TOPIC THREE: INTERPRETATION OF FINANCIAL STATEMENTS

Introduction
Understand the various types of analysis and interpretation of financial statement
Accounting ratios
Profitability ratios
Liquidity ratios
Efficiency ratios
Investment ratios
The usefulness and limitation of ratio analysis
Multivariate ratio analysis
LEARNING OUTCOME
After teaching this course the student should be able to:
Explain the role of accounting ratios in analysis and interpretation of information provided in
the financial statement.
Define each of the most commonly used accounting ratios
Perform a ratio analysis of a set financial statements
Explain the usefulness and limitation of ratio analysis
Briefly explain the technique of multivariate ratio analysis

RATIO ANALYSIS
INTERPRETATION OF FINANCIAL STATEMENTS
Financial statements are prepared with the aims of satisfying various demands of accounting
information users. Some of these users are less skilled in the techniques adopted in the
preparation of financial statements. The bold figures in the financial statements are less
informative to them. Therefore, to give more insight and better understanding of the statement,
ratios are applied.
An accounting is a measure of the relationship which exists between two figures shown in the
financial statements. Ratio analysis is a technique adopted to establish and present the
relationships and trends inherent in financial statement.
The purpose of the ratio analysis is to ascertain measures of liquidity, solvency, stability and
profitability of an enterprise.

TYPES OF ACCOUNTING RATIOS

The key accounting ratios can be classified into four main groups.
a. Profitability ratios: The profitability ratios are used to assess whether the business has
succeeded in making an acceptable level of profits
b. Liquidity ratios: Liquidity ratios are a measure of the ability of the business to pay its
debts as they fall due.
c. Efficiency ratios: The efficiency ratio provides some indication of the extent to which the
assets of the business have been efficiently used and managed
d. Investment ratios: Investment ratios are mainly of interest to investor or potential
investors and may help these users to decide whether or not a business represents a
worthwhile investment

PROFITABILITY RATIOS
The main profitability ratios are:
a. Gross profit margin: It express a company’s gross profit as a percentage of its
sales.

Gross profit margin = Gross profit × 100

Sales 1
b. Net profit margin: Refers is also to as profit margin which expresses a company’s
profit as a percentage of sales revenues. It can be calculated as follows:
Net profit margin = profit × 100
Sales 1
c. Return on capital employed (ROCE): This is important ratios express a
company’s profit as a percentage of amount of capital invested in the company.
Return on capital employed = profit before interest and tax
× 100
Capital employed
1
*capital employed = Share capital +reserves +Non-current liabilities
d. Return on Equity: This profitability ratio concentrate on the company’s ordinary
shareholders and compares their capital with the amount of profit which has been
earned on their behalf. Return on equity is usually calculated as follows:

Return on equity= = profit after interest, tax and preference dividend × 100
Ordinary shares and reserves 1

LIQUIDITY RATIOS
The main liquidity ratios are:
a. Current ratio: The purpose of the current ratio is a measure a company’s
ability to meet its short-terms financial obligation out of the current assets.
The current ratio is usually expressed as an actual ratio (eg 2:1) and can be
calculated as follows:
Current ratio = current assets
Current liabilities
b. The quick Acid Test ratio: This ratio indicates the ability of the company to
meet its short liabilities from current assets without having to sell inventories.
Quick Acids Test ratios= = current assets - inventories
Current liabilities

EFFICIENCY RATIOS
The main efficiency ratios are:
a. Asset turnover: This measures the efficiency with which a company’s
assets are used to generate sales revenue. The ratio is usually calculated
as follows:
Asset turnover = Sales = sales
Net assets capital employed
 b. Inventory holding period: Measures the average number of days which
elapse between acquiring an item of inventory and then selling or using
that item. This ratio is calculated as follows:
Inventory holding period= Average inventory × 365
Cost of sales
c. Inventory turnover: cost of sale (times)
Average inventory
This ratio indicates how many times inventory is turn during the period.

d. Trade receivables collection period: Measure the average number of days

which elapse between making a credit sale and receiving payment from
the customer. This ratio is calculated as follows:
Trade receivables collection period: Average trade receivables ×
365
Credit sales
e. Trade payables payment period: Measures the average number of days
which elapse between the date of a credit purchase and the date on which
payment is made to the supplier. This ratio is calculated as follows:
Trade payables payment period: Average trade payables × 365
Credit purchases

