- Basic Finance

1. ANALYSIS OF FINANCIAL
STATEMENTS AND CASH FLOWS
TOPIC 2

2. Learning Objectives
1. Understand the needs of financial statements.
2. Distinguish between income statement, balance sheet
and statement of cash flows and identify the items in
those statements.
3. Explain the usage of financial ratio analysis in financial
statements analysis.
4. Calculate liquidity ratio, asset management ratio,
profitability ratio, leverage ratio and market value ratio
to evaluate a company’s performance.
5. Describe the limitations of financial ratio analysis.
WRMAS 2

3. Needs of Financial Statements
• In Malaysia, Company Act 1965 required companies to
expose their annual report to Company Registrar.
• Among the content of the report is financial statement,
covers, income statement, balance sheet, cash flow
statement, and explanation notes about those accounts.
• Financial statements users can be classified into 2 types:
• Internal users- persons employed by the firm
• External users- potential investors, the Government,
lenders, the public etc...
WRMAS 3

4. INCOME STATEMENT
• Also known as Profit and Loss Statement.
• It measures the results of a firm’s operation over a specific
period.
• The bottom line of the income statement shows the firm’s profit
or loss for a period.
• Usefulness of income statement:
-Evaluate the past performance of the firm.
-Provide a basis for predicting future performance.
WRMAS 4

5. Income Statement Terms
• Revenue (Sales)-Income from sales of products or services
• Cost of Goods Sold (COGS)-Cost of producing the
goods/services to be sold
• Operating Expenses-Expenses related to marketing and
distributing the product or service and administration cost
(Example: marketing & selling, general & administrative,
depreciation expenses)
• Financing Costs-The interest paid to creditors/bondholders
• Tax Expenses-Amount of taxes owed, based upon taxable
income
WRMAS 5

6. Income Statement Form
SALES
- Cost of Goods Sold (COGS)
GROSS PROFIT
Operating Activities
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
Financing
EARNINGS AFTER TAXES (EAT) Activities
- Preferred Stock Dividends (if any)
NET INCOME (EARNING AVAILABLE FOR STOCKHOLDERS)
WRMAS 6

7. Example of Income Statement
WRMAS 7

8. Three additional important issues:
• Operating income is NOT affected by how the firm is
financed.
• Interest expense (financing cost) is subtracted from
income before computing the firm’s tax liability. i.e
Interest is not taxable expenses.
• Firm that has a positive net income does NOT necessarily
mean it has any cash
WRMAS 8

9. BALANCE SHEET
• Provides a snapshot of firm’s financial position at a particular date.
• It includes three main parts: assets, liabilities and equity.
 Assets (A) -Productive sources that give return to the company.
 Liabilities (L) - Creditors claim how those resources are
 Equity (E) - Owner claim financed
A=L+E
• The items are recorded at historical cost, so the book value of a
firm may be very different from its market value.
WRMAS 9

10. Balance Sheet Terms: Assets
• CURRENT ASSETS
The assets will not stay in the business for long (relatively
liquid), or expected to be converted into cash within 12
months.
 Cash – currency or coins owned by company either in bank
account or hand.
 Marketable security – investment on short term financial
assets with high liquidity. Example: T-bill, bankers
acceptance, etc.
 Accounts receivable – payments due from customers who
buy on credit.
 Inventory – raw materials, working in process and final
products that will be sold.
 Prepaid expenses – Items paid for in advance
WRMAS 10

11. Balance Sheet Terms: Assets
• FIXED ASSETS
The assets are held for more than one year. Fixed assets
typically include: plant and machinery, building and land.
• OTHER ASSETS
Assets that are neither current assets nor fixed assets. They
may include intangible assets that can’t be touched or saw
physically such as pattern, right and goodwill.
Balance Sheet Terms: Liabilities (Debt)
• LIABILITIES are money borrowed and must be repaid at
predetermined date.
current liabilities (must be repaid within twelve months)
long-term liabilities (repayment time exceeds one year).
WRMAS 11

12. Balance Sheet Terms: Liabilities (Debt)
• CURRENT LIABILITIES (Short-term Liabilities)
Liability that must be paid within 12 months.
 Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
 Accrued expenses (Short term liabilities incurred in the
firm’s operations but not yet paid for)
 Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)
• LONG-TERM LIABILITIES/DEBTS
Covers loan from bank or other sources that provide capital for
liability term more than 1 year.
(Example: buying machinery and building for period of 25 to 30
years using bank loan)
WRMAS 12

13. Balance Sheet Terms: Equity
• EQUITY
Shareholder’s investment in the firm in the form of preferred
stock and common stock.
 Preferred Stock (received dividend in fixed amount)
 Common Stock
 Treasury Stock (stock that has been re-purchased by the firm)
 Retained Earnings (earnings retained and will be reinvest in
the firm)
 Paid in Capital (money that a firm gets from potential
investors in addition to the stated value of the stock)
WRMAS 13

