Analysis and

interpretation of
financial statements
Lecture 4

1
Learning Objectives

1. Discuss the need for comparative analysis.

2. Identify the tools of financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Identify and calculate ratios used in analyzing a firm’s
financial position and performance.
6. Explain the limitations of financial statement analysis.

2
 WHO USES ACCOUNTING DATA?
Internal Users
Management IRB
Human Investors
Resources
There are two broad
groups of users of Labour
financial information: Unions
Finance
internal users and
external users.
Creditors
Marketing
Customers SCM
External
Users
WHO USES ACCOUNTING DATA?
COMMON QUESTIONS ASKED User
1. Can we afford to give our
employees a pay raise? Human Resources
2. Did the company earn a
satisfactory income? Investors
3. Do we need to borrow in the
near future? Management
4. Is cash sufficient to pay
dividends to the stockholders? Finance
5. What price for our product will
maximize net income? Marketing
6. Will the company be able to
pay its short-term debts? Creditors
The Use of Financial
Statements by Outsiders

Two concerns:
Creditors Liquidity
Profitability

Investors
Financial Reporting and Financial
Statements
Financial statements are
just one source of financial
accounting information.

6
LEARNING OBJECTIVE 1
Discuss the need for comparative analysis.

7
 NEED FOR COMPARATIVE ANALYSIS
The condensed balance sheet of Ramsey Corporation as at
31 December 2019 is presented below.

2019
Current assets $ 76,000
Non-current assets 99,000
Intangibles 25,000
Total assets $ 200,000
Current liabilities $ 40,800
Long-term liabilties 143,000
Stockholders' equity 16,200
Total liabilities & equity $ 200,000

What can you tell about the company from its 2019 balance sheet?
 NEED FOR COMPARATIVE ANALYSIS
Now compare two years’ balance sheets of Ramsey Corporation.

2019 2018
Current assets $ 76,000 $ 80,000
Non-current assets 99,000 90,000
Intangibles 25,000 40,000
Total assets $ 200,000 $ 210,000
Current liabilities $ 40,800 $ 48,000
Long-term liabilties 143,000 150,000
Stockholders' equity 16,200 12,000
Total liabilities & equity $ 200,000 $ 210,000

Does this tell you more about the company’s financial position?
 NEED FOR COMPARATIVE ANALYSIS
Let’s look at changes in the balances of assets, liabilities and
stockholders’ equity of Ramsey Corporation over two years in
more detail.
Increase Percentage
2019 2018 (Decrease) Change
Current assets $ 76,000 $ 80,000 $ (4,000) -5.0%
Non-current assets 99,000 90,000 9,000 10.0%
Intangibles 25,000 40,000 (15,000) -37.5%
Total assets $ 200,000 $ 210,000 $ (10,000) -4.8%
Current liabilities $ 40,800 $ 48,000 $ (7,200) -15.0%
Long-term liabilties 143,000 150,000 (7,000) -4.7%
Stockholders' equity 16,200 12,000 4,200 35.0%
Total liabilities & equity $ 200,000 $ 210,000 $ (10,000) -4.8%

What is your assessment of the company’s financial position

and performance now?
 NEED FOR COMPARATIVE ANALYSIS
The condensed income statement of Ramsey Corporation for
the year ended 2019 is shown below.

2019
Amount
Net sales $ 500,000
Cost of goods sold 420,000
Gross profit 80,000
Operating expense 44,000
Net profit $ 36,000

What can you tell about the financial performance of the company?
 NEED FOR COMPARATIVE ANALYSIS
Now compare two years’ financial statements below:

2019 2018
Amount Amount
Net sales $ 500,000 $ 600,000
Cost of goods sold 420,000 483,000
Gross profit 80,000 117,000
Operating expense 44,000 57,200
Net profit $ 36,000 $ 59,800

Does this give you more information about the financial

performance of the business?
 NEED FOR COMPARATIVE ANALYSIS
Let’s see how much revenues and expenses have changed
over the two years.

