CHAPTER 2

Financial Analysis

 Definitions and functions of

financial statement
 Financial ratios
 Basic sources and uses of
funds
 What is Financial Analysis?

“ Is the process of collecting and refining

financial data to provides necessary
information to aid decision making in an
effort to determine future course of actions”
 The Study of Financial Statement (i.e. historical
performance)
 Enables:
▪ To assess operating result & financial status
▪ To assist in developing plans and strategies
 Financial Statements

Consists of:
▪ A statement of financial position,
▪ A statement of financial performance,
▪ Cash flows statement,
▪ Statement of retained earnings

❑ Primary source of data information and the

standing of operations and financial
 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
Assets = Liabilities + Owner’s Equity
 Format
Statement of financial position 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

Fixed Assets Long Term Debt

Plant and Machinery
Land and Buildings Common Equity
Total Fixed Assets Common Stock
Preferred Stock
Retained Earnings

TOTAL ASSETS TOTAL LIABILITIES AND EQUITY

 Statement of financial position
(cont..)

Types of Assets
◼ Cash (i.e. cash balance from cash transaction)
◼ Marketable securities (i.e. temporary investment)
◼ A/c receivables (i.e. debtors)
◼ Inventories (i.e. materials, WIP & unsold product)
◼ Prepaid (i.e. advance payment on expenses)
◼ Fixed assets (subjected to depreciation)
 Statement of financial position
(cont..)

Types of Liabilities & Equities

◼ A/c payables (i.e. creditors)
◼ Notes payable (i.e. short term loan)
◼ Other payables (i.e. interest payment or income tax
payable)
◼ Accrued expenses (i.e. unpaid expenses )
◼ Capital stock (i.e. common or preferred stock)
◼ Retained earnings (i.e. reserved)
 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
 A statement of financial
performance(cont..)
statement of financial performance the year ended
December 20XX

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

plus: other income

less: Interest
Earnings Before Taxes
Financing less: Corporate Taxes
Net Income
Activities
Dividend: Preferred
Common
Retained Earnings
 A statement of financial
performance(cont..)

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)
 Statement of Retained Earnings

 Shows the distribution of the firm’s net

income
 How much the retained earnings
 Relates to dividend policy
 Investment & Need for Dividend
 Statement of Retained Earnings
(cont..)

Statement of Retained Earnings for the year ended December 31, 20X2

Balanced of retained earnings, Dec 31, 20X1 XXX

add: Earning after tax 20X2 XXX
less: Dividend, 20X2 XXX
Balanced of retained earnings, Dec 31, 20X2 XXXX
 Cash Flow Statement

 Summarizes the inflows and outflows of

cash transactions for the year
 Divided into 4 categories:
◼ C/flow from Operations
◼ C/flow from Investments
◼ C/flow from financings
◼ Reconciliation of cash
 Financial Ratios

 As an Analysis tools (i.e. to interpret

and evaluate firm’s performance)
 Base on Financial Statement
 Users (i.e. Managers, investors, or
interested parties )
 Two ways to interpret:
◼ Trend analysis (i.e. vertical or time
series)
◼ Comparative analysis (i.e. horizontal)
Uses of financial ratios in the firm
 Identify deficiencies in a firm’s performance
and take corrective action.
 Evaluate employee performance and
determine incentive compensation.
 Compare the financial performance of the
firm’s different divisions.
Uses of financial ratios in the firm
 Prepare, at both firm and division levels,
financial projections.
 Understand the financial performance of the
firm’s competitors.
 Evaluate the financial condition of a major
supplier.
Uses of financial ratios in the firm
Financial ratios are used by
 Lenders in deciding whether or not to lend to a
company.
 Credit-rating agencies in determining a firm’s
creditworthiness.
 Investors (shareholders and bondholders) in deciding
whether or not to invest in a company.
 Major suppliers in deciding to whether or not to
extend credit to a company or in designing the
specific credit terms.
 The Limitations of Financial Ratio
Analysis
1. It is sometimes difficult to identify industry categories or
comparable peers.
2. The published peer group or industry averages are only
approximations.
3. Industry averages may not provide a desirable target ratio.
4. Accounting practices differ widely among firms.
5. A high or low ratio does not automatically lead to a specific
conclusion.
6. Seasons may bias the numbers in the financial statements.
 Financial Ratios (cont..)

 Group into 5 categories

◼ Liquidity ratios (i.e. how liquid the firms to meet
short-term obligation)
◼ Activity ratios (i.e. to measure efficiency of
assets to generate sales)
◼ Leverage ratios (i.e. how firms finance the its
assets, to determine the capital structure)
◼ Profitability ratios (i.e. measure the efficiency of
firms to generate profit)
◼ Market/Equity ratios (i.e. concern to
shareholders)
 Financial Ratios (cont..)

Liquidity Ratios
Current Ratio
Answer in X, higher ratio reflect the ability to pay its short-term obligations
on time

Quick Ratio =

Answer in X, higher ratio reflect the ability to pay its short-term obligations
without rely on inventories
 Financial Ratios (cont..)

