Chapter 2 FM For BM

FINANCIAL MANAGEMENT
Chapter 2
Financial statement analysis
Financial analysis is designed to determine the relative strengths and weaknesses
of a company. Investors need this information to estimate both future cash flows from
the firm and the riskiness of those cash flows. Financial managers need the
information provided by analysis both to evaluate the firm’s past performance and
to map future plans. Financial analysis concentrates on financial statement analysis,
which highlights the key aspects of a firm’s operations.
Financial statement analysis: is a process of evaluating relationships between
component parts of financial statements to obtain a better understanding of the firm’s
financial condition and performance. The focus of financial analyses is on key
figures in the financial statements and the significant relationship that exists between
them.
Financial analysis helps users understand the numbers presented in the financial
statements and serves as a basis for financial decision making.
For example:
 Shareholders (present and prospective) are interested in the firm’s current and
future level of risk and return as these dimensions directly affect share
price.
 Creditors (present and prospective) are primarily concerned with the short
term liquidity of the firm i.e. its ability to pay its current liabilities as they
come due. A secondary concern of creditors (esp. long term creditors) is the
firm’s profitability. They want assurance that the business is healthy and will
continue to be successful.
Computation: involves the application of tools and techniques to gain a basic
understanding of the firm’s financial status and performance.
The most frequently used techniques in analyzing financial statements are:
a) Ratio analysis: converts figures in the financial statements to ratios.
b) Common size statements: express individual statement accounts as
percentage of a base amount.
PREPARED BY TIGISTU TEBRATU/MBA/ 2022
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 Common size balance sheet: is one in which each item is expressed as

a percentage of total assets.
 Common size income statement: is one in which each item is expressed
as a percentage of total sales.
N.B. Ratio and common size statements help standardize statements of different sizes
and currency. Example: statements of Ford and GM which are so different in size and
GM and Toyota which use different currency.
3. Evaluation and interpretation: involves the determination of the
meaningfulness of the analysis to develop conclusions and recommendations about
the firm’s financial performance and status.
Zebra Share Company
Comparative Balance Sheet
December 31, 2020 and 20021
(In thousands of Birr)
Assets 2021 2020
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800
Zebra Share Company

Income Statement
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For the Year Ended December 31, 2021
Net sales Br. 196,200,000

Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000
lease payment.
Zebra Share Company

Statement of Retained Earnings
For the Year Ended December 31, 2021
Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
Common 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000
2. RATIO Analysis
Ratio analysis involves the methods of calculating and interpreting financial ratios to
assess financial performance and status. It standardizes financial data by converting
birr figures in the financial statements in to ratios.
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Types of ratio comparisons

Three types of ratio comparisons include:
 Cross-sectional analysis: involves comparison of different firm’s financial
ratios at the same point in time. A firm’s ratios may be compared to those of
the industry leader (to increase efficiency) or to industry averages.
 Time series analysis (trend analysis) is the evaluation of the firm’s financial
performance over time using ratio analysis.
 Combined analysis: the most informative approach that combines cross-
sectional and time-series analyses. A combined view permits assessment of the
trend in the behavior of the ratio to the trend of the industry.
Types of ratios
liquidity ratio
activity ratio
debt ratio
profitability ratio
valuation ratios
Consider the following financial statements to illustrate the computation of the above
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. The following financial statements pertain to Zebra Share
Company. We will perform the necessary ratio analyses using them, and then evaluate
and interpret each analysis.
i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-
term creditors by using only current assets. This ratio relates current assets to current
liabilities
Current ratio = Current assets
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Current liabilities
Zebra’s current ratio (for 2021) = Br. 57,600 = 1.51 times

Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in
good position to meet its current obligations. Conversely, relatively low current ratio
is interpreted as an indication that the firm may not be able to easily meet its current
obligations.
ii) 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. Thus, the quick ratio measures a firm’s
ability to pay its current liabilities by using its most liquid assets into cash.
Quick ratio = Current assets – Inventory

Current liabilities
Zebra’s quick ratio (for 2021) = Br. 57,600 – Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in
current liabilities.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term
obligations, and the higher the quick ratio the more liquid the firm’s position. But the
quick ratio is more detailed and penetrating test of a firm’s liquidity position as it
considers only the quick asset.
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
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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. Activity ratios include:
i) Accounts Receivable turnover-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.
Accounts receivable turnover = Net sales

