EVALUATION OF FINANCIAL

PERFORMANCE

Topic 2
LESSON OBJECTIVE
At the end of this topic, you should be able to:

• Able to calculate the ratios and interpret the effect of the

ratios on firm’s position
• Able to perform the trend and cross-sectional analysis and
provide advice to firm’s management

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CONTENTS
Key Financial Statements

Financial Ratios Analysis

Du Pont Analysis

Types of Ratio Comparisons

Uses and Limitation of Ratio Analysis

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 Ratio analysis is used to evaluate the performance
of a firm. Ratios enable comparisons of performance
to be made between firms and across time periods.

Done to identify the strengths & weaknesses of the

FINANCIAL firm

ANALYSIS
The assessment of a firm’s financial Ratios are the TOOLS used to
performance (past and current) using
historical financial information from
analyse financial performance.
financial statements to estimate its
future performance.
RATIO ANALYSIS To compare
past and
current
performance
of a firm
To measure To measure
operational performance
efficiency with other
firms

OBJECTIVES

To measure To
operational standardize
risks financial info

To measure
performance
current
operations

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COMPARISONS
Time series/trend
analysis
Internal comparisons
Looking at the firm’s
own performance
over a period of
time
Types
Cross-sectional
analysis/inter-firm
comparison
External
comparisons
Compares
performance with
competitor firms

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FINANCIAL STATEMENTS
Statement of P&L and other comprehensive Measures profit/loss of a firm for an accounting
income year

Statement of financial position

Shows the assets, liabilities and shareholder’s funds/capital at a
specific point in time

Statement of cash flow Indicates the sources of cash ( cash inflows) and how cash is used
(outflows) for a given period

Statement of changes in Shows the changes in owner’s equity i.e. whether equity has increased or
equity decreased for a particular period.

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CASH FLOWS

Financial managers use

CASH FLOWS and not
profits when making
decisions

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USERS OF FIN. Managers

STATEMENTS Investors Shareholders

/ owners

Users
Government Creditors/
lenders

Customers Employees

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TYPES OF FINANCIAL RATIOS
• Liquidity ratios
• Shows the ability of the firm to pay the short-term borrowings as they become due
• Efficiency ratios (asset management ratios)
• Indicates management efficiency in using its assets to generate sales
• Leverage (debt management) ratios
• Indicates the level of borrowings of a firm in relation to its assets and equity
• Profitability ratios
• Demonstrates the firm’s efficiency in generating profits from its sales or asset utilisation
• Market ratios
• Reflects investor’s confidence in the firm’s future prospects based on its past performance

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 RATIO TYPE FORMULA WHAT DOES IT SHOW?
LIQUIDITY RATIOS
1. Current Ratio Current assets Measures a company’s ability to pay off current/short-
= X times
Current liabilities term liabilities with current assets

2.Acid-test ratio (Current (Current assets – Inventories – Prepaid expenses) Measures a company’s ability to pay off current/short-
= X times
ratio) Current liabilities term liabilities without having to sell its inventories

EFFICIENCY RATIOS
3. Inventory turnover ratio Cost of goods sold Measures how many times a company’s inventory is sold
= X times
Average inventory (or closing inventory) and replaced in the year

4. Average collection period Acc. Receivables Number of days the firm takes to collect its AR
=X days
(Annual credit sales ÷ 360 days)

5. Non-current assets Sales Efficiency in utilising NCA in generating sales

= X times
turnover Net NCA

6. Total assets turnover Sales Ability to generate sales from total assets:
= X times
Total assets

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LEVERAGE RATIOS
7. Debt ratio Total debt Indicates how much of the company is funded by debt in
= X%
Total assets relation to its assets, and therefore, its ability to pay off
its long-term liabilities with its available assets.

8. Debt to equity ratio Total debt Measures how much of the debt can be covered by
= X%
Total equity equity if the company needed to liquidate.
9. Times Interest Earned EBIT Measures how many times a company can cover its
= X times
Interest Expenses current interest payments with its available earnings.

(EBIT is the same as Operating Profit)

PROFITABILITY RATIOS
10. Gross profit margin Gross Profit Shows the ability of the company to control its COGS as
= X%
Sales well as its pricing policy.
11. Operating profit margin EBIT Shows the efficiency of the firm to generate profits from
= X%
Sales its core business operations.
12. Net profit margin Net income available for common stockholders∗ Indicates if the firm’s management is generating enough
= X%
Sales profit from its sales and whether operating costs and
overhead costs are under control.
*Net income available for common stockholders
= NPAT – Preference dividends
14. Return on assets (return Net income available for common stockholders Measure the firm’s efficiency in utilizing its assets to earn
= X%
on investments) Total assets profit

15. Return on equity Net income available for common stockholders Measure the profit earned by for common stockholders
= X%
Common equity from their investment in the firm
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MARKET RATIOS
16. Earnings per share Net income available for common stockholders Indicates how much profit a company earns per
= RM xx per share
(EPS) Number of ordinary shares ordinary share issued.

17. Dividends per share Ordinary dividends Shows the amount of dividends to be received
= RM xx per share
(DPS) Number of ordinary shares issued per ordinary share

18. Dividend payout ratio DPS Shows the proportion of earnings that will be
= X%
EPS distributed as dividends to ordinary shareholders.

19. P-E ratio Market price per share Shows if the firm’s shares are over-valued or
= X times
EPS undervalued, thus indicating investor’s confidence
in the firm’s future potential.

20. Dividend yield Latest DPS Shows the return earned per share
= X%
Current market price per share

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“ANY FOOL CAN KNOW;
THE POINT IS TO
UNDERSTAND”
EVALUATION OF FINANCIAL
PERFORMANCE ….continued
DU PONT ANALYSIS
• To explain the causes of poor ROE, this ratio is
analysed into its sub-component ratios.
• Management will clearly see the relationships
between the factors that affects the ROE
• Profitability
IN YOUR TEXTBOOK:
• Asset utilisation How to improve ROE?
• Leverage Advantages of ROE

• By understanding the interaction between those

factors, manager can decide what actions to
take to improve the ROE

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 ROE
DU PONT ANALYSIS (ROA/1- Debt ratio)

ROA 1 – Debt ratio

(Assets Turnover x NP margin) (known as Equity Multiplier)

Assets turnover NP margin

Sales/Total Net
assets income/sales
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COMMON SIZE ANALYSIS
• Vertical analysis using common size ratios

• In the P&L statement:

• Each items in P&L is calculated as a % of sales

• In the SFP:
• Each item is calculated as a % of total assets

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 COMMON SIZE ANALYSIS -
PURPOSE

To understand To compare
causes of change in performance with
company other companies
performance

To compare
performance of
company across
time(trend analysis)

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REMINDER

p.55 –
How to improve the firm’s ROE
Advantages of DuPont analysis

p.61-
Limitations of financial ratio analysis

Go through the comprehensive examples

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 END OF TOPIC 2

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