In the first module, we defined financial reporting as the process of recording, classifying, analysing, summarizing, and reporting financial information. We looked at how to record business transactions in books of prime entry, and how those entries are posted through the ledger. The ledger information was then summarized in a trial balance and reported to users in the form of a financial statement.*

The figures in financial statements don’t automatically explain what they mean for the business. To understand the entity’s health and performance, the statements need to be interpreted.

This chapter focuses on interpreting financial statements, mainly through accounting ratios. Ratio analysis isn’t only for external users such as investors and creditors. Management also relies on ratios for internal planning, performance monitoring, and decision-making.

Learning objective

By the end of this module, you should be able to:

• Describe how the interpretation and analysis of financial statements are used in a business environment.
• Explain the purpose of the interpretation of ratios.

Purpose of analysis of financial statements

Interpreting and analysing financial statements helps stakeholders assess a company’s financial health, performance, and stability. By examining indicators such as profitability, liquidity, and solvency:

• Managers can make more informed decisions about budgeting, investment, and resource allocation.
• Investors and creditors can evaluate risk and return, which helps them decide whether (and on what terms) to provide funding.
• Stakeholders can spot trends, inefficiencies, and areas for improvement, which supports strategic planning and competitive advantage.

Overall, financial statement analysis supports transparency, accountability, and sustainable business growth.

The purpose of interpreting ratios is to assess a company’s financial health by analysing relationships between key financial figures. Ratios help you:

• identify trends over time
• measure efficiency, profitability, and liquidity
• compare performance across periods or against industry benchmarks

This supports better decision-making by management, investors, and creditors.

For example, a lender may use liquidity ratios to judge whether a business can meet its short-term obligations before extending a loan. An investor may focus on profitability ratios to assess the return being generated on their investment.

Ratio analysis

Definitions

Ratio analysis

It is a method traditionally used by users who wish to understand more fully the financial statements and performance of the reporting entity.

Financial ratios help the user of the financial statements to assess the financial position of the entity, and or its financial performance.

It may be used to identify unusual items, trends, or financial problems; to be of any use, it depends entirely on comparisons being made.

A ratio calculated in isolation is meaningless. You can only interpret a ratio by comparing it with a benchmark. Common benchmarks include:

• the entity’s own results from prior periods
• forecasted performance (budgets or targets)
• other entities in the same industry
• the industry average

For instance, a gross profit margin of 40% tells us very little on its own. However, if the industry average is 55%, this suggests the entity may have a higher-than-average cost of sales, pricing issues, or inefficiencies in its production process. That difference signals an area that needs further investigation.

Forms of ratio analysis

Financial ratio analysis can be conducted using different approaches, each providing unique insights into a company’s performance and financial position. The two (2) main forms are:

1. Vertical analysis
2. Horizontal analysis

Vertical analysis

Vertical analysis examines the relationship between different items within a single financial statement for one accounting period. Common size analysis is a specific application of vertical analysis where each line item is expressed as a percentage of a base figure.

• In the statement of profit or loss, items are typically expressed as a percentage of sales revenue.
• In the statement of financial position, items are expressed as a percentage of total assets.

This approach helps you see the relative proportion of each component. It also supports comparisons between companies of different sizes because expressing items as percentages reduces the effect of scale.

Horizontal analysis

Horizontal analysis (also known as trend analysis) compares financial data across multiple accounting periods. It examines how individual line items have changed over time, typically expressed as either:

• absolute changes in monetary terms, or
• percentage changes from a base year

This method is useful for identifying trends, patterns, and growth rates in a company’s performance over time. It helps stakeholders judge whether key metrics are improving, deteriorating, or remaining stable.

For example, a consistent year-on-year increase in operating expenses as a percentage of revenue is a trend worth investigating, because it may indicate rising costs that are eroding profitability over time.

Definitions

Categories of accounting ratios

Ratios can be divided into five main categories, namely:

• Profitability ratios
• Liquidity ratios
• Efficiency ratios
• Gearing ratios
• Investor Ratios

This syllabus requires focus on the first four categories. We shall look at each of these categories. You are required to explain what the ratio measures, state the formula, calculate and or interpret the results of the ratio, as well as indicate its relationship with other ratios.

Understanding the interrelationships between ratios is particularly important, as ratios rarely tell the full story in isolation. A high profitability ratio, for example, may coexist with poor liquidity if profits are tied up in receivables, highlighting why multiple ratios must be considered together.