MBA Chapter3

MADAWALABU UNIVERSITY, BALE-ROBE, DECEMBER,2014
CHAPTER THREE
FINANCIAL STATEMENTS: ANALYSIS AND INTERPRETATION
Introduction
Financial statements provide the primary means for managers to communicate about the
financial condition of their organization to outside parties. Managers, investors, lenders,
financial analysts, and government agencies are among the users of financial statements.
Substantial information is conveyed by financial statements about the financial strength and
current performance of an enterprise. Although financial statements are prepared primarily for
users outside an organization, managers also find their organization’s financial statements
useful in making decisions. As managers develop operating plans, they think about how those
plans will affect the performance of the organization, as conveyed by the financial statements.
In this chapter, we explore how to analyze financial statements to glean the most information
about an organization.
Meaning of Financial Statements
Every business concern wants to know the various financial aspects for effective decision
making. The preparation of financial statement is required in order to achieve the objectives of
the firm as a whole. The term financial statement refers to an organized collection of data on the
basis of accounting principles and conventions to disclose its financial information. Financial
statements are broadly grouped in to four statements:
1. Income Statements (Trading, Profit and Loss Account)
2. Balance Sheets
3. Statement of Retained Earnings
4. Statement of Changes in Financial Position
The meaning and importance of the financial statements are as follows:
(1) Income Statements: The term 'Income Statements' is also known as Trading, Profit and
Loss Account. This is the first stage of preparation of final accounts in accounting cycle. The
purpose of preparing Trading, Profit and Loss Accounts to ascertain the Net Profit or Net Loss
of a business concern during the accounting period.
(2) Balance Sheet: Balance Sheet may be defined as "a statement of financial position of any
economic unit disclosing as at a given moment of time its assets, at cost, depreciated cost, or
other indicated value, its liabilities and its ownership equities." In other words, it is a statement
Financial and Managerial Acctg MBA612 Chapter 3: Compiled by Teferi Deyuu Page 1
which indicates the financial position or soundness of a business concern at a specific period of
time. Balance Sheet may also be described as a statement of source and application of funds
because it represents the source where the funds for the business were obtained and how the
funds were utilized in the business.
(3) Statement of Retained Earnings: This statement is considered to be as the connecting link
between the Profit and Loss Account and Balance Sheet. The accumulated excess of earning
over losses and dividend is treated as Retained Earnings. The balance of retained earnings
shown on the Profit and Loss Accounts and it is transferred to liability side of the balance sheet.
(4) Statement of Changes in Financial Position: Income Statements and Balance sheet do not
disclose the operational efficiency of the concern. In order to measure the operational efficiency
of the concern it is essential to identify the movement of working capital or cash inflow or cash
outflow of the business concern during the particular period. To highlight the changes of
financial position of a particular firm, the statement is prepared may emphasize of the following
aspects:
a) Fund Flow Statement is prepared to know the changes in the firm's working capital.
b) Cash Flow Statement is prepared to understand the changes in the firm's cash
position.
Statement of Changes in Financial Position is used for the changes in the firm's total financial
position.
Nature of Financial Statements

Financial Statements are prepared on the basis of business transactions recorded in the books of
Original Entry or Subsidiary Books, Ledger, and Trial Balance. Recording the transactions in
the books of primary entry supported by document proofs such as Vouchers, Invoice Note etc.
According to the American Institute of Certified Public Accountants, "Financial Statement
reflects a combination of recorded facts, accounting conventions and personal judgments and
conventions applied which affect them materially." It is therefore, nature and accuracy of the
data included in the financial statements which are influenced by the following factors:
(1) Recorded Facts.
(2) Generally Accepted Accounting Principles.
(3) Personal Judgments.
(4) Accounting Conventions.
Objectives of Financial Statements

