FINANCIAL STATEMENT ANALYSIS –TOPIC 2

Overview of Primary Analysis Techniques

Mrs. Teresa Ndirangu
Primary Analysis Techniques

Introduction

• The primary objective in most financial statement analysis is to value a firm’s equity
securities.
• The value of an equity security relates to the future profitability an investor anticipates
relative to the risk involved
• However, even if the objective is not valuation but simply performance assessment,
financial statement analysis examines aspects of a firm’s profitability and its risk.
• Examining the profitability of a firm in the recent past provides information that helps the
analyst project the firm’s future profitability and the expected return from investing in the
firm’s equity securities.
• Evaluations of risk involve judgments about a firm’s success in managing various
dimensions of risk in the past and its ability to manage risks in the future.(Discussion on
different types of risk?)
Tools for Financial Analysis
1. Comparative Financial Statement Analysis
2. Common Size Financial Statement Analysis
3. Ratio Analysis
4. Cash flow Analysis
5. Valuation
Ratio Analysis
• A ratio is an expression of a mathematical relationship between one quantity and another.
• If a ratio is to have any utility, the element which constitutes the ratio must express a
meaningful relationship.
• Typical ratios are fractions usually expressed in percent or times.

Types of ratios
1. Liquidity ratios
2. Profitability ratios
3. Gearing ratios
4. Activity ratios
ANALYSIS OF LIQUIDITY AND ACTIVITY
o Short-term liquidity refers to the ability of a firm to meet its current obligations as they
mature.
o Liquidity implies an ability to convert assets into cash or to obtain cash.
o Short-term refers to one year or the normal operating cycle of the business, whichever is
longer.
o Activity refers to the efficiency with which a firm uses its current assets.
NET WORKING CAPITAL

