Chapter - Two

Financial Statement Analysis

Financial Statements
 Financial statements are the end products of accounting system.
 The two basic financial statements required to be prepared for the
purpose of external reporting are;
1. Balance Sheet: A financial statement that summarizes the
information about the firm resources and claims to resources
(Creditors and Shareholders) at a specified date.
 It is valid only for a single day, the vary next day it will
become obsolete.
2. Income statement: A financial statement that shows the
changes in income, expenses, profit/ losses as a result of
business operations during the year.
 The income statement is valid for the whole year. 1
Importance of Financial Statements
Financial statements are the index of the financial affairs of a company.
 To owners of the company:- they reveal its progress as
evidence by earnings and current financial condition, and help
them make decisions on what to do with their investments
(shares of stock), i.e. hold, sell, or buy more.
 To the prospective investors:- they serve as mirror reflecting
potential investment opportunity and to assess the company's
potential for success and profitability.
 To the management:- they reveal the performance efficiency
of the business affairs.
 To the creditors:- they reflect the credit worthiness
(company’s ability to pay liabilities upon maturity (solvency)).
 To the government:- offers a basis of taxation, control of
costs, prices and profits and regulation purpose;
 To Employees:- to know the company’s profitability and
stability; 2
Financial Analysis Meaning and Importance
 The Financial analysis is the process of identifying and evaluating
the firm’s financial strength and weakness through properly
established relationships between the items of B/Sheet and
I/Statement of the firm.
 Typically, financial analysis is used to analyze whether an entity is
stable, solvent, liquid, or profitable enough to warrant a monetary
investment.
 Then is followed by interpretation.
 The term interpretation means explaining the meaning and
significance of data.
 It involves drawing inferences from the analyzed data about
the operational and financial results of the business and its
financial health.
 Analysis without interpretation is useless and interpretation
without analysis is impossible. 3
Objective of Financial Analysis
 The main objective of financial analysis is to reveal;
• The financial strengths and weaknesses,
• The safety of funds invested in the firm,
• The adequacy of its earnings,
• The ability to meet its obligations etc.
 The financial analysis reveals only what has happened in the past.
 But, we can predict the future based on past.
 Prediction of Net Income and Growth Prospects: investors and other
users interested in judging the earning potential of business enterprises
(future rates of return).
 Prediction of Bankruptcy and Failure: a set of financial ratios can
give early signal of corporate failure and creditworthiness of
enterprises.
 Loan Decision by Financial Institutions and Banks: Financial
statement analysis is enable financial institutions to make sound loan
or credit decision and helps in determining credit risk, deciding terms
and conditions of loan if allowed, interest rate, maturity date etc. 4
Techniques of Financial Analysis
 In the process of financial analysis various tools are employed.
 The most well-known tools amongst them are;
1. Trend Analysis (time serious analysis)
2. Industry/cross-sectional/ analysis
1. Trend Analysis: making a comparative study of the financial
statements for several years.
 Evaluate the performance of a firm by comparing its current year
ratios against the past years ratios.
 Gives an indication the direction of changes and whether the firm
performance has improved, declined or remain constant over time.
 More importantly understand the reason why ratios have changed.
2. Industry/cross-sectional analysis: comparing ratios of one firm
against another firms in the same industry at the same point time.
 This type of comparison indicates the relative financial position
and performance of the firm. 5
Meaning of Ratio and Ratio Analysis
 The term, ‘ratio’, refers to the numerical or quantitative
relationship between items or variables.
 the relationship between two groups or amounts that
expresses how much bigger one is than the other:
 Ratio analysis is the process of computing, determining and
interpreting the relationship between the component items of
Financial statements.
 The relationship between two accounting figures expressed
mathematically is known as “financial ratio” or simply as a
“ratio”.

