Interpretation of Financial Statements
Four families of ratios
Profitability: ROCE = operating profit ÷ capital employed (equity + non-current liabilities); gross margin = gross profit ÷ revenue; operating margin = operating profit ÷ revenue; asset turnover = revenue ÷ capital employed.
Liquidity and efficiency: current ratio = current assets ÷ current liabilities; quick ratio = (current assets − inventory) ÷ current liabilities; inventory days = inventory ÷ cost of sales × 365; receivable days = trade receivables ÷ revenue × 365; payable days = trade payables ÷ cost of sales × 365.
Gearing and risk: gearing = debt ÷ (debt + equity); interest cover = operating profit ÷ finance cost.
Investor ratios: EPS = profit attributable to ordinary shareholders ÷ number of ordinary shares; dividend cover = profit ÷ dividends; dividend yield = dividend per share ÷ share price; P/E ratio = share price ÷ EPS.
Traps: use credit sales and credit purchases when given for receivable and payable days; use cost of sales for inventory days and payable days; a company can be profitable yet illiquid; a share issue raises cash but dilutes EPS; differing accounting policies undermine comparisons. Ratio analysis is also limited - it is historical, ignores qualitative factors and is distorted by inflation, seasonality and window dressing.
Worked example: revenue $500,000 and trade receivables $60,000 give receivable days = 60,000 ÷ 500,000 × 365 = 43.8 days. If last year was 38 days, collection has slowed - but check whether a large late-year credit sale or changed credit terms explains it before drawing conclusions.
Rule of thumb: state the formula, compute, compare (prior year or competitor), then explain why the ratio moved and what it means for the business.