Chapter 19

Analysis and Interpretation of Financial

Statements

Introduction
Financial accounting is about providing information of general nature on a firm's performance to
users of such information. Published financial statements usually will be made available to a
whole range of interested persons. This ranges from individuals with relatively limited resources
to large investing companies. These users have diverse interests and therefore, each group of
users may place a different emphasis on particular information provided by financial statements.

Analysis and interpretation of financial statements include all measures and techniques employed
by users and financial analysts in order to obtain more useful information out of financial
statements.

Techniques of Analysis and Interpretation

Techniques of analysis of financial statements fall under two main categories, these are common-
size percentage based techniques and ratio analysis.

Common-size percentage based techniques show comparison or relationships expressed as:

i. Percentages of single items to an aggregate total, also known as vertical analysis, or

ii. Percentages increases and decreases for an item from one period to the next, known as
horizontal analysis.

Ratio analysis is the expression of logical relationship between certain items in the financial
statements.

Common - Size Percentage Based Techniques

A) Common-size Statements and Vertical Analysis

If one needs to compare financial statements of two firms that are of different sizes, absolute
figures are not very helpful and can sometimes be misleading. In order to aid such comparison
both firms' financial statements are translated into percentage figures, thus reducing them to a
"common size”. In order to obtain a common-size Statement of Comprehensive Income, all items
in this statement will be expressed as a percentage of total revenues. As for the Statement of
Financial Position, every item will be expressed as a percentage of total assets (i.e. liabilities plus
equity).

Illustration

Following are condensed Statements of Comprehensive Income of two companies Barobaro Ltd
424Introductory Financial Accounting

and Kijeba Ltd. expressed in shillings and percentages:

Barobaro Ltd and Kijeba Ltd

Condensed Statements of Comprehensive Income
for the year ended 31 December 20X2
Barobaro Ltd. Kijeba Ltd.
T.Shs Percent T.Shs Percent
Sales (net) 1,200,000 100% 600,000 100%
Cost of Sales 726,000 61% 330,000 55%
Gross Profit 474,000 40% 270,000 45%
Distribution expenses 226,300 19% 108,000 18%
Admin. expenses 118,700 10% 60,000 10%
Interest expense 15,000 1% 12,000 2%
Total Expense 360,000 30% 180,000 30%
Net Profit 114,000 10% 90,000 15%
Income Tax 26,000 2% 12,000 2%
Net profit after tax 88,000 7% 78,000 13%

If one looked at the performance of the two companies in absolute values, Barobaro Ltd seems to
perform better because it has higher profit figures. However, when absolute values are reduced to
percentages, Kijeba Ltd is a better performing company.

When such a statement as above is presented without the shilling value figures, that is, in
percentages only, it is known as a common-size statement. When such a statement as above is
presented with both shilling values and percentages but for only one company it is expressed as a
vertical analysis. Vertical analysis can be done for one year or over a number of years.

B) Horizontal Analysis

This technique makes use of comparative financial statements. Comparative financial statements
present the same firm's financial statements for two or more successive years alongside each
other. It is possible then to compute percentage changes (increases or decreases) in items in
financial statements over time. This is known as horizontal analysis. It helps detection of changes
in a firm's performance and highlights trends.

Illustration

The following comparative Statements of Comprehensive Income are given for Chungu
Company.

Chungu Company
Comparative Statement of Comprehensive Incomes
For years ended 31 Dec 20X2 and 20X1
Increase/
20X2 20X1 Percent
(Decrease)
Sales 1,530,500 1,234,000 296,500 24.0%
Sales returns 32,500 34,000 (1,500) -4.4%
Net sales 1,498,000 1,200,000 298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit 455,000 380,000 75,000 19.7%
 Analysis and Interpretation of Financial Statements 425

Increase/
20X2 20X1 Percent
(Decrease)
Selling expenses 191,000 147,000 44,000 29.9%
General expenses 104,000 97,400 6,600 6.8%
Total operating exp. 295,000 244,400 50,600 20.7%
Operating income 160,000 135,600 24,400 18.0%
Other income 8,500 11,000 (2,500) -22.7%
168,500 146,600 21,900 14.9%
Other expenses 6,000 12,000 (6,000) -50.0%
Profit before tax 162,500 134,600 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net Profit after tax 91,000 76,500 14,500 19.0%
Note:20X1 is the base year in computing the change percentages