The following are the important objectives of financial statements:
1. To provide adequate information about the source of finance and obligations of the
business entity.
2. To provide reliable information about the financial performance and financial soundness
of the concern.
3. To provide sufficient information about results of operations of business over a period
of time.
4. To provide useful information about the financial conditions of the business and
movement of resources in and out of business.
5. To provide necessary information to enable the users to evaluate the earning
performance of resources or managerial performance in forecasting the earning
potentials of business.
Limitations of Financial Statements
(1) Financial Statements are normally prepared on the basis of accounting principles,
conventions and past experiences. Therefore, they do not communicate much about the
profitability, solvency, stability, liquidity etc. of the undertakers to the users of the statements.
(2) Financial Statements emphasise to disclose only monetary facts, i.e., quantitative
information and ignore qualitative information.
(3) Financial Statements disclose only the historical information. It does not consider changes
in money value, fluctuations of price level etc. Thus, correct forecasting for future is not
possible.
(4) Influences of personal judgments leads to opportunities for manipulation while preparing of
financial statements.
(5) Information disclosed by financial statements based on accounting concepts and
conventions. It is unrealistic due to difference in terms and conditions and changes in economic
situations.
Analysis and Interpretations of Financial Statements

Presentation of financial statements is the important part of accounting process.
To provide more meaningful information and to enable the owners, investors, creditors or users
of financial statements to evaluate the operational efficiency of the concern during the
particular period. More useful information is required from the financial statements to make the
purposeful decisions about the profitability and financial soundness of the concern. In order to
fulfil the needs of the above, it is essential to consider analysis and interpretation of financial
statements.
Meaning of Analysis and Interpretations
The term "Analysis" refers to rearrangement of the data given in the financial statements. In
other words, simplification of data by methodical classification of the data given in the financial
statements.
The term "interpretation" refers to "explaining the meaning and significance of the data so
simplified." Both analysis and interpretations are closely connected and inter related. They are
complementary to each other. Therefore presentation of information becomes more purposeful
and meaningful-both analysis and interpretations are to be considered.
Metcalf and Tigard have defined financial statement analysis and interpretations as a process of
evaluating the relationship between component parts of a financial statement to obtain a
better understanding of a firm's position and performance.
The facts and figures in the financial statements can be transformed into meaningful and useful
figures through a process called "Analysis and Interpretations."
In other words, financial statement analysis and interpretation refer to the process of
establishing the meaningful relationship between the items of the two financial statements with
the objective of identifying the financial and operational strengths and weaknesses.
Types of Analysis and Interpretations
The analysis and interpretation of financial statements can be classified into different categories
A. Horizontal Analysis
B. Vertical Analysis.
C. Common-Size Statement
D. Trend Analysis
E. Financial Ratios
1. Horizontal Analysis: Horizontal analysis is also termed as Dynamic Analysis. Under
this type of analysis, comparative financial statements to calculate dollar or percentage
changes in a financial statement item from one period to the next. This type of
comparison helps to identify the trend in various indicators of performance. In this type
of analysis, current year figures are compared with base year for figures are presented
horizontally over a number of columns. Horizontal analysis is the percentage analysis
of increases and decreases in corresponding statements. The percent change in the cash
balances at the end of the preceding year from the end of the current year is an
example.
2. Vertical Analysis: Vertical Analysis is also termed as Static Analysis. Under this type
of analysis, number of ratios used for measuring the meaningful quantitative
relationship between the items of financial statements during the particular period. This
type of analysis is useful in comparing the performance, efficiency and profitability of
Vertical analysis is the percentage analysis showing the relationship of the component
parts to the total in a single statement. The percent of cash as a portion of total assets at
the end of the current year several companies in the same group or divisions in the
same company.
3. Common-Size Statement: Under this method, financial statements are analysed to
measure the relationship of various figures with some common base. Accordingly,
while preparing the Common Size Profit and Loss Account, total sa!es is taken as
common base and other items are expressed as a percentage of sales. Like this, in order
to prepare the Common Size Balance Sheet, the total assets or total liabilities are taken
as common base and all other items are expressed as a percentage of total assets and
liabilities.
4. Trend Analysis: Trend Analysis is one of the important technique which is used for
analysis and interpretations of financial statements. While applying this method, it is
necessary to select a period for a number of years in order to ascertain the percentage
relationship of various items in the financial statements comparing with the items in
base year. When a trend is to be determined by applying this method, earliest year or
first year is taken as the base year. The related items in the base year are taken as 100
and based on this trend percentage of corresponding figures of financial statements in
the other years are concluded. This analysis is useful in framing suitable policies and
forecasting in future also.
5. Financial Ratios: Financial ratios are useful indicators of a firm’s performance and
financial situation. Most ratios can be calculated from information provided by the
financial statements. Financial ratios can be used to analyze trends and to compare the
firm’s financials to those of other firms. In some cases, ratio analysis can predict future
bankruptcy. inancial ratios are mathematical comparisons of financial statement
accounts or categories. These relationships between the financial statement accounts
help investors, creditors, and internal company management understand how well a
business is performing and areas of needing improvement.
Financial ratios are the most common and widespread tools used to analyze a business'
financial standing. Ratios are easy to understand and simple to compute. They can also
be used to compare different companies in different industries. Since a ratio is simply a
mathematically comparison based on proportions, big and small companies can be use
ratios to compare their financial information. In a sense, financial ratios don't take into
consideration the size of a company or the industry. Ratios are just a raw computation
of financial position and performance.
Ratios allow us to compare companies across industries, big and small, to identify their
strengths and weaknesses. Financial ratios are often divided up into six main
categories: liquidity, solvency, efficiency, profitability, market prospect, investment
leverage, and coverage.
1. Liquidity Ratios: provide information about a firm’s ability to meet its short-term
financial obligations. They are of particular interest to those extending short-term credit
to the firm. Liquidity ratios analyze the ability of a company to pay off both its current
liabilities as they become due as well as their long-term liabilities as they become
current. In other words, these ratios show the cash levels of a company and the ability to
turn other assets into cash to pay off liabilities and other current obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of
how easy it will be for the company to raise enough cash or convert assets into cash.
Assets like accounts receivable, trading securities, and inventory are relatively easy for
many companies to convert into cash in the short term. Thus, all of these assets go into
the liquidity calculation of a company
Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the
quick ratio.
i. Current Ratio: The current ratio is a liquidity and efficiency ratio that measures a
firm's ability to pay off its short-term liabilities with its current assets. The current
ratio is an important measure of liquidity because short-term liabilities are due
within the next year.
This means that a company has a limited amount of time in order to raise the funds
to pay for these liabilities. Current assets like cash, cash equivalents, and marketable
securities can easily be converted into cash in the short term. This means that
companies with larger amounts of current assets will more easily be able to pay off
current liabilities when they become due without having to sell off long-term,
revenue generating assets.
GAAP requires that companies separate current and long-term assets and liabilities
on the balance sheet. This split allows investors and creditors to calculate important
ratios like the current ratio.
Analysis of Current Ratio
The current ratio helps investors and creditors understand the liquidity of a company
and how easily that company will be able to pay off its current liabilities. This ratio
expresses a firm's current debt in terms of current assets. So a current ratio of 4
would mean that the company has 4 times more current assets than current
liabilities.
A higher current ratio is always more favorable than a lower current ratio because
it shows the company can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually
means the company isn't making enough from operations to support activities. In
other words, the company is losing money. Sometimes this is the result of poor
collections of accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a
company is weighted down with a current debt, its cash flow will suffer.
The current ratio is the ratio of current assets to current liabilities:
Current Ratio = Current Assets

Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may
prefer a lower current ratio so that more of the firm’s assets are working to grow the business.
Typical values for the current ratio vary by firm and industry. For example, firms in cyclical
industries may maintain a higher current ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that are difficult to
liquidate quickly and that have uncertain liquidation values.
ii. Quick Ratio: The quick ratio is an alternative measure of liquidity that does not
include inventory in the current assets. The quick ratio or acid test ratio is a liquidity
ratio that measures the ability of a company to pay its current liabilities when they
come due with only quick assets. Quick assets are current assets that can be
converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-
term investments or marketable securities, and current accounts receivable are
considered quick assets.
Short-term investments or marketable securities include trading securities and
available for sale securities that can easily be converted into cash within the next 90
days. Marketable securities are traded on an open market with a known price and
readily available buyers.
The quick ratio is often called the acid test ratio in reference to the historical use of
acid to test metals for gold by the early miners.
The acid test of finance shows how well a company can quickly convert its assets
into cash in order to pay off its current liabilities. It also shows the level of quick
assets to current liabilities.
Analysis of Quick Ratio
The acid test ratio measures the liquidity of a company by showing its ability to pay
off its current liabilities with quick assets. If a firm has enough quick assets to cover
its total current liabilities, the firm will be able to pay off its obligations without
having to sell off any long-term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling off
these capital assets will not only hurt the company it will also show investors that
current operations aren't making enough profits to pay off current liabilities.
Higher quick ratios are more favorable for companies because it shows there are
more quick assets than current liabilities. A company with a quick ratio of 1
indicates that quick assets equal current assets. This also shows that the company
could pay off its current liabilities without selling any long-term assets. An acid
ratio of 2 shows that the company has twice as many quick assets than current
liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More assets
will be easily converted into cash if need be. This is a good sign for investors, but an
even better sign to creditors because creditors want to know they will be paid back
on time.
The quick ratio is defined as follows:
Quick Ratio = Current Assets – Inventory

Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick ratio often is referred to as
the acid test.
iii. Asset Turnover Ratios: Asset turnover ratios indicate of how efficiently the firm
utilizes its assets. They sometimes are referred to as efficiency ratios, asset
utilization ratios, or asset management ratios. Two commonly used asset turnover
ratios are receivables turnover and inventory turnover.
A. Receivables turnover is an indication of how quickly the firm collects its

accounts receivable. It's an efficiency ratio or activity ratio that measures how
many times a business can turn its accounts receivable into cash during a period.
In other words, the accounts receivable turnover ratio measures how many times
a business can collect its average accounts receivable during the year.
A turn refers to each time a company collects its average receivables. If a
company had $20,000 of average receivables during the year and collected
$40,000 of receivables during the year, the company would have turned its
accounts receivable twice because it collected twice the amount of average
receivables.
This ratio shows how efficient a company is at collecting its credit sales from
customers. Some companies collect their receivables from customers in 90 days
while other take up to 6 months to collect from customers. In some ways the
receivables turnover ratio can be viewed as a liquidity ratio as well. Companies
are more liquid the faster they can covert their receivables into cash.
The reason net credit sales are used instead of net sales is that cash sales don't
create receivables. Only credit sales establish a receivable, so the cash sales are
left out of the calculation. Net sales simply refers to sales minus returns and
refunded sales.
The net credit sales can usually be found on the company's income statement for
the year although not all companies report cash and credit sales separately.
Average receivables is calculated by adding the beginning and ending
receivables for the year and dividing by two. In a sense, this is a rough
calculation of the average receivables for the year.
Analysis of Accounts Turnover
Since the receivables turnover ratio measures a business' ability to efficiently
collect its receivables, it only makes sense that a higher ratio would be more
favorable. Higher ratios mean that companies are collecting their receivables
more frequently throughout the year. For instance, a ratio of 2 means that the
company collected its average receivables twice during the year. In other words,
this company is collecting is money from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company

can collect cash from customers sooner, it will be able to use that cash to pay
bills and other obligations sooner.
Accounts receivable turnover also is and indication of the quality of credit sales
and receivables. A company with a higher ratio shows that credit sales are more
likely to be collected than a company with a lower ratio. Since accounts
receivable are often posted as collateral for loans, quality of receivables is
important.
It is defined as follows:
Receivables Turnover = Annual Credit Sales

Accounts Receivable
The receivables turnover often is reported in terms of the number of days that credit sales
remain in accounts receivable before they are collected. This number is known as the collection
period. It is the accounts receivable balance divided by the average daily credit sales, calculated
as follows:
Average Collection Period = Accounts Receivable

Annual Credit Sales/ 365
The collection period also can be written as:
Average Collection Period = 365

Receivable Turnover
B. Inventory turnover: It is the cost of goods sold in a time period divided by the
average inventory level during the period. The inventory turnover ratio is an
efficiency ratio that shows how effectively inventory is managed by comparing
cost of goods sold with average inventory for a period. This measures how many
times average inventory is "turned" or sold during a period. In other words, it