Accounts receivable
Zebra’s accounts receivable turnover (for 2021) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
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.
There are alternate ways to calculate accounts receivable value like average receivables
and ending receivables. Though many analysts prefer the first, in our case we have
used the ending balances. In computing the accounts receivable turnover ratio, if
available, only credit sales should be used in the numerator as accounts receivable
arises only from credit sales.
ii) Days sales outstanding (DSO) – also called average collection period. 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.
Days sales outstanding = 365 days

Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days
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9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in
almost 39 days. If Zebra’s credit period is less than 39 days, some corrective actions
should be taken to improve the collection period.
The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover – measures how many times per year the inventory level is
sold (turned over).
Inventory turnover = Cost of goods sold

Inventory
For Zebra Company (2021) = Br. 159,600 = 6.41times

Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
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.
iv)Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It
shows how many birr of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales___

Net fixed assets
Zebra’s fixed assets turnover = Br. 196,200 = 2.04

Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed
assets.
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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.
The fixed assets turnover may be deceptively low or high. This is because the book
values of fixed assets may be considerably affected by cost of assets, time elapsed
since their acquisition, or method of depreciation used.
v) Total assets turnover – indicates the amount of net sales generated from each birr
of total tangible assets. It is a measure of the firm’s management efficiency in
managing its assets.
Total assets turnover = Net Sales
Total assets
Zebra’s total assets turnover = Br. 196,200 = 1.27

Br. 153, 900
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one
birr invested in total assets.
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. Leverage Ratios
Leverage ratios are also called debt management or utilization ratios. They measure
the extent to which a firm is financed with debt, or the firm’s ability to generate
sufficient income to meet its debt obligations. While there are many leverage ratios, we
will look at only the following three.
i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided
by debt.
Debt ratio = Total liabilities
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Total assets
Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900
Interpretation: At the end of 2021, 64% of Zebra’s total assets were financed by debt
and 36% (100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its
assets. Conversely, a low ratio implies the firm has funded its assets mainly with equity
sources. Debt ratio reflects the capital structure of a firm. The higher the debt ratio the
more the firm’s financial risk.
ii) Times interest earned – measures a firm’s ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)

Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
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 is
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.
iii) Fixed charges coverage – measures the ability of a firm to meet all fixed
obligations rather than interest payments alone. Fixed payment obligations include loan
interest and principal, lease payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes

Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore,
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Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32

Br. 3,000 + Br. 2,700
Interpretation: the fixed charges (interest and lease payments) of Zebra Share
Company are safely covered 2.32 times.
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.
i) Profit Margin – shows the percentage of each birr of net sales remaining after
deducting all expenses.
Profit margin = Net income

Net Sales
Zebra’s profit margin = Br. 3,900 = 2%

Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
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.
ii) Return on investment (assets) – measures how profitably a firm has used its
investment in total assets.
Return on investment = Net income

Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 %
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Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
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.
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on
investments made by themselves.
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%

Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment

1 – Debt ratio
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
off the owners.
5 Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range
planning. They include:
i) 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.
Earnings per share = Net income – Preferred stock dividend
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Number of common shares outstanding
Zebra’s EPs for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid
on each share of its common stock outstanding.
Dividends Per Share = Total cash dividends on common shares

Zebra’s DPs for 2022 = Br. 3,300 = Br. 1.00

Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to
stockholders.
Dividends pay-out = Dividends per share
Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
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III. DEBT MGT RATIOS

Also called solvency ratios, leverage ratios, or capital structure ratios
These are of two general types: those which show:
1. Degree of indebtedness - the extent to which a firm finances itself with debt as
opposed to equity, using balance sheet items
2. Ability to service (pay) debts- the ability of the firm to generate a level of income
sufficient to meet its obligations (fixed charges) such as interest, and principal
payments on loans, preferred dividends, etc.
The manner in which assets are financed has a number of implications:
► from debt and equity, debt is more risky.
► Employment of debt is advantageous in two ways: 1) owners can retain the firm with a
limited stake (investment) i.e. high EPS 2) their earnings ( EPS) will be magnified, when
the firm earns a rate of return on capital is higher than interest rate on borrowed funds.
The process of magnifying shareholders return through debt is called financial leverage.
High leverage also means high risk if firm’s rate of return is less than cost of debt also
bankruptcy in case of insolvency.
► A highly debt-burdened firm will find difficulty in raising funds from creditors and
owners in future.
⇒ Generally, leverage ratios are calculated to measure financial risk of a firm and its
ability to use debts to shareholders’ advantage.
To illustrate the leverage concept consider the following case. A firm is considering two
financing options for its $50,000 assets.
1. No debt plan- under which 200 shares of $250 per share are to be sold
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2. Debt plan – issuance of 100 shares at $250 and borrowing $25,000 at 12% annual
interest rate.
Regardless of which option is taken, the Co. expects sales to average $30,000, costs and
operating expenses to average $18,000, tax of 40%.
30000 18000  4800
EPS under the first plan =  36
200
12000  .12x25000  .4x9000

