FINANCIAL STATEMENT ANALYSIS

(RATIO ANALYSIS)

Analysis of financial statements indicates strength and weakness of a company as well as trends
in its activities. Financial statements include;
 Profit and loss Account/Income statement: Shows the performance of a company
throughout the financial period.
 Balance sheet/ Statement of financial position: Shows the financial position or status
of a company.
 Cash flow statement: Shows changes in cash position of the entity,
Financial statements can be analysed by the use of the following accounting ratios.

1.) LIQUIDITY RATIOS

This ratio measures ability of a firm to meet short term obligations and meet unexpected cash
needs. Higher liquidity ratios are better because they show ability to meet their short-term
obligations. They deals with cash, cash equivalent and current assets and include;

a) Current Ratio = CURRENT ASSETS

CURRENT LIABILITIES
Rule of thumb = 2:1
High ratio and low ratio is not desirable. Optimum ratio is the best. Mostly this ratio is taken
as a crude measure of credit risk.

b) Acid Test Ratio (Quick Ratio) CURRENT ASSETS – STOCK or LIQUID C.

ASSETS
CURRENT LIABILITIES C. LIABILITIES
Rule of thumb = 1:1

c) Cash Ratio = CASH & EQUIVALENTS

CURRENT LIABILITIES
Cash; money in the form of currency. Currency includes currency notes and coins.
Cash Equivalent; investments that can be readily converted to cash. Examples include
commercial paper, treasury bills, short term government bonds, marketable securities, and
money market holdings.

An item should satisfy the following criteria to qualify for cash equivalent.
 The investment should be short term.
They should mature in less than three months. If they mature in more than three months they
will be classified as other investments.
 They should be highly liquid.
This means that they should be easily sold in the market. The buyers of these investments
should be easily available.
 They should be convertible to known amounts of cash.
This means that their market price should be available and this market price should not be
subject to significant fluctuations.
 They should not be too risky.
There should be very little risk of changes in their value. This means that equity shares cannot
be classified as cash equivalents. But preferred shares purchased shortly before the redemption
date can be classified as cash equivalents.

d) Net Working Capital ratio (NWC)

= CURRENT ASSETS – CURRENT LIABILITIES
Net Working Capital (NWC) is the difference between Current Assets and Current Liabilities.
It is technically not a ratio but rather a simple financial metric that is closely related to the
various liquidity ratios.

e) Net working capital to sales ratio = WORKING CAPITAL

SALES
Indicates the firm's ability to finance additional sales without incurring additional debt. The
higher the ratio the better.

2.) LEVERAGE RATIOS (Gearing ratios/ Debt ratios.)

They measure relationship between funds supplied by owners with the financing provided by
the firm’s creditors. Leverage is approached in two ways:
 Balance sheet ratios;
They determine the extent to which borrowed funds have been used to finance the firm.
 Income statement ratios;
They determine the risk of failure to service the long term loans shareholders’ funds.

Leverage ratios include:

a.) Debt ratio = TOTAL LIABILITIES
TOTAL ASSETS
It indicates financial stability and financial risk of a business. Ordinary shareholders would
prefer a high ratio to benefit from debt while lenders would prefer a lower ratio to reduce
financial risk exposure of their debt.

b.) Long Term debt ratio = NON CURRENT LIABILITIES (Long Term
Debt)
TOTAL ASSETS
This measures the proportion of the total net assets financed by the non-owner supplied funds.
The higher the ratio, then the higher the financial risk.

c.) Equity ratio = SHAREHOLDERS’ EQUITY (SHE)

TOTAL ASSETS
SHE incorporates:
 Share capital
 
Share premium

Revenue reserve balances

Retained Earnings
SHE = Total Assets – Total Liabilities OR
= Share capital + Retained Earnings – Treasury shares/ stock

Treasury shares is reacquired stock which is bought back by the issuing company, reducing the
amount of outstanding stock on the open market ("open market" including insiders' holdings).

It’s used to indicate the financial stability of a business. A business that finances most of its
assets through equity is considered more stable than that which finances them through debt.

d.) Capitalization ratio

Measures the debt component of a company's capital structure (capitalization). It provides the
idea of a company's long-term stability and ability to withstand losses and business downturns.
While a high capitalization ratio can increase the return on equity because of the tax shield of
debt, a higher proportion of debt increases the risk of bankruptcy for a company.

Capitalization ratio can be classified into:

i) Long-term Debt to Capitalization
= Long-Term Debt
(Long-Term Debt + Shareholders’ Equity)

ii) Total Debt to Capitalization

= Total Debt
(Total Debt + Shareholders' Equity)

e.) Debt equity ratio = TOTAL LIABILITIES

SHAREHOLDERS’ EQUITY
This ratio relates borrowed finances to the finances provided by owners of the business.The
higher the ratio, then the higher the financial risk. This is unfavourable because it means that
the business relies more on external lenders thus it is at higher risk, especially at higher interest
rates.

Lower values of debt-to-equity ratio are favorable indicating less risk.

