Module 3 Financial Analysis

Module 3 Financial analysis 11/6/2023, 1:10 pm
Module 3 Financial analysis

Site: AIB Learning Hub Printed by: Ross Jorgensen
Course: 8006FMGT Financial Management 2023 Term 3 Date: Sunday, 11 June 2023, 12:40 PM
Book: Module 3 Financial analysis
https://learning.aib.edu.au/mod/book/tool/print/index.php?id=123944 Page 1 of 24
Description
 Audio version
Welcome to Week 3
This week we build on what we learned about financial statements in Module 2. Now, the focus is on learning how to interpret financial
statements. To make better decisions, it is important to interrelate the numbers in financial statements, rather than just looking at them in
absolute terms, and see what they tell you about the health of a business. The analysis and interpretation of financial figures is covered in
Module 3.
What you need to do this week:
1. Work through Module 3 Financial analysis. Take notes and list anything that you need further help with. You can ask questions on the
Class Forum and/or in the weekly webinar.
2. Complete the activities:
Activity 3.1 Financial ratios Part-1
Activity 3.4 Limitations of ratio analysis forum
3. Read more of the detailed information in Chapter 4 of the textbook, as signposted in the module.
4. Apply what you learn in this module to your First Assessment.
5. Attend the webinar and bring your questions about anything you did not understand.
This week, you will learn to:

identify different financial ratios and perform the basic calculations to produce the ratios
analyse and interpret financial ratios to establish the financial health of a business
apply the DuPont method and assess return on equity and performance
evaluate the limitations of financial ratios to establish the financial health of a business.
Table of contents
Introduction to financial analysis using ratios
Financial statements and ratios
Profitability ratios
Liquidity ratios
Activity 3.1 Financial ratios Part 1
Efficiency ratios
Leverage ratios
Market-value ratios
The DuPont method

Financial ratios for NFPs
Limitations of ratio analysis

Activity 3.4 Forum on the limitations of ratio analysis
Summary, resources and references
Introduction to financial analysis using ratios
Financial ratios provide a quick and relatively simple means of examining the financial health of a business. A ratio expresses the relationship
between one figure with another figure appearing in the financial statements and so offers a perspective in comparison. Depending on the
particular application context of the financial ratio analysis, the ratio of two items of financial data can be expressed as a dimensionless (no
units) number, a percentage or in units of time.
 Read
Section 4.2 on pages 88–90 of the textbook is an introduction to evaluating financial performance through ratio analysis. Note the
use of common-size balance sheets and income statements to control for size differences when comparing companies.
 Watch
The Linkedin Learning video Using financial statements (04:16 minutes) explains the benefits of using ratios to analyse financial
statements.
Stice, K & Stice, J 2019, Using financial statements, LinkedIn Learning video, viewed 15 May 2021,
https://www.linkedin.com/learning/financial-accounting-foundations/using-financial-statements?auth=true.
 Watch
David Zammit, the Head of Banking and Wealth Management Distribution at Citibank, discusses the use and importance of financial
analysis tools (AIB & Zammit 2021) (01:16 minutes).
01:18
Financial statements and ratios
Ratios can be broadly presented in 2 ways:
Trend or 'Horizontal' analysis. When undertaking a trend analysis, you are comparing the performance of a business over a time period.
Peer or 'Vertical' analysis. As the name suggests, peer analysis is about comparing your business with other similar businesses using a
common set of ratios.
Mini case study: Bia Ltd

