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Financial
Topic Statement

LEARNING OUTCOMES

After learning this topic, you should be able to:

1. Explain the following financial statements:
a) Balance Sheet;
b) Income Statement; and
c) Cash flow Statement.

2. Explain the information obtained from components of financial

statement;

3. Undertake calculation and interpretation of 5 different type of

financial statement;

4. Explain the usage of financial ratios; and

5. List the weaknesses in financial ratios analysis.

MIF208 INTRODUCTION TO FINANCE

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INTRODUCTION

Financial statement and its analysis are vital to a firm and its external parties. Internal parties
such as the management require information obtained from the financial statement to assist
them in planning, monitoring and decision making.

External parties such as commodity creditors would like to know the liquidity of firms and
their ability to pay their claims. Bondholders also would like to know the ability of firms to
pay the interest rate and capital money when the bond matures. Shareholders would like to
know profit of the firm and its performance before investing. Therefore, whether you are a
finance manager, creditor or investor, the understanding of financial statement and its analysis
are vital.

In this topic, you will learn about various types of financial statements, its components, and
followed by financial analysis which could be used to obtain important practical information
to certain groups.

6.1 FINANCIAL STATEMENTS

There are three types of basic financial statements:

a) Balance Sheet;
b) Income Statement; and
c) Cash Flow Statement.

5.1 .1 Balance Sheet

Balance Sheet is a statement which states the financial position of a firm for a certain period
of time. Balance sheet of a firm could change daily because inventory could either increase or
decrease daily and fixed assets, such as equipments could appreciate or depreciate its values.
Financial statement is divided into two divisions:
a) Assets; and
b) Liabilities and equities.
Refer to example 5.1, Balance Sheet of Syarikat Emas Bhd.
Asset are the sources owned by a firm. Assets could be separated into current assets and fixed
assets. Current assets should be able to change to cash in a period of less than one year.
Examples of current assets are cash, trade-able securities, accounts receivable, and inventories.
Fixed assets include plants and equipments. Assets illustrated at the left of balance sheet and
arranged according to their liquidity, which is the time required to change assets into cash.
Liabilities and equities are illustrated at the right of balance sheet. Liability is the demand of
firms’ assets. Account payable, notes payable, and accrual expenses are some of the current

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liabilities, whereby these liabilities will be maturing in a period of less than one year. Bonds
and bank loans which are more than one year are are categorized as long-term liability because
the firm is indebted to other party.
Equity is the demand of shareholders on assets of the firm and it could be in the form of priority
share, ordinary share, and undistributed profits.
Although accounting books stated that the assets listed on the left of balance sheet while
liabilities and equities are stated on the right of balance sheet, sometimes there are formats
whereby assets are listed at the top while liabilities and equities are listed at the bottom of the
balance sheet.
In accounting, all assets of the firm are owned by creditors and firm owners. Therefore, the
following equation is:

Assets = Liabilities + Equities

Example 5.1: Balance sheet of Syarikat Emas Bhd.

Syarikat Emas Bhd.
Income Statement
For Year Ending 31 December 1999 and 31 December 2000

Assets Year 2000 Year 1999

(RM’000) (RM’000)

Cash and marketable securities 300 2400

Accounts receivable 11,250 9450
Inventories 18,450 12,450
Total current assets 30,000 24,300
Net plants and equipments 30,000 26,100
Total assets 60,000 50,400

Liabilities and Equities

Accounts payable 1,800 900
Notes payable 3,300 1800
Accrual expenses 4,200 3900
Total current liabilities 9,300 6600
Long-term bonds 22,620 17,400
Total liabilities 31,920 24000
Priority Share (1200,000) 1,200 1,200
Ordinary share (15,000,000) 3900 3900
Retained earnings 22,980 21,300
Total equities 26,880 25,200
Total liabilities and equities 60,000 50,400

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YOUR IDEA

Sketch a chart to illustrate the categories below in a Balance Sheet

a) Current Assets
b) Fixed Assets
c) Current Liabilities
d) Fixed Liabilities
e) Equities

Information obtained from the Balance Sheet is as follows:

Generally, Balance Sheet provides information about the financing activities and investments
of firms.
Liabilities and equities provide an overview of the capital structure of firms.
We could view the total capital that consists of equities and the divisions paid by debts
(liability).
The separation of total liabilities (short term) and long term liabilities are also shown in the
Balance Sheet. This information is important for analyzing financial position of firms.
From the Balance Sheet, we could calculate the working capital. Working capital is the
difference between current assets and current liabilities.