3.) ACTIVITY RATIOS

These are the ratios that show how active a firm is in generating revenues and profits. It also
measures the efficiency with which a business uses its assets and liabilities to generate income.
Activity ratios include;

a) Rate of Stock Turn Over = COST OF SALES (Answered in ‘TIMES’)

STOCK (Average Stock)
The ratio shows how active the business is in restocking. The higher the ratio the better. A low
ratio implies slow moving stock thus will lead to the following costs;
 Cost of  Storage cost e.g.  Opportunity
obsolescence warehousing cost
 Cost of spoilage  Cost of pilferage

This is corroborated by stock holding period ratio.

b) Stock holding period = 365 OR 365 X STOCK

STOCK TURNOVER COST OF SALES

The lower the ratio the better (Answered in ‘DAYS’)

c) Debtors Turnover = CREDIT SALES (Answered in ‘TIMES’)

DEBTORS
Number of times collections are received from debtors after selling on A/c
The higher the ratio the better because it means there is better utilization of the credit facilities.
A low ratio implies there is a high level of outstanding debtors and it leads to the following
costs.
 Bad debts  Provisions for bad debts
 Cost of monitoring debtor  Cost of managing accounts receivables
 Opportunity cost

This can be managed /reversed by the following strategies

 Offer discounts-cash discounts
 Factoring; selling debtors to a special collection company
 Bill discounting promissory
 Specialize in cash sales

d) Debtor’s collection period = 365 (Answered in ‘DAYS’)

DEBTOR’S TURNOVER
The lower the ratio the faster the collection hence the better

e) Creditor’s turnover = CREDIT PURCHASES (Answered in ‘TIMES’)

CREDITORS
Shows the number of times payments are made to suppliers after buying on A/c. The lower the
ratio the better. A high ratio is disadvantageous due to opportunity cost and inefficient use of
credit facilities. This ratio can be corroborated confirmed by deferred payment period.

f) Deferred payment period = 365 (Answered in ‘DAYS’)

CREDITOR’S TURNOVER
The high the ratio the slower the payment hence the better

g) Assets turnover = SALES

TOTAL ASSETS
The higher the ratio, the better it is, since it implies the company is generating more revenues
per unit currency (say Ksh.) of assets.

h) Noncurrent assets turnover = SALES

NON CURRENT ASSETS
The higher the ratio the better
i) Current assets turnover = SALES
CURRENT ASSETS
The higher the better

4.) COST RATIOS

They are efficiency ratios with respect to revenues. The lower the ratio the better i.e. the more
efficient a firm is. They are inversely proportional to profitability ratios e.g.
Formula = Cost x 100
Sales
a.) Cost of sales ratio = COST OF SALES x 100
SALES

b.) Total cost ratio = TOTAL COST RATIO x 100

SALES
(All Costs are expressed over sales and answers are in %)

5.) COVERAGE RATIOS (Stability Ratios)

Ratios used to establish the ease of meeting financing and other obligations from normal
profits/ operations. Common obligation can include debt repayment, ordinary dividend,
preferential dividend, interest payment, redeeming preference share capital, lease charges,
fixed charge e.g. interests.
Formula = Profit (Answers are given in ‘TIMES’)
Obligation

a) Times debt coverage = EBIT

LONG TERM DEBT
Higher the ratio the better

b) Times interest coverage = EBIT

INTEREST
No of times interest can be served before profit is exhausted

c) Ordinary dividend coverage

= NET PROFIT AFTER TAX – PREFERENTIAL DIVIDEND (Irredeemable) OR
ORDINARY DIVIDEND
= NET PROFIT AFTER PREFERENTIAL DIVIDEND
ORDINARY DIVIDEND
It states the number of times an organization is capable of paying dividends to shareholders
from the profits earned during an accounting period.
For example; a dividend cover of 3 implies that a company has sufficient earnings to pay
dividends amounting to 3 times of the present dividend payout during the period
d) Preferential dividend coverage = NET PROFIT AFTER TAX
PREFERENTIAL DIVIDEND
It is a more important ratio if we are considering cumulative preferential shares

e) Times redeemable preference share capital coverage

= NET PROFIT
REDEEMABLE PREFERENCE SHARES
It applies to redeemable preference shares. It’s critical when nearing redemption or nearing
restrictive covenants.

f) Times fixed charge coverage

= EBIT + LEASE CHARGES
INTEREST + LEASE CHARGES + PREFERENTIAL DIVIDEND

Fixed charge coverage ratio is the number of times the company can cover its fixed charges
per year. The higher the number, the better the debt position of the firm, similar to the times
interest earned ratio. The fixed charge coverage ratio includes lease payments, interest
payments and preferential dividend

g) Time lease charge coverage = EBIT + LEASE CHARGES

LEASE CHARGES

6.) PROFITABILITY RATIOS

They measure yield ability of revenues and assets of a business entity. The ratios can either
relate to; * Income statement or * Balance sheet

i) Income Statement Profitability Ratios

They compare profits with level of sales. The higher the ratio the better. They are inversely
related to cost ratios.

a.) Gross profit margin = GROSS PROFIT x 100

SALES
It measures the efficiency and ability of business to control expenses associated with generating
trading income. The higher the ratio the better the ability to control those costs and vice versa.
The ratio is inversely proportional to cost of sales ratio.

b.) Net profit margin = NET PROFIT (After Tax) x 100

SALES
Measures efficiency and ability of business to control all the expenses associated with
generating net income. It is inversely proportional to total costs ratio. The higher the ratio the
better the ability to control for these costs and vice versa.