Let's return to consider Bia, which we first encountered in Week 1. Bia is now a public company but not yet listed on the Australian Stock
Exchange. It operates in the same retail industry as Harzey Pty Ltd and would therefore be classed as its peer. The chart below represents a
peer analysis of the return on assets for both Bia and Harzey for the period 2016 to 2019. With this data, we are now able to complete a
peer analysis by comparing the performance trends for both companies over the same period.
Source: Developed by AIB 2021
Ratio categories
Financial ratios provide a means of measuring performance to assess the financial health of a business. The diagram below lists the
categories of financial ratios and what they measure.
Source: Developed by AIB 2021
Each of these will be explained in detail in the following sections of this module, and there will be a guided application of relevant concepts
for Assessment 1.
 Optional reading
If you are interested in learning more about the use of financial ratios, this article reports on the analysis the authors conducted on
the role and use of financial ratios in a number of Eastern European transition countries in predicting financial distress.
Kliestik, T, Valaskova, K, Lazaroiu, G, Kovacova, M, & Vrbka, J 2020, ‘Remaining financially healthy and competitive: the role of
financial predictors’, Journal of Competitiveness, vol. 12, no. 1, pp.74–92.
Profitability ratios
Profitability can be measured in many ways. For example, one company may use net profit as a measure of profit, while others may use net
income, net profit after tax (NPAT) or earnings before interest and tax (EBIT). Profitability analysis helps a company understand its
financial health and make decisions accordingly.
Several drivers impact a company's profitability ratio, including the revenue line (sales volume and price) and the cost line. Some of the
common profitability ratios are as follows:
Gross Profit
Gross Profit Margin =
Sales
Net Profit
Net Profit Margin =
Sales
Operating Profit or EBIT
Return on Assets (ROA) =
Total Assets
Net Profit
Return on Equity (ROE) =
Equity
 Watch
In this video (04:29 minutes), AIB Academic Dr Christiana Osei Bonsu provides an overview of profitability ratios (AIB & Osei Bonsu
2023).
04:29
 Read
Pages 102–109 of the textbook cover profitability ratios in more detail and with examples. Note Checkpoint 4.3 (p. 105), which
gives an example of evaluating ROA earned by two peer companies.
Liquidity ratios
Liquidity ratios provide the basis for answering two questions:
1. Does the business have sufficient cash and near-cash assets to pay its bills on time?
2. How quickly does the business convert its liquid assets (accounts receivable and inventory) into cash?
There are two approaches to measuring the liquidity of a business.
1. Analysing measures of overall liquidity

The first approach is to measure the overall liquidity of the business using the current ratio and the quick (acid-test) ratio:
The current ratio measures a business’s capacity to meet its short-term obligations.
Current assets
Current ratio =
Current liabilities
The quick (acid-test) ratio eliminates inventories from current assets and, thus, measures a business's ability to pay urgent liabilities,
making it a more stringent measure of the business’s ability to meet short-term obligations.
Current assets − Inventory

Quick ratio (or acid-test ratio) =
Current liabilities
 Watch
In the video below (05:34 minutes), AIB academic Dr Kavita Goel provides an overview of the two most important liquidity ratios –
the current and quick ratios (AIB & Goel 2023).
05:34
2. Measuring the liquidity of individual assets

The second approach is to measure the liquidity of individual assets, which includes the following ratios:
The average collection period measures how quickly the business’s credit accounts (receivables) are collected. It is measured in units of
time, usually days.
Accounts receivable
Average collection period =
Annual credit sales / 365 days
The accounts receivable turnover ratio uses the same information as the average collection period ratio but is measured as a multiple, i.e.
‘so many times’. Note that ‘debtor’ is another name for ‘accounts receivable’.
Annual credit sales

Accounts receivable turnover =
Accounts receivable
Inventory turnover measures the number of times a business turns over its inventory in a year.
Cost of goods sold

