher proﬁ t. But Company B achieved that proﬁ t from sales of

$200,000, whereas Company A had only half that level of sales yet achieved a proﬁ t of only $1,000 less than

Company B.

We are now embarking on an important area of accounting, that of comparison . We are starting to compare

proﬁ t with sales revenue, and we are comparing one ﬁ rm with another. That is the key technique of the interpre-

tation of ﬁ nancial statements – comparison of one with another.

Let us tabulate the information given above:

Company Sales revenue Proﬁ t

A $100,000 $5,000

B $200,000 $6,000

C $300,000 $4,500

There are comparisons we can make here. Although Company B had the highest proﬁ t, it was only 3 per cent of

its sales revenue. That is found by the following formula:

Profit

Sales

 100

Company A achieved a proﬁ t of 5 per cent of sales, and Company C achieved a proﬁ t of only 1.5 per cent.

So Company C looks poor.

But that is taking only 1 year as information. It would be useful to look at last year’s results and see if any of

the companies have improved their proﬁ ts.

It might also be useful to compare the proﬁ t with other ﬁ gures, apart from sales. Suppose that the capital

employed in Company A is $50,000. A proﬁ t of $5,000 is a 10 per cent return on that capital. Suppose that

Company C’s capital employed is only $30,000. Its return on that capital is 15 per cent – so an investor might

prefer to choose Company C, while a lender might prefer Company B.

The point is that different users are looking for different information, which a set of ﬁ nancial statements on its

own does not necessarily provide. Comparing ﬁ gures with other ﬁ gures is a useful additional tool in providing

information to support decision-making. These tools are known as the techniques of ratio analysis.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.3 Calculating ratios

A ratio is simply a comparison of one ﬁ gure with another. In the above examples, we cal-

culated the percentage of proﬁ t compared with sales revenue for each year.

Using the formula above, for Company A the calculation is:

5 000

100 000

100 5

%

Calculating a percentage is only one method of presenting a ratio. The same ﬁ gures

could

be presented as a fraction:

5 000

100 000



which means that proﬁ t was

of sales revenue. The ﬁ gures could also be shown as a sim-

ple comparison:

5 000 100 000 1 20,:, : or

which means that each $1 of proﬁ t r

equired $20 of sales revenue.

There are other types of ratios, which will be explained later in the chapter.

14.3.1 Using the ratios

Calculating the ratios is only one step in the analysis process. Once that is done, the results

must be compared with other results. Comparison is commonly made between:

●

previous accounting periods;

●

other companies (perhaps in the same type of business);

●

budgets and expectations;

●

government statistics;

●

other ratios.

14.4 Types of ratios

Ratios can be classiﬁ ed into various groupings, according to the type of information they

convey. The main groupings are as follows:

●

p r o ﬁ tability (performance) ratios;

●

liquidity (solvency) ratios;

●

e f ﬁ ciency (use of assets) ratios;

●

capital structure (gearing) ratios;

●

security (investors) ratios.

The last group, security ratios, is not part of your syllabus for this subject. The above list is

not exhaustive – a ratio can be compiled from any data if it can be usefully interpreted.

STUDY MATERIAL C2

506

THE INTERPRETATION OF FINANCIAL STATEMENTS

The following income statement and statement of ﬁ nancial position will be used to

illustrate the calculation of accounting ratios and interpret them.

Income statement for the year ended 31 December year 8

$ $

Sales 23,636

Opening inventories 1,225

Purchases 8,999

10,224

Closing inventories (1,425)

Cost of sales (8,799)

Gross proﬁ t 14,837

Expenses (5,737)

Operating proﬁ t 9,100

Interest payable on bank loan (450)

P r o ﬁ t before tax 8,650

Income tax (1,000)

P r o ﬁ t for the period 7,650

Statement of ﬁ nancial position as at 31 December year 8

Assets $ $

Non-current assets 14,135

Current assets

Inventories 1,425

Receivables 542

Bank 7,037

Cash in hand 697

9,701

23,836

Equity and liabilities

Equity 18,250

Non-current liability

Bank loan 4,500

Current liability

Payables 1,086

23,836

14.5 Profitability ratios

These are also known as performance ratios . They compare proﬁ t at different levels with

other ﬁ gures, and are often presented as percentages.

507

FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.5.1 Gross profit margin

This ratio (also known as the gross proﬁ t to sales revenue ratio ) is calculated by:

Gross Profit

Sales

 100

14 837

23 636

100 62 8

t is normally expressed as a percentage, but do try to understand the meaning of the per-

centage. The calculation shows that for every $1 of sales revenue, 62.8 ¢ were available to

support the remaining expenses, the possible payment of dividends and the retention of

proﬁ ts for the future. While its value is useful for comparing the results of similar busi-

nesses, the trend of gross proﬁ t margins over time is a more appropriate use of the ratio.

Suppose the ratio in the previous year had been 64.3 per cent. How can we interpret the

decline over the year?

There are several possibilities:

●

sales revenue declined;

●

sales revenue remained the same, but costs have increased;

●

sales revenue increased, but costs increased by a greater proportion;

●

it was necessary to keep sales prices steady, despite rising costs, in order to retain market

share;

●

suppliers increased their prices, or perhaps the ﬁ rm lost the advantage of trade discounts;

●

the sales mix changed: if several different products are being sold they will not all be

equally proﬁ table. It is possible that in the current year we sold a higher proportion of

the less proﬁ table products.

