CHAPTER THREE

FINANCIAL ANALYSIS
 Financial
Analysis
• Financial analysis is the assessment of firm’s
past, present and anticipated future financial
condition.

• Its objectives are to determine the

firm’s
financial strength and identify it’s weaknesses.
 Sources of Financial Information
I. The Balance Sheet: ……analyzed to determine the
business' current ratio, its borrowing capacity and
opportunities to attract equity capital.

II. Income Statement………. provides a

measure of theoperation's performance bet
profitability. ter
and
III. Cash Flow Statement………the sources and
uses of the cash.
 Tools of Financial Analysis
• The most important tools for financial analysis
are:
i. Comparative Financial Statements
ii. Trend Analysis or Trend Ratios
iii. Common Size Statements
iv. Ratio Analysis
v. Fund Flow Analysis
vi. Cash Flow Analysis/
 Benchmarks for Evaluation

• There are three approaches:

– Rule of thumb

– Cross sectional analysis or industry average

– Time series analysis

 Ratio Analysis
• Ratio analysis expresses between
relationships different financial statements
items.
5
• Financial Ratios can be classified main
into categories:
1. Liquidity or Short-Term Solvency ratios
2. Asset Management or Activity Ratios
3. Financial Structure or Capitalisation Ratios
4. Profitability Ratios
5. Market Test Ratios
 1. Liquidity ratios
• Liquidity…………. Ability to short-term
pay obligations.

• Ratios:
a) current ratio
b) Quick ratio
c) Net Working capital
 a) Current Ratio
• ……………measures a firm’s ability to satisfy
or cover the claims of short term creditors by
using only current assets.

• Current Ratio = Current Assets

Current Liabilities
• Implication………………..
 Higher CR……….
excessive current assets items due
to: poor cash, credit, A/R, or/and inventory
management
a firm is not making full use of its
current borrowing capacity.
 Lower CR………
difficulty is there in paying its short
term obligations
under stocking that may cause
customer dissatisfaction.
 b) Quick (Acid-test) Ratio
• ………. measures the immediate short term
liquidity by removing the least liquid assets
such as: Prepaid Expenses and Inventories

• Quick Ratio = CA – Inventory – Prepayments

CL
 C) N W C
• ………. measures the difference between
current asset and current liabilities

• NWC= Current Assets Current

Liabilities

• +ve trends recommended

 2. Asset Management or Activity Ratios

• ……….indicates the efficiency of asset usage.

 ……… also show the speed with which assets

are being converted into revenues.

 Thus, ………ratios measure the degree to

which assets are efficiently employed in the
firm.
• ……..also it is a true liquidity measures.

• Ratios:
a. Inventory Turnover Ratio
b. Accounts Receivable Turnover Ratio
c. Total Asset Turnover
d. Fixed Asset turnover
 a. Inventory Turnover Ratio

• ……………indicates whether the investment in

inventory is efficiently used ( i.e. the liquidity of
inventory)

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory
• Reflects …………….. how many times per
period the inventory level is replaced or turned over.

• Implication………………..
 Higher …….…..
 Superior selling practice
improved profitability as less money is tied-up in
inventory.
High demand (unsatisfying customers)
 there may be less stocking
less risk of obsolescence and less holding costs
 b. A/R Turnover Ratio
• …………..it indicates how many times or how
rapidly accounts receivable is converted into cash
during a period

• ………..tells how successful the firm is in its

collection

• A/R turn over= Net sales (credit sales)

average A/R
• Implication………………..
 The higher…..
 More restrictive credit policy
i.e.
 short term credit period,
 more restrictive credit selection
 very aggressive collection policy

 more liberal cash discount offers larger

(i.e. discount)
 c. Fixed Asset Turnover

• ……………measures the efficiency with

which the firm has been using its fixed assets
to generate revenue.

• Fixed assets turnover = net sales

Avg net fixed assets
• Reflects ………… how much the
company generated for each birr invested in fixed
asset.
• Implication………………..
 The higher…..
the firm requires to make additional capital
investment to operate a higher level of
activity.

 The lower……..
 underutilization of available fixed assets
possibility to expand activity level
without requiring additional capital
investment,
 d. Total Asset Turnover

• ………….measures a firm’s efficiency

in management of its total assets to generate
revenues.

• Total Assets Turnover = Net sales

Net total assets
• Implication………………..
 The higher…..
greater efficiency in using assets to
produce revenues.
 And
 vice versa.
 3. Leverage ratios
• Solvency……….. is a firm’s ability to pay long term
debt as they come due.

• ……………..Long term funds management

• There are two types of debt measurement tools. These

are:
I. Financial Leverage Ratio
II. Coverage Ratio
 I. Financial Leverage
Ratio
 ……….these ratios examine balance sheet items
and determine the extent to which borrowed funds
have been used to finance the firm.

 Ratios:
Ia) Debt Ratio
Ib) Debt -Equity Ratio
 Ia) Debt Ratio
• ………….Shows the of
percentage financed through debt. assets

• Debt ratio = Total Liability

Total Assets
• Implication………………..

