Topic 3 Financial Statement and Financial Ratios Analysis

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS



27

t  Financial

3

Statements andFinancial Ratios Analysis

leaRninGoUtcomes Bytheendofthistopic,youshouldbeableto: 1.

Explai Exp laint nthe heimp impor ortan tance ceo ofna fnanci ncial alsta statem tement ents; s;

2.

Anal An alys yse efn fnan anci cial als sta tate teme ment nts; s;

3.

Calcul Cal culate atean andi dinte nterpr rpret etfna fnanci ncial alrat ratios ios;;

4.

Apply App lyrat ratio ioana analys lysis isin infna fnanci ncial alde decis cision ionma makin king; g;and and

5.

Discus Dis cusst sthe heli limit mitati ations onso ofn fnanc ancial ialra ratio tiosa sanal nalysi ysis. s.

 intRoDUction Financ Fina ncia ial l st stat atem emen ent t an and d it its s an anal alys ysis is ar are e vi vita tal l to an or orga gani nisa sati tion on an and d ex exte tern rnal al parties. parti es. The Theinter internal nal manag manageme ement nt o a comp company any re requir quires es ino inormati rmation on obtai obtained ned rom r om a fna fnanci ncial al stat statem ement ent to ass assist ist the them m in pla planni nning, ng, con contr troll olling ing and de decis cision ion making. External Extern al par partie ties s suc such h as bus busine iness sscr cred edito itors rsnee need d to tokn know owthe the liq liquid uidity ity pos positi ition on oafrm oa frm and its abi abilit lityto ytopay pay the theirclai irclaims. ms. Bo Bondhold ndholders ers too nee needto dtokno knowthe wthe frm’s frm ’s abi abilit lity y to pay int inter erest est and its pri princi ncipal pal whe when n the bon bond d mat matur ures. es. Be Beor ore e

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

investinginacompany,shareholdersneedtoknowthe investinginacompany,shareholde rsneedtoknowtheproftandpero proftandperormanceo rmanceo thecompanyconcerned.Thereor thecompanyconcerne d.Thereore,whetheryouareafnancialmanager e,whetheryouareafnancialmanager,creditor ,creditor orinv or invest estor or, , the und under erstan standin ding g o the fna fnanci ncial al sta statem tement ent and its ana analys lysis is is an important. In this Inthi s top topic, ic, yo you u wil will l belearn belearning ing thr three ee typ types esobasicfnanc obasicfnancial ial sta statem temen ents tsand and thei th eir r co comp mpon onen ents ts, , o oll llow owed ed by fn fnan anci cial al an anal alys ysis is wh whic ich h ca can n be us used ed to ga gain in importantpracticalinormationorthe importantpracticalin ormationorthebeneftocertainp beneftocertainparties. arties.

3.1

Financialstatements

Therearethree Therear ethreetypesobasicfnancialstatem typesobasicfnancialstatements: ents: (a) (a ) Ba Bala lanc nce eSh Shee eet; t; (b) Inc Income omeSt State ateme ment; nt;an and d (c) (c ) Ca Cash shF Flo low wSt State ateme ment nt.. Letustakealookateachtypeindetail.

3.1.1

B s

Balancesheetisthestatementothefrm’sfnancialpositionataspecifcpoint intime.Thebalancesheetoafrmmaychangedailybecauseinventoriesmay increase incr ease ordecre ordecreaseeachday aseeachday, ,andfxedassetssuchas andfxedassetssuchas equi equipmen pmentcan tcanbeadded beadded ordepreciate.A ordepr eciate.Afnancialstatementcanbed fnancialstatementcanbedividedintotwop ividedintotwoparts: arts: (a)Asset An as asse set t is a reso sour urcce ow owne ned d by a fr frm m. Ass sseets ca can n be se sep par arat ateed in into to current assetsand fxed assets.Currentassetscanbeconvertedintocashin periodlessthanoneyear.Examplesocurrentassetsarecash,marketable securi sec uritie ties, s, acc accoun ounts ts re recei ceivab vable le and inv invent entor ories ies. . On the oth other er han hand, d, fxe fxed d assetsincludeequipmentandplants.Assetsarearrangedinorderbasedon liquidity,thatis,timeneededtoconverttheassetsintocashmoney. (b)Liability and Equity clai aim m ag agai ains nst t th the e fr frm’ m’s s as asse sets ts. . Ac Acco coun unts ts rec ecei eiva vabl ble, e, no note tes s Liability is a cl payabl pay able e and acc accru rued edex expen penses ses ar are e cur curre rent nt lia liabil biliti ities es whi which chwil will l mat matur ure e in lessthanoneyear.Bondsandbankloanswhicharethefrm’sdebtstoother partiesarecategorisedaslong-termliabilityastheywillmatureinaperiod omorethanoneyear. Equity isa cla claimoshar imoshareho eholde ldersonthefrm’ rsonthefrm’sasset sassetswhich swhich may beinthe ormopreerenceshares,ordinarysharesandretainedearnings.

TOPIC 3



FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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Figure3.1showsabalancesheetoEmasLimitedCompany. Emas Limited Company Income Statement For the Years Ended 30th December 2010 and 31st December, 2011 Assets

2011 (RM’000)

2010 (RM’000)

Cash and Marketable Securities Accounts receivable Inventories Total Current Assets Net plant and equipment Total Assets

300 11,250 18,450 30,000 30,000 60,000

2,400 9,450 12,450 24,300 26,100 50,400

Liabilities and Equity Accounts payable Notes payable Accrued expense Total Current Liabilities Long-term bonds Total Liabilities Preerence shares (1,200,000) Ordinary shares (15,000,000) Retained earnings Total Equity Total Liabilities and Equity

1,800 3,300 4,200 9,300 22,620 31,920 1,200 3,900 22,980 26,880 60,000

900 1,800 3,900 6,600 17,400 24,000 1,200 3,900 21,300 25,200 50,400

Figure 3.1:BalancesheetoEmasLimitedCompany

Normally,assetsarenotedontheletsideoabalancesheetwhileliabilityand equityarenotedontherightsideoabalancesheet.Sometimes,assetsarenoted atthetopwhileliabilityandequityar atthetopwhileliability andequityarenotedatthebotto enotedatthebottomothebalanceshe mothebalancesheet. et. In accoun Inacc ountin ting, g,all all the frm frm’s ’s ass assets ets bel belon ong g to tocr cred edito itors rs and own owner ers s o othe the frm frm. . Thus,thereisanequationsuchasshownbelow:

Asset=Liability+Equity

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

activity3.1 Drawacharttoshowthepartsbelowinabalancesheet: (a) Current Assets

(d) Fixed Liabilities

(b) Fixed Assets

(e)

Equity

(c) (c ) Cu Curr rren ent tLi Liab abil ilit itie iess In gene nerral al, , a ba bala lan nce sh sheeet giv ivees in ino orrma mati tion on reg egar ard din ing g th the e fn fnan anci cin ng an and d inve in vest stme ment nt ac acti tivi viti ties es o a fr frm. m. Li Liab abil ilit itie ies s an and d ow owne ner’s r’s eq equi uity ty pr pres esen ent t a vi view ew o th the e rel elat ated ed fr frm’ m’s s ca capi pita tal l st stru ruct ctur ure. e. We ca can n se see e th the e pa part rt o th the e to tota tal l ca capi pita tal l whic wh ich h in incl clud udes es eq equi uity ty an and d th the e po port rtio ion n fn fnan ance ced d by de debt bt. . Se Segr greg egat atio ion n o th the e totalliabilitiesintocurrentliabilitiesandlong-termliabilitiesarealsoshownin the bal balanc ance e she sheet. et. Thi This s in inorm ormati ation onis is imp import ortant ant to toana analys lyse e the frm frm’s ’s fna fnanci ncial al posi po siti tion on. . Fr From om th the e ba bala lanc nce e sh shee eet, t, we ca can n al also so ca calc lcul ulat ate e th the e wo work rkin ing g ca capi pita tal. l. Workingcapitalisthed orkingcapitalisthedier ierencebetweencu encebetweencurrentassetsandc rrentassetsandcurrentliabilitie urrentliabilities. s. CurrentAssets–Cur tAssets–CurrentLiabilitie rentLiabilitiess Working Capital = Curren Working capitalcanbeobtainedbysubtractingcurrentliabilitiesromcurrent assets.Inormationonworkingcapitalisimportanttoevaluateafrm’sliquidity anditsabilitytopaybackshort-termclaimsonit.Afrm’sliquidityisimportant  because its business is likely to ail i the frm is unable to pay interest interestor or pay  backdebtwhenitmatures.  backdebtwhenitmatur es.

Balancesheetalsoshowsthecombin Balancesheet alsoshowsthecombinedassets edassetsheldbya heldbyafrmorthecurr frmorthecurrentasset entasset ratioandthe rat ioandthefrm frm’sfxed ’sfxed ass asset. et. Ia frm hol holdstoomuchfxed dstoomuchfxed ass assets ets com compar pared ed tocurrentassets,thefrm’scapitalwillbetiedupandthismayleadtocashow probl pr oblem ems s and fna fnanci ncial al ai ailur lure. e. Thi This s is cau caused sed by di difcu fculty lty in con conve verti rting ng fxe fxed d assetsintocashcomparedtocurrentassets.

selF-check3.1 Based Base d on Fi Figu gure re 3. 3.1, 1, ca calc lcul ulate ate th the e wo work rkin ing g ca capi pita tal l o Em Emas as Li Limi mite ted d Companyortheyears2010and2011.

TOPIC 3

3.1.2



FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

31

i   s

Income statementisastatementthatgivesinormationregardingthe revenues andexpendituresoafrminaspecifcperiodotime.Salesrevenueisshownin everyincomestatementandthisisollowedbyexpendituresorcostandtaxes.In  brie,an incomestatement indicatesa frm’sproft frm’sproftor orloss lossin ina aspecifcperiod specifcperiodo o timewhichisnormallyoneyear.Proftisimportanttoafrm’sowner,employees andsuppliersbecausewithoutpro andsuppliersbecau sewithoutproft,thefrmwillnotco ft,thefrmwillnotcontinuetoexist. ntinuetoexist.

PleasereertoFigur Pleasere ertoFigure3.2,IncomeStatem e3.2,IncomeStatementoEmasLimite entoEmasLimitedCompany: dCompany:

Emas Limited Company Income Statement or the Year Ended 31st December 2010 and 31st December 2011

Sales Cost o goods sold Gross proft Sales and administrative expenses Depreciation and amortisation Proft beore interest and taxes Less: Interest expenses Proft beore tax Tax Net Proft Preerence shares dividend Net Proft or ordinary shareholders Ordinary shares dividends Addition to Retained Earnings

2011 (RM’000)

201 0 (RM’000)

90,000 (74,846) 1 5 ,1 5 4 (3,640) (3,000) 8 ,5 1 4 (2,640) 5 ,8 7 4 (2 , 3 4 9 ) 3,525 (1 2 0 ) 3 ,4 0 5 (1,725) 1,680

85,500 (71,110) 14,390 (3,800) (2,700) 7,890 (1,800) 6,090 (2,430) 3,660 (120) 3,540 (1,950) 1,590

Figure 3.2:IncomestatementoEmasLimitedCompany

Incomestatementorproftandlossstatementgivesinormationtomeasurethe frm’s frm ’sper peror orman mance. ce. To me measu asure re the pe pero rorma rmance nce o oa a frm frm, , som some e asp aspect ects s o oan an organisationmustbeconsidered: (i) Sales fgure–Canbecomparedwiththefrm’ssalesinthepreviousyear andexpecteduturesales.Thisinormationcanbeusedorthepurposeo planningthefrm’suture. (ii) Gross proft–Canbecomparedtothesalesfguretoshowproftearnings romgoodssold.

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Gross Proft = Sales–CostoGoodsSold

(iii) Firm’s expenses–Canbecomparedwiththefrm’sexpensesinthe previousyeartoormu previo usyeartoormulatepoliciestode latepoliciestodecreasecost. creasecost. (iv) Net proft – Can be compared to sales. Normally, there are variationsbetweenproftabilityandsalesvolumes.Whenafrm’s salesvolumeishigh,itmayreceivealowerpe salesvolumeishigh,itmayr eceivealowerpercentageone rcentageonetproft. tproft. Howev How ever er, , the rat ratio ioo one net t sal saleses-pr proft oft is in inuen uenced ced by bythe the typ type e o  businessundertakenbythefrmcon  businessundertak enbythefrmconcerned. cerned. Net proft = GrossPr GrossProft–Salesand oft–SalesandAdministrativeE AdministrativeExpenses xpenses –DepreciationandAmortisation

selF-check3.2 Essay Question Wit ith h re eer eren ence ce to th the e in inco come me st stat atem emen ent t in Fi Figu gure re 3. 3.2, 2, di di er eren enti tiat ate e  betweengrossproftandn  betweengr ossproftandnetproft. etproft.

