finance management fin420 chp 3

Financial Analysis Chapter 3

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Financial analysis and planning are useful both to help

anticipate future conditions and, more importantly as a

starting point for planning actions that will influence the

future course of events.

Learning objectives

After learning this chapter, you should be able to:

1. Distinguish the concept of financial analysis, planning and forecasting.

2. Construct the sources and uses of cash flows statement.

3. Construct the cash budget.

4. Develop the pro forma financial statement i.e. the pro forma balance

sheet and income statement.

5. Analyse/interpret the company’s performance based on ratio and cash

flows analysis.

Financial Analysis

GOAL

Chapter 3 Financial Analysis

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3.0 INTRODUCTION

Financial analysis basically consists of two branches, that are (1) securities analysis, that

concern with analysis of investment analysis; and (2) corporate financial analysis that

concern with identification of problems, complications, and performances whether qualitative

or quantitative in an organization. Our focus is on the latter financial analysis to aid decision-

maker:

1. To assess the periodic operating results and financial status of the firm, and

2. To develop plans and strategies so as to keep the firm's performance in line with the

goal to maximize the owners' wealth.

This chapter will focus on essential areas of financial analysis that is financial ratio analysis

and the sources and uses of funds. Before introducing the concepts and procedures involve

in the analysis, it is utmost importance to understand the basic financial statements as they

represent the raw material for analysis. Lack of comprehension of the basic statements will

complicate the process of analyzing and provides little understanding.

The immediate concern is on the study of historical performance of the firm that involves in-

depth study of the firm's financial statements. The study will provide insights of the financial

relationship that exists at a given point in time and its trend over time. This analysis is vital in

determining the firm's future course of actions to ensure the achievement of wealth

maximization

3.1 BASIC FINANCIAL STATEMENTS

Financial statements represent a raw material for financial analysis, and are consists of: the

balance sheet, the income statement, the statement of changes in financial position, the

manufacturing statement, the statement of changes in stockholders' equity, and the

statement of changes in working capital.

3.1.1 Balance Sheet

A firm's balance sheet shows the financial position at one point in time

usually the last day of calendar or fiscal year. It is a summary of the firm's

resources (assets) balanced against its liabilities (debt) and stockholders'

equity (ownership). Table 3-1 shows the general format that displayed assets,


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liabilities, and equity from top to bottom in order of increasing liquidity. For

example, assets listed near the top can or will be converted to cash sooner

than those nearer the bottom. Similarly, liabilities listed near the top are due in

relatively short time in less than one year or just s few months.

Table 3-1 TMAmir Products: Balance sheet as of December 31, (thousands of RM)

19X1 19X2 Assets

Cash and marketable securities 200.00 150.00

Accounts receivable 450.00 425.00

Inventories 550.00 625.00

Total current assets 1,200.00 1,200.00

Plant and equipment 2,200.00 2,600.00

Less: Accumulated depreciation 1,000.00 1,200.00

Net plant and equipment 1,200.00 1,400.00

Total assets 2,400.00 2,600.00

Liabilities and Equity Accounts payable 120.00 150.00

Notes payable 60.00 100.00

Accruals 20.00 50.00

Total current liabilities 200.00 300.00

Bonds (10%) 600.00 600.00

Total debt 800.00 900.00

Preferred stock (7%) 100.00 100.00

Common stock (RM1 par) 300.00 300.00

Paid in capital or premium 500.00 500.00

Retained earnings 700.00 800.00

Total equity (net worth) 1,600.00 1,700.00

Total liabilities & net worth 2,400.00 2,600.00


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3.1.2 Assets

The first part of the balance sheet deals with the firm's assets; consist

of current assets and fixed assets.

1. Current assets. The components of current assets are cash and other

assets that are consumable or convertible to cash in a relatively short

time or less than 1 year. It represents working capital of the firm that

provides support for day-to-day operations, without which it cannot

operate efficiently. For example:

a. Cash are for conducting transactions, satisfying precautionary

needs and financing possible speculation.

b. Marketable securities that represent the firm’s short-term

investment in financial securities. These are near cash item

and part of the firm’s cash reserve in addition to cash.

c. Inventories that are needed for production and selling purpose

such as raw materials, work in progress and finished goods.

d. Accounts receivable that is amount owed by customers on

credit sales.

2. Fixed assets. Fixed assets such as equipment, lands, and buildings

are acquires for long-term use and cannot easily be converted into

cash within a short period without losing its value. It is normally stated

as:

a. Fixed assets as gross value or at book value and/or

b. Net value net plant that is gross value minus accumulated

depreciation.

c. Some firms may have patents and goodwill in their balance

sheet listed as other assets. Please note that these are the

intangible assets and should not be considered as part of the

analysis.


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3.1.3 Liabilities and Stockholders Equity

The second part deals with the firm's liabilities and stockholders' equity.

1. Liabilities can be divided into two categories.

a. Current liabilities, which are obligations due and payable within

a period of 1 year or less such as:

i. Accounts payable. The amount owed to suppliers for

credit purchases.

ii. Accruals. The amount owed to employees, utilities, and

taxing authorities for services rendered.

iii. Notes payable. The amount owed to short term lenders

such as bank overdraft and commercial paper.

b. Long-term liabilities or long-term debt are debt due or payable

beyond 1-year period, such as:

i. Term loans. Medium to long-term loans from financial

institutions for capital investment.

ii. Debentures. A bond that is backed only by the earning

power of the firm and no specific asset is pledged.

Investors are considered as general creditors of the

firm.

iii. Bonds. A corporate promissory note issued to

investors.

iv. Mortgages. Represent a loan or a bond that is backed

by the pledge of specific asset of the firm.

v. Leases. A legal contract whereby a lessee is able to

use certain assets without having to actually purchase

the assets. The firm is obligated to pay the periodic

payments for the assets.

