CHAPTER 3

Evaluation of Financial
Performance

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 What is Financial Analysis?
1. Assessment of a firm’s past, present
and anticipated future performance.
2. Analysis is based on the firm’s
financial statements.
3. Focus on historical performance to
estimate future performance.
4. Allows comparison of company’s
performance over time as well as its
performance relative to its
competitors.
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 Objectives of Financial Analysis
• To identify the firm’s strengths and
weaknesses so that the company
can capitalize these strengths and
take remedial and corrective
actions to improve its weaknesses.

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 FINANCIAL RATIOS
1. Mathematical aids for evaluation and
comparison of financial performance.
2. Computed based on the firm’s financial
statements.
3. Look at the relationship between individual
values and relate them to how a company has
performed in the past and might perform in the
future
4. Standardized financial information to facilitate
meaningful comparison.
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 Objectives of Ratio Analysis
1. To standardize financial information for
comparison purposes
2. To evaluate the firm’s current operation
3. To compare present performance with
past performance
4. To compare the firm’s performance with
other firms or industry standards.
5. To assess the efficiency of operations
6. To assess the risk of operations.

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 Types of Comparisons
1. Internal Comparison – analysis based
on comparisons of similar ratios for
the same firm at different periods. It
is also known as time series analysis.
2. External Comparison – involves
comparison of ratios of a firm with
ratios of other firms in similar
industry. This is also known as inter-
firms comparison or cross-sectional
analysis.

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 Users of Financial Statements
• Shareholders
• Managers
• Creditors
• Current and future employees
• Prospective investors
• Customers
• Government

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 Types of Ratios
1. Liquidity ratios
2. Efficiency ratios
3. Leverage ratios
4. Profitability ratios
5. Market ratios

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 Types of Ratios
1. Liquidity ratios
1. Current ratio
2. Acid Test Ratio

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 Types of Ratios
1. Liquidity ratios
 Show a firm’s ability to meet its short-
term financial obligations.
 The ratios compare the firms’ total
current assets with total current
liabilities.

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Types of Ratios

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Types of Ratios

Evaluation of Financial 12
Performance
 Types of Ratios
1. Current Ratio
= Current Assets
Current Liabilities
= 1,270
875
= 1.45 times

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 Liquidity Ratios
1. Show a firm’s ability to meet its short-
term financial obligations.
2. Two commonly used liquidity ratios:
a) Current Ratio
b) Quick Ratio or Acid Test Ratio
3. CR= CA/CL. It indicates the extent to
which current liabilities are covered by
current assets

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 Liquidity Ratios
4. A CR of 2X means that the firm has RM2 in
current assets for every RM1 in current
liabilities. It indicates that the firm has no
problem paying its current obligations on
time.
5. The ideal ratio of 2 times cannot be applied
to all companies because different types of
industry have different types of asset
requirements, and have different proportion
of current assets and current liabilities
6. It is most commonly used as a measure of
short-term solvency.

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 Liquidity Ratios
7. One drawback of current ratio is that
inventory may include many items that
are difficult to liquidate quickly and that
have uncertain liquidation values.
8. An alternative measure of liquidity is to
use quick ratio or acid test ratio.
9. QR = CA – Inventory – Prepayment
CL
10.QR indicates whether a firm has enough
CA to cover CL without selling inventory

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 Liquidity Ratios
11. Inventory is deducted because it
generally takes longer time to be
converted into cash. Prepaid expenses is
also deducted because they are expenses
that the firm has paid in advance and
cannot be used to pay obligations when
they come due.
12. Companies with quick ratio of less than 1
will not be able to pay its immediate
obligation and therefore should be looked
at with caution.

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 Causes for Liquidity Problem
1. Company is holding too much
stocks
2. Poor debtors’ collection system
3. Poor cash management
4. Company is using short-term
sources of financing to finance the
purchase of long-term assets

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Suggestions to Improve Liquidity
Position
1. Promote cash sales
2. Give cash discounts
3. Give discounts to encourage early payments
4. Improve collection system.
5. Adopt effective stock control system
6. Invest in marketable securities to earn income
7. Reduce current liabilities by paying off the
existing creditors or use long-term sources of
financing
8. Adopt hedging principle in financing the firm’s
assets.

