Specific Learning Objectives� Understand the need for interpreting financial

statements.

� Identify the different categories of financial ratiosand explain the purpose of each category.

� Identify the limitations of financial ratio analysis.

� Compute relevant financial ratios to evaluate thefinancial position of the company.

Problem Analysis

Adrian has money to invest

Financial StatementsFinancial Statements•Analysis

•Comparison

Other Business information

Plenty Call? Mass Comm?

Financial Statements: Financial Analysis

Financial Analysis with the use of financial ratiosis a useful way of interpreting financialstatements and making useful inference onstatements and making useful inference onprofitability, efficiency, liquidity, gearing, cashflow and investment.

Main Users of Financial Statements

Internal users:� Employees of the company

� Management

Shareholders of the company� Shareholders of the company

External users:� The loan - creditors group

� The business contacts, competitors

� The analyst /adviser

� Potential Investors

Categories of Ratio

Category Purpose

Profitability ratios (“PR”) Assess business’ ability to earna satisfactory profit

Long-term solvency / Gearing ratios (“GR”)

Assess the long term finance risk of the business

Liquidity ratios (“LR”) Assess whether business is able Liquidity ratios (“LR”) Assess whether business is able to pay its creditors, expenses, loans etc when due

Efficiency (“ER”) / Turnover ratio

Assess how efficiently the

company is using its resources

Shareholders’ investment ratios (“SR”)

Assess the relationship between returns and the money invested.

Profitability Ratio

The objective of profitability relates to a company’s

ability to earn a satisfactory profit so that the investors

and shareholders will continue to provide capital to it.

The profitability and return ratios are as follows:-The profitability and return ratios are as follows:-

1. Return on capital employed (ROCE)

2. Return on equity (ROE)

3. Gross profit as percentage of sales

4. Net profit as percentage of sales

Plenty Calls Mass Comm

Profit on ordinary activities before interest and taxation

Stockholders’ equity + long term liabilities

Return on Capital Employed (“ROCE”)

ROCE shows how adequate the return is for the amount of capital investors have invested. In this case, for every $1 of extra borrowing or investing, the company or the investors respectively can expect an earning of $0.88 (Plenty Calls) and $0.93 (Mass Comm).

$510,000

$400,000 + $180,000

= 0.88

$600,000

$546,600 + $100,000

= 0.93

Profit after tax and pref dividends

Ordinary shares and other equities

Plenty Calls Mass Comm

$394,400 $430,100

Return on Equity (“ROE”)

$400,000

= 0.99

$546,600

= 0.79

ROE reveals how much profit a company generates with the moneyshareholders have invested. This ratio suggests that, for every $1 ofinvestment, the investors can expect an earning of $0.99 (Plenty Calls) and$0.79 (Mass Comm).

Note: ROE is also understood as Net income before dividends paid to common

stock holders (but after dividends to preferred stock)/ Shareholders’ equity

excluding preferred shares. It is also known as "return on net worth".

Gross Profit (“GP”) & Net Profit (“NP”) as Percentage of Sales

Gross Profit x 100%

Sales

Net Profit x 100%

Sales

Plenty Calls Mass CommGross Profit Margin Net Profit Margin Gross Profit Margin Net Profit Margin

$430,100x100%$900,000x100%$394,400x100%$910,000x100% $430,100x100%

$1,700,000

= 25.30%

$900,000x100%

$1,700,000

= 52.94%

Gross profit margin tells an investor the percentage of revenue / sales left aftersubtracting the cost of goods sold. A company that boasts a higher gross profit marginthan its competitors and industry is more efficient. The gross profit margin of Plenty Callof 56.52% is higher than that of 52.94% for Mass Comm.

Net profit margin tells an investor how much profit for every sales dollar. Plenty Callhas a slightly lower net profit margin of 24.5% compared to Mass Comm of 25.30%.

$394,400x100%

$1,610,000

= 24.50%

$910,000x100%

$1,610,000

= 56.52%

Long Term Solvency/ Gearing Ratio (“GR”)

These are mostly used by providers of finance toassess the finance risk of the business.

The 3 main gearing ratios are as follows:The 3 main gearing ratios are as follows:

1. Debt ratio

2. Capital gearing

3. Interest coverage ratio

Debt Ratio

Total liabilities

Total assets

Plenty Calls Mass Comm

$215,000

$615,000

$165,000

$711,600$615,000

= 0.35

$711,600

= 0.23

Debt ratio greater than 1 indicates that a company has more liabilities than assets. On the other hand, a debt ratio of less than 1 indicates that a company has more assets than liabilities. The debt ratio can help investors determine a company's level of risk. This ratio suggests that, for every $1 of assets each owned, Plenty Calls has borrowed $0.35 and Mass Comm has borrowed $0.23.