o Is equal to current assets less current liabilities

o Net working capital is a safety cushion to creditors.
o The amount of and changes in net working capital from period to period are significant
measures of a company’s ability to pay its debts as they mature.
o Net working capital is generated to a great extent through events that occur during the
operating cycle of a business, including transactions involving:
1. Investing in inventories,
2. Converting inventories through sales to receivables,
3. Collecting the receivables, and
4. Using the cash to pay current debts and to replace the inventory sold.
CURRENT RATIO
o Current ratio is also called the working capital ratio.
o This compares assets which will become liquid within approximately twelve months with
liabilities which will be due for payment in the same period and is intended to indicate
whether there are sufficient short term assets to meet the short- term liabilities.
o The current ratio gauges how capable a business is in paying current liabilities by using
current assets only.
o A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1).
o However, an industry average may be a better standard than this rule of thumb.
o Any ratio below indicates that the entity may face liquidity problem.
The formula is:
Total Current Assets
Total Current Liabilities
QUICK (ACIT-TEST) RATIO
o A quick measure of the debt-paying ability of a company
o The quick ratio expresses the relationship of quick assets (cash, marketable securities, and
accounts receivable) to current liabilities.
o Inventory and prepaid expenses are not considered quick assets because they may not be
easily convertible into cash.
o A rule of thumb for the quick ratio is suggested as 1:1
The formula is:
(Cash + Accounts Receivable + any other quick assets)
Current Liabilities
,
OTHER LIQUIDITY RATIOS
o The cash ratio, also known as the doomsday ratio, is a more severe test of liquidity than the
acid-test ratio.
o The cash ratio is computed by dividing cash by current liabilities:
Note: This ratio is most relevant for companies in financial distress
The formula is:
Cash
Current liabilities
Cash burn rate =
Current assets
Average daily operating expenses
It measures how long the company keep running if the cash inflows begin to dry up
Note: The ratio is more relevant for start-up companies that often have little in the way of
revenues. A high value indicates no need for outside financing and further suggests that the
company is in the mature or declining phase of the corporate lifecycle.
ACTIVITY RATIOS
o Activity (asset utilization, turnover) ratios are used to determine how quickly various
accounts are converted into sales or cash.
o Overall liquidity ratios generally do not give an adequate picture of a company’s real
liquidity, due to differences in the kinds of current assets and liabilities the company holds.
Thus, it is necessary to evaluate the activity or liquidity of specific current accounts.
,
INVENTORY TURNOVER RATIO
It measures approximately the number of times an entity is able to acquire the inventories and
convert them into sales.
A lengthening inventory turnover period from one accounting year to the next indicates:
1. A slow down in trading
2. A build in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive.
The higher turnover ratio is good for the firm, but several aspects of inventory holding policy
have to be balanced like:
3. Lead times
4. Seasonal fluctuations in orders.
5. Alternative use of warehouse space.
6. Bulk discounts.
7. Likelihood of inventory perishing or becoming obsolete.
INVENTORY TURNOVER RATIO
This ratio shows how many times in one accounting period the company turns over (sells) its
inventory and is valuable for spotting under-stocking, overstocking, obsolescence and the
need for merchandising improvement. Faster turnovers are generally viewed as a positive
trend; they increase cash flow and reduce warehousing and other related costs.
The formula is:
Cost of Goods Sold
Average Inventory
DAYS INVENTORY
This ratio identifies the average length of time in days it takes the inventory to turn over. As
with inventory turnover (above), fewer days mean that inventory is being sold more quickly.
The formula is:
365 Days
Inventory Turnover
Receivable day’s ratio
o Accounts receivable ratios comprise the accounts receivable turnover and the average
collection period.
o The accounts receivable turnover gives the number of times accounts receivable is collected
during the year.
Receivable turnover
o Increase in receivable days may also indicate overtrading especially when the profit levels
increases, together with receivable amounts but there is no improvement in collection of
receivables.
The formula is:
Total Credit Sales
Accounts Receivable
o In general, the higher the accounts receivable turnover, the better since the company is
collecting quickly from customers and these funds can then be invested.
o An excessively high ratio may indicate that the company’s credit policy is too stringent, with
the company not tapping the potential for profit through sales to customers in higher risk
classes.
,
Accounts Receivable Collection Period:
This reveals how many days it takes to collect all accounts receivable. As with accounts
receivable turnover (above), fewer days means the company is collecting more quickly on its
accounts.
The formula is:
365 Days
Accounts Receivable Turnover
OR
Accounts Receivable x 365 days
Total Credit Sales
Payable day’s ratio
o Measures how long it takes for an entity to settle its creditors.
o The payable days should always be more than the receivable days.
o Increase in payable days may indicate that the business is facing cash flow problems and
will deter new and old suppliers from extending credit supplies to the business.
o On the other hand the business with short payable days indicates that it is not trusted by its
suppliers.
Accounts Payable Turnover:
o This ratio shows how many times in one accounting period the company turns over (repays)
its accounts payable to creditors. A higher number indicates either that the business has
decided to hold on to its money longer or that it is having greater difficulty paying
creditors.
The formula is:
Cost of Goods Sold
Accounts Payable
Days Payable:
This ratio shows how many days it takes to pay accounts payable. This ratio is similar to
accounts payable turnover (above.) The business may be losing valuable creditor discounts by
not paying promptly.
The formula is
365 days
Accounts Payable Turnover
OR
Accounts payable x 365 days
Total Credit Purchases
Cash Cycle
The reason why a business needs liquid assets is so that it can meet its debts when they fall
due.
Cash cycle looks at the cash movements from the purchase of inventories up to when the
customers settle their balances. So it is the flow of cash out of the business and back into it
again as a result of normal trading operations.
Management of liquid resources is closely connected to the management of working capital,
and in particular the management of inventories, receivables and payables
Cash cycle
The main points about the cash cycle are as follows:
1. The timing of cash flow in and out of a business does not coincide with the time when the
sales and cost of sales occur. Cash flows can be postponed by taking credit. Cash flow can
be delayed by having receivables.
2. The time between making a purchase and making a sale also affects cash flows. If the
inventories are held for a long time, the delay between the cash payments of inventories
and cash receipts from selling them will also be a long one.
Cash cycle
3. Holding inventories and having receivables can therefore be seen as two reasons why cash
receipts are delayed. If the business invests in working capital then its cash position will
decrease.
4. Similarly, taking credit from suppliers can be a reason why cash payments are delayed.
The business’s liquidity position will worsen when it has to pay the creditors, unless it can
get more cash in from sales and receivables in the mean time.
A short working capital cycle indicates the business is well managing its working capital.
PROFITABILITY RATIOS
It is a class of financial metrics that are used to assess a business's ability to generate earnings
as compared to its expenses and other relevant costs incurred during a specific period of time.
The profitability ratios help you to analyze where problems are occurring that make your
business unprofitable.
Users of this type of ratio include shareholders, employees, creditors, investors and
management.
Gross profit margin
Is what remains from sales after a company pays out the cost of goods sold.
Gross profit margin is expressed as a percentage.
It addresses three areas i.e. inventory control, pricing and production efficiency.
Gross profit margin=
Net sales- cost of goods sold
Net sales

