LECTURE 1

INTER PR ETATION OF
F INANCIAL STATEMENTS
U K A F 3 0 7 3 C O R P O R AT E R E P O R T I N G

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LECTURE OBJECTIVES
This lecture will consider the:

 Application of financial ratio analysis

as a tool in decision making

 Limitations of ratio analysis

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LECTURE OUTCOMES
At the end of the lecture, you should be able to:

 Explain the purposes of financial ratio analysis

 Compute various ratios as measures of a
company’s performance
 Interpret the ratios and apply them in decision
making
 Discuss the limitations of ratio analysis

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READINGS

Elliot, B and Elliot, J, Financial Accounting and

Reporting

Frank Wood, et al, Business Accounting 2, 14th

Edition

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 THE PURPOSES OF FINANCIAL STATEMENT
ANALYSIS USING RATIOS
 Evaluate performance of a firm given the strategy,
economic and industrial environment of the firm

 To help direct the user’s focus of attention by

identifying and highlighting areas of good and bad
performance and areas of significant change

 For comparison between time periods and entities

and to predict future performance

 To identify irregularities, anomalies and surprises

that require further investigation e.g. creative
accounting or fraud
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 TWO COMMON TYPES OF
COMPARISON
Time series analysis (Trend analysis)
 Comparison of current year’s information with
comparable prior periods’ information of a firm to
detect significant improvements or deterioration
in the firm’s financial or competitive position
E.g. 5 year financial highlights in annual reports

Cross-sectional analysis
 Comparison of a firm’s financial information with
industry data, which serves as a benchmark for
assessing the firm’s financial performance and
position with competitors in the same industry

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WHAT ARE RATIOS?
RATIOS DESCRIBE THE RELATIONSHIP
BETWEEN DIFFERENT ITEMS IN THE
FINANCIAL STATEMENTS
Types of ratio categories:
 Profitability
 Solvency (Liquidity)
 Efficiency
 Investment
 Capital Structure

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THE NEED FOR RATIOS

Company Gross profit Sales

RM’000 RM’000
A 200 848

B 300 1,252

C 500 2,127.5

D 350 1,468.4

Which company has the best profit?

Absolute figures are not meaningful

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THE NEED FOR RATIOS (CONT’D)
Company Gross margin %
= Gross profit / Sales
A 23.6

B 24.0

C 23.5

D 23.8

Which company is most profitable?

 Ratios are more useful

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USES OF RATIOS
RATIO MEASUREMENT
Profitability How much profit a business has made in
relation to size / capital

Liquidity How quickly the assets can be turned

into cash in short term

Efficiency How efficiently an entity has been

managed to generate sales

Investment Return on investment and risk

Capital structure Mix of financing between share capital

and borrowings; gearing risk

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RATIOS & INTEREST GROUPS
1 Profitability:
 shareholders, management, employees, suppliers, lenders,
competitors, investors

2 Solvency:
 Shareholders, suppliers, lenders, competitors

3 Efficiency:
 Shareholders, acquirers (of companies), competitors

4 Shareholder/investment:
 Shareholders, potential investors

5)Capital structure:
 Shareholders, lenders, suppliers, investors.
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PROFITABILITY
Measure the performance of
management
 To identify whether a company maybe
a worthwhile investment opportunity
 To determine a company’s
performance relative to its
competitors

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PROFITABILITY (CONT’D)
Gross profit margin % (Gross Profit / Sales)
 Shows ability to generate GP from sales, the
ability to control direct expenses with regards to
sales

Net profit Margin % (Profit before interest and

tax / Sales)
 Depends on the type of industry, company’s
pricing policy, sales volume and cost structure
 A higher margin generally suggests good
performance but should not be taken at face
value. Too high may suggest that the product is
being overpriced, resulting in decrease in
quantity sold 13
PROFITABILITY (CONT’D)
Return on capital employed %
Profit before interest and tax
Total assets – Current Liabilities
 Popular indicator of management efficiency
 Demonstrates how well management has utilised
total assets
 No exact definition of capital employed
e.g. ROCE = Asset turnover x Net profit margin
 Some factors impact ROCE e.g. asset valuation
process, depreciation policies, revaluation policies,
pricing policies, treatment of expenses  affects
comparison with other entities

