Interpretation of financial statements
The process of analysing financial statements and calculating financial ratios is often referred to as the “interpretation of financial statements.”
This is an attempt to glean as much information from the financial statements as possible and thereby improve decisions made using the financial statements.
Decisions made with the assistance of ratios
A ratio puts one figure in terms of another. They measure the relative scale of different numbers.
For example, a director might compare a company’s sales with its advertising costs in order to try and measure the effectiveness of its advertising spend in generating sales.
When users review a set of financial statements they will often calculate a wide range of financial ratios that provide the users with information about different aspects of the company.
Types of financial ratios
There are a large number of financial ratios and these can be grouped according to the type of information they attempt to provide. They can, for example, be grouped between Performance Ratios, Liquidity Ratios, Use of Resources Ratios and Financial Position Ratios.
In this section of the course we will look at a variety of different financial ratios that are commonly used by businesses, investors and lenders.
Using financial ratios
Financial ratios enable users to compare different aspects of a business against:
- Other businesses of different sizes
- Previous periods
- A previous period of a different length
- Targets or budgets
They are very good at identifying trends over time that would otherwise be overlooked.
Take care when using financial ratios
Whilst ratios can provide useful information, there is a danger that they may mislead users under certain circumstances. Users must therefore understand the various factors that could cause problems.
A single ratio tells us very little about a business. In order to be useful, a ratio should be put into some sort of context by providing a suitable “comparator” (e.g. the same ratio but for a different period).
Let’s say, for example, that a business calculates that 4% of the sales it makes on credit become irrecoverable. Without context we have no idea as to whether this 4% represents good or poor performance and its use is therefore limited.
There are various different comparators that businesses use to put their ratios into context and in fact, businesses often use more than one. A business’ financial ratio may be compared against the same ratio for:
- Previous periods of the business
- Competitors of the business
- Industry averages
- Budgets or targets
By putting the ratio into context, a user will gain a better understanding of the company’s performance and risk.
2 Accounting policies
When comparing ratios between different periods, or between a company and its competitors, we must consider whether the same accounting policies were used by the company and its comparator.
If a business and its competitor used different accounting policies when preparing their financial statements there may be difficulties in comparing any resulting financial ratios and the business could appear better or worse that it should.
For example, let’s say that a business has a policy of regularly revaluing its land and buildings to their fair values but its competitor doesn’t and instead values them using the Cost Model. Any financial ratio that involves either the values of the businesses’ non-current assets would be affected by this difference and make those ratios difficult to compare.
3 Short-term fluctuations
Sometimes, a company’s period-end balance in its statement of financial position might be unusually large or small due to short-term fluctuations in its trading activities.
For example, a business might find that its two largest customers both paid the amounts they owed to the business a few days late with the result that the business’ trade receivables at its year-end were significantly higher than usual. This would then distort any financial ratios that are based on the business’ trade receivables and could then give a misleading impression.
4 Ratio formulae
There are several financial ratios where different accountants might use slightly different formulae in their calculation. It is therefore important to identify the exact formula used when considering ratios. This is particularly important when looking at ratios calculated by other people.
A common area for disagreement is over the definition of “debt.” Some accountants might simply include all non-current borrowings, other might include current and non-current borrowings but exclude bank overdrafts and so on.
5 Absolute values
When ratios are calculated, we lose some financial information as the ratio provides relative values (i.e. one amount is put in terms of another) rather than absolute values (i.e. the actual values in currency terms).
For example, a company’s profits for the past two years are shown below.
For both years, the Profit Margin ratio has been calculated. These measure the percentage of sales that are converted into profits and are presented as percentages.
If we were just given the Profit Margin ratios we would assume that the company’s performance has improved from 2019 to 2020 as its profit margin rose from 25% to 35%. The actual figures for the year show a different story however, as the company’s sales and profits have worsened over the two year period.
It is therefore best if we are able to review both the original data (i.e. the financial statements) as well as the financial ratios.
6 Changes to strategy
If a business has changes its strategy we would expect some of its ratios to be affected by the change.
For example, if a business makes the decision to offer credit terms to its customers it is likely that there will be effects on the business’ sales, costs of sales, irrecoverable debts, profits, trade receivables and so on. These will then affect the business’ financial ratios.
When reviewing the ratios we must be aware of the business’ change of strategy or we are likely to misunderstand what the ratios are telling us.
Links between financial ratios
There are often links between different financial ratios, so that when one changes we would expected another to change in either the same way or the opposite way.
Links between different financial ratios arise where they are affected by the same cause. Any ratios that use some of the same values will be linked to some extent.
For example, Operating Profit Percentage is calculated by dividing Profit from Operations by Revenue and then expressing the result as a percentage. Gross Profit Percentage is quite similar in that is calculated by dividing Gross Profit by Revenue and then expressing the result as a percentage.
Both ratios are therefore affected by Revenue and both are also affected by the Cost of Sales. Any change in the Operating Profit Percentage will therefore be caused in part by the same factors that cause a change in the Gross Profit Percentage.