What Analysis and Interpretation Mean
Chapter Six
Syllabus topic 2, "Analysis and Interpretation of Financial Statements"
Pages 11 to 12 of 162
In one line
Analysis rearranges the figures so that relationships appear; interpretation draws the conclusion those relationships support.
The two acts
| Analysis | Interpretation | |
|---|---|---|
| What it does | Breaks up the statements into their parts and establishes the relationship between them | Explains what the relationships mean |
| Its output | A figure, a percentage, a ratio, a trend | A judgment, in words |
| Its skill | Arithmetic and classification | Reasoning and knowledge of the business |
| Can it be wrong? | Only by miscalculation | Yes, and often is |
| Example | Gross profit ratio has fallen from 32 per cent to 30 per cent | Either selling prices were cut, or input costs rose and were not passed on |
Analysis comes first and cannot be skipped. Interpretation comes second and is where the marks are.
What is being analysed
Two statements, and this whole paper reads only these two.
| Statement | What it says |
|---|---|
| The balance sheet | The position at a moment: what the business owns, what it owes and who financed it |
| The revenue statement | The performance over a period: what it earned and what it cost |
A third, the cash flow statement, is Module IV, and it explains the movement in one line of the balance sheet.
The parties who analyse, and what each is asking
| Who | The question they are asking | The tool that answers it |
|---|---|---|
| Shareholders | Is my money earning a return, and will the dividend continue | Return on equity capital, dividend payout, net profit ratio |
| Prospective investors | Is the trend rising or falling | Trend analysis, common size statements |
| Long-term lenders | Can it pay the interest and repay the principal | Debt equity, capital gearing, debt service ratio |
| Short-term creditors and bankers | Can it pay me in ninety days | Current ratio, liquid ratio, debtors turnover |
| Management | Is the business under control, and where is it leaking | All of them, and the trend of each |
| Employees | Can it pay a rise, and is it secure | Net profit ratio, trend of profits |
| Government and the tax authorities | Is it declaring what it earns | The statements themselves |
Naming the party is what turns a list of ratios into an answer. A ratio is only useful against a question, and the question comes from whoever is asking.
The types of analysis
Two classifications, and MU's problems use both words.
By the material used:
| Type | What it uses |
|---|---|
| External analysis | Only the published statements; done by outsiders, so limited to what is disclosed |
| Internal analysis | The books and records as well; done by management, so unlimited |
By the method:
| Type | What it compares |
|---|---|
| Horizontal, or dynamic | The same item across periods: this year against last, or five years. Trend analysis and comparative statements are horizontal |
| Vertical, or static | The items of one statement against each other at one date. Common size statements and most ratios are vertical |
What Analysis and Interpretation Mean
Notice the word "vertical" is doing two jobs in this paper, and they are not the same thing. Vertical analysis means comparing within one period. The vertical form means a statement set out down the page rather than in two sides. The next two chapters are about the form.
The steps of an analysis
- Decide the object: whose question is being answered.
- Collect the statements and, for a horizontal analysis, enough years.
- Rearrange them into a comparable form: this is where the vertical form comes in, and why it comes next.
- Compute the trends, percentages or ratios the object needs.
- Compare against a standard: the previous year, a budget, a rival, or the conventional norm.
- Interpret, and report in a form the reader can act on.
Step five is the one most often skipped. A ratio compared with nothing means nothing, and saying what you compared it against is part of the answer.
What it does NOT mean
Analysis does not create information. Everything it produces was already in the statements; it is made visible, not made.
Interpretation is not guessing. Every conclusion must be traceable to a figure, and where two explanations fit, an answer that names both is better than one that picks the wrong one confidently.
Neither can repair a bad statement. If the underlying accounts are window dressed, the analysis inherits the distortion in full.
Quick revision
| Analysis | Breaks up and relates; output is a figure |
| Interpretation | Explains; output is a judgment |
| Two statements read | Balance sheet, position; revenue statement, performance |
| By material | External, published only; internal, books as well |
| By method | Horizontal across periods; vertical within one |
| The step most skipped | Comparing against a standard |
Test yourself
- State the difference between analysis and interpretation in one sentence each.
- A banker deciding on a ninety-day overdraft is asking which question, and which ratios answer it?
- What is the difference between external and internal analysis?
- Is trend analysis horizontal or vertical?
- Give the two meanings the word "vertical" carries in this paper.
Answer in one sentence
1. Analysis breaks the statements into parts and establishes relationships between them; interpretation says what those relationships mean.
2. Whether the business can pay in ninety days, answered by the current ratio, the liquid ratio and the debtors turnover.
3. External analysis uses only the published statements and is limited to what is disclosed; internal analysis uses the books and records as well.
4. Horizontal, because it compares the same item across periods.
5. Vertical analysis means comparing items within one period, and the vertical form means a statement set out down the page instead of in two sides.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.