CHAPTER 2

FINANCIAL ANALYSIS AND

PLANNING
 INTRODUCTION
What is Financial Analysis??
• It is the assessment of a firm past, present and anticipated future
financial performance
• The analysis is made based on the firm’s financial statements
• It helps individual to check whether a business is doing better this
year than last year or doing better or worse than other companies
in the same industry
Objective of Financial Analysis
• Identify the firm’s strength and weaknesses
Financial Ratio
• The principal tool of financial analysis
• Ratios are mathematical aids for evaluation and comparison of
financial performance
• Financial ratios are computed based on the firms’ financial
statement
• Objective of Financial Ratio
1. To standardize financial information for comparison
purposes
2. To evaluate current operations of the company
3. To compare present performance with past
performance
4. To compare the performance of the company with other
firms or industry standard
5. To assess the efficiency of operations
6. To assess the risk of operations
 FINANCIAL STATEMENT
• There are four main components of financial statement:
1) Statement of profit and loss and other comprehensive income
2) Statement of financial position
3) Statement of cash flows
4) Statement of changes in equity
• Users of Financial Statements
 Several groups of people interested in obtaining the financial
statements for decision making purposes
1) Shareholders
• To ensure that they get good return and increase the value of
shares
• To decide whether they want to sell or retain their investments in
the firm
2) Manager
• To ensure they manage business efficiently and effectively to
wealth maximize its owner
• To evaluate the firm performance for planning, organizing and
controlling the firm resources
3) Creditors/lenders
• A person who supply goods and services on a credit basis as well as
banks providing loan to company
• Suppliers want to ensure that they are able to get timely payment
on the account due and banks are interested in company ability to
repay loan
4) Current and future employees
• Interested to know the firm’s ability to expand and grow to ensure
steady employment
• They need financial statement to determine the monetary benefits
that they can obtain from the firm
5) Prospective investors
• To assess profitability, stability, growth potential and financial
health before deciding whether to invest in the firm
6) Customers
• To ensure that the company can deliver not only the goods
ordered but also the legal obligations associated with guarantees,
warranties and provide after-sales customer service
7) Government
• Various government ministries and departments require financial
statements to ascertain a firm declaration and payment of taxes,
fix price of essential goods and utilities and make expansion plan
for the economy
Statement of Financial Position/Balance Sheet
• A summary of a business’s financial position during a certain
accounting period
Statement of Financial Position as at December 31st, 2014
Current Assets (RM 000)
Cash 20
Marketable securities 20
Account Receivable 30
Inventories 15
Prepaid Expenses/rent 5
Total Current Assets 90

Fixed Assets (Non-current Asset)

Property, plant and equipment 50
Less:
(-) Accumulated Depreciation 10
Net Fixed Asset 40
Total Assets 130
Current Liabilities
Account Payable 12
Notes Payable 5
Taxes Payable 7
Accruals 5
Bank Overdraft 6
Total Current Liabilities 35

Non-current Liabilities
Long term debt
Term loan 20
Debenture 10
Bonds 10
Stockholder equity
Preferred Stock 15
Common Stock 20
Retained Earning 20
Total liabilities and stockholders’ equity 130
Current Liabilities
Account Payable 12
Notes Payable 5
Taxes Payable 7
Accruals 5
Bank Overdraft 6
Total Current Liabilities 35

Non-current Liabilities
Long term debt
Term loan 20
Debenture 10
Bonds 10
Finance by:
Preference share capital 15
Ordinary share capital (RM1 per share) 20
Retained earnings 20
Total liabilities and stockholders’ equity 130
Fundamental Equation

Total Assets = Total Liabilities + Stockholders’ equity

Total Assets – Total Liabilities = Stockholders’ equity

Income statement or Statement of Profit and Loss

• It is a statement that will indicate what a firm gets
from its current operation
 Statement of Profit or Loss for the year ended
December 31st 2014
Sales 2 000 000
Less: Cost of goods sold 800 000
Gross Profit 1 200 000
Less: Depreciation 50 000
Operating expenses:
Selling Expenses 200 000
General and administrative Expenses 200 000
Operating Profit (EBIT)* 750 000
Less: Interest expenses 70 000
Earning Before Tax (EBT)* 680 000
Less: Tax (assume 40%) 272 000
Earning After Tax (Net Income) (Eat) 408 000
 Financial Ratio Analysis
• There are 5 types of financial Ratio
1) Liquidity Ratio
i) current ratio ii) Quick ratio

2) Activity Ratio/Efficiency Ratio

i) inventory turnover ratio ii) average collection period
iii) Fixed asset turnover iv) total asset turnover

3) Leverage Ratio
i) Debt ratio ii) time interest earned

4) Profitability Ratio
i) Gross profit margin ii) operating profit margin iii) net profit margin
Iv) Return on asset v) Return on equity