3.1.3

c c F Fw s s 

Cash ow sta Cash statem tement ent re reer ers s to the sta statem temen ent t tha that t re recor cords ds the e eec ects ts o a frm frm’s ’s acti ac tivi viti ties es su such ch as op oper erat atin ing, g, in inve vest stme ment nt an and d fn fnan anci cing ng o a fr frm’ m’s s ca cash sh o ow w oraspecifcperiod.Netcashowisthetotalcashattainedbyabusinessina specifcperiod,orexample,oneyear.Butthecashowattainedbyafrmmay notnecessarilybethetotalcashstatedintheitem“cash”onthebalancesheet  because the cash may be used to pay dividends, fnance account receiv receivable, able, investinfxedassets,increaseinventories,etc.Thereore,theavailabletotalcash in a bal balanc ance e she sheet et may be in inuen uenced ced by ac actor tors s suc such h as cas cash h ow ow, , cha change nges s in workingcapital, work ingcapital, chang changesin esinfxed fxed asset assets,company’ s,company’s stransa transaction ctions ssuchas suchasbuyin buying g andsellingosharesandbonds,dividendpaymentandsoon.Theseactorswill  bereectedinthecashow  bereectedinthe cashowstatementwhichshows statementwhichshowschangesinthe changesinthecashposition cashposition othefrm. Acashowstatementcanbediv Acasho wstatementcanbedividedintothr idedintothreepartsaccor eepartsaccordingtoitsactivities: dingtoitsactivities: (i) (i )

Ope perrat atin ing ga act ctiv ivit ity y;

(ii) (i i)

Inve In vest stme ment nta act ctiv ivit ity; y;a and nd

(iii) (ii i) Fin Financ ancing ingac activ tivity ity..

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS



33

PleasereertoFigur Pleasere ertoFigure3.3:Showscashowstateme e3.3:ShowscashowstatementoEmasLimited ntoEmasLimitedCompany Company.. Cas ash h o ow w st stat ateement is im imp port rtan ant t to a fn fnan anci cial al ma man nag ageer be beca cau use it giv ivees inormationregardin inormationr egardingthefrm’sabilitytog gthefrm’sabilitytogeneratesu eneratesufcientcashto: fcientcashto: (i)

Financ Fin anceo eorp rpur urcha chase sene newa wasse ssets tsor orthe thefr frm’s m’sex expan pansio sion; n;and and

(ii) (i i)

Pay Pa yba back cki its tsd deb ebts ts..

Emas Limited Company Cash Flow Statement For the Year Ended 31st December 2011 (RM‘000) Operating Activities Net Proft Additional(cashresources) Depreciation and amortisation Increase in Accounts Payable Increase in Accrued expenses

3 ,5 2 5 3 ,0 0 0 9 00 300

Less(usesocash) Incr In crea ease sei in nAc Acco coun unts tsR Rec ecei eiva vabl ble e                             Incr In crea ease sei in nin inve vent ntor orie ies s                                     Net cash provided rom operating activities

(1,800 (1,8 00)) (6,0 (6 ,000 00)) (7 5 )

Investment Activities PurchaseoPlant,Equipment and an dFi Fixe xed dAs Asse sets ts                                          Net Ne tca cash shp prrov ovid ided ed ro rom min inve vest stme ment nta act ctiv ivit itie ies s                

(6,90 (6, 900) 0) (6,9 (6 ,900 00))

Financing Activities Increase in notes payable Increase in bonds Dividendpaymentorpreerencesshare and an dor ordin dinar ary ysh shar ares es                                        Net cash rom fnancing activities

(1, ( 1,84 845) 5) 4,875

Increase (decrease) in cash Beginning cash balance Endin En ding gca cash shba balan lance ce                                      

(2,100) 2 ,4 0 0 RM 300

1 ,5 0 0 5 ,2 2 0

Figure 3.3:CashowstatementorEmasLimitedCompany

34



TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

selF-check3.3 True (T) or False (F) Statements

1.

Deprecia Depre ciatio tionexp nexpens ensesisanite esisanitemthat mthatwilladd willaddtothenet tothenetpro proftto ftto determinecashowromthe determinecash owromtheoperatingactivitie operatingactivities. s.

2.

Interest Inter est exp expens ensesare esare ite itemsoinve msoinvestm stment ent act activi ivitie tiesina sina cas cashow how statement.

3.

Any in Any incr crea ease se in ac acco coun unts ts rec ecei eiva vabl ble e an and d ac acco coun unts ts pa paya yabl ble e wi will ll  be added to net proft in determining cash ow rom operating activities.

4.

Purchaseo Purcha seofx fxed edasse assets tsort orthe hecom compan pany’ y’suse susewil willbe lbeded deduct ucted edto to determinecashowrominv determinecasho wrominvestmentactivities. estmentactivities.

3.2

Financialstatementsanalysis

Financialstatementsanalysisinvolves: (a) Compa Comparis rison onbet betwee ween n the frm frm’s ’spe pero rorm rmanc ance e wit with h oth otherfrms erfrmsin inthe the sam same e industry;and (b) Eval Evaluatio uationo nothe thefrm’ frm’sfnan sfnancialp cialpositi ositionr onromti omtimet metotim otime. e. Theseanalysescanbeusedby: (a) (a ) A fn fnan anci cial al ma mana nage ger r to id iden enti tiy y th the e fr frm’ m’s s we weak akne ness sses es an and d ta take ke st step eps s to improvethefrm’sper improv ethefrm’sperormance;and ormance;and (b) Inve Investor storstoe stoevalu valuateth atethefrm efrm’scu ’scurre rrentfn ntfnancial ancialstan standing ding..

3.2.1

R a

Inorm Ino rmat atio ion n ob obta tain ined ed r rom om th the e fn fnan anci cial al st stat atem emen ent t wi will ll as assi sist st in inve vest stor ors s an and d fnancialmanager fnanc ialmanagers stoorecas toorecast tthefrm’suture thefrm’suture per perorma ormancewhilemanagem ncewhilemanagement ent can ca n us use e th the e in ino orm rmat atio ion n ga gain ined ed to o orrec ecas ast t th the e si situ tuat atio ion n an and d as assi sist st th them em in plan pl anni ning ng o or r th the e u utu turre. A ba basi sic c me meth thod od to ob obta tain in us use eul ul in ino orm rmat atio ion n r rom om fnancialstatementsisthroughfnancialratioanalysis.

