UNIT 2

FINANCIAL STATEMENT ANALYSIS

2.1. Financial statements

In financial accounting, you have learned the process of preparation of financial statements.
Financial statements are the end products of accounting system. The two basic financial
statements are required to be prepared for the purpose of external reporting is balance sheet
and income statement. For internal purposes of planning, decision making and control much
more information is contained in Balance sheet and Income statement.

I. Balance Sheet:
This is one of the important financial statements. It indicates the financial position of an
accounting entity at a particular, specified movement of time. It is valid only for a single day,
the very next day it will become obsolete. It contains the information about the resources,
obligations of a business entity and the owner’s interest at a specified point of time.

II. Income statement:

This report has greatest importance to the users of financial statements. It is a performance
report recording the changes in income expenses, profit and losses as a result of business
operations during the year between two balance sheet dates. The income statement is valid
for the whole year.

2.2. Importance of financial statements

Financial statements are the index of the financial affairs of a company. To the owners of the
company, they reveal its progress as evidence by earnings and current financial condition; to
the prospective investors they serve as mirror reflecting potential investment opportunity; to
the creditors they reflect the credit worthiness; labor unions are able to know the fair sharing
of bonus; the economist can judge the extent to which the current economic environment has
effecting its business activity; to the government the financial statements offer a basis of
taxation, control of costs, prices and profits and; to the management they reveal the efficiency
with which business affairs are conducted.

2.3. Users of financial statements

The following are interested in financial statements

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1. Owners: The owners of a business unit have primary concern in operational and
financial results of the company. They wanted to know how safe their investment is and
how effectively it is being used. They expect periodical reports from the directors who
are the custodians of their money.
2. Managers: The managers are entrusted with the financial resources contributed by the
owners and other suppliers of funds for effective utilization. In their pursuit to take the
company to the destination of wealth maximization and maximization of economic
welfare of winners, the managers take several decisions. If their decisions are to be right
and timely, they require relevant financial information.
3. Creditors: The money suppliers are known as the creditors. They are interested in short-
run periodical payment i.e., payment of interest and in long-run to get back their money.
It may include the trade credits also. Thus, financial statements are highly useful.
4. Prospective Investors: Depending upon the financial performance, their financial
soundness and professional way managing the business activities may retain the interest
of existing stock holders and attract the potential. Prospective stock holder, who has the
inclination to invest their surplus or savings. The only basis for them to estimate the
financial position is company’s financial information i.e., income statement and balance
sheet.
5. Employees and Trade Unions: The financial statements are used by the employees
working in the company. It will help them to understand the earning capacity of the
firm and the amount spent on welfare, bonus fringe benefits, working conditions etc.
The trade unions will have better bargaining edge, when it has full information about
the financial date.
6. Consumers: The customers are also interested in the financial statements of a company.
Since, they are the one who is going to bear the cost of goods or services provided by a
company. A realistic appraisal of the firm activities through financial statements would
enable them to know whether they are over priced or exploited by being charged unduly
high rates/prices.
7. Government: It may be seen all over the world today that the governments as the
custodians of general public have assumed a dynamic role in shaping the economic
activities to take their own course in the hands of a few, self-interested capitalists, the
governments have started planning, regulating and controlling the economic affairs of
the country in a systematic way. All these efforts to be fruitful require information
about the economic activities of individual organizations. The financial statements of

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 individual companies serve as a source of information on the basis of tax levies,
granting subsidies or loans, imposing controls, fixing prices, offering protection or even
nationalization, taking over managements etc. the government uses the financial
statements of the business unit as a source.
2.4. Types of analysis

The financial analysis can be broadly divided into two

I) External analysis and

II) Internal analysis.
External Analysis: This kind of analysis will be undertaken by the outsiders of the business
unit. These outsiders include investors, creditors, money suppliers, government and labor
unions. They do not have the access to the records of the company and depend on the
published financial statements and other information which the company furnishes.

Internal Analysis: This analysis is done by persons within the organization. They will have
the access of data i.e., the records of accounting and other information related to the business.
They include executives or employees of the organization.

