topic 3 financial statement and financial ratios analysis

7/30/2019 Topic 3 Financial Statement and Financial Ratios Analysis

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS 27

leaRninGoUtcomes

Bytheendofthistopic,youshouldbeableto:

1. Explaintheimportanceofnancialstatements;

2. Analysefnancialstatements;

3. Calculateandinterpretfnancialratios;

4. Applyratioanalysisinfnancialdecisionmaking;and

5. Discussthelimitationsofnancialratiosanalysis.

t

3 Financial

StatementsandFinancialRatios

Analysis

intRoDUction

Financial statement and its analysis are vital to an organisation and externalparties. Theinternal management o a company requires inormation obtainedrom a fnancial statement to assist them in planning, controlling and decisionmaking.

External parties such as businesscreditorsneed toknowthe liquidity positionoafrmanditsabilitytopaytheirclaims.Bondholderstooneedtoknowthefrms ability to pay interest and its principal when the bond matures. Beore


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28 TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

investinginacompany,shareholdersneedtoknowtheproftandperormanceothecompanyconcerned.Thereore,whetheryouareafnancialmanager,creditoror investor, the understanding o the fnancial statement and its analysis is an

important.

Inthis topic, you will belearning three typesobasicfnancial statementsandtheir components, ollowed by fnancial analysis which can be used to gainimportantpracticalinormationorthebeneftocertainparties.

3.1Financialstatements

Therearethreetypesobasicfnancialstatements:

(a) BalanceSheet;

(b) IncomeStatement;and

(c) CashFlowStatement.

Letustakealookateachtypeindetail.

3.1.1 Bs

Balancesheetisthestatementothefrmsfnancialpositionataspecifcpointintime.Thebalancesheetoafrmmaychangedailybecauseinventoriesmay

increaseordecreaseeachday,andfxedassetssuchas equipmentcanbeaddedordepreciate.Afnancialstatementcanbedividedintotwoparts:

(a)AssetAn asset is a resource owned by a frm. Assets can be separated intocurrent assetsandfxed assets.Currentassetscanbeconvertedintocashinperiodlessthanoneyear.Examplesocurrentassetsarecash,marketablesecurities, accounts receivable and inventories. On the other hand, fxedassetsincludeequipmentandplants.Assetsarearrangedinorderbasedonliquidity,thatis,timeneededtoconverttheassetsintocashmoney.

(b)Liability and EquityLiability is a claim against the frms assets. Accounts receivable, notespayable and accruedexpenses are current liabilities whichwill mature inlessthanoneyear.Bondsandbankloanswhicharethefrmsdebtstootherpartiesarecategorisedaslong-termliabilityastheywillmatureinaperiodomorethanoneyear.

Equity isa claimoshareholdersonthefrmsassetswhichmaybeintheormopreerenceshares,ordinarysharesandretainedearnings.


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Figure3.1showsabalancesheetoEmasLimitedCompany.

Normally,assetsarenotedontheletsideoabalancesheetwhileliabilityandequityarenotedontherightsideoabalancesheet.Sometimes,assetsarenotedatthetopwhileliabilityandequityarenotedatthebottomothebalancesheet.

Inaccounting,all the frms assets belong tocreditors and owners othe frm.Thus,thereisanequationsuchasshownbelow:

Emas Limited Company

Income StatementFor the Years Ended 30th December 2010 and 31st December, 2011

Assets 2011 2010(RM000) (RM000)

CashandMarketableSecurities 300 2,400Accountsreceivable 11,250 9,450Inventories 18,450 12,450TotalCurrentAssets 30,000 24,300Netplantandequipment 30,000 26,100

TotalAssets 60,000 50,400

Liabilities and EquityAccountspayable 1,800 900Notespayable 3,300 1,800Accruedexpense 4,200 3,900TotalCurrentLiabilities 9,300 6,600Long-termbonds 22,620 17,400TotalLiabilities 31,920 24,000Preerenceshares(1,200,000) 1,200 1,200Ordinaryshares(15,000,000) 3,900 3,900