● EPS under the second plan =  54
100
Since the second plan has a higher leverage its earnings per share is magnified.
i. Leverage Ratios
a) Debt-Asset ratio (Debt Ratio)
- Debt Ratio measures the proportion of total assets financed by the firm’s creditors.
DR = total liabilities  1640  0.456  45.6%
total assets 3600
Industry average = 40%
Interpretation: 45.6% of the company’s total assets is financed b y debt funds. The
remaining 54.4% is obtained from equity. Since the average debt ratio for the industry is
about 40% Alpha would find it difficult to borrow additional funds with out first raising
equity capital. Creditors would be reluctant to lend the firm more money, and
⇒ DE =
management would probably be subjecting the firm to the risk of bankruptcy if it
sought to increase the debt ratio any further by borrowing additional funds.
N.B. 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, can
benefit from leverage because it magnifies earnings.
b) Debt Equity Ratio
Measures the extent to which debt financing sources are used relative to equity. i.e.
relative claims of creditors and shareholders against the assets of the firm.
Debt equity ratio= Total Debt  1640  0.84
stockholders’ equity 1960
Interpretation: For each dollar supplied by stockholders, creditors have supplied $0.84.
N.B. Debt to assets and debt to equity ratios are simply transformations of each other. Both
of the two indicate the same thing – the extent to which the firm has relied in financing its
assets.
TD
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TA  TD
⇒ DE(TA) – DE(TD) =TD
⇒ DE(TA) = TD + DE(TD)
DE DR
⇒ DR = 1  DE AND DE = 1  DR
ii. COVERAGE RATIOS
Measure a firm’s ability to meet (cover) fixed charge obligations such as:
⇒ Interest on loans
⇒ Lease payments
⇒ Preferred dividend
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a) Times Interest Earned (interest coverage) ratio

TIE measures a firm’s ability to pay interest on its debt using operating profits. It shows
the extent to which operating income can decline before the firm is unable to meet its
annual interest costs. Failure to meet these obligations can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
TIE = Earnings before Interest and Taxes = 410 = 4.56x
Interest Expense 90
Interpretation: Alpha generates $4.56 in operating income for each dollar of interest
expense that is far below the average for the industry. Thus alpha is covering its interest
charges by a relatively low margin of safety which reinforces our conclusion that it may
face difficulties if it attempts to borrow additional funds. A high TIE ratio implies the firm
has sufficient margin of safety to cover its interest charges. That is the firm’s earnings
could decline with out jeopardizing its ability to make interest payments.
N.B. Earnings before interest and taxes, rather than net income, is used in the numerator.
This is because interest is paid with pretax dollars; the firm’s ability to pay current interest
is not affected by taxes.
⇒ The Times-Interest-Earned ratio implicitly assumes that remaining income (after
subtracting production, operating, and administrative expenses from sales) is available to
meet interest expense. However, Earnings–Before-Interest–and-Taxes is an income
concept not a direct measure of cash. Consequently, this ratio provides only an indirect
measure of the firm’s ability to meet its interest payments.
b) Fixed Charge Coverage ratio: measures the firm’s ability to meet all fixed payment
obligations, such as loan interest and principal, lease payments, and preferred stock
dividends.
EBIT  Lease payments
FCCR =
Interest Lease payments Preferred dividend  Principal payments
1T
Where T = income tax rate
Additional information:
⇒ Alpha Co. has a 4- year financial lease requiring annual beginning of year payment of
35.
⇒ Annual principal repayment of the firm’s total outstanding debt amount to $71
⇒ The annual preferred stock dividend would total $10
⇒ Tax rate is 40%
410  35
FCCR = 90  35  71  10  1.71x
1  0.4
⇒ Interpretation: Fixed charges of Alpha Company are covered 1.71 times using its
earnings. This relatively low ratio gives creditors and preferred stockholders small
margins of safety incase Alpha Company experiences lower earnings.
⇒ A high ratio suggests greater protection incase of worsening of financial position.
c) Cash Coverage ratio:
- is a measure of cash available to pay interest.
A problem with TIE ratio is that it is based on EBIT that is not a real measure of Cash
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available to pay interest as it excludes non cash expenses.
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Cash coverage ratio = EBIT  depreciation  410 150  6.22

