AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis

CHAPTER TWO
FINANCIAL ANALYSES AND PLANNING
2.1. Financial Statement Analysis
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by
properly establishing relationships between the item of the balance sheet and the profit and loss account. It
is an evaluation of both a firm’s past financial performance and its prospects for the future.

Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with
other pertinent information, in order to formulate an assessment of a company’s present and future
financial condition and performance.

Financial statement analysis is a process of synthesis of summarization of financial statements and operative
data (presented in financial statements) with a view to getting an insight into the operative activities of a
business concern. It is a technique of investigating the financial positions and progress of the unit. By
establishing some relationship between balance sheet and income statement, analysis attempts to reveal the
meaning and importance of various items contained in the financial statements. An analysis of financial
statements gives a detailed account of business operations and their impact on the financial health of the
company.
For the purpose of financial analysis, we have to re-organize and re-arrange the data contained in financial
statements. The data may be grouped and re-grouped on the basis of resemblances and affinities into
categories of a few principal elements. These categories are clearly defined so that their computations can
be readily made. Through such classification and re-classification the financial statements will be recast and
presented in a condensed form. The changed arrangement of items will be different from the original
financial statements.
The analysis of financial data i.e., classification of the data into groups and sub-groups and establishment of
relationships among then, is followed by interpretation. The term interpretation means explaining the
meaning and significance of data. So simplified it involves drawing inferences from the analyzed data about
the different aspects of the operational and financial results of the business and its financial health.
Analysis and interpretation are closely inter-linked. They are complementary to each other. Analysis
without interpretation is useless and interpretation without analysis is impossible. But, generally, the term
analysis is used to include interpretation as well since, analysis is always aimed at interpretation of the
relationships that are established in the course of analysis. Thus, it can be stated that analysis involves
compilation, comparison and study of financial and operative data and preparation, study and interpretation
of the same.
2.1.1. Users of financial statement information
The following are interested in financial statement of a given firm.
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 owners, the managers take several
decisions. If their decisions are to be right and timely, they require relevant financial information.

Page 1 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
3. Creditors: Trade creditors: are interested in the firm’s ability to meet their claims over a very short
period of time. Their analysis will confine to the evaluation of the firm’s liquidity position. Suppliers
of long term debt: are concerned with the firm’s long term solvency and survival. They analyze the
firm’s profitability over time, its ability to generate cash to be able to pay interest and to repay
principal.
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 data.
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 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.

2.1.2. Vertical and horizontal Analysis (Common-size analysis)

Common-size analysis is the restatement of financial statement information in a standardized form.
 Horizontal common-size analysis uses the amounts in accounts in a specified year as the base, and
subsequent years’ amounts are stated as a percentage of the base value. Useful when comparing growth
of different accounts over time.
 Vertical common-size analysis uses the aggregate value in a financial statement for a given year as the
base, and each account’s amount is restated as a percentage of the aggregate.
- Balance sheet: Aggregate amount is total assets.
- Income statement: Aggregate amount is revenues or sales.

Page 2 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
ABC Company
Comparative Balance sheet
For Dec 31, 2017 & 2018 G.C
Assets 2018 2017 (base year)
Amounts ($) Amounts ($)
Cash and cash equivalents 427,000 149,000
Other current assets 2,266,000 411,000
Total current assets 2,693,000 560,000
Property, plant, and equipment 379,000 188,000
Intangible assets 194,000 106,000
Other assets 47,000 17,000
Total assets 3,313,000 871,000
Liabilities
Accounts payable 33,000 46,000
Other current liabilities 307,000 189,000
Total current liabilities 340,000 235,000
Long-term liabilities 44,000 47,000
Total liabilities 384,000 282,000
Stockholders’ Equity
Common stock 1,000 45,000
Retained earnings and other equity 2,928,000 544,000
Total stockholders’ equity 2,929,000 589,000
Total liabilities and stockholders’ 3,313,000 871,000
equity
ABC Company
Comparative Balance Sheet
For Dec 31, 2017 & 2018 (Horizontal Analysis)
Assets 2018 2017 (base year)
% %
Cash and cash equivalents 286% 100%
Other current assets 55.1% 100%
Total current assets 480% 100%
Property, plant, and equipment 201.6% 100%
Intangible assets 179% 100%
Other assets 276% 100%
Total assets 380.4% 100%
Liabilities
Accounts payable 71.7% 100%
Other current liabilities 162% 100%
Total current liabilities 144.7% 100%
Long-term liabilities 93.6% 100%
Total liabilities 136.2% 100%
Stockholders’ Equity
Common stock 2.2% 100%
Retained earnings and other 538.2% 100%
equity
Total stockholders’ equity 497.3% 100%
Total liabilities and 380.4% 100%
stockholders’ equity