INVESTMENT RATIOS
The main investment ratios are:
a. Earning per share (EPS): Is the amount of profit earned during an
accounting period for each ordinary share in issue during that period.
This important ratio is frequently used as an indicator of financial
performance and is calculate as follows:

Earnings per share = profit after tax and preference dividends × 100
Number of ordinary shares in issue

b. Price earnings (P/E) Ratio: The P/E ratio compares earning per share
with the market price of an ordinary share and calculates the number
of years which it would take to recover the market price paid for a
share if earnings remain constant in future years. This ratio is
calculated as follows:
P/E ratio = Market price per ordinary share
Earnings per share
 c. Dividend cover: Measures the number the number of times that the
ordinary dividend for an accounting period could have been paid out of
the available profits for that period. This ratio is calculated as follows:
Dividend cover: profit after tax and preference dividends
Ordinary dividends
d. Dividend yield: The dividend yield expresses the dividend per
ordinary share as a percentage of the market price per ordinary share.
This ratio is calculated as follows:
Dividend yield = dividend per ordinary share × 100%
Market price per ordinary shares
e. Capital gearing ratio: Measures the extent to which a company’s
long-term funds have been provided by lenders. This ratio is calculated
as follows:

Capital gearing ratio= preference share capital plus non-current liabilities

×100
Total share capital and reserves plus non-current
liabilities
f. Interest cover: is a measure of the number of times that the interest payable
for an accounting period could have been paid out of the available profits.
This ratio is calculated as follows:
Interest cover= profit before interest and tax
Interest payables

The usefulness of ratio analysis

a. It provides a good basis for assessment of managerial performance and
efficiency.
b. It reveals company financial performance and provides basis for comment on its
financial capabilities.
c. It establishes good basis for comparison between past, present and future
performance of an enterprise.
d. It helps to establishes changes and trends inherent in financial statements and
identify the underlying causes behind apparent changes and trends in company
performance
e. Forecasting and planning: the trend analysis in cost of sale, sales, profits and
other facts may be useful for forecasting and planning future business activities.
f. Budgeting: accounting ratios help to estimate budgeted figure. For example
sales budget may be prepared with the help of analysis of past sales.
g. Measurement of operational efficiency: Ratio analysis indicates the degree of
efficiency in the management and utilization of its assets.
 h. Communication: Ratios are effective means of communication and play vital
role in informing the progress made by the business concern to the owner or
other parties.
i. Indication of liquidity position: ratio analysis helps to the liquidity position of
the company.
j. Indication of long-term solvency position: Ratio analysis is also used to assess
the long-term debt paying capacity of a firm.
k. Indication of overall profitability: Ratios help to reveal the profitability status of
the company. This can be possible if all the ratios are considered together.
l. Aid to decision making.

The limitations of ratio analysis

a. Lack of standard definitions
b. Historical information: financial statements provide historical information. They do
not reflect current conditions; hence it is not useful in predicting the future.
c. Different Accounting policies: Different accounting policies regarding valuation of
inventories, charging depreciation etc. make the accounting data and accounting
ratios of firms non comparable.
d. Window Dressing: The term ‘window dressing’ means presenting the financial
statements in such a way to show a better position than what it actually is. Ratios
computed from such financial statement cannot be used for scanning the financial
position of the business.
e. Changes in prices level: Fixed assets shows the position statement at cost only.
Hence, it does not reflect the changes in price level. Thus, it makes comparison
difficult.
f. The use of different accounting dates

MULTIVARIATE RATIO ANALYSIS

Multivariate ratio analysis attempts to combine ratios together into a single index number
which may then be used to judge a company’s financial health and make
comparison of the company performance with another company over accounting
period. Some proponents of multivariate ratio analysis also claim that the technique
is able to predict corporate failure.
One example of multivariate analysis is the “Z-SCORE MODEL” devised by Edward
Altman in 1960

MEANING OF WINDOW DRESSING

Window dressing financial statements, which is also called cosmetic financial
reporting is a situation whereby the financial statements are prepared to
deliberately or intentionally falsify the accounts with a view to overstating the
performance of a business. When financial statements are so presented, it does not
show a true and fair view.
 Examples includes the following
a. Deliberate increase in the value of closing inventory to reduce cost of sales and
thereby increase profits
b. Falsification of receivables’ schedules in order to overstate assets of a business.
c. Keeping in store dormant or obsolete inventories which should been written off in
statement of comprehensive income.