14. Balance Sheet A = L + E
Assets Liabilities (Debt) & Equity
Current Assets Current Liabilities
Cash Accounts Payable
Accounts Receivable Accrued Expenses
Short-term notes
Inventories Long-Term Liabilities
Prepaid Expenses Long-term notes
Fixed Assets Mortgages
Machinery & Equipment Equity
Buildings and Land Preferred Stock
Other Assets Common Stock (Par value)
Paid in Capital
Copyrights, Goodwill &
Retained Earnings
patents
Treasury Stock
TOTAL ASSETS TOTAL LIABILITIES + EQUITY
WRMAS 14

15. Example of Balance Sheet
WRMAS 15

16. STATEMENT OF CASH FLOWS
• Definition: Shows the changes of cash for the company in
certain period of time.
• Profits in the income statement are calculated on “accrual
basis” rather than “cash basis”.
• Thus profits are not equal to cash.
• Accrual basis is the principle of recording revenues when
earned and expenses when incurred, rather than when cash is
received or paid.
– Thus sales revenue recorded in the income statement
includes both cash and credit sales.
• Treatment of long-term assets: Asset acquisitions (that will last
more than one year, such as equipment) are not recorded as an
expense but are written off every year as depreciation expense.
WRMAS 16

17. Statement Of Cash Flows
 Divided sources and uses of cash into THREE components:
 Cash flow from operations (ex. Sales revenue, labor expenses)
 Cash flow from investment (ex. Purchase of new equipment)
 Cash flow from financing (ex. Borrowing funds, payment of div)
WRMAS 17

18. Income Statement Conversion:
From Accrual to Cash Basis
• Two steps:
– Add back depreciation (as it is a non-cash expense) to net income
– Subtract any uncollected sales (i.e. increase in accounts receivable)
and cash payment for inventories (i.e. increase in inventories less
increase in accounts payables)
WRMAS 18

19. Example: Statement Of Cash Flows
WRMAS 19

20. USES OF FINANCIAL RATIO: Within
the Firm
• Identify deficiencies in a firm’s performance and take
corrective action.
• Evaluate employee performance and determine incentive
compensation.
• Compare the financial performance of different divisions
within the firm.
• Prepare, at both firm and division levels, financial projections.
• Compare performance against other firms (competitors) or
industry standards
• Evaluate the financial condition of a major supplier
WRMAS 20

21. USES OF FINANCIAL RATIO:
Outside the Firm used by
• Lenders in deciding whether or not to make a loan to a
company.
• Credit-rating agencies in determining a firm’s credit
worthiness.
• Investors (shareholders and bondholders) in deciding whether
or not to invest in a company.
• Major suppliers in deciding whether or not to grant credit
terms to a company.
WRMAS 21

22. Types of Analysis
 Trend analysis
Compare the current ratios with ratios in previous year. It
covers some time period so the analyst can see the
achievement flow for the company in longer period.
 Comparison analysis
Compare the company’s ratios with ratios of other equivalent
companies. If there is industry ratios, it can be used as a guide
to evaluate the position of the company in the industry.
 Benchmarking
Compare the company’s financial position with other
competitors.
WRMAS 22

23. Analyzing Financial Performance: Ratio
1. Liquidity Ratio
2. Asset Management/Activity Ratio
3. Profitability Ratio
4. Leverage Ratio
5. Market Value Ratio
WRMAS 23

24. Balance Sheet (For Ratios)
WRMAS 24

25. Income Statement (For Ratios)
WRMAS 25

26. LIQUIDITY RATIO
 How liquid is the firm?
 Liquidity shows the ability of the firm to pay its short term
debt in the time given. It indicates the ease with which non-
cash assets can be converted to cash to meet the financial
obligations.
 Generally, bigger liquidity ratios, give a better position of
the firm’s liquidity.
WRMAS 26

27. Liquidity Ratio
Working capital uses to measure the ability of a business to pay
it short term debt by current assets and shows the amount of
leaved current assets after current liabilities has been paid.
Working Capital = Current Assets – Current Liabilities
Davies Example?
The bigger the value the better the business because it is
able to pay its short term debt and it has higher current
assets for its operation.
WRMAS 27

28. Liquidity Ratio
Current ratio- compares cash and current assets that should be
converted into cash during the year with the liabilities that
should be paid within the year.
Current asset = X Times
Current ratio =
Current liability
Davies Example?
Davies has ____ in current assets for every $1 in current
liabilities.
The higher of this ratio means the business financial is better
where it has enough liquid asset of its operation.
WRMAS 28

