CHAPTER 2

Financial Analysis

FIN242
FUNDAMENTALS OF FINANCE
Prepared by:
Sylviannie Jimius
Chapter Contents:
2.0 Financial Analysis
2.1 Definitions and function of financial
statement
2.2 Financial ratios
2.3 Basic sources and uses of funds
2.0 Financial analysis
• Financial analysis basically consists of two branches, which is:
1. Securities analysis (investment analysis); and
2. Corporate financial analysis (identification qualitative and
quantitative of problems, complications, and performances in
an organization).

• Financial analysis provides aid for decision-maker to:

1. Assess the periodic operating results and financial status of the
firm, and
2. Develop plans and strategies to keep the firm’s performance in
line with the goal to maximize the owners’ wealth.
2.1 Definitions and function of
financial statement
• Financial Analysis can be defined as a process of
selecting, sorting, evaluating, and interpreting the past
financial data of a firm.

• It is useful as a tool to make financial decision.

• The main sources of financial analysis are:

1. Income Statement
2. Statement of Financial Positions
3. Statement of Retained Earnings
4. Statement of Cash Flows
1) Income Statement
- A financial statement summarizing the firm’s revenues and
expenses over an accounting period.

COMPANY NAME
INCOME STATEMENT FOR THE YEAR ENDED DEC 31st, 20XX
Sales
Less: Cost of goods sold (COGS)
Gross profit
Less: Operating expenses
Operating profit/ Earning before interests
and tax (EBIT)
Less: Interests
Earning before tax (EBT)
Less: Tax
Earning after tax (EAT)/ Net profit/ Net income
Less: Dividend
Retained earnings
2) Statement of Financial Positions
- A summary of company’s assets, liabilities and owner’s equity of
a company.
COMPANY NAME
STATEMENT OF FINANCIAL POSITION
FOR THE YEAR ENDED DEC 31st, 20XX
ASSETS RM LIABILITIES & EQUITY RM
Current Asset (CA) Current Liabilities (CL)

Non-current Asset Non-current Liabilities

(NCA) / Fixed Asset (NCL) / Long-term Asset
(FA) (LTL)

Equity
TOTAL EQUAL TOTAL EQUAL
3) Statement of Retained Earnings
- Distributions of the firm’s earnings were not paid out as
dividends.
4) Statement of Cash Flows
- It shows the actual cash generated over a period.
- It is also known as sources and uses of funds.

COMPANY NAME
STATEMENT OF SOURCES AND USES
FOR THE YEAR ENDED DEC 31st, 20XX

Sources of funds RM Uses of funds RM

TOTAL EQUAL TOTAL EQUAL

2.2 Financial ratios

• Financial ratios analysis is the method of

calculating, analyzing and interpreting financial
ratios to measure the firm’s performance and
status.

• It helps in providing clues to spot any patterns of

better or poorer performance in the past.
• Types of financial ratios analysis:

1. Cross-sectional Analysis
- Also known as comparative analysis and horizontal analysis.
- It involves comparing ratios of one firm with those similar
firms.

2. Time-series Analysis
- Also known as trend analysis and vertical analysis.
- Involves evaluating the company’s financial performance
over time.

3. Combines Analysis
- Combination of both cross sectional and time-series analysis
• Limitations of Financial ratios Analysis:

i. Non-comparative data. Large firms have many different divisions.

To use one set of ratios analysis to summarize the whole
companies is not viable anymore.

ii. Ignore seasonal factors. The calculation that based on historical

data may not reflect the true picture of the company’s
performance.

iii. Different accounting treatments. Using different types of

accounting method and reporting periods may distort the
comparison between companies even though they fall under the
same industries.

iv. Difficult to generalize a ratio as ‘good’, ’fair’ or ‘bad’.

v. Unreliable figures. Many firms will do window dressing on their

financial statements to make them look better for credit analysis.
• Financial ratios are normally grouped into 5 categories:
1. Liquidity ratios
- These ratios measure the firm’s ability to pay its short-term
obligations as they come due.

2. Activity ratios (also known as efficiency ratios)

- These ratios measure the effectiveness of the firm’s investment
decision and its ability in utilizing the firm’s assets to produce sales.

3. Leverage ratios (also known as debt ratios)

- These ratios measure the firm’s effectiveness in financing decisions
and the use of debt financing by the firm.

4. Profitability ratios
- These ratios measure the profitability of the firm’s overall business
operations.

5. Market/ Equity ratios

- These ratios relate the firm’s market price to its earnings.
1) LIQUIDITY RATIOS
These ratios consist of:

a) Current ratio = Current asset/ Current liabilities

= times
This ratio measures the ability of the firm to pay-off its current
liabilities with its current assets.
*the higher the ratio, the better.

b) Quick ratio = (Current assets – Inventory - Prepayment)/

Current liabilities
= times
Also known as Acid test ratio.
This ratio measures the ability of the firm to pay-off its current
liabilities with its most liquid assets.
*the higher the ratio, the better.
2) ACTIVITY RATIOS
These ratios consist of:

a) Inventory turnover = Sales/ Inventory

= times
This ratio measures the activity and the efficiency of the firm’s in
utilizing its inventory to generate sales.
But if there is no Sales, use the next formula;
Inventory turnover = COGS/ Inventory
= times
*the higher the ratio, the better.

b) Fixed assets turnover = Net sales/ Net fixed assets

= times
This ratio indicates how well the firm is using its fixed assets to
generate sales.
*the higher the ratio, the better.

