Topic   Financial

Statements and
3 Financial Ratio
Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the importance of financial statements;
2. Analyse financial statements;
3. Calculate and interpret financial ratios;
4. Apply financial ratio analysis in making decisions; and
5. Discuss the limitations of financial ratio analysis.

 INTRODUCTION
The financial statement and its analysis are vital to an organisation and external
parties. The internal management of a company requires information obtained
from a financial statement to assist them in planning, controlling and decision
making. Meanwhile, external parties such as business creditors need to know the
liquidity position of a firm and its ability to pay their claims. Bondholders also
need to know the firmÊs ability to pay interest and its principal when the bond
matures. Before investing in a company, shareholders need to know its profit and
performance.
30  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Therefore, whether you are a financial manager, creditor or investor, the

understanding of the financial statements and their analysis is important.
Figure 3.1 shows the typical groups who are interested in financial statements.

Figure 3.1: Typical users of financial statements

In this topic, you will be learning three types of basic financial statements and their
components. You will also be introduced to financial ratio analysis, which can be
used to gain important practical information for the benefit of certain parties.

3.1 FINANCIAL STATEMENTS

There are three types of basic financial statements as follows:

(a) Balance sheet;

(b) Income statement; and

(c) Cash flow statement.

Let us take a look at each type in detail.

3.1.1 Balance Sheet

A balance sheet is a statement of the firmÊs financial position at a specific point in
time. The balance sheet of a firm may change daily because inventories may
increase or decrease each day, and non-current assets such as equipment can be
added or depreciate in value. A financial statement (example in Figure 3.2) can be
divided into two parts:
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  31

(a) Assets
An asset is a resource owned by a firm. Assets can be separated into
current assets and non-current assets. Current assets can be converted into
cash in a period of less than one year. Examples of current assets are cash,
marketable securities, accounts receivable and inventories. On the other
hand, non-current assets include properties, equipment and plants. Assets
are arranged in order based on liquidity, that is, the time needed to convert
the assets into cash.

(b) Liabilities and Equity

A liability is a claim against the firmÊs assets. Accounts payable, notes
payable and accrued expenses are current liabilities that will mature in less
than one year. Bonds and bank loans, which are the firmÊs debts to other
parties, are categorised as non-current liabilities as they will mature in a
period of more than one year. Equity is a claim of shareholders on the firmÊs
assets, which may be in the form of preference shares, ordinary shares or
retained earnings.

Figure 3.2: Balance sheet of Emas Limited Company

32  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Normally, assets are noted on the left side of a balance sheet while liabilities and
equity are noted on the right side of a horizontal balance sheet format. In a vertical
format, assets are noted at the top while liabilities and equity are noted at the
bottom of the balance sheet.

In accounting, all the firmÊs assets belong to creditors and owners of the firm. Thus,
there is an equation such as shown below:

Asset = Liability + Equity

ACTIVITY 3.1

Draw a chart to show where the following information are found in a

balance sheet:

(a) Current assets; (d) Non-current liabilities; and

(b) Non-current assets; (e) Equity.

(c) Current liabilities;

In general, a balance sheet gives information regarding the financing and

investment activities of a firm. Liabilities and ownerÊs equity present a view of the
related firmÊs capital structure. We can see the part of the total capital that includes
equity and the portion financed by debt. Segregation of the total liabilities into
current liabilities and non-current liabilities are also shown in the balance sheet.
This information is important to analyse the firmÊs financial position. From the
balance sheet, we can also calculate the working capital. Working capital is the
difference between current assets and current liabilities.

Working Capital = Current assets ă Current liabilities

Working capital can be obtained by subtracting current liabilities from current

assets. Information on working capital is important to evaluate a firmÊs liquidity
and its ability to pay back short-term claims on it. A firmÊs liquidity is important
because the business is likely to fail if it is unable to pay interest or pay back debt
when it matures.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  33

The balance sheet also shows a firmÊs combined assets, or the ratio of current assets
to non-current assets. If a firm holds too much non-current assets compared
to current assets, the firmÊs capital will be tied up and this may lead to cash
flow problems and financial failure. This is caused by the difficulty in converting
non-current assets into cash compared to current assets.

SELF-CHECK 3.1

Based on Figure 3.2, calculate the working capital of Emas Limited

Company for the years 2017 and 2018.