2. Liquidity Ratios
Liquidity ratios indicate a firm’s ability to pay its obligations in the short run. Potential
lenders carefully examine these ratios before making short-term loans to the firm. The most
commonly used liquidity ratios include the current ratio, quick ratio, cash ratio, and net
working capital to total assets ratio. We discuss each in turn.
Current ratio
The most widely used liquidity ratio is the current ratio. The current ratio is computed by
dividing the firm’s current assets by its current liabilities.
Current ratio = Current assets
Current liabilities
The firm’s current liabilities in the denominator show the amount of short-term obligations
the firm faced at the balance sheet date; the current assets in the numerator indicate the
amount of short-term assets the firm could use to pay these obligations. For example, a
current ratio of 1.5 implies that a firm has $1.50 in current assets for every $1 in current
liabilities and thus has 1.5 times the current assets, or has its current liabilities covered

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1.5 times over. This does not necessarily mean, however, that the firm will be able to pay its
debts when they come due because of the timing of the current assets and liabilities. For
example, a large portion of a firm’s current liabilities may be due now but the company has
much of its current assets tied up in accounts receivable and inventories, which take time to
convert into cash in order to pay current obligations.
A declining current ratio may indicate a declining trend in a firm’s liquidity. Excessively high
current ratios, however, may indicate a firm may have too much of its long-term investor-
supplied capital invested in short-term, low-earning current assets.
Illustration –4
The assets and liabilities of a firm as on the 31 st of Dec., 2015 were as under. Calculate the
current ratio and its net working capital.
Assets Birr Liabilities & Capital Birr
Plant 4, 000, 000 Share Capital 3, 000, 000
Buildings 2, 000, 000 Reserves & Surplus 800, 000
Stock 1, 500, 000 Debentures 3, 000, 000
Receivables 1, 000, 000 Creditors 600, 000
Prepaid Expenses 250, 000 Bills Payable 200, 000
Marketable Securities 750, 000 Accrued Expenses 200, 000
Cash 2, 500 Provision for Taxation 650, 000
Long Term Loan 1, 300, 000
Solution
For calculating the current ratio we need to know the current assets and current liabilities
Current Assets Birr Current Liabilities Birr
Cash 250, 000 Creditors 600, 000
Mkt. Securities 750, 000 Bills Payable 200, 000
Debtors 1, 000, 000 Accrued Expenses 200, 000
Stock 1, 500, 000 Provision for Taxation 650, 000
Prepaid Expenses 250, 000 _________
_________
3, 750, 000 1, 650, 000
Current assets
Current Ratio = Current liabilities = 2.75:1
Net working capital = Current Assets – Current Liabilities
= Birr 3, 750, 000 – Birr 1, 650, 000 = Birr 2, 100, 000

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2. Quick Ratio or Acid Test Ratio
This ratio measures the relationship between Quick assets (or liquid assets) and current
liabilities. An asset is considered liquid if it can be converted into cash without loss of time or
value. Cash is the most liquid asset. Other assets which are considered to be relatively liquid
and include in the quick assets are accounts receivable (i.e. debtors and bills receivable) and
short term investments in securities. Stock or inventory is excluded because it is not easily
and readily convertible into cash. Similarly, prepaid expenses, which cannot be converted
into cash and be available to pay off current liabilities, should also be excluded form liquid
assets.
The quick ratio is calculated by dividing quick assets by current liabilities:
Quick assets
Quick Ratio = Current liabilities or currant receivable -inventory/ CL
Quick ratio is a more refined and vigorous measure of the firm’s liquidity. It is widely
accepted as the best test for the liquidity of a firm.
Generally, a quick ratio of 1:1 is considered to be satisfactory. But this ratio also should be
used carefully. It should also be subjected to qualitative tests, i.e., quality of the assets
included should be assessed.
Illustration –5
Taking the same particulars of assets and liabilities given in illustration –4 of the unit,
calculate the quick ratio.
Solution
Quick Assets Birr Current Liabilities Birr
Cash 250, 000 Current Liabilities 1, 650, 000
Securities 750, 000
Debtors 1, 000, 000
2, 000, 000
Quick assets Birr 2, 000 , 000
=
Quick Ratio = Current liabilities Birr 1, 650 , 000 = 1.21:1
3. Cash Position Ratio
This is also known as ‘super quick ratio’ or ‘super acid test ratio’. It is a still more rigorous
test of liquidity. For calculating this ratio, from the total quick assets the accounts recoverable
(debtors and bills receivable) will also be excluded.