From the horizontal analysis it is observed that:

i. Sales have increased by 24%

ii. Selling expenses have increased by 29.9%.One may want to obtain possible explanation
for the increase, especially the one out of proportion with the sales percentage increase.
iii. Cost of sales has gone up by 27.2%.Some explanation may be needed for the percentage
increase out of proportion with the increase in volume of sales.
iv. Other income has dropped significantly by 22.7%.

Horizontal analysis can be very helpful in interpretation of financial statements.

Ratio Analysis
Ratio analysis utilizes logical relationships between items in a firm's financial statements. The
object is to establish a pattern of key variables which are otherwise concealed in the information
provided in the Statement of Comprehensive Income or Statement of Financial Position.

Ratio analysis can be made for current year results or for results of the previous years as well. It
can also be employed in analysis of results of different comparable firms in the same year. One
main advantage of ratio analysis is that it allows for integrated analysis of items in both the
Statement of Comprehensive Income and the Statement of Financial Position. This provides a
broader dimension to analysis of results.

Financial ratios focus on several aspects of a firm's financial performance and financial position.
These ratios can be computed using only information disclosed in financial statements or they can
also incorporate information from stock exchange. Ratios that utilize market-based data are
known as market ratios. A company will have to be listed and quoted on the stock exchange for
such ratios to be computed.
Categories of Accounting Ratios

Accounting ratios are normally classified according to the aspects of business they are designed
to highlight. These aspects fall under the following categories:

a) Financial soundness and stability, short term and long term. During the short term the
interest is liquidity and during the long term it is solvency.
b) Profitability and return on equity or assets
c) Activity or efficiency measures and
426Introductory Financial Accounting

d) Capital structure or gearing measures.

e) Market - based ratios

Financial Soundness and Stability

These ratios measure the ability of the firm to meet its maturing obligations as they fall due, both
immediately and in the long run.

Current Ratio

This gives an indication of the ability of a firm to meet its current liabilities. It assumes that
current assets will be converted into cash to meet current liabilities. It is calculated as:

Current Assets
Current Ratio =
Current Liabilities

A number greater than one indicates a firm has the ability to meet its current liabilities while a
number less than one indicates potential problems in meeting current liabilities. This however, is
not conclusive, additional information may need to be obtained on nature of business and industry
environment.

Acid Test Ratio

Current ratio assumed that current assets could be converted into cash immediately. However, not
all current assets can be readily converted into cash. The acid test ratio recognizes this limitation
and excludes stocks, for example, in its computation. It is calculated as:

Current Assets - Stocks

Acid Test Ratio =
Current Liabilities

Other current assets like prepayments are also not readily available for meeting maturing
obligations. Therefore, in computing this ratio such items have to be considered if material.

Debt Service Coverage Ratio

This is also known as interest coverage ratio. It measures the ability of a firm to service from
operations interest payments that are due to loan financiers. Inability to pay interest on loans may
force financiers to put a firm under receivership and finally liquidation.

This ratio is computed as follows:

Profits before Interest and Taxes

Debt Service Coverage Ratio =
Annual Interest Payments

Debt Repayment Coverage

Borrowed money should eventually be used to generate profits. Repayment of borrowing then
will be made out of profits after interest charges and income tax. Debt repayment coverage ratio
gives an indication of the length of time it will take to repay borrowings out of profits of the
business.
It is calculated as:
 Analysis and Interpretation of Financial Statements 427

Long-term + Current Liabilities –

Debt Repayment Coverage = Current Assets
Profit after Interest and Tax

Profitability and Returns

Ratios associated with this aspect measure the ability of a firm to generate profits, that is,
revenues in excess of expenses. That ability can be measured according to volume of sales or
resources employed in generation of the profits. These ratios therefore measure the rate of
profitability per a shilling value of sales or an asset value. For profitability ratios, profit is taken to
be Net Profit before interest and taxes (PBIT).This is because performance resulting from
operating decisions needs to be separated from that which is influenced by financing decisions.
By using PBIT, distortions arising out of differences in capital structures and application of
taxation rules in computation of income tax for different companies are avoided.