measures how many times a company sold its total average inventory dollar
amount during the year. A company with $1,000 of average inventory and sales
of $10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components
of performance. The first component is stock purchasing. If larger amounts of
inventory are purchased during the year, the company will have to sell greater
amounts of inventory to improve its turnover. If the company can't sell these
greater amounts of inventory, it will incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases
otherwise the inventory will not turn effectively. That's why the purchasing and
sales departments must be in tune with each other.
Average inventory is used instead of ending inventory because many companies'
merchandise fluctuates greatly throughout the year. For instance, a company
might purchase a large quantity of merchandise January 1 and sell that for the
rest of the year. By December almost the entire inventory is sold and the ending
balance does not accurately reflect the company's actual inventory during the
year. Average inventory is usually calculated by adding the beginning and
ending inventory and dividing by two.
Analysis of Inventory Turnover
Inventory turnover is a measure of how efficiently a company can control its
merchandise, so it is important to have a high turn. This shows the company
does not overspend by buying too much inventory and wastes resources by
storing non-salable inventory. It also shows that the company can effectively sell
the inventory it buys.
This measurement also shows investors how liquid a company's inventory is.
Think about it. Inventory is one of the biggest assets a retailer reports on its
balance sheet. If this inventory can't be sold, it is worthless to the company. This
measurement shows how easily a company can turn its inventory into cash.
Creditors are particularly interested in this because inventory is often put up as
collateral for loans. Banks want to know that this inventory will be easy to sell.
Inventory turns vary with industry. For instance, the apparel industry will have
higher turns than the exotic car industry.
Inventory Turnover = Cost of Goods Sold

Average Inventory
The inventory turnover often is reported as the inventory period, which is the number of the
day’s worth of inventory on hand, calculated by dividing the inventory by the average daily
cost of goods sold:
Inventory Period = Average Inventory

Annual Cost of Goods Sold/ 365
The inventory period also can be written as:

Inventory Period = 365
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
2. Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.
i. Debt Ratio: is a solvency ratio that measures a firm's total liabilities as a percentage
of its total assets. In a sense, the debt ratio shows a company's ability to pay off its
liabilities with its assets. In other words, this shows how many assets the company
must sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher
levels of liabilities compared with assets are considered highly leveraged and more
risky for lenders.
This helps investors and creditors analysis the overall debt burden on the company
as well as the firm's ability to pay off the debt in future, uncertain economic times.
The debt ratio is calculated by dividing total liabilities by total assets. Both of these
numbers can easily be found the balance sheet.
Analysis of Debt Ratio
The debt ratio is shown in decimal format because it calculates total liabilities as a
percentage of total assets. As with many solvency ratios, a lower ratios is more
favorable than a higher ratio. A lower debt ratio usually implies a more stable
business with the potential of longevity because a company with lower ratio also has
lower overall debt. Each industry has its own benchmarks for debt, but .5 is
reasonable ratio.
A debt ratio of .5 is often considered to be less risky. This means that the company
has twice as many assets as liabilities. Or said a different way, this company's
liabilities are only 50 percent of its total assets. Essentially, only its creditors own
half of the company's assets and the shareholders own the remainder of the assets.
A ratio of 1 means that total liabilities equals total assets. In other words, the
company would have to sell off all of its assets in order to pay off its liabilities.
Obviously, this is a highly leverage firm. Once its assets are sold off, the business no
longer can operate.
The debt ratio is a fundamental solvency ratio because creditors are always
concerned about being repaid. When companies borrow more money, their ratio
increases creditors will no longer loan them money. Companies with higher debt
ratios are better off looking to equity financing to grow their operations.
The debit ratio is defined as total debt divided by total assets:
Debt Ratio = Total Debt

Total Assets
ii. Debt-Equity Ratio: is a financial, liquidity ratio that compares a company's total
debt to total equity. The debt to equity ratio shows the percentage of company
financing that comes from creditors and investors. A higher debt to equity ratio
indicates that more creditor financing (bank loans) is used than investor financing
(shareholders).
The debt to equity ratio is calculated by dividing total liabilities by total equity. The
debt to equity ratio is considered a balance sheet ratio because all of the elements are
reported on the balance sheet.
Analysis of Debt to Equity Ratio
Each industry has different debt to equity ratio benchmarks, as some industries tend
to use more debt financing than others. A debt ratio of .5 means that there are half as
many liabilities than there is equity. In other words, the assets of the company are
funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of
every dollar of company assets while creditors only own 33.3 cents on the dollar.
A debt to equity ratio of 1 would mean that investors and creditors have an equal
stake in the business assets.
A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to creditors
and investors than companies with a lower ratio. Unlike equity financing, debt must
be repaid to the lender. Since debt financing also requires debt servicing or regular
interest payments, debt can be a far more expensive form of financing than equity
financing. Companies leveraging large amounts of debt might not be able to make
the payments.
Creditors view a higher debt to equity ratio as risky because it shows that the
investors haven't funded the operations as much as creditors have. In other words,
investors don't have as much skin in the game as the creditors do. This could mean
that investors don't want to fund the business operations because the company isn't
performing well. Lack of performance might also be the reason why the company is
seeking out extra debt financing.
The debt-to-equity ratio is total debt divided by total equity:
Debt-to-Equity Ratio = Total Debt

