LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.
Ratio analysis measures the relative magnitude of two selected numerical values taken from a company’s financial statements and compares the result to prior years and other similar companies. Financial ratios are an effective tool for measuring: (a) liquidity (current ratio, acid-test ratio, accounts receivable collection period, and number of days of sales in inventory); (b) profitability (gross profit ratio, operating profit ratio, net profit ratio, sales to total assets ratio, return on total assets, and return on shareholders’ equity); (c) leverage (debt ratio, shareholders’ equity ratio, debt to shareholders’ equity ratio, and times interest earned ratio); and (d) market ratios (earnings per share, price-earnings ratio, and dividend yield ratio). Ratios help identify the areas that require further investigation.
LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.
Horizontal analysis involves the calculation of percentage changes from one or more years over the base year dollar amount. The base year is typically the oldest year and is always 100%. Vertical analysis requires that numbers in a financial statement be restated as percentages of a base dollar amount. For income statement analysis, the base amount used is sales. For balance sheet analysis, total assets, or total liabilities and shareholders’ equity, are used as the base amounts. When financial statements are converted to percentages, they are called common-size financial statements.
LO3 – (Appendix) Describe the Scott formula and explain how it is used to analyze financial statements.
The Scott formula separates return on shareholders’ equity into two components: return on operating capital (ROC) and return on leveraging (ROL). ROC can be further analysed as the product of the after-tax return on operating income x sales to operating capital ratio. ROL can be further analysed as (ROC – after-tax interest rate) x debt to shareholders’ equity ratio. The after-tax interest rate is calculated as [interest expense x (1- income tax rate)]/net financial debt.
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