Ratios falling under this category are:

Gross Margin Ratio

Commonly known as the gross profit ratio and computed as follows:

Gross Profit
Gross Margin = × 100
Sales

Unless there is a change in the relationship between Sales and Cost of Sales the Gross Margin
Ratio should show little change from one year to the next.

Net Profit Ratio

It shows net profit before interest and taxes as a percentage of sales. It gives some indication on
structure and changes in operating expenses. It is calculated as:

Profit before Interest and Taxes

Net Profit Ratio = × 100
Sales

Return on Capital Employed (ROCE)

This ratio measures profit per value of net assets. The net assets figure is arrived at by assuming
the value of fixed assets and current assets and deducting current liabilities. Alternatively, Capital
Employed is Total Assets minus Current liabilities.
ROCE is given by:

Profit before Interest and Taxes

ROCE = × 100
Capital Employed

Return on Total Assets

This ratio measures the ability of a firm in utilizing its total assets in generating profits.

It is given by:
428Introductory Financial Accounting

Profit before Interest and Taxes

Return on Total Assets = × 100
Total Assets

Where there is a significant change in total assets during a year, it is advisable to use an average
total assets figure in the above formula.

Activity or Efficiency Ratios

Various aspects of the efficiency with which assets are utilized can be gauged from turnover
ratios.

The most important ones are:

a) Inventory turnover
b) Collection period for Accounts Receivable
c) Collection period for Accounts Payable.
d) Total assets turnover.

Inventory Turnover

This measures the rate at which a business translates stocks into sales. If the rate is too slow or
decreasing this may indicate overstocking or presence of obsolete merchandise. If this rate is too
high it may indicate under stocking and other problems. Depending on the nature of the business
and industry, a certain range of rates is acceptable.

This ratio is calculated by:

Cost of Goods Sold

Inventory Turnover =
Average Stock

Where the figure of cost of goods sold is not available it can be substituted by a sales figure. This
should not make a significant interpretative problem as long as the formula is consistently
adhered to. It is also possible to use Closing Stock instead of Average Stock. This is especially
the case when stock levels remain more or less unchanged.

Accounts Receivable' Average Collection Period

Good credit control is an important aspect of sound financial management. The average length of
time Accounts Receivable take to pay the firm is an important indicator of management
efficiency.

The period is calculated as follows:

Accounts Receivable Accounts

Average Collection = Receivable
Period Credit Sales ÷ 365

Alternatively this ratio can be computed as follows:

Accounts Receivable = Accounts × 365

 Analysis and Interpretation of Financial Statements 429

Average Collection Receivable

Period Credit Sales

Accounts Payable' Average Payment Period

To put the Accounts Receivable' average collection period in perspective, credit period granted to
customers should not be out of line with the credit period granted by suppliers. Good financial
management should ensure a proper balance. Accounts Payable' average payment period is
calculated as follows:

Accounts Payable Accounts Payable

Average Payment = Credit Purchases ÷ 365
Period

Alternatively this ratio can be computed as follows:

Accounts Payable Accounts

Average Payment = Payable × 365
Period Credit Purchases

Total Assets Turnover

This indicates the ability of assets to generate revenues. How much does a shilling of asset
generate in terms of sales value?

Total assets turnover is given by:

Sales
Total Assets Turnover =
Total Assets

Capital Structure and Gearing Ratios.

The proportion of debt capital to total capital is an important variable to both equity holders and
financiers. It reflects riskiness of the business. Excessive debt has an inherent bankruptcy risk.

Gearing ratio defines the proportion of debt capital to ordinary share/equity capital. There are
two approaches to calculate gearing ratio. One is the proportion of debt capital to total capital and
the other is given by the proportion of debt capital to ordinary share capital.

