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Analysis and interpretation of Financial Statements Simplified Revision Notes for NSC Accounting
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Analysis and interpretation of Financial Statements
Financial analysis uses various ratios and indicators to assess a company's performance and financial position.
- Interpretation involves comparing current results with previous periods or industry benchmarks to understand trends and risks.
Key Areas of Analysis
| Area of Analysis | Description | Related Financial Indicators |
|---|---|---|
| Profitability | How effectively the company uses its assets to generate profit in normal operations. | • % Gross profit on sales • % Net profit on sales • % Operating expenses on sales • % Operating profit on sales • % Gross profit on cost of sales (Mark-up) |
| Liquidity | The company's ability to meet its immediate (short-term) debts. | • Current ratio • Acid-test (quick) ratio • Net current assets • Turnover rate of stock • Debtors' collection period • Creditors' payment period • Average period of stock on hand |
| Solvency | The capacity to settle all liabilities in the long-term. | • Solvency ratio • Net assets |
| Return | Evaluates whether shareholders earn a fair return on their investment. | • % Return on average shareholders' equity • Earnings per share (EPS) • Dividends per share (DPS) • Net asset value |
| Financial Risk (Gearing) | Assesses how much the company is financed by loans (borrowed money) compared to its own capital. | • Debt/Equity ratio • % Return on total capital employed |
How to Comment on Financial Indicators
- Identify the Question
- For example, if asked about liquidity, focus on ratios like the current ratio or acid-test ratio.
- Name the Indicator and Figures
- State the ratio or percentage (e.g., current ratio of 1.3:1 or acid-test ratio of 0.6:1).
- Compare Periods
- Check current year vs. previous year or an industry benchmark. Indicate if it has increased or decreased.
- Offer a General Comment
- Summarise what this means for the company (e.g., _"_The business has strong liquidity and can meet its short-term debts").
Worked examples:
Worked Example 1: Evaluating the Company's Liquidity
| Financial Indicator | 2010 | 2011 |
|---|---|---|
| Current Ratio | 1.3 : 1 | 2.1 : 1 |
| Acid Test Ratio | 0.6 : 1 | 1.4 : 1 |
- The current ratio has improved from 1.3:1 to 2.1:1.
- The acid test ratio has also increased from 0.6:1 to 1.4:1.
- This indicates a strong liquidity position, suggesting that the business can manage its short-term debts effectively.
Worked Example 2: Analysing the Earnings per Share (EPS) and Dividends per Share (DPS)
| Financial Indicator | 2010 | 2011 |
|---|---|---|
| Earnings per Share (EPS) | 35c/share | 15c/share |
| Dividends per Share (DPS) | 25c/share | 20c/share |
- EPS has decreased from 35c to 15c per share.
- DPS has declined from 25c to 20c per share.
- In 2010, EPS stood at 35c, while DPS was 25c, showing that 10c was retained for future growth.
- In 2011, they earned 15c per share yet distributed 20c per share as dividends, meaning that all of the previous year's retained income was used to bridge the difference.
Worked Example 7: Comment on the Debt/Equity Ratio
| Financial Indicator | 2010 | 2011 |
|---|---|---|
| Debt/Equity Ratio | 0.6 : 1 | 0.4 : 1 |
- The debt/equity ratio has dropped by 0.2 (from 0.6:1 to 0.4:1).
- By settling part of their debt, the company has lowered its financial risk.
Worked Example 8: Comment on the % Return on Shareholders' Equity (ROSHE)
| Financial Indicator | 2010 | 2011 |
|---|---|---|
| % Return on Shareholders' Equity (ROSHE) | 18 % | 24 % |
- ROSHE improved by 6%, from 18% to 24%.
- This rate of 24% should please investors, given that it generally surpasses returns on safer alternatives (e.g., fixed deposits).
Key formulae
Conclusion
By analysing and interpreting these key areas and indicators, stakeholders can evaluate a company's performance, financial stability, and potential risks. Always compare current figures with past results or benchmarks to judge progress.
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