FINANCIAL STATEMENT ANALYSIS : SERIES 1

F I NANC IA L stat em ent
ANA LYS IS

ROSMARIA BINTI ISMAIL
SITI ZAKIAH BINTI ABU BAKAR

Department of Commerce
Politeknik Melaka

Copyright i
declaration

Published by :

POLITEKNIK MELAKA (PMK)
NO 2, JALAN PPM 10,

PLAZA PANDAN MALIM,
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Tel : 06.337.600
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Website : http://www.polimelaka.edu.my

FINANCIAL STATEMENT ANALYSIS : SERIES 1

By :

ROSMARIA BINTI ISMAIL
SITI ZAKIAH BINTI ABU BAKAR

All rights reserved. This publication is protected by copyright and permission should be obtained from
publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form

or by any means, electronic, mechanical, photocopying, recording or likewise.

PREFACE ii

This e-book is specifically designed for diploma students without prior knowledge in finance.
Therefore, it has been written in such a way that it may equip the students with knowledge of business
finance.

Prepared in line with the relevant syllabus of Malaysian Polytechnics, the content of this e-book is
specifically covers the topic of FINANCIAL STATEMENT ANALYSIS. It discuss about financial statement
analysis of a company and analyse the firm’s financial ratios against the industrial average ratios. At the
end of the topic, this e-book also provides the discussion on limitation of financial ratios.

This e-book not only provides students with easy to follow and understand points, but also examples
and tutorial exercises to help students to understand the subject matter deeply.

It is hoped that this e-book will be useful for all students of Polytechnics and colleges. Any suggestions
towards its further improvement will be thankfully acknowledged and incorporated in the next edition.

ROSMARIA BINTI ISMAIL
SITI ZAKIAH BINTI ABU BAKAR
Department of Commerce
Politeknik Melaka

ACKNOWLEDGEMENT

We would like to record our warm appreciation
and thanks to the many parties who have
provided encouragement and helpful comments
towards the arrangement of this e-book. It is our
hope that this e-book would help students to gain
better understanding of the course.

ROSMARIA BINTI ISMAIL
SITI ZAKIAH BINTI ABU BAKAR
Department of Commerce
Politeknik Melaka

iii

TABLE OF CONTENTS

Copyright Declaration PAGE
Preface i
Acknowledgement ii
Financial Statement Analysis - Overview iii
Introduction 1
Financial Statement 2
Financial Statement Analysis 3
Financial Ratio Analysis 5
Liquidity Ratios 9
Asset Management Ratios 16
Profitability Ratios 17
Capital Structure Ratios 19
Market Value Ratios 21
Limitations of Financial Ratio Analysis 22
Exercise 23
List of References 24
25

FINANCIAL STATEMENT ANALYSIS OVERVIEW

Financial FS Firm’s FR Limitations
Statements Analysis vs Industry of financial

• SOCI • Importance AR ratios
• SOFP • Users
• CFS • Liquidity 1
• Asset

Management
Efficiency
• Profitability
• Capital
Structure
• Market Value

INTRODUCTION

 Businesses that trade as companies are required to produce the 2
financial statements annually.

 It provides an accounting-based picture of a firm’s financial position.
Somehow, it is like a report card of the organization on their activities.

 The information available can be used for different purposes by
different users.

 The statements are often used by managers as aids to financial
planning in that the data that they contain will be based on plans and
forecasts.

 While accountants focus on reporting what happened in the past,
Finance Managers use financial statements to draw inferences about
the future.

FINANCIAL STATEMENTS

 A formal record of the financial activities of a business, person, or other
entity.

 All the relevant financial information, presented in a structured manner and
in a form easy to understand.

 Typically include four basic financial statements, accompanied by a
management discussion and analysis :

 Statement of Comprehensive Income

 Statement of Financial Position

 Statement of Cash Flows 3

Statement of • Provides information on profitability of the firm’s
Comprehensive operations over a specified financial period.

Income • Summarizes the revenues, expenses, and results of
operations of a firm for a specified period of time.

Statement of • Reports the assets, liabilities and shareholders’
Financial equity as at a specific date.
Position
• A position statement that shows where the firm
stands in financial terms at a specific date.

Statement of • Provides information on the cash receipts,
Cash Flows payments and the consequential net change in cash
balances for a specified period.
4
• Sub divided into operating activities, investing
activities & financing activities cash flows.