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LIQUIDITY
Assess credit risk of entity and measure
entity’s ability to pay its debts as and when
due

Current Ratio (Current Assets /Current

Liabilities)
Sufficiency of short term assets to meet short term
liability
Compared with industry norm
If current ratio increased beyond normal range of
company/sector?
 Good/Beneficial reasons:
1. A build up of inventory to support a recent advertising
campaign
2. Permanent expansion of business which require continuing
higher level of inventories 15
 Unwelcome reasons:
 LIQUIDITY (CONT’D)
 Acid test / Quick ratio (Current assets -
Inventory) / Current Liabilities
 Exclude inventory due to its difficulties to convert to
cash at short span of time

 Trade Receivable days (Trade receivables / credit

sales x 365 days)
 Indicates efficiency of company at controlling its
collection of receivables
 Comparison with industry norm
 Compare with company’s credit policy

 Trade Payables days (Trade payables / credit

purchases * x 365 days) * or cost of sales 16
 Indicates credit period extended to a company by its
 LIQUIDITY (CONT’D)
Changes in receivables days might be misleading
 Should look at the root cause

Reduction in receivables days

1.Successful in reducing bad debts & eliminating poor risks
2.Extending discounts & incentives to encourage early payment

Increase in receivables days

3.Poor credit control and besieged with bad debts
4.May be strategy to attract new customers

Payables days changes:

5.Suppliers altering credit terms (more/less generous)
6.Company trying to gain maximum credit facilities -> increase
7.Company utilising early payment incentives -> decrease
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LIQUIDITY- (CONT’D)
 Some textbooks guidelines:
 Quick ratios at least 1:1
 Curent ratios at least 2:1

 Need to consider industry norm; also analyse the

nature of assets and liabilities

 E.g. current liabilities are due for payment at

varying times e.g. dividends, bank overdraft

 E.g. current assets comprised mainly of trade

receivables or mainly cash/bank

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 EFFICIENCY (ASSET MANAGEMENT)
 Measures how effectively the firm is managing its
assets

Asset turnover = Sales .

Total assets – Current Liabilities
 Measures the amount of sales generated by the
capital employed or total assets investment

 Lower (if compared with previous year) indicates:

1. Overinvestment (takeover target)
2. Assets are new
3. Co policy: prefer to purchase rather than lease/rent
 Extremely high may indicate high selling price
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EFFICIENCY (CONT.)
NCA Turnover Sales
.

Non-current Assets (@
NBV)

 Measures how effectively the firm uses its plant and

equipment to generate sales
 Higher ratio implies greater recovery of investment in PPE
 If NCA turnover is lower than its competitors, it may
suggest overinvestment in NCA
 Other factors to consider:
1. Depreciation rate
2. Purchase instead of lease
3. Relatively new assets i.e. start-up period
[1 – 3 affects denominator of formula] 20
EFFICIENCY (CONT.)
Inventory turnover days Inventory x 365 days
Cost of Sales

 Measure how efficient a business is at maintaining an

appropriate level of inventory; also an indicator of
liquidity
 Compute average of opening and closing inventory
 eliminate seasonal effects

 Lower ( low inventory level)

1. Greater efficiency
2. Inventory is running out often and not meeting demand
 Higher ( high inventory level)
1. Business may be slowing down
2. Lower efficiency, stocks piling, may have obsolete
stocks that could lead to liquidity crisis
3. Higher inventory volumes due to purchasing in bulk to
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obtain discounts
CAPITAL STRUCTURE
 Measures the way a company finances
its activities in the long term
 Measures a company’s ability to
handle its debts  gearing risk
 Measures the contributions of owners’
financing (equity) compared with
creditors’ financing (debt)
 Typical ratios are debt ratio, capital
gearing ratio, debt to equity ratio and
interest cover