Page 3 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
The vertical analysis of ABC’s balance sheet reveals several interesting things:
 Current assets make up 81.3% of total assets in 2018 and 64.3% of total assets in 2017. For most
companies this percentage is closer to 30%. The 81.3% of current assets represents a great deal of
liquidity and a significant increase in liquidity from 2017 to 2018.
 Property, plant, and equipment make up only 11.4% of total assets in 2018, but 21.6% of total assets in
2017. This percentage is low because of the nature of ABC’s business. ABC may not require many
buildings or equipment.
 Total liabilities are only 11.6% of total assets in 2018, but were 32.4% of total assets in 2017. This
improvement is positive for ABC. Stockholders’ equity makes up 88.4% of total assets in 2018 and
67.6% of total assets in 2017. Most of ABC’s equity is retained earnings and other equity—signs of a
strong company because most of the equity is internally generated rather than externally generated
(through stock share sales).
ABC Company
Comparative Balance Sheet
For Dec 31, 2017 & 2018 (Vertical Analysis)
Assets 2018 2017
% of the total % of the total
Cash and cash equivalents 12.9% 17.1%
Other current assets 68.4% 47.2%
Total current assets 81.3% 64.3%
Property, plant, and equipment, 11.44% 21.6%
Intangible assets 5.86% 12.1%
Other assets 1.42% 2%
Total assets 100% 100%
Liabilities
Accounts payable 1% 5.3%
Other current liabilities 9.3% 21.7%
Total current liabilities 10.3% 27%
Long-term liabilities 1.3% 5.4%
Total liabilities 11.6% 32.4%
Stockholders’ Equity
Common stock 0% 5.2%
Retained earnings and other 88.4% 62.4%
equity
Total stockholders’ equity 88.4% 67.6%
Total liabilities and 100% 100%
stockholders’ equity

Page 4 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
ABC Company
Comparative Income Statement
For Dec 31, 2017 & 2018
2018 Amounts ($) 2017 Amounts ($)
Revenues 3,189,000 1,466,000
Cost of revenues 1,456,000 626,000
Gross profit 1,731,000 840,000
Operating expenses:
Sales and marketing expense 246,000 120,000
General and administrative expense 140,000 57,000
Research and development expense 225,000 91,000
Other expense 470,000 225,000
Total operating expenses 1,081,000 493,000
Income before income tax 650,000 347,000
Income tax expense 251,000 241,000
Net income 399,000 106,000
ABC Company
Comparative Income Statement
For Dec 31, 2017 & 2018 (Vertical Analysis)
2018 2017
% of the total % of the total
Revenues 100% 100%
Cost of revenues 45.7% 42.7
Gross profit 54.3% 57.3
Operating expenses:
Sales and marketing expense 7.7% 8.2
General and administrative 4.4% 3.9
expense
Research and development 7.1% 6.2
expense
Other expense 14.7% 15.3
Total operating expenses 33.9% 33.6
Income before income tax 20.4% 23.7
Income tax expense 7.9% 16.4
Net income 12.5% 7.2

The vertical analysis percentage for ABC’s cost of revenues is 45.7% of net sales ($1,458/$3,189 = 0.457 or
45.7%) in 2018 and 42.7% ($626/$1,466 =0.427 or 42.7%) in 2017. This means that for every $1 in net
sales, almost $0.46 in 2018 and almost $0.43 in 2017 is spent on cost of revenue. On the bottom line, ABC’s
net income is 12.5% of revenues in 2018 and7.2% of revenues in 2017. That improvement from 2017 to
2018 is extremely good.
Suppose under normal conditions a company’s net income is 10% of revenues. A drop to 4% may cause
the investors to be alarmed and sell their stock.
2.1.3. Ratio Analysis
The term, ‘ratio’, refers to the numerical or quantitative relationship between items or variables. It shows an
arithmetical relationship between two figures. The relationship between two accounting figures expressed
mathematically is known as ‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are
generally expressed in three ways. It may be an amount obtained by dividing one value by another. For
Page 5 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
example, if the current assets of a business on a particular date are Birr 200,000 and its current liabilities
Birr 100,000 the resulting ratio would be Birr 200, 000 divided by 100,000 i.e., 2:1. The ratio can be
expressed as a percentage as well. Taking the same particulars, it may be stated that the current assets are
200% of the current liabilities. Sometimes ratios are expressed as so many ‘times’ or ‘fraction’: for example,
the current assets may be stated as being double the current liabilities or current liabilities was half of
current assets.
“Ratio analysis is the process of computing, determining and interpreting the relationship between the
component items of financial statements.”

2.1.3.1. Importance of Ratio Analysis

Ratio analysis is an extremely useful and the most widely used tool of financial analysis. It makes for easy
understanding of financial statements. It facilitates intra-firm and inter-firm comparison. Ratios act as an
index of the efficiency of the enterprise. A study of the trend of strategic ratios helps the management in
planning and forecasting. Ratios help the management in carrying out its functions of coordination, control
and communication. The analysis of ratios may reveal maladjustments in planning, organizing, coordinating
and monitoring different activities of an organization. It will help to identify the specific weak areas, causes
thereof and type of remedial actions called for. A purposeful ratio analysis helps in identifying problems
such as the following and in finding out suitable course of action.
 Whether the financial condition of the firm is basically sound,
 Whether the capital structure of the firm is appropriate,
 Whether the profitability of the enterprise is satisfactory,
 Whether the credit policy of the firm is sound, and
 Whether the firm is credit worthy.
In short, through the technique of ratio analysis the firm’s solvency both long and short term efficiency and
profitability can be assessed.
2.1.3.2. Standard of comparison
A single ratio in itself does not indicate favorable or unfavorable condition. It should be compared with
some standards. Those standards include:
 Time series analysis: is comparing of its present ratio with the past ratio (also called trend analysis). It
reflects whether the firm’s financial performance has improved, deteriorated, or remained constant over
time.
 Cross-sectional analysis: this is comparison ratios of one firm with some selected firms in the industry
at the same point in time. It is also called inter-firm analysis.
 Industry analysis: it is comparison of the average ratio of the industry of which the firm is a member.
There are certain difficulties in using industry average ratios such as;
 It is difficult to get average ratio for the industry.
 Even if ratios are available, it is the average of weak and strong firms, so its importance may become
less.
 Industry average ratios may be useless if firms in the same industry use different accounting policies
and practices.
 Pro-forma analysis: future ratios may use as the standard of comparison. Future ratios can be
developed from the projected, or pro-forma financial statements. The ratio indicates relative strengths
and weaknesses in the past and the future.

