BBFS4103

OUM Business School
BBFS4103
Financial Statement Analysis
Copyright © Open University Malaysia (OUM)

BBFS4103
FINANCIAL
STATEMENT
ANALYSIS
Rahimi Dollah

Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writer: Rahimi Dollah
Moderator: Liana Muhamad

University College Sedaya International
Desktop Publishing: Center for Instructional Design & Technology

Open University Malaysia
First Edition, May 2009
Copyright © Open University Malaysia (OUM), February 2011, BBFS4103

All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xi - xvi
Topic 1 Overview of Financial Statement Analysis 1

1.1 Business Analysis and Financial Analysis 2
1.1.1 Types of Business Analysis 4
1.1.2 Financial Analysis 6
1.1.3 Users of Financial Statement (Business and 9
Financial Analysis)
1.1.4 Financial Analysis Stages and Processes 10
1.1.5 Financial Statement and Basis of Analysis 11
1.2 Financial Statement Analysis Preview 11
1.2.1 Financial Analysis Techniques and Tools 12
1.2.2 Comparative Financial Statement Analysis 13
1.2.3 Common-size Financial Statement Analysis 16
1.2.4 Ratio Analysis 17
1.2.5 Implications for Analysis 19
1.2.6 Specialised Analytical Tools 19
Summary 20
Key Terms 21
Topic 2 Financial Reporting and Analysis 22

2.1 Financial Reporting and Analysis Environment 23
2.1.1 An Overview of Corporate Financial Reporting 23
in Malaysia
2.1.2 How Financial Reporting is Constructed 25
2.1.3 How the Elements are Recognised 28
2.2 Nature and Objective of Financial Accounting 30
2.2.1 What Financial Accounting Provides to Enterprises 32
2.2.2 The Financial Accounting Framework 33
2.3 The Importance of Accrual 34
2.4 Principles and Conventions that Determine 36
Accounting Rules
2.4.1 The Constraints on Reliable and Relevant Information 38
Summary 39
Key Terms 39

iv X TABLE OF CONTENTS
Topic 3 Analysing Financing Activities 40

3.1 Liabilities Preview 41
3.1.1 Current Liabilities: Characteristics and Its Activities 41
In Running Business Operations
3.1.2 Non-current Liabilities: Characteristics and Its 45
Activities in Running Business Operations
3.2 Leases 47
3.3 Post Retirement, Disclosure and Risks 50
3.3.1 Employee (Postretirement) Benefits or Pension Cost 50
3.3.2 How the Pension Fund Performance Reflects on
Company Performance 51
3.3.3 Pension Accounting and Financial Analysis 51
3.4 Contingencies and Commitments 54
3.4.1 Contingencies, Natures and Impact to 54
Financial Analysis
3.5 Off Balance Sheet Financing 56
3.5.1 Off Balance Sheet, Natures and Impact to 56
Financial Analysis
3.6 Equity Financing 57
3.6.1 Equity, Natures and Impact to Financial Analysis 57
Summary 61
Key Terms 62
Topic 4 Analysing Investing Activities 63

4.1 Current Assets Preview 64
4.1.1 Current Assets: Characteristics and Its Investing 64
Activities in Business Operations
4.2 Inventories and Receivables 70
4.2.1 Inventories and Receivables: Characteristics and 70
Analysing Stock
4.2.2 Analysing the Inventory Ratios 74
4.3 Long Term Assets 76
4.3.1 Long-term Assets: Characteristics and Its Activities 76
in Running Business Operations
4.4 Plant Assets and Natural Resources 79
4.4.1 Plant Assets (Property, Plant and Equipment) and 79
Identifying the Cost
4.4.2 Government Grants 79
4.4.3 Depreciation of Assets 80
4.4.4 Changing the Basis of Depreciation 81
4.4.5 Natural Resources and Identifying the Cost 82
and Recognition
4.5 Intangible Assets 82

TABLE OF CONTENTS W v
4.5.1 Intangible Assets, Natures and Impact to 83

Financial Analysis
Summary 85
Key Terms 86
Topic 5 Analysing Operating Activities 87

5.1 Income Measurement Preview 88
5.1.1 The Categories of Income 88
5.1.2 Accounting Concept of Income 89
5.1.3 Measuring Accounting Income 90
5.2 Nonrecurring Items 91
5.2.1 Extraordinary Items 91
5.2.2 Accounting Changes 92
5.2.3 Special Items or Exceptional Items 94
5.3 Revenue and Gain Recognition 95
5.3.1 Revenue Recognition from Sales of Goods 96
5.3.2 Revenue Recognition from Provision of Services 98
5.3.3 Revenue Recognition from Interest, 99
Royalties and Dividends
5.4 Deferred Charges 100
5.4.1 Research and Development 100
5.4.2 Computer Software Industries 101
5.4.3 Exploration and Development Costs in 101
Extractive Industries
5.5 Supplementary Employee Benefits 101
5.5.1 Supplementary Employee Benefits, Definition, 101
Accounting Treatment and Impact to Analysing
Operating Performance
5.6 Interest Cost 103
5.6.1 Interest Cost and Impact to Operating Analysis 103
5.7 Income Tax 105
5.7.1 Income Tax and Impact to Operating Analysis 105
Summary 107
Key Terms 108
References 108
Topic 6 Cash Flow Analysis 109

6.1 Identify Statement of Cash Flow 110
6.1.1 The Objectives of the Cash Flows Statement 110
6.1.2 Cash and Cash Equivalents 111
6.1.3 The Contents of the Statement 112
6.1.4 The Construction of the Cash Flow Statement 113

vi X TABLE OF CONTENTS
6.1.5 Items and Activities that are Omitted in the 116

Cash Flow Statement
6.2 Financial Ratio Analysis 120
6.3 Analysis Implications of Cash Flows 123
6.4 Analysis of Cash Flows 124
Summary 128
Key Terms 129
Topic 7 Return on Invested Capital 130

7.1 Importance of Return on Invested Capital (ROIC) 131
7.2 Components of Return on Invested Capital 132
7.2.1 Defining Invested Capital 132
7.2.2 Defining Income (Profit) 133
7.2.3 Adjustment to Invested Capital and Income 133
7.3 Analysing Return on Assets 134
7.3.1 Computing Return on Invested Capital 134
7.3.2 Improving Return on Invested Capital 137
7.3.3 Ratios That Influence Return on Invested Capital 139
7.3.4 Asset Turnover Analysis and Its Correlation 141
with Turnover
7.4 Analysing Return on Common Equity 142
7.4.1 Computing Return on Common Equity 142
7.4.2 Improving Return on Common Equity 143
Summary 146
Key Terms 147
Topic 8 Profitability Analysis 148

8.1 Analysing Company Profitability 149
8.1.1 Factors in Measuring Company Income 149
8.2 Analysing Company Revenues 150
8.2.1 Issues in Analysing Company Revenues 150
8.2.2 Relationship between Revenues, Receivables 152
and Inventories
8.3 Analysing Company Cost of Sales 154
8.3.1 Gross Profit and the Changes Impact to the 154
Profitability
8.3.2 Improving Profit Margin 155
8.4 Analysing Company Expenses 159
8.4.1 Selling Expenses 159
8.4.2 Depreciation of Expenses 159
8.4.3 Maintenance and Repair Expenses 160
8.4.4 General and Administrative Expenses 161
8.4.5 Financing Expenses 162

TABLE OF CONTENTS W vii
8.4.6 Provisions 164

Summary 165
Key Terms 166
Topic 9 Credit Analysis 167

9.1 Analysing Company Liquidity and Working Capital 168
9.1.1 Explaining Current Assets and Liabilities 168
9.1.2 Liquidity Measurement 168
9.1.3 Numerator of the Current Ratio 170
9.1.4 Current Ratio Analysis 171
9.2 Analysing Operating Activities 172
9.2.1 Analysing Company Liquidity 172
9.2.2 Additional Liquidity Measures 176
9.2.3 Operating Cycles of a Business 178
9.3 Capital Structure and Solvency Analysis 180
9.3.1 Capital Structure Ratio 180
9.3.2 Number of Times Interest Earned 182
9.3.3 Capital Structure and Solvency Analysis from 183
the LenderÊs View
9.4 Credit Analysis ă Credit Risk 184
9.4.1 Common Causes of Business Failure ă Poor Credit 184
Risk Analysis
Summary 185
Key Terms 186
References 187

TOPIK 2 KAEDAH DAN TEKNIK W 17

COURSE GUIDE

COURSE GUIDE DESCRIPTION
You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBFS4103 Financial Statement Analysis is one of the courses offered by the
Faculty of Business and Management at Open University Malaysia (OUM). This
course is worth 3 credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
It is a core course for students undergoing Bachelor of Accounting.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

xii  COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
LEARNING OUTCOMES
By the end of this course, you should be able to:
1. Discuss and explain the objectives and scope of financial statement analysis;
2. Interpret financial data and evaluate the performance of a company;
3. Apply accounting based ratios for defining strategic company policies;
4. Review activities associated with finance, investment and cash flow in a
business operation;
5. Evaluate the financial statement for business and investment decisions; and
6. Assess the limitations and challenges in financial statement analysis.
COURSE SYNOPSIS
This course is divided into 9 topics. The synopsis for each topic is presented below:
Topic 1 This topic will discuss the financial statement and its relevance in
financial analysis tasks. We will focus on financial statements users, what they
need and how it suits their needs. We will also learn about the types of business
activities and how they are reflected in the financial statement, financing,
investing and operating activities.
Topic 2 This topic dicusses the financial reporting environment in Malaysia,

including the principles behind the accounting standard. We also point-out the
advantages of accrual versus cash flows measures.
COURSE GUIDE  xiii
Topic 3 This topic discusses the process of analysing the financing activities in a
business. The process of analysisng consists of identifying the features of
liabilities, lease financing disclosure, employee benefits, contigencies and
committment as well as off balance sheet financing.
Topic 4 This topic discusses the process of explaining and analysing the investing
activities in a business. The process of analysing consists of identifying the
features of current assets, inventories and receivables, long term assets, plant and
natural resources.
Topic 5 This topic focuses on how we carry out analysis on operating activities,
by analysing accrual measures of both revenues and expenses. We will also learn
about net income analysis as well as explaining recognition methods for revenues
and expenses. We are going to distinguish the components of income and impact
for financial analysis.
Topic 6 This topic focuses on analysis of cash flow activities. We are going to
determine and explore the cash flow condition to identify the performance of the
company.
The objective of the cash flow statements is to determine the amounts, timing and
uncertainty of cash flow of financial reporting. Therefore the cash flows analysis
will help users to see how the balance sheet has changed from the beginning of
the accounting period to the end of the period.
Topic 7 This topic focuses on how we carry out analysis on companyÊs return.
Our focus of learning is on return on invested capital and the variation of capital
that has been analysed. Using relevant measures and tools such as ratio analysis,
we will explain the impact it will have on company analysis and decision.
Topic 8 This topic focuses on how we carry out analysis on profitability analysis,
by analysing and explaining income components. Our effort of analysis will
focus on the components of income and expenses in the profit and loss account
such as sales, cost of sales, taxes, selling and marketing expenses, financial cost.
We are going to distinguish the components of income, expenses and impact for
financial analysis.
Topic 9 This topic focuses on how we can apply tools for evaluating short-term
liquidity. We will apply accounting-based ratios, turnover, and operating activity
measures of liquidity. We will determine the capital structure and impact for
solvency.

xiv  COURSE GUIDE
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement should help you to organise
your study of this course to be more objective and more effective. Generally, the
text arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely gone through a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your progress of digesting the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It is inserted after you have gone through one sub-
section or sometimes a few sub-sections. It usually comes in the form of a
question that may require you to stop your reading and start thinking. When you
come across this component, try to reflect on what you have already gone
through. When you attempt to answer the question prompted, you should be
able to gauge whether you have understood what you have read (clearly,
vaguely or worse you might find out that you had not comprehended or retained
the sub-section(s) that you had just gone through). Most of the time, the answers
to the questions can be found directly from the module itself.
Activity: Like Self-Check, activities are also placed at various locations or junctures
throughout the module. Compared to Self-Check, Activity can appear in various
forms such as questions, short case studies or it may even ask you to conduct an
observation or research. Activity may also ask your opinion and evaluation on a
given scenario. When you come across an Activity, you should try to widen what
you have gathered from the module and introduce it to real situations. You should
engage yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of just having to recall and define.
Summary: You can find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points inside
the summary that you do not fully understand, it would be a good idea for you
to revisit the details from the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargons used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms from the module.

COURSE GUIDE  xv
References: References is where a list of relevant and useful textbooks, journals,

articles, electronic contents or sources can be found. This list can appear in a few
locations such as in the Course Guide (at References section), at the end of every
topic or at the back of the module. You are encouraged to read and refer to the
suggested sources to elicit the additional information needed as well as to
enhance your overall understanding of the course.
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Approved and adopted FRS Standard, Retrieved from http://www. masb.
org.my
Atrill P., & Mc Laney E.; Accounting and finance for non-specialists , Prentice
Hall, 2004
Bernstein Leopold. A., & Wild John.; Analysis of financial statement, Mc Graw
Hill, 1999
International Financial Reporting Standard, IFRS, Price Waterhouse Coopers

Retrieved from http://www.pwc.com, 2008
Malaysian Tax Booklet, 2007/2008, Price Waterhouse Coopers, Retrieved from

http://www.pwc.com/my
Wild John. J., Subramanyam K. R., & Halsey Robert. F.; Financial Statement
Analysis, Mc Graw-Hill, 2004.
TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for the
use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books24x7, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.
TOPIK 2 KAEDAH DAN TEKNIK W 17

T op i c X Overview
of Financial
1 Statement
Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the basic concept of financial analysis;
2. Differentiate between business and financial analysis;
3. Explain financial statement ă basis of analysis; and
4. Apply the tools used to evaluate financial statement.
X INTRODUCTION
This topic is an overview of Financial Statement Analysis. Financial statement
analysis is a process that examines past and current financial data for the
purpose of evaluating performance and estimating future and potential risks. It
is a structured and systematic approach used by financial analysts, investors,
suppliers, customers, potential employees and users who need to determine the
financial standing of a company.
We are going to learn how to analyse financial statements in order to be able to

make effective decisions. We need to familiarise ourselves with financial
reporting so as to learn more about a company; its strengths and weaknesses.
Analysis of financial statements focuses primarily on data provided in external
reports plus supplementary information provided by management.

2 X TOPIC 1 OVERVIEW OF FINANCIAL STATEMENT ANALYSIS
When carrying-out analysis, students should identify major changes or turning

points in trends, amounts, and relationships. Many different groups with
different interests are interested in getting financial information about a
company, especially the investors and creditors. The information gathered will
reflect the business of a company. But before we can understand this
ÂinformationÊ we need to first become experts on financial statement analysis.
Financial statement analysis assist investors, creditors or other users to find-out
the type of information they require for making decisions relating to their
interests in a particular company.
ACTIVITY 1.1
Select a public listed company. Point out the information that should
be focused on for decision making.
1.1 BUSINESS ANALYSIS AND FINANCIAL ANALYSIS

We begin by learning about business analysis. Business analysis is part and
parcel of financial statement analysis. It applies the techniques and judgemental
processes to determine business objectives, prospects and performance. Indeed it
is important for us to define the planned activities in a business plan in order to
properly analyse a companyÊs current and future prospects. The plan describes a
companyÊs vision, strategies and tactics for activities for the short and long term.
There are two steps to apply business analysis:
(i) Identifying the business vision and objectives

This is to determine the business vision and objectives of a company. We
can obtain such information of from the annual report, the companyÊs
website, the business directory (The Yellow Pages), Bursa Malaysia, Central
Bank of Malaysia, Securities or third party information providers. The
information to look out for are the company objectives, strategies, market
demand, competitive analysis, marketing strategies (pricing, position,
promotion and distribution), management performance, risk management
plan and financial total sales plan as well as its financial decisions.

TOPIC 1 OVERVIEW OF FINANCIAL STATEMENT ANALYSIS W 3
Figure 1.1: Activities and core business of Sime Darby Bhd.

Source: Aseambankers, Malaysia Equity Research 29 November, 2007
Figure 1.1 illustrates the activities and core business of Sime Darby Bhd. It
shows the break-down of core activities and its contribution to the
companyÊs sales and operating profit.
The table reveals the plantations sector as the biggest sales and operating
profit due to the attractive price of Palm Oil and the world biggest palm oil
plantation. Despite diversified activities, the companyÊs banking on
plantation is the most profitable activity in this group. The business
analysis also reveals the operations of the group in 20 countries and the
location which has contributed to the highest earnings of the company.
(ii) Determining business performance of a company

The second step is to determine the business performance of a company.
Looking at the case of Sime Darby Bhd again, we focus on the companyÊs
revenues and profitability.
As Figure 1.2 reveals, the companyÊs plantations business recorded the

biggest sales and operating profit due to the attractive price of Palm Oil.
Looking at these facts and figures, we have learned that while the companyÊs
activities are diversified ăthe companyÊs plantation activity is the most
profitable activity.
Figure 1.2: Pie charts showing revenue and profit of Sime Darby Bhd
1.1.1 Types of Business Analysis

Business analysis can be divided into two categories. They are:
(a) Credit Analysis ă the objective of doing a credit analysis is to evaluate the
creditworthiness of a company. This means the ability of the company to
meet the credit obligations or, in simple terms, its ability to pay off its bills.
Credit analysis typically focuses on two aspects: Liquidity and Solvency.
(i) Liquidity is to determine the company to sources its short term funds
and its ability to meet short term obligation. Analysts carry out this
analysis based on repayment terms and contract. Financial
institutions look to liquidity to conduct credit analyses to approve
loan applications or to extend existing credit line. Users who conduct

liquidity analysis are mainly venture capitalists, fund managers or

other investors who intend to invest in debt-based securities.
(ii) Solvency is done to determine whether the company long-term ability
to meet long-term obligations. This depends on long term business
prospects, on-going concerns and long term cash flows prospects.
Users who conduct solvency mainly come from different groups with
different decision contexts. Banks need to carry out solvency analysis
to review and check whether the company can meet its long term
obligations.
(b) Equity Analysis ă the objective of equity analysis is to evaluate the intrinsic
or fundamental values of a company. This evaluation is done as basis to
purchase shares whose prices are below the fundamental value and vice
versa. Contrasting credit analysis, equity analysis is done during the
assessment process. And it must be done comprehensively where all
aspects of the company, financial and non financial, must be taken into
account.
Type of Equity Analysis:

• Technical analysis ă an analysis of using charting and patterns movement
to examine current and future movement. Figure 1.3 is an example of
technical analysis produced by an equity analyst to advice investors on
when to buy Sime Darby shares based on price movement.
Figure 1.3: Technical Analysis


• Fundamental analysis ă a process of analysing financial position and

performance of a company. The major goal is to examine the fundamental
value without any reference to price movement. To determine
fundamental value, analysts conduct in-depth analysis of a companyÊs
business prospects and financial statement.
Equity analysis is mainly carried out by the Equity Analyst to provide the Equity
Investor a guide whether to invest or not to invest in companyÊs share.
1.1.2 Financial Analysis

Now letÊs resume our ultimate objective of our course: learning about financial
analysis. Financial analysis involves techniques, tools and judgemental processes
to examine quantitative information inside a financial statement so that a
companyÊs performance and financial position can be evaluated and future risks
and potential can be estimated. The quantitative information describes the
companyÊs assets, liabilities, as well as outside balance sheet information.
Financial analysis can yield valuable information about trends and relationships,
the quality of a companyÊs earnings, strengths and weakness of its financial
position. The major analysis focuses on profitability analysis, risk analysis and
analysis of sources and uses of funds.
Financial analysis begins with establishing the objective(s) of the analysis. An

analyst should establish what the objective and scope of work is first before
continuing with appropriate tools of evaluation. For example, are we going to
conduct analysis for granting credit facilities (loans) form financial institutions or
making an investment? Therefore, we must first determine our objective before
we can start the work.
The results of analysis are then summarised and interpreted. Conclusions are
reached and a report is made to the person(s) for whom the analysis was
undertaken. To evaluate financial statement, an analyst must take into account
the factors as described in Figure 1.4:-

Figure 1.4: Factors to take into account
The financial analysis of a company should include an examination of the

financial statements of the company, including the notes to the financial
statements and the auditorÊs report. The auditorÊs report will state whether the
financial statement has been audited. The report also indicates whether the
statement fairly represents the companyÊs financial position, result of operations,
and that change in financial position is in accordance with the financial reporting
standard on a basis consistent with the preceding year.
Notes to the financial statements are often very helpful. The notes explain the
accounting policies of the company and usually provide detailed explanations of
how those policies were applied, along with other supporting details.
Normally, analysts often compare the financial statements of one company with
other companies of the same industry ăespecially those companies whose
statements were previously compared to in previous years. This process
significantly broadens the scope of financial statement analysis.
To begin the analysis, addressing these questions will help guide us in getting an
effective analysis:

• Does the company have enough resources to grow?

• Does it have the capability to invest in a new project?
• How are we going to forecast future earnings and how accurate is the
forecast?
• How profitable will it be for the company to attract new investors or lenders?
• How did the company exceed in the previous projection or did it fail to meet
the projection?
After going through those questions, we can then start with the analysis based on
three different aspects: profitability, risk and uses of funds.
Financial statements and business activities explain how the two aspects are in
sync together from beginning to the end of a fiscal year. A business entity has to
go through the business cycle process, with the activities beginning with
formulating business plans and strategies. The next process continues with
sourcing financing from equity investors and creditors. Financing is required to
finance fixed assets or capital expenditure as well as to finance the current assets,
operating expenses or working capital requirement. The process of business
activities is illustrated in Figure 1.5.
Figure 1.5: The stages that the analyst should understand in order to carry out an
effective analysis

1.1.3 Users of Financial Statement (Business and

Financial Analysis)
We have discussed how the importance of financial statement is for users that
intend to analyse the company and how decision making can be been made
based on the composition of the group. This group is commonly classified into
two groups. Berstein & Wild (2000) classified Internal Users normally as the
executives of a company that are involved in running and making operating and
strategic decisions for the business. The financial reporting information is
generated and formatted according to internal decision makers such as the CEO,
the CFO or the Internal Auditor. External Users are the parties that are not
directly involved in the business, but nevertheless have a stake in it.
Atrill and Mclaney (2004) classified the user group and the uses of financial
information as Table 1.1 shows below:
Table 1.1: User Group and Uses of Financial Statement

User group Use
Customers To asses the ability of the business to continue operations and to supply
their needs.
Competitors To assess the threat posed by the business to their market share and
profitability. To provide a benchmark against which to asses their own
efficiency and performance.
Employees To asses the ability of the business to continue to provide employment
(non-management) and reward employees for their efforts.
Government To assess how much tax the business should pay, whether the business
complies with agreed pricing policies, and whether financial support is
needed.
Community To asses the ability of the business to continue to provide employment
representatives for the community and to purchase community resources. To assess
whether the business could help fund environmental improvements.
Investment analysts To assess the likely risks and returns associated with the business in
order to determine its investment potential, and to advise clients
accordingly.
Suppliers To asses the ability of the business to pay for the goods and services
supplied.
Lenders To asses the ability of the business to meet its obligations and to pay
interest and to repay the amount borrowed.
Managers To help make decisions and plans for the business, and to exercise
control so that plans come to fruition.
Owners To assess how effective the managers are in running the business, and to
make judgements about likely levels of risk and return in the future.

1.1.4 Financial Analysis Stages and Processes

(a) The process flow below indicates how to carry out and prepare a
comprehensive financial statement analysis.
Figure 1.6: Steps in carrying out analysis and report
We start our process by gathering information about the company via a website
like Companies Commission of Malaysia, Bursa Malaysia or a company
directory.
Then we resume our process by establishing the scope of analysis. From which
point of view do we intend to set-up the scope? For example, do we set up scope
from investor, creditor or from managementÊs point of view? T
Then we continue our process by selecting the right tools and techniques such as
ratios analysis, or any other.
The 4th stage is critical where we are going to use selected tools to come up with
results or analysis report. This is a complicated process where we need to come
up with assumptions and basis of assessment.
Finally, the final product is a report for users to make decision based on the
findings on the companyÊsÊ evaluation.
SELF CHECK 1.1
Review the process of identifying business and financial analysis report.

Check the process to see what are the skills that we need to enhance.

ACTIVITY 1.2
Relate to the company that youÊve been assigned to. Review the
annual report and describe the companyÊs business planning, future
direction and business outlook
1.1.5 Financial Statement and Basis of Analysis

As mentioned earlier, it is important to identify the businesses of a company in
order to conduct an effective analysis. Figure 1.5 we looked at earlier focuses on
business planning, sources of financing, investing and operating activities of a
company.
However, all that must tally with these questions as a basis to conduct an
analysis:
• What are the profits that the business has made, and how much is the
business worth on paper?
• What are the real profits and real value of the business?
1.2 FINANCIAL STATEMENT ANALYSIS PREVIEW

Financial statement analysis involves tools and techniques that enable analysts or
students to examine past and current financial statements. The process of
analysing financial statements requires different tools to fit the specific objective
set by users. We can select any analytical tool such as common-sized statements
and ratio analysis, accounting method choice on accounting numbers; undertake
co-relational and cross-sectional analysis of financial statements and the impact
of time series on financial statements numbers.
Bernstein & Wild (2000) lists out the six areas of concern that is essential for the
analyst to restate when undertaking financial statement analysis.

Table 1.2: The Six Areas of Concern
(i) Short term A companyÊs ability to meet short-term obligations

liquidity
(ii) Funds flow Future availability and disposition of cash
(iii) Capital A companyÊs ability to generate future revenues and meet
structure and long-term obligations
long-term
solvency
(iv) Return on A companyÊs availability to provide financial rewards
investment sufficient to attract and retain suppliers financing (credit)
(v) Asset utilization Asset intensity in generating revenues to reach a sufficient
level of profitability
(vi) Operating A companyÊs success at maximizing revenues and maximizing
performance expenses from long-run operating activities
1.2.1 Financial Analysis Techniques and Tools

Accountants and others have developed a variety of standardised tools and
techniques that can be used in financial statement analysis. Financial statements
procedures fall into three categories. Namely:
(a) Comparisons and measurements relating to financial data for two or more
periods,
(b) Comparisons and measurement relating to financial data of the current
period, and;
(c) Special-purpose examinations.
Now letÊs resume our explanation of financial analysis tools and techniques. Do
we need to learn all the techniques? The answer depends on the objectives and
the users.
A review of financial statements can involve all three types of analysis. The
following analytical tools will be discussed in this section to provide an overview
of financial statement analysis:
(i) Comparative financial statement analysis (which consists of):

• Horizontal analysis
• Vertical analysis

(ii) Common-size financial statements analysis

(iii) Ratio analysis
(iv) Specialised analytical tools
1.2.2 Comparative Financial Statement Analysis

Financial statements presenting financial data for two or more periods are called
comparative statements. Comparative financial statements usually give similar
reports for the current period and for one or more preceding periods.
Comparative financial statements provide analysts with significant information
about trends and relationships over two or more years. Comparative statements
are considerably more significant than a single-year statement.
The advantage of using this analysis is summarised in Figure 1.7.
Figure 1.7: Advantages of comparison analysis
There are two type of comparative analysis. They are:
• Horizontal analysis
Horizontal analysis points out trends and establishes relationship between
items that appear on the same row of a comparative statement. Horizontal
analysis discloses changes on items in financial statements over time. Each
item (such as turnover) on a row for a financial year-end is compared with

the same item in a different period. Horizontal analysis can be carried-out in

terms of changes in dollar amounts, in percentages of change, or in a ratio
format.
Analysts or users conduct these techniques by putting up the financial

statement data, side-by-side, year-by-year or in a horizontal basis. A
horizontal approach shows the trend of the analysis, the trend of the data and
the reasons behind the difference of the trends.
Table 1.3: Example of Horizontal Analysis

Horizontal Analysis of a Balance Sheet
HORIZONTAL BHD
Balance Sheet for the year end 2007 and 2008
Amount Percentage Ratio 2008
of
2007 2008 Change of Change To 2007
Assets
Cash 15,000 10,000 5,000 50.0 1.50
Trade debtor 5,000 10,000 (5000) (50.0) 0.50
Stock 30,000 - 30,000 - -
Property Plant 125,000 150,000 (25,000) (16.7) 0.83
& Equipment
Total Assets 175,000 170,000 5,000 2.9 1.03
Liabilities
Trade creditor 15,000 - 15,000 - -
Bonds payable - 100,000 100,000 (100.0) 0.00
EquityÊs
Common stock 155,000 80,000 75,000 93.8 1.94
Retained earning 5,000 (10,000) 15,000 - -
Total Liabilities & 175,000 170,000 5,000 2.9 1.03
Equity
Table 1.3 above illustrates horizontal analysis on a balance sheet. The amount
of change is computed by subtracting the amount for the base year (2007) from
the amount for the current year (2008). The percentage of change is computed
by dividing the amount of change by the base year. The year-to year ratio is
computed by dividing the current year data by the base year data. When the
base figure is positive, the RM change and the percentage change can be
computed validly. If the base figure is zero or a negative value, the RM change
and percentage change can be computed but the percentage change cannot. A
ratio can be computed only when two positive values are available.