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 Cash+Short Term Investments
Cash Position Ratio = Current Liabilities
The standard norm for this ratio, too, is 1:1.
This ratio is a conservative test of liquidity and is not widely used in practice.

By taking the particulars of assets and liabilities given in Illustration –1, the cash position
ratio of the firm can be calculated thus:
Cash+Securities
Cash Position Ratio = Current Liabilities
Birr 1,000,000
= Birr 1,650,000 =

3. Debt Management Ratios

Debt management ratios characterize a firm in terms of the relative mix of debt and equity
financing and provide measures of the long-term debt paying ability of the firm. The two
basic types of debt management ratios are leverage ratios and coverage ratios. The leverage
ratios include the debt ratio, debt-to-equity ratio, and long-term debt ratio, while the coverage
ratios include the interest coverage ratio and cash flow coverage ratio.
3.1. Debt Ratio
The debt ratio is computed by dividing a firm’s total (current and non-current) liabilities by
its total assets.

Debt ratio = Total liabilities

Total assets
This ratio measures the percentage of a firm’s total assets financed by debt. For example, if a
firm has $1 million in total liabilities and $2 million in total assets, its debt ratio is 50 percent,
meaning that the firm finances 50 percent of its assets with debt. The higher the debt ratio,
the more of a firm’s assets are provided by creditors relative to owners. It is a generalized
debt ratio in the sense that debt includes all current liabilities, non-current liabilities, and
long-term borrowings of the firm. Creditors prefer a low or moderate debt ratio because it
provides more protection if the firm experiences financial problems.
Two useful variations of the debt ratio are the debt-to-equity ratio and the equity
multiplier. The debt-to equity ratio is computed by dividing the firm’s total liabilities by its
total equity.

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 Debt-to-equity ratio = Total liabilities
Total equity
Returning to our example, a firm with $1 million in liabilities and $1 million in equity would
have a debt-to-equity ratio of 100 percent, meaning that the firm has $1 in debt financing for
each $1 in equity financing.
3.2. Long-term Debt Ratio
The long-term debt ratio is computed by dividing a firm’s long-term debt, usually defined
as all noncurrent liabilities, by its total assets. By excluding current liabilities, this ratio may
provide better insight into a firm’s debt management policy. Some current liabilities, such as
accounts payable, result from operations and may not be relevant to the firm’s debt
management policy.
Long-term debt ratio= Long-term debt
Total assets
When computing the debt ratio and long-term debt ratio, some managers and analysts use
total capital in the denominator in place of total assets. The resulting ratios are defined as the
debt-to-total-capital and long-term debt to total capital ratios, respectively. Total capital
includes all noncurrent liabilities plus equity, and thus excludes short-term debt.
We exclude short-term debt because it usually does not represent a permanent source of
financing and is thus constantly changing, and because some current liabilities, such as
accounts payable, reflect the firm’s trade practice more than its debt management policy.

3.3. Interest Coverage Ratio

The interest coverage ratio, also called times interest earned, is computed by dividing the
firm’s earnings before interest and taxes (EBIT) by its interest expense.
Interest coverage ratio = EBIT
Interest expense
This ratio measures the margin by which the firm can pay interest expense from its operating
earnings. A firm with EBIT of 100 and interest expense of 50 would have twice the EBIT it
needs to meet its interest expense payment and would have an interest coverage ratio of 2.0
times.
What is an acceptable interest coverage ratio? This largely depends on the expected level of
the firm’s future EBIT, as well as the volatility of EBIT. Firms with stable operating earnings

