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University of Libya BETC

Analysis of Financial Statements.

Analysis of financial statement is one of the


most common techniques of financial analysis,
in
which the financial performance and financial
health of a company are analyzed based on its
past
performance.`
Financial statement analysis is the process of
examining relationships among financial
statement
elements and making comparisons with
relevant information.

Prepared by: Muhammad akhtar


University of Libya BETC

Difference in Focus

Financial Statements are prepared by


financial accountants with a certain
perspective,
however the financial managers—the
end users of these financial statements,
have a different focus to
draw meaningful conclusions out of
these statements. These differences are
listed below

Prepared by: Muhammad akhtar


University of Libya BETC

Financial Accounting (FA) Focus:

• Use Historical Value (assets are


booked at original purchase price)
• Follow Accrual Principle (calculate Net
Income based on accrued expense and
accrued
revenue)
• How to most logically, clearly, and
completely represent the financial data.

Prepared by: Muhammad akhtar


University of Libya BETC

Accrual Concept
The income accruing to the owner of a business is not
necessarily the amount of cash actually received in a
period of account. Many difficult problems arise in
deciding how much income has actually accrued in any
period. Accrual of income is always measured over a
period of time which is normally the accounting year.
Expenses are costs incurred in earning revenues.
Those expenditures which may be charged against
revenues for a period will be considered as operating
expenses. The Accrual concept is applied both in
ascertaining the revenues for a period and in
ascertaining the expenses to be charged against the
revenues.

Prepared by: Muhammad akhtar


University of Libya BETC

Financial Management (FM) Focus:

Use Market Value (assets are valued at


current market price)
• Follow Incremental Cash Flows because an
Asset’s (and a Company’s) Value is
determined by the cash flows that it
generates.
• How to pick the best assets and liabilities
portfolios in order to maximize shareholder
wealth.

Prepared by: Muhammad akhtar


University of Libya BETC

Sources of Information Used for Comparison

Company’s past years financial statements


and forecast of results.
Information from credit agencies on other
companies in the same industries.
Information from trade association on the
industries average figures.
Notes to the financial statements also
provide additional information that may
greatly influence one’s judgment about the
future potential of the company.

Prepared by: Muhammad akhtar


University of Libya BETC

Classification of Accounting Ratios

Accounting ratios may be classified as


follows:
¨ Liquidity ratios
¨ Profitability ratios
¨ Efficiency ratios
¨ Investment ratios

Prepared by: Muhammad akhtar


University of Libya BETC

Liquidity Ratios or Working capital Ratio.


The liquidity ratios measure the firm’s abilities
to pay its debts as they fall due.
The following ratios provide an indication of the
firm’s liquidity position.
¨ Current ratio
¨ Quick Asset ratio
Current ratio = Current Assets/Current
Liabilities
Quick ratio (Asset test ratio) =Current Assets-
inventory/Current liabilities

Prepared by: Muhammad akhtar


University of Libya BETC

Current Ratio:
Current ratio: is a ratio between current assets and
liabilities, which tells that for every
dollar in current liabilities, how many current assets do
the company possess. Since the current
liabilities are usually paid out of current assets, it makes
sense to compare the two figures to assess the
liquidity of the firm. Liquidity implies the ease with which
the current liabilities can be paid off.
Generally, the higher the ratio, the better it is considered,
but too high a ratio may imply less productive
use of current assets. A ratio of two to one (2:1) is
considered ideal.
= Current Assets / Current Liabilities

Prepared by: Muhammad akhtar


University of Libya BETC

Quick Ratio / Acid Test ratio


Quick/Acid Test ratio: Quick ratio is relatively a stringent
measure of liquidity. The ratio is obtained
by subtracting inventory from current assets and dividing
the result by current liabilities. Inventory is
the least liquid of all current assets. By subtracting
inventory from current assets, we are actually
comparing more liquid assets with current liabilities. This
ratio not only helps in gauging the solvency
of the company, it may also show if the inventories are
piling up. A desirable quick ratio can range from
(0.8:1) to (1.5:1) depending on the nature of the
business.
= (Current Assets – Inventory) / Current Liabilities

Prepared by: Muhammad akhtar


University of Libya BETC

Question
Using the following information, you are required to calculate the
following:
A .Working Capital.
b. Working capital ratio.
c. Acid test ratio.
Year 8 Year 9
$ $
Stock 40,000 50,000
Debtors 10,000 12,000
Bank and Cash balances 5,000 3,000
Creditors 20,000 40,000

Prepared by: Muhammad akhtar


University of Libya BETC

Question
Using the following information, you are required to calculate the following:
A .Working Capital.
b. Working capital ratio.
c. Acid test ratio.