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CAPITAL STRUCTURE (CONT’D)

Debt ratio Total liabilities

Total assets

 Compares total debt with total assets

 Measures whether the company has sufficient
assets to meet all its liabilities when due
 Compare with industry norm
 Creditors prefer low debt ratios because the
lower the ratio, the greater the buffer against
creditors’ losses in the event of liquidation

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 CAPITAL STRUCTURE (CONT’D)
Capital gearing ratio Long term loans
Shareholders’
funds + LT loans*

 Contribution of long term lenders to long term

capital of the firm
 High gearing predominantly financed by debt
 Low gearing relies on equity finance

 Gearing affect company’s annual interest and

dividend payments
 The higher the ratio, the higher the risk, both in
respect of expectations of future dividends to
equity investors and the threat of liquidation 24
*LT loans = debentures, RPS or long-term
CAPITAL STRUCTURE (CONT’D)
Debt to equity Long-term loans
Shareholders’ funds

 Similar to capital gearing

 Measures the proportion of long-term loans to
equity
 The higher the ratio, the higher the risk, both in
terms of expectations of future dividends and
threat of liquidation

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CAPITAL STRUCTURE (CONT’D)
Interest cover Profit before interest and tax
Interest expense

 Indicates whether enough profit is earned to

pay interest
 Indication to creditors of how secure the
interest payments are
 Beware profit is not equal to cash
 Alternative measure: Use EBDITA (earnings before
depreciation, interest, tax and amortisation)

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 INVESTMENT RETURNS/SHAREHOLDERS’
RATIO
 Performance of the company in relation to share
price, dividends and shares issued

Dividend yield ( Gross dividend per share

/
Market price per share)
x 100%
 Measure real rate of return by comparing dividend
paid to the market price
 When making inter-company comparisons, be
mindful of different risk profile of investors (income
vs capital gain) and different dividend policies (in
mature vs expanding situation) 27
 INVESTMENT
RETURNS/SHAREHOLDERS’ RATIO (CONT’D)

Earnings per share

Net profit after tax and preference dividend and
NCI
Weighted average no of ordinary shares issued
during the year

 The earning power of each ordinary share

 One of the most widely used ratios to check on the

company’s performance

 Upward trend may indicate growth in earnings

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 INVESTMENT RETURNS/SHAREHOLDERS’
RATIO (CONT’D)
Dividend cover
Net profit after tax and preference dividend
and NCI
Net dividend (after tax) on ordinary shares

 Shows the proportion of profit distributed to

ordinary shareholders
 High dividend cover indicates that the
company is able to maintain its current level
of ordinary dividends
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 INVESTMENT RETURNS/ OR
SHAREHOLDERS’ RATIO (CONT’D)
Price earnings (P/E) ratio Market price / EPS

 Shows how market assesses performance of company

 a measure of market confidence
 A high P/E ratio
Market thinks that company’s future is good
Shares are in demand, hence the high share price

 Must consider P/E for industry or similar company

 P/E ratio can be used to check if shares are over/under

priced
 A share is overpriced if P/E ratio is higher than industry
norm or similar companies
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 LIMITATIONS OF FINANCIAL RATIO
ANALYSIS
 Historical data may cause distortions due to the
effects of inflation
 General yardsticks (e.g. a liquidity ratio of at
least 1) are not always appropriate for all types
of industry
 Surrogate data used for missing data in
published accounts can cause misleading
comparisons
 A single ratio may not be very informative by
itself, but a number of related ratios taken
together can provide strong indications of a
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company’s performance or financial position
NON- FINANCIAL FACTORS
 Factors that complement the traditional
financial ratios
 Give detailed information of the operations and
business prospects
Examples
 Production capacity and efficiency;
 Effective team of management;
 Business rivals or competitors;
 R&D capability;
 Future prospects;
 Legal and regulatory environment e.g. financial
institutions, utilities, pharmaceuticals
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