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1. Introduction
Financial analysis involves appraising and communicating the position, performance and prospects of a
business based on given and prepared statements and ratios. The ability to review, analyze and interpret a set
of financial statements is a key skill for a financial accountant. Analysis may involve any or all of the
following:
Common size analysis helps to identify whether costs have increased proportionately. Questions that might
be asked as a result of performing this analysis are as follows.
(a) Why has cost of sales increased as a proportion of revenue? Have selling prices reduced while cost per
unit remains the same or have costs increased?
(b) Why have distribution costs increased as a proportion of revenue? Have costs such as petrol increased or
are proportionately more items being distributed (this would be the case if prices have decreased)?
(c) There is a significant drop in the proportion of revenue spent on admin expenses. Is there a one-off item
of income in 2014 or a one-off expense in 2013 that has caused the change?
(d) Finance costs as a proportion of revenue have increased; the company appears to have borrowed money in
the year. This has been employed in the business and resulted in increased revenue.
Ratio analysis involves manipulating amounts in the financial statements to produce a ratio. This is then
compared with the same ratio for any of:
(1) Profitability
(2) Long-term solvency
(3) Short-term liquidity
(4) Efficiency (turnover ratios)
(5) Shareholders' investment ratios
2. Ratio analysis
For each of the categories of ratio, we will identify a number of standard measures or ratios that are normally
calculated and generally accepted as meaningful indicators.
It must be stressed, however, that each individual business must be considered separately, and a ratio that is
meaningful for a manufacturing company may be completely meaningless for a financial institution. Try not to be
too mechanical when working out ratios and constantly think about what you are trying to achieve.
To illustrate the calculation of ratios, the following statement of financial position and statement of profit or loss
figures will be used. We are using a separate statement of profit or loss for this example, as no items of other
comprehensive income are involved.