2019 2018 Increase Percentage

Amount Amount (Decrease) Change
Net sales $ 500,000 $ 600,000 $ (100,000) -16.7%
Cost of goods sold 420,000 483,000 $ (63,000) -13.0%
Gross profit 80,000 117,000 $ (37,000) -31.6%
Operating expense 44,000 57,200 $ (13,200) -23.1%
Net profit $ 36,000 $ 59,800 $ (23,800) -39.8%

Does this give you a better understanding of the financial

performance of the business?
NEED FOR COMPARATIVE ANALYSIS
Evaluation of the performance of a business is more
meaningful when accounting data in financial statements
are compared to something:
previous years’ financial reports
competitors’ accounting data
industry data
national economy
other items within the financial statements
LEARNING OBJECTIVE 2
Identify the tools of financial statement analysis.

15
BASICS OF FINANCIAL STATEMENT ANALYSIS
Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

Liquidity Intracompany Horizontal

Profitability Industry Vertical
Efficiency averages Ratio
Returns to Intercompany
shareholders
Capital
structure
LEARNING OBJECTIVE 3
Explain and apply horizontal analysis.

17
HORIZONTAL ANALYSIS

Horizontal analysis, also called trend analysis, is a

technique for evaluating a series of financial statement
data over a period of time.

Its purpose is to determine the increase or decrease that

has taken place.

Horizontal analysis is commonly applied to the balance

sheet, income statement, and statement of retained
earnings.
HORIZONTAL ANALYSIS
The comparative condensed balance sheets of Ramsey
Corporation are presented below.
Increase Percentage
2019 2018 (Decrease) Change
Current assets $ 46,000 $ 55,000 $ (9,000) -16.4%
Property, plant and
equipment 122,000 100,000 22,000 22.0%
Intangibles 20,000 25,000 (5,000) -20.0%
Total assets $ 188,000 $ 180,000 $ 8,000 4.4%
Current liabilities $ 45,800 $ 40,000 $ 5,800 14.5%
Long-term liabilties 111,000 117,000 (6,000) -5.1%
Stockholders' equity 31,200 23,000 8,200 35.7%
Total liabilities & equity $ 188,000 $ 180,000 $ 8,000 4.4%

Instructions: Prepare a horizontal analysis of the balance

sheet data for Ramsey Corporation using 2018 as a base.
TREND PERCENTAGES
• A type of horizontal analysis
• are calculated by selecting a base year whose amounts
are set equal to 100%.
• The amounts of each following year are expressed as a
percentage of the base amount.

Any year RM
Trend % =
Base year RM
TREND PERCENTAGES
Year 2019 2018 2017

Net Sales (RM) 858,000 803,000 781,000

Cost of sales (RM) 513,000 509,000 490,000
Gross profit (RM) 345,000 294,000 291,000

2017 is the base year.

What are the trend percentages?

TREND PERCENTAGES
Year
Year 2019 2010 20182009 2008
2017
Net sales (858k/781k) x 100% (803k/781k) x 100% (781k/781k) x 100%
= 109.9% = 102.8% = 100%

Cost
Cost of
of Sales
(513k/490k) x 100% (509k/490k) x 100% (490k/490k) x 100%
Sales = 104.7% = 103.9% = 100%

Gross Profit
Gross (345k/291k) x 100% (294k/291k) x 100% (291k/291k) x 100%
Profit = 118.6% = 101% = 100%

These percentages were calculated by

dividing each item by the base year.
Base year: Year 2017
 TREND PERCENTAGE INTERPRETATION
Trends indicate the direction a business is taking.

- Net sales increased a little in year 2018 and had a higher

increase in year 2019.

- Cost of sales increased from year 2017 to 2019, but at a

lower rate compared to increase in net sales in year 2019.

- Gross profit showed a high increase of 18.6%in year 2019

and only 1% increases in 2018. This low increment in 2018
is because the cost of sales in that year increased at a
higher rate than net sales.
GRAPHICAL PRESENTATION OF TREND ANALYSIS

Charts can provide a visual presentation of trends.

