FRK 122
Chapter 6: Analysis & interpretation of
financial statements
INTRODUCTION:
Financial ratio analysis is done by calculating and interpreting financial ratios to
assess an entity’s performance over time in relation to:
- other entities, and
- itself
Four basic groups of ratios:
- liquidity ratios,
- activity ratios, Measurement risks
- debt ratios, and
- profitability ratios -> Measures return
PURPOSE OF ANALYSING 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
- To assist investors in decision making, e.g. which company to invest in
- Most investments are made in companies (by buying shares)
, ADVANTAGES of ratio analysis DISADVANTAGES of ratio analysis
- May signal future financial problems - - A single ratio viewed in isolation does
can take corrective action timeously. not provide sufficient information to
judge the overall financial
- Encourages a thorough review of the performance. Need a holistic picture,
financial position and performance. thus use many ratios.
- A ratio requires special insight to
- Provides additional information to
interpret, and even then, it’s difficult to
financial statements.
determine whether a given ratio is
- Helpful in financial planning, control good or bad (even if it is compared to
and decision-making similar entities or industry) .
- Determines an entity’s relative - Comparison of ratios between
performance in relation to its given companies is restricted by different
industry and similar entities. accounting policies.
1. LIQUIDITY RATIOS:
Liquidity is measured by the ability to pay short-term obligations as they fall
due.
Best to understand the “maths” of the ratio (in red) first, then the
understanding and interpretation becomes easier.
1.1 Current ratio:
Current ratio = Current assets: Current liabilities
Also known as working capital ratio
Not useful in comparing with other entities, but useful for internal
management.
Measures an entity’s ability to meet its current obligations.
- A current ratio of 2:1 implies that the current assets will cover the
current liabilities at least twice.
- This is usually acceptable (norm), but differs per industry.
Chapter 6: Analysis & interpretation of
financial statements
INTRODUCTION:
Financial ratio analysis is done by calculating and interpreting financial ratios to
assess an entity’s performance over time in relation to:
- other entities, and
- itself
Four basic groups of ratios:
- liquidity ratios,
- activity ratios, Measurement risks
- debt ratios, and
- profitability ratios -> Measures return
PURPOSE OF ANALYSING 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
- To assist investors in decision making, e.g. which company to invest in
- Most investments are made in companies (by buying shares)
, ADVANTAGES of ratio analysis DISADVANTAGES of ratio analysis
- May signal future financial problems - - A single ratio viewed in isolation does
can take corrective action timeously. not provide sufficient information to
judge the overall financial
- Encourages a thorough review of the performance. Need a holistic picture,
financial position and performance. thus use many ratios.
- A ratio requires special insight to
- Provides additional information to
interpret, and even then, it’s difficult to
financial statements.
determine whether a given ratio is
- Helpful in financial planning, control good or bad (even if it is compared to
and decision-making similar entities or industry) .
- Determines an entity’s relative - Comparison of ratios between
performance in relation to its given companies is restricted by different
industry and similar entities. accounting policies.
1. LIQUIDITY RATIOS:
Liquidity is measured by the ability to pay short-term obligations as they fall
due.
Best to understand the “maths” of the ratio (in red) first, then the
understanding and interpretation becomes easier.
1.1 Current ratio:
Current ratio = Current assets: Current liabilities
Also known as working capital ratio
Not useful in comparing with other entities, but useful for internal
management.
Measures an entity’s ability to meet its current obligations.
- A current ratio of 2:1 implies that the current assets will cover the
current liabilities at least twice.
- This is usually acceptable (norm), but differs per industry.