Where changes indicate as percentage, no vertical addition or subtraction of

the percentages can be made because the percentages of changes are the
result of different bases. When individual amount have small base amounts, a
relatively small dollar change can result in a significant percentage change,
thereby assigning more importance to the item than might be meaningful.
A base-year-to-date approach to horizontal analysis is sometimes used to

disclose the cumulative percentage changes. When this approach is used, the
initial year is used as the base year, and the cumulative results from the
subsequent years are compared with the initial year to determine the
cumulative percentage changes.
• Vertical Analysis
Vertical analysis involves the conversion of items appearing in statement
columns into terms of percentage of a base figure to show the relative
significance of the items and to facilitate comparisons. For example,
individual items appearing in the income statement can be expressed as
percentage of sales. On the balance sheet, individual assets can be expressed
in terms of their relationship to total assets. Liabilities and shareholdersÊ
equity accounts can be expressed in terms of their relationship to total
liabilities and shareholdersÊ equity.
On a statement of changes in financial position, the increase in cash (or

working capital) is usually expressed as 100 percent. On the retained earning
statements, beginning retained earnings is 100 percent. Table 1.4 below
illustrates vertical analysis of a profit and loss account.
Table 1.4: Example of Vertical Analysis

Horizontal Analysis of an Income Statement
VERTICAL BHD
Income Statement for the Year End 2008
Percentage of
Net Turnover
Turnover (net) 200,000 100.0%
Cost of sales 50,000 25.0
Gross margin on turnover 150,000 75.0
Operating expenses 100,000 50.0
Net operating income 50,000 25.0
Corporate tax 25,000 12.5
Net profit 25,000 12.5%

1.2.3 Common-size Financial Statement Analysis

Statements that omit RM amount and show only percentages are referred to as
common-size analysis because each item in the statement has a common basis for
comparison, for example, total assets or net sales. Data for common-size
statements are computed in a manner similar to that described for vertical
analysis computations. Changes in size are emphasised in common-size
statement, which make efficiencies and inefficiencies easier to identify than in
comparative statements. For example, turnover salaries will indicate the
percentage of each turnover per RM they took each year. Table 1.5 illustrates a
common-size analysis of profit and loss account.
Table 1.5: Example of Common-Size Analysis

Common-Size Analysis of an Income Statement
COMMON-SIZE BHD
Income Statement for the Year End 2008
2007 2008
Turnover 100.0% 100.0%
Operating costs
Cost of sales 80.9% 80.7%
Selling, general and administrative expenses
Pensions 10.2% 9.9%
Corporate tax 1.9% 2.0%
Total operating costs 97.4% 99.2%
Net profit 2.6% 0.8%
When analysing balance sheet, common-size statements are useful in examining

the sources and structure of capital of the company, that is, relationship of
liabilities and equity capital. The analysis also enables analysts to obtain
information regarding the distribution of assets among current assets,
investments, property, plant and equipment, intangible assets, and other assets.
When analysing profit and loss account as illustrated in table 1.5, the statement
provides information relating to proportion of sales that is absorbed by cost of
sales and various expenses. When making comparisons, the statement
demonstrates changing or stable relationship within the group of asset, liabilities,
turnover, expenses and other financial statement categories. When conducting
analysis, student must be cautious when making such comparisons since the
percentage change can result from a change of the absolute amount of the item or
a change in the total of the group of which it is part of it or both.

1.2.4 Ratio Analysis

Financial ratios provides a quick and relatively a simple means of assessing
financial health of a business as well as an aid to understanding what the
financial statements are saying about the business.
It typically compares two related figures, usually both from the same set of
financial statements. Past periods, planned performance and the performance of
similar businesses are often used to provide benchmark ratios, however the
results must be interpreted cautiously.
This technique is the most popular tool used and accepted by analysts. A ratio is
a mathematical approach to express mathematical properties between two
quantities. For example, a ratio of 200 to 100 is expressed by 2:1. If a ratio is to
have any benefit, the elements that constitute the ratio must express a meaningful
relationship. For example, there is a relationship between net income and total
assets, and between current assets and current liabilities. Ratio analysis can
disclose relationships that show condition and trends that often cannot be noted
by inspection of the individual components of the ratio.
Ratios are generally not significant by themselves but assume significance when
they are compared with:
• Previous ratio
• Some predetermined standard
• Ratios of other enterprises in the same industry or
• Ratio of the industry within which the company operates
When we use this approach, ratios serve as `benchmarksÊ against which the
company can evaluate itself. Ratios enable us to answer questions concerning
specific issues and insights into the operations of a business enterprise.
When using ratios, students must comprehend the factors that enter into the
structure of the ratio and how the changes in such factors can influence the ratio.
For example, what impact does borrowing money from a bank have on the
current ratio? Will it increase, decrease, or have no impact on the ratio? If the
objective is to improve the ratio, what changes can be made in the components of
the ratio to accomplish the desired goal?
LetÊs examine Figure 1.8 which is a table that provides a set of financial
statements of Sime Darby Bhd. The company operates the biggest palm oil
plantation in the world. The table explains when to apply and calculate ratios.

The financial statements also provides key financial ratio to guide users for
decision making purposes.
Figure 1.8: Ratio analysis of Sime Darby Bhd


1.2.5 Implications for Analysis

LetÊs see the impact of ratio to our analysis process. Ratio analysis identifies
deviation (gap) in computed ratios and then examines the causes of the
deviations. For example, deviation from industry norms could indicate that the
firm was doing something different from the average enterprise in the industry,
excluding the businesses that did not survive.
Ratio should be used with caution; ratio should not be the sole basis for decision-
making or solution. Ratios are only as reliable and relevant as the data that goes
into them. One must constantly keep in mind that while financial statements are
prepared according to generally accepted accounting principles, the statements
reflect estimates and judgements that may or may not be particularly relevant in
an analysis that is directed toward a particular objective.
At times, ratios are difficult to interpret. For example exactly what does a 2:1
mean? Is it good or bad, favourable or unfavourable? Comparing ratios with
some standard, such as those preceding years, other companies, or industry can
provide some guidance.
Therefore, students should understand that ratios have certain limitations. In

addition to those mentioned above, these include:
(i) Ratios reflect past conditions, transactions, events, and circumstances

(ii) Ratios reflect book values, not real economics values or price-level effects.
(iii) The computation of ratios is not completely standardised.
(iv) The application of accounting principles and policies varies among firm,
and changes in their application from period to period affect the ratios.
(v) Inter-company comparisons are difficult when companies are diversified or
have different risk characteristics.
In spite of the difficulties associated with the formation and interpretation of

ratios, ratio analysis is an important technique for financial statement analysis
because it can identify significant fundamental and structural relationships and
trends.
1.2.6 Specialised Analytical Tools

In addition to comparative statements, common-size statements, and ratio
analysis, students have many specialised tools and techniques they can apply to

special-purpose studies. Additional procedures that are available for use in

special situations include:
(i) Cash flow analysis ă cash flow analysis is especially useful in evaluating
credit and investment decisions since it focuses on liquidity, solvency and
profitability relationships.
(ii) Gross margin analysis ă this analysis provides special insight into the
operating performance relationships.
(iii) Break-even analysis- this analysis discloses relationships between turnover
and patterns of cost behaviour for fixed and variables expenses.
(iv) Return-on-investment analysis ă provides a comprehensive measure of
financial performance.
These and other special tools of financial analysis will be further discussed in a
later topic.
Ć Financial Statement Analysis is a structured and systematic approach used by

financial analysts, investors, suppliers, customers, potential employees and
users who need to appraise the financial report and explain about a company
strategy, current performance and future prospects.
Ć Business analysis is part and parcel of financial statement analysis. It applies
the techniques and judgemental processes to determine business objectives,
prospect and performance of the business.
Ć Business analysis comprises of credit analysis and equity analysis. Credit
analysis goals is to evaluate liquidity and solvency, where equity analysis is
to evaluate the fundamental of a company
Ć Financial analysis is the use of financial statements to analyse a companyÊs
position and performance as well as future prospects.
Ć We need to determine steps in formulating business strategies, sourcing
financing or sourcing equity investor and business operation before we begin
on the analysis of a company.
Ć During the analysis process, some questions need to be recognised regarding
short term liquidity, funds flow, capital structure and long term solvency to
ensure the analysis are within the scope.
Ć The important tools to conduct analysis:
- Comparative Financial Statement Analysis
- Common-Size Financial Statement Analysis

- Ratio Analysis
- Specialised Analytical Tools
Asset utilisation External users

Business plan Fundamental analysis
Capital structure and long-term Internal users
solvency
Operating performance
Cash flows analysis
Return on investment
Credit analysis
Risk evaluation
Creditworthiness
Short term liquidity
Down up evaluation
Technical analysis
Equity analysis
Up down evaluation
External users

Topic X Financial
2 Reporting
and
Analysis
LEARNING OUTCOMES
1. Explain financial statement ă the reporting and analysis
environment;
2. Demonstrate the nature and objectives of financial accounting;
3. Prescribe the importance of accrual; and
4. Apply the principles and conventions that determine accounting
rules.
X INTRODUCTION
This topic focuses on financial reporting and its analysis. We are going to learn
about the financial reporting environment with the focus on local context of
financial reporting in Malaysia, which is based on accounting standards. The
importance of accrual versus cash flows measures will be discussed. Finally we
will explain accounting principles and rules.
ACTIVITY 2.1
Select a public listed company. Point out the information on the notes
to the account. List-out the notes that relate to the conventions of
accounting rules.

TOPIC 2 FINANCIAL REPORTING AND ANALYSIS W 23
2.1 FINANCIAL REPORTING AND ANALYSIS

ENVIRONMENT
We will begin by learning about our local accounting framework in the context of
the legal environment. Please refer to the chart below (Figure 2.1) which gives us
an overview of the financial reporting environment in Malaysia.
Figure 2.1: Financial reporting environment, regulators and entities in Malaysia
2.1.1 An Overview of Corporate Financial Reporting in

Malaysia
Section 169 and 326, The Companies Act 1965 and the Ninth Schedule are
concerned with the accrual disclosure of a companyÊs results of operations and
financial position.

24 X TOPIC 2 FINANCIAL REPORTING AND ANALYSIS
The principle role of financial reporting is to provide information that will help
in making business and economics decisions. The main objectives of financial
statements and reports are as follows: -
(a) To provide information that is useful for investments and credit decisions.
To be useful, financial statements and reports must be relevant,
understandable, reliable, complete, accurate objective, timely and
comparable.
(b) To provide information that is helpful to users in assessing the financial
position of the company in terms of liquidity and solvency that are adequate
to meet its obligations when the fall is due (maturity to pay).
(c) To provide information about the companyÊs financial performance and
earnings, its potential growth and prospects in the long run.
Financial statements and reports are prepared at least once in every year at
intervals of not more than 15 months to report on the results of the companyÊs
activities and its financial affairs. They must be presented to the shareholders at an
annual general meeting not more than 6 months after the end of the financial year.
They are audited documents which, after the date of the annual general meeting,
must be filed with the Companies Commission of Malaysia (CCM) within the
next 30 days (Section 143, Companies Act 1965).
The financial statements and reports of a Malaysian company are normally made
up of the following documents.
• Notice of annual general meeting (14 or 21 days)

• Chairman statements
• Report of the directors
• Consolidated profit and loss account
• Holding company profit and loss account
• Consolidated balance sheet
• Holding company balance sheet
• Consolidated statement of changes in financial position
• Notes forming part of the financial statements
• Report of the auditors
Other documents include statutory declaration by directors in pursuance of

section 169(16), Companies Act 1965 which is to be signed by a director or an

officer responsible for the financial management of the company and the group
before the commissioner for oaths.
In the case of the housing developer, the report of the auditors is signed pursuant
to Section 9 of the Housing Developers (Control and Licensing) Act 1966. For
financial institutions, the form and content of financial statements and the report
of directors would require the approval of Bank Negara Malaysia as provided for
in the Banking Act 1973 and the Islamic Banking Act 1983.
The Bursa Malaysia provides certain requirements that must be complied with in
relation to financial statements and reports of a public listed company. They are
to be issued to the companyÊs shareholders and the Bursa Malaysia within 6
months after the end of every financial year; in addition, they are required to
publish their interim results within 3 months after the half-year end in the end of
the newspaper as well, as notifying Bursa Malaysia at the same time.
2.1.2 How Financial Reporting is constructed

Accounting is a process that evolves from the framework of ideas. These ideas
determine the uses of appropriate accounting principles, rules and conventions,
which the accounts would observe in the preparation of financial statements of a
company. Before we move on to the financial accounting framework, it is
important to look at the objectives of financial accounting.
The framework shown in Figure 2.2 explains how the financial report is constructed.
The framework shows the objective, the characteristics and the elements. The
elements in the framework are explained later in the next section (2.2).

Figure 2.2: Framework of financial reporting

Sources: 1. IASB ă framework for the preparation and presentation of financial statements
2. Lazar, Choo, Arshad, 2006
The financial statement has five elements that consist of assets, liabilities,
equities, income and expenses.
Figure 2.3 shows the definition of the elements of financial statements and where
the benefits generated or obligations that resulted an outflow.


Figure 2.3: The elements of Financial Statement
2.1.3 How the Elements are Recognised

I believe, we all know the elements of financial reporting and the expected
benefits or losses from the elements represented in the balance sheet statement
and income (profit & loss) statement.
LetÊs look at how we define recognition of these elements. Any item can be
recognised if:
• It is possible that economic benefits will flow to and from the enterprise and,
• The item has a cost or value that can be measured with reliability (free from
errors and bias).

Please now refer to Figure 2.4.

Figure 2.4: Recognition of Assets, Liability, Income and Expenses
2.2 NATURE AND OBJECTIVE OF FINANCIAL

ACCOUNTING
LetÊs carry on with our discussion. We need to now understand the objectives of
financial accounting in order to make effective and accurate company analysis.
There are two main objectives of financial accounting. They are:

(i) Obtain Information for Decision-making

Getting information aids the user in determining and measuring the
usefulness or effects of financial reporting in order to make decisions.
The type of information that is important for decision making include

information about the financial position and performance of the company.
(ii) Stewardship
The concept points out the idea of the manager as a steward or a custodian
entrusted with the responsibility of safeguarding assets, increasing the
wealth of investors and protecting creditors. ItÊs also a matter of how
efficient managers are, in safeguarding the financial reporting of a company
in order to determine the efficiency of utilising the capital invested in the
company.
The results of stewardship can be distinguished by:
(a) Financial Position ă Balance Sheet. The balance sheet shows the
position that is affected by:
• The economic resources in the possession of the company. The
resources are important for analysts because it indicates how
effective the company utilises and replaces its assets, be it current
or non-current assets. This will influence the cash position of the
company. Our task as students is to determine how effective the
assets that are being used.
• The capital structure of the company. Financial structure refers to
the method the company had used to finance its operations. If we
can determine its structure we then understand how the company
is able to sustain itself in the long-run, understand its future
financing requirements and the current or future earnings to be
used for the operations.
• Liquidity and solvency. Liquidity is referred to the ability of the
company to meet its short-term commitment. Solvency relates to
the companyÊs long-term commitment.
• Ability to change in a dynamic business environment due to the
changes in various factors in the economy depending on the
demand from the industry.
(b) Performance ă the income statement shows the performance during

the fiscal year. It shows the revenues or income earned and expenses
incurred. Normally analysts use profit as indicator of performance.

(c) Changes in Financial Position ă Cash Flow Statement. The cash flow
statement represents the changes in financial position. The cash flow
shows the changes in financial position by revealing the cash flow
from operating, investing and financing activities.
(d) Notes and Supplementary Schedules ă itÊs also part of the

stewardship concept and part of financial statement. The statement
has some limitation in giving and describing the information to users,
therefore supplementary notes may give important information on the
financial statements that is useful to the users.
2.2.1 What Financial Accounting Provides to

Enterprises
Financial reporting is the backbone of the enterprise; itÊs a principal means of
communication on the entityÊs information.
Therefore it provides information that is:

(a) Useful in investment and credit decisions.
(b) Useful in determining cash flow prospects.
(c) Useful to learn about the economic resources (assets), claims on assets
(liabilities) and changes of the two aspects.
Figure 2.5: Financial information that is useful for business decisions

The diagram reveals how important financial reporting is to assist

entity/enterprises in making effective decisions.
For bankers and creditors, it is crucial to make a business decision on whether to

accept or reject and whether it is a good or a bad time to do so.
Normally, for investment bankers, financial reporting can provide the prospect to
invest in a big project based on cash flows. And to predict returns that they can
potentially get and the risks that they are willing to take.
2.2.2 The Financial Accounting Framework

The framework is a guide to construct financial reporting. This framework is
based on the ideas which rest on the following: -
• Accounting concepts
• Accounting principles
• Accounting methods/procedures
• Accounting policies
The basic criteria for evaluation of these ideas are as follows:-

• They must be relevant to the development of accounting logic.
• They must serve as a basis to derive further logical assumption.
• They must be acceptable by users of the financial information.
The main purpose of this framework is to explain accounting concepts,

principles, methods, and procedures and to guide in the development of
accounting policies for adoption based on certain assumptions.
Accounting concepts are generally accepted assumptions, which underline the

preparation of financial statements of a business. They are considered based on
three significant aspects, by the mean of:-
• First ă The uses of financial reporting
• Second ă The social and economics concepts of time and place
• Third ă The models of theories of people who prepare or use them

There are three fundamental accounting assumptions that need special mention.
They are:-
• Going concern
• Consistency
• Accrual
In addition to the above, the application, selection and preparation of financial

reporting is based on three concepts;-
• Prudence
• Substance over form
• Materiality
The other relevant accounting assumptions include:-

• Entity concept
• Objectivity concept
• Stable monetary concept
2.3 THE IMPORTANCE OF ACCRUAL

Today, most of the local or international business transactions run on credit,
where we are recognizing revenue earned and expenses happened regardless of
whether or not cash flow take place at the same time.
Under accrual basis, a transaction is recorded in the financial reporting when it

took place irrespective of whether cash was received or paid. Accruals of revenue
and cost have to be done as they are earned and incurred.
A typical example of a business entity that sells products on credit term is when
sales is immediately recorded and asset is considered received. And it will be
recorded even though the customer has yet to pay for the goods or the company
has yet to collect the payment.
Now, letÊs look and explore the fundamentals of accrual, which can help us to
understand the accrual concept:
(a) Accrual and cash flows

We must understand the relationship between accrual and cash flow by
distinguishing the type of cash flow.

The types of cash flow are:

• Operating cash flow indicates cash from operating activities
• Free cash flow indicates the activities of investments or divestments of
operating assets
• Net cash flow indicates the cash account balances
The relationship between accrual and the type of cash flow is distinguished
by the time of adjustment. The relationship in accounting adjustment is the
conversion of operating cash flow to net income. In other words, accrual
can be defined as accounting adjustment that converts operating cash flow
to net income.
These equations explain the conversion of operating cash flow to net

income, Net Income = Operating cash flow + accrual. However we must
realise the accruals above also consists of short-term accruals and long-term
accruals.
(b) Accrual Accounting, timing and matching Problems

We realise that the timing and matching is the different feature between
accrual accounting and cash accounting.
Accrual accounting overcomes timing and matching that is inherited from

cash accounting. Timing is when the cash flow does not happen at the same
time while the business activities are bringing in the cash. For examples
credit sales take place in March 2008 (1st quarter), but payment is only
received in June 2008(2nd quarter).
Matching is when the cash inflow and outflow of a business transaction do

not happen at the same time.
(c) Accrual ă revenue recognition and expense matching

• Apart from its direct impact to the balance sheet, it also has impacts on
profit and loss as well. The impact on revenue recognition is when the
company deliver its product or services. Revenue can be recognised
depending on the sales term: when the goods are being shipped, when
the sales documents are completed, or when the cash is being
transferred.
• The expenses match concurrently with revenue recognition (above).

(d) Short term accrual and long term accrual

These accrual cycles can help analysts to identify short term and long-term
working capital that the company needs to runs the business. Short-term
accrual arises from current asset and current liabilities such as stock (raw
material, work in process or finished products) and credit transaction.
Normally we can determine the cycle when carrying evaluation such as
asset conversion cycle analysis (to determine short term financing
requirement).
Long-term accrual arises from asset capitalisation, which generates long-

term assets such as plant, machinery and goodwill. Cost of these assets is
allocated over the benefit period of the assets.
2.4 PRINCIPLES AND CONVENTIONS THAT

DETERMINE ACCOUNTING RULES
There are six main accounting principles or concepts that determine the way that
accounts are prepared. It is important to realize these principles if you want to
understand financial reporting from a wide view. This concept is an important
part of the financial reporting framework.
The concepts and conventions of accounting are as follows: -
(a) Going Concern Concept

The business will carry on its operations continuously without being
wound up in the foreseeable future. It simply means that the enterprise has
no intention to stop the operation. For example, assets revealed in the
balance sheet are at historical cost because the entity will be operated over
the life of the assets. Then, if the enterprise has intention to stop the
business, the assets will be shown at the realisable value. Going concern
assumption has a direct impact on the valuation of the companyÊs assets. In
other words, the company does not intend to cease or liquidate its
operations.
(b) The Matching/Accrual Principle

All expenses and income should be accounted for in the period to which
they relate. This means that the profit and loss account do not necessarily
reflect the cash that has come in and gone out of the business. The sales are
the sales that have been legally made in the period and the costs are those
that relate to these sales. The fact that we have to consider the costs that
relate to the sales in the period means that we make judgements about what
the costs are.

(c) The Prudence Principle

This is the most important principle. All others are secondary to it.
Prudence means you must take into the profit and loss account any
probable losses, but you cannot take potential gains. Revenues and profit
cannot be anticipated, but companies must make provisions for items such
as possible bad debts. Companies also cannot include any increases in their
assets values in the profit and loss account, as they have yet to be realised.
(d) The consistency principle

Item should be accounted for in a consistent manner within a period and
from one period to the next period. This ensures the comparability of
accounts.
For example, if a company depreciates the property and plant using the
straight-line method, then all similar assets will be depreciated using the
same approach from year to year.
ACTIVITY 2.2
Review and identify Financial Reporting of Malaysia. What are the
laws and regulations that act as a guide to prepare financial reports
in Malaysia? What about your organisation? Please refer to Figure
2.1 as a guide.
(e) Substance over form

This tries to ensure that accounts reflect the commercial activity rather than
the strict letter of the law. If company has all the risks and reward
associated with owning something, it should be included in the accounts,
regardless of the legal position.
The way that long-term leases (finance leases) are treated in the accounts is
a good example of this. Finance leasing is just another form of borrowing
which can be particularly attractive to companies with tax losses.
The company leasing the assets has all the benefits and risks that are
associated with owning the assets. The asset is shown as fixed assets and
depreciated in the normal practice although the lessor owns the assets. The
amount owed to the leasing company, over the life of the lease, is included
in creditors.

(f) Materiality
Accounts do not include items that are considered to be immaterial, but it is
not possible to give a precise definition of what is and what is not material.
For example in some cases, an error less than 5 percent would be

considered satisfactory, but in other cases any error would be unacceptable.
For instance, a business with a multimillion Ringgit turnover ăan RM10,000
error in the materials cost is unlikely to be considered material, but an
RM10,000 error in the chairmanÊs salary, which is subject to specific
disclosure requirements, would be regarded as material.
2.4.1 The Constraints on Reliable and Relevant

Information
Sometimes, itÊs difficult to sort-out, which is more relevant or reliable. However,
it is important to see a balance between relevance and reliability.
Therefore a numbers of factors can affect the balance between relevance and
reliability.
• Timeliness ă the reporting-financial year-end could possibly make the
information reliable but not relevant.
• Balance between benefit and cost ă the benefits derived from the information
must be bigger than the cost.
• Industry practice ă in the case of industries that are regulated by Bank
Negara Malaysia, Banks and Financial Information Reporting adopt the
regulation of the report based on guidance provide by regulator.
• Balance between qualitative and creativity should exist, to balance off
between the assets.
• True and fair ă when the financial report can be assumed to present as true
and fair on the performance, position and changes of an enterprise.
ACTIVITY 2.3
Relate to the company that youÊve been selected. Review the annual
report and that reported under DirectorÊs Report and AuditorÊs
Report. Relate the comments to the accounting rules, for example
going concerns, whatÊs the impact to business decision.

• Analyst must understand the financial reporting environment, whether local

or international, to ensure that decisions have been made appropriately. They
should be aware or any impact on:
− The changes of financial reporting environment,
− Factors affecting statutory report and its influence to the business
decision,
− Other reporting features and how we are going to comply with the
reporting environment.
• The nature and purpose of accounting is mainly as a steward and to provide
information for decision making. However, we must ensure the information
provided by the accounting information is quality information based on
principles of accounting.
• Accrual is part of the todayÊs business, which is based on credit sales. The
concept of accrual, which requires adjustment, must be understood. To
ensure we can determine the accrual cycle we must describe the accrual
process, cycle, timing, adjustment, impact to the net income, cash flow and
last but not least, we must identify the short term and long term accrual.
Accrual Materiality
Adjustment Net income
Free cash flow Operating cash flow
Going-concern Short term accrual
Long term accrual

Topic X Analysing
3 Financing
Activities
LEARNING OUTCOMES
1. Identify the features of liabilities;
2. Analyse the lease financing and disclosure;
3. Interpret the nature of employee benefits, risks and disclosure;
4. Differentiate between contingencies and commitment;
5. Evaluate the balance sheet financing; and
6. Value the shareholdersÊ equity.
X INTRODUCTION
This topic focuses on how we are going to carry out analysis on financing
activities-both creditor and equity financing analysis. We will therefore need to
focus on creditor and equity components. This is done so as to effectively
evaluate the position of the companies and how to effectively use financing
resources to run the business.

