Topic 3 Financial Statement and Financial Ratios Analysis

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l e a R n i n G  o U t c o m e s

Bytheendofthistopic,youshouldbeableto: Bytheendofthistopic,youshouldbeableto: 1.

1. ExpExplailaintntheheimpimporortantanceceoofnafnancincialalstastatemtementents;s; 2.

2. AnAnalalysyseefnfnanancicialalsstatatetemementnts;s; 3.

3. CalCalculculateateanandidintenterprrpretetfnafnancincialalratratiosios;; 4.

4. AppApplylyratratioioanaanalyslysisisininfnafnancincialaldedeciscisionionmamakinking;g;andand 5.

5. DisDiscuscusststhehelilimitmitatiationsonsoofnfnancancialialraratiotiosasanalnalysiysis.s.

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Statements

andFinancial

Ratios

Analysis

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_intRoDUction

Fi Finanancnciaiallststatatememenenttananddititssananalalysysisis arareevivitatalltoto anan ororgaganinisasatitionon ananddexexteternrnalal parti

parties.es.TheTheinterinternalnalmanagmanagemeementntooaacompcompanyanyrerequirquiresesinoinormatirmationonobtaiobtainedned r

romom aafnafnancincialalstatstatemementent totoassassistist thethemmininplaplanninning,ng, concontrtrollollinging andand dedeciscisionion making.

making. Ext

Externernalalparpartietiesssucsuchhasasbusbusineinesssscrcrededitoitorsrsneeneeddtotoknknowowthethe liqliquiduidityity pospositiitionon oa

oafrmfrm andand itsits abiabilitlitytoytopaypay thetheirclaiirclaims.ms. BoBondholdndholdersers tootoo neeneedtodtoknoknowthewthe frm

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investinginacompany

investinginacompany,shareholde,shareholdersneedtoknowthersneedtoknowtheproftandperoproftandperormanceormanceo thecompanyconcerne

thecompanyconcerned.Thereord.Thereore,whetheryouareafnancialmanagere,whetheryouareafnancialmanager,creditor,creditor or

orinvinvestestoror,,thethe undundererstanstandindinggoothethe fnafnancincialalstastatemtementent andand itsits anaanalyslysisisisisanan important.

important. In

Inthithisstoptopic,ic, yoyouuwilwilllbelearnbelearninging thrthreeee typtypesesobasicfnancobasicfnancialial stastatemtemenentstsandand th

theieirrcocompmpononenentsts,, oollllowoweded byby fnfnanancicialal ananalalysysisis whwhicichh cacannbebe ususeded toto gagainin importantpracticalin

importantpracticalinormationortheormationorthebeneftocertainpbeneftocertainparties.arties.

3.1

3.1 Financialstatements

Financialstatements

Therear

Therearethreeethreetypesobasicfnancialstatemtypesobasicfnancialstatements:ents: (a

(a)) BaBalalancnceeShSheeeet;t; (b)

(b) IncIncomeomeStStateatemement;nt;anandd (c (c)) CaCashshFFlolowwStStateatemementnt.. Letustakealookateachtypeindetail. Letustakealookateachtypeindetail.

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Balancesheetisthestatementothefrm’sfnancialpositionataspecifcpoint Balancesheetisthestatementothefrm’sfnancialpositionataspecifcpoint intime.Thebalancesheetoafrmmaychangedailybecauseinventoriesmay intime.Thebalancesheetoafrmmaychangedailybecauseinventoriesmay incr

increaseease ordecreordecreaseeachdayaseeachday,,andfxedassetssuchasandfxedassetssuchasequiequipmenpmentcantcanbeaddedbeadded ordepr

ordepreciate.Aeciate.Afnancialstatementcanbedfnancialstatementcanbedividedintotwopividedintotwoparts:arts: (a)

(a)AssetAsset A

Annasassesettiiss aarreesosoururccee owownenedd byby aafrfrmm..AAsssseetsts cacannbebe seseppararatateedd inintoto

current assets

current assetsandandfxed assetsfxed assets.Currentassetscanbeconvertedintocashin.Currentassetscanbeconvertedintocashin periodlessthanoneyear.Examplesocurrentassetsarecash,marketable periodlessthanoneyear.Examplesocurrentassetsarecash,marketable sec

securiuritieties,s,accaccounountstsrereceiceivabvablele andand invinvententororiesies..OnOnthethe othothererhanhand,d,fxefxedd assetsincludeequipmentandplants.Assetsarearrangedinorderbasedon assetsincludeequipmentandplants.Assetsarearrangedinorderbasedon liquidity,thatis,timeneededtoconverttheassetsintocashmoney.

liquidity,thatis,timeneededtoconverttheassetsintocashmoney. (b)

(b)Liability and EquityLiability and Equity

Liability

Liability isis aaclclaiaimmagagaiainsnsttththeefrfrm’m’ssasassesetsts..AcAccocoununtsts rrececeieivavablble,e, nonotetess pay

payablableeandand accaccruruededexexpenpensesses arareecurcurrerentntlialiabilbilitiitieseswhiwhichchwilwilllmatmaturureeinin lessthanoneyear.Bondsandbankloanswhicharethefrm’sdebtstoother lessthanoneyear.Bondsandbankloanswhicharethefrm’sdebtstoother partiesarecategorisedaslong-termliabilityastheywillmatureinaperiod partiesarecategorisedaslong-termliabilityastheywillmatureinaperiod omorethanoneyear. omorethanoneyear. Equity

Equity isaisaclaclaimosharimosharehoeholdeldersonthefrm’rsonthefrm’sassetsassetswhichswhich maymay beinthebeinthe ormopreerenceshares,ordinarysharesandretainedearnings.

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Figure3.1showsabalancesheetoEmasLimitedCompany. Figure3.1showsabalancesheetoEmasLimitedCompany. Normally,assetsarenotedontheletsideoabalancesheetwhileliabilityand Normally,assetsarenotedontheletsideoabalancesheetwhileliabilityand equityarenotedontherightsideoabalancesheet.Sometimes,assetsarenoted equityarenotedontherightsideoabalancesheet.Sometimes,assetsarenoted atthetopwhileliability

atthetopwhileliabilityandequityarandequityarenotedatthebottoenotedatthebottomothebalanceshemothebalancesheet.et. In

Inaccaccounountinting,g,allall thethe frmfrm’s’sassassetsets belbelononggtotocrcrededitoitorsrsandand ownownererssoothethe frmfrm.. Thus,thereisanequationsuchasshownbelow:

Thus,thereisanequationsuchasshownbelow:

Emas Limited Company Emas Limited Company

Income Statement Income Statement For the Years Ended 30th December 2010 and

For the Years Ended 30th December 2010 and 31st December, 201131st December, 2011 Assets Assets 2011 2011 20102010 (RM’000) (RM’000) (RM’000) (RM’000) C Caasshhaanndd MaMarrkkeettaabblleeSeSeccuurriittiieess 330000 22,,440000 A Accccoouunnttssrreecceeiivvaabbllee 1111,,225500 99,,445500 I Innvveennttoorriieess 1818,,445500 1122,,445500 T Toottaall CCuurrrreennttAAsssseettss 3300,,000000 2244,,330000 N Neettppllaannttaannddeeqquuiippmmeenntt 3300,,000000 2266,,110000 T ToottaallAAsssseettss 6600,,000000 5500,,440000

