TOPIC 3

FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

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topic Financial

Statements and Financial Ratios Analysis

l eaRninG oUtcomes
By the end of this topic, you should be able to: 1. 2. 3. 4. 5. Explain the importance of fi nancial statements; Analyse fi nancial statements; Calculate and interpret fi nancial ratios; Apply ratio analysis in fi nancial decision making; and Discuss the limitations of fi nancial ratios analysis.

intRoDUction
Financial statement and its analysis are vital to an organisation and external parties. The internal management of a company requires information obtained from a fi nancial statement to assist them in planning, controlling and decision making. External parties such as business creditors need to know the liquidity position of a fi rm and its ability to pay their claims. Bond holders too need to know the fi rms ability to pay interest and its principal when the bond matures. Before

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

investing in a company, shareholders need to know the profit and performance of the company concerned. Therefore, whether you are a financial manager, creditor or investor, the understanding of the financial statement and its analysis is an important. In this topic, you will be learning three types of basic financial statements and their components, followed by financial analysis which can be used to gain important practical information for the benefit of certain parties.

3.1

Financial statements

There are three types of basic financial statements: (a) Balance Sheet; (b) Income Statement; and (c) Cash Flow Statement. Let us take a look at each type in detail.

3.1.1

Balance Sheet

Balance sheet is the statement of the firms financial position at a specific point in time. The balance sheet of a firm may change daily because inventories may increase or decrease each day, and fixed assets such as equipment can be added or depreciate. A financial statement can be divided into two parts: (a) Asset An asset is a resource owned by a firm. Assets can be separated into current assets and fixed assets. Current assets can be converted into cash in period less than one year. Examples of current assets are cash, marketable securities, accounts receivable and inventories. On the other hand, fixed assets include equipment and plants. Assets are arranged in order based on liquidity, that is, time needed to convert the assets into cash money. (b) Liability and Equity Liability is a claim against the firms assets. Accounts receivable, notes payable and accrued expenses are current liabilities which will mature in less than one year. Bonds and bank loans which are the firms debts to other parties are categorised as long-term liability as they will mature in a period of more than one year. Equity is a claim of shareholders on the firms assets which may be in the form of preference shares, ordinary shares and retained earnings.

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Figure 3.1 shows a balance sheet of Emas Limited Company.

Emas Limited Company Income Statement For the Years Ended 30th December 2010 and 31st December, 2011 Assets Cash and Marketable Securities Accounts receivable Inventories Total Current Assets Net plant and equipment Total Assets Liabilities and Equity Accounts payable Notes payable Accrued expense Total Current Liabilities Long-term bonds Total Liabilities Preference shares (1,200,000) Ordinary shares (15,000,000) Retained earnings Total Equity Total Liabilities and Equity 2011 (RM000) 300 11,250 18,450 30,000 30,000 60,000 1,800 3,300 4,200 9,300 22,620 31,920 1,200 3,900 22,980 26,880 60,000 2010 (RM000) 2,400 9,450 12,450 24,300 26,100 50,400 900 1,800 3,900 6,600 17,400 24,000 1,200 3,900 21,300 25,200 50,400

Figure 3.1: Balance sheet of Emas Limited Company

Normally, assets are noted on the left side of a balance sheet while liability and equity are noted on the right side of a balance sheet. Sometimes, assets are noted at the top while liability and equity are noted at the bottom of the balance sheet. In accounting, all the firms assets belong to creditors and owners of the firm. Thus, there is an equation such as shown below:
Asset = Liability + Equity

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

activity 3.1
Draw a chart to show the parts below in a balance sheet: (a) Current Assets (b) Fixed Assets (c) Current Liabilities In general, a balance sheet gives information regarding the financing and investment activities of a firm. Liabilities and owners equity present a view of the related firms capital structure. We can see the part of the total capital which includes equity and the portion financed by debt. Segregation of the total liabilities into current liabilities and long-term liabilities are also shown in the balance sheet. This information is important to analyse the firms financial position. From the balance sheet, we can also calculate the working capital. Working capital is the difference between current assets and current liabilities. Working Capital = Current Assets Current Liabilities Working capital can be obtained by subtracting current liabilities from current assets. Information on working capital is important to evaluate a firms liquidity and its ability to pay back short-term claims on it. A firms liquidity is important because its business is likely to fail if the firm is unable to pay interest or pay back debt when it matures. Balance sheet also shows the combined assets held by a firm or the current asset ratio and the firms fixed asset. If a firm holds too much fixed assets compared to current assets, the firms capital will be tied up and this may lead to cash flow problems and financial failure. This is caused by difficulty in converting fixed assets into cash compared to current assets. (d) Fixed Liabilities (e) Equity

self-check 3.1
Based on Figure 3.1, calculate the working capital of Emas Limited Company for the years 2010 and 2011.

