FIN 420

PPT 03

LOGO March 2015

CHAPTER 3

FINANCIAL RATIO AND ANALYSIS

Prepared By:

Dr. Norliza Che Yahya

Center for Economics and Finance Studies
Faculty of Business and Management
Universiti Teknologi MARA (UiTM),
42300 Puncak Alam Campus,
Office: PFI 04 -032 Office (tel): 03-3258 7077
Email: norliza9911@puncakalam.uitm.edu.my or norlizacheyahya@yahoo.com
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 SYLLABUS CONTENT
CODE CHAPTER WEEK NOTE
Ppt 01 Introduction to Financial Management 1
Ppt 02 Understanding Financial Statements 2
Ppt 03 Financial Ratios and Analysis 3 Test 1
Ppt 04 Financial Forecasting and Planning 4 (15 %)
Ppt 05 Working Capital Management 5
Ppt 06 Cash and Marketable Securities Management 6
Ppt 07 Accounts Receivable & Inventory Management 7
Ppt 08 Short Term Financing 8 Test 2
Ppt 09 Long Term Financing 9 (15%)
Ppt 10 Mathematics of Finance 10 & 11
Ppt 11 Capital Budgeting 12 & 13

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 CHAPTER OUTLINE

NO. CONTENT
1 Type of Financial Ratios
2 Types of Ratio Comparison (Trend Analysis)
3 Limitations

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 FINANCIAL RATIOS

What is Financial Ratios?

 An important analysis tool to analyze (i.e., calculate, interpret and

evaluate) a firm's financial performance at a point of time and over
certain period of time: (1) current performance; (2) past performances
based on actual statements; or (3) expected performance based on pro
forma or "what if“ statements.
 Is able to tell whether the company's financial standing and condition is
in good health or otherwise.
 Main sources of information are financial statements (e.g., balance sheet,
income statement).
 Interested parties: shareholders (investors), creditors, managers, prospects
investors, regulatory bodies, employees etc.

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 Type of Ratios Comparison

 Vertical or Trend or Time-Series Analysis

 Used to evaluate a firm’s performance over time (year to year).

 Horizontal or Comparative or Cross-Sectional Analysis

 Used to compare different firms at the same point in time.
 Industry comparative analysis
 One specific type of cross sectional analysis.
 Used to compare one firm’s financial performance to the industry’s
average performance.

 Combined Analysis
 Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis

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 TYPES OF FINANCIAL RATIOS (cont.)

 Classified into 5 main groups:

1. Liquidity ratios - measure the ability of a firm to meet maturing liabilities
by relying on current assets (i.e. how liquid the firms to meet short-term
obligation).
2. Asset management or Activity ratios or Efficiency ratios– measure
effectiveness of a firm in using its resources or assets (i.e. to measure
efficiency of assets to generate sales and cash).
3. Leverage or Debt ratios - measure the extent to which a firm had been
financed by debt (i.e. how firms finance its assets, to determine the capital
structure).
4. Profitability ratios - measure the profitability of the firm (i.e. measure the
efficiency of firms in using its investment and assets to generate profit or
income).
5. Market Ratios – measures the ability of the company to generate market
value in excess of its investment costs (i.e., reflected by the firm’s operation
with consideration of market (external) factors).

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 1) Liquidity Ratios
Liquidity ratios refer to the ability of a company to pay its short-term obligations using
current assets (i.e., cash or assets that can be easily converted into cash).
Measures company’s excess funds (liquid assets) available
[1] Net Working after paying its daily operating obligations or current debts.
Capital (NWC)
Indicator:-
NWC  Current Assets 
*The higher the NWC, the better or more liquid is the
Current Liabilities company (i.e., the company has excess in current assets).

Measure the company ability to pay its short-term liabilities

[2] Current Ratio (e.g., short term loan, acc. payables) using its liquid funds.
(CR)
Indicator:-
Current Assets
CR  *The higher the CR, the better or more liquid is the company.
Current Liabilities *<1 [bad]; = 1 [satisfactory]; >1 [good]

Measure the company ability to pay short-term obligations

[3] Quick / Acid Test without relying on least liquid assets. QR considers only
cash and current assets that can easily be converted into
Ratio (QR) cash (e.g., marketable securities).
Current Assets  Inventory
QR  Indicator:-
Current Liabilities *The higher the CR, the better or more liquid is the company.
*<1 [bad];7 = 1 [satisfactory]; >1 [good]
 2) Asset Management or Activity Ratios
Asset management or activity ratios measure the efficiency of a company in using
assets to generate sales or cash.

