CHAPTER TWO

FINANCIAL STATEMENT ANALYSIS

2.1. Financial statement analysis

The process of evaluating relationship between component parts of financial statements to obtain
better understanding of the firm’s position and performance is known as analysis of financial
statements.
2.2 Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of
ratios to interpret the financial statements so that the strength and weakness of a firm as well as
its historical performance and current financial condition can be determined.
The term ratio refers to the numerical or quantitative or mathematical relationship between two
items/variables, for example inventories to sales revenue.

2.3 Types of Ratio Comparisons

Ratio analysis is not merely the application of a formula to financial data to calculate a given
ratio. More important is the interpretation of the ratio value.To answer such questions as, is it too
high or too low? Is it good or bad? A meaningful standard or basis for comparison is needed.
Three types of ratio comparison can be made:
- Cross sectional analysis
- Time sectional analysis
- Combined analysis
A) Cross sectional Analysis: Cross sectional analysis involves the comparison of
different firm’s financial ratios at the same point in time. The typical business is
interested in how well it has performed in relation to other firms in the industry key
 competitor or group of competitors that it wishes to emulate an/or to the industry
average.
B) Time series Analysis: Time series analysis is applied when a financial analysis
evaluates performance over time. Comparison of current to past performance, using
ratio analysis allows the firm to determine whether it is progressing as planned.
Time series analysis is often helpful in checking the reasonableness of firms
projected (pro-forma) financial statements. A comparison of current and past ratios
to those resulting from an analysis of projected statements may reveal discrepancies
or over optimism.
The theory behind time series analysis is that all companies must to evaluated in relation to its
past performance, developing trends, must a isolated, and appropriate action must be taken to
direct the firm to word immediate and long term goals.
C) Combined Analysis: The most informative approach to ratio analysis is one that
combines cross-sectional and time series analysis. A combined view permits
assessment of the trend in the behavior of the ratio in relation to the trend for the
industry.
2.4 Interested Parties
Ratio analysis of firm’s financial statement is of interested to many parties of which some
includes the following:
a) Share holders
b) Creditors and
c) The firm’s own management
A) Share holders: Both present and prospective shareholders are interested in the
firm’s current and future level of risk and return. These two dimensions directly
affect share price.
B) Creditors: The firm’s creditors are primarily interested in the short-term liquidity
of the company and in its ability to make interest and principal payments. A
secondary concern of creditors is the firm’s profitability; they want assurance that
the business is health and will continue to be successful.
C) Management: Management, like stockholder, must be concerned with all aspects,
of the firm’s financial situation. Thus it attempts to operate in a manner that will
 result in financial ratios that will be considered favorable by both owners and
creditors. In addition, Management uses ratio to monitor the firm’s performance
from period to period. Any unexpected changes are examined to isolate
developing problems.
2.5 Types of Financial Ratios
Financial ratios can be divided for convenience in to four basic groups or categories.
1. Liquidity Ratios
2. Activity Ratio
3. Debt Ratio
4. Profitability Ratio
Dear learner! In order to see the use of financial analysis for different users the following
financial reports are presented to you. Before you deal with any computations look toughly
the statements.

BDC ENGINEERING COMPANY

COMPARATIVE BALANCE SHEET
DECEMBER 31, 2004 and 2005
(In thousands of Birrs)

2005 2004
Current Assets
Cash Br. 3,500 Br. 4,000
Marketable Securities 2,000 2,300
Accounts receivable 18,000 13,000
Inventories 21,500 19,700
Total Current assets Br.45,000 Br.39,000

Fixed Assets
Land and buildings Br.29,700 Br.25,200
Machinery and equipment 31,600 30,000
Total fixed assets Br.61,300 55,200
Less accumulated depreciation 18,300 17,200
 Net fixed assets Br.43,000 38,000
Total Assets Br.88,000 Br.77,000

Liabilities and Stockholders’ equity

Current Liabilities
Accounts payable Br.8,200 Br.7,000
Notes payble-10% bank 6,500 8,000
Accrued liabilities 1,900 1,700
Current maturity of long-term debt 4,000 4,000
Other liabilities 1,400 2,200
Total Liabilities Br.22,000 Br.22,900
Long-term liabilities
Long-term debt-12% mortgage bonds 29,000 31,000
Total liabilities Br.51,000 Br.53,900