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Who made analysis of financial statements?
 Two parties are involved in financial statement analysis; these are
1. Internal users (i.e., management and employees)
2. External users (i.e., Investors, creditors, regulatory agencies,
stock market analysts, auditors….etc.)
1. Internal users uses for planning, evaluating and controlling
company operations( for task/ operational purposes/).
2. External users uses for assessing past performance and current
financial position and making predictions about the future
profitability and solvency of the company as well as evaluating the
effectiveness of management (for prediction purpose).

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Importance of Ratio Analysis
 Ratios act as an index of the efficiency of the enterprise.
 It facilitates intra-and inter-firm comparison.
 A study of the trend ratios helps the management in planning
and forecasting.
 It will help to identify the specific weak areas, causes thereof
and type of remedial actions called for.
 A purposeful ratio analysis helps in identifying problems such as
the following and in finding out suitable course of action.
 Whether the financial condition of the firm is basically sound,
 Whether the capital structure of the firm is appropriate,
 Whether the profitability of the enterprise is satisfactory,
 Whether the credit policy of the firm is sound, and
 Whether the firm is credit worthy.
 In short, through the technique of ratio analysis the firm’s both long
and short term solvency and profitability can be assessed. 8
Classification of ratios
 The most important and commonly adopted classification of
ratios is on the basis of the purpose or function which the ratios
are expected to perform.
 Such ratios are also called ‘functional ratios’.

They include;
1. Liquidity ratios measures the ability of the firm to meet its
current financial obligations with current asset as and when
they mature.
2. Leverage ratios measure the firms ability to meet its long term
as well as short term obligation.
3. Activity ratios measure the efficiency with which the firm
utilizes its resources.
4. Profitability ratios measure the profit earnings capacity of the
enterprise. 9
 ABC cooperative union
Balance sheet
For the date of Sene30,20012
ASSETs LIABILITIES AND CAPITAL
Current asset 2012 Liabilities
2011 Current liabilities 2012
Cash---------------------------- 2011
2,500-----------3,000 Account payable----------------
Short-term investment------ 7,200------6,000
1,000-----------1,300 Notes payable-------------------
Account receivable---------- 5,500------7,000
16,000---------12,000 Accrued liabilities----------------
Inventories-------------------- 900---------700
20,500---------18,700 Current portion of L.T.L-------
Total current asset---------- 3,000------3,000
40,000---------35,000 Other current liabilities--------
Fixed asset 1,400------1,200
Building --------------------- Total current liabilities-------
28,700---------24,200 18,000-----17,900
Equipment’s------------------ Long term debt----------------
10

31,600---------29,000
 ABC cooperative union
Income statement
For the month ended Sene 30,2012
Revenue
2012 2011
Net sale------------------------------------------------------
120,000-----------------------110,000
Cost of Goods Sold------------------------------------------
90,000-------------------------83,000
Gross profit---------------------------------------------------
30,000-------------------------27,000
Operating expenses;
Selling expense--------------------------------------
5,000------------------------4,800
General and Administrative expense-------------
8,000------------------------7,600
Depreciation expense-------------------------------
1,100---------------------------800
Rent expense-----------------------------------------
1,650------------------------1,600 11
1. Liquidity Ratios
 Liquidity is the ability of a firm to meet its current or short-
term obligations when they become due.
 Liquidity is also known as short-term solvency of the firm.
 The liquidity ratios establish a relationship between current
assets to current liabilities.
 A firm’s liquidity should neither be too low nor too high but should
be adequate. b/c;
1. Low liquidity implies the firm’s inability to meet its
obligations.
This will result
 In bad credit rating,
 Loss of the creditors’ confidence or
 Even ultimately resulting in the shutting of the firm.
2. A very high liquidity position is also bad;
 It means the firm’s current assets are too large in proportion to
maturity obligations. 12
 Idle assets earn nothing to the firm
Liquidity ratio includes;
1. Current ratio,
2. Quick ratio or acid test ratio.
 Current assets include cash and those assets, converted into cash
within the accounting period: e.g., cash, marketable-securities,
account receivable, stock, prepaid expenses etc.
 Current liabilities are obligations which are to be paid within a
year which includes, creditors, bills payable, accrued expenses,
income tax liability and long term debt maturing in the current
year.
1. Current Ratio
 Current ratio is the ratio of total current assets to total current
liabilities.
Current assets
Current ratio = Current liabilitie s