ii) Balance Sheet Profitability Ratios

It is also called return ratios
a) Return on Investment (ROI) = NET PROFIT (After Interest & Tax) x
100
TOTAL ASSETS
Relates profits attained to assets employed in the accounting entity from the perspective of the
ordinary equity investors. The higher the ratio the better. (Can be expressed as a ratio or %)
This can as well be given as;
Gain from Investment – Cost of investment OR Earnings – Initial Investment
Cost of investment Initial Investment

b) Return on Total Assets (ROTA) ROTA = EBIT x 100

AVERAGE TOTAL ASSETS
Indicates relative efficiency with which all assets are used to generate profits. The higher the
ratio the better.

c) Return on Capital Employed (ROCE) EBIT x 100

CAPITAL EMPLOYED
The higher the ratio the higher the profitability and adequate return on capital employed.
Capital Employed = Equity + Non-current Liabilities (Long term Liabilities)
= Total Assets – Current Liabilities
Therefore the formula can also be;
= EBIT x 100
TOTAL ASSETS – CURRENT LIABILITIES

d) Return on shareholders’ equity (ROSHE)

ROSHE = EARNINGS AFTER TAX AND PREFERENTIAL DIVIDEND x 100
SHAREHOLDERS’ EQUITY
Evaluates the relative profitability of the common equity invested in a firm. It’s also called
ROCE (Return on common equity). The higher the ratio the higher the profitability of the
equity investment.

e) Net asset backing = SHAREHOLDERS’ EQUITY

NO OF SHARES
This is not strictly a return ratio. It could be used to indicate the extent of dilution of control of
existing ordinary equity holders. It could also be used to indicate the stake of ordinary
shareholders in the business. The higher the ratio the higher the stability and vice versa.

7.) MARKET EVALUATION (Stock Market Ratio)

They are used by investors in the stock exchange to make decisions on securities. They measure
return on investments and determine future prospects.

a) Earnings Per Share (E.P.S) NET PROFIT DUE TO ORDINARY

SHAREHOLDERS
NO. OF SHARES
Profitability of each share. The higher the ratio the better.

b) Earnings Yield = EARNING PER SHARE X 100 or EPS x 100

MARKET PRICE PER SHARE MPS
The ratio measures profitability to equity investors with respect to current investment. The
higher the ratio the higher the profitability thus the better.

c) Price Earnings Ratio (P.E) P/E = MPS

EPS
This ratio can be used to show: Stability of a business, Growth prospects, Payback period.
This ratio should be as low as possible i.e. the lower the ratio the better.

d) Dividend Per Share (D.P.S) DPS = TOTAL DIVIDEND (Ordinary)

NO OF ORDINARY SHARES
Evaluates the dividend paying ability of a business. A business can pay dividend through:
*Cash *Other assets *Extra shares

e) Dividend Yield = DPS x 100

MPS
For poor investors the higher the ratio the better but for corporate and wealthy the lower the
better and same case for DPS

f) Dividend Cover
= NET PROFIT AFTER TAX AND PREFERENCE DIVIDENDS OR
EPS
ORDINARY DIVIDENDS PAID AND PROPOSED
DPS
This gives the shareholder some idea as to the proportion that the ordinary dividends bear to
the amount available for distribution to ordinary shareholders. Usually, the dividend is
described as
being so many times covered by profits made. If, therefore, the dividend is said to be three
times
covered, it means that one-third of the available profits is being distributed as dividends.

g) Dividend Payout Ratio DPS x 100

EPS
This ratio represents dividend as a percentage of earnings per share. If the ratio is low then
retention percentage is high.
 Interpretation of Ratios
(1.) Over time
This can involve Time Series or Trend Comparison. The importance is to establish trend of
financial position so as to know if; >Business is stagnating
> Business is improving
>Business is declining

(2.) Across the Industry

This can involve Cross Sectional Analysis or Horizontal Analysis. The importance is to
establish; > Industry Average
> Industry Leader
> Similar Company
> Identify relative condition of a business hence carry out SWOT
analysis.

Advantages of Ratio Analysis

1. Guides management in future financial planning

2. Shows efficiency of the business organization
3. Allows comparison of firms figures with those of other firms in the same industry
4. Ensures effective cost control
5. Measures profitability and solvency
6. Helps in investment decisions
7. Provides greater clarity or meaning of data

Limitations/ Disadvantages of Ratio Analysis

[A] With Respect To Time Series Analysis

1. Inflation; Due to inflation the value of a shilling last year is not the same as this year.
2. Seasonality trends; There may be a trend that may be influenced by other factors e.g.
population growth or population decline.
3. Historical in nature; Historical trends may not necessarily reflect the future.
4. Changes; e.g. Legal changes, Economic changes, Regulatory changes, Changes in
standards.
[B] With Respect To Cross Sectional Analysis

1. Unlikely to find a similar company like yours thus giving a crude idea rather than a
perfect one
2. Differences in accounting policies e.g. a company may depreciate its assets using
reducing balance method while another uses straight line basis.
 3. Industry averages may be misleading. Average can be affected by extreme values e.g.
Co. A = 12 Million, Co. B = 6 Million, Co. C = 9 Million & Co. D = 1 Billion therefore
the average will be high due to Co. D.

