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FINM7409 Financial Management for
Decision Makers
Lecture 5: Financial Statement Analysis and Interpretation
Ref.: Chapter 8, Birt et al., 8e
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Roadmap for today
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1. Lecture
2. Key information about the Mid-semester
Exam next week (8:00AM, Wednesday,
August 30)
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1. Explain why different user groups require financial statements to be analysed and interpreted
2. Describe the nature and purpose of financial analysis
3. Apply the analytical methods of horizontal, trend, vertical, and ratio analyses
4. Define, calculate, and interpret the rations that measure profitability
5. Define, calculate, and interpret the rations that measure asset efficiency
6. Define, calculate, and interpret the rations that measure capital structure
7. Define, calculate, and interpret the rations that measure market performance
8. Explain the interrelationships between ratios and use ratio analysis to discuss the financial performance
and position of an entity
9. Discuss the limitations of ratio analysis
Learning outcomes
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 What is financial analysis?
 Uses reported numbers from financial statements to form opinions about an entity’s financial
position and performance
 Typically, about financial ratios and interpretation of such ratios
 Why financial ratios?
1. A quick and simple way to examine the financial health of a business
2. Can be used to compare the risk and return relationships in firms of different sizes
 Therefore, financial ratios can provide a profile of a business, its economic characteristics and
competitive strategies, as well as its unique operating, financial, and investment characteristics
Introduction
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 Caveat: This process of standardization may be deceptive because it ignores the following:
 Differences among industries
 Effect of varying capital structures
 Differences in accounting and reporting methods, esp. when comparing firms from different
countries
Introduction
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 User groups are interested in different aspects of a business
 Broad categories of users of financial statements:
1. Resource providers (e.g., creditors, lenders, shareholders and employees)
2. Recipients of goods and services (e.g., customers)
3. Parties performing an overview or regulatory function (e.g., the ATO, corporate regulators or a
statistical bureau)
4. Management: to assist in their decision-making
 Different user groups have different needs for information
Users and decision making
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 Credit analysts ⇒ credit status
 Financial institutions ⇒ credit risk
 Shareholders/investors ⇒ ability to make profits that can be
distributed or retained to reinvest
 Equity analysts ⇒ market value of a listed entity to make
buy/sell recommendations
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 Financial analysis involves expressing reported numbers from financial statements in relative terms
Why?
 Absolute numbers are not meaningful for evaluating a company’s past decisions and predicting its
future rewards and risks
 This applies to a comparison of different companies
 ⇒ Need to express a reported number in relation to other numbers
 This process involves comparing numbers to:
1. Equivalent numbers from previous years
2. Other figures in the financial statements
 4 methods:
Nature and purpose of financial analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 This method compares reported numbers in the current period with equivalent numbers for a previous
period
 E.g., numbers for 2023 compared with corresponding numbers for 2022
 Usually presented in a 2-column format
 One column for current period
 One column for previous period
 Purpose: To make it easier to calculate the absolute dollar change and the % change between the
two periods
Horizontal analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 Calculate the absolute $dollar$ change as follows:
 Calculate the % change as follows:
 Be careful when the previous-period number is 0 or when interpreting the direction of change, e.g.,
positive (increase), negative (decrease), or zero (no change)
Horizontal analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
Absolute $dollar$ change = Current-period number – Previous-period number
% Change = Absolute $dollar$ changePrevious − period number × 100
See Figures 8.1 – 8.3 of the
textbook for an example
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 This method predicts the future direction of various items based on the direction of the items in the past
 Usually requires ≥ 3 years of data for it to be meaningful:
 E.g., income statements for 3 consecutive (financial) years
 Trend analysis is useful in identifying the significance of an item relative to a base amount, so it is useful
for formulating predictions about the future prospects of a business
 To identify a trend in the data, convert the numbers into an index:
 E.g., for an analysis of 3 years 2017 – 2019, use 2017 as the base year and set the base year at an
index of 100, and then express all subsequent numbers for 2018 and 2019 relative to the base year
2017
Trend analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 As an example, to identify the trend for sales revenue over 2017 – 2019, use the following steps:
Trend analysis – Example
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Step 1: Set 2017 as the base year, assigning it an index of 100
Step 2: Divide 2018 sales revenue by 2017 sales revenue and
express it as an index by multiplying the result by 100
$6,854.3$5,628.0 × 100 = 122
1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 That calculate is for 1 year over 2017 – 2018
 What about for 2 years from 2017 through 2019?
