CHAPTER TWO  Financial data (the company’s annual
FINANCIAL ANALYSIS reports)
INTRODUCTION
The primary goal of financial management is to
maximize the stock price, not to maximize accounting
measures such as net income or EPS (Earnings per
share). However, accounting data do influence stock
prices, and to understand why a company is performing
the way it is and to forecast where it is heading, one
needs to evaluate the accounting information reported
in the financial statements. If management is to
maximize a firm’s value, it must take the advantage of
the firm’s value, the firm’s strengths and,
simultaneously, correct its weaknesses.
After completing this chapter, you will be able to:
 Understand why financial analysis is conducted
 Evaluate the financial performance of the firm and
its departments or divisions using different
techniques
 Understand the relationship between financial
analysis and financial planning
MEANING OF FINANCIAL ANALYSIS
Financial analysis is the process of identifying the
financial strengths and weaknesses of the firm by
properly establishing relationship between items of
financial statements for certain period. Financial
analysis is concerned with the selection, evaluation, and
interpretation of financial data to assist investment,
financing, and dividend decisions.
SOURCES OF DATA FOR FINANCIAL ANALYSIS
 The sources of data for financial analysis include:
 Financial statements
 Accompanying notes
 Independent auditor’s report
 Economic data (GDP and Consumer Price
Index)
 To assess the recent performance or
future prospects of the company or
industry.
 Available from government and
private sources, such as Central
Statistics Authority (CSA).
 Market data (market prices of securities)
 Can be found from financial press and
electronic media daily.
OBJECTIVES OF FINANCIAL ANALYSIS
The objectives of financial analysis vary across different
types of decision makers.
a. Management of the firm. The objective of financial
analysis is to:
 Evaluate whether the resources of the firm are
used most efficiently and effectively
 Evaluate whether the financial condition (status)
of the firm is sound.
 Analyze funds needed
 Analyze business and financial risk (Business risk
is the risk inherent in the operation of the
business whereas financial risk is the probability
that the firm fails to meet its obligations)
b. Trade Creditors (suppliers)
 To evaluate the firm’s short-term liquidity position
c. Suppliers of long-term funds
 To evaluate the firm’s long term solvency and
survival
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  To evaluate the firm’s ability to generate profits
and cash over time to pay interest and principal
d. Investors
 To evaluate the overall aspects of the firm’s
financial status (financial health)
 To analyze the firm’s present and future
profitability.
APPROACHES IN ANALYZING FINANCIAL
STATEMENTS
Generally, there are two approaches to financial
analysis.
i. Time series analysis
The easiest way to evaluate the performance of a firm
is to compare its present performance with past
performance. When financial ratios over a period of
time are compared, it is known as the time series (trend
or longitudinal) analysis. Time series (trend) analysis
looks for:
 Important trends in the firm’s data
 Shifts in trends
 Data outliers or values that deviate
substantially from the other data points.
ii. Cross sectional analysis
- To compare the performance of one firm with the
performance of selected firm (key competitor) in
the same industry, or industry average at the
same point in time
- This kind of comparison indicates the relative
financial position and performance of the firm.
Methods of Analyzing Financial Statements
Generally, there are four methods of analyzing financial
statements.
