7
Interpreting financial statements............................
and Alternative Theoretical
Perspectives
This chapter introduces the content of a company’s Annual Report and shows
how ratio analysis can be used to interpret financial statements. This interpretation
covers profitability, liquidity (cash flow), gearing (borrowings), activity/efficiency
and shareholder return. A case study demonstrates how the use of ratios can look
‘behind the numbers’ contained in an Annual Report. The chapter concludes with
several alternative theoretical frameworks on financial reporting.
Interpreting financial statements
Financial statements are an important part of a company’sAnnual Report,whichis
required for all companies listed on the Stock Exchange. For companies not listed,
the Companies Act requires the preparation of financial statements. The process of
interpreting financial statements begins with a consideration of the wider context:
economic conditions; changes in the industry (e.g. regulation, technology); and the
competitive advantage (e.g. marketing, operations, distribution etc.) held by the
business. Within this context, often gained through the financial press and trade
periodicals, the Annual Report itself can be considered.
The Annual Report for a listed company typically contains:
1 A financial summary – the key financial information.
2 The chairman’s or directors’ report. This provides a useful summary of the
key factors affecting the company’s performance over the past year and its
prospects for the future. It is important to read this information as it provides
a background to the financial statements, in particular the company’s products
and major market segments. It is important to ‘read between the lines’ in this
report, since the intention of the Annual Report is to paint a ‘glossy’ picture
of the business. However, as competitors will also read the Annual Report, the
company takes care not to disclose more than is necessary.
3 The statutory reports (i.e. those required by the Companies Act) by the directors
and auditors. These will help to identify any key issues that may be found in
the accounts themselves.