Specific Learning Objectives

Understand the need for interpreting financial

statements.

Identify the different categories of financial ratios

and explain the purpose of each category.

Identify the limitations of financial ratio analysis.

Compute relevant financial ratios to evaluate the

financial position of the company.
Problem Analysis
Adrian has
money to invest

Financial Statements
•Analysis
•Comparison
Other Business information

Plenty Call? Mass Comm?

Financial Statements: Financial Analysis

Financial Analysis with the use of financial ratios

is a useful way of interpreting financial
statements and making useful inference on
profitability, efficiency, liquidity, gearing, cash
flow and investment.
 Main Users of Financial Statements
Internal users:

Employees of the company

Management

Shareholders of the company
External users:

The loan - creditors group

The business contacts, competitors

The analyst /adviser

Potential Investors
 Categories of Ratio
Category Purpose
Profitability ratios (“PR”) Assess business’ ability to earn
a satisfactory profit
Long-term solvency / Gearing Assess the long term finance
ratios (“GR”) risk of the business
Liquidity ratios (“LR”) Assess whether business is able
to pay its creditors, expenses,
loans etc when due
Efficiency (“ER”) / Turnover Assess how efficiently the
ratio company is using its resources
Shareholders’ investment ratios Assess the relationship
(“SR”) between returns and the
money invested.
 Profitability Ratio
The objective of profitability relates to a company’s
ability to earn a satisfactory profit so that the investors
and shareholders will continue to provide capital to it.

The profitability and return ratios are as follows:-

1. Return on capital employed (ROCE)
2. Return on equity (ROE)
3. Gross profit as percentage of sales
4. Net profit as percentage of sales
 Return on Capital Employed (“ROCE”)
Profit on ordinary activities before interest and taxation
Stockholders’ equity + long term liabilities

Plenty Calls Mass Comm

$510,000 $600,000
$400,000 + $180,000 $546,600 + $100,000
= 0.88 = 0.93
ROCE shows how adequate the return is for the amount of capital
investors have invested. In this case, for every $1 of extra borrowing or
investing, the company or the investors respectively can expect an earning
of $0.88 (Plenty Calls) and $0.93 (Mass Comm).
 Return on Equity (“ROE”)
Profit after tax and pref dividends
Ordinary shares and other equities
Plenty Calls Mass Comm
$394,400 $430,100
$400,000 $546,600
= 0.99 = 0.79
ROE reveals how much profit a company generates with the money
shareholders have invested. This ratio suggests that, for every $1 of
investment, the investors can expect an earning of $0.99 (Plenty Calls) and
$0.79 (Mass Comm).
Note: ROE is also understood as Net income before dividends paid to common
stock holders (but after dividends to preferred stock)/ Shareholders’ equity
excluding preferred shares. It is also known as "return on net worth".
 Gross Profit (“GP”) & Net Profit (“NP”) as
Percentage of Sales
Gross Profit x 100% Net Profit x 100%
Sales Sales

Plenty Calls Mass Comm

Gross Profit Margin Net Profit Margin Gross Profit Margin Net Profit Margin

$910,000x100% $394,400x100% $900,000x100% $430,100x100%

$1,610,000 $1,610,000 $1,700,000 $1,700,000
= 56.52% = 24.50% = 52.94% = 25.30%

Gross profit margin tells an investor the percentage of revenue / sales left after
subtracting the cost of goods sold. A company that boasts a higher gross profit margin
than its competitors and industry is more efficient. The gross profit margin of Plenty Call
of 56.52% is higher than that of 52.94% for Mass Comm.
Net profit margin tells an investor how much profit for every sales dollar. Plenty Call
has a slightly lower net profit margin of 24.5% compared to Mass Comm of 25.30%.
Long Term Solvency/ Gearing Ratio (“GR”)

These are mostly used by providers of finance to

assess the finance risk of the business.