Liabilities and Equity Liabilities and Equity

A Accccoouunnttssppaayyaabbllee 11,,880000 990000 N Nootteessppaayyaabbllee 33,,330000 11,,880000 A Accccrruueedd eexxppeennssee 44,,220000 33,,990000 T Toottaall CCuurrrreennttLLiiaabbiilliittiieess 99,,330000 66,,660000 L Loonngg--tteerrmmbboonnddss 2222,,662200 1177,,440000 T Toottaall LLiiaabbiilliittiieess 3311,,992200 2244,,000000 P Prreeeerreenncceesshhaarreess ((11,,220000,,000000)) 11,,220000 11,,220000 O Orrddiinnaarryysshhaarreess((1155,,000000,,000000)) 33,,990000 33,,990000 R Reettaaiinneeddeeaarrnniinnggss 2222,,998800 2211,,330000 T Toottaall EEqquuiittyy 2266,,888800 2255,,220000 T

Total Liabilities otal Liabilities and Equityand Equity 60,00060,000 50,40050,400

Figure 3.1

Figure 3.1:BalancesheetoEmasLimitedCompany:BalancesheetoEmasLimitedCompany

Asset

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In

In ggeenenerralal,, aa babalalanncece shsheeetet ggiviveess ininoorrmamatitionon rregegararddiningg ththee fnfnanancicinngg anandd in

inveveststmementnt acactitivivititieses oo aafrfrm.m. LiLiababililititieiessananddowownener’sr’seqequiuityty prpresesenenttaaviviewew o

o ththeerrelelatateded frfrm’m’sscacapipitatallststruructcturure.e. WWeecacannseseeeththeepapartrt oo ththeetototatallcacapipitatall wh

whicichhininclclududeses eqequiuityty ananddththeepoportrtioionn fnfnananceceddbyby dedebtbt.. SeSegrgregegatatioionnoo ththee totalliabilitiesintocurrentliabilitiesandlong-termliabilitiesarealsoshownin totalliabilitiesintocurrentliabilitiesandlong-termliabilitiesarealsoshownin the

the balbalancanceeshesheet.et. ThiThissininormormatiationonisisimpimportortantant totoanaanalyslyseethethe frmfrm’s’sfnafnancincialal po

posisititionon.. FrFromom ththeebabalalancnceeshsheeeet,t, wewe cacannalalsoso cacalclcululatatee ththeewoworkrkiningg cacapipitatal.l. W

Workingcapitalisthedorkingcapitalisthedierierencebetweencuencebetweencurrentassetsandcrrentassetsandcurrentliabilitieurrentliabilities.s.

activity3.1 activity3.1 Drawacharttoshowthepartsbelowinabalancesheet: Drawacharttoshowthepartsbelowinabalancesheet: ( (aa)) CCuurrrreennttAAsssseettss ((dd)) FFiixxeeddLLiiaabbiilliittiieess ( (bb)) FFiixxeeddAAsssseettss ((ee)) EEqquuiittyy (c (c)) CuCurrrrenenttLiLiababililititieiess Working Capital =

Working Capital = CurrenCurrentAssets–CurtAssets–CurrentLiabilitierentLiabilitiess

Working capital

Working capitalcanbeobtainedbysubtractingcurrentliabilitiesromcurrentcanbeobtainedbysubtractingcurrentliabilitiesromcurrent assets.Inormationonworkingcapitalisimportanttoevaluateafrm’sliquidity assets.Inormationonworkingcapitalisimportanttoevaluateafrm’sliquidity anditsabilitytopaybackshort-termclaimsonit.Afrm’sliquidityisimportant anditsabilitytopaybackshort-termclaimsonit.Afrm’sliquidityisimportant because

becauseitsitsbusinessbusinessisislikelylikelytotoailailiithethefrmfrmisisunableunabletotopaypayinterestinterestororpaypay backdebtwhenitmatur

backdebtwhenitmatures.es. Balan

Balancesheetcesheetalsoshowsthecombinalsoshowsthecombinedassetsedassetsheldbyaheldbyafrmorthecurrfrmorthecurrentassetentasset rat

ratioandtheioandthefrmfrm’sfxed’sfxed assasset.et. IaIafrmfrm holholdstoomuchfxeddstoomuchfxed assassetsets comcomparpareded tocurrentassets,thefrm’scapitalwillbetiedupandthismayleadtocashow tocurrentassets,thefrm’scapitalwillbetiedupandthismayleadtocashow pr

probloblememssandand fnafnancincialalaiailurlure.e.ThiThissisiscaucausedsed bybydidifcufcultylty ininconconvevertirtingngfxefxedd assetsintocashcomparedtocurrentassets.

assetsintocashcomparedtocurrentassets.

selF-check3.1

Ba

Baseseddonon FiFigugurere 3.3.1,1, cacalclcululateate ththeewoworkrkininggcacapipitatalloo EmEmasasLiLimimitetedd Companyortheyears2010and2011.

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Income statement

Income statementisastatementthatgivesinormationregardingtheisastatementthatgivesinormationregardingtherevenuesrevenues and

andexpendituresexpendituresoafrminaspecifcperiodotime.Salesrevenueisshowninoafrminaspecifcperiodotime.Salesrevenueisshownin everyincomestatementandthisisollowedbyexpendituresorcostandtaxes.In everyincomestatementandthisisollowedbyexpendituresorcostandtaxes.In brie,an

brie,anincomestatementincomestatementindicatesaindicatesafrm’sproftfrm’sproftororlosslossininaaspecifcperiodspecifcperiodoo timewhichisnormallyoneyear.Proftisimportanttoafrm’sowner,employees timewhichisnormallyoneyear.Proftisimportanttoafrm’sowner,employees andsuppliersbecau

andsuppliersbecausewithoutprosewithoutproft,thefrmwillnotcoft,thefrmwillnotcontinuetoexist.ntinuetoexist. Pleasere

PleasereertoFigurertoFigure3.2,IncomeStateme3.2,IncomeStatementoEmasLimiteentoEmasLimitedCompany:dCompany:

Income Statement Income Statement or the Year Ended 31st December 2010 and

or the Year Ended 31st December 2010 and 31st December 201131st December 2011

2 2001111 22001100 (RM’000) (RM’000) (RM’000) (RM’000) S Saalleess 9900,,000000 8855,,550000 C Coossttooggooooddssssoolldd ((7744,,884466)) ((7711,,111100)) G Grroosssspprroofftt 1515,,115544 1144,,339900 S Saalleessaannddaaddmmiinniissttrraattiivveeeexxppeennsseess ((33,,664400)) ((33,,880000)) D Deepprreecciiaattiioonnaannddaammoorrttiissaattiioonn ((33,,000000)) ((22,,770000)) P Prrooffttbbeeoorree iinntteerreessttaannddttaaxxeess 8,8,551144 77,,889900 L Leessss::IInntteerreesstteexxppeennsseess ((22,,664400)) ((11,,880000)) P Prrooffttbbeeoorree ttaaxx 55,,887744 66,,009900 T Taaxx ((22,,334499)) ((22,,443300)) N NeettPPrroofftt 3,3,552255 33,,666600 P Prreeeerreenncceesshhaarreessddiivviiddeenndd ((112200)) ((112200)) N NeettPPrrooffttoorr oorrddiinnaarryyshshaarreehhoollddeerrss 33,,440055 33,,554400 O Orrddiinnaarryysshhaarreessddiivviiddeennddss ((11,,772255)) ((11,,995500)) Addition AdditionttooRReettaaiinneedd EEaarrnniinnggss 1,6801,680 1,5901,590 Incomestatementorproftandlossstatementgivesinormationtomeasurethe Incomestatementorproftandlossstatementgivesinormationtomeasurethe frm

frm’s’sperperorormanmance.ce. TToomemeasuasurere thethe peperorormarmancence ooaafrmfrm,,somsomeeaspaspectectssooanan organisationmustbeconsidered:

organisationmustbeconsidered: (i)