LEARNING OBJECTIVE 4
Describe and apply vertical analysis.

25
VERTICAL ANALYSIS

Vertical analysis, also called common-size analysis, is

a technique that expresses each financial statement item
as a percent of a base amount.

For example, on an income statement, we might say

that selling expenses are 16% of net sales.

Vertical analysis is commonly applied to the balance

sheet and the income statement.
 VERTICAL ANALYSIS
Vertical analysis of the income statement data for Ramsey
Corporation for 2 years.
2019 2018
Amount Percent Amount Percent
Net sales $ 600,000 100.0% $ 500,000 100.0%
Cost of goods sold 483,000 80.5% 420,000 84.0%
Gross profit 117,000 19.5% 80,000 16.0%
Operating expense 57,200 9.5% 44,000 8.8%
Net income $ 59,800 10.0% $ 36,000 7.2%

All items are stated as a percentage of Sales.

COMMON-SIZE STATEMENTS

• Reports only percentages

• Removes dollar value bias

o Bias from comparing numbers in absolute
rather than relative terms

• Common-size statements are used to compare

one company to other companies, and to the
industry average.
COMMON-SIZE STATEMENTS
Common-size balance sheets of Ramsey Corporation are
presented below.
2019 2018
Current assets 24.5% 30.6%
Property, plant and equipment 64.9% 55.6%
Intangibles 10.6% 13.9%
Total assets 100.0% 100.0%

Current liabilities 24.4% 22.2%

Long-term liabilties 59.0% 65.0%
Stockholders' equity 16.6% 12.8%
Total liabilities & equity 100.0% 100.0%

All items are stated as a percentage of Total Assets.

VERTICAL ANALYSIS

NOTE:

For the income statement, state all items as a

percentage of Sales.

For the balance sheet, state all items as a

percentage of Total Assets.
LEARNING OBJECTIVE 5
Identify and compute ratios used in analyzing a firm’s financial
position and performance.

31
WHAT ARE RATIOS?

 A ratio expresses the mathematical relationship

between one quantity and another.

 The relationship can be expressed in 3 ways:

 a percentage (220%),
 a rate (2.2 times), or
 a simple proportion (2.2 : 1).

 Ratios can provide clues to underlying conditions

that may not be apparent from individual financial
statement components.
RATIO ANALYSIS
Ratio analysis expresses the relationship among
selected items of financial statement data.

Ratios can be classified into categories that analyze the

key aspects of financial health

Liquidity
Financial Investment
ratios

Financial
Profitability Efficiency
gearing
RATIO ANALYSIS

Different users will emphasize different ratios for their

purposes.
RATIO ANALYSIS

A single ratio by itself is not very meaningful.

The discussion of ratios will

include the following types of
comparisons.
LIQUIDITY RATIOS

Ability to pay
current liabilities

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for
cash.
 Short-term creditors such as bankers and suppliers
are particularly interested in assessing liquidity.
The liquidity ratios are:
 Current ratio
 Acid-test ratio
LIQUIDITY RATIOS
Ability to Pay Current Liabilities

Working Current ratio Acid-test

capital • Most widely ratio
• Measures used • Tells if
ability to meet • Proportion of company
short-term current assets could pay all
obligations to current its current
liabilities liabilities
immediately
 LIQUIDITY RATIOS

Working capital = Current assets – Current liabilities

Results in a
dollar amount

Current assets
Current ratio =
Current liabilities
Both result
in a ratio

Current assets − Inventory

Acid-test ratio =
Current liabilities
 LIQUIDITY RATIOS

 Acid test ratio is also know as Quick ratio.