Page 6 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis

2.1.3.3. Classification of Ratios

Some writers have contended that there are as many as 429 business ratios. But all these ratios need not be
calculated for a particular study. On the basis of the nature of the business concern, the circumstances in
which it is operating, and the particular questions to be answered from the ratio analysis, certain ratios
should only be selected. Every attempt should be made to keep the number of ratios as far as possible to the
minimum. This avoids possible confusion in the interpretation of ratios.
The most important and commonly adopted classification of ratios is on the basis of the purpose or function
which the ratios are expected to perform. Such ratios are also called ‘functional ratios’. Financial ratios are
traditionally grouped into the following categories:
1) Short-term solvency, or liquidity ratios
2) Long-term solvency, or financial leverage ratios
3) Asset management, or turnover ratios and
4) Profitability ratios
5) Market value ratios
The management of the firm is interested in evaluating every activity of the firm. In view of the
requirements of the various users of financial analysis the functional classification of ratios becomes
important, some important functional ratios are explained here under:
1. Liquidity ratios
Liquidity is a company’s ability to meet its maturing short-term obligations. It is also called short term
solvency ratio, and its primary concern is the firm’s ability to pay its bills over short run without undue
stress. Companies having liquidity position have the ability to convert their assets into cash quickly at low
cost and without reducing the value of the asset.
Analyzing corporate liquidity helps to all managers as well as creditors. For creditors, if the company is in a
liquidity position, then it has well management of credit risk and can made timely payment of interest and
principal.

Liquidity ratios are static in nature as of year-end. Therefore, managers should see expected future cash flows.
If future cash outflows are expected to be high relative to inflows, the liquidity position of the company will
deteriorate. So managers should aware of the short term assets and liabilities are easily changed and measures of
liquidity can be outdated rapidly.
The liquidity ratios are classified in to different other specific ratios, which includes;
i. Net working capital ratio
ii. Current ratio
iii. Quick (acid-test) ratio
i. Net working capital ratio: net working capital ratio (NWC) is the difference between total current assets
and current liabilities.

Current assets are those assets that are expected to be converted into cash or used up within 1year. Current
liabilities are those liabilities that must be paid within 1 year; they are paid out of current assets. A large
balance is required when the entity has difficulty borrowing on short notice. i.e. high NWC is more
desirable.

Page 7 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
Relatively low level of this ratio indicates, the firm has low liquidity.
ii. Current Ratio: Current ratio is the ratio of total current assets to total current liabilities. It is calculated
by dividing current assets by current liabilities.
Current assets
Current ratio =
Current liabilities

This ratio is also called ‘working capital ratio’ because it is related to the working capital of the firm. The
current ratio is an important and most commonly used ratio to measure the short-term financial strength or
solvency of the firm. It indicates how many birr of current assets are available for one birr of current
liability. The higher the current ratio, the more is the firm’s ability to meet its current obligations and
the greater the safety of the funds of the short-term creditors. Thus the current ratio, in a way, provides
a margin of safety to the (short-term) creditors.

To the question, “What should be the current ratio of a firm?” there is no clear-cut answer, nor is there any
hard and fast rule for deciding it. Conventionally (The rule of thumb), a current ratio of 2:1 is considered
satisfactory. This rule is based on the logic that even in the worst situation where the value of current assets
is reduced by fifty percent; the firm will be able to meet its current obligations. The standard norm for the
current ratio (i.e. 2:1) may vary from firm to firm, industry to industry or for a firm from time to time. As
such, this norm of 2:1 should not be blindly followed. Also, it should be remembered that this current ratio
is a crude measure of liquidity. It is a quantitative rather than a qualitative index of liquidity. It takes into
account the total value of current assets without making any distinction between the various types of current
assets like receivables, inventory and so on. It does not measure the quality of these assets. If the firm’s
current assets include doubtful and slow paying receivables or slow moving and non-moving (non-saleable)
stock of goods, then the firm’s ability to meet obligations would be reduced. This aspect is ignored by the
current ratio. That is why too much reliance should not be placed on the current ratio. The ability of the
assets also should be ascertained.
A limitation of this ratio is that it may rise just prior to financial distress because of a company’s desire to
improve its cash position by selling fixed assets. Such dispositions have a detrimental effect upon
productive capacity. Another limitation of the current ratio is that it will be excessively high when inventory
is carried on the last-in, first-out (LIFO) basis.
iii. Quick (Acid-test) ratio (Q.R): it is found by dividing the most liquid current assets (cash, marketable
securities, and accounts receivable) by current liabilities. Inventory is not included because of the
length of time needed to convert inventory into cash. Prepaid expenses are also not included because
they are not convertible into cash and so are not capable of covering current liabilities.