(i) Sales fgureSales fgure–Canbecomparedwiththefrm’ssalesinthepreviousyear–Canbecomparedwiththefrm’ssalesinthepreviousyear andexpecteduturesales.Thisinormationcanbeusedorthepurposeo andexpecteduturesales.Thisinormationcanbeusedorthepurposeo planningthefrm’suture.

planningthefrm’suture. (ii)

(ii) Gross proftGross proft–Canbecomparedtothesalesfguretoshowproftearnings–Canbecomparedtothesalesfguretoshowproftearnings romgoodssold.

romgoodssold.

Figure 3.2

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(iii)

(iii) Firm’s expensesFirm’s expenses–Canbecomparedwiththefrm’sexpensesinthe–Canbecomparedwiththefrm’sexpensesinthe previo

previousyeartoormuusyeartoormulatepoliciestodelatepoliciestodecreasecost.creasecost. (iv)

(iv) Net proftNet proft –– CCaann bbee ccoommppaarreedd ttoo ssaalleess.. NNoorrmmaallllyy,, tthheerree aarree variationsbetweenproftabilityandsalesvolumes.Whenafrm’s variationsbetweenproftabilityandsalesvolumes.Whenafrm’s salesvolumeishigh,itmayr

salesvolumeishigh,itmayreceivealowerpeeceivealowerpercentageonercentageonetproft.tproft. How

Howeveverer,,thethe ratratioiooonenettsalsales-es-prproftoft isisininuenuencedced bybythethe typtypeeoo businessundertak

businessundertakenbythefrmconenbythefrmconcerned.cerned.

Gross Proft =

Gross Proft = Sales–CostoGoodsSoldSales–CostoGoodsSold

Net proft =

Net proft = GrossPrGrossProft–Salesandoft–SalesandAdministrativeEAdministrativeExpensesxpenses –DepreciationandAmortisation –DepreciationandAmortisation selF-check3.2 selF-check3.2 Essay Question Essay Question W

Witithh rreeererenencece toto ththeeinincocomeme ststatatememenentt inin FiFigugurere 3.3.2,2, didiererenentitiatatee betweengr

betweengrossproftandnossproftandnetproft.etproft.

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Cashhowow stastatemtementent rereerersstotothethe stastatemtemenenttthathattrerecorcordsdsthethe eeecectstsooaafrmfrm’s’s ac

actitivivititieses susuchch asas opopereratatining,g, ininveveststmementnt anandd fnfnanancicingng oo aafrfrm’m’ss cacashsh ooww oraspecifcperiod.Netcashowisthetotalcashattainedbyabusinessina oraspecifcperiod.Netcashowisthetotalcashattainedbyabusinessina specifcperiod,orexample,oneyear.Butthecashowattainedbyafrmmay specifcperiod,orexample,oneyear.Butthecashowattainedbyafrmmay notnecessarilybethetotalcashstatedintheitem“cash”onthebalancesheet notnecessarilybethetotalcashstatedintheitem“cash”onthebalancesheet because

because thethecashcash maymaybebe usedusedtoto paypay dividends,dividends,fnancefnance accountaccountreceivreceivable,able, investinfxedassets,increaseinventories,etc.Thereore,theavailabletotalcash investinfxedassets,increaseinventories,etc.Thereore,theavailabletotalcash in

inaabalbalancanceeshesheetetmaymay bebeininuenuencedced bybyacactortorsssucsuchhasascascashhowow,,chachangengessinin work

workingcapital,ingcapital, changchangesinesinfxedfxed assetassets,company’s,company’sstransatransactionctionsssuchassuchasbuyinbuyingg andsellingosharesandbonds,dividendpaymentandsoon.Theseactorswill andsellingosharesandbonds,dividendpaymentandsoon.Theseactorswill bereectedinthe

bereectedinthecashowcashowstatementwhichshowsstatementwhichshowschangesinthechangesinthecashpositioncashposition othefrm.

othefrm. Acasho

Acashowstatementcanbedivwstatementcanbedividedintothridedintothreepartsaccoreepartsaccordingtoitsactivities:dingtoitsactivities: (i

(i)) OOpeperratatininggaactctivivitityy;; (i

(ii)i) InInveveststmementntaactctivivitity;y;aandnd (ii

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Pleasere

PleasereertoFigurertoFigure3.3:Showscashowstatemee3.3:ShowscashowstatementoEmasLimitedntoEmasLimitedCompanyCompany.. C

Casashh ooww ststatateemmeentnt isis imimppoortrtanantt toto aa fnfnanancicialal mamannagageerr bebecacauusese itit ggiviveess inormationr

inormationregardinegardingthefrm’sabilitytoggthefrm’sabilitytogeneratesueneratesufcientcashto:fcientcashto: (i)

(i) FinFinancanceoeorprpururchachasesenenewawassessetstsororthethefrfrm’sm’sexexpanpansiosion;n;andand (i

(ii)i) PaPayybabackckiitstsddebebtsts..

Figure 3.3:

Figure 3.3:CashowstatementorEmasLimitedCompanyCashowstatementorEmasLimitedCompany

Cash Flow Statement Cash Flow Statement For the Year Ended 31st

For the Year Ended 31st December 2011December 2011 (RM‘000) (RM‘000) Operating Activities Operating Activities N NeettPPrroofftt 33,,552255 Additional(cashresources) Additional(cashresources) D Deepprreecciiaattiioonnaannddamamoorrttiissaattiioonn 33,,000000 I Innccrreeaassee iinnAAccccoouunnttssPPaayyaabbllee 990000 I Innccrreeaassee iinnAAccccrruueeddeexxppeennsseess 330000 Less(usesocash) Less(usesocash) In

IncrcreaeaseseiinnAcAccocoununtstsRecReceieivavablblee (1(1,8,80000)) In

Incrcreaeaseseiinnininveventntororieiess (6(6,0,00000)) N Neettccaasshhpprroovviiddeeddrroommooppeerraattiinnggaaccttiivviittiieess ((7755)) Investment Activities Investment Activities PurchaseoPlant,Equipment PurchaseoPlant,Equipment an

anddFiFixexeddAsAssesetsts ((6,6,90900)0) Ne

Nettcacashshpprrovovididededrorommininveveststmementntaactctivivititieiess (6(6,9,90000))