Note that debt capital plus ordinary share capital gives total capital.

Debt Capital
Debt-Equity Ratio =
Equity Capital

Debt Capital can also be expressed as a proportion of Total Capital and in this case the formula
for computing the ratio changes slightly to the following:

Debt Capital
Debt-Equity Ratio =
Debt Capital + Equity Capital
There are several advantages and disadvantages associated with gearing levels which will be
covered in an intermediate finance course.
430Introductory Financial Accounting

Market-based Ratios

These are additional ratios that can be computed when data from stock exchange are
incorporated. The most common are:

i. Dividend Yield
ii. Dividend Cover
iii. Earnings per Share and
iv. Price/Earnings Ratio.

Dividend Yield

This is given by:

Dividend per Share

Dividend Yield =
Share Market Price

It measures the return on the share invested using current market price of the share. If that return
is significantly lower than in alternative investment opportunities, shareholders may sell those
shares.

Dividend Cover

This ratio indicates the ability of a firm to sustain dividend payments out of its annual
distributable profits. It is calculated as follows:

Net Profit after Interest and Taxes

Dividend Cover =
Annual Dividends Payable

Earnings per Share (EPS)

This is the most commonly known and used ratio for valuing shares. It shows the amount of
profits made during the year and available to each share whether distributed as dividend or
retained for reinvestment in the business. It is calculated as follows:

Net Profit after Interest and Taxes

Earnings per Share =
Number of Ordinary Shares Issued

Price-Earnings Ratio (P/E Ratio)

This ratio is also widely used in financial press. It is usually used in establishing the market value
of a company.

It is calculated as:

Share Market Price

Price-Earnings Ratio =
Earnings per Share

Example

The following financial statements relate to Fresher’s Limited:

 Analysis and Interpretation of Financial Statements 431

Freshers Ltd
Statements of Comprehensive Income
For the years ended 31 Dec 20X7 and 20X8
20X7 20X8
000’s 000’s
T.Shs T.Shs
Sales 12,700 14,800
Cost of Goods Sold 6,260 7,200
Gross Profit 6,440 7,600
Expenses 5,240 5,960
Net Profit before tax 1,200 1,640
Corporation tax 600 800
Net Profit after tax 600 840
Proposed dividends 160 400
Retained Profits for the year 440 440

Notes:
a) Percentage of credit sales 90%
b) Interest paid on the TDFL Loan was 12%

20X7 20X8
000’s 000’s 000’s 000’s
T.Shs T.Shs T.Shs T.Shs
Non Current Assets:
Freehold Property at cost 600 2,100
less: Accumulated Depreciation 0 0
600 2,100
Fixtures and Fittings at cost 2,400 3,000
less: Accumulated Depreciation 560 700
1,840 2,300
Motor Vehicles at cost 700 700
less: Accumulated Depreciation 340 400
360 300
Total Net Non Current Assets 2,800 4,700

Current Assets:
Stocks 900 1,640
Accounts Receivable 1,300 1,880
Bank balance 1,360 240
Total Current Assets 3,560 3,760

Current Liabilities:
Trade Accounts Payable 700 1,420
432Introductory Financial Accounting

20X7 20X8
000’s 000’s 000’s 000’s
T.Shs T.Shs T.Shs T.Shs
Proposed Dividends 160 400
Total Current Liabilities 860 1,820
Net Current Assets 2,700 1,940
Total Net Assets 5,500 6,640

Financed by:
Authorised Share Capital 2,000 2,000
Issued and fully paid
Ordinary Shares T.Shs 10 each 1,500 2,000
Share Premium 0 200
Retained Earnings 2,800 3,240
Shareholders' Funds 4,300 5,440
12% TDFL Loan 1,200 1,200
Total Capital 5,500 6,640

Note: Share price at the end of December, 20X8 was T.Shs 32.

Even before any ratios are computed an analysis of the figures as presented in the financial
statements provides insightful information to the keen observer. Properties have gone up from
T.Shs 600,000 in 20X7 to T.Shs 2,100,000 in the following year. Similarly Fixtures and Fittings
have increased from T.Shs 2,400,000 in 20X7 to T.Shs 3,000,000 in the following year. Clearly
there is a major expansion plan underway but the key question is how are the new acquisition
getting financed?