5) Market Ratio
 Liquidity Ratios
• A firm ability to meet its short-term financial obligation, that is
whether the company has the resources to pay its creditors when
payments are due
• Compare the firm total current assets with total current liabilities
• Higher ratio indicate increased liquidity
• The higher the liquidity, the easier for the company to pay its
creditors on time

i) Current Ratio = Current Assets

Current Liabilities

 This ratio will measure the ability of the firm to pay off its debt with
its current asset
ii) Quick ratio/Acid test ratio =
Current Assets – Inventory – Prepaid expenses
Current Liabilities

• This ratio indicate whether a firm has enough current assets to

cover its current liabilities without selling inventory
• Losses will occur if a firm has to sell off the inventory
• This ratio will measure the ability of the firm to pay off its current
obligations with its most liquid asset
• **Inventories – It is a current asset that difficult to convert it to
cash (least liquid asset)
• **prepaid expenses – taken out of current asset because these are
expense that a firm has paid in advance
• If the quick ratio is much lower than current ratio, it means that
current asset is highly dependent on inventory. It show the
company may have over stock problem
 Activity Ratio/Efficiency Ratio
• It also called asset management ratios
• It measure how effectively the firm is managing its asset
generating sales
• It also show the firm efficiency in collecting debts as well as
turning its inventory into sales

i) Inventory turnover ratio = Cost of Good Sold

Inventories
• Indicates how many times the inventory is sold and replaced
in a year
• Business selling perishable goods have very high inventory
turn over
ii) Average collection period = Account Receivables
Average Credit Sales Per Day
or
Account Receivables
Annual Sales/360 days
• It indicates the number of days taken by a firm to collect its
accounts receivable and is a reflection of the company credit
policy, whether the company is practicing a strict or loose credit
policy
• If the credit period given to its customers is only 30 days but the
average collection shows more days, this will indicate that they
need to do an evaluation of their credit policy and collection
policy
• It shows the firm effectiveness and efficiency in extending credit
and collecting debts
• The shorter the average collection period, the faster the debtors
are paying their account, the more efficient the company is in
debtors collection
iii) Fixed asset turnover / non-current asset turnover
= Sales
Net Fixed Assets/net non-current asset

• It measures the firm efficiency in utilizing its property, plant and

equipment in generating sales

iv) Total asset turnover = Sales

Total assets

• Its indicate how well the firm is using its available fixed assets and
current to generate sales
 Leverage Ratios
• It measure the level of debt or borrowings in a firm
• They tell us whether the company uses more debt financing to
finance its assets and operations compared to equity financing
• Leverage is used to increase potential return of an investment
• The higher the level of debt, the higher the chance that the
company may not able to pay back its borrowing and interest
charge on time

i) Debt Ratio = Total Debt or Total Liabilities

Total Asset Total Asset
*Total Debt = current liabilities + long term liabilities

• Creditors and financial institutions will prefer a company with a

lower debt ratio, as it will reduce the potential losses
ii) Time interest earned = Earnings before interest and tax (EBIT)
Interest expense

• It measure the firm’s ability to cover its interest charges out of its
operating profits.
• The causes of high leverage maybe the company borrowing more
than necessary. This could be due to firms high dividend payout
ratio, leaving less retained profits for expansion purposes
• Leverage ratio can improve by financing capital investment from
issues of shares or retained profit
 Profitability Ratios
• It measure how effectively the firm uses its asset to make profits
• They show the profits earned for every dollar of sale made
• It also indicate the firm efficiency in controlling costs and its pricing
policy

i) Gross Profit Margin = Gross Profit or Sales – Cost of Goods Sold

Sales Sales
• It shows the percentage of sales remaining after deducting the costs
of making such sales

ii) Operating Profit Margin = Earnings before interest and tax

sales
• It is derived after deducting all costs and expenses excluding interest
charges and taxes from sales
• This is true profit from the company operation
iii) Net Profit Margin = Net income available to common stockholders
Sales

Or
Earning after interest and tax
Sales

• It refers to net profit after tax minus preference dividend

• Actual profit to ordinary shareholders
• Net profit after tax is derived after deducting all costs and expenses,
including interest and taxes
• Net profit margin will be low if operating expenses are high or if
using more debt financing (interest charges)
iv) Return on Asset = Net income available to common stockholders
Total Asset
Or
Earning after interest and tax
Total Asset

• Also known as return on investment (ROI)

• It indicates the management ability to make profits from the firm
investment in assets

v) Return on Equity = Net income available to common stockholder

Common equity
Or
Earning after interest and tax
Common equity
• It measures the profit earned by the common stockholders from
their investments in the company