Stockholders’ equity
Common stock-Br.5 par, 2,000 shares
authorized; 1,300 share
outstanding in 2005 and 1,000
shares outstanding in 2004 6,500 5,000
Capital in excess of par 14,000 5,350
Retained earnings 16,500 12,750
Total stockholders’ equity Br.37,000 Br.23,100
Total liabilities and stockholders’ equity Br.88,000 Br.77,000

BDC ENGINEERING COMPANY

INCOME STATEMENT
FOR THE YEARS ENDED DECEMBER 31, 2004 and 2005
(In thousands of Birrs)

2005 2004
Net sales Br.121,000 Br.111,000
Cost of good sold 91,000 84,000
Gross profit 30,000 27,000
Operating expenses
Selling 6,000 5,800
General and Administrative 8,000 7,600
Depreciation 2,100 1,800
Lease payments 1,650 1,600
17,750 16,800
Earnings before interest and taxes (EBIT) Br.12,250 Br.10,200
Interest expense
 Interest on bank notes 450 600
Interest on other debt 2,600 2,900
Earnings before taxes Br.9,200 Br.6,700
Taxes (34%) 3,128 2,278
Net income Br.6,072 Br.4,422

BDC ENGINEERING COMPANY

STATEMENT OF RETAINED EARNINGS
DECEMBER 31, 2005
(In thousands of Birrs)

Retained earnings –January 1 …………………………. Br. 12,750

Net income …………………………………………….. 6,072
Total …………………………………………….. Br. 18,822
Less cash dividends
Common stock -Br.2.00 per share ………………. 2,600
Retained earnings-December 31 ……………………….. Br. 16,222

The Industry Average of different ratios is given below for comparison purpose with BDC
ENGINEERING Company.

Ratio Industry Averages*

1. Liquidity ratios
a. Current ratio 2.00X
b. Quick ratio 1.25X
2. Assets Management ratio
a. Accounts Receivable turnover 10.40X
b. Average collection period 35.00 days
c. Inventory turnover 6.00 X
d. Fixed asset turnover 3.50 X
e. Total assets turnover 2.00X
3. Debt Management ratios
a. Debt ratio 45.00%
b. Debt-equity ratio 81.81%
c. Time-interest-earned 5.50X
 d. Fixed-charge-coverage 2.50X
4. Profitability ratios
a. Gross profit margin 26.00%
b. Operating profit margin 15.50%
c. Net profit margin 6.00%
d. Return on investment 12.00%
e. Return on equity 21.82%
5. Market/book ratio
a. Earnings per share Br. 15.50
b. Price/earnings ratio 12.00
c. Book value per share Br. 46.50
d. Dividend pay share Br. 1.10
e. Dividend per out 20.00%
f. Dividend per yield 1.67%
Industry averages are assured to remain constant for 2004 and 2005.
2.5.1 Liquidity Ratios: The liquidity ratios measure the ability of a firm to meet its short-
term obligations and reflect the short-term financial strength/solvency of a firm.
The two basic measures of liquidity are discussed below:
- Current ratio
- Quick (acid-Test) Ratio
A) Current ratio: The current ratio is one of the most commonly cited financial ratios, which
measures the firm’s ability to meet its short-term obligations by using only current assets.

