Chapter # 12

Interpretation of Financial Statements

Interpretation

After Preparing Financial Statements, Business Compare its;

Performance Past Target

With Competitors or any other business of same category

→ For this sake, Financial ratios are used which help users of
Financial Statements in;
• Analysing the performance
• Comparison with Competitors
• Decision making
• Point out weak areas of Business, etc.
 Categories of Financial Ratios

Profitability Working Capital Liquidity Debt

Ratios efficiency/turnover ratios Ratios Ratio
(1-8) (9-15) (16-17) (18-19)
Profitability ratios Working Capital efficiency/turnover ratios
1. Return on capital employed (ROCE) 9. Debtor turnover days
2. Return on ordinary shareholder capital/\ 10. Inventory turnover days
Return on equity 11. Creditor turnover days
3. Return on assets 12. Cash operating cycle/working capital cycle
4. Net profit/sales ratio 13. Debtor/receivable turnover
5. Gross profit/sales ratio 14. Stock turnover
6. Cost of sales/sales ratio, admin expense/sales ratio, 15. Creditor/payable turnover
selling expense/sales ratio
7. Sales/capital employed ratio or asset turnover ratio Liquidity ratios
8. Percentage annual growth in sales 16. Current ratios
17. Quick ratio/acid test ratio

Debt ratio
18. Gearing/leverage ratio
19. Interest Cover ratio
Users and their needs

User / stakeholder Ratio in which user is interested

Private investor Profitability ratios

Profitability ratios/working
Potential acquirer
capital efficiency ratios

Bank or potential lender Liquidity ratios and

who is providing loan gearing ratios
 1. “Return on capital employed” (ROCE)

Profit before interest & tax

x 100
Avg. Capital Employed

(Answer is in %)

Utility

• It measures how efficiently a company is generating profits from its capital employed

• The ratio shows the return on total funds invested in the business.

• The higher the ratio, the better it is.

• Capital employed means fund invested in the business.
2. Return on ordinary shareholder capital/
Return on equity

Profit after tax less irredeemable Preference Dividend

x 100
Avg Ordinary Equity

(Answer is in %)

Utility

• It measures how efficiently a company is generating profits from amount invested by its
shareholders.

• The higher the ratio, the better it is.

3. Return on assets
(Total or non-current as you wish)

Profit before interest & tax

x 100
Avg Total assets

(Answer is in %)

Utility

• It measures how efficiently management turns its assets into profit.

• The higher the ratio, the better it is.

4. Net Profit/sales ratio

Profit After tax

x 100
Net Sales

(Answer is in %)

Utility

• It shows net profit that is earned for every 100 rupees of sale. OR

• It shows percentage of sales that is leftover after business has paid all its expenses.

• The higher the ratio, the better it is.

5. Gross Profit/sales ratio

Gross Profit
x 100
Net Sales

(Answer is in %)
Utility

• It shows gross profit that is earned for every 100 rupees of sale.
• It should be sufficient enough to pay all expenses.

• The higher the ratio, the better it is.

• Sometimes sales increase but gross profit does not. Reasons:
1. Cost of purchases increased
2. How much is sold for each type of goods
3. To increase sale, sale price has been reduced
6 (a) Cost of sales/Sale ratio Utility
• It shows what extent of sale is an
Cost of sales
x 100 individual expense.
Net Sales
(Answer is in %) • The lower the ratio the better it is.

6 (b) Admin expense/sales ratio • The cost of sale/sale ratio does

not change normally with change
Admin expense in sale.
x 100
Net Sales • However admin/selling expenses
(Answer is in %) normally change with change in
sales.
6 (c) Selling expense/ sales ratio
• These ratios help in controlling
Selling expense and estimating future expenses.
x 100
Net Sales
(Answer is in %)
7. Sales / capital employed ratio
or Asset turnover ratio

Net Sales
Average Capital Employed

(Answer is in times)

Utility

• It measures how efficiently a company is making sales from assets.

• The higher the ratio the better it is.

8. Percentage annual growth in sales

It can be useful to measure the annual growth (or decline) in sales, measured
as a percentage of sales in the previous year.

For example:
If sales in the year just ended were Rs.5,800,000 and sales in the previous year
were Rs.5,500,000, the annual growth in sales has been
Rs. 300,000
x 100 % = 5.45 %
Rs. 5,500,000
 9. Debtor Turnover Days

Average Debtor
x 365
Credit Sales

(Answer in days)

Utility

• Measures the average number of days taken by an entity to collect its receivables.