Cash
equivalents
=
Cash + Short−term investments + Net current receivables
Current liabilities

 Net current receivables includes accounts receivable and

notes receivable, net of allowances.
 Inventory and prepaid expenses are not included in the acid
test because they are the least-liquid current assets.
LIQUIDITY RATIOS
Illustration Tukul Tool Company Sdn Bhd
Income Statement
For the Year Ended 31 December
2019 2018
RM RM
Net sales 1,818,500 1,750,500
Cost of goods sold 1,011,500 996,000
Gross profit 807,000 754,500
Selling and administrative expenses 506,000 479,000
Operating profit 301,000 275,500
Interest expense 18,000 14,000
Profit before tax 283,000 261,500
Tax expense 84,000 77,000
Net profit 199,000 184,500
LIQUIDITY RATIOS
Tukul Tool Company Sdn Bhd
Balance Sheets
31 December
Assets 2019 2018
RM RM
Current assets
Cash 60,100 64,200
Short-term investments 69,000 50,000
Accounts receivable (net) 107,800 102,800
Inventory 133,000 115,500
Total current assets 369,900 332,500
Plant assets (net) 600,300 520,300
Total assets 970,200 852,800
LIQUIDITY RATIOS
Liabilities and Stockholders' Equity 2019 2018
RM RM
Current liabilities
Accounts payable 160,000 145,400
Income taxes payable 43,500 42,000
Total current liabilities 203,500 187,400
Non-current liabilities: Bonds payable 200,000 200,000
Total liabilities 403,500 387,400
Equity
Share capital 280,000 300,000
Retained profits 286,700 165,400
Total equity 566,700 465,400
Total liabilities and equity 970,200 852,800
All sales were on account. The allowance for doubtful accounts was
RM3,200 on 31 December 2019, and RM3,000 on 31 December 2018.
LIQUIDITY RATIOS

Calculate the Current Ratio for 2019.

Current assets
Current ratio =
Current liabilities

RM369,900
=
RM203,500

= 1.82 : 1

The ratio of 1.82:1 means that for every dollar of

current liabilities, the company has RM1.82 of current
assets.

IS BS1 BS2
 LIQUIDITY RATIOS

Calculate the Acid-Test Ratio for 2019.

Acid-Test Ratio
=
Cash + Short−term investments + Net current receivables
Current liabilities

RM60,100 + RM69,000 + RM107,800

= = 1.16 : 1
RM203,500
The acid-test ratio measures immediate liquidity.
Alternatively,
Current assets − Inventory
Acid-test ratio =
Current liabilities
IS BS1 BS2
 Anchor Co. Ltd
Statement of Cash Flows
For the Year Ended 31 December 2018
Cash flows from operating activities: RM’000 RM’000
Receipts:
Collections from customers 271
Interest received on bills receivable 10
Dividends received on investments in shares 9
Total cash receipts 290
Payments: SCF can provide
To suppliers (133) another look at
To employees (58)
For interest (16) liquidity by showing
For income tax
Total cash payments
(15)
(222)
cash flows from
Net cash provided by operating activities 68 operating activities.
Cash flows from investing activities:
Acquisition of non-current assets (306)
Loan to another company (11)
Proceeds from sale of non-current assets 62
Net cash used in investing activities (255)
Cash flows from financing activities:
Proceeds from issue of ordinary shares 101
Proceeds from issue of long-term debt 94
Payment of long-term debts (11)
Payment of dividends (17)
Net cash used in financing activities 167
Net decrease in cash (20)
Cash balance, 31 December 2017 42
Cash balance, 31 December 2018 22
USING CASH FLOWS TO EVALUATE A COMPANY

Free Cash Flow

Free cash flow describes the cash remaining from operations

after adjustment for capital expenditures and dividends.
 Capital expenditures are needed to maintain the company’s
level of operations.
 Dividends are required to satisfy investors.

 FCF can be used to acquire new assets, for share buy-backs,

repay debt, or to pay dividends.
PROFITABILITY RATIOS

Measure
profitability

Measure the income or operating success of a company for a

given period of time.
 Profits, or the lack of it, affects the company’s ability to
obtain debt and equity financing, liquidity position, and the
ability to grow.
The profitability ratios:
 Return on capital employed (ROCE)
 Gross profit as a percentage of sales
 Net profit as a percentage of sales.
IS BS1 BS2
 PROFITABILITY RATIOS

Return on capital Operating profit

= × 100%
employed (ROCE) Long−term capital employed

Gross profit as a Gross profit

= × 100%
percentage of sales Net sales

Net profit as a Net profit

= × 100%
percentage of sales Net sales

For all ratios above, the higher the better.