Financing Activities Financing Activities I Innccrreeaassee iinnnnootteessppaayyaabbllee 11,,550000 I Innccrreeaassee iinnbboonnddss 55,,222200 Dividendpaymentorpreerencesshare Dividendpaymentorpreerencesshare an

anddorordindinararyyshsharareses ((1,1,84845)5) N Neettccaasshh rroommffnnaanncciinnggaaccttiivviittiieess 44,,887755 I Innccrreeaassee ((ddeeccrreeaassee)) iinnccaasshh ((22,,110000)) B Beeggiinnnniinnggccaasshh bbaallaannccee 22,,440000 En

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3.2

3.2 Financialstatementsanalysis

Financialstatementsanalysis

Financialstatementsanalysisinvolves: Financialstatementsanalysisinvolves: (a)

(a) CoCompamparisrisononbetbetweeweennthethe frmfrm’s’speperorormrmancanceewitwithhothotherfrmserfrmsininthethe samsamee industry;and

industry;and (b)

(b) EvalEvaluatiouationonothethefrm’frm’sfnansfnancialpcialpositiositionronromtiomtimetmetotimotime.e. Theseanalysescanbeusedby:

Theseanalysescanbeusedby: (a

(a)) AA fnfnanancicialal mamananagegerrtoto ididenentitiyy ththeefrfrm’m’ssweweakaknenesssseses ananddtatakeke ststepepsstoto improv

improvethefrm’sperethefrm’sperormance;andormance;and (b)

(b) InveInvestorstorstoestoevaluvaluatethatethefrmefrm’scu’scurrerrentfnntfnancialancialstanstandingding..

3

3 .

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2

2 .

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1

1 R

R

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a

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In

Inoormrmatatioionn obobtatainineded rromom ththee fnfnanancicialal ststatatememenentt wiwillll asassisistst ininveveststororss anandd fnanc

fnancialmanagerialmanagersstoorecastoorecasttthefrm’suturethefrm’suture perperormaormancewhilemanagemncewhilemanagementent ca

cann ususee ththee ininoormrmatatioionn gagainineded toto oorrececasastt ththeesisitutuatatioionn ananddasassisistst ththemem inin pl

plananniningng oorr ththee uututurre.e. AA babasisicc memeththodod toto obobtatainin ususeeulul ininoormrmatatioionn rromom fnancialstatementsisthroughfnancialratioanalysis.

fnancialstatementsisthroughfnancialratioanalysis.

3

3 .

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The

Therere arareefvefve catcategegorioriesoesofnafnancincialratioalratios.Eachs.Eachtyptypeeofnancofnancialial ratratiosios hashas itsits ownroletothemanagementandownerothefrm.Financialratiosconsisto ownroletothemanagementandownerothefrm.Financialratiosconsisto (reertoTable3.1): (reertoTable3.1): selF-check3.3 selF-check3.3

True (T) or False (F) Statements

True (T) or False (F) Statements 1.

1. DepDeprereciaciatiotionexpnexpensensesisaniteesisanitemthatmthatwilladdwilladdtothenettothenetproprofttoftto determinecash

determinecashowromtheowromtheoperatingactivitieoperatingactivities.s. 2.

2. IntIntererestest expexpensensesareesare iteitemsoinvemsoinvestmstmentent actactiviivitietiesinasinacascashowhow statement.

statement. 3.

3. AnAnyyinincrcreaeasese inin acaccocoununtsts rrececeieivavablbleeananddacaccocoununtsts papayayablbleewiwillll be

beaddedaddedtotonetnetproftproftinindeterminingdeterminingcashcashowowromromoperatingoperating activities.

activities. 4.

4. PurPurchachaseoseofxfxededasseassetstsortorthehecomcompanpany’y’susesusewilwillbelbededdeductuctededtoto determinecasho

(9)

Table 3.1:

Table 3.1:FinancialRatioFinancialRatio

T

Tyyppees s oo  FiFinnaanncciiaal l RRaattiiooss FFiinnaanncciiaal l RRaattiiooss

LiquidityRatios

LiquidityRatios ••CurrentratioCurrentratio

•

•Quickratio(Acidtestratio)Quickratio(Acidtestratio) AssetsManagementRatios

AssetsManagementRatios ••InventoryturnoverratioInventoryturnoverratio

•

•FixedassetsturnoverratioFixedassetsturnoverratio

•

•TotalassetsturnoverratioTotalassetsturnoverratio Debtmanagementratios

Debtmanagementratios ••DebtratioDebtratio

•

•TimesinterestearnedratioTimesinterestearnedratio Proftabilityratios

Proftabilityratios ••NetsalesproftNetsalesproft

•

•ReturnsocommonequityReturnsocommonequity Marketvalueratio

Marketvalueratio ••Price/earningratioPrice/earningratio

• •BookpershareratioBookpershareratio • •Market/bookratioMarket/bookratio Letustakealookateachtypeindetail. Letustakealookateachtypeindetail. activity3.2 activity3.2 Defnethemeaningoliquidassets. Defnethemeaningoliquidassets. (a)

(a) Liquidity RatioLiquidity Ratio

Liquidity ratio

Liquidity ratioisusedtoshowthecorrelationbetweencashandafrm’sisusedtoshowthecorrelationbetweencashandafrm’s cur

currerentntasseassetstswitwithhitsits curcurrerentntlialiabilbilitiities.es. LiqLiquiduid assassetetisisananassassetetthathattcancan easilybeconvertedintocashwithoutdecreasingmuchoitsvalue.Afrm’s easilybeconvertedintocashwithoutdecreasingmuchoitsvalue.Afrm’s liquiditystandingcananswerquestionsastowhetherafrmcanaordor liquiditystandingcananswerquestionsastowhetherafrmcanaordor hastheabilitytopayo

hastheabilitytopayoitsdebtswhentheditsdebtswhenthedateisdue.ateisdue. (i)

(i) Current RatioCurrent Ratio Thi

Thisrasratiotioshoshowstwstheherreqequenuencyccycurrurrententlialiabilbilitiitiesaesarerecovcovereredbedbycuycurrrrenentt as

assesetstsananddththisis isis cacalclcululatateded byby didivivididingng cucurrrrenenttasassesetsts wiwithth cucurrrrenentt liabilities.Acurrentassetincludescash,marketablesecurities,accounts liabilities.Acurrentassetincludescash,marketablesecurities,accounts re

receiceivabvableleandand invinvententoriories.es. WhiWhilelecurcurrerentntlialiabilbilitiitiesesincincludludeeaccaccounountsts payable,short-term

payable,short-termnotespayable,taxaccruedandothenotespayable,taxaccruedandotherexpensessuchrexpensessuch asemployees’wages.

asemployees’wages. Cu

Currrrenenttraratitioocacannbebeeexpxprresesseseddasasolollolowsws::

Current ratio

Current ratio == CurrentAssetsCurrentAssets C

(10)

Ac

AccocorrdidingngtothtotheexeexamamplpleoeoEmaEmasLisLimimitetedCodCompmpananyy,th,thecuecurrrrenentratratitioo iscalculatedasollows:

iscalculatedasollows:

The

Therereorore,e,curcurrerentntratratioioinin2012010i0is3s3.68.68andandoortrtheheyeyearar2012011i1is3s3.23.23.. (ii)