3.1.2 Income Statement

An income statement (like the one shown in Figure 3.3) is a statement that gives
information regarding the revenues and expenditures of a firm in a specific period
of time. Sales revenue is shown in every income statement and this is followed by
expenditures or costs and taxes. In brief, an income statement indicates a firmÊs
profit or loss in a specific period of time ă normally one year. Profit is important to
a firmÊs owner, employees and suppliers because without profit, the firm will not
continue to exist.

Figure 3.3: Income statement of Emas Limited Company

34  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

The income statement, also known as profit and loss statement, gives information
to measure the firmÊs performance. To measure the performance of a firm, the
following aspects of an organisation must be considered:

(a) Sales figure ă Can be compared with the firmÊs sales in the previous year
and expected future sales. This information can be used for the purpose of
planning the firmÊs future.

(b) Gross profit ă Can be compared to the sales figure to show profit earnings
from goods sold.

Gross Profit = Sales ă Cost of goods sold

(c) FirmÊs expenses ă Can be compared with the firmÊs expenses in the previous
year to formulate policies to decrease cost.

(d) Net profit ă Can be compared to sales. Normally, there are variations
between profitability and sales volumes. When a firmÊs sales volume is high,
it may receive a lower percentage of net profit. However, the ratio of net
sales-profit is influenced by the type of business undertaken by the firm
concerned.

Net profit = Gross profit ă Sales and administrative expenses

ă Depreciation and amortisation

SELF-CHECK 3.2

With reference to the income statement in Figure 3.3, differentiate

between gross profit and net profit.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  35

3.1.3 Cash Flow Statement

A cash flow statement refers to the statement that records the effects of a firmÊs
activities ă such as operating, investment and financing ă on its cash flow for a
specific period. Net cash flow is the total cash attained by a business in a specific
period, for example, one year. But the cash flow attained by a firm may not
necessarily be the total cash stated in the „cash‰ item on the balance sheet, because
the cash may be used to pay dividends, finance accounts receivable, invest in
non-current assets, increase inventories, etc. Therefore, the available total cash in
a balance sheet may be influenced by factors such as cash flow, changes in working
capital, changes in non-current assets, companyÊs transactions such as buying and
selling of shares and bonds, dividend payment and so on. These factors will be
reflected in the cash flow statement, which shows changes in the cash position of
the firm.

A cash flow statement (example in Figure 3.4) can be divided into three parts
according to its activities:

(a) Operating activity;

(b) Investment activity; and

(c) Financing activity.

The cash flow statement is important to a financial manager because it gives

information regarding the firmÊs ability to generate sufficient cash to:

(a) Finance or purchase new assets for the firmÊs expansion; and

(b) Pay back its debts.

36  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Figure 3.4: Cash flow statement for Emas Limited Company

 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  37

SELF-CHECK 3.3

Indicate TRUE (T) or FALSE (F) for each of the following statements

1. Depreciation expenses is an item that is added to the net profit to

determine cash flow from a firmÊs operating activities.

2. Interest expenses are items of investment activities in a cash flow

statement.

3. Any increase in accounts receivable and accounts payable will

be added to net profit in determining cash flow from operating
activities.

4. Purchase of non-current assets for the companyÊs use will be

deducted to determine cash flow from investment activities.

3.2 FINANCIAL STATEMENTS ANALYSIS

The analysis of financial statements involves:

(a) Comparison between the firmÊs performance with other firms in the same
industry; and

(b) Evaluation of the firmÊs financial position from time to time.

These analyses can be used by:

(a) A financial manager to identify the firmÊs weaknesses and take steps to
improve the firmÊs performance; and

(b) Investors to evaluate the firmÊs current financial standing.

38  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

3.2.1 Ratio Analysis

Information obtained from the financial statement will assist investors and
financial managers to forecast the firmÊs future performance. The firmÊs
management can also use the information gained to forecast the situation and
plan for the future. A basic method to obtain useful information from financial
statements is through financial ratio analysis.

There are five categories of financial ratios. Each type of financial ratio has its own
role to the management and owner of the firm. Financial ratios consist of (refer to
Table 3.1):

Table 3.1: Types of Financial Ratios

Type Ratio
Liquidity Ratios  Current ratio
 Quick ratio (Acid test ratio)
Asset Management Ratios Ć Inventory turnover ratio
Ć Non-current assets turnover ratio
 Total assets turnover ratio
Debt Management Ratios Ć Debt ratio
 Times interest earned ratio
Profitability Ratios Ć Net sales profit
 Returns of common equity
Market Value Ratios Ć Price/earnings ratio
Ć Book per share ratio
 Market/book ratio

Let us take a look at each type in detail.

