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Basic Ratio Analysis
Part 1 – Concept of Financial
Statement Analysis
1
How to Evaluate the Performance of a Business?
• Your uncle is carrying a trade business. He knows you are studying
business, accounting, and financial studies and asks if you could
provide him with some ideas on the financial performance and
position of his business.
• Can you give him some advise?
2
How to Evaluate the Performance of a Business?
• Three basic aspects
1. Financial Status: is the company financially sound,
solvent, or liquid?
2. Operational Efficiency: how successfully is the
business being run?
3. Investment Potentials: how do the financial status
and operational efficiency relate to investments of
fund provider?
3
Financial Analysis
• Financial analysis is about the use of accounting information to access
the financial performance and financial position of a company in
order to help management to make decisions on investment,
operation and financing.
• Therefore, it is important to understand the format and contents of
the financial reports of a company.
4
Financial Reports
• There are two major financial reports for a company:
– Income statement
– Statement of financial position
• These reports can provide information for various users in making
business decisions.
5
Users of Financial Reports
• The users of financial reports can broadly be categorised as:
– Resource providers (e.g. creditors, lenders, shareholders,
employees).
– Recipients of goods or services (i.e. customers, debtors).
– Government departments/Regulatory bodies (e.g. Inland Revenue
Department, Census and Statistics Department).
– Internal management to assist in their decision-making capacity.
6
Income Statement
• Purpose
– Measure of profit / loss for a trading period.
– Provide factors which have caused the profit / loss.
7
Income Statement
• Presenting the revenues and expenses of a company for one year.
• Layout of an income statement:
Sales
A
Cost of Goods Sold
B
Gross Profit
C=A–B
Expenses
D
Net Profit
E=C–D
Major component:
Sales: Income generated by the company
Cost of Goods Sold: Cost that a company pays directly for the products sold/services
rendered to customers
Expenses: Expenditures that a business incurs as a result of performing its normal
8
business operations
Income Statement – Example
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
9
Activity 1 – Class Discussion
• What can we know by reviewing a company’s income statement?
10
Activity 1 – Solution
• An income statement indicates the amount of profits generated by a
company over a given time period, i.e. 1 year.
• By reviewing the income statement, we can understand the financial
performance of a company in the following ways:
• How much sales it generated for the year?
• How much costs incurred for the production/merchandise of goods for the
year?
• What is the gross profit for the year?
• How much a company spent on operation such as administrative cost, sales
and marketing etc. for the year.
• What is the net profit earned for the year?
11
Statement of Financial Position
• The statement of financial position is a ‘snapshot in time’ which
shows the financial health of the company.
• It does not explain how well / poor the company has performed over
the year.
12
Statement of Financial Position
• Presenting the assets and liabilities of a business at a specific point in time i.e.
end of the year.
• Major components:
– Assets
• Fixed Assets – including land, buildings, equipment, motor vehicles etc.
• Current Assets – including inventory, account receivable (money owing to the company),
cash etc.
– Liabilities
• Non-current liabilities –those obligations the business has to meet beyond a year. E.g.
long-term loan etc.
• Current liabilities – those obligations the business has to meet within a year. E.g. account
payables (money owed by the company).
– Shareholders capital put into the business by the ‘owners’
• Paid-in capital/share capital – money contributed by the owners of the business.
• Retained profit/loss – cumulative profit/loss from prior years after distributions to owners.
13
Statement of
Financial Position
– Example
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
14
Activity 2 – Class Discussion
• A company’s financial statements consist of the income
statement and statement of financial position. Compare
these two statements.
15
Activity 2 – Solution
Purpose
Income statement
Measures the financial
performance/result of a
company’s operation.
Time
frame
Covers a specified period. i.e. 1
year
Major
items
Sales, Cost of sales, Gross profit,
Operating expenses, Operating
profit, Interest expenses,
Income tax and Net profits after
tax etc.
Statement of financial position
Measures the financial position of a
company. i.e. shows the company’s
assets, liabilities, and shareholders
equity.
At a given point in time. i.e. end of
the year
Non-current assets, Current assets,
Non-current liabilities, Current
liabilities, Share capital and Retained
earnings etc.
16
The End
17
Basic Ratio Analysis
Part 2 – Concept and General
Function of Accounting Ratios
18
Financial Statements Analysis
• Financial statement analysis is a study of the relationship between
Income Statement and Statement of Financial Position.
• Financial Statement Analysis – helps users to understand the financial
performance and financial position of a business so as to make
business decisions.
19
Four Aspects of Financial Statements Analysis
Ability to meet
short-term
obligations and
to efficiently
generate
revenues
Ability to provide
financial rewards
sufficient to
attract and retain
source providers
Liquidity
and
Efficiency
Profitability
Solvency
Market
Prospects
Ability to
generate future
revenues and
meet long-term
obligations
Ability to
generate
positive
market
expectations
20
Class Activity 1 – Class Discussion
• Your uncle has then provided you with the income statement and
statement of financial position of his business for the last two
financial years (see next slide) for your viewing.