(ii) Quick RatioQuick Ratio

Quickratioisalsoknownasanacidtestratio.Quickratiomeasuresthe Quickratioisalsoknownasanacidtestratio.Quickratiomeasuresthe frm’sabilitytopayshort-te

frm’sabilitytopayshort-termdebtswithouthavingrmdebtswithouthavingtosellinventorietosellinventories.s. Inve

Inventorntoryisyisdedudeductedcted roromcurrenmcurrentassetbecausethisassetistassetbecausethisassetistheleasttheleast liquidandithefrmisdissolved,inventorymightbetheassetwhich liquidandithefrmisdissolved,inventorymightbetheassetwhich couldincurlosses. couldincurlosses. Q Quuiicckk rraattiiooccaann bbee sshhoowwnn bbyytthhee oolllloowwiinngg oorrmmuullaa:: Quick Ratio

Quick Ratio==CurrentAssets–InventoriesCurrentAssets–Inventories C

Cuurrrreenntt LLiiaabbiilliittiieess

B

BaasseeddoonntthheeeexxaammpplleeooEEmmaassLLiimmiitteeddCCoommppaannyy,,tthheeqquuiicckkrraattiioowwhheenn calculatedisasollows: calculatedisasollows: Quick Ratio: Quick Ratio: Year2010= Year2010= 2424,3,30000––112,2,454500 =1.80=1.80 6 6,,660000 Year2011= Year2011= 3030,0,00000––118,8,454500 =1.24=1.24 9 9,,330000 T

Thhuuss,,qquuiicckkrraattiioooorrtthheeyyeeaarr22010100iis1s1..8800aannddoorrtthheeyyeeaarr22001111iiss11..2244.. Itshowsthatthefrmisabletopayitsshort-termdebtsbetterinthe Itshowsthatthefrmisabletopayitsshort-termdebtsbetterinthe year2010. year2010. Current ratio: Current ratio: Y Yeaearr20201010 :: 24,30024,300 =3.68=3.68 6 6,,660000 Y Yeaearr20201111 :: 30,00030,000 =3.23=3.23 9 9,,330000

(11)

(b)

(b) Asset Management RatioAsset Management Ratio A

Asssseett mmaannaaggeemmeenntt rraattiioo mmeeaassuurreess tthhee ffrrmm’’ss eeffcciieennccyy iinn mmaannaaggiinngg iittss assets.Theinormationr

assets.Theinormationregardingegardingtheassetmanagementratiocandeterminetheassetmanagementratiocandetermine whethereachtypeoassetsthathadbeenreportedintheBalanceSheet,too whethereachtypeoassetsthathadbeenreportedintheBalanceSheet,too muchortoolittle,isbasedonthecurrentsalesrequencyororecastedsales muchortoolittle,isbasedonthecurrentsalesrequencyororecastedsales requency.Iafrmhastoomanyassets,itscapitalistiedintheassetswhich requency.Iafrmhastoomanyassets,itscapitalistiedintheassetswhich willinvolveahighcostocapital.Asaconsequence,proftswilldecrease. willinvolveahighcostocapital.Asaconsequence,proftswilldecrease. Ontheother

Ontheotherhand,iahand,iafrmsavefrmsavestoolittleonassetstoolittleonassets,especis,especiallyinvallyinventoentories,ries, th

thisis wiwillll reresusultlt inin ththeelolossss oo clclieientntssbebecacaususeeoo lalackck oo ststococksks toto uulflfllththee customer’sdemand:

customer’sdemand: (i)

(i) Inventory Turnover RatioInventory Turnover Ratio

Inventory

Inventory TTurnoverurnoverRatiocanbeexpressedasollows:Ratiocanbeexpressedasollows:

selF-check3.4

Comp

Compareare currcurrentratioandquickratioorEmasentratioandquickratioorEmasLimiLimitedCompatedCompanyornyor theyears2010and2011.Whatisyouropinionregardingtheliquidity theyears2010and2011.Whatisyouropinionregardingtheliquidity positionothiscompany?

positionothiscompany?

Inventory Turnover Ratio

Inventory Turnover Ratio == CostogoodssoldCostogoodssold I

Innvveennttoorryy A

Ahighighinhinveventntororytuyturnrnovovererratratioioindindicicatatesesthathatsatsalelesarsaregoegoododandandinvinvenentotoryry tu

turnrnovoverer isis ququicick.k. ThTheeimimplplicicatatioionnisis ththatat ththeefrfrmmcacannrurunnititssbubusisinenessss wi

withthououtt hahavivingng toto titieeititss cacapipitatall inin ininveventntororieies.s.ThThisis isis bebecacaususeehoholdldiningg inv

invententorioriesesinvinvolvolvesescoscoststssucsuchhasascapcapitaitallcoscost,t,stostorinringgcoscost,t,andand insinsuraurancence co

costst.. ThTherereeorore,e, ththee hihighgherer ththee ininveventntororyy tuturnrnovoverer raratitio,o, ththee bebetttterer ththee situationorthefrm.

situationorthefrm. B

Basaseeddoonnththee eexxamampplele oo ththee EEmamassLLimimititeeddCComomppananyy,,ththee cacallcuculalatitioonnoorr inventoryturnoverratioisasollows: inventoryturnoverratioisasollows: Year2010==5.71 Year2010==5.71 Year2011==4.06 Year2011==4.06

Inventory Turnover Ratio

Inventory Turnover Ratio 71,110 71,110 12,450 12,450 74,846 74,846 18,450 18,450

(12)

Thu

Thus,ins,inveventontorytryturnurnovoverrerratiatioooorthrtheyeeyear2ar2010010is5.is5.71a71andndortortheyheyearear20120111 is4.06.Thismeansthatthefrm’spositionisbetterintheyear2010.

is4.06.Thismeansthatthefrm’spositionisbetterintheyear2010. (ii)

(ii) Fixed Asset Turnover RatioFixed Asset Turnover Ratio T

Thhiiss rraattiioo mmeeaassuurreess tthhee ffrrmm’’ss eeffcciieennccyy iinn uussiinngg ffxxeedd aasssseettss ssuucchh aass buildings

buildingsandandequipmentequipmenttotogenerategenerateprofts.profts.TheTheormulaormulaororfxedfxedassetasset turnoverratioisexpressedasollows:

turnoverratioisexpressedasollows: Ba

BasesedodonthntheexeexamamplpleoeoEmEmasasLimLimititededComCompapanyny,fx,fxededassassetetturturnonoveverrarratitioo is:

is:

Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio == SalesSales N

Neettffxxeedd aasssseettss

T

Total Aotal Asset sset TTurnover urnover RatioRatio == SalesSales T Toottaallaasssseettss Year2010==3.28 Year2010==3.28 Year2011==3.01 Year2011==3.01 85,500 85,500 26,100 26,100 90,300 90,300 30,000 30,000 Thu

Thus,fs,fxexedadassessettutturnornoveverrrratiatiooororthetheyeyearar2012010i0is3.s3.2828andandoortrtheheyeayear2r2010111 is3.00.Thismeansthatthefrm’sefciencyinmanagingitsfxedassetshad is3.00.Thismeansthatthefrm’sefciencyinmanagingitsfxedassetshad decreasedintheyear2011.

decreasedintheyear2011.