• A long average time suggests inefficient collection from debtor.

• The lower the days the better it is.

10. Inventory Turnover Days

Average Inventory
x 365
Cost of Goods Sold

(Answer in days)

Utility

• It measures the number days required to sell the inventory during the year.

• A small number of days indicate that a company is more efficient at selling its inventory.

• The lower the days, the better it is.

• A lengthy inventory period may indicate excessive buildup of inventories.

 11. Creditor Turnover Days

Avg Creditor
x 365
Credit Purchase

(Answer in days)

Utility

• It measures the average number of days in which a company makes payment to its
suppliers.

• It is compared with agreed credit period.

• If its too high then there is a risk of the suppliers not extending credit in future and may
loose goodwill.
12. Cash operating cycle/Working capital cycle

Inventory days + debtor days – Creditor days

Utility

• It is the length of time between organization’s payment for purchases and receipt of cash
from debtors.

• It should not be unreasonable in length. Longer cycle means too much is invested in
inventories and debtors.

• The shorter the cycle the better it is. The reasons of being shorter could be:
1. Inventories sold rapidly
2. Collecting debts quickly
3. Taking maximum credit possible
13. Debtor/Receivable turnover

Net Credit Sales

Avg Trade Debtors

(Answer in times)
Utility

• It shows speed within which debtors are collected.

• The higher the turnover, the shorter the time between sales and collecting cash.

• Higher turnover ratio shows speedy and effective collection.

14. Stock turnover

Cost of Goods Sold

Average Inventory

(Answer in times)

Utility

• It shows how many times stock is converted into sales.

• A high ratio indicates inventory is selling quickly.

• If the ratio is low, it suggests overstocking, obsolete inventory or selling issues.

• The higher the turnover the better it is.

15. Creditor/ Payable turnover

Net Credit Purchases

Avg Trade creditors

(Answer in times)
Utility
• It shows speed within which we are making payment to creditors.

• The higher the turnover, the shorter the period between purchases and payment.

• Higher turnover on one side shows that our creditors are happy however on other side we
are not using supplier funds to finance our operations

• A low turnover may be a sign of cash flow problems.

16. Current Ratio

Current Asset
Current Liabilities

(Answer in times)
Utility

• The ratio indicates the ability of the company to pay its current obligation out of the
current assets.

• An ideal current ratio is 2:1.

• A very high current ratio may mean there is excess cash that should possibly be invested
elsewhere in the business or that there is too much inventory.
17. Quick ratio/Acid test ratio

Current assets − Inventory

Current liabilities

(Answer in times)
Utility

• The ratio indicates the ability of the company to pay its current obligation out of the quick
assets.

• It is a better measurement of liquidity than current ratio.

• An ideal quick ratio is 1:1.

18. Gearing (It is also called as leverage)

Long term loans

a) x 100
Equity
Long term loans
b) x 100
Equity + long term loans
(Answer is in %)
Utility
• This ratio compares company’s total debts to company’s equity
• High geared or high leveraged company • Low geared or low leveraged
• It is the case when debt capital exceeds the equity company
• If answer to a) is above 100% or answer to b) is • Opposite of above discussion
above 50% the company is said to be highly geared. • Dangers of high gearing
• It means debt is greater than equity and the 1. Difficult to obtain more loan
company is risky as it relying more on debt. 2. Entity may not be able to meet its
obligations.
19. Interest Cover Ratio