[C] With Respect To a General View

1. Window dressing; Statements may be manipulated to portray a bad or favourable state.

2. Rule of the thumb; May be misleading e.g. A current ratio of 2:1 for a certain company
may not be applicable to other companies.
3. Ratios do not show where the mistake or error lies.
4. Ratios never show a complete picture of company’s activities.
ILUSTRATION I
The following financial statements relate to two wholesales, Jambo and Uhuru traders
operating in Nairobi.
Profit and loss accounts
JAMBO TRADERS UHURU TRADERS

Shs. Shs. Shs. Shs.

Sales 5,550,000 7,500,000

Less:Cost of goods sold

Opening stock 1,000,000 800,000

Add: Purchases 2,000,000 3,200,000

Less: Closing stock (600,000) (700,000)

(2,400,000) (3,300,000)

Gross profit 3,150,000 4,200,000

LESS: Expenses

Depreciation 50,000 150,000

Wages, salaries and commission 1,650,000 2,200,000

Other expenses 450,000 350,000

(2,150,000) (2,700,000)

Net profit 1,000,000 1,500,000

Balance sheets
JAMBO TRADERS UHURU TRADERS

FIXED ASSETS Shs. Shs. Shs. Shs.

Equipment at cost 500,000 1,000,000

Less:Depreciation to date (400,000) 100,000 (300,000) 700,000

CURRENT ASSETS

Stock 600,000 700,000

Debtors 1,250,000 1,000,000

 Bank 250,000 125,000

2,100,000 1,825,000

LESS CURRENT LIABILITIES

Creditors (1,040,000) 1,060,000 (1,005,000) 820,000

1,160,000 1,520,000

FINANCED BY:

Capital 760,000 720,000

Add Net profit 1,000,000 1,500,000

Less Drawings (600,000) (700,000)

1,160,000 1,520,000

Required:
Calculate the following ratios for each business and comment which business is more efficient
per every ratio.
1. Gross Profit Margin 6. Current ratio

2. Net Profit Margin 7. Acid test ratio

3. Expenses ratio 8. Debt ratio

4. Stock Turnover 9. Return on Investment (ROI)

5. Stock Holding Period 10. Return on Capital Employed (ROCE)

Solution:
RATIO FORMULA JAMBO TRADERS UHURU TRADERS

1. Gross Profit GROSS PROFIT x 100 3,150,000 x 100 = 56.8% 4,200,000 x 100 = 56%
Margin
SALES 5,550,000 7,500,000

Comments; Jambo traders is more efficient than Uhuru traders because the higher the ratio the better. Measures th
ability of a business to control expenses associated with generating trading income.

2. Net Profit NET PROFIT (After Tax) x 100 1,000,000 x 100 =18% 1,500,000 x 100 = 20%
Margin
SALES 5,550,000 7,500,000

Comments; Uhuru traders is more efficient than Jambo traders because the higher the ratio the better. Measures th
ability of a business to control expenses associated with generating net income.
3. Expenses COST X 100 2,150,000 x 100 =38.7% 2,700,000 x 100 = 36%
ratio
SALES 5,550,000 7,500,000

Comments; Uhuru traders is more efficient than Jambo traders because the lower the ratio the better. A lower rati
shows how efficient a business is.

4. Stock COST OF SALES 2,400,000 = 3 Times 3,300,000= 4.4 Times

Turnover
STOCK (Average Stock) 800,000 750,000

Comment; Uhuru traders is more efficient than Jambo traders because the higher the ratio the better. The rati
shows how active the business is in restocking. The higher the ratio the better.

5. Stock 365 365 = 122 Days 365 = 83 Days

Holding
STOCK TURNOVER 3 4.4
Period

Comment; Uhuru traders is more efficient than Jambo traders because the lower the ratio the better hence showin
fewer days of holding stock for a business.

6. Current CURRENT ASSETS 2,100,000 = 2:1 1,825,000 = 1.8:1

ratio
CURRENT LIABILITIES 1,040,000 1,005,000

Comments; Jambo traders is more efficient than Uhuru traders because it has a ratio that meets the rule of thum
while that of Uhuru traders is below the rule of thumb.

7. Acid test CURRENT ASSETS – STOCK 2,100,000 – 600,000= 1.4:1 1,825,000–700,000= 1.1:
ratio
CURRENT LIABILITIES 1,040,000 1,005,000

Comments; Jambo traders is more efficient than Uhuru traders because it has a ratio that is even above the rule o
thumb.

8. Debt ratio TOTAL LIABILITIES 1,040,000 = 0.47 820,000 = 0.32

TOTAL ASSETS 2,200,000 2,525,000

Comments; Uhuru traders is more efficient than Jambo traders because it has lower which shows reduced financia
risk exposure of debt.

9. Return on NET PROFIT (After Tax) x 100 1,000,000 x 100 =45.5% 1,500,000 x 100 = 59.4%
Investment
TOTAL ASSETS 2,200,000 2,525,000
(ROI)
Comments; Uhuru traders is more efficient than Jambo traders. The higher the ratio the better because it shows th
proportion of profits attained to assets employed.