Total long term debts

Shareholders’ equity + Total long term debts

$100,000

($546,600 + $100,000)

$180,000

($400,000+ $180,000)

Mass CommPlenty Calls

Capital Gearing Ratio

($546,600 + $100,000)

= 0.15

($400,000+ $180,000)

= 0.31

Income before interest & tax

Interest Expenses

Plenty Calls Mass Comm

$510,000

$18,000

$600,000

$9,500

Interest Coverage Ratio

$18,000

= 28.33

$9,500

= 63.16

Liquidity Ratio (“LR”)

A company may be profitable but if it fails to generateenough cash to settle its liability, it is said to beinsolvent or that it has poor liquidity.

The 2 main liquidity ratios are as follows:The 2 main liquidity ratios are as follows:

1. Current Ratio

2. Quick Ratio

Current assets

Current liabilities

Plenty Calls Mass Comm

$280,000

$35,000

$331,100

$65,000

Current Ratio

$35,000

= 8.00

$65,000

= 5.09

Current ratio compares assets which become liquid within approximately 12months with liabilities which will be due for payment in the same period and isintended to indicate whether there are sufficient short-term assets to meet theshort term liabilities.

Plenty Calls current ratio of 8 suggests that it has more short term assets tomeet short term liabilities and is thus more liquid.

Plenty Calls Mass Comm

($280,000 – $110,000) ($331,100 – $145,000)

Current assets – Inventory

Current liabilities

Quick Ratio

Quick ratio is similar to Current ratio but it omits inventory (considered to be relatively illiquid). Plenty Calls Quick ratio of 4.86 is higher than Mass Comm of 2.86, suggesting that Plenty Calls is more liquid.

Note: A very high current ratio or quick ratio may indicate too much cash (no proper investment/use of cash). Hence, it is beneficial for investors to look at the cash value for prudent investment decision making

$35,000

= 4.86

$65,000

= 2.86

Efficiency Turnover Ratio (“ER”)

The efficiency ratios measure how efficiently the company is using its assets.

The 3 main efficiency ratios are as follows:

1. Debtor Collection Period

2. Creditor Payment Period

3. Inventory Holding Period

Accounts receivable*

Sales

Plenty Calls Mass Comm

$85,000 X 365 days

$1,610,000

$86,600 X 365 days

$1,700,000

Debtor Collection PeriodX 365 days

$1,610,000

= 19.27 days

$1,700,000

= 18.59 days

Debt Collection Period measures how many days’ sales remain in AccountsReceivable. That is how efficient is the company in collecting its debts. The fewerdays the better. Hence Mass Comm of 18.59 days is slightly better than PlentyCalls of 19.27 days.*Note: Average Accounts Receivable

= Accounts receivable beginning of the year + Accounts receivable at end of year 2

Since the accounts receivable beginning of the year was not available in the problem statement, we could only use the end of year accounts receivable.

Accounts Payable*

Purchases*Plenty Calls Mass Comm

$29,000 X 365 days

$700,000

= 15.12 days

$32,500 X 365 days

$800,000

= 14.83 days

Creditor Payment PeriodX 365 days

= 15.12 days = 14.83 days

Credit Payment Period measures how promptly the company is paying its debts, MassComm (14.83 days) takes a shorter period to pay for its purchases as compared to PlentyCalls (15.12 days). A higher number indicates either that Plenty Calls has decided to holdon to its money longer or that it is having difficulty paying creditors.

*Note: Average Accounts Payable

= Accounts payable beginning of the year + Accounts payable at end of year 2

• Since the accounts payable beginning of the year was not available in the problem statement, we could only use the end of year accounts payable.

• The purchases figure is usually not available in published financial statements and so the cost of sales amount could be used in its place.

Plenty Calls Mass Comm

$110,000 X 365 days

$700,000

= 57.36 days

$145,000 X 365 days

$800,000

= 66.16 days

Inventory*

COGS

Inventory Holding PeriodX 365 days

Inventory Holding Period measures how efficient is the company in sellingits inventory. It indicates the holding period of the inventory in the warehouse.For Plenty Calls, its inventory holding period is 57.36 days. Mass Comm holdsits inventory for 66.16 days. Since Plenty Calls has a shorter inventory holdingperiod, it shows that it is selling its inventory faster than Mass Comm.Although PC is selling faster, it is not earning back its cash as fast as MC since ithas a higher debt collection period.

