22108 Chap.6 Financial Statement Analysis: Ratios, Horizontal, Vertical
Financial Statement Analysis: Ratios, Horizontal, Vertical
Week 6 closes the financial half of 22108 by asking what the statements you just built actually say. It covers who analyses and why, horizontal analysis (year-on-year change in dollars and per cent), vertical analysis (common-sizing every line against revenue or total assets), and the four ratio families the subject groups as liquidity, solvency, efficiency and profitability. The stated exit standard is that you can calculate the ratios AND say what they might mean, so interpretation carries as much weight here as arithmetic - a ratio is a prompt to investigate further, not a verdict. Watch the averaging convention and the credit-sales assumption: both are marks that get thrown away in the weekly Canvas quiz and in the final exam.
What this chapter covers
- 01What financial statement analysis is - reviewing the statements to make informed decisions - and who does it: shareholders, research analysts, employees and unions, lenders, customers, suppliers, regulators
- 02Horizontal analysis: dollar change = current - base; percentage change = (current - base) / base x 100; and the trend index for a multi-year series
- 03Vertical analysis (common-sizing): each profit-and-loss line as a percentage of revenue; each balance-sheet line as a percentage of total assets
- 04Liquidity: working capital = current assets - current liabilities; current ratio; quick ratio = (cash + short-term investments + accounts receivable) / current liabilities
- 05Solvency: debt-to-equity = total liabilities / total equity; times interest earned = EBIT / interest expense
- 06Efficiency: accounts receivable turnover = net credit sales / average accounts receivable; days in receivables = 365 / AR turnover; inventory turnover = cost of goods sold / average inventory; days in inventory = 365 / inventory turnover; total asset turnover = net sales / average total assets
- 07Profitability: profit margin = net profit / revenue; return on total assets = net income / average total assets; return on equity = net profit / average total equity
- 08The averaging rule (a flow over a stock uses the average of opening and closing) and the credit-sales assumption that makes net credit sales computable; then what to compare against - industry averages, longer-run trends, budgets and forecasts
A six-ratio pass over one year, with the two conventions that cost marks
- +1Liquidity, part one. Working capital = current assets - current liabilities = 150,000 - 75,000 = $75,000 (a dollar amount, not a ratio). Current ratio = current assets / current liabilities = 150,000 / 75,000 = 2.0 times.
- +1Liquidity, part two - the quick ratio strips out what cannot be turned into cash quickly. Quick ratio = (cash + short-term investments + accounts receivable) / current liabilities = (30,000 + 5,000 + 60,000) / 75,000 = 95,000 / 75,000 = 1.27 times. Inventory is deliberately excluded, which is why it sits below the current ratio.
- +1Receivables efficiency - two conventions apply at once. Net credit sales = 500,000 x 80% = $400,000 (cash sales never create a receivable). Average accounts receivable = (60,000 + 40,000) / 2 = $50,000. AR turnover = 400,000 / 50,000 = 8.0 times.
- +1Days in receivables = 365 / AR turnover = 365 / 8.0 = 45.6 days. Use 365, not 360.
- +1Inventory efficiency. Average inventory = (55,000 + 45,000) / 2 = $50,000. Inventory turnover = cost of goods sold / average inventory = 300,000 / 50,000 = 6.0 times. Days in inventory = 365 / 6.0 = 60.8 days. Note the numerator is cost of goods sold, not revenue - matching cost against cost.
- +1Profitability and the interpretation. Profit margin = net profit / revenue = 40,000 / 500,000 = 8.0%. Average total equity = (200,000 + 180,000) / 2 = $190,000, so return on equity = 40,000 / 190,000 = 21.1%. Interpretation: receivables have grown from $40,000 to $60,000, or 50%, while revenue supporting them has not grown at anything like that rate, and at 45.6 days customers are taking about a month and a half to pay. That is a prompt to ask what the stated credit terms are, whether a few large accounts are overdue, and whether a bad-debt problem is building - not a verdict that the business is failing.
Key terms
- Horizontal analysis
- Comparing each line item across time. Dollar change = current year - base year; percentage change = (current - base) / base x 100. Read it by asking which lines grew materially faster or slower than revenue.