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 Efficiency Ratios
1. Also referred as asset management ratios or
asset utilization ratios
2. Measure how effectively a firm is managing its
assets in generating sales.
3. Also show the firm’s efficiency in collecting
debts as well as turning its stocks into sales.
4. Comprised of:
1. Inventory Turnover ratio
2. Average Collection Period
3. Non-Current (Fixed Asset) Turnover
4. Total Asset Turnover

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 Inventory Turnover Ratio
1. ITR = Cost of Goods Sold
Average/Closing stocks
2. It indicates how many times the stock is sold
and replaced in a year.
3. The higher the ratio, the faster the stock is
being sold.
4. ITR can be expressed in terms of number of
days, and referred to as the inventory
conversion period. This can be calculated by
dividing 360 days by the inventory turnover.
5. An ITR of 6 times means an inventory
conversion period of 360 days/6 = 60 days. It
implies that the firm is able to sell the
inventories within 60 days.

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 Possible Causes of Poor Inventory
Turnover
1. Holding too much stock, that is
overstocking.
2. Large portion of stock consists of old or
obsolete stocks, or damaged stocks which
may be the result of poor stock control
system
3. Lack of sales promotion lead to lower sales
4. The firm do not provide trade discounts to
encourage bulk purchase
5. Firm’s pricing policy which affect the
demand for the firm’s products.
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 Suggestions for Improving
Inventory Turnover
1. If the company is overstocking, evaluate
stock control system & introduce a more
effective system or change its present
method of ordering stocks.
2. Cut down on slow-moving and obsolete
stocks by having stock clearance sales
3. Determine degree of competition,
whether the product is price elastic or
not

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 Average Collection Period
1. Also called “ Days sales outstanding”
2. Indicates the number of days taken by a
firm to collect its accounts receivable.
3. Reflects the company’s credit policy
whether they are loose or strict.
4. Shows the firm’s effectiveness and
efficiency in extending credit and
collecting debts.
5. The shorter the ACP, the more efficient
the company is in debt collection. It may
also indicate that the company is
operating on a cash basis.

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 Average Collection Period
6. ACP = Accounts Receivable
Annual Credit Sales / 360
• A ACP of 40 days means that the firm took 40
days to collect cash from their debtors.
• It can also be expressed as a number of times
and referred to as a Receivable Turnover
ratio.
• Receivables Turnover = 360
ACP
7. A Receivable Turnover of 4 times imply that
the firm is able to collect its debt within 90
days.
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Possible Causes of Poor Average
Collection Period
1. Lax or loose credit policy
2. Poor screening
3. No ageing of customers’ accounts
4. No reminders and follow up for late
payment
5. Not enough cash discounts given to
encourage early payments

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Suggestions to Shorten Average
Collection Period
1. Adopt a tighter collection policy
2. Prepare ageing of debtors’
accounts
3. Screen new customers before
allowing them credit sales
4. Offer cash discounts to encourage
early payments.

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 Fixed Assets Turnover & Total Asset
Turnover
1. FAT = Sales/ Net Fixed Assets
2. TAT = Sales / Total Assets
3. Measures firm’s efficiency in utilizing its
property, plant and equipment in
generating sales.
4. A higher ratio indicates that a firm is
generating a higher volume of sales with
the given amount of assets.
5. A lower ratio than the industry indicates
that a company should increase its sales or
disposed some of its assets.
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 Possible Causes of Low FAT & TAT &
Suggestions for Improvement
1. Under utilization of fixed assets which may be
due to too much investment in fixed assets
and current assets and inefficient use of these
assets to produce sales.
2. Insufficient sales
Suggestions for improvement:
1. Increase production
2. Dispose of idle fixed assets
3. Review selling price, implement aggressive
sales promotion or give trade discounts

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 Leverage Ratios
1. Also referred as Debt Management ratios
or Gearing ratios.
2. Leverage refers to the use of borrowed
capital or loans.
3. Measures the level of debt or borrowings
in a firm.
4. Highlight the ability of the firm to pay its
principal and interest charges.
5. Comprised of:
1. Debt ratio
2. Debt-to equity ratio
3. Times interest earned

