AN OVERVIEW

FINANCIAL CONCEPTS
AND ANALYSIS

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FINANCIAL ANALYSIS

 is a process of interpreting the past, present

and future financial condition of a company.

 evaluation of financial statements by using

Ratio Analysis and Fund Flow Analysis.

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 Financial Statements
1. Balance Sheet
2. Income Statement
3. Statement of changes in financial
position
4. Statement of retained earnings

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 1. Balance Sheet
 portrays the financial position of the
firm at a particular date.

 Represents assets, liabilities and

equities.

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 2. Income Statement
 States profit or loss of a firm for a
specific period.

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 3. Statement of changes in financial
position

 Indicates changes in financial position that

occur during a year.
 Complement two previous statement.
 Including changes in net income, retained
earning, assets and liabilities.

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 4. Statement of Retained Earnings

 reports how much of the firm’s earnings

(EAT) were retained in the business rather
than paid out as dividend.

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  a technique that
RATIO is commonly used
ANALYSIS to analyze
financial condition
of a firm.

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Why we need for ratio analysis?

 To evaluate the firm’s financial

performance for the usage of the
owners (investors), managers and
lenders of the firm.

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We will want to answer
questions about the firm’s

 Liquidity
 Activity (Efficient use of Assets)
 Leverage (Financing)
 Profitability

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 Financial Ratios
 Tools that help us determine the financial health of a
company.

TWO TECHNIQUES USED:

 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 known as industry average or
industry norm (comparative analysis).
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 Example:

Ali Baba BERHAD

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 Ali Baba Computers BHD.
Balance Sheet for the year 2006 and 2007 (in USD ‘ 000)
2006 2007

Cash 80 90
Account Receivables 170 190
Inventory 200 220
Net Fixed Asset 200 220
Total Assets 650 720

Account Payable 50 55
Notes Payable 110 135
Long Term Debt 90 105
Common Stock 100 100
Paid-in Capital 100 100
Retained Earning 200 225 13

Total Liability & Equity 650 720

 Income Statement for the year ended 2006 and 2007 (in USD ‘ 000)
31/12/2006 31/12/2007

Sales 900 1 000

Cost of goods sold 720 808
Gross profit 180 192
Operating expenses 80 90
Depreciation 20 22
Operating profit 80 80
Interest /profit payment 13 17
Net income before tax 67 63
Income tax (50%) 33.5 31.5
Net income after tax 33.5 31.5
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 1. Liquidity Ratios

 Do we have enough liquid assets

to meet approaching obligations?

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 Liquidity Ratios
 Liquidity of a business can be defined as
“its ability to meet maturing debt
obligations”

 Referring to short-term debt.

 That is, does or will the firm have the

resources to pay creditors when the debt
comes due?
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 a) Current Ratio

= current assets
current liabilities

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 Comment on single ratio:
 Current ratio = 2.81 times.

 The firm is liquid because the ratio is more

than 1. This indicates that the firm is able to
pay short term debt when it comes due.

 For every USD1.00 of current liabilities, the

firm has USD2.81 to be ready for a payment.
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 Trend Analysis
2006 2007

Current ratio 2.81 times 2.63 times

Comment : In 2007, the firm is less liquid

than the previous year. This indicates that
the ability to pay short term debt is
lower.
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 Comparative Analysis
2007 Industry Average

Current ratio 2.63 times 2.00 times

Comment : The firm is more liquid than

industry average. This indicates that the ability
of the firm to pay short term debt is higher.

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b) Acid Test Ratio (Quick Ratio)

= current assets - inventories

current liabilities

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 Comment on single ratio:
 Acid test ratio = 1.56 times.

 The firm is liquid because the ratio is more

than 1. This indicates that there is a greater
chance that the firm will be able to pay
creditors when payments are due.

 For every USD1.00 of current liabilities, the

firm has USD1.56 to be ready for a payment.
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 Trend Analysis
2006 2007

Acid Test Ratio 1.56 times 1.47 times

Comment : In 2007, the firm is less liquid

than the previous year. This indicates that
the ability to pay short term debt is
lower.
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 Comparative Analysis
2007 Industry Average

Acid Test Ratio 1.47 times 1.50 times

Comment : The firm is slightly less liquid

than industry average. This indicates that in
average the ability to pay short term debt
is slightly lower than other firms in the
industry.
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 2. Activity Ratios

 To see how efficient the firm in

using and managing their assets
to generate sales.

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 a) Average Collection Period

How long (in days) the firm takes to collect

their receivables from debtors.

