CHAPTER THREE

FINANCIAL ANALYSIS
 Financial Analysis
• Financial analysis is the assessment of firm’s
past, present and anticipated future financial
condition.

• Its objectives are to determine the firm’s

financial strength and identify it’s weaknesses.
 Sources of Financial Information
I. The Balance Sheet: ……analyzed to determine the
business' current ratio, its borrowing capacity and
opportunities to attract equity capital.

II. Income Statement………. provides a better

measure of the operation's performance and
profitability.

III. Cash Flow Statement………the sources and uses

of the cash.
 Tools of Financial Analysis
• The most important tools for financial analysis
are:
i. Comparative Financial Statements
ii. Trend Analysis or Trend Ratios
iii. Common Size Statements
iv. Ratio Analysis
v. Fund Flow Analysis
vi. Cash Flow Analysis/
 Benchmarks for Evaluation

• There are three approaches:

– Rule of thumb

– Cross sectional analysis or industry average

– Time series analysis

 Ratio Analysis
• Ratio analysis expresses relationships between
different financial statements items.

• Financial Ratios can be classified into 5 main

categories:

1. Liquidity or Short-Term Solvency ratios

2. Asset Management or Activity Ratios
3. Financial Structure or Capitalisation Ratios
4. Profitability Ratios
5. Market Test Ratios
 1. Liquidity ratios
• Liquidity…………. Ability to pay short-term
obligations.

• Ratios:
a) current ratio
b) Quick ratio
c) Net Working capital
 a) Current Ratio
• ……………measures a firm’s ability to satisfy
or cover the claims of short term creditors by
using only current assets.

• Current Ratio = Current Assets

Current Liabilities
• Implication………………..
✓ Higher CR……….
➢excessive current assets items due to: poor
cash, credit, A/R, or/and inventory management
➢a firm is not making full use of its current
borrowing capacity.
✓ Lower CR………
➢difficulty is there in paying its short term
obligations
➢under stocking that may cause customer
dissatisfaction.
 b) Quick (Acid-test) Ratio
• ………. measures the immediate short term
liquidity by removing the least liquid assets
such as: Prepaid Expenses and Inventories

• Quick Ratio = CA – Inventory – Prepayments

CL
 C) NWC
• ………. measures the difference between
current asset and current liabilities

• NWC= Current Assets Current Liabilities

• +ve trends recommended

 2. Asset Management or Activity Ratios

• ……….indicates the efficiency of asset usage.

▪ ……… also show the speed with which assets

are being converted into revenues.

▪ Thus, ………ratios measure the degree to

which assets are efficiently employed in the
firm.
• ……..also it is a true liquidity measures.

• Ratios:
a. Inventory Turnover Ratio
b. Accounts Receivable Turnover Ratio
c. Total Asset Turnover
d. Fixed Asset turnover
 a. Inventory Turnover Ratio

• ……………indicates whether the investment in

inventory is efficiently used ( i.e. the liquidity of
inventory)

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory
• Reflects …………….. how many times per period
the inventory level is replaced or turned over.

• Implication………………..
✓ Higher …….…..
➢ Superior selling practice
➢ improved profitability as less money is tied-up in
inventory.
➢High demand (unsatisfying customers)
➢ there may be less stocking
➢less risk of obsolescence and less holding costs
 b. A/R Turnover Ratio
• …………..it indicates how many times or how
rapidly accounts receivable is converted into cash
during a period

• ………..tells how successful the firm is in its

collection

• A/R turn over= Net sales (credit sales)

average A/R
• Implication………………..
✓ The higher…..
➢More restrictive credit policy
i.e.
✓ short term credit period,
✓more restrictive credit selection
✓very aggressive collection policy

➢more liberal cash discount offers (i.e. larger

discount)
 c. Fixed Asset Turnover

• ……………measures the efficiency with

which the firm has been using its fixed assets
to generate revenue.

• Fixed assets turnover = net sales

Avg net fixed assets
• Reflects ………… how much the company
generated for each birr invested in fixed asset.
• Implication………………..
✓ The higher…..
➢the firm requires to make additional capital
investment to operate a higher level of
activity.

✓ The lower……..
➢underutilization of available fixed assets
➢possibility to expand activity level without
requiring additional capital investment,
➢over investment in fixed assets or low sales
 d. Total Asset Turnover

• ………….measures a firm’s efficiency in

management of its total assets to generate revenues.

• Total Assets Turnover = Net sales

Net total assets
• Implication………………..
✓ The higher…..
➢ greater efficiency in using assets to produce
revenues.
➢ And
✓ vice versa.
 3. Leverage ratios
• Solvency……….. is a firm’s ability to pay long term
debt as they come due.

• ……………..Long term funds management

• There are two types of debt measurement tools. These

are:
I. Financial Leverage Ratio
II. Coverage Ratio
 I. Financial Leverage Ratio

▪ ……….these ratios examine balance sheet items

and determine the extent to which borrowed funds
have been used to finance the firm.

▪ Ratios:
Ia) Debt Ratio
Ib) Debt -Equity Ratio
 Ia) Debt Ratio
• ………….Shows the percentage of assets
financed through debt.

