T5_FINANCIAL STATEMENT ANALYSIS

DPA30063
FINANCIAL MANAGEMENT 1

TOPIC 5
FINANCIAL STATEMENT ANALYSIS

BY :
PN. ROSMARIA BINTI ISMAIL

DEPARTMENT OF COMMERCE

FINANCIAL STATEMENT ANALYSIS

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

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

Management
Efficiency
• Profitability
• Capital
Structure
• Market Value

INTRODUCTION

 Businesses that trade as companies are required to produce the 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

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’ equity
Financial 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, payments
Cash Flows and the consequential net change in cash balances for
a specified period.

• 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.

FINANCIAL STATEMENT ANALYSIS

Analysis Comparative
Method Analysis

Horizontal Intra
company
(within)

Vertical Inter
company

RATIO INDUSTRY AVERAGE

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
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.
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.

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.
6) To assess the risk of operations.

FINANCIAL RATIO ANALYSIS

BENEFITS of Financial Ratio Analysis

1) Helpful in decision making.
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.
 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

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

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

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 term
available to pay each dollar of current obligations without relying on inventory sales.

liabilities

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

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 average
accounts receivable are it takes to collect receivables.
“rolled over” during a year.
A longer (shorter) period means slower
(faster) collections and a larger (smaller)

investment in receivables

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 on the relation between
sold and replaced are held on average a firm’s sales and the
during the year, that before being sold; it also
indicates the quality of total assets
is, the relative
liquidity of the the inventory A higher turnover means
The more (fewer) days the firm is using its
inventories
required, the larger assets more efficiently
(smaller) will be the
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 a Measures how much a firm earns Ability of a firm to generate the net
firm ears from its from its revenue less its operating income from its sales after deducting
all expenses including interest & taxes.
revenue less the cost expenses.
of goods sold. Higher ratio is better  higher ability
Serves as an overall measure of of the firm to obtain profits for
operating effectiveness. distribution to the equity holders.

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
return being earned on shareholders’ accounting
return on their investment
the 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
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 Market Price per Share
No. of CS EPS Book Value per Share

Measures the amount of earning The price that the market places Indicates the value of equity for
available to CSH per share of CS on RM1 of a firm’s earnings. each share of common stock.

held. Indicates how much the investors are The price that the market places on RM1 of
willing to pay for each Ringgit of the shareholder’s investment in the
Higher earnings lead to higher dividend profits generated by a firm.
being paid out to CSH. business, measured by the equity-book
value per share.
Leads to higher market price of a firm’s
stock in the market place.

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 entries
and their corresponding ratios will vary with the time of year the statements are prepared