CHAPTER 2 : EVALUATION OF

FINANCIAL PERFORMANCE
LEARNING OBJECTIVES
At the end of this chapter, you should able to:
ö Understand about ratios and how to calculate them
ö Apply, analyse and evaluate the different ratio formulas to a given situation
ö Obtain the ability to calculate and interpret the meaning of financial ratios
Introduction
This chapter shows some of understanding of how to use ratio analysis for evaluating financial
performance. A firm operates from year to year, and at the end of each financial year, all relevant
parties would be interested in its performance for the year. This is important for them for being
interested in the firm’s standing in the industry.
2.2 What Is Financial Analysis?
It is refer to the assessment of firm’s past, present and anticipated future financial
performance. The analysis is made based on the firm’s financial statements. It is also
helps and individual to check whether a business is doing better this year compared
to last year.

Objectives of Financial Analysis

2.3 Financial Statements
Basically, financial statements consists of statement of balance sheet, comprehensive income, statement of financial
position, statement of changes in equity, cash flow statement also including supplementary notes, chairman’s’ statements,
directors’ report and auditors’ report.
1) The statement of comprehensive income measures the amount of profit (or loss) earn by a firm over the period
of time.
Kira Yamato Berhad
Statement of Comprehensive Income for the Year Ended 30 December 2017

RM
Sales 54,000.00
− Cost of Goods Sold 31,968.00
Gross Profit 22,032.00
− Selling & Administrative Expenses 13,230.00
Earnings Before Interest & Taxes 8,802.00
− Interest 1,356.00
Taxable Income 7,446.00
− Taxes 3,573.00
Net Income 3,873.00
Less: Dividends
Ordinary 1,000.00
2,873.00

Additional information:
The current market price for Kira Yamato Berhad is RM1.20.
 •The Statement of Financial Position shows the assets of the firm and the claims against these assets, represented by
the liabilities and the shareholders’ funds or capital at certain of time.
Kira Yamato Berhad
Statement of Financial Position as at 30 December 2017

Assets Liabilities and Equity

Current Assets: Current Liabilities:

Cash 20,430 Accounts Payable 5,200

Accounts Receivable 5,900 Utilities Payable 3,964

Inventory 4,320 Unearned Revenue 1,000

Prepaid Rent 24,000 Interest Payable 150

Notes Payable 20,000

Total Current Assets 54,650 Total Current Liabilities 30,314

Non-Current Assets: Long-term liabilities 100,000

Equipment 180,000 Common share (RM1 per share) 100,000

Accumulated Depreciation −1,100 Retained Earnings 3,236

Net Non-Current Assets 78,900

Total Assets 233,550 Total Liabilities and Equity 233,550

2.4 Financial Ratios
Ratio analysis is a method of comparison which is not depends on the size of the firm and used in an attempt to
standardize financial information to facilitate meaningful comparisons.

The objectives of ratio analysis are:

1) To standardize financial information for making comparison.

2) To evaluate current operation of the firm.
3) To make comparison between present and past performance.
4) To make comparison performance of the firm with other firms or industry standard
5) To assess the efficiency of operation of firm
6) To assess the risk of operation of firm
2.5 Types of Comparisons
1) Internal Comparison
Internal comparison is an analysis based on comparisons of similar ratios for the same firm. The comparison is in the
form of trend analysis. It is compares present ratios with past and expected future ratios. It is also known as time series
analysis.

2) External Comparison
External comparison involves comparisons of ratios of firm with ratios of others firms in similar industry. It is also known
as inter-firm comparison or cross-sectional analysis.

2.6 Types of Financial Ratios

1) Liquidity Ratios
2) Efficiency Ratios
3) Leverage Ratios
4) Profitability Ratios
5) Market Ratios
1) Liquidity Ratios

These ratios help us to understand if firm can meet its obligations over the short-run which is the firm has the
resources to pay its creditors when payments are due. Higher liquidity levels indicate that we can easily meet our
current obligations.

