Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 331

confined to listed companies, relating the company’s financial numbers to its share price, and indicate

the market’s sentiment towards the company. It is important to recognise that there is not necessarily a

consensus regarding the ratios that should be calculated in each category, or the method of calculating a

particular ratio.

Benchmarks

Just as a financial number expressed as an absolute dollar amount is limited for decision-making

purposes, a ratio is of limited usefulness unless it is compared to a relevant benchmark. Ratios are

useful when the returns and risks for entities over time are compared with those of entities in different

industries or with those of entities in the same industry. Comparing the ratio with a benchmark enables

the favourableness or otherwise of the ratio to be assessed. The various comparisons that can be made

include the following.

• A comparison of the entity’s ratios over time to identify trends. This permits users to assess the sta-

bility and/or directional changes in the ratios over time. Unfavourable trends should be investigated by

financial statement users.

• A comparison of the entity’s ratios with those of other entities operating in the same industry, referred

to as intra-industry analysis. For example, a potential investor who wishes to invest in banking shares

has identified four entities operating in that economic industry sector. The investor can use ratios to

compare their respective returns and risks.

• A comparison of the entity’s ratios with the industry averages. An industry norm is a relevant bench-

mark that enables a user to assess a particular entity’s return and risk relative to its competitors, to

determine if it is outperforming or lagging behind its peers. Industry averages for various economic

industry sectors are available through commercial databases.

• A comparison of the entity’s ratios with those of entities operating in different industries or with the

norms of other industries, referred to as inter-industry analysis. Caution is needed when such an

analysis is being undertaken as differences in industry structures will affect the ratios.

• A comparison of the entity’s ratios with arbitrary standards. It is not possible to specify what a ratio

should be, but users operate on rules of thumb that serve as crude points of initial assessment. For

example, a rule of thumb may be that a debt to equity ratio should not exceed 100 per cent. However,

given that the 100 per cent is arbitrary, if an entity has a higher ratio than this, it cannot be concluded

that the ratio is unsatisfactory and the entity is in financial distress.

When comparing an entity’s ratios over time or across industries, it is assumed that industry and entity

risk remain constant. If risk changes, then returns should also change. Caution needs to be exercised

when comparing entities within the same industry, as no two entities have identical products and product

markets. Similarly, caution is needed when judging the favourableness of an entity’s ratio with that of

entities in other industries as industry characteristics affect ratios. For example, a supermarket’s gross

profit generated per dollar of sales revenue would be substantially lower than that of a car manufacturer.

Financial ratios are also affected by an entity’s accounting policy choices and assumptions. Before

comparing the ratios for different entities, the consistency in the accounting policies and assumptions of

the entities should be reviewed. Similarly, before comparing an entity’s ratios over time, the consistency

of that entity’s accounting policy choices and assumptions should be checked. For example, an entity

that revalues its property, plant and equipment (PPE) may generate lower returns from its assets relative

to an entity that measures its PPE at cost, presuming that the value of PPE assets is increasing.

In the remainder of this chapter, we will introduce ratios in each of these categories, calculate the

ratios, compare them with relevant benchmarks, and interpret the ratios. The 2015 JB Hi-Fi Ltd finan-

cial statements will be used for this purpose, and the comparative benchmark will be the ratio for the

previous year. Other comparisons could include competitors’ ratios such as those of other listed com-

panies operating in the consumer retail industry, or industry averages. When performing ratio analysis

for a company with subsidiaries, consolidated figures should always be used. Although the calculation