ANALYSIS OF FINANCIAL STATEMENTS

5.1 INTRODUCTION

Projects as any other business organizations use resources in their operations.

These resources are made available to some projects or organizations and not to
others. It is very important for the projects or organizations employing these
resources to use them efficiently and effectively.

Thus it is important to analyze financial statements so as to evaluate performance

and financial positions. The trading and profit and loss account shows the results
of operations by way of profit and loss. The balance sheet shows the financial
position of the project or organization. More insight into the financial
performance and financial position of projects or organizations can be gained by
analyzing the financial statements by means of ratios.

The purpose of this handout is to describe, explain and discuss some ratios used to
evaluate a project’s/organization’s/company’s performance.

5.2 The Classification of Ratios

Financial ratios can be classified into five (5) categories.

(a) Solvency or liquidity ratios

(b) Profitability ratios
(c) Efficiency or activity ratios
(d) Leverage ratios
(e) Investment ratios (or stock market ratio)

We shall explain and discuss all the ratios but compute those for which data are
available
 Ratios
Liquidity ratios (solvency
ratios)
Profitability ratios
Efficiency ratios
Leverage ratios
Purpose Served
Show project’s/organization’s ability to
meet short-term obligations.
Gauge project’s/organization’s profitability
based on sales (or turnover) and investment
in assets.
How efficient operations have been and
how well assets have been used to generate
sales.
Show the extent of debt in financing the
project/organization/company

Invesment Ratios Show the performance of investment in

shares

To compute the various ratios we are going to use figures from the financial
statements of GMK Limited, which are attached.

5.2.1 SOLVENCY OR LIQUIDITY RATIOS

To evaluate an organization’s or project’s ability to pay short term debts as they
fall due current assets are compared to current liabilities in order to give the
current ratio. It is meaningful to assets this ability because current liabilities are
settled out of current assets, utilizing cash/bank.
The standard ratio is: 1:1.

Using information from the balance sheet of GMK

(a) Current Ratio

Current Assets K 712 884

Current Ratio = Current Liabilites = K 178 200 = 4.0

There are enough current assets to meet current liabilities. In fact, current
liabilities are covered 4 times by current assets. This is in excess of the
standard of 1:1. It is advisable for a project to be able to meet its current
liabilities because failure to do so will prompt creditors to take legal action
against the project which may include winding up operations.

Using liquid assets or quick assets are defined as current assets less stock
the quick ratio or acid test can be calculated. This is a further indicator of
ability to pay it excludes stock which might take long to sell and get cash.
 Current assets less stock are called quick assets. The ratio of quick assets
to current liabilities is called the quick ratio. For GMK this was:

(b) Quick Ratio Acid Test Ratio

Current Assets Less Stock

Quick Ratio Acid Test Ratio = Current Liabilities
K 712 884−277 300
= K 178 200

K 435584
= K 178200

= 2.4
Quick assets exceed current liabilities more than 2 times. Once more it is noticed
that current liabilities are more than adequately covered.

Current assets differ in their liquidity, some current assets are more liquid than
others. Stock is excluded from other current assets in order to show that it is the
least liquid of the current assets. It requires time to convert it into cash and may
also lose value. The problem is that by excluding stock it is implied that stock is
worthless. This is not true.

It is a fact that stock takes time to convert into cash or to liquidate it. But it can
never be wholly worthless. Other current assets such as debtors and cash are
more liquid than stock. The ability to pay short-term obligations is enhanced by
how fast debtors pay their debts and the speed of payment to suppliers.

Therefore, for GMK we can conclude that current assets are adequate to pay
current liabilities even when stock is excluded. However, GMK has
unnecessarily huge amounts of cash. Cash is not an earning asset. Cash does not
earn a return unless it is invested. Therefore, keeping huge amounts of cash in
hand and at bank is not productive. GMK should consider investing excess cash
in short-term investments to earn some return.

(c) Other ratios – Debtors, stock and creditors turnover are also helpful in the
evaluation of the liquidity of an entity.

Ratio Meaning
Debtor’s Turnover How fast they pay
 Stock Turnover How fast stock is bought and sold
Creditors Turnover How fast they are paid

It is beneficial if debtors pay faster than the entity pays creditors. See below for
computation of these ratios.

5.2.2 PROFITABILITY RATIOS

In the long run liquidity and solvency are meaningless if the organization is not profitable.
Profitability is imperative for survival and prosperity. Profitability refers to the ability to earn
more income than expenses. A profitable entity covers its expenses and earns extra income over
and above its expenses.