TOPIC 3 ANALYSING FINANCING ACTIVITIES W 41
ACTIVITY 3.1
Choose three public listed companies in Bursa Malaysia. Point out

the type of information to be focused, namely bank borrowings.
Which companies recorded up trends of borrowings for the last two
years? Identify the borrowing terms, type of facilities and the
borrowing purposes.
3.1 LIABILITIES PREVIEW

We begin our analysis by explaining both current and non-current liabilities as
part and parcel of financing resources in running the business operations. We
also distinguish the components of current (short term) liabilities and non-
current liabilities (long term liabilities). All the liabilities that we are going to
discuss are normally used by business entities in running day to day operations.
Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.
Three essential characteristics of an accounting liability include the following:

• A duty or obligation to pay exists.
• The duty is unavoidable by the entity.
• The event obligating the enterprise has occurred.
3.1.1 Current Liabilities: Characteristics and Its

Current liabilities can be defined as liabilities that fall due to payment in a short
period of less than twelve months. For example trade creditors, bank overdraft or
other short term bank facilities and provision for taxation and dividends are
current liabilities. It was categorised under the FRS139, Financial Instruments:
Recognition and Measurement.
Current liabilities usually consist of two types, which derive from operating
activities and borrowing activities:
A current liability which arises from operating activities can be used to run the
business activities, the items which are due within one year consist of:

42 X TOPIC 3 ANALYSING FINANCING ACTIVITIES
(a) Payment received on account

This would be the deposit that customers have made for goods that will be
received in the future. It is classified as creditor, as the company has a
liability to produce the goods or return the deposit (although under
different sales terms the deposit can be non-refundable).
(b) Trade creditors

This is the amount of money that the company owes for the goods and
services that have been supplied during the period. In many cases
(companies with good credit record with supplier) this is an important
source of funds to run the business activities.
(c) Other creditors

These are many other creditors that do not classify into any category.
Proposed dividends are also classed as creditors and are usually shown
separately.
(d) Corporation tax

This will include both the corporation tax and the advance corporation tax.
(e) Other taxation and social security

These are considered indirect, for example Services Tax, Custom & Excise
Tax, EPF and SOCSO.
(f) Accrued expenses and deferred income

Accrued expenses are the invoices that are outstanding for the goods and
services that have been used during the year. They will have been charged
to the profit and loss account.
Deferred income is money that has been received by the company and has
yet to be earned. For example, we buy a ticket to Bali from Air Asia three
months in advance. The airlines company will then have deferred income
but has yet to provide the travel. In other situations, companies that require
payment in advance can also be classified as accruals and deferred income.
(g) Proposed dividends

Although these cannot be paid until they have been approved by an
Annual general meeting, they are shown as creditors and have been
charged to the profit & loss account.
I suppose as a student you are quite familiar with bank overdrafts but there are a
number of short term borrowings or short term instruments that are available in
the market which can be used as sources of financing to run the business. Some
of the common short-term instruments in Malaysia consist of:

(a) Bill of exchange (BE)

Bill of exchange (bankerÊs acceptance normally named by many commercial
banks in Malaysia) is a short term facility issued by commercial banks or
licensed financial institutions approved by Bank Negara Malaysia.
The primary purpose of a bill of exchange is to finance the sale of goods

when the seller or exporter wishes to obtain payment at the time the goods
are despatched and the buyer wants to defer the payment until goods reach
him or later.
There are two types of bill of exchange:

(i) They are written by supplier, and signed by a customer in
acknowledge of the debt.
(ii) They can be sold, in legal terms `negotiable instrumentsÊ, this simply
means that you can sell the paper.
Figure 3.1: How BE works
BE typically had a maturity of three months or less than one year calendar.
If the supplier wants the cash today rather than the maturity date (3
months), he can sell the bill. They are bought by discount houses (in
Malaysia one of the dominant player is KAF Discount House). Discount

house is a money brokerage house and a licensed financial institution

which borrows short-term money from commercial banks and uses the cash
to buy various forms of financial instruments, like bill of exchange. If buyer
of the bill is going to have to wait for three monthÊs time, the buyer will be
losing three months of interest. BE is discounted, effectively, interest is
paid in advance ă the discount reflects the three months of interest lost. This
type of bill called a Trade Bill is used by commercial banks in Malaysia like
BankerÊs Acceptance.
(b) Notes
Notes are unsecured instruments. These are negotiable instruments and can
have a maturity of up to ten years and therefore, could be part of a
companyÊs long-term borrowings. However most have a shorter maturity
and a number of note issues are repayable at the option of the holders.
(c) Commercial paper

Commercial paper is a short-term negotiable instrument, usually issued to
investors at a discount to the face value. Commercial paper has become
very popular for large companies with good rating to issue commercial
paper as part of financing activities. In Malaysia it is known as short term
PDS (Private Debt Securities) and Credit Rating Company is responsible in
issuing credit rating of the company.
(d) Overdraft
Finally, the most popular short-term borrowing in Malaysia is overdraft.
The company will utilise the short-term borrowing by overdrawing the
limits and pay interest. The box below explains its Islamic products
equivalents offered by Islamic banks in Malaysia.
• Bill of Exchange (BE) ă Murabahah and Ad-Dayn. BE-Islamic

categorised under Murabahah concept (cost plus profit) but can be sold
before maturity using Ad-Dayn concept (selling of a debt at discount
value to get cash)
• Notes ă Murabahah Notes
• Commercial Papers ă Murabahah Notes
• Overdraft ă BaiÊ Inah Revolving Cash Lines

The figure below is an example of disclosure of borrowings extracted from MTD

capital bhd.
Figure 3.2: Disclosure of borrowings

Source: MTD Capital Bhd
3.1.2 Non-Current Liabilities: Characteristics and Its

Non-current liabilities or a long-term liability is defined as liabilities that are not
fall due (payable obligation) for payment in a short period of less than twelve
months. These include long-term borrowings.
Long-term borrowings can be obtained not only from financial institutions but
also in the form of financial instruments. A financial debt instrument or known
as Private Debt Securities (PDS) in Malaysia is one that is traded in the secondary
markets like Capital Market, meaning that these may be held by any investor.

Company borrowings may be secured or unsecured. Loans may be secured in

one of two ways:
(a) A fixed charge

Here the lender has the legal right to specified assets and the company
cannot dispose of these assets without the lenders permission
(b) A floating charge

This is a general charge of the companyÊs assets that usually relates to short
term fixed assets (plants, machinery, vehicles etc) whilst the lender has the
legal right to a group of assets, the company may continue to manage those
assets in the normal course of business.
Loans may or may not be secured, but security is not the only thing that banks
are interested in.
CompanyÊs borrowing which fall due more than one fiscal year can be defined in
the form of:
(a) Long term loans

These are conventional loans from banks or any other licensed financial
institutions approved by Bank Negara Malaysia where the interest is paid
throughout the loan and the loan is repaid at the end of the loan period.
(b) Debentures
A debenture is a document that creates a company debt. It is a negotiable
instrument and so can be bought and sold. Debentures are usually secured
thruÊ a debenture deed or trust deed. Some debentures make provisions for
part, or entirely, of the borrowings to be repaid by sinking fund or stages
build-up accounts. There are three different types of sinking fund:
(i) The original concept: this is similar to endowment policies that repay
mortgages. Money is invested to repay the debenture at the end of the
period. The other types of sinking fund are designed to repay some of
the loan.
(ii) The non-cumulative sinking fund: the company puts aside sufficient
money each year to redeem a fixed amount of the borrowings.
(iii) The cumulative sinking fund: the amount that the company uses to
redeem the debentures is variable, as it is a fixed amount of cash
coupled with the interest that has been saved by the prior redemption
of the debentures.

(c) Bonds
These are also negotiable instruments that are offered to the general public
and may or may not be secured on the companyÊs assets. The bondholderÊs
right, and the companyÊs duties, are covered by trust deed. A bondholder is
entitled to receive a stream of interest payments and the repayments of the
principal at maturity. Before a company has a bond issuance it will have the
debt credit rated by the rating agencies. In Malaysia rating agencies carry
out analysis from investorÊs point of view (e.g. Rating Agency of Malaysia
(RAM) or MARC)
3.2 LEASES
The FRS 117 defined the lease from a definition of a finance lease rather than
operating lease. Under the accounting standard, the assets are shown at the lower
part of the fair value and the present value of the minimum lease payments are
depreciated over the assetÊs useful life.
Under the accounting principles of substance over form, the assets should be
incorporated into the accounts if the company has the benefits and risks
associated with owning an asset, whereas asset leased under short term
agreement without any benefits of ownership (operating lease) and their lease
rentals will be charged to the profit and loss account.
(a) Finance Lease

It is difficult to distinguish between finance or operating lease, however, if
these two criteria are met, it can be defined as finance lease:
• The present value of the lease payments is at least 90 per cent of the fair
value of the leased asset;
• The present value will be calculated using the interest rate implicit in
the lease at the discount rate where the present value equals the fair
value of the asset.
Example:
A lessee agrees to pay RM100,000 per anum for 60 months or five years and
then at the end of repayment period to pay another RM10,000 to take the
legal ownership of the assets. The periodic payment made and the
guarantee of the residual value is called the minimum lease is RM510,000.
The figure is extracted from a quoted company in Bursa Malaysia, UEM

Builders Bhd shows the present value of finance lease liabilities. The notes
also show the amount due within 12 months and after 12 months.

Figure 3.3: Disclosure of finance lease

Source: Extracted from UEM Builders Bhd
There are two parties that are involved in leasing ă the lessees (who lease and use
the asset, but do not legally own it) and the lessor (who owns the asset and lease
it to another party)
(i) Lessee
Both the asset and the underlying liability should be shown on the balance
sheet. The asset should be depreciated over the shorter of the lease term
and the anticipated useful life. The lease rentals are then split between
interest and the capital repayment; this is determined by present-value
techniques. The total interest must be allocated to the profit and loss
account, normally using one of the three different methods:
• The actuarial method
• The sum-of-the-digits method
• The straight line method
(ii) Lessors
The legal owner of the asset, the lessor, will not show the asset on his
balance sheet. Instead, the lessor will show a debtor, representing the net
investment in the asset, which is analysed between amounts falling due
within a year and in more than a year. The lessor must calculate two
investment figures:

(i) The net investment in the assets. This is used for the valuation of
money the lessor has tied up in the lease, and is used for the
calculation of gross earnings.
(ii) The earnings in each period are calculated to give a constant return on
the lessorÊs net cash investment in the asset.
(b) Operating Lease

Operating lease is defined as any lease other than finance lease. Normally
financial institution in Malaysia implements this concept of lease and
adopted Hire Purchase Act as a guideline.
Operating lease in accounting treatment is treated in the same way as any

other short term hire agreement, which in Malaysia refers as Hire Purchase
Act. Under the accounting treatment, the lease rental is charged to the profit
and loss account as an operating cost. Neither the asset, nor the commitment
to the leasing company is shown on the balance sheet.
The concept of operating lease can be regarded as `off balance sheet

financingÊ (this will be discussed later) which is disclosed as notes to the
profit and loss account during the period, split between the hire of the plant
and machinery and other assets. As the leasing agreement represents a
contingent liability. The notes will disclose the annual commitment for the
operating leases. These will be analysed between:
• Leases expiring in one year
• Leases expiring between two and five years
• Leases expiring in more than five years
(c) Hire Purchase Agreement

Under Hire Purchase Act 1967(HPA Act 1967) Hire Purchase (HP) is
defined as one contract, which is for the hire of an asset, where the
ownership of that asset transfers to the hirer when he has fulfilled certain
conditions. A HP contract is treated in a similar way of operating a lease
contract.

3.3 POST RETIREMENT, DISCLOSURE AND RISKS
3.3.1 Employee (Postretirement) Benefits or Pension

Cost
Pension cost is part of a companyÊs liabilities. It can have a significant impact on
a companyÊs financial performance. If we are going to analyse and interpret a
companyÊs liabilities, the accounting and disclosure of retirement benefit must be
comprehended and analysed. Why do some companies record up trends and
why others record different trends?
The employee benefit is covered under FRS119. It defines all forms of

consideration given or promised by an entity in exchange services rendered by
its employees. These benefits include salary benefits, termination benefits and
post employment benefits.
When we carry-out company analysis, these costs should be comprehended and

we should identify the movement of the cost that consists of several components:
• Service cost
The primary component of pension cost is the deferred compensation to be
paid to employees in the future return for their current services. The service
cost is the actuarial present value of the benefits attributed by the pension
benefits formula to services rendered by the employees during the current
period.
Now we can distinguish that there are two types of pension cost schemes:
(i) Defined contribution scheme

We must comprehend that under this scheme, the contributions are
invested and the employeesÊ retirement scheme will be determined by
investment performance of the scheme. Under this scheme, the accounting
treatment is shown by the contributions relating to the period that will be
charged to the profit and loss account.
(ii) Defined benefits scheme

Under this type of scheme, employees are guaranteed a certain level of
retirement benefits. This is totally unrelated to the investment performance
of the scheme. If the scheme under performs, the company will have to
make additional contributions to honour its obligations. The company
therefore, assumes the risks involved in providing employeesÊ pensions.
Defined benefits scheme have traditionally been the type of scheme offered
by many companies in Malaysia.

Companies that operate under defined benefits scheme, are different from
the way it makes contributions into the scheme. Under this scheme,
accounting treatment is shown as part of the employment cost. However
the size of the employerÊs contribution in any year will in part depend upon
the performance of the fund. There may be sufficient money in the fund to
meet the obligations of the funds. In this situation the company would not
have to make any contributions to the scheme.
In order to calculate the pension costs charged to the periodÊs profit and
loss account, the company must:
• Determine the size of the fund required to meet its obligation
• Identify whether the fund is in surplus or deficit
• Account for the surplus / deficit in calculating the pension cost for the
period
• Identify the contribution rate for the scheme
3.3.2 How the Pension Fund Performance Reflects on

Company Performance
When we carry out analysis to determine the pension cost performance, we need
to look at the performance of pension cost. If the pension cost is in surplus, this
surplus should be spread over the remaining lives of employees. It is possible for
the surplus to be so large that a yearÊs share of the surplus could be greater than
the normal cost of pensions. The profit and loss account would then be credited
with the net amount. This can give rise to large differences in operating profit
when the fund moves into deficit, and a charge has to be made.
From the accounting treatment, many companies show pension cost surplus as a
part of debtor, and attribute a notional amount of interest to the prepayment.
These are purely accounting adjustments and may not represent cash flows into
the business.
3.3.3 Pension Accounting and Financial Analysis

From the accounting perspective, pension cost always refers to the notes of
accounts. Again when we put our self as an analyst, these are the areas of
concern of the financial statement:
• Is the fund a surplus or a deficit?
• How has this been accounted for?

If there is surplus:
• How much of the debtorsÊ figure is pension fund prepayment?
• Outside the management control. They are determined by an actuarial
valuation.
To explain details on the pension liabilities, assets and share capital items, it all
depends on the circumstances. Now look at the presentation on the balance sheet
as follows:
Assets
1. Prepaid pension cost
2. Intangible asset
Liabilities
1. Unfunded accrued pension cost
2. Additional pension liability
ShareholdersÊ Capital
1. Excess of additional pension liability over unrecognised prior service
cost (a deduction)
To determine the real case, students should look into the extract of the financial
statement of MTD Capital Bhd (Figure 3.4), a concession holder of Lebuhraya
Karak-KL. From the financial reporting, the numbers indicate that the liabilities are
recognised only by FYE2007 and no liabilities are recognised by FYE2006. And the
principal actuarial is used 6.5% of discount rate and 6.0% rate of salary increases.

Figure 3.4: Retirement benefits

Source: MTD Capital Bhd

3.4 CONTINGENCIES AND COMMITMENTS

Contingencies and commitments or contingent liabilities also contribute to the
financing activities that we must look into as a user of financial information.
A contingency can be defined as a condition, which could lead to a potential

gain, or liability, which has not materialised by the date of the balance sheet, as it
is dependent upon future events.
3.4.1 Contingencies, Natures and Impact to Financial

Analysis
Contingencies and commitments or contingent liabilities also contribute to the
parts of financing activities that we must look into. As a user of financial
statement, we are not only interested in what has happened and what will
probably happen, we are also concerned with what may happen (contingency). If
it fails to disclose the contingencies, the information could be misleading.
Some examples, which can be categorised as contingencies:

• Bill of exchange discounted with bankers
• Litigation cases, where the outcome resolved by a courtÊs decision
• Goods sold under warranties and guarantees
• Any uncalled liability on shares held as investments (unpaid portion of partly
paid shares held)
To explain the events and how it is disclosed in the financial statement (Figure
3.5) students should look into the extract from the notes of UEM Builder Bhd
(concession holders of Projek Lebuh Raya Utara Selatan ă PLUS) The notes
bellow reveal that 34 (a) is a Bank Guarantee for construction project and notes
on 34 (b) is categorised as arbitration cases and 34 (c) is a litigation cases.
SELF CHECK 3.2

Figure 3.5: Contingent liabilities

Source: UEM Builder Bhd

ACTIVITY 3.2
Review the process of analysing and identifying Off Balance Sheet
items. WhatÊs the impact on the financial statement if the contingent
liabilities take effect? You can refer to the item in Figure 3.6 on the
notes of UEM Builders Bhd.
3.5 OFF BALANCE SHEET FINANCING

The complexity of modern financing modes is Off Balance Sheet. It is part of the
sources of financing to run the business operating cycles. Students and analysts
or whoever must comprehend the nature and impact of off balance sheet
financing to the financial decision.
3.5.1 Off Balance Sheet, Natures and Impact To

Financial Analysis
Off balance sheet financing can be defined as non-recording of certain financing
obligations or the application of procedures that provide financing without
adding debt on a balance sheet, thus not affecting financial ratios or borrowing
capacity of an enterprise. Off-balance sheet items are often related to the sale of
receivables with recourse, leases and concession arrangement.
Typically in Malaysia this is highly complex financing. An example in our local

context of Off Balance Sheet Financing is Special Financing Vehicles (SPV).
Figure 3.6: How SPV operates
To explain how Sponsor Company forms into an SPV Company, the diagram
illustrates the flow of funds to finance project using the SPV approach. For
example, UEM Builders Bhd (UEM) has once again been awarded to design,
build and operate Penang Bridge 2 (2nd Link).

To illustrate this financing mode, UEM will use these concepts:

• UEM is identified as a sponsoring company. Sponsoring companies will set-up
an SPV company. Then the SPV is capitalized by sponsoring equity or other
third party investors (normally, institutional investor).
• The SPV leverages the equity investment from capital and equity market (also
known as structured financing) and purchases earning assets from or for the
sponsoring company.
• The cash flow from the earnings assets is used to repay the debt and provide a
return to the equity investors.
LetÊs say for example, we were given the assignment to undertake business and
financial analysis of this type of project, we must know the method of financing
used by sponsoring and SPV companies. This is to ensure that our reader also
comprehends our analysis on the companyÊs approach and the actual and
forecasted performance. This type of analysis is important for investors and for
analysts of credit rating agencies.
3.6 EQUITY FINANCING

In modern business transaction, we cannot avoid equity as part of the three
components as sources of activities to run business activities. Therefore itÊs crucial
to understand the fundamentals of equity when we carry out analysis of a
companyÊs financial position.
3.6.1 Equity, Natures and Impact to Financial

Analysis
Equity, along with assets and liabilities, is one of the three components used to
measure entities or company financial position.
Equity is defined in FRS framework as the residual interest in the entityÊs assets
after deducting all its liabilities. In a business enterprise, the equity or capital is the
ownership interest. FRS is also termed to encompass an entityÊs equity and
reserves.
In FRS, itÊs covered under FRS101 ă Presentation of Financial Statements.

In accounting for shareholdersÊ equity, the basic accounting purposes are the
following:
• To identify the source of corporate capital
• To identify legal capital
• To indicate the dividends that could be distributed to the stockholders
Equity that is classified includes various components with different

characteristics as follows:
(a) Share Capital

A distinction is usually made between capital originating from
stockholdersÊ investments, referred to as contributed capital or paid-up
capital, and equity originating from earnings, referred to as retained
earnings. The share capital section of a corporate balance sheet is usually
divided into three parts:
• Capital share ă the par or stated value of shares issued
• Additional paid-up capital or premium - primarily the excess of the
amounts paid over the par or stated value.
• Non-Distributable Reserve/Retained Earnings ă the undistributed
earnings of the corporation.
There are many types of share capital commonly used as an entityÊs

financing activities such as:
• Ordinary shares
Perhaps this is the biggest type of share capital used in Malaysia.
Ordinary shares normally have different voting rights, entitlement of
dividends and different entitlement and ranking in the event of
liquidation. However this is unusual due to the limitation of ordinary
shares which have one vote, dividends determined by directors, and
they have same rights in the events of liquidation.
• Preference shares
Preference shares usually have a fixed dividend, but participating
shares may receive an additional dividend reflecting the companyÊs
financial performance.

Preference shares can also:

• Be redeemed, also known as redeemable preference shares;
• Carry forward any dividend arrears ă cumulative preference
shares;
• Have the option of being converted into ordinary shares ă
convertible preference shares.
FRS also requires shares to be classified as non-equity and equity

shares. Non-equity shares have these criteria:
• A fixed dividend
• Limited rights in the event of a liquidation
• Redeemable
Consequently most preference shares would be classed as non-equity

shares. All other shares are classed as equity shares.
(b) Shares issues

When you look at business news section on local newspaper for example
The Edge or Star Biz, you will see: notice of shares issuance.
Companies may issue up to the amount of their authorised share capital,

but major new issues should be in the form of a right issue. Under right
issues the existing shareholders are offered the opportunity to buy new
shares in proportion to their existing holding. Shares may also be issued to
employees and directors, or offered as an alternative to a cash dividend.
(c) Reserves
Reserves can be classified as part of equity. Reserves can be classified into:
• Distributable reserve ă which can be used to pay dividend. This is the
accumulated profit & loss account.
• Non-distributable reserve ă the reserve usually arise from:
− Unrealised profit ă the revaluation reserve.
− A premium paid, above the nominal value, to acquire the
companyÊs share ă the share premium account.
− The cancellation or redemption of shares ă the capital redemption
reserves.
A negative balance in the balance sheet is referred to deficit. The reserve

account does not represent cash or any other assets. The directors of a
company may restrict, reserve, or appropriate retained earnings to show
that these funds cannot be used to distribute assets as dividends.
(d) Debt-Equity Hybrids

There are several instruments that have some of the characteristics of both
debt and equity. Only redeemable preference shares will be shown as part
of the shareholdersÊ fund. The others are classified as debt instruments, and
are separately disclosed as part of convertible debt.
The other non-equity instruments that will be shown as debt instruments. They
are:
• Convertible bonds ă convertible bonds give the holders the option to convert
into ordinary shares, rather than have a cash repayment of the bond.
• Redeemable preference shares ă these have to be repaid by a fixed date.
These are often regarded as debt, and dividends can even be linked to
interest rates.
• Mezzanine finance ă a loan that ranks behind other loans and is convertible
into ordinary shares at a predetermined rate.
Again, if we comprehended the nature of financing activities, itÊs easy for us to

undertake company analysis by observing and evaluating the financing trends
and we can come up with our findings and recommendations for users to make
decision.
ACTIVITY 3.3
Review the process of analysing and identifying financing activities.

Can we relate to prospective for a new IPOÊs (Initial Public
Offerings) Determine, the proportion of money from borrowing and
issuance of share capital? As an analyst which do you prefer, justify
your recommendation.
ACTIVITY 3.4
Again find-out which of the companies in Malaysia that extensively

use accrued expenses as a method to finance its business operations.
As a student give your views on the strategy used by the company
and impact to the companyÊs balance sheet position.

• This topic focuses on analysis on financing activities-both creditors and

equity financing. Analysis of these topics focuses on creditors and equities
components which are important to effectively evaluate the position of the
companies and how effective it is to use financing resources to run the
business.
• A current liability which arises from operating activities can be used to run
business activities, a current liability is the items that fall due within one year.
• Non- current liabilities or a long-term liability is defined as liabilities that are
not fall due (payable obligation) for payment in a short period of less than
twelve months.
• Long-term borrowings can be obtained not only from financial institutions but
also in the form of financial instruments.
• It is difficult to distinguish between finance or operating lease, however, if
certain criteria are met, it can be defined as finance lease:
• The employee benefit is defined as all forms of consideration given or
promised by an entity in exchange services rendered by its employees. These
benefits include salary benefits, termination benefits and post employment
benefits.
• A contingency can be a part of financing resources to run business activities. It
is defined as a condition, which could lead to a potential gain, or liability,
which has not materialised by the date of the balance sheet, as it is dependent
upon future events.
• Off balance sheet financing can be defined as non-recording of certain
financing obligations. An example of our local context of Off Balance Sheet
Financing is Special Financing Vehicles (SPV).
• Finally, one of the most important sources of funds to finance business
activities is equity. Equity is defined in FRS framework as the residual interest
in the entityÊs assets after deducting all its liabilities. FRS is also termed to
encompass an entityÊs equity and reserves.

Bill of exchange Overdraft

Commercial papers Preference share
Commitment Preferred share
Contingencies Private debt securities
Debentures Retirement benefit
Debt-equity hybrid Share capital
Long term loan Special purpose vehicles (SPV)
Mezzanine finance Trade creditor
Notes

Topic X Analysing
4 Investing
Activities
LEARNING OUTCOMES
1. Explain the features of current assets;
2. Distinguish inventories and receivables; and
3. Prescribe long term assets plant assets and natural resources and
intangible assets.
X INTRODUCTION
This topic focuses on how we carry out analysis on investing activities, both
current and long-term assets. Analysis of these topics focuses on the components
of the short term and long term which are important to determine and to
evaluate the position of the companies. We are going to determine how effective
and efficient the company utilise those assets to get maximum returns.
Our focus of analysing investing activities must be linked with assets recognition,
its cost allocation and disclosures according to Financial Reporting Standard
(FRS).

64 X TOPIC 4 ANALYSING INVESTING ACTIVITIES
ACTIVITY 4.1
From the selected 5 public listed companies in Bursa Malaysia,

point out the information to be focused, current and long-term
assets. Which companies recorded increase of current and long-
term assets for the last two years? Identify the impact to investorsÊ
decision.
4.1 CURRENT ASSETS PREVIEW

We begin our analysis by explaining both current and non-current assets as it is
part and parcel of investing activities. We also distinguish the components of
current (short term) assets and non-current assets (long term assets). All the
assets that we are going to discuss are normally used by companies in running
the day-to-day operations. We will also see how this reflects company
performance.
4.1.1 Current Assets: Characteristics and Its Investing

Activities in Business Operations
Current assets is defined as assets that is owned by companies and can be
converted in cash within one calendar year. This categorised under FRS
(Financial Reporting Standard) 125, Accounting for Investment. The standard
defines it as readily realisable and intended to be held for up to one year. The
investment must be shown at either market value or, the lower of cost and
market value. If they are shown at market value, the gain or losses can either be
shown at market value or shown in the profit and loss account, or even the
revaluation reserve.
Current assets that are used to invest in company activities consist of:
(a) Debtor/Receivables
This represents amount of money that is owed to the business and shown
as debtors. Not all debtors disclosed in a set of Malaysian accounts are
current, as some fall due after one year. The notes to the accounts will
disclose the separate components to the debtors. Not all debtors are related
to sales, it could be:

TOPIC 4 ANALYSING INVESTING ACTIVITIES W 65
• Trade debtors - these debtors represent the money owed for sales
during the year.
• Other debtors - this is money owed for sales of fixed assets and other
non trading items.
• Prepayments and accrued income.
• Any unpaid called-up share capital.
• Pension fund prepayment.
• Finance-lease receivables in finance companyÊs accounts.
Additionally, a parent companyÊs accounts must also legally disclose:

• Any amounts owed by groups undertakings - this will be shown on the
parent companyÊs balance sheet only;
• Any amounts owed by undertakings in which the company has a
participating interest
(b) Trade debtors

This is one of the most important elements of debtors figure in most
companyÊs account because itÊs related to the company sales. This is one
important element that students or business analysts must understand. The
nature of debtors among industries is different, for example, manufacturing
debtorÊs cycle is different against services, due to the different operating
cycle (from purchases of material to the collection of sales).
• Debtor days
It is an indicator to measure the numbers the business can collect money
from its customers. It is also called collection period.
Companies should be trying to reduce their investment in debtors, to

give as little credit as possible, in other words increase cash term.
However, we admit that todayÊs business transactions normally run on
credit sales, therefore, we need to balance between shortening the
collection period and gaining sales. Extending collection is effectively
the same as a price discount.
It is possible to quantify how long it takes the company to collect money

from its customers. The usual way of calculating this is to calculate the
debtor days by using the formula;

Debt collection = Trade debtors x 365

(days) Turnover
Debt collection = Trade debtors x 12

(months) Turnover
Example;
Given trade debtors of RM8.219 million and sales of RM50 million.
Ć Debt collection = RM8.219 million x 365 = 60 days

(days) RM50 million
This means that the company takes 60 days to collect credit sales.
Ć Debt collection = RM8.219 million x 12 = 1.97 months

(months) RM50 million
This indicates that the company takes 1.97 months to collect credit sales.
Ć Trade debtor = RM8.219 million x 100% = 16.4%

Sales RM50 million
From the calculation above, we gather that the company trade debtors
represents 16.4% of the total sales amounting RM50 million. If the
company can reduce collection period, this means that they are dealing
with a quality buyer.
To students, when you are conducting debt collection analysis, please

take note that trade debtors collection varies among different business
sectors. For strictly cash business like hypermarket, debt collection
value is normally `zeroÊ due to the cash business. However other sectors
might be different due to the different operating cycles. A falling in
collection period is generally a good indicator that the company has
effective financial control
To explain further on the debtorÊs collection, students should realise

that these issues will reflect the analysis that is being carried-out and
that it is also important for stakeholders to make decisions. We can get
relevant information from chairmanÊs report or notes to the account.

(i) Is any undue proportion due from one major customer or from
many customers in an industry?
(ii) Would failure of one or two customers have material effect to the
company?
(iii) WhatÊs the age pattern of debtorÊs?
(iv) Is there any adequate provision for bad and doubtful debt?
(v) Are there any of the debts, which fall due after one year,
considered long term in nature?
After understanding what we want to know in our debt analysis as

above, we could explore more about factors affecting the debt collection
period. Why do different companies have different collection period?
Others may have shorter collection period, is this assumed to be
preferable than longer ones? We should look into these factors to
explain our concerns of whether or not to change in collection period:
• The debt collection might increase due to:

− Changes in policy to a major customer because the major
customer gives new valuable order but with condition extending
credit sales from one month to two months.
− The granting of credit sales, for example for potential customer
with a good track record, as part of marketing strategy against
other competitors to retain the customer.
• Where there is poor credit control or account administration:

− If credit is given to unsatisfactory customers.
− If there is a lack of documents to send proper invoice to
customer, then the payment is not received at the agreed
payment date.
− If there is no consistent follow-up of overdue debts, by letter
and/or telephone, or caused by incompetence on behalf of the
person-in-charge.
− If factoring or invoice discounting is introduced or discontinued.
(explained in the Figure 4.1 below)

Figure 4.1: Factors affecting debt collection period
• Factoring
Factoring and invoice discounting are the ways of using debtors to obtain
finance. The company assigns the legal ownership of the debtors to the
factoring company in exchange for cash payment. The factor may or may not,
provide a credit control service (collection agent/service) for the company.
The cash payment may or may not be refundable. If the payment is
refundable the factoring agreement is known as `with recourseÊ or `non
recourseÊ agreement if it is not refundable. The flows as bellow illustrates
how factoring or invoice discounting works.

