Chapter 2

3
Financial Statement Analysis

Learning Outcomes
At the end of this chapter, you should be able to:

 Explain the purpose and importance of financial analysis
 Calculate and use a comprehensive set of
measurements to evaluate a firm’s performance
 Describe the limitations of financial ratio analysis
Financial Management Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 3– 3
Introduction
 Knowledge of financial statements and the

techniques in analysing financial statements is
desirable towards enabling one to make optimal
financial decisions that can have future impact on
the actions and direction of a firm.
 However, some form of restatement,
computations and analysis may be required
before information may be obtained from the
financial statements.

Financial Analysis and Financial
Ratios
 Financial analysis is the use of financial statements to
analyse a firm’s financial position and its
performance.
Questions:
 Does a firm have the resources to succeed and grow?
 Does it have adequate resources to invest in new projects?
 What are its sources of profitability?
 Did the earnings of the firm meet its forecast earnings?
 What are the sources of a firm’s future earnings power?

Financial Ratios
 Financial ratio analysis employs relative rather

than absolute concepts.
 Financial ratios help readers to identify the
financial strengths and weaknesses of a firm.
 Financial ratios are classified into:
- Profitability ratios
- Liquidity ratios
- Leverage ratios
- Efficiency ratios
- Market ratios
ABC Bhd
Income Statement for the year ended
31 December 2016

ABC Bhd
31 December 2016 (cont.)

ABC Bhd
31 December 2016 (cont.)

Benefits of Ratios
 Helpful in Decision Making

 Helpful in Financial Forecasting and Planning
 Helpful in Communication
 Helpful in Co-ordination
 Helps in Control
 Helpful for Shareholder’s decisions
 Helpful for Creditors’ decisions

Profitability Ratios
 Analyses the ability of management to generate

adequate profits from use of firm’s capital and
assets.
 Profitability ratios determine a firm’s bottom line.
Important ratios:
 Gross profit margin
 Operating profit margin
 Net profit margin (before or after tax)

Profitability Ratios (cont.)






Liquidity Ratios
 Measures the extent to which a firm has adequate

cash flows or liquid assets to meet the short-term
liabilities of the firm:
- Current ratio
- Acid Test Ratio (Quick Ratio)
- Inventory Turnover Ratio
- Accounts Receivables Turnover Ratio
- Accounts Payables Turnover Ratio

Current Ratio and Acid Test
Ratio (Quick Ratio)
Current assets
 Current ratio =
Current liabilities
 This ratio indicates the extent of a firm’s liquidity, as
measured by the firm’s liquid assets (current assets)
relative to its liquid liabilities (current liabilities).
Current assets  inventory

 Acid test ratio =
Current liabilities
 A more stringent version of liquidity ratio
 Acid test ratio measures the ratio of current assets (less
stock) to current liabilities.
Current Ratio and Acid Test
Ratio (Quick Ratio) (cont.)
1,182,000
 Current ratio = = 1.25 times
944,000
1,182,000  435,000
 Acid test ratio = = 0.791 times
944,000

Inventory Turnover Ratio
cost of goods sold

 Inventory turnover ratio =
stocks
 Inventory turnover ratio = 2,482,000 = 5.7 times

435,000
 Inventory turnover days = stocks
= 365 days
cost of goods sold
 Inventory turnover days = 435,000 = 63.97 days
× 365
2,482,000
 Indicates the relative liquidity of stocks in a firm

Accounts Receivables
Turnover Ratio
 Indicates how long it takes for a firm to collect its receivables
Credit sales
 Accounts receivables turnover ratio =
Trade debtors
3,393,000
 Accounts receivables turnover ratio = = 7.7 times
441,000
 Accounts receivables turnover days = Trade debtors × 365 days

Credit sales
 Accounts receivables turnover days = 441,000 × 365
3,393,000
= 47.44 days

