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ANALYSIS OF FINANCIAL

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