Profit before interest & tax

Interest expense
 Statements of financial position as at 31, March
Question # 01 Page # 903: 2013 2012 2013 2012
X Limited is a ceramics company, which has X Limited X Limited Y Limited Y Limited
hired you to assess its performance and for Rs.000 Rs.000 Rs.000 Rs.000
this purpose it has obtained the draft financial Assets
statements of another company named Y Non-current assets
Limited working in the same industry. The Plant and machinery 5,000 8,600 8,800 9,200
financial statements of each of the companies 5,000 8,600 8,800 9,200
Current assets
are as follows:
Inventories 4,200 1,600 1,500 1,200
Required: Trade receivables 2,400 1,900 1,900 1,100
Calculate the ratios for both companies and Bank and cash 2,300 400 2,200 1,000
comment on the ratios: 8,900 3,900 5,600 3,300
Total assets 13,900 12,500 14,400 12,500
Income statements for the year ended 31 March 2013 Equity and liabilities
X Limited Y Limited Equity shares of Rs.1 each 2,000 2,000 2,500 2,000
Rs.000 Rs.000 Share premium 1,900 2,100 1,200 1,700
Revenue 12,000 12,000 Retained earnings 3,200 2,200 2,000 1,500
Cost of sales (9,330) (9,330) 7,100 6,300 5,700 5,200
Gross profit 2,670 2,670 Non-current liabilities
Less; Loan 3,000 2,000 4,000 2,500
Administrative expenses (920) (920) 3,000 2,000 4,000 2,500
Distribution costs (490) (490) Current liabilities
Finance cost (510) (510) Trade payables 3,200 1,800 1,600 1,600
Profit before tax 750 750 Taxation 600 2,400 3,100 3,200
Income tax (150) (150) 3,800 4,200 4,700 4,800
Profit after tax 600 600 Total equity and liabilities 13,900 12,500 14,400 12,500
Question # 02 Page # 968: Amir Moon
The income statements and statements of financial Rs. Rs.
position of two manufacturing companies in the same Assets
sector are set out below. Non-current assets
Amir Moon Property - 500,000
Rs. Rs. Plant and equipment 190,000 280,000
Revenue 150,000 700,000 190,000 780,000
Cost of sales (60,000) (210,000) Current assets
Gross profit 90,000 490,000 Inventories 12,000 26,250
Distribution costs (13,000) (72,000) Trade receivables 37,500 105,000
Administrative expenses (15,000) (35,000) Cash at bank 500 22,000
Operating Profit 62,000 383,000 50,000 153,250
Interest expense (500) (12,000) Total assets 240,000 933,250
Profit before tax 61,500 371,000 Equity and liabilities
Income tax expense (16,605) (100,170) Equity
Profit for the period 44,895 270,830 Share capital 156,000 174,750
Required:
Retained earnings 51,395 390,830
(a) Compute the following ratios for each of the
207,395 565,580
companies: Non-current liabilities
(i) Profitability ratios Long-term debt 10,000 250,000
(ii) Working Capital ratios Current liabilities
(iii) Liquidity ratios Trade payables 22,605 117,670
(iv) Gearing ratios Total equity and liabilities 240,000 933,250
(b) Carry out comparative analysis of the companies based
on the computed ratios in (a) above.
 Chapter # 12

Interpretation of Financial Statements

Question # 04 Page # 946:
Ratio 2016 2015 2014 Industry average
(a) The following information has been Profit margin % 11% 10% 8% 10.45%
gathered by an analyst, in respect of Quick ratio 1.38 1.40 1.42 1.52
Dairy Foods Limited (DFL) which Current ratio 1.84 1.67 1.59 1.73
specializes in various dairy products. Days purchases in payables 80 91 89 82
In the latest annual report to the shareholders, Directors of DFL have claimed that liquidity position of the Company
has improved significantly.
Required: Critically analyze and discuss whether you agree with the claim. (03)

(b) Extracts from latest financial statements of two companies are as follows:
Extracts from statements of Extracts from statements of
comprehensive income financial position
A B Equity and A B A B
Assets
Rs. in million liabilities Rs. in “million” Rs. in “million”
Revenue 161,600 220,150 Equity and reserves 51,690 72,114 Fixed assets 34,460 48,076
Cost of sales (135,160) (180,520) Long term loan - 36,057 Stock in trade 21,700 20,000
Gross profit 26,440 39,630 Trade creditors 35,790 45,135 Trade debtors 24,470 44,030
Operating expenses (9,840) (13,870) Other payables 12,000 8,500 Cash and bank 18,850 49,700
Interest expense (720) (2,313) 99,480 161,806 99,480 161,806
Profit before tax 15,880 23,447
Income tax (333) (409)
Profit after tax 15,547 23,038
Required: Analyze the profitability, liquidity and working capital ratios of both the companies. (12)
 Chapter # 12