Accounts Payables Turnover
Ratio
 Indication of the extent of how quick the cash outflows are in

a firm
Credit purchases
 Accounts payables turnover ratio =
Trade creditors
2,482,000
 Accounts payables turnover ratio = = 7.3 times
343,000
 Accounts
Accounts payables
payables turnover days = ×365 days
Credit purchases
 Accounts payables turnover days = 343,000 ×365 =

50.44 days 2,482,000
Leverage Ratios
 Investigate how a firm is being financed and provide

indicators as to the extent a firm is able to meet the
interest payments
Questions:
 What is the relative ratio between the use of debt versus
equity to finance a firm’s assets?
 Has the firm used too much debt?
 Is the firm earning sufficiently to meet the interest
liabilities?
Important ratios:
 Debt ratio
 Interest cover ratio

Debt Ratio
Total liabilities
 Debt ratio = (1st formula)
Total assets
4,555,000
 Debt ratio = = 0.839 or 83.9%
5,426,000
 Indicates that slightly more than 83% of the firm’s total
assets is financed using debt (long- and short-term debt)
 Debt ratio = Total long-term borrowings (2nd formula)

Total equity
 Debt ratio = 3,800,000 = 4.36 or 436%
871,000
Interest Cover Ratio
Earnings before interest and tax

 Interest cover ratio =
Interest expense
272,000
 Interest cover ratio = = 3.63 times
75,000
 Firm has earnings before interest and tax that currently

covers up to 3.63 times its existing interest expense.
 Firm may still be able to take on further borrowings

Efficiency Ratios
 Efficiency ratios measure the extent to which a

firm is able to earn sufficient earnings and returns
to its investors (providers of finance).
 Earnings per share (EPS)
 Return on capital employed (ROCE)
 Return on assets (ROA)
 Return on equity (ROE)

Earnings Per Share
 Earnings per share =

Earnings attributable to ordinary shareholders
× 100 sen
Number of ordinary shares in issue
Earnings per share = 171,000

 × 100 = 34 sen
500,000
 For every one ordinary share held by shareholders,
ABC Bhd has earned 34 sen of income, which may be
either distributed to ordinary shareholders as dividends
or be kept in the firm as retained earnings, but still
belong to the ordinary shareholders.
Return on Capital Employed
(ROCE)
 Return on capital employed =
Earnings before interest and tax (EBIT)
× 100%
Capital employed
 Where capital employed = Long-term debt + Equity
 Return on capital employed = 272,000 × 100 = 6.32%

4,306,000
 Assessment of the level of efficiency of the management of
ABC Sdn Bhd:
For every RM1 of funding provided to the management of
ABC Bhd, the firm is able to earn a return of RM0.0632
annually on average.
Return on Assets (ROA)
 Return on assets = Profit after tax

× 100%
Total assets
 Total assets = Non current assets + Current assets
Return on assets = 171,000

× 100 = 3.15%

5,426,000
 Assessment of the level of efficiency of the management
of ABC Sdn Bhd:
For every RM1 of assets that is made available to the
firm or that the firm invests in, the management of ABC
Bhd is able to generate a return after tax of RM0.0315.

Return on Equity (ROE)
 Return on equity = Profit after tax

× 100%
Total shareholders' equity
 Return on ordinary equity =
Earnings attributable to ordinary shareholders
× 100%
Total shareholders' equity  Preference shares
 Return on equity = 171,000 = 19.63%
× 100%
871,000
 Return on ordinary equity =
171,000
× 100% = 19.63%
871,000
Market Ratios
 Market ratios are ratios that are based on the

market price of a firm’s share
 Price earnings ratio (P/E)
 Market-to-book ratio

Price Earnings Ratio (P/E)
Price per share

 P/E ratio =
Earnings per share
 P/E ratio = 350 = 10.29

34
 ABC Bhd’s shares currently sell for 10.29 times its
earnings.
 Generally, firms with high P/E ratios are generally taken
as firms with bright future prospects.

Market-to-Book Ratio
Price per share

 Market-to-book ratio =
Book value per share
871,000
 Book value per share = = 1.74
500,000
3.50
 Market-to-book ratio = = 2.01
1.74
 Market-to-book ratio compares the market price of a
firm’s shares relative to the historical cost of the shares.

