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Accounting and Finance: An Introduction - McLaney and Atrill (2018) - Chapter 7 (Summary)
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Week 5 – Finance and AccountingChapter 7 – Analyzing and Interpreting Financial
Statements
Financial Ratios
- Quick and relatively simple means of assessing the financial health of a business
- Simply relates one figure to another figure on the financial statements
- Helpful for comparison as problem of scale is eliminated
- Not difficult to calculate, but can be difficult to interpret
- Highlight financial strengths and weaknesses of a business but cannot explain why
Financial ratio classifications
Ratios tend to be grouped into categories, with each category relating to a particular aspect
of financial performance or position.
- Profitability: ratios provide some indication of the degree of success in achieving
creation of wealth; relate the profit made in relation to other key figures/resources
- Efficiency: measure efficiency with which particular resources have been used within
the business; also referred to as activity ratios
- Liquidity: vital to the survival of the business; ratios examine relationship between
liquid resources/cash and amounts due for payment in near future
- Financial Gearing: relationship between the contributions of financing a business
made by the owners and contribution made by others; level of gearing has effect on
level of risk
- Investment: assessing returns and performance of shares from perspective of
shareholders
The analyst must be clear who the target users are and why they need the information
(differences in information needs).
The Need for Comparison
It is only when we compare ratios with some ‘benchmark’ that the information can be
interpreted and evaluated.
- Past periods: possibility to detect trends over time; but, possibility that trading
conditions were quite different, operating inefficiencies may not be clearly exposed,
inflation
- Similar businesses: trading conditions may not be identical, different accounting
policies, difficult to obtain the financial statements
- Planned performance
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