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3.1.2

Income Statement

Income statement is a statement that gives information regarding the revenues and expenditures of a firm in a specific period of time. Sales revenue is shown in every income statement and this is followed by expenditures or cost and taxes. In brief, an income statement indicates a firms profit or loss in a specific period of time which is normally one year. Profit is important to a firms owner, employees and suppliers because without profit, the firm will not continue to exist. Please refer to Figure 3.2, Income Statement of Emas Limited Company:

Emas Limited Company Income Statement for the Year Ended 31st December 2010 and 31st December 2011 Sales Cost of goods sold Gross profit Sales and administrative expenses Depreciation and amortisation Profit before interest and taxes Less: Interest expenses Profit before tax Tax Net Profit Preference shares dividend Net Profit for ordinary shareholders Ordinary shares dividends Addition to Retained Earnings 2011 (RM000) 90,000 (74,846) 15,154 (3,640) (3,000) 8,514 (2,640) 5,874 (2,349) 3,525 (120) 3,405 (1,725) 1,680 2010 (RM000) 85,500 (71,110) 14,390 (3,800) (2,700) 7,890 (1,800) 6,090 (2,430) 3,660 (120) 3,540 (1,950) 1,590

Figure 3.2: Income statement of Emas Limited Company

Income statement or profit and loss statement gives information to measure the firms performance. To measure the performance of a firm, some aspects of an organisation must be considered: (i) Sales figure Can be compared with the firms sales in the previous year and expected future sales. This information can be used for the purpose of planning the firms future. (ii) Gross profit Can be compared to the sales figure to show profit earnings from goods sold.

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Gross Profit = Sales Cost of Goods Sold (iii) Firms expenses Can be compared with the firms expenses in the previous year to formulate policies to decrease cost. (iv) Net profit Can be compared to sales. Normally, there are variations between profitability and sales volumes. When a firms sales volume is high, it may receive a lower percentage of net profit. However, the ratio of net sales-profit is influenced by the type of business undertaken by the firm concerned. Net profit = Gross Profit Sales and Administrative Expenses Depreciation and Amortisation

self-check 3.2
Essay Question With reference to the income statement in Figure 3.2, differentiate between gross profit and net profit.

3.1.3

Cash Flow Statement

Cash flow statement refers to the statement that records the effects of a firms activities such as operating, investment and financing of a firms cash flow for a specific period. Net cash flow is the total cash attained by a business in a specific period, for example, one year. But the cash flow attained by a firm may not necessarily be the total cash stated in the item cash on the balance sheet because the cash may be used to pay dividends, finance account receivable, invest in fixed assets, increase inventories, etc. Therefore, the available total cash in a balance sheet may be influenced by factors such as cash flow, changes in working capital, changes in fixed assets, companys transactions such as buying and selling of shares and bonds, dividend payment and so on. These factors will be reflected in the cash flow statement which shows changes in the cash position of the firm. A cash flow statement can be divided into three parts according to its activities: (i) (ii) Operating activity; Investment activity; and

(iii) Financing activity.

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Please refer to Figure 3.3: Shows cash flow statement of Emas Limited Company. Cash flow statement is important to a financial manager because it gives information regarding the firms ability to generate sufficient cash to: (i) Finance or purchase new assets for the firms expansion; and (ii) Pay back its debts.

Emas Limited Company Cash Flow Statement For the Year Ended 31st December 2011 (RM000) Operating Activities Net Profit Additional (cash resources) Depreciation and amortisation Increase in Accounts Payable Increase in Accrued expenses Less (uses of cash) Increase in Accounts Receivable Increase in inventories Net cash provided from operating activities Investment Activities Purchase of Plant, Equipment and Fixed Assets Net cash provided from investment activities Financing Activities Increase in notes payable Increase in bonds Dividend payment for preferences share and ordinary shares Net cash from financing activities

3,525 3,000 900 300 (1,800) (6,000) (75)

(6,900) (6,900) 1,500 5,220 (1,845) 4,875 (2,100) 2,400 RM 300

Increase (decrease) in cash Beginning cash balance Ending cash balance Figure 3.3: Cash flow statement for Emas Limited Company

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self-check 3.3
True (T) or False (F) Statements 1. 2. 3. Depreciation expenses is an item that will add to the net profit to determine cash flow from the operating activities. Interest expenses are items of investment activities in a cash flow statement. Any increase in accounts receivable and accounts payable will be added to net profit in determining cash flow from operating activities. Purchase of fixed assets for the companys use will be deducted to determine cash flow from investment activities.

