FINANCIAL STATEMENTS ANALYSIS AND EVALUATION

1.0. INTRODUCTION

The financial statement analysis can be defined as the process of

identifying financial strengths and weaknesses of a company by properly

establishing relationships between the items in the statement of profit or

loss and items in the statement of financial position.

1.1. PARTIES WHO UNDERTAKE FINANCIAL STATEMENTS

ANALYSIS

Management
They analyse all aspect of the financial statements to ensure overall
financial success of the company.
Investors
Investors analyse the financial statements to determine the company’s
earning and their focus is on the company’s present and future profitability.
Providers of long term debts
They are concerned with company’s long term solvency and survival.
Suppliers of goods and services
They are interested in the company’s ability to meet their obligations over a
short period of time.

1.2. TYPES OF FINANCIAL STATEMENTS ANALYSIS

Time series Analysis
This has to do with comparing the present ratios with the past ratios e.g.
comparing the ratios of year 2018 with the ratios of 2017.
Cross Sectional Analysis
This involves comparing the ratios of one company with some selected
companies in the same industry at the same point in time.

Industry Analysis
This is the comparison of a company’s ratio with the average ratio of the
industry in which the company operates.
Pro-forma-Analysis
Using the future ratios as a standard of comparison

1.3. USEFULNESS OF FINANCIAL STATEMENT ANALYSIS

(a) It serves as a guide by providing the indication of a company’s past
performances and near-present financial position.
(b) It helps in predicting the company’s future performance.
(c) It helps in determining the ability of the company to pay its current
liabilities as they fall due.
(d) It assists in the inter-company comparison.
(e) It assists in the determination of the company’s ability to meet its
long-term obligation.
(f) It assists to determine the efficiency with which the company is
using its assets in generating revenue.
(g) It aids in the construction of a pattern of the firm’s behavior and
financial position.

1.4. LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS

The following constitute a limitation to financial statement analysis:
 i. Comparison may be difficult where financial statements are not
prepared on the same date.
ii. Ratios based on historical cost figures do not give true picture of
trends from year to year due to the impact of inflation.
iii. Comparing the financial statements of similar businesses can be
misleading for number of reasons, including effects of size
differences and of operating in different markets.
iv. Only items that can be measured in monetary terms are included
in the financial statements.
v. Information in the annual report and account may be inadequate to
enable detailed analysis to be carried out.
vi. Accounting policies of companies may differ thereby making
comparison difficult.
vii. Industrial average may not be available.
viii. There may simply be insufficient data to calculate the required
ratio.
ix. Unavailability of a “suitable yardstick” with which calculated ratio
may be compared.
x. Profit and capital employed are arbitrary figures. They depend on
the accounting policies adopted by the company.
xi. Use of creative accounting gives misleading results.

1.5. CATEGORIES OF RATIOS

Ratios are categorized into six groups, namely,
(a) Profitability /Financial Performance Ratios
(b) Efficiency/Activity Ratios
(c) Liquidity/Short Term Solvency Ratios
(d) Long Term Solvency/Financial Stability Ratios
(e) Investment Ratios
(f) Assets Utilization Ratios

