Lecture 1

Financial Statements Analysis and

Interpretation:
1. Users of financial statements and
their needs
2. Financial analysis techniques and
ratios
Accounting in Business
Objectives of financial reporting
1. To provide financial information about the
reporting entity that is useful for economic
decision-making
2. Economic decisions are decisions about
providing resources to an entity, for example
decision to
1) provide capital to a business
2) hold shares in a company
3) provide loan to a company
4) discontinue a business unit  
 
Objectives of financial reporting (continue)
3. Financial statements present information about the
entity’s:
1) Financial position – economic resources it controls,
its financial structure (and solvency and liquidity =
assets, liabilities, equity
2) Financial performance or results – revenue and
expenses = income, expenses
3) Changes in equity – shareholders’ capital and
reserves
4) Changes in cash flows
5) Notes and supplementary schedules
1) Financial Position
1. The Statement of Financial Position discloses the
financial position of an entity at a point in time.
2. The entity’s assets, liabilities, equity, reserves and
debts are presented.
3. By examining this statement, the user will be able to
discern:
1) The economic resources it controls.
2) Its financial structure.
3) Liquidity and solvency.
4) Capacity to adapt to changes in the environment.
2) Financial Performance
1. The Statement of Total Comprehensive
Income or Statement of Profit or Loss and
Other Comprehensive Income discloses the
performance of an entity during the period.
2. It discloses the revenue or income earned and
the expenses incurred to earn that revenue.
3. Profit is frequently used as a measure of
performance.
3) Changes in Financial Position
The Statement of Cash Flows discloses:
1. the changes in the financial position of an
entity from one period to another
2. the cash flows from the investing, financing
and operating activities of the entity during the
period.
Contents of company’s annual report

1. Notice of Annual General Meeting (AGM)

2. Chairman’s Statement
3. Corporate structure
4. Financial highlights
5. Corporate information
6. Profile of the Board of Directors
7. Statements on corporate governance, risk
management and internal control and the audit
committee report
8. Audited financial statements
9. Analysis of shareholdings
10. List of properties and other information
Importance of accounting to users of financial
information
Accounting is called the language of business because all
organizations set up an accounting information system
(AIS) to communicate data to help people make better
decisions. Accounting serves many users who can be
divided into two groups: external users and internal users.
Some financial information users’ needs

1. Board of directors, employees, management

and their representative groups are interested
in information about the stability and
profitability of their employers. They are also
interested in information which enables them
to assess the ability of the entity to provide
remuneration, retirement benefits and
employment opportunities.
Some financial information users’ needs (continue)

2. Investors are the providers of risk capital and

their advisers are concerned with the risk
inherent in, and return provided by, their
investments. They need information to help
them determine whether they should buy, hold
or sell.
3. Shareholders are also interested in
information which enables them to assess the
ability of the entity to pay dividends.
Some financial information users’ needs (continue)
4. Lenders are interested in information that
enables them to determine whether their loans,
and the interest attaching to them, will be paid
when due.
5. Suppliers and other creditors are interested in
information that enables them to determine
whether amounts owing to them will be paid
when due. Trade creditors are likely to be
interested in an entity over a shorter period than
lenders unless they are dependent upon the
continuation of the entity as a major customer.
Some financial information users’ needs (continue)
6. Customers have an interest in information about
the continuance of an entity, especially when
they have a long-term involvement with, or are
dependent on, the entity.
7. Governments and their agencies are interested
in the allocation of resources and, therefore, the
activities of entities. They also require
information in order to regulate the activities of
entities, determine taxation policies and as the
basis for national income and similar statistics.
Some financial information users’ needs (continue)
8. Business entities affect members of the public
in a variety of ways. For example, business
entities may make a substantial contribution to
the local economy in many ways including the
number of people they employ and their
patronage of local suppliers. Financial
statements may assist the public by providing
information about the trends and recent
developments in the prosperity of the entity and
the range of its activities.
Comparison of Responses by stakeholders
Loan Corporate Financial analysts,
Significance departments, controllers, Accountants, Potential investors,
Ranking Lenders Management Creditors shareholders
Earnings per Return on Equity
1 Debt/Equity Current Ratio
Share After Tax
Accounts
Debt/Equity
2 Current Ratio Receivable Price/Earnings Ratio
Ratio
Turnover
Cash
Return on
Flow/Current Return on Equity
3 Equity After Earnings per Share
Maturities Long- After Tax
Tax
Term Debt
Fixed Charge
4 Current ratio Debt/Equity Ratio Net Profit Margin
Coverage
Net Profit Net Profit
Return on Equity
5 Margin After Margin After Quick Ratio
Before Tax
Tax Tax