Retainedearnings 22,980 21,300TotalEquity 26,880 25,200Total Liabilities and Equity 60,000 50,400

Figure 3.1:BalancesheetoEmasLimitedCompany

Asset=Liability+Equity


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In general, a balance sheet gives inormation regarding the fnancing andinvestment activities o a frm. Liabilities and owners equity present a viewo the related frms capital structure. We can see the part o the total capital

which includes equity and the portion fnanced by debt. Segregation o thetotalliabilitiesintocurrentliabilitiesandlong-termliabilitiesarealsoshowninthe balance sheet. This inormationis important toanalyse the frms fnancialposition. From the balance sheet, we can also calculate the working capital.Workingcapitalisthedierencebetweencurrentassetsandcurrentliabilities.

activity3.1

Drawacharttoshowthepartsbelowinabalancesheet:(a) CurrentAssets (d) FixedLiabilities

(b) FixedAssets (e) Equity

(c) CurrentLiabilities

Working Capital = CurrentAssetsCurrentLiabilities

Working capitalcanbeobtainedbysubtractingcurrentliabilitiesromcurrentassets.Inormationonworkingcapitalisimportanttoevaluateafrmsliquidity

anditsabilitytopaybackshort-termclaimsonit.Afrmsliquidityisimportantbecause its business is likely to ail i the frm is unable to pay interestor paybackdebtwhenitmatures.

Balancesheetalsoshowsthecombinedassetsheldbyafrmorthecurrentassetratioandthefrmsfxed asset. Ia frm holdstoomuchfxed assets comparedtocurrentassets,thefrmscapitalwillbetiedupandthismayleadtocashowproblems and fnancial ailure. This is caused by difculty in converting fxedassetsintocashcomparedtocurrentassets.

selF-check3.1

Based on Figure 3.1, calculate the working capital o Emas LimitedCompanyortheyears2010and2011.


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3.1.2 is

Income statementisastatementthatgivesinormationregardingthe revenues

andexpendituresoafrminaspecifcperiodotime.Salesrevenueisshownineveryincomestatementandthisisollowedbyexpendituresorcostandtaxes.Inbrie,an incomestatementindicatesa frmsproftorlossinaspecifcperiodotimewhichisnormallyoneyear.Proftisimportanttoafrmsowner,employeesandsuppliersbecausewithoutproft,thefrmwillnotcontinuetoexist.

PleasereertoFigure3.2,IncomeStatementoEmasLimitedCompany:

Emas Limited Company

Income Statementor the Year Ended 31st December 2010 and 31st December 2011

2011 2010(RM000) (RM000)

Sales 90,000 85,500Costogoodssold (74,846) (71,110)Grossproft 15,154 14,390Salesandadministrativeexpenses (3,640) (3,800)Depreciationandamortisation (3,000) (2,700)

Proftbeoreinterestandtaxes 8,514 7,890Less:Interestexpenses (2,640) (1,800)Proftbeoretax 5,874 6,090Tax (2,349) (2,430)NetProft 3,525 3,660Preerencesharesdividend (120) (120)NetProftorordinaryshareholders 3,405 3,540Ordinarysharesdividends (1,725) (1,950)AdditiontoRetainedEarnings 1,680 1,590

Incomestatementorproftandlossstatementgivesinormationtomeasurethefrmsperormance. To measure the perormance oa frm, some aspects oanorganisationmustbeconsidered:

(i) Sales fgureCanbecomparedwiththefrmssalesinthepreviousyearandexpecteduturesales.Thisinormationcanbeusedorthepurposeoplanningthefrmsuture.

(ii) Gross proftCanbecomparedtothesalesfguretoshowproftearningsromgoodssold.

Figure 3.2:IncomestatementoEmasLimitedCompany


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(iii) Firms expensesCanbecomparedwiththefrmsexpensesinthepreviousyeartoormulatepoliciestodecreasecost.