The profitability ratios relate various measures of profit to sales and also sales and profit to
investment in assets.

(a) Gross Profit

Gross Pr ofit M arg in

×100
Gross Profit = ( Net )Sales

In GMK:

K 246 900
×100
Gross Profit = K 597 800
= 41%

The company earns a gross profit of K41.3 on sales of K100. This means cost of goods
sold as a percentage of sales is 58.7%. It would appear that the level of trading expenses
is higher than gross profit. Since it is out of gross profit that operating expenses are met
and a profit is earned, the gross profit is not adequate. Trading operations are not
profitable.

Therefore, trading operations should be revamped so as to make them more profitable by

generating more gross profit.

(b) Net profit before tax to Sales Ratio. This is obtained by finding the net profit before tax
divided by (net) sales.

Hence:
 K 115 144
×19 %
Net profit before tax to sales = K 597 800

(Net) sales = 100%

Cost of goods sold = 58.7%

Other expenses = 22.0%
(Gross Profit 41.3%) 100.0

It is also possible to relate Net profit after tax to sales.

This analysis confirms the fact that the cost of goods sold is too high compared to other
expenses which amount to only 22%.

GMK needs to reduce its expenses especially trading expenses to enhance its
profitability.

The other profitability measure is to compute total assets turnover or fixed assets
turnover.
Sales
The asset turnover = Total Assets

K 597 800
= K 926 384

= 0.65

This shows that K1 of the assets is generating only K0.65 of sales. This is less than
satisfactory. However, if we consider fixed assets only and compute their turnover, we
see that the Fixed Assets turnover is 2.8 as follows:

Sales
(Gross) Fixed Assets Turnover = Fixed Assets

K 597 800
= K 213 500

= 2.8

K1 of Fixed Assets is able to generate K2.8 of sales. This is much better than total assets
turnover. Since total assets are equal to current assets plus fixed assets, it would appear
that there is excessive investment in current assets in relation to the level of sales, hence
the dismal total assets turnover of K0.65 only.
 It is important to look at the ratio of Net Profit before tax in relation to capital employed
which in this case is total assets. This ratio shows the profitability of the investment in
the entity i.e. GMK in this case. This is the PRIMARY RATIO for an investor.

Net Pr ofit before tax

Earning Power or Return on Investment = Capital Employed

K 115 144
×100
= K 926 384

= 12.4%

A return of 12.4 is not satisfactory. Therefore, we can conclude that both the operations
of GMK and the profitability of the investment in it are low. This is a weak area.
Something should be done in future periods to improve this area. The improvement
needs to be planned so that when implemented in the future it will improve the operation
of GMK.

Further analysis can be done by relating the various expenses to sales. When such relationships
between expenses and sales are made over a period of time, a project will be able to see the
trends of expenses over time. Such an insight will be helpful in future financial planning.

5.2.3 ACTIVITY OR EFFICIENCY RATIOS

Operations/activities of GMK consist of buying goods from suppliers and reselling them to
customers. Goods are purchased and sold over the year. These operations use resources to
purchase goods and generate sales. In this process, Stock, Debtors and Creditors are created.
When goods are sold on credit, the debtors arise. How fast goods are being converted into sales
and replaced by other goods constitutes stock turnover. How fast stock is bought and sold is
certainly one measure of efficiency and effectiveness. How fast debtors are paying their
accounts is also an important measure of efficiency, especially in the management of working
capital.

The calculation of the various ratios is as below:

(i) Stock turnover ratio

Cost of Goods Sold

Stock turnover ratio = Clo sin g stock or average stock
 K 350 900 . 00
= K 277 300 . 00

= 1.3 times

Stock turnover indicates how fast goods are bought and sold. The higher the turnover,
the better because it is only when goods are sold that profit is generated. It is not good
for stocks to take a long time to be sold. The longer goods stay on the shelf, the more
likely they are to deteriorate an fail to be sold. Goods, which are unsold, represent
money tied in stocks. Thus the longer goods take to be sold, the higher the cost of funds
tied in those stocks.

A low stock turnover may be a sign of weakness in stock management.

Another way of looking at the stock turnover is to calculate how long it takes for stocks
to be bought and sold. This is done by the following:

K 277 300 Average Stock

×365 ×365
Stock turnover (days) = K 350 900 days = Cost of goods sold days.

= K288 days

Stocks take 288 days or about 10 months to be converted into sales. This is an extremely
long time. Stocks need to move faster than suggested by these figures. Please note that a
very high turnover may also not be good.