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can typically borrow more because of the lower probability of operating earnings dipping
below the level of interest expenses. Firms with more volatile and unpredictable operating
earnings should rely less on debt financing to avoid potential financial distress and
bankruptcy.
3.4. Cash Flow Coverage Ratio
The interest coverage ratio is an earnings-based ratio. Since firms pay debt and other
financial obligations with actual cash (not earnings), cash flow ratios may provide a better
indication of a firm’s ability to meet these obligations. One version of a cash flow coverage
ratio is computed by adding back depreciation to the firm’s EBIT in the numerator:
Cash flow coverage ratio = EBIT depreciation
Interest expense
Depreciation is added back to EBIT to estimate cash flow because depreciation is a noncash
expense subtracted from revenues to calculate EBIT on the income statement.
The interest coverage and cash flow coverage ratios for Home Depot for fiscal year 2005 are
shown below.
Interest coverage ratio = 5,909
37 = 159.70 times
Cash flow coverage ratio = 5,909 +903
37 = 184.11 times
Using reported interest expense may overstate coverage ratios because firms may capitalize
some interest costs incurred during the construction period of long-lived assets.

4. Asset Management Ratios

Asset management ratios, also referred to as asset utilization or asset efficiency ratios,
measure a firm’s ability to manage the assets at its disposal. Commonly used asset
management ratios include the accounts receivable turnover ratio, inventory turnover ratio,
accounts payable turnover ratio, fixed asset turnover ratio, and the total asset turnover ratio.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is computed by dividing net credit sales by the
average accounts receivable outstanding. When the financial statements do not separate cash
and credit sales, total net sales are often used in the numerator. Technically, the numerator
should only include credit sales because the accounts receivable in the denominator arise only
from credit sales.
Accounts receivable turnover ratio = Net credit sales

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 Average accounts receivable
This ratio measures how many times a firm’s accounts receivable are generated and collected
during the year. In general, higher receivables turnover ratios imply that a firm is managing
its accounts receivable efficiently. But a high accounts receivable turnover ratio may indicate
that a firm’s credit sales policy is too restrictive; management should consider whether a
more lenient policy could lead to enhanced sales. Managers should analyse the trade-off
between any increased sales from a more lenient credit policy and the associated costs of
longer collection periods and more uncollected receivables to determine whether changing
the firm’s credit sales policy could increase shareholder wealth.
Average accounts receivable is used in the denominator because the net credit sales is a
cumulative sales number that reflects operations over one year, while a balance sheet item
reflects the amount at the end of the fiscal year. Averaging a firm’s monthly or quarterly
receivables over the year typically yields a better estimate of the receivables outstanding
during the year. One common approach to determining average accounts receivable is to add
the beginning and ending amounts for the period and divide by two.
A variant of the accounts receivable turnover ratio is the receivables collection period,
which is computed by dividing 365 by the accounts receivable turnover ratio.
Receivables collection period = 365
Accounts receivable turnover ratio
As its name suggests, the receivables collection period indicates how many days a firm takes
to convert accounts receivable into cash. If the receivables collection period exceeds a firm’s
credit terms, this may indicate that a firm is ineffective in collecting its credit sales or is
granting credit to marginal customers. The receivables collection period for Home Depot is
24.97 days.
Receivables collection period = 365
14.62 = 24.97 days
4.1. Inventory Turnover Ratio
The inventory turnover ratio is computed by dividing the cost of goods sold by the average
inventory.
Inventory turnover ratio = Cost of goods sold
Average inventory
This ratio measures how many times a firm’s accounts payable are generated and paid during
the year. In general, as long as a firm pays its bills in a timely manner and satisfies its
financial obligations to its suppliers, the lower the payables turnover ratio the better.

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The accounts payable turnover ratio for Home Depot for fiscal year 2005 was 10.04 times.
Accounts payable turnover ratio = 40,139
(3,436 + 4,560) = 10.04 times
The accounts payable payment period can be computed by dividing 365 by the accounts
payable turnover ratio.
Accounts payable payment period = 365
Accounts payable turnover ratio
The accounts payable payment period measures how long, on average, a firm takes to pay its
accounts payable. Think of the accounts payable payment period as the counterpart to the
average collection period. In general, higher accounts payable payment periods are beneficial
to the firm as accounts payable are a low cost source of funds for the firm. The average
accounts payable payment period for Home Depot is 36.35 days.
Accounts payable payment period = 365
10.04 = 36.35 days
4.2. Asset Turnover Ratios
Other asset management measures include two ratios that measure how efficiently
management is using its fixed assets and total assets to generate sales. The fixed asset
turnover and total asset turnover ratios are computed by dividing net sales by the
appropriate asset figure:
Fixed asset turnover ratio = Net sales
Average net fixed assets