(iv) Net proft Can be compared to sales. Normally, there arevariationsbetweenproftabilityandsalesvolumes.Whenafrmssalesvolumeishigh,itmayreceivealowerpercentageonetproft.However, the ratioonet sales-proft is inuenced bythe type o

businessundertakenbythefrmconcerned.

Gross Proft = SalesCostoGoodsSold

Net proft = GrossProftSalesandAdministrativeExpenses DepreciationandAmortisation

selF-check3.2

Essay QuestionWith reerence to the income statement in Figure 3.2, dierentiate

betweengrossproftandnetproft.

3.1.3 cFws

Cash ow statement reers to the statement that records the eects o a frmsactivities such as operating, investment and fnancing o a frms cash oworaspecifcperiod.Netcashowisthetotalcashattainedbyabusinessinaspecifcperiod,orexample,oneyear.Butthecashowattainedbyafrmmaynotnecessarilybethetotalcashstatedintheitemcashonthebalancesheet

because the cash may be used to pay dividends, fnance account receivable,investinfxedassets,increaseinventories,etc.Thereore,theavailabletotalcash

in a balance sheet may be inuenced by actors such as cash ow, changes inworkingcapital,changesinfxedassets,companystransactionssuchasbuyingandsellingosharesandbonds,dividendpaymentandsoon.Theseactorswill

bereectedinthecashowstatementwhichshowschangesinthecashpositionothefrm.

Acashowstatementcanbedividedintothreepartsaccordingtoitsactivities:

(i) Operatingactivity;

(ii) Investmentactivity;and

(iii) Financingactivity.


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PleasereertoFigure3.3:ShowscashowstatementoEmasLimitedCompany.

Cash ow statement is important to a fnancial manager because it gives

inormationregardingthefrmsabilitytogeneratesufcientcashto:(i) Financeorpurchasenewassetsorthefrmsexpansion;and

(ii) Paybackitsdebts.

Figure 3.3:CashowstatementorEmasLimitedCompany

Emas Limited CompanyCash Flow Statement

For the Year Ended 31st December 2011(RM000)

Operating ActivitiesNetProft 3,525Additional(cashresources)Depreciationandamortisation 3,000IncreaseinAccountsPayable 900IncreaseinAccruedexpenses 300

Less(usesocash)IncreaseinAccountsReceivable (1,800)Increaseininventories (6,000)Netcashprovidedromoperatingactivities (75)

Investment ActivitiesPurchaseoPlant,EquipmentandFixedAssets (6,900)Netcashprovidedrominvestmentactivities (6,900)

Financing ActivitiesIncreaseinnotespayable 1,500Increaseinbonds 5,220Dividendpaymentorpreerencesshareandordinaryshares (1,845)

Netcashromfnancingactivities 4,875Increase(decrease)incash (2,100)Beginningcashbalance 2,400Endingcashbalance RM 300


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3.2Financialstatementsanalysis

Financialstatementsanalysisinvolves:

(a) Comparisonbetween the frmsperormance with otherfrmsinthe sameindustry;and

(b) Evaluationothefrmsfnancialpositionromtimetotime.

Theseanalysescanbeusedby:

(a) A fnancial manager to identiy the frms weaknesses and take steps toimprovethefrmsperormance;and

(b) Investorstoevaluatethefrmscurrentfnancialstanding.

3.2.1 Ra

Inormation obtained rom the fnancial statement will assist investors and

fnancialmanagerstoorecastthefrmsutureperormancewhilemanagementcan use the inormation gained to orecast the situation and assist them inplanning or the uture. A basic method to obtain useul inormation romfnancialstatementsisthroughfnancialratioanalysis.

3.2.2 tfFR

There arefve categorieso fnancialratios.Eachtypeofnancial ratios has itsownroletothemanagementandownerothefrm.Financialratiosconsisto(reertoTable3.1):

selF-check3.3

True (T) or False (F) Statements

1. Depreciationexpensesisanitemthatwilladdtothenetprofttodeterminecashowromtheoperatingactivities.

2. Interestexpensesareitemsoinvestmentactivitiesina cashowstatement.

3. Any increase in accounts receivable and accounts payable willbe added to net proft in determining cash ow rom operatingactivities.

