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FINANCIAL STATEMENTS ANALYSIS

• Is an assessment of the financial position of a business in past, present and future

FINANCIAL RATIOS ANALYSIS

• Is a relationship of one number with another number

2 TYPES COMPARISON i. INDUSTRY AVERAGES

- Ratios of one firm are compare with other firms within the same size & at the same time.

ii. TREND ANALYSIS

- Compare ratios of present with previous years CATEGORIES OF RATIOS

a. Liquidity Ratios b. Efficiency Ratios c. Leverage Ratios d. Profitability Ratios e. Market Ratios

a. Liquidity Ratios

Purpose – to determine firm’s ability to meet its maturing obligation (pay its current liabilities)

i. Current Ratio (CR) = Current assets Current Liabilities

ii. Quick Ratio/Acid test Ratio

= CA – Inventories – Prepaid expenses CL

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Low ratio- indicate firm may have difficulty to pay current liabilities on time (less liquid) High ratio – firm may sacrificing some return because too much financial capital is tied up in CA (more liquid) If CR is high but QR very low – indicate that firm may have too much stock b. Efficiency Ratios/assets management ratio/activity

ratios Purpose – to measure how effective firm in managing its assets to generate sales i. Inventory Turnover Ratio (IT)

= COGS OR = Sales Closing Stock Closing Stock

- IT shows number of times inventory is sold out

and re-stock or “Turned over” per year - High IT – is good, it may indicate high sales

volume/superior selling practices - Low IT – indicate excess or obsolete inventories

ii. Average Collection period (ACP)

ACP = Account Receivable X 360 days Credit Sales

- measure length of time taken to collect money from debtors Low ACP – is good, it indicate that firm manage to collect money in a short period i.e credit policy is good High ratio – contra from the above

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iii. Fixed Assets Turnover (FAT)

FAT = Sales. Net Fixed Assets -Low FAT – indicate firm not fully utilized it fixed assets to generate sale.

iv. Total Assets Turnover (TAT) TAT = Sales Total Assets Low ratio- indicate firm not generating sufficient volume of sales in relation to its total assets investments.

c. Leverage Ratios/gearing ratios

Purpose – to measure how much debts (liabilities) is use in business to buy (finance) assets i. Debt ratio (DR) = Total Liabilities

Total Assets

High ratio – is not good because the firm expose to high financial risk - firm may have problem to borrow money in the

future

ii. Time Interest Earn (TIE) = EBIT Interest Expense

Low TIE – indicate firm is less ability to pay its interest by using EBIT

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d. Profitability Ratio Purpose – to measure the effectiveness of the firm to generate profit in relation to sales, assets employed and shareholders investment.

i. GPM = Gross Profit

Sales Low ratio- may indicate excessive sales discount

ii. Net Profit margin (NPM) NPM = Earning available to common s/holders

Sales

- high ratio indicate firm is good in controlling administration expenses

iii. Return on Assets (ROA)

ROA = Earning available to common s/holders Total assets Low ratio may indicate

– assets is not efficiently utilized or - profit is very low

However, further analysis is necessary If NPM is not good – it could be because:

- high COGS (i.e markup is not sufficient) or - if GPM is adequate- low NPM is because of

high administration expenses If NPM is good but GPM is low- it could be because of low sale or high COGS.

iv. Return on Equity (ROE) ROE = Earning available to common s/holders Common Equity

= ROA (Du Pont equation) 1 – Debt ratio

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** Common equity = OSC + Reserves + Retained profit - it measure the firm’s return compare to total

equity.

e. Market Ratios - To measure the firm’s stock price to its earnings,

cash flow and book value per share i. EPS = Earning available to common

s/holders Number of ordinary share issued

- Shows number of ringgit earned for each share for the period

ii. Dividends per share (DPS) DPS = Ordinary dividends Number of shares issued

- indicates the actual cash received by investor on their investment.

iii. Price/Earnings (P/E) Ratio PE = Market price per share EPS

- Shows how much investors are willing to pay per dollar of reported profit

Limitations of Ratios Analysis – page 58

i. Multiple lines of business ii. Different accounting practices iii. Industry average may not provide a desirable target

standard iv. Seasonal factors v. Ratios can be too high or too low vi. “Window dressing” techniques. vii. Combination of good and bad ratios.

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User of Ratios Analysis i. Creditors

Short term creditors – interested in firm’s ability to pay loan promptly i.e liquidity ratio is important to them Long term creditor - interested in firm’s ability to pay interest regularly & principle once matured

- also on liquidating value of the firm - i.e interested in debt ratio & TIE ii. Management - to analyze, plan & control - interested in all of the ratios iii. Equity Investors

- interested in firm’s efficiency & growth prospects & high dividends

iv. Others – government, IRB, suppliers, employees &

public at large

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