CHAPTER TWO: FINANCIAL STATEMENT ANALYSIS

Financial analysis

Financial statement analysis generally begins with a set of financial ratios designed to reveal a
company’s strength & weaknesses as compared with other companies in the same industry, and
to show whether its financial position has been improving or deteriorating over time. The
primary goal of financial managers is to maximize the stock price, not accounting measures such
as net income or EPS. However, accounting data do influence stock price, and to understand why
a company is performing the way it is and to forecast where it is heading, one needs to evaluate
the accounting statements.
Sources of financial information’s
Financial statements help assess the financial well-being of the overall operation. Information
about the financial results of each enterprise and physical asset is important for management
decisions, but by themselves are inadequate for some decisions because they do not describe the
whole business. An understanding of the overall financial situation requires three key financial
documents: the balance sheet, the income statement and the cash flow statement.
 The Balance Sheet: The balance sheet shows the financial position of a firm at a particular
point of time. It also shows how the assets of a firm are financed.
 Income Statement: An income statement often provides a better measure of the
operation's performance and profitability. It shows the operating results of a firm, flows of
revenue and expenses.
 Cash Flow Statement: Reports the sources and uses of the operation’s cash resources.
Such statements not only show the change in the operation's cash resources throughout the
year, but also when the cash was received or spent.
The need for financial analysis
The following stakeholders are interested in financial statement analysis to make their respective
decision at right time.
The following are interested in financial statements analysis
 Investors: Investors fall into two categories, existing and potential. Some seek a
takeover, leading to majority control and shareholding.
 Lenders: These may supply funds to the organization on short and/or long-term basis.
There are several financial institutions and individuals willing to lend to progressive
companies but few to support those with lower earnings levels.

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  The Management: The managers are entrusted with the financial resources contributed
by owners and other suppliers of funds for effective utilization.
 Suppliers: Suppliers of products and services to the company would like their
investments - sales made on credit terms - received with surety.
 Employees: Many would consider employees the least affected of all when it comes to
analyzing the company's accounts. Think again. The employees will be first to feel the
change in circumstances as they may be promoted, demoted or fired
 Government bodies: As a rule, Companies House requires each company, private or
public, to submit their financial statements and accounts annually. The list of registered
companies and their most recent accounts are published in the Companies House official
publication.
 Competitors: It may seem odd, but existing competitors and new entrants have to
consider the likelihood of their success or failure in trying to conquer the market. Their
primary interest lies in the business ratios of efficiency/productivity and cash, debtor and
credit management.
Comparing financial ratios
To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.
 Cross – sectional analysis:
analysis: is the comparison of a firm’s ratios to those other firms in the
same industry at the same point in time. Here, the firm is interested in how well it has
performed in relation to other firms. Generally, cross – sectional analysis is preformed
based on industry averages of different financial ratios.
 Time – series analysis:
analysis: is an evaluation of a firm’s financial ratios over time. Here, the
current period ratios are compared with those of the past years. The purpose is to
determine whether the firm is progressing or deteriorating.
RATIO ANALYSIS
It is a mathematical relationship among money amounts in the financial statements. They
standardize financial data by converting money figures in the financial statements. Ratios are
usually stated in terms of times or percentages. Like any other financial analysis, a ratio analysis
helps us draw meaningful conclusions and interpretations about a firm’s financial condition and
performance.

Types of Ratio Comparisons

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Ratios don’t reveal much by themselves so usually make two basic types of comparisons:
Industry averages and Firm’s past own ratios
Type of Financial Ratio
1. Liquidity Ratios
2. Asset management Ratio or Activity ratio
3. Debt management Ratio
4. Profitability Ratio
5. Market value Ratio
Note: Use the appendix attached on page 10, 11 and 12 to compute the following
ratios
1. Liquidity ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets.
Three commonly used liquidity ratio are:
 Current ratio:
ratio: measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets.
Current Ratio (CR) = Current assets = _ CA_
Current liability CL
Example:

Note: high and/or increasing ratios indicate: ability to pay current liabilities by liquidating
current assets
 Quick ratio (Acid – test ratio): measures the short-term liquidity by removing the least liquid
current assets such as inventories. Inventories are removed because they are not readily or
easily convertible into cash.
Quick Ratio (QR) = (CA – I)/CL
Example:
Notes: high and/or increasing indicates: ability to pay current liabilities by liquidating current
assets other than inventory
 Cash ratio = (cash + short-term securities)
Current liabilities

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It is the most stringent measure of liquidity
Example:

Note: high and/or increasing indicates: ability to pay current liabilities with existing cash

2. Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over)
into sales or cost of goods sold. Activity ratios are also called asset management ratios, or asset
utilization ratios, or efficiency ratios. Generally, high turnover ratios are associated with good
asset management and low turnover ratios with poor asset management.

