UNDERSTANDING AND INTERPRETING FINANCIAL STATEMENTS

Understanding and Interpreting Financial Statements

Understanding and Interpreting Financial Statements

Introduction

The main purpose of this study is to understand the financial statements of Morrison, Sainsbury, Tesco and Asda by using the financial ratios, and to show the use of financial ratios.

Financial statements are summaries of monetary data about an enterprise. The most common financial statements include the balance sheet, the income statement, the statement of changes of financial position and the statement of retained earnings. These statements are used by management, labor, investors, creditors and government regulatory agencies, primarily. Financial statements may be drawn up for private individuals, non-profit organizations, retailers, wholesalers, manufacturers and service industries. The nature of the enterprise involved dramatically affects the kind of data available in the financial statements. The purposes of the user dramatically affects the data he or she will seek.

Reasons for Using Ratio Analysis

Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things(Griffiths, 1995).

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements(Black, 2005). Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy(Black, 2005).

The significance of a ratio can only truly be appreciated when:

It is compared with other ratios in the same set of financial statements(Atrill, 2008)

It is compared with the same ratio in previous financial statements (trend analysis).

It is compared with a standard of performance (industry average). Such a standard may be either the ratio which represents the typical performance of the trade or industry, or the ratio which represents the target set by management as desirable for the business (Griffiths, 1995).

In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very useful thing to know anyway! (Abraham, 2006)

There are several groups of ratios that each serves different purposes:

Liquidity Ratios provide measures of how easily a firm can meet its obligations.

Profitability Ratios indicate the earnings and profitability potential of a company.

Asset Management Ratios measure how efficiently a company can turn its assets into sales.

Debt Management Ratios indicate how leveraged a company is in terms of debt, and how well it can handle that debt with its assets and operating income.

Dividend/Market Value Ratios measure how well a company uses its assets to generate earnings for its investors.

Ratios can provide meaningful comparisons of companies in similar industries or of a company in a single industry. As such, financial ratios should be evaluated in comparison to other companies in the same industry (Castro, 2006). For example, a dividend ratio of 5.2 means nothing by itself, and means very different things if the industry average is 22.5 as opposed to 1.5. For businesses that have operations in more than one industry, ...