topic 3 financial statement and financial ratios analysis
TRANSCRIPT
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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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30 TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS
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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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS 31
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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32 TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS
(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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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS 41
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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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS 47
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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48 TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS
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