• What can you find out from the information provided on the financial
statements?
21
Class Activity 1 – Class Discussion
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
22
Purpose of Financial Statements Analysis
Using Ratios
What is ratios?
• A ratio expresses the relationship between two numbers, e.g., a given ratio of A:B
= 5:1 means A is 5 times B.
• A ratio by itself may have no meaning. Therefore comparison is required. For
example:
– Compare the ratios of current year with last year.
– Compare the ratios with other companies.
– The use of ratios for financial analysis is a quantitative method to explain the
financial performance and position of a company.
23
Purpose of Financial Statements Analysis
Using Ratios
• Ratios analysis is one of the popular ways to evaluate a company’s performance
and financial position by using data from a company’s income statement,
statement of financial position and certain market data.
• It involves the expression of the reported numbers in relative terms rather than
relying on the absolute numbers.
• It can highlight the strengths and weaknesses of companies.
24
Comparative Analysis
• Performance of a company cannot be determined by the amount
presented on the financial statements alone.
• The amount must be compared with other financial data to provide
more relevant information for decision-making.
• The following three types of comparisons can enhance decision
making usefulness of financial information:
– Intracompany comparison
– Intercompany comparison
– Industry averages comparison
25
Intracompany Comparison
• Comparisons within a company are often useful for identifying
changes in financial relationships and significant trends.
• E.g. a comparison of a company’s current year’s cash amount with the
prior year’s cash amount shows either an increase or a decrease in
the company cash position.
26
Intercompany Comparison
• Comparisons with other companies (e.g. competitors) provide an
insight into a business’s competitive position.
• Company can therefore make appropriate strategy in respond to its
competitors. E.g. pricing strategy
27
Industry Averages Comparison
• Comparisons with industry averages provide information about a
business's relative position within the industry.
• A business can understand its strengths and weaknesses in the
industry.
– E.g. compare the profit margin with the industry to see whether there is a
good control on spending.
28
Class Activity 2 – Group Discussion
• Divided into three groups which represent the 1. internal
management; 2. lenders; 3. shareholders (investors) of a company
and discuss how financial ratios can help each group to make
business decisions.
29
Class Activity 2 – Solution
Internal Uses of Financial Ratios:
• Financial ratios are internally used by
– management to
• Identify deficiencies of the company and take immediate remedial action such as poor
control on costs.
• Understand and compare the financial performance of different divisions, e.g. which
product lines are more profitable than the others within a company.
– employee to
• Ensure job security.
• Assess the potential for a pay rise.
30
Class Activity 2 – Solution
External Uses of Financial Ratios:
Financial ratios are externally used by:
• Lenders in deciding whether or not to provide loans to a company.
• Investors (shareholders and debenture holders) in deciding whether or not to
invest in a company e.g. buying the shares/debentures issued by the company.
• Major suppliers in deciding to whether or not to provide credit to a company.
31
The End
32
Basic Ratio Analysis
Part 3 – Calculation and
Interpretation of Profitability Ratios
(Gross Profit and Net Profit Margin)
33
Ratio Analysis
• Key types of ratios:
– Profitability ratios - to measure how profitable is its operating activities.
– Liquidity ratios – to measure the ability of a business to meet its short-term
debts.
– Solvency ratios – to measure the ability of a business to meet its long-term
debts.
– Market Prospects (Investment) ratios – to measure the investment
worthiness of the business. E.g. earnings per share or returns on investment.
34
Profitability Ratio
• Measure the income or operating profit of an enterprise for a given
period of time.
The profitability of a company may affects:
its ability to obtain debt and equity financing;
its liquidity position; and
its ability to grow.
35
Profitability Ratio
• In the income statement, there are four levels of profit for analysis:
– Gross profit
– Net profit before interest and tax (or called operating profit)
– Net profit before tax
– Net profit after tax
• Profitability ratio provides a comprehensive measure of a company’s
profitability and enables comparison with its competitors and the
industry average by using percentage.
36
Profitability Ratio
Key Profitability Ratios
•Gross Profit Ratio/Margin
•Net Profit Ratio/Margin
•Return on Capital Employed (ROCE)
37
Gross Profit Margin
• Gross profit = Total sale revenue – COGS
• The cost of goods sold is the cost of merchandise or the cost of
services.
• Gross profit margin shows the profitability of a company after
considering its cost of sales and the ability to cover its operating
expenses.
• The formula:
Gross profit margin 
Gross profit
100%
Sales
38
Gross Profit Margin
• The gross profit margin provides important information to
management.
