Financial Management
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Ch. 3: 1
Chapter 3
Financial Statement
Analysis
Financial Management
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Ch. 3: 2
Learning Objectives
At the end of this chapter, you should be able to:
 Explain the purpose and importance of financial
analysis
 Calculate and use a comprehensive set of
measurements to evaluate a firm’s performance
 Describe the limitations of financial ratio analysis
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Ch. 3: 3
Introduction

Knowledge of financial statements and the
techniques in analysing financial statements is
desirable towards enabling one to make optimal
financial decisions that can have future impact on
the actions and direction of a firm.

However, some form of restatement, computations
and analysis may be required before information
may be obtained from the financial statements.
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Ch. 3: 4
Financial Analysis and
Financial Ratios

Financial analysis is the use of financial statements to
analyse a firm’s financial position and its performance.
Questions:
 Does a firm have the resources to succeed and grow?
 Does it have adequate resources to invest in new
projects?
 What are its sources of profitability?
 Did the earnings of the firm meet its forecast earnings?
 What are the sources of a firm’s future earnings power?
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Ch. 3: 5
Financial Ratios



Financial ratio analysis employs relative rather than
absolute concepts.
Financial ratios help readers to identify the financial
strengths and weaknesses of a firm.
Financial ratios are classified into:
- Profitability ratios
- Liquidity ratios
- Leverage ratios
- Efficiency ratios
- Market ratios
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Ch. 3: 6
ABC Bhd
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Ch. 3: 7
ABC Bhd (cont.)
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Ch. 3: 8
Profitability Ratios

Analyses the ability of management to generate
adequate profits from use of firm’s capital and
assets.
 Gross profit margin
 Operating profit margin
 Net profit margin (before or after tax)
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Ch. 3: 9
Profitability Ratios (cont.)
Gross profit

Gross profit margin =

Revenue
Gross profit margin measures how much a firm earns
from its revenue less the cost of goods sold

Gross profit margin =

911,000
 100%
 100% = 26.85%
3,393,000
For every RM1 of revenue earned by the firm, its cost of
sales amounts to RM0.7315. ABC Bhd has earned
sufficient revenue to more than cover the cost of sales,
hence the positive gross profit margin, i.e. RM0.2685 of
gross profits for every RM1 of revenue made by firm.
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Ch. 3: 10
Profitability Ratios (cont.)

Operating profit margin =
Operating income
Revenue



 100%
Operating income = Revenue – Cost of goods sold –
Selling, general and administrative expenses –
Depreciation
272,000
 100% = 8.02%
Operating profit margin =
3,393,000
For every RM1 of revenue earned by the firm, the
revenue is enough to cover up to RM0.9198 of the firm’s
total operating expenses. Management has been able to
manage the forces that influence the amount of
operating income that a firm earns.
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Ch. 3: 11
Profitability Ratios (cont.)

Net profit margin = Profit before tax
Revenue

Net profit margin =

Net profit margin =
245,000
 100% = 7.22%
3,393,000
or
Profit after tax
Revenue

Net profit margin =
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171,000
3,393,000
 100%
 100%
 100% = 5.04%
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Ch. 3: 12
Liquidity Ratios

Measures the extent to which a firm has adequate
cash flows or liquid assets to meet the short-term
liabilities of the firm:
- Current ratio
- Acid Test Ratio (Quick Ratio)
- Stock Turnover Ratio
- Debtors Turnover Ratio
- Creditors Turnover Ratio
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Ch. 3: 13
Current Ratio and Acid Test
Ratio (Quick Ratio)
Current assets
Current liabilities

Current ratio =

This ratio indicates the extent of a firm’s liquidity, as
measured by the firm’s liquid assets (current assets)
relative to its liquid liabilities (current liabilities).

Acid test ratio =
Current assets-stock
Current liabilities


A more stringent version of liquidity ratio
Acid test ratio measures the ratio of current assets (less
stock) to current liabilities.
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Ch. 3: 14
Current Ratio and Acid Test
Ratio (Quick Ratio) (cont.)


Current ratio =
Acid test ratio =
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1,182,000
736,000
= 1.61 times
1,182,000 - 435,000
736,000
= 1.01 times
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Ch. 3: 15
Stock Turnover Ratio

Stock turnover ratio =

Stock turnover ratio =

Cost of goods sold
stocks
2,483,000
= 5.7 times
435,000
Stocks
= 365 days
Stock turnover days =
Cost of goods sold
435,000
X 365 = 63.97 days
2,482,000

Stock turnover days =

Indicates the relative liquidity of stocks in a firm
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Ch. 3: 16
Debtors Turnover Ratio



Indicates how long it takes for a firm to collect its
receivables
Credit sales
Debtors turnover ratio =
Trade debtors
Debtors turnover ratio =
3,393,000
= 7.7 times
441,000

Debtors turnover days = Trade debtors X 365 days
Credit sales

Debtors turnover days =
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441,000
= 47.44 days
X
365
3,393,000
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Ch. 3: 17
Creditors Turnover Ratio


Indication of the extent of how quick the cash outflows are
in a firm
Credit purchases
Creditors turnover ratio =
Trade creditors
2,482,000

Creditors turnover ratio =

Trade creditors
Creditors turnover days =
Credit purchases

Creditors turnover days =
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321,000
321,000
2,482,000
= 7.7 times
X 365 days
X 365 = 47.20 days
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Ch. 3: 18
Leverage Ratios
Investigate how a firm is being financed and provide
indicators as to the extent a firm is able to meet the
interest payments
Questions:
 What is the relative ratio between the use of debt
versus equity to finance a firm’s assets?
 Has the firm used too much debt?
 Is the firm earning sufficiently to meet the interest
liabilities?
 Debt ratio
 Interest cover ratio

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Ch. 3: 19
Debt Ratio


Debt ratio = Trade liabilities
Total assets
883,000 + 736,000
Debt ratio =
= 0.5617 or 56.17%
1,700,000 + 1,182,000

Indicates that slightly more than 50% of the firm’s total
assets is financed using debt (long and short term debt)

Total long term borrowings
Debt ratio =
Total equity

Debt ratio =
707,000
= 0.5598 or 55.98%
1,263,000
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Ch. 3: 20
Interest Cover Ratio
Earnings before interest and tax
Interest expense

Interest cover ratio =

320,000
Interest cover ratio =
75,000
= 4.3 times

Firm has earnings before interest and tax that currently
covers up to 4.3 times its existing interest expense.