1.5.1. PROFITABILITY ( OR FINANCIAL PERFORMANCE) RATIOS

These ratios measure the overall performance and effectiveness of the
company. Examples of profitability ratios are:
Gross Profit Margin
Higher gross profit margin indicates higher profit, while lower margin
indicates lower profit.
Net Profit Margin
This is a good measure of the company’s net trading result in relation to
other periods or even other firms in the same industry. Higher net profit
margin indicates higher net profit, while lower margin indicates lower profit.
Expenses Margin
Management generally has greater control over operating expenses than
over revenue. The operating expenses ratio is often used as a measure of
management’s ability to control its operating expenses.
Returns on Capital Employed
This measures the percentage of earnings generated by total assets. In
other words, it measures management ability to earn a return from funds
supplied from all sources. It is called the Return on equity if the capital
employed equals total equity. Here, the return will be only profit for the year
i.e. profit after tax (PAT). It is called the Return on Asset if capital employed
equals total assets i.e. total equity plus total liabilities sometimes less
current liabilities. Here, the return will be profit before interest and tax
(PBIT).
1.5.2. EFFICIENCY (OR ACTIVITY) RATIOS
These ratios measure how efficient the management of the company has
been in the management of the company’s working capital. Efficient
management of working capital improves the liquidity position of the
company. Examples of efficiency ratios include:
Inventory Turnover
This shows the speed in number of times per period at which the average
figure of inventory is being sold i.e turned over.
Inventory Period
This shows the number period i.e. days / weeks or months it takes the
company to hold inventory.
Accounts Receivable Turnover
This indicates the number of times receivables are collected from
customers in each period. In other words, it shows how quickly a company
converts its receivable into cash. The higher the receivable turnover, the
more liquid the company is.
Accounts Receivable Collection Period
This indicates how long it takes the company to collect receivables from the
customers. In other words, it measures the number of credit days given by
the company to its customers. The shorter the receivable collection period
the more liquidity the company is.
Accounts Payable Turnover
This indicates how many times the suppliers are paid in each period. In
other words, it measures the number of credit days received by the
company from its suppliers. The shorter the payable turnover, the more
liquidity the company is.

Accounts Payable Payment Period

This indicates how long it takes the management to pay the suppliers of
goods and services.
1.5.3. LIQUIDITY (OR SHORT TERM SOLVENCY) RATIOS
These ratios measure the ability of a company to meet its current (short-
term) obligations i.e pay its short-term debts. Examples of these ratios are:
Current Ratio
This measures the ability of a company to settle its total current liabilities
from its total current assets. Ideal ratio is 2:1.
Quick (or Acid Test) Ratio
This ratio measures the ability of a company to settle its total current
liabilities from its total current assets less value of closing inventory. Ideal
ratio is 1:1.

1.5.4. LONG TERM SOLVENCY (OR FINANCIAL STABILITY) RATIOS

These ratios measure the ability of a company to settle its long-term
liabilities and the interest on these liabilities. They also measure the
company’s ability to continue to operate as a going concern. The reason is
that if the long-term debt holders decide to pull out their funds from the
company, the operations of the company may collapse. Examples of these
ratios are:
Debt Ratio
This ratio measures the level of dependence of a company on debt finance.
High debt ratio indicates great dependency on debt finance. Above 50% is
high.

Debt: Equity Ratio

This measures the relationship between the total debt and total equity.
Above 100% is high. If it is high, investment is risky.
Gearing Ratio
This ratio measures the relationship between the fixed interest capital and
the total assets. If it is above 50%, it is high and indicates great
dependency on debt finance.
Proprietary (Equity or Net worth) Ratio
This ratio measures the relationship between the owners’ equity and the
total assets. It is used to evaluate the soundness of the capital structure of
the company.
Interest Cover
This measures the extent to which profit before interest and tax covers the
interest on loan. The higher the interest cover, the better for the company.

1.5.5. INVESTMENT RATIOS

These ratios measure the company’s earnings and growth potentials.
Examples of these ratios are:
Dividend per Share
This measures the amount of dividend to be paid for a unit of shares. The
higher, the more attractive the investment is.
Dividend Cover
This indicates the number of times, the earnings cover dividend.
Dividend Payout Ratio
This ratio shows the percentage of total dividend paid out of total earnings.

Dividend Yield
This is the return a shareholder is currently expecting on the share of the
company.
Earnings Yield
This also evaluates the shareholders’ return in relation to the market value
of the shares.
Earnings per Share
This is a measure of income earned on each ordinary shares. Earnings per
share amount must appear on the face income statement of the public
companies. Non-public companies are not required to disclose earnings
per share amounts.
Price-Earning (P/E) Ratio
This is an indicator of the earning performance of the ordinary shares. P/E
ratio is the reflection of the stock market assessment about the future
earnings of the company. Investors are willing to buy a unit of share for as
many as 15 to 20 times the current per share earnings because they feel
the future income growth of the firm will be sufficient to provide an
adequate return on investment.