29. Liquidity Ratio
Quick ratio (known also as asid test) -Compares cash and current
assets (minus inventory) that should be converted into cash during
the year with the liabilities that should be paid within the year.
What is the rationale for excluding inventories?
Current asset - Inventory = X Times
Quick ratio =
Current liability
Davies Example?
Davis has ____ in quick assets for every $1 in current liabilities.
The higher the ratio shows the business has enough quick assets
to pay its short term debt immediately.
WRMAS 29

30. ASSET MANAGEMENT RATIO
• How efficiently and effectively a company is using its assets
in the generation of revenues?
 It uses to identify the efficiency and effectiveness of the firm
in managing its assets.
 The firm should make basic decision about total investment in
account receivable, inventory and fixed assets.
 The firm is responsible to use the assets efficiency and
effectively.
WRMAS 30

31. Asset Management Ratio
Average collection period determines the average days for the
firm to collect its accounts receivable from customers in certain
period.
How long does it take to collect the firm’s receivables?
𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝒓𝒆𝒄𝒊𝒆𝒗𝒂𝒃𝒍𝒆
𝑨𝑪𝑷 = = 𝒅𝒂𝒚𝒔
𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔 /𝟑𝟔𝟓
Davies Example?
On average, Davies needs ____ days to collect payment on
accounts receivable.
A lower number of days is better because this means that the
company gets its money more quickly.
WRMAS 31

32. Asset Management Ratio
Account Receivable Turnover determines the ability of the
business to collect debt from its customers. It shows the number
of account receivable turn in a year. A turn covers the starting
period of account receivable until the due of the account.
ARTO = Credit sales = Times
Accounts receivable
Davies Example?
Higher is better because it shows the business can collect its
credit accounts immediately. If low, firms needs to take a look at
its credit and collections policy and be sure they are on target.
WRMAS 32

33. Asset Management Ratio
Inventory Turnover shows how many times per year the inventory
will be sold and replaced.
How many times is inventory rolled over per year?
Inventory Cost of goods sold = TIMES
=
turnover Inventory
Davies Example?
On average, ____ times passed between the acquisition and sale
of inventory.
The higher turnover means the firm in better position because it
shows the quick inventory movement. Inventory can be sold
quickly and replace back immediately.
WRMAS 33

34. Asset Management Ratio
Fixed Asset Turnover shows the efficiency of the firm in using fixed
asset in generating sales.
Sales
Fixed asset turnover = = TIMES
Total fixed assets
Davies Example?
Davies generates ____ in sales for every $1 invested in fixed assets.
The higher is better because it shows the effectiveness of the
firm to produce sales from its fixed assets.
WRMAS 34

35. Asset Management Ratio
Total Asset Turnover shows the efficiency of the firm to use its
assets to generate sales.
Sales
Total asset turnover = = TIMES
Total assets
Davies Example?
Davies is generating ____ in sales for every $1 invested in assets.
The higher is better because it shows the effectiveness of the
firm to use its assets to generate sales.
WRMAS 35

36. PROFITABILITY RATIO
 Are a company has an ability to generate profits relative to
sales, assets and equity?
 It shows a company's overall efficiency and performance.
 When these ratios are higher than a competitor's ratio or than
the company's ratio from a previous period, this is a sign that
the company is doing well.
WRMAS 36

37. Profitability Ratio
Gross Profit Margin looks at cost of goods sold as a percentage
of sales. It shows firm's ability to turn a dollar of sales into profit
after the cost of goods sold has been accounted for.
Gross Profit
Gross profit margin = = %
Sales
Davies Example?
For every $1 of sales, ____ of gross profit was made OR costs of
goods sold consumed ____ of every sales dollar.
Higher ratio is better because it indicates that the firm is
operating efficiently after sales costs are subtracted.
WRMAS 37

38. Profitability Ratio
Operating Profit Margin examines how effective the company is
in managing its cost of goods sold and operating expenses that
determine the operating profit (EBIT).
EBIT
Operating profit margin = = %
Sales
Davies Example?
For every $1 of sales, ____of EBIT was generated.
Higher ratio is better because it indicates that the firm is
managing its operating expenses efficiency
WRMAS 38

39. Profitability Ratio
Net Profit Margin determines profit earns from every dollar of
sales after all expenses, including cost of good sold, sales
expenses, general and admin cost, depreciation, interest and tax
completely paid.
Net income = %
Net profit margin =
Sales
Davies Example?
For every $1 of sales, ____of profit was generated.
The higher of this ratio is better because it shows the
reducing in expenses or cost in producing sales
WRMAS 39

40. Profitability Ratio
Return on Asset (ROA) determines the effectiveness of
management in using their assets to generate income.
Net income
Return on asset= = %
Total assets
Davies Example?
For every $1 of assets, ____ cents of profit was generated OR
Davies has a NI of ____ for each dollar of total assets.
The higher of this ratio is better because it shows the firm is
more effective in using their assets to generate sales.
WRMAS 40