(ii) Debtors Turnover

The speed with which debtors pay their accounts is crucial for cash flow management in
the organization.
Credit Sales
Debtors turnover ratio = Debtors

K 160 900
= K 75 000

= 2.1 times

Debtors buy goods on credit and pay for them later. Using figures in the given financial
statements it is clear that debtors take time to pay their accounts.

When debtors pay fast, the debtors turnover is high. What is shown above is that the
debtors are taking a long time to pay because the turnover is low at 2 times. This can best
 be understood by calculating how long (i.e. the number of days) the debtors take to settle
their accounts. This is calculated below:
Debtors
Time in days debtors take to pay (the collection period) = Credit Sales
365 days

75 000
×365
= 160 900 days

160 900
= 365

= 170 days
The level of debtors in relation to credit sales suggests that debtors take as long as 6 months to
pay their accounts. As the organization’s money is tied up in debtors it has to borrow money for
its operations. Therefore, the management of debtors is inefficient.

Trade Creditors 178 200

×365 days ×100
Trade creditors ratio = Credit Purchases = 524 200

= 124 days

This ratio shows the number of days’ credit is taken from suppliers.

Debtors take 170 days to pay their account but creditors are paid in 124 days. The desirable
situation is to pay creditors later than debtors pay the company. Therefore, the above situation
shows weakness in the management of working capital.

Therefore, the operations of GMK Limited are not efficient. With the same resources, GMK
Limited could earn more revenue and increase the returns on investment.

Net Working Capital Turnover

This turnover measures the efficiency in the management of working capital. An organization
invests in both fixed and working capital. Fixed capital is represented by fixed assets. On the
other hand, working capital represents a short term investment. Working capital turnover is
calculated by:

Sales Sales
Net Working Capital = Current Assets−Current Liabilities

For GMK the working capital turnover is:

 K 597 800
= K 534 684

= 1.1

The higher the Working Capital Turnover, the greater the efficiency in the management of
working capital and the larger the rate of profit generation. However, very high rates may show
a shortage of working capital i.e. there may be overtrading which is not DESIRABLE to the
entity. Too high or too low working capital turnover should be avoided. Therefore, it is
appropriate to establish the right turnover rate, not too low and not too high.

In the above case, the turnover of 1 is very low which means there is an excessive investment in
working capital. The stocks, debtors and cash i.e. current assets less current liabilities are
excessive. This is not ultimately good for GMK because both stock and debtors mean a lot of
money is tied up in these items. Cash does not earn any return. Hence very high levels of
working capital is injurious to the financial health of the entity. We have already seen the Fixed
Assets turnover. We have seen that it is not satisfactory either.

It can therefore be concluded that GMK is not efficiently managed. That is why profitability is
low although liquidity and solvency are good. There is need to plan for the improvement of
profitability and efficiency.

5.2.4 LEVERAGE RATIOS

The accounting equation states that:

ASSETS = LIABILITIES + OWNERS EQUITY

The equation represents two fundamental decisions, namely the financing and investment
decisions.

Assets represent how money is used in an entity. This is the investment decision. The liabilities
and owners equity constitute the way the organization is financed. It is normal to deduct current
liabilities from current assets to get net working capital. So the above equation can be rewritten
as follows:

FIXED ASSETS + CURRENT ASSETS – CURRENT LIABILITES = LONG-TERM LIABILITIES + OWNERS EQUITY

FIXED ASSETS + NET WORKING CAPITAL = LONG TERM LIABILITIES + OWNERS EQUITY
(INVESTMENT) (FINANCING)

Leverage ratios are concerned with the extent to which an entity is financed by debt. Relevant
ratios calculated are:

DEBT TO EQUITY RATIO

This shows long-term debt in relation to the funds from owners.

e.g. in GMK: 400 000 : 528 984 = 0.76

Alternatively, DEBT can be related to the TOTAL LONG TERM financing i.e. DEBT/DEBT +
EQUITY

400 000
×100
In GMK: 928 984 = 43%

Long-term lenders finance 43% of the long-term funds of GMK Limited. Interest has to be paid
on this debt. This interest is deductible from operating profit (or earnings) in arriving at the
income chargeable to tax. This is an advantage of debt finance compared to equity. But debt
must be used judiciously as excessive debt is risky or potentially harmful. It (Debt) can lead to
an entity winding up its operations as a result of failing to pay interest or to service its debt.

The ability to pay debt is measured by the number of times profit before interest and tax is
available to pay interest charges. The profit before interest and tax for GMK is K131 800. The
interest charges are K20 000. Therefore, the number of times profit before interest and tax
K 131 800
covers interest charges is K 20 000 = 6.59 or 7 times.