a. Ratio analysis
b. Common size statement analysis
c. Trend analysis
d. Index analysis
FINANCIAL RATIO ANALYSIS
Ratio is the indicated quotient of two mathematical
expressions. Ratio analysis is an analytical technique
that typically involves a comparison of the relationship
between two financial statement items. Financial ratios
are used to evaluate the financial condition and
profitability of the firm. Ratio analysis is a powerful tool
of financial analysis. Ratios are more meaningful if there
is standard of measurement or comparison. The
common standards are:
a. Historical standards
 Ratios computed from the company’s own
past experience
b. Horizontal standards
 Use of key competitor’s ratios or industry
averages
c. Budgeted standards
 Use of budgeted performance
d. Absolute standards
 Ratios generally recognized as being desirable
regardless of the type of company, the time,
stage of business cycle, or objective of the
analyst
Financial ratios can be designed to measure almost any
aspect of a corporation’s performance. In general,
analysts use ratios as one tool in identifying areas of
strength or weakness in an enterprise. Ratios, however,
tend to identify symptoms rather than problems. A ratio
whose value is judge to be “different” or unusually high
or low may help identify a significant event but will
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seldom provide enough information, in and of itself, to
identify the reasons for an event’s occurrence. b. Balance Sheet (in thousands)
2010 2011
MAJOR TYPES OF FINANCIAL RATIOS Assets:
Cash & marketable securities………….... 5,000 6,000
Generally, financial ratios can be classified in to five Accounts Receivable ………………. 4,000 5,000
categories; namely, Inventories ………………………………. 6,000 8,000
a. Liquidity ratios. Fixed Assets (net)………………………… 35,000 41,000
b. Asset management (Activity, or turnover) Ratios Total assets……………………………….. 50,000 60,000
c. Debt management (leverage or gearing) ratios Liabilities and Stockholders’ Equity
Liabilities:
d. Profitability and
Accounts payable ………………………. 4,000 5,000
e. Marketability ratios
Short-term Notes Payable ………………. 2,600 3,000
These ratios are discussed in the sections that follow Accruals ………………………………….. 3,000 2,000
using the data presented below for NOAH Company: Long-term debts ………………………….. 14,400 15,000
The following data pertains to NOAH Company for the Total Liabilities………………………….. 24,000 25,000
year needed December 31, 2010 and 2011: Stockholders’ Equity:
a. Income Statement (in thousands) Common stock ………………………… 16,000 23,000
2010 2011 Retained earnings……………………….. 10,000 12,000
Net sales(on credit)………………………….. 15,000 18,000 Total stockholders’ equity………………. 26,000 35,000
Less: Cost of Goods Sold …………………….. 5000 6,000 Total Liabilities & stockholders’ equity …. 50,000 60,000
Gross profit on sale ………………………….. 10,000 12,000
Less: Selling & administrative expenses……….. 2,800 3,000  There were 3,000,000 shares and 4,400,000 shares
Earning before interest and taxes ……………. 7,200 9,000 of common stock in 2010 and 2011 respectively.
Less: Interest expense …………………………... 1710 1,800  Selling and administrative expenses include rent of
Income before taxes …………………………… 5,490 7,200 Br. 200,000 in 2010 and Br. 220,000 in 2011.
Less: Income taxes (40%) ……………………… 2,196 2880
 The market prices per share are Br. 10 and Br. 12 in
Net income ………………………………………. 3,294 4,320
2010 and 2011 respectively
Less: Common dividends ……………………. 400 600
Increase in retained earnings …………………….. 2894 3720
Liquidity ratios
Liquidity ratios are used to measure a firm’s ability to
meet short-term obligations (or current liabilities).
Short-term obligations include accounts payable, short-
term notes payable, accruals (e.g. salaries payable,
rent payable, interest payable etc), and currently
maturing portion of long-term debts. They compare
short-term obligations to short-term (or current)
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resources on the assumption that current assets are
primarily available for the payment of shot-term
obligations. Current assets include cash, marketable
securities, receivables, and inventories. From these
ratios, much insight can be obtained into the present
cash solvency of the firm and the firm’s ability to
remain solvent in the event of adversity. The most
common ratios which indicate the extent of liquidity
are:
1. Current ratio and
2. Quick ratio
Current Ratio
Current ratio measures the ability of the firm to meet
short-term obligations from its current assets. Current
ratio is a measure of a firm’s short-term solvency. It is
computed by dividing current assets by current
liabilities.
Current Ratio = Current Assets
Current Liabilities
Using NOAH Company data, current ratio is computed
as follows:
Current Ratio (2010) = 15,000 = 1.56:1
9600
Current Ratio (2010) = 19,000 = 1.9:1
10,000
To be desirable, current ratio should be greater than or
equal to the standard. As compared to 2010, the
current ratio of 2011 is desirable.