Current Ratio = Current Assets

Current Liabilities

A current ratio of 2:1 is professionally cited as acceptable but a value’s acceptability depends on
the industry in which the firm operates. For Example, a current ratio of 1:.1 could be
unacceptable for a manufacturing firm. The more predictable a firm’s cash flows, the lower the
acceptable current ratio.
Current ratio for BDC Eng’g Co. (For 2005) = 45,000/22,000
= 2.05 times.
Interpretation
BDC ENGINEERING Co. has 2.05 Br. in current asset available for every Br. in current
liabilities. This ratio slightly exceeds the industry average (i.e. 2 times).Because the ratio is
greater than the industry average this firm is considered as strong in its current asset
management. However note that:
A very high current ratio may indicate (is caused by):
 Excessive cash due to poor cash management
 Excessive accounts receivable due to poor credit management
 Excessive inventory due to poor inventory management
The result of very high current ratio is to have an improved liquidity greater safety of funds of
short term creditors thereby reduced risk to creditor but a scarifies of profitable than plant assets..
Note that the current ratio is a crude measure of a firm’s liquidity position as it takes in to
account all current assets with out any distinction in their composition. It is a quantitative
(not qualitative) index of liquidity.
B .Quick (Acid-Test) Ratio: The quick (acid-test) ratio is similar to the current ratio
except that it excludes inventory, which is generally the least liquid current assets,
and prepaid expenses. It measures liquidity by considering only quick assets. Quick
assets include:
 Cash
 Marketable securities
 Receivables (such as notes receivable and account receivable)
Generally low liquidity of inventory results from two primary factor:
A) Many types of inventory cannot be sold easily because they are partially completed item,
obsolete items, special purpose item, etc and
B) The items are typically sold on credit, which means that they become accounts receivable
before being converted in to cash.
Note! Prepaid expenses are excluded because they are not available to pay current
debts.
Quick Ratio = Current assets – Inventory – Prepaid expense
Current Liabilities
A quick ratio of 1.1 or greater is occasionally recommended, but as with the current ratio, an
acceptable value depends on the industry.

Example: Quick ratio for BDC Eng’g Co. (for 2005)

= 23,500/22,000
= 1.07
Interpretation – BDC ENGINEERING Co. has 1.07 in quick asset for every Br. in current
liabilities. Recall that current ratio of BDC ENGINEERING Co. (2.22 times) was greater than
the industry average (2 times).
But the quick ratio (measure of liquidity by excluding inventory and prepaid expense) of BDC
ENGINEERING Co. (1.07 times) is less than the industry average. This suggests that the firm
has more inventories and/or prepayments than the industry average.

2.5.2 Activity (Or Utilization/Efficiency) Ratios

These ratios are also called efficiency ratios, or asset management ratios, or asset utilization
ratio. Asset management ratios usually compare the level of sales or cost of goods sold with the
level of investment in various asset accounts. These ratios answers question such as: Are assets
efficiently managed? How well a firm’s funds are utilized? etc.
Activity ratios are used to measure the speed with which various accounts are converted in to
sales or cash. With regard to current accounts, measures of liquidity are generally inadequate.
Difference in the composition of firm’s current assets and liabilities can significantly affect
“true” liquidity.
Activity ratios include following major components:
A) Inventory turn over ratio
B) Accounts receivable turn over
C) Average collection period
D) Average payable period
E) Fixed assets turn over ratio
F) Total assets turn over ratio
A) Inventory turn over ratio: It is computed by dividing the cost of goods sold by the
average inventory.
Thus,
Inventory turn over ratio = Cost of goods sold
Average inventory
The cost of goods sold mean sales minus profit (sales-gross profit). The average inventory
refers to the simple average of the opening and closing inventory.
The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of
liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on
the shelf or in the warehouse for a long time.
Example
Inventory turn over ratio (for BDC Eng’g Co., 2005)
= Cost of goods sold
Inventory
= 91,000 = 4.23 Times
21,500

Interpretation
BDC ENGINEERING Co. inventory is sold out or turned over 4.23 times per year. But
inventory turn over of BDC ENGINEERING Co. is below the industry average of 6 times. In
general, a high inventory turn over ratio is better than a low ratio as a high ratio implies goods
inventory management. In brief, a reasonable inventory turnover is what is suggested.
An inventory turnover (ITO) significantly higher than the industry average indicates:-
 Superior selling practice
 Improved liquidity and profitability as less money is tied up is inventory.
B) Account Receivable Turn over (ARTO): Accounts receivable turnover ratio
measures the liquidity of firm’s account receivable. That is, it indicates how money times
or how rapidly account receivable are converted in to cash during a year. In short it
answers the question what is the speed of conversion of account receivable in to cash?
ARTO = Net sales
Account Receivable

Example –
ARTO (BDC Eng’g Co. for 2005) = 121,000
18,000
= 6.72 times
Interpretation
BDC ENGINEERING Co. accounts receivable is converted in to cash 6.72 times in a year.
But this is considerably below the industry average of 10.4 times. And the firm is poor in its
credit management.
In general, a reasonably high ARTO is preferable.
A ratio substantially lowers than the industry average may suggest that a firm has:
 More liberal credit policy (i.e. longer times credit period), poor credit selection, and
inadequate collection or policy which could lead to:
i) Account receivable to be high and
ii) Higher bad debt or uncollectable receivable
 More restricted cash discount (i.e. no or little cash discount) that could makes sales to be
too low.
C) Average Collection Period (ACP): This represents the average length of time a
firm must wait to receive cash after making a sale. That is, it indicates how many days a
firm takes to convert receivables in to cash or number or day’s sales are tied up in
account receivable.

