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STATEMENTS

To Cover..

The annual report,

Financial ratios,

Trend and industrial analysis,

Limitations of ratio analysis,

Financial Statement Analysis

It is the process of identifying the financial

strengths and weaknesses of the firm by

properly establishing relationships between

items in the financial statements.

The Annual Report

Statement of financial position provides a

snapshot of a firms financial position at one point in

time.

Income statement summarizes a firms revenues

and expenses over a given period of time.

Statement of retained earnings shows how much

of the firms earnings were retained, rather than paid

out as dividends.

Statement of cash flows reports the impact of a

firms activities on cash flows over a given period of

time.

Ratio Analysis

This is a means of comparing and quantifying

relationships between financial variables such as those

found in the balance sheet and the profit & loss

account.

A single ratio in itself does not indicate a favourable or

unfavourable condition, it should be compared with

some standards.

Standards of Comparison

Ratios computed from past financial statements of

the same company

Ratios of the same industry

Ratios of some selected companies especially the

best in the particular industry the firm belongs to

Ratios developed using projected financial

statements of the company

Categories of Ratios

There are five main categories:

1. Liquidity

2. Leverage

3. Activity

4. Profitability

5. Equity

Categories of Ratios continued

1. Liquidity Ratios measure the firms ability to meet its short term

maturing obligations. It can therefore be used to measure the

financial risk of the company. The higher the liquidity ratio the

lower the financial risk. They are therefore inversely related to

financial risk.

2. Leverage Ratios measure the extent to which a firm is

financed by non owner supplied funds. These ratios can be used

to measure financial risk. They are directly related to financial

risk. Sometimes also known as gearing ratios.

3. Activity Ratios measure the efficiency with which a firm uses

its various resources to generate sales revenue. They are also

known as turnover ratios because they indicate the rate at which

assets are converted or turned into sales.

Categories of Ratios continued

4. Profitability Ratios measure managements overall

effectiveness as shown by returns generated on sales and

investments, therefore, profitability can be measured in

relation to:

Sales this indicates managements ability to control

production, operating and financial decisions.

Investments these measure the efficiency with which a

firm uses its funds to generate a return to the providers of

funds.

5. Equity (Evaluation) Ratios measure the firms overall

performance and it may be important in establishing the

theoretical value of the firms securities. They are therefore

very important to investors in determining whether their

securities are over valued or undervalues.

1. Liquidity Ratios

i) Current Ratio = C.A

C.L

It measures the firms ability to meet current obligations

given a level of current assets.

ii) Acid Test (Quick) Ratio = C.A stock

C.L

It is a more refined measure of liquidity because it

excludes stock which may not be easily converted to

cash in the short period.

Liquidity Ratios

iii) Cash Ratio = Cash + Marketable Securities

Current Liabilities

This is a highly refined measure of liquidity because even debtors

are excluded.

iv) Net Working Capital Ratio = Current Asset C liabilities

Net Assets (Total Assets C.L.)

This measures the firms potential reserve of funds and can be

related to net assets or capital employed.

For all these ratios, the higher the ratio, the more liquid the

company is and therefore the lower the financial risk.

2. Leverage or Gearing Ratios

i) Debt Ratio = Total liabilities

Total Assets

This measures the extent to which the firms assets have been

financed by non-owner supplied funds

ii) Debt Equity Ratio = Total liabilities

Equity (Net worth)/owner supplied funds

This shows the lenders contribution for each shilling of owners

contribution.

Leverage or Gearing Ratios

iii) Long Term Debt Ratio = Long term liabilities

Net Assets (T.A. C.L)

This ratio measures proportion of permanent assets

that have been financed by long-term debt.

For all the above ratios the higher the ratio the higher

the gearing position and therefore the higher the

financial risk.

Leverage or Gearing Ratios

iv) Times Interest Earned (Interest Coverage)

= Earnings before interest and tax + Depreciation

Interest Expense

This ratio measures the firms ability to meet its interest expense

out of its annual operations as shown by the operating profit.

Depreciation is added back since it is not a cash flow. In this case

the higher the ratio the lower the gearing position and therefore the

lower the financial risk. Too high a ratio may indicate that the firm

is very conservative in using debt and that it is not using credit to the best

advantage of share holders. On the other hand a low ratio indicates

excessive use of debt or inefficient operations. The finance manager

should therefore strike a balance and have a comfortable coverage ratio.

3. Activity or Turnover Ratios

i) Inventory (Stock) Turnover = Cost of Sales

Average inventory

it measures the efficiency with which a company uses

stock to generate sales. The higher the ratio, the more

active the firm is.

ii) Inventory Conversion Period = No. of days in the year

Inventory Turnover

this indicates the number of days it takes to convert inventory to

sales.