Current ratio indicates the availability of current assets
in Birr for every one Birr of current liability. For
example, current ratio of 2011 (1.9:1) indicated that
the firm has one Birr and ninety cents current assets for
every one Birr current liability. As a conventional rule a
ratio of 2:1 (2 to 1) or more is considered satisfactory.
Quick /Acid Test/ Ratio
Quick ratio serves the same general purpose as the
current ratio but exclude inventory from current assets.
This is done because inventories are typically a firm’s
least liquid current assets. Thus, the quick ratio
measures a corporation’s ability to pay its current
liabilities by converting its most liquid assets into cash.
It is computed by subtracting inventories from current
assets and dividing the remainder by current liabilities.
Quick Ratio = Current assets - Inventories
Current liabilities
The quick ratio is computed for NOAH Company as
follows:
Quick Ratio (2010) = 15,000 - 6000
9600
= 0.94:1
Quick Ratio (2011) = 19,000 - 8000
10,000
= 1.1:1
To be desirable, quick ratio should be greater than or
equal to the standard. Thus, NOAH Company’s quick
ratio of 2011 is desirable as compared to that of 2010.
If a company seeks to pay its current liabilities by using
its quick assets (Current assets minus inventories),
then its quick assets must equal or exceed its current
liabilities. Thus its quick ratio must be 1 or more. This is
the reasoning behind the quick ratio standard of 1.0
that many analysts use as the dividing line between
sufficient and insufficient liquidity.
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ASSET MANAGEMENT /ACTIVITY/ RATIO An alternative measure of inventory activity is inventory
Activity ratios, also known as efficiency or turnover turnover in days (ITD), or inventory period, which is
ratios, measure how effectively the firm is using its computed as follows:
assets in generating revenues or sales. Efficiency is
equated with rapid turnover, hence, these ratios are Inventory Period = 360_____
referred to collectively as activity ratios. Some activity Inventory turn over
ratios concentrate on individual assets such as Or equivalently
inventory or accounts receivable. Others look at overall Inventory × 360
corporate activity. Some of the major activity ratios are Sales
discussed as follows: Using NOAH Company’s data, inventory period is
i. Inventory Turn over (ITO) determined as follows:
Inventory turnover measures the number of time per Inventory Period (2010)= 360___
year, on average, that a corporation sells, or turns over, 3
its inventory. = 120 days
Inventory Period (2011)= 360___
Inventory Turnover = Sales 2.25
Inventory = 160 days
Using NOAH Company data, inventory turnover is Generally, to be desirable, inventory period should be
computed as follows: less than or equal to the standard. Accordingly, NOAH
Inventory Turnover (2010) = 15,000 Company’s inventory period is undesirable in 2011 as
5000 compared to 2010.
= 3 times
Inventory Turnover (2011) = 18,000 ii. Receivable Turn over (RTO)
8000 Receivable turnover ratio provides insight into the
= 2.25 times quality of the firm’s receivables and how successful the
firm is in its collection. This ratio tells us the number of
In general, high inventory turnover ratios are taken as times accounts receivable have been turned over
a sign of efficient management of inventory. (turned into cash) during the year. This ratio is
Accordingly, however, it may be concluded that NOAH calculated by dividing credit sales by ending balance of
Company was poor in managing inventories in 2011 as accounts receivable.
