module 6
PROFITABILITY
LIQUIDITY
GEARING
INVESTORS' RATIOS
LIMITATIONS
This Module covers the interpretation of financial
statements. It explains how to calculate the key ratios
and how they can be analysed and interpreted.
ANALYSIS OF
FINANCIAL
STATEMENTS
153
154
PROFITABILITY
Context
Profitability ratios show the returns generated by an entity. The most important profitability ratio is
Return on Investment (ROI).
Learning example 6.1
Dell Co has sales of $120m and a profit before interest and tax of $42m. Capital invested is $168m.
Required:
Calculate ROI, net profit margin and asset turnover.
Solution 6.1
6: Analysis of financial statements 155
156
PROFITABILITY
Context
Return on assets (ROA) and return on equity (ROE) are variants of ROI. They measure profit in
relation to the capital or funds invested in the entity.
Learning example 6.2
Walton Co has sales of $200m and a profit after interest and tax of $50m. Shareholders' equity is
$300m and interest bearing debt is $200. There are no preference shares in issue.
Required:
Calculate ROE, net profit margin, asset turnover (based on total assets less current liabilities) and
assets to equity.
Solution 6.2
6: Analysis of financial statements 157
158
LIQUIDITY
Context
While profitability is an important aspect of performance, an entity needs cash to survive. Liquidity
ratios assess how well the entity is managing its cash resources.
Learning example 6.3
The following are extracts from Camper Co's financial statements:
Statement of financial position $m Statement of profit or loss $m
Inventory 140 Revenue 2500
Trade receivables 175 Cost of sales (1850)
Cash 50 Gross profit 650
Trade payables 180
Required:
Calculate the current and quick ratios, receivables collection period, payables payment period and
inventory turnover in days.
Solution 6.3
6: Analysis of financial statements 159
160
GEARING
Context
Gearing ratios are concerned with how much the company owes in relation to its shareholders'
equity. They measure the risk attaching to an investment.
Learning example 6.4
Fisher Co has profit before interest and tax of $65m. The interest charge for the year was $45m on
loans of $450m. Capital invested (total assets less current liabilities) was $600m.
Required:
Calculate the gearing ratio and the interest cover ratio.
Solution 6.4
6: Analysis of financial statements 161
162
INVESTORS' RATIOS
Context
Investor ratios assist current and potential investors in deciding whether to continue to invest or
make an initial investment in a business.
Learning example 6.5
Rain Co made a profit after tax of $150 000 and declared a dividend of 5 cents per share for the
year ended 31 December 20X8. The company had 1 million ordinary shares on issue throughout the
year and the market price of a share was $1.20.
Required:
Calculate earnings per share, the dividend yield, dividend cover and price/earnings ratio.
Solution 6.5
6: Analysis of financial statements 163
164
LIMITATIONS
Context
There are a number of limitations to ratio analysis, one of which is the effect of accounting policy
choices which can mean that information is not comparable.
6: Analysis of financial statements 165
Reinforcement
Study Guide Module 6
Read through Module 6 and attempt the examples and questions.
Attempt the Quick Revision Questions within the Module and the Revision
Questions at the end of the Study Guide.
166
