FINANCIAL STATEMENT ANALYSIS:

18.1 Introduction

Financial statement analysis is one of the most functional

management activities in an organization. Like every other
function such as marketing , production and personnel analysis, it
is used to establish a relationship between the organization’s
objectives and costs, benefit, profits, losses and the variables that
influence their performances . Financial statement analysis is
fundamentally different from other management functional
analysis because it uses the actual financial data generated from
the business and incorporates a wide range of techniques to
determine the trend of performance among sister companies,
sectors , industries or countries .

The purpose of financial statement analysis :

Financial statement analysis is required for various purposes

in an organization by various users . Basically it is used for
comparisons in order to guide decision makers in reaching
quality and an informed decisions relating to the company’s
future engagements that could positively enhance corporate
performance such as:
 Company’s ability to meet recurrent obligations
 To measure the extent at which the firm has used its debt
resources for business operations
  To measure how efficiently the company is utilizing its various
asset in generating sales revenue
 To assess the overall company efficiency and stability.
Scope of financial statement analysis

There are different scopes or coverage of company’s financial

statement analysis namely ;

1. Trend analysis : –Periodic analysis such as past and present

years’ quarterly , weekly or daily analysis .
2. Cross-sectional sectional analysis : Compares sister
companies’ performances and efficiency as well as different
industrial sectors in the same country .
3. Cross –Border analysis : compares different countries
using same macroeconomic variables over time .
4. Companywide analysis : Comparing sister companies in the
same industries .

USERS OF FINANCIAL STATEMENT S: The results of companies

financial statement analysis are useful to following groups of
people :

 The shareholder
 Management,
 Economists and Analysts
 Bankers and fund providers
 Employers
 Consultants
  Creditors
 Various governments.

A summary of the contents of a published annual financial reports

of an organization :

1. The statement of financial statement

2. Statement of comprehensive income
3. Statement of changes in equity position
4. The cash flow statement
5. Value added statement
6. Notes to accounts
7. Auditors’ Reports
8. Chairman’s statements
9. 9Five year financial Summary

Financial Analysis Tools.

The analysis of financial statement information can be done

through many techniques. Although we may not delve into the
discussion of these techniques and tools, the key ones include ratio
analysis and Break-Even Point analysis.

The Ratio analysis tools / techniques are used to analyze and

interpret financial statement data and information for effective and
efficient decision making. It uses the data and information
extracted from the statement of comprehensive income and
financial position or balance sheet and cash flow statements)
respectively to analyze and interpret accounting information to
arrive at meaningful company decisions.

Some of the analysis tools include:

The analysis of financial (accounting) information through the use

of ratio analysis could be done through the following ratios:

(i) Profitability Ratio

Profitability ratio measures how efficient the firm has been in

posting high returns on total assets, capital and the rate of
turnover. The issue of profitability is critical to the firm because its
continued existence, expansion and growth are dependent on it.
Investors rely on these ratio for evaluation of the ability of the
company to offer expected return on investment over the investment
period. Among these ratios are : Return on Assets, Gross profit
Margin ratio , Net profit Margin ratio and return on capital
employed or shareholders ‘ funds etc

(ii) Activity Ratio

The activity ratio measures to what extent the firm is able to utilize
its long – term (fixed) assets to generate sales. It also determines
the frequency or regulatory at which the firm is able to turnover its
short-term (current) assets. Specifically, it tries to measure how
often the firm disposes its stock and collects its debts (accounts
receivable).

(iii) Leverage Ratio.

This ratio also called debt utilization ratio measures the extent of
combination of debt and equity finance in the running of the
business.

(iv) Liquidity Ratio.

Liquidity ratio tries to measure the ability of the firm to settle short
– term crystallizing obligations as they fall due. Is the firm liquid?
How liquid is the liquid.

CASH FLOW ANALYSIS : This statement is used to guide investors

who want to put their money into the business . Such investor
would want to know how the funds used by firm is being generated
and the cash flow statement provides details of sources of funds
and how they are used to generate income for the business.

