THE ANALYSIS OF

FINANCIAL STATEMENTS
Finance Book: Chapter Three
Accounting Book: Chapter Six
Chapter 3: Accounting.
OUTCOMES

At the end of this chapter students should:

•Have an understanding of company terminology
•Be able to draft a statement of comprehensive
income and a statement of financial position for a
company
•Be able to calculate selected liquidity, efficiency
and profitability ratios and interpret the results of
these ratios.
 3.1 INTRODUCTION

The purpose of financial analysis is either to:

•Evaluate the financial performance of the organisation
•To evaluate the position of the organisation during the
previous accounting period, or
•To evaluate the future plans of the organisation based on the
budgeted (or so-called pro-forma) statement of financial
performance (income statement) and statement of financial
position (balance sheet).
•The primary inputs in financial analysis (or ratio analysis as it
is sometimes called) are the organisation’s statement of
financial performance and statement of financial position for the
periods under evaluation.
3.2 TYPES OF COMPARISONS:
Ratio analysis

• Ratio analysis is not simply a matter of applying a

formula to financial data in order to calculate a
given ratio.
• More important is the interpretation of the ratio.
• To answer questions such as:
– “Is it too high or too low?” or
– “Is it good or bad?”
• A meaningful benchmark or basis for comparison
is needed.
 3.2 TYPES OF COMPARISONS:
Industry comparative analysis

• Industry comparative analysis involves the comparison

of the financial ratios of different organisations at the
same point in time.
• The analyst must recognise that ratio comparisons
resulting in large deviations from the norm are only a
symptom;
• Further analysis of the organisarion's financial
statements, is generally required to isolate the cause of
such symptoms and to develop corrective actions.
• The fundamental issue is that ratio analysis merely
directs the analyst to potential areas of concern.
 3.2 TYPES OF COMPARISONS:
Time-series analysis

• Time-series analysis is undertaken when a financial analyst

evaluates the performance of an organisation over time.
• As in industry comparative analysis, any significant year-to-
year changes should be evaluated to assess whether they
are symptomatic of major problems.
• The most informative approach to ratio analysis is one that
combines industry comarative and time-series analyses.
• Comparison of current with past performance utilising ratio
analysis allows the organisation to determine whether it is
progressing as planned.
 3.3 COMPARISONS
CAUTION WHEN USING RATIOS

• Firstly, a single ratio generally does not provide sufficient information

to allow one to judge the overall performance of the organisation; only
when a group of ratios is used do realistic judgements become
possible.
• Secondly, an analyst should be sure that the dates of the financial
statements being compared correspond. If not, the effects of
seasonality may lead to incorrect conclusions.
• Thirdly, it is best to use audited financial statements, otherwise the
data might not reflect the organisation’s true financial performance
and position.
• Fourthly, care should be taken not to adopt a “bigger is better”
approach, which could be misleading.
• Finally, it is important to make sure that the data being compared have
been developed in the same way.
 3.4 BASIC FINANCIAL RATIOS:
Five Basic Groups

• Profitability ratios:
– Gross profit margin
– Net profit margin
– Return on investment (ROI)
– Return on equity (ROE) or
– Return on net assets (RONA)
– There are many measures of profitability, all of which relate
the returns of the organisation to its sales, assets or equity.
– Without profits, present owners and creditors would become
concerned about the company’s sustainability due to the
negative impact of losses on the organisation’s liquidity and
solvency.
 3.4 BASIC FINANCIAL RATIOS:
Five Basic Groups

• Liquidity ratios:
– Net working capital
– Current ratio
– Quick (acid-test) ratio.
 3.4 BASIC FINANCIAL RATIOS:
Five Basic Groups

• Activity ratios
– Debt (or solvency) ratios
• Activity ratios:
– Are used to measure the speed with which various accounts
are converted into sales or cash. Measures of overall liquidity
are generally inadequate because differences in the
composition of a organisarion's current assets and liabilities
may significantly affect the organisarion's "true" liquidity.
– Measuring the activity of the most important current
accounts, which include inventory, accounts receivable and
accounts payable. The activity of fixed and total assets can
also be assessed.
 3.4 BASIC FINANCIAL RATIOS:
Five Basic Groups

• Debt (or solvency) ratios:

– The debt position of a organisarion indicates the amount of
other people's money that is being used in the attempt to
generate profits. It provides an indication of the solvency of
the organisarion.
– The greater the extent to which a organisarion makes use of
debt, the greater its financial leverage.
– The more debt or financial leverage a organisarion uses, the
greater its risk and required return will be.
– The most commonly used measures are the debt ratio and the
debt-equity ratio
• Securities market ratios:
 3.4 BASIC FINANCIAL RATIOS:
Five Basic Groups