a. Working Capital Year 8 Year 9


Current Asset-Current Liabilities 55000-20000=35000 65000-40000=25000

b. Working Capital Ratio 55000 : 20000 65000 : 40000


Current Asset /Current 2.75 :1 1.62 : 1
Liability
CA : CL

C. Acid test ratio: Quick 15000 : 20000 15000 : 40000


Asset:Current Liabilities
0.75 : 1 0.37 : 1
Quick Assets=Current Assets-
Stock

Prepared by: Muhammad akhtar


University of Libya BETC

Working Capital Ratio


b.This ratio aims to test the liquidity of the business. That is ability to pay
immediate debts out of current asset.
A good rate is at least 2: 1 ( 2 Current Assets to pay 1 Current liability)
In year 8, the liquidity is healthy but this could not be sustained in year 9, Where
the ratio has weaken.
C. Acid test ratio: There is insufficient liquid resources to pay current liabilites
A good ratio is a least 1: 1
In both years the ratios are below the minimum rate.

Prepared by: Muhammad akhtar


University of Libya BETC

Profitability Ratios
These ratios may be classified as follows:
Ratios that measure the returns on the firm’s
sales.
¨ Gross Profit margin
¨ Net Profit margin
Ratios that measure the returns on the firm’s
capital employed.
¨ Return on shareholder’s fund
¨ Return on equity fund

Prepared by: Muhammad akhtar


University of Libya BETC

Profitability Ratios
Ratios that measure the returns on the firm’s sales.

Gross profit Margin= Gross profit/Net sales x100

Net Profit Margin = Net profit before Tax/net sales x100

Ratios that measure the returns on the firm’s capital employed.

Return on shareholder’s fund:

Return on equity fund: Net profit after tax less preference


dividend/ Ordinary Share Capital + Reserves

Prepared by: Muhammad akhtar


University of Libya BETC

Efficiency Ratios

These ratios measure the management’s


abilities to control the resources efficiently
and effectively.
¨ Stock Turnover
¨ Debtors Turnover
¨ Creditors Turnover
¨ Fixed asset to sales ratios

Prepared by: Muhammad akhtar


University of Libya BETC

Efficiency Ratios

Stock Turnover = Cost of Goods Sold/Average stock

Debtors Turnover = Debtors/Credit Sales x 365

Creditors Turnover=

Fixed Asset to sales Ratio= Sales /Fixed Assets

Prepared by: Muhammad akhtar


University of Libya BETC

Investment Ratios
These Ratios are useful to users of financial statements in
making investment decisions.
1. Earning per share.
2. Price Earning ratio.
3. gearing.
4. Dividend yield.
5. Dividend cover.

Prepared by: Muhammad akhtar


University of Libya BETC

Earning Per Share


Earnings per share: Net profit available for equity shareholders/Number of Equity
shares.

Example.

Monica Plc has equity share capital consisting of 250,000 ordinary shares $1 each,
all ranking for dividend. Its after-tax profits available to equity holders total
$125,000. What is the figure for EPS?

Solution:

EPS = Net earnings


No of ordinary shares
ranking for dividend

= $125,000 = $0.50
250,000

Prepared by: Muhammad akhtar


University of Libya BETC

Price Earning Ratio

Exercise .

From Exercise Pervious , Monica’s shares stand at $4.50 each in


the market. What is the price earnings ratio?

Solution

P/E = Market price of one ordinary share


E.P.S
= $4.50
$0.50
= 9

Prepared by: Muhammad akhtar


University of Libya BETC

Gearing
Gearing is a measure of Financial Leverage, demonstrating the
degree to which a firm’s activities are funded by owner’s funds
verses creditor’s funds.
The higher a company’s degree of leverage
the more the company is considered risky

Financial Leverage:FL is the degree or extent to which a


company’s total capital is composed of debt. So a company with
80% debt is highly leveraged.
Gearing:Debt/Equity Ratio = (Total Liabilities) / (Shareholders
Equity). This is also known as Risk or
Gearing, the extent to which a company is financed by borrowed
funds; for example, if a company is
highly geared, it borrows a lot.

Prepared by: Muhammad akhtar


University of Libya BETC

Dividend yield
Dividend Yield
Some stockholders invest primarily to receive regular cash
income in the form of dividends.
Others do so to secure capital gains through rising market
price of common stock.
Dividend yield = Dividend per share x 100) %
Market price per share
Dividend Yield is anticipated annual dividend divided by the
market price of the stock.
The dividend yield on a company stock is the company's
annual dividend payments divided by its
market cap, or the dividend per share divided by the price
per share. It's often expressed as a percentage.

Prepared by: Muhammad akhtar


University of Libya BETC

Dividend Cover
Dividend Coverage Ratio: = Net income .
Amount of annual preferred dividend
Normal Ratio: 5 to 10
Note: Ratios should be used with other elements of
financial analysis. Most important is to use
common sense and judgments. Also study the industrial
sector in which the company operates and relate
“Industry Sector” climate to current and projected
economic developments.

Prepared by: Muhammad akhtar