(iii)

(iii) TTotal otal Asset Asset TTurnover urnover RatioRatio T

Totaotalalassessetttturnurnovovererratratioiocancanbebeshshownownbybyththeeollollowiowingngorormulmula:a:

N

Noorrmmaallllyy,, hhiigghh rraattiiooss oo ffxxeedd aasssseett ttuurrnnoovveerr aanndd ttoottaall aasssseett ttuurrnnoovveerr ar

areeprpreeererrered.d. ThThisis isis bebecacaususeeaahihighgh raratitiooinindidicacatetessththatat asassesetsts arareeususeded mo

morere eeecectivtivelyely totogegenernerateate salsales.es. BasBaseded ononthethe exaexamplmpleeooEmaEmassLimLimiteitedd Company,totalassetturnoverratiois:

(13)

Th

Therereeorore,e,tottotalalassassetetturturnonoveverrarratitioinointhetheyeayear20r201010is1.is1.7070andandororthetheyeayearr 2011is1.50.Thismeansthattotalassetsturnoverratioortheyear2010is 2011is1.50.Thismeansthattotalassetsturnoverratioortheyear2010is higher. higher. Year2010==1.70 Year2010==1.70 Year2011==1.50 Year2011==1.50 T

Total otal Asset Asset TTurnover urnover RatioRatio 85,500 85,500 50,400 50,400 90,000 90,000 60,000 60,000 activity3.3 activity3.3 Ba

Baseseddonon ththeeasassesettmamananagegemementnt raratitioooorrththeeEmEmasas LiLimimiteteddCoCompmpananyy 

oorr tthhee yyeeaarrss 22001100 anandd 22001111,, wwhhiicchh yyeeaarr hhaass mmoorree eeffcciieenntt aasssseettss management?Givereasonstosupportyouranswer.

management?Givereasonstosupportyouranswer.

(c)

(c) Debt Management RatioDebt Management Ratio T

Tototalal dedebtbtssususeded byby aafrfrmismisknknowownasnasfnfnanancicialal leleveveraragege..ImImplplicicatatioionsns oo usingdebtsascapitalare: usingdebtsascapitalare: ( (ii)) SShhaarreehhoollddeerrss ccaann ccoonnttiinnuuee ccoonnttrroolllliinngg aa ffrrmm bbyy oobbttaaiinniinngg uunnddss throughdebts; throughdebts; (ii

(ii)) CrCrededitoitorsusersuse equequityity toprotoprovividesecudesecuritritymargymargin.in. IIshasharereholholdedershavershave asmalltotalofnancialratio,thefrm’sriskwillbebornebycreditors; asmalltotalofnancialratio,thefrm’sriskwillbebornebycreditors; and and (i (iiiii)) II frfrmsms atattatainin hihighgherer reretuturnrnssththanan whwhatat hahassbebeenen papaidid asas inintetererestst onon debts,return

debts,returnsonowner’scapitalwillbehighersonowner’scapitalwillbehigher.. Therear

Therearetwotypesodeetwotypesodebtmanagementratiobtmanagementratios:s: (i)

(i) Debt RatioDebt Ratio De

Debtbt rratatioio mmeeasasurureessththee ppeerrcecentntagagee oounundsds prprovovidideedd byby crcrededititoorrs.s. Debtratiocanbeshownintheollowingormula:

Debtratiocanbeshownintheollowingormula:

Debt Ratio

Debt Ratio== TotaldebtsTotaldebts Totalassets Totalassets T Tototalal dedebtbt ininclclududeses cucurrrrenenttliliababililititieiessananddlolongng-t-terermmdedebtbts.s. CrCrededititororss preeralowdebtratioasitismoreadvantageousduringthetimea preeralowdebtratioasitismoreadvantageousduringthetimea

(14)

companyisdissolved.Forshareholders,theypreerahighdebtratio companyisdissolved.Forshareholders,theypreerahighdebtratio becauseitwillenlar

becauseitwillenlargetheexpegetheexpectedearnings.ctedearnings. B

Basaseedd onon ththeeeexaxammplplee oo EEmamassLLimimititeedd CCoompmpananyy,,ththee cacalclcuulalatitioonnoo debtratioisasollows: debtratioisasollows: = =

EarningsbeforeInterestandTax

Interestcharge

TimesInterestEarnedRatio TimesInterestEarnedRatio Thu

Thus,ts,thehededebtrbtratiatioiointhntheyeyearear2012010is0is0.40.48an8andodorthrtheyeyearear2012011is1is0.50.53.3. Thismeansthatthedebtratiohasincreasedintheyear2011.Thefrm Thismeansthatthedebtratiohasincreasedintheyear2011.Thefrm reliesmo

reliesmoreonitscrreonitscreditorstofnancetheeditorstofnancethetotalassetsortheyetotalassetsortheyear201ar2011.1. (ii)

(ii) Times Interest Earned RatioTimes Interest Earned Ratio Thi

Thisrasratiotioisuisusedsedtomtomeaseasururethethefrefrm’sm’sabilabilityitytoptopayiayitsantsannuanualinlinterterestest pa

paymymenent.t. II aafrfrmmisis ununabablele toto papayyooititssininteterresesttchcharargeges,s, crcrededititororss havetherighttotakelegalproceedingsagainstitandthismightcause havetherighttotakelegalproceedingsagainstitandthismightcause the

the comcompanpanyytotobecbecomeome banbankrkruptupt..FrFromomthethe crcredieditor’stor’spoipointntoovievieww thehigherafrm’stimesinterestearnedratio,thebetteritisorthem, thehigherafrm’stimesinterestearnedratio,thebetteritisorthem, because

becausethatthatshowsshowsthethefrm’sfrm’sabilityabilitytotopaypayinterestinterestannuallyannually..Hence,Hence, creditor’srisksareless.

creditor’srisksareless. T

Timeimesisintenterereststearearnednedraratiotiocacanbnbeseshowhowninintnthehennorormulmulababeloelow:w: Year2010==0.48 Year2010==0.48 Year2011==0.53 Year2011==0.53 24,000 24,000 50,400 50,400 31,920 31,920 60,000 60,000 Debt Ratio Debt Ratio

(15)

B

Basaseeddonon ththee eexxamampplele ooEmEmasas LLimimititeedd CComomppananyy,,ththee cacalclcululatatioionn oo timesinterestearnedis:

timesinterestearnedis:

Thu

Thus,ts,timeimesinsinterterestestearearnednedratratioiioishishighegherinrinthetheyeyear2ar2010010.Th.Thefrefrm’sm’sabiabilitlityy topayannualinter

topayannualinteresthaddeclinedesthaddeclinedintheyear201intheyear2011.1.

activity3.4 activity3.4 Writedowntheimportanceodebtmanagementratiototheollowing Writedowntheimportanceodebtmanagementratiototheollowing parties: parties: S Shhaarreehhoollddeerrss CCrreeddiittoorrss (d)

(d) Proftability RatioProftability Ratio P

Prrooffttaabbiilliittyy rraattiioo iinnddiiccaatteess tthhee ccoommbbiinneedd eeeeccttss oo lliiqquuiiddiittyy,, aasssseett manag

managemenementandtanddebtsdebts decidecisionsion onoperatonoperation.Inshort,proftion.Inshort,proftabiliabilityratioistyratiois theeecto

theeectovariouspolicievariouspoliciesanddecisionsothesanddecisionsothecompany:company: (i)

