Financial Analytics for Managerial Decisions

Analysis of financial statements

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Analysis of financial statements i

Contents

Introduction 1

Learning objectives 1

Key concepts 1
Why users require financial statements to be analysed 1
Nature and purpose of financial analysis 2
Analytical methods 2
Financial ratio analysis 2
Profitability analysis 3
Asset efficiency analysis 3
Liquidity analysis 3
Capital structure analysis 3
Market performance analysis 4
Integrated financial ratio analysis 4
Segment analysis 5
Limitations of financial ratios 5

Student activities 6

Summary 6

References 6

ii Analysis of financial statements

Introduction
The purpose of financial reporting is to meet the needs of external users of
accounting information. These users otherwise not have access to the
firm’s financial records and rely on publicly available statutory accounts.
The process of interpreting a firm’s financial statements can be facilitated
by various analytical methods. The following three units explain how to
conduct the analysis. This unit provides an introduction to the analysis with
the primary focus on the financial ratios.

Learning objectives
By the end of this topic you should be able to:
• Explain why different user groups require financial statements to be
analysed and interpreted
• Describe the nature and purpose of financial analysis
• Apply the analytical methods of horizontal, trend, vertical and ratio
analysis
• Define, calculate and interpret the ratios that measure profitability, asset
efficiency, liquidity, capital structure, and market performance
• Explain the interrelationships between ratios and use integrated financial
ratio analysis to discuss the financial performance and the position of an
entity
• Appraise the segment performance using relevant ratios
• Apply the analytical tool of graphs
• Discuss the limitations of ratio analysis.

Key concepts

Why users require financial statements to be

analysed
The financial statements assist users in decision-making. Analysing the past
financial performance and position of an entity s useful in predicting an
entity’s future performance and situation. Such analysis allows users to
detect changes in an entity’s performance, to gain an insight why changes
have occurred, and to assess the entity’s performance and position relative
to its peers and industry averages.

Analysis of financial statements 1

 Nature and purpose of financial analysis
Financial analysis refers to the assessments of an entity’s financial position
and performance. Conducting financial analysis gives users enhanced
understanding and appreciation of an entity’s financial health. The absolute
numbers in the financial statements are of limited usefulness. By expressing
the numbers in relative terms, the financial statements become more
meaningful and useful in evaluating an entity’s past decisions and predicting
future rewards and risks.

Analytical methods
A reported number or ratio on its own is of limited use. The analytical
methods of horizontal analysis, trend analysis, vertical (common size)
analysis and ratio analysis are designed to provide a comparative dimension
to the number or ratio.
Using horizontal analysis, the current reporting period’s number or ratio is
compared with that in previous years. Allowing absolute number change
and percentage change to be computed. If the comparative period extends
further, trends can be depicted. Such a comparison is referred to as trend
analysis or time–series analysis. Alternatively, the reported numbers in the
income statement (or in the balance sheet) can be expressed as a
percentage of base numbers in the income statement (or in the balance
sheet). Items in the income statement can be expressed as a percentage of
total revenue and items in the balance sheet can be expressed as a
percentage of total assets.

The analysis can also use the entities in the same industry as benchmarks and
compare the relative performance of the entity. This type of analysis is
usually called cross-sectional analysis. The purpose of cross-sectional analysis
is to examine the relative performance of an entity within the industry.
Valuable information can be found by analyzing the operating performance
within an industry. Gathering information from competitors can help to
identify the ‘best practice’ in an industry, which may prove to be beneficial.

Financial ratio analysis

The primary tool for evaluating an entity’s financial health is the
calculation of a variety of financial ratios. Ratio analysis involves expressing
one item in the financial statements relative to another item in the
financial statements. Through ratio analysis, users can explore relationships
between financial numbers and gain a better understanding of an entity’s
financial health. There are five categories of financial ratios: profitability,
asset efficiency, liquidity, capital structure and market performance. The
following sections will discuss these categories one by one.

2 Analysis of financial statements

Profitability analysis

Profitability relates an entity’s profit to the resources available to generate

profit and to an entity’s effectiveness in in converting income into profits.
The ratios measuring an entity’s profitability include the return on equity,
return on assets, gross profit margin, profit margin and expense ratios.

Asset efficiency analysis

Asset efficiency refers to the effectiveness of an entity’s investment in

assets to generate income. The ratios in this category typically relate a
particular class of assets to income. Ratios in this group include total asset
turnover ratio, days in debtors (accounts payable) and inventory. The lower
the days ratios, the quicker the turnover of debtors and inventory. The
ratio of days in accounts payable is calculated in a similar way.

Operating cycle is the length of time it takes for an entity to acquire goods,
sale them to customers and collect the cash from the sale. Cash conversion
cycle (or cash cycle) is the time that elapses between paying for the
inventory, selling the inventory and receiving cash from customers. the
operating cycle = days in inventory + days in debtors .The cash conversion
cycle = days in inventory + days in debtors (accounts receivable)– days in
accounts payable. The operating cycle is always longer than the cash
conversion cycle. The shorter the operating cycle, the better the entity’s
efficiency and liquidity.

Liquidity analysis

Liquidity refers to the ability of an entity to meet its short-term

commitments. The two common liquidity ratios are current ratio and quick
ratio. Expressing current assets relative to current liabilities indicates
dollar value of current assets available per dollar of current liabilities.
Recognising the inventory is the least liquid current assets, the quick ratio
removes inventory from current assets when comparing current assets to
current liabilities.

