CHAPTER 2

ANALYSIS OF
FINANCIAL STATEMENTS
 Annual Report and Users of
Financial Statements
 Financial Ratio Analysis
 Conducting a Complete Ratio
Analysis
 Weaknesses of Financial Ratios
 BASIC FINANCIAL
STATEMENT
 Annual report issued annually to
stockholder.
 It consists of :
 Verbal Statement
 Balance sheet,
 Income Statement,
 Cash flows statement,
 Statement of retained earnings

 Investors used to evaluate company performance & form

expectation about future earnings & dividends & about the
riskiness of the expected values
 Users of Financial
Statements
Users of Financial
Statements

Internal Users External Users

•Manager •Shareholder
• Other officer •Investors
•Creditors
•Customer
•Tax Agents
•Employees
 VERBAL STATEMENT
As a letter from the chairperson
of the BOD that describe the past
& expected performance of the
firms.
Explaining on the financial
statement
 BALANCE SHEET
Represent snapshot of firm’s financial
position at specific point in time
Consist of :
◦ Assets (i.e. current and fixed)
◦ Liabilities (i.e. short and long term)
◦ Owner’s equity (i.e. common equity)

Balance Sheet Equation

ASSET = LIABILITIES + OWNER’S
EQUITY
 Balance Sheet as at December 20XX

ASSETS LIABILITIES AND EQUITIES

Current Assets Current Liabilities
Marketable Securities Account Payable
Account Receivable Notes Payable
Inventories Accruals
Prepaid expenses Total Current Liabilities
Total Current Assets
Long Term Debt
Fixed Assets
Plant and Machinery Common Equity
Land and Buildings Common Stock
Total Fixed Assets Preferred Stock
Retained Earnings
Capital Invested
TOTAL ASSETS TOTAL LIABILITIES AND EQUITY
Types of Assets
Current Asset Fixed Assets
Cash Building
Marketable Securities Machine and Equipment
Account Receivables Long Term Investment
Inventory

Types of Liabilities
Current Liabilities Long Term Liabilities
Account Payable Long Term Debt
Notes Payable Mortgage Loans
Tax Accruals
Owners’ Equity

Owners’ Equity comprised of:

a) Preference Shares
b) Ordinary Shares
c) Paid up capital above par
d) Retained earnings
 INCOME STATEMENT
 The summary of the firm’s operating result over a
period of time
 Shows Revenues (i.e. sales & other income), costs
(i.e. COGS), expenses incurred & Profit

Profit = Sales - Expenses

Split into 2 parts:

◦ Operating activities
◦ Financing activities
 Income Statement for the year ended December 20XX

Revenue/Net Sales
OPERATING less: COGS
ACTIVITIES Gross Profit
less: Operating Expenses
Depreciation
Operating Income/EBIT

plus: other income

less: Interest
Earnings Before Taxes / EBT
FINANCING less: Corporate Taxes
ACTVITIES Net Income/ EAT
Dividend: Preferred
Common
Retained Earnings
Variables:
◦ Sales/Revenue (i.e. cash & credit
sales)
◦ COGS (i.e. cost to produce goods or
services)
◦ Operating exp (i.e. marketing,
administration etc)
◦ Interest (i.e. financing cost)
◦ Tax expenses (i.e. payment to govt)
◦ Net Income (i.e. to distribute to
shareholders)
 Financial Ratios
As an Analysis tools (i.e. to interpret and
evaluate firm’s performance)
determine the financial health of a company.
We can compare a company’s financial ratios
with its ratios in previous years (trend analysis
We can compare a company’s financial ratios
with those of its industry.
Base on financial statement
Users (i.e. Managers, investors, or interested
parties
Group into 5 categories
◦ Liquidity ratios
(how liquid the firms to meet short-term obligation)
◦ Activity ratios
◦ (to measure efficiency of assets to generate
sales)
◦ Leverage ratios
◦ (how firms finance its assets, to determine the
capital structure)
◦ Profitability ratios
◦ (measure the efficiency of firms to generate profit)
◦ Market/Equity ratios
◦ (concern to shareholders)
 Liquidity Ratios
Current Assets
Current Ratio = Current Liabilities

It shows the firm ability to pay its short term obligations

C.Asset – (Inventory + Prepayment)

Quick Ratio = Current Liabilities

Also known as Acid – Test Ratio. It measure firm’s ability to pay short tem
obligation without having rely on the sale of inventory.
 Net Working Capital = CA - CL

It measures the solvency in RM & not in ratio. Positive NMC indicates

the amount in CA that are financed with L/term financing. If NWC is
negative, it shows the amount of F.A that are financed with current
liabilities.
It shows how much a business have to run its business operation,
 Activity or Asset Management Ratios

Inventory Turnover = COGS or Sales

Inventory
It measures how effectively the firm is using its inventory to generate sales.
Low ITO shows the firm is holding excess & unproductive stock. In 1 year,
how many times it replace its stock.