4.

3.2

FINANCIAL STATEMENTs ANALYSIS

Financial statements analysis involves: (a) Comparison between the firms performance with other firms in the same industry; and (b) Evaluation of the firms financial position from time to time. These analyses can be used by: (a) A financial manager to identify the firms weaknesses and take steps to improve the firms performance; and (b) Investors to evaluate the firms current financial standing.

3.2.1

Ratio Analysis

Information obtained from the financial statement will assist investors and financial managers to forecast the firms future performance while management can use the information gained to forecast the situation and assist them in planning for the future. A basic method to obtain useful information from financial statements is through financial ratio analysis.

3.2.2

Types of Financial Ratios

There are five categories of financial ratios. Each type of financial ratios has its own role to the management and owner of the firm. Financial ratios consist of (refer to Table 3.1):

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Table 3.1: Financial Ratio Types of Financial Ratios Liquidity Ratios Assets Management Ratios Financial Ratios

Current ratio Quick ratio (Acid test ratio) Inventory turnover ratio Fixed assets turnover ratio Total assets turnover ratio Debt ratio Times interest earned ratio Net sales profit Returns of common equity Price/earning ratio Book per share ratio Market/book ratio

Debt management ratios Profitability ratios Market value ratio

Let us take a look at each type in detail.

activity 3.2
Define the meaning of liquid assets. (a) Liquidity Ratio Liquidity ratio is used to show the correlation between cash and a firms current assets with its current liabilities. Liquid asset is an asset that can easily be converted into cash without decreasing much of its value. A firms liquidity standing can answer questions as to whether a firm can afford or has the ability to pay off its debts when the date is due. (i) Current Ratio This ratio shows the frequency current liabilities are covered by current assets and this is calculated by dividing current assets with current liabilities. A current asset includes cash, marketable securities, accounts receivable and inventories. While current liabilities include accounts payable, short-term notes payable, tax accrued and other expenses such as employees wages. Current ratio can be expressed as follows: Current Assets Current ratio = Current Liabilities

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

According to the example of Emas Limited Company, the current ratio is calculated as follows: Current ratio: 24,300 Year 2010 : = 3.68 6,600 30,000 Year 2011 : = 3.23 9,300

Therefore, current ratio in 2010 is 3.68 and for the year 2011 is 3.23.

(ii) Quick Ratio Quick ratio is also known as an acid test ratio. Quick ratio measures the firms ability to pay short-term debts without having to sell inventories. Inventory is deducted from current asset because this asset is the least liquid and if the firm is dissolved, inventory might be the asset which could incur losses. Quick ratio can be shown by the following formula: Quick Ratio = Current Assets Inventories Current Liabilities

Based on the example of Emas Limited Company, the quick ratio when calculated is as follows: Quick Ratio: Year 2010 = Year 2011 = 24,300 12,450 = 1.80 6,600 30,000 18,450 = 1.24 9,300

Thus, quick ratio for the year 2010 is 1.80 and for the year 2011 is 1.24. It shows that the firm is able to pay its short-term debts better in the year 2010.

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self-check 3.4
Compare current ratio and quick ratio for Emas Limited Company for the years 2010 and 2011. What is your opinion regarding the liquidity position of this company?

(b) Asset Management Ratio Asset management ratio measures the firms efficiency in managing its assets. The information regarding the asset management ratio can determine whether each type of assets that had been reported in the Balance Sheet, too much or too little, is based on the current sales frequency or forecasted sales frequency. If a firm has too many assets, its capital is tied in the assets which will involve a high cost of capital. As a consequence, profits will decrease. On the other hand, if a firm saves too little on assets, especially inventories, this will result in the loss of clients because of lack of stocks to fulfil the customers demand: (i) Inventory Turnover Ratio Inventory Turnover Ratio can be expressed as follows: Inventory Turnover Ratio = Cost of goods sold Inventory

A high inventory turnover ratio indicates that sales are good and inventory turnover is quick. The implication is that the firm can run its business without having to tie its capital in inventories. This is because holding inventories involves costs such as capital cost, storing cost, and insurance cost. Therefore, the higher the inventory turnover ratio, the better the situation for the firm. Based on the example of the Emas Limited Company, the calculation for inventory turnover ratio is as follows: Inventory Turnover Ratio 71,110 Year 2010 = = 5.71 12,450 74,846 Year 2011 = = 4.06 18,450

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Thus, inventory turnover ratio for the year 2010 is 5.71 and for the year 2011 is 4.06. This means that the firms position is better in the year 2010.