OR

Like other liquidity ratios, quick ratios that are high are desirable. Using cash to buy inventories does not
affect current ratio, but it reduces quick ratio. Quick ratio of 1:1 is considered as standard value.
 Other liquidity ratios include cash ratio and interval measure.
 Cash ratio: a company’s most liquid assets are cash and marketable securities.

Page 8 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
Here, high ratio is needed, but low cash ratio may not matter, if the firm can borrow on short term
notice. So, the standard liquidity measures takes the firm’s ‘Reserve Borrowing Power’ in to
account.
 Interval measure: deals with how long the firm could keep up with its bills using only its cash and
other liquid assets.

High value of this ratio is needed, because how long the firm can cover the operational expenses is
indicated here.

2. Asset management, or turnover, ratios

The finances obtained by a firm from its owners and creditors will be invested in assets. These assets are
used by the firm to generate sales and profits. The amount of sales generated and the obtaining of the profits
depend on the efficient management of these assets by the firm. Activity ratios indicate the efficiency with
which the firm manages and used its assets. That is why these activity ratios are also known as ‘efficiency
ratios’. They are also called ‘turnover ratios’ because they indicate the speed with which assets are being
converted or turned over into sales. Thus the activity or turnover ratio measures the relationship between
sales on one side and various assets on the other. The underlying assumption here is that there exists an
appropriate balance between sales and different assets. A proper balance between sales and different assets
generally indicates the efficient management and use of the assets. Many activity ratios can be calculated to
know the efficiency of asset utilization. The following are some of the important activity ratios or turnover
ratios:

i. Accounts Receivable turnover

Credit sales are not an uncommon feature. When the firm sells goods on credit, Accounting receivables are
created. Accounting receivables are expected to be converted into cash over a short period and hence are
included in current assets. To a great extent the quality of debtors determines the liquidity position of the
firm. The quality of debtors can be judged on the basis of Accounts receivable turnover and average
collection period.

Receivable turnover is calculated by dividing credit sales by average receivables

Credit sales
Receivables turnover =
Averagereceivables

The average accounts receivable amount in the denominator is found by adding together accounts receivable
at the end of the current year and previous year and dividing by two.
This ratio measures the number of times the average balance in accounts receivable has been converted into
cash during the year. The higher the value of Accounts receivable turnover, the more efficient is the
management of assets.
If the information about credit sales opening and closing balances of receivables is not available in the
financial statements, the receivables turnover can be calculated by taking the total sales and closing balance
of receivables
Total sales
Receivables turnover =
Re ceivables
Page 9 of 20
 AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
Average Collection Period or Day 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. This ratio shows the nature of the firm’s credit policy also. The
average collection period is calculated by dividing days (or months) in a year by the receivables’ turnover.

ACP indicates the average length of time the firm must wait after making a sale before it receives cash which
is the average collection period.

ii. Inventory turnover ratio

If a company is holding excess inventories, it means that funds which could be invested elsewhere are being
tied up inventory. In addition, there will be high carrying cost for storing the goods, as well as the risk of
obsolesces. On the other hand, if inventory is too low, the company may lose customer because it has run
out of merchandise.
A ratio that is useful in evaluating asset management is the inventory turnover ratio, which measures how
often a company sales and replaces its inventory over a specified period of time, typically a year. For some
firms, particularly those in manufacturing and retailing, this is an important ratio, as inventory is often a
large asset for these companies.
Cost of goods sold
Inventory Turnover =
Average Inventory

Cost of goods sold (CGS) including those costs that are directly attributable to the production of goods or
products to be sold, including raw materials and labour costs. Cost of goods sold, sometimes labeled cost of
sales, is typically listed immediately after net sales (or net revenue), near the top of the income statements.
Recall that inventory is found on the balance sheet, and we calculate average inventory by finding the
average of the inventory values at the beginning and the end of the period.
If the particulars of cost of goods sold and average inventory are not available in the published financial
statements the Inventory turnover can be calculated by dividing sales by the inventory at the end, i.e.,
Sales
Inventory Turnover =
Closing Inventory

Between the two formulae given above for calculating the stock turnover the former is more logical and
more appropriate than the latter.
Generally, a high inventory turnover is an index of good inventory management and a low inventory
turnover indicates an inefficient inventory management. Low Inventory turnover implies the maintenance of
excessive stocks which are not warranted by production and sales activities. It also may be taken as an
indication of slow moving or non-moving and obsolete inventory. A too high inventory turnover also is not
good. It may be the result of a very low level of stocks which may result in frequent stock-outs. The stock
turnover should be neither too high nor too low.
3. Age of inventory:

Page 10 of 20
 AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
The length of the holding period shows a potentially greater risk of obsolescence.
4. Operating cycle: the operating cycle of a business is the number of days it takes to convert inventory
and receivables to cash.