Interpretation of Financial Statements

Question # 08 Page # 949: (Spring-19, 14 Marks)
Following are the summarised financial statements of Keyboard Limited (KL):
Statement of Profit or Loss Statement of Financial Position
2018 2017 2016 2018 2017 2016
---------Rs. in '000--------- ---------Rs. in '000---------
Sales 27,000 24,400 21,000 Fixed assets 12,500 10,800 11,800
Cost of goods sold (21,300) (19,400) (17,200) Current assets:
Gross profit 5,700 5,000 3,800 Inventory 4,000 4,500 3,000
Operating expenses (3,400) (3,000) (2,400) Debtors 4,200 3,200 1,800
Operating Profit 2,300 2,000 1,400 Cash - 800 2,100
Finance cost (300) (350) (400) Total current assets 8,200 8,500 6,900
Net profit 2,000 1,650 1,000 Total Assets 20,700 19,300 18,700
Required: Equity and Liabilities
Equity and reserves 10,400 9,000 8,600
(a) Compute the following ratios for 2018 and 2017:
Long term loan 4,400 5,000 5,600
(i) Profitability ratios
(ii) Working Capital ratios
Current liabilities:
(iii) Liquidity ratios
Creditors 3,500 4,400 4,200
(iv) Gearing ratios
Bank overdraft 1,500 - -
(b) Comment on the results of your calculation for year
Accrued expense 900 900 300
ended 2017 & 2018.
Total current liabilities 5,900 5,300 4,500
(c) Suggest three possible measures that can be taken
Total Equity and liabilities 20,700 19,300 18,700
by KL to improve working capital cycle days.
Question # 06 Page # 947: (Spring-18, Q # 07 – 11 Marks)
Boom Limited (BL) is a manufacturer of sports goods. Following financial statements for the year ended 31
December 2017 have been submitted to the Chief Executive Officer (CEO).
Statement of profit or loss Statement of financial position
Rs. in ‘000’ Rs. in ‘000’
Revenues 21,000 Assets
Cost of sales (17,500) Non-current assets
Gross profit 3,500 Property, plant and equipment 7,500
Operating expenses (1,900)
Finance cost (450) Current assets 1,500
Profit before tax 1,150 Total Assets 9,000
Taxation (345)
Profit after tax 805 Equity and liabilities
Although performance of BL has improved from the Equity
Share capital 4,000
last year, CEO wants to compare the results with other
Reserves 1,000
companies operating in sports manufacturing industry. 5,000
In this respect, following industry data has been Non-current liabilities 3,000
gathered: Current liabilities 1,000
Gross profit margin 23.5% Total Equity and liabilities 9,000
Net profit margin 7.7% Required:
Current ratio 2.75
(a) Compute BL’s ratios for comparison with the
Gearing ratio 50:50
Return on non-current asset 32.9%
industry.
Return on capital employed 27.4% (b) For each ratio, give one possible reason for
Return on equity 31.3% variation from the industry.
Question # 07 Page # 948: (Autumn-18, Q # 04 – 12 Marks)
SK Limited (SKL) deals in a single product. Following are the summarized financial statements of SKL for the year ended 31
December 2017:
Statement of financial position Statement of profit or loss
2017 2016 2017 2016
Rs. in million Units sold in million 39 30
Fixed assets 410 240
Current assets 90 200 Rs. in million
500 440 Sales 371 300
Cost of goods sold (273) (210)
Capital 280 260 Gross profit 98 90
Long-term loan 170 100 Selling and administrative (55) (60)
Current liabilities 50 80 Finance cost (13) (8)
500 440 Net profit 30 22
Additional information:
(i) With effect from 1 January 2017, selling price was decreased by 5% to boost sales volume.
(ii) During the year 2017, suppliers demanded price increase of 4%. SKL resisted the price increase. However, both parties
agreed to reduce the credit period.
(iii) SKL had been running its business in a rented building whose annual rent was Rs. 15 million. During the year, SKL
purchased this building for Rs. 200 million. Funds were arranged partially through a long-term loan. Useful life of the
building is estimated at 40 years.
(iv) 75% of the selling and administration cost incurred in 2016 was fixed cost.
Required:
(a) Compute the following ratios for 2016 and 2017:
• Gross profit margin • Net profit margin
• Return on assets • Return on capital employed
• Debt equity ratio • Current ratio
(b) Keeping in view the above information, comment on profitability and liquidity position of SKL for 2017.
Question # 01 Page # 945: (Autumn-11, Q # 06 – 06 Marks)
The following information pertains to Shale Distributors Limited (SDL):

Rs. in million
Sales 300
Purchases 140
Cost of goods sold 150
Trade receivables 50
Trade payables 21
Inventories 30

All the purchases and sales are on credit.