The instances in which the ratio analysis can assist to mitigate the
effect of window dressing
a. Times series analysis helps in detecting unusual trends in financial
statement.
b. Accounting ratios shows clearly the relationship between two accounting
variables such that the company’s profit is compared to the industries
averages.
c. Proforma analysis whereby ratios are compared with standards can help to
mitigate window dressing
d. Ratios are used in tracking relationships between statement of
comprehensive income and financial position items hence assist in isolating
any mismatch.

Below is the draft financial statement of Labaran plc. a manufacturer of fast

moving consumer goods.
statement of financial position as at:
2017 2016
₦0 ₦0
Non-Current Assets
property, plant and equipment 195,230 191,181
intangible assets 148,277 99,477
other non-current assets 1,226 1,927
344,733 292,585
Current Asset
Inventories 42,728 31,244
Trade receivables 20,384 19,974
Cash at bank 15,866 12,156
78,978 63,374
Total Assets 423,711 355,959

Equity and current liabilities

Equity
Ordinary share capital 3,998 3,964
share premium 73,770 64,950
Revaluation reserves 45,320
Retained earnings 99,692 96,343
222,780 165,257
Non-current liabilities:
Loan and borrowing 5,000 17,000
Employee benefits 13,209 10,101
18,209 27,101
Current liabilities:
Bank overdraft 8,028 12,676
current tax liabilities 19,606 19,024
Trade payables 155,088 131,901
182,722 163,601
Total Equity and liabilities 423,711 355,959

Statement of comprehensive income

2017 2016
SALE 344,562 313,743
COST OF SALE 201,103 -178,218
GROSS PROFIT 143,459 135,525
Distribution expenses -66,898 -61,357
ADMINISTRATIVE EXPENSES -21,747 -21,924
INTEREST PAYABLE -10,419 -13,228
PROFIT BEFORE TAX 44,395 39,016
TAXATION 13,581 -11,257
PROFIT AFTER TAX 30,814 27,759

Required
As a management Accountant of Labaran Plc, you are
required to analyse and interpret the profitability,
liquidity, and efficiency of Labaran plc and advised the
Board appropriately in the form of report

COMPUTATION OF FINANCIAL RATIOS FOR THE YEAR ENDED 2017

RATIOS FORMULARS WORKING 2017 WORKINGS 2016
PROFITABILITY
RATIOS          
ROCE( %) PBIT/C.E × 100 44,395+10,419   39,018+18,228  
    222,780+5000 24.10% 165,257+17,000 28.70%
           
GROSS PROSS
MARG GP × 100 143,459 × 100   135,525 × 100  
  SALES 344, 562 41.60% 313,743 43.20%
           
NET PROFIT
MARGIN PAT × 100 30,814× 100   27,759× 100  
  SALES 344,562 8.90% 313,743 8.80%
           
ROE(%) PAT × 100 30,814× 100   27,759× 100  
  EQUITY 222,780 13.80% 165,257 16.80%
           
EFFICIENCY RATIOS          
ASSET TURNOVER
(times) REVENUE ×100 344,562×100   313,743×100 1.7
1.5
  C. E 227,780 times 182,257 times
           
4.7 5.7
Inventory turnover cost of sales 201,103 times 178,218 times
(times) Av. Inventory 42,728   31,244  
           
19,974 ×
Trade receivable AV. Receivable 20384 ×365 22DAYS 365 34DAYS
collection periods credit sales 344,562   313,743  
(Days)          
           
Trade payable 281DAY
coll. A. payable ×365 155,088 ×365 S 131,901 ×365 270DAYS
period (DAYS) Credit purchase 201,103   178,218  
  or C.O.S        
           
LIQUIDITY
RATIOS          
Current Asset
Ratio C. A 78,978 0.43:1 63,374 0.39:1
  C.L 182,722   163,601  
           
Quick Test Ratio CA- Inventory 78,978-42,728 0.198:1 63,374-31,244 0.196:1
  Current Liability 182,722   163,601  
           
Cash Ratio Cash&CashEquiv 15,866 0.087:1 12,156 0.071:1
  Current liability 182,722   163,601  
           
TO: Board of Directors (Labaran PLC)
FROM: The Management Accountant
DATE: 30th April, 2021.
SUBJECT: FINANCIAL STATEMENT ANALYSIS FOR THE YEAR ENDED 2017
This analysis is based on the financial statements of Labaran Plc, a manufacturer of fast-
moving consumer goods, on the profitability, liquidity and efficiency of the company.

