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 companys 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 firms short-term
investment in financial securities. These are near cash item
and part of the firms 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 firms 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
Depreciation
a
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 Expenditures
b
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 asset
1
- Net fixed asset
0
+Depreciation
1

=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
Depreciation
a
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 Expenditures
b
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 =NWC
1
NWC
0

=(CA
1
CL
1
) - (CA
0
CL
0
)
=(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
19X0 19X1 19X2
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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

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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.


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QUESTION 1

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

Bank loans and notes payable 448
Accounts payable 148
Accured taxes 36
Other accured liabilities 191
Current liabilities 823
Long-term debt 631
Shareholders 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


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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 companys 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 Companys 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
Stockholders 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 Ilmus financial situations in terms of
liquidity, activity, debt and profitability ratio.

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FINANCE MANAGEMENT FIN420 CHP 3

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Financial Analysis Chapter 3

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