Required:
(a) Calculate the cash operating cycle of SDL and explain briefly its significance. (04)
(b) Describe any two limitations of accounting ratios. (Assume a 360-day year) (02)
Question # 12 Page # 951: (Autumn-21, Q # 01 – 07 Marks)
Following amounts have been extracted from the financial statements of Lithops Limited:

2020 2019
Rs. in million
Sales 500 450
Cost of goods sales 378 300
Trade receivables 95 80
Trade payables 72 60
Inventory 93 75
Cash at bank 12 16

All sales and purchases are made on credit.

Required:
(a) Calculate working capital cycle days for 2020. (Assume a 360 day year) (04)
(b) Suggest four possible measures that can be taken to reduce working capital cycle days. (03)
Question # 05 Page # 947:
Progressive Steel Limited (PSL) commenced business in 2015. The following comparative data
pertains to the year ended 30 June 2017:

PSL Industry
Description
2017 2016 2017
Gross profit margin 13% 13% 16%
Net profit margin 8% 7% 10%
Return on shareholders’ equity 22% 18% 25%
Current ratio 1.2 1.6 1.5
Debt to equity ratio 40:60 30:70 50:50
Cash operating cycle in days 119 135 118

Required:
For each ratio/data give possible reasons for variation from comparative and industry data.
(12)
 Chapter # 12

Interpretation of Financial Statements

Question # 02 Page # 945: (Autumn-16, Q # 07 – 10 Marks)
Following amounts have been determined from the records of Hassan Limited.

2014 2015 2016

Description
------Rs. in million------
Sales 100.00 120.00 135.00
Cost of sales 75.00 90.00 101.25
Profit before interest and tax 6.00 5.50 5.60
Account receivable 16.50 25.00 35.00
Account payable 13.00 13.00 15.00
Inventory 18.75 26.00 30.40
Cash at bank/(overdraft) 5.00 (0.50) (2.00)

Required:
Calculate liquidity ratios and working capital cycle for 2015 and 2016 and comment on the
results of your calculation, assuming that all sales and purchases are made on credit.
(10)
Question # 03 Page # 945: (Spring-16, Q # 03 – 06 Marks)
Ali and Bashir are chartered accountants and have been working as Managing Director (MD) and Chief Financial Officer
(CFO) in a listed company. In a recent meeting of the Board, the directors have decided to expand the business within six
months by opening 20 retail outlets. This expansion would require financing of Rs. 300 million which may be arranged
through bank loan.
The following information has been extracted from latest draft financial statements of the company:

Rs. in ‘000’
Sales 1,700
Gross profit 545
Tax expense 23
Following additional information is also available:
Profit after tax 40
• 80% of the sales are on credit.
Total assets 2,500
• Opening inventory was Rs. 100,000. Non-current assets 900
• 40% of current liabilities comprise of trade payables. Inventories 850

Required: Trade receivables 600

Share capital 800
Compute liquidity, debt and working capital ratios of the
Reserves 152
company. (06) Long term debt @ 9% 750
Question # 05 Page # 927:
Indicate the effect of the following transactions on working capital by placing a check mark if there is
• No effect with justification
• Increase with justification
• Decrease with justification

No effect Increase Decrease

1. Purchase of raw material of Rs. 50,000
2. Sale of finished goods of Rs. 65,400
3. Depreciation for the year Rs. 70,000
4. Operating expenses paid of Rs. 90,000
5. Purchased equipment of Rs. 120,000 on account
6. Paid cash Rs. 150,000 on account of payable 7.
7. Received Rs. 20,000 on account of receivables
8. Declared & paid a cash dividend of Rs. 40,000
9. Issued Rs. 100,000 capital for cash.
10. Borrowed Rs. 200,000 on short term loan.
Question # 11 Page # 951: (Spring-21, Q # 06 – 17 Marks)
Epivac Limited is considering to take some of the following measures during the last week of the year ending 31 March 2021 in order
to show better financial performance;
(i) Pay balance of a major supplier from bank overdraft facility and avail 5% discount.
(ii) Sell slow moving stock items at a price equal to cost.
(iii) Recover debtors’ balances by offering cash discounts of 10%.
(iv) Offer extended credit terms of 90 days which would increase sales at existing margins.
(v) Dispose-off some non-current assets at gain.
Required: State the effect (increase, decrease, no effect) of each of the above measure on the financial ratios as per following format:
Ratios (i) (ii) (iii) (iv) (v)
Gross Profit
(a) Gross profit margin x 100
Net Sales
Profit After tax
(b) Net profit margin x 100
Net Sales
Current Asset
(c) Current ratio
Current Liabilities
Cost of Goods Sold
(d) Stock turnover (times) Average Inventory
P𝐵𝐼𝑇
x 100
(e) Return on non-current assets Avg 𝑡𝑜𝑡𝑎𝑙 𝑁𝑜𝑛 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