Figure 4.2: Factoring or invoice discounting process
I reckon that as a student you are quite familiar with short-term securities in
Malaysia that can be used as investing instrument. Some of the common short-
term instruments in Malaysia are shown as below:
(a) Investments (short term)

Investment, which is recognised as part of current assets are not intended to
be held in the long term. They are held on a short-term basis, either as a
way of generating income from its cash balance, or by the company selling
the investments. The following may be disclosed as current asset
investments in a companyÊs accounts:
• Money market and other deposits;
• Listed and government securities;
• Certificates of deposit. This is a way of getting higher interest (or profits
for Islamic Deposit namely Mudharabah General Investment Account)
on deposits;
• Commercial paper (also known as instruments); and
• Short term Government papers (normally issued by Bank Negara
Malaysia).

Investment (FRS 132 and 139 ă Financial instrument ă disclosure and

recognition) are classed as assets available for sales, held for maturity, loan
and receivables and fair value through profit and loss.
(b) Cash at bank and in hand

It is hard to believe that the large sum that is often shown in a companyÊs
account is not placed on deposit and probably not always repayable on
demand.
Groups often have companies in the group with cash balances, and others
with bank overdraft. The group usually then comes to an agreement with
the bank to offset the bank overdraft against cash balances. The amount can
only be offset by bank overdrafts when the legal right of set-off exist.
4.2 INVENTORIES AND RECEIVABLES
4.2.1 Inventories and Receivables: Characteristics and

Analysing Stock
Inventories or stocks in Malaysia, are important assets on the balance sheet. The
stock values affect the reported profits of the business. They should initially be
recognised at the cost. Cost of inventory includes import duties, handling cost
and any other directly attributable costs less trade discounts, rebates and similar
items.
Inventories should be shown and valued at the lower cost level or net realisable
value. FRS 102 ă Inventories is defined as the inventories and accounting
treatment that should be implemented by and recognised at the cost and value of
the lower cost or net realisable value.
(a) Cost
The cost of stock includes production and other overheads that have been
incurred by the business to bring the inventory into its current condition.
Overhead are allocated to inventor based on the normal levels of activity.
This means that there are two problems involved in the allocation of
overheads to inventory. Companies have to decide on the:
• Method of apportionment
• Normal activity levels

Interest may also be charged to inventory, and this must be disclosed in the
notes to the accounts. Company often buy their materials (and other
expenses) at different prices through the year, and it is possible to have the
same products at different prices in inventory. Cost can be computed in a
number of different ways.
The main methods used are:

• First in, first out (FIFO) follows the principles of inventory rotation and
assumes that the most recent deliveries will be found in the inventory;
• A weighted average price;
• Last in, first out (LIFO) is the opposite of FIFO and assumes that the
most recent deliveries have been charged to the profit and loss account.
The following Table 4.1 is to illustrate the impact of using the different
methods.
Table 4.1: Impact of using different methods
Units Unit cost Total

1 Jan Opening inventory 1,500 1.00 1,500
28 Feb Purchases 2,000 1.05 2,100
1 Apr Purchases 1,500 1.06 1,590
30 June Purchases 2,000 1.08 2,160
31 Aug Purchases 2,200 1.10 2,420
30 Nov Purchases 1,500 1.13 1,695
10,700 11,465
31 Dec Closing inventory 1,000
To determine cost of sales we must find out the value of the closing
inventory.
• FIFO
The value of inventory shown on the balance sheet will be RM1, 130
(1,000 x 1.13, the latest price) and the cost of sales charged to the profit
and loss account will be RM10,335 (RM11,465-RM11,30)
• Average Cost
A weighted average cost is used, as unfortunately a simple average will
not give the degree of accuracy required. This is illustrated:

A simple average cost per unit would be:
RM1.00+RM1.05+RM1.06+RM1.08+RM1.10+RM1.13
6
= RM1.07 per unit
This would mean that RM10,379 (9,700 x 1.07) would be charged to profit
and loss account and inventory could be RM1,070. When we a use simple
average, the addition of the inventory and the cost of sales does not equal
the total cost of purchases, RM11,465. The inventory and the cost of sales
total RM11,449. To be exactly right a weighted average must be used.
A computation using weighted average cost per unit would be:
(1,500xRM1.00)+(2,000xRM1.05)+(1,500x1.06)+(2,000xRM1.10)+(1,500xR
M1.13)
10,700
= RM1.0714953
The extra decimal places ensure the accuracy, using the weighted
average which gives cost of sales of RM10,393.504 and closing inventory
of RM1,071.4953. These add up to the total cost of purchases, RM11,465
The three methods of valuing inventory will give different profits and
different inventory values on the balance sheet (Table 4.2):
Table 4.2: Inventory values of FIFO, Weighted average and LIFO

Cost of sales (RM) Inventory values (RM)
FIFO 10,335.00 1,130.00
Weighted average 10,393.50 1,071.50
LIFO 10,465.00 1,000.00
If we look at the impact on the profit and loss account (Table 4.3):
Table 4.3: Profit and loss account
FIFO Average LIFO
Turnover 18,000.00 18,000.00 18,000.00
Materials (10,335.00) (10,393.50) (10,465.00)
Staff cost (4,000) (4,000) (4,000)
Other costs (2,000) (2,000) (2,000)
Operating profit 1,665.00 1,606.50 1,535.00
From the analysis, we can see that LIFO gives us the smallest profit.

(b) Net realisable value

Net realisable value is effectively a market price for the inventory in its
current condition. The accounting standard defines it as the selling price
less than any further costs to completion, and sales, marketing and
distribution costs.
(c) Long-term contracts

There are special rules that apply to long-term contracts:
• The turnover should be recorded as a contract progresses, rather than
when it is completed; and
• Profit is also recorded when it arises
Consequently, it is unlikely that large long-term contract balances will be

found. Any long-term contract balances are reported net of:
• Any payment on account that are in excess of the turnover; and
• Any foreseeable losses.
Below is an example of a long-term contract.
Tri-Star Builder Sdn Bhd, a contractor with a long term-term contract has
certified work completed of RM590, 000 during a year. This is shown as the
turnover of the project. It has received a total of RM630, 000 in payments on
account from its customer. The total cost incurred on the project during the year
is RM550, 000, of which RM500, 000 has been transferred to cost of sales.
RM
Project costs incurred during the year 550,000
Transferred to cost of sales (500,000)
50,000
Excess of payments on account to be offset against long-term (40,000)
contract balances
Classified as long-term contract balances 10,000
The payments in advance were RM40, 000 greater than the turnover, therefore
the reported inventory is reduced to RM10, 000. The balance sheet note on
inventory should separately disclose the net cost of RM50, 000 and the applicable
payments on account of RM40, 000. Had the payments on account been RM60,
000 greater than the turnover, the inventory would be eliminated and RM10, 000
would be payments on accounts and separately disclosed in creditors. If all the
project costs had been transferred to the profit and loss account the payments on
account would be RM40, 000.

When analysing a company we need to see whether any charges in its

inventory have arisen from changes in sales or from changes in
management practice. We should be able to identify changes in inventory at
a quick look: ratio will help us measure them.
4.2.2 Analysing the Inventory Ratios

We have two ratios that help us to measure any changes in inventory level as
below:
(a) Inventory turn

This will tell us how many times in the period the company has converted
its inventory into sales. It is calculated by dividing either the turnover, or
the cost of sales, by the inventory. The higher the number, the shorter the
conversion period.
We will determine inventory turn using these ratios:
Turnover based = Turnover

Inventory
Cost of sales based = Cost of Sales

Inventory
Table 4.4a to Table 4.4c illustrate the inventory ratios, we will compute all
the stock ratios using the following information (RMÊ000);
Table 4.4 (a): Computing company AÊs stock ratio
Year 1 Year 2 Year 3 Year 4

Turnover 1,000 1,050 1,150 1,300
Cost of sales (400) (420) (450) (510)
Other operating costs (300) (310) (330) (350)
Inventory at the year end 100 110 125 150
We can see at a glance that company A is carrying its inventory for longer.
Sales in the period have risen by 30 per cent and inventory by 50 per cent.
Now we need to quantify the size of the problem. In our example the
inventory turn for the company would be:

Table 4.4 (b): Computing company AÊs inventory ratio
Inventory turn Year 1 Year 2 Year 3 Year 4

Turnover based 10 x 9.6 x 9.2 x 8.7 x
Cost of sales based 4.0 x 3.8 x 3.6x 3.4x
(b) Inventor days

This tells us how many days sales (or cost of sales) are held in inventory.
The inventory is divided by the turnover, or cost of sales, and then
multiplied by the number of days in the accounting period.
Table 4.4c: Computing Company AÊs inventory ratio

Turnover based Cost of sales based
Inventory x 365 Inventory x 365

Turnover Cost of sales
Using earlier example, the inventory inventory days:
Inventory days: Year 1 Year 2 Year 3 Year 4

Turnover based 36.5 38.2 39.7 42.1
Cost of sales based 91.3 95.6 101.4 107.4
Over the four years the companyÊs inventory levels have move from 36.5
(based on sales) days to 42.1 days which indicated its carrying much more
inventory than it used to.
Once we have identified a trend in the management of inventories, we

should try to identify why the management practice may have changed.
There will often be other information in the accounts that we can use to
help us understand why the inventory levels have changed.
Except when inventories are built up anticipation price rice or to purchase

on bulk quantity in order to get discount, well managed companies usually
try to carry the minimum inventory needed for the satisfactory running of
their business. They do so:-
• To minimise interest charges on the money tied-up in inventories;
• To save unnecessary storage costs; and
• To reduce the risks of being left with goods that canÊt be sold due to
deterioration, becoming obsolete or going out of fashion.

For the above company it does not indicate a good sign to the business
because the companyÊ inventory is increasing every year. Therefore they
need to reduce the inventory handling period.
4.3 LONG TERM ASSETS
4.3.1 Long-Term Assets: Characteristics and Its

Long term assets can be found on the balance sheet. We have learned on short-
term investment as part of short-term assets. A long-term asset is classed as
assets that company intends to keep it on a long-term basis. Fixed asset
investment, which company intends to keep for more than one year or more can
be classed as part of long-term assets.
Now we must identify that, there are many types of fixed assets investment that
can be classed as fixed asset investment, which comprises of:
(a) Subsidiaries
A subsidiary is not necessarily a company; it has included partnerships and
incorporated associations where the investing company controls the
business. Hence the term, Âundertaking.Ê Subsidiaries only appear as fixed
asset in the parent companyÊs balance sheet. In the group accounts the
assets and liabilities are consolidated.
(b) Associated Undertakings

An association is undertaking where the company has a participating
interest in a long-term investment and exercise significant influence over
the operational and financial policies of the associate.
Associates are explained under FRS128 ă which required using equity

method as accounting treatment. Under this method, the investment is
initially shown at cost, and subsequent value is then adjusted for the
investing companyÊs share of any changes in the associateÊs net assets. It is
presumed to exist when investor has at least 20% of control.
There are two types of associates classified as:
• Joint ventures
A joint venture is a contractual agreement between two or more parties
undertaking an economic activity that is subject to joint control. Joint
control is defined as contractually agreed sharing of control of an

economic activity. Joint ventures also required to use the equity

method.
• Significant associates and joint ventures

Additional disclosures required to be made when the associates or joint
ventures exceed 15% of the investing groupÊs:
− Gross assets
− Gross liabilities
− Turnover
− Operating results (on a three-year average)
If the threshold exceeded the investing company, information must be

disclosed on gross assets and liabilities on:
− Fixed assets
− Current assets
− Liabilities due within a year
− Liabilities due in more than a year
− Any other information that is necessary to understand, for example
the size of the debt and its maturity.
Figure 4.6 shows an example of a company structure.
H is the holding company of a group of companies, and is incorporated

in Malaysia.
• H holds 100,000 of the 100,000 ordinary/common shares of S
• H holds 7,500 of the 10,000 ordinary/common shares of T
• S holds 5,100 of the 10,000 ordinary/common shares of U
• T holds 1,000 of the 1,000 ordinary/common shares of V
The H group may be depicted thus:

Figure 4.6: Example of company structure: partially and wholly owned subsidiary
From Figure 4.6, the parent of subsidiary is the parent of its subsidiary.
The parent of a subsidiary is the parent of its subsidiary.
Therefore H group consists of:

• HÊs wholly owned subsidiary S
• HÊs partially owned listed subsidiary T (in which there is a 25%
minority)
• TÊs wholly owned subsidiary V (which in law is also subsidiary of
H, but colloquially a partially owned subsidiary of H)
• SÊs partially owned subsidiary U (in which there is 49% minority)
Why do we need to understand the above structure? The answer: when

conducting financial and business analysis, the structure has direct
impact on the investing activities in terms of return, income
contributions or risks.
Analysts in banks might want to determine the level of risks

concentration based on loans exposure or different subsidiaries. For
example, an equity analyst might wants to assess the return from
investment. Therefore as students we should understand the structure
of a company and the structure of investment to explore the
performance of the company.

(c) Other Investments

The accounting requirements in different companies are different as they
are listed on a stock exchange and unlisted investment, thus additional
investment is required for significant investment.
4.4 PLANT ASSETS AND NATURAL RESOURCES

An asset is regarded as a fixed asset if a company intends to use it on a
continuing basis in its activities. One of these fixed assets is known as tangible
assets, which is used in generating income. These assets would cover land and
building, plant assets, vehicles and natural resources.
4.4.1 Plant Assets (Property, Plant and Equipment)

and Identifying the Cost
These class of assets are disclosed under FRS 116 ă property, plant and
equipment, its is recognised when the cost of an asset can be reliably measured
and it is probable that the entity will obtain future economic benefits from the
assets.
Property, plant and equipment have different lives of assets and its depreciation
is calculated based on each individual partÊs live.
Those assets initially measured based on cost. The cost of assets is not necessarily
the same as the purchase price of the assets. The cost can include commissioning
cost and capitalised interest and it may well increase if the company later
improves the asset.
4.4.2 Government Grants

Government assistance can take many forms and will change over time. It is
recognised when it is likely that the company will comply with the conditions
relating to the grant and receive the grant. It is regarded as deferred income and
includes its creditor on the balance sheet. They are credited to the profit and loss
account over the life of the asset. Examples of Malaysian Government grants are
provided by SMIDEC and MTDC. ItÊs a grant for small and medium enterprises.
The grant received is in the form of capital grant (assets) or revenue grant (rental
or waiver to specific payment).

4.4.3 Depreciation of Assets

When we look at MalaysiaÊs financial reporting, all the property, plant and
equipment as well as Investment Properties depreciate. Upon the adoption of
FRS 140, Investment properties have also depreciated. The depreciation and
impairment losses are charged to the profit and loss account over the life of the
asset, using an appropriate measure met over the life of the assets.
The depreciation charge should take account of the assets:

• Cost
• Life
• Net residual value (the scrap value at the end of the day)
Typically in Malaysia there are two depreciation methods applied as below:
(a) The straight-line method

The company has RM10,000 to depreciate over five years, and would make
an annual charge to the net profit and loss account of RM2,000 (10,000 / 5)
This is the most popular method of depreciating assets in Malaysia.
The depreciation charge is constant at RM2, 000 per year and the value of
the asset is decreasing in a straight line. This is shown in the table below.
Table 4.5: Straight-line method of depreciation

Depreciation (RM) Asset value (RM)
1styear 2,000 8,490
2nd year 2,000 6,490
3rd year 2,000 4,490
4th year 2,000 2,490
5th year 2,000 490
(b) Reducing balance

This is also known as the declining-balance method. It uses a fixed
percentage each year and applies this to the diminishing value of the asset.
The percentage is calculated by using the following formula, which will
give the chosen residual value at the end of chosen life.
residual value
1− n
cost
(n is anticipated life of the asset)

Using the above formula, the percentage that would be used is 45.8%, and
this would give the following depreciation charges and assets value:
Table 4.6: Calculating depreciation charges and assets value

Depreciation (RM) Asset value (RM)
1st year 10,490 x 45.8% 4,805 5,685
2nd year 5,685 x 45.8% 2,604 3,081
3rd year 3,081 x 45.8% 1,411 1,670
4th year 1,670 x 45.8% 765 905
5th year 905 x 45.8% 414 491
4.4.4 Changing the Basis of Depreciation

In the Malaysian financial reporting environment, company is allowed to change
the method of depreciation if the changes give a true and fair view of the assets.
The changes will affect profitability, asset values and the financial ratios.
To explain the impact from the changes of the depreciation method, letÊs look at
the example of Table 4.7. The changes would improve the reported profitability for
the first three years and increase the value of the asset shown on the balance sheet.
Table 4.7: Impact from the changes of depreciation
Profit and loss account Balance sheet
Depreciation Increase Asset Increase
charge in profit value in asset
value
Reducing Straight line Reducing Straight
balance over over 10 year balance over line over
5 years 5 year 10 years
Residual 490 2,490 490 2,490
value
1st year 4,805 800 4,005 5,685 9,690 4,005
2nd year 2,604 800 1,804 3,081 8,890 5,809
3rd year 1,411 800 611 1,670 8,090 6,420
4th year 765 800 (35) 905 7,290 6,385
5th year 415 800 (385) 490 6,490 6,000
6th year 0 800 (800) 490 5,690 5,200
7th year 0 800 (800) 490 4,890 4,400
8th year 0 800 (800) 490 4,090 3,600
9th year 0 800 (800) 490 3,290 2,800
10th year 0 800 (800) 490 2,490 2,000

ACTIVITY 4.2
Review the process of analysing depreciation approach. Can we

relate to the companies that we have selected? Identify the most
common depreciation method applied by those companies? If you
are an accountant of the company, which method would you
prefer?
4.4.5 Natural Resources and Identifying the Cost and

Recognition.
Natural resources are rights to contract, to consume natural resources for
example mineral concession such as petroleum. Exploration and evaluation
assets are initially at cost. Natural resources are both tangible and intangible.
Therefore management should apply the classification consistently. Once it is
recognised, either they should apply cost or revaluation model for the
exploration and evaluation of the natural resources assets based on tangible
assets (FRS 116 - Property, Plant and Equipment) or intangible assets (FRS-138).
As soon as the assets are deemed technically feasible or technically

commercialised, they are no longer classified as evaluation and exploration
assets.
When the assets are not recovered, the impaired concept must be used (FRS 136-
impairment of assets).
Management should disclose the accounting policy, amount of resources and

expenses incurred in the financial statement.
4.5 INTANGIBLE ASSETS

An intangible asset is regarded as an asset that must be written down as the same
approach as tangible assets. The process is essentially the same as we term it as
amortising, rather than depreciating for fixed asset.

4.5.1 Intangible Assets, Natures and Impact to

Financial Analysis
These assets would cover the following assets:
• Development costs
• Concession, patents, licences, trade marks and similar rights and assets
• Goodwill
• Payment on account.
Although most companies do not currently reveal any intangible assets on the
balance sheet, there are many that could be included. For example:
• Capitalised research and development costs
• Concessions
• Patents and trade marks
• Brand names
• Goodwill
Under FRS 138 ă intangibles assets is defined by the standard as a non-financial

fixed asset that does not have physical substance, but is identifiable and
controlled by the company through custody or legal rights.
Under that standard, intangibles are classified as:

• External intangible assets due to external purchases should be recorded as
assets on the balance sheet
• Internally generated intangible assets should be recognised if the company
can establish a market value. They should be amortised over their useful
economic life.
The other requirement accounting treatment and disclosures on company

account that we must understand when carrying out any analysis is as follows:
(a) Goodwill
Purchased goodwill should be shown as intangible asset and amortised
over its useful life.
(b) Other intangible assets

These should only be recognised if the company can establish a market
value. They should be amortised over their useful economic life.

(c) Amortisation period

The asset life would usually not exceed twenty years, but it can be
indefinite. If the asset life exceeds twenty years, the intangibles should be
reviewed annually to ensure that their value has not eroded.
(d) Research cost

All research cost should be charged to the profit and loss account.
(e) Development cost

Development cost related to specific projects may be capitalised if the
project is technically feasible, likely to be profitable and the company has
the resources for project completion and launch. Any capitalised
development cost should be amortised over the period expected to benefit
from the development.
(f) Patents, trademarks and similar rights

Any assets classified as patents, trademark and similar rights are shown as
intangible assets on the balance sheet. They will be initially recorded at cost,
or valuation, and normally amortised over the shorter period attached to
the right, and period expected to benefit from the asset.
(g) Brand names

Brands may be shown as intangible assets on the balance sheet, and where
they are shown, they are often a significant proportion of the net assets.
They are initially shown at cost or valuation.
ACTIVITY 4.3
Relate to the company that youÊve been selected. Select and rank
the type of investment assets (choose 4 types of assets) that the 5
companies used to invest in the business operating cycles which
give better return.

• Analysis of investing activities focuses on assets, its nature, disclosure and

impact to our analysis.
• It focuses on how to evaluate the position of the companies and how effective
is in investing activities to get maximum return.
• Current assets are defined as an asset that are owned by companies and can
be converted in cash within a one calendar year and non-current is asset held
for more than one year.
• Inventories values (or we call it stocks in Malaysia) affect the reported profits
of the business. They should initially be recognised at the cost. Cost of
inventory includes import duties, handling cost and any other directly
attributable costs less trade discounts, rebates and similar items. It should be
shown and valued at the lower of cost or net realisable value.
• A long-term asset is classed as assets that company intends to keep on a long-
term basis. Fixed asset investment, which companies intend to keep for more
than one year or more, can be classed as part of long-term assets.
• There are many types of fixed assets investment that can be classed as fixed
asset investment, which comprises of:
− Subsidiaries
− Associated undertakings
• Intangibles assets is defined by the standard as a non-financial fixed asset
that does not have physical substance, but is identifiable and controlled by
the company through custody or legal rights. The assets consists of:
− Development costs
− Concession, patents, licences, trade marks and similar rights and assets
− Goodwill
− Payment on account.
− Capitalised research and development costs
− Concessions
− Patents and trade marks
− Brand names
− Goodwill

Amortisation LIFO
Associated undertaking Natural resources
Capital grant Net realisable value
Debtor days Offset agreement
Development costs Participating interest
Equity method Patent
FIFO Property, plant and equipment
Goodwill Research costs
Inventory days Revenue grant
Inventory urn Significant investment
Joint venture Straight-line method subsidiary
Licence Trademark

Topic X Analysing
5 Operating
Activities
LEARNING OUTCOMES
1. Describe the concept of income;
2. Measure the accounting income;
3. Evaluate the non recurring items;
4. Compare the revenue and gain recognition; and
5. Evaluate the impact of interest cost and income tax on operating
analysis.
X INTRODUCTION
This topic focuses on how we carry out analysis on operating activities, by
analysing accrual measures of both revenues and expenses. We will also learn
about the net income analysis. Finally, we are going to learn to distinguish the
components of income and impact for financial analysis.

88 X TOPIC 5 ANALYSING OPERATING ACTIVITIES
ACTIVITY 5.1
From the 5 public listed companies in Bursa Malaysia that has been
selected, look at the information that is to be focused, identify non-
recurring items, which companies recorded non-recurring items for
the last two years? Identify the impact to the companyÊs
profitability?
5.1 INCOME MEASUREMENT PREVIEW

We begin our analysis by explaining the concept of income. Income represents
both total revenue (turnover) and gains.
Revenues come up due to ordinary activities of an enterprise. Typical revenues

are sales of goods, provision of services, fees, interest income, dividend income,
royalty and rental income. And sales that the company has made during the
period, excluding any trade discounts, indirect taxes or any similar taxes.
However, gains come up not from normal activities but from disposal of assets.
In the income statement, gains shows as gain on disposal of non- current assets
and itÊs shown as net of related expenses.
Income and gains give rise to increase in economic benefits during the
accounting period. The benefits may come in the form of inflows or enhancement
of assets or decreases of liabilities that lead to increases of equity, other than
those relating to contributions from equity participants.
5.1.1 The Categories of Income

The income concept can be classed as income from an economic perspective or
income from an accounting perspective.
(a) Economic income

Economic income is defined as cash flow plus the change in the fair value of
the net assets. It consists of realised income (cash flow) and unrealised
income (holding gain or loss) components.
Therefore its measures are:

• The return of the securities which include both dividend and capital
appreciation

TOPIC 5 ANALYSING OPERATING ACTIVITIES W 89
• The change of shareholders value. ItÊs important to determine the actual

return of shareholdersÊ return. Therefore economic income is a
benchmark of a companyÊs performance.
The economic income of the above comprises of recurring and non-

recurring items.
(b) Permanent income

Permanent income is defined as a stable average income that a company is
expected to earn over its life. Unlike economic income, permanent income is
tied-up to company value therefore it reflects the long term sustainable
earnings of the company, which is essential for our equity and credit
analysis.
5.1.2 Accounting Concept of Income

Accounting income is based on accrual accounting concept. A major analysis to
measure company performance is to carry out accounting analysis. To
understand details on income from the accounting perspective, letÊs look at profit
and loss accounts.
The profit and loss accounts show whether the company has been selling its
goods and services for more or less than the cost it takes to make and deliver
them to customers. It takes the income from sales made in the period and then
deducts the costs that relate to those sales.
Three things to remember when we look at profit and loss (P&L) and its relation
to accounting income:
(a) It is historical
All figures on the profit and loss accounts will explain what has happened,
not what is happening now. This means that the P&L is historical, it always
says `for the year ending⁄for the six months ending⁄Ê
(b) It does not include capital expenditure

The only impact that capital expenditure has on profit and loss account is
depreciation charge. Consequently, a business can be profitable but run out
of cash due to capital expenditure programme.
(c) It is the accrual concept

This means it is not concerned about the cash received from customers, or
paid to suppliers, but just the sales has been made.

Consider this example ă if I buy a book for RM5.00 and sell it for RM8.00, the
profit and loss account records a profit of RM3.00. But I may have paid cash
to buy the book, and sold it on credit term. The profit remains the same even
though my cash is now at ăRM5.00. Thus a business can be profitable, but
run out of cash if the customers have not paid for the sales in the period. So,
what looks like a `profitableÊ business in the accounts may be making a loss
today and easily go into liquidation because it runs out of cash!
5.1.3 Measuring Accounting Income

As we discussed earlier, accounting income is determined by recognising
revenue and matching costs. Revenues and costs are the major composition of
accounting income.
(a) Revenue and Gains

Revenue represents the cash inflows such as total sales that the company
has made during the period, excluding any trade discounts, indirect taxes
or any similar taxes. The sales comprises of cash sales and prospective sales
such as credit sales. Gains are inflows that are not related to usual and on-
going business activities.
(b) Expenses and Losses

Expenses can be defined as any incurred out flows, prospective out flows or
allocation of past outflows of cash that arise from a companyÊs ongoing
operations. Losses will lead to the decreasing of net assets due to the
peripheral and incidental operations of a company.
FRS118 defines revenue as `the gross inflows of economic benefits during

the period arising in the course of the ordinary activities of an enterprise
when those inflows result in equity, other than increases relating to
contributions from equity participantsÊ. However, at times an enterprise
may collect on behalf of third parties such as tips for its employees, sales
taxes etc, these cannot be recognised as revenue.
FRS118 describes revenues from normal trading activities. Revenues from

cost of sales can be recognised when:
• The cost can be reliably measured
• The revenue can be reliably measured and it is probable that it will be
received
• The risks, rewards and management involvement is usually associated
with ownership having passed to the buyer

Revenues arising from provision of services should be recognised on a

percentage of a completion basis when the costs and completion stage can
be reliably measured at the balance sheet date.
This means that companies bring turnover into their profit and loss
accounts in a number of different ways broadly classified into those based
on an event transferring the ownership, and those based on time.
5.2 NONRECURRING ITEMS

We are going to list out and analyse nonrecurring items such as extraordinary
items, discontinued segments, accounting changes, restructuring charges and
special items. Non-recurring means any item that rarely happens during the
financial year end. The items are not classified as normal activities.
Now, learners should look at these nonrecurring items, paying close attention to
the impact on profit and loss.
5.2.1 Extraordinary Items

Extraordinary items are any abnormal material items arising outside of the
companyÊs ordinary activities that are not expected to recur in the future.
Therefore itÊs expected to occur infrequently.
FRS 108 (Changes in Accounting policies, Changes in Estimates and errors)

requires separate disclosures for any exceptional items or extraordinary items.
ItÊs required of the company to disclose the nature of extraordinary items, size
and relevant of the events to the financial performance.
Natural disaster is an example of extraordinary item which infrequently occurs.

