Interpretation of financial statements

In this essay, we will see how accounting ratio analysis is useful in the analysis and interpretation of financial statements. We shall also consider problems that are encountered when applying this technique. Accounting ratios can be used to examine various aspects of financial position and performance of a business. To start our analysis, we should know what is meant by an accounting ratio. “An accounting ratio is an arithmetic relationship between two figures in a company’s balance sheet, income statement, and certain market data, often indicates something about the company’s activities.

“( ) Ratios can be expressed in various forms, for example as a percentage, as a fraction or as a proportion. The way in which a particular ratio is presented will depend on the needs of those who will use the information. Although it is possible to calculate a large number of ratios, only a few, based on key relationships, are likely to be helpful to a user. Many ratios that could be calculated from the financial statements may not be considered because there is no clear or meaningful relationship between the items.

Accounting ratio classification By calculating a relatively small number of ratios, it is often possible to build up a reasonably good picture of the position and performance of a business. Thus, it is not surprising that accounting ratio analysis is widely used by those who have an interest in businesses and business performance. Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position.

The following broad categories provide a useful basis for explaining the nature of the accounting ratios to be dealt with: Profitability: this ratios provide and insight to the degree of success in achieving the purpose of creating wealth for the owners. Efficiency: ratios may be used to measure the efficiency with which certain resources have been utilized within the business. Liquidity: it is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations.

Certain ratios may be calculated that examine the relationship between liquid resources held and creditors due for payment in the near future. Gearing: this is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business. Investment: certain ratios are concerned with assessing the returns and performance of shares held in a particular business. The strengths of accounting ratio analysis

Barry Elliott and Jamie Elliott mentioned accounting ratios are useful in their book: ‘Accounting ratios identify irregularities, anomalies and surprises that require further investigation to ascertain the current and future financial standing of a company’ (Barry Elliott and Jamie Elliott, 2002) So far we know accounting ratios are useful, but we don’t know how useful they are. The next step we will discuss their usefulness at evaluating company’s performance. Need of comparison A ratio alone will not tell very much about the position or performance of a business.

For example, if a ratio reveals that a business was generating 100 pounds in sales per square metre of counter space, it would not be possible to deduce from this information alone whether this particular level of performance was good, bad or indifferent. It is only when compare this ratio with some ‘benchmark’ that the information can be interpreted and evaluated. Past period By comparing the ratio calculated with the ratio of a previous period, it is possible to detect whether there has been an improvement or deterioration in performance.

Indeed, it is often useful to track particular ratios over time (say, five or ten years) in order to see whether it is possible to detect trends Planned performance Ratios may be compared with the targets that management developed before the commencement of the period under review. The comparison of planned performance with actual performance may therefore be a useful way of revealing the level of achievement attained. Similar businesses In a competitive environment, a business must consider its performance in relation to those of other businesses operating in the same industry.

Survival may depend on the ability to achieve comparable levels of performance. Thus, a useful basis for comparing a particular ratio is the ratio achieved by similar businesses during the same periods. Through the comparison, the users of financial statements are able to identify and highlight in which area a company is performing good or bad, in which area it has significant change. User’s satisfaction Although there are many users of financial statements, it is not necessarily everything they will ever need to know.

Here we have listed the users of financial statements who want to know the sorts of things: Investors to help them determine whether they should buy shares in the business, hold on to the shares they already own or sell the shares they already own. They also want to assess the ability of the business to pay dividends. Lenders to determine whether their loans and interest will be paid when due Managers might need segmental and total information to see how they fit into the overall picture Employees

Information about the stability and profitability of their employers to assess the ability of the business to provide remuneration, retirement benefits and employment opportunities Suppliers and other trade creditors Businesses supplying goods and materials to other businesses will read their accounts to see that they don’t have problems: after all, any supplier wants to know if his customers are going to pay their bills! Customers The continuance of a business, especially when they have a long term involvement with, or are dependent on, the business

Governments and their agencies The allocation of resources and, therefore, the activities of business. To regulate the activities of business, determine taxation policies and as the basis for national income and similar statistics Local community Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area Financial analysts They need to know, for example, the accounting concepts employed for inventories, depreciation, bad debts and so on

Environmental groups many organizations now publish reports specifically aimed at informing us about how they are working to keep their environment clean. Researchers Researchers’ demands cover a very wide range of lines of enquiry ranging from detailed statistical analysis of the income statement and balance sheet data extending over many years to the qualitative analysis of the wording of the statements Different types of users of financial information are likely to have different information needs that will determine the ratios that they find useful.

For example, shareholders are likely to be interested in their returns in relation to the level of risk associated with their investment. Thus, profitability, investment and gearing ratios will be of particular interest. Long-term lenders are concerned with the long-term viability of the business. In order to help them to assess this, the profitability ratios and gearing ratios of the business are also likely to be of particular interest. Short-term lenders, such as suppliers, may be interested in the ability of the business to repay the amounts owing in the short term. As a result, the liquidity ratios should be of interest.