PROFITABILITY
These ratios measure how well the entity is performing in the area of returns. The higher the
ratios the better. The primary ratio here is Return on Capital Employed that measure the overall
profitability and efficiency of an entity.
The ROCE has significantly declined from 28.7% in 2016 to 24.1% in 2017. Also, Gross Profit
margin declined from 43.2% to 41.6% between 2016 and 2017 respectively. This reduction may
traceable to the falling profit margin.
Management is advised to look inward especially into the production area and the policy on
overhead with a view to cutting down unnecessary wastages.

EFFICIENCY
The ability of an entity to use it assets to generate revenue is measured by the efficiency ratios.
The higher the times the better. The principal ratios here is the asset turnover.
The asset turnover has slightly diminished from 1.7 times in 2016 to 1.5 times in 2017. In the
same vein, the Inventory turnover reduced from 5.7 times to 4.7 times. However, Labaran plc
has come to be more efficient in the collection of receivables from customers while trade
payables are gradually on the increase, the payment period is unreasonably long.
Management is advised to disposed off or possibly replace the non-performing non-current
assets. The use of Just -In-time (JIT) system of inventory control could be contemplated to
improve on the inventory holding period.

LIQUIDITY
These ratios measure the ability of an entity to settle its short-term obligations as they fall due.
The higher the ratios the better. The key ratios are the current, quick and cash ratios.
The liquidity position of Labaran plc is really worrisome as the key ratios aforementioned,
although these ratios marginally increased from 2016 to 2017 but they are below the generally
acceptable industry average. The two ratios are very poor.
Management is advised to consider disposing non-performing assets to cushion the liquidity
position.
In conclusion, the financial performance, efficiency and liquidity position of Labaran plc is poor.
However, if the recommendation aforesaid are implemented and a team of professional are
injected to manage the affairs of the company, the fortune can be turn around.

Management Accountant

ASSIGNMENT ON INTERPRETATION OF FINANCIAL

STATEMENT
 QUESTION 1
SOLUDO BANK PLC
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER
2006 2005
N000 N000
Gross earning 5,051,200 2,525,600
interest earning 4,965,000 2,441,000
net operating income 86,200 84,600
Depreciation 650 300
profit before tax 85,550 84,300
Taxation 550 250
profit after tax 85,000 84,050
Appropriation:
Transfer to statutory reserve -10,000 -5000
Transfer to general reserve -5,000 -2,500
proposed and final dividends -50,000 -75,050
unappropriated profit 20,000 1,500

STATEMENT OF FINANCIAL POSITION AS AT DECEMBER

ASSETS
Cash and short-term funds 100,000 40,000
placement with other banks 80,000 48,000
Treasury bills 85,000 50,200
Bills discounted 65,000 30,500
Other liquid investments 70,000 40,200
Loan and advances 1,500,000 730,600
Other assets 100,000 60,500
Fixed assets 3,000,000 1,000,000
5,000,000 2,000,000
LIABILITIES
Deposit current and other accounts 1,000,000 500,000
Taxation 550 250
Deferred taxation 825 312
proposed dividend 50,000 75,050
Ordinary share capital @50k 1,000,000 470,000
Retained earnings 22,000 8,000
statutory reserves 15,000 16,000
General reserves 8,625 5,438
Debenture 2,903,000 924,950
5,000,000 2,000,000

Market value of shares 1 kobo 1/2 kobo

Required:
Using the information provided in the financial statements above, compute the following ratios
for the year ended 31 December, 2006.
i. Cash and cash equivalents ratio
ii. Debt equity ratio
iii. Earnings per share (industrial average 100k)
iv. Dividend per share (industrial average 50k)
v. Primary ratio (industrial average 45k)
vi. P/E ratio (industrial average 10k)

(B) The bank’s board of directors is planning to raise N50 billion ordinary share capital in
the capital market to shore ups its capital base to the minimum capital requirements
as directed by the regulatory authorities. To this end, the board seeks your advice on
the success or otherwise of the new issue.
You are required to advise the board appropriately in for of report.
QUESTION 2
The issued share capital of Sorenson plc consists of 1,000,000 ordinary shares of 50p each and 250,000
6% preference shares of N1each.
In the year to 31 March 2014, the company’s profit after tax was N90,000. Dividends paid during the year
comprised the preference dividend for the year and an ordinary dividend of N55.000. The market price of
the company’s ordinary shares on 31 March 2014 was 70p per share.
Required:
Calculate the following ratios for Sorenson plc:
6 Earnings per share (b) Dividend cover
7 Dividend yield (d) Price earnings