1. ACCOUNTING Financial and Organisational Decision Making
Chapter 12
Financial statement analysis
Slides written and designed by
Tony Van Eekelen

2. Learning Objectives In this chapter you will be introduced to :
the users of financial statement analysis and how they use it
a plan for financial statement analysis
various techniques used for analysis
the limitations of analysis using financial ratios

3. Learning Objectives a range of financial ratios
ratios for public sector organisations
the uses of ratio analysis

4. Introduction
The financial statements of a firm are seen as a major source of information by many users for judging the risk and return elements of the entity.
By using ratio analysis one can make more in depth decision regarding these elements.

7. Users and uses of financial analysis
Internal users
management
for planning and control of the entity
monitoring performance, diagnosing problems and revising plans
External users
those making investment or lending decisions
those interest in the organisation’s performance

8. External users Two basic questions to be answered:
How well has the entity performed?
What is its present financial position?
Other questions need to be asked to answer above?
What is the rate of return of shareholders’ funds? Or on total assets?
What is the short and long term trend?
What can be done to improve it?
Different users will have different criteria for evaluation.

9. A planned approach to financial analysis
The following diagram (next slide) illustrates the process by which one should approach financial analysis.
Stage 3 relates to the questions to be answered; such as
How is the entity financed?
How profitable is the entity and how is the profit earned?
How efficient is the entity?
How solvent is the entity?
Is the performance satisfactory?
How does the financial markets rate the entity’s securities?
Are there any factors which may distort the interpretation?

10. A process for financial analysis
Identify the decision/s
to be made
Identify the user/s
of the information
Extract & supplement
financial statement
information as required
Identify questions that
need to be answered
to reach decisions
Interpret information
and significance compared with
a benchmark
Arrange information in a
form suitable for analysis
Prepare a report answering
questions posed
& making recommendations

11. Techniques used The most common is ratios.
Mainly to compare figures and to eliminate the size factor
The format can be expressed as
pure ratio
certain number of units
as a percentage - most common
as an index number

12. Techniques used
Cross sectional analysis is to compare one organisation with another or the industry average.
Common size financial statements are where the statement are converted to a % of one figure eg as a % of sales in the profit and loss
Time series analysis is to calculate the ratios over a period of time and analysis the trends.

13. Ratio analysis of financial statements
When conducting ratio analysis, ratios should be selected to answered the desired questions?
The range of ratios can be divided into 5 groups:
performance or profitability
operating efficiency
financial stability
cash flow ratios
per share ratios

14. Limitations of ratio analysis
Three main limitations exist with ratio analysis:
timing problems
reports are at a point in time.
Window dressing - ie by engaging in activities to effect reports at year end.
Time from end of period to publication of reports
timing of future inflows and outflows are not reported

15. Limitations of ratio analysis
The information base may cause problems such as:
lack of disclosure generally
minimum requires are set and lacks detail
variation valuation methods
revaluation of assets on ad hoc basis
variation in classification of information
using different accounting methods
use of historical cost accounting information

16. Limitations of ratio analysis
End use
Ratios are based upon the past and may not be a good indicator for the future.
No standard of evaluation exists; what is a “good ratio”?
Maybe receive conflicted results from ratios , thus making a overall conclusion difficult.

17. Performance ratios
These ratios need to assess the profitability of the entity.
Ratios included are:
gross profit margin – expenses ratio
net profit margin – asset turnover
quality of income ratio – return on assets
cash return on assets – return on equity
cash return to shareholders

18. Performance ratios Gross profit margin
Shows the relationship between mark up and sales; ie is the sales price high enough or is the cost price to high?

19. Performance ratios Expenses ratio Monitoring expenses
Net Profit Margin
reflects the return on sales ignoring gearing and taxation

20. Performance ratios Quality of income Asset Turnover
relationship between cash and profit
Asset Turnover
shows the sale generating ability of the assets

21. Performance ratios Cash return on assets
cash generating ability of assets to meet obligations
Return on assets
how profitable has the assets been?

22. Performance ratios Dupont formula
shows the break down of how the profit was made.
Was it that the assets did not generate sufficient sales or
Was it that sales were generated but cost control as profit eroding?

23. Performance ratios Return on equity Cash return to shareholders
shows the return to shareholders funds
Cash return to shareholders
may indicate the likelihood of dividends

24. Operating efficiency ratios
These ratios indicate how management are utilising the assets and maximising returns
Ratios included are:
inventory turnover
accounts receivable turnover
cash flows to sales
accounts payable turnover

25. Operating efficiency ratios
Inventory turnover
This ratio shows how quickly is the firm moving its inventory; ie converting to sales
Gives the number of times per year the inventory turns over.
Alternative measures is to convert into days; 365 divide by turnover.

26. Operating efficiency ratios
Accounts receivable turnover
how quickly the entity receives the cash from credit sales;
again can be expressed as times per year or number of days
if high, may result in bad debts and cash shortage

27. Operating efficiency ratios
Cash flow to sales
Accounts payable turnover
efficiency in paying creditors; discounts and poor ratings

28. Financial stability ratios
What is the financial risk of the entity and is it able to repay its debts?
Can be divided into short and long term ratios:
Short term
current ratio – quick asset ratio – cash flow ratio
Long term
debt to assets ratio
debt to equity ratio
times interest earned ratio
cash interest coverage
fixed charge coverage

29. Financial stability ratios
All the short term ratios are trying to analysis the liquidity of the entity. Will there be sufficient fund to repay debts in the short term?
Current ratio
Rule of thumb is 2:1 but if too high then not efficient use of assets

30. Financial stability ratios
Quick asset ratio
some assets maybe current but are not so liquid thus they are excluded from this ratio.
Cash flow ratio

31. Financial stability ratios
Debt to total assets
What is the financial risk of the entity?
Measures leverage and if to high may cause bankruptcy
Alternative measure:

32. Financial stability ratios
Times interest earned ratio
measures the safety margin of profit over interest payments
An alternative, as earnings is not all cash, then use Cash interest coverage

33. Per share ratios
There is a belief that the markets will price entities correctly, based upon available information. The following ratios show the markets evaluation of the entity.
Can be divided into two areas:
Earning
Dividend

34. Per share ratios Earnings ratios are as follows: Earnings per share
shows the return per share to shareholders.

35. Per share ratios Earnings Yield
is the rate of return based upon the current market price
can be effected by the market volatility
Price earnings ratio is an alternative to earning yield; and shows the number of years it will take for earnings to repay the market price.

36. Per share ratios Dividends per share Dividend Yield
refers to the amount of dividend received.
Dividend Yield
return based upon current market price

37. Per share ratios Dividend pay out ratio Net tangible asset backing
how much of the earnings is being retained or paid out?
Net tangible asset backing
price per share relating to tangible assets

38. Uses of ratios Other uses of financial ratios are:
as performance indicators
as predictors of financial distress
in making credit decisions
Other techniques are
discriminant analysis
modelling
simulation