The key elements in cash-flow statements are:

 Cash flow from operation: This section of the statement

discloses how much cash was generated from the firms normal
business activities like sales minus operating costs
 Changes in working capital has information about the usage
of current assets and liabilities of the business including cash
and cash equivalents used in generating more income.
  Changes in fixed assets and investment will reveal how
much fixed assets were acquired and sold for cash within the
period
 Cash-flow from financing activities will show us how much
loans were repaid or received with interest during the
operating period .
The total of the cash flow statement will indicate how the
company is generating or consuming cash

Limitations of ratios:

The use of ratio analysis to evaluate company performance however

is limited to by the following factors:

1. Confidentiality of some company information not made

available to outsiders
2. Companies have different accounting conventions
3. Different accounting policies that will make comparison
difficult
4. Accounting information are mostly historical nature so ratio
values are somehow outdated .
5. Most companies window dress their records to paint
positive picture about the company performance so such
accounting information may not be reliable or valid.
6. Interpreting ratio values may not be easy for some unskilled
managers
8.4 Calculation of Ratios.

Ratios may be analyzed through the use of data contained in a

financial. Let us present complete financials with accompanying
formula for the computation of ratios as shown below:

Jay -Jay Nig ltd Statement of Comprehensive Income for the year
ended 31 Dec.2009.

2009 2008 2007

N’000 N’000 N’000

Revenues: Net sales 2,101,222 2,090,115 2,041,050

Franchise 45,000 29,000 18,000

Total Revenues 2,146,222 2,119,115 2,059,050

Costs and Expenses:

Cost of sales 1,090,500 1,060,400 1,050,200

Selling Expenses 800,200 600,000 400,200

Expenses: 1,890,700 1,660,400 1,450,400

Operating Profit 255,522 458,715 608,650

Less Interest expenses:

Loan interest. (60,000) (55,000) (48,000)

Miscellaneous (45,000) ( 28,000) (29,000)

Total deductions 105,000 83,000 77,000

Income before Tax 150,522 375,715 531,650

Taxation ( 75,261 (187,757) (265,8225)

Net Income 75,261 187,958 265,825

Jay-Jay Nig. Ltd. Statement of financial Position as at 31stDec.

2009

Assets 2009 2008

(N) (N)

Current Assets 30,000 25,000

Cash 70,000 73,230

Notes receivable 160,000 158,000

Inventories 260,000 223,000

Total current Assets 260,000 223,000

Plant and Machinery 80,000 69,000

Fixtures and Fittings 68,000 58,000

Total Assets 408,000 383,230

2009 2008

Liabilities and Shareholders’ equity.

Current liabilities

Accounts payable 1,500

Accounts payable 2,000 1,080

Notes payable 1,800 1,080

Total taxes (including excess) 123,400 120,000

Dividends payable 800 650

Total Current Liabilities 128,000 123,230

Long – term liabilities 80,000 75,000

Total Shareholders’ equity 200,000 185,000

Total liabilities and

Shareholders’ equity 408,000 383,230

The calculation financial ratios for JayJay Nig Ltd for 2009 and
2008 is illustrated as follows :

Profitability and Investment Ratios: Generally the ratios

under this are used to assess company’s efficiency in terms of sales
and in terms usage of assets. Investors rely on these ratio for
evaluation of the ability of the company to offer expected return on
investment over the investment period. Among these ratios are :
Return on Assets, Gross profit Margin ratio , Net profit Margin ratio
and return on share holders’ funds etc

(i) Gross / operating margin : This ratio measures the

efficiency of the firm in generating income before incurring
general expenses.
= Gross Profit x 100
Sales 1

YR 2009 ==255,522/2,101,222*100/1= 12.16%

YR 2008 ==458715/2,090,115*100/1= 21.9%

(ii) Net profit margin: The ratio the relative performance

of the firm in terms of general expenses
= Net Income x 100
Sales 1
YR 2009 =75,261/2,101,222*100/1= 3.58%
Yr. 2008 =187,958/2,090,115*100/1= 9%

(iii) Return on Assets: (ROA): This measures the ability

of the company’s assets to generate profits of the firm. IeIt
shows how profitable the firm’s assets are.
= Net Income x 100
Shareholders’ Equity 1
 YR. 2009 = 75,261/408,000*100/1= 18.4 %
YR .2008 =187,958/383,230*100/1= 49%

(v) Earnings per share: This is the amount income

attributed to each unit of shares held by shareholders of
the firm.
= Net Income - Preference Dividend
Number of Shares outstanding
YR.2009 = 75,261-800/200,000 shares= 37k per share
YR . 2008= 187,958-650/185000shares= #1.05 per share

(vi) Dividend per share : The ratio measure the amount

of distributable profit paid for every unit of ordinary shares
held for the period.
= Earnings after tax
Number of shares outstanding

YR. 2009= 75261 /200,000 =37k per share

YR. 2008 = 187,958/185000= #1.01per share

iii Price/ Earnings ratio: This ratio captures the number of times it
will take the firm to recover the current market value of the firm . It
also indicates the public perception by the public of the future
prospects of the company.