2. Stockholders' equity represents ownership positions in the firm that

consist of:

a. Preferred stock. A type of equity that has certain priorities over

common stock but has no voting rights.


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b. Common equity. The accounts composed of common stock,

premium, or pain in capital, and retained earnings. Also called

net worth and stockholders’ equity.

i. Common stock is stated at par value of the outstanding

shares.

ii. Premium is the capital paid more than the par value of

the outstanding shares. For example, a firm issues

10,000 shares of common stocks with par value of RM1

and sells for RM4 per share when issued. This will lead

to an increase in common stock account of RM10,000

(=1 x 10,000 shares), and RM30,000 (=(4 – 3) x 10,000

shares) in premium account.

iii. Retained earnings. Represents the reinvestment of

stockholders' return in the firm; that is the accumulation

of prior earnings not allocated to common stockholders.

In certain cases, treasury stock account exists which shows

the amount spent to buy back the firm's own stocks or shares;

it will offset the common equity account.

3.1.4 The Income Statement

A firm's income statement represents a summary of the firm's operating

results over a period, normally for 1-year period. Table 3-2 shows the basic

format of the income statement. It shows:

1. The revenues that include sales and other income. It is normally

stated as net sales after sales allowances and represents inflows of

funds in exchange for goods or services rendered by the firm.

2. The costs and expenses incurred. Expenses are assets used or

consumed in the process of generating the revenues. However, some

expenses such as depreciation does not involve actual cash flow but it

reflects the usage of asset in producing the goods and services.


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3. The profit or loss after subtracting expenses from revenues. The net

profit after deducting the interest expenses and taxes are available for

distributions to preferred and common shareholders as dividends.

Table 3-2 TMAmir Products: Income Statements for Year Ended December 31, (thousands of RM)

19X1 19X2

Net sales 1,200.00 1,450.00

Cost of goods sold 700.00 850.00

Gross Profit 500.00 600.00

Operating expenses 30.00 40.00

Depreciation expense 180.00 200.00

Earnings before interest and taxes(EBIT) 290.00 360.00

Interest 60.00 70.00

Earnings before tax (EBT) 230.00 290.00

Taxes (40%) 92.00 116.00

Earnings after tax (Net Income) 138.00 174.00

Preferred stock dividends 7.00 7.00

Earnings available to common

stockholders (EACS) 131.00 167.00

Common stock dividends 31.00 67.00

Addition to retained earnings 100.00 100.00

Per share data: Common stock price RM2.00 RM2.20

Earnings per share 0.4367 0.5567

Dividends per share 0.1033 0.2233

3.1.5 The Statement of Changes in Financial Position

A firm's Statement of Changes in Financial Position or also known as the

Statement of Sources and Uses of Funds shows where the firm obtained the

funds, how the firm allocated the funds acquired and its impact on the firm's

liquidity position over the period. This statement is useful in analyzing

changes occurred and why it occurred as income statements and balance

sheet fail to show certain important details.


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3.1.6 The Manufacturing Statement

The manufacturing Statement is useful in analyzing the activities of a

manufacturing firm and not much of a merchandising firm. The statement

shows; the cost of raw materials, direct labor, and the factory overhead

incurred in the manufacturing process. As for merchandising firm, it may only

show the calculation of the cost of goods sold; by listing beginning inventory,

adding purchases, and subtracting ending inventory.

3.1.7 Statement of Changes in Stockholders' Equity

Unlike the balance sheet and income statement, statement of changes in

stockholders' equity has limited use in financial analysis. It merely shows how

profits and other transactions such as stocks repurchase affect retained

earnings and other components of the stockholders' position. This statement

is, however, important to reconcile changes in stockholders' equity over time

and provides additional financial data if required in the analysis.

3.18 The Statement of Changes in Working Capital

The statement shows sources and uses of working capital in a manner similar

to that of preparing a statement of sources and uses of funds. A firm may also

publish verbal financial statements in the annual report to explain the

accompanying financial statements. The information contained in this report

aids investors to have better knowledge of the firm to form certain

expectations about the future earnings and dividends, and about the riskiness

of these expected values.


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3.2 SOURCES AND USES OF FUNDS

It is also known as statement of changes in financial position that summarizes significant

financial changes that occurred over a given accounting period and can be prepared under

cash basis and working capital basis. It 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 balance sheet accounts

over time; with certain relevant financial figures from the income statement. In short:

1. Funds inflow into the firm is classified as sources and

2. Funds outflow represents 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. The steps in preparing the funds flow statement

consists of three steps as follows:

1. Analyze the balance sheets. Latest two balance sheets are required.

a. Calculate the amount of changes in balance sheet accounts the amount. The

purpose is to calculate the incremental change in the accounts from the

previous balance sheet, that is t=1 minus t=0 that signify the uses and

sources of funds for the firm within one year period.

b. Classify the incremental change is uses and sources accordingly. Ignore the

negative sign as it only indicates the direction of incremental change, and

absolute value is therefore relevant for the analysis purposes.


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2. Analyze the income statement to determine the flow of funds from operations.

a. Determine the net income for the year.

b. Determine the disposition of net income that is what proportion is paid out as

dividend to shareholders and what proportionate balance is reinvested in the

firm as retained earnings.

c. Determine the depreciation charges for the year. Note that if the figures are

not available; refer to the balance sheet accounts for the incremental change

in the accumulated depreciation. The differences can be considered as

present depreciation charges for the purpose of our analysis.

Unlike the balance sheet, only the present year income statement for 19X2 or t=1 is

required as its represent the firm’s operating results over the year period

3. Combine the information from these two statements to form the sources and uses statement.

To ease the analysis in step 1 and 2, the basic rules to classify the changes in

balance items and relevant income statement data are as follows:

• Sources of funds A decrease in an asset account

An increase in liability or equity account

Net profit after taxes/Earnings after tax/Net income

Depreciation and other non-cash expenditures

• Uses of funds An increase in an asset account

A decrease in liability and equity

Net loss from operations

Dividend payments

The basic principle of sources and uses of funds is in line with common sense:

1. An increase in assets requires more funds for investment (uses) and funds will

increase as assets are disposed (sources).


