Interpretation of Financial Statements
Interpretation of Financial Statements tests your ability to calculate and explain ratios from published or draft statements, and to comment on profitability, liquidity, efficiency, gearing and investor returns. MATSEC questions usually require calculation, comparison and a short evaluation of limitations.
Core rules
- Profitability: gross margin = gross profit ÷ revenue; net margin = profit before tax ÷ revenue; ROCE = operating profit ÷ capital employed (total assets − current liabilities, or equity + non-current liabilities).
- Liquidity: current ratio = current assets ÷ current liabilities; quick ratio = (current assets − inventory) ÷ current liabilities.
- Efficiency: inventory turnover = cost of sales ÷ average inventory; receivables collection period = trade receivables ÷ credit sales × 365.
- Gearing: debt ÷ (debt + equity) or debt ÷ equity - state which basis you use. Interest cover = operating profit ÷ finance costs.
Worked example
Operating profit €60,000; capital employed €400,000; current assets €150,000 including inventory €60,000; current liabilities €75,000.
ROCE = 60,000 ÷ 400,000 = 15%. Current ratio = 150,000 ÷ 75,000 = 2.0. Quick ratio = (150,000 − 60,000) ÷ 75,000 = 1.2. The current ratio looks comfortable, but the quick ratio shows that 40% of current assets are inventory, so liquidity depends on selling stock.
Marks-losing traps
- Using profit after tax in ROCE instead of operating profit.
- Mixing year-end and average balances without saying so.
- Treating a high current ratio as automatically good when it may reflect slow-moving inventory.
- Calculating gearing on one definition while commenting on another.
- Drawing firm conclusions without considering accounting policies, seasonality or industry norms.