- Vertical analysis (common-sizing)
- Expressing every line as a percentage of a base within the same statement - each profit-and-loss line over revenue, each balance-sheet line over total assets - so entities of different sizes, or the same entity across years, can be compared.
- Quick ratio
- (Cash + short-term investments + accounts receivable) / current liabilities. It strips out inventory and prepayments, the current assets that cannot be converted to cash quickly. A quick ratio far below the current ratio says the business is only liquid if it can sell its stock.
- Times interest earned
- EBIT (earnings before interest and taxes) / interest expense - how many times over the period's earnings could cover the period's interest bill. Approaching 1 means earnings barely cover interest.
- The averaging rule
- When a ratio divides an income-statement flow by a balance-sheet stock, use the average of the opening and closing balance: average X = (X current year + X previous year) / 2. It applies to accounts receivable, inventory, total assets and total equity.
- Net credit sales
- Total sales less cash sales - the only sales that create a receivable, and therefore the correct numerator for accounts receivable turnover. Where a question supplies an assumption such as 'assume 80% of sales are made on credit', apply it; if none is supplied, state your assumption.
Financial Statement Analysis: Ratios, Horizontal, Vertical FAQ
Is calculating the ratios enough for full marks?
No, and the subject says so explicitly: the exit standard is being able to calculate the ratios AND knowing how to interpret what they might mean. The framing that earns the interpretation marks is that analysis identifies areas you want to investigate further and ask more questions about - a ratio is a prompt, not a verdict. So finish every calculation with a sentence that names what moved, what it might indicate, and what you would want to look at next. A single ratio in isolation says almost nothing; comparison is what gives it meaning.
Why do some ratios use an average and others don't?
Because of what the two statements measure. A profit-and-loss figure is a flow accumulated over the whole period; a balance-sheet figure is a stock at one instant. Dividing a whole year's sales by a single closing receivables balance compares a year against a moment, which distorts the answer whenever the balance moved during the year. So whenever the numerator is a flow and the denominator is a stock - receivables turnover, inventory turnover, total asset turnover, return on assets, return on equity - use the average of the opening and closing balance. Ratios built from two balance-sheet figures, like the current ratio or debt-to-equity, need no averaging.
What do I compare a ratio against?
Four things, and the subject names three of them directly: industry averages or benchmarks, the entity's own trend over a longer run of years, and budgets or forecasts - which is the bridge into the management-accounting half of the subject in Topics 9 and 10. Direct competitors of similar size and business model are the natural fourth. Also carry the caveats: different industries have structurally different norms, and accounting policy choices such as depreciation method or inventory costing change ratios without changing the underlying economics.
Can AI help me with ratio analysis and interpretation?
Yes. Sia is an AI tutor built to mirror how 22108 is taught and assessed at University of Technology Sydney: it can check your formula set, catch the two convention errors that cost most marks (closing balances used where an average is required, and total sales used where net credit sales are required), and - more usefully - push your interpretation from 'the current ratio fell' to a proper 'what would you investigate next' answer. Give it a two-year comparative pair of your own and ask it to work through the analysis with you one ratio at a time. It explains step by step and does not do graded assessment for you; the UTS academic-integrity policy applies.
Exam move
Build the ratio set once as a formula sheet in your own handwriting, grouped into the four families, and then never copy a formula out of a slide extraction again - re-derive each from what it is measuring. Beside every formula write one line on what a high value suggests and one line on what a red flag looks like, because that column is where the interpretation marks live. Then work a two-year comparative pair in Excel with live formulas: run horizontal analysis down both statements, common-size both years vertically, and compute the full four-family set with AVERAGE() wherever a flow meets a stock. Engineer your practice case so something is visibly wrong - one expense growing much faster than revenue, receivables growing faster than sales, a deteriorating current ratio - and write the three questions you would ask management. Rehearse the two conventions until they are reflexes: average the stock, and use net credit sales for receivables turnover. Finally, remember this is the last topic of the financial half; from Week 7 the subject turns inward to management accounting, and both halves are examinable in the final exam.
Working through Financial Statement Analysis: Ratios, Horizontal, Vertical in 22108? Sia is AskSia’s AI Accounting tutor — ask any 22108 Financial Statement Analysis: Ratios, Horizontal, Vertical question and get a clear, step-by-step explanation grounded in how 22108 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