You can perhaps see that the above changes can be classiﬁ ed as either volume changes or

price changes.

The gross proﬁ t margin could be a measure of the effectiveness of the sales team, pric-

ing policies, purchasing methods and (in a manufacturing organisation) the production

processes.

The decline will not be as a result of holding inventories, as this is adjusted for in the

cost of sales calculation.

14.5.2 Gross profit mark-up

This ratio is an alternative measure of proﬁ tability. It is calculated by:

Gross Profit

Cost of sales

 100

14 837

8 799

100 168 6

t sho

ws us that the selling price of the goods was equal to the cost of those goods, plus

168.6 per cent of the cost. In other words, for every $1 we spent on the cost of goods, we

added $1.69 (approximately) to arrive at a selling price of $2.69.

Similar comments apply to this ratio as were applied to the gross proﬁ t margin.

STUDY MATERIAL C2

508

THE INTERPRETATION OF FINANCIAL STATEMENTS

14.5.3 Operating profit margin

This is calculated by:

Operating profit

Sales

 100

9100

23 636

100 38 5

The value of this ratio lies in its comparison over time and with other organisations and

the industry average. In this example the operating proﬁ t percentage was 38.5 per cent.

In itself, this has no meaning – only by comparing it as stated is it possible to derive any

beneﬁ t from the calculation. To interpret this percentage fully would involve an examina-

tion of its components. Given that operating proﬁ t is equal to gross proﬁ t less expenses, a

change in this percentage could arise either from a change in gross proﬁ t or from a change

in one or more of the expenses deducted from gross proﬁ t. Further analysis would be

needed.

14.5.4 Return on capital ratios

People who invest their money in a business are interested in the return the business is

earning on that capital. Expressing this return in the form of a ratio enables comparison

with other possible investment opportunities.

This ratio is a key measure of return. It measures the amount of earnings generated

per $1 of capital, and is usually stated as a percentage. The ratio can be calculated in sev-

eral different ways, according to the information required of it, and depending on what

is meant by the two terms ‘ capital employed ’ and ‘ return ’ . In this Learning System, two

methods of calculating the return on capital are discussed – the return on total capital

employed (ROCE) and the return on equity (ROE).

●

Capital employed can consist of total capital employed (equity  non-current liabilities)

or just equity. In using total capital employed we include long-term loans as well as equity,

and this is used when calculating ROCE. When calculating ROE, just the equity is used.

You should remember that equity is share capital plus all of the reserves. Furthermore, it

is more correct to use the average of capital employed during the year, as the proﬁ t has

been earned throughout the year. The capital at the start of the year will have been dif-

ferent, having been affected by share issues, loan issues or repayments, and the addition

of proﬁ t for the year. However, in many computer-based assessments, the question may

just require you to use the capital at the end of the year.

●

Return is another way of describing proﬁ t. The proﬁ t ﬁ gure to be taken will depend on

which ﬁ gure is taken for capital employed. If capital employed is taken as being total

capital employed, then it is the operating proﬁ t ﬁ gure that is required to be used as the

‘ return ’ , as this is the proﬁ t available to ﬁ nance the total investment in the business. If

the capital employed is equity, then the return is the ‘ proﬁ t for the period ’ , which is the

last line in the income statement. In other words, it is the proﬁ t for the year, after inter-

est and after tax.

The basic formula for return on capital ratios is:

Profit

Average total capital employed

100

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE INTERPRETATION OF FINANCIAL STATEMENTS

The ROCE is:

Operating Profit

Average capital employed by shareholders a

nnd lenders

100

This expr

esses the proﬁ t that is available to all providers of long-term capital, as a percent-

age of that capital. Using the ﬁ gures from the ﬁ nancial statements above, the calculation is:

9100

18 925

100 48

%

Average total capital employed is arrived at by taking the average of:

Closing total capital employed (18,250  4,500) 22,750

Opening total capital employed (22,750  7,650

retained proﬁ t)

15,100

37,850 2  $18,925

Note that the proﬁ t ﬁ gure used when calculating opening capital is ‘ retained ’ proﬁ t. This

would normally be the proﬁ t after the payment of dividends and would be found in the

statement of changes in equity. However, in this example there are no dividends paid and

therefore the ﬁ gure is taken from the income statement.

Overdrafts less cash balances, that is net overdrafts, are normally excluded from capi-

tal employed. This assumes that overdrafts are temporary and are not considered to be a

source of permanent ﬁ nance for the business.

The ROE is:

Profit for the period

Average equity

100

This expr

esses the proﬁ t that is available only to shareholders, as a percentage of their

funds. The calculation is also known as return on net assets, as equity  assets  liabilities.

(Which is a rearrangement of the accounting equation.)

Using the ﬁ gures in the ﬁ nancial statements above, the calculation is:

7 650

14 425

100 53

%

Average equity is arrived at by taking the average of:

Closing equity 18,250

Opening equity (18,250  7,650 proﬁ t) 10,600

28,850 2  $14,425

If it is not possible to calculate the average capital employed, then use the closing capital

ﬁ gure, but bear in mind that it may not be representative of the capital employed through

out the year.