DuPont Analysis
 Using the ‘Decomposed Formula’

 Basic formula is return on assets =
Profit after tax × Sales

Sales Total assets
Total assets
Return on equity = Return on assets ×
Equity
Profit tax Sales Total assets

= × ×
Sales Total assets Equity

DuPont Model – Further
Comments

Time Series Analysis
 Comparison between the firm’s current year

ratios with the same ratios of the corresponding
previous years
 Ascertain whether the firm’s situation has:
1. Improved
2. Worsened
3. Stayed the same
between one year and the subsequent year(s).

Time Series Analysis (cont.)
 Suppose ABC Bhd’s current ratio for the last

five years were as follows:
Year Current ratio
2012 5.32
2013 3.20
2014 2.56
2015 1.98
2016 1.61

Cross-sectional Analysis
 Comparison between the firm’s results and the results

of:
(a) Other firms in the same industry
(b) Other firms in other industries
 Users may then judge whether the firm has
outperformed or lagged behind against its competitors

Limitations of Ratios
 Difficulties in identifying suitable industry category to

classify a firm—firm may be involved in many different
activities (how to identify similar firms?)
 Effects of inflation ignore—can distort figures
 Accounting practices may differ between firms,
complicating comparisons of results between firms
 Results may be distorted if there exist changes in
accounting standards, resulting in changes in the
presentation of financial results

Limitations of Ratios (cont.)
 Firms may experience seasonality in their performance.

 An industry average may not be the desired target or
the norm, since industry averages represent averages
that includes the results of both good and bad
performing firms. Hence, one should seek to compare
against the ‘best in the class’.
 Progress of firm needs to be set in the context of what
other firms have done, and whether there exist
exceptional or special circumstances or environmental
or economic influences that impact firms’ performances.


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3

Financial Statement Analysis

At the end of this chapter, you should be able to:

Financial Management Third Edition All Rights Reserved

 Knowledge of financial statements and the

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Financial ratio analysis employs relative rather

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Helpful in Decision Making

Financial Management Third Edition All Rights Reserved

 Analyses the ability of management to generate

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Measures the extent to which a firm has adequate

Financial Management Third Edition All Rights Reserved

Current assets  inventory

Financial Management Third Edition All Rights Reserved

cost of goods sold

 Inventory turnover ratio = 2,482,000 = 5.7 times

Financial Management Third Edition All Rights Reserved

 Accounts receivables turnover days = Trade debtors × 365 days

Financial Management Third Edition All Rights Reserved

 Indication of the extent of how quick the cash outflows are in

 Accounts payables turnover days = 343,000 ×365 =

 Investigate how a firm is being financed and provide

Financial Management Third Edition All Rights Reserved

 Debt ratio = Total long-term borrowings (2nd formula)

Earnings before interest and tax

 Firm has earnings before interest and tax that currently

 Firm may still be able to take on further borrowings

Financial Management Third Edition All Rights Reserved

 Efficiency ratios measure the extent to which a

Financial Management Third Edition All Rights Reserved

 Earnings per share =

Earnings per share = 171,000

 Return on capital employed = 272,000 × 100 = 6.32%

 Return on assets = Profit after tax

Return on assets = 171,000

Financial Management Third Edition All Rights Reserved

 Return on equity = Profit after tax

 Market ratios are ratios that are based on the

Financial Management Third Edition All Rights Reserved

Price per share

 P/E ratio = 350 = 10.29

Financial Management Third Edition All Rights Reserved

Price per share

Financial Management Third Edition All Rights Reserved

 Using the ‘Decomposed Formula’

Profit after tax × Sales

Profit tax Sales Total assets

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Comparison between the firm’s current year

Financial Management Third Edition All Rights Reserved

 Suppose ABC Bhd’s current ratio for the last

Financial Management Third Edition All Rights Reserved

 Comparison between the firm’s results and the results

Financial Management Third Edition All Rights Reserved

 Difficulties in identifying suitable industry category to