Current assets − Inventory

(f) Quick ratio Current liabilities
 Chapter # 12

Interpretation of Financial Statements

Question # 14 Page # 953: (Spring-23, Q # 03 – 10 Marks)
You are working as the finance manager of Hittite Limited (HL). A new CFO has joined HL and has recommended changes to
accounting policies related to assets to improve HL’s financial ratios in the next financial statements. The CFO has suggested the
following changes to the policies:
(i) Subsequent measurement of investment property from cost model to fair value model.
(ii) Subsequent measurement of property, plant and equipment from cost model to revaluation model.
(iii) Cost formula for inventory from weighted average to FIFO method.
You may assume that:
• fair values / cost / prices of all assets would increase over the time.
• the maximum possible amount from the revaluation surplus to retained earnings would be transferred on an annual basis.
• periodic inventory system is followed by HL.
Required: State the effect (increase, decrease, no effect) of each of the above changes on the ratios in the next financial statements.
(Note: Use the following format) (10)
Change in policy of
Ratios property, plant and
Formula investment property inventory
equipment
Profit After tax
Net profit to sales ratio x 100
Net Sales
Profit before interest & tax
Return on assets x 100
Avg Total assets
Profit before interest & tax
Return on capital employed x 100
Avg. Capital Employed
Long term loans
Debt equity ratio x 100
Equity + long term loans
Current Asset
Current ratio
Current Liabilities
Question # 09 Page # 950: (Spring-20, Q # 06 – 16 Marks)
Following are the summarised financial statements of Shispare Limited (SL) and its competitor Trivor Limited (TL)
for the year ended 31 December 2019:
Statement of financial position
SL TL SL TL
Assets Equity & liabilities
Rs. in million Rs. in million
Fixed assets 5,400 7,800 Capital and reserves 8,400 9,450
Current assets: Long-term loan 1,900 4,600
Inventory 4,800 7,100 Current liabilities:
Debtors 2,700 3,200 Creditors 2,900 4,500
Cash 1,200 800 Accrued expenses 900 350
8,700 11,100 3,800 4,850
14,100 18,900 14,100 18,900

Required:
Compute relevant ratios for SL and TL to assess which Statement of profit or loss
company seems to: SL TL
(i) give more incentives to its customers to pay on time — Rs. in million —
(ii) avail extended credit terms from its suppliers Sales 16,700 35,400
(iii) be more efficient in the use of capital
Cost of goods sold (11,400) (27,800)
(iv) keep lower selling prices to gain the market share
(v) have better liquidity position Gross profit 5,300 7,600
(vi) have higher ability to convert its assets into profit Operating expenses (3,500) (4,900)
(vii) control operating expenses more efficiently Finance cost (250) (600)
(viii) have higher ability to raise bank loan in future Net profit 1,550 2,100
LO 2: FINANCIAL STATEMENTS ANALYSIS RISE Book Page # 920

Financial statement analysis is the process of analysing a company's past, current and projected

performance for decision-making purposes

Financial statement analysis allows analysts to identify trends by comparing ratios across

multiple periods and statement types to allow analysts to measure liquidity, profitability,

company-wide efficiency, and cash flow.

Financial statement analysis is of the following types:

• Horizontal analysis

• Vertical analysis

• Ratio analysis (already explained in above sections)

1. Horizontal analysis

Horizontal analysis is used to compare historical data, such as ratios, or line items, over a

number of accounting periods.