Average = A/c Receivables

Collection Period Daily Sales

OR
 Average = 360
Collection Period A/C R Turnover
Length of time that the firm must wait after making credit sales before
receiving cash.

A/C Receivable Credit Sales

= A/C Receivable
Turnover

It indicate, how many times AR is collected within 1 year.

 Fixed Assets Sales
= Fixed Assets
Turnover

It measure the firm’s utilization of its fixed assets. Higher ratio indicates
that more revenues can be generated per RM of investment in FA

Total Assets Sales

Turnover = Total Assets
It measure the firm’s effectiveness in using all its assets. Higher ratio is
preferable.
 Average 360
Inventory Sales = Inventory
Period Turnover

OR

Average
Inventory Sales = Inventory
Daily Sales
Period

It shows the number of days taken to make one round of inventory sales.
 Leverage or Solvency Ratios

Total Liabilities X 100

Debt Ratio = Total Assets

It measure the % of total funds provided by creditors compared to funds

by owner capital. High ratio, high financial risks

Debt L/T Liabilities

=
Equity Ratio Equity
It measure the relative funds provided by creditors as compared to owners
or net worth in the firm’s financial structure. Ratio >1 means creditor
provided more than owners. If ratio < 1 means more funds provided by
owners.
 Equity Multiplier = Total Asset
Total equity
It shows the asset ownership for each ringgit of equity.

Interest Coverage EBIT

= Interest
Ratio

It measure the firm’s ability to meet interest payment . Higher ratio

indicates higher capability to repay interest charges.
 Profitability Ratios

Gross Profit = Gross Profit X 100

Margin Sales
Expressed in %, measure the profitability of a firm. Every RM in sales, we
will able to known how much is the gross profit.

Operating
= Opr. Profit (EBIT) X 100
Profit Margin Sales
Expressed in %, it indicates how much operating profit is made from
every RM of sales.
Net Profit = Profit After Tax X 100
Margin Sales
Measure in %, higher ratio indicates better income to shareholders

Return On Profit After Tax

Assets = Total Assets X 100

It measure the firm’s overall return on all of its assets in %. It tells us how
much net profit is obtained from each RM of asset invested.
Return On Profit After Tax
= Total Equity X 100
Equity

It measures the rate of return on the investment of the common

stockholder or net worth. Higher return is preferable due to higher
return for the owners of the firm.

Earning Earnings After Tax

= No. of common shares
Per Share

Answer in RM, higher ratio indicates better income per share

 Market/Equity Ratios

Price to Market Price p/share

Earnings = EPS

Higher ratio indicates the firm’s market price is overvalued

Dividend p/share
Dividend Yield = Market price p/share

It measures the rate of return in the form of dividends received from

a share investment.
FINANCIAL RATIO ANALYSIS
Income Statement for the year ended December 31, 2008
Balance Sheet as at December 31, 2008
 Liquidity Ratios

Liquidity Ratios 2008 Industry

1) Current ratio (times)

Current Assets 146 1.85 2X

Current Liabilities 79

2) Quick ratio (times)

Current Assets- Inventories 146 - 82 0.81 1.2X

Current Liabilities 79

3) Net working Capital

Current Asset - Current Liablities 146 - 79 67.00 none

Profitability Ratios
Activity Ratios
Leverage or Solvency Ratios
 WEAKNESSES OF FINANCIAL
RATIOS
1) Accuracy
It depends on the accuracy of the data
found in financial statements

2) Industrial comparison
Industrial ratio is only a rough estimate
due
to difficulty to obtain the entire similar
firms in the same industry
3) Does not show the actual size
Financial ratio is a relative
measurement
and does not show the actual size of the
firm.

4) Cannot show the issue

Financial ratio is used to measure the
status
of the firm but it cannot show the issues
that had caused the situation.