OROMIA STATE UNIVERSITY

Project Management-Program

Course Title: Project Cost Management

Course Code: MAPMS 631

Credit Hours: 3
Instructor: Dr. Abdela Y. (Assistant Professor)
 Chapter 3:
Financial Statement Analysis
 3.1. FINANCIAL ANALYSIS
• Financial analysis is the process of selection,
evaluation and interpretation of financial
data, along with other pertinent information,
to assist in investment and other financial
decisions.
• It is a diagnostic tool of analysis that can
help management to identify the strength
and weakness of the firm so that corrective
actions can be taken starting from planning.
 3.2 APPROACHES TO FINANCIAL ANALYSIS
• Based on the information required for
financing and investing decisions, the
approaches of financial analysis include:
i) A comparison of the performance of a firm
with the performance of other firms in the
same industry.
ii) Evaluation of the performance or position of
a given firm overtime.
iii) Adjusting the financial statements of a firm
to a common size financial statement.
 Cont…
• According to users of financial information,
there are two techniques of financial analysis.
These are:
i) External Analysis – an analysis performed
by outsiders to the firm such as creditors,
investors, suppliers etc.
ii) Internal Analysis – an analysis performed
by corporate finance and accounting
departments for the purpose of planning,
evaluating, and controlling operating activities.
3.3 TOOLS &TECHNIQUES OF FINANCIAL
ANALYSIS
• The most frequently used techniques in
analyzing financial statements are:
Ratio Analysis– is a mathematical
relationship among money amounts in the
financial statements.
• They standardize financial data by converting
money figures in the financial statements.
• Ratios are usually stated in terms of times or
percentages.
Cont’d…
• Ratio analysis helps us to draw meaningful
conclusions and interpretations about a firm’s
financial condition and performance.
Common size Analysis–A common size
status expresses each item in the balance
sheet as a percentage of total assets and
each item of the income statement as a
percentage of total sales.
 Cont’d…
Index Analysis – expresses items in the
financial statements as an index relative to
the base year.
• All items in the base year are assumed to be
100%. Usually, this analysis is most
appropriate for income statement items.
Financial Statement Analysis
3.4 Basic Financial Statements
• The data used in analyzing financial
statements are contained in the financial
statements themselves, such as income
statement, balance sheet and statement of
retained earnings.
• In explaining financial statement analysis,
financial statements pertaining to Addis
Manufacturing Company are used throughout
this chapter.
 3.4.1 Income Statement
• As you know from you previous courses,
income statement measures the profitability
of business firm over a period of time.
3.4.2 Balance Sheet
A balance sheet basically summarizes the financial
position of the business firm. It usually contains two
sections:
1) The asset (i.e. uses of funds) section, and
2) The liabilities and shareholders' equity (i.e.
sources of funds) section.
The following is the comparative balance sheet for
Addis Manufacturing Company, an ideal business firm,
on Sene 30, 1992 E.C. and Sene 30, 1993 E.C.
0
 3.5 Ratio Analysis:
• The first step in undertaking financial
statements analysis is to read and
understand the financial statement and their
accompanying notes with care.
• This is followed by the computation and
interpreting what the ratios is to mean (i.e.
undertaking ratio analysis).
 3.5.1 Users of Financial Ratio
 Both lenders and potential lenders use financial
ratios to evaluate loan applications from
borrowing companies.
 Investors use financial ratios to assess the
future tale of the companies they are to make
investment with.
 Managers make use of financial ratios in order
to judge the performance of their companies
and to control the day-to-day operation of their
companies.
 Owners make use of financial ratios to evaluate
whether their companies are maximizing their
wealth or not.
 Cont’d…
Financial ratios judged to be high/low/acceptable
when they are compared w/t standards.
• Standard ratios could be:
 Industry standards- these are standard ratios
computed for companies operating in the same
industry.
 Management plans- these are ratios that the
management of a given company set as goals.
 Historical standards- these are financial
ratios developed from the historical records of
the company over say the last 10 years.
 3.5.2 Types of Financial Ratios
1) LIQUIDITY RATIOS: Liquidity ratios measure
the ability of business firm to pay its current
liabilities and current portion of long-term debts
as they mature.
• Liquidity ratios assume that current assets are
the principal sources of cash for meeting
current liabilities and current portion of long-
term loans.
• The two most widely used liquidity ratios are:
i) Current Ratio ii) Quick/Acid Test Ratio
 Cont’d…
Current Assets
i) Current Ratio= Current Liabilities
• The larger the current ratio is the less the
difficulty that the company faces in paying its
obligations at the right time.
• In many cases lenders frequently require the
current ratio of the borrowing company to