4. Purchaseofxedassetsorthecompanysusewillbedeductedto

determinecashowrominvestmentactivities.


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Table 3.1:FinancialRatio

Types o Financial Ratios Financial Ratios

LiquidityRatios CurrentratioQuickratio(Acidtestratio)

AssetsManagementRatios InventoryturnoverratioFixedassetsturnoverratioTotalassetsturnoverratio

Debtmanagementratios DebtratioTimesinterestearnedratio

Proftabilityratios NetsalesproftReturnsocommonequity

Marketvalueratio Price/earningratioBookpershareratioMarket/bookratio

Letustakealookateachtypeindetail.

activity3.2

Defnethemeaningoliquidassets.

(a) Liquidity RatioLiquidity ratioisusedtoshowthecorrelationbetweencashandafrmscurrent assets with its current liabilities. Liquid asset is an asset that caneasilybeconvertedintocashwithoutdecreasingmuchoitsvalue.Afrmsliquiditystandingcananswerquestionsastowhetherafrmcanaordorhastheabilitytopayoitsdebtswhenthedateisdue.

(i) Current Ratio

Thisratioshowstherequencycurrentliabilitiesarecoveredbycurrentassets and this is calculated by dividing current assets with currentliabilities.Acurrentassetincludescash,marketablesecurities,accountsreceivable and inventories. While current liabilities include accountspayable,short-termnotespayable,taxaccruedandotherexpensessuchasemployeeswages.

Currentratiocanbeexpressedasollows:

Current ratio =CurrentAssets

CurrentLiabilities


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AccordingtotheexampleoEmasLimitedCompany,thecurrentratioiscalculatedasollows:

Thereore,currentratioin2010is3.68andortheyear2011is3.23.

(ii) Quick Ratio Quickratioisalsoknownasanacidtestratio.Quickratiomeasuresthe

frmsabilitytopayshort-termdebtswithouthavingtosellinventories.Inventoryisdeductedromcurrentassetbecausethisassetistheleastliquidandithefrmisdissolved,inventorymightbetheassetwhichcouldincurlosses.

Quickratiocanbeshownbytheollowingormula:

Quick Ratio=

CurrentAssetsInventories CurrentLiabilities

BasedontheexampleoEmasLimitedCompany,thequickratiowhencalculatedisasollows:

Quick Ratio:

Year2010=

24,30012,450 =1.80 6,600

Year2011=

30,00018,450=1.24

9,300

Thus,quickratioortheyear2010is1.80andortheyear2011is1.24.Itshowsthatthefrmisabletopayitsshort-termdebtsbetterintheyear2010.

Current ratio:

Year2010 :24,300 =3.68

6,600

Year2011 :30,000 =3.23

9,300


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(b) Asset Management Ratio Asset management ratio measures the frms efciency in managing its

assets.TheinormationregardingtheassetmanagementratiocandeterminewhethereachtypeoassetsthathadbeenreportedintheBalanceSheet,toomuchortoolittle,isbasedonthecurrentsalesrequencyororecastedsalesrequency.Iafrmhastoomanyassets,itscapitalistiedintheassetswhich

willinvolveahighcostocapital.Asaconsequence,proftswilldecrease.Ontheotherhand,iafrmsavestoolittleonassets,especiallyinventories,this will result in the loss o clients because o lack o stocks to ulfl thecustomersdemand:

(i) Inventory Turnover RatioInventory TurnoverRatiocanbeexpressedasollows:

selF-check3.4

ComparecurrentratioandquickratioorEmasLimitedCompanyor

theyears2010and2011.Whatisyouropinionregardingtheliquiditypositionothiscompany?

