CHAPTER 7 ANALYSIS TOOLS

Prepared by: Nur Liyana Mohamed Yousop

CHAPTER OUTLINES
• Liquidity
Ratio Analysis • Leverage
• Activity
• Profitability

• Year-To-Year Change
Comparative Financial Statements Analysis
• Index-Number Trend Analysis

Common-Size Financial Statements

METHODS OF FINANCIAL STATEMENT ANALYSIS

Comparative Analysis
• Year to Year Common-Size
Ratio Analysis Analysis Analysis
• Index Number
Trend Analysis
RATIO ANALYSIS
USES OF RATIOS

Ratios are useful tools of financial statement analysis

because they conveniently summarise data in a form that is
more easily understood, interpreted and compared.

Ratios can be used to compare:

• Items within the income statement
• Balance sheet data
• Items from both the income statement and the balance sheet
 FRAMEWORK FOR ANALYSIS
Liquidity Assessing solvency
PROCESS
Asset Assessing efficiency
management/Activity

What are we looking for? Debt/Leverage/Capital Assessing financial

Structure stability

A framework to The relevant ratios to use Profitability Assessing firms’ return

establish a and their calculations
financial ratio Assessing market
analysis Market performance performance
Comparative analysis

Interpretation of the ratios

LIQUIDITY/SOLVENCY RATIOS
INTRODUCTION
OBJECTIVE

To measure whether the company able to meet its short

term obligation @ when they fall due.
RATIOS

• Measure the ability of a company to meet its

Current ratio short term debts and when they fall due

Quick asset • High inventories may lead to the highest value of the current ratio
ratio (e.g. merchandising company) even though their ability to pay short
term debts are poor.

• Thus, acid test ratio / quick asset ratio is more stringent in

calculating liquidity ratio
 FORMULA
FORMULA REMARKS ANALYSIS
Current
Ratio (CR) Current Assets ↑
@ Working Measure the ability of a company to
Current Liabilities is better
Capital meet its short term obligation.
(>1)
Ratio * times

Quick Ratio Current Assets - Inventory - Prepayment ↑ Measure the ability of firm to pay
(QR) / Acid Current Liabilities - Overdraft is better without having to rely on illiquid current
Test Ratio (>1) assets
* times
 FORMULA
FORMULA REMARKS ANALYSIS

Working capital is a measure of both a

Current Assets - Current Liabilities firm's efficiency and its short-term financial
Net Working
positive health. If positive, the firm can pay all of
Capital
is better its current liabilities using only current
(NWC)
*RM asset. (the firm is very liquid and
financially sound in the short term)

Cash and Cash Equivalents A ratio above 1 means that the company
Current Liabilities > 1 is will be able to pay off its current liabilities
Cash Ratios
better with cash and cash equivalents, and have
*% funds left over.
LEVERAGE RATIOS
CAPITAL STRUCTURE
INTRODUCTION
OBJECTIVE:

▪ To measure whether the long term financial stability of a

company depends much upon its capital structure

▪ i.e. the relationship between debt and equity. The greater

the proportion of debt used, the more exposed it is to a
business downturn.
RATIOS
Debt to Asset Ratio (DAR)

Debts to equity ratio (DER)

Long-term debts to equity ratio (LTDER)

Equity Ratio

Times Interest Cover Ratio (TIE)

 FORMULA
FORMULA ANALYSIS

The debt to assets ratio indicates the

Debt to Assets
proportion of a company's assets that are
Ratio (DAR) @ Total Debt
being financed with debt, rather than
Total Debt
is better equity. The ratio is used to determine the
Ratio
Total Assets financial risk (GEARING) of a business.
*%
DTER measures the riskiness of a
company's financial structure.
Debt to Equity Total Debt
is better A higher debt to equity ratio indicates
Ratio (DER)
that more creditor financing (bank loans)
Total Equity is used than investor financing
*% (shareholders).
FORMULA
FORMULA ANALYSIS