Total Equity
Debt ratios depend on the classification of long-term leases and on the classification of some
items as long-term debt or equity.
3. Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at generating
profits.
i. Gross-profit margin: is a measure of the gross profit earned on sales. The gross
profit margin considers the firm’s cost of goods sold, but does not include other
costs. The profit margin ratio, also called the return on sales ratio or gross profit
ratio, is a profitability ratio that measures the amount of net income earned with
each dollar of sales generated by comparing the net income and net sales of a
company. In other words, the profit margin ratio shows what percentage of sales are
left over after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can
convert sales into net income. Investors want to make sure profits are high enough to
distribute dividends while creditors want to make sure the company has enough
profits to pay back its loans. In other words, outside users want to know that the
company is running efficiently. An extremely low profit margin would indicate the
expenses are too high and the management needs to budget and cut expenses. The
return on sales ratio is often used by internal management to set performance goals
for the future.
Analysis of Gross Profit Margin ratio
The profit margin ratio directly measures what percentage of sales is made up of net
income. In other words, it measures how much profits are produced at a certain level
of sales. This ratio also indirectly measures how well a company manages its
expenses relative to its net sales. That is why companies strive to achieve higher
ratios. They can do this by either generating more revenues why keeping expenses
constant or keep revenues constant and lower expenses. Since most of the time
generating additional revenues is much more difficult than cutting expenses,
managers generally tend to reduce spending budgets to improve their profit ratio.
Like most profitability ratios, this ratio is best used to compare like sized companies
in the same industry. This ratio is also effective for measuring past performance of a
company.
It is defined as follows:
Gross Profit Margin = Sales – Cost of Goods Sold

Sales
ii. Return on Assets, often called the return on total assets, is a profitability ratio that
measures the net income produced by total assets during a period by comparing net
income to the average total assets. In other words, the return on assets ratio or ROA
measures how efficiently a company can manage its assets to produce profits during
a period.
Since company assets' sole purpose is to generate revenues and produce profits, this
ratio helps both management and investors see how well the company can convert
its investments in assets into profits. You can look at ROA as a return on investment
for the company since capital assets are often the biggest investment for most
companies. In this case, the company invests money into capital assets and the
return is measured in profits. In short, this ratio measures how profitable a
company's assets are.
The return on assets ratio formula is calculated by dividing net income by average
total assets.
This ratio can also be represented as a product of the profit margin and the total
asset turnover.
Either formula can be used to calculate the return on total assets. When using the
first formula, average total assets are usually used because asset totals can vary
throughout the year. Simply add the beginning and ending assets together on the
balance sheet and divide by two to calculate the average assets for the year. It might
be obvious, but it is important to mention that average total assets is the historical
cost of the assets on the balance sheet without taking into consideration the
accumulated depreciation. The net income can be found on the income statement.
Analysis of ROA
The return on assets ratio measures how effectively a company can turn earn a return
on its investment in assets. In other words, ROA shows how efficiently a company
can covert the money used to purchase assets into net income or profits.
Since all assets are either funded by equity or debt, some investors try to disregard
the costs of acquiring the assets in the return calculation by adding back interest
expense in the formula.
It only makes sense that a higher ratio is more favorable to investors because it
shows that the company is more effectively managing its assets to produce greater
amounts of net income. A positive ROA ratio usually indicates an upward profit
trend as well. ROA is most useful for comparing companies in the same industry as
different industries use assets differently. For instance, construction companies use
large, expensive equipment while software companies use computers and servers.
Return on assets is a measure of how effectively the firm’s assets are being used to
generate profits. It is defined as:
Return on Assets = Net Income