Liquidity Ratios
Net Working =
Capital
Answer in $, higher (i.e. positive value), absolute measure in liquidity
 Financial Ratios (cont..)
Activity Ratios
Inventory
Turnover =
Answer in X, higher ratio reflect the effectiveness of inventory to generate
sales

Answer in Days, higher ratio indicates that firm has problem in collecting
debt
 Financial Ratios (cont..)
Activity Ratios

Account
Receivable =
Turnover
Answer in X, higher ratio reflect the effectiveness in collecting receivables
 Financial Ratios (cont..)
Activity Ratios
Fixed Assets
Turnover =
Answer in X, higher ratio reflect the effectiveness of fixed assets to generate
sales

Total Assets =
Turnover
Answer in X, higher ratio reflect the effectiveness of total assets to generate
sales
 Financial Ratios (cont..)
Leverage or Solvency Ratios
Debt
Ratio =
Answer in %, higher ratio reflect the higher amount of debt to finance assets

Debt to
Equity =
Answer in %, higher ratio reflect the higher amount of debt (i.e. capital
structure
 Financial Ratios (cont..)
Leverage or Solvency Ratios
Time Interest
Earned =
Answer in X, higher ratio indicates that firm can meet loan requirement and
lower risk of default
 Financial Ratios (cont..)
Profitability Ratios
Gross Profit
Margin =
Answer in %, higher ratio indicates higher contribution margin

Operating
Profit Margin =
Answer in %, higher ratio indicates better productivity (i.e. operations)
 Financial Ratios (cont..)
Profitability Ratios
Net Profit
=
Margin
Answer in %, higher ratio indicates better income to shareholders

Return On
Assets
/ Investment
Answer in %, higher ratio indicates higher return on firm’s investment
 Financial Ratios (cont..)
Profitability Ratios

Return On =
Equity

Answer in %, higher ratio indicates higher return to shareholders

Example: Financial Ratio Analysis
Statement of financial performance for the year ended
December 31, 2020
RM'000
Revenue/Net Sales 1500
less: COGS 450
Gross Profit 1050
less: Operating Expenses 450
Other operating expenses 300
Operating Income(EBIT) 300

plus: other income none

less: Interest 25
Earnings Before Taxes 275
less: Corporate Taxes (40%) 110
Net Income 165
less: Dividend- Preferred none
Common 33
Retained Earnings 132
Example: Financial Ratio Analysis
(cont..)
Statement of financial position as at December 31, 2020

ASSETS LIABILITIES AND EQUITIES

Current Assets Current Liabilities
Cash 12 Account Payable 38
Account Receivable 44 Notes Payable 35
Inventories 82 Accruals 6
Prepaid expenses 8 Total Current Liabilities 79
Total Current Assets 146

Fixed Assets Long Term Debt 180

Plant and Machinery 170
Land and Buildings 450 Common Equity
Total Fixed Assets 620 Common Stock 100
Preferred Stock 150
Retained Earnings 257

TOTAL ASSETS 766 TOTAL LIABILITIES AND EQUITY 766

 Liquidity Ratios
Liquidity Ratios 2020 Industry
1) Current ratio (times)

Current Assets 146 1.85 2X

Current Liabilities 79

2) Quick ratio (times)

Current Assets-Prepaid- Inventories 146 -8- 82 0.71 1.2X

Current Liabilities 79

3) Net working Capital

Current Asset - Current Liablities 146 - 79 67.00 none

 Profitability Ratios
Profitability Ratios 2020 Industry

1) Return on Equity (%)

Earning after tax 165 32.54 32%

Common Equity 507

2) Return on Asset(%)

Earnings after tax 165 21.54 45%

Total assets 766

3) Gross Profit Margin(%)

Gross Profit 1050 70.00 65%

Sales 1500

4) Operating Margin(%)

Operating Income 300 20.00 30%

Sales 1500

5) Net Profit Margin(%)

Net Profit 165 11.00 9%

Sales 1500
 Activity Ratios
Activity Ratio 2020 Industry

1) Asset Turnover (times/yr)

Sales 1500 1.96 5X

Total Assets 766

2) A/c Receivables Turnover (times/yr)

Sales 1500 34.09 40X

A/c Receivables 44

3) Average Collection Period (days)

A/c Receivables 44 10.56 6 days

Daily Sales (1500/360)

4) Inventory Turnover (times/yr)

Sales 1500 18.29 20X

Inventory 82

5) Fixed Assets Turnover

Sales 1500 2.42 none

Fixed Assets 620
 Leverage or Solvency Ratios
Leverage (Solvency) Ratio 2003 2020 Industry
Industry

1) Debt Ratio

Total Debt 259 33.81 30%

Total Assets 766

2) Debt to Equity

Total Debt 259 51.08 50%

Equity 507

3) Time Interest Earned (time)

EBIT 300 12.00 10X

Interest 25
Tutorial (Refer to past year questions)

 Semester June 2019 – Part A: Question 1

 Semester Dec 2019 – Part A: Question 1
To be continued…