Inventory turnover =
Inventory
The three ratios above are also known as 'working capital management ratios’. These ratios can also be expressed in terms of a turnover
period (number of days). If you know the ‘turnover ratio’ figure, you can get the turnover period by dividing 365 by the turnover ratio. Working
capital is covered later in this module.
 Read
Pages 91–97 of the textbook further explain the five ratios outlined above that are used to measure different aspects of liquidity.
You should read this section to develop a working knowledge of these ratios.
What
Answer three questions about the profitability and liquidity ratios for the case study company, Bia Ltd. For Questions 1 and 2, check your
answers against the provided feedback. For Question 3, add your answer to a feedback database and compare your answer to those
submitted by other students. Prepare to discuss all questions further in the weekly webinar.
Why
This activity relates to this week's learning outcomes:
analyse and interpret financial ratios to establish the financial health of a business.
By analysing profitability ratios, you can determine if a business has earned adequate returns on its investment. By analysing liquidity ratios,
you can determine how able or efficient a business is in paying its bills on time. Therefore, this information will tell you a lot about the current
financial health of the business. You should apply what you learn from this activity to Assessment 1.
How
Here are the income statement and balance sheet of Bia Ltd for the period ending December 2020. Print version: Bia Ltd financial
statements.
Bia Ltd Bia Ltd
Income Statement for the Balance Sheet as at 31

Period Ending December 2020
December 2020
$M $M
Revenue 345 Assets
Less Cost of Sales 125 Current Assets
Gross Profit 220 Cash at Bank 40
Accounts Receivable 92
Less Expenses Inventory 150
Warehouse 25 Total Current Assets 282
Distribution 15
Selling and Marketing 35 Non-Current Assets 575
Depreciation 7
Administration 42 Total Assets 857
Interest Expense 15
Total Expenses 139 Liabilities
Current Liabilities
Net Profit Before Tax 81 Accounts Payable 134
Tax Expenses 24 Employee Entitlements 30
Net Profit After Tax 57 Total Current Liabilities 164
Non-Current Liabilities 250
Total Liabilities 414
Total Equity 443
Question 1
We see the Net Profit Margin will be
57
= 0.165 or 16.5%
345
So, what does this number tell us about Bia’s profitability at the end of December 2020? Can we interpret 16.5% as meaning this is a healthy
margin? We are not able to answer these key questions by this number alone. The answers are obtained by completing further analysis.
What other types of analysis are needed to help us interpret the 16.5% Net Profit Margin?
Question 2
What might happen to Bia’s Net Profit Margin in the next financial reporting period if their next marketing campaign does not result in
boosted sales?
Write your answers to questions 1 and 2 in the space provided. Select Check and then Show solution for feedback.
Question 1:
Trend analysis will help us see how the 16.5% December 2020 NPM compares with the trend for the last few years. Peer analysis can
further explain how this 16.5% compares to Bia’s competitor/s for the same period.
Question 2:
Revenue grows less proportionately than the additional marketing cost, so the Net Profit ratio will drop from 16.5%.
 Check
Question 3
Given Bia’s current assets are $282 million and current liabilities are $164 million, this indicates a current ratio of 1.71. How would you
interpret this in terms of Bia’s liquidity?
a. Is a current ratio of 1.71 a healthy level of liquidity?

b. Would a current ratio of 3.5 or 4.0 be a healthier level of liquidity?
Add your answers to 3a and 3b, with a brief explanation, to the Activity 3.1 feedback database on interpreting liquidity ratios.
Bring any follow-up questions to the weekly webinar and/or post them on the Class Forum.
E!ciency ratios
Asset management efficiency ratios are used to measure efficiency in the utilisation of assets to generate sales. Such ratios include:
Sales
Asset turnover ratio =
Total Assets
Sales
Fixed asset turnover ratio =
Fixed Assets
Each business may have its own measures of efficiency. For example, a trucking company may want to know how many kilometres per day
its fleet of trucks is doing. A mining company may want to measure how much material is uncovered by its excavators daily. A call centre
may want to know how many minutes, on average, it takes to resolve a phone query.
Measuring efficiency is common in businesses because lots of money is tied up with the assets. Measuring the income generated per dollar
of assets gives insights into how organisations can become more efficient and ultimately more profitable.
 Read
Pages 98–101 of the textbook give further information and examples of asset management efficiency ratios.
 Watch
The LinkedIn Learning video Fixed asset turnover and other utilisation of ratios (04:43 minutes) provides a more in-depth
explanation on using these efficiency ratios in managing a profitable business.
Stice, K & Stice, J 2020, Fixed asset turnover and other utilization ratios, LinkedIn Learning video, viewed 10 May 2021,
https://www.linkedin.com/learning/running-a-profitable-business-understanding-financial-ratios/fixed-asset-turnover-and-
other-utilization-ratios?auth=true.
Leverage ratios
Capital structure (leverage) ratios are used to provide the basis for answering questions about financial leverage, that is, how a business
finances its investments.
These questions are answered via the balance sheet through leverage ratios. Such ratios include the debt ratio (the proportion of the
business’s assets financed by borrowing or debt finance), the interest coverage ratio (the business’s ability to pay the interest expense on
its debt) and the equity multiplier (the ratio of total assets to total equity).
Total liabilities
Debt ratio =
Total assets
Operating profit or EBIT

