11

ANALYSIS OF FINANCIAL
STATEMENTS
 LEARNING OUTCOMES

At the end of this chapter, students should be able to:

q Understand financial statements
q Analyse financial statements
q Perform the comparative analysis and trend analysis
(time series analysis)
q Calculate different financial ratios: profitability, liquidity
and solvency ratios
q Critically examine the performance of an organisation

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–3
 INTRODUCTION

q The main source of data collection and analysis is the

annual financial report of the company.
q The annual report contains the following:
– Financial statements, which include the income statement,
statement of changes in equity, statement of financial position,
statement of cash flows and notes to the account.
– A brief description of accounting principles used.
– The auditors’ report and the management report
– Comparative financial data for at least two years, that includes
the current year and the previous year.
– Other financial and non-financial information and explanation.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–4
 INTRODUCTION (cont.)

q The purpose of the financial statement analysis is as

follows:
– Investors are interested to know the performance of companies,
to calculate their profits (returns) and for wealth creation.
– Lenders want to see the ability of the organisation to remit the
debt burden and all financial charges.
– Government agencies are interested to compute the actual tax
liability of the company and will try to find any kind of
manipulation in the account.
– Researchers may want the analysis for academic purposes.
– The media may study the report for comparison and publication
purposes.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–5
 COMPARATIVE ANALYSIS

q Comparative analysis is essential for ranking companies

in the industry, for investment decisions and for
managerial control.
q The three important comparisons are:
– Intra-company or within company comparison
– Inter-company comparison
– Industry average comparison

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–6
 COMPARATIVE ANALYSIS
(cont.)

q There are three most common analysis methods:

– Horizontal analysis
– Vertical analysis
– Ratio analysis
q Horizontal analysis
– Also known as the time series analysis, it is a technique used
to evaluate a series of data in financial statements over a period
of time. It aims to determine the total and changes in percentage
(increase or decrease) which have taken place.
– The main objective of horizontal analysis is to arrive at the
direction of the flow of information for each item in the statement.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–7
 COMPARATIVE ANALYSIS
(cont.)
– Horizontal analysis shows the development of the flow of
information for each item in detail (i.e. revenue, expenses, profit,
loss, assets, liabilities and capital equity).
– This analysis will be more meaningful if conducted for a long
tenure, e.g. 5 to 10 years.
q Vertical analysis
– Also known as common-size analysis, it states all the items in
financial statements in percentages of a base amount. This
approach enables companies to draw comparisons with other
companies of different sizes.
– Items in the income statement are usually shown in a
percentage form, based on total revenue received for the period.
This means all expenses are stated in the form of percentage to
total revenue/sales.
Fundamentals of Accounting for Non-accounting Students All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–8
 COMPARATIVE ANALYSIS
(cont.)
q Ratio analysis
– Ratio analysis shows the mathematical relation between the
quantity or value of one item and the quantity or value of another
item.
– The relationship can be illustrated in the form of percentage or
ratio.
– Ratio analysis can be divided into three categories: profitability
ratio, liquidity ratio, and solvency ratio.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–9
 TYPES OF RATIO ANALYSIS

q Profitability ratio
– This ratio is calculated to measure the income or the ability
of the business to run the operations for a certain period.
– This ratio is made up of the following:
• Profit margin
• Assets turnover
• Return on assets
• Return on shareholders’ equity
• Return on shares
• Price-earning ratio
• Ratio on payout

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–10
 TYPES OF RATIO ANALYSIS
(cont.)
q Profit margin
– This measures the percentage for every Ringgit of net
income from net sales for a certain period, illustrated as
follows:
Profit Margin = (Net Income/Net Sales) × 100
– If it is compared with gross profit, then it is called gross
profit margin (GPM) and if compared with net profit, then
it is called net profit margin (NPM).
GPM = (Gross Income/net Sales) × 100
NPM = (Net Income/Net Sales) × 100

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–11
 TYPES OF RATIO ANALYSIS
(cont.)
q Assets turnover
– This ratio measures the companies or business’
efficiency in using their assets to generate sales,
computed using the following formula:
Assets turnover = Net income/Average assets
Average Asset is (opening asset + closing asset)/2
q Return on assets
– This measures the profitability of the company as a
whole using the following formula:
Return on assets = Net income/Average assets

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–12
 TYPES OF RATIO ANALYSIS
(cont.)
q Return on shareholders’ equity
– This is one of the popular methods used in businesses to
measure the profitability of ordinary shareholders.
– Return on equity ordinary shareholders indicate the
amount of returns received on every Ringgit invested by
the owner or the ordinary shareholder, calculated as
follows:
Return on equity = Net Income x 100
Average equity of ordinary shareholders

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–13
 TYPES OF RATIO ANALYSIS
(cont.)

