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## FINANCIAL STATEMENT ANALYSIS DRAFT 1

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# FINANCIAL STATEMENT ANALYSIS DRAFT 1

### FINANCIAL STATEMENT ANALYSIS DRAFT 1

• FS analysis can be referred as a process of

understanding the risk and profitability of a company by
analyzing reported financial information.

• Financial analysis is the assessment of the company

past, present and anticipated future performance.

• Allows for comparisons over time/benchmark between

industry.

• Principal tool of financial analysis is the financial ratios.

• Ratios are mathematical aids for evaluation and

comparison of financial performance.

• Financial ratios look at the relationship between

individual values and relate them to how the company
have performed in the past and might be performed in
the future.

To standardize
financial

information for
comparison
purposes

To assess To evaluate
efficiency and current

risk of the performance

company

Importance
of FS

Analysis

To compare the To compare
performance of present

the company performance
with other firms with past

performance

1 2

LIQUIDITY PROFITABILITY

3 4

EFFICIENCY LEVERAGE

LIQUIDITY 1
RATIO

Liquidity ratios measure the ability of a business in settling its current
obligation or current debt. These ratios used to be the main concern of
creditors. Considering the capability of paying debt as soon as possible is
a way to avoid bad debt, the creditors will look into these ratios for credit
sales’ permission. Banks and financial institutions will also refer to these
ratios for any loan or borrowing approval purposes.

General principle of these ratios is higher ratio indicates better
performance. However, if these ratios beyond the normal circumstance or
become out of league, further analysis is necessary to tell what is actually
taking place. For instance, if the liquidity ratios are too high, it tells that the
business does not efficient in utilizing its current assets to generate future
return. Huge cash in hand is not necessarily important rather than
investing that cash, hoping for higher future return on investment.

prompt
payment to

creditors

Liquidity
Ratio

Current Acid
Ratio Test
Ratio

This ratio is also known This ratio is also called as
as working capital
ratio. If the business’s acid-test ratio. The
current ratio is more
than one, it indicates evaluation of this ratio is
that the company has
sufficient sources to more reliable compared to
cover its current debt.
current ratio as this ratio

excludes all least liquid

assets. The least liquid

assets such as prepayment

and inventory are not taken

into account in computing

quick ratio. This is due to

the nature of those assets

which are generally more

difficult to turn into cash.

Formula: Current Assets
Current Liability

Example: RM30,000
RM10,000

=3:1

Interpretation: For every RM1.00 of current liability, the company has
RM3.00 of current assets to repay the current liability

Formula: Current Assets – Inventory Prepayment
Current Liability

Example: RM30,000 – RM3,000 – RM2,000
RM10,000

= 2.5 : 1

Interpretation: For every RM1.00 of current liability, the company has
RM2.50 of its liquid assets to repay the current liability

PROFITABILITY 2
RATIO

Profitability ratios assess the ability of a business in generating or making
profit. These ratios tell whether the business is profitable or not. Hence,
profitability ratios always capture the attention of investors, owners,
partners or any parties who will entitle to the return. There is no guarantee
that higher gross profit margin leads to higher net profit margin.

High net profit ratio depends on the ability of the business in managing
and controlling its operating or daily expenditures. Due to that, net profit
margin provides more accurate measurement rather than gross profit
margin in terms of evaluating credibility to generate net profit.

Gross Profit Margin

This ratio shows how much the business gain from the
products/services sold after deducting cost of goods sold.

It shows the relationship between gross profit and net
sales

Example: RM130,000 x 100
RM180,000
= 72.20%

For every RM1.00 of sales, the company is able to
generate RM0.72 of gross profit

Net Profit Ratio

This ratio shows the ability of a business to generate profit
from the sales made. This ratio is crucial for investors as it

predicts the dividend distribution

Example: RM80,000 x 100
RM180,000
= 44.40%

For every RM1.00 of sales, the company is able to
generate RM0.44 of net profit

Return On Asset

This ratio measures the profitability of a business in
relation to its total assets. This ratio indicates how well
a company is performing by comparing the profit (net
income) it is generating to the capital it was invested

in assets

Formula: Net Profit x 100
Total Assets

Example: RM80,000 x 100
RM280,000

= 28.50%

Company earn RM0.29 for every RM1.00 of assets

Return On Capital Employed

This ratio identifies the efficiency of utilization of a

capital investment. It provides better indication of
financial performance for a business funded by both

equity and debt

Example: RM45,000 x 100
RM120,000
= 37.50%

For every RM1.00 of sales, the company is able to
generate RM0.67 of operating profit

EFFICIENCY 3
RATIO

Efficiency ratios are important to evaluate the capability of a business in
managing its business resources and transform them to income. These
ratios help in analysing a business ability to employ its resources such as
capital and assets to produce income. In other words, these ratios show
how long period is needed to generate income. Length of time/period is
the most essential for these ratios.