3.2.2

t ff F   R R  

There ar There are efve fve cat categ egori orieso eso fna fnanci ncialratio alratios.Each s.Eachtyp type eofnanc ofnancial ial rat ratios ios has its ownroletothemanagementandownerothefrm.Financialratiosconsisto (reertoTable3.1):

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS



35

Table 3.1:FinancialRatio Types o Financial Ratios

Financial Ratios

LiquidityRatios

•Currentratio •Quickratio(Acidtestratio)

AssetsManagementRatios

•Inventoryturnoverratio •Fixedassetsturnoverratio •Totalassetsturnoverratio

Debtmanagementratios

•Debtratio •Timesinterestearnedratio

Proftabilityratios

•Netsalesproft •Returnsocommonequity

Marketvalueratio

•Price/earningratio •Bookpershareratio •Market/bookratio

Letustakealookateachtypeindetail.

activity3.2 Defnethemeaningoliquidassets. (a) Liquidity Ratio Liquidity ratioisusedtoshowthecorrelationbetweencashandafrm’s curre cur rent nt asse assets ts wit with h its cur curre rent nt lia liabil biliti ities. es. Liq Liquid uid ass asset et is an ass asset et tha that t can easilybeconvertedintocashwithoutdecreasingmuchoitsvalue.Afrm’s liquiditystandingcananswerquestionsastowhetherafrmcanaordor hastheabilitytopayoitsdebtswhenthed hastheabilitytopayo itsdebtswhenthedateisdue. ateisdue. (i) Current Ratio Thisra Thi sratio tiosho showst wsthe her req equen uencyc cycurr urrent entlia liabil biliti itiesa esare recov cover eredb edbycu ycurr rren ent t asse as sets ts an and d th this is is ca calc lcul ulat ated ed by di divi vidi ding ng cu curr rren ent t as asse sets ts wi with th cu curr rren ent t liabilities.Acurrentassetincludescash,marketablesecurities,accounts recei re ceivab vable le and inv invent entori ories. es. Whi While le cur curre rent nt lia liabil biliti ities es inc includ lude e acc accoun ounts ts payable,short-termnotespayable,taxaccruedandothe payable,short-term notespayable,taxaccruedandotherexpensessuch rexpensessuch asemployees’wages. Curr Cu rren ent tra rati tio oca can nbe bee exp xprres esse sed das as ol ollo lows ws:: Current ratio =

CurrentAssets Current Liabilities

36

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Accorrdi Acco ding ngtoth totheex eexam ampl pleo eoEma EmasLi sLimi mite tedCo dComp mpan any y,th ,thecu ecurr rren entra trati tio o iscalculatedasollows: Current ratio:

Yea ear r20 2010 10 :

24,300 =3.68 6,600

30,000 Yea ear r20 20111 : =3.23 9,300 There The reor ore, e,cur curre rent ntrat ratio ioin in201 2010i 0is3 s3.68 .68and ando ort rthe heye year ar201 2011i 1is3 s3.23 .23.. (ii) Quick Ratio Quickratioisalsoknownasanacidtestratio.Quickratiomeasuresthe frm’sabilitytopayshort-termdebtswithouthaving frm’sabilitytopayshort-te rmdebtswithouthavingtosellinventorie tosellinventories. s. Inventor Inve ntoryis yisdedu deducted cted ro romcurren mcurrentassetbecausethisassetis tassetbecausethisassetis theleast liquidandithefrmisdissolved,inventorymightbetheassetwhich couldincurlosses. Quick ratio can be shown by the ollowing ormula: CurrentAssets–Inventories Quick Ratio= Current Liabilities Basedo on nt th hee ex xampleo oE Em masL LiimitedC Co ompany,t th heq qu uickr raatiow wh hen calculatedisasollows: Quick Ratio:

 24 24,3 ,300 00– –1 12, 2,45 450 0 =1.80 Year2010= 6,600  30 30,0 ,000 00– –1 18, 8,45 450 0 Year2011= =1.24 9,300 Thus,q qu uickr raatio o ort th hey yeear2 201 0100i is1 s1..80a an nd o ort th hey yeear2 20011i iss1 1..24. Itshowsthatthefrmisabletopayitsshort-termdebtsbetterinthe year2010.

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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37

selF-check3.4 Compare curr Compare currentratioandquickratioorEmas entratioandquickratioorEmasLimi LimitedCompa tedCompanyor nyor theyears2010and2011.Whatisyouropinionregardingtheliquidity positionothiscompany?

(b) Asset Management Ratio Asset management ratio measures the frm’s efciency in managing its assets.Theinormationregarding assets.Theinormationr egardingtheassetmanagementratiocandetermine theassetmanagementratiocandetermine whethereachtypeoassetsthathadbeenreportedintheBalanceSheet,too muchortoolittle,isbasedonthecurrentsalesrequencyororecastedsales requency.Iafrmhastoomanyassets,itscapitalistiedintheassetswhich willinvolveahighcostocapital.Asaconsequence,proftswilldecrease. Ontheotherhand,ia Ontheother hand,iafrmsave frmsavestoolittleonasset stoolittleonassets,especi s,especiallyinv allyinvento entories, ries, this th is wi will ll re resu sult lt in th the e lo loss ss o cl clie ient nts s be beca caus use e o la lack ck o st stoc ocks ks to u ulf lfl l th the e customer’sdemand: (i) Inventory Turnover Ratio Inventory Turnover Ratiocanbeexpressedasollows:

Inventory Turnover Ratio =

Costogoodssold Inventory

Ahig highin hinve vent ntor orytu yturn rnov over errat ratio ioind indic icat ates estha thatsa tsale lesar sarego egood odand andinv inven ento tory ry turn tu rnov over er is qu quic ick. k. Th The e im impl plic icat atio ion n is th that at th the e fr frm m ca can n ru run n it its s bu busi sine ness ss with wi thou out t ha havi ving ng to ti tie e it its s ca capi pita tal l in in inve vent ntor orie ies. s. Th This is is be beca caus use e ho hold ldin ing g invent inv entori ories esinv involv olves escos costs ts suc such h as cap capita ital l cos cost, t, sto storin ring g cos cost, t, and ins insura urance nce cost co st. . Th Ther ere eor ore, e, th the e hi high gher er th the e in inve vent ntor ory y tu turn rnov over er ra rati tio, o, th the e be bett tter er th the e situationorthefrm. Bas aseed on th thee exam amp ple o th thee Ema mas s Lim imit iteed Com omp pan any y, th thee ca callcu cula lati tio on o orr inventoryturnoverratioisasollows: Inventory Turnover Ratio