• If it declines, the management may consider:
– to increase selling price if possible
– to reduce cost of sales e.g. find another supplier who can provide
materials at lower cost.
39
Financial Statements of ABC Ltd
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
40
Activity 1 – Calculation of Gross Profit Margin
• Given the following information, calculate and comment the gross
profit margin for the years of 20X4 and 20X5.
20X4
20X5
Sales
$100,000
$120,000
Cost of goods sold
$54,000
$62,000
Gross profit
?
?
Gross profit margin
?
?
41
Activity 1 – Solution
20X4
20X5
Sales
$100,000
$120,000
Cost of goods sold
$54,000
$62,000
Gross profit
$46,000
$58,000
46%
48.3%
Gross profit margin
• Comment: The GP margin is better in 20X5 which indicates that there
is a better control in purchase cost.
42
Net Profit Margin
• Net profit = Total revenue – Total costs
• This ratio shows a company’s ability to earn a net income from
sales after deducting operating expenses.
• This ratio serves as an overall measure of the company’s
operating effectiveness.
• The formula:
Net profit before tax
Net profit margin 
100%
Sales
43
Net Profit Margin
• Management concerns net profit margin as it provides
information about the ability of the company to manage costs
and expenses and generate profits.
• A lower net profit margin may indicate poor control on operating
expense.
44
Financial Statements of ABC Ltd
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
45
Activity 2 – Calculation of Net Profit Margin
• Given the following information, calculate and comment the net
profit margin for the years of 20X4 and 20X5.
20X4
20X5
Sales
$100,000
$120,000
Cost of goods sold
$54,000
$62,000
Gross profit
$46,000
$58,000
Operating expenses
$33,000
$44,000
Net profit
?
?
Net profit margin
?
?
46
Activity 2 – Solution
20X4
20X5
Sales
$100,000
$120,000
Cost of goods sold
$54,000
$62,000
Gross profit
$46,000
$58,000
Operating expenses
$33,000
$44,000
Net profit
$13,000
$14,000
13%
11.7%
Net profit margin
• Comment: The NP margin has declined in 20X5 which indicates that
the company’s control in operating expense is poorer, making the %
increase in operating expense exceeded the % increase in GP margin.
47
The End
48
Basic Ratio Analysis
Part 4 – Calculation and Interpretation
of Profitability Ratios
(Return on Capital Employed)
49
Class Activity 1 – Class Discussion
How are gross profit margin and net
profit margin different from each?
50
Activity 1 – Solution
• Gross profit margin: a ratio that indicates the gross profit earned by a
company as a percentage of its sales. The focus of it is to analyse the
efficiency of using cost of merchandise/services to generate profits.
• Net profit margin: a ratio that measures the net income of the firm as
a percentage of sales. The focus of it is to analyse the overall control
on operating expenses such as administrative, sales and marketing,
and logistic expenses to generate profits.
51
Return on capital employed (ROCE)
• Return = Net profit before interest and tax
• It is a measure of the efficiency of the company in using its capital to generate
profit.
• Generally – the higher the ratio, the more effective the company is in using its
capital
• The Formula:
Profit before interest and tax
Return on capital employed 
100%
Average capital employed
Capital employed =
Sole proprietorships: capital account balance
Partnerships: capital account balances + current account balances (if any)
Limited companies: non-current liabilities + shareholders’ fund
52
Financial Statements of ABC Ltd
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
53
Can the Company Produce Adequate
Profits from its Capital?
• One of the most important issues that management of a company to
consider is whether the company can provide adequate return to its
resources providers/investors (i.e. shareholders) whose purpose of
making investments is to earn profits.
• The reason of using net profit before interest and tax in calculating
ROCE is that such profit is the income generated from the company’s
assets regardless of how the company’s funds come from.
• If the company relies heavily on borrowing, the net profit before tax
will be adversely affected because of high interest expense and hence
affect the comparison with companies with different capital structure.
54
Class Activity 2 – Calculation of Profitability Ratios
Refer to the
financial
statements
of XYZ Ltd,
calculate and
comment its
profitability
ratios.
XYZ Ltd
Income Statement
For the year ended 31 December
20X5
20X4
$'000
$'000
Sales
3,310
2,952
Cost of sales
(1,840)
(1,632)
Gross profit
1,470
1,320
Expenses
Distribution
(288)
(225)
Selling and marketing
(349)
(293)
General and
(227)
(187)
administrative
Operating profit
606
615
Interest expenses
(105)
(87)
Profit before tax
501
528
Income tax expenses
(92)
(96)
Profit after tax
409
432
XYZ Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
20X4
$'000
5,500
5,220
Current assets
Inventories
Trade receivables
331
504
292
463
Cash and bank
222
108
1,057
863
396
92
488
367
96
463
6,069
5,620
4,000
1,022
5,022
4,000
855
4,855
1,047
6,069
765 55
5,620
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
Class Activity 2 – Calculation of Profitability Ratios
Calculations
The Gross Profit Margin for XYZ Ltd:
20X5: $1,470/$3,310 x 100% = 44.41%
20X4: $1,320/$2,952 x 100% = 44.72%
The Net Profit Margin for XYZ Ltd:
20X5: $501/$3,310 x 100% = 15.14%
20X4: $528/$2,952 x 100% = 17.89%
The Return on Capital Employed for XYZ Ltd:
20X5: $606/$6,069 x 100% = 9.99%
20X4: $615/$5,620 x 100% = 10.94%
Comments
The GP margin for the two years are
more or less the same which indicates
a consistency in pricing products and
sourcing materials.
