Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 355

debtors and days inventory. The former measures the average period of time it takes to collect the

cash from debtors, while the latter reflects the average length of time the inventory is in stock before

it is sold. A lower days ratio is desirable, as it reflects a quicker turnover of debtors and inventory.

8.6 Define, calculate and interpret the ratios that measure liquidity.

Liquidity refers to the ability of an entity to meet its short-term commitments. Creditors and

employees expect to be paid for services and goods provided, and liquidity ratios indicate the like-

lihood that an entity will be able to make such payments. The two common liquidity measures are

the current ratio and quick ratio. Expressing current assets relative to current liabilities indicates

the dollar value of current assets available per dollar of current liabilities. Recognising that inven-

tory is the least liquid current asset, the quick ratio removes inventory from current assets when

comparing current assets to current liabilities.

8.7 Define, calculate and interpret the ratios that measure capital structure.

To be viable in the long term an entity must be able to satisfy its long-term commitments. The

ability to do so depends on an entity’s financial risk and profitability. An entity must finance its

investments in assets using new equity, retained earnings or debt. An entity’s capital structure

refers to the entity’s relative use of debt and equity funding to finance assets. Capital structure

ratios relate the proportion of debt funding relative to equity funding in financing an entity’s assets.

Financial risk increases as the proportion of debt funding relative to equity funding increases. The

debt ratio expresses the total liability figure relative to total assets, thereby reflecting the entity’s

reliance on debt to finance investments in assets. Variations of this ratio include expressing equity

as a proportion of assets or debt as a proportion of equity. The ability of an entity to absorb interest

costs associated with borrowings is measured using the interest coverage ratio. This ratio indicates

an entity’s ability to meet interest commitments from its current year’s profits.

8.8 Define, calculate and interpret the ratios that measure market performance.

Market performance ratios are relevant only for entities listed on organised securities exchanges,

as they relate reported numbers to the number of shares on issue or the market price of the share.

The common market performance ratios that were introduced in this chapter include net tangible

asset backing per share, earnings per share, dividend per share, the dividend payout ratio and the

price earnings ratio. It is common practice to compare these ratios with those of the entity’s com-

petitors, and to assess the trend in the ratios.

8.9 Explain the interrelationships between ratios and use ratio analysis to discuss the financial
performance and position of an entity.
Calculating a ratio and ascertaining how it varies (compared with previous years or other entities)
raises the question of why the variation occurs. Recognising that various ratios are interrelated
enables a user to explore why the variation occurs. For example, in explaining why the ROE has
improved or declined, the user can see what has happened to the entity’s ROA and financial risk.
Explanations as to why the ROA has changed can be explored by calculating the profit margin and
asset efficiency ratios. Appreciating the interrelationships enriches explanations and understanding
of an entity’s financial circumstances. Rather than focusing solely on what the ratio is and how it
has changed, analysing the interrelationships between ratios helps to better explain why the vari-
ations occurred.

8.10 Discuss the limitations of ratio analysis.

Ratio analysis provides valuable insights into the financial position and performance of an entity,

but the process has its limitations. Due consideration must be given to such limitations when inter-

preting and relying on the ratios to form an opinion about an entity’s financial health, both past

and present. The limitations can relate to the quality of the financial statements and the data dis-

closed (or not disclosed). Comprehensive and effective fundamental analysis considers information

beyond, and in addition to, reported financial numbers. In particular, social and environmental

performance is becoming increasingly important.