FIN 260/242

FUNDAMENTAL OF FINANCE

FINANCIAL ANALYSIS
 FINANCIAL ANALYSIS

Definition:

Financial analysis is the process of collecting and refining

financial data, to provide necessary information to aid
decision making in an effort to determine future course of
actions, that will ensure owners wealth.
It concerns with identification of problems and complications whether
qualitatively or quantitatively.
It deals with the historical aspects of firms performance – study of firms
financial statements – looking into its position at the point of time and its trends
over time.
 FINANCIAL ANALYSIS
Why have to do Financial Analysis?
1. To assess operating results and financial status of the firm
( Controlling).

2. To assist management in making plans and strategies so as

to keep firm in line towards maximizing owners wealth
( Planning) - evaluate firm’s performance
- find information for planning
- identify problems for corrective actions.

3) Financial analysis is useful to evaluate possible outcome

and consequences for the proposed investment and or
financing – identify types of necessary action to be taken.
 BALANCE SHEET
 Balance sheet is the most basic and
essential financial statement.
 Described by basic accounting equation
whereby Assets = Total of liabilities +
Owners Equity.
 Purpose of balance sheet is to show:
 the wealth of the company (assets) and
the two possible claims on that wealth which
are creditors claim (liabilities) and owners
claim (owner’s equity / stockholders equity)
at a given point in time.
 SYARIKAT SENI BINA
BALANCE SHEET AS AT 31 DECEMBER 2012
2011 2012
RM RM
ASSETS
Current assets
Cash 40,000 0
Accounts receivable 120,000 390,000
Inventories 150,000 300,000
Fixed Assets
Building 100,000 135,000
------------ ------------
Total assets 410,000 825,000
======= =======
LIABILITIES & EQUITY
Current Liabilities
Note payable 0 200,000
Accounts payable 110,000 210,000
Accruals 70,000 130,000
Long Term Liabilities
Long-term loan 50,000 30,000
Owners Equity
Common shares 100,000 120,000
Retained earnings 80,000 135,000
------------ -------------
Total Liabilities And Equity 410,000 825,000
======= =======
BALANCE SHEET: ASSETS

Left hand side – shows firm Investment Decisions

Assets – what the business Owns?

Consists of;

Current Assets

– Cash (actual money) and other assets that can be converted into cash in less than
1year. It represent WORKING CAPITAL – WHICH PROVIDE SUPPORT FOR
DAY TO DAY OPERATIONS. Without working capital the firm cannot operate
efficiently.

Fixed Assets

– Asset acquired for long term use to generate income. They cannot be easily
converted into cash within a short period of time.
 They could be stated in Gross Value (Book value) or Net Value = Gross
Value LESS Accumulated Depreciation
 E.g. Land, building, motor vehicles, equipment, premises etc.
BALANCE SHEET: LIABILITIES
Hand Side – shows firm’s Financial Decisions.
LIABILITIES
– What the business wed to lender (bank).
Long Term Liabilities
– Debts which are due or payable beyond 1 year e.g. Long term Debt,
Bonds, Debentures.
Current Liabilities
– Debts that are due and payable within 1 year period or less. e.g.
Account payable – amount owed to supplier, Accruals ( wages accruals,
Tax accruals)– amount owed to employees and tax authority. e.g. Notes
payable – amount firm.
STOCKHOLDERS EQUITY OR OWNERS EQUITY
– represents the owners claim on the Right Owes? Consist of;
e.g. Common Equity – represent the ownership position in the firm. ( Equity
Account consists of;\Common Stock, Premium = is capital paid in excess of par
value of common stock, Retained Earnings). Preferred Stock.
 INCOME STATEMENT

Income statement shows the change

in equity as a result of operating a
business during a specific period of
time.
This statement shows the change in
owner’s equity that results from
the sales made to customers
(revenue) minus the resources
consumed to operate the business
(expenses).
 SYARIKAT SENI BINA
INCOME STATEMENT 31 DECEMBER 2011 AND 2012

2011 2012
RM RM
Sales 800,000 1,600,000
Cost of goods sold (COGS) 600,000 1,248,000
----------- -------------
Gross profit (GP) 200,000 352,000
Less Depreciation 10,000 12,000
Operating expenses 90,000 162,000
----------- -------------
Earnings before interest & taxes (EBIT)
(Operating Profit ) 100,000 178,000
Less: Interest 10,000 5,000
----------- --------------
Earnings before taxes (EBT) 90,000 173,000
Less: Taxes 50,000 90,000
----------- --------------
Earnings after Taxes (EAT/ NPAT / NI ) 40,000 83,000
Add Depreciation 10,000 12,000
====== ========
Earnings after Taxes (EAT/ NPAT / NI ) 50,000 95,000
USERS OF FINANCIAL STATEMENTS