compared 2010. Sometimes a high inventory turnover Receivable Turn over = Annual Credit Sales
indicates a hand to mouth existence. It, therefore, Accounts Receivable
might actually be a symptom of maintaining too low NOAH Company’s Receivable Turnover is computed as
level of inventory and incurring frequent stock outs. follows:
Relatively low inventory turnover is often a sign of Receivable Turnover (2010) = 15,000
excessive, slow moving, or obsolete items in inventory. 4,000
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 = 3.75 times
Receivable Turnover (2011) = 18,000 Given NOAH company’s data, total assets turnover is
5,000 computed as follows:
= 3.6 times
To be desirable, receivable turnover should be greater TATO (2010)= 15,000_
than or equal to the standard. As a result, NOAH 50,000
company’s receivable turnover for 2011 is undesirable = 0.30
as compared to that of 2010. The higher the turnover, TATO (2011)= 18,000__
the shorter the time between the typical sales and cash 60,000
collection. = 0.30
Receivable Turn Over in Days (RTD), Days Sales To be desirable, Total Assets Turnover should be
Outstanding or Average Collection Period (ACP), is greater than or equal to the standard. Thus, total asset
calculated as: turnover of NOAH Company for 2011 is desirable as
ACP = 360__________ compared to that of 2010.
Receivable turn over
Or Alternatively, iv. Fixed Assets Turnover (FATO)
ACP = Accounts receivable × 360 It is used to measure how effectively the firm uses its
Total annual credit Sales plant assets in generating sales. Fixed Assets turnover
is computed as follows:
Using NOAH Company data, ACP is computed as FATO = __Sales___
follows: Fixed Assets
ACP (2010)= 360__ = 96 days Using NOAH Company’s data, fixed assets turnover is
3.75 computed as follows:
ACP (2011)= 360__ = 100 days FATO (2010) = 15,000_
3.60 35,000
ACP figure tells us the average number of days that = 0.43
receivables are outstanding before being collected. FATO (2011) = 18,000_
Generally, a lower ACP is desirable. NOAH Company’s 41,000
ACP for 2011 is undesirable as compared to that of = 0.44
2010. To be desirable, fixed assets turnover should be greater
iii. Total Assets Turn over (TATO) than or equal to the standard. Therefore, NOAH
This ratio shows the firm’s ability in generating sales Company’s fixed assets turnover for 2011 is desirable
from all financial resources committed to total assets. as compared to that of 2010.
Thus’
TATO = ____Sales___
Total Assets
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DEBT MANAGEMENT (LEVERAGE) RATIOS
Leverage refers to the use of fixed costs in an attempt
to increase profitability. There are two types of
leverages; namely, operating leverage and financial
leverage. Operating leverage refers to the extent to
which the firm uses fixed operating costs. On the other
hand, financial leverage refers to the extent to which
the firm uses debts in financing its assets.
Debt management ratios are used to evaluate the
extent to which the firm uses debt financing. They
indicate the debt burden of the firm. Different debt
management ratios are used to evaluate the debt
burden of the firm. Some of them are discussed in the
following section:
i. Debt Ratio
Debt ratio, also called total debt-to-total assets (D/A)
ratio, measures the extent to which the firm is using
borrowed money. It may be calculated as follows:
Debt ratio = Total Liabilities
Total Assets
For NOAH company, debt ratio is computed as follows:
Debt ratio (2010) = 24,000
50,000
= 0.48
Debt ratio (2011) = 25,000
60,000
= 0.42
Generally, creditors would like a lower debt ratio to be
desirable. When compared with 2010, NOAH Company’s
debt ratio is desirable in 2011.
ii. Debt- to- Equity (D/E) ratio
Debt-Equity ratio measures the proportion of debt
capital in terms of equity capital. Debt-to-equity ratio is
computed by simply dividing the total debt of the firm
(including current liabilities) by shareholders’ equity.
Debt-to-Equity Ratio = Total Liabilities
Shareholders’ Equity
Creditors would generally like this ratio to be low. The
lower the ratio, the higher the level of the firm’s
financing that is being provided by shareholders and the
larger the creditor cushion (margin of protection) in the
event of shrinking asset values or outright losses.
Depending on the purpose for which the ratio is used,
preferred stock is sometimes included as debt rather
than as equity when debt ratios are calculated.
Preferred stock represents a prior claim from the
standpoint of the investors in common stock;
consequently, investors might include preferred stock
as debt when analyzing a firm. The ratio of debt to
equity will vary according to the nature of the business
and the variability of cash flows.
