ACC60104

Introduction to Accounting
Lecture 1:
Financial Statement Analysis (Ratio
Analysis)

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 Learning Objectives of Session…

• Calculate common financial ratios

• Interpret financial statements using basic financial
ratios
• Use and interpret ratios to analyse financial
performance and for decision making
• Appreciate the application of financial ratios as signal
for financial trouble
• Explain the limitations of ratio analysis
 FINANCIAL ANALYSIS
Looking at the various parts of the financial statements:
1) to relate SOCI with SOFP to the picture as a whole
2) to determine any meaningful or useful interpretation.

SOCI & SOFP should be read & analyzed jointly.

• OBJECTIVE OF SOCI: to show economic results of profit-
motivated operations.
• OBJECTIVE OF SOFP: to provide a picture of the financial
condition of a business.

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 THE 4 KEY FINANCIAL STATEMENTS

So far, we have learned to prepare the following key financial statements:

1. The Income Statement / SOCI

2. The Balance Sheet / SOFP
3. The statement of Stockholders equity
4. The statement of Cash Flows or Cash
Flow Statement / CFS

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 THE 4 KEY FINANCIAL STATEMENTS

We have the key financial statements,

great!!!

So what do we do with it?

Analyze to find out the

company’s performance.
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 What is Ratio Analysis?

Ratio analysis is the study of evaluating various

aspects of a company's operating and financial
performance such as its efficiency, liquidity,
profitability and solvency. The trend of
these ratios over time is studied to check
whether they are improving or deteriorating.

Ratio analysis is most useful to evaluate the

health AND in highlighting areas for further
investigation of a business / company
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USERS OF FINANCIAL ANALYSIS RESULTS:
1) MANAGEMENT
• Concern about the internal operating
efficiency of the organization – look for
indications that things are running smoothly,
goals are met, and various depts. are
managed as profitably as possible.
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2. CURRENT & POTENTIAL CREDITORS
• Concern about whether the organization can
pay them – look for indication of the level of
safety of their trade credit.

3. CURRENT & PROSPECTIVE SHAREHOLDERS

• Concern about whether the organization will
give return to their investment – look for
indication of the risk of they investing in the
organization.

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What? Why do it? – so we can evaluate financial and
economic results of an organization.

How to do it?
1. Cross-sectional analysis is the comparison of different
firms’ financial ratios at the same point in time;
involves comparing the firm’s ratios from year to year
2. Benchmarking is a type of cross-sectional analysis in
which the firm’s ratio values are compared to those of
a key competitor or group of competitors that it wishes
to emulate.
3. Compare between the industry average as a whole.

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 Tools of Analysis
• There are three main ways to analyze financial
statements:
– Horizontal analysis provides a year-to-year
comparison of a company’s performance in
different periods.
– Vertical analysis provides a way to compare
different companies.
– Ratio analysis can be used to provide information
about a company’s performance.

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 How Do We Use Horizontal Analysis to
Analyze a Business?
• Many decisions hinge on whether the
numbers are increasing or decreasing.
• Sales may have increased, but considered in
isolation, this fact is not very helpful.
• Horizontal analysis is the study of percentage
changes in comparative financial statements.
 How Do We Use Horizontal Analysis to
Analyze a Business?
• Assume Smart Touch Learning has net
sales of $858,000 in 2018 and $803,000
in 2017. Prepare the horizontal analysis:
Step 1: Compute the dollar amount of change in sales from 2017-2018

Step 2: Divide the dollar amount of change by the base period amount
and multiply by 100. This computes the percentage change for the period:
Horizontal Analysis of the Income Statement
Horizontal Analysis of the Balance Sheet
Horizontal Analysis of the Balance Sheet
 Trend Analysis
• Trend analysis is a form of horizontal analysis.
• Trend percentages indicate the direction a
business is taking.
• The formula for trend analysis is as follows:
 Trend Analysis
• Smart Touch Learning’s net sales were
$750,000 for 2014 and rose to $858,000 in
2018. The base year is 2014, so that year’s
percentage is set equal to 100.
 How Do We Use Vertical Analysis to
Analyze a Business?
• Vertical analysis of a financial statement
shows the relationship of each item to its base
amount, the 100% figure.
• Every other item on the statement is then
reported as a percentage of that base.
Vertical Analysis of the Income Statement
Vertical Analysis of the Balance Sheet
Vertical Analysis of the Balance Sheet
 Common-Size Statements
• To compare one company to another
company, we can use a common-size
statement.
• A common-size statement reports only
percentages.
• By reporting only percentages, it removes
dollar value bias we see when comparing
numbers in absolute terms (dollars).
Common-Size Statements
 Benchmarking
• Benchmarking is the practice of comparing a
company with other leading companies.
• There are two main types of benchmarking:
– Benchmarking against a key competitor
– Benchmarking against the industry average
Benchmarking
 Types of Ratios… they are used for the
following purposes:

Ability to sell
Ability to pay Ability to pay long-
inventory and
current liabilities term debt
collect receivables

Measure Analyzing stock as

profitability an investment
 Let’s use
this SOFP
as our
example
for the
calculation
of ratios
 Let’s use
this SOFP
as our
example
for the
calculation
of ratios
 Evaluating Ability to Pay Current Liabilities

Working capital Current ratio Acid-test ratio

• Measures ability to • Most widely used • Tells if company
meet short-term • Proportion of could pay all its
obligations current assets to current liabilities
current liabilities immediately

.
 Ability to Pay Current Liabilities
Working Current Current
capital assets liabilities

Results in a
dollar amount

Current Current Current

ratio assets liabilities

Both result in a
ratio
Cash + short-term Current
Acid-test investments + net liabilities
ratio current receivables
 Measuring Ability to Pay Current Liabilities

Current
Current or
orworking
working capital
capital ratio:
ratio:
Current
CurrentAssets
Assets
Current
Currentratio
ratio == Current
CurrentLiabilities
Liabilities

• Formula: Current assets (s,d,c,b,ai,pe,sti)

Current liabilities (cr,od,pi,ae,tax,pd,stL)
• Gives measure of the short-term safety of the organization
or liquidity or ability to service/pay short term obligations.
• Ideal level? – 1.5 : 1
• e.g. 5 : 1 imply the firm has RM5 of assets to cover every
RM1 in liabilities.
• e.g. 1.8: 1 suggest the firm only has RM1.80 in
Current assets to cover every RM1 it owes OR
its current liabilities.
 Evaluating the Ability to Pay
Current Liabilities
• Working capital measures the ability
to meet short-term obligations with
current assets. Working capital is
defined as follows:
 Current Ratio
• The most widely used ratio is the current ratio.
This ratio measures a company’s ability to pay
its current liabilities with its current assets.
 Cash Ratio
• The cash ratio helps determine a company’s
ability to meet its short-term obligations.
 Measuring Ability to Pay Current Liabilities
Acid-test
Acid-test ratio:
ratio:
Cash
CashAssets
Assets++Short-term
Short-terminvestment+
investment+NetNetReceivables
Receivables
Current
CurrentLiabilities
Liabilities

• Formula : Current Assets – Stock .

Current liabilities
• Ideal level? 1:1
• The omission of stock gives an indication of the cash the
firm has in relation to its liabilities.
• e.g. a ratio of 3:1 would suggest the firm has 3 times as
much cash as it owes – very healthy!
• e.g. a ratio of 0.5:1 suggest the firm has twice as much
liabilities as it has cash to pay for those liabilities.
 Acid-Test (or Quick) Ratio
• The acid-test ratio (sometimes called the quick
ratio) tells us whether a company can pay all
its current liabilities if they come due
immediately.
Evaluating the Ability to Sell Merchandise Inventory
and Collect Receivables

• Five ratios that measure a company’s ability to

sell merchandise inventory and collect
receivables are:
– Inventory turnover
– Days’ sales in inventory
– Gross profit percentage
– Accounts receivable turnover ratio
– Days’ sales in receivables
 Ability to Sell Inventory and Collect Receivables

Inventory turnover Accounts receivable

• Measures number of turnover
times a company sells • Measures ability to collect
inventory during a year cash from credit
customers

.
Ability to Sell Inventory and Collect Receivables

Inventory Cost of Average

turnover goods sold inventory

The higher the

turnover, the quicker
it’s selling

Accounts Net credit Average

receivable sales accounts
turnover receivable
The higher the
turnover, the quicker
.
the collections
 Inventory Turnover
• The inventory turnover ratio measures the
number of times a company sells its average
level of merchandise inventory during a year.
 Ability to Sell Inventory

Inventory
Inventory turnover:
turnover:
Cost
Costof
ofgoods
goodssold
sold
Inventory
Inventoryturnover
turnover == Average
Averageinventory
inventorybalance
balance

• Shows how quickly the stock is being used/sold`.