• Securities market ratios:

– The earnings per share (EPS), dividend per share (DPS),
dividend yield (DY) and price-earnings ratio (P/E ratio), are
only applicable to organisations listed on a securities
exchange.
Example of a statement of financial performance.
Statement of financial performance for the year
ended 28 February 2018
Sales 9 000 000
Less: cost of goods sold 4 500 000
Gross profit 4 500 000

Less: operating expenses 3 090 000

Operating profit 1 410 000
Less: interest expense 24 000
Net profit before tax 1 386 000
Less: tax (28%) 388 080
Net profit after tax 997 920
Net profit distributed as follows:
Dividends to ordinary shareholders 277 200
Retained earnings 720 720
997 920
Example of a statement of financial position.
Statement of financial position as at 28 February 2018

Fixed assets 7 500 000 Shareholders’

interest:
Current assets: Ordinary shares 5 000 000
Cash 100 000 Retained earnings 1 000 000

Accounts 900 000 Long-term debt 1 900 000

receivable
Inventory 600 000 Current liabilities:

Accounts payable 1 200 000

Total assets 9 100 000 Equity and 9 100 000

liabilities

Additional information:
• Number of ordinary shares issued: 2 500 000 at 200 cents each
•Current market price of the share: 350 cents
 The gross profit margin is calculated as
follows:

• Gross profit margin = sales – cost of goods sold sales × 100/1

• The gross profit margin indicates the contribution from the

organisation’s core business towards covering the organisation’s
operating expenses.

• Example Based on the financial statements provided in Tables 3.1 and

3.2 on p. 42

• The gross profit margin may be calculated as follows:

• Gross profit margin = R 4 500 000 x 100
R 9 000 000 1
= 50%
• From the above calculations it should be evident that gross
profit is influenced by the sales level and the cost of goods sold.
 The gross profit margin:
Corrective action.

• If an organisation’s gross profit margin is not

satisfactory, management could consider increasing
income from sales and/or decreasing expenses.
• More specifically, management should consider the following:
– Increase sales through improved marketing.
– Supply chain managers could lower the levels of inventory.
– Attempt to produce at a lower cost (in the case of mining and
manufacturing organisations) or to buy at better prices (in the
case of retailing organisations).
– Produce fewer quantities (in the case of mining and
manufacturing organisations) or buy less stock (in the case of
retailing organisations) during periods of declining sales.
 The net profit margin is calculated as
follows:

• The net profit margin measures the percentage of each sales rand
remaining after all expenses, including taxes, have been deducted.

• Net profit margin = net profit after tax x 100

sales 1

Example Based on the statement of financial

performance in Table 3.1, p. 42:

• The organisation’s net profit margin may be calculated as

follows:
• Net profit margin = R 997 920 X 100
R 9 000 1
= 11.09%
 The net profit margin:
Corrective action

• The higher the net profit margin, the better. The net profit margin is a
commonly cited measure of an organisation’s success with respect to
earnings on sales.

Corrective action
If an organisation’s net profit margin is not satisfactory, management
could consider:
• Increasing income from sales and/or decreasing expenses.
• More specifically, management should consider the following:
– Increase sales through more efficient and effective marketing.
– Reduce expenses.
 The return on investment (ROI):

• The return on investment (ROI), sometimes also called return on

assets (ROA), measures the overall effectiveness of management in
generating profits with its available assets.

ROI = net profit after x 100

tax total assets 1

Example Based on the financial statements in Tables 3.1 and 3.2, the
organisation’s ROI may be calculated as follows:

ROI = R 997 920 x 100

R 9 100 000 1 = 10.97%
 The return on investment (ROI):
Corrective action

If an organisation’s ROI is not satisfactory, management could consider

the following:
•Increase revenue by increasing sales or the price of goods and
services.
•Lower the operating expenses, such as salaries, by retrenching some
of the employees.
•Reduce the investment in current assets, such as inventory and
accounts receivable during periods of declining sales.
•Evaluate the effectiveness and efficiency of the fixed assets with a view
to improving productivity and/or unbundling business units with low or
no profitability.
•Improve the effectiveness and efficiency of employees through training.
 The return on equity (ROE):

The ROE measures the return earned on the owners’ investment.