ACTIVITY 3.2

What do you understand by the term liquid assets? Explain and share
with your coursemates on myINSPIRE.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  39

3.2.2 Liquidity Ratios

Liquidity ratios are used to show the correlation between cash and a firmÊs current
assets with its current liabilities. Liquid assets can easily be converted into cash
without decreasing much of its value. A firmÊs liquidity standing can answer
questions as to whether a firm can afford or has the ability to pay off its debts when
the date is due.

(a) Current Ratio

This ratio shows the frequency that current liabilities are covered by
current assets and this is calculated by dividing current assets with current
liabilities. Current assets include cash, marketable securities, accounts
receivable and inventories. Meanwhile, current liabilities include accounts
payable, short-term notes payable, tax accrued and other expenses such as
employeesÊ wages.

The current ratio can be expressed as follows:

Current assets
Current Ratio =
Current liabilities

According to the example of Emas Limited Company, the current ratio is

calculated as follows:

Current Ratio:
24,300
Year 2017:  3.68
6,600
30,000
Year 2018:  3.23
9,300

Therefore, the current ratio in 2017 is 3.68 and for the year 2018 is 3.23.

(b) Quick Ratio

Also known as an acid test ratio, the quick ratio measures the firmÊs ability
to pay short-term debts without having to sell inventory. Inventory is
deducted from current assets because it is the least liquid asset. Should the
firm be dissolved, inventory might be the asset that could incur losses.
Prepaid expenses are also deducted from the total current assets since these
are expenses that are paid in advance.
40  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

A firmÊs quick ratio can be shown by the following formula:

Current assets  Inventory  Prepaid expenses

Quick Ratio =
Current liabilities

Based on the example of Emas Limited Company, the quick ratio is as

follows:

Quick Ratio:
24,300  12,450  0
Year 2017 =  1.80
6,600
30,000  18,450  0
Year 2018 =  1.24
9,300

Thus, quick ratio for the year 2017 is 1.80 and for the year 2018 is 1.24. It shows
that the firm is able to pay its short-term debts better in the year 2017.

SELF-CHECK 3.4
Compare the current ratio and quick ratio for Emas Limited Company
for the years 2017 and 2018. What is your opinion regarding the liquidity
position of this company?

3.2.3 Asset Management Ratios

An asset management ratio measures the firmÊs efficiency in managing its assets.
The information from the asset management ratio can determine whether there is
too much or too little of each type of asset reported in the Balance Sheet, based on
the frequency of current or forecasted sales. If a firm has too many assets, its capital
is tied in the assets, which will involve a high cost of capital. As a consequence,
profits will decrease. On the other hand, if a firm saves too little on assets,
especially inventory, this will result in the loss of clients because of there is not
enough stocks to fulfil the demand.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  41

(a) Inventory Turnover Ratio

This ratio can be expressed as follows:

Cost of goods sold

Inventory Turnover Ratio =
Inventory

A high inventory turnover ratio indicates that sales are good and inventory
turnover is quick. The implication is that the firm can run its business
without having to tie its capital in inventory. This is because holding
inventory involves costs such as capital cost, storing cost, and insurance cost.
Therefore, the higher the inventory turnover ratio, the better the situation for
the firm.

Based on the example of Emas Limited Company, the calculation for

inventory turnover ratio is as follows:

Inventory Turnover Ratio:

71,110
Year 2017 =  5.71
12,450
74,846
Year 2018 =  4.06
18,450

Thus, Emas Limited CompanyÊs inventory turnover ratio for the year 2017 is
5.71 and for the year 2018 is 4.06. This means that the firmÊs position was
better in the year 2017.

(b) Non-current Asset Turnover Ratio

This ratio measures the firmÊs efficiency in using non-current assets such as
buildings and equipment to generate profits. The formula for non-current
asset turnover ratio is expressed as follows:

Sales
Non-current Assets Turnover Ratio =
Net non-current assets
42  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Based on the example of Emas Limited Company, its non-current asset

turnover ratio is:

Inventory Turnover Ratio:

85,500
Year 2017 =  3.28
26,100
90,000
Year 2018 =  3.00
30,000

Thus, the non-current asset turnover ratio is 3.28 for the year 2017 and 3.00
for the year 2018. This means that the firmÊs efficiency in managing its
non-current assets had decreased in the year 2018.