• The quicker the stock turnover the better.
• e.g. stock turnover of 76 days tells us that the firm will
keep the stock for 76 days before it sells them all out.
• e.g. stock turnover of 4.8 times tells us that we have to
keep the stock for 4.8 times in a year.
• If our stock TO is not good hence we need to think of
strategies to improve it. For eg, do more promo,
give discounts, hold less stocks etc.
 Days’ Sales in Inventory
• Days’ sales in inventory measures the average
number of days merchandise inventory is held
by the company.
 Gross Profit Percentage GPM
• The gross profit percentage measures the
profitability of each net sales dollar above the
cost of goods sold.
 Ability to Collect Receivables
Receivables
Receivables (or
(ordebtors)
debtors) turnover:
turnover:
Net
Netcredit
creditsales
salesrevenue
revenue
Receivables
Receivablesturnover
turnover == Average
Averagereceivables
receivablesbalance
balance

• Debtors turnover calculated in times shows us how many times

per year does the debtor pays us.
• e.g. debtors turnover of 6 times tells us that we collected the
debts from debtors 6 times a year.
• in times a year: it is the more times the better.
• If our Debtor’s TO is not good hence we need to think of
strategies to improve it. For eg, tighten credit period, give early
payment discounts, have better screening for future debtors.
.
Accounts Receivable Turnover Ratio
• The accounts receivable turnover ratio
measures the number of times the company
collects the average receivables balance in a
year.
 Ability to Collect Receivables
Average
Average collection
collection period:
period:
365
365
Average
Averagecollection
collectionperiod
period== Receivables
ReceivablesTurnover
Turnover

• Debtors turnover calculated in days shows how long does

our debtors take to pay us.
• e.g. debtors turnover of 60 days tells us that the debtors
pays us in every 60 day
• in days: it is the shorter the better.
• If our Debtor’s TO is not good hence we need to think of
strategies to improve it. For eg, tighten credit period, give
early payment discounts, have better screening for future
debtors.
.
 Days’ Sales in Receivables
• Days’ sales in receivables indicates how many
days it takes to collect the average level of
receivables.
 Evaluating the Ability to Pay
Long-Term Debt
• Most businesses have long-term debt.
• Three key indicators of a business’s ability to
pay long-term liabilities are the:
– Debt ratio
– Debt to equity ratio
– Times-interest-earned ratio
 Ability to Pay Long-Term Debt

Debt ratio Times-interest-

• Shows portion of asset
financed with debt
• The higher the ratio, the
higher the risk
earned ratio
• Measures number of
times income can cover
interest expense
• High ratio indicates ease
in paying interest

.
 Ability to Pay Long-Term Debts

Total
Debt ratio Total assets
liabilities

Times
interest Operating Interest
earned income expense

.
 Ability to Pay Long-Term Debts
Debt
Debt ratio:
ratio:
Total
TotalLiabilities
Liabilities
Debt
Debtratio
ratio == Total
TotalAssets
Assets

• Compares the total liabilities to total assets.

• Concerns whether the firm has sufficient assets to meet
all its liabilities when due.
• e.g. debt to asset ratio of 44.8% shows that 44.8% of the
total assets were financed by the liabilities.

.
 Debt Ratio
• The debt ratio shows the proportion of assets
financed with debt and is calculated by
dividing total liabilities by total assets.
 Debt to Equity Ratio
• The debt to equity ratio shows the proportion
of total liabilities relative to total equity.
• This ratio measures financial leverage.
 Times-Interest-Earned Ratio
• The times-interest-earned ratio evaluates a
business’s ability to pay interest expense. This
ratio is also called the interest coverage ratio.
 Evaluating Profitability
• Five ratios used to evaluate a company’s
profitability are:
– Profit margin ratio
– Rate of return on total assets
– Asset turnover ratio
– Rate of return on common stockholders’ equity
– Earnings per share
 Measuring Profitability

Return on net sales Return on total assets

(Net profit margin) • Measures success in using
• Percent of each sales dollar assets to earn a profit
earned as net income

Return on common Earnings per share

stockholders’ equity • Net income earned for
• How much income is each common (ordinary)
earned for dollar invested share
by common shareholders
 Measuring Profitability

Return on
Net income Net sales
sales

Net income + Interest expense

Return on
assets
Average total assets
 Measuring Profitability

Return on
Net income – Preferred dividends
equity

Average ordinary shares

Earnings per Net income – Preferred dividends

share

Number of ordinary shares outstanding

 Measuring Profitability

Return
Return on
on Sales
Sales (Net
(Net Profit
Profit Margin):
Margin):
Net
NetIncome
Income xx100
100
Return
Returnon
onSales
Sales == NetNetSales
Sales

• Net profit takes into account the fixed costs

involved in production – the expenses or
overheads.
• e.g. a net profit margin of 11.75% means that for
every RM1 of sales, the firm makes RM0.1175 net
profit
 Profit Margin Ratio
• The profit margin ratio shows how much net
income a business earns on every $1 of sales.
 Rate of Return on Total Assets
• The rate of return on total assets measures a
company’s success in using assets to earn a
profit.
 Asset Turnover Ratio
• The asset turnover ratio measures the amount
of net sales generated for each average dollar
of total assets invested.
 Measuring Profitability
Return
Return on
on common
common stockholders’
stockholders’equity:
equity:
Return
Returnon
on Net
NetIncome
Income––Preference
Preferencedividends
dividends
equity
equity == Average
Averageordinary
ordinaryshares
shares

• The higher the better.