remain at or above 2.0 times as a condition
for grading or continuing the commercial and
industrial loans.
 Cont’d…
• The current ratios of Addis manufacturing
Company show that the company has 1.96 Birr
in current assets for each Birr of current
liabilities during 1992 and 2.22 Birr in current
assets for each Birr of current liabilities during
1993.
• It is very difficult to say these ratios are high or
low as we don’t have industry standard, or
management plan or historical standard against
we compare these current ratios.
• But one can say that Addis Company is more
capable in 1993 to pay its current liabilities than
in 1992.
 ii) Quick/Acid Test Ratio:
• It considers only quick current assets such as
cash, marketable securities, and account
receivables.
• This is done because inventories, prepaid
expenses and supplies cannot easily be
converted back to cash.
 Cont’d…
• Thus, the quick ratio measures the ability of
the company to pay its current liabilities by
converting its most liquid assets to cash
which is easier.
Quick Ratio = Current assets  (Pr epaid epense  Supplies  inventories)
Current liabilities
 Cont’d…
• The Company's quick ratio should be 1.0
times or more than that.
• In the case of Addis Manufacturing Company,
the quick assets of 91 cents are available to
meet each Birr of current liabilities.
• This implies that the quick assets are not
enough to settle all the current obligations.
• Unless the company converts the non-quick
current assets to the extent they provide
cash that is enough to pay the remaining 9
cents for each Birr of current liabilities…
 Cont’d…
the company will face difficulty in meeting its
obligation.
• The quick ratio of 1.08 times for 1993, on the
other hand, implies that the company has
1.08 Birr of quick assets for each Birr of
current liabilities.
• Again, the company is in good liquidity
position during 1993 compared to 1992.
 2) ACTIVITY RATIOS
• It measure the degree of efficiency with in
which the company utilizes its resources.
Efficiency is equated with rapid resource
turnovers.
i) Account 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
• 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
inadequate cash collection efforts.
 Cont’d…
• Interpretation: Addis’s accounts receivable
get converted into cash 9.17 times a year in
the year 1992 and 7.5 times a year in 1993.
• In general, a reasonably higher accounts
receivable turnover ratio is preferable.
• Addis manufacturing company has higher
A/R turnover for the year 1992 compared to
1993.
• There are alternate ways to calculate
accounts receivable value like average
receivables and ending receivables.
 Cont’d…
• 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.
 Cont’d…
ii) Average Collection Period – also called
‘Days sales outstanding’ (DSO).
• This ratio tries to measure the average
number of days it takes for the company to
collect its account.
• The shorter the average collection period the
better is the company's activities.
• It also indicates how many days a firm’s
sales are outstanding in accounts receivable.
 Cont’d…
Average collection period = 365 days___
A/R turnover
• The ACP of a firm is directly affected by the
accounts receivable turnover ratio.
• Generally, a reasonably short-collection period
is preferable.
• An increase, or decrease in the values of ACP
should not be used to evaluate the effort of
the company puts in collecting its receivables.
 Cont’d…
Interpretation: Credit customers on the
average are paying their bills in almost 40
days for the year 1992, & 49 days for the
year 1993.
• Based on this Addis’s manufacturing firm has
better collection period on the year 1992 i.e.,
average 40 days than the year 1993 i.e.,
average 49 days.
iii) Inventory turnover ratio
• This ratio is meaningful for companies like
Addis Manufacturing Company which hold
inventories of different kinds (It could be
merchandise, raw material, processed goods
and so on).
• It indicates the efficiency of the firm in
producing and selling its product.
 Cont’d…
• These ratio measures the number of times
per year that the company sells its inventory.
• It is computed by dividing the Birr amount of
CGS by the Birr amount of inventory at the
closing date of the accounting period.
Costs of goods sold
Inventory turnover = Inventory balance
• The CGS figure may not be available, so it is
possible to replace w/t sales figure to find
inventory turn over ratio.
 Cont’d…
• In general, high inventory turnover may be
taken as a sign of good inventory
management.
• Other things being the same, inventory
turnover ratios computed for Addis
Manufacturing Company indicate that the
company was able to sell its inventories 4.44
times and 4.39 times during 1992 and 1993
E.C respectively.
 iv) Total Assets Turnover Ratio
• It measures the r/s b/n a birr of sales & birr
of assets, usually on the yearly basis.
• It is also a measure of the overall activity of
the company.
• Basically the company wants to generate as
much birr as possible in the form of sales per
a birr of an investment it made in assets.
• It is computed by dividing the total net sales
of the company by its total assets on the
closing date of the accounting period.
 Cont’d…
Net Sales
Total assets turnover =
Total assets