(c) Total Asset Turnover Ratio

This can be calculated using the following formula:

Sales
Total Asset Turnover Ratio =
Total assets

Normally, it is preferable to have high ratios of non-current asset turnover

and total asset turnover. This is because a high ratio indicates that assets
are used more effectively to generate sales. Based on the example of Emas
Limited Company, the total asset turnover ratio is:

Total Asset Turnover Ratio:

85,500
Year 2017 =  1.70
50,400
90,000
Year 2018 =  1.50
60,000

Therefore, total asset turnover ratio is 1.70 in the year 2017 and 1.50 for the
year 2018. This means that the total asset turnover ratio for the year 2017 is
higher.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  43

ACTIVITY 3.3

Based on the asset management ratios for the Emas Limited Company
for the years 2017 and 2018, in which year was the company more
efficiently managing its assets? Give reasons to support your answer.
Share and crosscheck your answers on myINSPIRE.

3.2.4 Debt Management Ratios

Total debts used by a firm is known as financial leverage. The implications of using
debts as capital are:

(a) Shareholders can continue controlling a firm by obtaining funds through

debts;

(b) Creditors use equity to provide security margins. If shareholders have a

small total of financial ratio, the firmÊs risk will be borne by creditors; and

(c) If firms attain higher returns than what has been paid as interest on debts,
the returns on ownerÊs capital will be higher.

There are two types of debt management ratios:

(a) Debt Ratio

This measures the percentage of funds provided by creditors. The debt ratio
can be calculated using the following formula:

Total debt
Debt Ratio =
Total assets

Total debt includes current liabilities and non-current liabilities. Creditors

prefer a low debt ratio as it is more advantagous when a company is
dissolved. For shareholders, they prefer a high debt ratio because it will
enlarge the expected earnings.
44  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Based on the example of Emas Limited Company, the calculation of debt

ratio is as follows:

Debt Ratio:
24,000
Year 2017 =  0.48  48%
50,400
31,920
Year 2018 =  0.53  53%
60,000

Thus, the debt ratio is 48% in the year 2017 and 53% for the year 2018. This
means that the debt ratio has increased in the year 2018. The firm relies more
on its creditors to finance its total assets for the year 2018.

(b) Times Interest Earned Ratio

This ratio is used to measure the firmÊs ability to pay its annual interest
payment. If a firm is unable to pay off its interest charges, creditors have the
right to take legal proceedings against it and this might cause the company
to become bankrupt. From the creditorÊs point of view, it is better for the firm
to have a high times interest earned ratio, because that shows the firmÊs
ability to pay interest annually. Hence, the creditorÊs risk is smaller.

The times interest earned ratio is calculated using the following formula:

Earnings before interest and tax

Times Interest Earned Ratio =
Interest expenses

Based on the example of Emas Limited Company, its times interest earned
ratio is as follows:

Times Interest Earned Ratio:

7,890
Year 2017 =  4.38
1,800
8,514
Year 2018 =  3.23
2,640

Thus, the times interest earned ratio is higher in the year 2017. This shows
the firmÊs ability to pay annual interest declined in the year 2018.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  45

ACTIVITY 3.4

State the importance of debt management ratio to the following

parties:

(a) Shareholders; and

(b) Creditors

Share and crosscheck your answers with your coursemates on

myINSPIRE.

3.2.5 Profitability Ratios

Profitability ratios indicate the combined effects of liquidity, asset management
and debts decision on the firmÊs operations. In short, the profitability ratio is
the effect of various policies and decisions of the company. The two types of
profitability ratios are net profit margin and return on equity (ROE).

(a) Net Profit Margin

This ratio measures income from every ringgit of sales. Net profit margin can
be shown by the following formula:

Net profit available for ordinary shareholders

Net Profit Margin =
Sales

Based on the example of Emas Limited Company, the net profit margin is:

Net Profit Margin:

3,540
Year 2017 =  0.041  4.1%
85,500
3,405
Year 2018 =  0.038  3.8%
90,000

The net profit margin for the year 2017 is 4.1% and in the year 2018 is 3.8%.
This indicates that the firmÊs net profit margin in year 2017 is higher than
2018. This margin went down in year 2018.
46  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

(b) Return on Equity (ROE)

This ratio measures the rate of returns earned on the investment of ordinary
shareholders. Return on equity is calculated using the following formula:

Net profit available for ordinary shareholders

Return on Equity =
Ordinary shares equity

Based on the example of Emas Limited Company, the return on common

equity is as follows:

Return on Equity (ROE):

3,540
Year 2017 =  0.13409  13.41%
26,400
3,405
Year 2018 =  0.12126  12.13%
28,080

Therefore, the return on equity is 13.41% for the year 2017 is and 12.13% for
the year 2018. So, it shows that return on equity for the year 2017 is higher.