The NP margin of 20X5 is lower than
20X4 by 2.75% which indicates a
poorer control on operating expenses.
The ROCE of 20X5 is lower than 2014
by 0.95% which indicates the company
is less effectively in using its capital to
generate returns.
56
Purposes of Using Profitability Ratios
• The use of profitability ratios can help to evaluate historical
performance of a company and to serve as the basis for making
projections about and improving the future financial performance.
• The analysis helps users to identify critical relationships between
different items in income statement.
• The use of ratios can provide a standardised financial information for
users to make comparisons between companies with different sizes
or within the same company at different times.
57
The End
58
Basic Ratio Analysis
Part 5 – Working Capital and
its Management
59
Working Capital
• Working capital = the difference between current assets and current
liabilities
• It provides information to access whether the company has sufficient
funds to settle its liabilities at the right time .
Working capital
= CA - CL
60
Activity 1 – Class Discussion
• Companies should have a positive amount of working capital, i.e.
current assets are greater than current liabilities.
• What happens if there were a negative working capital (i.e. current
assets < current liabilities)?
61
Activity 1 – Solution
• The working capital compares the amount of current assets to the
current liabilities, it helps to see if the company is able to settle the
short-term obligations at the right time.
• Therefore, the larger the working capital a company has, the more
able it will be to pay its debt as it comes due.
• A negative working capital may indicate the company is unable to pay
its short-term debts and may raise the concern from its lenders.
• The company may need to source additional fund for its operation
e.g. by additional long-term borrowing
62
Activity 2 – Calculation of Working Capital
Refer to the
financial
statements
of XYZ Ltd,
calculate its
working
capital for
the two
years.
XYZ Ltd
Income Statement
For the year ended 31 December
20X5
20X4
$'000
$'000
Sales
3,310
2,952
Cost of sales
(1,840)
(1,632)
Gross profit
1,470
1,320
Expenses
Distribution
(288)
(225)
Selling and marketing
(349)
(293)
General and
(227)
(187)
administrative
Operating profit
606
615
Interest expenses
(105)
(87)
Profit before tax
501
528
Income tax expenses
(92)
(96)
Profit after tax
409
432
XYZ Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
20X4
$'000
5,500
5,220
Current assets
Inventories
Trade receivables
331
504
292
463
Cash and bank
222
108
1,057
863
396
92
488
367
96
463
6,069
5,620
4,000
1,022
5,022
4,000
855
4,855
1,047
6,069
765 63
5,620
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
Activity 2 –Working Capital of XYZ Ltd
20X5
Working Capital
20X4
Working Capital
=
Current Assets –
=
$1,057
=
$569
=
=
=
–
Current Assets –
$863
–
$400
Current Liabilities
$488
Current Liabilities
$463
64
Changes in Working Capital
• Increase in total working capital is caused by any transactions that:
– ↑ total current assets by more than the ↑ in total current liabilities
– ↓ total current assets by less than the ↓ in total current liabilities
65
Changes in Working Capital
• Reasons for an increase in total working capital:
– Issue of new shares for cash. (cash ↑ and share capital↑, working capital ↑)
– Acquire new long-term loan or issue of bonds. (cash ↑ and non-current
liabilities↑, working capital ↑)
– Sale of non-current asset (cash ↑ and non-current asset ↓, working capital
↑)(Purchase of non-current asset → working capital ↓).
– Increase in trading profit – selling goods/services at a profit brings cash into
the business. (cash ↑ and retained earnings ↑, working capital ↑)
66
Changes in Working Capital
• Total working capital will not change when:
– Buy goods on credit - inventory ↑ (current asset) and trade payable ↑
(current liability) by the same amount.
– Goods sold at cost on credit - inventory ↓ and trade receivable ↑ by the
same amount.
– Payment to suppliers - trade payables ↓ and cash ↓ by the same amount.
– Payment from customers - trade receivables ↓ and cash ↑ by the same
amount.
67
Discussion Question
Which of the following would lead to an immediate increase in cash inflow
for a particular period?
A.
B.
C.
D.
