St.

Joseph’s College of Commerce (Autonomous)

Bengaluru – 560 025

Module 3
Analysis of Financial Statements

FORMULAS and INFERENCES:

1. Gross profit Margin = (Gross profit / Revenue ) x 100

Gross profit margin is the percentage of revenue retained after costs of

sale are deducted.

2. Operating profit Margin = (Operating Profit/revenue) x 100

(Operating profit = Gross profit – operating expenses ) = EBIT

The operating profit margin is the trading or operating profit in relation to

revenue, expressed as a percentage

3. Profit before tax margin = (Profit before tax / Revenue) x 100

Profit before tax margin expresses the relationship between profit before
tax and sales.

4. Effective tax rate = (Tax expense / Profit before tax (excl Associate
share of profit)) x 100

Effective tax rate assesses the extent of the impact that tax has on the
entity's profit.

5. Return on capital employed = (Operating profit / Capital employed)

x 100

It assesses the efficiency with which the entity uses its assets to produce
profit.

6. Capital employed = Share capital + Reserves + Interest bearing

borrowings – Non current assets that do not contribute to operating
profit ( such as Investments)
7. Current Ratio = Current Asset / Current Liabilities

The current ratio guides us to the extent that the entity is able to meet its
current liabilities as they fall due.

8. Quick Ratio = (Current assets – Inventory) / Current liabilities

The quick ratio gives a better indicator of liquidity as it removes the least
liquid current asset, the inventory.

Current Assets = Cash and cash equivalent + Inventory + Bills

receivables +Short term loans and advances + Debtors + Any
receivables
Current liabilities = Creditors + Bills payable + Bank overdraft + Short
term loans + Outstanding expenses + Provision for tax + Any other

9. Inventory holding period = (Inventory / Cost of Sales ) x 365 days

(( Inventory
Turnover Ratio = (Cost of sales / Average Inventory) ))
Average Inventory = (Opening stock + Closing stock) / 2

The inventory holding period is an average number of days that inventory

is held before being sold. It indicates how much working capital is tied up
in goods in the warehouse.

10. Receivables collection period = (Receivables / Revenue ) x

365 days
Debtors Turnover Ratio = Credit sales / Average accounts receivable

The receivables collection period tells us the number of days it takes on

average to receive payment from credit customers. It should be based on
the credit agreements with customers.

11. Payables payment period = (Trade payables / Cost of sales) x

365 days

The payables payment period is the length of time it takes to pay

suppliers for goods bought on credit.

12. Asset turnover = (Revenue / Capital employed)

Asset turnover measures how much revenue is being generated from the
overall capital invested.

13. Non-current asset turnover = ( Revenue / Non-current assets )

Non-current asset turnover is a similar calculation but measuring the

efficiency/activity of non-current assets only

(NOTE: Over-trading : When an entity grows rapidly there is a risk of over-

trading, i.e. expanding the entity without adequate long term or short
term finance. Inventory, receivables and payables increase but there is a
decline in cash and the entity may be unable to pay its suppliers as debts
fall due. )
 14. Gearing Ratio = Debt / ( Debt + Equity) OR Debt / Equity

Gearing is an important measure of risk and a guide to the long term

solvency of the entity. Ideal ratio is 2:1, using Debt capital for the benefit
of equity shareholders, is gearing/ Financial leverage.

15. Interest cover (in times)= Operating profit /Finance cost

Interest cover indicates the number of times profits will cover the interest
charge. The higher the ratio, the better. If it is too low, this indicates the
entity is struggling to earn profits that cover its minimum interest
payments.

16. Average rate of borrowing = Finance cost / Borrowings

Average rate of borrowings indicates the typical interest rate that the
entity pays on its debt finance. A high rate would suggest that lenders
consider the entity to be a relatively high risk.

17. Dividend cover (in times) = Profit for the year / Dividends

Dividend cover indicates the number of times profits will cover the
dividend. The higher the ratio the better as shareholders may expect a
sustainable dividend payment.

18. Cash return on capital employed = Cash generated from

operations / cash employed

For many external users, cash is a more significant indicator than profit.

19. Cash generated from operations to total debt = Cash

generated from operations / Total long-term borrowings

This gives an indication of an entity’s ability to meet its long-term

obligations.