Inventory Turnover Ratio =Costogoodssold

Inventory

Ahighinventoryturnoverratioindicatesthatsalesaregoodandinventoryturnover is quick. The implication is that the frm can run its businesswithout having to tie its capital in inventories. This is because holdinginventories involvescosts such as capital cost, storing cost, and insurancecost. Thereore, the higher the inventory turnover ratio, the better thesituationorthefrm.

Based on the example o the Emas Limited Company, the calculation or

inventoryturnoverratioisasollows:

Year2010==5.71

Year2011==4.06

Inventory Turnover Ratio

71,110

12,450

74,846

18,450


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Thus,inventoryturnoverratioortheyear2010is5.71andortheyear2011is4.06.Thismeansthatthefrmspositionisbetterintheyear2010.

(ii) Fixed Asset Turnover Ratio This ratio measures the frms efciency in using fxed assets such asbuildings and equipment to generate profts. The ormula or fxed assetturnoverratioisexpressedasollows:

BasedontheexampleoEmasLimitedCompany,fxedassetturnoverratiois:

Fixed Assets Turnover Ratio =Sales

Netfxedassets

Total Asset Turnover Ratio =Sales

Totalassets

Year2010==3.28

Year2011==3.01

85,500

26,100

90,300

30,000

Thus,fxedassetturnoverratioortheyear2010is3.28andortheyear2011is3.00.Thismeansthatthefrmsefciencyinmanagingitsfxedassetshaddecreasedintheyear2011.

(iii) Total Asset Turnover Ratio Totalassetturnoverratiocanbeshownbytheollowingormula:

Normally, high ratios o fxed asset turnover and total asset turnoverare preerred. This is because a high ratio indicates that assets are usedmore eectively togenerate sales. Based onthe example oEmas LimitedCompany,totalassetturnoverratiois:


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Thereore,totalassetturnoverratiointheyear2010is1.70andortheyear2011is1.50.Thismeansthattotalassetsturnoverratioortheyear2010ishigher.

Year2010==1.70

Year2011==1.50

Total Asset Turnover Ratio

85,500

50,400

90,000

60,000

activity3.3

Based on the asset management ratio or the Emas Limited Companyor the years 2010 and 2011, which year has more efcient assetsmanagement?Givereasonstosupportyouranswer.

(c) Debt Management Ratio Total debts used by a frmis knownas fnancial leverage. Implications o

usingdebtsascapitalare:(i) Shareholders can continue controlling a frm by obtaining unds

throughdebts;

(ii) Creditorsuseequitytoprovidesecuritymargin.I shareholdershaveasmalltotalofnancialratio,thefrmsriskwillbebornebycreditors;and

(iii) I frms attain higher returns than what has been paid as interest ondebts,returnsonownerscapitalwillbehigher.

Therearetwotypesodebtmanagementratios:

(i) Debt Ratio Debt ratio measures the percentage o unds provided by creditors.

Debtratiocanbeshownintheollowingormula:

Debt Ratio=Totaldebts

Totalassets

Total debt includes current liabilities and long-term debts. Creditorspreeralowdebtratioasitismoreadvantageousduringthetimea


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companyisdissolved.Forshareholders,theypreerahighdebtratiobecauseitwillenlargetheexpectedearnings.

Based on the example o Emas Limited Company, the calculation odebtratioisasollows:

=EarningsbeforeInterestandTax

InterestchargeTimesInterestEarnedRatio

Thus,thedebtratiointheyear2010is0.48andortheyear2011is0.53.Thismeansthatthedebtratiohasincreasedintheyear2011.Thefrmreliesmoreonitscreditorstofnancethetotalassetsortheyear2011.

(ii) Times Interest Earned Ratio Thisratioisusedtomeasurethefrmsabilitytopayitsannualinterest

payment. I a frm is unable to pay o its interest charges, creditorshavetherighttotakelegalproceedingsagainstitandthismightcausethe company to become bankrupt. From the creditors point o viewthehigherafrmstimesinterestearnedratio,thebetteritisorthem,because that shows the frms ability to pay interestannually. Hence,creditorsrisksareless.