Note: For every “Net Sales”, just take the

amount of “Sales” from Income Statement
c) Total assets turnover = Net sales/ Total assets
= times
This ratio measures how well the firm is using its assets to
generate sales.
*the higher the ratio, the better.

d) Average collection period = (Acc. Receivable/ Net sales)

x 360
= days
This ratio determines whether the firm is efficient in its
collection policy.
*the lower the ratio, the better.
3) LEVERAGE RATIOS
These ratios consists of:

a) Debt ratio = (Total debts/ Total assets) x 100

=%
This ratio measures the amount of percentage of assets that
being financed through debt.
*the lower the ratio, the better.

b) Debt to equity ratio = Long-term debt/ Total equity

= times
This ratio shows the relationship between long-term debt and
equity.
*Total equity refers to preferred shares, common shares, paid
in capital and retained earnings.
*Sometimes the answer is in percentage.
*the lower the ratio, the better.

Note: Total debts = Current liabilities + long-term liabilities

Total assets = Current assets + Net fixed assets
 c) Times interests earned = EBIT/ Interest
= times
This ratio measures the ability of the firm in paying its fixed
obligation on interest.
*the higher the ratio, the better.

4) PROFITABILITY RATIOS
This ratio consists of:

a) Gross profit margin = (Gross profit/ Net sales) x 100

=%
This ratio shows the remaining cash the firm has after paying
its trade credit.
*the higher the ratio, the better.

Note: EBIT = Earnings Before Interest and Tax

b) Operating profit margin = (Operating profit/ Sales) x 100
=%
This ratio shows the profit the firm gets for each RM invested.
*the higher the ratio, the better.

c) Net profit margin = (EAT/ Net sales) x 100

=%
This ratio measures the degree of sales in RM that remains
after all expenses have been deducted.
*the higher the ratio, the better.

d) Return on total assets = (EAT/ Total assets) x 100

=%
It also known as return on investment. This ratio measures the
effectiveness of the firm to generate profit with all its assets.
*the higher the ratio, the better.

Note: EAT (Earning After Tax) = Net Income = Net Profit

 e) Return on equity = (EAT/ Total equity) x 100
=%
This ratio measures the return earned for each RM of the
investment made.
*the higher the ratio, the better.

5) MARKET RATIOS
These ratio consist of:

a) Earnings per share = Earnings for common shareholder/

NOSO
= RM
This ratio shows the amount of income earned on a share of
common stock.
*the higher the ratio, the better.

Note: NOSO = Number of shares outstanding

b) Price earnings ratio = Market price/ Earnings per share
= RM
This ratio shows how much an investor is willing to pay for RM1
of earnings.
*the higher the ratio, the better.

c) Dividend payout ratio = Common stock dividend/ Net income

= RM
This ratio measures the portion of earnings is being paid out as
dividends.
*the higher the ratio, the better.
Few examples of comments are as below:

• Liquidity ratios (CR is worse, QR is better)

– Current ratio of the company is bad. This shows that the company
unable to meet its current obligations as they come due. However, when
we look at the company’s quick ratio, they are better than the industry
showing that the firm is able to pay-off its current liabilities with its most
liquid assets.
• Leverage ratios (All ratios are worse than the industry)
– The company’s leverage ratio are worse than the industry. This shows
that the company is not effective in their financing decision compared to
the industry.
• Activity ratios (FATO & ACP worse, ITO better)
– The company FATO & ACP is worse than the industry. This shows that
the company is less efficient in utilizing its fixed assets to generate
sales and also inefficient in collecting debt. It is however efficient in
utilizing its inventory to generate more sales.
• Profitability ratios (All ratios are better than the industry)
– For profitability ratios, the company is better than the industry. This
shows that the company are able to make profit from its overall
business operations.
2.3 Basic sources and uses of
funds
• It is also known as statement of changes in financial position the
summarizes significant financial changes that occurred over a given
accounting period and can be prepared under cash basis and
working capital basis.

• Focuses on the flow of funds in the firm and provides insights on:
1. Where did the firm get its funds during the year?
2. What did the firm do with its available funds?
3. How the operations during the year affect the firm’s liquidity,
increase or decrease? It is measured by the change in net
working capital, that is current assets minus current liabilities.
• The funds flow statements constructed by combining
changes in statement of financial positions accounts
over time.
1. Funds inflow into the firm (sources)
2. Funds outflow (uses)

• The total sources of funds are the amount of funds

available in a given time period that are available for
investment and other purposes by the firm; and
therefore, at any given time, total sources must equal to
total uses.

• Sources and uses statement is also an excellent

planning device for the firm.
• The basic principles of sources and uses of funds can be summarize
as below:

SOURCES OF FUNDS USES OF FUNDS

• Decrease in Assets (↓ A) -ve • Increase in Assets (↑ A) +ve
• Increase in Liabilities (↑ L) +ve • Decrease in Liabilities (↓ L) -ve
• Increase in Accruals (↑ Accruals) • Net loss after tax
• Sales of stock/shares • Decrease in Retained earnings
(↓ RE)
• *Increase in Depreciation (↑ Depr.) • **Cash dividend paid (Div.)
• EAT/ NI/ NP • ***Net capital expenditure (NCE)
• * Depr. : Always get from IS/ other info. If there is depr. in IS/ other
info because it represents the actual amount for the year, then you
need to calculate NCE. After that, the depr. value needs to be
recorded back in Sources column.

• ** Dividend : Always need to be calculated!

EAT - ∆ RE

• *** NCE : Calculated when there is Depr. in IS/ other info.

NFA1 – NFA0 + Depr.
After calculating NCE, record it in Uses column.
Then there is no need to record NFA.
 ! REMINDERS !
vLook for exercises from past year
questions.

vDon’t forget to read the slides

together with your book.

“Beware of little expenses. A small leak will sink a great ship.” – B.F.