Sale of goods on credit.
Sale of a non-current asset at loss.
Payment of dividend to shareholders.
Settlement to suppliers.
68
Working Capital Management
• Working capital management is the emphasis in managing all aspects
of both the current assets and the current liabilities in order to
minimize the risk of insolvency while maximizing the return on assets.
• Its objective is to maintain the optimum balance of each of the
working capital components.
69
Working Capital Management
• A good working capital management can help a company to consider
the following:
•
•
•
•
What types and amounts of current assets should it hold?
What types and amounts of short-term financing should it employ?
How does it ensure there is sufficient cash to meet on-going obligations?
How does it forecast its cash needs?
70
The Relationship of Working Capital
Management and Business Solvency
• A major responsibility of the financial manager is to ensure that
adequate flow of cash is available for the business to operate
efficiently.
• E.g. some payments can be delayed without endangering the company’s
financial position, but others must be paid on time such as the repayment of
loan. If the company does not have sufficient cash settle the ‘must pay’
amount on time, it will have the risk of liquidation when it is sued by the
creditors.
71
Working Capital Policies
Working Capital
Policy
Levels of
Current
Assets
How Current
Assets are
Financed
Current Ratio
Trade-off
Between
Profitability and
Risk
Conservative
High
With Longterm Debt and
Equity
Higher than
Industry
Average
Lower Profits /
Lower Risk
Aggressive
Low
With Shortterm Debt
Lower than
Industry
Average
Higher Profits /
Higher Risk
72
Class Activity 3 – Group Discussion
• How a conservative working capital policy lowers
profitability and risk?
73
Class Activity 3 – Solution
Characteristics of a Conservative Working Capital Policy
Higher Level
of Cash
Higher Level of
Accounts
Receivable
Reduce
Greater cost of
investment
financing and
opportunity
possibly more
write-offs
Reduce risk
Won’t miss a
because cash is potentially
readily
profitable sale
available
Higher Level
of Inventory
Less Short-term Debt
/Greater Long-term
Liabilities
Higher
Interest expenses are
carrying costs higher for long-term
and higher
debt
obsolescence
Fewer stock- Less short-term debt
outs
payments to meet
Impact
Lower
Return
Less
Risk
74
The End
75
Basic Ratio Analysis
Part 6 –Liquidity Position and
Liquidity Problems
76
Liquidity
• Liquidity is defined as the ability to pay debts when they come due.
• The optimum level of liquidity for a business varies from industry to
industry.
• Short-term creditors such as bankers and suppliers concern about the
liquidity of a company as it may affect their decision to provide
funds/credit.
77
How Liquid Is the Company?
Liquidity is measured by two approaches:
• Comparing the company’s current assets and current liabilities.
• Examining the company’s ability to convert accounts receivables
and inventory into cash on a timely basis.
78
Liquid Assets
• The information from financial statements can provide an
understanding of the liquid asset of the company and its liquidity.
• A liquid asset is one that can be converted quickly into cash at the
market price. E.g. trade receivable. This provides information about
how liquid is the company. A company holding too many inventories
may indicate a relatively low liquidity than a company holding more
cash.
79
Class Activity 1 – Class Discussion
Can you give some other
examples of liquid assets?
80
Class Activity 1 – Solution
• Cash
• Marketable securities e.g. investment in stocks
81
Risks Associated with Cash Flows & Liquidity
• Cash receipts will be lower than expected or cash payments will be
higher than expected.
• The company will face a cash shortage if it is unable to borrow the
money it needs or unable to raise more cash by selling off its assets in
due course.
• The interest earned from bank deposit turns out to be much lower
than the borrowing cost to settle immediate debts when the
company is facing a cash shortage.
82
Activity 2 – Group Discussion
• How can we know if a company has a liquidity problem?
83
Activity 2 – Signs of Liquidity Problems
• Decline in daily or weekly cash inflows.
• Decline in operating profit which indicates the company is unable to
pass the cost on to customers.
• Unexpected build-up of accounts receivable or inventory which
indicates the company may not be able to collect money from
customers or is unable to sell goods.
• Unexpected build-up of accounts payable indicates the company is
unable to pay to its suppliers.
• Decline in company’s working capital.
84
How to Cope with Liquidity Problems
• A company might consider the following methods to cope with the
liquidity problems:
• Offering an early settlement discount to its customers. This is a reduction in
the amount of the payment required from the customer provided that the
customer pays within a specified time limit.
• Keep less inventory – e.g. applying Just-in-time inventory system to reduce
the carrying cost and increase the cash balance.
• When there is no harm to the relationship with suppliers, defer payment to
suppliers as possible as it can.
