Chapter 19

Analysis and interpretation of

financial statements
(adapted by L Bayne)

©2020 John Wiley & Sons Australia Ltd

 Aim

• To refresh your Fin St Analysis knowledge from

ACCT1101.
• We will be applying and interpreting these
techniques, ratios and analyses during ACCT3321.
 Practice questions

Ch19 from Hoggett et al. 2021, 11th ed (provided on

LMS):

Discussion q2 (see chapter provided on LMS)

 Sources of financial information

• 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.
• Industry data are available from Dun & Bradstreet,
and from databases such as the ASX.
• Individual company and industry analyses are also
available from stockbroking firms.
 The need for analytical techniques

• Identify significant changes and relationships

• Forecast an entity’s ability to pay its debts when due
• Forecast an entity’s ability to operate at a satisfactory
level of profitability.
 Percentage analysis

• Horizontal analysis:
– An analysis of the change from year to year in
individual statement items is called horizontal
analysis.
– The percentage change is calculated by dividing
the increase or decrease from the base year in
dollars by the base-year amount.
 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:
– Horizontal analysis compares the proportional
changes in a specific item from one period to the
next; 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, so
there are a number of ratios that could be calculated.
 Ratio analysis

• 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

• Profitability ratios:
– Return on assets:

– Return on ordinary equity:

 Ratio analysis

• Profitability ratios:
– Profit margin:

– Gross profit margin:

 Ratio analysis

• Profitability ratios:
– Expense ratio:

– Earnings per share:

 Ratio analysis

• Profitability ratios:
– Price–earnings ratio and earnings yield:

– Dividend yield and payout ratio:

 Ratio analysis

• 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.
– Current ratio:
 Ratio analysis

• Liquidity ratios:
– Quick ratio or acid-test ratio:

– Receivables (or debtors) turnover:

 Ratio analysis

• 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

• 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

• Financial stability ratios:

– Equity ratio:

– Capitalisation ratio:
 Ratio analysis

• Financial stability ratios:

– Times interest earned:

– Asset turnover ratio:

 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 computerised, 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.
 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.
• 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
financial performance 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

• The analytical techniques introduced in this chapter

are useful for providing insights into the financial
position and financial performance of a particular
entity.
• 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.
 Limitations of financial analysis

• Year-end data may not be typical of the entity’s

position during the year.
• Lack of disclosure in general purpose financial
reports may inhibit the extent of the analysis.
• The existence of one-off, or non-recurring, items in a
statement of financial performance, 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 not be comparable.