20. Net cash from operating activities to capital expenditure =

Net cash from operating activities / Net capital expenditure x 100

This gives some idea of the extent to which the entity can finance its
capital expenditure out of cash flows from operating activities
PROBLEMS
1. Below are the financial statements for T for the years ended 30
June 2015 and 2016.
201 2015
6
$00 $000
0
Revenue 180 150
Cost of sales (65) (60)
Gross profit 115 90
Operating expenses (40) (29)
Share of profit of associate 59 -
Finance costs (24) (10)
Profit before tax 110 51
Tax (14) (13)
Profit for the year 96 38

Other comprehensive income:

Items that may be reclassified
subsequently to P/L
Gains on revaluation of FVOCI 14 5
financial assets
Items that will not be reclassified to
P/L
Revaluation of PPE 30 -
Total comprehensive income 140 43
Statement of changes in Equity
Opening balance 100 82
Issue of shares 3 -
Total comprehensive income for the 140 43
year
Dividends (25) (25)

218 100

Statements of Financial Position

2016 ( $000) 2015 ($000)
Noncurrent
assets
PPE 266 190
Investment 250 -
 in associate
Other 31 17
financial
assets
207
Current
assets
Inventory 15 12
Receivables 49 37
Cash and - 64 1 50
cash
equivalents
611 257
Equity
Share 12 10
capital
Share 5 4
premium
Revaluation 30 -
surplus
FVOCI 21 7
Retained 150 79
earnings

Non Current
liabilities
Long term 335 110
borrowings
Deferred tax 14 349 15 125

Current
liabilities
Trade 12 11
payables
Overdraft 9 -
Taxation 13 11
Provisions 10 44 10 32

611 257

Required:

For each of the two years, calculate the following ratios for T and suggest
reasons why the ratios have changed.

Gross profit margin

Operating profit margin
Profit before tax margin
 Effective tax rate
Return on capital employed
EBITDA (Addl information: Depreciation : 2016= 6, 2015 = 3. )
Current Ratio
Quick ratio
Inventory holding period
Receivables collection period
Payables payment period
Asset turnover
Non-current asset turnover
Gearing ratio
Interest cover ratio
Average rate of borrowing
Dividend cover

2. Neville is a company that manufactures and retails office

products. Their summarised financial statements for the year
ended 30 June 2014 and 2015 are given below:

Statements of profit or loss for the year ended 30 June

2015 2014
$000 $000
Revenue 13,91,820 11,59,850
Cost of sales (10,50,825) (7,53,450)
Gross profit 3,40,995 4,06,400
Operating expenses (161,450) (1,70,950)
Profit from operations 1,79,545 2,35,450
Finance costs (10,000) (14,000)
Profits before tax 1,69,545 2,21,450
Tax (50,800) (66,300)
Profit for the year 1,18,745 1,55,150

Statement of financial position as at 30 June

2015 2014
$000 $000
Non-current assets 5,09,590 3,41,400
Current assets
Inventory 1,09,400 88,760
Receivables 4,19,455 2,06,550
Bank - 95,400
10,38,445 7,32,110

Share capital 1,00,000 1,00,000

Share premium 20,000 20,000
Revaluation reserve 50,000 -
Retained earnings 3,76,165 2,87,420
5,46,165 4,07,420
Non current liabilities 61,600 83,100
Current liabilities
Payables 2,95,480 1,79,590
Overdraft 80,200 -
Tax 55,000 62,000
10,38,445 7,32,110

The directors concluded that their revenue for the year ended 30 June
20X4 fell below budget and introduced measures in the year end 30 June
20X5 to improve the situation. These included:

 Cutting prices

 Extending credit facilities to customers

 Purchasing additional machinery in order to be able to manufacture

more products.

The directors are now reviewing the results for the year ended 30
June 20X5 and have asked for your advice, as an external business
consultant, as to whether or not the above strategies have been
successful.

Required:

Prepare a report to the directors of Neville assessing the

performance and position of the company in the year ended 30 June
20X5 compared to the previous year and advise them on whether or
not you believe that their strategies have been successful.

Analysis of Cash Flow Statement

3. SCF is considering the acquisition of FGH, one of its suppliers.

SCF always looks carefully at the liquidity position of potential
targets, having been exposed to cash flow problems in earlier
acquisitions. If acquired, SCF would like to retain the existing
management team of FGH.
You work as an accountant for SCF and the Managing Director
has asked you to perform an analysis of FGH's most recent
statement of cash flows to determine how well the management
team is controlling cash.
FGH has been trading for a number of years and is currently
going through a period of expansion of its core business area.
The FGH statement of cash flows for the year ended 31
December 20X0 is presented below.

$000 $000
Profit before tax 2,200
Adjustments for:
Depreciation 380
Gain on sale of investments (50)
Loss on sale of property, Plant 45
and equipment
Investment income (180)
Interest costs 420
2,815
Increase in receivables (400)
Increase in inventories (390)
Increase in payables 550
Cash generated from 2,575
operations
Interest paid (400)
Income taxes paid (760)
Net cash from operating 1,415
activities
Cash flows from investing
activities
Acquisition of subsidiary, net (800)
of cash acquired
Acquisition of PPE (340)
Proceeds from sale of 70
equipment
Proceeds from sale of 150
investments
Interest received 100
Dividends received 80
Net cash used in investing (740)
activities
Cash flows from financing
activities
Issue of shares 300
Proceeds from long term 300
borrowings
Dividend paid to equity (1,000)
shareholders of the parent
Net cash used in financing (400)
activities
Net increase in cash and cash 275
equivalents
Cash and cash equivalents at 110
the beginning of the period
Cash and cash equivalents at 385
the end of the period
 Prepare a memo to the Managing Director assessing the cash
management of FGH based on your analysis of the statement of
cash flows.

