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Financial Reporting

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Lecture Outline

 Financial Accounting  Interpreting Financial


 Defined Statements
 Characteristics

 Preparing Financial
Statements
 Income Statement
 Balance Sheet

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Financial Accounting

 Communication of financial information to external


users. Specifically;
 Financial Performance – Income Statement
 Is the business making a profit
 Financial Position – Balance Sheet
 What how strong is the business financially

 Without financial accounting, the economy could not


operate effectively.
 no-one would know whether it was safe to invest or lend
money to an entity.
 If no one invested or lent money, organisations could not
grow.

The annual report, and in particular the financial statements, are the primary
source of information for investors, lenders and suppliers. Investors and
lenders are afraid of losing their money so they look to the financial statements
to assess the financial strength and performance of a company before making
an investment decision. Financial statements are supposed to provide a true
and fair view of an organisations financial position and performance. If the
information within the financial statements is reliable then it enables
investors/lenders to make sound investment decisions and hence lowers the
risk associated with investment and lending.

However, if the information contained within the financial statements is


unreliable (false or misleading) it increases the risk to investors and lenders of
making poor decisions (i.e. investing in an organisation on the brink of
collapse). If investors and lenders lose faith in the reliability of financial
statements then they may withdraw from the market completely. If this occurs
it becomes very difficult, and expensive, for organisations to obtain finance to
support their growth.

As was seen in the US following events with Enron and Worldcom in the early
part of this decade, a loss of investor confidence in financial reporting can have
serious, adverse consequences for the economy, growth and the ability of
graduates to obtain jobs.
The Enron share price fell dramatically in a very short period of time. The
financial statements did not warn investors of the perilous position of the
company and consequently many investors lost a very significant amount of
money. This, and other similar scandals around the same time, caused
investors to lose confidence in financial statements and withdraw from the
market. The government responded with stringent regulations and tough
criminal penalties to minimise the risk of these scandals reoccurring and to
inturn increase investor confidence in financial reporting.
Financial Reporting

 Reporting entities must prepare financial


statements at the end of the financial year.
1. public companies,
2. large partnerships,
3. large private companies

 Non Reporting entities (sole traders, small


partnerships) may need to prepare financial
statements in order to:
 obtain loans
 attract investors (i.e. additional partners)
 sell the business

The reporting entity rule is a very logical one. If an organisation is likely to


have external users who are interested in the organisations performance then it
is considered to be a reporting entity and is required to prepare financial
statements. Examples of reporting entities are shown in this slide.

If there are unlikely to be external users then an organisation is not a reporting


entity and does not have to prepare financial statements (i.e. if it is unlikely
anyone will ever read the financial statements then why should a non reporting
entity be compelled to prepare them). Preparing financial statements requires a
significant amount of time and money so the advantage of being a non
reporting entity is the saving in time and cost.
Financial Reporting
Financial Year (Australia)
Financial Year Begins: 1 July

Financial Year Ends: 30 June

Current Financial Year


 1 July 2008 – 30 June 2009

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Financial Accounts

 All components of an organisations financial


activity is recorded within specific ‘accounts’.

 Each ‘account’ records just one thing.


 Cash: The amount of cash available to the business
 Accounts Receivable: Amount owed by customers
 Inventory: Value of inventory held by the business
 Accounts Payable: Amount owed to suppliers
 Loan Payable: Amount owed to lenders
 Capital: Value of assets contributed to the business by the owner
 Retained Profits: Owners share of profits

To be able to do any of the remaining topics you must know what each account
used in this unit records and how it is classified. Students experiencing
difficulties with later topics can generally trace their problems back to this
topic and a failure to be able to explain what each account records and how it
is classified.
Financial Accounting
Elements
 Each financial account can be classified into one of
five elements (A.L.O.R.E). The elements, and the
statement in which they appear, is shown below:

1. Assets Balance
2. Liabilities Sheet
3. Owners Equity

4. Revenues Income
5. Expenses Statement

One of the most common mistakes in the final exam is student’s placing
balance sheet items in the income statement and vice versa. If you can
understand that Assets, Liabilities and Equity items never appear in the income
statement and revenues and expenses never appear in the balance sheet then
you are well on the track to doing well.
Income Statement

 Statement showing the performance (profit)


of a business over a given period (i.e. 12
months, 6 months, 3 months, 1 month).

Profit = Revenue - Expenses

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Income Statement
Revenue
Revenue is the total income earned in a period.
 Recorded in the period EARNED even if payment
has not been received
 Can also include a saving in outflow (i.e. discount
received)

Under the accrual system, an organisation would recognise (record) income


only when the income has been earned (when the work has been done or the
service provided). If a service was provided in September but the customer did
not pay for this service until October then the business would recognise the
income in September (i.e. when the service is provided).