The End
86
Basic Ratio Analysis
Part 7 – Calculation and Interpretation
of Liquidity Ratio (Current Ratio and
Acid-test Ratio)
87
Liquidity Ratios
• The calculation of liquidity ratios can show the company’s ability to
convert its assets into cash for settlement of its the short-term
liabilities within short period of time.
• Even a profitable company can fail because of cash flow problems
other than any other reason.
88
Measuring Liquidity:
Compare a company’s current assets with its current liabilities using:
Current
Ratio
Acid-test
Ratio
89
Current Ratio
• It represents the proportion of current assets to current liabilities.
• It is used to assess the ability of a business to pay its short-term debts
when they fall due, and gives an indication of the margin of safety to
meet the fluctuations which may arise from time to time in the flow
of funds.
• The formula:
Current assets
Current ratio 
Current liabilities
90
Current Ratio
• It compares a company’s current assets to its current liabilities.
– A current ratio of 2:1 means the company has sufficient liquidity to cover its
short-term liabilities twice over.
– A current ratio of 0.8:1 would suggest that the company is unable to meet its
short-term liabilities and could be in a weak financial position.
• A ratio below 1 does not mean the company will be bankrupt but of a
higher risk of being bankrupt.
91
Current Ratio – Too High/Too Low
• If the ratio is too high (e.g. 5:1), the company may be holding too
many idle short-term assets. (e.g. cash that earns little or no interest
income).
• If the ratio is too low (e.g. 0.5:1), it may indicate that the company
may not be able to meet its debts when they fall due and face
liquidity problems.
92
Financial Statements of ABC Ltd
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
93
Activity 1 – Calculation of Current Ratio
• Given the following information, calculate and comment the current
ratio for the years of 20X4 and 20X5.
20X4
20X5
Inventory
$163,000
$116,000
Accounts receivable
$146,000
$162,000
Cash and bank
$23,000
$44,000
Accounts payable
$155,000
$171,000
94
Activity 1 – Solution
20X4
20X5
Current Ratio ($163,000 + $146,000 +$ 23,000) ($116,000 + $162,000 +$44,000)
/ $155,000 = 2.14
/ $171,000 = 1.88
• Comment: The current ratio has declined in 20X5 which means it is
less liquid than 20X4. However, it is still satisfactory as the ratio is
higher than 1 which means it has sufficient current assets to cover its
current liabilities.
95
Limitation of Using Current Ratio
• Disadvantage of using current ratio
– Misleading i.e. a high current ratio is not necessarily good.
• When using current ratio, it is assumed that the accounts receivable
will be collected on a timely basis and the inventories can be sold
without any delay.
• If the inventory by its nature is less liquid than its accounts receivable,
i.e. it takes more time to sell than to receive cash from customers, the
liquidity of the company will be decreased.
• Therefore, a more stringent measure of liquidity may help to assess
the liquidity of the company.
96
Acid Test/Quick/Liquid Ratio
• Acid test ratio (or quick/liquid ratio) is a more conservative measure
than the current ratio in measuring a company’s liquidity. The
numerator consists of the most liquid current assets only.
• In businesses with a slow inventory turnover, it is probably
inappropriate to regard inventory as a ‘quick asset’ that will soon be
converted into cash.
• Quick assets are those can be converted into cash quickly. They
consist of all the current assets except “INVENTORY”.
97
Acid Test/Quick/Liquid Ratio
• The Acid Test Ratio indicates whether a company can meet its shortterm liabilities without having to dispose of its inventory.
• The formula: Acid test ratio  Current assets less inventory
Current liabilitie s
• Comparing the Current ratio and the Acid Test ratio therefore gives an
indication of the relative size of the inventory holdings of a company.
98
Acid Test/Quick/Liquid Ratio – Too High/Too Low
• If the ratio is too high, the company may be holding excessive liquid
assets.
• If the ratio is too low, it is probable that the company cannot settle it
short-term debts and at a risk of liquidity problem.
99
Financial Statements of ABC Ltd
ABC Ltd
Income Statement
For the year ended 31 December
20X5
$'000
1,850
(935)
915
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(135)
(182)
(174)
424
(26)
398
(66)
332
20X4
$'000
1,560
(753)
807
(108)
(161)
(155)
383
(24)
359
(56)
303
ABC Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
3,200
3,000
212
304
118
634
189
286
225
700
285
66
351
250
56
306
3,483
3,394
2,200
786
2,986
2,200
454
2,654
497
3,483
740
3,394
100
Activity 2 – Calculation of Acid Test Ratio
• Given the following information, calculate the acid test ratio for the
year of 20X4 and 20X5 and comment the ratios by comparing with
the current ratio calculated in activity 1.
