INTRODUCTION

➢ The overall objective of financial statement analysis is to make an informed decision. The
kind of decision will vary depending on the needs of the analyst.
➢ Financial statements are analysed to enable the user of those statements to be better able
to interpret the information they provide.
➢ The process of analysis and interpretation is aimed at establishing trends for the particular
firm under review and at comparing the results and trends revealed by the analysis with
those of the past or other similar firms in order to determine the relative strength of the firm.
➢ The information, as it appears in the financial statements, cannot be used directly for
evaluation and decision making.
➢ Users of the statements evaluate the information provided in the statements with the aid of
financial analysis. Financial analysis and interpretation is done by using ratio analysis.

THE PURPOSE OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

➢ Is to provide useful information to the different users of the financial statements.

➢ The type of analysis and interpretation and the extent to which it is done, depends on who
the user of the information is and for what purpose the information will be used.
WHO ARE THE USERS OF FINANCIAL STATEMENTS?

USER INFORMATION REQUIRED

Shareholders return on investment and growth in value of investment

Providers of LT Finance ability to repay amounts owed to them on time

Creditors short-term liquidity of entity

Employees profitability of the entity as this impacts job security

Management performance of the entity, efficiency and profitability of the entity

Auditors express an opinion on fair presentation of AFS

SARS Use financial statement analysis to check the reasonableness of

income tax returns
TOOLS AND TECHNIQUES FOR THE ANALYSIS OF FINANCIAL STATEMENTS

➢ The analyst has a variety of techniques available for analysing financial statements and
can choose the technique best suited to a specific purpose.
➢ Among the more common analytical techniques are:
o Comparative financial statements and trend anaysis
o Indexed financial statements
o Normalized or common size statements
o Ratio analysis

Comparative financial statements

➢ The comparison of financial statements is accomplished by setting up Statements side-by-

side and reviewing the changes that have occurred from year to year. The most important
factor revealed by comparative financial statements is the trend. The trend will indicate the
direction of change, the rate of change, and the amount of the change.

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

2024 2023 Trend
Sales/Revenue 850 000 900 000
Profit for the year 230 000 180 000
Index analysis

➢ Index analysis is similar to comparative financial statements except that a base year is
chosen and all values for that year are expressed as 100%. Subsequent years are then
expressed in terms of percentages calculated on the base year.

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

2024 2023 2024-Index 2023-Index
Sales 550 000 650 000
Cost of sales (200 000) (320 000)
Gross profit 350 000 330 000
Other income 40 000 50 000
Other expenses (120 000) (160 000)
Profit before tax 270 000 220 000

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

2024 2023 2024-Index 2023-Index
Non-Current asset 300 000 280 000
Current assets 200 000 250 000
Total assets 500 000 530 000
Equity 320 000 240 000
Liabilities 180 000 290 000
Total equity and liabs 500 000 530 000
Common size analysis

➢ In a common size Statements of Financial Position, each item is expressed as a

percentage of total assets. In the common size Statement of Comprehensive Income, sales
revenue is expressed as 100% and every other item is expressed as a percentage of sales
revenue.

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

2024 2023 2024-Index 2023-Index
Sales 550 000 650 000
Cost of sales (200 000) (320 000)
Gross profit 350 000 330 000
Other income 40 000 50 000
Other expenses (120 000) (160 000)
Profit before tax 270 000 220 000
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
2024 2023 2024-Index 2023-Index
Non-Current asset 300 000 280 000
Current assets 200 000 250 000
Total assets 500 000 530 000
Equity 320 000 240 000
Liabilities 180 000 290 000
Total equity and liabs 500 000 530 000
Ratio analysis

➢ A ratio expresses the relationship between one quantity and another.

➢ A ratio contains little meaningful information on its own. For a ratio to be effectively
interpreted, it needs to be either compared with historic ratios to identify trends, or with
industry ratios
➢ Ratios can be broadly categorized under the following headings:
✓ Liquidity
✓ Profitability
✓ Leverage
✓ Capital structure
✓ Security of income

LIQUIDITY

➢ Liquidity is the ability of an enterprise to meet its short term obligations (current liabilities)
by using its short term assets (Current assets). If an enterprise cannot meet its immediate
obligations, it will not take long before it is in serious trouble or even collapse. As a result
of this, liquidity ratios are of great interest to all users. There are seven main liquidity ratios:
Current ratio: This measures the ability of the enterprise to meet its immediate financial
commitments. The general standard for this ratio is 2:1.

