Chapter 19

Analysis and interpretation

of financial statements
 Learning objectives
After studying this presentation you should be able to:
19.1 obtain information about entities for the
purpose of analysing their performance and
financial position
19.2 prepare horizontal, trend and vertical analyses of
an entity’s financial statements and be able to
interpret these analyses
 Learning objectives
19.3 conduct ratio analysis to assess an entity’s
profitability, liquidity, and financial stability
19.4 explain the relationships among ratios to
assess the interaction between profitability,
liquidity and financial stability
19.5 analyse and interpret the ratio information
provided by a statement of cash flows
19.6 discuss the limitations of traditional financial
statement analysis
 Users of financial statements analysis
• Financial advisory services publish financial data for most
companies, and details of company reports are generally available
in most public libraries and libraries of universities.
• Individual company and industry analyses are also available from
stockbroking firms. Managers, for strategic and operational decision
making.
• Investors and financial analysts, to evaluate management
performance and to make investment decisions.
• Creditors, to make lending decisions.
• Auditors, to assess the reasonableness of financial statement
values.
• Suppliers, to assess opportunities and ability to repay.
 Sources of financial information
• Financial statements are only one source of information about a
company.
• Other sources of information include:
– financial newspapers
– press releases
– internet
– economy-wide factors
– information about other companies.
• Financial advisory services publish financial data for most
companies, and details of company reports are generally available
in most public libraries and libraries of universities.
• Individual company and industry analyses are also available from
stockbroking firms.
 The need of analytical techniques
• A reported profit of $5,000,000 would be more useful if compared
with:
– Last year’s profit
– The current year’s sales
– The profits of other businesses in the same industry
– The asset base available to generate the profit
– Some predetermined standard established by the statement user
• Reported dollar amounts are frequently to eliminate the effect of
the size of the entity being analyzed:
– horizontal analysis and vertical percentage analysis: reported dollar
amounts are converted into percentages of some base item
– ratio analysis: the relationship between two items is expressed as a
ratio
 Percentage analysis
• Horizontal analysis:
– An analysis of the preceding year’s financial
statements is generally performed as a starting
point for forecasting future performance
– An analysis of the change from year to year in
individual statement items is called horizontal
analysis
– Horizontal analysis compares the proportional
changes in a specific item from one period to the
next
 Percentage analysis
• Horizontal analysis:
– In calculating the increase or decrease in dollar
amounts, the earlier statement is used as the base
year.
The percentage change
= the increase or decrease from the base year x 100
the base-year amount
Example: Cash account: BB $1400, EB $1610
Percentage increase = 210/1400 x 100 = 15%
 Percentage analysis
• Trend analysis:
– When financial data are available for 3 or more years,
trend analysis is a technique commonly used by financial
analysts to assess the entity’s growth prospects.
– In this analysis, the earliest period is the base period,
with all subsequent periods compared with the base.
– It is assumed that the base year selected is fairly typical
of the entity’s operations.
 Percentage analysis
• Vertical analysis:
– Involves restating the dollar amount of each item
reported on an individual financial statement as a
percentage of a specific item on the same statement,
referred to as the base amount.
– Such statements are often called common size
statements since all items are presented as a percentage
of some common base amount.
 Ratio analysis
• A financial statement ratio is calculated by dividing the
dollar amount of one item reported in the financial
statements by the dollar amount of another item
reported.
• The purpose is to express a relationship between two
relevant items that is easy to interpret and compare with
other information.
• Relevant relationships can exist between items in the
same financial statement or between items reported in
two or more different financial statements
 Ratio analysis
• Ratios summarize large amounts of financial
statement information.
• Ratio analysis adds meaning to the information in
financial statements.
• Ratios are scaled measures, so that values of the
same ratio can be usefully compared over time or
across companies.
• Ratios are useful in making various kinds of
decisions.
 Ratio analysis
1. Profitability ratios:
– Profitability analysis consists of tests used to evaluate
an entity’s financial performance during the year.
– Profit potential is important to long-term creditors
and shareholders because the entity must operate at
a satisfactory profit to survive.
– Profit potential is also important to suppliers and
trade unions who are interested in maintaining a
continuing relationship with a financially sound entity.
 Ratio analysis
1. Profitability ratios:
– Return on assets:

– Return on ordinary equity:

• Profit before tax is often used rather than the after-tax figure
• If return on equity is greater than return on assets, the
company is using leverage to the benefit of shareholders
• Values of these ratios generally range between 5% and 20%
• ROE and ROA will naturally tend to be lower in highly
competitive industries
 Ratio analysis
1. Profitability ratios:
– Profit margin:

– Gross profit margin:

 Ratio analysis
1. Profitability ratios:
– Expense ratio:

– Earnings per share:

 Ratio analysis
1. Profitability ratios:
– Price–earnings ratio and earnings yield:

– Dividend yield and payout ratio:

 Ratio analysis
2. Liquidity ratios:
– Liquidity is an important factor in financial statement analysis
since an entity that cannot meet its short term obligations
may be forced into liquidation.
– Measures the company’s ability to pay its short-term debts as
they fall due
– Current ratio:

• A low ratio may indicate a problem in paying short-term debts,

and a high ratio may indicate an excessive investment in non-
productive current assets
 Ratio analysis
2. Liquidity ratios:
– Quick ratio or acid-test ratio:

– Receivables (or debtors) turnover:

 Ratio analysis
2. Liquidity ratios:
– Inventory turnover:
• The inventory turnover ratio is a measure of the
adequacy of inventory and how efficiently it is being
managed.
• The ratio is an expression of the number of times
the average inventory balance was sold and then
replaced during the year.
 Ratio analysis
3. Financial stability ratios:
– Financial stability relates to the entity’s ability to
continue operations in the long term, to satisfy its
long-term commitments, and still have sufficient
working capital left over to operate successfully.
– Debt ratio:
 Ratio analysis
3. Financial stability ratios:
– Equity ratio:

– Capitalization ratio:
 Ratio analysis
3. Financial stability ratios:
– Times interest earned:

– Asset turnover ratio:

 Ratio analysis
4. Relationship between ratios:
• Many ratios are related, and any analysis will benefit from
an understanding of these relationships
For example:
– Activity (turnover) ratios are related to liquidity ratios.
– Profitability ratios are related to financing ratios.
– Profitability ratios are related to activity (turnover)
ratios.
– And so on
 Some important relationships
• It is important to understand certain relationships
which can reveal significant components in maximising
Profitability.
• For instance, the return on assets, calculated in the
section on ‘Profitability ratios’, may also be determined
as the product of the profit margin and asset turnover
ratios, as follows.
 Some important relationships
• Another important relationship is that between return
on assets and return on ordinary equity:

• If the accounting system is computerized, calculation of

all the ratios may be done at any time for internal
purposes by the computer
 Analysis using cash flows
• Ratios derived from the statement of cash flows can help
the analyst evaluate the cash sufficiency of the entity
– i.e. the adequacy of the cash flows to meet the
entity’s cash needs, and the cash flow efficiency of the
entity
– i.e. how well the entity generates cash flows relative
both to other periods and to other entities
• The ratios are not useful in themselves, but must be
compared with the same ratios in previous periods and
for the industry in order to assess the entity’s relative
performance
 Analysis using cash flows
• Cash sufficiency ratios:
– The purpose in calculating these ratios is to assess
the entity’s relative ability to generate sufficient
cash to meet the entity’s cash flow needs.
– All ratios are based on the entity’s cash flows from
operations, and attempt to assess whether these
cash flows are sufficient for the payment of debt,
acquisitions of assets and payment of dividends.
 Analysis using cash flows
• Cash sufficiency ratios:
– Cash flow adequacy ratio:

– Repayment of long-term borrowings ratio:

 Analysis using cash flows
• Cash sufficiency ratios:
– Dividend payment ratio:

– Reinvestment ratio:
 Analysis using cash flows
• Cash sufficiency ratios
– Debt coverage ratio:
• The ratio uses information provided by the
statement of cash flows and the statement of
financial position to access the entity’s ability to
generate cash from operations for paying its long-
term debt commitments
• It is calculated as follows:
 Analysis using cash flows
• Cash flow efficiency ratios:
– Analysts, and the investors and creditors they
represent, are always interested in an entity’s
efficiency in generating profits.
– Cash flow efficiency ratios attempt to assess the
relationship between items in the statement of profit
or loss and other comprehensive income with cash
flows as disclosed in the statement of cash flows, in an
attempt to assess the efficiency of an entity in turning
accrual-based profits into actual cash flows.
 Analysis using cash flows
• Cash flow efficiency ratios:
– Cash flow to revenue ratio:

– Operations index:
 Analysis using cash flows
• Cash flow efficiency ratios:
– Cash flow return on assets:
• In order to compare this with the entity’s accrual-
based return on assets, the cash flow return must be
calculated on a consistent basis with the accrual-
based return.
• The total assets must reflect the average assets for
the period.
 Limitations of financial analysis
• Financial analysis is performed on historical data
mainly for the purpose of forecasting future
performance.
• The measurement base used in calculating the
analytical measures often is historical cost.
• Year-end data may not be typical of the entity’s
position during the year.
• The existence of one-off, or non-recurring, items in a
statement of profit or loss and other comprehensive
income, e.g. losses through floods, may inhibit the
determination of trends to assess business efficiency.
 Limitations of financial analysis
• Sometimes the information contained in the
general purpose reports may be subject to
modifications, supplementations and/or
qualifications expressed in accompanying
documents such as directors’ reports and
auditors’ reports.
• Entities may be not comparable. Ratio
comparisons across companies can be misleading
if the companies operate in different industries or
are substantially different in other ways.
 Limitations of financial analysis
• Ratio comparisons across companies can be
misleading if the companies use different
accounting methods
• Failure to adjust for inflation or market values
results in current dollar amounts often being
compared to past dollar amounts.
• Ratios tell only part of the story. To
understand the full story requires a deeper
understanding of a company and its industry.