Accounting Business Reporting for Decision Making

332 Accounting: Business Reporting for Decision Making

process may appear to be fairly mechanical, the benefit of ratio analysis comes from interpreting and

interrelating the ratios to answer the ‘why’ questions — for example, why did profitability decline? Why

has liquidity improved? Why is the entity’s efficiency declining? A summary of the ratios presented in

this chapter is provided as appendix 8A.

VALUE TO BUSINESS

•   A ratio compares one item in the financial statements with another item in the financial statements,

with the aim of expressing a relationship between two relevant items that is easy to interpret.

•   Ratios can be grouped into the following categories:

• profitability ratios


• efficiency ratios


• liquidity ratios


• capital structure ratios


• market performance ratios (relevant only to entities listed on an organised securities exchange).
  • To interpret the favourableness or otherwise of ratios, it is necessary to compare the ratios with
  relevant benchmarks.

8.4 Profitability analysis

LEARNING OBJECTIVE 8.4 Define, calculate and interpret the ratios that measure profitability.

An entity’s ability to generate profits and return on investment is one of the prime indicators of its finan-

cial health. In this section, we introduce the ratios that are useful in assessing an entity’s profitability.

Return on equity

Owners are interested in the return that the entity is generating for them. This test of an entity’s

performance is the return on equity (ROE). The return on equity, expressed as a percentage,

is computed by relating the profit that the entity has generated for its owners during the period to

the owners’ investments in the entity. For a non-company entity, the ROE is the profit available to

the owners divided by the owners’ equity in the business. When calculating the ROE for a company,

we are interested in the profit available to the ordinary equity holders of the parent entity relative to

the ordinary shareholders’ equity in the company. The equity comprises any capital invested, retained

earnings and reserves.

Profit available to owners

×100 = x%

Average equity

Profit is the current year’s profit available for distribution to the owners. The numerator, profit, is

obtained from the statement of profit or loss. The denominator, equity, is obtained from the equity sec-

tion of the balance sheet. When analysing a company, some analysts exclude the impact of significant

items, which can distort the ratio by their size or nature and so distort the trends in the ratio over time.

It is also necessary to exclude any dividends due to preference shareholders (should they exist), as the

preference shareholders are entitled to receive their dividends before any distributions of profit can be

made to ordinary shareholders. The equity figure before minority interests and preference capital is

obtained from the balance sheet. As the numerator of this ratio is a flow item and the denominator is

a stock item, the stock item is averaged by summing the balance at the start and end of the reporting

period and dividing this by 2. This assumes that any change between opening and closing balances

occurred evenly throughout the reporting period.