A short operating cycle is desirable.

ii. Fixed assets turnover
This ratio measures the firm’s efficiency in utilizing its fixed assets. Firms which have large investments in
fixed assets usually consider this ratio important. It indicates the extent of capacity utilization in the firm.
The ratio is calculated by dividing the total value of sales by the amount of fixed assets invested.

A high ratio is an indicator of overtrading while a low ratio suggests idle capacity or excessive investment in
fixed assets. Normally, a ratio of five times is taken as a standard.
Some analysts suggest the exclusion on intangible assets like goodwill, patents, etc., for calculating this
ratio. For calculating this ratio, the gross fixed assets figure is preferred to the net value figure.
iii. Total Assets Turnover Ratio
This ratio measures the overall performance and efficiency of the business enterprise. It points out the extent
of efficiency in the use of assets by the firm. This ratio is calculated by dividing the annual sales value by
the value of total assets.

Normally, the value of salesTotalshould be considered to be twice that of the assets. A lower ratio than this
assets
indicates that the assets are lying idle while a higher ratio may mean that there is overtrading. Sometimes,
intangible assets (goodwill, patents, etc) are excluded from the total assets and the total tangible assets-
turnover ratio is calculated.
3. Long-Term Solvency, or Financial Leverage Ratios
The long-term creditors (debenture holders, financial institutions, etc) are more concerned with the firm’s
long-term financial position than with others. They judge the financial soundness of the firm in terms of its
ability to pay interest regularly as well as make repayment of the principal either in one lump sum or in
instalments. The long-term solvency of the firm can be examined with the help of the leverage or capital
structure ratios. These ratios indicate the funds provided by owners and creditors. Generally, there should be
an appropriate mix of debt and owners’ equity in financing the firm’s assets. Each of the two sources of
funds, viz., creditors and owners depending on which of them has been used to finance a firm’s assets, has a
number of implications. Between debt and equity (owners’ funds) debt is more risky from the firm’s view
point. Irrespective of the profits made or losses incurred, the firm has a legal obligation to pay interest on
debt. If the firm fails to pay to debt holders in time, they can take legal action against the firm to get
payment and even can force the firm into liquidation. But at the same time the use of debt is advantageous
to the owners of the firm. They can retain the control of the firm without dilution and their earnings will be
enlarged when the firm earns at a rate higher than the interest rate on the debt. The owner’s equity is created
as the margin of safety by the creditors. In view of the above stated facts, it is relevant to assess the long-
term solvency of the firm in terms of the owner’s and creditor’s contribution to the firm’s total
capitalization.

Page 11 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
Leverage ratios can be calculated from the Balance Sheet items to determine the proportion of debt in the
total capital of the firm. Though there are many variations of these ratios all of them indicate the extent to
which the firm has used debt in financing its assets.
Leverage ratios are also calculated from the income statements items to determine the extent to which
operating profits are sufficient to cover the fixed charges. This type of leverage ratios are popularly known
as ‘coverage ratios’ the most commonly calculated leverage ratios include:
1) Debt to total assets (Debt) Ratio
2) Debt equity ratio
3) Interest coverage ratio
i. Debt to total assets (Debt) Ratio
The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of funds
provided by creditors:
Debt ratio = Total liabilities
Total assets
The debt ratio quantifies how leveraged a company is, and a company's degree of leverage is often a
measure of risk. When the debt ratio is high, the company has a lot of debt relative to its assets. It is thus
carrying a bigger burden in the sense that principal and interest payments take a significant amount of the
company's cash flows, and a hiccup in financial performance or a rise in interest rates could result in default.
When the debt ratio is low, principal and interest payments don't command such a large portion of the
company's cash flows, and the company is not as sensitive to changes in business or interest rates from this
perspective. However, a low debt ratio may also indicate that the company has an opportunity to use
leverage as a means of responsibly growing the business that it is not taking advantage of. Debt ratio also
reflects the capital structure of a firm
Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses
in the event of liquidation. Stockholders, on the other hand, may want more leverage because it can magnify
expected earnings.
ii. Debt-Equity Ratio
This is one of the measures of the long-term solvency of a firm. This reveals the relationship between
borrowed funds and the owners’ capital of a firm. In other words, it measures the relative claims of creditors
and owners against the assets of the firm. This ratio is calculated in different ways. One way is to calculate
the debt equity ratio in terms of the relative proportions of long-term debt (non-current liabilities) and
shareholders’ equity (i.e., common shareholders’ equity and preference shareholders equity).
Long term liability
Debt-Equity ratio =
Shareholders' equity
Past accumulated losses and deferred expenditure should be excluded from the shareholders equity. The
shareholders equity is also known as the net worth accordingly, this ratio is also called debt to net worth
ratio.’
Another approach to the calculation of the debt-equity ratio is to divide the total debt (i.e., long term
liabilities plus current liabilities) by the shareholders’ equity.
Total debt
Debt-equity ratio =
Shareholders' equity
There is no unanimity of opinion regarding the inclusion of current liabilities in debt for the purpose of
calculating the debt-equity ratio. One opinion is to exclude current liabilities because of the following
aspects:
Page 12 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
 Current liabilities are of short-term nature and the liquidity ratios explain the firm’s ability to meet
these liabilities;
 The amount of current liabilities widely fluctuates during a year and the interest amount does not
bear any relationship to the book value of current liabilities shown in the Balance Sheet.
The inclusion of current liabilities in the debt is favored on the following grounds:
 Whether long term or short term, liabilities represent the firm’s obligations and so should be
considered in knowing the risk concerning the firm.
 Like long-term loans short-term loans to have a cost.
 The pressure from short-term liabilities, in fact, is more on the firm than that of the long-term debt.

