CHAPTER 2
Financial Analysis
Definitions and functions of
financial statement
Financial ratios
Basic sources and uses of
funds
1
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 asses operating result & financial status
To assist in developing plans and strategies
2
Financial Statements
Consists of:
Balance sheet,
Income Statement,
Cash flows statement,
Statement of retained earnings
Primary source of data information and the
standing of operations and financial
3
Balance Sheet
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
4
Format of Balance Sheet
Balance Sheet as at 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
5
Balance Sheet (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)
6
Balance Sheet (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)
7
Income Statement
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
8
Income Statement (cont..)
Income Statement for 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
9
Income Statement (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)
10
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
11
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
12
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
13
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.
Compare year by year)
Comparative analysis (i.e. horizontal. Compare
with industry)
14
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)
15
Financial Ratios (cont..)
Liquidity Ratios
Current Assets
Current Ratio = Current Liabilities
Answer in X, higher ratio reflect the ability to pay its short term obligations
on time
Quick Ratio = Current Asset - Inventory
Current Liabilities
Answer in X, higher ratio reflect the ability to pay its short term obligations
without rely on inventories
16
Financial Ratios (cont..)
Liquidity Ratios
Net Working = CA - CL
Capital
Answer in $, higher (i.e. positive value), absolute measure in liquidity
17
Financial Ratios (cont..)
Activity Ratios
Inventory COGS or Sales
Turnover = Inventory
Answer in X, higher ratio reflect the effectiveness of inventory to generate
sales
Average A/c Receivables(360)
Collection Period = Sales(Credit)
Answer in Days, higher ratio indicates that firm has problem in collecting
debt
18
Financial Ratios (cont..)
Activity Ratios
A/C Receivable Sales (credit)
Turnover = A/C Receivable
Answer in X, higher ratio reflect the effectiveness in collecting receivables
19
Financial Ratios (cont..)
Activity Ratios
Fixed Assets Sales
Turnover = Fixed Assets
Answer in X, higher ratio reflect the effectiveness of fixed assets to generate
sales
Sales
Total Assets = Total Assets
Turnover
Answer in X, higher ratio reflect the effectiveness of total assets to generate
sales
20
Financial Ratios (cont..)
Leverage or Solvency Ratios
Debt Total Debt
Ratio = Total Assets
Answer in %, higher ratio reflect the higher amount of debt to finance assets
Debt to Long Term Debt
Equity = Equity
Answer in X, higher ratio reflect the higher amount of debt (i.e. capital
structure
21
Financial Ratios (cont..)
Leverage or Solvency Ratios
Time Interest EBIT
Earned = Interest
Answer in X, higher ratio indicates that firm can meet loan requirement and
lower risk of default
22
Financial Ratios (cont..)
Profitability Ratios
Gross Profit Gross Profit
Margin = Sales
Answer in %, higher ratio indicates higher contribution margin
Operating Operating Profit @EBIT
Profit Margin = Sales
Answer in %, higher ratio indicates better productivity (i.e. operations)
23
Financial Ratios (cont..)
Profitability Ratios
Net Profit Earnings After Tax
Margin = Sales
Answer in %, higher ratio indicates better income to shareholders
Return On Earnings After Tax
Assets = Total Assets
Answer in %, higher ratio indicates higher return on firm’s investment
24
Financial Ratios (cont..)
Profitability Ratios
Return On = Earnings After Tax
Equity Total Equity
Answer in %, higher ratio indicates higher return to shareholders
25
Financial Ratios (cont..)
Market/Equity Ratios
Earning Earnings After Tax
Per Share = No. of common shares
Answer in $, higher ratio indicates better income per share
Price to Market Price p/share
= EPS
Earnings
Answer in X, higher ratio indicates the firm’s market price is overvalued
26
Limitations Financial Ratio
1) Non Comparative Data- difficult to find
company that involved in one type of
business.
2) Different Accounting Treatment- a firm
might use FIFO or LIFO in inventories
system and different depreciation method
3) Unreliable Figure- Some firm may overstate
real figure to show good financial condition
of company-(Window dressing) 27
Financial Ratio Analysis
Income Statement for the year ended December 31, 2003
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 28
Financial Ratio Analysis (cont..)
Balance Sheet as at December 31, 2000 &2003
ASSETS 2003 LIABILITIES AND EQUITIES 2003
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
29
Liquidity Ratios
Liquidity Ratios 2003 Industry
1) Current ratio (times) Comment:
1)Liquidity ratio
Current Assets 146 1.85 2X company lower than
Current Liabilities 79 industry.