 The higher…..
 difficulty in raising additional debt.
a higher rate of return (interest rate) for taking
high-risk may required by creditors
Less protection for the creditors while financial
problems
 And
 vice versa.
 Ib) Debt -Equity Ratio

• …………determined to ascertain the proportion

between the outsiders’ funds and shareholders’
funds in the capital structure of an enterprise.

• Debt -equity ratio = Total Liability

Stockholders' Equity

• Reflects …………… the soundness of the long-

term financial policies pursued by the business
enterprise.
 II. Coverage Ratio
• ……measures the risk of debt

• ………….calculated by income statement

ratios designed to determine the number of
times fixed charges are covered by operating
profits.

 Ratios:
IIa) Times Interest Earned Ratio
IIb) Cash Coverage Ratio
 IIa) Times Interest Earned Ratio

• …………….It measures the firm’s ability

to pay contractual interest.

• Times Interest Earned =

EBIT
Interest
• Reflects …………… the number of times
fixed charges are covered by operating profits
with out causing financial problems.

• Implication………………..
 The higher…..
 the less resulting financial losses
 the more capable is the firm to pay.
 And
 vice-versa.
 IIb) Cash Coverage Ratio
• …………indicates the extent to which earnings may
fall with out causing any problem to the firm
regarding the payment of the interest charges.

• ………… it excludes the reduction of non-cash

expenses in computing EBTI.

• Cash Coverage Ratio= EBIT + Depreciation

Interest
 4. Profitability Ratios
 Profitability……. is the ability of an entity to earn
profits.

 ………this ability to earn profits depends on the

effectiveness and efficiency of operations as well as
resources available.

 Profitability analysis…… focuses primarily on the

relationship between operating results reported in the
income statement and resources reported in the
balance sheet.
• ……………….the profitability analysis:

• Analysing in relation to
sales

• Analysing in relation to
assets
• Ratios:
a) Gross Profit Margin
b) Operating Profit Margin
c) Net Profit Margin

d) Return on Investment (ROI)

e) Return on Equity
f) Earning per Share (EPS)
 a) Gross Profit Margin

• .........It indicates management effectiveness in pricing

policy, generating sales and controlling production
costs.
• .……… it helps in ascertaining whether the
average percentage of mark-up on the goods is
maintained.

• Gross Profit Margin = Gross Profit

Net Sales
• Reflects……………. the overall limit within which a
business must manage its operating expenses

• Implication………………..
 The higher…..
 good management on costs
 efficient utilization of assets
 favorable terms to purchase of raw materials
lower cost of production.
 vice versa.
 b) Operating Profit Margin
• …….measures how much the firm earn
on each sales after covering operating
expenses.
• OP Margin = Operating Profit
Net Sales
 c) Net Profit Margin
• …………..measures the ability of the firm to
turn each birr of sales in to net profit.

• ……………….non operating incomes and

expenses are excluded for calculating this
ratio.

• Net Profit Margin = Net Income

Net Sales
 d) Return on Investment /ROI
• …………….. measures the overall
effectiveness of in generating
management
profit with its available assets

• ROA =Net Income

Total Assets
• Reflects……………. the percentage of
return on the total capital employed in the
business.

• ………… or, measures the profit which

a firm earns on investing a unit of capital.
 e) Return on Equity
• …………….. measures the effectiveness of
management in generating profit with its
available total shareholders’ equity.

• ROE = Net Income

Stockholders Equity
 f) Earning per Share (EPS)
• …………..measure of profitability of a firm
from the point of view of the ordinary
shareholders.

• ………….It reveals the profit available to each

ordinary share.

• EPS = Earning Available for Common Stockholders

No. of Shares of Common Stock Outstanding
 Market Value Ratio
• Market value or valuation ratios
are the most significant
measures of a
firm's performance, since they
measures the performance the
of
firm's common stocks in the
capital market.
 Price- Earnings (P/E) Ratio
• The price earning ratio is an indicator of the
firm's growth prospects, risk characteristics,
shareholders orientation corporate reputation,
and the firm's level of liquidity.
• The P/E ratio can be calculated as:

P/E Ratio = Market Price per Share

Earning per Share
Market Value to Book Value (Market-
to-Book) Ratios
• The market value to book value ratio is a
measure of firm's contributing to
the wealth in the society. It
creation as:
calculated is
 Limitatio
• Many n firms operate different
divisions
large in different industries
• Most firms to be better than
average,
want so attaining
performance
merely average
• Inflation may have badly distorted firm’s
balance sheets - “true” values.
• Seasonal factors can also distort a
ratio analysis.
 Limitaion
• Firms can employ “window dressing”
techniques to make their financial statements
look stronger.
• Different accounting practices can distort
comparisons
• It is difficult to generalize about whether a
particular ratio is “good” or “bad
• Effective use of financial ratios requires that
the financial statements upon which they are
based are accurate
Any Q