Interpreting Company Accounting Information for IAI Actuarial Business Finance

What this chapter covers

Interpreting company accounting information: topics in the order to study them

1. 1Purpose and Users of Company AccountsStart here because it tells you who the analysis is for, and every later comment depends on the user's viewpoint.
2. 2Profitability RatiosProfit margins and returns are the most common starting point and introduce the habit of comparing and explaining changes.
3. 3Liquidity and Efficiency RatiosThese use the balance sheet and link to working capital, and they build on the profit figures you have just studied.
4. 4Gearing and Solvency RatiosLearn these after the earlier ratios because they bring in financing choices and long-term risk.
5. 5Investor Ratios and Market MeasuresThey need profit, capital structure and share data, so they come after the other ratio groups.
6. 6Cash Flow Statement AnalysisOnce you know the ratio groups, you can see where profit and cash differ and test the story the ratios tell.
7. 7Limitations of Ratio Analysis and ComparisonsFinish with the limits so you can add proper caveats to every answer you have practised.

How to prepare Interpreting company accounting information

1. Write each ratio on one page with its formula, what a high or low value means, and one likely cause for each.
2. Learn ratio definitions exactly as the IAI study material gives them, because definitions of items such as capital employed can vary. State the definition you use in written answers.
3. Practise with one set of accounts across several years. Calculate every ratio group, then write three or four sentences on the trend.
4. Always link ratios together. For example, a falling margin with rising asset turnover may point to a price-cutting strategy.
5. Work through cash flow statements and ask why profit and operating cash flow differ, looking at working capital, depreciation and capital spending.
6. Do timed multiple-choice questions on ratio calculations, then timed written questions that ask for comment and limitations.
7. In the last week, redo past questions and check that each answer names the user, the evidence, the explanation and a caveat.

Common mistakes in Interpreting company accounting information

• Giving ratio values with no explanation.

  Fix: After each ratio, state what it means, how it has changed and a likely reason for the change.

• Mixing ratio definitions between questions.

  Fix: Follow the study material and write the formula you use in your answer.

• Comparing a company with a different industry or a different year-end.

  Fix: Compare with the same firm over time and with similar firms, and mention any differences in size or policy.

• Treating high liquidity or low gearing as always good.

  Fix: Say that the right level depends on the industry and strategy. Excess cash may mean idle resources.

• Ignoring the cash flow statement when profit looks strong.

  Fix: Compare profit with operating cash flow and look for growth in receivables, inventory or heavy capital spending.

• Leaving out limitations of ratio analysis.

  Fix: End each commentary with at least two caveats, such as historic cost values, accounting policy choices and window dressing.

Last-day revision: Interpreting company accounting information

• ✓Users of accounts include investors, lenders, employees, suppliers, customers, managers and regulators, and each wants different information.
• ✓Gross margin = gross profit ÷ revenue; operating margin = operating profit ÷ revenue.
• ✓Return on capital employed compares operating profit with the capital used; use the definition given in your study material.
• ✓Asset turnover = revenue ÷ assets used, and it shows how well assets generate sales.
• ✓Current ratio = current assets ÷ current liabilities; the quick ratio leaves out inventory.
• ✓Inventory, receivables and payables days show how long working capital is tied up.
• ✓Gearing compares debt with equity or total capital; higher gearing means higher financial risk.
• ✓Interest cover = operating profit ÷ interest, and it shows how safely interest is paid.
• ✓Earnings per share = profit attributable to ordinary shareholders ÷ number of ordinary shares.
• ✓Price earnings ratio = share price ÷ earnings per share.
• ✓Dividend cover = earnings ÷ dividends, and it shows how easily a dividend is paid.
• ✓Profit is not cash; check the cash flow statement for cash from operations, investing and financing.
• ✓Ratios depend on accounting policies, timing, size and industry, so compare like with like.

Interpreting company accounting information practice questions

• Sundaram Ltd reported profit before tax of ₹800,000 after charging depreciation of ₹150,000 and interest expense of ₹60,000, and after credi…
• A bank is considering a three-year term loan to a manufacturing company. Which feature of the company's accounts would be of most direct int…
• A company's gross profit margin has remained stable, but its net profit margin has fallen sharply over two years. Which is the most likely e…
• Which of the following correctly defines the net profit margin of a company?
• An analyst wants to reduce the limitations of ratio analysis when assessing a listed Indian manufacturer. Which approach is most appropriate…
• A company's share price rises while its earnings per share stay constant. What happens to its price-earnings ratio and earnings yield?
• A financial analyst compares the current ratio of an Indian cement manufacturer with that of an Indian software services company and conclud…
• A profitable company reports steadily rising profit after tax, but its net cash from operating activities has been falling for three years, …

Interpreting company accounting information in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• ACCA Applied KnowledgeRatios
• CMA IntermediateFinancial Ratio Analysis
• ACCA Applied SkillsCalculation and interpretation of accounting ratios and trends to address users' and stakeholders' needs
• CA IntermediateFinancial Analysis and Planning - Ratio Analysis