Key: Debt Liquidity Profitability Other

Common-sized financial statements
1. Common-sized financial statements are useful for
overall review of an entity’s financial structure and
performance.
2. The various components are in percentages (%)
3. The comparison can be vertical (same year) and/or
horizontal (over a period of time)
Formula
1. Vertical Analysis (%) = (Amount in Line Item
in Base Year / Amount in Base Year) x 100
Example: COS/Sales = 100/360 x 100 = 28%
2. Horizontal Analysis (%) = [(Amount in
Comparison Year – Amount in Base Item) /
Amount in Base Year] x 100
Example: Revenue = [(360 – 300) / 300] x 100 =
20%
Vertical comparison – sales revenue as the base amount

1.Marginal change in cost structure with an increase in

revenue.
2.Revenue increase but fall in gross profit and net profit.
Vertical comparison – total assets and total liabilities as base amount

1.Slight change in the capital structure.

2.Debt has marginally increased.
3.Although non-current assets have increased, but has
decreased when compared to total assets.
Horizontal comparison – 20x4 as the base year
Horizontal comparison – 20x4 as the base year

Total assets have increased by 21% and 50% increase

in current assets. This is in line with the 40% increase
in current liabilities.
Financial analysis techniques
Two methods to analyze and interpret a business:
1) Quantitative method which is the financial
technical analysis using ratios
2) Qualitative method using non-financial data to
generate meaningful information e.g. using
reports such as corporate governance or
Chairman’s report or industry reports to identify
SWOT (Strengths, Weaknesses, Opportunities,
Threats) factors impacting the reporting entity
Financial analysis using ratios
Uses of ratios:
1. Ratio analysis identifies important items of both
financial and non-financial data and relates to
one another in the entity, and to the factors
external to the entity.
2. Accounting ratios are used to interpret the
financial statements of an entity, and to identify
and highlight significant changes and to
ascertain an entity’s strengths and
weaknesses.
Financial analysis using ratios (continue)
3. Ratio analysis expresses one figure as a ratio
or a percentage of another figure, as they are
some economic relationship between the
numerator and denominator to derive
significant or useful ratios.
4. Objectives of ratio analysis is to derive
relationships and trends that will not be
evident from a superficial examination of the
financial statements.
Financial analysis using ratios (continue)
5. Financial ratios might not necessarily provide the
answers or causes to the strengths or weaknesses.
6. The current year’s ratios can be used to evaluate the
relative performance of the entity by comparing
them against the following:
1) Results of the previous years by the same company
(trend analysis)
2) Budgets or the company’s predetermined standards
3) Results of other companies in the same industry
(inter-firm comparison)
4) Predetermined standards for the industry
Benefits of using financial ratios
There are limitations to the use of ratios for analysis
purpose, but there are some benefits:
1) Inter-firm comparisons are useful yardsticks for
comparing results and to improve a
company’s financial performance and
position
2) Comparisons with company’s own previous
financial results and budgets or predetermined
standards to measure management’s efficiency
and effectiveness
The use of accounting ratios to evaluate
performance/profitability/return: an illustration 1