Two commonly used liquidity ratios are:

a. Current Ratio
b. Acid-test / Quick ratio
a. Current Ratio (CR)
simply current assets divided by current liabilities. Current assets include (cash, accounts receivable, marketable
securities, inventories, and prepaid expenses and accrued revenues). Current liabilities include (accounts payable, notes
payable, salaries payable, taxes payable, current maturities of long-term obligations, prepaid revenues and accrued
expenses).

If current ratio less than 1 time means that even if the firm liquidates all of its
current assets, it would still be unable to cover its current liabilities. From the
above calculation Kira Yamato Berhad get more than 1 time. Having 1.80 times
means, for every RM1 of current liabilities, the firm has RM1.80 of current asset as
a backup.
Implications
A current ratio with less than one can operate in certain types of company. Current ratio will become less if
inventory turns into cash much more rapidly when the accounts payable become due. Low current ratios can also
defined for businesses that can collect cash from customers long before they need to pay their suppliers.

Suggestions
Pay off some of the current liabilities. To improve this, consider using some of the cash to pay off the debts. It
should paid off as often. It will decrease the level of current liabilities and can improve the current ratio.
b. Acid-test Ratio (Quick Ratio) - This ratio indicates whether a firm has enough current assets to cover its current liabilities
without selling inventory. This is because the inventory is typically least liquid asset out of the total current asset and
generally takes a longer time to be converted into cash.

Prepaid expenses are also taken out from the total current assets because the firm had paid in advance.

Companies with quick ratio of less than 1 will not be able to

pays its immediate obligations. Besides, if quick ratio much
lower than the current ratio, it means that current assets are
highly dependent on inventory. Meaning that, the firm may
have oversharing problem.
Implications

While an acid test ratio less than one doesn't mean the corporate goes into default or bankruptcy, it may mean that
the corporate is relying heavily on inventory or different assets to pay its short term liabilities. The upper the ratio, the
higher the company's liquidity position. However, too high could indicate that the corporate has an excessive amount
of money sitting in its reserves. It’s going to conjointly mean that the corporate contains a high accounts assets,
indicating that the corporate could also be having issues grouping on its account assets.

Suggestions

To improve the acid-test ratio, stock ought to be reduced and sold-out for money. The firm might implement a just-in-
time stock system to lower involved stock. All business activities and expenses is examined and enhancements in
potency planned and place into action. Often, creating workers redundant can scale back workers prices. Customers
should be ironed to pay any outstanding accounts. Current assets can be created as liquid as potential, and increased.
2) Efficiency Ratios

This ratio also called asset management ratios. It measures how effectiveness the firm is managing its assets in
generating sales. This ratio shows the amount of sales generated for every ringgit of asset investment.

Efficiency ratio includes:

a. Inventory Turnover Ratio (ITO)
b. Fixed Asset Turnover (FATO)
c. Total Asset Turnover (TATO)
d. Average Collection Period (ACP)
a. Inventory Turnover (ITO)
indicates how many times the inventory is sold and replaced in one year. The higher the ratio, the faster the inventory
is being sold. It shows that companies’ inventory are highly marketable. If low inventory turnover indicates the firm
have poor sales and consequently excess inventory and this is not a good sign because the product are kept in the
warehouse.

Implications
Low inventory turnover ratio is a signal of incompetence. It also indicates either poor
sales or excess in inventory. A low turnover rate can indicate poor liquidity,
overstocking, and undesirability of stock. Other than that it reflects a planned
inventory build-up in the case shortages of materials or in anticipation of rapidly
rising prices.

Suggestions
Another way to improve company inventory turnover ratio is to increase company’s
sales. The company needs to formulate better marketing strategies to create more
demand in the industry. For example they can focus on advertisements or have
promotional events and offers. Company also can eliminate safety stock and old
inventory.
b. Fixed Asset Turnover (FATO)
This ratio measures the firm’s efficiency in utilizing its property, plant and equipment in generating sales. A lower
ratio indicates that a firm should increase its sales, or some assets may need to be disposed of. From the answer
below we can conclude that the firm no utilizing its assets in generating sales.