The 3 main gearing ratios are as follows:

1. Debt ratio
2. Capital gearing
3. Interest coverage ratio
 Debt Ratio
Total liabilities
Total assets
Plenty Calls Mass Comm
$215,000 $165,000
$615,000 $711,600
= 0.35 = 0.23

Debt ratio greater than 1 indicates that a company has more liabilities than
assets. On the other hand, a debt ratio of less than 1 indicates that a company
has more assets than liabilities. The debt ratio can help investors determine a
company's level of risk. This ratio suggests that, for every $1 of assets each
owned, Plenty Calls has borrowed $0.35 and Mass Comm has borrowed
$0.23.
 Capital Gearing Ratio
Total long term debts
Shareholders’ equity + Total long term debts
Plenty Calls Mass Comm
$180,000 $100,000
($400,000+ $180,000) ($546,600 + $100,000)
= 0.31 = 0.15
 Interest Coverage Ratio
Income before interest & tax
Interest Expenses
Plenty Calls Mass Comm
$510,000 $600,000
$18,000 $9,500
= 28.33 = 63.16
 Liquidity Ratio (“LR”)
A company may be profitable but if it fails to generate
enough cash to settle its liability, it is said to be
insolvent or that it has poor liquidity.

The 2 main liquidity ratios are as follows:

1. Current Ratio
2. Quick Ratio
 Current Ratio
Current assets
Current liabilities
Plenty Calls Mass Comm
$280,000 $331,100
$35,000 $65,000
= 8.00 = 5.09
Current ratio compares assets which become liquid within approximately 12
months with liabilities which will be due for payment in the same period and is
intended to indicate whether there are sufficient short-term assets to meet the
short term liabilities.
Plenty Calls current ratio of 8 suggests that it has more short term assets to
meet short term liabilities and is thus more liquid.
 Quick Ratio
Current assets – Inventory
Current liabilities
Plenty Calls Mass Comm
($280,000 – $110,000) ($331,100 – $145,000)
$35,000 $65,000
= 4.86 = 2.86

Quick ratio is similar to Current ratio but it omits inventory (considered to

be relatively illiquid). Plenty Calls Quick ratio of 4.86 is higher than Mass
Comm of 2.86, suggesting that Plenty Calls is more liquid.

Note: A very high current ratio or quick ratio may indicate too much cash (no
proper investment/use of cash). Hence, it is beneficial for investors to look at the
cash value for prudent investment decision making
 Efficiency Turnover Ratio (“ER”)

The efficiency ratios measure how efficiently the

company is using its assets.

The 3 main efficiency ratios are as follows:

1. Debtor Collection Period
2. Creditor Payment Period
3. Inventory Holding Period
 Debtor Collection Period
Accounts receivable* X 365 days
Sales
Plenty Calls Mass Comm
$85,000 X 365 days $86,600 X 365 days
$1,610,000 $1,700,000
= 19.27 days = 18.59 days
Debt Collection Period measures how many days’ sales remain in Accounts
Receivable. That is how efficient is the company in collecting its debts. The fewer
days the better. Hence Mass Comm of 18.59 days is slightly better than Plenty
Calls of 19.27 days.
*Note: Average Accounts Receivable
= Accounts receivable beginning of the year + Accounts receivable at end of year
2
Since the accounts receivable beginning of the year was not available in the problem statement, we
could only use the end of year accounts receivable.
 Creditor Payment Period
Accounts Payable* X 365 days
Purchases*
Plenty Calls Mass Comm

$29,000 X 365 days $32,500 X 365 days

$700,000 $800,000
= 15.12 days = 14.83 days

Credit Payment Period measures how promptly the company is paying its debts, Mass
Comm (14.83 days) takes a shorter period to pay for its purchases as compared to Plenty
Calls (15.12 days). A higher number indicates either that Plenty Calls has decided to hold
on to its money longer or that it is having difficulty paying creditors.
*Note: Average Accounts Payable
= Accounts payable beginning of the year + Accounts payable at end of year
2
• Since the accounts payable beginning of the year was not available in the problem statement, we
could only use the end of year accounts payable.
• The purchases figure is usually not available in published financial statements and so the cost of sales
amount could be used in its place.
 Inventory Holding Period
Inventory* X 365 days
COGS
Plenty Calls Mass Comm
$110,000 X 365 days $145,000 X 365 days
$700,000 $800,000
= 57.36 days = 66.16 days
Inventory Holding Period measures how efficient is the company in selling
its inventory. It indicates the holding period of the inventory in the warehouse.
For Plenty Calls, its inventory holding period is 57.36 days. Mass Comm holds
its inventory for 66.16 days. Since Plenty Calls has a shorter inventory holding
period, it shows that it is selling its inventory faster than Mass Comm.
Although PC is selling faster, it is not earning back its cash as fast as MC since it
has a higher debt collection period.
*Note: Average Inventory = Inventory beginning of the year + Inventory at end of year
2
Since the inventory beginning of the year was not available in the problem statement, we could only
use the end of year inventory. In addition, net inventory provides for provisions (such as write downs)
and should be used when available.
 Shareholders’ Investment Ratio

Investment ratios are concerned with the return on
investment for shareholders, and with the
relationship between return and the value of an
investment in company’s shares.