3.2.6 Market Value Ratios

Market value ratios comprise ratios that correlates the firmÊs stock price to the
earnings per share based on book value. This ratio gives information to the
management regarding the investorsÊ view on the firmÊs past performance as well
as future prospects. The three types of market value ratios are as follows:

(a) Price Earnings (P/E) Ratio

This ratio shows how much investors are willing to pay for each ringgit of
the profit reported. This ratio can be expressed as follows:

Market price per share

Price Earnings Ratio =
Earnings per share
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  47

(b) Book Value Per Share

This ratio is calculated using the following formula:

Common equity
Book Value Per Share =
Outstanding shares

(c) Market to Book Ratio

This can be expressed as follows:

Market price per share

Market to Book Ratio =
Book value per share

In using financial ratios, it is important for a financial manager to compare the

firmÊs performance in different time periods or make comparisons of firms in the
same industry to get a comprehensive view of the firmÊs performance. This is
known as flow analyses of financial ratios.

Table 3.2 summarises the formulas of financial ratios that we have discussed in this
subtopic.

Table 3.2: Formulas of Financial Ratios

Type of Financial Ratios Formula

Liquidity ratios Current ratio

Current assets
Current liabilities

Quick ratio

Current assets  Prepaid expenses

Current liability
48  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Asset management ratios Inventory turnover ratio

Cost of goods sold

Inventory

Non-current assets turnover ratio

Sales
Net non -current assets

Total assets turnover ratio

Sales
Total assets

Debt management ratios Debt ratio

Total debt
Total assets

Times interest earned ratio

Earnings before interest and tax

Interest expenses

Profitability ratios Net profit margin

Net profit available for ordinary shareholders

Sales

Return on equity

Net profit available for ordinary shareholders

Ordinary shares equity
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  49

Market value ratios Price earnings ratio

Market price per share

Earnings per share

Book value per share

Common equity
Outstanding shares

Market to book ratio

Market price per share

Book value per share

3.2.7 Uses of Financial Ratios

ACTIVITY 3.5

Team up with a coursemate for this activity. Based on your collective

knowledge of financial ratios, discuss how they assist organisations in
making decisions. Share the conclusions of your discussion with others
on myINSPIRE.

Financial ratios can be used to interpret financial information in a way that is easily
understood. Compared to the figures in financial statements, financial ratios can
give a more comprehensive reflection of the firmÊs performance. For example, if a
financial manager wishes to know a firmÊs liquidity standing, he can refer to the
liquidity ratios, namely the current ratio and quick ratio. For an investor who
wishes to know the firmÊs profitability, he can refer to profitability ratios such as
net profit margin and return on common stock equity. If financial ratios can be
collected for several years, comparison can be made by showing their flows in the
form of graphs, thus making the information easily understood.
50  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Financial ratios can be used to construct a firmÊs financial profiles. It can evaluate
various aspects of firmÊs financial performance and standing. This information can
be used in the decision-making process by the firmÊs management team, suppliers,
investors, banks and so on.

Financial ratios (especially if flow analyses or comparisons are made) can measure
the firmÊs financial health and give an „early warning‰ sign on the difficulties it
may be facing. Therefore, a financial manager may propose appropriate steps to
solve the problem before it becomes too acute.

ACTIVITY 3.6

Prepare a list of financial ratios that you might scrutinise before

purchasing shares of a firm. Explain your choices and share your answer
on myINSPIRE.

3.2.8 Limitations of Financial Ratio Analysis

Although financial ratios are a useful and quick way to analyse the status and
performance of a business, it has some limitations, which should be considered by
a financial manager when using financial ratios. Among the limitations are as
follows:

(a) Financial ratios rely on data obtained from financial statements. Thus,
whether the resulting calculations can be trusted or not depends on the
quality of the financial statements. Weaknesses in the financial statement will
be reflected in the financial ratios and interpreting information from these
ratios is useless because the financial data is inaccurate. Apart from that, one
of the important factors that needs to be taken into consideration when
preparing the financial statements is the effect of inflation, which may
misrepresent the value of non-current assets such as properties, profit and
loss figures, etc.