 An important and most commonly used ratio to measure the short-

term financial strength or solvency of the firm.
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 The higher the current ratio, the more is the firm’s ability to meet
its current obligations and the greater the safety of the funds of the
short-term creditors.
 The current ratio for ABC Company during 2011 and 2012 is as
follows; Current assets 35,000
Current Ratio 2011 = Current liabilitie s = = 1.96:1 or 1.96 times
17,900
Current assets 40,000
Current Ratio 2012 = Current liabilitie s = = 2.22:1 or 2.22 times
18,000
Interpretation;
 In general the larger the current ratio indicates the less difficulty
that the firm faces in paying its current obligation on the right
time, other things remain constant.
 As indicated above the current ratio of the company show that the
firm has birr 1.96 in the current asset for each (1) birr of current
liability during 2011 and birr 2.22 during 2012.
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2. Quick Ratio or Acid Test Ratio
 This ratio measures the relationship between quick assets (or
most liquid assets) and current liabilities.
 An asset is considered liquid if it can be converted into cash
without loss of time or value.
 Assets which are considered to be relatively liquid and include in
the quick assets are cash, accounts receivable and short-term
investments in securities.
 Stock or inventory is excluded because it is not easily and
readily convertible into cash and
 Prepaid expenses, which cannot be converted into cash and be
available to pay off current liabilities, should also be excluded
from liquid assets.

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 Quick assets
Quick Ratio =Current liabilitie s  CA  (lessliquid assets ) / CL

 It is widely accepted as the best test for the liquidity of a firm.

 If the firm wants to cover its current obligation by using its quick
assets, the quick assets should be equal or greater than its
current obligation.
 A quick ratio of 1:1 is considered to be satisfactory.
Quick assets Birr (35,000  18,700)
Quick Ratio 2011 = 
Current liabilitie s Birr 17,900
Birr 16,300
  0.91 : 1
Birr 17,900

Quick assets Birr (40000  20,500)

Quick Ratio 2012 = 
Current liabilitie s Birr 18,000
Birr 19,500
  1.08 : 1
Birr 18,000
Interpretation;
• As of ABC Co. the quick asset of birr 0.91 was available for each
birr of current obligation during 2011 and birr 1.08 during 2012. 16
2. Leverage Ratios/Capital Structure/ Ratios
 Also known as “debt management ratios”.
 The long-term creditors (debenture holders, financial institutions,
etc.) are more concerned with the firm’s long-term financial
position.
 It measures the firms ability to pay interest regularly as well as
make repayment of the principal either in one lump-sum or in
installments.
 These ratios indicate appropriate mix of debt and owners’ equity
in financing the firm’s assets.
 If the firm fails to pay to debt holders in time, they can take legal
action against the firm to get payment and even can force the firm
into liquidation.
 But at the same time the use of debt is advantageous to the firm.
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 Leverage ratios can be calculated from the Balance Sheet items
to determine the proportion of debt and total capital of the firm.
 Leverage ratios are also calculated from the income statements
items to determine the extent to which operating profits are
sufficient to cover the fixed charges.
Balance Sheet based ratios
A. Debt-Equity Ratio
 This is one of the measures of the long-term solvency of a
firm which reveals the relationship between borrowed funds
and the owners’ capital of a firm.
 It measures the relative claims of creditors and owners against
the assets of the firm.
Solvency : refers to the ability of a company to generate a stream of cash
inflows sufficient to maintain its productive capacity and still meet the interest
and principal payment on its long-term debt. 18
 A high debt-equity ratio indicates a large share of financing by the
creditors in relation to the owners or a larger claim of the creditors
than those of owners.
 A very high debt-equity ratio is unfavorable and introduces an
element of inflexibility in the firm’s operations.
 During periods of low profits a highly debt financed company
will be under great pressure; it cannot earn enough profits
even to pay the interest charges.
Debt-equity ratio =
Total debt
Debt-equity ratio 2011 = Shareholde rs ' equity
 47,900 / 23,100  2.07

