Extract and adjust the information provided in accounting reports to facilitate their decision making.
- - How well has the entity performed?
- - What is its financial position?
Creditors are Interested in
The entity's ability to
- - discharge its debts
- - make payments to suppliers
- - pay interest
- - repay loans
Owners are Interested in
The financial solvency of the organisation and the extent of unpaid capital, which they could be liable to contribute in the event of liquidation.
The ability of an organisation to pay its debts into the future in a timely manner.
Planned Approach to Financial Analysis
- - Identify the user/s of the information
- - Identify the decision/s to be made
- - Identify questions that need to be answered to reach decisions
- - Extract and supplement financial statement information as required
- - Arrange information in a form suitable for analysis
- Interpret information and interpret significance compared with a 'benchmark'
- - Prepare a report answering questions posed and making recommendations
Show the relationship between one organisation and another at a particular point in time.
May also show the relationship with a benchmark at a single point in time.
Generally relate to the performance of one organisation over a period of time, often several years.
Relationship Between 2 Figures
- - Pure ratio, 3:1
- - Certain number of units, 6c per share or 30 days
- - Percentage, 200%
- - Index number
Benchmarks for Financial Analysis
- - National or world practice
- - Averages for the industry
- - Other organisations in the same industry
- - The one organisation over a number of years
- - Alternative forms of investment
- - Performance (or profitability)
- - Operating efficiency
- - Financial stability (or liquidity/solvency)
- - Cash flow ratios
- - Per-share ratios
Return on Equity
The profit or loss earned in utilising the investment of the owners.
Gross Profit Margin
Gross profit margin = gross profit / net sales
Expense Components Ratio
Represents the relative importance of various expenses in the earning of profit by comparing them to the sales for the period.
Return on Sales Ratio (Net Profit Ratio)
Shows the percentage of sales or service revenue that remains after taking account of all expenses.
Quality of Income Ratio (Operations Index)
Quality of income = cash flow from operations / earnings after interest and tax
Asset Turnover Ratio
Measures the relationship of sales to total assets.
Asset turnover = net sales / total assets
Cash Return on Assets
The cash-generating ability of the assets.
Cash return on assets = cash flow from operations (before interest and tax) / total assets
Return on Assets (ROA)
Results from the interaction of the profitability of sales with the rate at which sales occur.
<earnings before interest and tax / average (or year end) total assets> = <earnings before interest and tax / sales> x <sales / average (or year end) total assets>
Return on Equity Ratio
The relationship between net profit after interest and tax and the total investment the shareholders have in a firm.
Return on equity = earnings after interest and tax / ordinary shareholders' equity
Cash Return on Shareholders' Equity
Shows the return in cash available to the shareholders from their investment.
Cash return on equity = cash flow from operations / shareholders' equity
Measures the efficiency of inventory management.
Days inventory is on hand = 365 / inventory turnover
Inventory Turnover Ratio
A measure of efficiency with respect to the level of inventory in relation to sales and costs of goods sold.
Inventory turnover = cost of goods sold / average (or year end) inventory
Accounts Receivable Turnover
A measure of the efficiency of the management of 'credit' customers, usually expressed as the average number of days credit customers take to pay their debt to the firm.
Accounts receivable turnover = gross credit sales / average (or year end) gross accounts receivable
Average Collection Period
Average collection period = 365 / accounts receivable turnover
Cash Flow to Sales Ratio
The efficiency of management in generating a net positive cash inflow from its sales.
Cash flow to sales = cash flow from operations / sales
Current Ratio (Working Capital Ratio)
Represents the difference between current assets and current liabilities.
Current ratio = current assets / current liabilities
Quick Asset Ratio (Acid-Test Ratio)
A more immediate measure of liquidity is obtained by excluding the less liquid current assets and the less pressing current liabilities in a ratio of quick assets to quick liabilities.
Quick asset ratio = quick assets / quick liabilities
Debt to Assets Ratio
Measures the percentage of total funds provided by creditors.
Debt to assets ratio = total debts / total assets
Debt to Equity Ratio
An alternative way of measuring the extent of leverage.
Debt to equity ratio = total debt / owners' equity
Times Interest Earned Ratio
The amount of profits committed to interest payments.
Times interest earned ratio = earnings before interest and tax / interest charges
Dividend Per Share (DPS)
A measure of the cash flow they will receive from their investment.
DPS = ordinary dividends / number of ordinary shares
Measures the dividend component of shareholders' total returns.
Dividend yield = DPS / share price
Limitations of Ratio Analysis
- - Timing
- - The information base used
- - The end use to be made of the analysis
Temporarily changing the appearance of the financial statements by engaging in activities that have an effect for only a short period around the entity's balance date.
Information Base Problems
- - Lack of disclosure generally, and lack of specific detail in published financial statements
- - Variation in valuation methods
- - Deliberate manipulation of data
- - Variation in classification of information
- - Use of historical cost accounting information
End Use Problems
- - Ratios use information from the past and so they are not necessarily good indicators of the future.
- - No evaluation can take place until some standard for evaluation has been established.
- - Some ratios appear 'satisfactory' and some appear 'unsatisfactory', may be difficult to reach an overall conclusion about the entity's financial performance and financial position.