1Return on EBIT x 100 1,000,000 x 100 =86.2% 1,500,000 x 100 =98.7%

1Capital
CAPITAL EMPLOYED 1,160,000 1,520,000
Employed

Comments; Uhuru traders is more efficient than Jambo traders because the higher the ratio the higher th
profitability due to an adequate return on capital employed

ILUSTRATION II
Riziki limited is an expanding private company that is planning to review its trend for the
current and previous year so as to embark on new strategies.
Profit Statement for Year Ended 31st December
YEAR 2010 (Shs.) 2011 (Shs.)

Sales 2,000,000 3,200,000

Less:Cost of goods sold (1,100,000) (1,800,00)

Gross profit 900,000 1,400,000

LESS: Trading Expenses (450,000) (550,000)

Earnings Before Interest & Tax 450,000 850,000

Less:Debenture Interest (25,000) (25,000)

Earnings Before Tax 425,000 825,000

Less: Corporation Tax (160,000) (320,000)

Earning After Tax 265,000 505,000

Less: Ordinary Share Dividend (125,000) (175,000)

Undistributed Profit for the year 140,000 330,000

Balance Sheet As At 31st December

YEAR 2010 (Shs.) 2011 (Shs.)

Fixed Asset at cost 1,000,000 1,400,000

Less:Depreciation to date (200,000) 800,000 (250,000) 1,150,000

Current Assets
 Stock 400,000 550,000

Debtors 250,000 350,000

Bank 80,000 ----------

730,000 900,000

Less Current Liabilities

Creditors 145,000 200,000

Taxation 160,000 320,000

Proposed dividend 125,000 175,000

Bank Overdraft --------- 65,000

(430,000) (760,000)

1,100,000 1,290,000

FINANCED BY:

Authorized and Issued Share Capital 1,000,000 1,000,000

Ordinary Share Capital (50,000 share @ Sh. 10) 500,000 500,000

Undistributed Profit 350,000 680,000

10% Debentures 250,000 110,000

1,100,000 1,290,000

NOTE: Opening stock for year 2010 and 2011 is Shs. 120,000 and Shs. 190,000 respectively
Required:
[a] Calculate six accounting ratios for both 2010 and 2011 which would assess profitability and
liquidity of Riziki limited.
[b] Comment on the current position of Riziki limited with the aid of ratios and in comparison
to the two years.
Solution:

RATIO FORMULA 2010 2011

1. Return on EBIT x 100 450,000 x 100 =41% 850,000 x 100 =66%

Capital
CAPITAL EMPLOYED 1,100,000 1,290,000
Employed

(ROCE)
 Comments; There is an improvement in 2011 due to increase in the ratio showing higher profitability due to a
adequate return on capital employed

2. Gross Profit GROSS PROFIT x 100 900,000 x 100 = 45% 1,400,000 x 100 = 44%
Margin
SALES 2,000,000 3,200,000

Comments; There is a decline in 2011 due to decrease in the ratio showing lower ability of the business to contro
expenses associated with generating trading income.

3. Net Profit NET PROFIT (After Tax) x 100 265,000 x 100 =13.3% 505,000 x 100 = 15.8%
Margin
SALES 2,000,000 3,200,000

Comments; There is an improvement in 2011 due to increase in the ratio showing higher ability of the business t
control expenses associated with generating net income.

4. Total Asset SALES 2,000,000 = 0.765 Times 3,200,000 = 1.56 Times

Turnover
TOTAL ASSETS 1,530,000 2,050,000

Comments; There is an improvement in 2011 due to increase in the ratio showing more efficiency in generatin
revenues and profits using available resources.

5. Stock COST OF SALES 1,100,000 = 4.23 Times 1,800,000= 4.86 Times

Turnover
STOCK (Average Stock) 260,000 370,000

Comment; There is an improvement in 2011 due to increase in the ratio and the higher the ratio the better. The rati
shows how active the business is in restocking.

6. Stock 365 365 = 87 Days 365 = 75 Days

Holding
STOCK TURNOVER 4.23 4.86
Period

Comment; There is an improvement in 2011 due to decrease in the ratio (days) and the lower the ratio the bette
hence showing fewer days of holding stock for a business.

7. Current CURRENT ASSETS 730,000 = 1.7:1 900,000 = 1.2:1

ratio
CURRENT LIABILITIES 430,000 760,000

Comments; There is a decline in 2011 due to decrease in the ratio that goes far below the rule of thumb that is 2:1

8. Acid test CURRENT ASSETS – STOCK 730,000 – 400,000= 0.8:1 900,000–550,000= 0.5:1
ratio
CURRENT LIABILITIES 430,000 760,000

Comments; There is a decline in 2011 due to decrease in the ratio that goes even lower that of the rule of thum
(1:1)
9. Debt ratio TOTAL LIABILITIES 680,000 = 0.44 870,000 = 0.42

TOTAL ASSETS 1,530,000 2,050,000

Comments; There is an improvement in 2011 due to decrease in the ratio which shows reduced financial ris
exposure of debt.