Comparisons between entities – which of the

following companies is the most profitable?
Co. A Co. B
RM000 RM000
Profit 200 1,000
Net assets 500 10,000

Return on assets invested 40% 10%

The use of accounting ratios to evaluate
performance/profitability/return: an illustration 2
Comparisons over time – has there been an increase
or decrease in profitability from one year to the next?
Previous Current
year year
RM000 RM000
Profit 900 1000
Net assets 8,000 10,000
Return 11.25% 10%
In both cases, a comparison of the absolute profits
would give a misleading evaluation which needs to be
made in terms of the return on assets invested.
Classification of financial ratios
1. Accounting ratios derived from:
1) Statement of Profit or Loss
2) Statement of Financial Position
3) Combination of items in 1) and 2)

2. Market/investors or other ratios

1) Statement of Profit or Loss ratios
1. Gross profit ratio = (Gross profit / Sales) x 100 = x %
2. Net profit ratio = (Net profit before tax / Sales) x 100 =
x%
3. Expenses to sales = (Individual expense / Sales) x 100
=x%
4. Fixed interest cover = Net operating profit / Fixed
interest = x times
5. Fixed dividend cover = Net profit after tax / Fixed
dividend = x times
6. Dividend cover for equity = Net profit after tax
attributable to ordinary shareholders / Dividend paid and
proposed = x times
2) Statement of Financial Position ratios
1. Current or working capital ratio =
1) Current assets / Current liabilities : 1
or
2) Net cash flow from operation after tax and interest
payments / Current liabilities = x times
2. Liquid or acid ratio = Liquid assets / Current
liabilities : 1
3. Gearing ratio = Long-term loans and preference
share capital / Shareholders’ equity x 100 = x %
4. Proprietary or shareholders’ ratio = Shareholders’
fund / Total assets x 100 = x %
3) Combination of Statement of Profit or Loss and
Statement of Financial Position ratios

1. Return on capital employed (ROCE) =

1) (Net profit before interest and tax / Capital [i.e.
share capital, reserves and borrowings]) x 100 =
x%
or
2) (Net profit after interest / Capital employed ([i.e.
ordinary share capital and reserves]) x 100 = x %
2. Earnings per share = (Profit after tax –
preference dividend / Weighted average number
of ordinary shares in issue) x 100 = x sen
3) Combination of Statement of Profit or Loss and
Statement of Financial Position ratios (continue)

2. Inventory turnover =
1) Cost of sales / Average inventory = x times
or
2) Cost of sales / Closing inventory = x times
or
3) (Average inventory / Cost of sales) x 12 months =
x months
4) (Average inventory / Cost of sales) x 365 days = x
days
3) Combination of Statement of Profit or Loss and
Statement of Financial Position ratios (continue)
3. Receivables or debtors turnover =
1) Credit sales / Year-end trade receivables = x times
or
2) Credit sales / Average trade receivables = x times
3) (Closing or average trade receivables / Credit sales)
x 365 = x days
4. Trade payable repayment period =
1) (Closing or average trade payables / Credit
purchases) x 12 months = x months
or
2) (Closing or average trade payables / Credit
purchases) x 365 = x days
3) Combination of Statement of Profit or Loss and
Statement of Financial Position ratios (continue)
5. Total asset turnover =
1) Sales / Closing or average total assets : 1
or
2) Sales / Working capital : 1
6. Sales to capital employed = Sales / Capital
employed : 1
4) Marketing or other ratios
1. Price earnings ratio = Market price of shares /
Earnings per share = x times
2. Earnings yield ratio = (Earnings per share /
Market value per share) x 100 = x %
3. Dividend yield ratio = (Dividend per share /
Market value per share) x 100 = x %
4. Earnings per share = Net profits – Preference
share dividends / Weighted average number of
ordinary shares
Example

Profits grew by 15% in 20x8 (from XXX in 20x7 to XXX in 20x8)