Such events occur beyond the managementÊs control. Thus the items also reveal
the risk exposures of the company. But sometimes we can assume extraordinary
items of the companies operated in `the rings of earthquakeÊ (such as The
Philippine) may recur due to possibility of earthquake. Therefore analysts must
take into consideration of adjusting and evaluating the earning power of the
company.
Extraordinary items are shown on the profit and loss account after tax, and do
not affect earnings per share, therefore analysts must realise that when
extraordinary items occur, the performance of earning per share are not affected.

5.2.2 Accounting Changes

Company could change the accounting policy for many reasons. Accounting
policy could be changed due to:-
• Introduction of new standard, for example from Malaysia Accounting
Standard Board (MASB) to Financial Reporting Standard (FRS) or current
standard which is regulated by Bank Negara Malaysia to FRS (for Financial
Institution);
• Changes of policy to reveal more true and fair picture of the company;
• For window dress purposes to attract investor by showing high earning
power;
• To comply with regulator or listing requirement, for example companies that
intend to be listed in US Stock Exchange must comply with US GAAP.
Once the changes have taken place, it must be adopted based on consistency to
similar transactions and events, therefore it should not be changed without any
justification.
As an analyst, letÊs look and distinguish four types of accounting changes which
directly affect financial analysis:-
(a) Changes in accounting principles

(b) Changes in reporting entity
(c) Correction of error
(d) Changes of accounting estimates
The Figure 5.1 is a disclosure of changes of accounting policy extracted from

Sapura Crest Petroleum Bhd.

Figure 5.1: Disclosure of changes of accounting policy

Source: Sapura Crest Petroleum Bhd

5.2.3 Special Items or Exceptional Items

Special items or exceptional items are material events or transactions which are
required to be disclosed if the company wants to give a true and fair view of the
financial statement. Typically itÊs been disclosed in the notes to the accounts.
The only special items that are shown on the profit and loss account after
operating profit, and before interest are as follows:
(a) Profits and losses on the sale of fixed assets or impairment of long lived assets
Fixed assets are the assets that the business intends to keep to generate
turnover. However, companies sell the assets when the assets reach the end
of the useful life. When fixed assets are sold, they have a value in the books.
The sale of assets will affect profitability if the sales generate more or less of
the asset value.
For example, if a company, Highway Builder Sdn Bhd bought a machine for
RM15, 000 and depreciated it by RM10,000, it would be recorded a worth of
RM5,000. Then the machine sold for RM6, 000 and the company will report
RM1, 000 profits on sales of the assets. However if the assets only been
disposed for RM3, 000, a loss of RM3, 000 will be reported in operating profit.
(b) Profits and losses on the sale or termination of operations or impairment of

other assets
In addition to the sale of fixed assets, the company may write off other
types of assets such as:
(i) Other business operations
(ii) Receivables
(iii) Inventories
(iv) Goodwill
While the write off of receivables and inventories is based on reasonable

judgement, the profit from sale of other business operations or subsidiaries
must consider the goodwill that was paid to acquire the business, as well as
the current value of the business in the companyÊs accounts. Therefore it is
concluded that the profit or loss recorded on the sale of assets are
determined by the value that these assets have in the accounts.

(c) The cost of a restructuring or reorganisation that has material effect on the
nature or focus of a company operations
The cost of restructuring is directly correlated with changes of business
strategy and business operating model. Restructuring that is typically
related to the business strategies are listed as follows:
• Divestment of business operations
• Termination of contractual agreement
• Cease of product lines
• WorkerÊs retrenchment or voluntary separation scheme (VSS)
• Change in management constitution
• Writing off assets with investment in new technologies
These exercises have been extensively implemented by Malaysian

companies, especially those listed in Bursa Malaysia during the economic
crisis in 1997. Those strategies and exercises come with a cost. Those
companies normally make a provision for the cost of restructuring exercise.
This provision is charged to the current income as special items. Therefore,
analysts must look into the special items and the type of events that lead to
special items when carrying-out analysis on the companyÊs performance to
explain the fundamental trends of the company profitability.
5.3 REVENUE AND GAIN RECOGNITION

In this unit we are going to identify revenue and gains: the fundamentals of
revenue and gains and how we determine the companyÊs revenue and gains
performance. Revenue is defined as any inflows due to enhancement or
utilisation of companyÊs assets or settlements of its liability, whereas a gain arises
from incidental transaction, which affects the net asset of the company.
FRS 118 (Revenue) explains revenue recognition. Those which are concerned
with revenues derive from:
Ć The sales of goods
Ć The rendering of services
Ć The utilisation of others than assets that generate incomes such as royalty
payments, dividends and interest received (these would not normally be
regarded as part of a companyÊs turnover)
The above revenues only apply to the normal companyÊs trading activities.

To meet revenue recognition criteria, these conditions must be met:

Ć It is possible to measure the revenue reliably
Ć It is probable the company will receive the revenue
5.3.1 Revenue Recognition from Sales of Goods

Now, we move on to the revenue arising from the sale of goods. To ensure
revenue can be recognised, it must meet the conditions below:
Ć The company has transferred the significant risks and rewards of ownership
to the buyer, for example the transfer of a legal title. This can be illustrated
below, when exporter transfers the goods using export documents such as
bill of exchange; the legal ownership of the goods is transferred to the
purchaser. However in some cases depending on the business or credit term,
the transfer of risks and rewards may not be at the same time as transfer of
the good or title. To mitigate the risks, exporters or buyers could be covered
by taking insurance (depending the type of risks)
Ć The company doesnÊt have any control over the goods, and thereÊs no
involvement over the goodÊs ownership. For example under the contract of
selling a cutter machinery, Cut-X Sdn. Bhd. is liable to install the cutter
machine to the buyer, the Cut-X Sdn. Bhd. still has a significant part of sales
contract and the installation has not been completed.
Ć The cost can be reliably measured. Any related expenses to the revenue are
recognised simultaneously. This is consistent with the matching concept that
we have learned in Topic 2.
Ć The economic benefits from the transaction will flow to the enterprise. Its
means at the point of sales, revenue is recognised but when ÂcollectabilityÊ is
questionable, the revenue is not adjusted but an uncollectible amount is
recognised as revenue. For example in the banking industry, customersÊ
monthly loan instalment is in arrears (overdue) for five months and the
arrears are not collectible. However bank still recognises five months arrears
as revenue. The bank will only be suspended from the income recognition
when the arrears reach 6 months.
Ć The amount of revenue can be measured reliably.

For better understanding please refer to the charts below.
Initial production Income

process recognised when
invoice issued
Figure 5.2: Examples of revenue recognition, a normal good transaction
Figure 5.3: Examples of revenue recognition of an international trade using trade

documents e.g. - Bill of Exchange

5.3.2 Revenue Recognition from Provision of Services

Revenues arising from provision of services should be accounted using the
percentage of completion and other additional conditions that must be complied
before revenue can be recognised. The outcome can be estimated reliably when
the following conditions are satisfied:
Ć The amount of revenue can be measured reliably.
Ć The economic benefits from the transaction will flow to the enterprise
Ć The completion stage can be reliably measured at the balance-sheet date
Ć The costs can be reliably measured.
Example:
Pro Builder Sdn Bhd (PBSB) is awarded to build a hospital by Ministry of Health
(MoH) on 1st April, 2004. The contract price is worth RM5 million. Pro Builder
Sdn Bhd expected that it will take three years to complete the project and the cost
incurred is RM4 million. In 2004, PBSB manages to complete part of the project
and the cost incurred is RM1 million. By the end of 2004 PBSB had received
RM800, 000 from MoH.
So, how much can PBSB recognise as revenue for 2004?
As part of project completed, PPSB can recognise a percentage of the revenue

which relates to the work completed. A common approach that is normally used
is recognition based on work done. The basis used can be the cost incurred to
date to total cost.
Cost to date Total RM1 million

Total estimated x Revenue = RM4 million x RM5
cost million
= RM1.25 million
Extract from PPSB Income Statement will be as follows:
RM million
Turnover 1.25
Cost of sales 1.00
Gross profit 0.25

The revenue recognised for PPSB in 2004 is RM1.25 million and not the amount
cash received, RM800,000 and the different RM450,000 is due from the MoH is
classified as a current asset. However, if MoH had paid RM1.5 to PPSB, then
there is liability of RM250, 000.
Therefore we advised learners to review the figure of completion project to

ensure that our assessment to determine companyÊs revenue for further analysis
is correct and accurate.
5.3.3 Revenue Recognition from Interest, Royalties

and Dividends
Revenues from other income such as interest income are recognised using
effective interest rate methods. Where royalty such as income from franchisee
fees is recognised, this will be based on accrual basis with accordance to the
agreed agreement. Dividends are recognised when shareholderÊs right to receive
payment is established.
Example:
(i) Revenue from Interest for conventional fixed deposit or profit for Islamic
Fixed Deposit
It should be recognised on a time proportion.
On 1st April, 2008, Pro Builder Sdn. Bhd (PPSB) had deposited RM10, 000
in Maybank Islamic Bhd, Global Currency Fixed Deposit Account. The
current rate is 10% p.a. payable at the end of each year. At 31st December,
2008, the profit earned by PPSB will be RM10, 000 x 10% x 9/12 = RM750
Therefore we advise learners to review the tenor and profit (or interest)
term that the company deposited the money to ensure our assessment to
determine companyÊs revenue form interest or profit earned is correct and
accurate.
(ii) Royalties should be recognised on an accrual basis in accordance with the

agreed terms of the relevant agreement.
Senario Jr is a new artist with a local recording company. Royalty payable

to Senario Jr under the agreement is RM10 for every compact disc sold.
During the year the recording company had produced 500,000 units but
had sold only 200,000 units only. Therefore Senario Jr can only recognise
the royalty income as RM10 x 200,000 = RM2 million only.

Therefore analysts are advised to be aware of the parameters to recognise

revenue such as copies sold, to ensure any assessment to determine
companyÊs revenue form royalties is correct and accurate.
(iii) Dividends should be recognised when the shareholdersÊ right to receive

dividends payment.
Again, Pro Builder Sdn Bhd (PPSB), holds 100,000 ordinary shares in Air
Malaysia Bhd. At the annual general meeting held on 5th May, 2008, Air
Malaysia BhdÊs directors proposed a dividend of 10% for the year 2007. For
PPSB, they have the right to receive the dividends only when it is declared
and so it can be recognised as revenue on 5th May, 2008 and it will not be
considered as revenue of the year 2007.
It is important for students to identify the date of dividends announcement

(current year) and the base year (previous year) that the dividends are
declared.
5.4 DEFERRED CHARGES

We have explained in an earlier section that research and development can be
capitalised as intangible assets. However any expenses incurred during the
research stage should be charged to profit and loss account. These are a part of
deferred charges which can be defined as any cost incurred that are deferred
because they are expected to benefit in the future period.
5.4.1 Research and Development

Companies are normally extensively involved in research and development.
Research mainly involves expenses for exploring and maintaining new products,
where development is the process to transfer from research stage to commercial
stage (product to sell)
Any expenses during the research stage should be charged to the profit and loss
account, whereas development cost should be capitalised as intangible assets.
Analysts should distinguish the criteria of research expenses and development
cost in analysing company performance especially companies that are involved
in research and development activities. Analysts form venture capital normally
to undertake company analysis before they come up with investment proposals
to the shareholdersÊ. Venture capital is a form of investment instrument
especially for research-based companies such as high technology, biotechnology
or any company involved in R&D, which is exposed to high risk of return. These
sectors are not suitable to apply traditional mode of financing such as bank loan.

5.4.2 Computer Software Industries

Development of software is different against normal R&D Company. The cost
incurred must be deferred to match future revenues.
For example in year 2008 Gen2 System Bhd is awarded a contract for provision of
new Geographic Information System by Government of Malaysia and they
should deliver and release the system by 2010. Until the release of the product,
any expenses during the technology feasibility could be deferred to match the
delivery date (future revenue).
5.4.3 Exploration and Development Costs in

Extractive Industries
The cost incurred during the search of mineral deposits such as upstream
petroleum industries is very high and risky. Any expenses during exploration
should be charged to the profit and loss account if the reserve is unsuccessfully
explored or amortised when the reserves are discovered.
ACTIVITY 5.2
Review the process of identifying non-recurring items. If you are an

accountant of the company, how are you going to explain the impact
of income recognition to the users of the financial statement?
5.5 SUPPLEMENTARY EMPLOYEE BENEFITS
5.5.1 Supplementary Employee Benefits, Definition,

Accounting Treatment and Impact to Analysing
Operating Performance
When we look at our terms of employment or collective agreement between
employee and trade union, there are some benefits offered by employers. Some
benefits other than salaries and wages include: bonuses, profit sharing, ex-gratia,
and insurance as well as employee stock options. In this context of analysing
operating activities, we are going to explain the Employee Share Option and
impact to companyÊs performance analysis.

Employee Shares Option Scheme (ESOP) or share based payment is one popular
method that has been used by employee as an compensation incentive.
FRS 2 defines Share based payment as entities which receive goods or services as
consideration for either equity instruments of the entity (or the entityÊs parent or
another entity within the same group) (Âequity-settled share-based paymentÊ) or
for cash (or other assets), where the amount is based on the price or value of the
entity's shares (Âcash-settled share-based paymentÊ). In this situation entity refers
to employees that have been offered employee share option payment (ESOP) by
employer.
Under FRS 2, ÂShare-based paymentÊ, the accounting treatment is based on the

fair value of the instruments. The accounting in this area can be difficult, due to
complex models that need to be used to calculate the fair value of options and
also due to the variety and complexity of schemes. In addition, the standard
requires extensive disclosures.
When we analyse a companyÊs profit and loss account, we will find that the
company charges the expenses to the profit and loss account. However, entities
or employees sometimes also pay for other expenses such as professional fees,
and for the acquisition of the share.
As an analyst or student, we have to look into the trends and how it correlates
with profitability of the company. We should determine the economic benefits
from ESOP and how certain industries can retain their human capital or reduce
staff turnover by offering ESOP to staff and management.
The result generally is to reduce reported profits, especially in entities that use
share-based payment extensively as part of their remuneration strategy. All
transactions involving share-based payment are recognized as expenses or assets,
as appropriate, over any vesting period.
Equity-settled share-based payment transactions are measured at the grant date

fair value for employee services; and, for non-employee transactions, at the fair
value of the goods or services received at the date on which the entity recognises
the goods or services. If the fair value of the goods or services cannot be
estimated reliably ă such as employee services or circumstances in which the
goods or services cannot be specifically identified ă the entity uses the fair value
of the equity instruments granted.
Since the publication of IFRIC 8, ÂScope of IFRS 2Ê, in January 2006, management
needs to consider if there are any unidentifiable goods or services received or to
be received by the entity, as these also have to be measured in accordance with

IFRS 2. Once the grant date fair value has been determined, equity-settled share
based payment transactions are not re-measured.
ACTIVITY 5.3
Relate to the company that youÊve been selected. Select and rank the
type of exceptional or extraordinary item that might affect
shareholdersÊ return.
5.6 INTEREST COST
5.6.1 Interest Cost and Impact to Operating Analysis

Interest is the cost of using the money from a borrower. ItÊs directly charged to
the profit and loss accounts. Interest expense is determined by principal, tenor
and interest rate. Amortisation of any cost involved such as premium or discount
of borrowings, finance charges, finance leases or exchange difference from
foreign exchange borrowings are considered as adjustment to interest cost.
Under FRS 123 companies are allowed to choose to capitalise or expense

borrowing costs incurred that are directly attributable to the acquisition,
production or construction of a qualifying asset.
However, the IASB has revised IAS 23 (which is known as FRS 123 in Malaysia
context) for accounting periods beginning on or after 1 January, 2009 with earlier
application permitted. The revised IAS 23 removes the option to expense
borrowing costs and requires borrowing costs directly attributable to the
acquisition, construction or production of a qualifying asset to be capitalised.
Under Islamic financing, cost of financing is known as profit, and then it will be
added up with the cost (or principal). This is different from interest because
Islamic financing is based on transactions and the transaction must have an
underlying asset.
Example:
Due to increases in demand from local and overseas market, on 1st January 2003
Pro Digital Sdn. Bhd, was secured financing from local bank amounting
RM600,000 to finance both a construction of a new plant and for operations. At
financial year end 2005, the outstanding borrowings were RM400,000 with no
capital repayment in year 2005. The borrowings mainly part finance for the
construction of the plant at a cost of RM300,000. Pro Digital wants to capitalise

borrowing costs on qualifying assets. The details of the borrowing are as follows:
31st Dec, 2005

RM
12% Loan stock 100,000
10% Term loan 220,000
8% Redeemable preference shares 80,000
The company wants to capitalise the borrowing costs, so we can compute as

follows:
Principal as (a) (b) (a)x(b)

31st Dec, 2005 Weighted Interest
RM average rate
12% Loan stock 100,000 25% 12% 3.0%
10% Term loan 220,000 55% 10% 5.5%
8% Redeemable 80,000 20% 8% 1.6%
preference shares
Total 400,000 100% 10.1%
Total interest
Principal as 31st Dec, 2005 Interest Total
RM rate interest
12% Loan stock 100,000 12% 12,000
10% Term loan 220,000 10% 22,000
8% Redeemable 80,000 8% 6,400
preference shares
Total 400,000 40,400
RM
Interest that can be capitalised RM300,000 x 10.1% 30,300
Interest that can be charged as expenses 10,100
40,400
From the above computation we can conclude that the amount the company
should capitalise is RM30, 300.
The capitalisation will take effect when expenditure for the asset is being
incurred, the borrowing costs are being incurred and any necessary activities to
prepare for the intended use or sale are in progress.

The capitalisation process might be suspended when the active development is

interrupted. Finally, once the activities are completed and the assets are ready to
use and the owner gets the economic benefits, the capitalisation should be
ceased.
5.7 INCOME TAX
5.7.1 Income Tax and Impact to Operating Analysis

Income tax on the profit or loss for the year comprises current and deferred tax.
Current tax is the expected amount of income taxes payable in respect of the
taxable profit for the year and is measured using the tax rates that have been
enacted at the balance sheet date.
Deferred tax is provided for, using the liability method. In principle, deferred tax
liabilities are recognised for all taxable temporary differences and deferred tax
assets are recognised for all deductible temporary differences, unused tax losses
and unused tax credits to the extent that it is probable that taxable profit will be
available against which the deductible temporary differences, unused tax losses
and unused tax credits can be utilised.
Deferred tax is not recognised if the temporary difference arises from goodwill or
negative goodwill or from the initial recognition of an asset or liability in a
transaction which is not a business combination and at the time of the
transaction, affects neither accounting profit nor taxable profit.
Deferred tax is measured at the tax rates that are expected to be applied in the
period when the asset is realised or the liability is settled, based on tax rates that
have been enacted or substantively enacted at the balance sheet date.
Deferred tax is recognised as income or an expense and included in the profit or

loss for the period, except when it arises from a transaction which is recognised
directly in equity, in which case the deferred tax is also recognised directly in
equity, or when it arises from a business combination that is an acquisition, in
which case the deferred tax is included in the resulting goodwill or the amount of
any excess of the acquirerÊs interest is the net fair value of the acquirerÊs
identifiable assets, liabilities and contingent liabilities over the cost of the
combination.

The deferred tax will be calculated on timing difference. This is illustrated in the
table below:
Table 5.1: How deferred tax is calculated

Note: The capital allowance for the assets is calculated on a `reducing balanceÊ
Capital CompanyÊs Timing Deferred tax

allowance depreciation charge difference (charge)/credit in the year
Year 1 25,000 20,000 5,000 (1,550)
Year 2 18,750 20,000 (1,250) 388
Year 3 14,063 20,000 (5,937) 1,840
Year 4 10,547 20,000 (9,453) 2,930
Year 5 7,910 20,000 12,090) 3,748
To illustrate the calculation and impact of the tax charge in the profit and loss
account, see the table below. We will assume that the pre-tax profits are constant
over five year at RM100,000 and corporation tax remain at 31%.
Table 5.2: Calculation and impact of tax charge in the profit and loss account
Year 1 Year 2 Year 3 Year 4 Year 5

Profit before tax 100,000 100,000 100,000 100,000 100,000
Depreciation 20,000 20,000 20,000 20,000 20,000
120,000 120,000 120,000 120,000 120,000
Capital allowance (25,000) (18,750) (14,063) (10,547) (7,910)
Taxable profit 95,000 101,250 105,937 109,453 112,090
Corporation (29,450) (31,388) (32,840) (33,930) (34,748)
tax@31%
Deferred tax (1,550) 388 1,840 2,930 3,748
Total tax charge (31,000) (31,000) (31,000) (31,000) (31,000)
Profit after tax 69,000 69,000 69,000 69,000 69,000
We can clearly see how accruing deferred tax has the effect of equalizing the tax
charged to the profit and loss account over the life of the asset.
When we charge deferred tax on the profit and loss account, it has to show up
somewhere on the balance sheet. It will either show as a liability or an asset. The
table below shows the balance entries.

Table 5.3: Balance entries after computing
Year 1 Year 2 Year 3 Year 4 Year 5

Opening deferred tax (1,150) (1,162) 678 3,608
balance
Deferred tax (1,550) 388 1,840) 2,930 3,748
(charge)/credit in the year
Closing deferred tax (1,550) (1,162) 678 3,608 7,356
(provision)/asset
The deferred tax asset exist at the end of the fifth year because the machine still
has a residual value in the tax accounts of RM23,730 (31% of RM23,730 is
RM356.30) We can see that for the last three years our example has a deferred tax
asset. However you will rarely see these in practice, as we are looking at an
example at one machine in isolation. A company will have assets and liabilities
that cancel each other out.
• Income represents the total sales that that the company has made during the
period, excluding any trade discounts, indirect taxes or any similar taxes.
• Economic income is defined as cash flow plus the change in the fair value of
the net assets. It consists of realised income (cash flow) and unrealised
income (holding gain or loss) components.
• Permanent income is defined as a stable average income that a company is
expected to earn over its life.
• Accounting income is based on the accrual accounting concept. Accounting
income is determined by recognising revenue and matching costs. Revenue
and costs are the major composition of accounting income.
• Nonrecurring items are as follows:
− Extraordinary items
− Accounting changes
− Special items or exceptional items
− Profit and loss on the sale of fixed assets or impairment of long lived
assets
− Profit and loss on the termination of operation or impairment of other
assets
− The cost of restructuring or reorganisation

Accounting changes Impaired asset

Cost of restructuring Impaired asset
Deferred charges Permanent income
Economic income Research and development
Expenses and losses Revenues and gains
Exploration and development cost Special items
Extraordinary items

Topic X Cash Flow
6 Analysis
LEARNING OUTCOMES
1. Determine the cash flow conditions;
2. Analyse the financial ratios;
3. Assess the limitations in cash flow reporting; and
4. Apply cash flows as a tool to evaluate a company’s performance.
X INTRODUCTION
This topic focuses on how to carry out analysis on cash flow activities. We are going
to determine the cash flow condition to identify the performance of a company.
The objective of the cash flow statement is to determine the amount, timing and
uncertainty of cash flow of financial reporting. Therefore cash flow helps users to
see how the balance sheet has changed from the beginning of the accounting
period to the end of the period.
ACTIVITY 6.1
From the financial statements that you have selected; point out the
information that cannot readily be obtained from cash flow
statements?
6.1 IDENTIFY STATEMENT OF CASH FLOW

We begin our analysis by explaining the concept of cash flow, which is essential
for a companyÊs sustainability. Our scope of analysis should include the
statement prepared based on cash basis and not on accrual basis. The statement

110  TOPIC 6 CASH FLOW ANALYSIS
presents a detailed summary of how the company must be able to generate cash
flow from operating itself or other sources in determining company performance.
The specific guideline of cash flow income definition is found in the FRS 107,
which defines the cash flow statement as one of the primary statements in
financial reporting (along with the income statement, balance sheet and
statement of changes in equity). It presents the generation and uses of Âcash and
cash equivalentsÊ by category namely ăoperating, investing·and financed over a
specific period of time. It provides users with a basis to assess the entityÊs ability
to generate and utilise its cash.
The cash flow statement shows the cash in and cash out during the year and the
statement consist of cash flow from:-
Ć Trading- shown under the heading operating activities
Ć Dividends from joint ventures and associates - under separate heading,
associates and joint ventures
Ć Interest, (mark-up profit for Islamic Financing), dividends received and any
dividends paid to `non-equityÊ shares and minority interests ă shown under
return on investment heading and servicing of finance.
Ć Tax-shown under taxation heading
Ć Buying and selling fixed assets ăshown under capital expenditures and
financial investment
Ć Dividend paid to ordinary shareholders
Ć Short term investments that are shown as current investment
Ć Share and loans
6.1.1 The Objectives of the Cash Flows Statement

The statementÊs value is that it helps users include the needs for:
(i) Liquidity ă the nearness to cash of its assets and liabilities.
(ii) Operating capability ă the ability to maintain a given level of operations.
(iii) Financial flexibility ă the ability to take effective actions to alter the amount
and timing of future cash flows so that the company can respond to
unexpected needs and opportunities.

TOPIC 6 CASH FLOW ANALYSIS  111
The statement of cash flow can also help external users to evaluate:
(i) A firmÊs ability to generate positive future cash flows.
(ii) A firmÊs ability to meet its obligations and pay dividends.
(iii) A firmÊs needs for external financing.
(iv) The differences between a firmÊs net income and associated cash receipts
and payments.
(v) The cash and non-cash aspects of a firmÊs investing and financing
transactions during the accounting period.
Generally information on the gross amounts of cash receipts and cash payments
during a period is more relevant than information about the net amount. For
example, investing and financing activities that provide both cash receipts and
cash payments during an accounting period should be reported separately on the
statements of cash flow. If a company is going to issue new long-term debt to
retire maturing debt, under financing activities, the cash that proceeds from the
issuance long-term debt should be reported separately from cash payments for
maturing debt issues.
Cash flows are important indicators of a firmÊs profitability and viability. Cash
basis information provides critical support to accrual basis accounting, but does
not replace the need for accrual basis accounting.
6.1.2 Cash and Cash Equivalents

We have learned about cash and cash equivalents, now we need to learn about
what cash and cash equivalents actually are, and why it is an important element
in cash flow statements. In the cash flow statement, cash flow includes `cash and
cash equivalentsÊ. Cash equivalents are short-term liquid investments, such as
government bills, negotiable instruments, money market instruments and other
short-term maturity instruments.
They must be readily convertible to known amounts of cash and are close to
maturity so that they correlate with the changes of interest rates. Therefore as an
analyst, we should understand the movement of interest rates and risks when
determining the cash and cash equivalent analysis. You should learn about the
impact of those cash factors with the company policy. Any policy set-up by an
entity will determine how the cash and cash equivalent is treated. Any changes
in the policy will have significant impact on the presentation of the financial
reporting of an entity. Refer to Figure 6.1.

Figure 6.1: Articulations of the financial statements
6.1.3 The Contents of the Statement

Now letÊs look at the contents of the statements. It serves us better to learn the
overall contents to ensure we can distinguish the classes of activities in the
statements.
(a) Operating activities include all transactions and events that are not
investing and financing activities. Such activities include revenues and
expense transactions associated with the sale of products or the delivery of
services. E.g. all activities that enters into the determination of net income.
Operating activities for a company could include cash flows from:
(i) Cash inflows from selling of goods, providing of services, dividend
income, interest income.
(ii) Cash outflows for inventory, salaries, tax expenses, interest expenses,
and other expenses
(b) Financing activities involve liabilities and shareholdersÊ funds items and
include:
(i) Cash inflows from sales of share capital and issuance of bonds, notes,
mortgages, and other short-term and long-term borrowings.
(ii) Cash outflows for purchase of government bill, repayment of
principal on borrowings and cash dividends.

(c) Investing activities include:

(i) cash inflows from sale of plant assets and investment securities or
collection of loans made by the entity
(ii) cash outflows for acquisition of plant assets, purchase of investment
or securities, and loans made by the entity.
In the statement, the inflow and outflows for each category should be shown
separately, and the net cash flows (the difference between the inflows and
outflows) should be reported.
The statement must also clearly show:

(a) The net increase and decrease in cash for the period and;
(b) A reconciliation of the beginning cash balance to the ending cash balance.
6.1.4 The Construction of the Cash Flow Statement

The first component of Cash Flows Statement is operating activities.
(a) Cash Flow from operating activities:-

The benchmark to a successful business is to determine the cash flows from
operating activities. If a company consistently records positive cash flows
from activities, it can be concluded that the company is able to continue its
business. If the cash flow from operating is red (negative), then the
company would not be able to continue operations. A negative operational
cash flow is serious, especially if tax and dividends are being paid.
Before we undertake a companyÊs cash flow analysis, we should

understand that the cash flow from operating also indicates:-
ă The amount of cash that was utilised to expand the growth of the
companyÊs operating requirement such as acquisition of fixed assets,
servicing borrowing, servicing dividends and other operating
requirement as what we learnt in Topic 5.
Therefore we need to:

- Make a comparison or trend analysis against previous yearÊs operating cash
flows.
- Make a comparison with previous yearÊs operating cash flowÊs condition
with companies within the same industry.

