This document provides an overview of financial statement analysis techniques including various types of ratios that can be used to analyze a company's profitability, liquidity, efficiency, and capital structure. It defines key ratios such as return on capital employed, gross profit margin, current ratio, inventory turnover, earnings per share, and others. It explains how to calculate these ratios using elements of the income statement and balance sheet and discusses how various stakeholders use ratio analysis to evaluate company performance.

1. CHAPTER 2 ANALYSIS
OF FINANCIAL
STATEMENT
BAF2023 FFM

2. Learning Outcomes
 Explain the use of ratios can help to analyze
the profitability, liquidity, efficiency and capital
structure of business
 Calculate main accounting ratios
 Interpret the results of calculating accounting
ratios
 Explain the investors’ choice in choosing
between shares and debentures
 Explain trend analysis
 Explain limitations of accounting statements

3. Topic Outlines
Profitability Ratios
 1 Return on Capital Employed
(ROCE)
 2 Gross Profit Margin
 3 Net Profit Margin
 4 Return on Assets
 5 Return on Equity
Liquidity Ratios
 1 Current Ratio
 2 Quick Ratio/ Acid Test Ratio
 3 Times Interest Earned Ratio
Efficiency Ratios
 1 Inventory Turnover Ratio
 2 Accounts Receivable Turnover
Ratio
 3 Day Sales Outstanding
 4 Accounts Payable Turnover Ratio
 5 Asset Turnover Ratio
Shareholder Ratios
 1 Earnings per share
 2 Price/Earnings Ratio (P/E)
 3 Dividend Yield
Capital Structure Ratios
 1 Gearing Ratio

4. Users of Ratio
• Shareholders, management, employees,
creditors, competitors, potential investors
Profitability
• Shareholders, suppliers, creditors,
competitors
Liquidity
• Shareholders, potential purchasers,
competitors
Efficiency
• Shareholders, potential investors
Shareholder
• Shareholders, lenders, creditors, potential
investors
Capital structure

6. Name of Business
Income Statement for the year ended 31 December 20xx
Sales xxx
Less: COGS
Add Beginning Inventory xx
Add Purchases xx
Less Closing stocks (xx)
COGS (xxx)
Gross Profit/(loss) xxx
Less: Operating Expenses
Utilities xx
Stationaries xx
Rental xx
Insurance xx
Salary / Wages xx
Office Expenses xx
Total Operating Expenses (xxx)
Net Profit/(loss) xxx

7. Why use Ratio?
 Ratio analysis is a useful management tool
that will improve your understanding of
financial results and trends over time, and
provide key indicators of organizational
performance. Managers will use ratio
analysis to pinpoint strengths and
weaknesses from which strategies and
initiatives can be formed.

8. Why use Ratio?
 Company A
 2017
 Profit = RM25,000
 2018
 Profit = RM49,000
 Company B
 2017
 Profit = RM1,675,000
 2018
 Profit = RM1,839,500
Which is a better company?
a) Performance
b) Value
c) Size

9. Profitability Ratio
Financial metrics that are used to assess a
business’s ability to generate earnings as
compared to its expenses and other relevant
costs incurred during a specific period of
time.
Most of these ratios, having higher value
relative to a competitor’s ratio or the same
ratio from a previous period is indicative that
the company is doing well.
How many example of ratio will be covered?

10. Return on Capital Employed
Measures a company’s profitability and the efficiency with
which its capital is employed
Capital employed is the sum shareholders’ equity and debt
liabilities (Total Assets – Current Liabilities)
Often calculated based on ‘Average Capital Employed’ which
takes the average of opening and closing capital employed
for the time period
Higher ROCE indicates more efficient use of capital ( should
be higher than the company’s capital cost, otherwise it
indicates that the company is not employing its capital
effectively and is not generating shareholder value)
 Earnings Before Interest and Tax (EBIT) / Capital
Employed

11. Gross/Net Profit margin
Is the percentage of revenue after expenses have been
deducted from sales
Measurement reveals the amount of profit that a business
can extract from its total sales
Intended to be a measure of the overall success of a
business
A high profit margin indicates business is pricing its products
correctly and is exercising good cost control
 Gross Profit or Net Profit / Sales