Timesinterestearnedratiocanbeshowninthenormulabelow:

Year2010==0.48

Year2011==0.53

24,000

50,400

31,920

60,000

Debt Ratio


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Based on the example o Emas Limited Company, the calculation otimesinterestearnedis:

Thus,timesinterestearnedratioishigherintheyear2010.Thefrmsability

topayannualinteresthaddeclinedintheyear2011.

activity3.4

Writedowntheimportanceodebtmanagementratiototheollowingparties:

Shareholders Creditors

(d) Proftability Ratio

Proftability ratio indicates the combined eects o liquidity, assetmanagementanddebtsdecisiononoperation.Inshort,proftabilityratioistheeectovariouspoliciesanddecisionsothecompany:

(i) Proft Margin on Sales Thisratiomeasuresincomeromeveryringgitosales. Proftmarginonsalescanbeshownbytheollowingormula:

Based on the example o Emas Limited Company, proft margin onsalesis:

Year2010==4.38

Year2011==3.23

7,890

1,800

8,514

2,640

Times Interest Earned Ratio


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Thereore,netproft margin or the year 2010 is 4.1% and in year 2011is3.8%.Itindicatesthatthefrmsnetproftmargininyear2010ishigherthan2011.

Thus,proftmarginonsalesortheyear2010is4.1%andortheyear2011is3.8%.Thismeansthatproftmarginonsalesishigherortheyear2010.Thismarginwentdownintheyear2011.

Proft Margin on Sales=Earningavailableortheshareholders

Sales

Year2010==0.041=4.1%

Proft Margin on Sales

3,540

85,500

Year2011==0.038=3.8%3,405

90,000

Year2010==0.1405=14.05%

Year2011==0.1267=12.67%

Return on Common Stock Equity

3,540

25,200

3,405

26,880

(ii) Return on Common Equity

Thisratiomeasurestherateoreturnsearnedontheinvestmentoordinaryshareholders. Return on common equity can be shown by the ollowingormula:

BasedontheexampleoEmasLimitedCompany,returnoncommonequityisasollows:

Return on Common Equity=Netproftavailableorordinaryshareholders

Ordinarysharesequity


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Thereore, the return on common equity or the year 2010 is 14.05% and12.67%ortheyear2011.So,itshowsthatreturnoncommonequityortheyear2010ishigher.

(e) Market Value Ratio Market valueratiois aseto ratios that correlates thefrmsstockpriceto

theearningso(bookvalue)persharebasedonbookvalue.Thisratiogivesinormationtothemanagementregardingtheinvestorsviewonthefrmsperormanceinthepastanditsutureprospects:

(i) Price/Earnings Ratio Thisratioshowshowmuchinvestorsarewillingtopayoreachringgit

otheproftreported.Thisratiocanbeexpressedasollows:

=Marketpricepershare

Bookvaluepershare

= Pricepershare

Earningspershare

(ii) Book Value Per Share Bookvaluepershareratiocanbeshownbytheollowingormula:

= Commonequity

Outstandingshares

(iii) Market/Book Ratio Market/Bookratiocanbeexpressedasollows:

(iv) Flow Analysis o Financial Ratio Inusingfnancialratio,itisimportantorafnancialmanagertomake

timecomparisonorcomparisonsofrmsinthesameindustrytogetacomprehensiveviewothefrmsperormance.

Price/Earning Ratio

Book Value Per Share Ratio

Market/Book Ratio


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Table 3.2:FinancialRatiosFormula

Types o Financial Ratio Financial Ratios Formula

(a)Liquidityratio Currentratio

Quickratio

(b)Assetmanagementratio InventoryTurnoverRatio

Fixedassetsturnoverratio

Totalassetsturnoverratio

(d)Proftabilityratio Proftmarginonsales

Returnoncommonequity

Current Assets

Current Liabilities

Sales

Net fxed assets

Cost o goods sold

Inventory

Sales

Total assets

Net proft available or ordinary shareholders

Ordinary shares equity

Earnings available or the shareholders

Sales

Current Asset - Inventories

Current Liability

Table3.2listsallthefnancialratiosormulasthatwehavediscussedearlier.