Expenses are recognised when incurred (used). If an employee works for a


business in September, but is not paid until December then the business would
recognise the expense in September (this is when the employee was used).

“Saving in outflow” refers to situations where you save money. If you owe
$1,000 and someone pays the debt for you then you have saved $1,000. This
saving is treated as revenue. The most common form of saving in outflow is
when you receive a discount. If you owe $1,000 but receive a 10% discount
then you only have to pay $900. The $100 saving is treated as revenue.
Income Statement
Revenue Accounts
1. Sales Revenue
 Income earned by selling goods to customers.
2. Fees Revenue
 Income earned by providing services to customers.
3. Interest Revenue
 Interest earned on investments
4. Discount Received
 Savings in outflow

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These are four accounts you must be aware of.

A retail entity (a business that sells goods to customers) records its revenue in
a ‘Sales Revenue’ account.

A service entity(a business that provides services to customers) records its


revenue in a ‘Service Revenue’ account.
Income Statement
Expenses
 ‘Loss or consumption of economic benefits’.
 Discount Allowed: Value of discount given to customers
 Wages Expense: Value of labour used in a period
 Electricity Expense: Value of electricity used in a period
 Rent Expense: Value of rental premises used in a period

 Expenses are recorded in the period INCURRED.


 When, for example, the electricity, water and telephone is
actually used, even if the expenses have not been paid.

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Accrual Accounting

 On the 28th of June you pay $1,000 rent for the


month of July.

30/6/08 Period A 30/6/09 Period B 30/6/10

Paid Incurred

 The Rent is an expense of period B


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Slides 12-15 are used to practice the recognition principals of accrual


accounting. Many students will understandably find it difficult to ignore cash
(i.e. the timing of payments and receipts) as our lives are based on ‘when do I
need to pay’ and ‘when do I get the money’.

In this example, even though the $1,000 is paid in Period A (financial year
ended 30/6/09) the rent is actually an expense of the next period, Period B
(financial year ended 30/6/10) as that is when the premises will actually be
used.
Accrual Accounting

 An employee worked for the business but at the


end of June has not received the $500 owed.

30/6/07 Period A 30/6/08 Period B 30/6/09


Incurred Paid

The wages is an expense of period A

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The employee was used (worked for the business) in Period A, but was not
paid until Period B. Under accrual accounting, cash is ignored and the only
thing that matters is when the employee was used, hence the wages expense is
recognised (recorded) in Period A.
Accrual Accounting

 On the 29th June a customer pays you $20 to


mow his lawn in July.

30/6/07 Period A 30/6/08 Period B 30/6/09

Received Earned

 The $20 is revenue for the period B.

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Under accrual accounting, the only thing that matters, in relation to recognition
of revenue, is when the work was done. In this example the cash was received
in Period A but the work was not done until Period B.

Regardless of the fact the business already has the cash, the revenue would not
be recognised until Period B.
Accrual Accounting

 You mow a customers lawn on 26th June for


$20, but do not receive payment until 2 July.

30/6/08 Period A 30/6/09 Period B 30/6/10

Earned Received

 The $20 is revenue in period A.


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This is the opposite of the previous example. In this case the work was
performed in Period A, but the money was not received until Period B. Even
though the customer has not yet paid the revenue would be recorded in Period
A because this is when the work was done.
Accrual Accounting
Edwards Painting Business
Month 1
 Edward completes $19,000 worth of work on credit
(customers have not yet paid). An employee
worked with Edward, but his wages for the month
have not been paid.

Month 2
 Didn’t Work. Received $19,000 from customers.

Month 3
 Didn’t work. Paid $4,000 wages to employee.

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Accrual Profit

1 2 3
Revenue 19,000 0 0

Expenses 4,000 0 0

Profit 15,000 0 0

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The accrual method provides an accurate indication of how the business has
performed over the three month period (i.e. all the work was done in Month 1,
no work done in months 2 and 3). It does so because the profit for a particular
month includes only the revenues earned and expenses incurred in that month.

In contrast, profit calculated using the cash method would have shown a profit
of zero in month 1, $19,000 in month 2 and a loss of $4,000 in month 3. The
cash method would therefore suggest month 2 was the most productive for the
business and yet no work was done in this month. The cash method would
also suggest nothing happened in month 1 and yet this is when all the work
was done.
Lecture Illustration I

 Refer to Lecture Illustration I

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Assets

First Test – Is an item an asset?


