Section I | Part I

TOPIC 6: FINANCIAL
STATEMENT ANALYSIS
Section I | Part I

Financial Statement Analysis

• Financial Statement Analysis is the process of
identifying the financial strengths and weaknesses
of the firm/business.
• This is by properly establishing relationships
between the items of the balance sheet/SOFP and
the profit and loss account/Income statement.
Section I | Part I

Users of Financial Statement Analysis

Trade creditors:
• They are interested in a firms ability to meet their
claims over a very short period of time.
• Their analysis is therefore confined to evaluation of
firms liquidity position.
Suppliers of long-term debt:
• They analyze the firms profitability over time, its
ability to generate cash to be able to pay interest
and repay principal.
Section I | Part I

Users of Financial Statement Analysis

Investors:
• They are concerned about the firms earnings.
• They are also interested in the firms financial structure
and the extent that it influences the firm’s earnings
ability.
Management:
• They are interested in every aspect of the firm
because it is their responsibility to see that the
resources of the firm are used most efficiently and
effectively.
 Section I | Part I

Methods of FSA
• There are two key methods for analyzing financial
statements:
Use of horizontal and vertical analysis.
Use of many kinds of ratios.
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Horizontal and vertical analysis

• Horizontal analysis is the comparison of financial
information over a series of reporting periods.
• Vertical analysis is the proportional analysis of a
financial statement, where each line item on a
financial statement is listed as a percentage of
another item.
Section I | Part I

Horizontal and vertical analysis

• Vertical analysis means that every line item on an
income statement is stated as a percentage of gross
sales, while every line item on a balance sheet is
stated as a percentage of total assets.
• Thus, horizontal analysis is the review of the results
of multiple time periods, while vertical analysis is
the review of the proportion of accounts to each
other within a single period.
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Ratio analysis
• Ratios are used to calculate the relative size of one
number in relation to another.
• After a ratio is calculated, you can then compare it
to the same ratio calculated for a prior period, on
an industry average, on competitors ratios or
projected ratios to see if the company is performing
in accordance with expectations.
Section I | Part I

Categories of Ratios

There are five main categories of ratios:

1. Liquidity
2. Leverage/ Gearing
3. Activity/ Turnover
4. Profitability
5. Equity/ Valuation
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LIQUIDITY RATIOS
• These ratios measure the ability of a firm to meet
its current obligations.
• A firm that fails to meet its obligations due to lack
of sufficient liquidity will result in a poor credit
worthiness and lack of confidence from creditors.
• A very high degree of liquidity is also bad since idle
assets earn nothing.
 Section I | Part I

LIQUIDITY RATIOS

i) Current Ratio = Current assets (CA)

Current liabilities (CL)
• It measures the firm’s ability to meet current obligations given
a level of current assets. A current ratio of 2 to 1 is satisfactory.
This is because even if the value of current assets become half
the firm will still be able to meet its obligation. A ratio below
2:1 is insufficiently liquid.
ii) Acid Test (Quick) Ratio = CA – Stock
CL
• It is a more refined measure of liquidity because it excludes
stock which may not be easily converted to cash in the short
period. A quick ratio of 1 to 1 is satisfactory.
Section I | Part I

LIQUIDITY RATIOS
Cash Ratio =Cash + Marketable Securities
iii)

Current Liabilities
This is a highly refined measure of liquidity because
even debtors are excluded.
For all these ratios, the higher the ratio, the more
liquid the company is and therefore the lower the
financial risk.
Note of caution: Liquidity ratios can mislead since
current assets and liabilities can change quickly
especially for seasonal businesses.
Section I | Part I

ACTIVITY RATIOS (Turnover

Ratios)
• Activity ratios are employed to evaluate the
efficiency with which the firm manages and utilizes
its assets.
• They are also called turnover ratios because they
indicate the speed with which assets are being
converted into sales.
• These ratios answer this question: Does the
amount of each type of asset seem reasonable, too
high, or too low in view of current and projected
sales?
Section I | Part I

Activity or Turnover Ratios

i) Inventory (Stock) Turnover = Cost of Sales
Average Inventory (OI+CI/2)
• It measures the efficiency with which a company uses stock to generate
sales. The higher the ratio, the active the firm is. (labelled in terms of
times)
ii) Inventory Conversion Period = No. of days in the year
Inventory Turnover
• This indicates the number of days it takes to convert inventory to sales.