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2. There will be an increase in liabilities and/or equity if the firm is acquiring funds from

outside (sources) and consequently will decrease after repayment and/or

repurchases (uses).

The sources and uses statement is also an excellent planning device for the firm. We can

change the tense of the verb in the three basic questions to the future tense and ask:

1. Where will the firm get its funds for the upcoming year?

2. What will the firm do with the funds obtained?

3. How will future operations affect the firm's liquidity?

When constructed in the future tense, statements are referred to as Pro-Forma or what-if

statements. Thus a sources and uses statement prepared for planning purposes would be

called a Pro-Forma Sources and Uses Statement.

To illustrate the development of the statements, please refer to the financial statements for

TM Amir Products presented in Table 3-1 and Table 3-2. The first step is to calculate

relevant changes (X2 – X1) in the balance sheet items as shown in Table 3-3, and classified

each item accordingly as sources or uses based on the given guidelines.

Table 3.3 TMAmir Products: Balance Sheet Analysis for Funds Flow Statements (thousands of

RM)

19X1 19X2 X2 – X1 Sources Uses Assets

Cash and marketable securities 200.00 150.00 50.00 50.00

Accounts receivable 450.00 425.00 25.00 25.00

Inventories 550.00 625.00 75.00 75.00

Net plant and equipment 1,200.00 1,400.00 200.00 200.00

Total assets 2,400.00 2,600.00

Liabilities and Equity Accounts payable 120.00 150.00 30.00 30.00

Notes payable 60.00 100.00 40.00 40.00

Accruals 20.00 50.00 30.00 30.00

Bonds (10%) 600.00 600.00


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Preferred stock (7%) 100.00 100.00

Common stock (RM1 par) 300.00 300.00

Paid in capital or premium 500.00 500.00

Retained earnings 700.00 800.00 100.00 100.00

Total liabilities & net worth 2,400.00 2,600.00

Total Sources and Uses 275.00 275.00

The above statements classify depreciation, as source of funds, but in does not really

provide funds because it is a non-cash expense added back to net income to estimate the

firm's cash flow from operations. Therefore, if the firm has no sales, the depreciation could

not provide any cash flow.

The second step is to analyze the income statement for necessary information. From Table

3-2, the following financial data can be identified from income statement for 19X2:

1. Earnings available to common stockholders RM167

2. Common stock dividend RM 67

3. Additions to retained earnings RM100 (=167 – 67)

4. Depreciation RM200

Note that earnings available to common stockholders will equal to net income if there is no

preferred stock account in the balance sheet. To determine items 2, 3 and 4 for the sample

example is relatively easy, as the financial figures are readily available. What if you have to

look for in the balance sheet instead with only Earnings available to common stockholders

available? The information from the balance sheet be done as follows:

1. Earnings available to common stockholders = RM167

2. Changes in retained earnings = RM100 (=RM800 – RM700)

3. Therefore, dividend payment for t=1 = RM67 (=RM167 – RM100)

4. Changes in accumulated depreciation = RM200(=RM1,200 – RM1,000)

Notes: 1. An increase in depreciation is actually a decrease in the asset

account and thus is a source of funds.

2. Assets are reported at historical cost and therefore not represent current

market value.


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In certain cases, the depreciation charges stated in the income statement is not the same as

in the change in accumulated depreciation in the balance sheet. In this case, the

depreciation charges in the income statement will be used as it represent the actual

depreciation for the year. However, if there is no information regarding the depreciation

charges in the income statement, the changes in accumulated depreciation can be

considered as the depreciation charges for the year.

Utilizing the financial data from the above calculation and Table 3-3, the funds flow

statement on cash basis as shown in Table 3.4 can be developed.

Table 3.4 Tmamir Products: Funds Flow Statement (Cash Basis). For The Year Ending

December 31, 19X2 (In Thousands Of RM)

Sources of Funds Funds from Operations

Earnings after Tax (EAT) 167.00

Depreciationa 200.00

Total Funds from Operations RM367.00

Proceeds From Changes in Working Capital

Decrease in Cash & Marketable Securities 50.00

Decrease In Accounts Receivable 25.00

Increase In Accounts Payable 30.00

Increase In Notes Payable 40.00

Increase in Accruals 30.00

Total Sources of Short-Term Funds RM175.00

Total Sources of Funds RM542.00


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Uses of Funds Long-term uses of funds

Net Capital Expendituresb 400.00

Dividends Paid to Shareholders 67.00

Total uses of long-term funds RM467.00

Changes in Working Capital

Increase in Inventories 75.00

Total uses of short-term funds RM 75.00

Total uses of funds RM542.00 Notes: a Always tries to get the depreciation expense from the income statement. The

reason for this is that if a depreciable asset was sold during the year then the

change in the accumulated depreciation account will understate the actual

depreciation.

b Net capital expenditures (NCE) are actual capital expenditures for the year

minus the original costs of any fixed assets sold. The following equation is

applicable to determine the net capital expenditures:

NCE = Net fixed asset1 - Net fixed asset0 + Depreciation1

= 1,400 – 1,200 + 200

= RM400

The cash basis provides the answers for first and second questions that is:

1. How much and from where the funds are from?

2. What are the funds for and how much?

To answer the third question, the effects on liquidity from operations, the summary of funds

flow statement should be developed as shown in Table 3-5.