An analysis of the financing section of the Statement of Financial Position should be able to
provide some information on the way the non current assets are being financed. The company
raised equity capital to the tune of T.Shs 700,000, T.Shs 200,000 being share premium. There is
no change in long term borrowing. Clearly this level of financing is not enough to explain the
acquisition of the properties and fixtures and fittings. It is possible that short term financing has
been used and this information can be obtained in analysis of the relationship between Current
Assets and Current Liabilities.

Stocks have increased from T.Shs 900,000 in 20X7 to T.Shs 1,640,000 in 20X8 – 82 percent
increase within a year. Accounts Receivable however, have increased as a slower rate from T.Shs
1,300,000 in 20X7 to T.Shs 1,800,000 in 20X8 – an increase of 45 percent in percentage terms.
The increase in current assets could only be financed by short term credit facilities. Consequently,
Trade Accounts Payable have doubled from T.Shs 700,000 in 20X7 to T.Shs 1,420,000 in 20X8.
It is also noticed that cash balances have severely shrunk from T.Shs 1,360,000 in 20X7 to T.Shs
240,000 the following year.

Profits have increased but only by 37 percent from T.Shs 1,200,000 in 20X7 to T.Shs 1,640,000
the following year. Surprisingly dividends have outstripped the growth in profitability – from a
dividend of T.Shs 160,000 in 20X7 to T.Shs 400,000 the following year – a growth of 150
percent. Sales have only grown by 17 percent.

From the analysis it is evident that the company needs to be more careful about the growth pattern
 Analysis and Interpretation of Financial Statements 433

and the way it is financed. It appears to finance growth through its short term resources and short
term borrowing. As a result its short term liquidity suffers – something that can have serious
implications for the company.

Ratios computed from the financial statements illustrate the observations made.

20X7 20X8
Liquidity and solvency Ratios:
Current ratio 4.14 2.07
Acid Test Ratio 3.09 1.16
Debt Service Cover Ratio 9.33 12.39
Debt Repayment ratio

Profitability Ratios:
Gross Margin 50.71% 51.35%
Net Margin 9.45% 11.08%
ROCE 24.44% 26.87%
Return on Total Assets 21.13% 21.09%

Activity and Efficiency Ratios:

Inventory Turnover 4.93 5.67
Average Accounts Receivable Collection Period in days 50.77 43.57
Total Assets Turnover 2 1.75

Gearing Ratios:
Debt Equity Ratio 27.91% 22.06%
Debt to Total Capital Ratio 21.82% 18.07%

Market based Ratios:

Dividend yield 6.25%
Dividend Cover 3.75 2.1
EPS T.Shs 4 4.2
P/E Ratio 7.62

Detailed interpretation of the ratios will depend on the norms in businesses of similar nature.
Nevertheless, even without industry ratio comparison there are a number of useful observations
that can be made about the company and its financial health and performance.

Comparative Analysis of Financial Statements

Financial statement data are often used for comparative analysis of two types:
Comparisons of data of one firm with another or other firms at the same point or points in time,
this is cross-sectional analysis.
Comparisons of data of a firm at different points in time, this is time series analysis.
434Introductory Financial Accounting

Cross-sectional Analysis

For comparisons of one firm with another or other firms to be meaningful, those firms must have
some similar attributes. This could be based on the following groupings:

a) Firms having similar production processes or similar distribution systems.

b) Firms producing or dealing with similar products.

In cross-sectional comparison, there must be some benchmark or standard developed for firms
operating in the same grouping. These are known as industry standard or ratios.

Time-series Analysis

This form of analysis seeks to describe a pattern or behavior over time for some variables like
Sales, Profits or Return on Capital Employed. For such analysis to be meaningful, data in
financial statements being observed must have been prepared on the same accounting bases. Time
series analysis must also take account of any structural change that has taken place in a firm.