10 Return on NET PROFIT (After Tax) x 100 265,000 x 100 =17.3% 505,000 x 100 = 24.6%
Investment
TOTAL ASSETS 1,530,000 2,050,000
(ROI)

Comments; There is an improvement in 2011 due to increase in the ratio and the higher the ratio the better it show
the proportion of profits attained to assets employed.
 Con’t…

RATIO FORMULA 2010 2011

11 Equity Ratio SHAREHOLDERS’ EQUITY (SHE) 850,000 = 0.56 1,180,000 = 0.58

TOTAL ASSETS 1,530,000 2,050,000

Comments; There is an improvement in 2011 due to increase in the ratio showing more stability in equity financing

12 Times EBIT 450,000 = 18 Times 850,000 = 34 Times

interest
INTEREST 25,000 25,000
coverage

Comments; There is an improvement in 2011 due to increase in the ratio showingno of times interest can be serve
before profit is exhausted

13 Return on EARNINGS AFTER TAX AND 265,000= 0.31 x 100 = 31% 505,000 = 0.00043 x 100
Shareholder PREFERENTIAL DIVIDEND
850,000 1,180,000 = 0.043%
s’ Equity
SHAREHOLDERS’ EQUITY
(ROSHE)

Comments; There is a decline in 2011 due to decrease in the ratio because The higher the ratio the higher th
profitability of the equity investment.

14 Return on EBIT x 100 450,000 x 100 = 29% 850,000 x 100 = 41%

total assets
TOTAL ASSETS 1,530,000 2,050,000
(ROTA)

Comments; There is an improvement in 2011 due to increase in the ratio showing more efficiency with which a
assets are used to generate profits

15 Earnings NET PROFIT DUE TO ORDINARY 265,000= Sh. 5.30/ Share 505,000=Sh. 10.10/ Shar
Per Share SHAREHOLDERS
50,000 50,000
(E.P.S)
NO OF SHARES

Comment; There is an improvement in 2011 due to increase in the ratio because the higher the ratio the higher th
profitability of each share.

16 Dividend TOTAL DIVIDEND (Ordinary) 125,000= Sh. 2.50/ Share 175,000=Sh. 3.50/ Share
Per Share
NO OF ORDINARY SHARES 50,000 50,000
(D.P.S)

Comment; There is an improvement in 2011 due to increase in the ratio because the higher the ratio the higher th
dividend of each share.
17 Dividend DPS x 100 2.50 = 0.47 3.50 = 0.34
Payout
EPS 5.30 10.10
Ratio

Comments; There is an improvement in 2011 due to decrease in the ratio because if the ratio is low then retentio
percentage is high.
ILLUSTRATION III
The following financial statements relates to ABC limited for the year ending 2006.
ABC Ltd
Profit and Loss Account for the year ended 31.12.2006
Sales 850,000

Less:Cost of sales

Opening stock 99,500

Purchases 559,500

Less Closing Stock (149,000) (510,000)

Gross profit 340,000

LESS: Expenses

Selling and distribution 30,000

Depreciation 10,000

Administration expenses 135,000 (175,000)

Earnings before interest & taxes 165,000

Interest (15,000)

Earnings before tax 150,000

Less: Corporation Tax (50%) (75,000)

Earning After Tax 75,000

Less: Ordinary Share Dividend (0.75 per share) (15,000)

Retained Profit for the year 60,000

Balance Sheet as at 31 December 2006

Fixed Assets Shs. Shs. Shs.

Land and Buildings 250,000

Plant & Machinery 80,000

330,000

Current Assets

Inventory 149,000
 Debtors 75,000

Less Provision for bad debts (4,000) 71,000

Cash 30,000

250,000

Less Current Liabilities

Creditors (130,00)

Working Capital 120,000

NET WORTH 450,000

FINANCED BY:

Issued share capital (20,000 share of Sh. 10) 200,000

Reserve 90,000

Retained profit 60,000

Long term Debt 100,000

450,000

Additional Note
*Cash purchases amount to 14,250. *Assume Market Price for the ABC’S shares is
Sh20/Share.
Required;
Calculate the following ratios:

LIQUIDITY RATIOS GEARING RATIOS

1. Current Ratio 1. Debt Ratio
2. Quick Ratio/ Acid Test Ratio 2. Debt Equity Ratio
3. Cash Ratio 3. Long Term Debt Ratio
4. Net Working Capital Ratio.
ACTIVITY RATIOS PROFITABILITY RATIOS
1. Stock Turnover Gross Profit Margin
2. Debtors Turnover Net Profit Margin
3. Average Collection Period Return on Investment
4. Creditors Turnover Return on Capital Employed
5. Non Current Assets Turnover
6. Total Assets Turnover
EQUITY RATIOS
1. Earnings Per Share (EPS)
2. Earnings Yield
3. Dividend Per Share
 Solution:
RATIO FORMULA SOLUTION COMMENT

LIQUDITY RATIOS

1. Current Current Assets 250,000 = 1.92 : 1 The higher the ratio then the
Ratio more liquid the firm is.
Current Liabilities 130,000

2. Quick Ratio/ Current Assets - Inventories 250,000 – 149,000 = 0.78 The higher the ratio, the better
Acid Test :1 for the firm as it means an
Ratio Current Liabilities improved liquidity position.
130,000

3. Cash Ratio Cash + Marketable Securities 30,000 = 0.23 : 1 The higher the ratio, the bette
for the firm as the Liquidit
Current Liabilities 130,000 position is improved.