Long Term Long Term Debt LTDER measures the riskiness of a company's
Debt to
Total Equity is better financial structure but the measurement focus
Equity
solely on long term debt.
Ratio * %

If the outcome of the calculation is high, this

Total Equity
implies that management has minimized the
use of debt to fund its asset requirements,
Equity Total Assets is better
which represents a conservative way to run the
Ratio
entity. Conversely, a low ratio indicates that a
large amount of debt was used to pay for the
assets
 FORMULA
FORMULA REMARKS ANALYSIS
Measure of how well a company can meet its
interest-payment obligations.

EBIT A ratio of less than one indicates that a business

Times Interest Interest Expense may not be in a position to pay its interest
Cover Ratio * times obligations, and so is more likely to default on its
is better
(TIE) / Interest debt.
Coverage Ratio
A much higher ratio is a strong indicator that the
ability to service debt is not a problem for a
borrower.
ASSET MANAGEMENT RATIOS
ACTIVITY RATIOS / EFFICIENCY RATIOS
INTRODUCTION
OBJECTIVE:

▪ To measure the ability of the company to use or manage its assets.

▪ Ineffective use or manage of assets results in:

o The need for more finance
o Unnecessary interest cost
o A corresponding inferior return on capital (i.e. invest more in
assets but return is less)

▪ Moreover, low activity ratios may indicate problems in managing

account receivable or obsolescence in inventory or equipment which
may signal business difficulties.
RATIOS
Total Asset Turnover
(TATO)

Inventory
Turnover (ITO) Fixed Asset Turnover (FATO)

Accounts Debtor Days (ACP)

Receivable
Turnover (ARTO)
 FORMULA
FORMULA REMARKS ANALYSIS

Inventory Revenues @ Sales

Turnover (ITO) ↑ Measure the effectiveness of a firm in using
OR; Inventory Inventories is better its inventory to generate sales.
Utilization Ratio
*times

Sales or Revenue Measure the ability of firm in utilizing its

non-current assets.
Fixed Assets Total Fixed Assets
↑
Turnover (FATO) * times is better A high turn over indicates that assets are
being utilized efficiently and large amount
of sales are generated using a small amount
of assets.
FORMULA
FORMULA REMARKS ANALYSIS

Measure how quickly cash is collected from

Account Receivable x 360
trade debtors.
Average
Credit Sales @ Sales ↓
Collection When the debtor days are reduced, less
is better
Period (ACP) fund would be tied up in trade debtors and
* days
thereby increasing the cash or liquidity
position of a firm.
FORMULA
FORMULA REMARKS ANALYSIS

Measures how many times a business can

Credit Sales @ Sales collect its average accounts receivable
during the year. Higher ratios mean that
Account Receivable companies are collecting their receivables
Account
more frequently throughout the year.
Receivable * times ↑
Turnover is better
For instance, a ratio of 2 means that the
(ARTO)
company collected its average receivables
twice during the year. In other words, this
company is collecting is money from
customers every six months.
FORMULA
FORMULA REMARKS ANALYSIS

Measure the ability of firm in utilizing its overall

assets (efficient). Higher turnover ratios mean the
Sales company is using its assets more efficiently.
Total Assets ↑
Total Assets
Turnover (TATO) is better
* times Lower ratios mean that the company isn't using its
assets efficiently and most likely have management
or production problems.
PROBABILITY RATIOS
INTRODCUTION
OBJECTIVE:

▪ Show a company's ability to generate profits from its operations.