Debt-to- Equity ration may also be computed as
follows:
D/E = D/A D = Debts A = Assets
1 – D/A E = Stockholders’ equity
From NOAH company example, debt ratio for 2010 is
48% and D/E ratio is Equal to:
D/E = 0.48_
1 – 0.48
= 0.92
iii. Equity Multiplier
The role of equity multiplier is the same as that of debt
ratio. It measures the extent to which the firm uses
debt financing in its capital structure. It may be
obtained by dividing total assets by total stockholders’
equity.
Equity Multiplier = Total Assets________
Total stockholders’ Equity
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Equity Multiplier (2010) = 50,000
26,000
= 1.92
Equity Multiplier (2011) = 60,000
35,000
= 1.71
A lower equity multiplier is desirable.
iv. Times Interest Earned (TIE) ratio
It is used to measure the ability of the firm to meet
interest obligations from its profits. It indicates the
number of times Earning Before Interest and Taxes
(EBIT) is available to cover interest obligations. It is
computed as follows:
TIE = Earning before interest and taxes
Interest Expense
Using NOAH Company’s data, times interest earned
ratio is calculated as follows:
TIE (2010) = 7200 = 4.21 times
1710
TIE (2011) = 9000 = 5 times
1800
To be desirable, times interest earned ratio should be
greater than or equal to the standard.
v. Fixed Charges Coverage (FCC) ratio
Fixed charges coverage ratio is used to measure the
ability of the firm to meet all fixed obligations such as
interest, lease payments (rent), and sinking fund
payments. It is computed as the ratio of earnings
before fixed obligations and fixed charges or
obligations.
FCC = EBIT + Lease Payments_______________
Interest + Lease + Sinking Fund Payments
1 – tax rate
It is assumed that profits are used to pay fixed charges.
Sinking fund payments are made with after tax Birr
whereas interest and lease payments are made with
pre-tax Birr. As a result, the sinking fund payments
must be grossed up by dividing by (1- tax rate) to find
the before tax income required to pay taxes and still
have enough money left to make the sinking fund
payment.
For NOAH company, FCC ratio is computed as follows:
FCC (2010) = 7200 + 200 = 3.87 times
1710 + 200
FCC (2011) = 9000 + 220 = 4.56 times
1800 + 220
To be desirable, fixed charges coverage ratio should be
greater than or equal to the standard. Comparing with
2010, the fixed charges coverage ratio of 2011 is
desirable. NOAH Company does not have sinking fund
payment in both years.
PROFITABILITY RATIOS
As a group, these ratios allow the analyst to evaluate
the earning power of the firm with respect to given level
of sales, total assets, and owner’s equity.
Profits are essential; however it would be wrong to
assume that every action initiated by management of a
company should be aimed at maximizing profits,
irrespective of social consequences. It is unfortunate
that the word “profit” is looked upon as a term of
business since some firms always act to maximize
profits at the cost of employees, customers, and society
at large. Except such infrequent cases, it is a fact that
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sufficient profits must be earned due to the following ii. Net Profit Margin
reasons: It measures the percentage of each sale Birr remaining
 to attract outside capital for expansion after deducting all expenses. This ratio shows the
 to cover operating expenses, interest expense, earnings left for shareholders (both common &
and other fixed charges preferred) as a percentage of net sales. This ratio
 to earn profits for owners establishes a relationship between net income and net
 to contribute–towards social welfare sales and indicates management’s efficiency in
 for survival and growth of the firm over the long- manufacturing, administering, selling, financing, pricing
run & etc. and tax management.