Activity or Turnover Ratios

iii) Receivables/Debtors Turnover = Credit Sales____________

Average Accounts Receivables

this indicates the number of times debtors paid within the year. It

may also indicate how efficient the firm is in the management of

credit.

iv) Average Collection Period = No. of days in the year

Debtors Turnover

this indicates the number of days on average that debtors take to

pay their dues.

Activity or Turnover Ratios

v) Creditors Turnover = Credit Purchases

Average Accounts Payables

this indicates the number of times creditors are paid during the

year.

vi) Payables Deferral Period = No. of days in the year

Creditors Turnover

this indicates the number of days on average the firm takes to pay

its creditors.

Activity or Turnover Ratios

vii) Cash Conversion Cycle

= Inventory Conversion Period + Average Collection Period

Payables Deferral Period

= I.C.P. + A.C.P. P.D.P.

viii) Cash Turnover = No. of days in the year

Cash Conversion Cycle

Asset Turnover Ratios

i) Fixed Asset Turnover Ratio = Sales_______

Average Fixed Assets

ii) Total Asset Turnover Ratio = Sales___

Total Assets

These ratios indicate how efficiently the company uses assets to

generate sale i.e. how much volume of business does the firm

generate for its size of assets.

4. Profitability Ratios

In Relation to sales

i) Gross Profit Margin = Gross Profit

Sales

This measures the firms ability to control production expenses.

ii) Operating Profit Margin = Operating Profit

Sales

iii) Operating Expense Ratio = Operating Expenses

Sales

Measures firms ability to control production and operation

decisions.

Profitability in Relation to sales continued

iv) Net Profit Margin = Net Profit after Tax

Sales

It measures firms ability to control production, operating and

financing decisions.

Profitability in Relation to Investments

i) Return on Investment (ROI)/Return on Assets (ROA)

= Net profit after tax

Total Investment/Assets

It measures firms ability to generate a return to owners using total

funds.

ii) Return on Net Assets = Net profit after tax

Net Assets (Capital Employed)

Measures the efficiency with which the company uses long term

funds to generate a return to shareholders.

Profitability in Relation to investments

continued

iii) Return on Equity/Net Worth

= Net Income

Equity/Net worth

Measures the efficiency with which a company uses

owner supplied funds to generate returns to equity

holders.

5. Equity or Valuation Ratios

i) Earnings Per Share (EPS)

= Net Income

No. of common shares outstanding

This indicates the amount that a shareholder expects to earn for

every share held.

ii) Earnings Yield = EPS

Market Price per share

This shows the amount that a share holder earns for every share

invested in the company. This ratio can be used to compare

securities of relatively different sizes.

Equity or Valuation Ratios continued

iii) Dividends Per Share (DPS)

= Total Common/Ordinary dividends

No. of Common Shares Outstanding

This indicates the amount shareholders would receive from the

company in form of dividends for every share held.

iv) Dividend Yield = DPS

MPS (Market price per share)

Indicates amount of dividend received for every shilling invested.

Equity or Valuation Ratios continued

v) Dividend Payout Ratio

= DPS, DY, Total Common Dividends

EPS EY Net Income

This shows the proportion of earnings that the company pays out

to shareholders as dividends.

vi) Retention Ratio = Net income Total common dividend

Net Income

Shows proportion of earnings that the firm retains.

Equity or Valuation Ratios continued

vii) Price Earnings Ratio (P/E Ratio)

= Market price per share ; 1_____

E.P.S. Earnings yield

This ratio measures the pay back period i.e. number of years it takes the

investor to recover his investment in the share from the earnings

generated from that share.

This ratio is very important because it can be used to measure the relative

risk of the firm. Firms in the same risk class will have the same P/E ratio.

It is assumed that the P/E ratio of a firm remains constant over time.

Equity or Valuation Ratios continued

ix) Book Value per Share Ratio = Total common equity

No. of common shares outstanding

Indicates amount that every shareholder would receive for every share

held if the firm was liquidated and asset sold at their book value.

x) Market Book Value Ratio = Market Price per Share

Book Value per Share

It indicates the value attached by the market to the company as a going

concern. It therefore measures the goodwill of the company. If ratio is

greater than 1, then company has positive goodwill and should continue

as a going concern. If less than 1, then company has negative goodwill

and should be liquidated.

Important Ratios

Current Ratio

Quick Ratio

Debt Ratio

Debt to Equity Ratio

Times Interest Earned

Average Collection Period

Payables Deferral Period

Important Ratios

Inventory Conversion Period

Cash Conversion Cycle

Total Asset Turnover Ratio

Gross Profit Margin

Net Profit Margin

Return on Investment

Return on Equity

Important Ratios

Earnings Per Share

Dividends Per Share

Dividend Payout Ratio

Retention Ratio

Price Earnings Ratio

Book Value per Share Ratio

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