•ROE = net profit after tax x 100

shareholders’ equity 1

Alternatively:

ROE = net profit x sales x total assets x 100

sales total assets shareholders’ equity 1
The return on equity (ROE):

Example Based on the figures from the financial statements in

Tables 3.1 and 3.2 p. 42:

• The ROE may be calculated as follows:

• ROE = R 997 920 x 100

R 6 000 000 1
= 16.6%
 The return on equity (ROE):
Corrective action

If an organisation’s ROE is not satisfactory, then management

could consider the following:

•Increase revenue by increasing sales or the price of goods and

services.
•Lower the operating expenses.
•Improve marketing to improve the asset turnover rate.
•Increase the leverage (gearing) by making greater use of debt to
finance the organisation.
 The return on net assets (RONA):

• The return on net assets (RONA) is closely related to ROE. This may
be calculated as follows:

• RONA = net profit x 100

total assets – liabilities 1

RONA is an ideal tool in situations where the amount of equity has to

be determined by means of the accounting equation.
 3.4.2 Liquidity ratios

• Liquidity can be measured by calculating net working capital, current

ratio and the quick (acid-test) ratio.
Net working capital
This is calculated by subtracting current liabilities from current assets.

Net working capital = current assets – current liabilities

Example:
The net working capital for the organisation being studied (the financial
statements of which can be seen in Tables 3.1 and 3.2, p. 42) is as
follows:

Net working capital = R1 600 000 – R1 200 000 = R400 000

 Liquidity ratios:
Corrective action

• If an organisation’s net working capital is not satisfactory,

management could consider the following:

– Accelerate cash inflow by offering cash discounts for early

settlement of debtors’ accounts or factoring accounts receivable
– Buy fewer goods on credit (as long as the organisation has
adequate cash inflow) in order to reduce the current liabilities.
– Decrease inventory by selling more goods, thus improving sales
and increasing cash or accounts receivable.
– Increase current assets by increasing the level of ending
inventory, as long as the inventory can be sold soon after the
commencement of the new accounting period.
 Liquidity ratios:
Current ratio

• The current ratio is one of the most commonly cited financial ratios and is
expressed as follows:
• Current ratio = current assets___
current liabilities
Example:
The current ratio for the data of the organisation as indicated in Tables 3.1
and 3.2 is as follows:

Current ratio = R 1 600 000

R 1 200 000 = 1.33

• A current ratio of 2.0 is usually cited as an acceptable value.

• However, this depends on the industry in which an organisation operates.
 Liquidity ratios:
Current ratio
Corrective action:

• If an organisation’s current ratio is not satisfactory, management

could consider the following:
• Accelerate cash inflow by offering cash discounts for early
settlement of debtors’ accounts or factoring accounts receivable
• Buy fewer goods on credit (as long as the organisation has adequate
cash inflow) in order to reduce the current liabilities.
• Decrease inventory by selling more goods, thus improving sales and
increasing cash or accounts receivable.
• Increase current assets by increasing the level of ending inventory,
as long as the inventory can be sold soon after the commencement
of the new accounting period.
 Liquidity ratios:
Quick (acid-test) ratio

The quick (acid-test) ratio is similar to the current ratio except that it
excludes inventory from current assets; calculated as follows:
Quick ratio = current assets – inventory
current liabilities
Example The quick ratio for the data of the organisation as indicated
in Tables 3.1 and 3.2 is 0.83:

Quick ratio = R 1 600 000 – R 600 000

R 1 200 000
= 0.83

A quick ratio of 1.0 or greater is usually acceptable, because it means

the organisation has at least R1 in cash and accounts receivable
available to cover each rand of its accounts payable
 Liquidity ratios:
Quick (acid-test) ratio
Corrective action:

If an organisation’s quick ratio is not satisfactory, management could

consider the following:

•Accelerate cash inflow by offering cash discounts for early settlement

of debtors’ accounts or factoring accounts receivable.
•Buy fewer goods on credit (as long as the organisation has adequate
cash inflow) in order to reduce the current liabilities.
•Decrease inventory by selling more goods, thus improving sales and
increasing cash or accounts receivable.
 Activity ratios

• Activity ratios are used to measure the speed with which various accounts
are converted into sales or cash.
• A number of ratios are available for measuring the activity of the most
important current accounts, which include inventory, accounts receivable
and accounts payable.
Inventory turnover
• The activity, or liquidity, of an organisation’s inventory is commonly
measured by its turnover.
• This is calculated as follows:
• Inventory turnover = cost of goods sold
average inventory
The average inventory may be found thus:
• (beginning inventory + ending inventory) ÷ 2
 Activity ratios
Example
Corrective action

• Inventory turnover = cost of goods sold

average inventory

• Inventory turnover = R 4 500 000 = 7.5 times p.a.

R 600 000
The inventory turnover of the organisation as indicated in Tables 3.1
and 3.2 is 7.5 times per annum (assuming the average inventory is
R600 000).