FINANCIAL STATEMENT ANALYSIS

Financial analysis is the evaluation of a firm’s past, present and
anticipated future financial performance and financial condition.

Made based on the firm’s financial statements.

Its objectives are to identify the firm’s financial strengths and
weaknesses and to provide the essential foundation for financial

decision-making and planning.

Helps an individual to check whether a business is doing better this

year than it was last year, or whether it is doing better or worse

than other companies in the same industry. 5

FINANCIAL STATEMENT ANALYSIS

Analysis Comparative
Method Analysis

Horizontal Intra
company
(within)

Vertical Inter
company

RATIO INDUSTRY AVERAGE 6

FINANCIAL STATEMENT ANALYSIS

I M P O R T A N C E of Financial Statement Analysis is as follows :

To assess the periodic operating results and 7
financial status of a firm.

To develop plans and strategies as to
keep a firm’s performance in line with
the goal to maximize shareholder’s
wealth.

FINANCIAL STATEMENT ANALYSIS

U S E R S of Financial Statement Analysis is as follows :

1) THE INVESTORS (CAPITAL VENTURES) are interested to know the
performance of the companies for calculating their returns and wealth
creation.

2) LENDERS / CREDITORS want to see the ability of the organization to remit the
debt burden and all financial charges.

3) GOVERNMENT AGENCY such as Inland Revenue Board are interested to
compute the actual tax liability of the company and try to find any kind of
window dressing or manipulation in the accounts.

4) RESEARCHER will do the analysis for academic purposes. 8

5) MEDIA will study the report for comparison and publication purposes.

FINANCIAL RATIO ANALYSIS

 Ratio is a mathematical relationship between one number to another number.
 Ratio is used as an index for evaluating the financial performance of the business

concern.
 An accounting ratio shows the mathematical relationship between two figures,

which have meaningful relation with each other.

FINANCIAL RATIO ANALYSIS

 Used to summarize the information in a firm’s financial statements in assessing its financial
health.

 Involves calculating and analyzing financial ratios to assess a firm’s performance and to
identify actions that could improve firm performance.

 Look at the relationship between individual values & relate them to how a firm has
performed in the past, and might perform in the future.

9

FINANCIAL RATIO ANALYSIS

PURPOSE of Financial Ratio Analysis

1) To standardize financial information for comparison purposes.

2) To evaluate current operations of the company.

3) To compare present performance with past performance.

4) To compare the performance of the company with other firms or industry
standards.

5) To assess the efficiency of operations. 10
6) To assess the risk of operations.

FINANCIAL RATIO ANALYSIS

BENEFITS of Financial Ratio Analysis

1) Helpful in decision making. 11
2) Helpful in financial forecasting and planning.
3) Helpful in communication.
4) Helpful in coordination.
5) Helps in control.
6) Helpful for shareholder’s decision.
7) Helpful for creditor’s decision.

FINANCIAL RATIO ANALYSIS

USERS of Financial Ratio Analysis

Within the firm, M A N A G E R S use financial ratios to:

 Identify deficiencies in the firm’s performance and take corrective action.

 Evaluate employee performance and determine incentive compensation.

 Compare the financial performance of the firm’s different divisions.

 Prepare, at both the firm and division levels, financial projections, such as
those associated with the launch of a new product.

 Understand the financial performance of the firm’s competitors. 12
 Evaluate the financial condition of a major supplier.

FINANCIAL RATIO ANALYSIS

USERS of Financial Ratio Analysis

Outside the company, financial ratios can be used by:

 L E N D E R S to decide whether or not to make a loan to the
company.

 C R E D I T - R A T I N G A G E N C I E S to determine the firm’s
creditworthiness.

 I N V E S T O R S to decide whether or not to invest in a company.

 M A J O R S U P P L I E R S to decide whether or not to grant 13
credit terms to a company

LIQUIDITY RATIOS

Current Ratio Quick Ratio

ASSET MANAGEMENT
EFFICIENCY RATIOS

Accounts Receivable Inventory Turnover Ratio Total Assets Turnover
Turnover Ratio Inventory Turnover Days
14
Account Receivables
Turnover Days

Gross Profit CAPITAL STRUCTURE
Margin RATIOS

Operating Total Debt Ratio Times Interest
Profit Margin Earned

PROFITABILITY Net Profit MARKET VALUE RATIOS Earnings Per Share
RATIOS Margin Price Earnings Ratio
Market-to-book Ratio
Return On
Assets 15

Return On
Equity

LIQUIDITY  Liquidity is related to the ease and quickness with which a
RATIOS firm can convert its noncash assets into cash to have the
ability to pay maturing obligations.
Current Ratio
 It is also called as short-term ratio.
 This ratio helps to measure of the overall ability of a firm to

meet its maturing obligations by relying on its current assets.
 Used to assess how well the business manages its working

capital.