12. Return on Assets
Measures the net income produced by total assets during a
period by comparing net income to the average total assets
Measures how efficiently a company can manage its assets
to produce profits during a period
Measure how effectively a company can turn earn a return on
its investment in assets
Shows how efficiently a company can convert the money
used to purchase assets into net income or profits
 Net Profit/ Total Assets

13. Return on Equity
Measures the ability of a firm to generate profits from its
shareholders investments in the company
Shows how much profit each dollar of common stockholders’
equity generates
Show how effective management is at using equity financing
( money from shareholders) to fund operations and grow the
company
Higher ROE indicates the company is using its investors'’
fund effectively
 Net Income/ Equity

14. Liquidity Ratios
Determine a company’s ability to pay off its short-term debts
obligations
The higher the value of the ratio, the larger the margin of
safety that the company possesses to cover short-term debts
Analyze the ability of a company to pay off both its current
liabilities as they become due as well as their long term
liabilities as they become current
Show cash levels of a company and ability to turn other
assets into cash to pay off liabilities and other current
obligations
 How many ratios will be covered?

16. Current ratio
Measures a firm’s ability to pay off its short term liabilities
with its current assets
Companies with larger amounts of current assets will easily
pay off current liabilities when they become due without
having to sell long-term, revenue generating assets
Help investors and creditors understand the liquidity of a
company and how easily that a company will be able to pay
off its current liabilities
A higher current ratio more favorable than a lower current
ratio because it shows the company can easily pay current
debt
 Current Assets / Current Liabilities

17. Quick ratio/ Acid Test ratio
Ability of a company to pay its current liabilities when
they come due with only quick assets
Quick assets are current assets that can be converted
to cash within 90 days or in the short term (cash, cash
equivalents, short term investments or marketable
securities and current account receivables)
Higher quick ratios more favorable because it shows
there are more quick assets than current liabilities
Current Assets – Inventory / Current Liabilities

18. Times Interest Earned ratio
Also known as interest coverage ratio
Measures the proportionate amount of income that can be
used to cover interest expenses in the future
Measures a firm’s ability to make interest and debt service
payments
Interest expenses considered to be fixed expenses, if the
company can’t make the payments, it could go bankrupt and
cease to exist
Ratio indicates how many times a company could pay the
interest with its before tax income, so larger ratios are
considered more favorable than smaller ratios
 Earning before Tax and Interest/ Interest

19. Efficiency Ratio
 measure a company's ability to use its assets
and manage its liabilities effectively.

20. Inventory turnover ratio
Show how effectively inventory is managed by
comparing cost of goods sold with average
inventory for a period
Measures how many times average inventory is
turned or sold during a period
Measures how many times a company sold its
total average inventory dollar amount during the
year
Cost of Good sold / Inventory

21. Account receivables turnover
ratio
Measures how many times a business can turn its
accounts receivable into cash during the period
How many times a business can collect its average
accounts receivables during the year
Show how efficient a company is collecting its credit
sales from customers
Higher efficiency is favorable from a cash flow ( the
sooner the company collect cash from customer, it will
be able to pay bills and other obligations sooner)
 Sales /Average Account receivables

22. Days Sales Outstanding
 Average collection period or days’ sales in receivables
 Measures the number of days it takes a company to collect cash
from its credit sales
 Shows the liquidity and efficiency of a company’s collections
department
 Shows how well a company can collect cash from its customers
 The sooner cash can be collected, the sooner this cash can be
used for other operations
 Lower ratio is more favorable because it means companies collect
cash earlier from customers
 365 days / Receivable Turnover ratio

23. Account payable turnover ratio
Shows a company’s ability to pay off its accounts
payable by comparing net credit purchases to the
average accounts payable during a period
Show how many times a company can pay off its
average accounts payable balance during the course
of a year
It is used by suppliers and creditors to help decide
whether or not to grant credit to business
A higher ratio shows suppliers and creditors that the
company pays its bills frequently and regularly
Purchase / Average account payable

24. Asset turnover ratio
 The asset turnover ratio is an efficiency ratio that
measures a company’s ability to generate sales from its
assets by comparing net sales with average total assets.
 In other words, this ratio shows how efficiently a
company can use its assets to generate sales.
 The total asset turnover ratio calculates net sales as a
percentage of assets to show how many sales are
generated from each dollar of company assets. For
instance, a ratio of .5 means that each dollar of assets
generates 50 cents of sales.
 Sales / total assets

25. Shareholder Ratio
 The shareholder equity ratio determines how
much shareholders would receive in the event
of a company-wide liquidation.
 The ratio, expressed as a percentage, is
calculated by dividing total shareholders'
equity by total assets of the firm, and it
represents the amount of assets on which
shareholders have a residual claim.