71,110 Year2010==5.71 12,450 74,846 Year2011==4.06 18,450

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Thus,inve Thus,in vento ntoryt ryturn urnov overr errati atioo oorth rtheye eyear2 ar2010 010is5. is5.71a 71and ndort orthey heyear ear201 2011 1 is4.06.Thismeansthatthefrm’spositionisbetterintheyear2010. (ii) Fixed Asset Turnover Ratio This ratio measures the frm’s efciency in using fxed assets such as  buildings and equipment to generate profts. The ormula or fxed asset turnoverratioisexpressedasollows: Basedo Base donth ntheex eexam ampl pleo eoEm Emas asLim Limit ited edCom Compa pany ny,fx ,fxed edass asset ettur turno nove verra rrati tio o is: Fixed Assets Turnover Ratio =

Sales Net fxed assets

Thus,fxe Thus,f xeda dasse ssettu tturno rnove verr rrati atio oor orthe theye year ar201 2010i 0is3. s3.28 28and ando ort rthe heyea year2 r201 011 1 is3.00.Thismeansthatthefrm’sefciencyinmanagingitsfxedassetshad decreasedintheyear2011. 85,500 Year2010==3.28 26,100 90,300 Year2011==3.01 30,000

(iii) Total Asset Turnover Ratio Tota otala lasse ssett tturn urnov over errat ratio iocan canbe besh shown ownby byth the eoll ollowi owing ngor ormul mula: a: Total Asset A sset Turnover Ratio =

Sales Total assets

Normally, high ratios o fxed asset turnover and total asset turnover are ar e pr pre eer erre red. d. Th This is is be beca caus use e a hi high gh ra rati tio o in indi dica cate tes s th that at as asse sets ts ar are e us used ed more mo re e eec ectiv tively ely to toge gener nerate ate sal sales. es. Bas Based ed on onthe the exa exampl mple e o oEma Emas s Lim Limite ited d Company,totalassetturnoverratiois:

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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39

Total Asset Turnover Ratio

85,500 Year2010==1.70 50,400 90,000 Year2011==1.50 60,000

There Ther eor ore, e,tot total alass asset ettur turno nove verra rrati tioin ointhe theyea year20 r2010 10is1. is1.70 70and andor orthe theyea year r 2011is1.50.Thismeansthattotalassetsturnoverratioortheyear2010is higher.

activity3.3 Based Base d on th the e as asse set t ma mana nage geme ment nt ra rati tio o o or r th the e Em Emas as Li Limi mite ted d Co Comp mpan any y or the years 2010 an and d 2011, which year has more efcient assets management?Givereasonstosupportyouranswer.

(c) Debt Management Ratio Tot otal al de debt bts s us used ed by a fr frmis mis kn know ownas nas fn fnan anci cial al le leve vera rage ge. . Im Impl plic icat atio ions ns o usingdebtsascapitalare: (i)

Shareholders can continue controlling a frm by obtaining unds throughdebts;

(ii) (ii ) Cred Credito itorsuse rsuse equ equity ity topro toprovi videsecu desecurit ritymarg ymargin. in. I sha share rehol holde dershave rshave asmalltotalofnancialratio,thefrm’sriskwillbebornebycreditors; and (iii (i ii) ) I fr frms ms at atta tain in hi high gher er re retu turn rns s th than an wh what at ha has s be been en pa paid id as in inte tere rest st on debts,returnsonowner’scapitalwillbehigher debts,return sonowner’scapitalwillbehigher.. Therearetwotypesode Therear etwotypesodebtmanagementratio btmanagementratios: s: (i) Debt Ratio Debt De bt rat atio io meas asur urees th thee perce cent ntag agee o un unds ds pr prov ovid ideed by cr cred edit ito ors. Debtratiocanbeshownintheollowingormula: Debt Ratio=

Totaldebts Totalassets

Tot otal al de debt bt in incl clud udes es cu curr rren ent t li liab abil ilit itie ies s an and d lo long ng-t -ter erm m de debt bts. s. Cr Cred edit itor ors s preeralowdebtratioasitismoreadvantageousduringthetimea

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

companyisdissolved.Forshareholders,theypreerahighdebtratio  becauseitwillenlargetheexpe  becauseitwillenlar getheexpectedearnings. ctedearnings. Bas aseed on th the e exa xam mpl plee o Ema mas s Lim imit iteed Comp mpan any y, th thee ca calc lcu ula lati tio on o debtratioisasollows:

Debt Ratio

24,000 Year2010==0.48 50,400 31,920 Year2011==0.53 60,000

Thus,the Thus,t hede debtr btrati atioi ointh nthey eyear ear201 2010is 0is0.4 0.48an 8ando dorth rthey eyear ear201 2011is 1is0.5 0.53. 3. Thismeansthatthedebtratiohasincreasedintheyear2011.Thefrm reliesmoreonitscr reliesmo reonitscreditorstofnancethe editorstofnancethetotalassetsortheye totalassetsortheyear201 ar2011. 1. (ii) Times Interest Earned Ratio Thisra Thi sratio tioisu isused sedtom tomeas easur ureth ethefr efrm’s m’sabil ability itytop topayi ayitsan tsannua nualin linter terest est paym pa ymen ent. t. I a fr frm m is un unab able le to pa pay y o o  it its s in inte terres est t ch char arge ges, s, cr cred edit itor ors s havetherighttotakelegalproceedingsagainstitandthismightcause the com compan pany y to bec become ome ban bankr krupt upt. . Fr From om the cr credi editor’s tor’s poi point nt o vie view w thehigherafrm’stimesinterestearnedratio,thebetteritisorthem,  because that shows the frm’s ability to pay interest interestannually annually.. Hence, creditor’srisksareless. Time imesi sinte ntere rest stear earned nedra ratio tioca canb nbes eshow howni nint nthe hen nor ormul mulab abelo elow: w:

EarningsbeforeInterestandTax Interestcharge

TimesInterestEarnedRatio=

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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41

Bas aseed on th thee exam amp ple o Em Emas as Lim imit iteed Com omp pan any y, th thee ca calc lcul ulat atio ion n o timesinterestearnedis: Times Interest Earned Ratio