 Must possess future economic benefit
 Must help an organisation make money (private sector)
or provide a service (public sector).

 Control
 Organisation must have the ability to deny or regulate
access.

 Result of a past transaction or event

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An item has future economic benefit if it helps an organisation achieve its


objective. The objective of private sector businesses is to make money
therefore anything that helps to achieve this objective satisfies the first criteria
(i.e. machinery, buildings, computers, delivery vehicles). The objective of
public sector organisations is to provide a service so anything which helps the
public sector to do this therefore satisfies the criteria (i.e. libraries, hospitals,
street lights, footpaths, roads).

It is worthwhile noting that ‘ownership’ is not one of the essential criteria.


Without going into detail, as it is beyond the scope of this unit, in some
circumstances it is possible to control an item but not own it.
Assets

Second Test – Can the asset be ‘recognised’


 Can the assets value be reliably measured?
 Historical cost: Original price paid for the asset
 Fair Value: Market value of asset today.
 Present value: Present value of cash flows asset
will generate.

 Is it probable economic benefits will occur?

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It is possible that an asset may not be included on the balance sheet because it
fails the second test. An oil discovery for example, satisfies the first test
however if it is unclear how much oil has been discovered then it cannot be
measured reliably and hence fails the second text.

To improve the relevance of information to users of financial statements


(primarily investors), without compromising too greatly on reliability,
accounting standards require organisations to record asset values in different
ways. Where possible, assets are recorded at present value or fair value. If
this cannot be done reliably then historical cost is used.
Assets

Current Assets
 Assets the business estimates it will hold for less
than 12 months from the reporting date.
 Cash
 Accounts Receivable
 Inventory

Non Current Assets


 Assets the business estimates it will hold for more
than 12 months from the reporting date
 Motor Vehicles
 Machinery

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Liabilities

First Test – Does a liability exist?


 Present obligation to sacrifice economic benefit.
 Result of a past transaction or event

Second Test – Can we recognise the liability?


 Reliable Measurement
 It must be probable that sacrifice of economic benefits will
occur.

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Present obligation is the important phrase in this definition. If an organisation


was being sued for $1 million in damages it would not record this amount as a
liability because until the court’s decision is made there is no present
obligation on the business to pay $1 million.

Similarly, if a lawnmower man cuts the lawn of a business every month and
charges $50 each time the business would not record next months, or later
months, amounts as a liability because there is no present obligation to pay the
lawnmower man $50 (i.e. there is no obligation to pay until the lawnmower
man actually cuts the grass).
Liabilities

Current Liabilities
 Liabilities that are payable within 12 months of the
reporting date.
 Accounts payable
 Short term loan

Non Current Liabilities


 Liabilities which are not due within 12 months of the
reporting date.
 Long term loans

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There are many types of Non Current Liabilities but the only one dealt with in
Accounting 100 is long term loans.
Equity

 Residual interest in the assets after liabilities have


been deducted.

Capital A [Amount invested by Partner A]


Capital B [Amount invested by Partner B]

Retained Profits A [Partner A’s share of profit]


Retained Profits B [Partner B’s share of profit]

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Each partners share of profit is allocated to them via their Retained Profit
account.

In Lecture illustration 1 for example, the profit is $1,200 and the profit was
allocated as follows:

Belita 800
Tiana 400

Given the business had only been operating one month the retained profit
accounts for both partners was previously zero therefore the retained profit
accounts for both partners as at 30 June 2009 would appear in the balance
sheet as follows:

Retained Profit – Belita 800


Retained Profit – Tiana 400
Lecture Illustration II

 Refer to Lecture Illustration II

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Accounting Entity Principle

 The personal assets and liabilities of the


owner(s) must be kept separate from those of
the business.

Owner Business
Assets Liab. Assets Liab.

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The owner must not include, for example, his/her personal assets (home, car
etc) or liabilities (loans) on the balance sheet of their business.
Interpreting Financial Statements
Ratio Analysis
 Profitability Ratios
 Designed to help investors evaluate a firms ability to control

expenses and earn an adequate return.

 Liquidity Ratios
 Enables the user to evaluate the ability of an entity to repay

its short term liabilities as they fall due.

 Leverage Ratios
 Measures the extent to which an entity relies on debt

financing.

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The remainder of this topic will address the meaning of information contained
within the financial statements and how this information can be used for
decision making.

Reading pages and pages of financial statements can create information


overload and it can be very difficult to interpret how an organisation is
performing. One method of simplifying the interpretation of financial
statements is ratio analysis. Each ratio measures one aspect of an
organisation’s operations. Collectively, a series of ratios can summarise the
performance of an organisation as shown on slide 45.