Account Measures the company ability to collect debts or credit

[1] Receivable sales (acc. receivables) from customers.
Turnover (ARTO)
Indicator:-
Sales *The higher the ARTO, the better or more effective is
ARTO  the company in collecting debts from customers.
Acc Receivables
Measures the average days taken by the company to
[2] Average Collection collect credit sales (acc. receivables).
Period (ACP)
Indicator:-
 Acc Receivables  *The shorter the ACP, the better as the company is
ACP    x 360 able to collect the debts within shorter period.
 Sales  *ACP shorter than Credit Terms,
the better.
Measures the average days taken by the company to
[3] Average Payment
pay credit purchases (acc. payables) to suppliers.
Period (APP)
 Acc Payables  Indicator:-
APP    x 360 *The longer the APP, the better as it reflects the
 Purchases  availability of cash in the company.
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 2) Asset Management or Activity Ratios (cont.)

Inventory Measures the company ability to use inventory to

[4] generate sales. ITO also shows the number of times the
Turnover (ITO) inventory can be sold in a year.
COGS
ITO  Indicator:-
Inventory *The higher the ITO, the better or more effective is the
company is using inventory to generate sales.

Measures the company efficiency in using only fixed

[5] Fixed Asset assets (e.g., plant, land, machinery, building) to produce
Turnover (FATO) goods or products for sales.
Sales Indicator:-
FATO  *The higher the FATO, the better or more effective is the
Fixed Assets company in using fixed assets to generate sales.

Measures the company efficiency in using all resources or

[6] Total Asset assets (i.e., current assets + fixed assets) to generate
Turnover (TATO) sales.
Indicator:-
Sales
TATO  *The higher the TATO, the better or more effective is the
Total Assets company is using all its resources or assets to generate
sales.
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 3) Leverage or Debt Ratios
Leverage and debt ratios measure a company’s level of debts and its ability to fulfill
and pay for financial obligations.
Measures the percentage of total assets that are financed
[1] Debt Ratio (DR) by debts. DR indicates the amount of debt in the company
financial (or capital) structure.
 Total Liabilities 
DR    x 100 Indicator:-
 Total Assets  The higher the DR, the higher is the company risk.
Thus, the lower the DR, the better.

[2] Debt to Equity Quite similar to DR. Measure the amount of debt being
utilized relative to the capital provided by the company’s
Ratio (DER)
owners.
 Total Liabilities  Indicator:-
DER    x 100 The higher the DER, the higher is the company risk.
 Total Equity  Thus, the lower the DER, the better.

[3] Time Interest Measure the company ability to pay or serve its financial
interest expenses applied on the debt used.
Earned (TIE)
Indicator:-
EBIT The higher the TIE, the better as it indicates higher
TIE  company’s ability to pay the interest.
Interest Expenses
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 4) Profitability Ratios
Profitability ratios measure a company effectiveness to generate profits from
investment and sales.
Measures the gross profit or income generated from sales
Gross Profit Margin before take into account the administration expenses.
[1]
(GPM)
Indicator:-
*The higher the GPM, the better or more effective is the
 Gross Profit 
GPM    x 100 company in generating gross profit.
 Sales 
Measures the net profit generated from sales after deducting
the administration expenses, interest expenses & tax
[2] Net Profit Margin expenses.
(NPM)
Indicator:-
 Net Profit  *The higher the NPM, the better or more effective is the
NPM    x 100 company in generating net profit or PAT or EAT.
 Sales 
Measures the profit generated from sales after deducting the
[3] Operating Profit administration expenses but before deducting interest and tax
Margin (OPM)
Indicator:-
 EBIT  *The higher the OPM, the better or more effective is the
OPM    x 100 company is generating profit after deducing operating
 Sales  expenses.
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 4) Profitability Ratios (cont.)

Measures the company ability and effectiveness to use its

Return on Assets total assets in generating net profits.
[4]
(ROA) Indicator:-
*The higher the ROA, the better or more effective is the
 Net Profit 
ROA    x 100 company in generating net profit using total assets.
 Total Assets 

Measures the company ability and effectiveness to use its

[5] Return on Equity total equity in generating net profits. Also, ROE measures
(ROE) the company ability in generating net profits to its
shareholders.
 Net Profit 
ROA    x 100 Indicator:-
 Total Equity  *The higher the ROE, the better or more effective is the
company in generating net profit using total equity.

