Financial Statement Analysis and Ratios

This assignment delves into the analysis of financial statements, focusing particularly on the use of financial ratios. It explains how ratios can be used to assess a company's profitability, liquidity, and ability to generate returns on invested capital. The text also acknowledges the limitations of using ratios for comparison, such as industry differences, inflation effects, seasonal variations, and varying accounting practices. Additionally, it highlights the challenges in interpreting ratio values due to their context-dependency, emphasizing that a high or low ratio may not always indicate a positive or negative situation depending on the company's specific circumstances.

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Ratio Analysis
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Financial Ratios
a) Return on Capital employed(ROCE)
This ratio measures the efficiency of a company in generating profits from its employed capital.
ROCE= Net profit (EBIT)/ employed Capital
OR net operating profit/(Total Assets-Total Liabilities)
Net operating profit =12,000
Total Assets=(Fixed assets +Current Assets)
132000+7250=139,250
Total Liabilities=Current Liabilities+ Long term liabilities(loan)
2250+60000=62,250
=12,000/(139250-62250)
=12000/77000=0.156
b)Asset utilization Ratio
This ratio calculates the total revenue that the company makes for every dollar of its assets.
When this ratio increases it means that the company is more efficient with each dollar of its
assets.

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Significance:The significance of this ratio is that it is used to compare efficiency of the company
overtime.
Formula= Revenue/ Average total assets
Revenue=195000
Average total assets=137000
=195000/137000=1.4:1
This means that the company generates $1.4 for every $1 dollar of the company’s assets.
b) Acid Test Ratio
quick ratio is the other name of this ratio is used to measure the ability of the company to honor
its short term liabilities with quick assets such as cash equivalents,cash, marketable securities or
short term investments and accounts receivables.
Formulae;(Cash+ equivalents of cash+short term investments+ Current receivables)/current
liabilities
OR
(Total Current Assets-inventory-Prepaid Asset)/Current Liabilities
Current assets=7250
Inventory=5200
Current liabilities=2250

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=(7250-5200)/2250=0.91
A ratio of less than 1 indicates that the company has cash problems and therefore this company
may have difficulties in paying up current liabilities when they are due. The ideal ratio is 1.5-2
which means that the company has sufficient working capital.
d) Debtor’s day
It is the number of days a customer takes time to pay
Debtor Days = Debtors / Average daily sales = Debtors / (Sales / 365)
Sales= 195000
Debtors= 1900
Debtors days= 1900 / (195000/365)
=1900/534.25
= 3.556 days
Significance: it only takes less than four days for the customers to pay up their debts. This means
that the company will have a very short time to get its money back.
e)Gearing (expressed as a percentage)
It is the degree of leverage by comparing all the debt of the company to shareholders equity
Gearing ratio = company debt ÷ capital employed * 100%
Long term debt= 60000

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Shareholders equity = 70000
Gearing ratio= 60000/70000* 100%
= 85.7%
Significance: at 85%, the gearing ratio is very high meaning that it has a lot of debt in
comparison with the capital employed. It is alarming to the management.
Strengths of financial ratios as a method of interpretations of financial statements
There are several strengths or advantages of using financial ratio analysis in interpretations and
analysis of financial statements (Bergevin, 2002).The analysis of the financial data contained in
the financial statements (quantitative data) is fully understood when done in combination with
the study of the sector and its environment (qualitative data). Only from their combination can a
complete analysis of the financial situation of the company be comprehensively done (Bragg,
2012).
The analysis of the financial statements is useful because it highlights financially the weaknesses
and strengths of the businesses. The realization of these analyzes is a valuable tool for the
operations of a company, it is also an effective ally for the decisions of the management
(Balasundaram, 2012). This makes the financial statements become strategic ally a tool for
decision making control, planning and project studies.
Today's organizations cannot be competitive if they do not have an efficient information system.
In a globalized environment, where competition is intense among organizations, a constant and
accurate flow of information is needed to make the right decisions in order to achieve their goals.

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Strategic importance of the financial statements analysis
Ratios can tell the management if the company is profitable and if it can adequately remunerate
the capital invested (Castagna and Fede, n.d.). If a company is liquid when it has sufficient
means to cover the necessary disbursements without having a cash deficit. Shows the income
and outflows of cash produced in the period and their respective sources and uses. This technique
of analysis consists of comparing the financial statements of two or more accounting exercises
and determining the changes that have been presented in the different periods (Robinson et al.,
2015).
Limitations of financial analysis to the interpretation of financial statements
One of the limitations of financial ratios is that in instances where the firm is operating in
different industries , it is difficult for ratios to present a meaningful industry average. Second,
inflation distorts a company’s balance sheet and therefore comparative analysis is difficult in
terms of making comparison of companies of different ages (Palepu, Healy and Peek, 2016).
Third, seasonal factors also make the financial analysis not accurate because there is a chance of
misinterpretation (Parker, 2007). For example, inventory may be high when one does not need
the said good for a particular season, therefore distorting some accounts in the balance
sheet.There is also a factor of companies using different accounting practices (Palepu, Healy and
Peek, 2016). For example, a company uses LIFO and another one uses FIFO as a method of
inventory valuation which can easily distort comparisons. A company may have weak or strong/
good ratios, which makes it difficult for analyst to know if the company is doing good or bad
(Wahlen, 2017). It is difficult to tell if a ratio is good or not, for example, in a company that is

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always classified as high growth, this may be a good sign. On the other hand, in a company that
is no longer considered as a growth company it is a bad sign.

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References
Balasundaram, N. (2012). Ratio analysis. [Place of publication not identified]: Lap Lambert
Academic Publ.
Bergevin, P. (2002). Financial statement analysis. Upper Saddle River, N.J.: Prentice Hall.
Bragg, S. (2012). Business Ratios and Formulas: A Comprehensive Guide, 3rd Edition. John
Wiley & Sons.
Castagna, A. and Fede, F. (n.d.). Measuring and managing liquidity risk.
Palepu, K., Healy, P. and Peek, E. (2016). Business analysis and valuation. Andover, Hampshire,
United Kingdom: Cengage Learning EMEA.
Parker, R. (2007). Understanding company financial statements. London: Penguin.
Robinson, T., Henry, E., Pirie, W., Broihahn, M. and Cope, A. (2015). International Financial
Statement Analysis. Somerset: Wiley.
WAHLEN, J. (2017). FINANCIAL REPORTING, FINANCIAL STATEMENT ANALYSIS AND
VALUATION. [S.l.]: CENGAGE LEARNING.