Implications
A low ratio indicates that a business is overinvested in fixed assets. The company
has made a large investment in fixed assets, with a time delay before the new assets
start generating revenues. It can explained that if the company just made some new
large purchases of fixed assets for modernization, the low fixed asset turnover may
have a negative implication.

Suggestions
Company can increase revenue which is the assets might be properly utilized, and
company can increase its sales by more promotions and by make proper schedule of
movements for the finished goods. Company also can liquidate assets any unused
assets should be liquidated rapidly. Assets, that are not used commonly, should be
analysed to see whether there is a sense in retaining those. Mostly, the company
should sell those assets that do not make sales to the company.
c. Total Asset Turnover (TATO)
This ratio measures the firm’s efficiency in utilizing its total assets in generating sales. A lower ratio indicates that a
firm should increase its sales or some assets may need to be disposed of. A firm should try to increase its
production, so that the assets are used more efficiently. Base on answer below it is expected that the firm would
slowly turnover their assets through sales.

Implications
High Cash Balance can affect in very low returns. Having more assets in cash is a not an
efficient use of capital for a company. A company may have sales different for each year. It
can be experiencing a decline in its business and its sales drop expressively in a year.

Suggestions
Improve efficiency can affects to the low asset turnover ratio because of inefficient use of
assets. The company should analyse how the assets are used to improve the productivity
of each asset in the company.
 d. Average Collection Period (ACP)
It is shows the firm’s effectiveness and efficiency is extending credit and collecting debts. The shorter the ratio, the
faster the debtors are paying their accounts and more efficient the firm in debtors collection.

The reasons for longer collection periods include a slack credit policy, no
reminders and follow up for late payment or no cash discount given to customer to
attract customer to make early payment. The suggestion to the firm is they can
tighter collection policy for example shorten debtors’ collection period.

Implications
The problem may not be a lack of sales if the company never seems to have enough cash on hand. It could be collections of
delayed. When customers don't get their payments on time, company have to pay customer’s bills and expenses which it can
be out of company reserves. Those reserves can decrease and disappear if customers frequently pay late.

Suggestions
The list should be organised by due date, and it should be updated at least weekly. The main take away is that an accounts
receivable tracking system, whether automated or manual, from the system it can benefit accounts receivable management.
3) Leverage Ratios

This ratio measures the level of debt in organization. It tells us whether the firm uses more debt financing to finance
its asset and operations rather than use equity financing. In this ratio show that the higher the ratio the higher the
risk which is the higher the chance of the firm to pay back its borrowings.

Leverage ratios include:

a. Debt Ratio (DR)
b. Debt to Equity Ratio (DER)
c. Times Interest Earned (TIE)
a. Debt Ratio (DR)
The debt ratio shows a firm’s ability to pay its debt or liability with its assets. Meaning that it shows how many assets
the firm must sell in order to pay all of companies’ liabilities. Usually they use 50% as a benchmark for reasonable
ratio. A debt ratio of 50% or less is considered to be less risky. This means that the firm has twice as many assets as
liabilities.

Implications
Utilities can contributes a higher debt ratio. Items such as trade payables and
goodwill tend to be excluded to provide a more precise image of the
company’s long-term debt liability compared to their assets.

Suggestions
The company can focus seriously on increasing the sales without any
increase in overhead expenses. When company increase in sales, it can be
used to reduce the debt and improve the debt to total asset ratio.
b. Debt to Equity Ratio (DER)
It is measures the percentage of borrowings compared with equity. The debt to equity ratio shows the percentage of
firm financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor
financing is used than investor financing (shareholders). A lower debt to equity ratio usually implies a more financially
stable business. Companies with a high debt to equity ratio are considered more risky to investors and creditors than
companies with a lower ratio.

