Week Seven Flashcards
Explain why different user groups require financial statements to be analysed and interpreted.
The financial statements assist users in their decision making. The decisions being made by users vary. For example, the decision may involve whether to advance credit to an entity, purchase or sell an ownership stake in an entity, or lend money to an entity to acquire assets.
Irrespective of the decision being made, an analysis of an entity’s financial statements can inform the decision-making process. Analysing the past financial performance and position of an entity is useful in predicting an entity’s future performance and profitability. Such analysis allows users to detect changes in an entity’s performance, to gain an insight as to why the changes have occurred, and to assess the entity’s performance and position relative to its peers, industry averages or unrelated entities.
Describe the nature and purpose of financial analysis.
Financial analysis refers to the assessment of an entity’s financial position and profitability. Conducting financial analysis gives the user an enhanced understanding and appreciation of an entity’s financial health. The reported numbers are of limited usefulness, given that they are in absolute dollar amounts. 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.
Apply the analytical methods of horizontal, trend, vertical and ratio analysis.
A reported number or ratio on its own is of limited usefulness. The analytical methods of horizontal analysis, trend analysis, vertical analysis and ratio analysis are designed to add 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, permitting the absolute dollar 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. Alternatively, the reported numbers in the income statement (or in the balance sheet) can be expressed as a percentage of a base number in the income statement (or in the balance sheet). Items in the balance sheet are expressed as a percentage of total assets, and items in the income statement are expressed as a percentage of sales revenue.
Ratio analysis involves expressing one item in the financial statements relative to another item in the financial statements to add meaning to the reported numbers. Through ratio analysis, users can explore relevant relationships between reported financial numbers and gain a better understanding of an entity’s financial health.
Define, calculate and interpret the ratios that measure profitability.
Profitability refers to an entity’s performance during the reporting period or over a number of reporting periods. Profitability is not identical to profit.
Profitability relates an entity’s profit to the resources (assets or equity) available to generate profits, and to an entity’s effectiveness in converting income to profits. In comparison, profit is an amount measured in absolute dollars. The distinction is important because one entity can generate less profit than another entity but be more profitable than that other entity.
Assessing an entity’s historical profitability helps users to form an opinion about its expected future profitability. The ratios that measure an entity’s profitability include the return on equity, the return on assets, gross profit margin, and profit margin and expense ratios.
Define, calculate and interpret the ratios that measure asset efficiency.
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.
The asset turnover is calculated as income divided by total assets, and reveals the average sales dollars generated for every dollar invested in assets.
The asset efficiency ratios that are commonly referred to are the days debtors and days inventory. The former measures the average period of time it takes to collect the cash from debtors, while the latter reflects the average length of time the inventory is in stock before it is sold. A lower days ratio is desirable, as it reflects a quicker turnover of debtors and inventory.
Define, calculate and interpret the ratios that measure liquidity.
Liquidity refers to the ability of an entity to meet its short-term commitments. Creditors and employees expect to be paid for services and goods provided, and liquidity ratios indicate the likelihood that an entity will be able to make such payments.
The two common liquidity measures are the current ratio and quick ratio. Expressing current assets relative to current liabilities indicates the dollar value of current assets available per dollar of current liabilities.
Recognising that inventory is the least liquid current asset, the quick ratio removes inventory from current assets when comparing current assets to current liabilities.
Define, calculate and interpret the ratios that measure capital structure.
To be viable in the long term an entity must be able to satisfy its long-term commitments. The ability to do so depends on an entity’s financial risk and profitability.
An entity must finance its investments in assets using new equity, retained earnings or debt. An entity’s capital structure refers to the entity’s relative use of debt and equity funding to finance assets. Capital structure ratios relate the proportion of debt funding relative to equity funding in financing an entity’s assets.
Financial risk increases as the proportion of debt funding relative to equity funding increases. The debt ratio expresses the total liability figure relative to total assets, thereby reflecting the entity’s reliance on debt to finance investments in assets. Variations of this ratio include expressing equity as a proportion of assets or debt as a proportion of equity.
The ability of an entity to absorb interest costs associated with borrowings is measured using the interest coverage ratio. This ratio indicates an entity’s ability to meet interest commitments from its current year’s profits.
Define, calculate and interpret the ratios that measure market performance.
Market performance ratios are relevant only for entities listed on organised securities exchanges, as they relate reported numbers to the number of shares on issue or the market price of the share.
The common market performance ratios that are introduced in this chapter include net tangible asset backing per share, earnings per share, dividend per share, the dividend payout ratio and the 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.
Explain the interrelationships between ratios and use ratio analysis to discuss the financial performance and position of an entity.
Calculating a ratio and ascertaining how it varies (compared with previous years or other entities) raises the question of why the variation occurs.
Recognising that various ratios are interrelated enables a user to explore why the variation occurs. For example, in explaining why the ROE has improved or declined, the user can see what has happened to the entity’s ROA and financial risk. Explanations as to why the ROA has changed can be explored by calculating the profit margin and asset efficiency ratios.
Appreciating the interrelationships enriches explanations and understanding of an entity’s financial circumstances. Rather than focusing solely on what the ratio is and how it has changed, analysing the interrelationships between ratios helps to better explain why the variations occurred.
Discuss the limitations of ratio analysis.
Ratio analysis provides valuable insights into the financial position and performance of an entity, but the process has its limitations. Due consideration must be given to such limitations when interpreting and relying on the ratios to form an opinion about an entity’s financial health, both past and present. The limitations can relate to the quality of the financial statements and the data disclosed (or not disclosed).
Comprehensive and effective fundamental analysis considers information beyond, and in addition to, reported financial numbers. In particular, social and environmental performance is becoming increasingly important.
Horizontal analysis
Compares the reported numbers in the current period with the equivalent numbers for a preceeding period. This permits the user to readily calculate the absolute dollar change and the percentage change in the reported numbers between periods. The dollar change is calculated as the dollar change in the reported number in the previous reporting period. The percentage change is calculated as the dollar change in the reported number between the current and previous reporting periods, divided by the value of the reported item in the previous year. Horizontal analysis highlights the magnitutde and significance of the dollar changes.
Trend analysis
Need the last three years of data. Trend analysis of a particular item involves expressing the item in subsequent years, relative to a selected base year. The base year is typically given a value of 100. Trend analysis is useful in identifying the significance of an item relative to a base amount. Identifying trends is useful in formulating predictions as to the future prospects of the entity.
Vertical analysis
Compares items in a financial statement to an anchor item in the same statement. The anchor item in the balance sheet is total assets; in the income statement it is revenue. All asset, liability and equity items are expressed as a percentage of total assets, and all income and expense items are expressed as a percentage of revenue. A vertical analysis identifies the importance of an item relative to the anchor item.
Ratio
compares one item in the financial statements with another item in the financial states, with the aim of expressing a relationship between two relevant items that is easy to interpret. to interpret the favourableness or otherwise of ratios, it is necessary to compare the ratios with relevant benchmarks
Ratio groups
- profitability ratios
- efficiency ratios
- liquidity ratios
- captical structure ratios
- market performance ratios ( relevant only to entities listed on an organisation securities exchange)
