Chapter 6 Analysis and Interpretation of financial statements of FRK122 and FRK121
The summary discusses Ratio Analysis, Liquidity ratios, Profitability, and activity ratios.
The formulas of gross profit percentage ratio, current ratio, acid-test ratio, inventory turnover rate, number of days i...
CHAPTER 6
ANALYSIS & INTERPRETATION
OF FINANCIAL STATEMENTS
, Purpose of analysis of financial statements
To determine if goals met
For financial planning & decision making about future
To compare results over time (to itself & similar entities)
To benchmark against industry norms
Investors interested in deciding which company to invest in & how much to invest - share price
& dividends per share are good indicators for this
Most investments are made in companies (by buying shares)
o Company is a legal entity in its own right - can enter into contracts, liable to pay taxes
and can be sued as an entity, separate from the owners of the entity.
o Can raise large sums of money through share capital
o Shareholders appoint a board of directors (BOD) that manage company
o BOD determine dividends to the shareholders
Advantages of ratio analysis
May signal future financial problems - can take corrective action timeously
Encourages/forces a thorough review of the financial position and performance
Provides additional information to financial statements
Helpful in financial planning, control and decision-making
Determines an entity’s relative performance in relation to its given industry and similar entities
Disadvantages of ratio analysis
A single ratio (viewed in isolation) does not provide sufficient information to judge the overall
financial performance. Need a holistic pic, thus use many ratios
A ratio requires special insight/skills to interpret it, and even then it’s difficult to determine
whether a given ratio is good or bad (even if it is compared to similar entities or industry)
Comparison of ratios between companies is restricted by different accounting policies.
Liquidity ratios
Liquidity is measured by an entity’s ability to pay its short-term (current) obligations as they fall due
1. Current ratio:
Also known as working capital ratio
not useful in comparing with other entities, but useful for internal management
Popular ratio - measures an entity’s ability to meet its current obligations
Current ratio = Current assets : Current liabilities
- A current ratio of 2:1 means that the current assets will cover the current
liabilities at least twice
- This is usually acceptable, but differs per industry
2. The acid-test ratio
Similar to current ratio, but current assets exclude inventory
- Why? least liquid current asset - cannot easily be converted into cash/sold
because partially completed or obsolete or special-purpose items or perishable,
etc.
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