IS BS1 BS2
PROFITABILITY RATIOS
Calculate the Return on Capital Employed (ROCE)
ratio for 2019.

Return on capital Operating profit

= × 100%
employed (ROCE) Share capital + Reserves
+ Non−current liabilities

RM301,000
= = 39.3%
RM566,700 + RM200,000

Shows how many dollars of operating profit the

company earned for each dollar invested in the
business.

IS BS1 BS2
PROFITABILITY RATIOS

Calculate the Gross profit as a percentage of sales

(gross profit margin) ratio for 2019.

Gross profit
Gross profit margin = × 100%
Net sales

RM807,000
= = 44.4%
RM1,818,500

Measures the percentage of each dollar of sales that

results in gross profit.

IS BS1 BS2
PROFITABILITY RATIOS

Calculate the Net profit as a percentage of sales (net

profit margin) ratio for 2019.

Net profit
Net profit margin = × 100%
Net sales

RM199,000
= = 10.9%
RM1,818,500

Measures the percentage of each dollar of sales that

results in net profit.

IS BS1 BS2
Operating Return on Assets (ORA)

 ORA indicates the level of operating profits

relative to the firm's total assets.
 Equation: EBIT

Use average because TA 301,000

=
used to generate profit 970,200 + 852,800
during the year changes. 2
= 33.0%
52
 Disaggregation of Operating Return
on Assets

To increase ORA, management must increase operating profit margin

and total asset turnover.
Managing Operations: Operating Profit
Margin (OPM)
OPM examines how effective the company is in managing
its cost of goods sold and operating expenses that
determine the operating profit.
 measures the percentage of each sales dollar remaining
after all costs and expenses other than interest, taxes, and
preferred stock dividends are deducted.

301,000
=
1,818,500
= 16.55%
54
Managing Assets: Total Asset Turnover
This ratio measures how efficiently a firm is using
its assets in generating sales.

Sales per dollar of assets.

1,818,500
=
970,200 + 852,800
2
= 187.44%
55
Managing Assets: Fixed Asset Turnover
Examines efficiency in generating sales from
investment in “fixed assets”.

Sales per dollar of

1,818,500
fixed assets. =
600,300 + 520,300
2
= 324.56%
56
Managing Assets:
Return On Total Assets
Measures the overall effectiveness of
management in generating profits with its available
assets.
Return on total assets (ROA) EAT

Earnings available for ordinary shareholders

=
Total assets
199,000
=
970,200 + 852,800
2
= 21.83%
57
EFFICIENCY RATIOS

Ability to sell
inventory and
collect receivables

The efficiency ratios are as follows:

 Inventory turnover
 Accounts receivable/sales ratio
 Accounts payable/purchases ratio.

IS BS1 BS2
EFFICIENCY RATIOS
The higher the
turnover, the
quicker it’s
selling.
Cost of goods sold
Inventory turnover =
Average inventory

The lower, the

quicker the
collections.
Accounts
Accounts receivable
receivable/ = × 365
Sales
Sales ratio

IS BS1 BS2
EFFICIENCY RATIOS

Accounts
Accounts payable
payable/Purchases = × 365
Purchases
ratio
The higher,
the slower
the payments

IS BS1 BS2
EFFICIENCY RATIOS

Calculate the Inventory Turnover ratio for 2019.

Cost of goods sold

Inventory turnover =
Average inventory

1,011,500
=
(133,000 + 115,500) / 2

= 8.1 times

Inventory turnover measures the number of times, on

average, the inventory is sold during the period.
IS BS1 BS2
EFFICIENCY RATIOS
A variant of inventory turnover is the
days in inventory:
365 days
Days in inventory =
Inventory turnover

365 days
= every 45.1 days
8.1 times
This shows that the company takes, on average,
45.1 days to sell their inventory.