Interest coverage ratio =
Interest expense
Total assets
Equity multiplier =
Total equity
 Read
Pages 97–98 of the textbook give you a working knowledge of capital structure (leverage) ratios.
 Watch
The LinkedIn Learning video on Leverage ratios (06:33 minutes) further breaks down how to read and interpret measures of
leverage and how to use this information to determine the financial health of a business.
Stice, K & Stice, J 2020, Leverage ratios, LinkedIn Learning video, viewed 10 May 2021,
https://www.linkedin.com/learning/running-a-profitable-business-understanding-financial-ratios/leverage-ratios-2?auth=true.
What
Answer some questions about the efficiency and leverage ratios for the case study company, Bia Ltd. Check your answers against the
feedback provided.
Why
By looking at efficiency ratios, you can assess how well a business utilises its assets to generate sales. By calculating debt and interest
coverage ratios, you can assess how well a business balances debt and equity to finance its assets. You should apply what you learn from
this activity to Assessment 1.
How
Here are the income statement and balance sheet of Bia Ltd for the period ending December 2020. Print version: Bia Ltd financial
statements.
Bia Ltd Bia Ltd
Income Statement for the Period Ending Balance Sheet as at 31 December 2020
December 2020
$M $M
Revenue 345 Assets
Less Cost of Sales 125 Current Assets
Gross Profit 220 Cash at Bank 40
Accounts Receivable 92
Less Expenses Inventory 150
Warehouse 25 Total Current Assets 282
Distribution 15
Selling and Marketing 35 Non-Current Assets 575
Depreciation 7
Administration 42 Total Assets 857
Interest Expense 15
Total Expenses 139 Liabilities
Current Liabilities
Net Profit Before Tax 81 Accounts Payable 134
Tax Expenses 24 Employee Entitlements 30
Net Profit After Tax 57 Total Current Liabilities 164
Non-Current Liabilities 250
Total Liabilities 414
Total Equity 443
Questions
Choose the best answer to questions 1 to 3.
Market-value ratios
The basic question that market-value ratios allow us to address is 'How are the company’s shares valued in the stock market?' Up to this
point, the financial ratios you have studied in this module have involved only accounting data, but the ratios that use information from stock
markets also reveal important insights.
Price-earnings (P/E) ratio

This shows the price investors pay per dollar of earnings and indicates how much investors are prepared to pay for the company’s shares.
$$ \text{Price–earnings ratio} = { \text{Market price per share} \over \text{Earnings per share} } $$
Market-to-book ratio
This measures the value of the company’s shares relative to the investment made by the shareholder.
$$ \text{Market-to-book ratio} = { \text{Market price per share} \over \text{Book value per share} } $$
Note: $$\text{Book value per share} = {\text{Total book value equity} \over \text{Number of ordinary shares}}$$
 Read
Pages 109–112 of the textbook discuss market-value ratios and address the question, ‘Are the ordinary shareholders receiving
sufficient returns on their investment?’ Pages 113-114 also sum up the various ratios introduced in this module.
 Watch
The LinkedIn Learning video Price-earnings (P/E ratios) (04:34 minutes) illustrates how this ratio is used to estimate a company’s
market value.
Stice, K & Stice, J 2019, Price-earnings (P/E ratios), LinkedIn Learning video, viewed 15 May 2021,
https://www.linkedin.com/learning/financial-accounting-foundations/price-earnings-p-e-ratio?auth=true.
The DuPont method
When Net Profit is divided by Equity, we get the Return on Equity (ROE), one of the many profitability ratios. A way of getting a better
understanding of what is driving the business’s ROE is by using the DuPont method.
$$ \text{ROE (DuPont Method)} = \text{Net profit margin} \times \text{Asset turnover} \times \text{Equity multiplier} $$
The DuPont method decomposes the ROE into three factors, namely
net profit margin