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Types o Financial Ratio Financial Ratios Formula

(e)Marketvalueratio Price/EarningsRatio

BookValuePerShare

Market/BookRatio

3.2.3 UfFR

Price per share

Earning per share

Common equity

Outstanding shares

Market price per share

Book value per share

activity3.5

Basedontheavailablefnancialratios,inyourownopinion,howdotheseratiosassistorganisationsinmakingdecisions?

Financial ratios can be used to interpret fnancial inormation in a way that iseasily understood. Financial ratios can give a more comprehensive reectioncompared to the real fgures as stated in fnancial statements. For example, iafnancialmanagerwishestoknowafrmsliquiditystanding,hehasonlytoreertothefnancialratiossuchascurrentratioandquickratio.Foraninvestorwhowishestoknowthefrmsproftability,hecanreertotheproftabilityratiossuch asproft margin onsalesand return oncommon stockequity. Ifnancialratios can be collected or several years, comparison can be made by showingtheirowsin the ormograph,thusmakingdispersionoinormationbythemanagementeasier.Financialratioscanbeusedtoconstructafrmsfnancialprofles.Itcanevaluatevarious aspects o frms fnancial perormance and standing. This inormationcan be used in the decision-making process by the frms management team,suppliers,investors,banksandsoon.


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Financial ratios (especially i ow analysis or comparisons between are made)canmeasurethefrmshealthandgiveanearlywarningsignonthedifcultieswhich may be aced by the frm. Thereore, a fnancial manager may propose

appropriatestepstosolvetheproblembeoreitbecomestooacute.

activity3.6

Prepare a list o fnancial ratios which you might scrutinise beorepurchasingafrmsshare.

3.2.4 WfFRaAlthough fnancial ratio is a useul and quick way to analyse the status andperormanceoabusiness,ithassomeweaknessesandthisshouldbeconsidered

byafnancialmanagerwhenusingfnancialratios.Amongsttheweaknessesare:

(a) Financial ratios rely on data obtained rom fnancial statements. Thus,whether the fnancial ratios calculated can be trusted or not depends onthe quality o the fnancial statements. Weaknesses which exist in thefnancialstatementwillbereectedinthefnancialratiosandinterpretinginormation rom these ratios is useless because the fnancial data is

inaccurate. Apart rom that, one o the important actors which needs tobe taken into consideration in preparing the fnancial statements is theeectoinationwhichmaymisrepresentthevalueofxedassetssuchasproperties,proftandlossfgures,etc.

(b) Financial ratios measure the frms relative standing and perormanceand donottakeintoaccount its absolutesize. Sometimes,realfgures cangive a better overall reection when we make a comparison o the frmsperormancebetweentwodierenttimeperiodsorbetweentwodierentfrms.

(c) Normally,fnancialratio oa frm iscomparedwiththe industryaveragesratios where basic signs are used to look at the frms standing andperormance compared to other frms. It should be reminded that thiscomparisonmightnotbeappropriatebecauseitisdifculttofndtwofrmswiththesamekindobusiness. Eventhoughtheremayexist two frmsinthesameindustry,oneothefrmsmighthavemiscellaneousactivitiesinothertypesobusiness.Inaddition,accountingpolicy,fnancialpolicy,and


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fnancial year may dier, and this will complicate the comparison thusweakeningtheuseofnancialratios.

(d) Financialratioswhicharebasedonabalancesheetmightnotgiveaccurateinormationbecauseabalancesheetgivesareectionothefrmatacertainpoint o time only. Thus, a fnancial ratio calculated based on the datao a balance sheet statement does not represent the frms standing andperormanceinthewholeyear.Theseweaknessesareevenmoreobviousinseasonalbusinesses.