20X4
20X5
Inventory
$163,000
$116,000
Accounts receivable
$146,000
$162,000
Cash and bank
$23,000
$44,000
Accounts payable
$155,000
$171,000
101
Activity 2 – Solution
20X4
20X5
Current Ratio ($163,000 + $146,000 +$ 23,000) ($116,000 + $162,000 +$44,000)
/ $155,000 = 2.14
/ $171,000 = 1.88
Acid Test
Ratio
($146,000 +$ 23,000) / $155,000 ($162,000 +$44,000) / $171,000
= 1.09
= 1.20
• Comment: The current ratio suggests that 20X4 is more liquid while the
acid test ratio indicates the contrast. The difference must come from the
amount of inventories relative to its respective current liabilities of the two
years . i.e. higher current ratio for 20X4 indicates that it has relatively more
inventory than current liabilities then that in 20X5.
• However, it is still satisfactory as the acid-test ratio is higher than 1, which
means other than inventories, the company has sufficient current assets to
102
cover its current liabilities.
Acid Test/Quick/Liquid Ratio
• Advantages of using acid test ratio
– A more conservative measure of liquidity than current ratio which the ratio
focuses on the more-liquid assets of a company.
– Can compare with the current ratio and see whether the company’s current
assets are dependent on inventory or not.
• Disadvantage of using acid test ratio
– Same as the use of current ratio, misleading information can be provided i.e.
a high acid test ratio is not necessarily good as the company may be holding
too many idle short-term assets.
103
The End
104
Basic Ratio Analysis
Part 8 – Evaluation on the Liquidity
and Profitability of a Business Using
Accounting Ratios and Its Limitation
105
How to Evaluate a Business?
• Recall in Part 1 of the lesson, your uncle who is carrying a trade
business knows you are studying business, accounting, and financial
studies and asks if you could provide him with some ideas on the
financial performance and position of his business.
• After having learnt some basic ratios in the previous lessons, can you
give him some advise now?
106
Can you give your uncle some advise?
• Yes!
• By the use of accounting ratios, we can evaluate the financial
performance and financial position of a business so as to make a
better business decision.
Now, try to calculate the profitability and
liquidity ratios for your uncle’s business, OPQ
Limited, for the year 20X4 and 20X5 and provide
basic analysis for the changes of ratios.
107
Evaluation of a Company Using Accounting Ratios
Evaluate the
financial
performance
and financial
position of
OPQ Ltd by
using
accounting
ratios.
OPQ Ltd
Income Statement
For the year ended 31 December
20X5
$'000
3,882
(2,323)
1,559
Sales
Cost of sales
Gross profit
Expenses
Distribution
Selling and marketing
General and administrative
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
(382)
(336)
(224)
617
(102)
515
(85)
430
20X4
$'000
3,323
(1,905)
1,418
(371)
(302)
(216)
529
(101)
428
(72)
356
OPQ Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
Current assets
Inventories
Trade receivables
Cash and bank
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
Non-current liabilities
Long-term loan
20X4
$'000
7,050
6,624
386
716
83
1,185
412
323
428
1,163
367
85
452
311
72
383
7,783
7,404
3,800
1,403
5,203
3,800
1,024
4,824
2,580
7,783
2,580
7,404
108
Evaluation of a Company Using Accounting Ratios
Calculations
The Gross Profit Margin for OPQ Ltd:
20X5: $1,559/$3,882 x 100% = 40.16%
20X4: $1,418/$3,323 x 100% = 42.67%
The Net Profit Margin for OPQ Ltd:
20X5: $515/$3,882 x 100% = 13.27%
20X4: $428/$3,323 x 100% = 12.88%
The Return on Capital Employed for OPQ Ltd:
20X5: $617/$7,783 x 100% = 7.93%
20X4: $529/$7,404 x 100% = 7.14%
Comments
The GP margin of 20X5 is lower than
20X4 by 2.51% which indicates a poorer
control on purchase cost or reduction in
pricing products to stimulate sales.
The NP margin of 20X5 is slightly higher
than 20X4 by 0.39% which indicates a
better control of operating expenses.
The ROCE of 20X5 is higher than 2014
by 0.79% which indicates the company
is more effectively in using its capital to
generate returns.
109
Evaluation of a Company Using Accounting Ratios
Calculations
The current ratio for OPQ Ltd:
20X5: $1,185/$452= 2.62 times
20X4: $1,163/$383 = 3.04 times
Comments
The current ratio for 20X5 is lower than
20X4 which indicates the ability to settle
short-term debts is declined. It is still at an
acceptable level (i.e. 2.62 times) but cash
balance reduced significantly and the trade
receivables are increased by 2.2 times may
indicate a problem of bad debts.
The acid test ratio for OPQLtd:
The acid test ratio for 20X5 is lower than
20X5: ($1,185 - $386)/$452 = 1.76 times 20X4 but still at an acceptable level (i.e.
20X4: ($1,163 - $412)/$383 = 1.96 times 1.76 times) which indicates the ability of a
company to meet its liabilities without
having to dispose of its inventory is fine.
