Topic Six: Analysis & Interpretation of Financial Reports

Chapter Eight

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Identify why different user groups require financial reports to be analysed and interpreted Understand the nature and purpose of financial analysis

Appreciate the analytical methods of horizontal analysis, trend analysis, vertical analysis and ratio analysis

Define profitability and be able to describe and calculate the ratios that measure profitability Define asset efficiency and be able to describe and calculate the ratios that measure asset efficiency

Define liquidity and be able to describe and calculate the ratios that measure liquidity Define capital structure and be able to describe and calculate the ratios that measure capital structure

Define market performance and be able to describe and calculate the ratios that measure market performance

Understand the interrelationships between ratios

To appreciate the limitations of ratio analysis

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1. Users

The users of financial reports can broadly be categorised as:

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resource providers (e.g. creditors, lenders, shareholders, employees)

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recipients of goods and services (i.e. customers, debtors)

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parties performing an overview or regulatory function (e.g. tax office, corporate regulator, statistical bureau)

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internal management to assist in their decision-making capacity

Financial analysis involves expressing the reported numbers in relative terms rather than relying on the absolute numbers and it can highlight the strengths and weaknesses of firms

By evaluating an entity’s financial past (via financial analysis) users are in a better position to form an opinion as to the entity’s future financial health. 2

2. The nature and purpose of financial analysis

It is essential in financial analysis to compare figures with:

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the equivalent figures from previous years and with

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other figures in the financial statements

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3. Analytical methods

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Horizontal analysis

Trend analysis

Vertical analysis

Ratio analysis

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Horizontal analysis

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Compares the reported numbers in the current period with the equivalent numbers for a preceding period, usually the immediate preceding period

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Can be expressed as a number or as a percentage

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Reported number in reporting period (t) less reported number in reporting period (t-1)

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[Reported number in reporting period (t) less reported number in reporting period (t-1)] / reported number in reporting period (t-1)

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Trend analysis

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Is aimed at predicting the future direction of various items based on an analysis of the direction of the items in the past (over at least

3 years)

A base (anchor) year is used – with a given value of 100

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Vertical analysis

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Involves comparing the items in a financial statement to an anchor item in the same financial statement:

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Revenue and expense items are expressed as a percentage of sales or revenue A, L and Equity items are expressed as a percentage of total assets

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Example of vertical analysis

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Ratio analysis

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An expression of one item in the financial statements to another item in the financial statements

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The ratio comparison can be between two different statements

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Ratio categories

(1) profitability ratios

(2) efficiency ratios

(3) liquidity ratios

(4) capital structure ratios

(5) market performance ratios

Comparative Benchmarks are often used

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4. Profitability ratios

Informs users as to the returns and risks associated with the investment decision

Is one of the prime indicators of an entities financial health

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Return on Equity (ROE) ratio*

Net profit * 100

Average equity (excluding OEI)

(compares a firm’s profits to the equity invested and is a strong indicator of performance)

NB: OEI = Outside equity interests

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Return on Assets (ROA) ratio*

EBIT * 100

Average Total Assets

(compares a firm’s profits to the assets that are available to generate the profits) NB: EBIT = Earnings before interest and tax

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Net Profit