Capital structure analysis

An entity’s capital structure refers to the entity’s relative use of debt and

Analysis of financial statements 3

 equity to fund assets. The level of debt a company has is known as
financial leverage. While it can be advantageous to a company, too much
debt can result in an organization suffering financial distress. An important
debt or leverage ratio is times-interest-earned (TIE). This ratio measures
the profit available to pay the interest on the debt. Other leverage ratios
are the debt ratio and the debt to equity ratio.

Market performance analysis

Market performance ratios are only relevant for entities listed on a stock
exchange. The common market performance ratios include net tangible
assets per share, earnings per share, dividend per share, dividend payout
ratio and price earnings ratio. It is common practice to compare these
ratios with those of the entity’s competitors, and to assess the trend in the
ratios.

Integrated financial ratio analysis

As noted in the previous unit, the ROE measures the return a business
generated on its equity capital. To understand a company’s ROE, a useful
technique is to decompose the ROE into its component parts. This is usually
referred to as DuPont analysis. There are several methods to decompose the
ROE. The most common method is illustrated here.

Net income
ROE = Average shareholdes′ equity
Net income Average total assets
= Average total assets x Average shareholders′ equity

which can be interpreted as

ROE = ROA x Leverage

In other words, ROE is a function of a company’s ROA and its use of financial
leverage. A company can improve its ROA by improving ROA or making more
effective use of leverage. If a company had no leverage (no liabilities), its
leverage ratio would equal 1.0 and ROE would equal ROA. As a company takes
on liabilities, its leverage increases. As long as a company is able to borrow at
a rate lower than the marginal rate it can earn investing the borrowed money
in its business, the company is making an effective use of leverage and ROE
would increase as leverage increases. If a company’s borrowing cost exceeds
the marginal rate it can earn on investing, ROE would decline as leverage
increased because the effect of borrowing would be to depress ROA.
The ROA can be further decomposed and ROE can be expressed as a product of
three component ratios:

Net income Revenue Average total assets

ROE = Revenue
x Average total assets x Average shareholders′ equity

4 Analysis of financial statements

Which can be interpreted as
ROE = Net profit margin x Asset turnover x Leverage

The first term on the right hand side of this equation is the net profit margin,
an indicator of profitability: how much money a company derives per one
money unit of sales. The second term on the right is the asset turnover ratio,
an indicator of efficiency: how much revenue a company generates per one
money unit of assets. The third term on the right-hand side of the Equation is
a measure of financial leverage, an indicator of solvency. This decomposition
illustrates that a company’s ROE is a function of its net profit margin, its
efficiency, and its leverage.

Segment analysis
Managers often need to evaluate the performance underlying business
segments to understand in detail the company as a whole. Public traded
companies are required to provide limited segment information under the
IFRS. Based on limited segment information that companies are required to
present, a variety of useful ratios can be computed, for instance, segment
profit margin, segment asset turnover, segment ROA, segment debt ratio. The
segment profit margin measures the operating profitability of the segment
relative to revenues, whereas the segment ROA measures the operating
profitability relative to assets. Segment turnover measures the overall
efficiency of the segment: how much revenue is generated per unit of assets.
The segment debt ratio examines the level of liabilities of the segment. When
a specific segment is underperforming, the managers may need strategies to
increase its performance or in the worst case, discontinue the division.

Limitations of financial ratios

Whilst ratio analysis provides valuable information it is important to keep in
mind some caveats. First of all, remember that, if you are assessing financial
statements, these statements refer to the company’s past performance.
Ratios do not predict the future! Another matter to keep in mind is that
accounting treatment of certain items such as inventory may have an impact
on the ratio figure obtained.
Be aware that different analysts may calculate financial ratios in different
ways. Whilst generally the trends will be the same no matter what the detail
of the calculation, it makes sense to be alert to this situation.

Required reading
Birt, J, Chalmers, K, Maloney, S, Brooks, A, Oliver, J & Bond, D 2020,
Accounting: Business Reporting for Decision Making, 7th edn. Milton,
QLD, John Wiley and Sons Australia
Chapter 8 (recommended text)
Analysis of financial statements 5
 Additional reading
Gibson, C 2013, Financial Reporting and Analysis, 13e, Cengage.

CFA Institute 2015, Financial Reporting and Analysis, Wiley.

Student activities

Activity
Work through exercises 8.16, 8.17, 8.27, 8.29, 8.31,8.46 and 8.50.

Summary
Financial ratio analysis provides a useful tool to understand the financial
performance and position of a company. The ratios are usually categorized
into five types: profitability, efficiency, liquidity, capital structure and
market performance. It is important to note that one financial ratio tells
little about a company. It is the trend or comparison with a benchmark that
sheds light on the situation. It is also important to note that financial ratio
analysis also has limitations.

References
Birt, J, Chalmers, K, Maloney, S, Brooks, A, Oliver, J & Bond, D 2020,
Accounting: Business Reporting for Decision Making, 7th ed. Milton, QLD,
John Wiley and Sons Australia
Gibson, C 2013, Financial Reporting and Analysis, 13e, Cengage.
CFA Institute 2015, Financial Reporting and Analysis, Wiley.

6 Analysis of financial statements