Question to be asked.
o How good is a company at running its business?
o Does its performance seem to be getting better or worse?
o Is it making any money?
o How profitable is it compared with its competitors?
RATIOS

Return on Assets (ROA)

Return on Equity (ROE)

Net Profit Margin (NPM)

FORMULA
FORMULA REMARKS ANALYSIS

Measures how effectively a firm can earn

a return on its investment in assets.
Return on Earning After Taxes
↑ In other words, the ROA measures how
Assets (ROA Total Assets is better efficiently a company can manage its
@ ROI)
assets to produce profits during a period.
*%

Measures how much profits are produced

at a certain level of sales.
Net Profit Earning After Taxes ↑
In other words, it shows how much net
Margin (NPM) is better
Sales income a business makes from each dollar
of sales.
*%
FORMULA
FORMULA REMARKS ANALYSIS

Measures how efficiently a firm can use

the money from shareholders to
generate profits and grow the company.

E.g. A return on 1 means that every

Return on ↑
Earning After Taxes dollar of common stockholders’ equity
Equity (ROE) is better
Shareholders' Equity generates 1 dollar of net income. This is
an important measurement for potential
investors because they want to see how
*% efficiently a company will use their
money to generate net income.
COMPARATIVE ANALYSIS
The form of horizontal analysis encountered most often uses comparative financial
statement items of 2 or more years showing absolute and percentage changes of the
financial statement items being analyzed.

(1) Year-To-Year Change Analysis

(2) Index-Number Trend Analysis

(3) Common Size Financial Statement

 Horizontal Analysis
YEAR-TO-YEAR CHANGE ANALYSIS
YEAR-TO-YEAR CHANGE ANALYSIS
Also known as “Comparative Financial Statement Analysis”

Comparative financial statement analysis is to examine what changes have occurred over time and the
reasons for the changes.

Analysis:

• Step 1: Compute Changes → Changes = Year1 –Year0

• Step 2: Compute % Change → % Change = Change x Year0 x100
• Step 3: If +ve → Increase, If –ve → Decrease
YEAR-TO-YEAR CHANGE ANALYSIS
Example:

The management of Clover Company provides you with

comparative balance sheets of the years ended December 31,
1999 and 1998. Management asks you to prepare a horizontal
analysis on the information.
YEAR-TO-YEAR CHANGE ANALYSIS
YEAR-TO-YEAR CHANGE ANALYSIS

$12,000 – $23,500 = $(11,500)

YEAR-TO-YEAR CHANGE ANALYSIS

($11,500 ÷ $23,500) × 100% = 48.9%

YEAR-TO-YEAR CHANGE ANALYSIS
Note: The same method will
be used for the income
statements
 Horizontal Analysis
INDEX NUMBER TREND ANALYSIS
INDEX NUMBER-TREND INDEX ANALYSIS
1. Also known as “Horizontal Analysis”
2. An analysis of percentage financial statements
where all balance sheet or income statement
figures for a base year equal 100.0 (percent) and
subsequent financial statement items are
expressed as percentages of their values in the
base year.
3. Allow users to quickly compare the percentage
change of an item or account.
INDEX NUMBER TREND ANALYSIS-BALANCE
SHEETS (ASSETS) Base year =100/148 x 100

As Reported Indexed
(thousands of RM) (%)
Assets 2014 2015 2016 2014 2015 2016
Cash 148 100 90 100.0 67.6 60.8
Account Receivable 283 410 394 100.0 144.9 139.2
Inventory 322 616 696 100.0 191.3 216.1
Other Current Assets 10 14 15 100.0 140.0 150.0
Total Current Assets 763 1,140 1,195 100.0 149.4 156.6
Net Fixed Assets 349 631 701 100.0 180.8 200.9
Long Term Investment 0 50 50 100.0 inf. inf.
Other Long Term 111 223 223 100.0 200.9 200.9
Investment
Total Assets 1,223 2,044 2,169 100.0 167.1 177.4
INDEX NUMBER TREND ANALYSIS-BALANCE
SHEETS (LIABILITIES & EQUITY) Base year =295/290 x 100