Firm may still be able to take on further borrowings
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Ch. 3: 21
Efficiency Ratios





Efficiency ratios measure the extent to which a firm
is able to earn sufficient earnings and returns to its
investors.
Earnings per share (EPS)
Return on capital employed (ROCE)
Return on assets (RoA)
Return on equity (RoE)
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Ch. 3: 22
Earnings Per Share

Earnings per share =
Earnings attributable to ordinary shareholders
X 100 cents
Number of ordinary shares in issue
151,000
X 100 = 151 cents
100,000

Earnings per share =

For every one ordinary share held by shareholders, ABC
Bhd has earned 151 cents of income, which may be
either distributed to ordinary shareholders as dividends
or be kept in the firm as retained earnings, but still
belong to the ordinary shareholders.
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Ch. 3: 23
Return on Capital Employed
(ROCE)

Return on capital employed =
Earnings before interest and tax (EBIT)
X 100%
Capital employed

Where capital employed = Long term debt + Equity

320,000
Return on capital employed =
X 100 = 16.24%
1,970,000

Assessment of the level of efficiency of the management of
ABC Sdn Bhd:
For every RM1 of funding provided to the management of
ABC Bhd, the firm is able to earn a return of RM0.1624
annually on average.
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Ch. 3: 24
Return on Assets (RoA)

Return on assets = Profit after tax
Total assets

Total assets = Non current assets + Current assets
X 100%
171,000
X 100 = 5.93%
 Return on assets =
2,882,000

Assessment of the level of efficiency of the
management of ABC Sdn Bhd:
For every RM1 of assets that is made available to the
firm or that the firm invests in, the management of ABC
Bhd is able to generate a return after tax of RM0.0593.
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Ch. 3: 25
Return on Equity (RoE)
Profit after tax
X 100%
Total shareholders' equity

Return on equity =

Return on ordinary equity =
Earnings attributable to ordinary shareholders
Total shareholders' equity-Preference shares
X 100%

Return on equity = 171,000 X 100% = 13.54%
1,263,000

Return on ordinary equity =
151,000
X 100% = 12.43%
1,263,000-48,000
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Ch. 3: 26
Market Ratios

Market ratios are ratios that are based on the
market price of a firm’s share

Price earnings ratio (P/E)

Market-to-book ratio
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Ch. 3: 27
Price Earnings Ratio (P/E)
Profit share
Earnings per share

P/E ratio =

P/E ratio = 1350
151


= 8.94
ABC Bhd’s shares currently sell for 8.94 times its
earnings.
Generally, firms with high P/E ratios are generally taken
as firms with bright future prospects.
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Ch. 3: 28
Market-to-Book Ratio

Profit per share
Market-to-book ratio =
Book value per share
1,263,000 - 48,000
= 12.15
100,000

Book value per share =

13.50
Market-to-book ratio =
= 1.11
12.15

Market-to-book ratio compares the market price of a
firm’s shares relative to the historical cost of the shares.
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Ch. 3: 29
DuPont Analysis


Using the ‘Decomposed Formula’
Basic formula is Return on assets =
Profit after tax
Sales
X
Sales
Total assets
Total assets
Return on equity = (Return on assets) X
Equity
=
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Profit tax
Total assets
Sales
X
X
Sales
Total assets
Equity
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Ch. 3: 30
Du Pont Analysis
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Ch. 3: 31
Time Series Analysis

Comparison between the firm’s current year
ratios with the same ratios of the corresponding
previous years
 Ascertain whether the firm’s situation has:
1. Improved
2. Worsened
3. Stayed the same
between one year and the subsequent year(s).
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Ch. 3: 32
Time Series Analysis (cont.)

Suppose ABC Bhd’s current ratio for the last five
years were as follows:
Year
Current ratio
2005
5.32
2006
3.20
2007
2.56
2008
1.98
2009
1.61
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Ch. 3: 33
Cross-sectional Analysis

Comparisons between the firm’s results and the
results of:
a) Other firms in the same industry
b) Other firms in other industries
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Ch. 3: 34
Limitations of Ratios

Difficulties in identifying suitable industry category to
classify a firm—firm may be involved in many
different activities (how to identify similar firms?)

Effects of inflation ignore—can distort figures

Accounting practices may differ between firms,
complicating comparisons of results between firms

Results may be distorted if there exist changes in
accounting standards, resulting in changes in the
presentation of financial results
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Ch. 3: 35
Limitations of Ratios (cont.)



Firms may experience seasonality in their
performance.
An industry average may not be the desired target
or the norm, since industry averages represent
averages that includes the results of both good and
bad performing firms. Hence, one should seek to
compare against the ‘best in the class’.
Progress of firm needs to be set in the context of
what other firms have done, and whether there exist
exceptional or special circumstances or
environmental or economic influences that impact
firms’ performances.
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Ch. 3: 36