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Current and future developments in the company's markets, at home and overseas, recent 

acquisitions or disposals of a subsidiary by the company 

(d) Any 

other 

noticeable features of the financial statements, such as events after the reporting 

period, contingent liabilities and the company's taxation position 

2.1 Example: calculating ratios 

To illustrate the calculation of ratios, the following statement of financial position and statement of profit 

or loss figures will be used. 

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CHAPTER 26  

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  INTERPRETATION OF FINANCIAL STATEMENTS 

 

461 

FURLONG CO STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8 

 Notes 

20X8 

20X7 

 

 

$      

$      

Revenue 

1 

 3,095,576   1,909,051 

Operating profit 

1 

    359,501      244,229 

Interest 

2 

      17,371        19,127 

Profit before tax 

 

    342,130      225,102 

Income tax 

 

      74,200        31,272 

Profit for the year 

 

    267,930      193,830 

FURLONG CO STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8 

 

Notes 

20X8 

20X7 

 

 

$

 

$ 

$

 

$ 

Assets 

 

 

 

 

Non-current assets 

 

 

 

 

 

   Tangible non-current assets 

 

   

   802,180 

  

   656,071

Current assets 

 

 

 

 

 

   Inventories 

 

      

64,422

 

 

86,550

 

 

   Receivables 

3 

 

1,002,701

 

   

853,441

 

 

   Cash at bank and in hand 

 

  

      1,327

 

 

  68,363

 

 

 

   

1,068,450 

  

1,008,354

Total assets 

 

   

1,870,630 

  

1,664,425

 

 

 

 

 

Equity and liabilities  

 

 

 

 

Equity 

 

 

 

 

    

Ordinary shares 10c each 

5 

    

210,000

 

 

210,000

 

    

Share premium account

 

 

 

     48,178

 

 

  48,178

 

    

Retained earnings 

 

  

  630,721

 

  

 393,791

 

 

 

 

    888,899 

 

    651,969

Non-current liabilities 

 

 

 

 

 

   10% loan notes 20X4/20X9 

 

      

100,000 

     

100,000

Current liabilities 

4 

   

   881,731 

  

   912,456

Total equity and liabilities  

 

   

1,870,630 

  

1,664,425

NOTES TO THE ACCOUNTS 

 

 

 

20X8

 

20X7

 

 

 

$ 

$ 

1 

Sales revenue and profit 

 

 

 

Sales revenue 

 3,095,576 

 1,909,051 

 

Cost of sales 

 2,402,609 

 1,441,950 

 

Gross profit 

 692,967 

 467,101 

 

Administration expenses 

   

 

333,466 

  

 

222,872 

 

Operating profit 

  

 

359,501 

   

 

244,229 

 

Depreciation charged 

 151,107 

 120,147 

2 

Interest 

 

 

 

Payable on bank overdrafts and other loans 

 8,115 

 11,909 

 

Payable on loan notes 

 10,000 

 10,000 

 

 

 18,115 

 21,909 

 

Receivable on short-term deposits 

      744 

   2,782 

 

Net payable 

 17,371 

 19,127 

3 

 

Receivables 

 

 

 

 

Amounts falling due within one year 

 

 

 

 

   Trade receivables 

 884,559 

 760,252 

 

 

   Prepayments and accrued income 

   97,022 

   45,729 

 

 

 981,581 

 805,981 

 

 

Amounts falling due after more than one year 

 

 

 

 

   Trade receivables 

      21,120 

   47,460 

 

 

Total receivables 

 1,002,701 

 853,441 

 

  

 

 

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PART H: INTERPRETATION OF FINANCIAL STATEMENTS 

 

462

 

 

 

 

20X8

 

20X7

 

 

 

$ 

$ 

4 

Current liabilities  

 

 

Trade payables 

 627,018 

 545,340 

 

  

Accruals and deferred income 

 81,279 

 280,464 

 

 

Income taxes 

 108,000 

 37,200 

 

 

Other taxes  

   65,434 

   49,452 

 

 

 881,731 

 912,456 

5 

 

Share capital 

 

 

 

 

Authorised ordinary shares of 10c each 

 1,000,000 

 1,000,000 

 

 

Issued and fully paid ordinary shares of 10c each 

    210,000 

      210,00 

 

3

   Profitability and return  

Profitability ratios include: 

 

Return on capital employed 

 

Net profit as a percentage of sales 

 

Asset turnover ratio 

 

Gross profit as a percentage of sales  

In our example, the company made a profit in both 20X8 and 20X7, and there was an increase in profit 

between one year and the next: 

(a) 

Of 52% before taxation 

(b) 

Of 39% after taxation 

Profit before taxation is generally thought to be a better figure to use than profit after taxation, because 

there might be unusual variations in the tax charge from year to year which would not affect the 

underlying profitability of the company's operations. 