Debt-equity ratio 2012 Total debt

 45,000 / 37,000  1.22
= Shareholde rs ' equity

Interpretation;
• During 2011 and 2012 the creditors have provided about birr 2.07 and birr
1.22 for every single birr contributed by shareholders in financing the
assets of the firm respectively. 19
B. Debt –Asset Ratio (Debt Ratio)
 Measures the extent to which the total assets of the firm have been
financed by external (borrowed) funds.
 A higher debt ratio means that the firm must pay a high interest
rate on its borrowings and in some future time, the firm will not be
borrow at all.
 Generally, creditors prefer a low debt ratio since it implies a high
protection of their position.
Debt ratio =

= 47,900/71,000 = 0.6746 or 67.46%

= 45,000/82,000 = 0.5488 or 54.88%

Interpretation:
 During 2011 and 2012, 67.46% and 54.88% of the total assets were
financed by borrowed funds, the remaining 32.54% and 45.12 % was
financed by funds contributed by shareholders and retained earnings of the
firm respectively. 20
C. Long Term Debt-Equity Ratio
 This ratio measures the extent to which long term debt is used.
 A higher ratio implies that a higher portion of debt
financing come from long-term debt sources.
 In general creditors prefer minimum debt-equity ratio since
it means lower risk for the interest.
Long Term Debt-Equity Ratio =

LTDE Ratio 2011 = = 30,000/23,100= 1.3 or 130%

LTDE Ratio 2012 = = 27,000/37,000 = 0.73 or 73%

Interpretation;
 During 2011 the ratio (130%) was extremely high which can
evidence the riskiness of the firm for its creditors.
 However, the decrease to 73% during the year 2012 may be signals
an improvement of the risk factor. 21
 Income Statement based ratios
A. Time-Interest Coverage Ratio:
 Measures the extent to which the operating income can cover
its annual interest costs.
Time-Interest Coverage Ratio =

TICR 2011 = = 12,200/4,660 = 2.62 times

TICR 2012 = = 14,250/4,150 = 3.43 times

Interpretation:
 The ratios revealed that the firm earnings before interest and taxes
are 2.62 times and 3.43 times higher than the respective interest
expense of the firm during 2011 and 2012 respectively.
 In general, creditors prefer the higher time interest coverage ratio.
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3. Activity (Turn Over or efficiency) Ratios
 The finances obtained by a firm from its owners and creditors
will be invested in assets to generate sales and profits.
 The amount of sales generated and obtaining of the profits
depend on the efficient management of these assets by the firm.
 Activity ratios known as ‘efficiency ratios’ because it measures
the firm efficiency to manages and used its assets.
 Also called ‘turn over ratios’ because they indicate the speed
with which assets are being converted or turned over into sales.
 Thus, the activity ratio measures the relationship between sales
on one side and various assets items on the other.

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The ffs are some of the important activity ratios or turnover ratios:
A. Total Assets Turn over Ratio
 It measures the overall performance and efficiency of the
business.
Total Assets Turn over Ratio =

 Normally, the value of sales should to be considered twice that

of the assets.
 A lower ratio indicates that the assets are lying idle
 A very higher ratio may mean that there is overtrading.

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 TATR 2011 = = 110,000/71,000 = 1.55 times

TATR 2012 = = 120,000/82,000 = 1.46 times

Interpretation:
 The TATR result implies that, the firm was able to generate birr 1.55
and 1.46 for a single birr invested in its assets during 2011 and 2012
respectively.
 Even though, the total volume of sales was greater during the year
2012, the ratio shows that the firm was more efficient in total assets
utilization during 2011.
 Thus, the decline in the ratio during 2012 may indicate a decrease in
the efficiency of asset utilization in generating sales.