Quick (Acid Test) Ratio

Current Assets Current Assets – Inventories
Current Liabilities Current Liabilities

Measures the dollars of current assets Measures a firm’s ability to pay off short
available to pay each dollar of current term obligations without relying on
inventory sales.
liabilities

A higher ratio means greater liquidity. A higher ratio means greater liquidity 16

ASSET MANAGEMENT EFFICIENCY RATIOS

 Measure how effectively the firm is managing its assets in generating sales and its contribution
towards the achievement of a firm’s goal

 These ratios look at the manager’s effectiveness in managing a firm’s assets and efficiency in
handling a firm’s operations.

Accounts Receivable Turnover Ratio Account Receivables Turnover Days

Credit Sales Account Receivables x 365 days
Accounts Receivable Credit Sales

Expresses how often Expresses how many days on
accounts receivable are average it takes to collect
“rolled over” during a year. receivables.

A longer (shorter) period means slower
(faster) collections and a larger (smaller)
investment in receivables 17

ASSET MANAGEMENT EFFICIENCY RATIOS

Inventory Turnover Ratio Inventory Turnover Days Total Assets Turnover

COGS Inventory x 365 days Sales
Inventory COGS Total Assets

Measures the Measures the number of An overall measure of
number of times a days a firm’s inventories asset efficiency based
firm’s inventories
are held on average on the relation
are sold and before being sold; it also between a firm’s sales
replaced during the indicates the quality of
and the total assets
year, that is, the the inventory
relative liquidity of The more (fewer) days A higher turnover means
the firm is using its
the inventories required, the larger
(smaller) will be the assets more efficiently 18
investment in inventories

PROFITABILITY RATIOS

 Analyses the ability of management to generate adequate profits use of the firm’s capital and assets.

 Show the combined effects of liquidity, asset management, and debt management on the overall operating
results of the firm.

 Among the most watched & best known of the financial ratios where the firm values (or stock prices) react
quickly to unexpected changes in these ratios.

Gross Profit Operating Profit Net Profit
Margin Margin Margin

Gross Profit x 100% Operating Profit x 100% Profit After Tax x 100%
Sales Sales Sales

Measures how much Measures how much a firm earns Ability of a firm to generate the net
a firm ears from its from its revenue less its operating income from its sales after deducting
revenue less the cost
expenses. all expenses including interest &
of goods sold. taxes.
Serves as an overall measure of
operating effectiveness. Higher ratio is better  higher ability
of the firm to obtain profits for

distribution to the equity holders. 19

PROFITABILITY RATIOS

Return on Assets Return on Equity

Profit After Tax x 100% Profit After Tax x 100%
Total Assets Total Equity

Indicates the rate of Measures the 20
return being earned on the shareholders’ accounting
return on their investment
firm’s assets

CAPITAL STRUCTURE RATIOS

 Leverage Ratios or Gearing Ratios or Debt Management Ratios.
 To evaluate a firm’s financial structure; (1) the extent to which a firm is levered by debt; (2) the

ability to service its debt; and (3) the degree of financial risk inherent in the financial structure,
 Measure how effectively the firm uses its assets to make profits.

Total Debt Ratio Times Interest Earned

Total Liabilities x 100% EBIT
Total Assets Interest Expense

Measures the extent to which a firm has Measures a firm’s ability to meet its
been financed with debt. interest payments using its annual

The higher (lower) the debt ratio, the more operating earnings.
(less) financial risk the firm is assuming
Indicates a company’s ability to service its 21
interest payments.

MARKET  Shows management’s performance in terms of creating or
VALUE RATIOS destroying shareholder value.

 Indicate what investors think of management’s past
performance and future prospects.