Total Assets
iii. Return on Equity (ROE): is the bottom line measure for the shareholders,
measuring the profits earned for each dollar invested in the firm’s stock. The return
on equity ratio or ROE is a profitability ratio that measures the ability of a firm to
generate profits from its shareholders investments in the company. In other words,
the return on equity ratio shows how much profit each dollar of common
stockholders' equity generates.
So a return on 1 means that every dollar of common stockholders' equity generates 1
dollar of net income. This is an important measurement for potential investors
because they want to see how efficiently a company will use their money to generate
net income. ROE is also an indicator of how effective management is at using equity
financing to fund operations and grow the company.
Most of the time, ROE is computed for common shareholders. In this case, preferred
dividends are not included in the calculation because these profits are not available
to common stockholders. Preferred dividends are then taken out of net income for
the calculation. Also, average common stockholder's equity is usually used, so an
average of beginning and ending equity is calculated.
Analysis of ROE
Return on equity measures how efficiently a firm can use the money from
shareholders to generate profits and grow the company. Unlike other return on
investment ratios, ROE is a profitability ratio from the investor's point of view—not
the company. In other words, this ratio calculates how much money is made based
on the investors' investment in the company, not the company's investment in assets
or something else.
Investors want to see a high return on equity ratio because this indicates that the
company is using its investors' funds effectively. Higher ratios are almost always
better than lower ratios, but have to be compared to other companies' ratios in the
industry. Since every industry has different levels of investors and income, ROE
can't be used to compare companies outside of their industries very effectively.
Many investors also choose to calculate the return on equity at the beginning of a
period and the end of a period to see the change in return. This helps track a
company's progress and ability to maintain a positive earnings trend.
Return on equity is defined as follows:
Return on Equity = Net Income

Shareholder Equity
Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:
 A reference point is needed. To be meaningful, most ratios must be compared to
historical values of the same firm, the firm’s forecasts, or ratios of similar firms.
 Most ratios by themselves are not highly meaningful. They should be viewed as
indicators, with several of them combined to paint a picture of the firm’s situation.
 Year-end values may not be representative. Certain account balances that are used to
calculate ratios may increase or decrease at the end of the accounting period because of
seasonal factors. Such changes may distort the value of the ratio. Average values should
be used when they are available.
 Ratios are subject to the limitations of accounting methods. Different accounting
choices may result in significantly different ratio values.
General Questions
1. What do you understand by financial statements?
2. Explain briefly the nature and scope of financial statements.
3. Discuss the important objectives of financial statements.
4. What are limitations of financial statements?
5. Explain the analysis and interpretation of financial statements.
6. Write short notes on :
a. Horizontal Analysis.
b. Vertical Analysis.
c. Ratios Analysis.
7. Explain in brief the procedure for preparing the comparative financial statements.
8. Discuss the different techniques or tools of Financial Analysis.
9. What do you understand by Trend Analysis?
10. Write a brief note on Common Size Statements.

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MADAWALABU UNIVERSITY, BALE-ROBE, DECEMBER,2014

Nature of Financial Statements

Objectives of Financial Statements

Analysis and Interpretations of Financial Statements

The current ratio is the ratio of current assets to current liabilities:

Current Ratio = Current Assets

Analysis of Quick Ratio

Quick Ratio = Current Assets – Inventory

A. Receivables turnover is an indication of how quickly the firm collects its

Higher efficiency is favorable from a cash flow standpoint as well. If a company

Receivables Turnover = Annual Credit Sales

Average Collection Period = Accounts Receivable

The collection period also can be written as:

Average Collection Period = 365

times average inventory is "turned" or sold during a period. In other words, it

Inventory Turnover = Cost of Goods Sold

Inventory Period = Average Inventory

The inventory period also can be written as:

Debt Ratio = Total Debt

The debt-to-equity ratio is total debt divided by total equity:

Debt-to-Equity Ratio = Total Debt

Gross Profit Margin = Sales – Cost of Goods Sold

Return on Assets = Net Income

Return on Equity = Net Income

Use and Limitations of Financial Ratios

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