• The total assets turnover ratio of 1.55 times

during 1992 implies that the company was
able to generate 1.55 Birr for a single birr it
has invested in its assets during the year.
• During 1993, on the other hand, the
company was able to make net sales of 1.46
birr for each birr it has invested in the total
assets.
 Cont’d…
• Though the total volume of sales is greater
during 1993, the assets turnover ratios show
that the company was efficient in generating
higher net sales per birr of investment in
asset in 1992 than in 1993.
• The decrease in the asset turnover ratio in
1993 may indicate a decrease in the
utilization of the assets for generating the
desired sales revenue.
 3) DEBT MANAGEMENT/LEVERAGE RATIOS
• Also called solvency/capital structure/financial
leverage ratios.
• These ratios measure the extent to which a
company finances itself with debt as opposed to
equity financing.
• Financial ratios provide the basis for answering
two basic questions:
i. How is the company finance its assets? And
ii. Can the company afford the level of fixed
charges associated with the use of non-
owners-supplied funds such as bond interest
and principal payments?
 i) Balance sheet leverage ratios:
• These ratios provide the basis for answering
the question, Where did the company obtain
financing for its investments?
The balance sheet leverage ratios include:
1. Debt ratio or debt-asset ratio: it measures
the extent to which the total assets of the
company have been financed using borrowed
funds.
total liabilities
Debt-asset ratio = total assets
• Too much debt financing is risky to the
company.
 Cont’d…
• At the end of 1992, 67.46 percent of the
total assets of Addis Manufacturing Company
were financed by funds secured in the form
of current and long-term liabilities.
• The remaining 32.54 percent was financed
by funds contributed by shareholders and
retained from the profits earned by the
company.
• Similarly, debt financing constitutes about 55
percent of the total assets of the company
during 1993.
 Cont’d…
• This leaves 45 percent of the total assets to
be financing has declined during 1993
compared to 1992 signaling good condition.
• Too much debt financing is risky to the
company.
• Addis manufacturing company can borrow
much more money during 1993 than it could
do in 1992 because the asset structure of
the company was more debt-dominated in
1992 than in 1993.
 Cont’d…
• Hence, lenders are willing to give loans to
the company during 1993 when debt-asset
ratio is less than during 1992 when debt-
asset ratio is high.
• Creditors prefer low debt-asset ratios, b/c
the lower the ratios, the lower the chance of
losing their money upon maturity, or
liquidation.
• The owners may want higher debt (leverage)
ratios because the cost of borrowed money
is usually less than the cost of owners' funds.
Cont’d…
• The co. may find it difficult to borrow
additional funds without first raising more
equity otherwise, creditors would be
reluctant to lend more money to the
company with its debt-dominated capital
structure.
• Though creditors are willing to give loans to
debt dominated borrower they are willing at
higher interest rate that commensurate with
the high risk they are taking as lenders.
 Cont’d…
2. Long-Term Debt- Equity Ratio: - This ratio
measures the extent to which long-term
financing sources are provided by creditors
(debt-holders).
• The ratio is computed by dividing long-term
debts by stockholders' equity.
Long term debt
Long-term debt - equity ratio = Shareholders equity