• The turnover is meaningful only if it is compared with that of other

organisations in the same industry or with the organisation’s
inventory turnover performance in the past.
• Corrective action If an organisation’s inventory turnover is not
satisfactory, management could consider lowering inventory levels.
 Activity ratios
Average collection period

• The average collection period (ACP), or average age of

accounts receivable, is useful for evaluating credit and
collection policies.
• ACP = accounts receivable
annual sales ÷ 360

• This equation assumes a 360-day year.

Activity ratios
Example

• The average collection period for the organisation in our

example is as follows:

• ACP = accounts receivable

annual sales ÷ 360

• ACP = R 900 000 ÷ 360

• R 9 000 000
= 36 days

• It takes the organisation 36 days to collect an account

receivable.
 Activity ratios
Corrective action:

If an organisation’s average collection period is not satisfactory,

management could consider doing the following:
•Increase cash sales, thereby reducing sales on credit and lowering
the accounts receivable.
•Offer discounts for early settlement to debtors, thus accelerating
the collection period.
•Factor all or part of the accounts receivable – this will improve
cash flow but will reduce the profitability of the organisation due to
the fees charged by the factoring organisation.
•Send out account statements earlier and ensure that mistakes in
them are kept to a minimum.
•Charge interest on overdue accounts.
 Activity ratios
Average payment period
Example:

• The average payment period (APP) is determined by dividing the

average daily credit purchases into the accounts payable balance.
• APP = accounts payable ÷ 360
annual purchases on credit
• This equation assumes a 360-day year.
Example:
• The average payment period for the organisation is as follows
(assume credit purchases amounted to R4 400 000)
• APP = R 1 200 000 ÷ 360 = 98 days
• R 4 400 000
• On average, it takes the organisation 98 days to pay its accounts
payable.
 Activity ratios
Average payment period
Corrective action:

• If an organisarion's average payment period is not

satisfactory, and to prevent suppliers from changing
their terms to cash on delivery, the organisarion
would have to investigate the reasons for late
payment and attempt to ensure prompt payment.
• One of the reasons for late payment might be
incorrect invoices and account statements.
 Measures of debt
Debt ratio & debt-equity ratio

• The debt position of an organisation indicates the amount of

other people’s money that is being used in the attempt to
generate profits.
• The financial analyst is most concerned with long-term debts,
since these commit the organisarion to paying interest over the
long run and eventually to repaying the borrowed funds.
• In general, the greater the extent to which a organisarion makes
use of debt, the greater its financial leverage
• Two of the most commonly used measures are the debt ratio
and the debt-equity ratio.
• The debt ratio provides an indication of the solvency of the
organisation.
 Measures of debt
Debt ratio
Example

• The debt ratio measures the proportion of total assets provided

by the organisation’s creditors.
• Debt ratio = total liabilities x 100
• total assets 1

Debt ratio = R 3 100 000 x 100 = 34.07%

R 9 100 000 1
The debt ratio for the organisation as indicated in Tables 3.1 and
3.2 is 34.07%:
• This indicates that the organisation has financed 34.07% of its
assets with debt.
• The higher this ratio, the more financial leverage the organisation
has.
 Measures of debt
Debt ratio
Corrective action

• Issue new ordinary shares, as long as this is done by means of a

rights issue to prevent dilution of the shareholding of current
shareholders.
• Reduce the current liabilities by accelerating cash inflow and use
this to pay off creditors or any overdraft the organisation might have.

If an organisation’s debt ratio is too low, management could consider

these measures:
• Buy back some of its ordinary shares by raising long-term loans or
selling bonds/debentures to pay for the shares.
• Increase purchases of goods on credit from suppliers.
 Measures of debt
Debt-equity ratio
Example

• Indicates the relationship between the long-term funds provided by

creditors and those provided by the organisation’s owners.
• It is commonly used to measure the degree of financial leverage of
the organisation and is defined as follows:
• Debt-equity ratio = long-term debt x 100
shareholders’ equity 1
Example: Debt-equity ratio = R1 900 000 x 100 = 31.67%
R6 000 000 1
• The organisation indicated in Tables 3.1 and 3.2, the debt-equity
ratio is 31.67%:
• The organisation’s long-term debts are therefore only 31.67% as
large as owners’ (shareholders’) equity.
 Measures of debt
Debt-equity ratio
Corrective action:

• If an organisation’s debt-equity ratio is too high, management could

consider issuing new ordinary shares, as long as this is done by
means of a rights issue to prevent dilution of the shareholding of
current shareholders.
• The equity raised may be used to replace long-term loans.
• If an organisation’s debt-equity ratio is too low, management could
consider buying back some of its ordinary shares by raising long-
term loans or selling bonds/debentures to pay for the shares.
• This reduces the number of ordinary shares issued, lowers the
supply of shares and could increase the share price.
• It also results in an increase in earnings per share due to the smaller
number of ordinary shares and could lower the cost of capital.
 Securities market ratios

• The ratios discussed in this section are:

– the earnings per share (EPS)
– dividend per share (DPS)
– dividend yield (DY)
– price-earnings ratio (P/E ratio)

• The above is only applicable to organisations listed

on a securities exchange such as the JSE.
 Securities market ratios
Earnings per share (EPS)
Example

• EPS measures the return earned on behalf of each ordinary share

that has been issued.
• It is usually carefully monitored by investment analysts and
portfolio managers.
• EPS = (earnings after tax – preference dividend) ÷ number of
ordinary shares issued.
• Example: using the figures from Table 3.2 and assuming that 2 500
000 ordinary shares were issued at a par value of R2 each, the EPS
may be found as follows:
• EPS = R997 920 = 40 cents
2 500 000
 Securities market ratios
Earnings per share (EPS)
Corrective action:

• If an organisation’s EPS is too high, management could consider

issuing new ordinary shares, as long as this is done by means of
a rights issue to prevent dilution of the shareholding of current
shareholders.
• If an organisation’s EPS is too low, management could consider
the following:
– Buy back some of its ordinary shares by raising long-term
loans or selling bonds/ debentures to pay for the shares. This
reduces the number of ordinary shares issued, lowers the
supply of shares and could increase the share price.
– Improve the profitability of the organisarion through better
marketing and/or reducing expenses.
– Discontinue the use of preference share financing, if possible.
Securities market ratios
Dividend per share
Example

• EPS does not represent the amount of earnings actually

distributed to shareholders.
• The earnings distributed to ordinary shareholders are reflected
by the dividend per share.
• DPS is calculated as follows:
• DPS = dividends for ordinary shareholders
• number of ordinary shares issued

Example: the dividend per share for the organisation as indicated

in Tables 3.1 and 3.2 is 11 cents:

DPS = R277 200 = 11 cents

• 2 500 000
Securities market ratios
Dividend per share
Corrective action

• If an organisation’s DPS is too high, management

could consider declaring a lower dividend and/or
reducing the number of ordinary shares.

• Note: Investors tend to prefer to invest in the

shares of organisations with good prospects,
particularly if increases in the EPS and DPS are
expected to be announced in the financial
statements.
 Price-earnings ratio
Example

• The P/E ratio is calculated as follows:

P/E ratio = current market price per ordinary share
earnings per share
Example: for the organisation as indicated in Tables 3.1 and 3.2, the
P/E ratio is 8.75:
• P/E ratio = 350 cents = 8.75
• 40 cents
• A P/E of 8.75 means that investors are paying R8.75 for each R1 of
earnings.
• It could also be seen as the number of years it will take for the
earnings to equal the current market price.
• Different investors will set their own limits of what they would find
acceptable and will buy shares accordingly
Price-earnings ratio
Corrective action

• Some investors also multiply the P/E by the

expected EPS to find a rough approximation of
the value of an ordinary share.
• Management has no direct control over the
market price of the shares of the organisation. If
the P/E is too low, management will have to focus
on improving profitability and lowering the cost
of capital (if possible) in order to improve the
organisation's ability to create value and attract
investors' interest.
 Earnings yield
Example:
Corrective action:

• The earnings yield indicates the current income-producing power

per ordinary share at the current market price. This is the
opposite of the P/E ratio.
• Earnings yield = earnings per share x 100
current market price 1

• Example: using the figures for the organisation indicated in

Tables 3.1 and 3.2 gives an earnings yield of 11.4%:
Earnings yield = 40 x 100 = 11.4%
350 1
• Corrective action: The earnings yield may be improved by
increasing profitability and using leverage to reduce the number
of shares, thus increasing the earnings per share.
 Dividend yield

• The EPS is not all paid out to shareholders, but rather the
dividends per share is the actual cash flow shareholders receive –
that is, the DY (dividend yield).

• DY = dividends per share x 100

current market price 1
• Example: using the figures for the organisation indicated in
Tables 3.1 and 3.2, the DY is 3%:
Dividend yield = 11 x 100 = 3%
350 1

Corrective action: An organisation that needs to improve its DY

must improve its profitability.
THE ANALYSIS OF FINANCIAL STATEMENTS:
Finance Book: Chapter Three
Accounting Book: Chapter Six

Any
Questions?