Total asset turnover ratio = Net sales

Average total assets
The fixed asset turnover ratio indicates how effectively a firm’s management uses its net
fixed assets to generate sales. Similarly, the total asset turnover ratio indicates how
effectively management uses total assets to generate sales. For example, a fixed asset
turnover of 2.0 times would indicate that the firm generates $2.00 of net sales for each dollar
invested in net fixed assets. Higher asset turnover ratios generally indicate more efficient use
of the firm’s assets.
5. Profitability Ratios
Profitability ratios measure the earning power of a firm. They measure management’s
ability to control expenses in relation to sales and reflect a firm’s operating performance,
riskiness, and leverage. Some of the most commonly used profitability ratios include the

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gross profit margin, operating profit margin, net profit margin, return on assets, and total
return on assets, return on total equity, and return on common equity.
Profitability in relation to sales
Under this category many profitability ratios are calculated relating different concepts of
profit to the sales value. Some such ratios are:
5.1. Gross Profit margin or Gross Profit to Sales
This ratio is calculated by dividing gross profit by sales value.
Gross profit Sales−Cost of goods sold
=
Gross profit margin = Sales Sales
This ratio is usually expressed as a percentage. It indicates the efficiency with which
management produces each unit of product or service. It reveals the spread (difference)
between sales value and cost of goods sold. A high gross profit margin (compared to the
industry average) indicates relating lower cost of production of the firm concerned. It is an
index of good management. A lower gross margin indicates higher cost of goods sold (which
might be due to purchase of an unfavorable items inefficient utilization of plant and
machinery or over-investment in plant, machinery and equipment), or lower sales values
(which could be due to fall in prices in the market, reduction in selling price, less volume of
sales, etc.)
5.2. Gross Operating Margin
This ratio is calculated by dividing gross operating margin by sales.
Gross operating margin = Gross profit minus operating expenses except depreciation.
This ratio indicates the extent to which the selling price per unit may decline without
incurring any loss in the business operations. It is rather difficult to evolve a standard norm
for this ratio. But it should not be lower than that of similar concerns.
Example: Sales: Birr 1, 000, 000; Gross profit: Birr 500, 000; Operating expenses excluding
depreciation: Birr 100, 000; Depreciation: Birr 10, 000.
Birr 500, 000−Birr 100,000
Gross operating margin = Birr 1,000 ,000 = 40%
5.3. Net Operating Margin
This ratio is calculated by dividing the net operating profit by (net) sales. The net operating
profit is obtained by deducting depreciation form the gross operating profit. Taking the
particulars of the example given above, the net operating margin may be calculated as
follows:

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 Gross Operating Margin−Depreciation×100
Net Operating Margin = Sales
Birr 400, 000−Birr 10 , 000
= Birr 1,000 ,000 = 39%
For this ratio no standard norm is evolved. The ratio of a firm may be compared with that of
sister concerns to measure the relative position.
5.4. Net Profit Margins or Net Profit to Sales
This is one of the very important ratios and measures the profitableness of sales. It is
calculated by dividing the net profit by sales. The Net profit is obtained by subtracting
operating expenses and income tax from the gross profit. Generally, non-operating incomes
and expenses are excluded for calculating this ratio. This ratio measures the ability of the firm
to turn each Birr of sales into net profit. It also indicates the firm’s capacity to withstand
adverse economic conditions. A high net profit margin is a welcome feature to a firm and it
enables the firm to accelerate its profit at a faster rate than a firm with a low net profit
margin.
In order to have a more meaningful interpretation of the profitability of a firm, both gross
margin and net margin should jointly be evaluated. If the gross margin has been on the
increase without a corresponding increase in net margin, it indicates that the operating
expenses relating to sales have been increasing. The analyst should further analyze in order to
find out the expenses which are increasing. The net profit margin can remain constant or
increase with a fall in gross margin only if the operating expenses decrease sufficiently.
5.5. Operating Ratio
The ratio is an index of the operating efficiency of the firm. It explains the changes in the net
profit margin. This ratio is calculated by dividing all operating expenses (i.e., cost of goods
sold plus administration and selling expenses) by sales.
Cost of goods sold+Operating expenses
Operating ratio = Sales
This ratio is also expressed as a percentage.