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 Debt Ratio
1. DR = Total debt
Total assets
2. It measures how much debt is used
to finance the firm’s assets
3. Total debt comprises both current
liabilities and long-term debt.
4. Creditors prefer low debt ratios
because it reduces the potential
loss that may occur in the event of
liquidation.
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 Debt Ratio
5. The owners may want more
leverage because it magnifies
earnings.
6. A debt ratio of 55% means that
the creditors have supplied more
than half the firm’s total
financing.
7. If a company’s debt ratio is
significantly higher than industry
ratio, it would experience difficulty
in raising additional borrowings.
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 Debt-to-Equity Ratio
• Debt/Equity ratio = Total Debt
Total Equity
• Measures the percentage of
borrowing used compared to equity

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 Times Interest Earned (TIE)
1. Also referred as “Interest
Coverage” ratio
2. Ratio of EBIT to interest expenses.
(EBIT/Interest expense)
3. Measures the ability of the firm to
meet its annual interest payments.
4. The higher the ratio, the higher is
the firm’s ability to fulfill its interest
obligations.
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Possible Causes of High Leverage
& Suggestions for Improvement
• Causes:
1. High borrowings due to high dividend
policy
• Suggestions:
1. Review dividend policy
2. Finance capital investment from
retained earnings
3. Have optimum mixture in its sources
of financing
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 Profitability Ratios
1. Measures how effective the firm uses its
assets to make profit.
2. Shows the combined effects of liquidity,
assets management and debt
management on operating results.
3. Also indicate the firm’s efficiency in
controlling costs and the pricing policy of
the firm
4. It shows the profits earned for every RM
of sales made or the profits earned per
RM of investments in assets.

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 Profitability Ratios
5. Comprised of:
1. Gross Profit Margin
2. Operating Profit Margin
3. Net Profit Margin
4. Return on Assets
5. Return on Equity

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 Gross Profit Margin
1. A measure of the gross profit earned on
sales.
2. GPM = Sales – Cost of Goods Sold
Sales
3. GPM is the percentage of sales remaining
after deducting the cost of sales.
4. A GPM of 30% means that the company is
making 30 sen gross profit for every RM1 of
sales made.
5. A high GPM reflects good earning potential.
It also shows the efficiency of the company
in controlling its costs of goods sold and the
pricing policy implemented.
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 Possible Causes of Low GPM &
Suggestions for Improvement
• Causes:
– Insufficient sales volume due to high selling
price or higher costs of goods sold
– Higher costs of goods sold may be due to
expensive sources in supply of goods, higher
labor costs and high production wastages.
• Suggestions:
– Review pricing policy
– Reduce cost of goods sold by changing
supplier
– Reduce labor cost and production wastage

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 Operating Profit Margin
1. Operating profit is also referred to
Earnings Before Interest and Tax.
2. Percentage of sales remaining after
deducting all costs and expenses
excluding interest and tax from sales.
3. OPM = EBIT/Sales
4. The higher the operating profit margin,
the higher is the profitability of the
company.

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 Possible Causes of Lower Operating
Margins & Suggestions for
Improvement
• Causes:
1. Lower gross profit margin
2. High operating expenses.
3. Lower selling price
• Suggestions:
1. Reduce cost of goods sold
2. Reduce operating expenses
3. Review selling price

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 Net Profit Margin
1. NPM= Net Income Available to CS
Sales
2. Net Income available to common
shareholders refers to net profit
after tax minus preferred dividend.
If there is no preference shares, the
net income available to common
shareholders is equal to net income
after tax.
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Causes of Low Net Profit Margin
& Suggestions for Improvement
• Causes:
1. High operating expenses
2. High interest charges
• Suggestions:
1. Reduce operating expenses
2. Review financing strategies

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 Return on Assets (ROA)
1. Is also known as Return on
Investment (ROI)
2. Indicates management’s ability to
make profits from the firm’s
investment is assets.
3. ROA = Net Income Available to Common Shareholders
Total Assets

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 Return on Equity (ROE)
1. Measures the profit earned by the
common shareholders from their
investment in the company.
2. The higher the ROE, the better the
return for the shareholders.
3. ROE = Net Income Available to Common Shareholders
Common Equity

