Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 349

VALUE TO BUSINESS

•   Market performance ratios are applicable to companies listed on organised securities exchanges as

the ratios relate reported financial numbers to the number of shares on issue or the market price of

the shares.

•   Some common market performance ratios are the net tangible asset backing per share, earnings per

share, dividends per share and the price earnings ratio.

8.9 Ratio interrelationships

LEARNING OBJECTIVE 8.9 Explain the interrelationships between ratios and use ratio analysis to
discuss the financial performance and position of an entity.

Financial analysis is used to assess an entity’s financial health, both past and future. The value of con-

ducting ratio analysis, a key tool of financial analysis, is in interpreting ratios and explaining why the

ratios may be different from those of:

• previous years


• competitors


• industry averages


• entities in unrelated industries.

Ratio analysis is a convenient starting point for isolating and explaining reasons for differences.

Understanding what each ratio is measuring, and how the ratios interrelate, helps users to answer the

‘why’ questions. For example, as demonstrated in the previous sections, any change in an entity’s ROE

will be attributable to changes in the entity’s ROA and its financial risk. To analyse the underlying

reason for the change in ROE, it is necessary to examine what has happened to an entity’s ROA and its

financial risk. Similarly, an entity’s ROA reflects its asset efficiency and profitability; explaining why the

ROA has changed therefore necessitates an examination of profitability ratios and asset efficiency ratios.

Figure 8.12 illustrates the disaggregation of the ROA. It can be seen that the ROA is the product of the

profit margin and the asset turnover ratio. An entity’s profit margin is affected by its gross profit margin

and expense ratios. An entity’s asset efficiency significantly depends on the efficient management of

inventory and debtors.

In presenting the 2015 and 2014 profitability, asset efficiency, liquidity, capital structure and

market performance ratios for JB Hi-Fi Ltd, an attempt has been made to link the ratios to describe

the financial health of the entity. For example, ratio analysis revealed that the decline in the ROE

was not due to a decline in the ROA as the latter increased. Instead, it reflected the entity’s lower use

of debt, given that the debt was being used effectively with the return on assets financed by the use

of debt exceeding the cost of the debt. The ROA increased between 2014 and 2015, reflecting both

a higher profit margin and higher asset efficiency. The profit margin improved from 3.69 per cent

in 2014 to 3.74 per cent in 2015. This improvement is attributable to a higher gross profit margin

(21.86 per cent in 2015 and 21.70 per cent in 2014) that was partly offset by a higher expense ratio.

The asset efficiency improved slightly, with the asset turnover at 4.16 times in 2015 compared to

4.09 times in 2014. The inventory and the days debtors remained consistent from 2014 to 2015, with

both higher by one day.

The interrelationships between ratios are depicted in figure 8.12. This provides a useful template to

use when conducting ratio analysis or structuring a report on an entity’s financial position and perfor-

mance. For the purpose of illustration, the ratios for JB Hi-Fi Ltd have been included in this diagram.

It is important to remember, however, that ratios can be affected by the individual accounting policies

applied to a company’s financial data, or by significant changes to accounting standards. For example,

the implementation of IFRS distorted PER ratios due to significant changes in rules for determining cer-

tain revenue and expense items.