(i) Proft Margin on SalesProft Margin on Sales Th

Thisisrratatioiommeaeasusureressinincocomemerromomeeveveryryrrininggggititoosasaleles.s. Pr

Profofttmamargrgininoonnsasalelesscacannbebesshohownwnbbyyththeeoollllowowininggoormrmulula:a: B Baasseedd oonn tthhee eexxaammppllee oo EEmmaass LLiimmiitteedd CCoommppaannyy,, pprroofftt mmaarrggiinn oonn salesis: salesis: Year2010==4.38 Year2010==4.38 Year2011==3.23 Year2011==3.23 7,890 7,890 1,800 1,800 8,514 8,514 2,640 2,640

Times Interest Earned Ratio

(16)

T

Theherreeoorree,ne,netprtprooftft mmarargginin oror ththee yyeearar 20201010 isis 4.4.1%1% anandd inin yyeearar 2020111is1is 3.8%.Itindicatesthatthefrm’snetproftmargininyear2010ishigherthan 3.8%.Itindicatesthatthefrm’snetproftmargininyear2010ishigherthan 2011.

2011. Thu

Thus,ps,proroftmftmararginginononsalsalesesororthetheyeyear2ar2010010isis4.14.1%an%anddororthetheyeyear2ar201011is1is 3.8%.Thismeansthatproftmarginonsalesishigherortheyear2010.This 3.8%.Thismeansthatproftmarginonsalesishigherortheyear2010.This marginwentdownintheyear2011.

marginwentdownintheyear2011.

Proft Margin on Sales

Proft Margin on Sales== EarningavailableortheshareholdersEarningavailableortheshareholders Sales

Sales

Year2010==0.041=4.1% Year2010==0.041=4.1%

Proft Margin on Sales

Proft Margin on Sales 3,540 3,540 85,500 85,500 Year2011==0.038=3.8% Year2011==0.038=3.8%3,4053,405 90,000 90,000 Year2010==0.1405=14.05% Year2010==0.1405=14.05% Year2011==0.1267=12.67% Year2011==0.1267=12.67%

Return on Common Stock Equity

Return on Common Stock Equity 3,540 3,540 25,200 25,200 3,405 3,405 26,880 26,880 (ii)

(ii) Return on Common EquityReturn on Common Equity Thi

Thisrasratiotiomeameasursurestestherherateateororetueturnsrnsearearnednedonthontheineinvevestmstmententoooordrdinainaryry sh

shararehehololdedersrs..ReRetuturnrn onon cocommmmonon eqequiuityty cacannbebe shshowownnbyby ththeeoollllowowiningg ormula:

ormula:

Bas

BasededonthontheexeexampampleoleoEmEmasLasLimiimitedtedComCompanpanyy,r,retueturnornonconcommommoneqnequituityy isasollows:

isasollows:

Return on Common Equity

Return on Common Equity== NetproftavNetproftavailableororailableorordinarysharedinaryshareholdersholders Ordinarysharesequity

(17)

T

Theherreeoorree,,ththee rreetuturnrn onon cocommmomonneeququiityty oorrththee yyeearar 20201010 isis 1414.0.05%5% anandd 12.67%

12.67%ortheyear201ortheyear2011.So,itshowsthatretu1.So,itshowsthatreturnoncommornoncommonequitynequityortheorthe year2010ishigher.

year2010ishigher. (e)

(e) Market Value RatioMarket Value Ratio Ma

Markrketet vavalulueraeratitioisois aseasetoto raratitiosos ththatat cocorrrrelelatateses ththefrefrm’m’sstsstocockprkpricicetoeto theearningso(bookvalue)persharebasedonbookvalue.Thisratiogives theearningso(bookvalue)persharebasedonbookvalue.Thisratiogives inor

inormatiomationtontothemanagethemanagementregmentregardardingtheinvestoingtheinvestors’viewonthers’viewonthefrm’frm’ss perormance

perormanceinthepastanditsuturinthepastanditsutureprospeceprospects:ts: (i)

(i) Price/Earnings RatioPrice/Earnings Ratio Thi

Thisrsratiatiososhowhowshoshowmwmuchuchinvinvestestorsorsararewewillillingingtotopaypayoorereachachriringgnggitit othepro

otheproftreporteftreported.Thisratiocanbeexd.Thisratiocanbeexpressedasopressedasollows:llows:

= =MarketpricepershareMarketpricepershare Bookvaluepershare Bookvaluepershare = = PricepersharePricepershare Earningspershare Earningspershare (ii)

(ii) Book Value Per ShareBook Value Per Share Boo

Bookvkvalualuepeperershasharereraratiotiocacanbnbeseshohownwnbybythetheoollollowinwinggormormulaula::

=

= CommonequityCommonequity

Outstandingshares

(iii)

(iii) Market/Book RatioMarket/Book Ratio Ma

Markrketet/B/Booookkraratitioocacannbebeeexpxpreressssededaassoollllowows:s:

(iv)

(iv) Flow Analysis o Financial RatioFlow Analysis o Financial Ratio In

Inusiusingngfnafnancnciaialralratitio,o,itisitisimpimporortatantntororafnaafnancnciaialmalmananagegertortomakmakee time

timecomparicomparisonorcompasonorcomparisonrisonsofrmsinthesameindustrsofrmsinthesameindustrytogetaytogeta compreh

comprehensiveviewoensiveviewothefrm’sperthefrm’sperormance.ormance.

Price/Earning Ratio

Book Value Per Share Ratio

Market/Book Ratio

(18)

Table 3.2:

Table 3.2:FinancialRatiosFormulaFinancialRatiosFormula

T Tyyppees s oo  FFiinnaanncciiaal l RRaattiioo FFiinnaanncciiaal l RRaattiioos s FFoorrmmuullaa ( (aa)) LLiiqquuiiddiittyyrraattiio o CCuurrrreennttrraattiioo Quickratio Quickratio (b

(b))AsAssesettmamananagegemementntrratatio io InInvenventotoryryTTururnonoveverrRaRatiotio

Fixedassetsturnoverratio Fixedassetsturnoverratio Totalassetsturnoverratio Totalassetsturnoverratio ( (dd)) PPrrooffttaabbiilliittyyrraattiio o PPrrooffttmmaarrggiinnoonnssaalleess Returnoncommonequity Returnoncommonequity Current Assets Current Assets Current Liabilities Current Liabilities Sales Sales Net fxed assets Net fxed assets

Cost o goods sold Cost o goods sold

Inventory Inventory Sales Sales Total assets Total assets Net proft

Net proft available or available or ordinary sharehoordinary shareholderslders Ordinary shares equity

Ordinary shares equity

Earnings available or the shareholders Earnings available or the shareholders

Sales Sales

Current Asset - Inventories Current Asset - Inventories

Current Liability Current Liability

T

(19)

T

Tyyppees s oo  FFiinnaanncciiaal l RRaattiioo FFiinnaanncciiaal l RRaattiioos s FFoorrmmuullaa

(

(ee)) MMaarrkkeettvvaaluluee rraattio io PPrricicee//EEaarrnnininggssRRaatitioo

BookValuePerShare BookValuePerShare Market/BookRatio Market/BookRatio

3.