Implications
A reasonable amount of debt can help improve small business, but too much
amount of debt can burden the company with high interest payments. If the
company fail to make the interest payments, creditors might take the
company’s assets or force it into bankruptcy.

Suggestions
Affordable growth in the company, it shouldn't be ratcheting up company
debt to equity ratio. Company should Increase the revenue and keep the ratio
stable when the sales increase, the company will reinvest, adding assets or
paying down debt.
c. Times Interest Earned (TIE) - this is about the firm’s ability to fulfil interest obligations by using operating profit. The
higher the ratio the higher the firm can pay off on interest obligations. The formula is operating income also known as
earnings before interest tax divide by interest expense.

Implications
If company fail to meet obligation to paid interest rate, it will bring a company
into bankruptcy. It is used by both lenders and borrowers in determining a
company’s debt capacity.

Suggestions
It is most favourable if the company have higher value of times interest earned
(TIE) ratio as it shows that the company has sufficient earnings to pay off interest
expense and hence its debt obligations.
4) Profitability Ratios
This ratio indicates how well the firm utilizes its assets to make profit for firm and value for shareholder.

Profitability ratios include:

a. Gross profit margin (GPM)
b. Operating profit margin (OPM)
c. Net profit margin (NPM)
d. Return on asset (ROA)
e. Return on equity (ROE)
a. Gross Profit Margin (GPM)
It measures how efficiently a firm uses its materials and labour to produce and sell products profitably. The higher
the ratio indicates the firm doing well on its cost of goods sold.

Implications
The costs to produce or supply may increase. These factors may lead to them
negotiating or simply charging to the company for higher rates on goods. If
higher COGS it is negatively affects to the company’s gross profit margin.

Suggestions
It is a good performance of management if the management has achieved
the higher prices because of the introduction of new features and improved
the quality of product. So company can increase the price of the product and
it would directly impact gross margin
b. Operating Profit Margin (OPM)
This ratio is important to both creditors and investors because it helps show how strong and profitable a firm’s
operations are. For instance, a firm that receives 30 percent of its revenue from its operations means that it is running
its operations smoothly and this income supports the firm. It also means this firm depends on the income from
operations. If operations start to decline, the firm will have to find a new way to generate income.

Implications
Any decline in sales accompanied by an equivalent amount of decline in the sum of
cost of goods sold and expenses will not affect your operating profit.

Suggestions
Reduce Cost of Goods Sold is one of the method to improve operation income.
Company should Review all of the expenses that relate to cost of goods sold. These
costs can be manufacturing labour, supplies necessary for the manufacturing process
or the direct purchase price of company’s inventory. Increase Sales Revenue can
raise company’s sales revenues can help to increase operating income.
 c. Net Profit Margin (NPM)
It shows how much net income a business makes from each dollar of sales. A higher margin is always better than a
lower margin because it means that the firm is able to translate more of its sales into profits at the end of the period.

Implications
Price changes greatly affect how many units a company can sell, which in turn impacts the overall profit numbers. So this
is one of the primary factors that contribute to the change in net profit margin which is an increase or decrease of the
price of the sold units.

Suggestions
Funding expansion can be an effective long-term strategy for improving the net margin because it increases production
capacity, drives higher sales volume and reduces the average cost per item produced.
 d. Return on Asset (ROA) / Return on Investment (ROI)
Measures how efficiently a firm can manage its assets to produce profits during a period. Higher ratio is more
favourable to investors because it shows that the firm is more effectively managing its assets to produce greater
amounts of net income.

Implications
Overcapacity can give impacts to the company because assets are sitting idle part of the time. If company has
overcapacity but strong profit margins, a price cut might increase market share and capacity utilization.