• Debt ratio = Total Liability

Total Assets
• Implication………………..

✓ The higher…..
➢difficulty in raising additional debt.
➢a higher rate of return (interest rate) for taking
high-risk may required by creditors
➢Less protection for the creditors while financial
problems
➢ And
✓ vice versa.
 Ib) Debt -Equity Ratio

• …………determined to ascertain the proportion

between the outsiders’ funds and shareholders’
funds in the capital structure of an enterprise.

• Debt -equity ratio = Total Liability

Stockholders' Equity

• Reflects …………… the soundness of the long-

term financial policies pursued by the business
enterprise.
 II. Coverage Ratio
• ……measures the risk of debt

• ………….calculated by income statement

ratios designed to determine the number of
times fixed charges are covered by operating
profits.

▪ Ratios:
IIa) Times Interest Earned Ratio
IIb) Cash Coverage Ratio
 IIa) Times Interest Earned Ratio

• …………….It measures the firm’s ability to

pay contractual interest.

• Times Interest Earned = EBIT

Interest
• Reflects …………… the number of times
fixed charges are covered by operating profits
with out causing financial problems.

• Implication………………..
✓ The higher…..
➢ the less resulting financial losses
➢ the more capable is the firm to pay.
➢ And
✓ vice-versa.
 IIb) Cash Coverage Ratio
• …………indicates the extent to which earnings may
fall with out causing any problem to the firm
regarding the payment of the interest charges.

• ………… it excludes the reduction of non-cash

expenses in computing EBTI.

• Cash Coverage Ratio= EBIT + Depreciation

Interest
 4. Profitability Ratios
▪ Profitability……. is the ability of an entity to earn
profits.

▪ ………this ability to earn profits depends on the

effectiveness and efficiency of operations as well as
resources available.

▪ Profitability analysis…… focuses primarily on the

relationship between operating results reported in the
income statement and resources reported in the
balance sheet.
• ……………….the profitability analysis:

• Analysing in relation to sales

• Analysing in relation to assets

• Ratios:
a) Gross Profit Margin
b) Operating Profit Margin
c) Net Profit Margin

d) Return on Investment (ROI)

e) Return on Equity
f) Earning per Share (EPS)
 a) Gross Profit Margin

• .........It indicates management effectiveness in pricing

policy, generating sales and controlling production
costs.
• .……… it helps in ascertaining whether the average
percentage of mark-up on the goods is maintained.

• Gross Profit Margin = Gross Profit

Net Sales
• Reflects……………. the overall limit within which a
business must manage its operating expenses

• Implication………………..
✓ The higher…..
➢ good management on costs
➢ efficient utilization of assets
➢ favorable terms to purchase of raw materials
➢lower cost of production.
✓ vice versa.
 b) Operating Profit Margin
• …….measures how much the firm earn on
each sales after covering operating expenses.

• OP Margin = Operating Profit

Net Sales
 c) Net Profit Margin
• …………..measures the ability of the firm to
turn each birr of sales in to net profit.

• ……………….non operating incomes and

expenses are excluded for calculating this
ratio.

• Net Profit Margin = Net Income

Net Sales
 d) Return on Investment /ROI
• …………….. measures the overall
effectiveness of management in generating
profit with its available assets

• ROA =Net Income

Total Assets
• Reflects……………. the percentage of return
on the total capital employed in the business.

• ………… or, measures the profit which a

firm earns on investing a unit of capital.
 e) Return on Equity
• …………….. measures the effectiveness of
management in generating profit with its
available total shareholders’ equity.

• ROE = Net Income

Stockholders Equity
 f) Earning per Share (EPS)
• …………..measure of profitability of a firm
from the point of view of the ordinary
shareholders.

• ………….It reveals the profit available to each

ordinary share.

• EPS = Earning Available for Common Stockholders

No. of Shares of Common Stock Outstanding
 Market Value Ratio
• Market value or valuation ratios are
the most significant measures of a
firm's performance, since they
measures the performance of the
firm's common stocks in the capital
market.
 Price- Earnings (P/E) Ratio
• The price earning ratio is an indicator of the
firm's growth prospects, risk characteristics,
shareholders orientation corporate reputation,
and the firm's level of liquidity.
• The P/E ratio can be calculated as:

P/E Ratio = Market Price per Share

Earning per Share
Market Value to Book Value (Market-
to-Book) Ratios

• The market value to book value ratio is a

measure of the firm's contributing to
wealth creation in the society. It is
calculated as:
 Limitation
• Many large firms operate different
divisions in different industries
• Most firms want to be better than
average, so merely attaining average
performance
• Inflation may have badly distorted firm’s
balance sheets - “true” values.
• Seasonal factors can also distort a ratio
analysis.
 Limitaion
• Firms can employ “window dressing”
techniques to make their financial statements
look stronger.
• Different accounting practices can distort
comparisons
• It is difficult to generalize about whether a
particular ratio is “good” or “bad
• Effective use of financial ratios requires that
the financial statements upon which they are
based are accurate
Any Q