interest 90
Alpha Co. is able to generate cash from operation of 6.22 times its obligation for interest.
4. PROFITABILITY RATIOS
Profitability ratios provide an overall evaluation of performance of a firm and its
management. The ratios examined thus far provide some information about how the
firm operates, but profitability ratios show the combined effects of liquidity, asset
management, and debt management on operating results. i.e. they give final answers
about how effectively the firm is managed.
Profitability ratios measure the returns generated by the firm from several aspects: a)
on a per share basis b) on a per dollar basis c) on per dollar of asset basis d) on per
dollar of stockholders’ equity basis.
Profitability ratios measure the over all management effectiveness in generating profit
on sales, total assets and owners equity.
a) Gross profit margin: measures the percentage of each sales dollar remaining after
the firm has paid for its goods. It indicates management’s effectiveness in pricing its
products, generating sales and in controlling production costs.
Gross profit margin = gross profit  980  0.3192  31.92%

net sales 3070
Interpretation: alpha company generates gross margin of $0.32 from each dollar sale.
This is slightly beyond the industry average indicating that the pricing policy and
production cost control of the company is in a good position.
b) Operating profit margin: measures the percentage of profits earned on each sales
dollar before interest and taxes. It measures pure profits earned on each dollar as it ignores
any financial or government charges (interest and taxes) and measures only the profits
earned on operations. A high operating profit margin is generally preferred.
Operating profit margin = operating profits  EBIT  410 13.30
net sales net sales 3070
Interpretation: alpha company generates 13.3% or 13.3 cents in operating profit per dollar f
net sales. This is above the industry average indicating that the firm incurs relatively lower
operating costs and has high selling prices or high volume of sales. That is, it gets better
profit from its operating activities.
c) Net profit margin (or profit margin)

► measures the percentage of each sales dollar remaining after deducting all expenses,
including taxes. Profit margin is a function of three factors: sales generating capacity (sales
volume), pricing strategy, and cost controlling strategy.
Net profit margin = net income

 230
 0.075  7.5%
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net sales
3070
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Industry average: Alpha xo generates 7.5 cents in profit for every dollar in sales. This is
slightly above the average for the industry indicating that alpha has a relatively higher
sales and/or lower expenses i.e. better selling practices and cost reduction management.
d) Return on investment (return on assets)

► ROI measures the overall effectiveness of management in generating profits with its
available assets. Profit margin measures profitability per sales dollar, and total assets
turnover ratio measures how well assets are managed. Thus ROI can be understood as
occurring from a combination of profit margin and activity.
 net income  230

ROI= = = 0.064 6.4%
total assets 3600
Du Pont formula:
ROI = net income  net sales  profit margin total assets turnover
net sales total assets
= .075 × 0.85 = 6.4%

Industry average = 4.8%
Interpretation: Alpha generates a return of 6.4 cents on each dollar invested in its assets
which is well above the industry average. This positive result is both from better
management of assets and a better profit margin.
N.B. ► To increase ROI companies should work for better rate of profitability and
better rate of asset turnover.
. ► ROI relates size to profits. If a corporation increases in size (as measured by total
assets) but does not increase its earnings after taxes proportionately; then its ROI
will decrease.
e) Return on equity (Return on net worth)
This ratio measures the return earned on the owners’ (both common and preferred)
investment in the firm. It indicates management’s performance for owners.
ROE  net income  230 11.73%
stockholders’ equity 1960
Industry average: alpha generates about 12 cents for every dollar in stockholders’ equity.
This is well above the industry average indicating that management is performing
relatively more effectively to provide owners an above average return on their investment.
Modified Du Pont formula:

NI  total assets
ROE =
total assets stockholders’ equity
But, SHE = (1 – Debt Ratio) × Total Assets
ROE  NI  total assets
total assets (1  debt ratio)total assets
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1 ROI
ROE = ROI x (1  debt ratio)  (1  debt ratio)
NI
ROE   equity multiplier
total assets
N.B. ►Too high ROE might indicate greater use of debt (higher leverage) which might be risky.
i.e. the ROE ratio might decrease if the firm is unable to earn a rate of return that exceeds
its cost of debt financing.
► Too low ROE might suggest a more conservative financing policy.
5. Market Value Ratios