(ii) Fixed Asset Turnover Ratio This ratio measures the firms efficiency in using fixed assets such as buildings and equipment to generate profits. The formula for fixed asset turnover ratio is expressed as follows: Based on the example of Emas Limited Company, fixed asset turnover ratio is: Sales Fixed Assets Turnover Ratio = Net fixed assets Thus, fixed asset turnover ratio for the year 2010 is 3.28 and for the year 2011 is 3.00. This means that the firms efficiency in managing its fixed assets had decreased in the year 2011. 85,500 Year 2010 = = 3.28 26,100 90,300 Year 2011 = = 3.01 30,000

(iii) Total Asset Turnover Ratio Total asset turnover ratio can be shown by the following formula: Total Asset Turnover Ratio = Sales Total assets

Normally, high ratios of fixed asset turnover and total asset turnover are preferred. This is because a high ratio indicates that assets are used more effectively to generate sales. Based on the example of Emas Limited Company, total asset turnover ratio is:

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Total Asset Turnover Ratio 85,500 Year 2010 = = 1.70 50,400 90,000 Year 2011 = = 1.50 60,000

Therefore, total asset turnover ratio in the year 2010 is 1.70 and for the year 2011 is 1.50. This means that total assets turnover ratio for the year 2010 is higher.

activity 3.3
Based on the asset management ratio for the Emas Limited Company for the years 2010 and 2011, which year has more efficient assets management? Give reasons to support your answer.

(c) Debt Management Ratio Total debts used by a firm is known as financial leverage. Implications of using debts as capital are: (i) Shareholders can continue controlling a firm by obtaining funds through debts; (ii) Creditors use equity to provide security margin. If shareholders have a small total of financial ratio, the firms risk will be borne by creditors; and (iii) If firms attain higher returns than what has been paid as interest on debts, returns on owners capital will be higher. There are two types of debt management ratios: (i) Debt Ratio Debt ratio measures the percentage of funds provided by creditors. Debt ratio can be shown in the following formula: Debt Ratio = Total debts Total assets

Total debt includes current liabilities and long-term debts. Creditors prefer a low debt ratio as it is more advantageous during the time a

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

company is dissolved. For shareholders, they prefer a high debt ratio because it will enlarge the expected earnings. Based on the example of Emas Limited Company, the calculation of debt ratio is as follows:

Debt Ratio 24,000 Year 2010 = = 0.48 50,400 31,920 Year 2011 = = 0.53 60,000

Thus, the debt ratio in the year 2010 is 0.48 and for the year 2011 is 0.53. This means that the debt ratio has increased in the year 2011. The firm relies more on its creditors to finance the total assets for the year 2011.

(ii) Times Interest Earned Ratio This ratio is used to measure the firms ability to pay its annual interest payment. If a firm is unable to pay off its interest charges, creditors have the right to take legal proceedings against it and this might cause the company to become bankrupt. From the creditors point of view the higher a firms times interest earned ratio, the better it is for them, because that shows the firms ability to pay interest annually. Hence, creditors risks are less. Times interest earned ratio can be shown in then formula below:

Times Interest Earned Ratio =

Earnings before Interest and Tax Interest charge

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Based on the example of Emas Limited Company, the calculation of times interest earned is: Times Interest Earned Ratio 7,890 Year 2010 = = 4.38 1,800 8,514 Year 2011 = = 3.23 2,640

Thus, times interest earned ratio is higher in the year 2010. The firms ability to pay annual interest had declined in the year 2011.

activity 3.4
Write down the importance of debt management ratio to the following parties:
Shareholders Creditors

(d) Profitability Ratio Profitability ratio indicates the combined effects of liquidity, asset management and debts decision on operation. In short, profitability ratio is the effect of various policies and decisions of the company: (i) Profit Margin on Sales This ratio measures income from every ringgit of sales. Profit margin on sales can be shown by the following formula: Based on the example of Emas Limited Company, profit margin on sales is:

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Profit Margin on Sales =

Earning available for the shareholders Sales

Therefore, net profit margin for the year 2010 is 4.1% and in year 2011 is 3.8%. It indicates that the firms net profit margin in year 2010 is higher than 2011. Thus, profit margin on sales for the year 2010 is 4.1% and for the year 2011 is 3.8%. This means that profit margin on sales is higher for the year 2010. This margin went down in the year 2011. Profit Margin on Sales 3,540 Year 2010 = = 0.041 = 4.1% 85,500 3,405 Year 2011 = = 0.038 = 3.8% 90,000

(ii) Return on Common Equity This ratio measures the rate of returns earned on the investment of ordinary shareholders. Return on common equity can be shown by the following formula: Net profit available for ordinary shareholders Ordinary shares equity

Return on Common Equity =

Based on the example of Emas Limited Company, return on common equity is as follows: Return on Common Stock Equity 3,540 Year 2010 = = 0.1405 = 14.05% 25,200 3,405 Year 2011 = = 0.1267 = 12.67% 26,880

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Therefore, the return on common equity for the year 2010 is 14.05% and 12.67% for the year 2011. So, it shows that return on common equity for the year 2010 is higher.

(e) Market Value Ratio Market value ratio is a set of ratios that correlates the firms stock price to the earnings of (book value) per share based on book value. This ratio gives information to the management regarding the investors view on the firms performance in the past and its future prospects: (i) Price/Earnings Ratio This ratio shows how much investors are willing to pay for each ringgit of the profit reported. This ratio can be expressed as follows:
Price per share Earnings per share

Price/Earnings Ratio Price/Earning Ratio =

(ii) Book Value Per Share Book value per share ratio can be shown by the following formula: Book Book Value Per Share Ratio Value Per Share Ratio = Common equity
Outstanding shares

(iii) Market/Book Ratio Market/Book ratio can be expressed as follows:

Market price per share Book value per share

Market/Book Ratio Market/Book Ratio =

(iv) Flow Analysis of Financial Ratio In using financial ratio, it is important for a financial manager to make time comparison or comparisons of firms in the same industry to get a comprehensive view of the firms performance.

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Table 3.2 lists all the financial ratios formulas that we have discussed earlier.
Table 3.2: Financial Ratios Formula Types of Financial Ratio (a) Liquidity ratio Financial Ratios Formula Current ratio Current Assets Current Liabilities Quick ratio Current Asset - Inventories Current Liability (b) Asset management ratio Inventory Turnover Ratio Cost of goods sold Inventory Fixed assets turnover ratio Sales Total assets Total assets turnover ratio Sales Net fixed assets (d) Profitability ratio Profit margin on sales Earnings available for the shareholders Sales Return on common equity Net profit available for ordinary shareholders Ordinary shares equity

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Types of Financial Ratio (e) Market value ratio

Financial Ratios Formula Price/ Earnings Ratio Price per share Earning per share Book Value Per Share Common equity Outstanding shares Market/ Book Ratio Market price per share Book value per share

3.2.3

Uses of Financial Ratios

activity 3.5
Based on the available financial ratios, in your own opinion, how do these ratios assist organisations in making decisions?

Financial ratios can be used to interpret financial information in a way that is easily understood. Financial ratios can give a more comprehensive reflection compared to the real figures as stated in financial statements. For example, if a financial manager wishes to know a firms liquidity standing, he has only to refer to the financial ratios such as current ratio and quick ratio. For an investor who wishes to know the firms profitability, he can refer to the profitability ratios such as profit margin on sales and return on common stock equity. If financial ratios can be collected for several years, comparison can be made by showing their flows in the form of graph, thus making dispersion of information by the management easier. Financial ratios can be used to construct a firms financial profiles. It can evaluate various aspects of firms financial performance and standing. This information can be used in the decision-making process by the firms management team, suppliers, investors, banks and so on.

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Financial ratios (especially if flow analysis or comparisons between are made) can measure the firms health and give an early warning sign on the difficulties which may be faced by the firm. Therefore, a financial manager may propose appropriate steps to solve the problem before it becomes too acute.

activity 3.6
Prepare a list of financial ratios which you might scrutinise before purchasing a firms share.

