Interpreting financial statements requires analysis and appraisal of the performance and position of an entity. Candidates require good interpretation skills and a good understanding of what the information means in the context of a question.
Interpreting financial and non-financial information is an important aspect of the Financial Reporting (FR) exam and is an important skill to develop in advance of the Strategic Business Reporting (SBR) exam.
In the FR exam, you will often be required to make use of ratios to aid interpretation of the financial statements for the current year and to compare them to the results of a prior period, another entity, or against industry averages.
Increasingly, candidate exam performance is demonstrating a lack of commercial awareness and knowledge that sometimes does not go beyond the 'rote learning' of ratios and associated commentary. Candidates regularly state facts such as 'gross profit margin has increased' or, 'payables days have gone down' but this offers no interpretation of the reason for the change in ratio. As a result, markers find it difficult to award sufficient marks to candidates to achieve a pass.
This article is designed to aid candidates in understanding what is expected to create a good answer to a financial statements interpretation question.
When marking this style of question some common weaknesses have been identified, which are highlighted below:
Questions relating to interpreting financial statements will also include some background information and accompanying details in the scenario. A weak answer will make no attempt to refer to this information and, therefore, will often score few marks. It is important that you carefully consider this information and incorporate it into your response because it has been provided for a reason. Do not simply list all the possibilities of why a ratio may have changed; link the reason to the scenario that you have been provided with.
EXAMPLE
The question scenario may provide you with a set of financial statements and some further information such as details of non-current assets (potentially including a revaluation, a major asset purchase or disposal) or measures undertaken during the year in an attempt to improve performance. When constructing your answer, you must consider the effect that this information would have on the company results.
A major asset disposal would most likely have a significant impact on a company's financial statements in that it would result in a gain or loss on disposal being taken to the statement of profit or loss and cash being received. It is worth noting that while the current year results will be affected by this, it is a one-off adjustment and this needs to be factored in when comparing it with the results of other periods. When calculating ratios, the disposal will improve asset turnover as the asset base over which revenue is spread becomes smaller and will, therefore, also improve return on capital employed (ROCE). The operating profit margin is also likely to be affected as the profit or loss on disposal will be included when calculating this.
It is often worth calculating some of the ratios (e.g. ROCE or operating profit margin) again without the one-off disposal information, as arguably this will help to make the information more comparable. If time is limited, a comment about the disposal's effect will be sufficient.
From a liquidity point of view, the cash received on disposal of the asset will have increased cash flow during the year - ask yourself what would have happened if the company had not received this cash. For example, are they already operating with an overdraft? If so, the cash flow position would be far worse without the cash from the disposal proceeds.
If a revaluation of non-current assets has taken place during the year the capital employed base will increase - this will have the impact of reducing both the asset turnover and return on capital employed ratios without any real change in operating capacity or profitability.
A major asset purchase again would cause both asset turnover and return on capital employed to deteriorate as the capital employed base would grow. It may appear that as a result of the purchase, the company has become less efficient at generating revenue and profit but this may not always be the case.
If, for example, the purchase took place during the latter half of the year, the new asset will not have contributed to a full year's profit and it may be that in future periods the business will begin to see a better return as a result of the investment. When analysing the performance and position of the company, if management have implemented measures during the year to improve performance it is worth considering if these measures have been effective. If, for example, a company chose to give rebates to customers for orders above a set quantity level then this would have the impact of improving revenue at the sacrifice of gross profit margin.
Ratios can generally be broken down into several key areas:
For the FR exam, candidates need to know the formulae for the relevant ratios and also what movements in these ratios could possibly mean. Provided below is a brief overview of the key ratios and what movements could indicate - further clarification and understanding can be found in study texts and by practising past questions.
Note that the list of ratios below is not exhaustive and does not fully cover the ratios which may be required in an exam or may otherwise aid in your appraisal of a company.
Return on capital employed (ROCE)
Profit before interest and tax
Shareholders' equity + debt
Capital employed represents the debt and equity with which the company generates profits.
Therefore, capital employed = shareholders' equity + long-term debt = total assets - current liabilities
ROCE is generally considered to be the primary profitability ratio as it shows how well a business has generated profit from its long-term financing. An increase in ROCE is generally considered to be an improvement.
Movements in ROCE are best interpreted by examining profit margins and asset turnover in more detail (often referred to as the secondary ratios) as ROCE is made up of these component parts. For example, an improvement in ROCE could be due to an improvement in margins or more efficient use of assets.
Asset turnover
Revenue
Total assets - current liabilities
Asset turnover shows how efficiently management have utilised net assets to generate revenue. When looking at the components of the ratio, a change will be linked to either a movement in revenue, a movement in net assets, or both.