These ratios relate the firm’s stock price to its earnings and book value per share.
If a firm’s liquidity, asset management, debt management, and profitability ratios are all good, then
its market value ratios will be high, its stock price will probably be as high as can be expected.
a) Earnings per share
Earning per share represents the number of dollars earned common stock. It is generally of interest to
present and prospective owners and management and is considered as important indicator of
corporate success.
EPS =Earnings available to common share
EPS  net income  preferred dividend  230 10 = 2.75

number of common shares outstanding 80
Industry average: 2.26
Interpretation: Alpha earns $2.75 on behalf of each share outstanding, a higher one as compared to
the industry average.
b) Price/ earnings ratio
This ratio reflects the amount investors are willing to pay for each dollar of the firm’s earnings. It
measures the degree of confidence (or certainty) that investors have in the firm’s future
performance. i.e. The higher the P/E ratio, the greater the investors’ confidence in the firm. P/E
ratios are higher for , other things held constant, but they are lower for riskier firms.
 Market price per share of common stock
P/E ratio
Earnings per share
Assume for Alpha that its common stock was selling at 32 1/4 (or 32.25) and it has 80 4
shares of common stock outstanding.
P/E= 32.25 = 11.73

2.75
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Industry average = 12.50

Interpretation: investors were paying $11.73 for each dollar of earnings. This is below the industry
average indicating poor performance by management and high risk. (Use of a relatively higher
debt.).This suggests that the firm is regarded as being some what riskier than most, as having poorer
growth prospects, or both.
c) Market/ Book ratio

This ratio indicates how equity investors regard the company. Companies with relatively high rates
of return on equity generally sell at higher multiples of book value than those with low returns.
 market price per share
Market/ book ratio
book value per share
Book value per share  common equity  620  7.75

share-outstanding 80
32.25
Market/ book value ratio  = 4.16
7.75
Industry average = 5
Interpretation: investors are willing to pay less for Alpha’s book value than for that of an average
firm in the industry reinforcing the above conclusion.
Page 22

Chapter 2 FM For BM

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Chapter 2 FM For BM

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FINANCIAL MANAGEMENT

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

 Common size balance sheet: is one in which each item is expressed as

Zebra Share Company

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

For the Year Ended December 31, 2021

Net sales Br. 196,200,000

Zebra Share Company

Retained earnings at beginning of year Br. 9,000,000

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Types of ratio comparisons

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Zebra’s current ratio (for 2021) = Br. 57,600 = 1.51 times

Quick ratio = Current assets – Inventory

asset management ratios, or asset utilization ratios, or efficiency ratios. Generally,

Accounts receivable turnover = Net sales

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

Days sales outstanding = 365 days

Zebra’s days sales outstanding = 365 days = 39 days

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Inventory turnover = Cost of goods sold

For Zebra Company (2021) = Br. 159,600 = 6.41times

Fixed assets turnover = Net sales___

Zebra’s fixed assets turnover = Br. 196,200 = 2.04

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Zebra’s total assets turnover = Br. 196,200 = 1.27

Debt ratio = Total liabilities

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Zebra’s debt ratio = Br. 98,100 = 64%

Times interest earned = Earnings before interest and taxes (EBIT)

Fixed charges coverage = Income before fixed charges and taxes

Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32

Profit margin = Net income

Zebra’s profit margin = Br. 3,900 = 2%

Return on investment = Net income

Zebra’s return on investment = Br. 3,900 = 2.53 %

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Generally, a high return on investment is sought by firms. This can be achieved by

Zebra’s return on equity = Br. 3,900 = 6.99%

Return on equity = Return on investment

Earnings per share = Net income – Preferred stock dividend

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Number of common shares outstanding

Dividends Per Share = Total cash dividends on common shares

Zebra’s DPs for 2022 = Br. 3,300 = Br. 1.00

Interpretation: Zebra distributed Br. 1 per share in dividends.

Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

III. DEBT MGT RATIOS

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

12000  .12x25000  .4x9000

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

ii. COVERAGE RATIOS

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

a) Times Interest Earned (interest coverage) ratio

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

available to pay interest as it excludes non cash expenses.

PREPARED BY TIGISTU TEBRATU/MBA/ 2022

Cash coverage ratio = EBIT  depreciation  410 150  6.22

Gross profit margin = gross profit  980  0.3192  31.92%

c) Net profit margin (or profit margin)

Net profit margin = net income

PREPARED BY TIGISTU TEBRATU/MBA/ 2022