asset turnover ratio
equity multiplier (ratio of total assets to total equity).
Examining each of these components might provide the answer to the questions of what the major influence in the business’s ROE is, and
what is causing the business’s ROE to diverge from that of its competitors or industry average.
 Watch
Watch the following video in which Dr Kavita Goel explains the importance of the DuPont method in understanding the Return on
Equity (ROE) ratio, a measure of the profitability of the business, using an example (AIB & Goel 2022) (05:41 minutes).
05:41
 Read
Pages 107–109 of the textbook provide a working knowledge of the DuPont method. You should have already read these pages
when considering profitability ratios, but complete a quick review of the equations for decomposing the return on equity ratio at this
point, if necessary.
What
Perform simple calculations to find financial ratios for Bia Ltd's competitors.
Why
apply the DuPont method and assess return on equity (ROE) and performance
By finding market-value ratios, you will get an idea of how the stock market values a company’s shares, and thus you will be able to assess
its performance through trend and peer analysis. Applying the DuPont method allows you to get the Return on Equity (ROE), which shows
you what drives profitability. You should apply what you learn from this activity to Assessment 1.
How
Question 1
Harzey Pty Ltd, one of Bia’s competitors. Harzey’s balance sheet, as per its annual report to shareholders, lists total assets of $1 billion, $100
million in current liabilities, $400 million in long-term debt, $500 million in ordinary equity and 50 million ordinary shares.
Based on the above, if Harzey’s current share price is $50, then its market-to-book ratio is 5.
True False
 Check
Question 2
Bryley Ltd is a key competitor of both Bia Ltd and Harzey Pty Ltd in the same retail sector. As part of my peer analysis, I want to examine
Bryley’s ROE last year. Bryley Ltd earned a net profit margin of 5% last year and had an equity multiplier of 3.0. Its total assets are $100
million and its sales are $150 million.
Show Worked Solution
Bring any follow-up questions to the weekly webinar and/or post them to the Class Forum.
Financial ratios for NFPs
While many ratios can help us evaluate the financial health of a Not-For-Profit organisation, the optional reading below focuses on the main
ones that can be readily employed, particularly the ratios used to measure liquidity, solvency, and activity effectiveness. These ratios are
grouped under each dimension of financial health the organisation should focus on for survival and prosperity.
 Read
Read pages 13–15 of the following reading for an explanation of liquidity, solvency, and activity effectiveness ratios.
CPA Australia 2012, Financial management of not-for-profit organisations, viewed 17 November 2022,
https://www.cpaaustralia.com.au/professional-resources/not-for-profit.
Limitations of ratio analysis
Ratios are not infallible measures of a company’s financial health, and when employing them, you should bear in mind the following
limitations:
It is sometimes difficult to identify the industry category to which a company belongs when it engages in multiple lines of business, e.g. a
large multinational like General Electric Company.
Published industry averages are approximations only and not exact measures.
Different companies may use different accounting policies and practices, e.g. different asset costing methods.
Financial ratios can appear favourable (or unfavourable) but may be too high or too low.
Many companies experience seasonality in their operations, e.g. a ski resort or fishing operation.
 Read
Section 4.5 'Limitations of ratio analysis', on pages 117–118 of the textbook, gives an expanded discussion of the above-
mentioned limitations.
 Watch
Learn more about the pitfalls of ratio analysis in the LinkedIn Learning video What financial ratio analysis can NOT do (02:16
minutes).
Stice, K & Stice, J 2020, What financial ratios can NOT do, LinkedIn Learning video, viewed 10 May 2021,
https://www.linkedin.com/learning/running-a-profitable-business-understanding-financial-ratios/what-financial-ratio-analysis-
can-not-do?auth=true.
Activity 3.4 Forum on the limitations of ratio analysis
What
Contribute to a discussion forum on the limitations of ratio analysis.
Why
This activity relates to this week's learning outcome: evaluate the limitations of financial ratios to establish the health of a business. You
should apply what you learn from this activity to Assessment 1.
How
1. What are the limitations to ratio analysis that managers must consider when using this measurement to diagnose the financial health of a
business?
2. Share your answers on the Activity 3.4 forum on the limitations of ratio analysis.
3. To maximise the learning value of this activity, read some of the other posts and reply to another post that confirms and/or extends your
ideas. You will also be able to discuss this topic further in this week's webinar.
Summary, resources and references
In this module, we have worked through how to analyse financial performance using ratios. We looked at profitability, liquidity, efficiency,
leverage and market ratios. We also covered the highly effective DuPont method of decomposing the profitability measure of return on equity
(ROE). As we have learned, whilst ratios are very useful in analysing financial performance, there are some limitations that managers need to
consider when making decisions based on them.
In the next module, we focus on another key aspect of financial management—the time value of money.
Resources and references