 Account Receivables Turnover (ARTO): measures how efficiently a firm’s accounts

receivable is being managed. It indicates how many times or how rapidly accounts receivable
are converted into cash during a year.

ARTO = Net Sales

A/R
Example:

In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio

substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or in adequate cash collection
efforts.

 Average Collection period (The Days Sales outstanding-DSO): It seeks to measure the
average number of days it takes for a firm to collect its accounts receivable. In other words, it
indicates how many days a firm’s sales are outstanding in accounts receivable.
Average Collection period = 360
ARTO
Example:

The average collection period of a firm is directly affected by the accounts receivable turnover
ratio. Generally, a reasonably short-collection period is preferable.

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 Account payable turnover (APTO): It measures how rapidly creditors are paid.

APTO = Net Purchase

A/P
Example:
 Average payment period: It measures the average length of time creditors must wait to
receive their cash.
Average payment period = 365
APTO
Example:
 Inventory Turnover: measures how many times per year the inventory level is sold (turned
over).
Inventory Turnover (ITO) = Cost of Goods sold
Inventories
Example:
Notes: In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can apply
sales. In general, a high inventory turnover is better than a low turnover. But abnormally high
inventory turnover might result from very low level of inventory. This indicates that stock outs
will occur and sales have been very low. A very low turnover, on the other hand, results from
excessive inventory levels, presence of inferior quality, damaged or obsolete inventory, or
unexpectedly low volume of sales.
 Fixed asset turnover: measures how efficiently a firm uses it fixed assets. It shows how
many birrs of sales are generated from one birr of fixed assets.
Fixed Asset Turnover = Sales [Net]
Net Fixed assets
Example:

A fixed assets turnover ratio substantially lower than other similar firms indicates
underutilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.

 Total asset turnover (TATO)

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Indicate how much birr in sales the firm squeezes out of each dollar it has invested in assets and
measures the turnover of all the firm’s assets.
TATO = _Sales_
Total Assets
Example:
Note: A high total assets turnover is supposed to indicate efficient asset management, and low
turnover indicates a firm is not generating a sufficient level of sales in relation to its investment
in assets.

3. Debt Management Ratio

Debt management ratio reveals i, the extent to which the firm is financed with debt, and ii, its
likelihood of defaulting on its debt obligations. The extent to which a firm uses debt financing, or
financial leverage, has three important implications:
If the firm earns more on investments financed with borrowed funds that it pays in interest, the
return on the owner’s capital is magnified, or “leverage”
These ratios are called solvency ratio, leverage ratio, debt management ratios, and capital
structure ratios.
 Debt ratio: To measure or shows the relative extent to which the firm is using borrowed
money and to measures the proportion of total assets financed by the firm’s creditors.
Debt ratio = Total debt
Total asset
Example:

 Debt to equity ratio: it indicates the relationship b/n the long-term funds provided by
creditors and those provided by the firm’s owners. These ratios reflect the relative claim of
creditors and shareholder against the asset of the firm. - It indicates the extent to which debt
financing is used relative to equity financing.
Debt to equity ratio = total liability
Stockholders’ equity
Example:
 Time interest earned ratio: It measures the firm’s ability to make contractual interest
payment from operating profit. The higher the value of this ratio, the better able the firm is to
fulfill its interest obligation.

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 TIE ratio = EBIT
Interest charge
Example:

The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available
to meet its interest obligations. However, earnings before interest and taxes are an income
concept and not a direct measure of cash. Hence, this ratio provides only an indirect measure of
the firm’s ability to meet its interest payments.
 Fixed payment coverage ratio: It measures the firm's ability to meet all fixed payment
obligations such as interest, principal amount, lease payments, and preferred stock dividends
Fixed charges coverage = Income before fixed charges and taxes
Fixed charges
Example:

Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.
The fixed charges coverage ratio is required because failure of the firm to meet any financial
obligation will endanger the position of a firm
4. Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, total assets,
and owner’s equity. The following ratios are among the many measures of a firm’s profitability.
 Gross Profit Margin (PM) = Gross profit
Sales
Example:
 Net profit margin: shows the percentage of each birr of net sales remaining after deducting
all expenses.
= Net profit
Net sales
Example:

The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as
well as the amount of all costs and expenses of a firm.

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 Return on Assets or investment (ROA or ROI): measures how profitably a firm has used
its investment in total assets.
Return on assets (ROA) = Net income
Total assets
Example:

Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.

 Return on equity (ROE): indicates the rate of return earned by a firm’s stockholders on
investments made by them.

