Interpretation of Financial Statements
Analysis
Interpretation of Financial Statements
Syllabus tag: KASNEB CPA | Intermediate Level | CA23 Financial Reporting and Analysis | Topic 10 Interpretation of Financial Statements
Lesson objectives
By the end of this topic, you will be able to:
- Compute the full set of ratios from one set of accounts
- Decompose ROE using the DuPont identity
- Interpret a ratio in context rather than merely calculating it
- Identify the effect of accounting policy choices on comparability
- Recognise the warning signs of creative accounting
Why this matters
Everything earlier in this paper produced numbers. This topic asks what they mean — which is the part an examiner marks most heavily, because calculating a ratio is arithmetic and interpreting it is judgement.
One set of accounts throughout
Simba Ltd, year ended 31 December.
| Income statement | KES |
|---|---|
| Revenue | 84,000,000 |
| Cost of sales | (54,600,000) |
| Gross profit | 29,400,000 |
| Operating expenses | (15,960,000) |
| EBIT | 13,440,000 |
| Finance costs | (2,240,000) |
| Profit before tax | 11,200,000 |
| Tax | (3,360,000) |
| Profit after tax | 7,840,000 |
| Balance sheet | KES |
|---|---|
| Inventory | 9,100,000 |
| Receivables | 12,600,000 |
| Total current assets | 24,500,000 |
| Current liabilities (payables 8,190,000) | 14,000,000 |
| Equity | 42,000,000 |
| Long-term debt | 28,000,000 |
11,200,000 shares in issue, trading at KES 9.80.
Profitability
| Ratio | Working | Result |
|---|---|---|
| Gross margin | 29,400 / 84,000 | 35.0% |
| Operating margin | 13,440 / 84,000 | 16.0% |
| Net margin | 7,840 / 84,000 | 9.33% |
| ROCE | 13,440 / 70,000 | 19.2% |
| ROE | 7,840 / 42,000 | 18.67% |
Efficiency and liquidity
| Ratio | Working | Result |
|---|---|---|
| Asset turnover | 84,000 / 70,000 | 1.2 times |
| Inventory days | 9,100 / 54,600 × 365 | 60.83 |
| Receivable days | 12,600 / 84,000 × 365 | 54.75 |
| Payable days | 8,190 / 54,600 × 365 | 54.75 |
| Cash operating cycle | 60.83 + 54.75 − 54.75 | 60.83 days |
| Current ratio | 24,500 / 14,000 | 1.75 times |
| Quick ratio | 15,400 / 14,000 | 1.10 times |
Gearing and investor ratios
| Ratio | Working | Result |
|---|---|---|
| Gearing | 28,000 / 70,000 | 40.0% |
| Interest cover | 13,440 / 2,240 | 6.0 times |
| EPS | 7,840,000 / 11,200,000 | KES 0.70 |
| P/E | 9.80 / 0.70 | 14.0 |
The DuPont decomposition
ROE = Net margin × Asset turnover × Equity multiplier
= 9.33% × 1.2 × (70,000 / 42,000) = 9.33% × 1.2 × 1.667 = 18.67%
which reconciles to the ROE computed directly.
This is the most useful analytical step available, because it says why the return is what it is. An ROE of 18.67% built on a fat margin is a different business from the same 18.67% built on heavy borrowing, and only the decomposition distinguishes them.
Interpreting rather than calculating
A ratio alone means nothing. It needs a comparison — the same company over time, a competitor, or an industry benchmark. A gross margin of 35% is excellent for a supermarket and poor for a software firm.
Direction can mislead. A current ratio rising from 1.75 to 3.5 sounds like improving health and may mean inventory is not selling and receivables are not being collected.
Ratios interact. A falling gross margin with rising volume usually means prices were cut to win sales — visible only by reading the two together.
Always link back to cash. Profit is an opinion; cash is a fact. A company whose profit rises while cash generated from operations falls is the pattern worth investigating, whatever the ratios say.
:::checkpoint Simba's receivable days and payable days are both 54.75. Explain what that means for the funding of its trading cycle, and say what would happen to its cash position if suppliers shortened their terms to 30 days. :::
Accounting policy and comparability
Two companies with identical operations can report different ratios purely through policy choices:
- Depreciation method and useful life — affects profit and asset values, so ROCE and asset turnover both move
- Inventory formula — FIFO reports higher profit than weighted average when prices rise
- Revaluation versus cost for property — revaluing raises equity and capital employed, so ROCE and ROE both fall even though nothing about the trading has changed
- Capitalising versus expensing development costs — changes profit, assets and gearing at once
Before comparing two companies, read the accounting policies note. Two sets of ratios computed on different policies are not comparable, however carefully each was calculated.
Warning signs
Patterns worth treating as questions rather than conclusions:
- Profit rising while operating cash flow falls
- Receivable days lengthening year on year
- Revenue recognised near the year end in unusual volume
- Frequent changes of accounting policy or of estimate
- One-off gains repeatedly described as exceptional
- A large gap between profit before tax and taxable profit
None proves anything. Each is a reason to read further.
Limitations
- Historic. The accounts describe a year that has ended.
- A single snapshot. Balance sheet figures are one day's position and can be arranged to look favourable.
- Nothing qualitative. Ratios say nothing about management, staff, brand, or the order book.
- Inflation. Comparing years without adjustment overstates growth.
- Group accounts obscure detail. A strong division can conceal a failing one.
:::checkpoint A company revalues its properties upward by KES 30 million. Its trading is unchanged. State what happens to ROCE, gearing and asset turnover, and explain why an analyst should not read the movement as deterioration. :::