Working capital = Current Assets – Current Liabilities

Working capital could be obtained by deducting current assets from current liabilities.
Information on the working capital is useful in evaluating the liquidity of firms and their ability
to reimburse short term demands. Liquidity to firms is vital because businesses may fail if they
could not finance their interest or loan when it matures.
Balance Sheet also illustrates the total assets held by firms or the current assets ratios and fixed
assets. If firms consists of too many fixed assets compared to current assets, their capitals will
be ted-up and it might cause cash flow problems and also financial failures. This is caused by
the difficulty of changing fixed assets to cash compared to current assets.

Exercise 5.1

Based on Example 5.1, calculate the Working Capital of Syarikat Emas Bhd. For year
1999 and 2000.
5.1 .2 Income Statement

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Income Statement is a statement which provides information about yields and expenditures of
a firm for a certain period of time. Sales revenue is illustrated in every income statements and
this is followed by expenditures or costs and taxes.briefly, income statement illustrates profit
or loss of firms for a period of time, usually one year. Profit is important to the firm owners,
workers and suppliers because without profits, firms could not continue to exist.
Refer to Example 5.2, Income Statement of Syarikat Emas Bhd.
Returns is the influx of assets such as cash emerged as the result of goods or services sold, fees
paid by members or from interests earned from investment funds.
Total expenses refer to the efflux of assets which includes cost of goods sold, workers salary,
rent, sale expenses and administrations, insurance and others.

Syarikat Emas Bhd.

Income Statement
For Year Ending 31 December 1999 and 31 December 2000

Year 2000 Year 1999

(RM’000) (RM’000)

Sales 90,000 85,500

Cost of goods sold 74,846 71,110
Gross profits 15,154 14,390
Sale and administrative expenses 3,640 3,800
Depreciation and Amortization 3,000 2,700
Earnings before interest and taxes 8,514 7,890
Less interest 2,640 1,800
Earning before taxes 5,874 6,090
Taxes 2,349 2,430
Net profits 3,525 3,660
Priority share dividends 120 120
Net profit available to ordinary shareholders 3,405 3,540
Ordinary share dividends 1,725 1,950
Changes in retained earnings 1,680 1,590

Information obtained from income statement is as follows:

Income Statement or Profit and Loss Statement provides information to determine the
performance of firms. To determine performance of firms, several aspects must be emphasized:
a) Sale figures – this could be compared to past year sales and predicted future sales of
the firm. This information could be used by firms for their future planning purposes.
b) Gross profits – this could be compared with the sales figures that illustrates profit from
goods sold.

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Gross Profit = Sales – Cost of goods sold

c) Expenses of firms – this could be compared with the past expenses of firms in order to
identify which policy could be used to reduce costs.
d) Net profits – this could be compared with sales. Usually, the profitability and sales
volume are interchangeable, whereby if a firm generated a high sales volume, it might
have the possibility of receiving a lower percentage of net profits. However, net profits-
sales ratios is influenced by the type of business conducted.

Net profit = Gross profit – Sale and administrative expenses – Depreciations and
amortizations.

Exercise 5.2

Refer to the Income Statement in Example 5.2, differentiate between gross profits and net
profit.