ACP = 365 Days ACP = Receivable = Receivables

ARTO Average Sales per day Annual sales/365 days

ACP for BDC Eng’g Co. (for 2005)

ACP = 365 = 54 Days or Br.18,000 = 54 Days

6.72 121,000/365
Interpretation: Customers of BDC ENGINEERING Co. on the ACP of 54 days is greater
than that of both the industry average (35 days) and BDC ENGINEERING Co.
Short collection period is preferable.
BDC ENGINEERING Co. takes about 54 days to collect its account receivable and this
lengthy collection period suggests that the firm might have potential problems in that:
 It isn’t effective in collecting its account receivable
 It may be giving credit to marginal customer
 Thus, the firm liquidity and profitability are adversely affected.
D) Accounts Payable Turn over (APTO): Measures how rapidly creditors are paid.
That is, how rapidly or how many time accounts payable are paid during a year. The
following example which is not on the stated firm explains the APTO:
Example: Data for EAST AFRICAN Share Company for 2004
Net purchase (on credit)……….…………………..Br.200,000
Accounts payable, Dec. 31, 2004…………………...Br.50,000
APTO = Net purchase
Accounts Payable
= 200,000
50,000

= 4 Times
Interpretation
Assume that industry average of APTO is 7 times. EAST AFRICAN Share Company pays its
creditors in lower times a year (i.e., 5 times) as compared to other firms in the industry (i.e., 7
times). That is, it may be rated a risk borrower.
E) Average payment period (APP): Measures the average length of time creditors
must wait to receive their cash or simply the average time needed by a firm to pay its
accounts payable to its creditors or suppliers from which purchase is made. Therefore, for
the above example, EAST AFRICAN, the APP is:

APP = 365 days or APP = A/P

APTO Average Purchase per day

= A/P
Annual Perchase/365 days
APP for EAST AFRICA Share Company (for 2004) = 365 = 91 days
4 times
Or = Br.50,000 = 91 days
Br.200,000/365
Interpretation
EAST AFRICA Share Company would pays its customers or creditors on average of 91 days.
F) Fixed assets turn over (FATO): The fixed asset turnover ratio measures the
efficiency with which the firm has been using its fixed assets to generate sales. This ratio
indicates management’s efficiency in managing fixed assets.

Fixed asset Turn over = Sales (net)

Net fixed assets

Net fixed assets mean cost of fixed assets net of depreciation. Generally, higher fixed asset
turnover are preferred, because they reflect greater efficiency of fixed asset utilization.
Example
Fixed assets turn over (BDC Eng’g Co., for 2005) = Net sales
Net Fixed assets

= 121,000
43,000

= 2.81 Times
Interpretation
 BDC ENGINEERING Co. generates Br. 2.81 in net sales for every Br. invested in its
fixed assets. However, this is below the industry average of 3.5 times.
 Other things being equal a ratio substantially below the industry average:
 Shows underutilization of available fixed asset (i.e. presence of idle capacity) relative
to the industry.
  Indicates possibility to expand activity level with out requiring additional capital
investment.
 Shows over investment in fixed assets low sales, or both
 Helps the manager to reject funds requested by production managers for new capital
investment.
 Suggests that sales should be increased, some fixed assets should be disposed of or
both.
G) Total Asset Turn over (TATO): Measure’s the management efficiency in
managing its total assets to generate sales. “How much sales Birrs is generated per Birr
of investment in assets?”