A higher operating ratio is always unfavorable because it would leave only a small amount of
operating income for meeting non-operating expenses (like interest) dividends, etc. In other
to get an idea about the operating efficiency of the firm, this ratio over a number of years
should be studied. Variations on the operating ratio occur because of many factors such as
changes in operating expenses and cost of goods sold, changes in sale price or demand for the

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product and volume of sales. Thus there are both internal and external (and uncontrollable)
factors which influence the operating ratio of a firm. As such, this ratio should be used
cautiously. This ratio again cannot be of much use to firms where the non-operating incomes
and expenses constitute a significant part of the total income.
Example
Sales: Birr 2, 000, 000; Opening Stock: Birr 200, 000; Manufacturing cost: Birr 1, 000, 000;
Closing Stock: Birr 150, 000; Administrative Expenses: Birr 50, 000; Selling Expenses: Birr
40,000; Depreciation: Birr 40, 000. Calculate the operating ratio.
Solution
Cost of goods sold+Operating expenses
Operating Ratio = Sales
(Birr 200 ,000+1 , 000 ,000−Birr 150 ,000 )+(Birr 50 , 000+Birr 40 , 000+Birr 40 , 000)
=
Birr 2 ,000 ,000
Birr 1,050 ,000+Birr 130 ,000 Birr 1 ,180 ,000
= = =0 .59 or 59 %
Birr 2 ,000 ,000 Birr 2,000 ,000
5.6.Expense Ratios
The operating ratio gives an aggregate picture of the operating efficiency of the firm. To
know how individual expense items behave, the ratio of each individual operating expense to
sales should be calculated. These ratios, when studied over a period of years, help in knowing
the managerial efficiency in the fields of operations concerned. Taking the particulars of the
example given for operating ratio, calculation of different ratios can be as follows:
Birr 1,050,000
Cost of goods sold to Sales = Birr 2,000,000 = 52.5%
Birr 50,000
Administrative expenses to Sales = Birr 2,000,000 = 2.5%
Birr 40,000
Selling Expenses to Sales = Birr 2,000,000 = 2.00%
Birr 40,000
Depreciation to Sales = Birr 2,000,000 2.00%
Illustration –8
Calculate the profitability ratios relating to sales from the following Income Statement of
S.S.PLC.
Income Statement for the year ending on …
Sales 2, 000, 000

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(-) Cost of Goods 1, 400, 000
Gross Profit 600,000
(-) Operating Expenses:
Office 50, 000
Selling & Distribution 20, 000
70, 000
Gross Operating Margin 530, 000
(-) Depreciation 130, 000
Net Operating Profit 400, 000
+ Non-operating income 10, 000
(-) Non-operating exp. Int. 20, 000
10, 000
Net Profit before tax 390, 000
(-) Income Tax (50%) 195,000
Profit After Tax 195,000
Solution
Gross Profit Birr 600 ,000
×100= ×100=30 %
Gross Profit Margin = Sales Birr 200 ,000
Gross Operating Margin =

Gross Operating Profit Birr 530 , 000

= ×100=26 . 5 %
Sales Birr 2 , 000 , 000
Net Operating Profit Birr 400 ,000
= =20 %
Net Operating Profit = Sales Birr 2, 000 , 000
Net Profit After Tax Birr 195 ,000
= =9 .75 %
Net Profit Margin = Sales Birr 2 , 000 ,000
Cost of goods sold+Operation Expenses
Operating Ratio = Sales
Birr 1, 400,000+Birr 50 ,000+Birr 20, 000+Birr 130 ,000
=
Birr 2 ,000,000
Birr 1,600,000
= =80 %
Birr 2 ,000,000
Birr 1 ,400,000
=70%
Cost of goods sold to Sales = Birr 2 ,000,000