114 X TOPIC 6 CASH FLOW ANALYSIS
Cash flow from operating activities can be prepared using two methods namely:
(a) Direct method:-

The direct method shows the cash receipts (inflows) and payments
outflows and it is easy for non-accountant users to understand. This type of
format has not been used in financial reporting but is easy to understand by
other users such as the creditors, buyers and bankers.
Cash flow from operating activities for direct method shows:-

(i) Cash inflows
Ć Cash received from customers, including lessees and licences
Ć Interest and dividends payment received
Ć Other operating cash receipts, if any.
(ii) Payments
Ć Cash paid to supplier
Ć Cash paid to, on behalf of employees
Ć Other cash paid
(iii) Net cash in flow from operating activities
(b) Indirect Method

If we need to analyse a companyÊs operating cash flow that uses the indirect
method, we must understand that it is used to show reconciliation to
operating profit. It begins with operating profit and adds back (adjustment)
with paper charges such as depreciation and amortisation or others.
The net cash flow from operating activities is determined by adjusting the
profit from operation (profit before tax) for the effects of:
Ć Non-cash items (e.g. depreciation, amortization);
Ć Items for which the cash effects are not operating cash flow (e.g.
gain/loss on disposal of assets); and
Ć Changes in the operating working capital (e.g. changes in inventories,
debtors and creditors)

Additions Net Income Deductions
Depreciation expenses Amortisation of bond premium

Amortisation of intangible assets Decrease in deferred income-tax
Amortisation of bond discount liability
Increase in deferred income tax liability Increase on investment in common
Loss on investment in common share stock using the equity method
capital using the equity method Gain on sale of plant assets
Loss on the sale of plants assets Increase in debtors
Decrease in debtors Increase in stock (inventories)
Decrease in stock (inventories) Increase in prepaid expense
Decrease in prepaid expense Decrease in creditors
Increase in creditors Decrease in accrued liabilities
Increase in accrued liabilities
Net cash flow from operating activities
Figure 6.2: Common adjustment made to net income to compute net cash flow from
operating activities under the indirect method.
Then it is adjusted for any changes in working capital (other than cash and cash
equivalent) such as changes in inventory, debtors, accruals, creditors and
prepayment. Increases in working capital indicate more cash has been used or
more cash is required for working capital, where decreases in working capital
indicate that less cash was spent.
To summarise the direct and indirect methods, when the indirect method is used
for operating activities, net income reported on the income statement is
reconciled with the cash basis of accounting.
When the direct method is used, revenues and expenses are converted from the
accrual basis of accounting to the cash basis of accounting. The direct method is
considered more informative because it focuses more directly on cash flows
rather than the reconciliation of the accrual to the cash basis.
When the direct method is used, the preparer must present a reconciliation of net
income to net cash flows from operating activities. This requires a separate
schedule.

6.1.5 Items and Activities That Are Omitted in the

Cash Flow Statement
There are three items or activities that are excluded from cash flow reporting
such as:
(a) Significant non-cash transactions:

Some significant non cash transactions and other events that are investing
or financing activities are excluded from the body of the cash flow
statements.
The items are presented either in a separate schedule or described below:

(i) The acquisition of assets by assuming liabilities through the issuance
of equities securities.
(ii) Exchanges of no monetary assets.
(iii) Conversion of debts and preferred stock
(iv) The issuance of equity securities to retire debt. Share dividends, share
splits and appropriations of retained earnings are generally not
reported as significant non-cash transaction
(b) Cash Flow per Share

A cash flow per share amount shall not be reported in the statement of cash
flows. This avoids confusing cash flow per share with the significant
earnings per share amount reported in the income statement. Net income is
generally a better measure of performance than cash flows. The statement
of cash flow is not an alternative to the income statement.
(c) Foreign Operations

An entity with foreign operations will include in its cash flow statements
the reporting currency equivalent of local currency cash flows using the
current exchange rate at the time of the cash flows. This means that a
statement reporting in USD shall first convert cash flows in other currencies
to USD for reporting purposes. The effect of exchange rate changes on cash
balances held in local currencies shall be identified separately in the
statement of cash flows and reported as part of the reconciliation of the
change in cash and cash equivalent during the period.
Table 6.1 illustrates how we derive cash flow statement using the direct method:-

Table 6.1: Cash Flow Statement for the Year Ended 31st December, 2007
CASH FLOW FROM OPERATING ACTIVITIES RMÊMil

Cash received from customers 464,000
Cash paid to suppliers (260,000)
Cash paid to employees (67,000)
Cash paid for rent (24,000)
Cash paid for interest (27,000)
Cash paid for taxes (16,000)
Net cash provided by operating activities 70,000
CASH FLOW FROM INVESTING ACTIVITIES:

Purchase of machinery (122,000)
Proceeds from disposal of machinery 14,000
Net cash from financing activities (108,000)
CASH FLOW FROM FINANCING ACTIVITIES:

Proceeds from issuance of bonds 210,000
Dividends paid (8,000)
Net cash from financing activities 202,000
Net increase in cash and cash equivalents 164,000

Cash and cash equivalents at the beginning of year 23,000
Cash and cash equivalents at the end of year 187,000
Notes 1:
Reconciliation of Net Income to Net Cash Provided by Operating Activities
RMÊMil
Net Income 34,000
Adjustments to reconcile net income to net cash provided by 464,000
operating activities:
Depreciation expense 10,000
Decrease in debtors 44,000
Decrease in merchandise stocks 9,000
Increase in creditors 3,000
Loss on sale of machinery 1,000
Amortisation of premium on bonds payable (1,000)
Decrease in income taxes payable (20,000)
Decrease in interest payable (10,000)
Total adjustments 36,000
Net cash provided by operating activities 70,000

Notes 2:
Non-cash Investing and Financing Activities
RMÊMil
Conversion of bonds payable into common share 138,000
Notes payable issued for machinery acquired 50,000
Table 6.2 illustrates how we derive from using the indirect method.
CASH FLOW FROM OPERATING ACTIVITIES RMÊMil

Operating profit 70
Depreciation 40
Less: Increase in debtors (out flow) (50)
Plus: Decrease in stocks (inflow) 50
Increase in creditor (inflow) 70
Net cash generated/ (used) from operating activities 180
From the above example, the company generated RM110 (RM70 + RM40) from
the yearÊs sales but managed to generate RM180 during the year - the balance
from the reduction in the working capital. Although debtors have increased, this
has been more than offset by the reduction in stock and the increase in creditors.
(d) Taxation
Tax paid represents the actual tax paid by the company during the year; it
will be the tax charge during the year (based on current year assessment).
(e) Cash flow from investing activities (capital expenditure and financial
investment)
This item represents the inflows from investing activities that take place
from sale of fixed assets and long-term investment. The cash received from
the disposal of these assets are recorded as cash inflows. However, any
acquisition of fixed assets and long-term investment by cash payment are
classified as cash outflows and would be regarded as part of acquisitions
and disposals.
Table 6.3 gives an example of an investing transaction.

Table 6.3: Investing cash flows
INVESTING TRANSACTION RMÊMil

(a) Purchase of new machinery 90
(b) Purchase of motor vehicles 40
(c) Purchase of fixed asset investment (other than associates & joint 20
venture)
(d) Investment in associate undertaking 10
(e) Proceeds from sale of machinery 20
(f) Proceeds from sale of motor vehicles 50
(g) Purchase of subsidiary 20
The entries to prepare the cash flow statement are shown under cash flow from
investing activities as shown in the table below.
Table 6.4: Cash flow from investing activities
CASH FLOW FROM INVESTING ACTIVITIES RMÊ000

Payments to acquire tangible fixed assets (a+b) (130)
Payments to acquire fixed assets investment (c ) (20)
Receipts from the sale of tangible fixed assets (f+g) 250
Net cash generated/ (used) from investing activities 1,250
The rest of the items should be shown under acquisition and disposal (financing
activities)
(f) Cash flow from financing activities (borrowing and issuance)

This item represents the cash flow from raising or repayment of capital and
borrowings. The activities can be classified and disclosed as cash flows
from financing activities if the above activities involve cash transactions
during the year. Any investment and financing that do not affect cash flow
is not disclosed, but shown in the schedule to the cash flow statement.
The transaction, as shown in the table below, illustrates the transaction to

be classed as financing activities:-

Table 6.5: Cash flow from Financing Activities
CASH FLOW FROM FINANCING ACTIVITIES RMÊ000

Proceeds from share issue 250
Increase in short-term borrowings 50
Repayment of long-term loan (20)
Capital element of finance lease rental payments (40)
Net cash generated/ (used) from financing 240
(g) Net increases/decrease in cash and cash equivalents

This covers cash, any deposits that are repayable on demand, together with
bank overdraft and other loans that are repayable on demands. For
example a company had opening cash balances of RM30,000 and closing
cash balances of RM45,000, the cash flow statement would show an increase
in cash of RM15,000.
6.2 FINANCIAL RATIO ANALYSIS

Now, we are going learn about ratios and how to determine the ratios that are
important in evaluating a company financial performance based on cash flows
information. Cash flow ratio can assist us as analysts in evaluating a companyÊs
financial performance in terms of its strengths and weaknesses, financial
management, investing policies, profitability, efficiency, cash sources, and cash
adequacy. Cash flow data can be useful in predicting bankruptcy and financial
distress. Developing benchmarks for each cash flow ratio in a particular industry
can make the ratio more meaningful.
Useful ratios can be constructed from data on statements of cash flows, the
income statement, and the balance sheet:
(a) Example of cash flow ratios:

A company has 100,000 shares of common equity outstanding. The
companyÊs turnover is RM1, 000,000 and has total assets of RM1, 164,000.
The ratio computed should be compared with prior yearÊs ratio of the
company, with the ratios of similar companies, and with the industry in
which the company operates. The ratios could also be compared with
budgeted ratios that were available. Compute the following ratios
associated with the cash flows statement:

(i) One ratio to provide some information concerning the quality of the
companyÊs earnings for the period.
Net income
Cash provided by operating activities
RM34,000
RM70,000
0.486
For every RM1 from operating activities, it gives the company about
RM0.486
(ii) Two ratios related to financial management as reflected in operating

activities and financing activities of the company.

Total sources of cash
RM70,000
RM164,000
0.427
For every RM1 from sources of cash, it gives the companyÊs operating
activities about RM0.427.
Cash provided by financing activities

Total sources of cash
RM202,000
RM164,000
1.23
For every RM1 from sources of cash, it gives the companyÊs financing
activities about RM1.23.

(iii) Cash flow per share of common share capital.
Net increase in cash

Number of common share capital outstanding
RM164,000
100,000 shares
1.64
(iv) Dividend payout
Dividend per RM
RM8,000
RM70,000
0.114
For every RM1 from sources of operating activities, its give the companyÊs
about RM0.114, which means RM0.114 dividend per RM is derived from
cash provided by operating expense.
(v) Reinvestment
Dividend per RM
RM8,000
RM70,000
0.114
(vi) Efficiency: (1) sales and (2) total assets.

Turnover
RM70,000
1,000,000
0.07

6.3 ANALYSIS IMPLICATIONS OF CASH FLOWS

We are going to explain the limitations in cash flow reporting as a source of
information in determining company performance. However it cannot possibly
give us all the answers when determining a companyÊs performance.
Now letÊs look at these items as follows which explains the limitation of cash
flow and what the cash flow fails to tell us:-
Ć What is happening today. Remember, that itÊs out of date when we finally
obtain and read the cash flow statement. A cash flow statement is a record of
historical facts. It will record expenditure of a new plant and machinery but it
does not explain whether it is important for business expansion or whether or
not it will be profitable.
Ć The companyÊs borrowing facilities, or how close the company was utilised to
its maximum facility in the year (although it is available elsewhere in the
companyÊs accounts).
Ć Similarly, it may show an expansion of inventories (or debtors), but it does
not tell us whether this was due to:
- poor inventory or production control
- inability to sell the finished product; or
- a deliberate act of policy, because of a feared shortage of supply, a
potential price rise, or the need to build up stocks of a new model or
product before it is launched.
Furthermore, in the case of increased debtors, it will not tell us whether it is

- the debtors who are slow to pay; or
- the credit policy which has changed; or
- the account department that has fallen behind with invoicing; or because
- it merely represents the expansion of turnover.
Ć It will show how new capital was raised, but not tell us the intention or
purpose of the capital.
Ć When companies have large amounts of cash in the cash flow statement, it
does not tell us where the cash is and where it has been spent.

6.4 ANALYSIS OF CASH FLOWS

We have just identified limitation of using cash flow statements; in this unit we
are going to carry out cash flow analysis.
When we look at cash flow statement, we understand that it shows where the
sources of money during the financial year end calendar are. There are some
areas of concern that analysts should look at when analysing companyÊs cash
flow. The questions that we need to look at and ask are as follows:-
Ć Is the company using its resources? This can be determined by the utilisation
and management of liquid resources.
Ć Can the company finance its capital expenditure out of its own resources?
This can be found by deducting the cash flows from return on investment
and servicing of finance, taxation and equity dividends paid from the cash
flow from operating activities (cash flow from investing and financing minus
cash flow from operating activities).
Ć Will the company be able to repay loans from its own resources? This can be
found by:
- Adding this to the cash and short-term investments shown on the balance
sheet;
- Comparing cash outflows to repay loan with the loan-repayment
schedule
Ć Is the company generating more cash than it needs? This may well increase
the share price if the cash balances are increasing every year. This is found in
the same way as identifying whether the company is living within its means
(resources capacity).
Again, to illustrate the cash flow analysis, we are going to use cash flow
information of a listed company, Sapura Crest Petroleum Bhd. We will analyse
the condition and performance of the company using cash flow information.

Table 6.6: Analysis of Sapura Crest Petroleum BhdÊs Cash Flows in Financial Year Ended
2006, 2007 and 2006 (Extracted from Annual Report of Sapura CrestÊs Petroleum Bhd)
2008 2007 2006
CASH FLOWS FROM OPERATING ACTIVITIES

Profit before tax 35,166 21,594 34,271
Adjustments for:
Depreciation of property, plant and equipment 1,311 1,226 663
Gain on disposal of property, plant and equipment (6) (25) 1
Property, plant and equipment written off - 3 4
Share options granted under ESOS 602 166 -
Interest expense 28,874 8,095 9,946
Dividend income (52,662) - -
Interest income (10,154) (11,124) (3,407)
Net unrealised foreign exchange gain (515) (22,644) (3,846)
Operating profit/(loss) before working capital 2,616 (207,568) 37,632
changes (757) (207,568) (143,377)
Increase in balances with related companies 4,320 (1,054) 4,832
Decrease/(Increase) in other receivables 2,775 12,033 2,796
Increase in other payables
Cash generated from/(used in) operating activities 8,854 (199,298) (98,177)
Interest paid (443) (518) (1,414)

Taxes paid (2,963) - (11,501)
Net cash generated from/(used in) operating 5,458 (199,816) (111,032)
activities
CASH FLOWS FROM INVESTING ACTIVITIES 8 230,959 -

Proceeds from disposal of property, plant and (518) (1,013) (295,941)
equipment 187 2,984 2,120
Purchase of property, plant and equipment (14,300) - -
Interest received
Deferred contingent consideration paid for
acquisition of subsidiaries
Net cash (used in)/generated from investing (14,623) 232,930 (294,221)
activities

CASH FLOWS FROM FINANCING ACTIVITIES

Redemption of RCCPS - (20,235) -
Proceeds from issuance of new shares pursuant to 3,123 (165) (118)
warrants 12,856 3,767 596
Proceeds from issuance of new shares pursuant to (165) (165) (165)
ESOS (2,000) - -
Repayment of hire purchase creditors - - 158,259
Repayment of revolving credits (16,367) (9,567) (10,232)
Advances from a subsidiary
Dividend paid
Net cash used in financing activities (2,553) (26,250) 148,505
NET (DECREASE)/INCREASE IN CASH AND (11,718) 6,824 (256,748)

CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS AT 14,330 7,506 264,254
BEGINNING OF YEAR 2,612 14,330 7,506
CASH AND CASH EQUIVALENTS AT END OF
YEAR (NOTE 22)
Quick observations from the above cash flows statement:-
Ć Disposals
There is a large amount of assets disposal that has a big impact on the 2007
cash flows, but only a small amount has been recorded in 2008. The disposal
of assets in 2007 has led to the positive net cash from investing activities.
Ć Increasing dividends
The cash outflow for dividends rose dramatically, from RM16.36Mil in 2008
from against RM9.56Mil in 2007 and RM10.23Mil in 2006.
Ć Increasing capital expenditure (cash outflow) and financial investment

The company capital expenditure fell steadily from 2006 to 2008, however
overall cash flow from investing recorded a net cash due to the proceed from
disposal of property, plant and equipment for RM232Mil in 2007 and but in
2008 itÊs only recorded a small amount of RM8,000.
Ć Living within its means (within its resources capacity)?

The companyÊs cash flows from operating activities during 2007 are not
sufficient to cover capital expenditure in 2007, but in 2008, net cash flows
from operating activities are able to cover capital expenditure amount in
2008.

Ć Able to repay loans?

The company is able to service the scheduled loans and the company has also
paid-off revolving credit in 2008. The trend of repayment is consistent and we
can conclude that there is no other new long-term facilities that have been
taken-up by the client. But to explore the repayment in detail, we have to look
into the notes in the balance sheet, and the amount due in 12 months (loan
repayment schedule).
Ć Cash interest cover

This measures a companyÊs ability to pay interest out of the operating cash
flow and is calculated by using the following formula:
Cash flow from operating activities

Interest paid
The net cash from operation in 2008 is bigger than repayment of

loans/financing for 2008, however in the earlier year; it indicates that cash
flows from operation (used or deficit) are in red which might not indicate as a
good signal.
Ć Operating cash flows

This item shows us that:
ă The net cash from operating activities rose dramatically in 2008, as

compared to 2006 and 2007 which recorded net cash used (deficit).
ă The company is expanding business operations in 2008 that led to high

profit before tax against two consecutive years that recorded net cash
used.
ă The net cash used recorded in the year are due to a significant amount of
changes in working capital in 2006 and 2007.
We can conclude that the company is in the midst of recovering in 2008,

however we find that part of the business strategy is to finance the business
cycle. And we notice that short term business income is done through short
term revolving facilities.

ACTIVITY 6.3
Relate to the company that weÊve selected, Sapura Crest Petroleum Bhd.
Can you see how we can improve the overall cash flows reporting so
that it attracts shareholder to reinvest in the company?
ACTIVITY 6.4
Review the process of analysing Cash flows. Can we distinguish and

identify the ways to improve cash flows reporting?
 Analysis of cash activities must be related and must start with accrual
analysis.
 Statement of cash flows is found in FRS 107, which classed cash flows as a
part of financial reporting.
 Cash flows indicate the cash inflow and outflows during the year consisting
of operating activities, financing activities, investment activities and cash
balances.
 Cash flows consists of two methods of preparation namely: direct method
which is suitable for non-finance users and investors and the indirect method
which is suitable for accountants and finance users in their decision-making
purposes.
 Cash flows has certain limitations.
 If we carried-out cash flows analysis, we should focus our analysing on:
- Impact from disposal of assets
- Increasing dividends
- Increasing capital expenditure (cash outflow) and financial statement.
- Living within resources capacity.
- Determining companyÊs ability for sustainable using the cash that they
owe.
- Decision to be made based on the findings and assessment.

Capital expenditures Free cash flow

Cash and cash equivalent Indirect method
Direct method Mark-up profit (for the mode of Islamic
Financing)

Topic X Return on
7 Invested
Capital
LEARNING OUTCOMES
1. Recognise the importance of return on invested capital;
2. Analyse the components of return on invested capital;
3. Evaluate the two ratios that effect return on invested capital;
4. Compute and interpret return on assets; and
5. Analyse and interpret return on common equity.
X INTRODUCTION
This topic focuses on how we carry out analysis on a companyÊs return. Our
focus is on the return on invested capital and the variation of capital that has
been analysed. Using relevant measures and tools such as ratio analysis, we will
learn about the impact it has on a companyÊs performance.
ACTIVITY 7.1
Identify the factors that cause increases of return on assets for the short
term and long term. Identify the impact it would have on investorÊs
decision making.

TOPIC 7 RETURN ON INVESTED CAPITAL  131
7.1 IMPORTANCE OF RETURN ON INVESTED

CAPITAL (ROIC)
LetÊs begin our analysis by learning about the importance of return on invested
capital (ROIC) in our analysis. First of all, analysis of ROIC is sometimes also known
as return on investment or return on capital employed (ROCE). ROCE is widely
used by Bursa Malaysia in their report and analysis. The ultimate objective of ROCE
or ROIC is to determine the performance and return from our invested capital, and
the ability to raise capital from different sources, invest and determine the invested
return as well as determine the ability to pay the investment obligation.
We can list out some important factors of ROIC in company analysis as follows:
(a) Measuring Managerial Effectiveness

The effectiveness and effort to utilise and manage the invested capital is
related to the skill and competency of the management, with the objective
to maximise return to the shareholder. This relates to the agency theory
where the management is responsible for business operation and strategy,
and at the same time responsible to give better returns to stakeholders.
(b) Measuring Profitability

ROIC is the key success factor and key performance indicator to a
companyÊs sustainability in terms of profitability (profit and loss
performance) and the quality of its assets (balance sheet).
(c) Measure of Forecasted Earnings

ROIC is the key success factor and key performance indicator to the
companyÊs earning forecast. The expectation to improve a companyÊs
earning is based on current business strategy, business prospect and
current ROIC with some adjustment to achieve the projected ROIC for the
next financial year-end. Current and forecasted ROIC is used to attract
prospective investors or creditors as sources to invest in a company.
(d) Measure for Planning and Control

ROIC is the key success factor and key performance indicator to the
companyÊs planning and control. ROIC is used as a tool to gauge the
performance of the business operating units. Certain levels or indicators of
ROIC can be used as an early signal to ensure the companies are well
managed and are controlling all the resources and projects effectively.
The objective is to ensure their return or profitability is not below the level
or indicator that has been established for the companyÊs ROIC.

132  TOPIC 7 RETURN ON INVESTED CAPITAL
7.2 COMPONENTS OF RETURN ON INVESTED

CAPITAL
When we look at invested capital components, we must know that it reflects the
income and financing levels of the company. It shows the components of income,
assets and equity capital that have been used to generate income.
We start our explanation of the ROIC components as follows.
7.2.1 Defining Invested Capital

Now letÊs move on to these items as follows which are classed as components of
return on invested capital:
(a) Total Assets

Total assets are part and parcel of ROIC assessment. It shows how the
company is effectively managing the assets. In order to measure the return
from total assets, the analysis of total assets does not differentiate the asset
from internal sources or external sources (financing/borrowing). The
analysis of total assets components must take into consideration the three
adjustments as below:
(i) Intangible Assets Adjustment
Adjustment has to be made to exclude intangible assets from invested
capital. This is because the value of intangible assets, which are
subject to annual adjustment, has to be made to ensure we evaluate
the correct value of total assets.
(ii) Accumulated Depreciation Adjustment
Adjustment has to be made to ensure it is consistent with the
computation of net depreciation expenses in profit and loss.
(b) Equity Capital

The use of equity capital as the basis of ROIC reflects the level of leverage
(debt) capital. Therefore, debt equityÊs mode of financing such as preferred
share is excluded from the computation of return of equity capital, since it
gives fixed return to the company.
(c) Book Value versus Market Value of Capital

ROIC is normally computed using historical information rather than
current market values. Sometimes interim reporting or market values are
more accurate to give a true picture of the companyÊs condition. Research

houses, via periodical research analysis, typically use current market value
to provide analysis to investors or users.
(d) Investor versus Company Invested Capital

A company must differentiate between the companyÊs invested capital and
investorÊs invested capital (price paid for companyÊs securities).
(e) Computing Invested Capital for the Period

We are going to compute invested capital by comparing its income for the
period against the investment for the period. The invested capital is based on
average capital for the period due to the changes in the capital for the period.
7.2.2 Defining Income (Profit)

Income is essential in determining ROIC. Therefore, the definition of income
depends on:
Ć Whether or not we use income before interest expenses if invested capital is assets.
Ć Whether or not we use income after tax and preferred dividends if our
invested capital is common equity capital.
Ć The userÊs perspective. Tax is excluded due to the fact that tax is not
considered as operating items. However we must recognise tax expenses.
This is because it reduces income, especially to determine invested capital for
return on shareholdersÊ equity.
7.2.3 Adjustment to Invested Capital and Income

Analysts should be aware that accounting figures which are not included in the
financial reporting need to be included here. Therefore, some adjustments have
to be made to ensure we get the accurate figure for any decision making
purposes.
All companies make five major adjustments to ensure that the costs that are
charged to the profit and loss account are those that relate to the sales that have
been made within the period.
Changes are made to the profit and loss account to include:

(i) Provisions for likely costs
(ii) Accrued expenses
(iii) Depreciation

The following are adjustments made in a balance sheet:

ă Stock ă a companyÊs policy on valuing stock can have a significant impact on
the reported profits. Higher stock values can give higher profits (refers to
analysis of current assets-stocks)
ă Prepayments
The calculation in 7.3 shows two different calculations of return on assets:

standard calculation without adjustment and adjusted calculation.
7.3 ANALYSING RETURN ON ASSETS
7.3.1 Computing Return on Invested Capital

Now, letÊs continue with our analysis. We are going to start our analysis of ROIC
by using ratio analysis and financial information as follows:
Table 7.1: Mstar Bhd, Profit and Loss Account for the year ended 31 December
for calculation and analysis
2007 2008
(RMÊ000) (RMÊ000)
Turnover 1,100 1,000
Cost of sales (650) (600)
Gross Profit 450 400
Administration & expenses (160) (130)
Distribution expenses (70) (60)
Rationalisation provision (10)
Operating profit (profit before tax and interest) 220 200
Interest received 40 20
Interest paid (10) (70)
Profit before tax 250 150
Tax (60) (50)
Profit after tax 190 100
Dividends (100) (60)
Retained profit 90 40
Note: Depreciation charged to operating profit 45 50

Table 7.2: Mstar Bhd, Balance Sheet as at 31 December for calculation and analysis
2007 2008
(RMÊ000) (RMÊ000)
ASSETS
Fixed assets
Tangible fixed assets
Cost/valuation 1,500 1,650
Depreciation to date (700) (750)
Book value 800 900
Investments 200 200
1,000 1,100
Current assets:
Stocks:
Raw material 30 50
Material in progress 120 200
150 300
Trade debtors 170 240
Cash 120 70
440 610
TOTAL ASSETS 1,440 1,710
Current Liabilities(due in a year): 80 100

Trade creditors 60 50
Tax 80 60
Dividends 0 0
Bank borrowings 0 0
220 210
Long-term Liabilities (due more than a year):

Loans 60 100
Provisions for liabilities and charges 10 20
70 120
Capital and reserves:

Share capital (RM1.00 shares) 150 200
Share premium 50 130
Revaluation 60
Goodwill (300) (300)
Profit & Loss Account 1,250 1,290
1,150 1,380
TOTAL LIABILITIES AND EQUITIES 1,440 1,710

Firstly we will identify ROIC by computing return on capital employed (ROCE).

The return on invested capital is a measure of the return being generated on the
capital that is being used by the company. The typical calculation used by
analysts defines the capital as a long-term capital tied-up in the business. This is
regardless of whether the capital is in the form of equity or debt.
However, in recent years many analysts have changed the approach to compute
ROCE by including short-term debt as part of ROCE.
The objective of ROCE is to measure overall return earned on all the capital
employed including loans as well as equity, i.e. evaluates companyÊs
performance.
Typically, the traditional definition of capital employed is the total assets less
current liabilities. This equals the capital + reserves + minority interest +
provisions + creditors falling due in more than a year.
ROCE will guide us to compare companies with different capital structures, to

identify who is generating the best return overall. If our area of concern is purely
with the return of shareholders, we would compute return on equity ratio.
The ROCE is simply:

Profit before tax and interest
Capital employed
Why do we choose profit before tax and interest? Why not after tax? The answer
is simply because we want to ensure that we are able to compare performance in
two ways:
(a) Over time ă we want to look at profit before tax, due to the fact that tax
rules change every year (refer to our nationÊs budget). If are trying to
evaluate a companyÊs performance over time, we need to ignore the factors
outside its control.
(b) With other companies in the same sector ă if we want to compare

companies with different capital structures, we have to recognise that the
price that the company pays to service debt and interest comes out of pre-
tax profit. Dividends come out of after tax profit. Using profit before
interest ensures that we are computing apples with apples.
Now letÊs focus on this financial information from Mstar BhdÊs financial
reporting given to all of us as readers, students or analysts to compute the return
of capital, and all subsequent ratios.

