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FINM7409 Financial Management for
Decision Makers
Lecture 5: Financial Statement Analysis and Interpretation
CRICOS code 00025B
Roadmap for today
Lecture 5 2
FINM7409
1. Lecture
2. Key information about the Mid-semester
Exam next week (8:00AM, Wednesday,
August 30)
CRICOS code 00025B
1. Explain why different user groups require financial statements to be analysed and interpreted
2. Describe the nature and purpose of financial analysis
3. Apply the analytical methods of horizontal, trend, vertical, and ratio analyses
4. Define, calculate, and interpret the rations that measure profitability
5. Define, calculate, and interpret the rations that measure asset efficiency
6. Define, calculate, and interpret the rations that measure capital structure
7. Define, calculate, and interpret the rations that measure market performance
8. Explain the interrelationships between ratios and use ratio analysis to discuss the financial performance
and position of an entity
9. Discuss the limitations of ratio analysis
Learning outcomes
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CRICOS code 00025B
What is financial analysis?
Uses reported numbers from financial statements to form opinions about an entity’s financial
position and performance
Typically, about financial ratios and interpretation of such ratios
Why financial ratios?
1. A quick and simple way to examine the financial health of a business
2. Can be used to compare the risk and return relationships in firms of different sizes
Therefore, financial ratios can provide a profile of a business, its economic characteristics and
competitive strategies, as well as its unique operating, financial, and investment characteristics
Introduction
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CRICOS code 00025B
Caveat: This process of standardization may be deceptive because it ignores the following:
Differences among industries
Effect of varying capital structures
Differences in accounting and reporting methods, esp. when comparing firms from different
countries
Introduction
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CRICOS code 00025B
User groups are interested in different aspects of a business
Broad categories of users of financial statements:
1. Resource providers (e.g., creditors, lenders, shareholders and employees)
2. Recipients of goods and services (e.g., customers)
3. Parties performing an overview or regulatory function (e.g., the ATO, corporate regulators or a
statistical bureau)
4. Management: to assist in their decision-making
Different user groups have different needs for information
Users and decision making
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Credit analysts ⇒ credit status
Financial institutions ⇒ credit risk
Shareholders/investors ⇒ ability to make profits that can be
distributed or retained to reinvest
Equity analysts ⇒ market value of a listed entity to make
buy/sell recommendations
CRICOS code 00025B
Financial analysis involves expressing reported numbers from financial statements in relative terms
Why?
Absolute numbers are not meaningful for evaluating a company’s past decisions and predicting its
future rewards and risks
This applies to a comparison of different companies
⇒ Need to express a reported number in relation to other numbers
This process involves comparing numbers to:
1. Equivalent numbers from previous years
2. Other figures in the financial statements
4 methods:
Nature and purpose of financial analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
CRICOS code 00025B
This method compares reported numbers in the current period with equivalent numbers for a previous
period
E.g., numbers for 2023 compared with corresponding numbers for 2022
Usually presented in a 2-column format
One column for current period
One column for previous period
Purpose: To make it easier to calculate the absolute dollar change and the % change between the
two periods
Horizontal analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
CRICOS code 00025B
Calculate the absolute $dollar$ change as follows:
Calculate the % change as follows:
Be careful when the previous-period number is 0 or when interpreting the direction of change, e.g.,
positive (increase), negative (decrease), or zero (no change)
Horizontal analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
Absolute $dollar$ change = Current-period number – Previous-period number
% Change = Absolute $dollar$ changePrevious − period number × 100
See Figures 8.1 – 8.3 of the
textbook for an example
CRICOS code 00025B
This method predicts the future direction of various items based on the direction of the items in the past
Usually requires ≥ 3 years of data for it to be meaningful:
E.g., income statements for 3 consecutive (financial) years
Trend analysis is useful in identifying the significance of an item relative to a base amount, so it is useful
for formulating predictions about the future prospects of a business
To identify a trend in the data, convert the numbers into an index:
E.g., for an analysis of 3 years 2017 – 2019, use 2017 as the base year and set the base year at an
index of 100, and then express all subsequent numbers for 2018 and 2019 relative to the base year
2017
Trend analysis
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1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
CRICOS code 00025B
As an example, to identify the trend for sales revenue over 2017 – 2019, use the following steps:
Trend analysis – Example
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Step 1: Set 2017 as the base year, assigning it an index of 100
Step 2: Divide 2018 sales revenue by 2017 sales revenue and
express it as an index by multiplying the result by 100
$6,854.3$5,628.0 × 100 = 122
1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
CRICOS code 00025B
That calculate is for 1 year over 2017 – 2018
What about for 2 years from 2017 through 2019?
Trend analysis – Example
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$7,095.3$5,628.0 × 100 = 126
1. Horizontal analysis
2. Trend analysis
3. Vertical analysis
4. Ratio analysis
CRICOS code 00025B