Limitations of Analysis and Interpretation of Financial Statements

A) Non Availability of Data

When dealing with private companies it can be quite difficult to obtain data and financial
statements from firms of interest to an analyst. Even in public companies there may be limited
financial disclosures which could result in non-availability of data.

B) Absence of Qualitative Data and Information

Accounting figures do not fully encompass qualitative attributes of a firm. These may be
important in interpretation of financial statements, absence of which may distort the analysis.

C) Non-Uniformity in Reporting Periods

When entities report results in different time periods, comparison of results is also limited.

D) Non-Uniformity in Accounting Estimates and Policies

Firms can choose different accounting methods and still remain within Standard Accounting
Practice. Differences in accounting estimates can result in incomparability of results of firms.

e) Inflation

Conventional financial statements do not take account of inflation. Therefore, in time series
analysis the effects of inflation on financial statements under observation need to be taken
account of.
 Analysis and Interpretation of Financial Statements 435

Review Questions
1. Define analysis and interpretation of financial statements.

2. What are the two main categories of techniques employed in interpretation of financial
statements?

3. What are common-size statements?

4. Explain horizontal analysis.

5. What is the object of ratio analysis?

6. What is the advantage of ratio analysis over horizontal and vertical analysis?

7. Two types of ratios can be calculated depending on sources of their data, what are they?

8. It is helpful to categorize ratios according to aspects of business they focus on. Mention
four of those categories.

9. Show how you would compute any two ratios in each of the categories in question 8
above.

10. In profitability ratios, computation of profit is taken to be net profit before interest
expenses and income tax. Why?

11. Why would both the shareholders and loan capital providers be interested in the level of
debt in a firm?

12. List any four market based ratios you know and show how they are computed.

13. Dividend yield shows relative attractiveness of an investment in shares, is that true?

14. List down the limitations of analysis and interpretation of financial statements.

Exercises
1. The following data for Boni Company were available at the year-end:

Net income Shs. 2,000,000

Dividends on Ordinary Shares Shs. 6 per share
Ordinary shares issued shs. 100 each 1500000 shares
Market Price Shs. 120 per share

Compute:
(a) Dividend yield
(b) P/E Ratio

2. The following data were available from the records of Bomani Ltd at the year end:
TAS
436Introductory Financial Accounting

Liquid assets 1,650,000.00

Current assets 2,200,000.00
Average Trade Accounts 150,000.00
Receivable
Average Stocks 420,000.00
Current liabilities 550,000.00
Net Credit sales 1,200,000.00
Cost of Goods sold 840,000.00

Number of days in a year used: 360 days

Compute the following ratios and explain the significance of each:

(a) Quick or Acid Test ratio
(b) Current ratio
(c) Accounts Receivable Turnover
(d) Inventory Turnover
(e) Average collection period of Accounts Receivable.

3. The financial statements for a company reported the following data for the year ended 31
December 20X2:

Sales revenue Shs. 5,000,000

Net Profit Shs. 200,000
Interest expense Shs. 30,000
Total assets Shs. 2,000,000
Shareholders capital Shs. 1,500,000
Ordinary shares in issue 150,000 shares
Market price per share Shs. 150

Compute the following ratios and explain the significance of each:

(i) Profit margin

(ii) Return on Total assets
(iii) Return on owner's equity
(iv) Earnings per share
(v) Price-earnings ratio
(vi) Debt-equity ratio

4. (a) Sham Corporation reported the following information for 20X2:

TAS
Net profit 300,000.00
Total Assets 1,500,000.00
Total owner's equity 600,000.00

Sham's debt/equity ratio was:

(a) 1.5
(b) 1.0
 Analysis and Interpretation of Financial Statements 437

(c) .6
(d) .4
(e) cannot be determined
(f) None of the above; it was ………

(b) Zai & Co's working capital was shs. 300,000 and total current liabilities was two thirds of the
amount. Therefore current ratio was:
(a) 1:1
(b) 2:1
(c) 3:1
(d) 4:1
(e) None of the above; it was …….

(c) Which of the following is not a test of solvency?