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of
goods sold. It is a very simple idea and it tells us how much gross profit per Shs.1 of turnover
our business is earning.
Net profit margin
The net profit margin ratio tells us the amount of net profit per Shs.1 of turnover a business has
earned. That is, after taking account of the cost of sales, the administration costs, the selling
and distributions costs and all other costs, the net profit is the profit that is left, out of which
they will pay interest, tax, dividends and so on.
The formula is:
Net Profit
Total Sales
Return on assets
This formula measures how effectively your business uses its assets to create revenue.
This evaluates how effectively the company employs its assets to generate a return. It measures
efficiency.
The formula is:
Net Profit Before Taxes
Total Assets
Return on equity
This is also called return on investment (ROI).
It determines the rate of return on the invested capital. It is used to compare investment in the
company against other investment opportunities, such as stocks, real estate, savings, etc.
The formula is:
Net Profit Before Taxes
Net Worth
This ratio is specifically for shareholders and is aimed at measuring the return they should
expect from their shares in the business.
Return on capital employed
o It is impossible to assess profits or profit growth properly without relating them to the
amount of funds (capital) that were employed in making profits.
o ROCE is one of the most important profitability ratios which assess how much the capital
invested has earned during the period.
o ROCE is an opportunity cost to the potential investor and when making decisions investor
will always compare the return which the entity will generate as opposed with the return
they can earn on other investments i.e. Bank’s investment rates.
The formula is:
Net Profit Before Interest and Taxes
Capital Employed
SOLVENCY RATIOS (DEBT MANAGEMENT RATIOS)
o These ratios are also called the gearing ratios.
o These are mostly used by providers of finance to assess the finance risk of the business.
o A business with large proportional of debt capital to equity capital is said to be high geared.
o Long-term solvency has to do with the business’s ability to survive for many years.
o The aim of long-term solvency analysis is to point out early that a business is on the road to
bankruptcy.
Debt equity ratio
Measures the direct proportion of debt to equity capital.
A ratio over 100% indicates a highly geared company.
The formula is:
Total Debts
Total net Assets (Total assets + Total liabilities)
Total gearing ratio
This is calculated as the proportion of borrowed capital to total capital employed for the
business. The purpose is the same as the debt equity ratio that is to measure financial risk of
the business.
The formula is:
Total long term Debt (Long term debt + pref. share)
Shareholders Equity + Total long term debt
Interest cover
o If a business is highly geared it will be paying more interest.
o The ratio measures the ability of the business to pay interest to its lenders.
o Low interest cover is associated with high gearing.
o The interest cover ratio shows whether a company is earning enough profits before interest
and tax to pay its interest cost comfortably, or whether its interest cost are high in relation
to the size of its profit, so that a fall in PBIT would then have a significant effect on profits
available for ordinary shareholders.
The formula is:
Profit before interest and tax
Interest Paid