Interpretation of Debt-Equity ratio

For the analysis of capital structure of a firm debt-equity ratio is important. It shows the extent to which debt
financing has been used in the business. It also shows the relative contributions of the creditors and the
owners of the business to it. A high debt-equity ratio indicates a large share of financing by the creditors in
relation to the owners or a larger claim of the creditors than those of owners. The D-E ratio indicates the
margin of safety to the creditors. A very high D-E ratio is unfavorable to the firm and introduces an element
of inflexibility in the firm’s operations. During periods of low profits a highly debt financed company will
be under great pressure; it cannot earn enough profits even to pay the interest charges. A low debt-equity
ratio implies a smaller claim of the creditors or a greater claim of the owners.
An ideal D-E ratio is 1:1. However, much will depend on the nature of the enterprise and the economic
conditions in which it is operating. In periods of prosperity and high economic activity, a large proportion of
the debt may be used while the reverse should be done during periods of adversity.
iii. Interest coverage ratio
Another tool for understanding a company’s financial leverage is the interest coverage ratio, sometimes
called the times interest earned ratio. As the name of this ratio implies, the interest coverage ratio measures
a firm’s ability to pay the interest on its debt. Many companies may not be able to pay the full amount of
debt owed in the short term, but a company that cannot at least pay the interest on its debt is at risk for
significant financial problems. The interest coverage ratio measures a company’s ability to pay interest on
debt out of income or earnings.
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
The interest expense value is found on the income statement. When a company reports no non-operating
income, EBIT is often used synonymously with the terms operating income or operating profit.
A higher coverage ratio is desirable form the point of view of creditors. But too high a ratio indicates that
the firm is very conservative in using debt. On the other hand, a low coverage ratio indicates excessive use
of debt or inefficient operations.
4. Profitability ratios
Every firm should earn adequate profits in order to survive in the immediate present and grow over a long
period of time. In fact, the profit is what makes the business firm run. It is described as the magic eye that
mirrors all aspects of the business operations of the firm. Profit is also stated as the primary and final
objective of a business enterprise. It is also an indicator of the firm’s efficiency of operations. There are
different persons interested in knowing the profits of the firm. The management of the firm regards profits
as an indication of efficiency and as a measure of control. Owners take it as a measure of the worth of their
Page 13 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
investment in the business. To the creditors profits are a measure of the margin of safety. Employees look at
profits as a source of fringe benefits. To the government they act as a measure of the firm’s tax paying
ability and a basis for legislative action. To the customers they are a hint for demanding price cuts. To the
firm they constitute a less cumbersome and low cost source of finance for existence and growth. Finally, to
the country profits are an index of the economic progress, the national income generated and the rise in the
standard of living of the people. Therefore, every firm should earn sufficient profits in order to discharge its
obligations to the various persons concerned.
Profitability means the ability to make profits. Profitability ratios are calculated to measure the profitability
of the firm and its operating efficiency. They relate profits earned by a firm to different parameters like
sales, capital employed and net worth. But while making financial ratio analysis relating to profits, it should
be noted that there are different concepts of profits such as contribution (sales revenue minus variable
costs), gross profit, profit before tax, profit after tax, profit before interest and taxes, operating profit, profit
has to be used for making the profitability analysis suitable for analyzing specific problems. Profitability
ratios can be calculated with reference to the different concepts of profit mentioned earlier. Profitability of
the firm can be measured by calculating several interrelated ratios demanded by the aims of the analyst. The
profitability of a firm can be measured and analyzed from the point of view of management, owners (i.e.,
shareholders in the case of companies) and creditors. From the management point of view, profitability
ratios are calculated for measuring the efficiency of operations.
i. Gross Profit margin or Gross Profit to Sales
The gross margin ratio indicates the gross margin generated for each dollar in net sales and is calculated as
gross margin (which is net sales minus cost of goods sold) divided by net sales:

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 gross margin ratio increase due to any of the following factors:
 Higher sales price, costs of good sold remain constant.
 Lower costs of goods sold, sales price remain constant.
 A combination of variations in sales prices and costs, the margin widening.
 An increase in the proportionate volume of higher margin items.
A low gross profit margin may reflect from:
Higher costs of goods sold, inefficient utilization of plant and machineries (over investment on plant assets),
and decreasing of prices in the market.
ii. 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.

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.

Page 14 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
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.
A higher value represents a company that is efficient in its production and operations. A low net profit
margin may reflect inefficient operations and poor management, as well as a company that would be at risk
financially if sales were to decline.
iii. Profitability in relation to investment
Profitability of a firm can also be measured in terms of the investment made. The term, ‘investment’, may
refer to total assets, total operation assets, capital employed or the owners’ equity. Accordingly, many
profitability ratios in relation to investment can be calculated. The important ratios in relation to investment
can be calculated. The important ratios are discussed here under:
iv. Return on assets
Return on Assets measures the net income returned on each dollar of assets. This ratio measures overall
profitability from our investment in assets. Higher rates of return are desirable.