Inventory turnover ratios vary considerably among industries.

IS BS1 BS2
 EFFICIENCY RATIOS

Calculate the Accounts receivable/sales ratio for 2019.

Accounts
receivable/ = Average accounts receivable × 365
Sales ratio Sales

107,800 + 102,800
2
= × 365
1,818,500

= 21.1 days

This means that receivables are collected on average

every 21.1 days. Also known as days sales outstanding.

IS BS1 BS2
 EFFICIENCY RATIOS

Calculate the Accounts payable/purchases ratio for 2019.

Accounts payable/ Average accounts payable

= × 365
Purchases ratio Purchases

Assume purchases total RM1,029,000.

160,000 + 145,400
2
× 365 = 54.2 days
1,029,000

This means that suppliers are paid on average every 54.2 days.
Also known as days of payables outstanding.
IS BS1 BS2
SHAREHOLDER RATIOS

Analyzing equity
(shares) as an
investment

The shareholder ratios are as follows:

 Earning per share (EPS)

 Price/earnings ratio (P/E)
 Dividend yield
 Dividend cover.

IS BS1 BS2
 SHAREHOLDER RATIOS

Net profit after interest and tax

Earnings per = Number of ordinary shares issued
share (EPS)

Price/earnings Market price per share

=
ratio (P/E) Earnings per share

IS BS1 BS2
SHAREHOLDER RATIOS

Gross dividend per share

Dividend yield =
Market price per share

Net profit after tax

Dividend cover =
Ordinary dividends paid and
proposed

IS BS1 BS2
SHAREHOLDER RATIOS

Calculate the Earnings Per Share for 2019.

Earnings per Net profit after interest and tax

=
share (EPS) Number of ordinary shares issued

RM199,000
= RM3.49 per share
57,000 (given)

A measure of the net profit earned on each ordinary share.

IS BS1 BS2
SHAREHOLDER RATIOS

Calculate the Price Earnings Ratio for 2019.

Price/earnings Market price per share

=
ratio (P/E) Earnings per share

RM25 (given)
= 7.16 times
RM3.49

The price-earnings (PE) ratio reflects investors’

assessments of a company’s future earnings.

IS BS1 BS2
SHAREHOLDER RATIOS

Calculate the Dividend Yield for 2019.

Gross dividend per share

Dividend yield =
Market price per share

RM77,700∗
56,000
= 5.6%
RM25 (given)

Measures the real rate of return by comparing the

dividend paid to the market price of a share.
* From analysis of retained earnings.
IS BS1 BS2
SHAREHOLDER RATIOS

Calculate the Dividend Cover for 2019.

Net profit after tax

Dividend cover =
Ordinary dividends paid and
proposed

RM199,000
= 2.56 times
RM77,700∗

A measure of how much of earnings is distributed in

the form of cash dividends.
* From analysis of retained earnings.
IS BS1 BS2
SHAREHOLDER RATIOS

Calculate the Dividend Payout Ratio for 2019.

Ordinary dividends paid and
proposed
Dividend payout ratio =
Net profit after tax

RM77,700∗
= 39%
RM199,000

The inverse of the dividend cover ratio.

Measures the percentage of earnings distributed in the
form of cash dividends.
* From analysis of retained earnings.
IS BS1 BS2
LEVERAGE

 Trading on the equity

• Company borrows at a lower rate, then invests the money to
earn a higher rate
• Aims to achieve:

Return on equity Return on assets

 Increases profits during good times, but compounds

losses during bad times
CAPITAL STRUCTURE RATIOS

Ability to pay
long-term debt

Long−term liabilities
Gearing = × 100
Total equity + Long−term liabilities

Percentage of total company funding through borrowing

as opposed to equity.
CAPITAL STRUCTURE RATIOS

Calculate the Gearing ratio for 2019.

200,000
= 26.1%
566,700 + 200,000

Measures the ratio of debt to total long-term finance.