Current assets/Current liabilities (measured as a ratio)

Acid test ratio: This ratio is the same as the current ratio only inventory or stock is excluded
as this is the least liquid of the current assets. The general standard for this ratio is 1:1.

(Current asset – Inventory) / Current liabilities (measured as a ratio)

Debt settlement period: This ratio measures in years the time it would take for the enterprise
to repay all its debts out of cash flow.

(Total debt – cash) / Cash flow for the year (measured in years)

Debtors’ collection period: This ratio measures how long it takes for an enterprise to collect
its trade debtors.

Trade Debtors/Credit sales x 365 (measured in days)

Creditors’ payment period: This ratio measures how long it takes for an enterprise to pay its
trade creditors.

Trade Creditors/Credit purchases x 365 (measured in days)

Stock turnover period: This ratio measures how long stock sits on the shelves before it is sold
or used.

Closing stock / Cost of sales x 365 (measured in days)

Business cycle: This ratio measures how long it takes from the time something is purchased
to the time the money is received from its sale.

Debtors’ collection period xxx

Stock turnover period xxx

Creditors’ payment period (xxx)

Business cycle xxx (measured in days)

PROFITABILITY

➢ Profitability measures the ability of an enterprise to generate profits or returns from assets.
There are eight main ratios.

Return on equity (before tax): This ratio measures the return the equity shareholders receive
before tax.

Earnings ordinary shareholders (before tax)/Ordinary equity x 100 (measured as a %)

Return on equity (after tax): This ratio is the same as the Return on equity (before tax) above
except that it is stated after tax expense.

Earnings ordinary shareholders (after tax) Ordinary equity x 100 (measured as a %)

Return on assets (ROA): This ratio measures the return {earnings before interest and tax
(EBIT)}as a percentage of total assets.

Earnings before interest and tax (EBIT)/Total assets x 100 (measured as a %)

Gross profit %: This ratio measures the difference between the cost of purchasing or
producing goods and turnover.

Gross profit/Sales x 100 (measured as a %)

Net profit %: This ratio measures the efficiency of the enterprise in terms of cost control. Net
profit here is the net profit from operating activities before interest and tax as per net profit above

Net profit/Sales x 100 (measured as a %)

LEVERAGE/GEARING

➢ Leverage is also known as gearing or borrowing. The leverage ratios, therefore, establish
whether or not the company is better off by borrowing.

The total leverage ratio: This ratio will establish whether the funding provided by sources other
than the equity shareholders has helped improve the return to the equity shareholders in total.

Return on equity (before tax)/Return on assets (measured as a number)

The total leverage effect: This measures the extent to which arranging external sources of
funding has helped or not helped the equity shareholders.

Return on equity (before tax) xx,xx%

Less: Return on assets (xx,xx%)

Total leverage effect xx,xx%

CAPITAL STRUCTURE

➢ Capital structure is about how the enterprise is structured in terms of where the funds come
from. It is primarily concerned with the funding provided by the equity shareholders and the
funding provided by others.

Ordinary shareholders equity to total assets: This ratio calculates the percentage of funds
provided by the equity shareholders as a percentage of the total assets.

Ordinary shareholders equity/Total assets x 100 (measured as a %)

Total outside funding to total assets: This ratio calculates the percentage of funds provided
by outside sources as a percentage of total assets.

Total outside funding/Total assets x 100 (measured as a %)

Debt equity ratio: This ratio compares long-term funding only to total shareholders interest.
Debt/Total shareholders interest (measured as a ratio)

Total assets to total debt: This ratio measured the number of times debt is covered by assets.
Total assets/Total debt (measured as number of times)
Total shareholders’ interest to total assets: The percentage of total assets funded by all the
shareholders is indicated by this ratio.

Total shareholders’ interest/Total assets x 100 (measured as a %)

SECURITY OF INCOME

➢ Any investor putting money into another enterprise is concerned with two things, namely,
getting a return and getting the money back one day. The security of income ratios focus
on how secure the return (interest, dividends etc.) is.

Interest cover: This ratio measures the number of times interest is covered by income before
interest.

EBIT (Earnings before interest and tax)/Interest (measured as number of times)

Preference dividend cover: This ratio measures the number of times preference dividends
are covered by income before preference dividends.

Income after tax/Preference dividends (measured as number of times)

Ordinary dividend cover: This ratio measures the number of times ordinary dividends are
covered by the income available to ordinary shareholders.

Earnings ordinary shareholders/Ordinary dividends (measured as number of times)