1. Shareholders/owners – interested in the profits

earned, financial health performance and potential
growth of the company.
2. Managers – need financial statements to evaluate
the firm’s performance, for planning, organizing
and controlling the firm’s resources.
3. Creditors/lenders – interested in the firm’s
profitability and in the firm’s ability to repay loans.
4. Current and future employees – to determine the
monetary benefits that they can obtain from the
firm.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 10
USERS OF FINANCIAL STATEMENTS

5. Prospective investors – to assess profitability,

stability, growth potential and financial health.
6. Customers – to ensure that the company can deliver
not only the goods ordered but also the legal
obligations associated with guarantees, warranties
or deferred benefits
7. Government – to determine the firm’s declaration
and payment of taxes, fix price of essential goods
and utilities and make expansion plans for the
economy.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 11
WHAT IS FINANCIAL ANALYSIS?

1. Assessment of a firm’s past, present and anticipated

future performance.
2. Analysis is based on the firm’s financial statements.
3. Focus on historical performance to estimate future
performance.
4. Allows comparison of company’s performance over
time as well as its performance relative to its
competitors.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 12
OBJECTIVES OF FINANCIAL ANALYSIS

To identify the firm’s strengths so that the

company can capitalize these strengths
and weaknesses so that the firm can take
remedial and corrective actions.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 13
FINANCIAL RATIOS
1. Useful indicators of a firm’s performance and
financial situation.
2. Mathematical aids for evaluation and comparison of
financial performance.
3. Used to analyze trends and to compare the firm’s
financials to those of other firms.
4. Tell use whether the business :
1. Is profitable
2. Has enough money to pay its bills
3. Could be paying its employees higher wages
4. Is paying its share of tax
5. Is using its assets efficiently
6. Has a gearing problem
E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 14
OBJECTIVES OF RATIO ANALYSIS

1. To standardize financial information for comparison

purposes
2. To evaluate the firm’s current operation
3. To compare present performance with past performance
4. To compare the firm’s performance with other firms or
industry standards.
5. To assess the efficiency of operations
6. To assess the risk of operations.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 15
TYPES OF COMPARISONS
1. Internal Comparison – analysis based on comparisons of
similar ratios for the same firm at different periods. It is also
known as time series analysis or horizontal analysis. For
example, comparing this year’s profitability with last year’s
profitability. The objective is to analyze the financial
condition and performance of the firm over time.

2. External Comparison – involves comparison of ratios of a

firm with ratios of other firms in similar industry. This is
also known as cross-sectional analysis or vertical analysis.
The objective is to identify the firm’s strength and
weaknesses as compared to its competitors.

E V A L U A T I O N O F F I N A N C I A L P E R F O R M AN C E 16
 Liquidity Ratios:
the company’s ability to Efficiency/Activity
meet day-to-day Leverage Ratios:
Ratios: how well the
operating expenses and amount of debt used
company is managing
satisfy short-term by the company
obligations as they
its assets
become due

Profitability Ratios: Market Ratios:

measures how converts key financial
successful the information into per-
company is at creating share basis to simplify
profits financial analysis
 Current Ratio
Provides an indication of the extend to the firm’s liquidity; how far
the claims of short term creditors are covered by current assets
Higher ratio: better
Liquidity Ratios

Lower ratio: worse

Current Ratio, CR = Current Asset

Current Liabilities
Acid-test Ratio (Quick Ratio)
• Measure ability of firm to pay off its short term obligations
without having rely on the sale of inventory
• Higher ratio: better
• Lower ratio: worse

Quick Ratio, QR = Current Asset - Inventories

Current Liabilities
 Net Working Capital (Working Capital Ratio)
A measure of both a company's efficiency and its short-
term financial health. This ratio indicates whether a
Liquidity Ratios

company has enough short term assets to cover its

short term debt. Anything below 1 indicates negative
W/C (working capital). While anything over 2 means
that the company is not investing excess assets. Most
believe that a ratio between 1.2 and 2.0 is sufficient.
Show in RM value how much current asset
is more than current liabilities.