7,890 Year2010==4.38 1,800 8,514 Year2011==3.23 2,640

Thus,time Thus,t imesin sinter terest estear earned nedrat ratioi ioishi shighe gherin rinthe theye year2 ar2010 010.Th .Thefr efrm’s m’sabi abilit lity y topayannualinteresthaddeclined topayannualinter esthaddeclinedintheyear201 intheyear2011. 1.

activity3.4 Writedowntheimportanceodebtmanagementratiototheollowing parties: Shareholders

Creditors

(d) Proftability Ratio Proftability ratio indicates the combined eects o liquidity, asset managemen manag ementand tanddebts debts deci decision sion onoperat onoperation.Inshort,proft ion.Inshort,proftabili abilityratiois tyratiois theeectovariouspolicie theeecto variouspoliciesanddecisionsothe sanddecisionsothecompany: company: (i) Proft Margin on Sales This Th isr rat atio iom mea easu sure res sin inco come me rrom ome eve very ryr rin ingg ggit ito o sa sale les. s. Prof Pr oft tma marg rgin ino on nsa sale les sca can nbe bes sho hown wnb by yth the eo oll llow owin ing go orm rmul ula: a: Based on the example o Emas Limited Company, proft margin on salesis:

42

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Proft Margin on Sales=

Earningavailableortheshareholders Sales

The herreo orre,ne ,netpr tpro oft mar arg gin or th thee year 20 2010 10 is 4. 4.1% 1% an and d in year 20 20111is 3.8%.Itindicatesthatthefrm’snetproftmargininyear2010ishigherthan 2011. Thus,pro Thus,p roftm ftmar argin ginon onsal sales esor orthe theye year2 ar2010 010is is4.1 4.1%an %and dor orthe theye year2 ar201 011is 1is 3.8%.Thismeansthatproftmarginonsalesishigherortheyear2010.This marginwentdownintheyear2011. Proft Margin on Sales

3,540 Year2010==0.041=4.1% 85,500 3,405 Year2011==0.038=3.8% 90,000

(ii) Return on Common Equity  Thisra Thi sratio tiomea measur surest esther herate ateor oretu eturns rnsear earned nedonth onthein einve vestm stment entoo oord rdina inary ry shar sh areh ehol olde ders rs. . Re Retu turn rn on co comm mmon on eq equi uity ty ca can n be sh show own n by th the e o oll llow owin ing g ormula:

Return on Common Equity =

Netproftavailableoror Netproftav ailableorordinaryshare dinaryshareholders holders Ordinarysharesequity

Basedonth Based ontheex eexamp ampleo leoEm EmasL asLimi imited tedCom Compan pany y,r ,retu eturno rnonco ncommo mmoneq nequit uity y isasollows: Return on Common Stock Equity

3,540 Year2010==0.1405=14.05% 25,200 3,405 Year2011==0.1267=12.67% 26,880

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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43

The herreo orre, th thee retu turn rn on co com mmo mon n equ quiity o or r th thee year 20 2010 10 is 14 14.0 .05% 5% an and d 12.67%ortheyear201 12.67% ortheyear2011.So,itshowsthatretu 1.So,itshowsthatreturnoncommo rnoncommonequity nequityorthe orthe year2010ishigher. (e) Market Value Ratio Mark Ma rket et va valu luera erati tiois ois ase aseto to ra rati tios os th that at co corr rrel elat ates es th thefr efrm’ m’sst sstoc ockpr kpric iceto eto theearningso(bookvalue)persharebasedonbookvalue.Thisratiogives inormatio inor mationto ntothemanage themanagementreg mentregard ardingtheinvesto ingtheinvestors’viewonthe rs’viewonthefrm’ frm’s s perormanceinthepastanditsutur perormance inthepastanditsutureprospec eprospects: ts: (i) Price/Earnings Ratio Thisr Thi srati atios oshow howsho showm wmuch uchinv invest estors orsar arew ewill illing ingto topay payo ore reach achri ringg nggit it otheproftreporte othepro ftreported.Thisratiocanbeex d.Thisratiocanbeexpressedaso pressedasollows: llows:

Price/Earning Ratio

=

Pricepershare Earningspershare

(ii) Book Value Per Share Bookv Boo kvalu aluep eper ersha share rera ratio tioca canb nbes esho hown wnby bythe theo ollo llowin wing gorm ormula ula:: Book Value Per Share Ratio =

Commonequity Outstandingshares

(iii) Market/Book Ratio Mark Ma rket et/B /Boo ook kra rati tio oca can nbe bee exp xpre ress ssed eda as so oll llow ows: s: Marketpricepershare Market/Book Ratio = Bookvaluepershare

(iv) Flow Analysis o Financial Ratio Inusi In using ngfna fnanc ncia ialra lrati tio, o,itis itisimp impor orta tant ntor orafna afnanc ncia ialma lmana nage gerto rtomak make e timecompari time comparisonorcompa sonorcomparison risonsofrmsinthesameindustr sofrmsinthesameindustrytogeta ytogeta comprehensiveviewo compreh ensiveviewothefrm’sper thefrm’sperormance. ormance.

44

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Table3.2listsallthefnancialratioso able3.2listsallthefnancialratiosormulasthatwehaved rmulasthatwehavediscussedearlier iscussedearlier.. Table 3.2:FinancialRatiosFormula Types o Financial Ratio

(a) Liquidity ratio

Financial Ratios Formula

Current ratio Current Assets Current Liabilities

Quickratio Current Asset - Inventories Current Liability

(b) (b ) As Asse set tma mana nage geme ment ntr rat atio io

Inven In vento tory ryT Tur urno nove ver rRa Ratio tio Cost o goods sold Inventory

Fixedassetsturnoverratio Sales Total assets

Totalassetsturnoverratio Sales Net fxed assets

(d) Proftability ratio

Proft margin on sales Earnings available or the shareholders Sales

Returnoncommonequity Net proft available or ordinary shareholders shareholders Ordinary shares equity

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Types o Financial Ratio

(e) Market valu luee ratio



45

Financial Ratios Formula

Pric icee/ Earnin ing gs Rati tio o Price per share Earning per share

BookValuePerShare Common equity Outstanding shares

Market/BookRatio Market price per share Book value per share

3.2. 3. 2.3 3

U U  f fF F    R R  

activity3.5 Basedontheavaila Basedon theavailablefnanci blefnancialratios,inyourownopinio alratios,inyourownopinion,howdo n,howdothese these ratiosassistorganisationsinmakingdecisions?

