354 Accounting: Business Reporting for Decision Making
Summary of learning objectives
8.1 Explain why different user groups require financial statements to be analysed and
interpreted.
The financial statements assist users in their decision making. The decisions being made by users
vary. For example, the decision may involve whether to advance credit to an entity, purchase
or sell an ownership stake in an entity, or lend money to an entity to acquire assets. Irrespec-
tive of the decision being made, an analysis of an entity’s financial statements can inform the
decision-making process. Analysing the past financial performance and position of an entity is
useful in predicting an entity’s future performance and profitability. Such analysis allows users
to detect changes in an entity’s performance, to gain an insight as to why the changes have
occurred, and to assess the entity’s performance and position relative to its peers, industry
averages or unrelated entities.
8.2 Describe the nature and purpose of financial analysis.
Financial analysis refers to the assessment of an entity’s financial position and profitability. Con-
ducting financial analysis gives the user an enhanced understanding and appreciation of an entity’s
financial health. The reported numbers are of limited usefulness, given that they are in absolute
dollar amounts. By expressing the numbers in relative terms, the financial statements become more
meaningful and useful in evaluating an entity’s past decisions and predicting future rewards and
risks.8.3 Apply the analytical methods of horizontal, trend, vertical and ratio analysis.
A reported number or ratio on its own is of limited usefulness. The analytical methods of hori-
zontal analysis, trend analysis, vertical analysis and ratio analysis are designed to add a comparative
dimension to the number or ratio. Using horizontal analysis, the current reporting period’s number
or ratio is compared with that in previous years, permitting the absolute dollar change and per-
centage change to be computed. If the comparative period extends further, trends can be depicted.
Such a comparison is referred to as trend analysis. Alternatively, the reported numbers in the state-
ment of profit or loss (or in the balance sheet) can be expressed as a percentage of a base number in
the statement of profit or loss (or in the balance sheet). Items in the balance sheet are expressed as a
percentage of total assets, and items in the statement of profit or loss are expressed as a percentage
of sales revenue. Ratio analysis involves expressing one item in the financial statements relative
to another item in the financial statements to add meaning to the reported numbers. Through ratio
analysis, users can explore relevant relationships between reported financial numbers and gain a
better understanding of an entity’s financial health.8.4 Define, calculate and interpret the ratios that measure profitability.
Profitability refers to an entity’s performance during the reporting period or over a number of
reporting periods. Profitability is not identical to profit. Profitability relates an entity’s profit to the
resources (assets or equity) available to generate profits, and to an entity’s effectiveness in converting
income to profits. In comparison, profit is an amount measured in absolute dollars. The distinction is
important because one entity can generate less profit than another entity but be more profitable than
that other entity. Assessing an entity’s historical profitability helps users to form an opinion about
its expected future profitability. The ratios that measure an entity’s profitability include the return on
equity, the return on assets, gross profit margin, profit margin and expense ratios.8.5 Define, calculate and interpret the ratios that measure asset efficiency.
Asset efficiency refers to the effectiveness of an entity’s investment in assets to generate income.
The ratios in this category typically relate a particular class of assets to income. The asset turnover
is calculated as income divided by total assets, and reveals the average sales dollars generated for
every dollar invested in assets. The asset efficiency ratios that are commonly referred to are the days