The main shareholders’ investment ratios are as
follows:
1. Dividend Cover
2.Dividends Yield
3. Price Earning Ratio

As the companies (Plenty Calls and Mass Comm)
are not listed on public exchange, there is no price
or dividend per share information to compute their
ratios.
 Summary
RATIOS Plenty Calls Mass Comm
PR - ROCE 0.88 0.93
PR - ROE 0.99 0.79
PR - GP Margin 56.52% 52.94%
PR - NP Margin 24.50% 25.30%
GR - Debt Ratio 0.35 0.23
GR – Capital Gearing 0.31 0.15
GR – Interest Coverage Ratio 28.33 63.16
LR – Current Ratio 8.00 5.09
LR – Quick Ratio 4.86 2.86
ER - Debtor Collection Period 19.27 days 18.59 days
ER - Creditor Payment Period 15.12 days 14.83 days
ER - Inventory Holding Period 57.36 days 66.16 days
 Summary on Financial Statements of
Plenty Calls (PC) and Mass Comm (MC)

Both PC and MC are relatively close in their performance for the year 2008
in terms of profitability ratio and efficiency ratios.

MC has managed their gearing better than PC.

Although PC has a higher level of debt than MC, we need more information to
understand why PC needs to borrow (e.g. expansion, R&D, etc).

PC has a higher level of liquidity and shorter inventory holding period

compared to MC.

In terms of liquidity, PC scores better than MC and is able to repay its short term debts.

PC may be too liquid and not managing its short term finance well. It may be holding too
much cash and should invest any excess cash or use the excess cash to repay some of its
loans.
 Summary on Financial Statements of
Plenty Calls (PC) and Mass Comm (MC)

Based on the financial statements provided for financial year ended 31 Dec
2008, MC may seem to have performed better.

However, it would be prudent for Adrian to look at past year financial

results of both companies to see the general trend of their performance
and reference their performance to other companies in the same industry.
 Limitations of Financial Ratio Analysis

Financial ratios are tools to assist business decisions,
but they are rarely adequate in itself, being
quantitative in nature.

The financial ratios are only as good as the sources

where they come from, which are influenced by:-

Accounting standards of the country

Management’s inclination to adopt standards that only reflect
well on the company, etc
 Interpretation of
Non-Financial Information

In order to make a holistic & meaningful comparison

of PC and MC, Adrian has to use other information as
well from other sources.

For Example:

Market information on market standing

Reputation

Adrian’s risk appetite and investment objectives
 Mind Map
Current
Benchmark
Ratio
Quick Ratio
Shareholders’ Analyse and
Investment Compare Liquidity
Ratio

Profitability
INVEST Efficiency

ROCE Debt
Gearing Collection

ROE
Debt Capital Creditor Payment
Gross Profit Ratio Gearing
Margin
Inventory Holding
Interest Coverage
Net Profit Margin Ratio
Resources
Websites

Analyzing your Financial Ratios [Retrieved on 24 Feb 2009]
http://www.va-
interactive.com/inbusiness/editorial/finance/ibt/ratio_analysis.html

Financial Ratio Tutorial [Retrieved on 24 Feb 2009]
http://www.investopedia.com/university/ratios/

Textbooks

Lawrence Gitman, Chapter 2, Principles of Managerial Finance, 11th Edition,
Pearson Education

Frank Wood & AlanSangster, Chapter 27, 28, Business Accounting 2, 10th
edition, Prentice Hall

Gerald I White, Ashwinpaul C Sondhi, Dov Fried, Chapter 4, The Analysis
& Use of Financial Statements, – 3rd Edition, John Wiley

Charles H. Gibson, Chapter 5, Financial Reporting & Analysis – Using
Financial Accounting Information

Sebastian Chong, Current Cases in Comparative Business Analysis,
Financial Info Analysis Pte Ltd

Harrison and Horngren, Chapter 13, Financial Accounting, Sixth Edition,
Pearson – Prentice Hall