As Reported Indexed
(thousands of RM) (%)
Liabilities & Equity 2014 2015 2016 2014 2015 2016
Note Payable 290 295 290 100.0 101.7 100.0
Account Payable 81 94 94 100.0 116.0 116.0
Accrued Taxes 13 16 16 100.0 123.1 123.1
Other Accruals 15 100 100 100.0 666.7 666.7
Total Current Liabilities 399 505 500 100.0 126.6 125.3
Long Term Debt 150 453 530 100.0 302.0 353.3
Equity 674 1,086 1,139 100.0 161.1 169.0
Total Liabilities and Equity 1,223 2,044 2,169 100.0 167.1 177.4
INDEX NUMBER TREND ANALYSIS-BALANCE
SHEETS (INCOME STATEMENT) Base year =2106/1235 x 100

As Reported Indexed
(thousands of RM) (%)
Liabilities & Equity 2014 2015 2016 2014 2015 2016
Note Payable 1,235 2,106 2,211 100.0 170.5 179.0
Account Payable 849 1,501 1,599 100.0 176.8 188.3
Accrued Taxes 386 605 612 100.0 156.7 158.5
Other Accruals 180 383 402 100.0 212.8 223.3
Total Current Liabilities 206 222 210 100.0 107.8 101.9
Long Term Debt 20 51 59 100.0 255.0 295.0
Equity 186 171 151 100.0 91.9 81.2
Total Liabilities and Equity 112 103 91 100.0 92.0 81.3
 Vertical Analysis
COMMON SIZE ANALYSIS
INTRODUCTION
Common Size Analysis
All balance sheet items are divided by:
1. total assets for assets and;
Balance Sheet 2. total liabilities and equity for
liabilities and equity items.

All income statement items are divided

Income Statement by net sales or revenues
COMMON SIZE – BALANCE SHEETS (ASSETS)
=148/1223 x 100

As Reported Common-Size
(thousands of RM) (%)
Assets 2014 2015 2016 2014 2015 2016
Cash 148 100 90 12.10 4.89 4.15
Account Receivable 283 410 394 23.14 20.06 18.17
Inventory 322 616 696 26.33 30.14 32.09
Other Current Assets 10 14 15 0.82 0.68 0.69
Total Current Assets 763 1,140 1,195 62.39 55.77 55.09
Net Fixed Assets 349 631 701 28.54 30.87 32.32
Long Term Investment 0 50 50 0.00 2.45 2.31
Other Long Term 111 223 223 9.08 10.91 10.28
Investment
Total Assets 1,223 2,044 2,169 100.0 100.0 100.0
COMMON SIZE – BALANCE SHEETS (LIABILITIES &
EQUITY) =295/2044 x 100

As Reported Common-Size
(thousands of RM) (%)
Liabilities & Equity 2014 2015 2016 2014 2015 2016
Note Payable 290 295 290 23.71 14.43 13.37
Account Payable 81 94 94 6.62 4.60 4.33
Accrued Taxes 13 16 16 1.06 0.78 0.74
Other Accruals 15 100 100 1.23 4.89 4.61
Total Current Liabilities 399 505 500 32.62 24.71 23.05
Long Term Debt 150 453 530 12.26 22.16 24.44
Equity 674 1,086 1,139 55.11 53.13 52.51
Total Liabilities and Equity 1,223 2,044 2,169 100.0 100.0 100.0
COMMON SIZE – INCOME STATEMENT
=1501/2106 x 100

As Reported Common-Size
(thousands of RM) (%)
2014 2015 2016 2014 2015 2016
Net Sales 1,235 2,106 2,211 100.0 100.0 100.0
COGS 849 1,501 1,599 68.7 71.3 72.3
Gross Profit 386 605 612 31.3 28.7 27.7
Expenses 180 383 402 14.6 18.2 18.2
Earning Before Interest & Taxes 206 222 210 16.7 10.5 9.5
Interest Expense 20 51 59 1.6 2.4 2.7
Earning Before Taxes 186 171 151 15.1 8.1 6.8
Earning After Taxes 112 103 91 9.1 4.9 4.1
END OF CHAPTER 7