INSTRUCTOR’S MANUAL

CHAPTER
Financial Statement
3 Analysis

Learning Objectives
• Explain the purpose and importance of financial analysis
• Calculate and use a comprehensive set of measurements to evaluate a fi rm’s performance
• Describe the limitations of financial ratio analysis

Key Teaching Points

FINANCIAL ANALYSIS AND FINANCIAL RATIOS
• Financial analysis is the use of financial statements to analyse a firm’s financial position and its
performance.
• To make financial information that is sourced from financial statements be more useful, financial
ratios that restate the financial figures in relative terms are used to identify the financial strengths
and weaknesses of a firm.
• Financial ratios may be used to answer the following questions:
(a) Does a firm have the resources to succeed and grow?
(b) Does it have adequate resources to invest in new projects?
(c) What are its sources of profitability?
(d) Did the earnings of the firm meet its forecast earnings?
(e) What are the sources of a firm’s future earnings power?
• The benefits of ratios include the following:
(a) Helpful in Decision Making
(b) Helpful in Financial Forecasting and Planning
(c) Helpful in Communication
(d) Helpful in Co-ordination
(e) Helps in Control
(f) Helpful for Shareholder’s decisions
(g) Helpful for Creditors’ decisions

PROFITABILITY RATIOS
• Financial analysis is the use of financial statements to analyse a firm’s financial position and its
performance.
• Profitability ratios analyses whether the management of a firm is generating adequate profits from
the use of the firm’s capital and assets.
• The ratios show a firm’s overall efficiency and performance. The ratios also represent the firm’s
ability to translate monetary sales into profits
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• Ratios used are:

(a) Gross profit margin
(b) Operating profit margin
(c) Net profit margin

LIQUIDITY RATIOS
• Liquidity ratios seeks to answer the question as to the extent to which the firm has adequate cash
flows or assets that are near to cash that would be sufficient to meet the short term liabilities of the
firm.
• Ratios used are:
(a) Current ratio (e) Debtors turnover ratio
(b) Acid test ratio (f) Debtors turnover days
(c) Stock turnover ratio (g) Creditors turnover ratio
(d) Stock turnover days (h) Credit turnover days

LEVERAGE RATIOS
• Leverage ratios seeks to investigate how a firm is being financed and provide indicators as to the
extent a firm is able to meet the interest payments. Relevant ratios include:
(a) Debt ratio
(b) Interest cover ratio

EFFICIENCY RATIOS
• Efficiency ratios provide investors with information as to the extent to which the management of
the firm has been efficient in ensuring that the business earns sufficient returns to its providers of
finance, debt and/or equity. Relevant ratios are:
(a) Earnings per share
(b) Return on capital employed
(c) Return on assets
(d) Return on equity
(e) Return on ordinary equity

MARKET RATIOS
• Market ratios are based on the market price of a firm’s share. Market ratios include: a) P/E ratio b)
Market-to-book ratio

DUPONT ANALYSIS
• DuPont technique integrates various elements and components of the balance sheet and income
statement to arrive at a comprehensive analysis of any firm. It decomposes the return on equity
formula into various components that allows for better analysis by various stakeholders in a firm
and allows for the better appreciation by the stakeholders as to how their areas of responsibilities
contribute to the improvement of the performance of the firm.

TIME SERIES AND CROSS-SECTIONAL ANALYSIS

• When performing ratio analysis, users should appreciate that ratios, when computed on their
own, can also be limited in their usefulness. To better analyse the performance of the firm and in
particular, the firm’s management, ratios computed should be analysed using the approaches of:
(a) Time series analysis
(b) Cross-sectional analysis
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LIMITATION OF RATIOS
• There exist limitations when using ratio analysis:
(a) Effects of inflation tend to be ignored.
(b) Accounting practices may differ between firms, complicating comparisons of results between
firms.
(c) Distortion can arise due to changes in accounting standards.
(d) Firms may experience seasonality in their performance that can complicate time series
analysis.
(e) Firms may have different accounting year ends.
(f) Industry averages may not also be the desired target or the norm.
(g) Progress of a firm should consider the context and influences on other firms that may not be
available to the firm in question.