320 Accounting: Business Reporting for Decision Making
Chapter 8 preview
In earlier chapters, the various financial statements were introduced: the balance sheet, the statement
of profit or loss, the statement of comprehensive income, the statement of changes in equity and the
statement of cash flows. A fundamental purpose of preparing these statements is to provide useful infor-
mation to assist users in their decision making. The financial data in these statements are expressed in
monetary terms, with corresponding figures for the comparative year provided. To better understand the
consequences of an entity’s operating, investing and financing decisions, it is necessary to analyse the
relationships between the numbers in the financial statements, rather than relying on the absolute values
in one particular period or a particular statement.
Fundamental analysis refers to analysing many aspects of an entity to assess the entity. Funda-
mental analysis involves reviewing the state of the industry in which the entity operates, as well as the
entity’s financial statements, its management and governance, and its competitive positioning. While
fundamental analysis is conducted on historical data and current information, the purpose of the analysis
is to make predictions about the entity’s future.
One aspect of fundamental analysis is financial analysis. Financial analysis uses the reported financial
numbers to form opinions about the entity’s financial performance and position. It is typically associated
with, but not restricted to, the calculation and interpretation of ratios. The calculation phase is a mechanical
process, with the real benefit of financial analysis being the interpretative stage. When interpreting a ratio,
it is important to understand what the ratio is measuring and to compare it to an appropriate benchmark. It
must be remembered that the inputs to financial analysis are the numbers reported in financial statements.
Given that an entity’s accounting policy choices and management estimations affect the reported numbers,
consideration must be given to this when comparing ratios over time or across entities.
This chapter describes the importance of financial analysis for financial statement users. Financial
analysis adds further meaning to the reported numbers, allowing users to make a better assessment of an
entity’s profitability, efficiency, liquidity, capital structure and market performance. Consider Advantage
Tennis Coaching (ATC), the tennis coaching business in the earlier chapters, and JB Hi-Fi Ltd. What are
you able to infer from knowing that ATC generated a $16 370 profit for a particular month and that JB
Hi-Fi Ltd generated a $136.5 million profit in 2015? Your assessments would be enhanced if you could
compare these profit figures with prior years, those of other similar entities, and the resources invested
to generate the profits. This chapter discusses how the reported numbers can be compared with other
reported numbers to assist users’ decision making. Just as an absolute dollar figure is limited in its use-
fulness, a ratio is also of limited use unless it can be benchmarked. We also discuss the benchmarks that
can be used, in addition to noting the limitations associated with financial analysis.
8.1 Users and decision making
LEARNING OBJECTIVE 8.1 Explain why different user groups require financial statements to be analysed
and interpreted.
As discussed in chapter 1, the users of financial statements can be categorised as resource providers (e.g. credi-
tors, lenders, shareholders and employees); recipients of goods and services (e.g. customers and debtors); and
parties performing an overview or regulatory function (e.g. the taxation office, corporate regulators, or a stat-
istical bureau). User groups are interested in different aspects of the entity, and various information sources are
available to interested parties to facilitate their decision making. Such information sources include the financial
press, trade-related magazines, research reports from broking houses, industry publications, online databases
(e.g. Dun & Bradstreet), and government statistics. Another important source of information is financial state-
ments. With a knowledge and understanding of information contained in financial statements, financial analysis
can provide information specific to the users’ needs. Financial analysis is an analytical method in which reported
financial numbers are used to form opinions as to the entity’s past and future performance and position.
The decisions that users make vary. For example, before deciding whether to supply goods and services on
credit to an entity, creditors would be interested in the entity’s ability to pay the debts within the credit period