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Table 3.5 Mekar Inc.: Summary of Funds Flow Statement (Working capital basis) For the

Year Ending December 31, 19X2 (In thousands of RM)

Sources of Funds

Funds from operations

Earnings after tax (EAT) 167.00

Depreciationa 200.00

Total Funds from Operations RM367.00

Changes in net working capital RM100.00 Total sources of funds RM467.00

Uses of Funds

Long-term uses of funds

Net Capital Expendituresb 400.00

Dividends Paid to Shareholders 67.00

Total uses of long-term funds RM467.00

Total uses of funds RM467.00

It summarizes the working capital accounts, current assets (CA) and current liabilities (CL)

as change in net working capital (NWC), as follows:

∆NWC = NWC1 – NWC0

= (CA1 – CL1) - (CA0 – CL0)

= (1,200 – 900) – (1,200 – 1,000)

= – RM100

Since the change in net working capital is negative, it shows that the liquidity in 19X2 tends

to decrease during the operations. The negative change in net working capital can be

classified as sources in the summary of funds flow statement. In the event that the change is

positive, it represents an increase in liquidity and a uses in the statement.

The essential difference between the cash basis and working capital basis is the

presentation of relative changes in working capital accounts. The cash basis tend to itemize


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the items as listed in the balance sheet, but working capital basis tend to summarize the

accounts in net working capital to show the relative change in liquidity position of the firm in

the given period. Other entries are the same.

3.3 FINANCIAL RATIOS

Financial ratio analysis is an important tool to analyze a company's performance at a point of

time and over certain period of time: (1) current performance; (2) past performances based

on actual statements; or (3) expected performance based on pro forma or "what if"

statements. It is designed to show relationships among financial statements extracted from

the financial statements, either balance sheet or profit and loss statement. The results are

then compared to historical data and/or industry average to assess the current or expected

performance of the firm. It tends to ask questions pertaining the firm's performance that is to

uncover necessary information for controlling and planning purposes.

Through this analysis, one will be able to tell whether the company's financial standing and

condition is in good health or otherwise. The analysis is not only important to the firm's

management, but also to creditors, regulating bodies, and the shareholders.

Although there are many ratios, the main ratios are classified into five groups: liquidity,

activity, leverage, profitability and market ratios. For the calculations presented in the

following ratio analysis, refer to the financial statements for TM Amir Products for 19X2 and

19X1 as presented in Table 3-1 and 3-2.

3.3.1 Liquidity Ratios

The liquidity ratios are a measure of the overall ability of the firm to meet its

maturing obligations by relying on its current assets. In other words, it

measures the liquidity or availability of the firm's liquid resources to pay

current and maturing liabilities on time. As a basic rule, higher ratios are

better as it represents higher ability to pay. Cautions however must be

observed in interpretations; as excessive liquidity may indicate too much

investment in current assets. This represents lower risk of technical

insolvency but may lead to lower profits as investment in current assets is not

productive as compared to fixed assets.


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Current ratio (CR)

It is a measure of short-term solvency and indicates the extend to

which the claims of short-term creditors are covered by current assets.

This assumes that current assets can be converted to cash in a timely

and orderly fashion. Other things being equal, higher ratio is desirable

as it indicates higher ability to pay. Average current ratio is

approximately 1.5.

CR = current assets / current liabilities

X1 = 1,200 / 200 = 6.00x

X2 = 1,200 / 300 = 4.00x

Quick ratio (QR)

The quick ratio, also known as acid test ratio is measure of the firm's

ability to pay off its short-term obligations without having to rely the

least liquid current assets such as inventories and prepaid. These

assets do not meet the criterion of a liquid asset to be converted to

cash; (1) in relatively short time; and (2) without loosing its value.

Higher ratio is preferred, but ratio with less than 1.0 are not

uncommon and it should not cause an alarm.

QR = (Current assets - inventories – Prepaid) / Current Liabilities

X1 = (1,200 – 550) / 200 = 3.25x

X2 = (1,200 – 625) / 300 = 1.92x

Net working capital (NWC)

It is measured in Ringgits, and commonly accepted as the absolute

measure of the firm's liquidity or solvency. The net working capital

indicates the amount of current assets financed by equity or long-term

debt, and thus it provides the degree of margin of safety to short term

lenders and creditors. Higher Ringgits is desirable as it provides

greater margin of safety.


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NWC = Current Assets - Current Liabilities

X1 = 1,200 – 200 = RM1,000

X2 = 12,00 – 300 = RM 900

As previously mentioned, the study of the firm's liquidity must be done

judiciously as higher excessive liquidity is detrimental to the firm's

profitability. This is due to the fact that current assets are not

productive and only act as a support to day-today operations of the

firm. The best approach to analyze liquidity continuously to ensure

that the firm maintains a certain level of liquidity without subjecting to

unnecessary risks.

3.3.2 Leverage Ratios

The purpose of these ratios is to evaluate the firm's financial structure; (1) the

extent to which the firm is levered by debt; (2) the ability to service its debt;

and (3) the degree of financial risk inherent in the financial structure. As the

firm use credit facilities from any financial institution, it will have to pay fixed

obligations in the form of interest and principal payments.

Higher degree of indebtedness will results in higher risks as it indicates the

firm is subject to higher fixed-payment obligations, and will reduce taxable

income and thus profits. Inability to maintain sales and other operating

characteristics may increase financial risk as debt must be serviced

regardless of the firm's sales and profits.

As rule of thumb, higher risks are associated with higher return. With proper

use of debt or leverage, the firm is will be able to get more profits as; (1) the

cost of debt is cheaper, interest is tax-deductible; and (2) the firm finances its

activities with less equity, and any profits will be appropriated among a

relatively few stockholders. These will results in higher earning per share.


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Debt Ratio (DR)

This ratio measures the proportion of the firm's total debt to its total

assets. It indicates the amount of debt in the financial structure, and

thus higher percentage associated with higher risk. This ratio is

important to the creditors to analyze the long-term financial risk of the

company and relative credit risks before approval of the loan applied.