8006FMGT Required and optional resources
8006FMGT References

Module 3 Financial Analysis

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Module 3 Financial analysis 11/6/2023, 1:10 pm

Module 3 Financial analysis

What you need to do this week:

This week, you will learn to:

Introduction to financial analysis using ratios

Financial statements and ratios

The DuPont method

Financial ratios for NFPs

Limitations of ratio analysis

Summary, resources and references

Introduction to financial analysis using ratios

Financial statements and ratios

Ratios can be broadly presented in 2 ways:

Mini case study: Bia Ltd

Source: Developed by AIB 2021

Source: Developed by AIB 2021

Liquidity ratios provide the basis for answering two questions:

There are two approaches to measuring the liquidity of a business.

1. Analysing measures of overall liquidity

Current assets − Inventory

2. Measuring the liquidity of individual assets

Annual credit sales

Cost of goods sold

Activity 3.1 Financial ratios Part 1

Bia Ltd Bia Ltd

Income Statement for the Balance Sheet as at 31

Revenue 345 Assets

Less Cost of Sales 125 Current Assets

Gross Profit 220 Cash at Bank 40

Less Expenses Inventory 150

Warehouse 25 Total Current Assets 282

Selling and Marketing 35 Non-Current Assets 575

Administration 42 Total Assets 857

Total Expenses 139 Liabilities

Net Profit Before Tax 81 Accounts Payable 134

Tax Expenses 24 Employee Entitlements 30

Net Profit After Tax 57 Total Current Liabilities 164

Non-Current Liabilities 250

Total Liabilities 414

Total Equity 443

a. Is a current ratio of 1.71 a healthy level of liquidity?

Operating profit or EBIT

Activity 3.2 Financial ratios Part 2

Bia Ltd Bia Ltd

Revenue 345 Assets

Less Cost of Sales 125 Current Assets

Gross Profit 220 Cash at Bank 40

Less Expenses Inventory 150

Warehouse 25 Total Current Assets 282

Selling and Marketing 35 Non-Current Assets 575

Administration 42 Total Assets 857

Total Expenses 139 Liabilities

Net Profit Before Tax 81 Accounts Payable 134

Tax Expenses 24 Employee Entitlements 30

Net Profit After Tax 57 Total Current Liabilities 164

Non-Current Liabilities 250

Total Liabilities 414

Total Equity 443

Price-earnings (P/E) ratio

The DuPont method

net profit margin

Activity 3.3 Financial ratios Part 3

Show Worked Solution

Financial ratios for NFPs