Thus, the financial managers should continuously Net Profit Margin = Net Income
evaluate the efficiency of its company in terms of Net Sales
profits. To this end, profitability ratios are calculated to For NOAH company, net profit margin is calculated as
measure the operating efficiency of the company follows:
because they give final answers about how the firm is Net Profit margin (2010) = 3294
being managed. They measure the combined effect of 15,000
asset management, debt management, and liquidity on = 21.96%
the profitability of the firm. Net Profit margin (2011) = 4320
i. Gross Profit Margin 18,000
This ratio indicates the percentage of each sale Birr = 24%
remaining after deducting the cost of goods sold. The To be desirable, net profit margin ratio should be
ratio reflects management’s effectiveness in pricing greater than or equal to the standard. Accordingly,
policy, generating sales, and production efficiency (i.e. since net profit margin ratio of 2011 is greater than that
how well the purchase or production cost of goods is of 2010, it is considered desirable.
controlled).
Gross Profit Margin = Gross Profit iii. Return on investment (ROI) also called Return
Net Sales on Assets (ROA)
Using NOAH company data, gross profit margin ratio is It measures the amount of profit generated on
computed as follows: investments in assets.
Gross Profit Margin (2010) = 10,000 ROI (ROA) = Net Income
15,000 Total Assets
= 0.67 NOAH Company’s return on investments is computed as
Gross Profit Margin (2011) = 12,000 follows:
18,000 ROI (2010) = 3294 = 6.6%
= 0.67 50,000
Generally, a higher gross profit margin ratio is ROI (2011) = 4320 = 7.2%
desirable. 60,000
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Generally, a higher ROA is desirable.
iv. Return of Equity (ROE)
It measures the rate of return realized by a firm’s
stockholders on their investment and serves as an
indicator of management performance. ROE measures
the return earned on the owners’ investment. ROE also
called the Return on Stockholders Equity or Return on
Net Worth. It measures corporate profitability per Birr
of equity capital. The shareholders equity will include
common stock, preferred stock, premium on common,
& preferred stock, and retained earnings.
Return on equity (ROE) = Net Income____
Stockholders equity
This ratio indicates how well the firm has used the
resources of the owners. Thus, this ratio is of great
interest to present as well as prospective shareholders
and also of great concern to management, which has
the responsibility of maximizing the owners’ welfare.
The formula for ROE includes preferred dividends in the
net income figure and preferred stock in the
shareholders’ equity. However, because the amount of
preferred stock & its impact on a firm are generally
quite small, or non-existent, this formula is a
reasonably good approximation of the true owns (i.e.
the common stockholders return).
For NOAH Company, ROE is computed as follows:
ROE (2010) = 3294 = 12.7%
26,000
ROE (2011) = 4320 = 12.3%
35,000
Return on Equity (ROE) may also be computed using
the following formula:
ROE = ROA
1 – D/A
ROE (2010) = 0.066__ = 12.7%
1 – 0.48
v. Earnings Per share (EPS)
It expresses the profit earned per common share by a
corporation during the reporting period. It provides a
measure of over all performance and is an indicator of
the possible amount of dividends that may be expected.
The earning per share calculations made over years
indicates whether or not the firm’s earning power on
per share basis has changed over that period. The
earning per share is generally of interest to present or
prospective shareholders and management. Hence,
they are closely watched by the investing public and are
considered an important indicator of corporate success.
Earning per share simply shows the profitability of the
firm on a per share basis, it does not reflect how much
is paid as dividend and how much is retained in the
business. But as a profitability index, it is a valuable
and widely used ratio.
Earning per share is computed on common stock by
dividing dividend on common stock by number of
common stock outstanding.
EPS = Earnings Available to common stock
Number of common stock outstanding
Or
EPS = Net Income - Preferred stock dividend
Number of common shares outstanding
For NOAH Company, Earning per share on common
stock is computed as follows:
EPS (2010) = 3294 - 0 = 1.098
3000
EPS (2011) = 4320 - 0 = 0.98
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 4400
Generally, a higher earning per share is desirable.
vi. Dividend per share (DPS)
It represents the Birr amount of cash dividends a
corporation paid on each share of its common stock
outstanding during the reporting period.