This means that profit before interest and tax can fall 7 times before GMK Limited fails to pay
interest on the loan. GMK is therefore able to service its debt.

Debt in the long term financing of a project/organization/company shows the extent of financial
risk. Excessive debt shows high financial risk. That is interest charges become burdensome and
the company might fail to pay back the debt.

These figures are rough guides. The cover is based on earnings as reported in the profit and loss
account. However, it may be appropriate to assess the firm’s ability to repay interest charges on
the basis of the firm’s expected cash flows instead of on reported operating profits.

There is a view that it is not only the payment of periodic interest but also the periodic repayment
of the principal is important. Hence it is important to calculate the cover taking into account
both interest and the annual repayment of the principal by the following:

Earnings beforeint erest and taxes

Interest and annual repayment ratio = Interest + Annual Re payment Charg es
[ ]
1
i−t

1
[ ]
where t = corporation tax rate. The i−t adjusts the annual repayment to the before tax basis.
This adjustment is made because repayments are out of after tax profits. This cover shows how
many times interest charges and annual repayments of principal are covered by current earnings
before interest and taxes.

For GMK the above cover = 2.6 times assuming an annual repayment of K20 000 per year for 20
years and a tax rate of 35%.

5.2.5INVESTMENT RATIOS (STOCK MARKET RATIOS)

Investors purchase shares in the hope that they will receive dividends and capital gains. When
profits are made, tax is paid on them leaving profits after tax. Capital gains arise upon sale of
shares at a price higher than the cost of the shares.

Using data from financial statement a number of investment ratios can be calculated:

Gross Dividend per share

×100
(1) Dividend yield = Market price per share

Gross dividends are related to the share price to obtain a yield.

This yield is important to an investor as one of the reasons for buying shares is to receive
a dividend on each of the shares bought. When dividends are declared and we cannot
calculate this yield and other investment ratios because we do not have data.

Earnings per share after tax and pref . dividend

×100
(2) Earnings yield = Market price per share

Profit after tax is what is available to shareholders who are existing investors in the
company’s shares. Preference shareholders receive their dividends prior to the ordinary
shareholders. Hence the preference dividend is deducted and what is left is what is
available to ordinary shareholders. Even if not all profits made are paid to the
shareholders, profit after tax belongs to shareholders. This yield can be compared with
the return obtained by the company i.e. Net Profit after tax divided by capital employed.

(3) P/E ratio when the earnings yield is turned upside down (i.e. invested) it gives the
price/earnings (P/E) ratio.

A high P/E ratio indicates that the market expectation is that the company’s profits will
rise in the future, and a low P/E ratio shows the opposite. But a company’s share price
may fluctuate for reasons other than change in profit expectations e.g. market
expectations of a takeover bid may increase the market price of shares of a company.
(4) Earnings Per Share (EPS)

When profit after tax available to ordinary shareholders is divided by the number of
shares issued, the earnings per share (EPS) is obtained. This is a more useful indicator of
a Company’s progress than the simple annual trend of profits because it shows whether a
Company deploys the money profitably.

(5) Dividend Cover

This is obtained by the following calculation:

Earnings after tax and preference dividend

×100
Ordinary dividend

It shows the number of times a dividend goes into the after tax earnings available to
ordinary shareholders.

Once again note that it is not possible to calculate these investment ratios based on the
GMK Limited data/figures. There are no data to use n the calculation of these investment
ratios. These ratios have been explained to make you aware that investment ratios can
also be calculated. In fact, there are newspapers and magazines, which publish stock
market ratios on a daily basis. Where such ratios exist one should determine what they
mean to learn how companies are doing.

5.3 CONCLUSION
The overall evaluation of the performance of GMK is that the company is not efficiently
managed although it is liquid and solvent (i.e. it is able to pay its short term debts). It is not
enough to only be able to pay debts.

Profitability requires to be improved. Primarily it would appear that the generation of sales have
to be revamped and the profitability of these sales need to be enhanced. Management of GMK
should focus on improving working capital management.

GMK has substantial debts, but debt is NOT EXCESSIVE. However, the company needs to
improve the use of resources at its disposal.
Finally, it is important to point out that the data we have used in the analysis is over a very short
period, a period of one year. Accordingly some of the conclusions may be invalid on account of
data not being typical of GMK. However, ratios point to something to be looked into. There is
need to consider other information to arrive at more valid conclusions.