Trend analysis – Example
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$7,095.3$5,628.0 × 100 = 126
1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 We can graph trend figures to visually depict the direction and magnitude of a financial item, like so:
Trend analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 This method compares the items in a financial statement to other items in the same statement
 Presented this way, the financial statement is often called “common-size” statement
 It uses a reported item as an anchor point to which other items are compared
 E.g., in a balance sheet, the anchor point is usually total assets so that every other item on the
balance sheet is expressed as a percentage % of the total assets
 E.g., in an income statement, the anchor point is usually sales revenue
Vertical analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 Take PPE from a balance sheet as
an example
 To perform a vertical analysis for
this item, divide it by total assets
and then multiply by 100, like so
Vertical analysis – Example
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
$169.0$3,255.3 × 100 ≈ 5.0%
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 A ratio is simply a comparison of one item in a financial statement to another item in a financial
statement (not necessarily in the same statement)
 Ratio analysis examines the relationship between two quantities to express it as a ratio or a percentage
%
 Comparisons between items from different financial statements are not always straightforward.
Ratio analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
 Flow items – items that are generated over a period of time, e.g.,
items from an income statement
 Stock items – items that are reported at a particular point in time,
e.g., items from a balance sheet
Why?
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 Ratio analysis is conducted in 3 steps:
 Step 1: Calculate a meaningful ratio by expressing the dollar amount of an item in a financial
statement by the dollar amount of another item in a financial statement
 Step 2: Compare the ratio with a benchmark
 Step 3: Interpret the ratio and explain why it differs from previous years, from comparative entities,
or from industry averages
 The purpose of ratio analysis is to express a relationship between two relevant items so that it is easy to
interpret the relation
Ratio analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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 Ratio analysis focuses on 5 groups:
1. Profitability
2. Efficiency
3. Liquidity
4. Capital structure
5. Market performance
 To be useful, ratios need to be compared with those of entities in different industries or those in the
same industry – called a benchmark
 Comparison over time
 Comparison with those of other entities in the same industry (intra-industry analysis)
 Comparison with industry averages
 Comparison with those of entities in different industries or with the norms of other industries (inter-
industry analysis)
 Comparison with arbitrary standards
Ratio analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
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Profitability ratios:
1. ROE
2. ROA
3. Gross profit margin
4. Profit margin
5. Cash flows – to – sales
 Return on equity (ROE) reflects the annual return generated by an entity for its
owners for each dollar of the owners’ funds invested in the entity
 Return on assets (ROA) reflects the results of an entity’s ability to convert its
sales revenue into profit and to generate income from its asset investment
Profitability ratios
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ROE = Profit available to ownersAverage equity × 100 = ? %
ROA = Profit (Loss)Average total assets × 100 = ? %
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Cash flows − to − sales = Cash from operatingSales revenue × 100 =? %
 Gross profit margin compares an entity’s gross profit to its sales revenue,
thereby revealing what % of sales revenue results in profit (or loss)
 Profit margin:
 Cash flows-to-sales (from last week) measures the relative amount of cash flows
generated by each dollar of sales revenue
Profitability ratios
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Gross profit margin = Gross profitSales revenue × 100 = ? %
Profit margin = Profit (Loss)Sales revenue × 100 =? %
Profitability ratios:
1. ROE
2. ROA
3. Gross profit margin
4. Profit margin
5. Cash flows – to – sales