41. Profitability Ratio
Return on Equity (ROE) determines the efficiency of the firm to
generate income for its shareholder.
Are the Firm’s managers providing a good return on the capital
provided by the shareholders?
Net income = %
Return on equity =
Total equity
Davies Example?
For every $1 invested by shareholders, ____ of additional wealth
(profit) was generated OR Davies has a NI of ____ for each dollar of
total equity.
Higher of this ratios is better because it shows the firm is able to
produce higher profit to its owners.
WRMAS 41

42. LEVERAGE RATIO
 Does the firm finance its assets by debt or equity
or both?
 Leverage ratio shows the ability of the firm to fulfill
its responsibility or obligation to their creditors.
 This ratio determines the effectiveness of
management in using and managing capital.
WRMAS 42

43. Leverage Ratio
Debt Ratio shows the percentage of firm’s assets that financed by
debt (implying the balance is financed by equity).
Debt ratio = Total debt
Total assets = %
Davies Example?
Davies finances ____ of firm’s assets by debt and ____by equity.
The lower is better because the less total debt the business has in
comparison to its asset base (high ratio-in danger of becoming
insolvent and/or going bankrupt)
WRMAS 43

44. Leverage Ratio
Debt to Equity Ratio measures the percentage of liability
covers by equity.
Total debt
DOE = = %
Total equity
Davies Example?
Davies finances ____ of firm’s equity by debt OR For every dollar of
Davies owned by the shareholders, Davies owes ____ to creditors.
The lower of this ratio is better because it indicates a safer
investment to potential owners of the company.
WRMAS 44

45. Leverage Ratio
Times Interest Earned (TIE) measures how many times the firm
has profit to pay interest expenses. This ratio indicates the
amount of operating income available to service interest
payments.
TIE = Operating profit (EBIT)
= TIMES
Interest expense
Davies Example?
Davies operating income are ____ the annual interest expense
OR ____% of the operating profits goes towards servicing the
debt.
The higher of this ratio is better because it shows the firm is able
to pay the interest expenses.
WRMAS 45

46. MARKET VALUE RATIO
 Are the firm’s managers creating shareholder value?
 Ratios relate an observable market value, the stock price, to
book values obtained from the firm's financial statements.
Earning Per Share represents the portion of a firm's
earnings, that is allocated to each share of common stock.
Net income = $
Earning Per Share=
No. of Share outstanding
Davies Example?
Davies generated profits of ____ for each share issued.
A high EPS is better because it is capable of generating a
significant dividend for investors
WRMAS 46

47. Market Value Ratio
Price-Earning Ratio (P/E) indicates how much investors are
willing to pay for $1 of reported income.
Price-Earning = Price per share
= TIMES
Ratio Earning per share
Davies Example?
To buy one share investors are prepared to pay ____ the profit
earned per share.
A high P/E ratio is better because it shows that investors are
anticipating higher growth in the future.
WRMAS 47

48. Market Value Ratio
Price (Market)-to-book-Ratio measures how much a company
worth at present, in comparison with the amount of capital
invested by current and past shareholders into it. It shows
firm's success in creating value for its stockholders.
Price-to-book Ratio = Price per share
Book value per share
where
Book Value Per Share = Total Equity
No. of share outstanding
Davies Example?
A ratio greater than 1 indicates that the shares are more valuable
than what the shareholders originally paid.
WRMAS 48

49. LIMITATIONS OF FINANCIAL RATIO
ANALYSIS
Ratios can provide meaningful comparisons of companies in
similar industries. Also, keep in mind that ratio analysis does not
tell the entire story. Why?
1) Many large firms operate in multiple lines of business. It is
difficult to find a meaningful set of industry-average ratios.
2) Seasonal factors can also distort ratio analysis.
3) Industry averages may not provide a desirable target ratio.
WRMAS 49

50. 4) A company may have some good and some bad ratios, making
it difficult to tell if it's a good or weak company. A high or low
ratio does not automatically lead to a specific favorable or
unfavorable conclusion.
5) Different accounting method among the firm results different
calculation of ratios. For example, in calculating inventory and
depreciation.
6) Industry average is only estimation and guidelines. Industry
average is not necessarily a desirable target and required
ratio. It only illustrates the firm position in industry.
WRMAS 50

51. Bonus Questions
1. You know that the return on equity (ROE) is 18%. If sales
were $4 million, the debt ratio was 0.40 and the total debt is
$2 million, What is return on assets (ROA)?
2. You are given the following information: Stockholders’
equity=$1,250; Shares outstanding=25; Market/Book
ratio=1.5. Calculate the market price.
WRMAS 51