Inventory Turnover
Ratio

Average Collection
Period

Total Asset
Turnover

Inventory Turnover
Ratio

This ratio indicates the time needed for a business to convert its inventory
into sales. The higher ratio tells that the business is more often replacing
its inventory which depicts the efficiency in selling its product, hence
capable to generate income within a short period of time. The situation
indirectly tells us that the business may have good marketing strategy,
high quality product at reasonable price and easy accessibility to the
products.

*
**

COSG = beginning inventory + purchase – ending inventory
Average inventory = (beginning inventory + ending inventory) ÷ 2

Example: Within an accounting
period, the company has
RM50,000
RM5,000 replaced its average
inventory 10 times
=10 times

Average Collection
Period

This ratio shows the length of time needed for a business to collects all its
money from its debtors. Specifically, this ratio shows the association
between average account receivable and total credit sales. Short average
collection period indicates that the business is efficient to avoid any
possibility of bad debt. Nevertheless, too short average collection periods
defines that the business is stringent in dealing with its debtors.

Example: The company is able to
collect its debt within 41
RM20,000 x 365 days days of the accounting
RM180,000
period
= 40.5 days or 41 days

Total Asset
Turnover

This ratio is used to measure how efficiently the business uses its assets
to generate sales. The higher the ratio, the more efficient the business is
in utilizing its assets to generate sales and increase productivity.

Example: For every RM1.00 of
average total assets, the
RM180,000 company can generate
RM450,000
RM0.40 net sales
= 0.4

LEVERAGE 4
RATIO

Leverage ratios are used to determine the relative level of debt load that
a business has incurred. These ratios compare the total debt obligation to
either the assets or equity of a business. A high ratio indicates that a
business may have incurred a higher level of debt than it can be
reasonably expected to service with ongoing cash flows. This is a major
concern, since high leverage is associated with a heightened risk of
bankruptcy.

Debt to Equity
Ratio

Debt Ratio Time Interest
Earned

Leverage
Ratio

Definition

This ratio indicates the proportion
between business’ debt and its total assets.
A business with higher debt is considered
highly leverage or geared and riskier.
The ratio shows how much the company
relies on debt to finance its assets.

Formula

Example

RM30,000 x 100
RM90,000
= 33.3%

Interpretation

• The more debt compared to assets a
company has, which is signaled by a
high debt ratio, the riskier it is
considered to be.

• The assets were financed by debt
33.3%.

• 33.3% of total assets are financed by
creditors.

Definition

This ratio helps to know the proportion of
equity and debt to finance the total assets.
High debt-to-equity ratio means that the
business is being financed more by
creditor rather than shareholders.

Similar with debt ratio, higher debt-to-
equity ratio indicates that the business has
higher possibility to bankruptcy.

Formula

Example

RM30,000 x 100
RM50,000
= 60%

Interpretation

• This ratio measures the relationship
between the capital contributed by
creditors and the capital contributed by
shareholders.

• Contribution of creditors is only 50%
from contribution of investor.

Definition

This ratio shows the ability of a business to
cover its interest expense using its
operating income. Higher times interest
earned indicates that the company has no
problem to pay its borrowing or loan,
including both principal and interest.

The bank or creditor feel more confident to
approve loan or borrowing if the business
has consistent high times interest earned
ratio.

Formula

Example

RM45,000
RM7,500
= 6 times

Interpretation

• Determines the interest payment
ability of the company against the
debt it owes.

Distorted by inflation

• Since the information is historical,
inflation may have occurred and the
figures may be distorted.

Different accounting practices
distorts comparison

• Different accounting practices will make
comparison less accurate and invalid.

Information can be manipulated

• Ratio analysis is based entirely on the data
statements.

• Management has opportunity to
manipulate the figures to make the
company’s performance looks good.

CONCLUSION

Current ratio Higher ratio is better Lower ratio is better
Quick ratio 
Gross profit ratio  
Net profit ratio  
Return on asset ratio  
Return on capital employed 
Inventory turnover ratio 
Average collection period 
Total asset turnover
Debt ratio 
Debt-to-equity ratio
Times interest earned 

Financial ratios are commonly used as a means of
financial statements analysis to identify or evaluate
financial performance and position. Interpretations
of the ratios will always be carried out with care due
to limitations such as different accounting policies,
fiscal years and manipulations.

Urdu Itihas 6th
Urdu Samanya Vidnyan 6th