TATO = Net sales

Total Assets
Example
TATO for BDC Eng’g Co. (for 2005) = Br.121,000
Br.88,000
= 1.38 times
Interpretation
BDC ENGINEERING Co. Generates Br.1.38 in net sales for every Br. invested in total assets.
How ever, this is below the industry average of 2 times.
 A high ratio suggests greater efficiency in using assets to produce sale.
 A low ratio suggests that BDC ENGINEERING Co. is not generating a sufficient
volume of sales for the size of its investment in assets. BDC ENGINEERING Co.
should take steps to
- Increase sales
- Dispose of some of its investment in assets
- Or both
2.5.3 Leverage /debt Ratios
- These ratios examine balance sheet ratio and determine the extent to which borrowed
funds have been used to finance the firm. Financial leverage ratios are
based on the relationship between borrowed funds and owner’s capital.
 - Some of the common Leverage ratios include
a) Debt – ratio
b) Debt – equity ratio
c) Times – interest – earned ratio
d) Fixed – payment coverage ratio

A) Debt – ratio (debt – asset ratio): Measures the percentage of total asset financed
by debt or simply the percentage of total funds provided by creditors.

Debt Asset Ratio = Total Debt

Total Assets
For BDC Eng’g Co. (for 2005) = Br.51,000
88,000
= 0.5795

= 57.95%
 58 %
Interpretation
Creditors have supplied BDC ENGINEERING Co. about 58 percents of every
Br. in assets. This is quite above the industry average of 45%. Hence,BDC
ENGINEERING Co. may face some difficulty in raising additional debt.
Substantially higher ratio shows:
o More of a firm’s assets are provided by creditor relative to owners
o Further creditors may require a higher rate of return for taking higher risk.
o Higher risk for existing creditors as there is no sufficient margin of safety to
them.
 Creditors prefer moderate or low debt asset ratio because the lower the ratio the greater
the cushion against creditors losses in the events of liquidation. That is, low or moderate
 debt – asset ratio provides creditor more protection in case the firm experiences financial
problems.
B) Debit -Equity Ratio: Expresses the relationship between the amounts of a firm’s
total assets financed by creditor (debt) and owners (equity). Thus, this ratio reflects the
relative claims of creditors and shareholders’ against the assets of the firm. It gives an
answer for the question:
“What is the preparation of Debt and Equity in financing the assets of a firm?”

Debt- Equity Ratio = Total Debt

Stockholders’Equity

For BDC Eng’g Co. (for 2005) = Br.51,000 = 1.3783 = 137.83%

Br.37,000
Interpretation
Creditors of BDC ENGINEERING Co. Provided about Br.1.39 in financing for every Br.
contributed by owners. Therefore, BDC ENGINEERING Co. has more financial leverage
than the average for the industry (81.82%) and, consequently, may have greater financial
charges (interest).
C) Times – Interest Earned Ratio : The times – interest earned ratio measures the
firm’s ability to make contractual interest payments from operating profit. The higher the
value of this ratio, the better is the firm to fulfill its interest obligation.

Time – Interest Earned = Earning before interest and Tax (EBIT)

Interest

In general, this ratio measures the extent to which earnings can decline with out the resulting
financial amazement to the firm because of inability to meet annual interest costs.
As a rule, the times – interest earned ratio of a least 3.0 and preferable closed to 5.0 is
suggested.
Time interest earned ratio (BDC Eng’g Co. (for 2005))
= EBIT
Interest expense
Or
= Earning before tax + Interest
Interest

= 12,250 = 4.01 times

3,050
Interpretation
BDC ENGINEERING Co. earns 4.01 times more than its interest changes. However, BDC
ENGINEERING Co. times interest earned ratio is below the industry average of 5.5 times
showing that BDC ENGINEERING Co. is making extensive use of credit of financial
operations.
A low ratio suggests:
 Creditors are more at risk in relating interest due.
 Failure to meet interest can bring legal action by creditor possibly resulting in
bankruptcy.
 The firm may face difficulty in raising additional financing thought debt as it is more risk
than similar firms.
A high ratio suggests that the firm has sufficient margin of safety to cover its interest charges and
the firm’s earning could decline without jeopardizing the firm’s ability to make interest
payments.
D) Fixed – Payment Coverage Ratio: The fixed payment coverage ratio measures
the firm’s ability to meet all fixed payment obligations, such as loan interest principal,
lease payments, and preferred stock dividends. Like the time – interest earned ratio, the
higher is value the better.