2)It shows that the
2) Quick ratio (times) company cannot meet
short term obligation
Current Assets- Inventories 146 - 82 0.81 1.2X
Current Liabilities 79
3) Net working Capital
Current Asset - Current Liablities 146 - 79 67.00 none 30
Profitability Ratios
Profitability Ratios 2003 Industry
1) Return on Equity (%)
Comment:
Earning after tax
Common Equity
165
507
32.54 32% 1)Profitabilty ratio of
2) Return on Asset(%)
the company is higher
Earnings after tax 165 21.54 45%
than industry
Total assets 766 2)It shows that the
3) Gross Profit Margin(%) company earns more
Gross Profit
Sales
1050
1500
70.00 65% Ringgit(RM)
4) Operating Margin(%)
Operating Income 300 20.00 30%
Sales 1500
5) Net Profit Margin(%)
Net Profit 165 11.00 9%
Sales 1500 31
Activity Ratios
Activity Ratio 2003 Industry
1) Asset Turnover (times/yr) Comment:
Sales 1500 1.96 5X 1)Activity ratio of the
Total Assets 766
2) A/c Receivables Turnover (times/yr)
company lower than
Sales 1500 34.09 40X
industry
A/c Receivables 44 2)It shows that the
3) Average Collection Period (days) company is not
A/c Receivables
Daily Sales
44
(1550/360)
10.22 6 days utilizing its asset
4) Inventory Turnover (times/yr)
efficiently and
COGS or Sales 1500 18.29 20X
effectively
Inventory 82
5) Fixed Assets Turnover
Sales 1500 2.42 none
Fixed Assets 620 32
Leverage or Solvency Ratios
Leverage (Solvency) Ratio 2003 Industry
Comment:
1) Debt Ratio 1)Leverage ratio of
Total Debt 259 33.81 30% the company is bad
Total Assets 766 than industry
2) Debt to Equity
2)It shows that the
company is not good
Total Debt 259 51.08 50% in managing its debt
Equity 507
& has lower
3) Time Interest Earned (time) financial risk
EBIT 300 12.00 10X
Interest 25
33
Sources and Uses of Funds
Is a Statement of changes in financial position
(i.e. assets, equity & liabilities)
Summarized all the new or additional Sources
and Uses for investment purpose
Questions:
Where did firms get its funds during the year?
What did the firm do with available funds?
How does operations affect firm’s assets and
liabilities?
34
Sources and Uses of Funds
Funds Flow Statement
Combine changes in B/Sheet with other relevant
financial figures (i.e. income statement)
Funds inflow – Sources
Funds outflow – Uses
Total Sources of Funds = Total Uses of Funds
35
Funds Flow Statement (cont..)
How to Identify Sources and Uses of Funds?
Sources of Funds Uses Of Funds
Decrease in Asset Increase in Asset
Increase in Liability & Decrease in Liability
Equity &Equity
EAT/Net profit Net loss from operations
Depreciation *Dividend
* Dividend = Net Income1 – ( ∆ Retained Earnings)
36
Mekar Inc Bhd
Balance Sheet as at 31 December 20X1 and 20X2
(RM'000) 20X1 20X2
Current Assets
Cash 28 97
Marketable Securities 42 10
Account Receivable 93 128
Inventories 65 85
Total Current Assets 228 320
Fixed Assets
Gross Fixed Assets 887 1020 To Analyze the
less: depreciation 226 285
Total Fixed Assets 661 735 Balance Sheet,
TOTAL ASSETS 889 1,055 Two BS is required
Current Liabilities
Account Payable 64 95
Notes Payable 20 87
Accrued Expenses 95 75
Total Current Liabilites 179 257
Long Term Debt 297 318
Common Equity
Common Stock 140 160
Paid in capital 108 120
Retained Earnings 165 200 37
TOTAL LIABILITIES AND EQUITY 889 1,055
Analyze Income Statement
Mekar Inc Bhd Dividend is
Income statement for the year ended 31 December 20X2 Transferred to the
(RM'000) 20X2 Fund Flow
Revenue/Net Sales 960 Statement
less: COGS 624
Gross Profit 336
less: Operating Expenses 167
Depreciation 19
Operating Income/EBIT 150
less: Interest Expenses 30
Earnings Before Taxes 120
less: Corporate Taxes 48
Net Income 72
less: Dividend 37 BUT
Retained Earnings 35 If there is no IS
Div = EAT- (RE1+RE0)
38
Mekar Inc Bhd
Analysis for Funds Flow Statement for the year ended 31 Dec 20X2
(RM'000) 20X1 20X2 X2-X1 S/U
Current Assets
Cash 28 97 69 U
Marketable Securities 42 10 -32 S
Account Receivable 93 128 35 U
Inventories 65 85 20 U
Total Current Assets 228 320
Fixed Assets
All the items in
Gross Fixed Assets 887 1020 133 U BS need to be
less: depreciation 226 285 59 S subtracted, X2-X1
Total Fixed Assets 661 735
TOTAL ASSETS 889 1,055 And then transfer
To Funds Flow
Current Liabilities Statement
Account Payable 64 95 31 S
Notes Payable 20 87 67 S
Except
Accrued Expenses 95 75 -20 U Retained Earnings
Total Current Liabilites 179 257 (GFA and Dep)
Long Term Debt 297 318 21 S
Common Equity
Common Stock 140 160 20 S
Paid in capital 108 120 12 S
Retained Earnings 165 200 35 NA
TOTAL LIABILITIES AND EQUITY 889 1,055 39
Mekar Inc Bhd
Funds Flow Statement for the year ended 31 Dec 20X2
(RM'000)
Sources of Funds
Funds from operations Depreciation:
EAT 72
a
Extract from IS
Depreciation 19
Total Funds from operations 91 or
(Take the difference in BS)
Proceeds from the sale of:
New long-term debt 21
New common stock 20
New paid in capital 12
Total sources from long term funds 53
Proceeds from changes of WC “Parenthesis”
Sale in short-term securities 32 If there is no IS
Increase in acc payables 31
Increase in notes payables 67 available
Total sources from short-term funds 130
Total sources of funds 274
Uses of Funds
Long-term uses of funds
Net capital expenditure
b
93
Net Capex:
Dividend 37 Net FA1 – Net FA0+ Dep
Total uses of long-term funds 130
or
Changes in WC (Gross FA1 – Gross FA0 )
Increase in cash 69
Increase Account Receivable 35
Increase in Inventories 20
Decrease in misc liabilities 20 40
Total uses of short-term funds 144
Total uses of funds 274
