INTRODUCTION TO

ACCOUNTING

Financial Statements Analysis

Basic Financial Analysis

• Ratio analysis involves

methods of calculating and
interpreting financial ratios
to assess a firm’s financial
condition and performance.
• It is of interest to
shareholders, creditors, and
the firm’s own management
 Using Financial Ratios:
Types of Ratio Comparisons
• Trend or time-series analysis
– Used to evaluate a firm’s performance
over time

• Cross-sectional analysis
– Used to compare different firms at the same point in time
 Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Cross-sectional analysis
– Industry comparative analysis
• One specific type of cross sectional analysis. Used to compare one
firm’s financial performance to the industry’s average performance

– Benchmarking
• A type of cross sectional analysis in which the firm’s ratio values
are compared to those of a key competitor or group of
competitors that it wishes to emulate
 Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
• Combined Analysis
– Combined analysis simply uses a combination of both time
series analysis and cross-sectional analysis
 Ratio Analysis

• Liquidity Ratios – measures capacity to meet short

term obligation
• Activity Ratios – measures effective use of resources
• Leverage (gearing) Ratios – measures indebtedness
• Profitability Ratios – measures overall profitability
• Market Ratios – measures based on market price of
shares - important to investors
 LIQUIDITY RATIOS

• 1. CURRENT RATIO
• measures firm’s ability to meet its short-term obligation
 The higher the ratio, the more liquid the firm is.
 A current ratio of 2.0 is occasionally acceptable
 Current ratio = Current Assets
Current liabilities
 CURRENT RATIO

• A company has total assets of RM150,000,

equity of RM 75,000 and non-current assets of
RM 50,000 and non-current liabilities of RM
50,000. Calculate the current ratio of the
company.
 CURRENT RATIO

• Asset= Liabilities + Equity

• Total asset= current+ non current
– Current asset = 150k – 50 k = 100k
• Total liabilities = Total Asset – Equity = 150k – 75k =
75k
• Current liabilities = 75k – 50k =25k
• Current ratio = 100k/25k = 4
 CURRENT RATIO

• enough cash to be able to pay its debts

• but not too much finance tied up in current assets
which could be reinvested or distributed to
shareholders
• A low current ratio suggest that the business is not
well placed to pay its debts
 LIQUIDITY RATIOS

2. Quick (acid-test) Ratio

• similar to current ratio but excludes inventory
 A quick ratio of 1.0 or greater is occasionally
recommended – but depends on the industry
 Quick ratio = current asset – Inventory
current liabilities
 LIQUIDITY RATIOS

cash 60 000 Account payable 30000

Marketable 10000 Accrued 20000
securities expenses
Account 40000 Notes payable 5000
receivables
Inventory 50000 Current portion 10000
of long term debt
 LIQUIDITY RATIOS

• Quick ratio = (160k – 50k )/65K

• = 1.69
• Quick ratio of greater than 1.0 are sufficiently able to
meet their short-term liabilities with its most liquid
assets.
• Assets such as cash and marketable securities are quick
sources of cash. Inventories generally take time to be
converted into cash.
• Low or decreasing quick ratios generally suggest that a
company is over-leveraged, struggling to maintain or
grow sales, paying bills too quickly or collecting
receivables too slowly.
 ACTIVITY RATIO

• Inventory Ratio – measures the activity/liquidity of a firm’s inventory

– COGS/ Inventory OR Sales/ Inventory
 A high ratio implies either strong sales or ineffective buying.
 A low turnover implies poor sales and, therefore, excess inventory.
 Average Collection Period – average amount of time needed to collect
accounts receivable
– Account receivable/Average sales per day
 Meaningful only in relation to the firm’s credit terms (credit-terms 30 days
and average collection period 60days – poorly managed credit)
 ACTIVITY RATIO

• Average Payment Period – average amount of time needed to pay

accounts payable
– Account payable/ Average purchase per day
 Meaningful only in relation to the average credit terms extended to
the firm (credit terms 30 days, average payment period 90 days – low
credit rating)
• Total Asset Turnover – indicates the efficiency with which the firm uses its
assets to generate sales
– Sales/ Total assets
 Generally, the higher the firm’s total asset turnover, the more
efficiently its assets have been used
 ACTIVITY RATIOS