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Profitability ratios – JB Hi-Fi, 2020 – 2021
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See Page 304
for details
Profitability ratios:
1. ROE
2. ROA
3. Gross profit margin
4. Profit margin
5. Cash flows – to – sales
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 Asset turnover ratio reflects an entity’s overall efficiency in generating income
per $dollar$ of investment in assets
 Days inventory ratio reflects the average amount of times (measured in # days)
it takes an entity to sell its inventory
Asset efficiency ratios
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Asset efficiency ratios:
1. Asset turnover
2. Days inventory
3. Days debtors
4. Times inventory turnover
5. Times debtors turnover
Asset turnover = Sales revenueAverage total assets =? times
Days in inventory = Average inventoryCOGS × 365 =? days
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 Days debtors ratio reflects the average amount of times (measured in # days) it
takes an entity to collect the $money$ from its trade-related accounts receivable
 Times inventory turnover ratio reflects the number of times per year (instead of
the number of days per year) that the inventory is turned over
 Times debtors turnover ratio reflects the number of times per year that trade
debtors are turned over
Asset efficiency ratios
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Asset efficiency ratios:
1. Asset turnover
2. Days inventory
3. Days debtors
4. Times inventory turnover
5. Times debtors turnover
Days debtor = Average trade debtorsSales revenue × 365 =? days
Times inventory turnover = COGSAverage inventory =? times
Times debtors turnover = Sales revenueAverage trade debtors =? times
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See Page 307
for details
 An entity’s operating cycle (also known as activity cycle) considers the days inventory and days debtors
in conjunction
Operating cycle of a business
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Asset efficiency ratios – JB Hi-Fi Ltd., 2020
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See Page 307
for details
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 A creditor can take legal action against an entity for its inability to pay its debts
when they are due
 Liquidity ratios assess the ability of an entity to meet its short-term cash-flow
obligations
 ⇒ These ratios focus on current assets and current liabilities
 Recall:
 An entity must maintain enough working capital to satisfy its short-term
obligations and requirements
 However, excess working capital is also undesirable because the funds get tied
up instead of being invested elsewhere to earn higher returns
Liquidity ratios
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Working capital = Current assets – Current liabilities
Liquidity ratios:
1. Current ratio
2. Quick ratio
3. Cash flow ratio
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 Current ratio and quick ratio (also known as acid-test ratio) are often used to assess an entity’s liquidity
position
 Both ratios reflect the dollars of current assets (or current assets available) to service a dollar of current
liabilities
 Quick ratio is a more stringent test of liquidity because it looks at current assets that are available
(inventory takes time to convert into cash)
 These ratios can vary a lot among industries, e.g., high ratios for manufacturing or retail industries
because these firms have large inventories, but small ratios for service-related industries
Current ratio and quick ratio
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Current ratio = Current assets
Current liabilities =? times Quick ratio = Current assets−InventoryCurrent liabilities =? times
Liquidity ratios:
1. Current ratio
2. Quick ratio
3. Cash flow ratio
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 Cash flow ratio assess an entity’s ability to cover its current obligations using
cash flows from operating activities
 It may better reflect the entity’s liquidity position since it focuses on cash flows
generated over an entire reporting period instead of at a particular point in time
as with current and quick ratios
Cash flow ratio
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Cash flow ratio = Net cash flows from operations
Current liabilities =? times
Liquidity ratios:
1. Current ratio
2. Quick ratio
3. Cash flow ratio
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Liquidity ratios – JB Hi-Fi Ltd.