25
B. Inventory Turn-over Ratio
 This ratio indicates the efficiency of the firm’s inventory
management.
 It measures the number of times per year the firm sales its
inventories.
 This ratio indicates the rapidity of the stock is turning into
receivables through sales.
 Generally, a high inventory turnover is an index of good
inventory management and a low inventory turnover indicates
an inefficient inventory management.
 Low stock turnover implies;
 the maintenance of excessive stocks which are not
warranted by production and sales activities.
 indication of slow/non moving and obsolete inventory.
 A too high inventory turnover also is not good.
 It may be the result of a very low level of stocks which
may result in frequent stock-outs. 26
 The stock turnover should be neither too high nor too low.
Inventory Turn over ratio =

Average Age of Inventory =

ITR 2011 = = 83,000/18,700 = 4.44 times

Average Age of Inventory
= 360/4.44 = 81 days
=
ITR 2012 = = 90,000/20,500 = 4.39 times

Average Age of Inventory = 360/4.39 = 82 days

=
Interpretation;
 In general high inventory turnover ratio may be taken as a sign of
good inventory management and efficiency.
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C. Average Collection Period
 This ratio measures the average collection period or the average
number of days it takes for a firm to collect its account
receivables.
 It is computed in two-step procedures.
1. The first step is computing the average daily credit sale and
2. the second step is computing the average collection period.
1st , Daily Credit Sale (DCS) =

2nd, Average collection period (ACP) =

 Assume that the firm in our example makes its all sales on credit;
Daily Credit Sales = 110,000/360 = 305.56 Br/day
ACP 2011 = 12,000/305.56 = 39.27 days
Daily Credit Sales = 120,000/360 = 333.33 Br/day
ACP 2012 = 16,000/333.33 = 48 days
Interpretation: the shorter is the ACP is the better the firm’s efficiency.
 For ABC, it was relatively better collection period during 2011 than 2012.28
4. Profitability ratios
 Every firm should earn adequate profits in order to survive and
grow.
 Profitability ratios measure the overall performance of a firm and
its efficiency in managing assets, liabilities, and equity.
 It is an indicator of the firm’s efficiency of operations.
 There are two types of profitability ratios calculated for this
purpose.;
1. Profitability in relation to sales, and
2. Profitability in relation to investment.

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 Profitability in relation to Sales
 Profitability ratios calculated relating different concepts of profit to
the sales value.
I. Gross Profit margin ratio
 It measures the relationship between the firm’s sale and its gross
profit.
Gross profit Sales  Cost of goods sold
Gross profit margin ratio 
Sales Sales
=
GPMR 2011 = 27,000/110,000 = 0.2455 or 24.55%
GPMR 2012 = 30,000/120,000 = 0.25 or 25%
Interpretation:
 The gross profit margin of the firm constitute 24.55% and 25% of the
firm’s net sales during the respective periods.
 This ratio indicate the firms mark ups on its CGS as well as the ability
of the firm’s management to minimize the CGS relation to net sales.
 Generally, larger GPM Ratio implies lower CGS and higher
efficiency. 30
II. Operating Profit Margin Ratio
 Operating profit margin is the excess of gross profit over
operating expenses.
 Operating income is an income from the firms operation.
 This ratio reflects the firm’s operating expenses as well as its
CGS.
Operating Profit Margin Ratio =

OPMR 2011 = 12,200/110,000 = 0.1109 or 11.09%

OPMR 2012 = 14,250/120,000 = 0.1188 or 11.88%

Interpretation:
 The ratio of ABC indicates that the firm left with 11.09% and
11.88% of its net sells after covering its cost of goods sold and all
operating expenses during 2011 and 2012 respectively.
 Generally, the higher ratio indicates higher efficiency.
31
III. Net Profit Margins Ratio
 This ratio measures the ability of the firm to turn each Birr of
sales into net profit and capacity to withstand adverse
economic conditions.
 Net profit = Gross profit - Operating expenses - Income tax.