DR = Total debt / Total assets

X1 = 800 / 2,400 = 33.33%

X2 = 900 / 2,600 = 34.62%

Debt Equity Ratio (DER)

This ratio is quiet similar to debt ratio. It measures the amount of debt

being utilized relative to the capital provided by the owners. A ratio of

greater than 1.0 indicates that the firm used more debt than equity in

financing its activities, and the debt ratio is greater than 50 percent.

Higher ratio is less desirable as it indicates greater use of debt and

financial risk.

DER = Total debt / Tangible net worth

X1 = 800 / 1,600 = 0.50x

X2 = 900 / 1,700 = 0.53x

The tangible net worth in calculating DER represents net worth or total

equity minus intangible assets such as goodwill. What is total equity?

Usually total equity is the total value of common shares at par, paid-in

capital, and retained earnings. This deduction of intangible assets is

necessary to show actual funds provided by owners of the firm.

Time Interest Earned (TIE)

The time interest earned ratio or interest coverage ratio measures the

ability of the firm to pay the interest charges applied on the debts

used. It represents the margin by which the firm's EBIT can declines


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before the firm has trouble in meeting its interest obligations. Higher

ratio is desirable as it indicates higher margin of safety.

TIE = EBIT / Interest charges

X1 = 290 / 60 = 4.83x

X2 = 360 / 70 = 5.14x

3.3.3 Activity Ratios

The activity ratios look at the manager's: (1) effectiveness in managing the

firm's assets; and (2) efficiency in handling the firm's operations. In essence,

it indicates how efficient the manager uses the available resources in order to

generate sales and its contribution towards the achievement of the firm's goal;

to maximize the shareholders' wealth.

The analysis will look at the management of: (1) total assets; (2) fixed assets;

and (3) certain component of current assets. Other things being equal, higher

ratio is desirable as it indicates greater efficiency.

Average Collection Period (ACP)

This ratio is to determine the average length of time taken by the firm

to collect its debt, from the credit sales. It is used to appraise the firm's

account receivable that relates to firm's credit policy: (1) credit

standard; (2) credit terms; and (3) collection policy. Let assume from

this point onwards that all TM Amir's sales are on credit and 360 days

a year. If there is no information on credit sales, net sales figure can

be used as a replacement. Higher ACP is not desirable as it indicates

lower cash cycle and high cost of capital due to high investments in

accounts receivable.

ACP = (Accounts receivable x 360) / Credit sales

X1 = (450 x 360) / 1,200 = 135 days

X2 = (425 x 360) / 1,450 = 106 days

The same concept can be used to determine the average length of

time taken by the firm to pay its debt, from credit purchases or


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accounts payable. The measure is known as the average payment

period (APP) as follows:

APP = (Accounts payable x 360) / Credit purchases

Accounts receivable Turnover (ARTO)

The Accounts receivable turnover is the reciprocal of the average

collection period. Higher accounts receivable turnover indicates that:

(1) efficient receivable management with low average collection

period; and (2) funds "tied-up" in receivable are released for other

productive investment.

ARTO = 360 / Average Collection Period

X1 = 360 / 135 = 2.67x

X2 = 360 / 105 = 3.43x

Alternatively ARTO = Net sales / Accounts receivable

X1 = 1,200 / 450 = 2.67x

X2 = 1,450 / 425 = 3.43x

Inventory Turnover (ITO)

It is also known as inventory utilization ratio, and as a measure of how

effective the firm uses inventory to generate sales. Higher inventory

turnover is associated with higher risk of inability to meet production

and sales demand. It is however preferred because it represents: (1)

more efficient inventory management; (2) lower cost of investment in

inventories; and (3) a positive contribution the firm's profitability. If the

ratio is too low, it may indicate that the firm is holding excessive and

unproductive inventories or it has a very high sales service level to

avoid stock out. If information on cost of goods sold is not available,

net sales figure can be used as a replacement.

ITO = Cost of goods sold / Inventories

X1 = 700 / 550 = 1.27x

X2 = 850 / 625 = 1.36x


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Fixed Asset Turnover (FATO)

It is also known as fixed asset utilization ratio, and a measure of the

firm's efficiency in using its plant and machinery to generate goods or

products for sales. Higher ratio is desirable as it indicates the firm's

efficiency in generating sales from the available fixed assets and

greater payoff from capital investments. In interpreting the ratio,

cautions are necessary as normal fixed asset turnover varies

depending on the nature of the operations and the stage of the firm's

operations.

FATO = Net sales / Net fixed assets

X1 = 1,200 / 1,200 = 1.00x

X2 = 1,450 / 1,400 = 1.04x

Total Assets Turnover (TATO) It is also known as total asset utilization ratio, and as a measure the

firm's ability to manage all of its resources invested to generate sales.

Higher ratio is preferred as it indicates better efficiency in managing

the resources or the management control over its investments in

assets.

TATO = Net sales / Total assets

X1 = 1,200 / 2.400 = 0.50x

X2 = 1,450 / 2,600 = 0.53x

3.3.4 Profitability Ratios

The profitability ratios measure the relative success of the firm; that is the

combined effect of liquidity, activity, and leverage management on the firm's

overall operating results. Any decisions in the respective areas will result in

risk and return tradeoffs, and thus will directly influence the profitability of the

firm.

It relates to the firm's ability to obtain returns relative to sales, assets, and

equity. Higher ratio is preferred as it tends to satisfy and meet the


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expectations of all parties involved on the firm's operations that include

management team, employees, creditors, and stockholders. These will

promote the: (1) achievement of wealth maximization; (2) firm's ability to

attract outside capital; and (3) the firm's ability to sustain growth.

In analyzing the firm's profitability performance, all ratios must be considered

explicitly before any conclusions are made. Each ratio presented will try to

look at profitability at different angles, and the complete picture can be formed

after all ratios are analyzed.

Gross Profit Margin (GPM)

It measures the ability of the firm to control the variable cost

component or cost of goods sold in the firm. Higher ratio is desirable

as it indicates lower cost of goods sold relative to sales.