Suggestions
Replace out-of-date equipment and technology with updated versions. It can help employees in the company can
improve productivity which means generate more work product with the same human resources. Increase utilization of
company's physical plant by leasing out unused space in the office building or in manufacturing facility. Increase the
revenue is one of the company’s continuing objective of all businesses, but if it can accomplish this without increasing
asset base.
 e. Return on Equity (ROE)
As an indicator of how effective management is at using equity financing to fund operations and grow the firm. Return
on 1 means that every dollar of common shareholders’ equity generates 1 dollar of net income. This is an important
measurement for potential investors because they want to see how efficiently a firm will use their money to generate
net income.

Implications
If a company negotiates lower costs with its product suppliers, it improves profit and return on equity, If inflation leads to
higher supply costs, return in equity will decrease.

Suggestions
Another way to raise return on equity is to maintain costs while revenue raises or to cut costs. A company may close
down unsuccessful business centres to remove inefficient cost. Reducing utility expenses is another savings strategy. A
company can try to perform better on this metric by decreasing the amount of assets it uses to achieve a certain level of
sales.
5) Market Ratios
These measures all have one factor in common; they're evaluating the current market price of a share of
common share versus an indicator of the firm's ability to generate profits or assets held by the firm.

The most common market ratios are:

a. Earnings Per Share (EPS)
b. Dividend Per Share (DPS)
c. Dividend Pay-out Ratio (DPR)
d. Price Earnings Ratio (PE)
e. Dividend Yield (DY)
a. Earnings Per share (EPS)
This is the amount of money each shareholder would receive per share if all of the profits were distributed to the
outstanding shares at the end of the year. Higher earnings per share is always better because this means the firm is
more profitable and the firm has more profits to distribute to its shareholders.

Implications
Earnings per share can decrease if the profits going down, but it is not necessarily happen because sometimes earning
per share can decrease when profit is going up. Certain companies can manipulate the profit so as investors should
invest in clean and clear corporate governance along with experienced management

Suggestions
Look out the price earnings ratio when figuring earning per share. If the ratio is going down so as investor should not to
take an exit action but should find why earning per share start going up or going down.
b. Dividend Per Share (DPS)
Indicates the amount of dividend payment that a shareholder receives for each share held. From the answer below
the firm only can paying RM0.01 dividend per share to its existing ordinary shareholder.

Implications
In dividend per share some limitations occur. Investor don’t know how much the company paid to the shareholder and it
cannot predict what the return on investment is. Other than that, how much profit per share shareholder earned which
might have been distributed as a dividend.

Suggestions
A company needs funds to expand and grow, so it infrequently pays out all the profits of the company in dividends, but it
may have a particularly good year where it has generated more profits from its operations, so company can decides to
pay out more in dividends.
c. Dividend Pay-out Ratio (DPR)
This ratio shows the portion of profits the firm decides to keep funding operations and the portion of profits in the
company it is given to its shareholders. For this ratio it makes investor interested because they want to know if
companies are paying out a reasonable portion of net income to investors. The answer below the firm distributes 25%
of its earning dividends and retains only 75% of the balance for reinvestment.

Implications
Under this condition, company should standby profit back into the business by
repurchase shares. When companies use the money to repurchase the share, the
income will be greater because with the lower rate of tax on capital earnings,
comparing to dividends pay-outs to shareholders with higher rate of tax on
dividends.

Suggestions
Company should aware that Investors are mostly interested in the dividend pay-
out ratio because they want to know if companies are paying out a reasonable
portion of net income to investors.
d. Price Earnings Ratio (PE)
The price earnings ratio shows what the market is willing to pay for a share based on its current earnings. A firm with a
high P/E ratio usually indicated positive future performance and investors are willing to pay more for this firm’s shares.
The higher the ratio the higher the investors’ confidence.

Implications
The limitation in price earnings ratio is when economy face with high inflations so that investors cannot get clear picture
about the valuation of stock during the downturn phase

Suggestions
As investor, always make comparisons the historical price earnings ratio, if it is find earning per share is increasing but
price earning is in bad conditions this can consider the opportunity to buy the stocks.
e. Dividend Yield (DY)
Investors want to know how much dividends they are getting for every dollar that the share is worth. A firm with a high
dividend yield pays its investors a large dividend compared to the fair market value of the share. This means the
investors are getting highly compensated for their investments compared with lower dividend yielding shares.

