Analysis of Financial Statements

Objective A & B: Interpretation and Conclusions

Calculating ratios is only the first step — the real skill is interpretation. A structured approach to financial statement analysis involves:

1. Calculate

Compute the relevant ratios from the given financial data.

2. Compare

Compare the ratios against:

• Prior year figures (trend analysis)
• Industry averages (benchmarking)
• Competitor figures (competitive analysis)

3. Explain

Identify possible reasons for changes or differences. For example:

• A declining gross profit margin might indicate rising input costs, increased competition, or a shift to lower-margin products
• An increasing receivables days figure might indicate poor credit control or a deliberate strategy to attract customers with longer payment terms

4. Conclude

Draw valid conclusions based on the evidence. Avoid speculation — base conclusions on the data available.

5. Present

Tailor the presentation to the audience. An investor wants to know about returns and risk. A lender wants to know about liquidity and gearing. A manager wants to know about operational efficiency.

Interrelationships in Practice

When analysing a company, look for patterns across ratio categories:

• High profitability + poor liquidity = the company is profitable but may struggle to pay short-term debts (perhaps due to rapid growth tying up cash in receivables and inventory)
• Low gearing + high interest cover = low financial risk but potentially lower returns for shareholders
• Improving asset turnover + stable margins = growing revenue without proportional cost increases