GPM = Gross profit / Net sales

X1 = 500 / 1,200 = 41.67%

X2 = 600 / 1,450 = 41.38%

Operating Profit Margin (OPM)

It is a measure of the operating profit (EBIT) relative to sales. In relate

to the firm's ability to control all costs except interest and taxes its

operations. Higher ratio is preferred as it indicates a lower cost

structure and will result in higher profits.

OPM = EBIT / Sales

X1 = 290 / 1,200 = 24.17%

X2 = 360 / 1,450 = 24.83%

Operating Ratio (OR)

This ratio is similar to OPM, except it looks at the costs not the profits.

It provides an indication of the management's control of its cost of

operations. It relates to the cost structure or amount of total operating


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expenses used to generate sales. Lower ratio is desirable as it

translates to better efficiency and higher profits can be expected.

OR = Total operating expenses / Net sales

X1 = (700 + 30 + 180) / 1,200 = 75.83%

X2 = (850 + 40 + 200) / 1,450 = 75.17%

Net Profit Margin (NPM)

This ratio measures the after-tax profit per Ringgit of sales. It is the

ability of the firm to generate the net income from its sales after

deducting all expenses including interest and taxes. Higher ratio is

better as it indicates higher ability of the firm to obtain profits for

distribution to the equity holders and internal source of financing to

support normal growth.

NPM = Net income / Net sales

X1 = 138 / 1,200 = 11.50%

X2 = 174 / 1,450 = 12.00%

Return on Equity (ROE)

This ratio measures the common shareholders' rate of return on their

investment in the company that is by looking at profitability of the firm

relative to common equity. Higher ratio id desirable as it indicates

higher annual payoff to investors.

ROE = (Net income – Preferred stock dividend) / (Net worth –

preferred stock)

X1 = (138 – 7) / (1,600 – 100) = 8.73%

X2 = (174 – 7) / (1,700 – 100) = 10.44%

Return on Asset (ROA)

It is also known as return on investment, and is a measure the firm's

ability to generate net income relative to total assets employed in its

operations. In essence, it shows the net result of the firm's investment


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decisions on liquidity and the utilization of all assets to generate sales

and hence profits. Higher ratio is preferred as it will be able to

maintain growth and attract outside capital.

ROA = Net income / Total assets

X1 = 138 / 2,400 = 5.75%

X2 = 174 / 2,600 = 6.69%

3.3.5 Market Ratios

This set of ratios is important to publicly traded firms as they are used in stock

valuation process that is in deciding securities for investment portfolio. Similar

to profitability, these ratios depend on the performance of the firm in

managing liquidity, activity, and leverage positions. The results of the firm's

operations are reflected in the market price of the firm's share. Management

continuously monitors the price movements in the market to provide insights

on the investors' approvals and perceptions of the company's actions.

The feedback will provide the necessary information for controlling and

planning purposes, to ensure that the firm is moving in line towards the

achievement of wealth maximization.

Earnings Per Share (EPS)

This ratio measures the amount of earnings available to common

stockholders per share of common stock held. Under normal

circumstances, higher earnings lead to higher dividend being paid out

to stockholders. This consequently leads to higher market price of the

company's stock in the market place.

EPS = (Net income - preferred stock dividend) / Outstanding

common shares

X1 = (138 – 7) / 300 = RM0.4367

X2 = (174 – 7) / 300 = RM0.5567


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Dividend per Share (DPS)

It shows the amount of current earnings paid out on per share basis to

common stockholders. The amount paid dependent on the

management discretion after considering the financial needs of the

firm and the dividend policy. Higher value reflects higher dividends

received per share of common stock.

DPS = Cash dividend to common stockholders / Outstanding

common shares

X1 = 31 / 300 = RM0.1033

X2 = 67 / 300 = RM0.2233

Dividend Payout Ratio (DPR)

It indicates the amount of current earnings available to common

stockholders paid-out as dividend. The ratio will depend on the

company's dividend policy and its dependence on internally generated

funds to support growth. The investors prefer higher ratio and it

indicates that the firm either in less need for financing or it relies

heavily on external financing to support growth.

DPR = Cash dividend to common stockholders / (Net income –

Preferred dividends)

X1 = 31 / (138 – 7) = 23.70%

X2 = 67 / (174 – 7) = 40.12%

Another ratio related to DPR is the retention rate (RR). It measures

the ratio of earnings available to common stockholders that are

retained in the firm as stockholders' reinvestment. It is calculated as 1

minus DPR. For example:

RR = 1 – DPR

X1 = 1 – 0.2370 = 76.30%

X2 = 1 – 0.4012 = 59.88%


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Dividend Yield (DY)

It is also known as current yield, and it is a measure of current rate of

return earned by investors’ per share basis from their investments. At

any given time, investors will earn income from dividends and capital

gains. Other things equal, higher dividend yield tends to depress the

market price of the firm's shares.

DY = Dividends per share / Market price of a share

X1 = 0.1033 / 2.00 = 5.17%

X2 = 0.2233 / 2.20 = 10.15%

Book values Per Share (BVPS)

It indicates the value of equity for each share of common stock. The

value of intangible is excluded in the calculations. This is the

accounting book value and does not reflect the true value of the firm.

The market price of the shares is normally above the BVPS in the long

run.

BVPS = Tangible net worth / Number of common shares outstanding

X1 = 1,600 / 300 = RM5.33

X2 = 1,700 / 300 = RM5.67

Price Earnings Ratio (PER)

This ratio shows the relationship between the market price of the

company's share and earnings per share. It indicates the investors'

preference of the company's share in respect to the earnings

available; that is how much the investors are willing to pay for each

dollar of profits generates by the company.

PER = Market price per share / Earnings per share

X1 = 2.00 / 0.4367 = 4.58x

X2 = 2.20 / 0.5567 = 3.95x

Ratios calculated by individually have little meanings. Proper analysis

in trying to understand and interpret the overall ratios is crucial to


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provide the necessary information to assess the firm's developing

trends, strengths and weaknesses.