(a) Debt to equity ratio

(b) Owner's equity to total capital ratio
(c) Debt capital to total capital ratio
(d) Earnings per share ratio
(e) All of the above are tests of solvency.

(d) In ratio analysis, which of the following is not a test of profitability?

(a) Leverage
(b) Profit margin
(c) Return on total assets
(d) Earnings per share
(e) None of the above.

5. "Ratio analysis is an important technique in the interpretation of financial statements"

(a) What is ratio analysis?

(b) What standards can be used to compare ratios?

(c) What are the limitations in producing and analysing meaningful ratios?

(d) Explain the following and give one example of each, showing how it is calculated:

(i) liquidity ratios

(ii) profitability ratios
(iii) market ratios.
438Introductory Financial Accounting

Problems
1. The portion of Statement of Comprehensive Income of two companies, each for the six
months ended 30 Jan. 20-0 show:

Company X
Shs. Shs.
Sales 289,600.00
Less: Cost of Sales
Opening Stocks 19,000.00
Add: Purchases 235,100.00
Goods Available for Sale 254,100.00
Less: Closing Stocks 21,100.00 233,000.00
Gross Profit 56,600.00

The Statement of Financial Position show Accounts Receivable of 55,000

Company Y
Shs. Shs.
Sales 182,500.00
Less: Cost of Sales
Opening Stocks 30,000.00
Add: Purchases 151,700.00
Goods Available for Sale 181,700.00
Less: Closing Stocks 39,700.00 142,000.00
Gross Profit 40,500.00

The Statement of Financial Position shows Accounts Receivable of 12,000.

The terms of sale by both companies are identical and require net cash within 14 days of
delivery.

Required:

Compare the average collection periods of these two companies.

2. A trader in your town, Horn, has called to see you with his accountant, as he is in financial
difficulties in continuing his business and is seeking additional capital. The accountant tells
you that Horn's present position arises because his average collection period for collection of
trade debts is high, while his rate of stock turnover is low for the type of business carried on.

Required:

How would the accountant have made these two calculations? What steps should Horn take
to remedy his position before you consider advising a client of yours to lend him money?

3. Mega Fashions is a retail trading company specialising in ladies' fashion-wear. A detailed

Statement of Comprehensive Income for the year ended 31 Dec. 20-5 shows the following
 Analysis and Interpretation of Financial Statements 439

position:

31st December, 20-4 31st December, 20-5

T.Shs. '000 T.Shs. '000 T.Shs. '000 T.Shs. '000

120,000.00 Sales 150,000.00

Less: Cost of sales
36,000.00 Opening stock 39,000.00
83,000.00 Purchases 136,000.00
119,000.00 175,000.00
39,000.00 Less: Closing stock 62,500.00
80,000.00 112,500.00
40,000.00 Gross profit 37,500.00
Deduct:
15,000.00 Wages and salaries 16,000.00
500.00 Rates 500.00
240.00 Telephone 260.00
400.00 Light and heat 420.00
640.00 Delivery van exp. 250.00
320.00 Repairs and renewals 1,000.00
42.00 Bank interest 125.00
45.00 Bank commission 52.00
300.00 Audit fee 350.00
100.00 Loan interest 100.00
145.00 Bad debts 2,350.00
20.00 Legal charges 100.00
600.00 Depreciation 650.00
18,352.00 22,157.00
21,648.00 Net profit for the year before taxation 15,343.00

You are required to write a short report to the directors commenting on the results shown and
the comparison with the previous year.
440Introductory Financial Accounting

4. Viatu Bora Co. imports shoes from manufacturers and wholesales to retail shops. All
purchases and sales are made on credit.

Agreed credit terms are:

1) Payment to manufacturers should be made within 60 days of receipt of goods.

2) Payment from retail shops should be received within 30 days of invoice.

The trade is not seasonal but has grown rapidly since the business was set up four years ago.