Fixed-payment Coverage Ratio = Earning before interest and tax + lease Payment
Interest + lease payments + {(principal payment + preferred stock dividends) X {1/ (1-T)}
Where T is the corporate tax rate applicable to the firm’s in come. The term 1/ (1-T) is included
to adjust the after tax principal and preferred stock divided payments back to a before – tax value
of all other terms. Fixed payment coverage ratio measures risk.
Like the times interest earned ratio the lower the fixed coverage ratio, the greater the risk to both
lenders and owners, and the greater the ratio, the lower the risk.
Example
Fixed charge Coverage = 12,250 + 1,650
3,050 + 1,650 + [3000/1-0.34]
= 13,900
9,245
= 1.50 times
Interpretation
BDC ENGINEERING Co. is able to cover its fixed charges only 1.50times compared with the
industry average of 2.5 times. This means BDC ENGINEERING Co. earns Br. 1.50 profits
for every Br. of fixed change payment. The low ratio gives creditors a small margin of safety in
case BDC ENGINEERING Co. experiences lower earnings.
Note that BDC ENGINEERING Co. does not have any preferred stock holders, but the firm
did repay part of its long-term debt during the accounting period. If the ratio is lower, creditors
and preferred stockholder view the firm as more risky and the firm may be unable to meet its
fixed charges of earnings decline and may be forced in to bankruptcy. A high ratio suggests a
larger cushion of protection in the events of worsening financial position.
2.5.4 Profitability Ratios
 Profitability is the net result of a large number of policies and decisions. Thus,
profitability ratios give final answers about how effectively the firm is being managed.
 These ratios are used to evaluate the over all management effectiveness and specifically
indicate how effectively a firms management generates profits on Sales, Total assets,
and Owners equity.
Profitability ratio indicates the firm’s effectiveness in terms of profit margins and rate of return
on investment. Some of this group of ratio included:
a) Gross profit margin
b) Operating profit margin
c) Net profit margin
d) Return on investment (ROI)
 e) Return on equity (ROE)

A. Gross Profit Margin

- Indicates the percentage of each sales Br. remaining after deducting the cost of goods
sold.
- This ratio indicates management effectiveness in:
 Pricing policy
 Generating sales, and
 Controlling production cost;

Gross- Profit- Margin = Gross profit

Net Sales

Example
For BDC Eng’g Co. (for 2005)= Br.30,000 =25%
Br.121,000

Interpretation
25 percents remain from each Br. of sales after deducting cost of goods sold. BDC
ENGINEERING Co. gross profit margin is slightly lower than the industry average of 26%
suggesting that the firm is similar to other companies in its industry with regarded to:
- Pricing policies and
- Production costs
B) Operating profit Margin
- Indicates the percentage of each sales Br. remaining after deducting both costs of goods
sold and operating expenses.
- It represents the profit earned on a firm ordinary business activities before deducting
interest and taxes
 Operating Profit margin = EBIT = operating income
Net sales Net Sales

Example
For BDC Eng’g Co. (for 2005)= Br.12, 250 =10.12 %
Br.121, 000
Interpretation
BDC ENGINEERING Co. generates 10.12% or nearly 10 percents in operating profits per Br.
of net sales. This ratio is below the industry average of 15.50% and may suggest that relative to
the average firm in its industry, BDC ENGINEERING Co. has,
 Higher operating costs, and/or
 Lower selling prices
C) Net profit Margin: Measures the percentage of each sales Br.
remaining after deducting all expenses.

Net Profit Margin = Net income

Net Sales

Example
For BDC Eng’g Co. (for 2005)= Br.6072 = 5.02%
Br.121,000
Interpretation
BDC ENGINEERING Co. generates slightly more than 5 percents in profits for every Br. in
sales. This ratio is slightly below the industry average of 6% suggesting that the firm’s sales are
too low, expenses too high, or both.
D) Return on Investment (ROI)
 This ratio is also called Return on assets (ROA)
 This ratio measures the overall effectiveness of management in generating profits from its
total investment in assets.
 ROI = Net income
Total Assets
Example
For BDC Eng’g Co. (for 2005)= Br.6072
Br.88,000
= 6.9%, the firm generates little less than 8 percents for every
Birr invested in assets
Interpretation
BDC ENGINEERING Co. 6.9 ROI in substantially below the industry average of 22%. To
improve its profit margin BDC ENGINEERING Co. should increase its sales relative to its
costs or reduce costs relative to sales.
E) Return On Equity (ROE) : Measures the rate of return realized by a firm’s stock
holders on their investment and serves as an indicator of management performance and
- High ROE indicates effective management performance
- Low ROE indicates in effective management performance

ROE = Net income

Stockholders Equity

Example: for BDC Eng’g Co. (for 2005) = Br.6072 =16.41%

Br.37, 000
BDC ENGINEERING Co. generates about 16 percents for every Br. in shareholder’s equity.
Note:
 A substantially high ROE may indicate that a firm is more risk due to higher financial
leverage.
 A substantially low ROE may indicate more conservative financing.