Implications
As with all valuation ratios, dividend yield must be used with attentiveness. Investment with high dividend yields might
seem like bargains, but these companies are often going through financial problems that have caused their stock price to
drop

Suggestions
Dividend yields can be defined of an investment’s productivity and some view it like a rate of interest earned on an
investment. When companies are paying high dividends to their shareholders, it can give a sign on various aspects of the
firm, such as the firm may be currently undervalued or it is trying to attract new and large number of investors..
2.7 Summary

This chapter discussed about the evaluation of company’s financial performance. The main objective of financial
statements is ratio analysis which is used to evaluate several aspects of a company’s financial and operating
performance for example its efficiency, liquidity, profitability and solvency. The other thing is the firms can
expand their performance by exploiting on their strength and improving their weaknesses. Interpretation of
ratio analysis is very important so that company can make decision correctly.
References :
Arwa Mohammad, Ahmad Hadi Ibrahim, Izyani Hasbullah, Nor Asilah Amin, Nurhidayatul Asyikin
Ramlan, Nur Azlina Abdullah, Nurul Fazlin Ab.Mutalib,Siti Zuraidah Zainal, Wan Hereezuan Wan
Ab Rahim, (2018) Financial Management, Kolej Poly-Tech MARA Sdn Bhd
SELF -TEST QUESTION
1. Why financial ratio analysis is important when analysing a company's financial performance?
2. Analyse methods by which an organizations can improve its quick ratio
3. Describe why increase in inventory turnover is considered to be a good thing.
4. What are the factors can influence the price of a share.
5. How investors can use price earnings ratio as indicator to make investments.
PROBLEMS
1. The following data apply to HRZ Associates:

Cash and marketable securities RM 100,000,000

Fixed assets RM 280,000,000
Sales RM 700,000,000
Net income RM 50,000,000
Quick ratio 2 times
Current ratio 3 times
Days sales outstanding (DSO) 42 days

a. Find SMD’s account receivable, current liabilities and current asset

2. Adam are the financial manager of MAZ Corporation. He would like to assess the efficiency ratios and
leverage ratios of the company and how these ratios can affect the firm’s profitability. The financial statements
of MAZ Corporation for the year ended 31 December 2016 as follows:

MAZ Corporation
Income Statement for the year ended 31 December 2016

RM’000

Net Sales 6,039,950

Cost of Goods 3,593,070
Gross Profit 2,446,880

Selling, General and Administrative 2,218,540

Expenses (including depreciation)

Income from Operations 228,340

Other Income (expenses):
Interest and other income 14,470
Interest Expense (10,180)

Income Before Income Taxes 232,630

Income Tax Provision 102,000

Net Income 130,630

 MAZ Corporation
Balance Sheet as at 31 December 2016

RM'000
Assets
Current Assets:
Cash and Cash Equivalents 272,000
Receivables 220,000
Inventory 538,000
Prepaid Expenses 54,000
Total Current Assets 1,076,000

Property, Plant & Equipment (at cost):

Land and Buildings 531,270
Fixtures and equipment 476,460
Leasehold improvements 16,460
Construction in progress ----
Less Accumulated Depreciation (248,430)
Property, Plant & Equipment, net 775,760
Total Assets 1,851,760

Liabilities and Stockholders’ Equity

Current Liabilities:
Accounts Payable 377,970
Advance Payment on Orders 4,460
Income Taxes Payable 70,800
Other Current Obligations 104,510
Total Current Liabilities 557,740

Long-Term Debt 267,720

Stockholders’ Equity:
Common Stock 171,400
Retained Earnings 983,800
Less Treasury Stock, at cost (128,900)
Total Stockholders’ Equity 1,026,300
Total Liabilities and Equity 1,851,760