Financial analysts and investors need to identify trends and growth patterns in the company’s

performance over a number of years, a year-end balance sheet or income statement is not

enough to evaluate whether the company is operating efficiently and profitably. Horizontal

analysis also makes it easier to compare growth rates and profitability among different

companies. The following is the formula for horizontal analysis:

𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑐𝑜𝑚𝑝𝑎𝑟𝑖𝑠𝑜𝑛 𝑦𝑒𝑎𝑟 – 𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

x 100
𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
Carnations Ltd
%age change from
Profit & Loss Account 2018 2017 Calculation
For the year ended 31.12.18 2017 to 2018
Rs. in millions
Sales 86,320 75,200

Cost of Sales (44,618) (40,900)

Gross Profit 41,702 34,300

Distribution costs (19,597) (15,380)

Administrative expenses (2,339) (2,053)

Other operating expenses (1,322) (1,052)

Other income 1,488 1,000

Profit before interest 19,932 16,815

Finance cost (343) (300)

Profit before taxation 19,589 16,515

2. Vertical analysis

In vertical analysis each category of accounts on the balance sheet is shown as a percentage of

the total account.

Line items on an income statement can be stated as a percentage of gross sales, while line

items on a balance sheet can be stated as a percentage of total assets or liabilities. This analysis

of income statements gives the company a heads up if cost of goods sold or any other expense

appears to be too high when compared to sales and allows the management to identify the

reasons and take action to fix the problem(s).

Carnations Ltd 2018 2017
Statement of Financial Position ------------------ Rs. in millions ------------------
For the year ended 31.12.18 Calculations Calculations
Assets
Non-Current Assets
Property, plant & equipment 15,000 12,000
Intangibles 500 600
Long term investments 120 100
Long term loans 200 150
Long term deposits andprepayments 70 180
15,890 13,030
Current Assets
Stores and spares 650 585
Stock in trade 6,000 5,500
Trade debts 2500 1200
Loans and advances 800 300
Short term deposits andprepayments 750 900
Other receivables 350 175
Cash and bank balances 8,500 15,000
19,550 23,660
Total assets 35,440 36,690
 2018 2017
------------------ Rs. in millions ------------------
Calculations Calculations
Equity and liabilities
Share capital and reserves
Share capital 1,000 1,000
Reserves 2,950 7,095

Liabilities
Non-current liabilities
Staff retirement benefits 290 295

Current liabilities
Trade and other payables 30,000 27,500
Provisions 1200 800
Total current liabilities 31,200 28,300
Total liabilities 31,490 28,595
Total equity and liabilities 35,440 36,690
Window dressing
One should also be careful of unethical practices like window dressing while interpreting the financial
statements. Window dressing is the adaptation of the rules and practices to present financial
statements in a way that business situation appears better than it actually is. This manipulates the
financial information and misleads the users of financial statements.
Some of the ways in financial statements may be manipulated include:
• Delay in paying suppliers, so that the period-end cash balance appears higher.
• Using lower estimate for allowance for doubtful debts.
• Capitalize smaller expenditures that would normally be charged to expense, to increase reported
profits.
• Offer customers an early shipment discount, thereby accelerating revenues from a future period
into the current period.
• Lower depreciation expense by using higher useful lives or residual values, etc.
Question # 13 Page # 952: (Spring-22, Q # 07 – 15 Marks)
Qamar Limited (QL) is in the business of consumer goods. Following are the summarized financial statements of QL for 2021:
Statement of financial position as at 31 December 2021 Rs. million
Rs. million Rs. million Sales 2,150
Assets Equity and liabilities Cost of goods sold (1,900)
Fixed assets 550 Share capital 600 Gross profit 250
Retained earnings 319 Selling and administrative expenses (93)
Current assets: Long-term loan 350 Other income 40
Inventory 440 Current liabilities: Finance cost (35)
Trade debtors 350 Trade creditors 150 Net profit 162
Short term investment 160 Other payables 70
Cash and bank balances 39 Current maturity of loan 50
Gross profit margin 9.5% Net profit margin 3.9%
1,539 1,539
Interest cover 2.4 times Inventory holding period 90.4 days
Extracts from management reports submitted to the board of 16.8%
Debtors’ turnover
Return on non-current assets 7.3 times
directors: (i) Ratios for the year 2020: Creditor payment period 55.1 days
Acid test 0.9 times
(ii) Important financial and operating decisions taken during the year 2021:
• QL renewed a large contract with a customer. In the renewed contract, extended credit terms were given to the
customer.
• A major supplier agreed to reduce the prices by 10% on the condition of cash purchases only. This reduction helped
QL to avoid increase in prices of its products despite increase in prices by competitors.
• Increasing working capital demands were met by making a share issue. A part of the proceeds from the issue were
also used to prepay a significant portion of the long-term loan.
• QL disposed of its main warehouse in the last month of the year at a gain of Rs. 25 million. The sale proceeds are
temporarily invested in a short-term investment.
Required: (a) Compute QL’s ratios for 2021 for comparison with 2020. (06)
(b) Keeping in view the financial and operating decisions extracted from management reports, provide reasons for variation
in the ratios computed in (a) above. (09)
 Chapter # 12