= accounts receivable
daily credit sales

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a) Average Collection Period

accounts receivable ; or
daily credit sales

accounts receivable ; or
credit sales / 365

accounts receivable X
365
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credit sales
 Comment on single ratio:
 ACP = 69 days

 The firm is taking about 69 days to collect

the firm’s receivables. This indicates that the
firm is quite efficient in managing their
receivables.

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 Trend Analysis
2006 2007

ACP 68 days 69.4 days

Comment : In 2007, the firm is taking the

same period of time to collect it’s
receivables than in year 2006.

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 Comparative Analysis
2007 Industry Average

ACP 69.4 days 30 days

Comment :
 The firm is taking longer period to collect the
firm’s receivables than the industry average.

 This indicates that the firm is slower in the

collection and not being careful in its collection
policies. The firm may not be managing
receivables effectively.
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 b) Inventory Turnover
 Indicates the effectiveness of inventory
management. How many times the firm turns
over their inventories per year.

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 b) Inventory Turnover

= Cost of goods sold ; or

Inventory

= Sales
Inventory

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 Comment on single ratio:
 Inventory Turnover = 3.6 times

 ABC turns their inventory over 3.6 times

per year.

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 Trend Analysis
2006 2007

Inventory 3.6 times 3.67 times

Turnover

Comment : In 2007, ABC turns their

inventory over the same times per year
as in year 2006.

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 Comparative Analysis
2007 Industry Average
Inventory 3.67 times 5.20 times
Turnover

Comment : The firm’s inventory turnover is

lower than industry average. This indicates
that the firm is less efficient in managing
their inventories.

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Low inventory turnover:

The firm may have too much

inventory, which is expensive
because:
 Inventory takes up costly
warehouse space.
 Some items may become spoiled
or obsolete. 36
 c) Total Asset Turnover
 Indicates management’s effectiveness at
managing a firm’s assets (refers to total
assets) – as indicated by the amount of
sales generated per one dollar of total
assets.

sales
total assets
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 Comment on single ratio:
 TATO = 1.38 times

 This ratio shows that the firm is quite efficient

in using its asset to generate sales. This
company is making USD1.38 of sales for
every USD1 invested in total assets.

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 Trend Analysis
2006 2007

TATO 1.38 times 1.39 times

Comment : In 2007, the firm has the same

efficiency level in using its asset to
generate sales as in year 2006.

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 Comparative Analysis
2007 Industry Average

TATO 1.39 times 1.50 times

Comment : The firm’s total asset turnover is

lower than industry average. This indicates
that the firm is less efficient in using their
assets to generate sales.

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 d) Fixed Asset Turnover
 Indicates management’s effectiveness at
managing a firm’s fixed assets – as
indicated by the amount of sales generated
per one dollar of fixed assets.

sales
fixed assets
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 Comment on single ratio:
 FATO = 4.5 times

 This ratio shows that the firm is efficient in

using its asset to generate sales. This
company is making USD4.50 of sales for
every ringgit invested in fixed assets.

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 Trend Analysis
2006 2007

FATO 4.50 times 4.55 times

Comment : In 2007, the firm has the same

efficiency level in using its fixed asset to
generate sales as in year 2006.

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 Comparative Analysis
2007 Industry Average

FATO 4.55 times 7.30 times

Comment : The firm’s fixed assets turnover

is very much lower than industry average.
This indicates that the firm is less efficient
in using their fixed assets to generate sales.

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 3. Leverage Ratios
(financing decisions)
 Measure the impact of using debt
capital to finance assets.
 Firms use debt to lever (increase)
returns on common equity.

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 a) Debt Ratio
Debt ratio indicates how much debt is
used to finance a firm’s assets.

In general companies finance about 40%

of their assets with debt and 60% with
equity.

total debt
total assets
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 Comment on single ratio:
 Debt ratio = 38%

 This ratio shows that the firm finance 38% of

their assets with debt and the other 62% with
equity.

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 Trend Analysis
2006 2007

Debt 38% 41%

ratio

Comment : In 2007, the firm used slightly

more debt to finance its assets as
compared to 2006.

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 Comparative Analysis
2007 Industry Average

Debt 41% 35%

ratio

Comment : The firm’s debt ratio is higher

than industry average. This indicates that
the firm uses more debt to finance their
assets. The firm is taking higher risk.
However, it is still in the normal range.
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 b) Debt Equity Ratio
Measures the relationship between the
long-term fund provided by
creditors/lenders and those provided by
the owner.