Ratios measure different areas of an organisations operations. Rather than


examining pages and pages of financial statements users can therefore target
the areas that are of primary interest to them. The net profit margin measures
the profitability of an organisation which is important to investors. The current
ratio measures liquidity which is particularly important to suppliers. The debt
to equity and interest coverage ratios measure the level of financial risk an
organisation has which is of special interest to lenders.
Profitability Ratios

Profit Margin = O.P.A.T x 100


Net Sales

 O.P.A.T = Operating profit after tax

 Expressed as a percentage (i.e. 10%)

 Shows the amount of operating profit earned for every $1 of


sales.
 If profit margin is 10% then for every $100 of sales the
organisation makes an operating profit of $10.

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Net Sales = Sales less Sales Returns

The profit margin or net profit margin shows how much net profit an
organisation is making for each dollar of sales. Accounting 100 deals
primarily with partnerships and consequently the income statements in this unit
will not show the following:

Operating Profit before Tax 100,000


Income Tax Expense 30,000
Operating Profit after Tax 70,000

This is how the income statement for a company may look. As partnerships
are not separate legal entities they are not taxed and consequently the income
statement for a partnership does not include income tax expense. The profits
for the business are instead distributed to the partners and the partners are
taxed as individuals. In calculating the profit margin for a partnership, simply
use the operating profit figure.
Profit Margin
Industry Averages (Australia)
Industry (Aust.) Profit Margin

Food & Staples Retailing 3.4%


(Woolworths) (2007 = 3.0%)
Materials (BHP) 25.6%
(2007 = 34.2%)
Transportation (Qantas) 4.6%
(2007 = 5.2%)

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Industry information is not provided for this ratio therefore I have shown individual
company’s within each industry. BHP is one of the world’s largest mining companies,
Qantas is Australia’s only international airline and Woolworths is one of the largest
grocery stores in Australia.
Profit Margin: Increasing

 Greater control of costs (i.e. operating expenses


and/or cost of goods sold have declined relative to
selling price).

 Increase in selling price with a less than proportional


increase in cost of goods sold and operating costs.
 Selling price increases by 6% but costs increase by only
3%

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Profit Margin: Decreasing

 Operating costs or cost of goods sold in


increasing but selling price remains the
same.

 Operating costs and/or cost of goods sold are


increasing at a greater rate than selling price.

 Selling price is falling while operating costs


and cost of goods sold remain unchanged.

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Liquidity Ratio

Current Ratio = Current Assets


Current Liabilities

 Average on the ASX (2009): 1.64:1

 For every $1 in current liabilities, a business has


$1.56 in current assets.

 If ratio lower than 1, business can’t meet its


obligations to creditors.

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ASX = Australian Stock Exchange


Current Ratio
What does it measure?
 If the short term creditors (current liabilities)
of a business were to demand immediate
payment, can the business pay these debts
by:
 Using cash at bank
 Collecting money owed by customers
 Selling off all inventory
 Converting short term investments to cash
 Collecting prepayments

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Current Ratio
Should it be maximised?
 A high current ratio may indicate the business
has excessive:
Cash Earning very little interest in a bank
account.
Accounts Money that has not been collected.
Receivable
Inventory Excessive inventory earns no income
(increases costs of holding inventory).
Prepayments Money that has gone

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This slide demonstrates that the Current Assets section is not a productive area
and therefore a business would wish to minimise the resources held in this
area. Excessive cash earning little interest could be more productively
invested in long term investments which produce significantly higher returns.

A large accounts receivable balance is also not productive - it is generating no


return for the business. A business would want to collect the outstanding
amounts as soon as possible so the cash can be invested in longer term, high
return projects. A high accounts receivable figure could also indicate poor
credit collection procedures which may in turn suggest a higher rate of bad
debts (the longer people take to pay the more likely they will never pay).

Similarly, a high inventory balance is not efficient. A clothing store which


sells only $1,000 worth of inventory per week does not need to hold $50,000
worth of inventory. The business would be better to hold around $5,000 worth
of inventory and use the $45,000 to invest in projects earning a return rather
than buying a further $45,000 worth of inventory that will just sit in the store.
Aside from the opportunity cost, holding too much inventory can also create
additional costs such as higher rent (the more inventory held, the more space
required and hence the higher the rent) and higher insurance costs (the more
inventory held, the greater the insurance cost). There is a potential opportunity
cost in terms of lost sales but if managed effectively this cost is generally
outweighed by the additional costs of holding too much inventory.
Current Ratio
Industry Averages (Australia)

Industry Current Ratio

Food Retailing 1.27


(2007 = 1.24)
Materials (Mining) 7.67
(2007 = 7.29)
Transportation 1.25
(2007 = 1.23)

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Current Ratio
Trends
 If the current ratio is increasing:
 Stronger liquidity or inefficient use of assets?