Earnings Per Share Price Earnings Ratio Market-To-Book
Ratio
Earnings Attributable to CSH Market Price per Share
No. of CS EPS Market Price per Share
Book Value per Share
Measures the amount of earning The price that the market
available to CSH per share of CS places on RM1 of a firm’s Indicates the value of equity for
each share of common stock.
held. earnings.
The price that the market places on RM1 of 22
Higher earnings lead to higher Indicates how much the investors the shareholder’s investment in the
dividend being paid out to CSH. are willing to pay for each Ringgit
Leads to higher market price of a business, measured by the equity-book
firm’s stock in the market place. of profits generated by a firm. value per share.

LIMITATIONS OF FINANCIAL RATIO ANALYSIS

1) PUBLISHED PEER GROUP OR INDUSTRY AVERAGES ARE ONLY APPROXIMATIONS. They provide the
user with general guidelines, rather than scientifically determined averages of the ratios for all. It
could be better for a firm to make comparisons with market leader

2) COMPARISON WITH INDUSTRY AVERAGES IS DIFFICULT FOR CONGLOMERATES. If a firm is involved
in various kinds of businesses or has many divisions in different industries, its industry category is
often difficult to identify. Ratio analysis is more useful to smaller companies than diversified
companies.

3) ACCOUNTING PRACTICES DIFFER WIDELY AMONG FIRMS. For example, different firms choose
different methods to depreciate their fixed assets. Differences such as these can make the
computed ratios of different firms difficult to compare.

4) DIFFICULT TO CONCLUDE WHETHER A FINANCIAL RATIO IS GOOD OR BAD. For example, a current
ratio that falls below the norm might indicate (a) the possibility that the firm has inadequate
liquidity and may at some future date be unable to pay its bills on time, or (b) the firm is managing
its accounts receivable and inventories more efficiently than other similar firms.

5) MANY FIRMS EXPERIENCE SEASONAL CHANGES IN THEIR OPERATIONS. As a result, their SOFP 23
entries and their corresponding ratios will vary with the time of year the statements are prepared

EXERCISE

The following is the financial statements of Howlite Corporation. As a financial analyst, you are required to analyze Howlite’s financial performance for the year 202X.

HOWLITE CORPORATION HOWLITE CORPORATION
Statement of Financial Position as at 30th June 202X Statement of Comprehensive Income for the year ended 30th June 202X

RM (millions) RM (millions)

ASSETS 98 Sales 2,311
Current assets 188 Cost of goods sold (1,344)
Gross profit
Cash Operating expenses 967
Accounts receivable Administrative expenses (146)
Earnings before interest and tax (EBIT) (130)
Inventory 422 Interest paid
Earnings before tax (EBT) 691
Total 708 Tax (34%) (141)
Earnings after tax (EAT) 550
Non-current assets 2,880 Common stock dividends (187)
Net plant and equipment Retained earnings 363
(121)
TOTAL ASSETS 3,588 242

LIABILITIES AND OWNERS’ EQUITY Howlite Corporation has 33 million shares outstanding and the stock sold for RM88 per share
Current liabilities at the end of the year. Below is the industry average ratios for 202X.

Accounts payable 344 Current Ratio 1.28 x Quick Ratio 0.51 x
Notes payable 196 Accounts Receivable Turnover Ratio 10.45 x Inventory Turnover Ratio 3.84 x
Total 540 Account Receivables Turnover Days 35 days Inventory Turnover Days 95 days
Long term debt 457 Total Assets Turnover 0.72 x Gross Profit Margin 46.51%
Operating Profit Margin 27.73% Net Profit Margin 14.27%
Owners’ equity 550 Return On Asset 12.89% Return On Equity 12.94%
Common stock 2,041 Total Debt Ratio 32.92% Times Interest Earned
Retained earnings 2,591 Earnings Per Share RM10.20 Price Earnings Ratio 4x
Total 3,588 Market-To-Book Ratio 7.5 x
1.07 x
TOTAL LIABILITIES AND OWNERS’ EQUITY
Calculate the indicated ratios. Comment about the financial ratio of Howlite Corporation against 24
industry average ratio. Assume 365 days per annum.

LIST OF REFERENCES

Ng Kean Kok, Z. W. (2017). Financial Management (3rd ed.). Malaysia: Oxford Fajar.

Arthur J. Keown, j. M. (2017). Foundations of Finance (9th ed.). Malaysia: Pearson.

Sherida Titman, A. J. (2018). Financial Management: Principles and Applications
(13th ed.). Malaysia, Pearson.

Stephen A.Ross, R. W. (2016). Fundamentals of Corporate Fiannce (2nd ed.). Asia
Global Edition: McGraw Hill.

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