• The long-term debt-equity ratio of the

company decreased from 130 percent in
1992 to 73 percent in 1993.
 Cont’d…
Interpretation: the long-term debt-equity
ratio of 130 percent achieved during 1992
can be for a single birr of share holders'
equity in the long-term financing there is
1.30 birr of long-term debt in the long-term
financing.
• In other words the long-term financing 2.30
birr was made 1 birr from share holders'
equity and 1.30 birr from long-term debt.
 Cont’d…
• In the same way, a single birr in the long-
term equity financing is combined with 73
cents of long-term debt financing to form a
total long-term financing of 1.73 birr during
1993.
• In other words, for each birr obtained from
shareholders' equity, the long-term debt
holders contributed 73 cents in the long-term
financing during the year.
Cont’d…
The decrease in LTD-Equity ratio may be caused
by several factors some of which are:
 Some long-term debts might be matured and
paid out, which reduce the balance of long-
term debts,
 The company might increase the level of its
shareholders' equity either by issuing additional
shares at premium, and
 Some amount might be added to the
company's retained earnings due to retention
of the portion of full amount of net income.
Cont’d…
• Debt-equity ratio: expresses the r/s b/n the
amount of the total assets of the company
financed by creditors (debt) and owners
(equity).
• Thus, this ratio reflects the relative claims of
creditors and shareholders against the total
assets of the company.
• This ratio provides answer to the question:
What are the proportions of debts and equity
in financing in the total assets of the company?
Total debts
Debt - equity ratio =
Shareholders' equity
a) Coverage Ratios: provide the basis for
answering the question of whether the company
has used too much financial leverage. It include
the followings:
Time interest earned ratio (Interest coverage
ratio): This ratio measures the extent to which
operating income can decline before the company is
unable to meet its annual interest costs.
• Failure to meet this obligation can bring legal
action by the company’s creditors, possibly
resulting in bankruptcy.
• Dividing earnings before interest and taxes
(EBIT) by the interest charges during the year.
 Cont’d…
• EBIT, rather than N.I, is used as a
numerator in the formula because interest is
paid with the pre-tax income and company’s
ability of paying interest charges is not
affected by taxes.

Earnings before int erest and taxes

Interest coverage ratio = Interest exp enses
 Cont’d…
• Generally, the lower time interest earned ratio
suggests that creditors are at risk in receiving
the interest payments that are due; the
creditors may take legal action that may result
in bankrupting the company; and
• The company may face difficulty in raising
additional financing through debt issues as the
company is under risk of paying interest
charges.
• A larger interest coverage ratio, on the other
hand, suggests that the company has sufficient
margin of safety to cover its interest expenses.
 4) PROFITABILITY RATIOS
• Profitability is the net result of a number of
policies and decisions.
• The profitability ratios provide the overall
evaluation of performance of the company
and its management.
• These ratios show the combined effects of
liquidity, activity and average ratios on the
operating result of the company.
Cont’d…
1. Gross profit margin:
Gross profit margin = Gross profit
Net sales
Interpretation: the company’s gross profit
constitutes 24.55 percent and 25 percent of
the company’s net sales during 1992 and
1993 respectively.
• These ratios reflect the company’s markups
on costs of goods sold as well as the ability of
the company’s management to minimize the
costs of goods sold in relation to net sales.
 Cont’d…
2. Operating profit margin: - moving down
in the income statements, the next profit
figure following gross profit is the operating
income (or EBIT).
• The operating profit is the excess of gross
profit over the total operating expenses.
• Operating Π margins reflect the company’s
operating expenses as well as its CGS.
 Cont’d…
• Interpretation: Addis company remained
with 11.09 percent and 11.88 percent of its
net sales after covering its cost of goods sold
and all operating expenses during 1992 and
1993 respectively.
 Cont’d…
3. Net profit margin ratio:-
• The net profit margin on net sales measures
the profitability of the company on a per birr
basis of net sales.
• This ratio is calculated by:
Net profit margin = Earnings after taxes(N.I)
Net sales
• Net profit margin of the company is also
influenced by the amount of interest
expenses/charges & income tax expense
because net profit is an EAIT.
 Cont’d…
Interpretation: These net profit margin
ratios can be interpreted in such a way that
Addis manufacturing company had earned
4.52 percent, or nearly 5 cents net income
per birr of net sales it made during 1992 and
5.56 percent or nearly 6 cents per birr of
sales it made during 1993.
 Cont’d…
4. Return on Investment (ROI):
• Also known as return on Assets (ROA).
• Measures the company’s profitability per birr
of investment in the total assets.
• The ROI or ROA is calculated by dividing
earnings after taxes by total assets.
Return on Investment (ROI)=EAT(Net Income)
Total Assets
Cont’d…
Interpretation: Thus, Addis manufacturing
company generated 7.01 percent, or about 7
cents in the form of net income out of each
birr it invested in its total assets during 1992,
and 8.13 percent, or about 8 cents in the
form of net income out of each birr of
investment in its total assets during 1993.
End of Chapter 3