= 57.36 days = 66.16 days

*Note: Average Inventory = Inventory beginning of the year + Inventory at end of year

2Since the inventory beginning of the year was not available in the problem statement, we could only use the end of year inventory. In addition, net inventory provides for provisions (such as write downs) and should be used when available.

Shareholders’ Investment Ratio

� Investment ratios are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

� The main shareholders’ investment ratios are as follows:follows:

1. Dividend Cover2.Dividends Yield3. Price Earning Ratio

� As the companies (Plenty Calls and Mass Comm) are not listed on public exchange, there is no price or dividend per share information to compute their ratios.

Summary

RATIOS Plenty Calls Mass Comm

PR - ROCE 0.88 0.93PR - ROE 0.99 0.79PR - GP Margin 56.52% 52.94%PR - NP Margin 24.50% 25.30%GR - Debt Ratio 0.35 0.23GR – Capital Gearing 0.31 0.15GR – Capital Gearing 0.31 0.15GR – Interest Coverage Ratio 28.33 63.16LR – Current Ratio 8.00 5.09LR – Quick Ratio 4.86 2.86ER - Debtor Collection Period 19.27 days 18.59 daysER - Creditor Payment Period 15.12 days 14.83 daysER - Inventory Holding Period 57.36 days 66.16 days

Summary on Financial Statements of

Plenty Calls (PC) and Mass Comm (MC)

� Both PC and MC are relatively close in their performance for the year 2008 in terms of profitability ratio and efficiency ratios.

� MC has managed their gearing better than PC.

� Although PC has a higher level of debt than MC, we need more information to � Although PC has a higher level of debt than MC, we need more information to understand why PC needs to borrow (e.g. expansion, R&D, etc).

� PC has a higher level of liquidity and shorter inventory holding period compared to MC.� In terms of liquidity, PC scores better than MC and is able to repay its short term debts.

� PC may be too liquid and not managing its short term finance well. It may be holding too much cash and should invest any excess cash or use the excess cash to repay some of its loans.

Summary on Financial Statements of

Plenty Calls (PC) and Mass Comm (MC)

� Based on the financial statements provided for financial year ended 31 Dec 2008, MC may seem to have performed better.

� However, it would be prudent for Adrian to look at past year financial results of both companies to see the general trend of their performance results of both companies to see the general trend of their performance and reference their performance to other companies in the same industry.

� Financial ratios are tools to assist business decisions,but they are rarely adequate in itself, beingquantitative in nature.

� The financial ratios are only as good as the sources

Limitations of Financial Ratio Analysis

� The financial ratios are only as good as the sourceswhere they come from, which are influenced by:-� Accounting standards of the country

� Management’s inclination to adopt standards that only reflectwell on the company, etc

In order to make a holistic & meaningful comparisonof PC and MC, Adrian has to use other information aswell from other sources.

Interpretation of Non-Financial Information

For Example:� Market information on market standing� Reputation� Adrian’s risk appetite and investment objectives

Mind Map

INVEST

Analyse and Compare Liquidity

Profitability

BenchmarkCurrent

Ratio

Quick RatioShareholders’

Investment Ratio

INVEST Efficiency

Gearing

Profitability

ROCE

ROE

Gross Profit Margin

Net Profit Margin

Debt Ratio

Capital Gearing

Interest Coverage Ratio

Inventory Holding

Debt Collection

Creditor Payment

ResourcesWebsites� Analyzing your Financial Ratios [Retrieved on 24 Feb 2009]

http://www.va-interactive.com/inbusiness/editorial/finance/ibt/ratio_analysis.html

� Financial Ratio Tutorial [Retrieved on 24 Feb 2009]http://www.investopedia.com/university/ratios/

Textbooks� Lawrence Gitman, Chapter 2, Principles of Managerial Finance, 11th Edition,

Pearson EducationPearson Education� Frank Wood & AlanSangster, Chapter 27, 28, Business Accounting 2, 10th

edition, Prentice Hall � Gerald I White, Ashwinpaul C Sondhi, Dov Fried, Chapter 4, The Analysis

& Use of Financial Statements, – 3rd Edition, John Wiley� Charles H. Gibson, Chapter 5, Financial Reporting & Analysis – Using

Financial Accounting Information� Sebastian Chong, Current Cases in Comparative Business Analysis,

Financial Info Analysis Pte Ltd � Harrison and Horngren, Chapter 13, Financial Accounting, Sixth Edition,

Pearson – Prentice Hall