The higher the ratio, the more highly geared the
company → riskier.

IS BS1 BS2
Changing the gearing of a company

To reduce gearing To increase gearing

 By issuing new ordinary  By issuing loan notes
shares  By buying back ordinary
 By retaining profits shares
 By redeeming loan notes  By issuing new preference
shares (a special class of
shares considered like a liability
because they are entitled to
guaranteed dividends)
ABILITY TO PAY LONG-TERM DEBT

Debt ratio Times-interest-

• Shows portion of earned ratio
assets financed with • Measures number of
debt times income can
• The higher the ratio, cover interest
the higher the risk expense
• High ratio indicates
ease in paying interest
ABILITY TO PAY LONG-TERM DEBT

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍
Debt ratio =
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍
Debt to equity ratio =
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆

𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
Times interest earned =
𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆
 Debt ratio:
Total Liabilities
Debt ratio = Total Assets

Debt ratio: 2019

RM403,500
Debt ratio = = 0.416 (41.6%)
RM970,200

Debt ratio: 2018

RM387,400
Debt ratio = = 0.454 (45.4%)
RM852,800
.
 Debt to equity ratio:
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Debt to equity ratio =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒

Debt to equity ratio: 2019

RM403,500
Debt to equity ratio = = 0.712 (71.2%)
RM566,700

Debt to equity ratio: 2018

RM387,400
Debt to equity ratio = = 0.832 (83.2%)
RM465,400
.
• Measures financial leverage – proportion of total
liabilities relative to proportion of total equity that
is financing the company’s assets.

• Ratio > 1 – the company is financing more assets

with debt than with equity. The higher the ratio,
the higher the company’s financial risk.

.
 Times interest earned ratio:
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Times interest earned =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒

Times interest earned: 2019

RM301,000
Times interest earned = = 16.7 times
RM18,000

Times interest earned: 2018

RM275,500
Times interest earned = = 19.7 times
RM14,000
• A higher interest coverage ratio indicates ease
in paying interest expense.

• The norm falls in the range 2.0 to 3.0 times.

• Based on Tukul Tool Company’s debt ratio

and its times interest earned ratio, the
company appears to have little difficulty
servicing its debt.

.
PRESENTATION OF RATIOS
Trends can be discerned more easily in graphs.
PRESENTATION OF RATIOS
 Red Flags
 Suspicious movements of sales, inventory,
and receivables
 Earnings problems
 Decreased cash flow
 Too much debt
 Inability to collect receivables
 Inventory buildup

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LEARNING OBJECTIVE 6
Explain the limitations of financial statement analysis.

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LIMITATIONS OF FINANCIAL ANALYSIS
1. Using historical data mainly for the purpose of forecasting
future performance.

2. Historical cost used in analytical measures, e.g. in ratio

analysis.
• may be misleading when interpreting trends or when
comparing between entities
• Some ratios use current dollars (e.g. current year’s revenues
and expenses) and historical cost (e.g. fixed assets) – e.g.
return on total assets

3. Year-end data may not be typical of the entity’s position

during the year – management may attempt to engage in
activities at end of the year to improve ratios.
LIMITATIONS OF FINANCIAL ANALYSIS
4. Lack of disclosure may inhibit extent of analysis.

5. One-off (non-recurring) items in income statement

may inhibit determination of trends to assess business
efficiency.

6. Some info in financial statements may be subject to

modifications, supplementations and/or qualifications,
e.g. in directors’ reports and auditors’ reports.

7. Entities may not be comparable.

Interpreting financial
statements:
Summary of the
main analytical
techniques
Self-study
 Dyson, J. R. & Franklin, E., 2017. Accounting for Non-
Accounting Students. 9th ed. Harlow, England: Pearson.
Chapter 10
 Atrill, P. & McLaney, E., 2017, Accounting and Finance
for Non-Specialists, 10th ed, Harlow, England: Pearson,
Chapter 6
 Your own research of other sources.
 Attempt the online quizzes
 Do the tutorial questions before the next class.

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