(b) Financial ratios measure the firmÊs relative standing and performance
and do not take into account its absolute size. Sometimes, real figures can
give a better overall reflection when we make a comparison of the firmÊs
performance between two different time periods or between two different
firms.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  51

(c) Normally, a firmÊs financial ratios are compared with industry averages,
where basic signs are used to look at the firmÊs standing and performance
compared to other firms. It should be reminded that this comparison might
not be appropriate because it is difficult to find two firms with the same kind
of business. Even though there may exist two firms in the same industry, one
of the firms might have miscellaneous activities in other types of business. In
addition, the accounting policies, financial policies, and financial years may
differ, and this will complicate the comparison thus weakening the use of
financial ratios.

(d) Financial ratios that are based on a balance sheet might not give accurate
information because a balance sheet only gives a reflection of the firm at a
certain point in time. Thus, a financial ratio calculated based on the data
of a balance sheet statement does not represent the firmÊs standing and
performance for the whole year. These weaknesses are even more obvious in
seasonal businesses.

(e) Although financial ratios are used to analyse a firmÊs strengths and
weaknesses, they cannot identify the factors that had brought it to that
position. A more detailed investigation into the firmÊs practices and business
records is still needed to identify those factors.

SELF-CHECK 3.5

Indicate TRUE (T) or FALSE (F) for each of the following statements

1. Debt financing is also known as equity financing.

2. Interest expenses are subtracted before tax levied.

3. Profitability ratios indicate the combined effects of liquidity, assets

management and debt on operational decisions.

4. The current ratio is a stricter liquidity measurement compared to

quick ratio.
52  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

 There are three important financial statements, which are the balance sheet,
income statement and cash flow statement. Information can be obtained from
each of the financial statements to calculate certain financial ratios to measure
the liquidity, asset management, debt management, profit and the firmÊs
market value.

 A balance sheet is a statement that shows a firmÊs financial standing at a certain

point in time. The balance sheet can be divided into two parts:

ă Assets (current assets + non-current asset); and

ă Liabilities (current liabilities + non-current liabilities) and equity

(preferences shares, common shares and retained earnings).

 Information that could be obtained from a balance sheet are:

ă The capital structure of the company; and

ă The working capital

 The income statement shows:

ă A firmÊs revenues and expenditures at a certain point in time; and

ă A firmÊs profit and loss for a certain period of time, normally one year.

 The cash flow statement indicates the effects of the firmÊs activities on cash
flows of the firm for a certain period of time. The firmÊs activities are:

ă Operating activity;

ă Investment activity; and

ă Financing activity.

 Analysis of financial statements involves two main tasks: comparison of the

firmÊs performance with other firms in the same industry; and evaluation of
the flow of the firmÊs standing between certain time periods.
 TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  53

 Financial ratios include:

ă Liquidity ratios (current ratio, quick ratio);

ă Asset management ratios (inventory turnover ratio, non-current asset

turnover ratio, total asset turnover ratio);

ă Debt management ratios (debt ratio, times interest earned ratio);

ă Profitability ratios (net profit margin, return on equity); and

ă Market value ratios (price earnings ratio, book value per share ratio, market
to book value ratio).

 Financial ratios can be used for:

ă Interpreting financial information into a form that is easily understood;

Constructing a firmÊs financial profile; and

ă Measuring the firmÊs financial health and give an „early warning‰ sign on
difficulties it may be facing.

 Even though financial ratios can be used to interpret financial information into
a format that could be easily understood, and to measure the firmÊs health as
well as construct the firmÊs profile, we cannot rely entirely on ratio analysis in
making our decision because there are several limitations that need to be
considered.

 The limitations of financial ratio analysis are as follows:

ă If the financial data is inaccurate, this will influence the quality and
accuracy of the financial ratios;

ă Financial ratios measure the firmÊs relative standing and performance

without taking into consideration its absolute size;

ă Comparing the financial ratio of a firm with other firms in the same
industry might not be suitable if there are firms that run miscellaneous
types of business activities;

ă The economic situation always changes but financial ratios are calculated
based on financial statements at a certain point in time, for example balance
sheets; and

ă A firmÊs financial standing can be affected by many factors.

54  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS

Asset management ratio Financial terms

Debt management ratio Liquidity ratio
Financial ratios Market value ratio
Financial ratio analysis Profitability ratio
Financial statement