330 Accounting: Business Reporting for Decision Making
VALUE TO BUSINESS• Vertical analysis compares items in a financial statement to an anchor item in the same statement.
The anchor item in the balance sheet is total assets; in the statement of profit or loss it is revenue.
All asset, liability and equity items are expressed as a percentage of total assets, and all income and
expense items are expressed as a percentage of revenue.
• A vertical analysis identifies the importance of an item relative to the anchor item.Ratio analysis
The financial analysis tool that we will concentrate on for the remainder of the chapter is ratio analysis.
A ratio is simply a comparison of one item in a financial statement relative to another item in a financial
statement — one item is divided by another to create the ratio. Ratio analysis examines the relation-
ship between two quantitative amounts with the aim of expressing the relationship in ratio or percentage
form. In chapter 7, you were introduced to some ratios calculated using information from the statement
of cash flows. The amounts compared do not necessarily have to be in the same statement, because it is
often meaningful to compare items in the statement of profit or loss or statement of cash flows to those
in the balance sheet. However, comparisons between these statements are not always straightforward,
because the statement of profit or loss and statement of cash flows involve flow items that are generated
over a period of time, whereas the balance sheet reports stock items at a point in time. For example,
consider an entity that generated a profit of $50 000. The entity’s investment in assets is $500 000 for
the majority of the reporting period, but rises to $1 000 000 following the purchase of an asset close to
reporting year-end. For the majority of the year, the entity had investments of $500 000 from which to
generate profit. If the $50 000 profit generated over the year is compared to the assets at the end of the
year (i.e. $1 000 000), the profit per dollar of investment will be understated and not reflect the fact that
the $1 000 000 investment existed for only a small portion of the year. As a result, when calculating
ratios involving a comparison of a ‘stock’ and a ‘flow’ item, the average of the ‘stock’ item during the
year is often used instead of the year-end figure. To calculate the average, the beginning year value and
ending year value are added, with the sum being divided by two. The ratio calculations in this chapter
use average balances when comparing stock and flow items. For simplicity, often the year-end balance of
stock items is used in ratio analysis.
Ratio analysis is a three-step process.
Step 1: Calculate a meaningful ratio by expressing the dollar amount of an item in a financial statement
by the dollar amount of another item in a financial statement.
Step 2: Compare the ratio with a benchmark.
Step 3: Interpret the ratio and seek to explain why it differs from previous years, from comparative
entities or from industry averages.
The purpose of ratio analysis is to express a relationship between two relevant items that is easy to
interpret and compare. In this chapter, we will categorise ratios into five groups:
- profitability ratios
- efficiency ratios
- liquidity ratios
- capital structure ratios
- market performance ratios (relevant to companies listed on an organised securities exchange).
The ratios in each of the categories help users in their decision making concerning the allocation of
scarce resources. The profitability ratios inform users as to the profit associated with their equity invest-
ment. The efficiency ratios shed light on management’s effectiveness in managing the assets entrusted
to it. An entity’s ability to meet its short-term commitments is indicated by liquidity ratios, while its
long-term stability and financing decisions are reflected in capital structure ratios. The market perfor-
mance ratios (or market test ratios) generally require share price data. For this reason, they are usually