Interpreting Financial Statements

Your FR exam will be here before we know it. Are you spending enough time practicing the interpretations question? Do you know the approach to take and what the marker is looking for?

Too many students dive straight into the numbers and the ratio calculations, without ‘figuring out’ the story. There is always a story behind an interpretations question. You must be the journalist and find the story! Only once you have found the story can you tell it. And telling the story is what will gain you marks. I want to help you learn how to write an answer that the marker wants to read and one that will score you a good pass.

Find the story

Let’s imagine you were asked to compare a company’s financial statements with the prior year numbers and give a year-on-year analysis of the company’s performance. First, identify from the scenario ‘what we know’. Start at the top. What has happened to revenue compared to last year? Then look at the bottom line: profit or loss for the year. How much has profit gone up or down? Have there been any large movements on the statement of financial position? What facts and circumstances have we been told? Has a subsidiary been acquired or disposed of in the year, what decisions has management taken this year? What would you expect to be the impact of these events on the financial statements? Do the numbers (including any ratios you calculate) actually support this? In other words, gather the information you are given to create an expectation of what story you expect to tell. Then pair this story with your numbers and ratios and hopefully the two will agree.

Some other do’s and don’ts include:

Start at the top!

Start your discussion of profitability with why revenue has moved and why gross profit and operating profit margins have moved. Work your way down the statement of profit or loss. The examiner has stated that students who start by making one or two points on revenue produce better answers!

Leave ROCE until later

Do NOT start your discussion with return on capital employed (ROCE) and why it has moved – this will not help you and is likely to lead to a generic answer. For example, a weak script might state that ROCE improved which means there has been an increase in efficiency in the business. This generic, rote-learned response won’t earn you marks because it is not a proper explanation of why ROCE has improved.

Evidence is key

Your answers should contain explanations based on evidence given in the scenario. You must ensure that you incorporate the events from the scenario into your answer – anything else is guesswork! Guesswork is not backed up by the evidence in the scenario and will gain no marks. For example, if a company sold a highly profitable subsidiary at the start of the current year and you calculate that the group’s profit margins fell sharply, it would be reasonable to suggest that because the subsidiary is no longer consolidated (owing to its disposal) and because the subsidiary had much higher profit margins than the rest of the group, the group profit margins have deteriorated.

How much?

Quantify your answer. If a profit margin has risen, quantify the increase (e.g. operating profit margin has risen from 10% to 15%).

Ratios should strengthen the story

Remember that ratios back up your story, not the other way round! So don’t simply describe why each ratio has gone up or down – this will produce bland commentary and will probably neglect ‘the story’. You will create a better answer if you start with an observation about something that has happened in the year and then provide a ratio movement that is consistent with what has happened. For example, ‘the cash balance fell by 5 million dollars in the year and there is now an overdraft of 3 million dollars.’ The reason why the cash balance fell is because the company spent money on a large expansion and it used its overdraft facility in order to finance this. Consequently the current ratio has fallen from X to Y.

Why does it matter?

If you can, give a ‘so what?’ comment. For example, following on from the scenario above, you could state that relying on an overdraft to fund an expansion is both expensive and very risky: not only is an overdraft not cheap, but there is also a danger that it could be withdrawn at any moment. If the company does not have the funds to repay the overdraft on demand, this could lead to a solvency problem.

Any tips?

Where appropriate, give a recommendation. For example, you could say it would be sensible to fund an expansion through a long-term form of finance, such as through a share issue or through loan finance.

Remove one-offs

More sophisticated answers will strip out ‘one-off events’ (e.g. a disposal of a subsidiary, an impairment, a one-off provision) from relevant ratios. Although these events can provide good explanations for movements in numbers and ratios, they can obscure the view of the big picture. One-off events are not expected to be repeated, so it is helpful to assess the performance of the business without them.

And finally…

Write a conclusion: a simple summary. If the question asked for an investment decision, give one!

Sarah Ardiles is an ACCA FR online lecturer with FME Learn Online

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