This document discusses analyzing financial statements through ratios and the weighted average cost of capital (WACC). It introduces various types of ratios to evaluate aspects like profitability, efficiency, liquidity, financial gearing, and investments. It then explains how to calculate WACC by finding the costs of debt and equity using formulas, and weighing them based on the capital structure. Finally, it notes limitations of the WACC approach in accounting for different risk levels of investment opportunities.

1. CHAPTER 3: ANALYSING
AND INTERPRETING
FINANCIAL STATEMENTS

2. INTRODUCTION
Analysis and interpretation of financial statements means
looking at the various parts of the financial statements, relating the
parts to each other and to the picture as a whole and determining if
any meaningful and useful interpretation of data can be made out of
this analysis.

4. FINANCIAL RATIOS
• Compares two related figures, usually both from the same set of
financial statements.
• Ratios help to highlight the financial strengths and weaknesses
of a business.
• Ratios can be expressed in various forms, for example as a
percentage or as a proportion. The way that a particular ratio is
presented will depend on the needs of those who will use the
information.

5. FINANCIAL RATIO CLASSIFICATIONS

6. PROFITABILITY
The following ratios may be used to evaluate the profitability of the
business:
● return on ordinary shareholders’ funds
● return on capital employed
● operating profit margin
● gross profit margin

7. EFFICIENCY
Efficiency ratios are used to try to assess how successfully the various
resources of the business are managed. The following ratios consider
some of the more important aspects of resource management:
● average inventories turnover period
● average settlement period for trade receivables
● average settlement period for trade payables
● sales revenue to capital employed
● sales revenue per employee

8. LIQUIDITY
Liquidity ratios are concerned with the ability of the business to meet
its short-term financial obligations. The following ratios are widely
used:
● current ratio
● acid test ratio

9. FINANCIAL GEARING
Financial gearing occurs when a business is financed, at least in part, by
borrowing instead of by finance provided by the owners (the
shareholders) as equity. Two ratios are widely used to assess gearing:
● gearing ratio
● interest cover ratio

10. INVESTMENT RATIOS
There are various ratios available that are designed to help
shareholders assess the returns on their investment. The following are
widely used:
● dividend payout ratio
● dividend cover ratio
● dividend yield ratio
● earnings per share

11. LIMITATIONS OF RATIO ANALYSIS
● Ratios are only as reliable as the financial statements from which
they derive.
● Creative accounting can deliberately distort the portrayal of financial
health.
● Ratios provide only part of the picture and there should not be over-
reliance on them.
● It can be difficult to find a suitable benchmark (for example, another
business) to compare with.
● Some ratios could mislead due to the ‘snapshot’ nature of the
statement of financial position.

12. CHAPTER 8: THE COST OF
CAPITAL AND THE CAPITAL
STRUCTURE DECISION

13. CAPITAL STRUCTURE & COST OF CAPITAL
• Capital Structure refers to the mix of both short-and long-term debt
held by the business, along with the levels of common and preferred
equity.
• Cost of Capital is the minimum rate of return or profit a company
must earn before generating value. It is used as the discount rate in
Net Present Value (NPV) calculations and as the ‘hurdle rate’ when
assessing IRR calculations.

14. WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
A firm’s cost of capital is typically calculated using the weighted average
cost of capital formula that considers the cost of both debt and equity
capital.

15. WACC (Finding the cost of debt)
The cost of debt is merely the interest rate paid by the company on it’s
debt. However, since interest expense is tax-deductible, the debt is
calculated on an after-tax basis as follows:

16. WACC( Finding the cost of equity)
The cost of equity is more complicated since the rate of return
demanded by equity investors is not as clearly defined as it is by
lenders. The cost of equity is approximated by the capital asset pricing
model as follows:

17. CALCULATING WACC

18. LIMITATIONS OF WACC APPROACH
The WACC approach has been criticized for failing to take proper
account of risk in investment decisions. In practice, different
investment opportunities are likely to have different levels of risk and
so the cost of capital for each project should be adjusted accordingly.
We know that risk-averse investors require higher returns to
compensate for higher levels of risk.