The accounts for the year ended 31 Dec. 20-1, together with the comparative figures for the
previous year, are shown below:

Statement of Financial Position as at 31st December:

20-1 20-0
Assets T.Shs. '000 T.Shs. '000
Furniture, fixtures and equipment:
cost 1,300.00 900.00
accumulated depreciation (340.00) (310.00)
Motor vehicles:
cost 500.00 300.00
accumulated depreciation (180.00) (80.00)
Stock 3,600.00 1,200.00
Trade Accounts Receivable 2,030.00 990.00
Total assets 6,910.00 3,000.00

Capital and Liabilities

Ordinary shares of sh.1 each fully paid 500.00 300.00
Share premium account 100.00 50.00
Retained profits 1,400.00 650.00
Unsecured loan repayable 31 Dec. 19-1 1,000.00
Taxation payable 250.00 100.00
Trade Accounts Payable 1,810.00 800.00
Bank overdraft 1,850.00 200.00
Total capital and liabilities 6,910.00 2,100.00

There were no disposal of non current assets during the year.

 Analysis and Interpretation of Financial Statements 441

Statement of Comprehensive Income for the year ended 31st December:

20-1 20-0
T.Shs. '000 T.Shs. '000 T.Shs. '000 T.Shs. '000
Sales 13,500.00 7,500.00
Cost of goods sold
Opening stock 1,200.00 750.00
Purchases 13,200.00 6,450.00
14,400.00 7,200.00
Less: Closing stock 3,600.00 1,200.00
10,800.00 6,000.00
Gross profit 2,700.00 1,500.00
Expenses 1,250.00 900.00
Profit before tax 1,450.00 600.00
Taxation payable 250.00 100.00
Profit after tax 1,200.00 500.00
Dividend paid 450.00 300.00
Profit retained 750.00 200.00

You are required to:

(a) Prepare a statement explaining the increase in the overdraft between 1 Jan. and 31 Dec.
20-1.

(b) Calculate for both 20-0 and 20-1:

(i) Stock-turn based on year-end and average stocks,
(ii) average period of credit taken by customers,
(iii) average period of credit taken from suppliers.

(c) Comment on the financial strength of the company.

5. Two financial analysts are having a disagreement. One says, "I don’t know why you don't use
net income to average total assets as the measure of efficient asset usage. After all, net
income is the final result. It represents what really happened. How can you ignore taxes and
interests? They are real and they happen".
442Introductory Financial Accounting

The second analyst replies, "That isn't the point.Net income represents the combined results
of several different types of management, actions, government policies and even acts of God.
By using Profits before interest and taxes, I can somewhat pinpoint responsibility to operating
management."

Who is correct? Discuss with a good example.

6. The following details were extracted from the books of Ridhaa & Co. a grocer, whose year
end is 30th September.

20X2 20X3
Shs. Shs.
Sales 2,754,000.00 3,078,000.00
Purchases 2,254,500.00 2,640,600.00
Administration expenses 192,900.00 246,300.00
Selling & Distribution 165,300.00 138,300.00
Financial expenses 54,900.00 153,900.00
Drawings 67,500.00 87,300.00

You are given the following information:

(i) Stocks at cost were as follows:

Shs.
30 Sept. 20X1 405,000.00
30 Sept. 20X2 456,300.00
30 Sept. 20X3 788,400.00

(ii) The credit balance on Ridhaa's capital account on October 1st, 20X1 was Shs. 243,000.

Required:

(a) Show the results achieved in each year and show the gross and net profit rates.

(b) Calculate 3 other significant ratios in each year and

(c) Write a brief report on your interpretation of the results.

 Analysis and Interpretation of Financial Statements 443

7. The following information relates to the finances of Ragge Dolle Ltd.

Issued share capital Shs. '000

100,000 8 % shares of shs. 100 each 10,000.00
600,000 ordinary shares of 50 each 30,000.00
40,000.00

Net profit, before dividends have been

charged for the year ended 30 Jun. 20-7
15,800.00

Dividend of 20% declared on ordinary shares.

The current market price of the ordinary shares is 200 per share, and that of the preference
shares is 80 per share.

You are required to calculate:

a) the dividend yield for both the ordinary shares and the preference shares;

b) the number of times that the dividend on the ordinary shares is covered by available
profit;

c) the price earnings ratio applicable to the ordinary shares.