Net Profit Margins Ratio =

NPMR 2011 = 7,540/120,000 = 0.0685 or 6.58%

NPMR (2012) = 10,100/120,000 = 0.0842 or 8.42%
Interpretation:
 ABC has earned 6.85% net income per birr of net sales it made
during 2011; and 8.42% net income per birr of net sales during
2012.
 Generally, the higher the net profit margin ratio points out the
higher the efficiency of the firm. 32
 Profitability in relation to Investment
I. Return on Total Assets (ROA) or Return on Investment (ROI)
 Measures overall efficiency of firm in managing investment in
assets and generating profits.
 Measures the firm’s profitability per birr of investment in total
assets.
Return on Total Assets =

ROA 2011 = 7,540/71,000 = 0.1062 or 10.62%

ROA 2012 = 10,100/82,000 = 0.1232 or 12.32%
Interpretation:
 This ratio indicated that the firm generates 10.62% or birr 0.1062 in
2011 and 12.32% or birr 0.1232 in 2012 in the form of net income out
of each birr invested in its total assets during the years.
 Generally, the higher ROI in 2012 indicates that the improvement in the
efficiency of the firms overall performance. 33
II. Return on Equity (ROE)
 Measures the firm’s profitability per birr of stockholdrs’
investment.

Return on Equity =

ROE 2011 = 7,540/23,100 = 0.3264 or 32.64%

ROE 2012 = 10,100/37,000 = 0.2729 or 27.29%

Interpretation:
 This ratio indicated that the firm generates 32.64% or birr 0.3264 in 2011
and 27.29% or birr 0.2729 in 2012 in the form of net income out of each
birr invested by shareholders during the years.
 Generally, the lower ROE in 2012 indicates that the poor efficiency of
the firms overall performance.

Market Ratios.pptx
34
Limitations of Ratio Analysis
 Ratios are meaningless, if detached from their source.
 Ratios become useful only when they are compared with some
standards.
 Ratio analysis should be made with care in the case of inter-firm
comparison.
 Unless the firms in question follow identical accounting
methods for items like depreciation, stock valuation, deferred
revenue expenditure, the writing off of capital items, etc.,
ratios will not reflect the figures which are truly comparable.
 No ratio may be regarded as good or bad as such.
 It may be an indication the firm is weak or strong, not a
conclusive proof thereof.
 Ratio analysis may give misleading results if the effect of changes
in price level is not taken into account.
35
 The nature of the business (whether trading or manufacturing)
and the industry’s characteristics which affect the figures in the
financial statements and their inter-relationships should be clearly
understood and born in mind in order to make meaningful ratio
analysis.
 The social, economic and political conditions which form the
background for the firm’s operations should be understood so as
to make ratio analysis meaningful.
 Inflation distorts balance sheets
 Depreciation and inventory costs affect income statements
 Comparative analysis of firm over time
 Comparing firms of different ages
 Window dressing techniques:
 Make financial statements appear better than they actually
are
 Borrowing “long-term” to be repaid quickly distorts
liquidity ratios 36
These limitations, to a considerable extent, can be
eliminated/Corrected:
 If the analysis is related to one firm over a period of time;
 If the results of the firm are compared with suitable norms or
standards;
 If the ratios are used primarily for the identification of areas for
further managerial analysis and formulation of alternatives
available to the management in solving such problems;
 If the ratios are interpreted in the light of social, political,
economic, technological and business conditions under which the
firm operates.
 If ratio analysis is done consciously and used with a measure of
caution, reason, and logic it can be a powerful management tool not
so much for providing answers but for highlighting management
issues and for identifying possible alternatives.
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End of chapter – two

Thank You !!!

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