Return on Equity (ROE) = Net profit after tax

Stockholder’s equity
Modified DuPont formula ROE = ROI
1-debt asset ratio
Example:
A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better offs the owners.
DuPont System of Analysis
It is an approach to assess that a firm’s return on assets and return on equity show not only the
firm’s earning power but also efficiency and leverage. This analysis breaks down these two ratios
as follows:
Return on assets = Profit margin X Total assets turnover
Return on equity =Profit margin X Total assets turnover X Total assets/equity
= Profit Margin X Total assets turnover X Equity Multiplier
5. Market Value Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:
 Earnings per share (EPS): expresses the profits earned on each share of a firm’s common
stock outstanding. It does not reflect how much is paid as dividends.
= Net income after tax – preferred stock dividend

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 Number of common shares outstanding
EPS
 Dividend per share (DPS): represents the amount of cash dividends a firm paid on each
share of its common stock outstanding.

= Total cash dividend on common share

Number of common share outstanding
 Dividend payout ratio: shows the percentage of earnings paid to stockholders.
= cash dividend per share
EPS
= Total dividend to common stock
Total earning available or common stock holders

LIMITATIONS OF RATIO ANALYSIS

Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.

2. Sometimes a comparison of ratios between different firms is difficult. One reason could be a
single firm may have different divisions operating in different industries. Another reason could
be the financial statements may not be dated at the same point in time.

3. The financial statements of firms are not always reliable, particularly, when they are not
audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
5. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example,
the inventory turnover ratio for a stationery materials selling company will be different at
different time periods of a year.

ABC Manufacturing Company

Comparative Balance Sheet
December 31, 1997 and 1998
(In thousands of dollars)

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Current Assets 1998 1997

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Cash $ 2,500 $ 3,000
Marketable securities 1,000 1,300
Accounts receivable 16,000 12,000
Inventories 20,500 18,700
Total current assets $ 40,000 $ 35,000
Fixed Assets
Land and buildings $ 28,700 $ 24,200
Machinery and equipment 31,600 29,000
Total fixed assets $ 60,300 53,200
Less accumulated depreciation 18,300 17,200
Net fixed assets $ 42,000 36,000
Total Assets $ 82,000 $ 71,000
Liabilities and Stockholder’s equity
Current Liabilities
Account payable $ 7,200 $ 6,000
Notes payable – 10% bank 5,500 7,000
Accrued liabilities 900 700
Current maturity of long-term debt 3,000 3,000
Other liabilities 1,400 1,200
Total current liabilities $ 18,000 $ 17,900
Long-term Liabilities
Long-term debt – 12% mortgage bonds $ 27,000 $ 30,000
Total Liabilities $ 45,000 $ 47,900
Stockholders’ equity
Common stock - $ 5 par, 2,000,000 shares authorized;
1,300,000 share outstanding in 1998 and 1,000,000 share 6,500 5,000
outstanding in 1997
Capital in excess of par 14,000 5,350
Retained earnings 16,500 12,750
Total stockholders’ equity $ 37,000 $ 23,100
Total liabilities and stockholders’ equity $ 82,000 $ 71,000
ABC Manufacturing Company
Income Statement
For the year ended December 31, 1997 and 1998
(In thousands of dollars)
1998 1997
Net sales $ 120,000 $ 110,000
Cost of Goods Sold 90,000 83,000
Gross profit 30,000 27,000
Operating expenses
Selling 5,000 4,800
General and Administrative 8,000 7,600
Depreciation 1,100 800
Lease payments 1,650 1,600
Earnings before interest and taxes (EBIT) $ 14,250 $ 12,200
Interest Expense
Interest on bank notes 550 700

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 Interest on other debt 3,600 3,960
Earnings before taxes $ 10,100 $ 7,450
Taxes (34%) 3,434 2,560
Net income $ 6,666 $ 4,976

ABC Manufacturing Company

Statement of Retain Earning
December 31, 1998
(In thousands of dollars)
Retain Earnings – January 1 $ 12,750
Net Income 6,666
Total 19,416
Less cash dividends
Common stock - $ 2.00 per share 2,600
Retain Earnings – December 31 $ 16,816

The Industry Average of different ratios is given below for comparison purpose with ABC
Company.
Ratio Industry Averages*
1. Liquidity ratios
A. Current ratio 2.00x
B. Quick ratio 1.25x
2. Assets Management ratio
A. Account receivable turnover 10.40x
B. Average collection period 35days
C. Inventory turnover 6.00x
D. Fixed asset turnover 3.50x
E. Total asset turnover 2.00x
3. Debt Management ratios
A. Debt ratio 45%
B. Debt-equity ratio 81.81%
C. Time-interest earned 5.50x
D. Fixed charge coverage 2.50x
4. Profitability ratio
A. Gross profit margin 26%
B. Operating profit margin 15.50%
C. Net profit margin 6.00%
D. Return on investment 12%
E. Return on equity 21.82%
5. Market/book ratio
A. Earnings per share $15.50
B. Price/earnings ratio 12.00
C. Book value per share 46.50
D. Dividend per share 1.10
E. Dividend pay out 20.00%
F. Dividend yield 1.67%
* Industry averages are assured to remain constant for 1997 and 1998

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