Introductory Accounting

Semester 2, 2011

Financial Ratio Analysis

Exam Guide
Ratios are examinable either as an entire discussion question (analysis) or
as a question involving calculations and analysis.

Students usually struggle to write good analysis and suggest ways of

improving financial performance. So if you want to get good marks, make
sure you practice writing!

How to write a good Ratio

Analysis?
Here are some tips on what the examiners are looking for:

1. If you are analysing Liquidity/Profitability/ Efficiency/ Gearing explain

exactly what they mean.
2. Tell your reader which ratios measure
Liquidity/Profitability/Efficiency/ Gearing and which ones you will be
using in your analysis.
3. Explain the meaning of each ratio and apply it to the company that
you are analysing (Company X).

E.g. The Current Ratio measures whether a company's short-term assets (cash, cash
equivalents, marketable securities, receivables and inventory) are readily available to
pay off its short-term liabilities (notes payable, current portion of term debt, payables,
accrued expenses and taxes). CompanyXs Current Ratio was more than 1 throughout
the period so the business is generally considered to have good short-term financial
strength.

4. If you have information for more than one period make sure you
analyse trends and comment on whether there is an improvement
or deterioration in the ratios.

E.g. The ratio of Days Inventory Turnover is an efficiency and activity ratio that
measures how long it takes a business to convert its inventory into sales or revenue.
Despite a slight deterioration in this ratio from 2004 to 2005(16 days to 17 days),
CompanyX appears to be able to turn its inventory into revenue quite quickly.

5. Explain how the behaviours of different ratios within a category

relate to each other.

E.g. The Acid Test Ratio is also known as quick ratio and is a more conservative
measure of liquidity than the Current Ratio because it excludes inventory and
prepayments, which are more difficult to turn into cash. The behavior of this ratio
confirms our earlier conclusions based on the Current Ratio. CompanyX does not
Introductory Accounting
Semester 2, 2011
appear to have any liquidity problems. The business is able to meet its short term
obligations by using its cash reserves and accounts receivable.

6. If you are given information for the industry make sure you compare
the companys performance with the industrys performance.

E.g. It appears that the companyX has been more aggressive than its competitors in
financing its growth with debt and this is reflected in its steeper degree of leverage
(Debt to Equity Ratio was 103% in 2003 and 104% in 2004 vs the industry average of
75%). As a result, the companyX is more vulnerable to downturns in the business
cycle than its peers, regardless of how bad sales are, the company must continue to
service its debt.

7. If required, suggest ways to improve financial performance.

- E.g. To improve profitability company X should reduce unnecessary costs or find

ways to save costs.