1. Profit growth, by itself, is good news and more than

10% sounds a significant improvement or
achievement. Further comment should be made to
describe what this achievement means to the
company, eg, whether its is in line with the company
target, whether it is an excellent achievement in the
backdrop of challenging business environment, etc.
2. Although it is good news for the firm, there is
insufficient details to determine whether it is the
results of the management’s efforts, what the
management has done, whether this good result is
likely to continue in the future, etc.
Profits grew by 15% in 20x8 (from XX in 20x7 to XXX in 20x8)

1. If it was due to higher revenue earned during the

year, highlight what the company has done (may be
introduced new products, entered into new
markets, etc) or what has happened (maybe
competitors faced troubles, good economy resulted
in higher demand, etc) that caused the company to
score higher revenue.
2. If it was due to slower increase in (or lower)
expenses incurred during the year, highlight what
the company has done (may be introduced more
efficient processes, cost cutting exercise, etc) or
what has happened (may be lower raw material
price as determined by the market, etc) that cause
the company to record higher profits.
Strategic management and organisational contexts

“Organisational context” refers to:

Small business
Organisational
size Multinationals

Organisational Manufacturing
type Services

Public sector
Organisational
purpose Not-for-profit
Lifecycle model

Shakeout stage (S)

Growth stage (G) Maturity stage (M)

Development stage (I) Decline stage (D)

I G S M D
Streamline Quality
Products Basic Improving Standardised
d deteriorated
Variety to
Few & Reduced
Buyers Curious choose Brand loyalty
unaware purchases
from
Declining
Fight for Weaker Aim to market
Competitors Negligible market players maintain size;
share forced out share players exit
industry
 Assessing the macro-economic environment of a firm using PESTEL

Macro-environment: the external environmental factors that affect

the entity’s operations but are beyond its control.
How could changes How will changes in the political scenario
in the current legal affect us?
system affect us? Political
forces How would
Economic the economic
Legal forces
Organisation situation
forces
impact us?
Environment Social forces
al forces
Technologica What socio-
Are we l forces cultural factors
complying would impact us?
with current
environmenta How can changes in technology affect us and
l norms? our customers?
 Macro and micro-levels of PEST
Level Organisational Departmental
1. government policies 1. organisational strategy
Political 2. possible changes of government 2. company policies
3. industry regulation 3. organisational structure
1. general state of economy/stock
market
2. level of exchange rates, interest 1. budget allocations
Economic
rates 2. cross-charging policies
3. level of disposable income in the
marketplace
Organisational culture, work
Fashions, trends, social priorities,
Sociological practices, level of autonomy
demographics
among staff.
Technology owned and used
in-house, level to which
Technological New technologies outsourced, availability of
standard packages to suit the
department's task
Porter’s five forces model
1. helps identify sources of competition in an industry or sector
2. helps companies understand how profitable the industry is and what
the company can do to mitigate negative forces and therefore improve
profitability
3. should be used at the level of strategic business unit (SBU) rather
than the organisation as a whole
4. SBU = part of entity for which there is a distinct market for goods /
services
5. 5 forces are not independent of each other – one force can trigger
changes in the other
Threat of new entrants
Bargaining Bargaining
power of Competitive power of
suppliers rivalry buyers

Threat of substitutes
1. Non-financial factors
Ratios measure only limited information and relationships between
figures in the accounts, ie, offer a restricted view of ‘relative’
performance and position - not the full picture. Non-monetary
factors – important and related non-financial information either
internal or external, is not reflected in the ratios:
1. The health of the industry or economy in which it operates;
2. Changes in interest rates;
3. Changes in taxation;
4. Effects of inflation
5. Changes in commodity prices;
6. Currency fluctuations;
7. Availability of substitute products;
8. Competition from other firms - pressure on sales prices etc;
9. New technology;
10. Capability of Directors and senior management team;
11. Relationship with environment and society;
12. Future plan of the company.