There are many factors that could both improve or deteriorate asset turnover. For example, a significant increase in sales revenue would contribute to an increase in asset turnover or, if the business disposes of some non-current assets then the asset base would become smaller, thus improving the result.
Profit margins
Gross or Operating profit
Revenue
The gross profit margin looks at the performance of the business at the direct trading level. Typically, variations in this ratio are due to changes in the selling price/sales volume or changes in cost of sales. For example, cost of sales may include inventory write downs that may have occurred during the period due to damage or obsolescence.
The operating profit margin is generally calculated by comparing the profit before interest and tax of a business (i.e. operating profit) to revenue. However, be aware that in the exam, the examiner may specifically request that the calculation is made using profit before tax.
Analysing the operating profit margin enables you to determine how well the business has managed to control its indirect costs during the period. In the exam, when interpreting operating profit margin, it is advisable to link the result back to the gross profit margin. For example, if gross profit margin deteriorated in the year then it would be expected that operating profit margin would also fall.
However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost control or perhaps there could be a one-off profit on disposal distorting the operating profit figure. It is important to consider what information in the scenario might be used to appropriately interpret the information.
Current ratio
Current assets
Current liabilities
The current ratio considers how well a business can cover the current liabilities with its current assets. It is a common belief that the ideal for this ratio is between 1.5 and 2 to 1 so that a business may comfortably cover its current liabilities when they fall due.
However, this ideal will vary from industry to industry. For example, a business in the service industry would have little or no inventory and therefore could have a current ratio of less than 1. This does not necessarily mean that it has liquidity problems, so it is better to compare the result to previous years or industry averages and always be guided by the details in the scenario.
Quick ratio (sometimes referred to as acid test ratio)
Current assets - inventory
Current liabilities
The quick ratio excludes inventory as it takes longer to turn into cash and therefore places emphasis on the business's 'quick assets' and whether these are sufficient to cover the current liabilities. Here the ideal ratio is thought to be 1:1 but, as with the current ratio, this will vary depending on the industry in which the business operates.
When assessing both the current and the quick ratios, look at the information provided within the question to consider whether the company is overdrawn at the year-end. The overdraft is an additional factor indicating potential liquidity problems and this form of finance is both expensive (higher rates of interest) and risky (repayable on demand).
Receivables collection period (in days)
Receivables x 365
Credit sales
It is preferable to have a short credit period for receivables as this will aid a business's cash flow. However, some businesses base their strategy on long credit periods. For example, a business that sells sofas might offer a long credit period to achieve higher sales and be more competitive than similar entities offering shorter credit periods.
If the receivables days are shorter compared to the prior period it could indicate better credit control or settlement discounts being offered to collect cash more quickly. An increase in receivables days could indicate a deterioration in credit control or potential bad debts.
Payables collection period (in days)
Payables x 365
Credit purchases*
*(or cost of sales if not available)
An increase in payables days could indicate that a business is having cash flow difficulties and is therefore delaying payments using suppliers as a free source of finance. It is important that a business pays within the agreed credit period to avoid conflict with suppliers. If the payables days are reducing, this indicates suppliers are being paid more quickly. This could be due to credit terms being tightened or taking advantage of early settlement discounts being offered.
Inventory days (inventory holding period)
Closing (or average) inventory x 365
Cost of sales
Generally, the lower the number of days that inventory is held, the better. This is because holding inventory for long periods of time constrains cash flow and increases the risks associated with holding the inventory. The longer inventory is held, the greater the risk that it could be subject to theft, damage or obsolescence. However, a business should always ensure that there is sufficient inventory to meet the demand of its customers.
Gearing
Debt or Debt
Equity Debt + equity
The gearing ratio is of particular importance to a business as it indicates how risky a business is perceived to be based on its level of borrowing. As borrowing increases, so does the risk as the business is now liable to not only repay the debt but meet any related interest commitments. In addition, it could potentially be more difficult and expensive to raise further debt finance.
If a company has a high level of gearing, it does not necessarily mean that it will face difficulties as a result of this. For example, if the business has a high level of security in the form of tangible non-current assets and can comfortably cover its interest payments then a high level of gearing should not give an investor cause for concern.
In the exam, make sure all calculations required are attempted so that you can offer possible reasons for any changes in the discussion part of the question.
There is no absolute correct answer to a financial statements interpretation question. What sets a good answer apart from a poor one is the discussion of possible reasons for why changes in the ratios may have occurred (specifically in the given scenario) and arriving at an appropriate conclusion.
Written by a member of the Financial Reporting examining team