*Account receivable turnover ratio

•= Net Credit sales/ Average Account Receivables
•Measures the efficiency of a business in collecting its
credit sales
•High value of accounts receivable turnover is favorable
•Lower figure may indicate inefficiency in collecting
outstanding sales
 ACTIVITY RATIOS

Account payable turnover ratio

•= Total purchases/ Average Account Payable
•* Purchase = COGS+ ending inventory - opening
inventory
•Evaluates how fast a company pays off its creditors
•A high ratio means there is a relatively short time
between purchase of goods and services and payment
for them.
•A lower account payable turnover ratio signifies that a
company is slow in paying its suppliers.
 DEBT RATIO

• Debt Ratio – measures the proportion of total assets financed by

the firm’s creditors
– Total liabilities/ Total assets
– The higher this ratio, the greater the firms’ degree of
indebtedness, the more financial leverage it has
• Times Interest Earned Ratio – measures the firms’ ability to make
contractual interest payments
– EBIT (Earnings Before Interest and Tax)/Interest
– The higher the better – a value of at least 3.0 and preferably
closer to 5.0 is often suggested
• Fixed-Payment Coverage Ratio – measures the firms’ ability to
meet all fixed-payment obligations (loan interest and principal,
lease payments, preferred stock dividend)
= EBIT+LP/I+LP +((PP +PSD)*(1/1-T))
– The higher, the better. Also measures risk, the lower the ratio,
the greater the risk to both lenders and owners
 DEBT RATIO

*Debt to equity ratio

•= Total liabilities/ shareholders equity
•Higher ratio is unfavorable because it means that the
business relies more on external lenders thus it is at
higher risk, especially at higher interest rates.
•Lower ratio is favorable indicating less risk.
 PROFITABILITY RATIOS
• Gross Profit Margin – measures the percentage of each sales dollar remaining after the firm has
paid for its goods
– Gross profit/ Sales
– The higher, the better
• Operating Profit Margin – measures the percentage of each sales dollar remaining after all costs
and expenses other than interest, taxes, and preferred stock dividends are deducted
– Operating profit/ Sales
– A higher operating profit margin is preferred
• Net Profit Margin - measures the percentage of each sales dollar remaining after all costs and
expenses including interest, taxes, and preferred stock dividends are deducted
– Earnings for stockholders/Sales
– The higher the firm’s net profit margin, the better
 PROFITABILITY RATIOS

• Earnings per share (EPS) – represents the dollar amount earned on behalf
of each outstanding share of common stock
– Earnings for stockholder/Number of shares of stock outstanding
– The higher, the better
• Return on Total Assets (ROA) – how efficient management is at using its
assets to generate earnings.– return on investment
– Earnings for stockholder/ Total assets
– The higher, the better
• Return on Common Equity (ROE) – how much profit a company
generates with the money shareholders have invested.
– Earnings for stockholder/ Common stock equity
– The higher, the better
 MARKET RATIOS

• Price/Earnings (P/E) Ratio – measures the amount that

investors are willing to pay for each dollar of a firm’s earnings
– Market price per share of common stock/EPS
– Indicates the degree of confidence that investors have in
the firm’s future performance (the higher, the greater the
confidence)
• Market/Book (M/B) Ratio – compare a company's current market
price to its book value
– Market price per share of common stock/ Book value per share of
common stock
– Performing stocks – higher M/B ratios
 MARKET RATIOS

*Price/Earnings (P/E) Ratio

•ratio tells how much the market is willing to pay for a company’s
earnings
•Higher ratio indicates that the market has high hopes for the
future of the share and therefore it has bid up the price.
•A lower ratio indicates the market does not have much
confidence in the future of the share.
•if a company is currently trading at $43 a share and earnings
over the last 12 months were $1.95 per share, the P/E ratio for
the stock would be 22.05 ($43/$1.95).
•the interpretation is that an investor is willing to pay $22.05 for
$1 of current earnings.
 Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

2-24
 Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

2-25