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See Page 310 for
details
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 An entity’s capital structure is the proportion of debt financing relative to equity financing
 It reflects the entity’s financing decisions – raising funds through debt and equity issuance
 Therefore, capital structure ratios (also called gearing ratios or solvency ratios) are useful for assessing
an entity’s long-term viability
 Pros and cons of using debt:
1. Pros:
 cheaper source of funds
 tax deductibility
2. Cons:
 burdensome if used excessively, e.g., cost of servicing the debt exceeds the return generated by
investments in assets, depressing ROE
Capital structure ratios
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 All these ratios reflect an entity’s use of debt relative to equity to finance its
investment in assets
Capital structure ratios
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Capital structure ratios:
1. Debt-to-equity ratio
2. Debt ratio
3. Equity ratio
Debt-to-equity ratio = Total liabilities
Total equity × 100 =? %
Debt ratio = Total liabilities
Total assets × 100 =? %
Equity ratio = Total equity
Total assets × 100 =? %
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Capital structure ratios
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Debt ratio = Total liabilities
Total assets × 100 =? %
Equity ratio = Total equity
Total assets × 100 =? %
Debt-to-equity ratio = Total liabilities
Total equity × 100 =? %
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• Interest coverage ratio (also called times interest earned) assesses the financial risk of an entity. It
measures the number of times an entity’s EBIT covers its net financing costs
• Debt coverage ratio assesses an entity’s ability to survive in the longer term and remain solvent. It
measures how long it takes to repay the existing long-term debt commitments at the current operating
level
Interest servicing ratios
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Interest coverage ratio = EBIT
Net finance costs =? times
Debt coverage ratio = Non−current liabilities
Net cash flows from operations =? times
Interest servicing ratios:
1. Interest coverage ratio
2. Debt coverage ratio
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Capital structure ratios – JB Hi-Fi Ltd
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Interest coverage ratio = EBIT
Net finance costs =? times
Debt coverage ratio = Non−current liabilities
Net cash flows from operations =? times
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NTAB = Ordinary shareholders′equity −Intangible assets# ordinary shares on issue at year end =? cents per share
EPS = Profit available to ordinary shareholders
Weighted # ordinary shares on issue =? cents per share
 Net tangible asset backing (NTAB) per share provides an indication of an entity’s
book value of tangible assets per ordinary share on issue
 Intangible assets are excluded from this ratio because they are hard to identify
and measure
 Earnings per share (EPS) reflects an entity’s ability to generate earnings for
each ordinary share on issue
Market performance analysis
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Market performance ratios:
1. NTAB
2. EPS
3. CFPS
4. DPS
5. P/E
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 Operating cash flows per share reflects the net cash flows from operating
activities that are available for distribution to shareholders as dividends and for
funding future investments
 Dividend per share (DPS) indicates the distribution of a company’s profits in the
form of dividends on a per-share basis
 Price-earnings ratio (P/E) reflects how much investors are willing to pay for each
dollar of earnings generated by the entity. This ratio varies much among
industries
Operating cash flow per share = Net cash flows from operating
Weighted # ordinary shares on issue =? cents per share
DPS = Dividends paid to ordinary shareholders−Preferred dividends
Weighted # ordinary shares on issue =? cents per share
P/E = Current share price
EPS
=? times
Market performance ratios
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Market performance ratios:
1. NTAB
2. EPS
3. CFPS
4. DPS
5. P/E
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Market performance ratios – JB Hi-Fi Ltd.
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See Page 315
for details
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 In presenting profitability, asset efficiency, liquidity, capital structure and market performance ratios, we
attempt to link ratios to describe the financial health of a firm
 Ratio analysis is valuable because it helps to interpret and explain why ratios may be different from
those of:
 previous years
 competitors
 industry averages
 entities in unrelated industries
Ratio interrelationships
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 When using financial ratios to assess an entity’s financial health, it is important to consider the following
issues
 The quality of a ratio depends on the quality of the entity’s financial information (i.e., financial
statements)
 Disclosure policy, details in the financial statements, accounting policy/choices, etc.
 “Earnings management”
 Sometimes the information needed to calculate a ratio is not available, so an alternative estimate must
be used
 Financial statements provide historical information only. The past may not represent the future
 Non-financial aspects of a company, e.g., ESG
Limitations of ratio analysis
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Thank you