DPS = Cash Dividends on Common stock
Number of Common shares outstanding
NOAH Company’s dividend per share is computed as
follows:
DPS (2010) = 400 = 0.13
3000
DPS (2011) = 600 = 0.14
4400
vii. Payout ratio
It shows the percentage of earnings paid to
stockholders. That is, the payout ratio expresses the
cash dividend paid per share as a percentage of EPS.
Pay Out Ratio = Dividend Per Share
Earnings Per Share
For NOAH Company, payout ratio is computed as
follows:
Payout ratio (2010) = 0.13/1.098 = 0.12
Payout ratio (2011) = 0.14/0.98 = 0.14
MARKETABILITY RATIOS
They measure the perception of the future earning
power of the company by the market. These are ratios
used primarily for investment decisions and long-range
planning. They rely on financial market data, such as
the market price of securities. The major marketability
ratios are:
a. Price / Earning (P/E) Ratio
b. Market-to-Book (M/B)ratio
a. Price- Earning (P/E) Ratio
It expresses the multiple that the market places on a
firm’s earnings per share and is commonly used to
assess the owners’ appraisal of share value. The level of
the P/E ratio indicates the degree of confidence (or
certainty) that investors have in the firm’s future
performance. The P/E ratio represents the amount
investors are willing to pay for each dollar of the firm’s
earnings. A high P/E multiple reflects the market’s
perception of the firm’s growth prospects (i.e. the
higher the P/E ratio, the greater investors confidence in
firm’s future). If investors believe that a firm’s future
earnings potential is good, they may be willing to pay a
higher price for the stock and thus boost its P/E.
Price Earnings Ratio = Market Price per share
Earning per share
NOAH Company’s P/E ratio is computed as follows:
P/E ratio (2010) = 10/1.098 = 9.12
P/E ratio (2011) = 12/0.98 = 12.24
** P/E ratio has to be interpreted with caution because
it may rise if earnings dropped while the market price of
stock rises.
b. Market-to Book ratio
It measures whether the firm has created value for its
shareholders. If M/B ratio is greater than 1, it is said
that the firm has created value for its shareholders.
If M/B ratio is less than 1, the value of the firm has
declined.
M/B ratio is computed as the ratio of Market price per
share to book value per share. Book value per share is
determined by dividing total stockholders’ equity by
Number of common stock outstanding.
For NOAH Company, book value per share and M/B
ratio are determined as follows:
Book value per share (2010) = 26,000/3000 = 8.67
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M/B ratio (2010) = 10/8.67 = 1.15
Book value per share (2011) = 35,000/3400 = 7.95
M/B ratio (2011) = 12/7.95 = 1.51
According to the above analysis, NOAH Company has
created value for its shareholders in both years since
M/B ratio is greater than 1.
The Du Pont Identity
Du Pont is the name of a person who managed a
corporation named Du Pont Corporation. Du Pont was
very much interested in ROE as an important measure
of the performance of his corporation. He developed
ROE model based on three major factors. These are:
1. Net profit margin
2. Total asset turnover, and
3. Equity Multiplier
Based on the above factors, he developed ROE model
and called it Du Pont Identity. The Du Pont identity is
shown below:
ROE = Net Profit X Total Assets X Equity
Margin Turnover Multiplier
ROE (2010) = 0.30 X 0.2196 X 1.92 = 0.127
ROE (2011) = 0.30 X 0.24 X 1.71 = 0.123
EVALUATION OF RATIO ANALYSIS
The intelligent use of ratio analysis requires an
understanding of the advantages & limitations of this
technique.
Advantages of Ratio Analysis
1. Ratios are easy to compute
2. Ratios provide a standard of comparison at a point in
time and allow comparisons to be made with
industry averages.
3. Ratios can be used to analyze a corporation’s
financial time series in order to discover trends,
shifts in trends and data outliers.
4. Ratios are useful in identifying problem areas of a
firm.
5. When combined with other tools, ratio analysis
makes an important contribution to the task of
evaluating a corporation’s financial performance.