26. Earning per share
Also known as net income per share
Measures the amount of net income earned per
share of stock outstanding
Shows how profitable a company is on a shareholders
basis
Higher EPS us always better than a lower ratio
because this means the company is more profitable (
company has more profits to distribute to its
shareholders)
Higher EPS often makes the stock price of a company
rise

27. Price Earning ratio
Is a market prospect ratio that calculates the market value of
a stock relative to its earnings by comparing the market price
per share by the earnings per share
Shows what the market is willing to pay for a stock based on
its current earnings
Evaluate what a stock’s fair market value by predicting future
earnings per share (higher future earnings are expected to
issue higher dividends)
Company with higher P/E ratio indicated positive future
performance and investors are willing to pay more for this
company’s shares
Price per share / earning per share

28. Dividend Yield
Measures the amount of cash dividends distributed to
common shareholders to the market value per share
Used by investors to show how their investment in
stock is generating either cash flows in the form of
dividends or increases in asset value by stock
appreciation
Investors want to know how much dividends they are
getting for every dollar that the stock is worth
Company with high dividend yield pay its investors a
large dividend compared to the fair market value of
the stock

29. Capital Structure
Capital structure is how a firm finances its overall
operations and growth by using different sources
of funds
Debt comes in the form of bond issues or long
term notes payable, while equity is classified as
common stock, preferred stock or retained
earnings
Short term debt such as working capital
requirements also considered to be part of the
capital structure

30. Gearing ratio
Measures the proportion of a company’s borrowed funds to
its equity
Indicates the financial risk to which a business is subjected,
since excessive debt can lead to financial difficulties
A high gearing ratio represents a high proportion of debt to
equity (great deal of leverage, where company is using debt
to pay for its continuing operations)
A low gearing ratio may be indicative of conservative financial
management, but also mean a company is located in a high
cyclical industry
 Long term liabilities / capital employed

31. Choosing between shares and
debentures
 Lower Risk
 Debenture holders have their interest paid to them whether or not
profits are made
 If there is insufficient cash funds available to pay debenture
dividends, many debentures give their holders the right to sell of
some or all of the assets of the company, to recoup the amount of
their debentures before anyone else has a claim
 Ranks above the shares of that same company
 Medium Risk
 Preference shareholders have their dividends paid after the
debenture interest has been paid, but before the ordinary
shareholders
 Still dependent upon the profits being available for distribution
 Highest Risk
 Ordinary shareholders ( must give way to both debenture holders and
to preference shares for interest and dividends)
 Ordinary shareholders ( must give way to both debenture holders and
to preference shares for interest and dividends)
 However, should the remaining profits for distribution be very high
then they may get a high return on their money

32. Trend Analysis
One of the tools for the analysis of the company’s
monetary statements for the investment purposes
To determine the financial position of the business
The financial statements of the company are compared
with each other for several years after converted into
percentage form in order to compare them with each
other
Trend analysis percentage = (figure of the previous
period- figure of the current period) / total both figures
If the current-year percentages were greater than
previous year percentage (current-year result is better

33. Limitation of Accounting
statement
Impossible to sensibly compare two businesses which are
completely unlike one another
Compare a supermarket’s figures with those of a
chemical factory would be rather pointless
A lot of other factors that the past-focused financial
statements do not disclose
Desire to keep money measurement concept, objectives
will exclude great deal of desirable information

34. Comparative ratios and
benchmarking
Comparisons –a company’s ratios are
compared with those of other firms in the
same industry, that is, to industry average
figures.
Benchmarking –compare ratios with
those a smaller set of leading companies

35. END OF
CHAPTERS
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