4. Net Working Net Working Capital 120,000 = 0.27 : 1 The higher the ratio the better
Capital for the firm and therefore the
Ratio. (CA -CL) 450,000 improved Liquidity position.
Net Assets (Net Worth)

GEARING RATIOS

5. Debt Ratio Total Liabilities 230,000 = 0.4 The higher the ratio, the higher
the financial risk. (Measures
Total Assets 580,000 proportion of total assets
financed by non owner supplie
funds)

6. Debt Equity Total Liabilities 230,000 = 0.66 The higher the ratio, then the
Ratio higher the financial risk.
Net Worth (share holders 350,000 (Measures financing by the
funds) non-owner supplied funds in
relation to the amount financed
by the owners)

7. Long Term Non Current Liabilities 100,000 = 0.2 The higher the ratio, then the
Debt Ratio higher the financial risk.
Net Assets 450,000 (Measures proportion of total
 net assets financed by the non-
owner supplied funds.)

ACTIVITY RATIOS

8. Stock Cost of Sales 510,000 = 4.1 Times The higher the ratio the more
Turnover active the firm is.( Number of
Average Stocks 124,250 times stock has been converted
to sales in a financial year)

9. Debtors Credit Sales 850,000 = 11.97 The higher the ratio, the more
Turnover active the firm has been
Debtors 71,000 (Business had debtors over 11
times to generate the sales)

10. Average 360 360 = 31 days The lesser the period, the better
Collection for the firm as it improves the
Debtors Turnover 11.97 liquidity position.
Period

(Measure the number of days

takes for debtors to pay up)

11. Creditors Credit Purchases 545,250 = 4.2 Times The lesser the ratio the better.
Turnover
Creditors 130,000 (Measure no. of times we hav
creditors during a financia
period)

12. Non Current Sales 850,000 = 2.54 Times The higher the ratio the mor
Assets active the firm. (Measures th
Non Current Assets 330,000 efficiency with which the firm
Turnover
using its Non Current Assets t
generate sales)

13. Total Assets Sales 850,000 = 1.47 Times Measures the efficiency with
Turnover which the firm is using its total
Total Assets 580,000 assets to generate sales.

PROFITABILITY RATIOS

14. Gross Profit Gross Profit x 100 165,000 x 100 = 19% The higher the margin, the mor
Margin profitable the firm is.
Sales 850,000

15. Net Profit Net Profit (After Tax)x 100 75,000 x 100 = 9% The higher the margin, the mor
Margin profitable the firm is.
Sales 850,000
16. Return on Net Profit (After Tax) x 100 75,000 x 100 = 13% The higher the ratio the more
Investment efficient is the firm. Shows how
Total Assets 580,000 efficient the firm has been in
using the total assets to generat
returns in the business.

17. Return on EBIT x 100 165,000 = 37% The higher the ratio the more
Capital efficient is the firm. Measures
Employed Capital Employed 450,000 how efficient the firm has been
in using the net assets to
generate returns in the business

EQUITY RATIOS

18. Earnings Per Net Profit due to Ordinary 75,000 = Sh. 3.75/ Share This is the return expected by
Share (Eps) Shareholders an investor for every share held
20,000 in the firm.
No. of Shares

19. Earnings Earnings Per Share x 100 3.75  100% = 19% The higher the amounts, th
Yield better for the firm. (Retur
Market price per share 20 amount expected by
shareholder for every shillin
invested in the business)

20. Dividend Per Total Dividend (Ordinary) 15,000 = Sh. 0.75/ Share The higher the amounts, th
Share better for the firm. (Amoun
No Of Ordinary Shares 20,000 expected by an investor fo
every share held in the firm)
ILLUSTRATION IV
Raha Ltd is a new entrant in the market. It’s reviewing the financial statements of two
companies, Hyper Ltd and Super Ltd to ascertain its position. All the companies trade in
supplying house hold goods. Their most recent financial statements appear below.

PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31 MARCH 20X8
HYPER LTD SUPER LTD

Shs. Shs. Shs. Shs.

Sales 4,000,000 6,000,000

Less:Cost of goods sold

Opening stock 200,000 800,000

Add: Purchases 3,200,000 4,800,000

Less: Closing stock (400,000) (800,000)

(3,000,000) (4,800,000)

Gross profit 1,000,000 1,200,000

LESS: Expenses

Distribution Cost 200,000 150,000

Administrative Expenses 290,000 (490,000) 250,000 (400,000)

Earnings before interest and tax 510,000 800,000

Interest Paid (10,000) (400,000)

Earning before tax 500,000 400,000

Taxation (120,000) (90,000)

Net profit 380,000 310,000

Balance Sheets As At 31 March 20x8

Fixed Asset at cost HYPER LTD SUPER LTD

Warehouse and office buildings 1,200,000 5,000,000

Equipment and vehicles 600,000 1,800,000 1,000,000 6,000,000

Current Assets
 Stock 400,000 800,000

Debtors 800,000 900,000

Prepaid Expenses 150,000 80,000

Bank --------- 100,000

1,350,000 1,880,000

Less Current Liabilities

Creditors 800,000 800,000

Accruals 80,000 100,000

Bank Overdraft 200,000 ----------

Taxation 120,000 (1,200,000) 90,000 (990,000)

Net Worth 1,950,000 6,890,000

FINANCED BY:

Share Capital 1,000,000 1,600,000

Revaluation reserve ----------- 500,000

Undistributed Profit (Profit & Loss A/c) 950,000 790,000

10% Long term loan ---------- 4,000,000

1,950,000 6,890,000

Required:
a) Measure profitability, liquidity, gearing and management of the elements of working
capital by use of THREE ratios for each category for both Hyper and Super ltd. Show
all workings. (12 marks)

b) Compare the two companies with regards to the calculated ratios. (8 marks)

SOLUTION a)
Profitability Ratios HYPER LTD SUPER LTD

1. Gross Profit Gross Profit x 100 1,000,000 100% = 25% 1,200,000 100% = 20%
Margin
Sales 4,000,000 6,000,000

2. Net Profit Net Profit (After Tax) x 100 500,000 100% = 12.5% 400,000 100% = 6.7%
Margin
Sales 4,000,000 6,000,000
3. Return on EBIT x 100 510,000 = 26.2% 800,000 = 11.6%
Capital
Employed Capital Employed 1,950,000 6,890,000

4. Return on Net Profit (After Tax) x 100 380,000 x 100 = 12.1% 310,000 x 100 = 3.9%
Investment
Total Assets 3,150,000 7,880,000

5. Return on Earnings After Tax and 380,000 x 100 = 19.5% 310,000 x 100 = 10.7%
Shareholder Preferential Dividend
’s Equity 1,950,000 2,890,000
(ROSHE) Shareholders’ Equity

6. Return on EBIT x 100 510,000x 100 = 16.2% 800,000x 100 = 10.2%

total assets
(ROTA) TOTAL ASSETS 3,150,000 7,880,000

Liquidity Ratios HYPER LTD SUPER LTD

1. Current Current Assets 1,350,000 = 1.1:1 1,880,000 = 1.9:1

Ratio
Current Liabilities 1,200,00 990,000

2. Quick Ratio/ Current Assets - Inventories 1,350,000 – 400,000 = 1,880,000 – 800,000 = 1.1:1
Acid Test 0.8:1
Ratio Current Liabilities 990,000
1,200,000

3. Net Working Net Working Capital 150,000 = 0.08: 1 890,000 = 0.13: 1

Capital
Ratio. (CA -CL) 1,950,000 6,890,000

Net Assets (Net Worth)

Gearing Ratios HYPER LTD SUPER LTD

1. Debt Ratio Total Liabilities 1,200,000 = 0.38 4,990,000 = 0.63

Total Assets 3,150,000 7,880,000

2. Debt Equity Total Liabilities 1,200,000 = 0.62 4,990,000 = 1.73

Ratio
Share holders funds 1,950,000 2,890,000
3. Long Term Non Current Liabilities --------------- 4,000,000= 0.58
Debt Ratio
Net Assets 6,890,000

ACTIVITY RATIO HYPER LTD SUPER LTD

1. Stock Holding 365 365= 37 Days 365 = 61 Days

Period
Stocks Turnover 10 6

Stocks Turnover = Cost of Sales 3,000,000 = 10 4,800,000 = 6

Stock 300,000 800,000

2. Debtors Days 365 365 = 73 Days 365 = 55 Days

(Debtors
Collection Debtors Turnover 5 6.7
Period) Debtors Turnover = Credit Sales 4,000,000 = 5 6,000,000 = 6.7

Debtors 800,000 900,000

3. Creditors Days 365 365 = 92 Days 365 = 61 Days

(Average
Collection Creditors Turnover 4 6
Period) Creditors Turnover = Credit Purchases 3,200,000 = 4 4,800,000 = 6

Creditors 800,000 800,000

b)
Profitability
 Hyper has a higher gross margin than Super. This may indicate a differing pricing
policy.
 Super’s net margin is lower than Hyper’s. Super’s expenses are therefore proportionally
higher. It should be noted that Super’s bottom line profit is reduced significantly by the
interest charge.
 Return on Super’s capital is around half of Hyper’s. Super has a higher fixed asset base
due in part to a revaluation. It may be that a revaluation of Hyper’s assets will partially
close the gap.
Liquidity
 Super has nearly twice as many current assets as current liabilities. Although both
companies’ quick ratios are much closer, Hyper’s liquidity does appear to be an issue
especially as there is no cash at hand. It would be wise to examine projected cashflows
to see how readily Hyper’s profits will improve this situation.
Working capital management
 Hyper is turning stock over more quickly than Super. This is beneficial in a market
which can be subject to obsolescence.
  Hyper’s creditor and debtor days are a cause for concern. Debtors should be collected
within the shortest time possible hence Super ltd collects its debts faster than Hyper.
 Creditors should be paid at least as quickly as Super pays theirs. Hyper risks damaging
the goodwill it has with its suppliers.
Gearing
 Super is highly geared whereas Hyper has no long-term loans. Super’s gearing means
that should profits fall they may not be in a position to pay the loan interest. Hyper’s
capital is entirely share capital and so a fixed return is not required.
 Super’s loan appears to be fixed rate. This means that in times of falling interest rates
Super will have higher interest costs than say, Hyper, if Hyper borrowed the same
amount. The converse is true in times of rising interest rates.
 As Hyper has no long-term loans they may be able to borrow in order to improve
liquidity.