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 Market Ratios
1. Also called “Investors” ratios.
2. Relate a firm’s stock price to its earnings and
book value per share.
3. Indicate what investors think of the company’s
past performance and future prospects.
4. Measures the investors’ perception and
judgment towards the firm’s growth potential
5. Comprised of:
1. Earnings per share
2. Dividend per share
3. Dividend payout ratio
4. Price/earnings ratio
5. Dividend Yield
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 Earnings Per share (EPS)
1. It indicates the profit earned per unit of
issued share.
2. EPS = NI Available to Common Shareholder
Number of Ordinary Shares
Issued
3. A higher value indicates a higher profit
per share.

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 Dividend Per Share
1. It indicates the amount of dividend
received by ordinary shareholders for
each unit of ordinary shares held.
2. Dividend per share = Dividend
Number of Ordinary shares
issued

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 Dividend Payout Ratio
1. Indicates the proportion of earnings that is
distributed as dividends to shareholders
2. Dividend payout ratios for high growth
companies are usually lower because most of
the profits made are spent on reinvestment
and expansion
3. Companies will try to maintain a stable
dividend payout ratio.
4. Dividend payout ratio = Dividend per share
Earnings per
share

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 Price/Earnings ratio (P/E)
1. Compares the current market price with
earnings to establish whether a stock is
over or under valued.
2. Shows how much investors are willing to
pay for the company’s earnings
3. Measures the investors’ confidence in the
firm’s future prospects.
4. P/E ratio = Market price per share
Earnings per share

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 Dividend Yield (DY)
1. Used to indicate the return earned on
shares
2. Compares the dividend per share
received by the shareholders with the
current market price.
3. DY = Latest annual dividend
Current Market Price per share

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 Common Size Ratios
1. Also known as vertical analysis
2. Can be prepared from both income statement
and balance sheet
3. Each item on the financial statement is
calculated as percentage of the total.
4. Allows companies to compare performance from
period to period as well as from company to
company regardless of the size of the company.
5. To study trends with its own past financial
statements.
6. The objective is to understand why changes
have occurred and what to do in response.

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 DU PONT Analysis
1. Act as a search technique , aimed at finding the
key areas responsible for the firm’s financial
condition
2. Used to analyze a firm’s profitability and ROE
3. Allows management to view more clearly what
determines or influences ROE and the
interrelationship between net profit margin,
asset turnover and debt ratio.
4. Breaks down ROE into 3 parts, that is, profit
margin, total assts turnover and financial
leverage.
5. ROE = NP margin x Total Asset turnover
(1 – Debt ratio)

= ROA/(1- Debt ratio)

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 Du Pont Analysis
6. ROE = ROA x Total Assets
Total Equity
7. ROE = ROA x Equity Multiplier

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 Equity Multiplier
• Measures a firm’s total assets per RM of
shareholders’ equity.
• Equity Multiplier = Total Assets
Total shareholders’ equity
• Indicates how a company uses debt in
asset financing
• A higher equity multiplier means higher
financial leverage

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How to Improve the Firm’s ROE
1. Increase sales without a disproportionate
increase in costs and expenses
2. Reduce the firm’s COGS or operating
expenses
3. Increase sales relative to the asset base or
decrease the amounts invested in the
company’s assets
4. Increase the use of debt relative to equity,
but only to the extent that it does not
jeopardize the firm’s financial position.

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Advantages of DU PONT Analysis
• Makes it possible to assess all aspects of the
firm’s activities in order to isolate key areas
of responsibility
• Allows management to view more clearly
what drives the ROE
• Provides management with a road map to
follow in assessing their effectiveness in
managing the firm’s resources so as to
maximize the return earned on owners’
investment.

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 Limitations of Financial Ratios
1. Comparison with industry averages is difficult
for conglomerates
2. Average performance as shown in the industry
averages may not be desirable
3. Seasonal factors can also distort ratios
4. Inflation distorts the firm’s financial
statements
5. Different operating and accounting practices
make comparison difficult
6. It is sometimes difficult to conclude whether a
ratio is good or bad.
7. It is difficult to conclude whether a firm’s
overall performance is good or bad.
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