(e) Although the fnancial ratios are used to analyse the strengths andweaknesses o a frm, it cannot identiy actors which had brought it tothatposition.Amoredetailedinvestigationintoitspracticesandbusinessrecordsisstillneededtoidentiythoseactors.

Ttue (T) or False (F) Statements

1. Debtfnancingisalsoknownasequityfnancing.

2. Interestexpensesaresubtractedbeoretaxlevied.

3. Proftabilityratioindicatesthecombinedeectsoliquidity,assets

managementanddebtonoperationaldecision.

4. Currentratioisamorestrictliquiditymeasurementcomparedtoquickratio.

selF-check3.5

3.3impoRtantFacts

Balancesheetisastatementthatshowsafrmsfnancialstandingatacertain

pointotime.Balancesheetcanbedividedintotwoparts:

(a) Assets:(currentassets+fxedasset);and

(b) Liabilities: (current liabilities + long-term debt) and equity: (preerencesshares,commonsharesandretainedearnings).


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Inormationthatcouldbeobtainedromabalancesheetare:

(a) Reectionothecapitalstructureothecompany

(b) Inormationonworkingcapital

Incomestatementshows:

(a) Afrmsrevenuesandexpendituresatacertainpointotime;and

(b) Afrmsproftandlossoracertainperiodotime,normallyoneyear.

Cashowstatementindicatestheeectsothefrmsactivitiesoncashowsothefrmoracertainperiodotime.Firmsactivitiesare:

(a) Operatingactivity;

(b) Investmentactivity;and(c) Financingactivity.

Financialstatementsanalysisinvolves:

(a) Comparison o the frms perormance with other frms in the sameindustry;and

(b) Evaluationotheowothefrmsstandingbetweencertaintimeperiods.

Financialratiosinclude:

(a) Liquidityratios:currentratio,quickratio;

(b) Assets management ratios: inventory turnover ratio, fxed asset turnoverratio,totalassetturnoverratio;

(c) Debtmanagementratios:debtratio,timesinterestearnedratio;

(d) Proftability ratios: proft margin on sales; and return on common equity;and

(e) Market value ratios: price/earnings ratio, book value per share ratio,market/bookvalueratio.

UsesoFinancialRatios:

(a) Interpretfnancialinormationintoaormthatiseasilyunderstood;

(b) Constructafrmsfnancialprofle;and

(c) Measurethefrmshealthandgiveanearlywarningsignonthedifcultywhichmaybeacedbyafrm.


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Theweaknessesofnancialratioanalysisare:

(a) I the fnancial ratio data is inaccurate, this will inuence the quality andaccuracyothefnancialratios;

(b) The fnancialratiosmeasuresthefrms relative standingandperormancewithouttakingintoconsiderationtheabsolutesize;

(c) Comparingthefnancialratiooafrmwithotherfrmsinthesameindustrymightnotbesuitableitherearefrmswhichrunmiscellaneoustypeso

businessactivity;

(d) The economics situation always changesbut fnancialratios arecalculatedbasedonfnancialstatementsatacertainpointotime,orexamplebalancesheet;and

(e) Financialstandingoafrmcanbeaectedbymanyactors.

sUmmaRy

There are three important fnancial statements balance sheet, incomestatementandcashowstatement.

Inormationcanbe obtainedromeachothefnancialstatementsandthisinormation can be used to calculate certain fnancial ratios to measurethe liquidity, assets management, debt management, proft and the frms

marketvalue.

Even though fnancial ratios canbeused to interpretfnancial inormationinto a ormat that could be easily understood, and to measure the frmshealthaswellasconstructthefrmsprofle,wecannotrelyentirelyonratioanalysisinmakingourdecisionbecausethereareseveralweaknessesthatneedtobeconsidered.

Assetmanagementratio

Debtmanagementratio

Financialratios

Financialratioanalysis

Financialstatement

Financialterms

Liquidityratio

Marketvalueratio

Proftabilityratio

topic 3 financial statement and financial ratios analysis

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