3.3.6 Uses of Financial Ratios

All the ratios are worthless without proper and correct interpretation and

analysis. It is more crucial to understand the concepts and rational behind the

data than to master the calculations. There are two ways to interpret the

ratios beside the interpretations of its meaning individually:

1. Trend analysis. The trend analysis or historical standards employ a

time series approach to measure the firm's performance over time.

Proper analysis requires at least three to five years of data to assess

the performance with relative accuracy. From the trends developed,

the performance of the firm whether is improving or declining can be

observed as shown in Figure 3-1.

Figure 3.1 Sample Graph for Trend Analysis

2. Comparative analysis. The comparative analysis or industry

standards are a cross-sectional approach that measures the firm's

performance to the industry average or other companies within the

same time frame.

a. Other companies. In this study, a firm's ratios are compared

to another firm's ratios or its competitor. The other company

must be in the same size and nature of business as well as the

target market.

5

6

4

0

1

2

3

4

5

6

7

1 9 X 0 1 9 X 1 1 9 X 2

Y e a r

Cur

rent

ratio

S e rie s 1


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b. Industry average index. This index contains the average

ratios among the companies in a specific industry. By

comparing the firm's ratios and the industry average index, the

firm can assess its performance in relative to other companies

in the industry.

The most common approach is by comparing with industry average index.

Average index is the compilation of all relevant ratios of the companies in a

particular industry. Figure 3.2 shows how industry average index is

determined; that is the median data of the companies involved.

Figure 3.2 Industry Average Ranking Current ratio 3.1 1.2 0.6 25% 25% 25% 25% High . . . . . Low

To illustrate the basic ratio analysis, Table 3.6 provides a summary

performance for TM Amir Products for 19X1 and 19X2, with appropriate

industry index for 19X2. From the data presented, the following analysis can

be made:


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Table 3-6 TM Amir Products: Ratio Analysis for 19X2

INDUSTRY FIRM EVALUATIONS

RATIOS INDEX 19X2 19X1 19X2 COMP TREND Liquidity Current ratio 1.20 6.00 4.00 + –

Quick ratio 0.80 3.25 1.92 + –

Net working capital – RM1000 RM900 NA –

Activity Avg. collection period 47 days 135 days 106 days – +

Inventory turnover 6.00 1.27 1.36 – +

Total assets turnover 1.20 0.50 0.56 – +

Fixed assets turnover 1.50 1.00 1.04 – +

Leverage Debt ratio 44.50% 33.33% 34.50% + –

Debt equity ratio 0.80 0.50 0.53 + –

Time interest earned 7.00 4.83 5.14 – +

Profitability Gross Profit Margin – 41.67% 41.38% NA –

Net profit margin 5.00% 11.50% 12.00% + +

Operating ratio 90.00% 75.83% 75.17% + +

Return on asset 6.00% 5.75% 6.69% – +

Return on equity 14.00% 8.73% 10.44% – +

Market Earnings per share – RM0.4367 RM0.5567 NA +

Dividend per share – RM0.1033 RM0.2233 NA +

Dividend payout ratio 50.00% 23.70% 40.12% NA +

Book value per share – RM5.33 RM5.67 NA +

Price earnings ratio 11.00 4.55 3.93 – –

Dividend yield 4.00% 5.17% 10.15% + +

Where : + increase, – decrease, 0 same, and NA mean not applicable

: COMP (Comparative analysis) and TREND (Trend analysis)


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Liquidity

The firm's ability to meet short-term obligations tends to decrease in

19X2 compared to 19X1, as all of the liquidity ratios declined. This

decline does not represent a threat to the firm's solvency, as its ability

is more than double that of the industry indexes. In essence, the firm

holds too much of liquid assets on hand and poses too much liquidity

that relates to low risk of insolvency, and low expected returns. Thus,

the decline indicates an improvement in an attempt to reduce

investments in less productive assets, to fixed assets that can

translate to higher profitability.

Activity

The firm's ability to manage assets effectively and efficiently tends to

improve for 19X2, that could results in higher profits. Compared to the

industry indexes, however, the firm's performance is not at par as that

of the average firms in the industry. The firm is under utilizing its

assets to generate sales, and thus relatively low profits compared to

its full potentials.

Leverage

For 19X2, the firms increase its debt in financial structure and do not

cause an alarm, as the ratio is relatively low. It does not pose much

pressure on financial risk. Even with the increase in debt ratio, the

firm's ability to service its debt tends to increase due to higher

earnings before tax from operations. The firm's propensity to use debt

is lower than the industry average. This represent the opportunity for

the firm to utilize leverage in future financing as it could improves the

profitability of the firm due to lower cost of debt financing and stable

number of common shares outstanding.


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Profitability

From operations, the firm manages to improve its profitability as

shown an increase in all profitability ratios except for net profit margin.

The firm is able to maintain its profits even with the increase in cost of

goods sold due to the decrease in overall cost of operations and better

management of the firm's resources as indicates earlier in liquidity,

activity and leverage ratios.

Market

The firm manages to provide more earnings to stockholders and has

increased dividend payment. Consequently, the price earnings ratio

declines due to decreasing in shares' prices. This leads to the

increase in dividend yield. In addition, in 19X2, the management tends

to reduce its dependency on internally generated funds to finance its

operations.

In conclusion, investors view that the firm has a relatively high risk.

Investors are not willing to hold the firm's shares as shown in a low

price earnings' ratio and a lower market price relative to its book value

per share. Therefore, the firm needs to improve its overall

management to be able to compete, sustain growth, increase market

acceptance, and to ensure its viability in the long run. The above

analysis provides some insights on how horizontal analysis

uncovers information to aids decision-making. It involves the

comparison of the same ratio historically and/or to the industry

standards.

Another method to analyze the ratios is by using vertical analysis.