Interpretation of Financial Statements

Question # 15 Page # 954: (Autumn-23, Q # 08 – 15 Marks)
Whale Limited (WL) is a growing business in the electronic items industry and operates two owned outlets. Below
are the summarized financial statements of WL for 2023:
Statement of financial position as at 31 March 2023 Statement of profit or loss for year ended 31 March 2023
Assets Rs. in '000 Equity and liabilities Rs. in '000 Rs. in '000
Fixed assets 52,514 Share capital 11,000 Sales 67,851
Inventory 11,528 Retained earnings 25,535 Cost of sales (47,528)
Trade receivables 6,874 Long-term loan 21,625 Gross profit 20,323
Cash 2,658 Trade payables 9,874 Selling and administrative expenses (7,584)
Accrued expenses 5,540 Interest expenses (5,147)
73,574 73,574 Net profit 7,592

Extracts from management reports: Gross profit margin 36.2% Quick ratio 1.1 times
(i) Ratios for the year ended 31 March 2022: Operating profit margin 30.0% Interest cover 17.5 times
(ii) Key events during the year: Return on capital employed 51.7% Asset turnover 1.7 times
• A new outlet was inaugurated. The cost of Average time to pay 35 days Inventory turnover 9.0 times
purchasing the outlet was financed through another long-term loan from a bank. The sales prices at the
new outlet are kept lower to attract customers.
• Despite an increase in sales promotional activities, the sales at the new outlet were below expectation but
are expected to increase from next year. • Inventory at the new outlet was build-up by utilising liquid
funds available with WL and the extended credit facility from suppliers.
• The interest rate on existing bank loans has increased due to rise in the market interest rate.
Required: (a) Compute WL’s ratios for 2023 in comparison with 2022. (06)
(b) Keeping in view the key events during the year, provide possible reasons for the variation(s) in the ratios
computed in (a) above. (09)
Limitations of ratio analysis:
Financial statements are time and cost producing. Ratio analysis can be used to compare information taken from the
financial statements to gain an analytical understanding of the results, financial position and cash flows of a business. This
analysis is a useful tool, especially for an outsider such as a supplier, lender or an investor.
However, there are a number of limitations of ratio analysis which are given below:
1. Historical
All of the information used in ratio analysis is derived from actual historical results. This does not mean that the same
results will carry forward into the future. However, you can use ratio analysis on pro forma information and compare it to
historical results for consistency.
2. Historical versus current cost
The information on the income statement is stated in current costs (or close to it), whereas many elements of the
statement of financial position are stated at historical cost (which could vary substantially from current costs). This
disparity can result in unusual ratio results.
3. Inflationary effect
If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not
comparable across periods. For example, if the inflation rate was 100% in one year, sales would appear to have doubled
over the preceding year, when in fact sales did not change at all.
4. Aggregation
The information in a financial statement line item that you are using for a ratio analysis may have been aggregated differently in the
past, so that running the ratio analysis on a trend line does not compare the same information through the entire trend period.
5. Accounting policies and estimates
Different companies in a similar industry may have different policies for recording the same accounting transaction. This means that
comparing the ratio results of different companies may be like comparing apples and oranges. For example, one company might use
reducing balance method while another company uses straight-line depreciation.
6. Business conditions
You need to place ratio analysis in the context of the general business environment. For example, 60 days of sales outstanding for
receivables might be considered poor in a period of rapidly growing sales but might be excellent during an economic contraction
when customers are in severe financial condition and unable to pay their bills.
7. Interpretation
It can be quite difficult to ascertain the reason for the results of a ratio. For example, an acid test ratio of 2:1 might appear to be
excellent, until you realize that the company just sold a large amount of its stock to bolster its cash position. A more detailed analysis
might reveal that the acid test ratio will only temporarily be at that level and will probably decline in the near future.
8. Company strategy
It can be difficult to interpret a ratio analysis comparison between two companies that are pursuing different strategies. For example,
one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market
share. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and
gross margins are higher, but it will never attain the revenue levels of the first company.