Limitations of Ratio Analysis
1. It is difficult to develop meaningful set of industry
averages for comparative purposes, especially for
a firm, which operates a number of different
divisions.
2. Inflation has badly distorted the firm’s financial
statements
3. Seasonal factors can distort a ratio analysis.
4. Firms can employ “window dressing”
techniques to make their financial statements
look stronger.
5. Different accounting practices can distort
comparisons.
6. It is difficult to generalize about whether a
particular ratio is ”good” or “bad”
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Common-Size Statement Analysis, Trend Sales 100,000 150,000 200,000
Analysis, & Index Analysis Less: Cost of Goods Sold 60,000 90,000 120,000
1. Common-Size Statement Analysis Gross Profit 40,000 60,000 80,000
 Each item in the balance sheet is expressed as a Less: Selling and Adm. Exp. 25,000 32,000 35,000
percentage of total assets. Operating Income 15,000 28,000 45,000
 Each item in the income statement is expressed Less: Interest Expense 5,000 5,000 6,000
as a percentage of net sales. Income Before Taxes 10,000 23,000 39,000
2. Trend Analysis Less: Income Taxes (40%) 4,000 9,200 15,600
 Deals the study of the percentage change in
Net Income 6,000 13,800 23,400
financial statement items over time
3. Index Analysis
Required: Using the above data, conduct:
 Deals financial statement items are expressed as
a percentage relative to the base year a. Common Size Statement Analysis
b. Index Analysis
Illustration
Solution
The following data is compiled for ABC Company for the
a. Common-Size Statement Analysis
years ended on December 31, 2009, 2010, and 2011: 2009 2010 2011
2009 2010 2011 a. Balance sheet (%)
a. Balance sheet Assets:
Assets: Cash 12 12.5 15.14
Cash 15,000 20,000 28,000 As/R 16 13.75 16.22
As/R 20,000 22,000 30,000 Inventories 32 37.5 35.14
Inventories 40,000 60,000 65,000 Fixed Assets (net) 40 36.25 33.51
Fixed Assets (net) 50,000 58,000 62,000 Total assets 100 100 100
Total assets 125,000 160,000 185,000
Liabilities and Equity: Liabilities and Equity:
Current Liabilities 10,000 12,000 15,000 Current Liabilities 8 7.5 8.12
Long-Term Debts 15,000 20,000 20,000 Long-Term Debts 12 12.5 10.81
Total Liabilities 25,000 32,000 35,000 Total Liabilities 20 20 18.92
Equity 100,000 128,000 150,000 Equity 80 80 81.08
Total Liabilities & Equity Total Liabilities & Equity 100 100 100
125,000 160,000 185,000
b. Income Statement b. Income Statement (%)
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 2009 2010 2011
Sales 100 100 100 b. Income Statement (%)
Less: Cost of Goods Sold 60 60 60 2009 2010 2011
Gross Profit 40 40 40 Sales 100 150 200
Less: Selling and Adm. Expenses 25 21 17.5 Less: Cost of Goods Sold 100 150 200
Operating Income 15 19 22.5 Gross Profit 100 150 200
Less: Interest Expense 5 3 3 Less: Selling and Adm. Expenses 100 128 140
Income Before Taxes 10 16 19.5 Operating Income 100 187 300
Less: Income Taxes (40%) 4 6 7.8 Less: Interest Expense 100 100 120
Net Income 6 10 11.7 Income Before Taxes 100 230 390
Less: Income Taxes (40%) 100 230 390
Net Income 100 230 390
b. Index Analysis

2009 2010 2011

a. Balance sheet (%)
Assets:
Cash 100 133 187
As/R 100 110 150
Inventories 100 150 162.5
Fixed Assets (net) 100 116 124
Total assets 100 128 148
Liabilities and Equity:
Current Liabilities 100 120 150
Long-Term Debts 100 133 133
Total Liabilities 100 128 140
Equity 100 128 150
Total Liabilities & Equity 100 128 148

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