Liquidity refers to the ability of an entity to convert its assets into cash. Relevant ratios
include:
o Current ratio
What current assets do you have in comparison to current liabilities
Do you have enough to pay off current liabilities
o Quick ratio
o Days debtor’s ratio
o Days inventory ratio
How long inventory sticks on the shelf
Provide useful information to assist users in making informed decisions relevant to their
circumstances
Information contained in reports are just numbers- difficult to compare in absolute terms
o Example: if you have 2 companies that are of different sizes- how do you know which
one is performing better than the other?
Just because company X has a larger profit than company Z.. does it mean
that it is more efficient?
o Difficult to answer by just looking at reports with numbers
o Price/Book Value
o Debt/Equity
o Return of Equity
o Current Ratio
o Net Profit Margin
Financial analysis involves expressing the reported numbers in relative terms rather than
relying on the absolute numbers
Highlight the strengths and weakness of entities
Important decision-making tool for evaluating the historical health of an entity and predicting
an entity’s future financial wellbeing
- Fundamental analysis refers to analysing many aspects of an entity to assess the entity,
including reviewing the state of the industry in which the entity operates, as well as the
entity’s financial statements, its management and governance, and its competitive
positioning.
- While fundamental analysis is conducted on historical data and current information
- Purpose of the analysis is to make predictions about the entity’s future
- One aspect of fundamental analysis is financial analysis
- When interpreting a ratio- it is important to understand what the ratio is measuring and to
compare it to an appropriate benchmark
- An entity’s accounting policy choices and management decisions affect the report numbers
and should be taken into consideration when comparing ratios
- Financial analysis adds further meaning to the report numbers- allowing users to make better
assessment of an entity’s profitability, efficiency, liquidity, capital structure and market
performance
o Compares the reported numbers in the current period with the equivalent numbers for
a previous period – usually the immediate preceding period
o Financial statements are usually presented in a two-column format containing the
figures for the current reporting period and the figures for the comparative reporting
period
o Permits the user to readily calculate the absolute dollar change and the percentage
change in the reported numbers between periods
o Dollar change= current period’s number – previous period’s number
Trend Analysis:
o Similar to horizontal
o Converts figures to an index measured against a base year
o Tries to predict the future direction of various items on the basis of the direction of
various items on the basis of the direction of the items in the past
o To calculate a trend- at least 3 years of data is required
o 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
o Useful in identifying the significance of an item relative to a base amount
o Identifying trends is useful in formulating predictions as to future prospects of the
entity
Vertical Analysis
o Recast each financial statement to express dollar amounts as a percentage of an
item or total in the financial statement
o Another method of converting the absolute dollar values in financial statements into
more meaningful figures
o Compares financial statement to an anchor item in the same statement
o The anchor item in the balance sheet is total assets, in the income statement it is
revenue
o All asset, liability and equity items are expressed as a percentage of total assets, and
all income and expense items are expressed as percentage of revenue
o A vertical analysis identifies the importance of an item relative to the anchor item
Ratio Analysis:
o Ratio= simply a comparison of one item in a financial statement relative to another
item in a financial statement- one item is divided by another to create the ratio
o Ration analysis= examines the relationship between two quantitative amounts with
the aim of expressing the relationship in ratio or percentage form
o Comparison between these statements Is not always straightforward, because the
income statement and statement of cash flows involve flow items that are generated
over a period of time
Flow items= item in the financial statements that generated over a period of
time
o The balance sheet reports stock items
Stock items= item in the financial statement as at a point of time
o 3 step processes
1. Calculate the meaningful ratio by expressing he dollar amount of an item in a
financial statement by the dollar amount of another item in a financial statement
2. Compare the ratio with a benchmark
3. Interpret the ratio and seek to explain why it differs from previous years, from
comparative entities or from industry averages
Benchmark:
Example (JB HiFi)
o Accepted arbitrary standards (rule of thumb) compare JB HiFi’s ratio to the
commonly accepted minimums
o Management budgets/targets JB HiFi’s actual ratio results compared to JB HiFi’s
forecasted results
o Comparison to previous years compare JB HiFi’s 2015 ratios to JB HiFi’s 2013
and 2014
o Comparison to competitors Compare JB HiFi’s ratio to electronic retailer The Good
Guys ratio
o Industry averages JB HiFi’s ratio compared to the industry as a whole
o Return on assets
How effective management has been in employing assets to generate a
return
If there was a return on assets of 15.2%- for every 1 dollar of asset used by
management they generated at return/profit of 15.2 cents
o Profit margin
Profitability of each dollar of sales
4.97%- business is generating profit of 497 cents for every 1 dollar of sales
per period
o Return on equity
Return on shareholders’ investment
Return on equity 23.7% = indicate that for every 1 dollar of investment the
company would generate a return/profit of 23.7 cents
Efficiency
o Days in inventory
How long on average it takes
to sell inventory?
This level of ratio which is
considered good or bad – can
dependent on the industry that
the business is operating in
Businesses with perishable
goods (example: florist) shorter
period of time in which they sell
they inventory than a business
selling luxury cars
o Days in debtors
How long on average it is taking for debtor to pay
Quicker is better
Can also be linked to the number of days credit a business has offered to its
customers
Liquidity:
o Current ratio
Indicates the ability of the business to pay of its current liabilities with its
current assets
Example: current ratio of 3.25:1 – indicates the business has $3.25 of current
asset to cover every $1 of current liabilities
Considered a good coverage
o Quick ratio
The ability of the business to cover its current liabilities with its most liquid
current assets ONLY
Inventory is taken out of the ratio- in order to convert inventory to cash you
need to sell it and that may take time
Capital Structure:
o Debt to equity
o Debt ratio
o Equity Ratio
- ^^^ All indicators of the amount of debt/equity finance the business has
Market Performance
o Net tangible asset backing per share
Indicates the book value of the company’s tangible assets per ordinary share
on issue
o Payout ratio
Indicates the percentage of profits paid out to ordinary shareholders as
dividends
Important to those investors to purchase shares to receive their return on
investment by way of dividends
Ratio interrelationships
Many of the ratios should be viewed together
Movement in one ratio can be explained by movement in another
Historical data