• Shows how effective the firm is in using its capital to
generate profit.
• It is part of the measure of efficiency in the firm and use of
capital.
• e.g. a ROCE of 31.8% means that the company uses RM1 of
capital to generate RM0.32 in profit to the shareholders.
 Rate of Return on Common Stockholders’
Equity
• The rate of return on common stockholders’
equity shows how much income is earned for
each $1 invested by the common
shareholders.
 Rate of Return on Common Stockholders’
Equity
• When a company has a higher rate of return
on stockholders’ equity than its rate of return
on total assets, this is called trading on the
equity.
• Trading on the equity is earning more income
on borrowed money than the related interest
expense, thereby increasing the earnings for
the owners of the business.
 Measuring Profitability
Earnings
Earnings per
pershare:
share:
Net
NetIncome–
Income–Preference
Preferencedividends
dividends
EPS
EPS == No.
No.of
ofordinary
ordinaryshares
sharesoutstanding
outstanding

EPS is important because it is becoming common to express the

profit in this form rather than large dollar amounts.
 Earnings per Share (EPS)
• The earnings per share (EPS) reports the
amount of net income (loss) for each share of
the company’s outstanding common stock.
 Evaluating Stock as an Investment
• Investors purchase stock to earn a return on
their investment.
• This return consists of two parts:
– Gains (or losses) from selling the stock at a price
above (or below) purchase price
– Dividends
 Analyzing Stock Investments

Price/earnings Dividend yield

ratio (P/E) • Percent of market
• Market price value that is
compared to EPS returned as
dividends
 Analyzing Stock Investments

Market price Earnings per

P/E ratio
per share share

Dividend Dividends Market price

yield per share per share
 Analyzing Stock Investments
Price-earnings
Price-earnings ratio:
ratio:
Market
Marketprice
priceper
pershare
share
P/E
P/Eratio
ratio == Earnings
Earningsper
pershare
share

Dividend
Dividend yield
yield ratio:
ratio:
Dividend
Dividendper
pershare
share
Dividend
Dividendyield
yield == Market
Marketprice
priceper
pershare
share
 Price/Earnings Ratio
• The price/earnings ratio is the ratio of the
market price of a share of common stock to
the company’s earnings per share.
 Dividend Yield
• The dividend yield measures the percentage
of a stock’s market value that is returned
annually as dividends to shareholders.
 Dividend Payout (extra ratio)
• The dividend payout measures the percentage
of earnings paid annually to common
shareholders as cash dividends.
 Questions addressed by Analysis

• How efficient is the business?

• Asset management

• Financing issues

• Share market performance

• Solvency questions (short & long-term)

Hence if abnormality pops up, it will be flagged.

Red Flags in Financial Statement Analysis
• Analysts look for red flags in financial
statements that may signal financial trouble.
Examples:
– Movement of sales, merchandise inventory, and
receivables
– Earnings problems
– Decreased cash flow
– Too much debt
– Inability to collect receivables
– Buildup of merchandise inventories
Limitations of Financial Ratios
There are some important limitations of financial ratios that we must
understand:

• Inflation may have badly distorted a company's balance sheet.

In this case, profits will also be affected. Thus a ratio analysis of
one company over time or a comparative analysis of companies
of different ages must be interpreted with judgment.
• A company may have some good and some bad ratios, making
it difficult to tell if it's a good or weak company.
• It is difficult to generalize about whether a ratio is good or not.
A high cash ratio in a historically classified growth company
may be interpreted as a good sign, but could also be seen as a
sign that the company is no longer a growth company and
should command lower valuations.
Limitations of Financial Ratios (continued)

• Different accounting practices can distort comparisons even

within the same company (leasing versus buying equipment,
LIFO versus FIFO, etc.).
• Many large firms operate different divisions in different
industries. For these companies it is difficult to find a
meaningful set of industry-average ratios.
• Seasonal factors can also distort ratio analysis. Understanding
seasonal factors that affect a business can reduce the chance
of misinterpretation. For example, a retailer's inventory may
be high in the summer in preparation for the back-to-school
season. As a result, the company's accounts payable will be
high and its ROA low.
Summary of Ratios Used
Summary of Ratios Used
 Summary of Ratios Used in
Financial Statement Analysis
 Tutorial Questions
 
Short Exercises Questions: S17-2, S17-3,
S17-4
 
Exercises: E17-20, E17-21, E17-22
 
Problems: P17-30A (req 1), P17-31A,
P17-32A

Add Q: 1 & 2
0102723912 Gregory
01128188585
See you next lecture
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