First we look at these ratios, the return on capital employed:
Ć Standard Calculation
2007 2008
Profit before tax (RMÊ000) (RMÊ000)
and interest 220 = 18.0% 200 = 13.3%
Capital employed 1,220 1,500
After adjustment in the financial figures, we will get different result.
Ć Adjusted Calculation
2007 2008
(RMÊ000) (RMÊ000)
Profit before tax and
interest 220 = 14.5% 200 = 11.5%
Then, we can see that the return on capital has fallen over the two years, but this
information on its own is not as useful as it seems. We would also need to know
more detail in order to make more of an accurate decision.
ă What the companyÊs return on capital was in preceding years;
ă What the risk-free rate is (for example money market or fixed deposit
placement), and how risky the company is; and
ă What returns on capital other companies in the sector got.
When conducting company analysis, all ratios need to be looked at in context,

not in isolation; therefore any ratio is tied-up with others.
7.3.2 Improving Return on Invested Capital

How about improving the ROIC? Why? Improving the return on capital is a
combination of improving profit margins and to ensure that it is becoming more
efficient in the utilisation of capital. LetÊs look at these relationships and we will
learn more about ratios that are related to ROIC.

Figure 7.3: Relation between capital employed and revenue (turnover or sales)
If we expand the ratio, we can then improve the other two ratios. The return on
capital is a straight-line multiplication of the two ratios as shown above. It is also
known as asset turns, which is derived from profit margin and asset turnover or
asset turn.
The asset turnover tells us how many ringgit worth of sales are generated for
every ringgit of capital. It is a measure of how efficiently the company is utilising
its capital. When it indicates a fall, this shows that the company is becoming less
efficient, a rise indicates improved efficiency.
The ratio indicates that profit margin is unchanged over the year
2007 2008
(RMÊ000) (RMÊ000)
Profit before tax and 220 = 20.0% 200 = 20.0%
interest
The calculation below shows the fall in the return on capital arises solely from the
reduction in the asset turn:
Standard Calculation
2007 2008
(RMÊ000) (RMÊ000)
Turnover 1,100 = 0.902 1,000 = 0.667
Adjusted Calculation
2007 2008
1,100 = 0.724 1,000 = 0.575
Turnover

The adjusted calculation above also indicates the fall in the return on capital. We
can see every ringgit of capital generated RM0.724 sales in 2007, but in 2008 this
has fallen to RM0.575.
Therefore, if the company wants to improve the return on capital employed, it

has two options:
Ć Improve its profits margin; or
Ć Use its assets more effectively to generate more sales per ringgit of capital; or
Ć Invest in the business.
7.3.3 Ratios that Influence Return on Invested Capital

I believe that you now fully understand the relationship between asset turn and
return on capital invested. As we have discussed earlier, we now know that asset
turn is tied-up to return on capital invested.
This is illustrated in Figure 7.4 below:
Figure 7.4: Relationship between asset turn and return on capital invested
Now, to comprehend the linkages between the ratios, letÊs look at the two ratios,
which linked to the return on capital invested, is asset turn or asset turnover and
working capital ratio.
(a) Asset Turn

Asset turn (asset turnover) measures the effort which companies utilise its
assets to generate sales so this would ignore any investments, as they do not
generate sales. Asset turn would generate income, either from associated
undertakings, or as dividend income. Any intangible assets will be included
if they can generate sales and other items can only be included if they can
generate sales. Revaluation is excluded because it will distort the trend.

In our example, the fixed asset turn would be calculated as follows:
2007 2008
(RMÊ000) (RMÊ000)
Turnover 1,100 = 1.38 1,000 = 1.19
Fixed assets 800 840
From the calculation, it can be concluded that the additional investments in

fixed assets has not generated any additional sales. This would be perfectly
acceptable if the investment had been made to improve the production and
to reduce cost (many capital expenditure projects are justified by cost
reduction). Unfortunately, this had not happened either. However, it may
be that the equipment had only recently been installed and the company
has yet to receive any benefits.
(b) Working Capital Ratio

Working capital normally consists of stocks, plus trade debtors and less
trade creditors. Therefore, the working capital example will be:
2007 2008
Inventory (RMÊ000) (RMÊ000)
150 300
plus Debtors 170 240
less Trade creditors (80) (100)
Working capital 240 440
So we can compute working capital ratio:
2007 2008
(RMÊ000) (RMÊ000)
Working capital 240 = 21.82 440 = 44
Now, we know from the calculation that in 2007, 21.82 percent of the turnover is
needed for the working capital. However, the ratio is at a rise in 2008 even
though there is a small decrease of turnover. It indicates that we need to improve
working capital requirement in order to maintain the current sales. This might be
influenced by rising cost of material or increasing of working capital requirement
during the year end or that probably the stock carrying days have been
increased.

We have explained the ways we calculate the working capital ratios, but how are
we going to determine how the company can improve the ratio, to give a better
picture to users? As analysts, how can we determine the trend?
Firstly, we should look at the stock. You have got two ways to look at the
company inventories: by looking at how many years the company has turned its
inventory over, or you can work out how many days the company is carrying its
inventory. We can use any tool to measures the inventory efficiency.
Secondly, it is normally difficult to obtain the inventory related to sales and the
merchandise sales period, but we could use cost of sales as a rough calculation.
We could use sales based using these ratios, turnover/inventory or cost of sales
based using cost of sales / inventory ratio.
And thirdly, we could calculate sales using inventory days using

inventory/turnover x 365 days or cost of sales based by using inventory/cost of
sales x 365 days.
I believe that all this is a bit complicated, but we will learn about working capital
analysis and ratio in the last topic that deals with credit analysis.
7.3.4 Asset Turnover Analysis and its Correlation with

Turnover
In our earlier discussion, we have learnt about the tools in analysing asset
turnover. We should now look at components of asset turn that are related to
return on capital invested. This is because any changes of these factors might
significantly change the numbers that represent the performance of the company.
Refer to the Figure 7.5.

Figure 7.5: Relationship between assets and turnover
7.4 ANALYSING RETURN ON COMMON

EQUITY
7.4.1 Computing Return on Common Equity

Now letÊs begin learning about return on invested capital by first understanding
return on common equity. Why common equity? Common equity is important to
investors in terms of the power to control the company using their right to vote.
Where creditors and preference shareholders are present, we assume that
creditors prefer dividend because creditors have to deal with fixed interest.
This ratio indicates the managementÊs success or failure at maximising the return
to common equity based on their investment in the company.
Now, as an analyst whatÊs the objective of return on common equity? The

objective is to measure the overall return from our equity (minus preferred
shares).
LetÊs move on with our analysis. We are going to expand our analysis of ROIC by
using ratio Return on Common Equity (ROCE). In actual situations, we use the
ratio as computed as:
Net Income ă Preferred dividends
Average common equity

Therefore we compute MstarÊs ROCE for the 2008 as:
2008
(RMÊ000)
Net Income ă Preferred Dividend 220 = 0.17
Average Common Equity 1,265
We can also expand the ratio into these components:
Ć ROCE = Adjusted profit margin x Asset turnover x Leverage
Net
Net income-
income-
Preferred
Preferred x x Average
dividend =
dividend Sales assets
Average common Sales Average Average
equity assets common equity
2007 2008
(RMÊ000) (RMÊ000)
Profit before tax and 220 = 20.0% 200 = 20.0%
interest
7.4.2 Improving Return on Common Equity

In our earlier discussion we have managed to understand return on equity, now
we are going to look at the broad picture: from a comprehensive return on
invested capital.
The comprehensive formula takes into account the major items to go to the
balance sheet and income statement and so represents a comprehensive overview
of performance.

Figure 7.6: The relationship of ROIC to balance sheet and income statement
The basic formula for computing a comprehensive return on invested capital

involves the following components:
Return on
Invested Capital = Capital turnover x Profit margin
Return on = Turnover x Net profit

Invested Capital
Capital employed Turnover

Capital turnover is the ratio of turnover (sales or revenue) to capital employed in

generating the sales. Capital turnover is a measure of the use of assets in relation
to sales. Typically, the larger the volume of sales that management can generate
on a given investment in assets, the more efficient are its operation. Capital
employed can be either (1) working capital (i.e. current assets minus current
liabilities) or (2) total assets. Profit margin is the ratio of net profit to sales.
The figure below shows us how to compute ROIC:
Condensed Income Statement RM

Turnover 1,000,000
Less: Cost and expenses 800,000
Net Income 200,000
From Balance Sheet RM

Working capital 100,000
Plant and equipment 300,000
Total assets (capital employed) 400,000
Return on Invested = Turnover x Net Profit

Capital Capital employed Turnover
Return on Invested = 1,000,000 x 200,000

Capital 400,000 1,000,000
Again, ROIC can be restated as follows:
Return on Invested = Profit margin x Capital turnover

Capital
Return on Invested = 20% x 2.5

Capital
Figure 7.7: Computation for return on invested capital

Various actions can be taken to improve ROIC including the following:

(i) Increase total revenue (turnover or sales) by increasing volumes, sales price
while maintaining or improving the margin on sales.
(ii) Decrease expenses, thereby increasing net income
(iii) Reduce the amount of capital employed (for example, reduce the stock level
inventory), improve collection of trade debtor without decreasing sales.
Now, we have computed ROIC, itÊs time to explain advantages of using ROI
analysis as follows:
(i) Focuses managementÊs attention on earning the best return on total assets
(ii) Serves as a measure of managementÊs efficiency and effectiveness
(iii) Integrates financial planning, budgeting, sales objectives, cost control and
profit-making activities.
(iv) Provides a basis for comparing companies
(v) Provides a motivational basis for management
(vi) Identifies weaknesses in the utilisation of assets
ACTIVITY 7.2
Review the process of analysing return on invested capital. How are we

going to utilise and maximise the return of assets?
 The objective of ROCE is to measure overall return earned on all the capital
employed including loans as well as equity, i.e. evaluation of companyÊs
performance.
 The ultimate objective of ROCE or ROIC is to determine the performance and
return from our invested capital and the ability to raise capital from different
sources, invest and determine the invested return as well as determine the
ability to pay the investment obligation.
 Some importance factors of ROIC in company analysis are as follows: -
ă Measuring managerial effectiveness
ă Measuring profitability

ă Measure of Forecasted Earnings

ă Measure for Planning and Control
 Various actions can be taken to improve ROIC including the following:-
ă Increase total revenue (turnover or sales) by increasing volumes, sales
price, or some combination, while maintaining or improving the margin
on sales.
ă Decrease expenses, thereby increasing net income
ă Reduce the amount of capital employed (for example reduce the stock
level (inventory), improve collection of trade debtor without decreasing
sales.
 Advantages of using ROI analysis are as follows:
ă Focuses managementÊs attention on earning the best return on total assets
ă Serves as a measure of managementÊs efficiency and effectiveness
ă Integrates financial planning, budgeting, sales objectives, cost control and
profit-making activities.
ă Provide a basis for comparing companies
ă Provides a motivational basis for management
ă Identifies weaknesses in the utilisation of assets
Capital turnover Return on capital invested (ROIC)

Return on assets (ROA) Return on common equity (ROCE)
Return on capital employed (ROCE)

Topic X Profitability
8 Analysis
LEARNING OUTCOMES
1. Explain the importance of company profitability analysis;
2. Analyse and interpret company revenue, its sources, recognition and
approach to asses profitability;
3. Determine the company gross profit and factors to improve gross
profit;
4. Evaluate the company expenses, measurement and analysis; and
5. Summarise the issues in analysis company revenues.
X INTRODUCTION
This topic focuses on how we carry out profitability analysis, by analysing and
explaining income components. Our analysis will focus on the components of
income and expenses made in the profit and loss account. These include sales,
cost of sales, taxes, selling and marketing expenses, and financial cost. We are
going to distinguish the components of income, the expenses and impact for
financial analysis.
ACTIVITY 8.1
Identify two factors that could go up with the gross margin, and two
factors that could go down with the gross margin. Identify the impact
to the companyÊs profitability. If for the past three years it shows a
consistent slip in profitability, what are the measures to curb this
trend?

TOPIC 8 PROFITABILITY ANALYSIS  149
8.1 ANALYSING COMPANY PROFITABILITY

We begin our analysis by learning about the importance of profitability to
different types of users. To understand better the analysis of company
profitability, we are going to have to determine companyÊs profitability based on
these issues:
Ć What is the method to measure the companyÊs income?
Ć What is the quality of income?
Ć How persistent (including stability and trend) are income and its
components?
Ć What is the income power?
For creditors, the above questions are important for any decision making such as
to offer credit lines or not based on profitability performance.
8.1.1 Factors in Measuring Company Income

Below are the numbers of issues that is essential in measuring income. It consists
of four aspects:
(a) Estimation Issues

Estimation issues are based on future events when the revenue and
expenses can be predicted and recognised.
(b) Accounting Method

The income measurement is based on regulatory needs which are governed
by accounting standards such as International Accounting Standard or local
accounting standard, e.g.: Malaysia Accounting Standards (FRS). These
reflect how the income is being measured and reported.
(c) Incentive for Disclosure

The incentive for disclosure is aimed to provide fair view to users. The
incentive gives the company motivation to disclose profitability income as
an effort to attract investors or any business decision that can give the
company an advantage over competitors.
(d) Diversity across Users

The objective of profitability reporting is to serve the interest of many users.
Therefore analysts should conduct and adjust the profitability analysis
based on userÊs requirement.

150  TOPIC 8 PROFITABILITY ANALYSIS
8.2 ANALYSING COMPANY REVENUES
8.2.1 Issues In Analysing Company Revenues

Now letÊs look at our analysis of revenues that are based on several areas as
follows:
(a) Major Sources of Revenue

It is important to distinguish the major sources of revenue. Different
companies have different sources of revenue based on the product,
corporate structure, market capitalisation, location, market size, business
plan and competition. Therefore, analysts have to carry out in-depth
analysis to explain the major sources of income.
Figure 8.1: Extract from Maybank Equity Research on KFCÊs Malaysia sources of income
The above figure shows the revenue (turnover) of KFC Holdings Bhd.
Using segmental analysis; this shows the biggest sources of revenue come
from KFC (fast food restaurant), secondly from Integrated Poultry and the
rest from other activity or subsidiaries. On the right hand side, it also
reveals the factors that lead to the rise and fall of the figure. Analysts
normally use common size approach to show the major class of revenue.
Students can use different approaches or diagrams to show the analysis.
The most important part of our presentation is to ensure that the reader
understands what we are going to deliver to them.
(b) Persistence of Revenues

Part of revenues assessment is stability and trend. Stability and trend are
issues that are important for any analysis. Two useful methods in assessing
stability and trend are listed as follows:
Ć Trend Percent Analysis

A trend percent analysis is used by setting 1=100. Revenues are evaluated
based on indexes segments.
Example:
FYE 2008 FYE 2007 FYE 2008 FYE 2009

SegmentÊs Turnover Yr 1 Yr 2 Yr 3 Yr 4
RestaurantÊs chain 100 110 114 121
Poultry 100 120 135 150
Distribution ArmÊs 100 98 94 90
From the above figures, it shows that Year 1 (base year) starts with 100, Year 2 to
4 show the up and down of the segment. All segments show growth due to the
increases in consumer spending and market demand. Only distribution segments
record down trends, this is due to the increases of global fuel cost from FYE2007
onwards. ItÊs easy for decision makers to look at the trends when we use this
approach.
Ć ManagementÊs Discussion and Analysis (MD&A) (or Board of DirectorÊs

Report)
Our local context of MD&A is known as Board of DirectorÊs Report or BDR
and can be obtained in the companyÊs annual report.
BDR is a statutory requirement for companiesÊ financial statements in Malaysia.

In terms of revenues reporting, BDR reports consolidated accounts of companies
and groups for the financial year in respect to the state of affairs of the holding
company and all its subsidiaries at the end of the financial year. The revenue of
income is often revealed in BDR. This report explains the sources and the trends
of revenues as well as any event that takes place and that leads to effect of
revenue reporting.
In terms of revenue reporting, BDR reveals the information that is related to

revenues as follows:
Ć Any changes in revenues and expenses due to the changes in operating cost.
Ć Any growth of revenues and its impact to the overall revenues
Ć Provides information and notes that relate to financial reporting but are not
explained in the financial reporting.

152 X TOPIC 8 PROFITABILITY ANALYSIS
Figure 8.2: Board of DirectorsÊ Report, extract from Sapura Crest Petroleum BhdÊs Annual
Report ă Chairman Statement.
The ChairmanÊs Statement reveals the prospect and outlook of the company to
tap market opportunities in the sectors that they are involved in.
8.2.2 Relationship between Revenues, Receivables

and Inventories
These items have been discussed in Topic 5. However, students must understand
that any expansion in capital expenditure (assets to generate income) might lead
to additional inventories to produce products, increases of receivables due to
increases of collection period and finally increases of turnover. Those expansions

might be financed via external funding such as borrowings or internal funds such
as retained earnings.
These items are related to each other. Relationship between revenues and
receivables is based on the operating cycle which can be explained by short-term
liquidity. When conducting analysis, analysts should be aware that some
relationships are based on business strategy such as extension of credit sales. Any
collection of sales might affect revenue trends. This can be gauged by conducting
a trend analysis for at least 2 or 3 years.
Figure 8.3: Shows relationship between assets, inventories and collections that have
direct impact to turnover/revenue
However there are number of problem of revenue recognition when a company

intends to increase its revenue.
In a cash business, it is not too difficult to recognise revenue, but in credit sales it
is complicated to recognise revenue. In earlier topics, I believe you have been
shown diagrams and figures on how company recognises its revenue.
The problems in recognising revenues are as follows:

Ć Delivery of goods or transfer of titles (ownership) that determine revenues.
Sometimes, company adjusts the process by delaying the delivery until the
end of the year to show companyÊs revenue.

Ć Revenue is bridging different accounting periods. It is difficult to find out

when revenue is linked to different accounting periods as in the case of long-
term contracts. Companies must then determine the accounting period in
which they will recognise the revenue.
Ć Calculating the percentage of completion. In long-term contracts, there are
different ways of calculating the percentage of contract completion that will
give different revenue figures. Some companies might recognise based on
agreed stage payment or percentage of completion.
The relationship between revenues and inventories is related to the quality of

inventory and assets turnover. The increases in finished products might lead to
decreases in raw material purchases or work in process, and thus we expect a
decline in production.
8.3 ANALYSING COMPANY COST OF SALES

The cost of sales is normally the biggest cost item of companies. It indicates the
cost of purchasing material or cost of providing services depending on a
companyÊs activities. It is important to identify whether a companyÊs
effectiveness in purchasing material affects gross margin.
8.3.1 Gross Profit and the Changes Impact to the

Profitability
As the largest cost incurred, cost of sales is a component of gross margin. Gross
margin is defined as revenues less cost of sales.
Analysis of gross profit requires analysts (especially external analysts) to access

non-disclosure information and data. Such data consists of numbers of units sold
as well as unit per cost and per selling prices.
Analysis of gross profit is focused on the changes of cost of sales items. The
changes that we should look at are:
Ć Increase/decrease in sales volume
Ć Increase/decrease in sales price
Ć Increase/decrease in cost per unit

8.3.2 Improving Profit Margin

When measuring cost of sales, we should also be aware of factors that represent
the elements of profit margin. There are two ways to improve profit margin, either
increase the sales or reduce the costs. Increasing the sales is an obvious strategy for
the company, but this would make it more difficult for the users of financial report
to spot. It is much easier to spot companies trying to reduce their cost.
While conducting analysis, we should keep in mind these factors and whatÊs the
explanation behind such factors because these factors can indicate the improving
of profit margin or decreasing of profit margin.
There are factors that we should be aware of when conducting gross profit
assessment:
(a) Operating Profit

This is an important component of profit before interest and tax (PBIT)
margin. Any analysis of profitability must include an operating profit
margin. If a company wants to improve its profit margin, it must reduce the
cost or grow revenues. It can improve its operating profit margin by
increasing prices, increasing volumes, reducing costs, changing the sales
and product mix (if the margin comes from higher margin product or
services, profit will improve).
It is possible to look at a year-to-year basis to assess the movement of the

cost over a number of years. It would be most appropriate if we can make a
comparison against the competitor in the same market to gauge the pattern,
movement and structure of the cost.

Figure 8.4: Strategies to improves profit margin
(b) Share of AssociateÊs Profit and Losses

It is important to recognise the profit from associates. However using this
information in determining profit margin will distort the ratio because
associates turnover are usually not included in the group turnover shown
in profit and loss.
(c) Profit on Sales of Assets

Depending on the nature of the company business, sales of assets does not
indicate the sources of profit and loss, for example, a company that is
involved in buying and selling properties should not be seen as one-off
companies. For instance, a developer company is always buying and selling
properties as part of its core business and the transactions can indicate the
movement of operating margin.

Figure 8.5: Profit on sales of a property developer and impact to profitability margin
The above figure recorded a dramatic impact for a property developer but
the transactions are not relevant to other sectors such as the manufacturing
or services sectors. Therefore, to ensure our analysis is correct, we should
be well-versed about the type of industry and how they make profit that is
different to other sectors to ensure that we come out with accurate analyses.
(d) Profit on Sale of Subsidiary

Profit or loss on sale of assets should be seen as one-off transaction. If the
company you are analysing has significant profit or loss from selling
subsidiaries, you would be recommended to exclude them from the main
analysis because it is only a one-off transaction that rarely happens.
(e) Profit from Discontinued Activities

A discontinued operation is one that has been sold or terminated during the
year, or shortly after the year end. This means that the assets and liabilities
may still be shown on the balance sheet and therefore included in capital
invested.
(f) Improving the Asset Utilisation

If the company wants to use the same amount (or less) capital to generate
more sales, it needs to improve its assets utilisation. Therefore we need to
look at the trend of spending. We would normally look at two aspects:
improving profitability by improving asset utilisation, and reducing
working capital requirement.

Figure 8.6: Impact of improving assets utilisation
(g) Reducing the Cost

In reality, we should realise most cost cannot be changed. Every sales
documents (invoice) has to show up somewhere in the accounts, but is it an
income statement or a balance sheet item? Certain cost can be capitalised in
balance sheet but this is not allowed with others. Some approaches of
reducing cost involve `paperÊ charges that reflect the cost that relates to the
sales made in the period. These adjustments are known as `creative
accountingÊ for the purpose to cover or hide probable bad debts.
There are two possibilities for creative accounting to reduce the costs:
(i) Charging the cost to the balance sheet. This would include
transferring costs to inventory and capitalising interest.
(ii) Reducing the paper charges made to the profit and loss account. This
would include provisions, exchange differences and depreciation.

8.4 ANALYSING COMPANY EXPENSES

Expenses always match revenues. Sometimes analysts measure the performance
of a company based on its expenses. Analysts typically use a number of tools
such as common-size analysis, index number analysis and operating ratio
analysis.
8.4.1 Selling Expenses

Analysis of selling expenses normally focuses on these areas:
Ć Measuring the relationship between revenues and expenses
Ć Assessing bad debt expenses
Ć Evaluating the trend and productivity of future-directed marketing expenses
8.4.2 Depreciation of Expenses

Depreciation was discussed in detail in the earlier unit. As a paper charge,
depreciation offers considerable scope for creative accounting. There are three
avenues for the decision:
Ć Change the assets life
Ć Change the method of calculating the annual depreciation charge
Ć Change the net residual value
As a student or when we work as an analyst, to spot any changes in the

depreciation policy, you need to read the notes carefully and compare the
accounting policies and profits declared from one year to the next year. If the
profit is declared in 2006, is the same profit shown for the comparative purpose
in 2007? Has there been a significant change in number in the balance sheet? If
there is a change in a number of assets, there has been a change in the
depreciation policy. There is no right and wrong answer of changing the
depreciation policy, our concerned is the trends in performance. Students should
be aware that we are looking to the changes in accounting policy of the company
that make the numbers less comparable. We need to exclude these changes from
our analysis to establish a trend.

8.4.3 Maintenance and Repair Expenses

As an analyst, to spot trend in maintenance and repair expenses is very
important for decision making. These expenses are tied-up with levels of
production or sometimes even the ageing of the plant and equipment.
Maintenance expenses for certain industries cannot be halted and should be done
according to a specific schedule. For example, maintenance for aircrafts must be
done according to flight hours. Therefore, any reduction in maintenance
expenses might lead to the breach of industry safety and customers could lose
confidence in the company and the final impact could be a loss of revenue.
From Figure 8.7, we can see that the company with high maintenance expenses
are due to relying too much on old assets.
Figure 8.7: Impact from expenses in assetÊs maintenance

TOPIC 8 PROFITABILITY ANALYSIS W 161
8.4.4 General and Administrative Expenses

Again, as students or when we work as analysts, to spot trends in general and
administrative expenses is crucial for decision making.
General and administrative expenses mostly consist of fixed expenses such as

salaries and rent. During the healthy economic times, these expenses might go up
because increases in revenue could increase salaries, bonuses, commissions and
travelling expenses. However, some companies take stern action to curb general
and administrative expenses.
For example, one of the biggest foreign banks in Malaysia (credit card unit)
outsourced the function of selling credit cards to third-party companies. This
enabled them to reduce salary expenses, EPF contribution and travelling
expenses.
Therefore, students should also point out the strengths and weaknesses of the
strategies adopted by the company ă whether it can bring down the cost of
general and administrative expenses or not.
Figure 8.8 explains the strategies that are adopted by a company and how it
impacts profitability. Company with less automation and long business processes
cannot avoid high general and administrative expenses (G&A). However,
companies with paperless or a smaller workforce that adopts outsource approach
could very much reduce G&A expenses. For example, an airlines company with a
small workforce could cut the G&A expenses by using check-in machines and
enable clients to use the Internet to book flight tickets. Compare this to a
competitor with a bigger workforce. Indeed, it will need to spend more.
Therefore, an analyst should also point out the strengths and weaknesses of the
strategies adopted by the company on whether it could bring down the cost of
general and administrative expenses or not.

Figure 8.8: Company strategies and impact to profitability
ACTIVITY 8.2
Find out the best strategy to reduce general and administrative cost in
your organisation and justify the strategy that you recommended.
8.4.5 Financing Expenses

Financing expenses or borrowing cost has been discussed in earlier topics and
classified as expenses. Any changes in borrowing or financial expenses could
influence the profitability reporting.
Therefore, if students and analysts are given tasks to evaluate financing cost, they
should understand the borrowing ratio especially interests cover. When we are

looking at a companyÊs borrowings, we are concerned about its ability to pay the
interest and repay the loans when they fall due. To see if the company is having
any difficulties in paying the interest, we need to look at both the profit and loss
account and the cash flow statement.
Interest cover identifies how many times a company can pay the interest out of
the available profit or cash. It is simply calculated as:
Profit before interest
Interest payable
The higher the ratio indicates that the company has a good ability to pay off the
interest. Ideally, we would want to see an interest cover falling between four to
six times, depending on the risk profile of the company. The riskier the company
the more cover we would want to see, as the profit would be more unpredictable.
Most interest cover ratios are prepared from the profit and loss account, but
interest is paid from cash. It is useful to look at the cash interest cover. To do this,
we need to look at the cash flow statement:
Operational Cash Flow
Interest paid
Example:
If a company has profit before interest of RM45,000 and interest of RM30,000, its
interest cover would be 1.5 times. It shows how many times the interest bill could
be paid out of the available profits. An interest cover of 1.5 times would be
regarded as low, if interest rose and profits fell, the company could experience
difficulties paying interest on its loans, it may not be able to repay those loans.
When we undertake borrowing assessment, high level of borrowing and poor

interest cover is an indication of possible future solvency problem.
Example of sub prime or credit crunch crisis can be seen in the case of the United
States in 2008, where banks offered mortgage loans (real estate borrowing) to
clients that have high risk profile i.e. low interest coverage and thus many people
borrowed up to the maximum margin. However, when the US Interest rate went
up they could not cover the monthly repayment. In addition to that, banks
classified the loan as default loans and had to make provision and reported loss
in their financial statements. These not only affected consumer loans but also
corporate loans that finance their property.

Interest cover is crucial when we are given tasks to conduct a companyÊs ability
to repay their borrowings. Companies in Malaysia (listed and non-listed
companies) during the financial crisis of 1997-1998 went into liquidation were
highly geared company (borrowing ratio to shareholdersÊ is bigger) with low
interest covers. In fact, a company does not even need to be highly geared, even if
borrowings are relatively low, it could still have poor interest cover. The
important question is can the company afford to service its debt?
Students can conduct sensitivity analysis to determine the level of profitability

that they can cover interest cover. We could work out the effect that a 1 percent
change in interest rates would have on both earnings and interest cover.
ACTIVITY 8.3
If you are an accountant of a public listed company, how are you going to
analyse and explain to the decision maker on the global impact of credit
crisis if your foreign borrowing exposure is 10% of the companyÊs
borrowings?
8.4.6 Provisions
Provisions have always been used by companies to `smoothenÊ its profits.
Investors, especially from share markets, would like to see a steady growth of
income. For a listed company, disclosing profit on a year creates an expectation
for the next year. For this reason, there is always the tendency to make a large
provision during a good year (taking a prudent view) and small provision in a
bad year.
For example (of a listed company):
If the market expects the company to announce a profit of RM100 million but it
looks like it is going to be RM130 million, should the company report RM120
million? The market usually behaves this way. If the company reports a profit of
RM120 million, they would expect RM130 million next year. So, we could make
provisions to report a stable income for the year.
Most of the provisions have the effect of moving profit from one year to the next.
When analysing accounts, we need to read the notes to see if any provisions have
been disclosed and to determine their impact on the financial performance of the
company.