The average total assets amount is found by adding together total assets at the end of the current year and
previous year and dividing by two. 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.
v. Return on Shareholders’ Equity
The shareholders of a company may comprise equity shareholders and Preference shareholders. Preference
shareholders are the shareholders who have a priority in receiving dividends (and in the return of capital at
the time of winding up of the company). The rate of dividend on the preference shares is fixed. But the
ordinary or common shareholders are the residual claimants of the profits and ultimate beneficiaries of the
company. The rate of dividend on these shares is not fixed. When the company earns profits it may
distribute all or a part of the profits as dividends to the equity shareholders or retain them in the business
itself. But the profits after taxes and after Preference Shares dividend payment present the return as equity of
the shareholders.
A return on shareholders’ equity is calculated to assess the profitability of the owners’ investment. The
shareholders’ equity is ascertained by adding up equity Share capital, Preference share capital, share
premium, reserves and surplus. If any accumulated losses are there, they should be deducted from this
amount. The shareholder’s equity is also called net worth.
Return on shareholders’ equity or return on net worth is calculated by dividing the net profit after tax by the
total shareholders’ equity or net worth.

This ratio reveals how profitably owners’ funds have been utilized by the firm. A comparison of this ratio
with that of similar firms and with the industry average shows, the relative financial soundness and
performance of the firm.

Page 15 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
If a firm has preference and ordinary shares, so as to calculate the return on equity, we deduct the dividends
to be paid for preference shareholders from net income and use only common shares instead of total equity.
Thus;

High value of return on equity is desirable

vi. Basic earning power (BEP) ratio: this shows the raw earning power of a firm’s assets, before the
influence of taxes and leverages, and it is useful for comparing firms with different tax situations and
different degree of financial leverages.

High value of this ratio is desirable.

5. Market value ratio
Market value ratio relates the firm’s stock price to its earnings, cash flow and book value per share. Those
values are out of the financial statements of a firm, but used to measure the value of the stock (shares) of a
firm.
i. Earning per share (EPS) ratio: this indicates the amounts of earnings of a firm relative to number
of shares outstanding.

Profit After Tax - Pref.Dividend

EPS =
No. of Equity Share Outs tan ding
EPS is a widely used ratio, especially for analyzing the effect of a change in leverage on the net operating
earnings to the equity shareholders. This analysis is of immense value in evolving an appropriate capital
structure for a firm.
High value of this ratio is desirable.
ii. Price/earnings ratio: evaluates the firm relationship with is stockholders. A high P/E ratio is good
because it indicates the investing public considers the firm in a favorable sight.

Price/earnings ratio shows how much investors are willing to pay per dollar of reported profits.

iii. Dividend per Share (DPS)

The net profits after taxes and Preference dividend belong to the equity shareholders and EPS reveals how
much of it is per share. But no company is under the obligation to distribute all the profits as dividends to
the shareholders. In pursuance of the policy which the company has evolved it may retain all or some profits
and distribute the balance as dividends. A large number of potential or prospective investors are interested
in knowing the dividends which the company distributes per share. The Dividend per Share (DPS) is
calculated by dividing the profits distributed as dividend by the number of equity share outstanding.
Earnings distributed as dividend to equity shareholders
D.P.S. =
No. of equity shares outstanding

Page 16 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
iv. Dividend payout ratio: this indicates that how much earnings are to be distributed as dividend to
shareholders and how much will retained within the firm to be reinvested to generate more earnings.

v. Market value to book value ratio: firms that have relatively high rates of return on equity generally
sell at higher multiples of book value than those with low return.

High value of this ratio is needed, so as to consider the firm has high earnings.

Du Pont Analysis
We have seen that ROA and ROE ratios above. The difference between the two performance measurement
is a reflection of the use of debt financing, or financial leverage.
There is a chart called Do Pont chart that is designed by a USA company so as to show the relationships
among ROE and ROA, asset turnover, leverage. Just look at the following equations.

If there the capital structure of a given firm is only shareholders equity, then the total asset will be the same
with equity, as there is no loan from outsiders. As a result, the above two equations will be combined as
follow;

The Du Pont formula also shows an important tie-in between the profit margin and the return on total assets.
The relationship is:
Return on assets = profit margin X total asset turnover

From this, the ROA can be raised by increasing either the profit margin or the asset turnover.
There is an equation called, equity multiplier which helps as to determine the level of leverage of a given
firm.

Firms that use a large amount of debt financing (more leverage) will necessarily have a high equity
multiplier; the more the debt, the less the equity, hence the higher the equity multiplier
ROE =ROA × Equity multiplier

The Extended Du Pont Equation, which shows how the profit margin, the assets turnover ratio, and the
equity multiplier combine to determine the ROE:

ROE = (Profit margin) (Total assets turnover) (Equity multiplier

Page 17 of 20
AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis

Here, The Du Pont identity tells us that ROE is affected by three things:
1. Operating efficiency (as measured by profit margin)
2. Asset use efficiency (as measured by total asset turnover)
3. Financial leverage (as measured by the equity multiplier)
Weakness in either operating or asset use efficiency (or both) will show up in a diminished return on assets,
which will translate into a lower ROE.
Considering the Du Pont identity, it appears that the ROE could be leveraged up by increasing the amount
of debt in the firm. It turns out this will only happen if the firm’s ROA exceeds the interest rate on the debt.
ROE

