Module I

First: why do we analyse financial statements at all?

When a company publishes its financial statements, it’s basically giving

 Shareholders (current and potential)

 Lenders (banks)

 Suppliers

 Employees

 Analysts

These people don’t have access to internal records, so the financial

Now here’s the key point:

For example:

 Is a profit of $1 million good or bad?

 Is cash of $200,000 enough?

 Is debt too high?

You can’t tell just by looking at the figures in isolation.

What does interpretation of financial statements mean?

Interpretation means:

 Turning financial data into useful information

 Understanding performance, liquidity, and efficiency

 Identifying trends, strengths, and weaknesses

We do this by:

 Calculating ratios

 Comparing them:

o Over time (this year vs last year)

o Against other companies

This helps users make decisions, such as:

 Should I invest?

 Should I lend money?

 Is the business financially stable?

Limitations (very important to understand)

Ratio analysis is useful, but not perfect.

External users face problems because:

 They don’t have detailed internal information

 Different companies use different accounting policies

 Ratios can be distorted by:

o One-off events

o Inflation

o Different business models

So ratios guide decisions, but they don’t give absolute answers.

Now let’s talk about the ratios themselves

Ratios are grouped into four main areas:

1. Profitability

2. Liquidity

3. Efficiency

4. Working capital management

Let’s go through them slowly and logically.

1️⃣ Profitability ratios – “How well does the business make profit?”

Return on Capital Employed (ROCE)

Think of ROCE like this:

“For every $1 invested in the business long-term, how much profit is

It measures how efficiently a company uses:

 Long-term loans

A higher ROCE is better, because it means the company is getting more

But be careful:

 ROCE can increase just because assets are old and written down

 That doesn’t mean the business is actually performing better

So ROCE should always be:

 Compared year to year

 Compared with the interest rate on loans

If ROCE is lower than borrowing costs, that’s a bad sign.

Breaking ROCE down: profit margin and asset turnover

ROCE is influenced by two things:

1. How much profit the company makes on sales

2. How efficiently it uses its assets

That’s why we also look at profit margins and asset turnover.

Gross Profit Margin

This looks at performance at the trading level.

It asks:

“After paying for the goods sold, how much profit is left from sales?”

If gross profit margin changes, it’s usually because:

 Selling prices changed

 Cost of sales changed

A falling gross margin can be a warning sign of:

 Rising costs

 Price competition

Net (Operating) Profit Margin

This looks at:

It includes things like:

 Admin costs

 Distribution

 Overheads

When analysing this, you should link it back to gross profit.

For example:

 If gross margin falls but net margin stays stable, that suggests good
cost control

 If net margin improves suddenly, it could be due to a one-off gain,

Return on Equity (ROE)

ROE focuses on shareholders.

It asks:

“How much profit is earned for the shareholders’ investment?”

A high ROE suggests:

 The business is good at generating profit

 It may be able to fund growth internally

But again, context matters — high debt can inflate ROE.

2️⃣ Liquidity ratios – “Can the business pay its short-term debts?”

Profit doesn’t matter if a company runs out of cash.

That’s why liquidity is crucial.

Current Ratio

This asks:

“Does the business have enough current assets to cover current

Traditionally, 1.5–2:1 is seen as comfortable, but:

 This depends on the industry

 Service businesses often operate with lower ratios

 It may mean cash is being wasted instead of invested

Quick Ratio (Acid Test)

This is a stricter test.

It removes inventory because:

 Inventory may not be easy to sell quickly

 Or may only be sold at a discount

The quick ratio asks:

“If we ignore inventory, can we still pay our short-term debts?”

A ratio of around 1:1 is often considered healthy, but again, it depends on

Also watch for:

 Bank overdrafts — they are expensive and risky

3️⃣ Efficiency ratios – “How well is the business managing working

These ratios explain cash flow behaviour, not profit.

Inventory Turnover Period

This tells us:

“How long does inventory sit in the warehouse before being sold?”

Shorter is usually better because:

 Cash isn’t tied up

 Less risk of damage or obsolescence

But:

 Too low might mean stock shortages

 The business must meet customer demand

Receivables Collection Period

This asks:

“How long do customers take to pay?”

 Improve cash flow

 Suggest good credit control

Longer periods could mean:

 Weak credit control

 Risk of bad debts

 Or a deliberate strategy to boost sales

Payables Payment Period

This measures:

“How long the business takes to pay suppliers.”

Paying later:

 Helps cash flow

 But may damage supplier relationships

Paying earlier:

 Could mean taking advantage of discounts

 Or that suppliers have tightened credit terms

4️⃣ Working Capital Cycle (Cash Cycle)

This ties everything together.

It shows:

“How long cash is tied up in operations before it comes back in.”

Formula (conceptually):

 Time inventory is held

 Plus time customers take to pay

 Minus time suppliers allow before payment

A shorter cash cycle is better because:

 Less cash is needed to operate

 Liquidity risk is lower

Operating Profit (or PBIT) × 100

--------------------------------

Capital Employed

Where:

Capital Employed = Total Assets − Current Liabilities

(or Equity + Long-term liabilities)

Asset Turnover

Revenue

---------

Capital Employed

Return on Equity (ROE)

Profit for the Year × 100

------------------------

Shareholders’ Equity

Gross Profit Margin

Gross Profit × 100

------------------

Revenue

Net Profit Margin (Operating Profit Margin)

Operating Profit (PBIT) × 100

-----------------------------

Revenue

⚠️Use profit before tax instead only if the question tells you to.

2️⃣ Liquidity Ratios

Current Ratio
Current Assets

---------------

Current Liabilities

Quick Ratio (Acid Test Ratio)

Current Assets − Inventories

----------------------------

Current Liabilities

3️⃣ Efficiency Ratios

Inventory Turnover Period (Days)

Inventory × 365

---------------

Cost of Sales

(Inventory can be closing or average, depending on the question.)

Receivables Collection Period (Days)

Trade Receivables × 365

-----------------------

Credit Sales

Payables Payment Period (Days)

Trade Payables × 365

--------------------

Credit Purchases

4️⃣ Working Capital / Cash Cycle

Working Capital Cycle (Days)

Inventory Days

+ Receivables Days

− Payables Days