Analysing and Interpreting Financial Statements
The ratio families
Candidates must be fluent in five groups: profitability (gross margin, operating margin, return on capital employed, return on equity), liquidity (current ratio, quick ratio, cash cycle), efficiency (inventory days, receivable days, payable days, asset turnover), gearing (debt/equity, interest cover) and investor (EPS per IAS 33, price/earnings, dividend cover, dividend yield). Calculation is the easy mark; interpretation is where the marks are. Always explain a movement twice: the business cause (volumes, prices, mix, credit terms) and the accounting cause (policy choice, estimate change, one-off item).
Traps
- Using closing rather than average balances for return and turnover ratios where opening figures are available.
- Forgetting that a revaluation, a finance lease or capitalised development costs distort comparison between entities.
- Ignoring the IAS 33 adjustment of the EPS denominator for bonus issues and rights issues, and the dilutive effect of options and convertibles.
- Describing a ratio as good or bad without stating the benchmark or trend it is judged against.
- Year-end window dressing: a short-term loan repaid just before the year end flatters the current ratio.
Common-size analysis (each line as a percentage of revenue or of total assets) and trend analysis over three to five years answer interpretation questions far more convincingly than a single year.
Worked example. Profit before interest and tax is $200,000; equity $800,000, non-current liabilities $400,000, current liabilities $200,000. Capital employed = total assets less current liabilities = 800,000 + 400,000 = $1,200,000. ROCE = 200,000 / 1,200,000 = 16.7%. Compare it with the prior year and with the cost of borrowing before judging performance.