2.5.5 MARKET/BOOK RATIOS

 These ratios are primarily used for investment decisions and long-range planning and
include.
 A) Earnings per Share (EPS): Expresses the profit earned per common share
outstanding during the reporting period. It provides a measure of overall performance and
is an indicator of the possible amount of dividends that may be expected.

EPS = Net income – Preferred stock dividend

Number of common stock outstanding

= Earning available for common stockholders

Number of common stock outstanding

Example
For BDC Eng’g Co. (for 2005)= Br.6072 = Br.4.67
1,300 shares
Interpretation
BDC ENGINEERING Co. EPS of Br.4.67 is below the industry average of Br.5.50. This
may deter prospective investors from investing in the company and existing investors could
present challenge to management.
Note: EPS doesn’t show how much is paid as dividend and how much is retained
B) Price/Earning Ratio (P/E): Expresses the multiple that the market places on a
firm’s EPS and is commonly used to asses the owner’s appraisal of share value.

P/E ratio = Current Market price per share

EPS

Assume the BDC ENGINEERING Co. Year end (i.e., Dec. 31, 2005) market price of
common stock is Br.35 per share.
 P/E for BDC Eng’g Co. (for 2005) = Br.35 = 7.49 times
Br.4.67
Interpretation
The market is willing to pay about Br.7 for every Br. in earnings. However, the market is willing
to pay Br.12 for every Br. in earnings for other firms in the industry. BDC ENGINEERING
Co. lower P/E suggests that investors don’t value the firm as highly as other firms, perhaps
because its growth potential in earnings is not perceived to be as great as other firms in its
industry.
Note: A high P/E multiple often reflects the market’s perception of the firm’s growth prospects.
Thus, if investors believe that a firms future earnings potential is good, they may be willing to
pay a higher price for the stock and boast its P/E multiple.
C) Book Value per Share: Is the value of each share of common stock based on the
firm’s accounting records.

Book value per share =Total stock holder equity – preferred stock
Number of common stock out standing

Example
For BDC Eng’g Co. (for 2005)=Br.37,000 = 28.46
1300 shares
Interpretation
BDC ENGINEERING Co. book value per share of Br.28.46 is considerably below the
industry average of Br.46. 50 purchase.
D) Dividends per share (DPS): Shows the Br. amount of dividends paid on a share of
common stock outstanding during the reporting period.

DPS = Total cash dividends on common share

Number of common shares out standing

Example
For BDCEng’g Co. (for 2005) = Br.2600 = Br.2
1,300 shares
Interpretation
BDC ENGINEERING Co. pays Br.2 in dividends for each share of common stock
outstanding that is more than the industry average of Br. 1.10 per share.
F) Dividend Payout Ratio: Show the percentage of earning paid to share holders. It
expresses the cash dividends paid per share as a percentage of EPS

Dividend pay out Ratio = Cash dividend per share

EPS
Or
Dividend pay out ratio = Total dividend to common stock
Total earnings available for common stock holder

Example
For BDC Eng’g Co. (for 2005) = Br.2 = 43%
Br.4.67
Or
= Br.2600 = 43%
Br.6072

Interpretation
BDC ENGINEERING Co. paid 43% of its earnings in dividends that are higher than 20%
industry average. This higher ratio may reflect BDC ENGINEERING Co. is lower growth
opportunities than the average for other firms in its industry.
G) Dividend Yield: Shows the rate earned by shareholders from dividends relative to
the current price of the stock. Dividend yield is part of a stock’s total return.

Dividend yield = Cash dividends per share

Current market price per share
Example
For BDC Eng’g Co. (for 2005)= Br.2 = 5.71%
 Br.35
Interpretation
BDC ENGINEERING Co. dividend yield of 5.71% considerably above the industry average
of 1.67%. The higher dividend yield may reflect fewer investment opportunities on the part of
BDC ENGINEERING Co. relative to the industry as a whole.