Unlike the horizontal analysis, it involves in depth study of cause and

effect relationships that exist in different ratios at a given point in time,

that is other ratio(s) can support a condition suggested by one ratio.

For example, the relationships that exist in the current ratio and quick

ratio, and the inventory turnover as discussed in the preceding

paragraphs. The differences between current ratio and quick ratio

reflect the effectiveness of the firm's management of its inventories.

The findings, then, supported by the inventory turnover ratio.


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3.3.7 Limitations of Financial Ratios

Ratio analysis is very important to financial managers to uncover trends,

strengths, and weaknesses. This will enable managers to take appropriate

actions to correct any deficiencies and/or to enhance any strength to ensure

the achievement of the firm's goal to maximize owners' wealth. Although ratio

analysis is important, it has some drawbacks especially when using industry

average index.

Non-Comparative Data

Sometimes it is difficult to identify the industry category a particular

company is belonging to. The reason behind it is the diversification

practiced by many companies in the market place. Thus, it is difficult

to find a company that involves in only one type of business can be

classified purely as within a particular industry.

Different Accounting Treatments

There are certain items in the financial statements are not consistent

from one firm to another due to differences in accounting system. A

firm might use LIFO or FIFO in inventories' management and different

depreciation method in preparing the income statement and balance

sheet.

Unreliable Figures

Publicly published financial figures are not reliable source of financial

data. For example, the figures published may overstate the real figure

to please the investors and show of good financial conditions of the

company. The practice of "window dressing" may result in hypothetical

figures so that the company will look good in the eyes the investors; A

profitable company might have zero amount of cash in the bank due to

large portion of sales is being made in credit.

Given the present of several constrains; the interpretation of ratio

analysis must be made judiciously. In addition, the question of the


56 | P a g e

stage where the firm is operating at is crucial as new newly

established companies are not as stable as the companies that are in

the industry for quite sometimes. For example, a company that is in

the development stage might incur heavy debts with low liquidity. This

does not mean that the company is in a very bad shape. Therefore,

ratio analyst must take a cautious and judicious approach to

avoid any misinterpretation of results gathered.


57 | P a g e

QUESTION 1

You are required by your manager to make a trend analysis of Wira Manufacturing

Company’s financial position to be presented at the forthcoming Board meeting. You

are given the following data for your analysis :

WIRA MANUFACTURING COMPANY, Balance Sheet as at :

(in thousands RM)

ASSETS December 31, 2001

Cash and cash equivalents 178

Accounts receivable 678

Inventories, at lower of cost or market 1329

Prepaid expenses 21

Accumulated tax prepayments 35

Current assets 2241

Fixed assets at cost 1596

Less : Accumulated depreciation (857)

Net fixed assets 739

Investment, long term 65

Other assets, long term 205

Total assets 3250


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LIABILITIES AND SHAREHOLDER’S EQUITY

Bank loans and notes payable 448

Accounts payable 148

Accured taxes 36

Other accured liabilities 191

Current liabilities 823

Long-term debt 631

Shareholder’s equity

Common stock, RM1 par value 421

Additional paid-in capital 361

Retained earnings 1014

Total shareholders’ equity 1796

Total liabilities and shareholders’ equity 3250

WIRA MANUFACTURING COMPANY, Income Statement for Year Ending: (in thousands RM)

December 31, 2001

Net sales 3992

Cost of goods sold 2680

Gross profit 1312

Selling, general, and administrative expenses 912

Earnings before interest and taxes 400

Interest expense 85

Earnings before taxes 315

Income taxes 114

Earnings after taxes 201


59 | P a g e

Industry average ratios: Current ratio 2.10

Quick ratio 1.10

Inventory turnover 3.30

Average collection period 45 days

Debt-equity ratio 80%

Times interest earned ratio 4.0

Gross profit margin 23.8%

Net profit margin 4.7%

Return on total assets 7.8%

Return on equity 14.04%

a) Calculate the relevant financial ratios of Wira Manufacturing Company for the year

2001.

(12.5 marks)

b) Briefly summarize your trend analysis for the company’s liquidity, activity, profitability

and leverage.

(7.5 marks)

(Total : 20 marks)


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QUESTION 2

Below are the financial statements of Puncak Ilmu Sdn Bhd for the financial year

ending 2002.

Puncak Ilmu Company’s Balance Sheet December 31, 2002

RM RM

Cash 240,000 Accounts payable 380,000

Accounts Recievables 320,000 Notes payable 420,000

Inventory 1,040,000 Other current liabilities

50,000

Total current 1,600,000 Total current liabilities 850,000

Net plant and equipment 800,000 Long-term debt 800,000

Stockholder’s equity 750,000

Total liabilities and

Total assets 2,400,000 stockholders’ equity 2,400,000 ======== ========


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Income Statement For the Year Ending December 31, 2002

RM RM

Sales Revenue 3,000,000

Cost of goods sold (1,800,000)

Gross profit 1,200,000

Selling, general and administrative expenses (860,000)

Earnings before interest and taxes 340,000

Interest:

Notes 37,800

Long-term debt 80,000 Total interest charges (117,800)

Earnings before taxes 222,200

Income tax (88,880)

Earnings after taxes 133,320 ========

Industry Averages

Current ratio 2.5 times

Quick ratio 1.1 times

Average collection period 28 days

Inventory turnover 2.4 times

Total asset turbover ratio 1.4 times

Times interest earned ratio 3.5 times

Debt – equity ratio 1.8 times

Long – term debt ratio 0.48 times

Gross profit margin 3.7 percent

Net profit margin 5 percent

Return on total assets 6.2 percent

Return on equity 19 percent

a) Calculate each of the above ratios, margin, returns and turnovers for Puncak Ilmu. b) Based on your answers in (a), analyse Puncak Ilmu’s financial situations in terms of

liquidity, activity, debt and profitability ratio.


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finance management fin420 chp 3

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