 If the current ratio is decreasing:


 Decline in liquidity or more efficient use of assets?

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Organisations prefer to have most of their available resources in the non


current asset section. It is this section which generates the most returns for a
business.
Leverage Ratio

Debt to Equity Ratio = Total Liabilities


Total Equity

 Shows the financial structure of the firm.

 Average on ASX (2009): 36.9%

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The Debt to Equity ratio measures the financial risk associated with a business.
(i.e. the risk of defaulting on an interest payment). The higher the ratio, the
more debt the business has and therefore the more interest payments it has to
make and therefore the higher the risk of defaulting on one of these payments.
Debt To Equity Ratio
Industry Averages (Australia)
Industry Debt to Equity

Food & Staples Retailing 50.8%


(2007 = 61.4%)
Materials - BHP 41.8%
Rio Tinto 189%

Transportation 55%
(2007 = 54.2%)
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No information for Materials sector so individual companies given. Rio Tinto is


another major mining company. Rio Tinto, BHP and some Brazilian companies
supply China with a very high percentage of its Iron-Ore. The very high debt to equity
ratio for Rio Tinto is the result of investments in infrastructure projects to enable them
to ship more iron-ore to China and take advantage of the record prices for iron-ore
which existed less than 12 months ago. It should be compared to the Interest coverage
ratio for Rio Tinto which suggests it can easily manage this debt level.
Debt to Equity: Increasing

 Increased borrowing may fund expansion


leading to growth and higher profits.
or
 More of the firms operations are financed by
debt leading to:
 Increased interest payments
 Increased risk of failure

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Debt to Equity: Decreasing

 Less of the firms operations are financed by


debt leading to:
 Reduced interest payments
 Lower risk of failure

 Insufficient borrowing may impede growth.

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Interest Coverage Ratio
or Times Interest Earned
OPBT + Interest Expense
Interest Expense

 Measures the extent to which an organisation can


meet interest payments using current profits.

 A ratio of 4:1
 An organisation is making $4 in operating profit for every
$1 of interest expense (i.e. profit can cover interest
expense four times).

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OPBT = Operating Profit Before Tax

As discussed earlier, a partnership is not a separate legal entity and


consequently is not taxed. When calculating this ratio for a partnership simply
use the operating profit.

The rule of thumb for this ratio is that a ratio of at least 4:1 should be
maintained
Interest Coverage Ratio
Industry Averages (Australia)

Industry Interest Coverage

Food & Staples Retailing 1.97


(2007 = 4.68)
Materials (Mining)
(2007 = 20.00)
Transport 4.75
(2007 = 5.71)

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Again, the mining sector is an aberration in comparison to other sectors. The average
for the mining sector is still 20. For the ASX it is 5.38.
Interest Coverage Ratio
Trend
 Declining Ratio
 Capacity to meet interest payments has declined.
 Greater risk of defaulting on a payment.

 Increasing Ratio
 Capacity to meet interest payments has
increased.

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Interest Coverage Ratio
Trend
 High debt to equity ratio is ok if:
 interest coverage ratio is also high (i.e. the
business has the capacity to cover the higher
interest expenses).

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Ratio Analysis
Benefits

Ratio 2007 2008 2009


Profit Margin (%) 4.3 5.7 6.4
Current 1.6 1.75 1.82
Quick 1.1 1.15 1.19
Debt to Equity (%) 65 82 105
Interest Coverage 7.7 7.4 6.7

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Ratio analysis can summarise 3 years worth of financial statements down to half a
page. This allows trends and/or areas of concern to be quickly identified.

Ratios are also very useful for users who do not understand accrual accounting (i.e.
investors who have not studied an accounting degree can quickly learn the meaning of
ratios and how to interpret them).
Ratio Analysis
Limitations
1. Ratios mean nothing on their own. To be useful a
ratio must be compared with:
 Previous periods
 A competitor
 An industry average or benchmark.

2. Ratios highlight trends but do not identify the


problem itself.
3. Ratios can be manipulated.

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A profit margin of 10% on its own means nothing. However if it is known that
the margin last year was 8% and the year before that 5% then we can start to
draw some meaningful conclusions. Similarly, if we know the industry
average (the average profit margin for all competitors) is 16% then more
information can be drawn from the ratios.