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 Birr 50,000
=2.5%
Office Expenses to Sales = Birr 2,000,000
Br. 20,000
1.00%
Selling and distribution expenses to Sales = Br. 2,000,000
Br . 130,000
=6.5%
Depreciation to Sales = Br. 2,000,000
Profitability of a firm in relation to sales can also be analyzed by calculating the activity of
turnover ratios which have already been explained in the earlier unit.
5.7 Return on Assets
The return on assets (ROA) ratio measures the net income generated from each dollar
invested in total assets, and is usually calculated as:
Return on assets = Net income
Average total assets
The net income should be from recurring operations, thereby excluding income or loss from
transactions outside the ordinary course of business. Analysts often compute average total
assets as the sum of the beginning and ending total assets for the period divided by two. ROA
ratios are also affected by the age of a firm’s plant and equipment, especially during periods
of moderate to high inflation. If the firm’s fixed assets are old and have been depreciated to a
low book value, and the assets have not lost their productive ability, then the low figure in the
denominator will inflate ROA.

5.8. Total Return on Assets

Since total assets are financed by both debt and equity and provide returns to both groups of
investors, some analysts compute total return on assets by adding a firm’s interest expense
to the numerator.
Total return on assets = Net income Interest expense
Average total assets
Without this adjustment, firms with high relative amounts of debt financing will have lower
returns on assets.
5.9.Return on Total Equity
The return on total equity (ROE) ratio measures the accounting return earned on the capital
provided by the firm’s preferred and common stockholders. The computation of ROE is:

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Return on total equity = Net income
Average total equity
ROE indicates how well management has used shareholder resources to generate net income.
This ratio is often referred to as return on total equity (ROTE) because the equity figure
includes both common and preferred equity and the net income before any dividends paid to
common or preferred shareholders.
5.10. Return on Common Equity
Return on common equity (ROCE) focuses on just the return to common shareholders and
is computed by removing the dividends to preferred shareholders from net income and
dividing by the capital provided by common shareholders.
Return on common equity = Net income - Preferred dividends
Average common equity
Both return on equity ratios are accounting-based measures that do not typically represent the
actual return earned by shareholders. Net income is an accrual-based accounting measure of
profit earned during the period and may differ substantially from the net cash flow generated
during the period. Also, the equity amount in the denominator represents the equity capital
that has been invested in the firm, including reinvestment of retained earnings, but does not
represent the current market value of the firm’s equity investment.
6. Market Value Ratios
Market value ratios use market data such as stock price to provide useful information about
the firm’s relative value. Commonly used market value ratios include the price-to-earnings
ratio, market-to-book value ratio, dividend yield, and dividend playout.
Price/earnings Ratio
The price/earnings (P/E) ratio, one of the most widely used financial ratios, is computed by
dividing the market price per share of the firm’s common stock by its earnings per share.
Price/earnings ratio = Market price per share
Earnings per share
The P/E ratio indicates how much investors are willing to pay per dollar of earnings for
shares of the firm’s common stock. It provides an important indication of how the market
perceives the growth and profit opportunities of a firm. High growth firms with strong future
profit opportunities will command higher P/E ratios than firms with lower expected growth
and profits. The P/E ratio has several potential shortcomings. For example, a firm can have

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negative earnings, which produces a meaningless P/E ratio. In addition management can
distort reported earnings because of the discretion allowed by accounting practices.
6.1.Market-to-book Value Ratio
A firm’s market-to-book value ratio is computed by dividing the market value of the firm’s
equity by its book value of equity.
Market-to-book value ratio = Market value of equity
Book value of equity
In this ratio, book value of equity equals total assets minus total liabilities less preferred
stock. The market-to-book value ratio measures how much value the firm has created for its
shareholders. To the extent the ratio exceeds 1.0 times, management has succeeded in
creating value for the shareholders. If the book value of a firm’s equity is understated due to
inflation, the ratio will provide an imprecise measure of this relationship. Home Depot’s
market to book ratio is computed below:
6.2. Dividend Yield and Playout
Dividend yield is computed by dividing a firm’s dividends per share by the market price of
its common stock.
Dividend yield = Dividends per share
Market price per share
Dividend yield represents part of a stock’s total return; another part of a stock’s total return is
price appreciation. The dividend payout is the percentage of a firm’s earnings paid out as
cash dividends.
Dividend payout = Cash dividends per share
Earnings per share

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