Analysis and Interpretation of Financial Statements (Grade 12 NSC Matric Accounting): Revision Notes

Analysis and Interpretation of Financial Statements

Financial statement analysis is a crucial skill that helps us understand how well a company is performing financially. Think of it as giving a company a health check-up using numbers from their financial statements. This process involves examining key financial ratios and indicators to make informed judgements about a company's financial position and performance.

The five main areas of financial analysis

When analysing financial statements, we focus on five key areas that together give us a complete picture of a company's financial health.

Profitability analysis

Profitability measures how efficient a company is in its normal operating activities. It answers the question: "How good is this company at making profit from its business operations?"

The key profitability indicators include:

• Gross profit on sales - Shows what percentage of sales revenue remains after paying for the cost of goods sold
• Net profit on sales - Reveals what percentage of sales revenue remains as final profit after all expenses
• Operating expenses on sales - Indicates how much of sales revenue is consumed by operating expenses
• Operating profit on sales - Shows the profit margin from core business operations
• Gross profit on cost of sales (mark-up) - Demonstrates how much profit is added on top of the cost price

Liquidity analysis

Liquidity examines a company's ability to pay off its immediate short-term debts. This is vital because even profitable companies can fail if they cannot meet their immediate obligations.

Important liquidity ratios include:

• Current ratio - Compares current assets to current liabilities
• Acid test ratio - A stricter measure that excludes inventory from current assets
• Net current assets (working capital) - The difference between current assets and current liabilities
• Turnover rate of stock - How quickly inventory is sold and replaced
• Debtors' collection period - How long it takes to collect money owed by customers
• Creditors' payment period - How long the company takes to pay its suppliers
• Average period of stock on hand - How long inventory sits before being sold

Solvency analysis

Solvency measures a company's ability to pay off all its debts, both short-term and long-term. It assesses the company's long-term financial stability.

Key solvency indicators are:

• Solvency ratio - Compares total assets to total liabilities
• Net assets - The value remaining for shareholders after all debts are paid

Return analysis

Return analysis determines whether shareholders are earning a fair amount on their investment compared to alternative investment opportunities.

Essential return measures include:

• Percentage return on average shareholders' equity (ROSHE) - Shows the return generated on shareholders' investment
• Earnings per share (EPS) - The profit attributable to each share
• Dividends per share (DPS) - The actual cash payment received per share
• Net asset value per share - The book value of each share

Financial risk or gearing analysis

This area examines to what extent the company is financed by borrowed money compared to its own capital. Higher borrowing means higher financial risk but potentially higher returns.

Key gearing ratios include:

• Debt to equity ratio - Compares borrowed funds to shareholders' equity
• Percentage return on total capital employed - Measures return on all capital used in the business

Four-step approach to commenting on financial indicators

Essential financial ratio formulas

Understanding how to calculate key ratios is fundamental to financial analysis. Here are the most important formulas you need to know:

Profitability ratios

• Gross profit margin = $\frac{\text{Gross profit}}{\text{Sales}} \times 100$
• Net profit margin = $\frac{\text{Net profit after tax}}{\text{Sales}} \times 100$
• Operating profit margin = $\frac{\text{Operating profit}}{\text{Sales}} \times 100$
• Gross profit mark-up = $\frac{\text{Gross profit}}{\text{Cost of sales}} \times 100$

Liquidity ratios

• Current ratio = $\frac{\text{Current assets}}{\text{Current liabilities}}$
• Acid test ratio = $\frac{\text{Current assets - Inventories}}{\text{Current liabilities}}$
• Stock turnover = $\frac{\text{Cost of sales}}{\text{Average stock}}$

Solvency ratios

• Solvency ratio = $\frac{\text{Total assets}}{\text{Total liabilities}}$
• Net assets = Total assets - Total liabilities

Return ratios

• Return on shareholders' equity = $\frac{\text{Net profit after tax}}{\text{Average shareholders' equity}} \times 100$
• Earnings per share = $\frac{\text{Net profit after tax}}{\text{Number of issued shares}} \times 100$
• Dividends per share = $\frac{\text{Total dividends}}{\text{Number of issued shares}} \times 100$
• Net asset value per share = $\frac{\text{Shareholders' equity}}{\text{Number of issued shares}} \times 100$

Gearing ratios

• Debt to equity ratio = $\frac{\text{Non-current liabilities}}{\text{Shareholders' equity}}$

Interpreting financial ratios

When interpreting ratios, remember these key principles:

Practical example: analysing liquidity

Key exam tips