Return on asset X Equity multiplier

Net profit margin X Total asset turnover

Net income ÷ Sales Sales ÷ Total asset

Sales total costs fixed asset + current asset

Costs of goods sold Cash

Depreciation and Amortization Marketable securities
Operating expenses Account receivables
Miscellaneous expenses Inventories
Interest expense
Tax

Looking beyond the numbers

Sound financial analysis involves more than just calculating numbers; good analysis requires that certain
qualitative factors be considered when evaluating a company. These factors, as summarized by the
American Association of Individual Investors (AAII), include the following:
1. Are the company’s revenues tied to one key customer? If so, the company’s performance may
decline dramatically if the customer goes elsewhere. On the other hand, if the relationship is firmly
entrenched, this might actually stabilize sales.
2. To what extent are the company’s revenues tied to one key product? Companies that rely on a
single product may be more efficient and focused, but a lack of diversification increases risk. If revenues
come from several different products, the overall bottom line will be less affected by a drop in the demand
for any one product.
3. To what extent does the company rely on a single supplier? Depending on a single supplier may
lead to unanticipated shortages, which investors and potential creditors should consider.

Page 18 of 20
 AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
4. What percentage of the company’s business is generated overseas? Companies with a large
percentage of overseas business are often able to realize higher growth and larger profit margins. However,
firms with large overseas operations find that the value of their operations depends in large part on the value
of the local currency. Thus, fluctuations in currency markets create additional risks for firms with large
overseas operations. Also, the potential stability of the region is important.
5. Competition. Generally, increased competition lowers prices and profit margins. In forecasting
future performance, it is important to assess both the likely actions of the current competition and the
likelihood of new competitors in the future.
6. Future prospects. Does the company invest heavily in research and development?
If so, its future prospects may depend critically on the success of new products in the pipeline. For example,
the market’s assessment of a computer company depends on how next year’s products are shaping up.
Likewise, investors in pharmaceutical companies are interested in knowing whether the company has
developed any potential blockbuster drugs that are doing well in the required tests.
7. Legal and regulatory environment. Changes in laws and regulations have important implications for
many industries. For example, when forecasting the future of tobacco companies, it is crucial to factor in the
effects of proposed regulations and pending or likely lawsuits. Likewise, when assessing banks,
telecommunications firms, and electric utilities, analysts need to forecast both the extent to which these
industries will be regulated in the future, and the ability of individual firms to respond to changes in
regulation.

Limitations of ratio analysis

While ratio analysis can provide useful information concerning a company’s operations and financial
condition, it does have limitations that necessitate care and judgment. Some potential problems are listed
below:
I. Many large firms operate different divisions in different industries, and for such companies it is
difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more useful for small,
narrowly focused firms than for large, multidivisional ones.
II. Most firms want to be better than average, so merely attaining average performance is not
necessarily good. As a target for high-level performance, it is best to focus on the industry leaders’ ratios.
Benchmarking helps in this regard.
III. Inflation may have badly distorted firms’ balance sheets—recorded values are often substantially
different from “true” values. Further, since inflation affects both depreciation charges and inventory costs,
profits are also affected. Thus, a ratio analysis for one firm over time, or a comparative analysis of firms of
different ages, must be interpreted with judgment.
IV. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a food
processor will be radically different if the balance sheet figure used for inventory is the one just before
versus just after the close of the canning season. This problem can be minimized by using monthly averages
for inventory (and receivables) when calculating turnover ratios.
V. Firms can employ “window dressing” techniques to make their financial statements look stronger.
To illustrate, a ABC Co. borrowed on a two-year basis on December 29, 2008, held the proceeds of the loan
as cash for a few days, and then paid off the loan ahead of time on January 2, 2009. This improved his
current and quick ratios, and made his year-end 2008 balance sheet look good. However, the improvement
was strictly window dressing; a week later the balance sheet was back at the old level.
VI. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among firms. Also, if one
Page 19 of 20
 AKU, CoBE, Department of AcFn Short Note on Financial Statement Analysis
firm leases a substantial amount of its productive equipment, then its assets may appear low relative to sales
because leased assets often do not appear on the balance sheet. At the same time, the liability associated
with the lease obligation may not be shown as a debt. Therefore, leasing can artificially improve both the
turnover and the debt ratios. However, the accounting profession has taken steps to reduce this problem.
VII. It is difficult to generalize about whether a particular ratio is “good” or “bad.” For example, a high
current ratio may indicate a strong liquidity position, which is good, or excessive cash, which is bad
(because excess cash in the bank is a nonearning asset). Similarly, a high fixed assets turnover ratio may
denote either a firm that uses its assets efficiently or one that is undercapitalized and cannot afford to buy
enough assets.
VIII. A firm may have some ratios that look “good” and others that look “bad,” making it difficult to tell
whether the company is, on balance, strong or weak. However, statistical procedures can be used to analyze
the net effects of a set of ratios. Many banks and other lending organizations use such procedures to analyze
firms’ financial ratios, and then to classify them according to their probability of getting into financial
trouble.

Page 20 of 20