1.5.6. ASSETS UTILIZATION RATIOS

These ratios measure how efficient the company is utilising its assets to
generate revenue. Examples of these ratios are:
 Total Assets Turnover
This ratio measures the number of times the total revenue covers the total
assets of the company.

Non-current Assets Turnover

This measures the number of times the company’s revenue covers its non-
current assets.
Working Capital (or current Asset) Turnover
This measures the number of times the company’s revenue covers its
current assets.
Net working capital (Net current Assets) Turnover
This measures how many times the company’s sales covers its net current
assets.
1.6. STANDARDS USED FOR COMPARISON OF RATIOS
The standards used for the comparison of ratios are:
(a) Past Ratios
(b) Competitor Ratios
(c) Industry Ratios
(d) Projected Ratios.

SUMMARY OF RATIOS
PROFITABILITY RATIOS:
(1) Gross profit margin = Gross profit x 100 = %
Revenue 1

(2) Net profit margin = Net profit before interest & tax x 100 = %
Revenue 1
(3) Expenses margin = Expenses x 100 = %
Revenue 1

(4) Return on Capital Employed (ROCE) = Return x 100 =%

Capital Employed 1

Note:
(a) Where capital employed equals total assets i.e. total equity plus total
liabilities (Gross capital employed) or total assets less current liabilities
(Net capital employed), the return will be profit before interest and tax
(PBIT). Here we calculate the return on asset.
(b) Where capital employed equals total equity, the return will be profit for
the year i.e. profit after tax (PAT). Here we calculate the return on equity
or return on shareholders’ fund.
(c) The best to use is (a) since it takes into account the totality of the capital
employed.

EFFICIENCY (PERFORMANCE OR ACTIVITY) RATIOS:

(1) Inventory turnover = Cost of Sales = times
Average Inventory
(2) Inventory period = Average Inventory x 365 = days
Cost of sales
(3) Account receivable turnover = Credit Revenue = times
Average receivable

(4) Receivable collection period = Average Receivable x365=days

Credit Revenue

(5) Accounts payable turnover = Credit Purchases = times

Average Payable

(6) Accounts payable payment period = Average Payable x 365 = days

 Credit Purchases

LIQUITY OR SHORTERM SOLVENCY RATIOS:

(1) Current Ratio = Current Assets
Current Liabilities Ideal Ratio is 2:1

(2) Acid Test/Quick Ratio= Current Assets-inventory Ideal Ratio 1:1

Current Liabilities

LONG TERM SOLVENCY OR FINANCIAL STABILITY RATIOS:

(1) Debt Ratio = Total Debt x 100 = %

Total Assets 1

(2) Gearing Ratio = Fixed Interest Capital x 100 = %

Equity + Long- term Debt 1

Note: Fixed Interest Capital = Loan notes + Preference Shares

(3) Debt: Equity Ratio = Total Debt x 100 = %

Total Equity 1

(4) Interest Cover = Profit before Interest and Tax = times

Interest

(5) Proprietary Ratio = Total Equity x 100 = %

Total Tangible Assets 1

(6) Cash flow ratio = Net Cash Flow x 100 = %

Total Debt 1

Note: Net cash flow = Net profit before interest & tax + depreciation, while
Total debt = Total liabilities

INVESTMENT RATIOS:
(1) Dividends per share = Total dividend = N or Kobo
No. of ordinary shares
 (2) Earnings per share = Profit for the year – Pref. Dividend
No. of ordinary shares issued
(3) Price-Earnings Ratio (P/E Ratio) = Market Price Per Share
Earnings Per Share

(4) Dividend Cover = Earnings Per Share = times

Dividend Per Share

(5) Dividend Payout Ratio = Dividend Per Share x 100 = %

Earnings Per Share 1

(6) Dividend yield = Dividend Per Share x 100 = %

Market Price per Share 1
(7) Earnings yield = Earnings Per Share x 100 = %
Market Price per Share 1
ASSETS UTILISATION RATIOS:

(1) Total Assets Turnover = Revenue = times

Total Assets

(2) Non- Current Assets Turnover = Revenue = times

Non-current Assets

(3) Net Current Assets Turnover = Revenue = times

Net Current Asset

ILLUSTRATION
MOWEL PLC
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH
2021:
2021 2020
N’000 N’000
Revenue 411,590 349,200
Cost of sales (247,860) (214,720)
Gross profit 163,730 134,480
Distribution Expenses (66,040) (54,270)
Administrative Expenses (46,270) (34,830)
Finance costs (1,500) (1,500)
Profit before Tax 49,920 43,880
Income tax expense (19,960) (15,550)
Profit for the year 29,960 28,330
Dividend paid 15,410 12,140
MOWEL PLC

STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 2021:

2021 2020
N’000 N’000
Non- current assets:
Property, plant and equipment 159,300 130,400
Current Assets:
Inventories 60,020 51,390
Trade Receivable 10,870 4,180
Bank & cash balances 61,120 43,640
Total assets 291,310 229,610

Equity:
Ordinary share capital @ 1N each 59,000 50,000
Share premium 28,400 28,400
Retained earnings 39,500 14,340
Revaluation reserve 41,230 41,230
168,130 133,970
Liabilities:
Non- current liabilities:
Loan notes 15,000 15,000
Current liabilities:
Trade payable 83,110 53,120
Bank overdraft 17,210 21,350
Taxation 7,860 6,170
Equity and liabilities 291,310 229,610

Additional information:
(a) All sales and purchases are on credit
(b) Purchases, trade receivable and trade payable during the year are:
Year Purchases Receivables Payables
 N’000 N’000 N’000
2021 256,490 10,870 83,110
2020 220,150 4,180 53,120
2019 180,190 2,620 40,050
(c) The market price of the company’s share has been fairly stable at
N20.14 per share. The closing inventory of Mowel Plc. as at 31
December 2019 was N42,500.

You are required to calculate the following ratios:

(a) Profitability Ratios
(b) Activity or Efficiency Ratios
(c) Liquidity Ratios
(d) Long-Term Solvency(or Financial Stability) Ratios
(e) Shareholders’ Investment Ratios
(f) Assets Utilization Ratios

ASSIGNMENT
Below are the statements of financial position of Onye Nigeria Plc as at
31October 2020 and extract from the statement of profit or loss for the year
ended on that date:
Onye Nigeria Plc
Statement of financial position as at 31October 2020
2020 2019
Non-current assets: N’000 N’000
Property plant and equipment 8,325 6,435
Current assets:
Inventories 2,880 2,205
Trade receivables 5,535 4,860
Cash and bank 360 540
17,100 14,040
Equity and liabilities:
Ordinary share capital 3,600 3,600
Retained earnings 5,603 3,938
Non-current liabilities:
10% loan notes 3,600 2,700
Current liabilities:
Trade payables 3,375 3,105
Bank overdraft 495 360
Taxation 135 90
Accrued expenses 292 247
17,100 14,040

Onye Nigeria Plc

Extracts from Statement of profit or loss for the year ended October 31
2020 2019
N’000 N’000
Revenue 50,400 43,875
Cost of sales 38,070 30,713
Profit before taxation 2,093 1,440

(1) Additional information:

The profit before tax is after charging
2020 2019
N’000 N’000
Depreciation 1,620 1,620
interest on loan note 360 270
 Interest on bank overdraft 68 41
Audit fees 54 45

(2) The latest industry average ratios is as follows:

ROCE (capital employed = equity and loan notes) 18.50%
Net profit margin 4.73%
Gross profit margin 35.23%
Assets turnover 3.91 times
Current ratio 1.90:1
Quick ratio 1.27:1
Trade receivables period 52 days
Trade payables period 49 days
Inventory turnover 18.30 times
Gearing ratio 32.71%

Required:
(a) Calculate the above ratios of Onye Nigeria Plc for years 2019 and
2020.
(b) Analyse the performance and liquidity of Onye Nigeria Plc for year
2020.