Financial Financ ial rat ratios ios can be use used d to int inter erpr pret et fna fnanci ncial al in inorm ormati ation on in a way tha that t is easily eas ily und under ersto stood od. . Fin Financ ancial ial rat ratios ios can giv give e a mo more re com compr preh ehens ensive ive re reec ectio tion n compar com pared ed to the re real al fg fgur ures es as sta stated ted in fna fnanci ncial al sta statem tement ents. s. Fo For r exa exampl mple, e, i afnancialmanagerwishestoknowafrm’sliquiditystanding,hehasonlyto reertothefnancialratiossuchascurrentratioandquickratio.Foraninvestor whowishestoknowthefrm’sproftability,hecanreertotheproftabilityratios such suc h as aspr proft oft mar margin gin on onsal sales esand and re retur turn n oncommo oncommon n sto stock ckeq equit uity y. I Ifna fnanci ncial al ratios rat ios can be col collec lected ted or sev severa eral l yea years, rs, com compar pariso ison n can be mad made e by sho showin wing g theirowsin the irowsin the or orm mograp ograph,thusmakin h,thusmaking gdis disper persio sion noino oinorma rmatio tion nbythe bythe managementeasier. Financialratioscanbeusedtoconstructafrm’sfnancialprofles.Itcanevaluate various vari ous aspec aspects ts o frm’ frm’s s fnanc fnancial ial per perorma ormance nce and stand standing. ing. This Thisino inormati rmation on can ca n be us used ed in th the e de deci cisi sion on-m -mak akin ing g pr proc oces ess s by th the e fr frm’ m’s s ma mana nage geme ment nt te team am, , suppliers,investors,banksandsoon.

46

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TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Financial Financ ial rat ratios ios (es (espe pecia cially lly i ow ana analys lysis is or com compar pariso isons ns bet betwee ween n ar are e mad made) e) canmeasurethefrm’shealthandgivean“earlywarning”signonthedifculties which whi ch may be ac aced ed by the frm frm. . The There reor ore, e, a fna fnanci ncial al man manage ager r may pr prop opose ose appropriatestepstosolveth appropr iatestepstosolvetheproblem eproblembeoreitbe beoreitbecomestooacute. comestooacute.

activity3.6 Prepar aree a list o fnancial ratios which you might scrutinise beore purchasingafrm’sshare.

3.2. 3. 2.4 4

W W    f fF F   R R  a a  

Althou Alth ough gh fn fnan anci cial al ra rati tio o is a us use eul ul an and d qu quic ick k wa way y to an anal alys yse e th the e st stat atus us an and d perormanceoabusiness,ithassomeweaknessesandthisshouldbeconsidered  byafnancialmanagerwhenusingfnancialratio  byafnancialmanagerwh enusingfnancialratios.Among s.Amongsttheweaknessesar sttheweaknessesare: e: (a) (a ) Fina Financ ncia ial l ra rati tios os rel ely y on da data ta ob obta tain ined ed r rom om fn fnan anci cial al st stat atem emen ents ts. . Th Thus us, , whet wh ethe her r th the e fn fnan anci cial al ra rati tios os ca calc lcul ulat ated ed ca can n be tr trus uste ted d or no not t de depe pend nds s on the th e qu qual alit ity y o th the e fn fnan anci cial al st stat atem emen ents ts. . Wea eakn knes esse ses s wh whic ich h ex exis ist t in th the e fnancialstatementwillbereectedinthefnancialratiosandinterpreting inor in orm mat atio ion n r ro om th theese rat atio ios s is use selless be beca cau use th the e fn fnan anci cial al dat ata a is inaccu ina ccurat rate. e. Apa Apart rt r rom om tha that, t, one o the imp impor ortan tant t ac actor tors s whi which ch nee needs ds to  be taken into consideration in prepari preparing ng the fnancial statements is the eectoinationwhichmaymisrepresentthevalueofxedassetssuchas properties,proftand proper ties,proftandlossfgures,e lossfgures,etc. tc. (b) Fin inan anci cial al rat atio ios s meas asur uree th thee frm rm’s ’s relat atiive st stan andi ding ng an and d pero orm rman ance ce and donot donottak take eint into oacc accoun ount t its abs absolu olutesize. tesize. Som Someti etime mes, s,re real alfgu fgure res s can give giv e a bet better ter ove overal rall l re reec ectio tion n whe when n we mak make e a com compar pariso ison n o the frm frm’s ’s perormancebetweentwodierenttimeperiodsorbetweentwodierent frms. (c)

Normally Normal ly, ,fna fnanci ncialratio alratio oa frm iscompa iscompare red dwit with hthe the ind indust ustryaver ryaverage ages s ratios where basic signs are used to look at the frm’s standing and per pe ror orma manc nce e co comp mpar ared ed to ot othe her r fr frms ms. . It sh shou ould ld be rem emin inde ded d th that at th this is comparisonmightnotbeappropriatebecauseitisdifculttofndtwofrms withthe wit hthesam samekindo ekindobus busine iness. ss. Ev Eventhou enthoughther ghtheremay emayex exist ist two frm frms sin in thesameindustry,oneothefrmsmighthavemiscellaneousactivitiesin othertypesobusiness.Inaddition,accountingpolicy,fnancialpolicy,and

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS



47

fnanci fnan cial al ye year ar ma may y di di er er, , an and d th this is wi will ll co comp mpli lica cate te th the e co comp mpar aris ison on th thus us weakeningtheuseofnancialratios. (d) Financialratio Financialratioswhicharebasedona swhicharebasedonabalan balancesheetmigh cesheetmightnotgiveaccurate tnotgiveaccurate inormationbecauseabalancesheetgivesareectionothefrmatacertain poin po int t o ti time me on only ly. . Th Thus us, , a fn fnan anci cial al ra rati tio o ca calc lcul ulat ated ed ba base sed d on th the e da data ta o a ba bala lanc nce e sh shee eet t st stat atem emen ent t do does es no not t rep epre rese sent nt th the e fr frm’ m’s s st stan andi ding ng an and d perormanceinthewholeyear.Theseweaknessesareevenmoreobviousin seasonalbusinesses. (e)

Although the fnancial ratios are used to analyse the strengths and weak we akne nesse sses s o a fr frm, m, it ca cann nnot ot id iden enti tiy y a act ctor ors s wh whic ich h ha had d br brou ough ght t it to thatposition.Amoredetailedinvestigationintoitspracticesandbusiness recordsisstillneededto recor dsisstillneededtoidentiythose identiythoseactors. actors.

selF-check3.5 Ttue (T) or False (F) Statements

1.