5.1.3 Cash Flow Statement

Cash flow statement is a statement which records the effect of activities such as operating
activity, investment, and cash flow payment of firms for a certain period of time. Net cash flow
is the total cash obtained by a certain business for a certain period of time, e.g. one year.
However, the cash flow obtained by firms might not be the total cash obtained at item ‘cash’
in the Balance Sheet because this cash might be use to pay dividends, accounts payable,
investment in fixed assets, increase inventories, and so forth. With this, the total cash in the
balance sheet could be influenced by factors like cash flow, changes in working capital,
changes in fixed assets, company transactions such as selling or buying share and bonds,
dividend payments, and others. These factors will be reflected in the Cash Flow Statement
which illustrates the changes of cash position in a company.
Cash flow Statement could be divided into three divisions according to their activities:
1. Operational activity
2. Investment activity
3. Financing activity
Refer to Example 5.3: Cash Flow Statement of Syarikat Emas Bhd.
Information obtained from Cash Flow Statement is as follows:
Cash flow statement is important to finance managers because it provides information such as:
a) The ability of firms to generate sufficient cash for financing or purchasing of new assets
for expansion; and

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b) The ability of firms to generate sufficient cash for financing loans.

Example 5.3: Cash Flow Statement of Syarikat Emas Bhd.

Syarikat Emas Bhd.

Cash Flow Statement
For Year Ending 31 December 2000

Assets Year 2000 Year 1999

(RM’000) (RM’000)

Cash and marketable securities 300 2400

Accounts receivable 11,250 9450
Inventories 18,450 12,450
Total current assets 30,000 24,300
Net plants and equipments 30,000 26,100
Total assets 60,000 50,400

Liabilities and Equities

Accounts payable 1,800 900
Notes payable 3,300 1800
Accrual expenses 4,200 3900
Total current liabilities 9,300 6600
Long-term bonds 22,620 17,400
Total liabilities 31,920 24000
Priority Share (1200,000) 1,200 1,200
Ordinary share (15,000,000) 3900 3900
Retained earnings 22,980 21,300
Total equities 26,880 25,200
Total liabilities and equities 60,000 50,400

Exercise 5.3

State whether the following statements is True (T) or False (F).

1. Depreciation expense is an item that will be added into the net profit in
determining the cash flow from operational activities.
2. Interest expense is considered as an item in the investment activities in the cash
flow statement.
3. Any increase in accounts receivable and accounts payable will be added into the
net profit in determining the cash flow from operating activities.
4. Purchasing fixed assets for company uses will be deducted to determine the cash
flow from investment activities.

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5.2 FINANCIAL STATEMENT ANALYSIS

Financial statement analysis involves:

a) Comparing a firm’s performance with other firms in the same industry
b) Evaluating financial position of firms from time to time
These analyses could be used by:
a) Finance managers to identify weaknesses and undertake steps to improve performance
of his firm.
b) Investors to evaluate current financial position of firms.

5.2.1 Ratio Analaysis

Information obtained from the financial statement could assist investors and finance managers
to predict the future of firms, while the management could use the information obtained to
predict the future scenario and assist them in planning for the future. A basic method to obtain
useful information is from the financial statement through financial ratios analysis.

5.2.2 Types of financial analysis

1. Liquidity Ratios – current ratios, quick ratios (acid-test ratios)

2. Assets Management Ratios – inventory turnover ratios, fixed asset turnover ratios,
total assets turnover ratios.
3. Debt Management Ratios – debt ratios, times interest earned ratios.
4. Profitability Ratios – operating profit margin, return on ordinary equity
5. Market Value Ratios – price/ earning ratios, ratios per share, market/share ratios.

a) Liquidity Ratios
A liquidity ratio is used to illustrate the relationship between cash and current assets of a firm
with its current liabilities. A liquidity ratio is an asset which could be turned into cash easily
without depreciating much of the assets value. A firm’s liquidity position could provide
information to answer questions such as whether this firm is able to pay its debt at the maturity
date or otherwise.
b) Current Ratios
This ratio shows how many times that current liabilities are covered by total assets and this is
calculated by dividing the current assets with current liabilities. Current assets include cash,
trade-able securities, accounts payables and inventories. Current liabilities include account
payable, payable short term notes, accured taxes, and other expenses such as workers wages.

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