Net working capital, NWC = Total Current

Asset – Total Current Liabilities
 Average Collection Period
Average length of time that firm must wait after making credit
sales before receiving the cash
Higher ratio: worse
Activity Ratios

Lower ratio: better

ACP = Account Receivable (360)

Net Sales

Inventory Turnover
• How effective the firm use its inventory to generate sales,
holding excess and unproductive stocks
• Higher ratio: better
• Lower ratio: worse

Inventory Turnover = Cost of Good Sold

(ITO) Inventory
 Total Asset Turnover
how efficiently and effectively the company is using its assets to
support sales
Higher ratio: better
Activity Ratios

Lower ratio: worse

TATO = Net Sales

Total Assets

Fixed Asset Turnover

• how efficiently and effectively the company is using its fixed
assets like plant and equipment to support sales
• Higher ratio: better
• Lower ratio: worse

FATO = Net Sales

Net Fixed Assets
 Debt Ratio
• Measure the percentage of total funds provided by
creditors as compared to funds provide from owners
capital
Leverage Ratios

• Higher ratio: worse

• Lower ratio: preferable
Debt Ratio, DR = Total Debt
Total Assets

Debt to Equity Ratio

• how much debt the company is using to support its
business compared to how much stockholders’ equity it is
using to support its business
• Higher ratio: high risk
• Lower ratio: less risk

Debt to Equity Ratio = Long Term Debt

(DER) Shareholder’s equity
 Times Interest Earned
• measures the ability of the firm to meet its fixed interest
payments
• Higher ratio: better
Leverage Ratios

• Lower ratio: worse

Times Interest Earned = EBIT

(TIE) Interest
 Net Profit Margin
• amount of profit earned from sales and other operations
Profitability Ratios
• Higher ratio: better
• Lower ratio: worse

Net Profit Margin = Net Profit

(NPM) Net Sales

Gross Profit Margin

• Measure the firm’s ability to control cost of good sold
relative to its sales revenue
• Higher ratio: better
• Lower ratio: worse

Gross Profit Margin = Gross Profit

(GPM) Net Sales
 Return on Assets
• amount of profit earned on each dollar invested in assets;
Profitability Ratios
measures management’s efficiency at using assets
• Higher ratio: better
• Lower ratio: worse

Return on Assets = Net Profit

(ROA) Total Assets

Return on Equity
• amount of profit earned on each dollar invested by
stockholders; measures management’s efficiency at using
stockholders’ funds
• Higher ratio: better
• Lower ratio: worse

Return on Equity = Net Profit

(ROE) Shareholders’ Equity
 Operating Profit Margin
Profitability Ratios
• Operating margin is a measurement of what proportion of a
company's revenue is left over after paying for variable costs
of production such as wages, raw materials, etc.
• Higher ratio: better
• Lower ratio: worse

Operating Profit
Margin = Operating Profit
(OPM) Net Sales
 Price/Earning Ratio
• Shows how the stock market is pricing the company’s
common stock
• One of the most widely used ratios in common stock selection
Market Ratios

• Often used in stock valuation models

• Higher ratio: more expensive
• Lower ratio: less expensive

Market price of common stock

P/E 
EPS

Net profit after taxes  Preferred dividends

EPS 
Number of common shares outstanding
 What is the P/E ratio for a company with profits of
$139.7 million, 61,815,000 outstanding shares of
common stock and a current market price of $41.50
per share?
Market Ratios

$139,700,000
EPS  or $2.26
61,815,000 shares

$41.50
Price/Earnings ratio  or 18.4
$2.26
 Dividends per Share
• the amount of dividends paid out to common stockholders

Annual dividends paid to common stock

Dividends per share 
Market Ratios

Number of common shares outstanding

Dividend Payout Ratio (DPOR)

• how much of its earnings a company pays out to
stockholders in the form of dividends
– Traditional payout ratios have been 40% to 60%
– Recent trends have been lower payout ratios, with more tax
efficient stock buyback programs used frequently
– High payout ratios may be difficult to maintain and the stock
market does not like cuts in dividends

Dividends per share

Payout ratio 
Earnings per share
 Earnings Per S hare

Earnings Per Share: the amount of annual earnings

available to common stockholders, stated on a per-
share basis

• Earnings are important to stock price

• Earnings help determine dividend payouts

Net profit
 Preferred dividends
after taxes
EPS 
(RM) Number of shares of
common stock outstanding
 Dividend Yield

Dividend Yield: a measure to relate dividends to

share price on a percentage basis
• Indicates the rate of current income earned on the
investment dollar
• Convenient method to compare income return to other
investment alternatives

Annual dividends received per share

Dividend yield 
(%) Current market price of the stock
BREAKING DOWN RETURN ON ASSETS
(ROA)
Breaking down ROA allows investors to identify the
components that are driving company profits.

ROA  Net profit margin  Total asset turnover

Investors want to know if ROA is moving up (or

down) because of improvement (or
deterioration) in the company’s profit margin
and/or its total asset turnover.
BREAKING DOWN RETURN ON ASSETS
(ROA) (CONT'D)
Breaking down ROE allows investors to identify
the impact of financial leverage on company
return.
ROE  ROA  Equity multiplier
Total assets
Equity multiplier 
Total stockholders’ equity

Investors want to know if ROE is moving up (or

down) because of how much debt the company
is using or because of how the firm is managing
its assets and operations.