2.

2. 3

3

U





f

F









R







Price per share Price per share Earning per share Earning per share

Common equity Common equity Outstanding shares Outstanding shares

Market price per share Market price per share Book value per share Book value per share

activity3.5

Based

Basedonontheavailatheavailablefnanciblefnancialratios,inyourownopinioalratios,inyourownopinion,howdon,howdothesethese ratiosassistorganisationsinmakingdecisions?

ratiosassistorganisationsinmakingdecisions?

Fin

Financancialial ratratiosios cancan bebeuseuseddtotointintererprpretetfnafnancincialalininormormatiationonininaawayway thathattisis eas

easilyily undundererstostoodod.. FinFinancancialial ratratiosios cancan givgiveeaa momorere comcomprprehehensensiveive rereecectiotionn com

comparpareded totothethe rerealalfgfgururesesasasstastatedted ininfnafnancincialalstastatemtementents.s.FoForrexaexamplmple,e,ii afnancialmanagerwishestoknowafrm’sliquiditystanding,hehasonlyto afnancialmanagerwishestoknowafrm’sliquiditystanding,hehasonlyto reertothefnancialratiossuchascurrentratioandquickratio.Foraninvestor reertothefnancialratiossuchascurrentratioandquickratio.Foraninvestor whowishestoknowthefrm’sproftability,hecanreertotheproftabilityratios whowishestoknowthefrm’sproftability,hecanreertotheproftabilityratios suc

suchhasasprproftoft marmargingin ononsalsalesesandand rereturturnnoncommooncommonnstostockckeqequituityy..IIfnafnancincialal rat

ratiosios cancan bebecolcolleclectedted oror sevseveraerallyeayears,rs, comcomparparisoisonncancan bebemadmadeebybyshoshowinwingg the

theirowsinirowsinthethe orormmograpograph,thusmakinh,thusmakinggdisdisperpersiosionnoinooinormarmatiotionnbythebythe managementeasier.

managementeasier.

Financialratioscanbeusedtoconstructafrm’sfnancialprofles.Itcanevaluate Financialratioscanbeusedtoconstructafrm’sfnancialprofles.Itcanevaluate vari

variousousaspecaspectstsoofrm’frm’ssfnancfnancialialperperormaormancenceandandstandstanding.ing. ThisThisinoinormatirmationon ca

cannbebe ususeded inin ththeededecicisisionon-m-makakininggprprococesesssbyby ththeefrfrm’m’ssmamananagegemementnt teteamam,, suppliers,investors,banksandsoon.

(20)

Fin

Financancialial ratratiosios (es(espepeciaciallylly iiowow anaanalyslysisisororcomcomparparisoisonsnsbetbetweeweennarareemadmade)e) canmeasurethefrm’shealthandgivean“earlywarning”signonthedifculties canmeasurethefrm’shealthandgivean“earlywarning”signonthedifculties whi

whichchmaymay bebeacacededbybythethe frmfrm..TheTherereorore,e,aafnafnancincialalmanmanageagerrmaymay prpropoposeose appropr

appropriatestepstosolvethiatestepstosolvetheproblemeproblembeoreitbebeoreitbecomestooacute.comestooacute.

activity3.6 activity3.6 P Prreeppararee aa lliisstt oo ffnnaanncciiaall rraattiiooss wwhhiicchh yyoouu mmiigghhtt ssccrruuttiinniissee bbeeoorree purchasingafrm’sshare. purchasingafrm’sshare.

3.

2.

2. 4

4

W









f

F







R





a





Al

Alththououghgh fnfnanancicialal raratitiooisis aaususeeulul ananddququicickkwawayytoto ananalalysyseeththeeststatatusus anandd perormanceoabusiness,ithassomeweaknessesandthisshouldbeconsidered perormanceoabusiness,ithassomeweaknessesandthisshouldbeconsidered byafnancialmanagerwh

byafnancialmanagerwhenusingfnancialratioenusingfnancialratios.Amongs.Amongsttheweaknessesarsttheweaknessesare:e: (a

(a)) FiFinanancnciaiall raratitiosos rrelelyy onon dadatata obobtatainineded rromom fnfnanancicialal ststatatememenentsts.. ThThusus,, wh

whetetheherrththeefnfnanancicialal raratitiosos cacalclcululatateded cacannbebe trtrususteteddoror nonottdedepependndssonon th

thee ququalalitityy oo ththee fnfnanancicialal ststatatememenentsts.. WWeaeaknknesessesess whwhicichh exexisistt inin ththee fnancialstatementwillbereectedinthefnancialratiosandinterpreting fnancialstatementwillbereectedinthefnancialratiosandinterpreting in

inorormmatatioionn rroomm ththeesese rratatioioss iiss uuseselleessss bebecacauusese ththee fnfnanancicialal ddatataa isis ina

inaccuccuratrate.e.ApaApartrtrromomthathat,t,oneone oothethe impimporortantanttacactortorsswhiwhichchneeneedsdstoto be

be takentaken intointo considerationconsideration inin preparipreparingng thethe fnancialfnancial statementsstatements isis thethe eectoinationwhichmaymisrepresentthevalueofxedassetssuchas eectoinationwhichmaymisrepresentthevalueofxedassetssuchas proper

properties,proftandties,proftandlossfgures,elossfgures,etc.tc. (

(b)b) FFininanancicialal rratatioioss mmeeasasururee ththee ffrmrm’s’s rreellatatiivvee ststanandidingng anandd ppeerroormrmanancece and

and donotdonottaktakeeintintooaccaccounounttitsits absabsoluolutesize.tesize. SomSometietimemes,s,rerealalfgufgureresscancan giv

giveeaabetbetterter oveoveralralllrereecectiotionnwhewhennwewemakmakeeaacomcomparparisoisonnoothethe frmfrm’s’s perormancebetweentwodierenttimeperiodsorbetweentwodierent perormancebetweentwodierenttimeperiodsorbetweentwodierent frms.

frms. (c)

(c) NorNormalmallyly,,fnafnancincialratioalratio oaoafrmfrm iscompaiscomparereddwitwithhthethe indindustustryaverryaverageagess r raattiiooss wwhheerree bbaassiicc ssiiggnnss aarree uusseedd ttoo llooookk aatt tthhee ffrrmm’’ss ssttaannddiinngg aanndd pe perrorormamancncee cocompmparareded toto ototheherr frfrmsms.. ItIt shshououldld bebe rrememinindededd ththatat ththisis comparisonmightnotbeappropriatebecauseitisdifculttofndtwofrms comparisonmightnotbeappropriatebecauseitisdifculttofndtwofrms wit

withthehthesamsamekindoekindobusbusineiness.ss. EvEventhouenthoughtherghtheremayemayexexistist twotwo frmfrmssinin thesameindustry,oneothefrmsmighthavemiscellaneousactivitiesin thesameindustry,oneothefrmsmighthavemiscellaneousactivitiesin othertypesobusiness.Inaddition,accountingpolicy,fnancialpolicy,and othertypesobusiness.Inaddition,accountingpolicy,fnancialpolicy,and