BSB110 Lecture Notes - Lecture 3: Financial Statement Analysis, Financial Statement, Financial Ratio
Week 3 Accounting Lecture Notes
Financial Statement Analysis and Decision Making
Purpose of Financial Statement Analysis
• Accounting has been defined as a means of communicating relevant and reliable
financial information about a reporting entity to its users
• Financial statements include a wealth of information which is designed to
communicate information about the entity to the users of financial reports
• Every item in financial reports represents something important or material
• Its significance can be determined only in relation to something else – single
numbers on their own do not provide useful information.
• Most of the information contained in financial statements is expressed in monetary
terms
• $ amounts are important BUT not particularly useful for comparative purposes
between entities
Limitations of Dollar Value Comparisons
• The current years profit needs to be compared with other information such as:
o Last years profit
o The current years sales
o The profits of other entities in the same industry
o The value of assets used to generate the profit
Financial Statement Analysis
• To overcome this, financial statement analysis is a technique used by analysts to
achieve information useful for decision making including:
o Assessing the financial health of a business
o To compare current performance with past performance
o To compare and benchmark against industry competitors and even across
other industries
Comparative Analysis
• Types of useful comparative information:
o Intra-entity basis:
▪ Comparisons within a single entity (detects changes in financial
relationships and trends)
o Industry averages:
▪ Between entities in same industry (determines position relative to
others)
o Inter-entity basis:
▪ Between other entities (indicates competitive position)
• Basic comparative analysis techniques:
o Horizontal analysis:
▪ Evaluates a series of financial data over time.
o Vertical analysis:
▪ Evaluates financial items in relation to a base amount.
o Ratio analysis:
▪ Evaluates a comprehensive range of financial relationships
representing different aspects of an entitys activities.
find more resources at oneclass.com
find more resources at oneclass.com
Horizontal Analysis
• Used to evaluate a series of financial statement data over a period of time
• Analyses increases or decreases that have occurred from a particular base year
• Figures are stated as both dollar amounts and as percentages
• Percentages removes the effect of size, so relative magnitude of change is revealed.
• One year is selected as the base year and then increases or decreases are based on
the formula:
Vertical Analysis
• Evaluates financial
statement data by
expressing each item as a
percentage of a base
amount to indicate
relative magnitude
• Useful for comparing
companies of different
sizes
• Calculated percentages
can also be tracked over
time to determine
patterns of change
find more resources at oneclass.com
find more resources at oneclass.com
Ratio Analysis
• Ratios are important tools that can be used to evaluate the financial performance
and health of a business
• Ratios are of more use when used with something we can compare to (i.e. industry
benchmarks and trends from prior years)
• Ratios must be interpreted in context (industry, size, economic conditions)
• Note that we will not cover all of the ratios in the text book in the lecture (we have
kept the numbering of the ratios consistent with the text book for easy reference
from the lecture to the text) but you are required to know them all
• Financial ratio analysis will provide warning signs that could allow a business to solve
problems before they become significant, such as:
o Inconsistent movement of sales, inventory and receivables;
o Earnings problems;
o Decreased cash flow;
o Too much debt;
o Inability to collect receivables;
o Build-up of inventories.
• Ratios are clues, not answers.
• Ratios can be calculated in different ways.
o Many analysts have their own formulae.
o Sometimes there are different industry practices.
o Can use end of year balance sheet data (highlights change across the year) or
average between start and finish (gives a smoothed long term trend).
• Ratio analysis can be used to make both:
o Intra-company comparisons.
o Inter-entity comparisons.
• Three types of ratios:
1. Liquidity
2. Solvency
3. Profitability
Liquidity Ratios
• Liquidity ratios measure the short-term ability of an entity to pay its debts and meet
unexpected needs for cash
o Important to bankers, suppliers and other short-term creditors
1. Current Ratio:
• Expresses the relationship of current assets to current liabilities.
• Widely used for evaluating an entitys short term debt paying ability.
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Comparative analysis: types of useful comparative information: Intra-entity basis: comparisons within a single entity (detects changes in financial relationships and trends) Industry averages: between entities in same industry (determines position relative to others) Inconsistent movement of sales, inventory and receivables: earnings problems, decreased cash flow, too much debt; Inter-entity comparisons: three types of ratios, liquidity, solvency, profitability. Liquidity ratios: liquidity ratios measure the short-term ability of an entity to pay its debts and meet unexpected needs for cash. Solvency ratios: solvency ratios measure the ability of an entity to survive over a long period of time. Indicates degree of leverage (percentage of total assets funded through debt): times interest earned ratio: Indicates entity(cid:1685)s ability to sustain debt by measuring its ability meet interest payments from operating profit. E. g. http://www. smh. com. au/business/markets: price-earnings ratio, measures ratio of market price of each ordinary share to earnings per share, reflects investors(cid:1685) assessments of an entity(cid:1685)s future earnings.
