Chapter 2:

Evaluation of Financial
Performance

Analysis of Financial Performance:

Financial Ratios Analysis

Evaluation of Financial 1
Performance
 Key Financial Statements

• Statement of Profit or Loss and Other

Comprehensive Income

• Statement of Financial Position

• Statement of Changes in Equity

• Cash Flow Statement

Evaluation of Financial 2
Performance
 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.
Evaluation of Financial 3
Performance
 Objectives of Financial Analysis
• To identify the firm’s strengths and
weaknesses
• The company can capitalize these
strengths and take remedial and
corrective actions to improve its
weaknesses.

Evaluation of Financial 4
Performance
 FINANCIAL RATIOS
1. Mathematical aids for evaluation and
comparison of financial performance.
2. 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
3. Standardized financial information to facilitate
meaningful comparison.

Evaluation of Financial 5
Performance
 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.

Evaluation of Financial 6
Performance
 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
(competitor). This is also known as inter-
firm or cross-sectional analysis.

Evaluation of Financial 7
Performance
 Users of Financial Statements
• Shareholders
• Managers
• Creditors
• Current and future employees
• Prospective investors
• Customers
• Government

Evaluation of Financial 8
Performance
 Types of Ratios
1. Liquidity ratios
2. Efficiency ratios
3. Leverage ratios
4. Profitability ratios
5. Market ratios

Evaluation of Financial 9
Performance
 Liquidity Ratios
1. Show a firm’s ability to meet its short-
term financial obligations.
2. Two commonly used liquidity ratios:
a) Current Ratio (CR)
b) Quick Ratio (QR)/Acid Test Ratio
3. CR= Current assets/ current liabilities
(CA/CL). It indicates the extent to which
current liabilities are covered by current
assets

Evaluation of Financial 10
Performance
 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 measure of short-
term solvency.

Evaluation of Financial 11
Performance
 Liquidity Ratios
7. One drawback of current ratio is that
inventory may include as part of the
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
Evaluation of Financial 12
Performance
 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.

Evaluation of Financial 13
Performance
 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

Evaluation of Financial 14
Performance
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; temporary assets use short term, permanent
assets use long term financing

Evaluation of Financial 15
Performance
 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. Fixed Asset Turnover
4. Total Asset Turnover

Evaluation of Financial 16
Performance
 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.

Evaluation of Financial 17
Performance
 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.

Evaluation of Financial 18
Performance
 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

Evaluation of Financial 19
Performance
 Average Collection Period
1. Also called “ Days sales outstanding”
(DSO)
2. 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 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.

Evaluation of Financial 20
Performance
 Average Collection Period
6. ACP = Accounts Receivable x 360 days
Annual Credit Sales
• 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
10. A Receivable Turnover of 4 times imply that
the firm is able to collect its debt within 90
days.
Evaluation of Financial 21
Performance
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. No enough cash discounts given to
encourage early payments

Evaluation of Financial 22
Performance
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.

Evaluation of Financial 23
Performance
 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.
Evaluation of Financial 24
Performance
 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:
3. Increase production
4. Dispose of idle fixed assets
5. Review selling price, implement aggressive
sales promotion or give trade discounts

Evaluation of Financial 25
Performance
 Leverage ratios
1. Also referred as Debt Management ratios
or Gearing ratios.
2. Measures the level of debt or borrowings
in a firm. (The use of borrowed capital or
loans.)
3. Highlight the ability of the firm to pay its
principal and interest charges.
4. Comprised of:
1. Debt ratio
2. Debt-to equity ratio
3. Times interest earned

Evaluation of Financial 26
Performance
 Debt ratio
1. DR = Total debt x 100
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.
Evaluation of Financial 27
Performance
 Debt ratio
5. The owners may want more
leverage because it increase
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.

Evaluation of Financial 28
Performance
 Debt-to-Equity Ratio
• Debt/Equity ratio= Total Debt x 100
Total Equity
• Measures the percentage of
borrowing used compared to equity

Evaluation of Financial 29
Performance
 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.
Evaluation of Financial 30
Performance
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
Evaluation of Financial 31
Performance
 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.

Evaluation of Financial 32
Performance
 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

Evaluation of Financial 33
Performance
 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.
Evaluation of Financial 34
Performance
 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

Evaluation of Financial 35
Performance
 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.

Evaluation of Financial 36
Performance
 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

Evaluation of Financial 37
Performance
 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.
3. If there is no preference shares, the net income
available to common shareholders is equal to
net income after tax.
4. Preference shares or preference dividend is not
counted.

Evaluation of Financial 38
Performance
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

Evaluation of Financial 39
Performance
 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 in assets.
3. ROA = Net Income Available to Common
Shareholders
Total Assets

Evaluation of Financial 40
Performance
 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

* Common equity will include retained earnings, share

premium, ordinary shares, etc

Evaluation of Financial 41
Performance
 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

Evaluation of Financial 42
Performance
 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.

Evaluation of Financial 43
Performance
 Dividend Per Share
1. It indicates the amount of dividend
received by ordinary shareholders for
each unit of ordinary shares held.
2. DPS = Dividend
Number of Ordinary shares issued

Evaluation of Financial 44
Performance
 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 spend on reinvestment
and expansion
3. Companies will try to maintain a stable
dividend payout ratio.
4. DPR = Dividend par share
Earnings per share

Evaluation of Financial 45
Performance
 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

Evaluation of Financial 46
Performance
 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

Evaluation of Financial 47
Performance
 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.
Evaluation of Financial 48
Performance
THANK YOU

Evaluation of Financial 49
Performance