NB: OI = Opening inventory, CI = Closing inventory

Section I | Part I

Activity or Turnover Ratios

iii) Debtors Turnover =. Credit Sales____________
Average Debtors (O.D + C.D)
2
• This indicates the number of times debtors paid within the year. It may
also indicate how efficient the firm is in the management of credit.

iv) Average Collection Period = No. of days in the year

Debtors Turnover
• This indicates the number of days on average that debtors take to pay
their dues.
Section I | Part I

Activity or Turnover Ratios

v) Creditors Turnover = Credit Purchases
Average Creditors (O.C + C.C)
2
• This indicates the number of times creditors are paid during the year.

vi) Payables Deferral Period = No. of days in the year

Creditors Turnover
• This indicates the number of days on average the firm takes to pay its
creditors.
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Asset Turnover Ratios

They indicate the relationship between sales and assets.

i) Total Asset Turnover Ratio = Sales _

Total Assets
• These ratio indicates how efficiently the company uses assets to
generate sale i.e. how much volume of business does the firm generate
for its size of assets.
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Leverage ratios/ Gearing Ratio

• These ratios indicate mix of funds provided by
owners and lenders. They analyze the long term
solvency of the firm.
• The manner in which assets are financed has some
implication:
1. Debt is more risky than equity. A firm has a legal
responsibility to pay interest.
2. Use of debt is advantageous for the company since the
shareholders retain control.
3. A highly debt burdened firm will find difficulty in
raising funds from creditors and owners.
 Section I | Part I

Leverage ratios/ Gearing Ratios

i) Debt Ratio = Total Debt
Capital employed/Net assets
This measures the extent to which the firms assets have been financed by non-
owner supplied funds
• Capital employed includes: long term debt and net worth.
• Capital employed equals net assets that consist of net fixed assets plus net
current assets.
• Total debt will include short and long-term borrowings from financial
institutions, debentures, bank borrowing and any other interest bearing loan.
• A debt ratio of for example 0.646 means that lenders have financed 64.6
percent net assets and the owners have provided the remainder 35.4 per cent.
Section I | Part I

Leverage ratios
ii) Debt Equity Ratio = Long term Debt
Equity (Net worth)/Owner supplied funds

• This shows the lenders contribution for each shilling of

owners contribution.
• For all the above ratios the higher the ratio the higher the
gearing position and therefore the higher the financial risk.
Section I | Part I

PROFITABILITY RATIOS
Section I | Part I
Profitability Ratios
In Relation to sales
i) Gross Profit Margin = Gross Profit = 1M
Sales 3M
• This ratio reflects the efficiency with which management produces each unit of a
product.
• This measures the firms ability to control production expenses. A high gross profit
margin ratio relative to the industry implies that the firm is able to produce at
relatively lower cost and is a sign of good management.

(ii) Net Profit Margin = Net Profit after Tax

Sales
• It measures firms ability to control production, operating and financing decisions.
• Net profits is obtained when operating expenses, interest and taxes are subtracted
from the gross profit
 Section I | Part I
Profitability in Relation to
Investments
i) Return on Investment (ROI)/Return on Assets (ROA)
= Net profit after tax Total Investment/Assets
• It measures firm’s ability to generate a return to owners using total funds.

ii) ) Return on Equity/Net Worth (ROE)

= Earning attributable to equity holders
Equity/Net worth

• Measures the efficiency with which a company uses owner supplied funds to
generate returns to equity holders.
• Earning attributable to equity holders = Net profit after tax – Preference Dividends.
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VALUATION RATIOS
Section I | Part I

Equity or Valuation Ratios

i) Earnings Per Share (EPS)

= Earning attributable to equity holders. 85,000 (25,000 RETAINED
No. of common shares outstanding 1500

• This indicates the amount that a shareholder expects to earn for every
share held.
ii) Dividends Per Share (DPS)
= Earnings paid to shareholders(divideds)
No. of Common Shares Outstanding
• This indicates the amount shareholders would receive from the
company in form of dividends for every share held.
Section I | Part I

Equity or Valuation Ratios continued…

iii) Price Earnings Ratio (P/E Ratio)
= Market price per share
Earning Per Share
• This ratio is very important because it can be used to measure the
relative risk of the firm. Firms in the same risk class will have the same
P/E ratio.
• It is assumed that the P/E ratio of a firm remains constant over time.
• The price-earnings ratio is widely used by the security analysts to value
the firm’s performance as expected by investors.
• It indicates investors’ judgement or expectations about the firm’s
performance. Management is also interested in this market appraisal
of the firm’s performance and will like to find the causes if the P/E ratio
declines.
Section I | Part I

Significance of ratio analysis

Measures:
1. Firms ability to meet its short term monitoring obligations
2. The extent to which a firm is financed by non-owners supplied
funds
3. The efficiency with which a firm uses its resources to generate
sales, revenue and profit
4. Firms ability to control operating, production and financing
decisions
5. Firms overall performance
6. Firms performance over time
7. Firms performance in comparison to other firms in same industry
 Section I | Part I

Limitations of ratio analysis

• Ratios are computed using historical data and therefore may not be accurate
indication of the future.
• Ratios are computed at a specific time therefore suffer from short-term
changes e.g. as in purchasing power – this makes trend analysis difficult.
• Differences in accounting policies e.g. stock valuation method used may make
inter-firm analysis difficult.
• It is impossible to carry out an industrial analysis where only one firm
comprises the industry.
• It is difficult to categorise firms into industry classes due to diversification i.e.
some companies operate across industries – this makes cross-sectional
difficult.
• Ratios cannot be computed for non-quantifiable factors of the firm e.g. level
of management skills, type of the firm.
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