TOPIC 8 PROFITABILITY ANALYSIS W 165
ACTIVITY 8.4
Relate to the company that youÊve been selected. Select and rank the type
of exceptional or extraordinary item that might affect shareholdersÊ return.
• Components of income and expenses in the profit and loss account consists of
sales, cost of sales, taxes, selling and marketing expenses, financial cost.
• To understand the analysis of company profitability, we should determine
companyÊs profitability based on these issues as follows:
- What is the method to measure the companyÊs income?
- What is the quality of income?
- How persistent (including stability and trend) are income and its
component?
- What is the income power?
• The following below are four issues that are essential in measuring income:
(a) Estimation issues
(b) Accounting method
(c) Incentive for disclosure
(d) Diversity across users
• Major sources of revenue

Company have different sources of revenue based on product, corporate
structure, market capitalisation, location, market size, business plan and
competition. Analysis has to be carried out in-depth analysis to explain the
major sources of income.
• Part of revenues assessment is to determine stability and trends.
• Board of Director Report is a statutory requirement to the financial statement
in Malaysia. This report explains the sources and the trends of revenues as
well as any events that take place that led to effect of the revenue reporting.
• Relationship between revenues and receivables is based on operating cycles
which can be explained by short-term liquidity. Some relationships are based

on business strategy such as extension of credit sales. Any collection of sales

might affect the revenues trends.
 Analysis of gross profit is focusing on the changes of cost of sales items. The
changes that we should look at are:
ă Increase/(decrease) in sales volume
ă Increase/(decrease) in sales price
ă Increase/(decrease) in cost per unit
 Expenses always match revenues. Sometimes analysts measure the
performance based on companyÊs expenses. There are a number of tools to
determine expenses trend such as common-size analysis, index number
analysis and operating ratio analysis.
Accounting changes Impaired asset

Cost of restructuring Impaired asset
Deferred charges Permanent income
Economic income Research and development
Expenses and losses Revenues and gains
Exploration and development cost Special items
Extraordinary items

Topic X Credit
9 Analysis
LEARNING OUTCOMES
1. Explain the importance of liquidity;
2. Analyse operating activities based on liquidity’s aspects;
3. Evaluate liquidity position and additional liquidity measures;
4. Compute the capital structure ratio and solvency analysis; and
5. Summarise the causes of business failure.
X INTRODUCTION
This topic focuses on how to carry out analysis on liquidity aspects, by analysing
and explaining liquidity components. We will focus on liquidity analysis using
accounting based ratios, turnover and operating activities to measure liquidity.
By doing analysis, we will learn about the impact that liquidity position has on a
companyÊs short-term performance. We are going to distinguish the importance
of capital structure and its impact on credit analysis.
ACTIVITY 9.1
Identify at least three factors related to liquidity position. If you were to
conduct financial analysis for a prospective investor, and results show that
the past three years of the company shows inconsistence of liquidity trend,
what would your advice be to the prospective investor? You could list out
your findings and recommendations to justify your advice.

168 X TOPIC 9 CREDIT ANALYSIS
9.1 ANALYSING COMPANY LIQUIDITY AND

WORKING CAPITAL
Now, letÊs starts our analysis by learning about the importance of liquidity to
ensure that a company can meet its current commitment especially to creditors.
To fully understand the analysis of company liquidity, we first have to learn
about the number of liquidity components that are related to liquidity aspects.
For users such as creditors, the liquidity aspect is important for any sort of
decision making like having to offer new credit lines or extending existing credit
lines based on current ratio condition.
9.1.1 Explaining Current Assets and Liabilities

These two components are related to liquidity aspects. Normally liquidity ratios
are dependent on the movement of these two ratios. Working capital
requirement is also dependent on these factors.
Current assets have been discussed in an earlier topic; so, let us recap. Current
assets are cash or other assets that are expected to be converted into cash, sold or
consumed within a one year operating cycle. Current assets normally include
cash, marketable securities (short term), trade and non-trade debtors, inventory
and prepaid expenses.
Current liabilities are typically classified as obligations that are expected to be

satisfied within a one-year operating period. Current liabilities consist of trade
and non-trade creditors, notes payable, short-term borrowings, taxes payable,
accrued expenses and the current portion of long-term borrowings.
Therefore those two aspects are essential in determining further assessment of

liquidity and working capital requirement of a company. A company needs to
strike a balance between existing current assets and liabilities, and forecasted
assets and liabilities to ensure that the company is on the right track in meeting
its obligations. You should take note that this analysis is important for creditors
or short-term investors for making correct decisions. Creditors normally prefer a
company with higher current and quick ratios as well as short operating cycles.
9.1.2 Liquidity Measurement

We have learned that current assets and current liabilities are the important
components of liquidity. However, to compute or to measure liquidity, we have

TOPIC 9 CREDIT ANALYSIS W 169
two approaches that we can work from, working capital approach and current
ratio approach.
(a) Working Capital Approach

Why would we use this approach and who normally uses this approach?
Normally, bankers and trade creditors would prefer a company with
positive working capital.
The working capital is important for two reasons:

Ć Firstly, if it is high ă expansion of the business, especially rapid
expansion, is going to use up a lot of cash.
Ć Secondly, if it not kept under control, the business will use up more
cash than it should.
Some types of businesses are well placed with working capital, for example,
supermarkets and hypermarkets. In contrast, in a sector like building
materials, you would usually find that the company has to keep large
stocks in order to provide good service to its customers nationwide.
The working capital requirement is computed as:
Working capital = Current assets ă Current liabilities
However, students should be aware that positive working capital does not
mean that it is a good signal. Companies sometimes manage working
capital and ratios just before financial statements are presented to make
those items looks ÂbetterÊ. This practice is known as `window dressingÊ.
Refer to the following table.
Table 9.1: Example of Âwindow dressingÊ
2008 2007
(RM’Mil) (RM’Mil)
Inventory 327.8 217.0
+ trade debtors 394.0 316.2
- trade creditors (178.0) (134.2)
= Working capital 543.8 399.0
Turnover 2,127.3 2,038.6
Working Capital Ratio 25.6% 19.6%

If the ratio remained at the 2007 level in 2008, only RM2,127 million x 0.196
= RM416.9 million would have been tied up in working capital, rather than
RM543.8 million. Having RM126.9 million less tied up would have saved
about RM10 million interests on borrowings.
(b) Current Ratio Approach

The second approach to measure liquidity is using the current ratio
approach. The current ratio indicates the relative relationship between
current assets and current liabilities. The current ratio is defined as:
Current ratio = Current Assets

Current liabilities
Example:
2008 2007
(RM) (RM)
Current assets 800,000 760,000
Current liabilities 340,000 362,000
Current ratio 2.35 2.10
The 2008 ratio indicates that there is RM2.35 of current assets for each RM1
current liability. This represents a better indicator over 2007. A normal indicator
suggests that a ratio 2:1 is ordinarily satisfactory, but this does not necessarily
indicate a good signal. However, a numbers of factors could affect the ratio such
as industry practices, the firmÊs operating cycle, and the mix of current assets. A
very low current ratio could be a cause for concern because impending cash flow
problems. An excessively high current ratio could suggest that the firm is not
managing its current assets properly.
9.1.3 Numerator of the Current Ratio

Each of these components has direct relationship with current ratio as illustrated
below:

Figure 9.1: The relationship between current ratio and the components
9.1.4 Current Ratio Analysis

When conducting current ratio analysis, you might wonder at what condition or
position should the company put its current ratio.
I believe that there are no simple answers for such a question, because it all
depends on a numbers of factors, including the following:
(i) The nature of the companyÊs business

If large inventories and the giving of credit terms are normal to the
business, the current ratio needs to be higher than the general average,
whereas a retail business with only cash sales, no work in progress and
stocks financed mainly by suppliers (i.e. trade creditors a large items) may
be expected to have a lower than average current ratio.
(ii) The quality of the current assets

Stocks, for example may be readily saleable, such as gold, or half-completed
houses in a property slump.
(iii) The imminence of current liabilities

A large borrowing due for repayment could be uncomfortable. It could be
acutely uncomfortable if gearing was already high, there was no chance of

equity issue and neither cash nor further overdraft facility available. These
factors will reflect the current ratio position in the balance sheet.
(iv) The volatility of working capital requirements

A company with highly seasonal business activities, for example a Hari
Raya card manufacturer, may well make use of a much higher average level
of borrowings during the year than what the balance sheet shows,
particularly because companies usually arrange their year-end to coincide
with low inventories or a low level of activity. When the interest charge in
the income statement is excessively large in comparison to the borrowings
shown in the balance sheet, this is a clear indication that borrowings during
the year have been significantly higher than at the year-end.
Because of the above factors, the most informative feature of a current ratio is its
normal level and any trend from year to year. A drop below normal levels is
worth investigating, and a continuing decline is a warning signal that should not
be ignored.
9.2 ANALYSING OPERATING ACTIVITIES
9.2.1 Analysing Company Liquidity

Now letÊs look at our analysis of operating measures of liquidity which is
important in credit analysis. The three operating activities that measure liquidity
are based on debtors (especially trade debtors), inventories and current liabilities.
(a) Debtors Liquidity Measures

It is important to learn about how debtors are related to the companyÊs
liquidity. Different companies have different levels of liquidity. Companies
such as a supermarket chain, whose turnover is almost entirely based on
cash, will have a few debtors. Therefore, analysts have to carry out in-depth
analysis to explain the type of liquidity based on the different industries.
Debt collection period:
The ratio trade debtors/sales can be used to monitor a companyÊs credit

control. I believe, a meaningful measure is that which is expressed in terms
of time, as the debt collection period (or the collection period), in days or
months.

Trade debtors
Debt collection period (days) = × 365
Sales
Trade debtors
Debt collection period (months) = × 12
Sales
But it may be expressed simply as a percentage of sales:
Trade debtors x 100

Sales
Example:
Table 9.2: Example of debt collection and its impact

2008 2007
(RMÊ000) (RMÊ000)
Income Statement
Turnover 96,766 98,895
Note on debtors
Trade debtors 25,568 20,699
Ratio (calculated)
Trade Debtors/Turnover x 100 26.4% 20.9%
A falling in a collection period is generally a good sign, as it is an indication

of effective financial control. But it could reflect a desperate need for cash
(liquidity), involving extra discounts for cash.
On the other hand, a mark rise in the ratio as illustrated earlier in Figure 9.1
indicates a warning signal. The huge jump (longer collection period or less
liquidity) in the ratio could lead to something that is not right.
And this includes:

Ć Bad debt provisioning
Ć Changes in collection period, longer collection period given (delay in
collection period) to a numbers of customers
Ć Poor credit control
Ć A subsidiary is being disposed or acquired
Ć A debt is factoring or discounted.
So students should get back to the chairman statement to find out

additional information for our analysis. Therefore, in this case the
chairmanÊs statement reveals that:
Notes:
ChairmanÊs Statement
⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄
Bad debt provision:
The board investigated and reviewed the debt of one subsidiary and found
that for the past two years, the level of bad debt provisioning was not
adequate; therefore there is a provision of RM3.52 million which has been
fully charged as exceptional items.
⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄⁄
So we can conclude that additional information is required to ensure that

we get the right information for our analysis if the numbers cannot provide
information for our decision.
(b) Inventories Turnover Measures

The inventory turnover ratio establishes the relationship between the
volumes of goods sold and inventories. Again, similar to what we have
discussed earlier on the debtors, inventory is different within the different
industries. For example, a grocery outlet may have an average turnover of
20, whereas a furniture store could normally have a smaller turnover.
The inventory turnover is calculated using the average inventory as the

denominator because the ratio is intended to measure activity or turnover
during the period.
Cost of sales
Iventory turnover =
(Opening inventory + Closing inventory) ÷ 2
Cost of sales
Iventory turnover =
Average inventory

Example:
RM 1, 070, 000
Iventory turnover for 2008 =
RM 365, 000
= 2.93
RM 1, 034, 000
Iventory turnover for 2007 =
RM 370, 000
= 2.79
The turnover of 2.93 in 2008 indicates that the goods are bought and sold
out more than 2.93 times per year on average. Generally, a high inventory
turnover indicates that the
Ć firm is operating effectively as far as inventory is concerned
(purchasing, receiving, storing, selling)
Ć firmÊs investment in inventories is reduced
(c) Current Liabilities Liquidity Measures

A relationship of debtors especially trade debtors to purchases of the period
can provide information concerning the proportion of payables
outstanding. This ratio is computed as follows:
Trade creditors
Trade creditors to purchases =
Purchases
To compute the dayÊs purchases represented by debtors, the following

formula is used:
Trade creditors
Days' purchases in trade creditors =
Purchases / 365
The trade creditorsÊ ratio is a useful tool to determine current liabilities

liquidity measures. The trade creditorsÊ ratio is useful when compared to
the credit terms given by suppliers. If the average dayÊs creditor is
increasing, it could indicate that trade credit is being used increasingly as a
source of funds. If the companyÊs trade creditor is less than the industry
average, it could indicate that management is underutilising available
credit. If it exceeds the industry average, it could indicate that the company
is overdue on its payables. From the lenders perspective (bankers) or
supplierÊs perspective, they might reduce or recall any underutilised

portion of credit line (overdraft or supplierÊs credit lines) because it will

reflect its liquidity position and ability to pay-off the borrowings.
9.2.2 Additional Liquidity Measures

There are additional factors in determining a companyÊs liquidity. First, let us
look at these tools:
(i) Current Assets Composition

The composition of current assets is an indicator of liquidity position.
Analysts can determine which components of the current assets that can be
turned into cash and increase its current ratio. We could use common size
analysis or use diagrams or charts to illustrate the composition of current
assets, especially liquid assets.
(ii) Acid Test (Quick) Ratio

A quick measure to determine the debt-paying ability of a company is
referred to as the acid test ratio.
The acid test ratio expresses the relationship of quick assets (cash,
marketable securities, and trade debtors) to current liabilities. Stocks and
prepaid expenses are not considered quick assets because they may not be
convertible into cash.
The tools are more of a severe test of a companyÊs short-term ability to pay
debts than the current ratio. Again as we discussed earlier, industry
practices and companyÊs special operating circumstances must always be
considered. Refer to the example below:
Quick Assets
2008 Acid test ratio =
Current liabilities
RM 432, 000
=
RM 340, 00
= RM1.3to1
RM 384, 000
2007Acid test ratio =
RM 362, 000
= RM 1.06 to 1
Figure 9.3: Acid-test ratio for 2008 and 2007 (based on the earlier example)

For each RM1 of current liabilities in 2008, there is RM1.30 of quick assets
available to pay the obligations. As can be seen, there has been a significant
improvement in the quick ratio.
It is important for us, as analysts, to understand how various transactions

affect particular ratios and working capital. Selected transactions will be
used to demonstrate this issue.
Assume that a company has an acid test ratio of 2:1. The following
transactions occurred, and their effects on the acid test ratio and on
working capital are shown below:
Acid test Working

ratio capital
1. A trade creditors account is paid in cash + 0

2. An a trade debtor is collected 0 0
3. Inventory is purchased for cash - 0
4. Inventory is purchased on account - 0
5. A cash dividend is declared - -
6. Land is purchased for cash - -
7. Land is purchased for common share 0 0
8. Marketable securities are sold for cash at a loss - -
9. Marketable securities are purchased for cash 0 0
10. Bonds are purchased for cash and held as - -
long-term investment
11. Common share is issued at a discount for cash + +
12. The cash dividend declared earlier is + 0
distributed
The cash ratio is more of a severe test of liquidity than the acid test ratio.
The cash ratio is computed by dividing cash by current liabilities.
(iii) Cash Flow Measures

Cash flow analysis should not be overlooked when evaluating the liquidity
of a company. Especially useful cash flow ratios include:
- Current liabilities to cash flows
- Cash and cash equivalents to annual cash expenses
- Non-cash income to total net income
- Cash flow to annual cash expenses

When analysing sales performance, as itÊs related to operational

performance, the management of a company could use the following ratios:
Ratio Interpretation
Sales/number of call Response per call
Travel expense/days Cost awareness
Selling expenses/sales Response per selling effort
Sales/sales orders Sales efficiency
Number of calls/day Sales effort
These ratios are useful in developing trend information and an overall picture of
the companyÊs sales efforts. These ratios must be used with considerable care
since they do not represent sophisticated marketing analysis techniques.
9.2.3 Operating Cycles of a Business

I believe that you now understand income recognition and business cycles as we
have discussed this in an earlier topic. Operating cycles is a process of a business
from its preparation stage to the sale of goods/provision of services and
collection of debtors account.
Now, we are going to touch on the business cycle but its scope is on the
relationship with a companyÊs liquidity position. Normally, bankers conduct this
analysis to determine short-term borrowing required by their customers. Bankers
look at the gap from production to the collection period to identify liquidity
requirements.

Figure 9.2: Normal operating cycles of a business
The above figure shows that the overall operating cycles is based on a 68-day
period. This indicates that the companyÊs cash is tied up in stocks and debtors for
68 days. Therefore, bankers normally give 68 to 70 days short-term financing for
the operating cycles.
Operating cycles is important to analysts because:

Ć It represents the `heartbeatÊ of a business (as revealed by figure 9.2)
Ć It forms the basis of a business Ânet working capital needÊ
Ć It is the cash generating machine of a business providing the necessary cash
flow to honour its obligations
Ć It provides a focus of approach in assessing operating risks affecting a
businessÊ ability to generate cash flow

9.3 CAPITAL STRUCTURE AND SOLVENCY

ANALYSIS
In the earlier part of this unit, we have discussed the analysis of company
liquidity; now we move on to capital structure and solvency analysis.
The capital structure of a company or enterprise consists of debt and equity

funds for the purpose of business operations. Why do we need to determine
capital structure and solvency? The answer is simply because we need to
determine the financial stability and long-term solvency of the enterprise.
Different financial statement users need the information for their business
decision, lenders to determine how much borrowing (especially long term) can
be offered to the company based on the capital and solvency condition, investors
need to mitigate the risk before they invest the money in the company and we, as
students, need to evaluate the condition for our academic analysis.
9.3.1 Capital Structure Ratio

Before we move on to compute capital structure ratio (gearing in Malaysia and
UK context), we need to comprehend the relationship between equity to total
liabilities.
Figure 9.3: Impact between liabilities, increases of equity or decreases of equity
So, the above figure shows the relationship between liabilities and equities and
how this reflects the creditors.

Therefore, we now move on to the computation of ratio. The capital structure

ratio is derived as follows:
Total liabilities
Total liabilities to equity =
Total equity
If we want to measure the capital employed, we simply change the equity with
capital employed.
Total liabilities
Total liabilities to capital employed =
Total capital employed
To learn more about computation and impact of capital structure ratio, look at
the table below.
Table: 9.4: An example of capital structure
Notes Company
A B C
(RMÊ000) (RMÊ000) (RMÊ000)
Ordinary share capital 600 500 250
Reserve 850 550 300
Ordinary shareholdersÊ funds (A) 1,450 1,050 550
Redeemable preference share (B) - 100 -

capital (3.5%)
Minorities (C) 150 150 150
Provisions 400 400 400
Loan share (10%) (D) - 150 400
Overdraft (currently 12%) (E) - 150 400
Capital employed (F) 2,000 2,000 2,000
A B C
Debt/Equity =
B+D+E 0% 33% 128%
A+C
Debt/Capital employed = 0% 20% 45%

B+D+E
F
Capital structure None Low High

Notes:
• (Company B) Because preference share is carrying a fixed rate dividend
ahead of ordinary share, it should be treated as debt.
• (Company C) Minority have been included as equity in the computation of
debt/equity ratio on the assumption that minority interests in subsidiaries
are all pure (non-redeemable equity).
From the above table, we compute three different companies: A, B and C. We

included short-term borrowings such as overdraft and other borrowings, which
are due within one year as well as capital employed to show long-term
borrowings.
As you can see, debt/equity ratio is a more sensitive measurement of capital

structure (or gearing) (equity based) than capital employed. But our analysis can
still be distorted by differences of tax deferred under provisions among the
company.
We see from creditor protection, the company with high capital structure like in
the case of Company C, gives less protection to creditors when compared to
Company B.
9.3.2 Number of Times Interest Earned

The number of times interest is earned ratio is a measure of the debt position of a
firm in relation to its earnings.
This ratio emphasises the importance of a companyÊs covering of total interest

charges. The ratio indicates the companyÊs ability to meet interest payments and
the degree of safety available to creditors. Students must be aware of the impact
of the interest expense differs between companies. There are different stages of
the business cycles and stages of the life cycles of the business.
The ratio is computed by dividing income before tax and interest charges. The
ratio applies to income before tax and interest, because the income indicates the
incomes available is sufficient to cover interest. Income taxes are only paid after
interest charges have been taken care of.

The ratio is computed as follows:
Income before taxes and interest charges

Times interest earned (TIE) =
Interest charges
RM 95, 500 + RM 41, 500 + RM 34, 000
=
RM 34, 000
= 5.03 times
RM 81, 000 + RM 44, 000 + RM 34, 000
2007 TIE ratio =
RM 34, 000
= 4.68 times
9.3.3 Capital Structure and Solvency Analysis from

the Lender’s View
Lenders or creditors (classed as bankerÊs or trade creditors) also evaluate their
customersÊ position based on capital structure and solvency.
BankerÊs assessments are normally based on:

Ć Ability of the business to cover the interest. Normally, bankers call the ability
to repay debt as a `first way outÊ. How income is generated from its
operations can cover the debt services ratio as well as interest cover.
Ć To mitigate the risk, banks will reduce the margin financed, by requiring
borrower to provide contributions. For example, if the cost of asset
acquisition is RM1 million, bank only financed up to 70% or RM0.7 million,
the difference of 30% or RM0.3 million must be contributed by clients via
increasing paid-up capital and thus, the leverage or gearing level will be
reduced. This measure will cushion creditors to mitigate the risk if the client
defaults to serve the borrowings. Hence, the assets need to be disposed.
Ć Business life cycle and risk level. Related to the stages of business and credit
risk (risk if the repayment defaulted).
Ć Track record or database or information from the industry.
Trade creditorÊs assessments are based on:

Ć Ability to pay off approved credit lines according to agreed credit
term/maturity.
Ć Track record, third party views (other suppliers)

9.4 CREDIT ANALYSIS – CREDIT RISK

I believe we have completed the process of identifying company liquidity, capital
structure, and finally we have learned to identify companyÊs solvencyÊs position.
However, due to the dynamics of credit analysis, it is required of us to have basic

knowledge of credit risk. Students who plan to work in the financial industry or
work with a big supplier company should have basic knowledge of this analysis.
Credit risk is the probability of incurring losses in the event that the borrower
defaults, or in the event of a decline of the borrowerÊs credit quality.
ACTIVITY 9.2
Review the process of identifying credit analysis. You have been given
three years financial statement of an existing customer. If you are a credit
analyst in a bank, which ratio is suitable in evaluating the clientÊs liquidity,
capital structure and solvency condition for the purpose of additional
credit lines to the customer?
9.4.1 Common Causes of Business Failure – Poor

Credit Risk Analysis
There are a number of common business failures that lead to credit risk and will
reflect on the companyÊs liquidity, capital structure and solvency analysis.
Ć Poor management or mismanagement
Ć Large commitment/acquisitions
Ć Prolonged overtrading
Ć Diversification into products, business or markets which are unfamiliar
Ć Adverse market or product changes ă product or business life cycles
Ć Intense competition
Ć Financial resources drained out for unintended purposes.
Ć Inadequate financial control ă lack of financial navigation system
Ć Over concentration on customers, contracts, market etc.

ACTIVITY 9.3
Give your thoughts on the current `credit crunch crisisÊ with special
focus on the United States. Why did it happen? Based on your
observation and analysis, list out some possible strategies to ensure it
doesnÊt happen in Malaysia.
• Credit analysis focuses on the liquidity analysis using accounting-based

ratios, turnover and operating activities to measure liquidity. This impacts
liquidity position on the companyÊs short-term performance.
• Credit analysis is important to offer new credit lines or extending existing

credit lines based on current ratio condition.
• The approach to measure companyÊs liquidity:

ă Working capital approach.
ă Current ratio approach.
• The approach to measure performance of operating activities is related to the

three measures of:
ă Debtors
ă Inventory turnover
ă Current liabilities
• There are additional numbers in determining companyÊs liquidity. These

consist of:
ă Current asset composition
ă Acid test ratio
ă Cash flow measure
• Operating cycles is a process of a business from its preparation stage to sale

of goods/provision of services and collection of debtors account. It is a part
of credit analysis to identify liquidity requirement and is typically used by
bankers to evaluate short term borrowings especially to finance working
capital requirement.

• The capital structure of a company or enterprise consists of debt and equity

funds for the purpose of business operations. The objective of capital
structure analysis is to determine the financial stability and long-term
solvency of the enterprise, especially the ability to pay off long term debt.
• Analysts normally use the ratio tools like:

ă Capital structure ratio
ă Times interest earned
• Credit risk is the probability of incurring losses in the event of default of the
borrower, or in the event of a declining of the borrowerÊs credit quality.
Acid test ratio Current ratio approach

Business life cycles Debtors turnover ratio
Capital structure ratio Loan default
Cash flows measure Stock turnover ratio
Credit crunch Times interest earned
Credit risks Working capital approach
Current liabilities Working capital requirement

REFERENCES W 161
References
Approved and adopted FRS Standard. www.masb.org.my
Atrill P. And Mc Laney E. (2004). Accounting and finance for non-specialists.

Prentice Hall.
Bernstein Leopold. A. and Wild John. (1999). Analysis of Financial Statement.

Mc Graw Hill.
International Financial Reporting Standard. (2008). Price Waterhouse Coopers
Lazar J., Choo., C.,C. and Arshad R. (2006). Financial reporting standard for
Malaysia. Mc Graw Hill.
Malaysian Tax Booklet. (2007/2008). Price Waterhouse Coopers.
Wild John. J., Subramanyam K.R., and Halsey Robert. F. (2004). Financial
statement analysis. Mc Graw-Hill.

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OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
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OUM Business School

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Module Writer: Rahimi Dollah

Moderator: Liana Muhamad

Desktop Publishing: Center for Instructional Design & Technology

First Edition, May 2009

Copyright © Open University Malaysia (OUM), February 2011, BBFS4103

Copyright © Open University Malaysia (OUM)

Topic 1 Overview of Financial Statement Analysis 1

Topic 2 Financial Reporting and Analysis 22

Copyright © Open University Malaysia (OUM)

Topic 3 Analysing Financing Activities 40

Topic 4 Analysing Investing Activities 63

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4.5.1 Intangible Assets, Natures and Impact to 83

Topic 5 Analysing Operating Activities 87

Topic 6 Cash Flow Analysis 109

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6.1.5 Items and Activities that are Omitted in the 116

Topic 7 Return on Invested Capital 130

Topic 8 Profitability Analysis 148

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8.4.6 Provisions 164

Topic 9 Credit Analysis 167

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Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

Topic 2 This topic dicusses the financial reporting environment in Malaysia,

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TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

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References: References is where a list of relevant and useful textbooks, journals,

International Financial Reporting Standard, IFRS, Price Waterhouse Coopers

Malaysian Tax Booklet, 2007/2008, Price Waterhouse Coopers, Retrieved from

TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

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We are going to learn how to analyse financial statements in order to be able to

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When carrying-out analysis, students should identify major changes or turning

1.1 BUSINESS ANALYSIS AND FINANCIAL ANALYSIS

There are two steps to apply business analysis:

(i) Identifying the business vision and objectives

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Figure 1.1: Activities and core business of Sime Darby Bhd.

(ii) Determining business performance of a company

As Figure 1.2 reveals, the companyÊs plantations business recorded the

1.1.1 Types of Business Analysis

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liquidity analysis are mainly venture capitalists, fund managers or

Type of Equity Analysis:

Figure 1.3: Technical Analysis

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• Fundamental analysis ă a process of analysing financial position and

1.1.2 Financial Analysis

Financial analysis begins with establishing the objective(s) of the analysis. An

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Figure 1.4: Factors to take into account

The financial analysis of a company should include an examination of the

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