It refers to how much financing was

funded by long-term liabilities as
compared to equity.

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 b) Debt Equity Ratio

= Long-term debt
total stockholders equity

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 Comment on single ratio:
 DER = 22.5 %

 This ratio shows that in financing its activities

the firm used 22.5% long-term debt as
compared to the total stockholders equity.

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 Trend Analysis
2006 2007

DER 22.5% 24.7%

Comment : In 2007, the firm used slightly

more long-term debt to finance its
activities as compared to 2006.

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 Comparative Analysis
2007 Industry Average

DER 24.7% 17%

Comment : The firm’s debt equity ratio is

higher than industry average. This
indicates that the firm uses more long-term
debt as compared to shareholders equity.
The firm is taking higher risk.
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 3. Profitability Ratios

 Measure how efficiently the

firm’s assets and capital to
generate profits.

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 a) Net profit margin
Measures the net income of a firm as a
percent of sales.

Net profit
Sales

*Net Profit = Net income =

Earnings After Tax (EAT)
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 Comment on single ratio:
 NPM = 3.72%

 This ratio shows that the net profit of ABC is

3.72% out of total sales. In other words, this
company can only generate net profit of
USD0.04 out of USD1 sales.

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 Trend Analysis
2006 2007

NPM 3.72% 3.15%

Comment : In 2007, the firm generate

slightly less net profit out of its total sales as
compared to the previous year.

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 Comparative Analysis
2007 Industry Average

NPM 3.15% 5.50%

Comment : The firm’s net profit margin is

lower than industry average. This indicates
that the firm is generating lower net profit
out of its sales as compared to its industry.

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 b) Gross profit margin
Measures the gross profit of a firm as a
percent of sales.

Gross profit
Sales

*Net Profit = Net income =

Earnings After Tax (EAT)
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 Comment on single ratio:
 GPM = 20%

 This ratio shows that the gross profit of ABC

BHD is 20% out of total sales. In other words,
this company can only generate gross profit of
USD0.20 out of USD1 sales.

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 Trend Analysis
2006 2007

GPM 20% 19.2%

Comment : In 2007, the firm generate

slightly less gross profit out of its total sales
as compared to the previous year.

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 Comparative Analysis
2007 Industry Average

GPM 19.2% 40%

Comment : The firm’s gross profit margin is

lower than industry average. This indicates
that the firm is generating lower gross profit
out of its sales as compared to its industry.

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 c) Return on Equity
How well are the firm’s managers
maximizing shareholder wealth?

net income
Total equity

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 Comment on single ratio:
 ROE = 8.38%

 This ratio shows that the owner of the firm

(shareholders) earned 8.38% return on their
investment in the firm.

* The higher the return the better because more

returns can be received by the owners.
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 Trend Analysis
2006 2007

ROE 8.38% 7.41%

Comment : In 2007, the owner of the firm

(shareholders) earned slightly lower return
on their investment as compared to 2006.

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 Comparative Analysis
2007 Industry Average

ROE 7.41% 12%

Comment : The firm’s return on equity is

very much lower than industry average.
This indicates that the owner of the firm
(shareholders) earned lower return on their
investment as compared to its industry.
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 e) Return on Total Assets /
Return on Investment

 Measures the overall effectiveness of

management in generating profits out of
the investment in total asset.

The higher the ratio the better because

the management is able to generate more
returns
net income
Total assets
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 Comment on single ratio:
 ROTA/ROI = 5.15%

 This ratio shows that the ability of the firm to

generate profit out of its investment in total
asset is only 5.15% which is very low . In other
words, this company can only generate net
profit of USD0.05 out of USD1 invested in
total assets.
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 Trend Analysis
2006 2007

ROTA/ROI 5.15% 4.38%

Comment : In 2007, the ability of the firm to

generate profit out of its investment in total
asset is much more lower than in 2006.

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 Comparative Analysis
2007 Industry Average

ROTA/ROI 4.38% 10%

Comment : The firm’s return on total assets

is very much lower than industry average.
This indicates that the ability of the firm to
generate profit out of its investment in total
asset is much more lower than its industry.
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 Limitations of ratio analysis
 It is sometimes difficult to understand the
industry category.

 Industry averages are only approximations.

 Differences in accounting practices will lead to

differences in computed ratios.

 Industry averages may not provide a desirable

target ratio. 72
 Seasonality effects.

 A single ratio does not provide sufficient

information.

 Etc.

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