P/E ratio = Market price per / Earnings per share = y*

 (b) Activity Ratios: This ratio is used to assess frequency or
velocity of business activities of the organization in terms of
conversion of stocks to sales revenue

(i) Inventory Turnover: This ratio indicates the rate or the number
of times per period at which stocks are turned over or replenished
through sales

= Cost of sales

Average stock

Where average stock= opening stock +closing stock/2

YR.2009 =2,101,222/160,000 =13Times

YR. 2008 = 2,090,115/158,000 =13Times

(ii) Debtors Turnover: This ratio shows the rate at which debtors
paying up their bills.

= Credit Sales x Number of days in the unit

Average Debtors 1

YR. 2009= 2101,222/70,000=

YR. 2008 = 2090,115/73,000=

Note: In absence of credit sales, opening and closing debtors

we adopt the formula. Total Sales
 Debtors/Receivables

(iii) Average collection period: The number of days the company

takes to receive cash from the debtor resulting from credit
sates . The shorter the debtors collection period the better for
the firm.

= Debtors (receivable) x 365 days

Sales

YR. 2009 = 70000/2101,222*365 = 12 Days

YR .2008 = 73230/2,090,115*365= 12.7 days

(iv) Creditors payment period : This measures the number of days

it takes the company to pay back its creditors resulting from credit
purchases. The longer the days the better for the company.

creditors/Credit purchases=365/1 =Days

(i) Total Assets Turnover

= Sales
Total Assets
= X

(c) Leverage / Debt Utilization Ratio/Gearing ratio

(i) Debt / Equity Ratio

 = Long – term Liabilities

Net Assets or Shareholders fund

80,000/200,000 = 40

75,000/383,230 = 19.5

(i) Debt ratio:

= Total Debt (current liability+ (long – term liabilities)
Total Assets
2009= 208000/408000= 0.51:1
2008= 198,230/383,230= 0.51:1
(ii) Proprietary Ratio: The ratio show how much the company is
exposed to overall company’s liabilities. The higher this ratio
the better for company’s shareholders.
= Shareholders’ Funds
Total Tangible Assets
2009 =200,000/408,000= 0.49 1
2008 = 185,000/383230 =0.482: 1

i. Fixed Interest Coverage Ratio: The ratio indicates the number

of times the fixed interest expense is paid out of the operating
income in order to meet up with the external financial
obligations. A ratio of 2 or 3 is good
= Net Income before interest and taxes
Fixed Charge
 2009 = 150522/60,000 = 2.5times
2008 = 375,715/55,000 =6.8 times

(d) Liquidity Ratios : The ratios are used to evaluate the

ability of the firm to meet its short financial obligations . It tests
the how liquid a company is terms of meeting recurrent business
expenses . A ratio of 2 :1 is good for current ratio, 1:1 for acid ratio
is also good and a working capital ratio of 2: 1 is a good sign of
liquidity

(i) Current ratio

= Current Assets

Current Liabilities

2009 = 260000/128000= 2.03:1

2008 = 223000/123230= 1.8:1

(ii) Acid – Test or Quick Ratio

Current Assets – Inventory

Current Liabilities

2009 = 260000,-160000/128000=0.78:1

2008 = 223000-158000/123230 = 0.53:1

Working capital ratio : shows the relationship between the
companies working capital and total assets .

Working capital ratio = working capital/Total Assets .

Where :

Working Capital = Total current assets – Total current liabilities

Total Assets = Stocks, cash in hand , cash at bank , accounts

receivables , accrued income and prepaid expenses etc

Current liabilities = Bank over drafts short term loans, accrued

expenses prepaid income , creditors/bills payables etc