3.2.4

Weaknesses of Financial Ratios Analysis

Although financial ratio is a useful and quick way to analyse the status and performance of a business, it has some weaknesses and this should be considered by a financial manager when using financial ratios. Amongst the weaknesses are: (a) Financial ratios rely on data obtained from financial statements. Thus, whether the financial ratios calculated can be trusted or not depends on the quality of the financial statements. Weaknesses which exist in the financial statement will be reflected in the financial ratios and interpreting information from these ratios is useless because the financial data is inaccurate. Apart from that, one of the important factors which needs to be taken into consideration in preparing the financial statements is the effect of inflation which may misrepresent the value of fixed assets such as properties, profit and loss figures, etc. (b) Financial ratios measure the firms relative standing and performance and do not take into account its absolute size. Sometimes, real figures can give a better overall reflection when we make a comparison of the firms performance between two different time periods or between two different firms. (c) Normally, financial ratio of a firm is compared with the industry averages ratios where basic signs are used to look at the firms standing and performance compared to other firms. It should be reminded that this comparison might not be appropriate because it is difficult to find two firms with the same kind of business. Even though there may exist two firms in the same industry, one of the firms might have miscellaneous activities in other types of business. In addition, accounting policy, financial policy, and

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financial year may differ, and this will complicate the comparison thus weakening the use of financial ratios. (d) Financial ratios which are based on a balance sheet might not give accurate information because a balance sheet gives a reflection of the firm at a certain point of time only. Thus, a financial ratio calculated based on the data of a balance sheet statement does not represent the firms standing and performance in the whole year. These weaknesses are even more obvious in seasonal businesses. (e) Although the financial ratios are used to analyse the strengths and weaknesses of a firm, it cannot identify factors which had brought it to that position. A more detailed investigation into its practices and business records is still needed to identify those factors.

SELF-CHECK 3.5
Ttue (T) or False (F) Statements 1. 2. 3. 4. Debt financing is also known as equity financing. Interest expenses are subtracted before tax levied. Profitability ratio indicates the combined effects of liquidity, assets management and debt on operational decision. Current ratio is a more strict liquidity measurement compared to quick ratio.

3.3

important facts

Balance sheet is a statement that shows a firms financial standing at a certain point of time. Balance sheet can be divided into two parts: (a) Assets: (current assets + fixed asset); and (b) Liabilities: (current liabilities + long-term debt) and equity: (preferences shares, common shares and retained earnings).

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TOPIC 3 FINANCIAL STATEMENT AND FINANCIAL RATIOS ANALYSIS

Information that could be obtained from a balance sheet are: (a) Reflection of the capital structure of the company (b) Information on working capital Income statement shows: (a) A firms revenues and expenditures at a certain point of time; and (b) A firms profit and loss for a certain period of time, normally one year. Cash flow statement indicates the effects of the firms activities on cash flows of the firm for a certain period of time. Firms activities are: (a) Operating activity; (b) Investment activity; and (c) Financing activity. Financial statements analysis involves: (a) Comparison of the firms performance with other firms in the same industry; and (b) Evaluation of the flow of the firms standing between certain time periods. Financial ratios include: (a) Liquidity ratios: current ratio, quick ratio; (b) Assets management ratios: inventory turnover ratio, fixed asset turnover ratio, total asset turnover ratio; (c) Debt management ratios: debt ratio, times interest earned ratio; (d) Profitability ratios: profit margin on sales; and return on common equity; and (e) Market value ratios: price/earnings ratio, book value per share ratio, market/book value ratio. Uses of Financial Ratios: (a) Interpret financial information into a form that is easily understood; (b) Construct a firms financial profile; and (c) Measure the firms health and give an early warning sign on the difficulty which may be faced by a firm.

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The weaknesses of financial ratio analysis are: (a) If the financial ratio data is inaccurate, this will influence the quality and accuracy of the financial ratios; (b) The financial ratios measures the firms relative standing and performance without taking into consideration the absolute size; (c) Comparing the financial ratio of a firm with other firms in the same industry might not be suitable if there are firms which run miscellaneous types of business activity; (d) The economics situation always changes but financial ratios are calculated based on financial statements at a certain point of time, for example balance sheet; and (e) Financial standing of a firm can be affected by many factors.

SUMMARY
There are three important financial statements balance sheet, income statement and cash flow statement. Information can be obtained from each of the financial statements and this information can be used to calculate certain financial ratios to measure the liquidity, assets management, debt management, profit and the firms market value. Even though financial ratios can be used to interpret financial information into a format that could be easily understood, and to measure the firms health as well as construct the firms profile, we cannot rely entirely on ratio analysis in making our decision because there are several weaknesses that need to be considered.

Asset management ratio Debt management ratio Financial ratios Financial ratio analysis Financial statement

Financial terms Liquidity ratio Market value ratio Profitability ratio