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 5) Market Ratios
Market ratio measures a company ability to generate market value from
investment.
Measures the amount of earnings available for each of the
Earnings Per Share common shareholders’ shares. EPS also measures the profit
[1]
(EPS) generated from each share.
Net Profit - Dividend
EPS  Indicator:-
Total Number of Shares Outstanding *The higher the EPS, the better as it indicates higher
dividend is paid out to shareholders and higher market value.

[2] Dividend Per Share Measures how much dividend is paid (dividend income) to
(DPS) each of the share.
Indicator:-
Dividend
DPS  *The higher the DPS, the better as it reflects higher dividends
Total Number of Shares Outstanding received per share.

[3] Measures return earned by investors’ per share from their

Dividend Yield (DY) investments.
DPS
DY  Indicator:-
Market Price of a Share
*The higher the DY, the better as it reflects higher investors’
earning.
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 LIMITATIONS OF FINANCIAL RATIOS
Ratio analysis is very important to financial managers to uncover trends,
strengths, and weaknesses. However, it has some drawbacks especially
when using industry average index.

1. Unreliable Figures - The practice of "window dressing" may result in

hypothetical figures so that the company will look good in the eyes the
investors.
2. Different Accounting Treatments - There are certain items in the financial
statements are not consistent from one firm to another due to differences in
accounting system (e.g., LIFO or FIFO in inventories management).
3. Non-Comparative Data - Sometimes it is difficult to classify industry for
comparison as a result of the diversification practiced by many companies in
the market place.
4. Benchmark on average index - Industry averages are just average.
Comparison should actually be done with above average industry.

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Exercise: Calculation and Interpretation of Financial Ratios

Based on the Balance Sheet and Income Statement, you are required to calculated
and interpret the relevant financial ratios.
Income Statement as at December 31, Balance Sheet as at December 31, 2000 &2003
2003 RM'000
Revenue/Net Sales 1500 ASSETS 2003 LIABILITIES AND EQUITIES 2003
less: COGS 450 Current Assets Current Liabilities
Gross Profit 1050 Cash 12 Account Payable 38
Account Receivable 44 Notes Payable 35
less: Operating Expenses 450
Inventories 82 Accruals 6
Other operating expenses 300 Prepaid expenses 8 Total Current Liabilities 79
Operating Income(EBIT) 300 Total Current Assets 146

plus: other income none Fixed Assets Long Term Debt 180
less: Interest 25 Plant and Machinery 170
Earnings Before Taxes 275 Land and Buildings 450 Common Equity
less: Corporate Taxes (40%) 110 Total Fixed Assets 620 Common Stock 100
Preferred Stock 150
Net Income 165
Retained Earnings 257
less: Dividend- Preferred none
Common 33 TOTAL ASSETS 766 TOTAL LIABILITIES AND EQUITY 766
Retained Earnings 132
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Solution: Calculation and Interpretation of Financial Ratios

Liquidity Ratios 2003 Industry

1) Current ratio (times)

Current Assets 146 1.85 2X

Current Liabilities 79

2) Quick ratio (times)

Current Assets- Inventories 146 - 82 0.81 1.2X

Current Liabilities 79

3) Net working Capital

Current Asset - Current Liablities 146 - 79 67.00 none

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Solution: Calculation and Interpretation of Financial Ratios
Profitability Ratios 2003 Industry

1) Return on Equity (%)

Earning after tax 165 32.54 32%

Common Equity 507

2) Return on Asset(%)

Earnings after tax 165 21.54 45%

Total assets 766

3) Gross Profit Margin(%)

Gross Profit 1050 70.00 65%

Sales 1500

4) Operating Margin(%)

Operating Income 300 20.00 30%

Sales 1500

5) Net Profit Margin(%)

Net Profit 165 11.00 9%

Sales 1500

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Solution: Calculation and Interpretation of Financial Ratios
Activity Ratio 2003 Industry

1) Asset Turnover (times/yr)

Sales 1500 1.96 5X

Total Assets 766

2) A/c Receivables Turnover (times/yr)

Sales 1500 34.09 40X

A/c Receivables 44

3) Average Collection Period (days)

A/c Receivables 44 10.22 6 days

Daily Sales (1550/360)

4) Inventory Turnover (times/yr)

COGS or Sales 1500 18.29 20X

Inventory 82

5) Fixed Assets Turnover

Sales 1500 2.42 none

Fixed Assets 620

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 Past Semester Questions
1. April 2010, Q1

2. June 2014, Q1

3. January 2013, Q1

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LOGO

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