q Earnings per share

– Used to measure the amount of net income received by
the company for every ordinary share issued,
calculated as follows:
Earnings per share = Net income
Total ordinary shares issued (units)
– Here, net income is profit after tax. If any preference
shares has been issued by the company, then the
preference dividend should be deducted from the net
income before calculating the EPS.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–14
 TYPES OF RATIO ANALYSIS
(cont.)

q Price-earning ratio
– This measures the market price per ordinary share
when compared with the earning per share of the
company. The formula is:
Price-earnings ratio = Market price of ordinary shares
Earnings per share

– Price-earnings ratio demonstrates the investors’

evaluation on future earnings in the company.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–15
 TYPES OF RATIO ANALYSIS
(cont.)

q Payout ratio
– Payout ratio is also known as dividend rate. This ratio
measures the ability of the company to distribute cash
dividends.
– A company that enjoys a high rate of return will prefer a
low pay off ratio, because a big portion of the net income
will be invested back into the business.
– Thus, the dividend paid by the company will be low. The
formula is:

Payout Ratio = Cash Dividend

Net Income

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–16
 TYPES OF RATIO ANALYSIS
(cont.)

q Liquidity ratio
– Also known as liquid cash ratio, it measures the short-
term ability of the business or company to pay all matured
debts, as well as measures the ability of the company to
have reasonable cash to meet unexpected needs for cash
(contingency plan).
– It can be divided into four types:
• Current ratio
• Quick ratio
• Trade receivables turnover ratio
• Inventory turnover ratio

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–17
 TYPES OF RATIO ANALYSIS
(cont.)

q Current ratio
– Shows the relationship between current assets and current
liabilities.
– This ratio is used widely to evaluate the degree of
liquidity of the company and the ability of the company
to settle its debts in the short term. The formula is:
Current Ratio = Current Assets/Current Liabilities

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–18
 TYPES OF RATIO ANALYSIS
(cont.)

q Quick ratio
– Also known as acid-test ratio, this shows the relationship
between cash, marketable securities (shares) and net
trade receivables (debtors) with current liabilities.
– It measures the ability of the company to settle its
short-term debts fast (immediately). The formula is:
Quick Ratio = (Cash + Marketable securities + Net trade
receivables)/Current liabilities
OR
(Current assets − Inventory)/Current liabilities

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–19
 TYPES OF RATIO ANALYSIS
(cont.)

q Trade receivables turnover ratio

– This ratio measures the number of times, on average,
receivables can be collected in a certain period.
– It is usually used to evaluate the effectiveness of the
credit policy and the debt collection policy of the
company, calculated as follows:

Trade receivable turnover ratio = Net sales − Cash sales

Average net trade receivables (debtors)
= Credit sales
Average net trade receivables (debtors)

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–20
 TYPES OF RATIO ANALYSIS
(cont.)

q Inventory turnover ratio

– This ratio measures the efficiency or number of times
the inventory can be sold by the company.
– The inventory turnover can also be defined as:

Inventory turnover ratio = Cost of sales

Average inventories

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–21
 TYPES OF RATIO ANALYSIS
(cont.)

q Solvency ratio
– This ratio measures the ability of the business to survive
over a long period of time.
– This ratio includes three categories: debts to total assets,
times interest earned ratio and cash debts coverage ratio.
• Debts to Total Assets Ratio: measures the total assets
percentage received from trade payables. The formula is:

Debts to total assets ratio = (Total Debts/Total Assets) × 100

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–22
 TYPES OF RATIO ANALYSIS
(cont.)
• Times Interest Earned Ratio: reveals the number of times a
company is able to repay its interest when the loan has
matured. The formula is:

Times interest earned ratio = Income before tax and interest

Interest expenses

• Cash Debts Coverage Ratio: measures the ability of the

company to pay back its liabilities by cash received from the
operating activities in the long run. The formula is:

Cash debts coverage ratio = Net cash from operational activities

Average liabilities

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–23
 LIMITATIONS OF RATIO
ANALYSIS

q The major limitations are as follows:

– Authenticity of data
– Valuation of data
– Non-uniformity in calculations
– Diversified operations

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–24
 TREND ANALYSIS

q This is also called time series analysis.

q Trend analysis can be determined based on ratio
analysis.
q This can be presented in the form of a graph. This
approach enables the company to analyse the progress
and help with planning for the future.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–25
 TREND ANALYSIS (cont.)

q Figure 11.1 shows the difference between the current ratio

of a company and the average current ratio of the industry
between 2011 and 2016.

Figure 11.1 Comparison between Syarikat Astaka’s current ratio and

the industry’s average current ratio, 2011–2016
Fundamentals of Accounting for Non-accounting Students All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–26
 TREND ANALYSIS (cont.)

q It can be concluded that the financial position of

Syarikat Astaka is much better than that of other
companies in the same industry, in terms of current
ratio.
q Trend analysis helps in decision-making based on the
information available for both company and the industry
average.

Fundamentals of Accounting for Non-accounting Students All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–27