Debtfnancingisalsoknownasequityfnancing.

2.

Interestexpensesaresubtr Interestexp ensesaresubtractedbeor actedbeoretaxlevied. etaxlevied.

3.

Proftabilityratioindicatesthecombinedeectsoliquidity,assets managementanddebtonoperationaldecision.

4.

Currentratioisamorestrictliquiditymeasurementcomparedto quickratio.

3.3

impoRtantFacts

Balancesheetisastatementthatshowsafrm’sfnancialstandingatacertain pointotime.Balancesheetcanbediv pointotime.B alancesheetcanbedividedintotwopar idedintotwoparts: ts: (a) Asset Assets:(c s:(curr urrenta entassets ssets+fx +fxedas edasset); set);and and (b) (b ) Liab Liabil ilit itie ies: s: (c (cur urre rent nt li liab abil ilit itie ies s + lo long ng-t -ter erm m de debt bt) ) an and d eq equi uity ty: : (p (pre ree ere renc nces es shares,commonsharesandr shares,commo nsharesandretainedearning etainedearnings). s).

48



TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Inormationthatcouldbeobtainedr Inormationthatcoul dbeobtainedromabalancesheetar omabalancesheetare: e: (a) Ree Reection ctionot otheca hecapital pitalstru structur ctureo eothe thecomp company any (b) In Inorm ormati ation onon onwor workin kingc gcapi apital tal Incomestatementshows: (a) Afrm’ frm’sr sreven evenuesa uesande ndexpen xpenditu ditures resatac atacertai ertainpo npointo intotim time;an e;and d (b) Afrm’sproftan frm’sproftandlossoracertainpe dlossoracertainperiodotime,no riodotime,normallyoneye rmallyoneyear ar.. Cashowstatementindicatestheeectsothefrm’sactivitiesoncashowso thefrmoracertainperiodotime thefrmoracertai nperiodotime.Firm’sactivitiesar .Firm’sactivitiesare: e: (a) (a ) Op Oper erat atin ing gac acti tivi vity ty;; (b) Inv Invest estmen menta tacti ctivit vity; y;and and (c) (c ) Fi Fina nanc ncin ing gac acti tivi vity ty.. Financialstatementsanalysisinvolves: (a) Comparison o the frm’s perormance with other frms in the same industry;and (b) Eval Evaluatio uationo nothe theowo owothe thefrm’ frm’sstan sstanding dingbetw between eencert certainti aintimep meperio eriods. ds. Financialratiosinclude: (a) Liqu Liquidity idityratio ratios:cu s:curre rrentra ntratio, tio,quick quickrati ratio; o; (b) (b ) Asse Assets ts ma mana nage geme ment nt ra rati tios os: : in inve vent ntor ory y tu turn rnov over er ra rati tio, o, fx fxed ed as asse set t tu turn rnov over er ratio,totalassetturnoverratio; (c) Debt Debtmana manageme gementra ntratios: tios:debt debtrati ratio,tim o,timesin esinter tereste estearne arnedrat dratio; io; (d) Proft Proftabi abilit lity y rat ratios ios: : pr proft oft mar margin gin on sal sales; es; and re retur turn n on com commo mon n eq equit uity; y; and (e) Mar ark ket val alu ue rat atio ios: s: pri rice ce/e /ear arn nin ing gs ra rati tio o, bo boo ok val alue ue pe perr sh shar aree ra rati tio o, market/bookvalueratio. UsesoFinancialRatios: (a) Inter Interpre pretfnan tfnanciali cialinor normatio mationint nintoa oaorm ormthati thatiseas seasilyu ilyunder nderstood stood; ; (b) Cons Construc tructafr tafrm’sf m’sfnanci nancialpr alprofle ofle;and ;and (c) Measure Measurethefrm thefrm’sheal ’shealthandgi thandgivean“e vean“early arlywarnin warning”sig g”signonthed nonthedifc ifculty ulty whichmaybeacedbyafrm.

TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS



49

Theweaknessesofnancialratioanalysisare: (a) (a ) I th the e fn fnan anci cial al ra rati tio o da data ta is in inac accu cura rate te, , th this is wi will ll in inu uen ence ce th the e qu qual alit ity y an and d accuracyothefnancialratios; (b) The fna fnanci ncialratio alratios smea measur suresthefrm’s esthefrm’s re relat lative ive sta standi ndingandpero ngandperorma rmance nce withouttakingintoconsiderationtheabsolutesize; (c) Comparing Comparingthef thefnanci nancialrat alratioo iooafrm afrmwith withothe otherfrm rfrmsint sinthesam hesameind eindustry ustry mightnotbesuitableitherearefrmswhichrunmiscellaneoustypeso  businessactivity; (d) The eco econom nomics ics sit situat uation ion alw always ays cha chang ngesbut esbut fna fnanci ncial alrat ratios ios ar are ecal calcul culate ated d  basedonfnancialstatementsata  basedonfnancial statementsatacertainpointo certainpointotime,orexamplebalance time,orexamplebalance sheet;and (e) Finan Financials cialstandi tandingo ngoaf afrmca rmcanbe nbeae aected ctedbym bymany anyactor actors. s.

sUmmaRy •

There are three important fnancial statements balance sheet, income statementandcashowstatement.

•

Inorm Ino rmat atio ioncan ncan be ob obta tain ined ed r rom om ea each ch o th thefna efnanc ncia ialsta lstate teme ment ntsand sand th this is ino in orm rmati ation on ca can n be us used ed to ca calc lcul ulat ate e ce cert rtai ain n fn fnan anci cial al ra rati tios os to me meas asur ure e the liq liquid uidity ity, , ass assets ets man manage ageme ment, nt, deb debt t man manage agemen ment, t, pr proft oft and the frm frm’s ’s marketvalue.

•

Even th Even thou ough gh fn fnan anci cial al ra rati tios os ca canbe nbeus used ed to in inte terp rpre retfnan tfnanci cial al in ino orm rmat atio ion n into in to a o orm rmat at th that at co coul uld d be ea easi sily ly un unde ders rsto tood od, , an and d to me meas asur ure e th the e fr frm’ m’s s healthaswellasconstructthefrm’sprofle,wecannotrelyentirelyonratio analysisinmakingourdecisionbecausethereareseveralweaknessesthat needtobeconsidered.

Assetmanagementratio Debtmanagementratio Financialratios Financialratioanalysis Financialstatement

Financialterms Liquidityratio Marketvalueratio Proftabilityratio