110
Activity 1 –
Case Study
Your uncle’s business is the
supplier of DEF Ltd. Your
uncle is now considering
whether it is appropriate to
sell goods to DEF Ltd on
credit or COD (Cash on
Delivery). (Demanding COD
might cause DEF Ltd buy less
from your uncle’s company.)
Use accounting ratios to help
your uncle to make decision.
DEF Ltd
Income Statement
For the year ended 31 December
20X5
$'000
Sales
5,220
Cost of sales
(3,380)
Gross profit
1,840
Expenses
20X4
$'000
5,530
(3,410)
2,120
DEF Ltd
Statement of Financial Position
As at 31 December
20X5
$'000
Non-current assets
Equipments
8,250
7,273
Current assets
Distribution
(522)
(482)
Inventories
338
284
Selling and marketing
(414)
(398)
Trade receivables
536
406
General and administrative
(331)
(303)
Cash and bank
34
128
573
(108)
465
(65)
400
937
(66)
871
(42)
829
908
818
782
65
847
434
42
476
8,311
7,615
5,500
1,688
7,188
5,500
1,288
6,788
1,123
8,311
827
7,615
Operating profit
Interest expenses
Profit before tax
Income tax expenses
Profit after tax
Current liabilities
Trade payables
Tax payable
Total assets less current liabilities
Financed by:
Share capital
Retained earnings
111
20X4
$'000
Non-current liabilities
Long-term loan
Activity 1 – Solution
20X5 Ratio
Calculation
Result
Gross Profit Margin
$1,840 / $5,220
35.25%
Net Profit Margin
$465 / $5,220
8.91%
ROCE
$573 / $8,311
6.89%
Current Ratio
$908 / $847
1.07
Acid Test Ratio
($908 - $338) / $847
0.67
20X4 Ratio
Calculation
Result
Gross Profit Margin
$2,120 / $5,530
38.34%
Net Profit Margin
$871 / $5,530
15.75%
ROCE
$937 / $7,615
12.3%
Current Ratio
$818 / $476
1.72
Acid Test Ratio
($818 - $284) / $476
1.12
112
Activity 1 – Solution
Ratio
Gross Profit Margin
Net Profit Margin
Comments
The GP margin of 20X5 is lower than 20X4 by 3.09% which indicates there
may be keen competition on selling price or poor control on purchase cost.
The NP margin of 20X5 is significantly dropped by 6.84% compared with
20X4. One of the reasons is the decline in sales. Besides, there seems a
poorer control of operating expenses.
ROCE
The ROCE of 20X5 is significantly dropped by 5.41% compared with 20X4
which indicates the company is less effectively in using its capital assets to
generate returns.
Current Ratio
The current ratio for 20X5 is lower than 20X4 which indicates the ability to
settle short-term debts is worsen.
Acid Test Ratio
The acid test ratio for 20X5 is significantly dropped and below 1 which
indicates the ability of a company to meet its liabilities without having to
dispose of its inventory is deteriorated and there is a risk of insolvency.
113
Activity 1 – Solution
• Suggested solution for your uncle:
• While DEF Ltd’s ratios appear to be deteriorating, its profitability and liquidity
ratios are low. It is suggested not to arrange credit to the DEF Ltd under its
current situation as there is a risk that DEF Ltd is not able to settle the
invoices.
• Terms of COD might be hard and might push DEF Ltd into liquidity problem
but it is safe for supplier to avoid the risk of bad debt.
• Unless DEF Ltd can improve its profitability and especially liquidity ratios, e.g.
by tightening its cost and infusion of equity capital into the company, it is
suggested not to provide credit but ask for COD.
114
What other factors will you consider?
• Despite the use of accounting ratios to make decision, there are some
other factors that may affect business decision.
• Examples:
• Is your uncle’s revenues tied to one or few key customers (i.e. is DEF Ltd the
major customer of your uncle’s business)? If so, the income will be declined
significantly if the relationship with DEF Ltd is broken.
• Is the legal and regulatory environment favourable to the DEF Ltd? If so, it
will enhance the future financial performance and position of the business.
115
The Limitations of Accounting Ratio Analysis
•
The financial performance of a company may be affected by external
environmental factors which beyond their control. E.g. economic downturn will
lead to poor performance of the company.
•
It is sometimes difficult to identify other companies for comparison as there
may not be any company running the same business as one another.
•
Financial statements use historic information. i.e. does not meant the trend will
continue.
•
Accounting practices differ widely among companies. E.g. the inventory
valuation or depreciation methods used may make the comparison distorted.
•
A high or low ratio does not automatically lead to a specific conclusion. Other
factors (as discussed in previous slide) should also be considered.
•
Financial statements cover the financial information for one year and seasonal
factors may not be reflected therein.
116
The End
117