Another profit figure that should be calculated is PBIT, profit before interest and tax. This is the amount 

of profit which the company earned before having to pay interest to the providers of loan capital. By 

providers of loan capital, we usually mean longer-term loan capital, such as loan notes and medium-term 

bank loans, which will be shown in the statement of financial position as non-current liabilities. 

PBIT is therefore: 

(a) 

The profit before taxation; plus 

(b) 

Interest charges on long-term loans.  

Published accounts do not always give sufficient detail on interest payable to determine how much is 

interest on long-term finance. We will assume in our example that the whole of the interest payable 

($18,115, note 2) relates to long-term finance. 

PBIT in our example is therefore: 

 

20X8 

20X7 

 

$ 

$ 

Profit before tax 

 

342,130 

 

225,102 

Interest payable 

 

  18,115 

 

  21,909 

PBIT 

 

360,245 

 

247,011 

This shows a 46% growth between 20X7 and 20X8. 

3.1 Return on capital employed (ROCE) 

It is impossible to assess profits or profit growth properly without relating them to the amount of funds 

(capital) that were employed in making the profits. The most important profitability ratio is therefore 

return on capital employed (ROCE), which states the profit as a percentage of the amount of capital 

employed. ROCE measures the overall efficiency of a company in employing the resources available to it.  

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CHAPTER 26  

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  INTERPRETATION OF FINANCIAL STATEMENTS 

 

463 

FORMULA TO LEARN 

ROCE  

= 

employed

 

Capital

taxation

 

and

 

interest

 

before

 

Profit

 × 100% 

Capital  

= 

Shareholders' equity plus long-term liabilities 

employed 

 

(or total assets less current liabilities) 

 

The underlying principle is that we must compare like with like, and so if capital means share capital 

and reserves plus long-term liabilities and debt capital, profit must mean the profit earned by all this 

capital together. This is PBIT, since interest is the return for loan capital. 

In our example, capital employed   = 

20X8: $1,870,630 – $881,731 = $988,899 

      20X7: 

$1,664,425 

– 

$912,456 

= 

$751,969 

These total figures are the total assets less current liabilities figures for 20X8 and 20X7 in the statement 

of financial position. 

 

 20X8 

20X7 

ROCE = 

$$

$360,245 

 $247,011 

  

$988,899 

$751,969 

 = 

36.4%  32.8% 

What does a company's ROCE tell us? What should we be looking for? There are three comparisons that 

can be made. 

(a) The 

change in ROCE from one year to the next can be examined. In this example, there has been 

an increase in ROCE by about 4% from its 20X7 level. 

(b) The 

ROCE being earned by other companies, if this information is available, can be compared 

with the ROCE of this company. Here the information is not available. 

(c) 

A comparison of the ROCE with current market borrowing rates may be made. 

(i) 

What would be the cost of extra borrowing to the company if it needed more loans, and is 

it earning a ROCE that suggests it could make profits to make such borrowing worthwhile? 

(ii) 

Is the company making a ROCE which suggests that it is getting value for money from its 

current borrowing? 

(iii) 

Companies are in a risk business and commercial borrowing rates are a good independent 

benchmark against which company performance can be judged. 

In this example, if we suppose that current market interest rates, say, for medium-term borrowing from 

banks, is around 10%, then the company's actual ROCE of 36% in 20X8 would not seem low. On the 

contrary, it might seem high. 

However, it is easier to spot a low ROCE than a high one, because there is always a chance that the 

company's non-current assets, especially property, are undervalued in its statement of financial position, 

and so the capital employed figure might be unrealistically low. If the company had earned a ROCE not 

of 36% but of, say, only 6%, then its return would have been below current borrowing rates and so 

disappointingly low. 

3.2 Return on equity (ROE) 

Return on equity (ROE) gives a more restricted view of capital than ROCE, but it is based on the same 

principles. 

FORMULA TO LEARN 

ROE  = 

 funds

rs

shareholde

Equity 

dividend

 

preference

 

and

tax 

after 

 

Profit

   

 

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