TOPIC 2

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
 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
Income Statement for the year ended
31 December 2016 (cont.)
ABC Bhd
Income Statement for the year ended
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.)
◻ 
Profitability Ratios (cont.)
◻ 
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
stocks
◻ Inventory turnover days = X 365 days
cost of goods sold

◻ Inventory turnover days = 435,00

× 365= 63.97 days
0
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

◻ Accounts receivables turnover ratio = 3,393,00 = 7.7 times

0441,00
0
◻ Accounts receivables turnover days = Trade debtors × 365 days
Credit sales
441,000
◻ Accounts receivables turnover days = × 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
2,4
◻Accounts payables turnover ratio = 82, = 7.3 times
34
000
3,0
Accounts payables
◻Accounts payables turnover days = 00 ×365 days
Credit purchases
343,000 ×365
◻Accounts payables turnover days =2,482,000 = 50.44 days
 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)

Total long-term borrowings nd

◻ Debt ratio = (2 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 = 75,000= 3.63 times

◻ 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 = 34 sen
× 100
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
272,000
◻ Return on capital employed = × 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 × 100% = 19.63%

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
350
◻ P/E ratio = = 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.
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.
Common Size Statements – Standardizing Financial
Information

◻ A common size financial statement is a

standardized version of a financial statement in
which all entries are presented in percentages.

◻ A common size financial statement helps to

compare entries in a firm’s financial statements,
even if the firms are not of equal size.
Common Size Statements – Standardizing Financial
Information (cont.)

◻ How to prepare a common size financial statement?

🞑 For a common size income statement, divide each
entry in the income statement by the company’s sales.
🞑 For a common size balance sheet, divide each entry in
the balance sheet by the firm’s total assets.
Common Size Income Statement
(H. J. Boswell, Inc.)
Table 4-1 Observations
◻ Table 4-1 is created by dividing each entry in the income
statement found in Table 3-1 by firm sales for 2010.
🞑 Cost of goods sold make up 75% of the firm’s sales resulting in a gross
profit of 25%.
🞑 Selling expenses account for about 3% of sales. Income taxes account
for 4.1% of the firm’s sales.
🞑 After accounting for all expenses, the firm generates net income of
7.6% of firm’s sales.
Common Size
Balance Sheet
(H. J. Boswell,
Inc.)
Table 4-2 Observations
◻ Table 4-2 is created by dividing each entry in the
balance sheet found in Table 3-2 by total assets for
the year.
🞑 Total current assets increased by 5.6% in 2010 while
total current liabilities declined by 2%.
🞑 Long-term debt account for 39.2% of firm’s assets,
showing a decline of 1.7%.
🞑 Retained earnings increased by 5.8% in 2010.
END OF TOPIC QUESTIONS