4. Tuyet is a public limited company that prepares its financial

statements in accordance with International Financial Reporting
Standards and has a year end of 31 December 20X1. It
manufactures furniture that is sold to a range of retail outlets. As
at the year end Tuyet has loans outstanding, with repayments of
$7 million due annually in each of the next four years.

You are a potential investor in Tuyet. You are analysing its

statement of cash flows for the year ended 31 December 20X1,
which is presented below:

$m
Cash flow from operating activities
Profit before tax 35
Finance cost 5
Depreciation 12
Profit on disposal of PPE (8)
Reduction in Provisions (6)
Increase in inventories (19)
Increase in receivables (14)
Increase in payables 13
Cash generated from operations 18
Interest paid (5)
Tax paid (10)
3
Cash flows from investing activities
Proceeds from sale of PPE 20
Purchases of PPE (30)
(10)
Cash flows from financing activities
Proceeds from shares 15
Repayment of loans (7)
Dividends paid - 8

Increase in cash and cash 1

equivalents
Opening cash and cash equivalent (5)
Closing cash and cash equivalent (4)

From analysis of the statement of cash flows, what conclusions would you
draw about Tuyet?
Revision for Exam:
1. The following extracts of Jim’s financial statements are
available:
$000
Redeemable preference 50
shares
Ordinary share capital 900
Share premium 400
Retained earnings 400
10% Loan notes 150

The gearing ratio of Jim will be ??

(Use (Debt / Debt + Equity) and Debit / Equity )

a.8.3%
b.10.5%
c.15.8%
d.22.2%

2. The following extracts from Patel’s financial statements are

available.
$000
Profit from operations 400
Finance costs (50)
Profit before tax 350

Ordinary share capital 900

Retained earnings 300
10% Loan notes 500

What are the return on capital employed and pre-ax

return on equity?
a. 23.5 % , 23.5%
b. 20.6%, 29.2%
c. 23.5% , 29.2 %
d. 28.6% , 23.5%
3. The acid test should include
a. Raw materials
b. Work in progress
c. Trade receivables
d. Non-current liabilities

4. Lytham plc recognised an impairment loss in relation to

property, plant and equipment in profit or loss during the
year.
What was the effect its recognition on Lytham plc’s gearing and non-
current asset turnover?

A An increase in gearing and an increase in non-current asset

turnover

B No change in gearing and a decrease in non-current asset

turnover

C An increase in gearing and a decrease in non-current asset

turnover

D No change in gearing and an increase in non-current asset

turnover

5. JT operates in a highly seasonal industry. An analyst has

sought to assess JT by comparing its ratios to ratios of the
business sector average for the year ended 31 December
20X3.

Which of the following is likely to be a limitation of this analysis?

A The average figures have been taken from entities whose year
ends occur at different points across the year

B The industry has experienced significant falls in demand over the

past two years

C All of the entities in the sector prepare financial statements under

IFRS Standards

D An error was discovered relating to JT’s 20X2 financial

statements. This was corrected in 20X3.

6. The following information has been taken from the accounting

records of FX for the year ended 31 December 20X4.
FX's working capital (cash) cycle is 55 days. FX's trade payable
payment period is 40 days
Credit sales amounted to $2 million, and year end receivables were
$274,000
All calculations should be made to the nearest full day. The trading
year is 365 days.
What is the inventory turnover period as at 31 December 20X4?
 50 days
 45 days
 65 days
 35 days
7. Incorrectly treating a lease rental as an operating expense is likely to
have what impact on ratios?

1. Non-current asset turnover will be understated

2. Interest cover will be understated

3. Return on capital employed will be understated

4. Gearing will be understated

8. The following extracts of Greg’s financial statements are available:

$
Dividend paid 140,000
Ordinary share capital $1 1,000,000
Retained earnings 2,900,000
Share price 2.50
Profit for the year 330,000
1. What is the dividend yield for Greg?
a. 14%
b. 42.4%
c. 4.8%
d. 5.6%
2. What is the dividend cover?
a. 2.4 times
b. 17.9 times
c. 20.7 times
d. 7.1 times
3. Which of the following ratios is likely to be most relevant for a
local charity?
a. Earnings per share
b. Return on capital employed
c. Operating profit margin
d. Acid test ratio