FINANCIAL STATEMENT ANALYSIS

Chapter Two

1
Introduction

 What is Financial statement?

 What are the basic F/statements prepared
for the purpose of internal and external
reporting?
 Explain their use

2
 MEANING, SIGNIFICANCE AND OBJECTIVES
OF FINANCIAL ANALYSIS
 Financial analysis refers to analysis of financial
statements and it is a process of evaluating the
relationships among component parts of financial
statements.
 The focus of financial analysis is on key figure in the
financial statements and the significant relationships that
exist between them.

3
 The analysis of financial statements is designed to
reveal the relative strengths and weakness of a firm.
 Financial analysis helps users obtain a better
understanding of the firm’s financial conditions and
performance.
 It also helps users understand the numbers presented in
the financial statements and serve as a basis for
financial decisions.

4
Types of Financial Analysis

 Financial statement analysis may be classified into two

major types:

A. External analysis and

B. Internal analysis.

5
 A. External analysis:

 Outsiders of the business concern such as investors, creditors,

government organizations and other credit agencies do normally
external analyses.
 External analysis is very much useful to understand the financial
and operational position of the business concern.
 External analysis mainly depends on the published financial
statement of the concern.
 This analysis provides only limited information about the business
concern.
6
 B. Internal Analysis
 The company itself discloses some of the valuable
information in this type of analysis.
 used to understand the operational performances of

each and every department and unit of the business

concern.
 helps to take decisions regarding achieving the goals of

the business concern

 have access to financial data of the company.

7
TECHNIQUES OF FINANCIAL STATEMENT
ANALYSIS

1. Comparative Statement Analysis

2. Trend Analysis ( horizontal analysis)
3. Common Size Analysis ( vertical analysis)
4. Fund Flow & Cash Flow Statement analysis
5. Ratio Analysis

8
 Con…
2. Trend Analysis (Horizontal Analysis)
• It is used to evaluate the trend in the accounts over the

accounting periods.
• It is usually shown on a comparative financial statement.
• In a horizontal analysis it is essential to show both the

amount of the change and the percentage of the change

because either one alone might be misleading.
• The calculation of trend percentages involves the calculation of
percentage relationship that each item bears to the same item in
the base year.

9
Horizontal Analysis of Balance Sheet
      Increase (Decrease)
      during 2012
Assets 2012 2011
Amount Percent

Current assets Br. 1,528.6 Br. 1,428.8 Br. 99.8 7.0%

Plant assets (net) 2,932.9 2,784.8 148.1 5.3

Other assets 588.5 201.0 387.5 192.8

Total assets Br. 5,050.0 Br. 4,414.6 Br. 635.4 14.4%

Liabilities stock holder’s equity

Current Liability Br. 2,199.0 Br. 1,265.4 Br. 933.6 73.8%

Long-term Liabilities 1,568.6 1,558.3 10.3 0.7

Total Liabilities 3,767.6 2,823.7 943.9 33.4

Stockholders’ equity

Common stock 201.8 183.0 18.8 10.3

Retained earnings & other 3,984.0 3,769.1 214.9 5.7

Treasury stock (cost) (2,903.4) (2,361.2) 542.2 23.0

Total stockholders’ equity 1,282.4 1,590.9 (308.5) (19.4)

Total Liabilities and Stockholders’ Br. 5,050.0 Br.4, 414.6 Br. 635.4 14.4%
equity 10
 Cont’d………………
2. Common Size Analysis (Vertical Analysis)
• It is analysis of financial statements where a significant

item in a financial statement is used as a base value and

all other items are compared against it.
• In balance sheet analysis, all balance sheet items might

be expressed as percentages of total assets.

• In income statement analysis, all income statement items

might be expressed as percentages of net sales.

Illustration…….

11
Common Size Analysis (Vertical Analysis)
Biftu Company
Condensed Balance sheet  
December 31
  2012 2011  
Assets Amount Percent Amount Percent  
Current assets Br.1,528.6 30.3% Br. 1,428.8 32.4  
Plant Assets (net) 2,932.9 58.0 2,784.8 63.0  
Other assets 588.5 11.7 201.0 4. 6
Total assets Br. 5,050.0 100.0% Br. 4,414.6 100.0%
Liabilities & Stockholders' equity        

Current liabilities Br. 2,199.0 43.5% Br. 1,265.4 28.7

Long-term liabilities 1,568.6 31.1 1,558.3 35.3
Total Liabilities 3,767.6 74.6 2,823.7 64.0
       
Stockholders' equity:
Common stock 201.8 4.0 183.0 4.1
Retained earnings & other 3,984. 78.9 3,769.1 85.4
Treasury stock cost) (2,903.4) (57.5) (2,361.2) (53.5)
Total stockholders' equity Br. 1,282.4 25.4 Br. 1,590.9 36.0
Total liabilities & Stockholders' equity         12
Ratio Analysis
 Ratio shows the mathematical relationship between two
figures, which have meaningful relation with each other
 Financial ratio analysis is the most common form of

financial statements analysis

 Financial ratio:

◦ Is used as an index for evaluating the financial performance of

the business.
◦ Compare items on a single financial statement or examine the
relationships between items on two financial statements
◦ Generally hold no meaning unless they are compared against
something

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Objectives of Ratio Analysis
 To standardize financial information for comparisons
 To evaluate current operations
 To compare current performance with past performance
 To compare performance against other firms or industry
standards
 To study the efficiency of operations
 To study the risk of operations
 To find out the ability of the firm to meet its debts (liquidity).
 To help investors in evaluating sustainability of returns
on their investment

14
Advantages of Ratios Analysis
 Simplifies financial statements
 Facilitates inter-firm comparison
 Helps in planning
 Makes inter-firm comparison possible
 Help in investment decisions

15
Limitations of ratio analysis
 Limitationof financial statement
 Comparative study required
 Problems of price level change
 Lack of adequate standard
 Limited use of single ratios
 Personal bias
 Incomparable

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TYPES OF FINANCIAL RATIOS
 LIQUIDITY RATIO(LR)
 ACTIVITY RATIO
 SOLVENCY RATIO
 PROFITABILITY RATIO (PR)
 MARKET VALUE RATIO

17
1) Liquidity Ratios (LR)
Liquidity ratios measure the ability of a firm to meet its
immediate obligations and reflect the short – term financial
strength or solvency of a firm.
Liquidity ratios measure a firm’s ability to pay its current liabilities
as they mature by using current assets.
There are two commonly used liquidity ratios: current ratio and
quick ratio.

18
 Cont’d…
i) Current ratio(CR) – measures the ability of a firm to
satisfy or cover the claims of short-term creditors by
using only current assets.
 This ratio relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
 Relatively high current ratio is interpreted as an indication
that the firm is liquid and in good position to meet its
current obligations.

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Current ratio
 Acceptable current ratio values vary from industry to
industry
 As a conventional rule, current ratio of 2:1 is considered
satisfactory for merchandising firms.
 However, the arbitrary ratio of 2:1 should not be, blindly,
followed.

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 Limitations of Current Ratio
 It is crude ratio because it measures only the quantity
and not the quality of the current assets.
 Even if the ratio is favorable, the firm may be in financial

trouble, because of more stock and work in process

which is not easily convertible into cash.
 Window dressing: It can be very easily manipulated by

overvaluing the current assets.

 An equal change in both current assets and current

liabilities would change the ratio.

 Current ratio is also affected by seasonality.

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 The current ratio can yield misleading results under the
following circumstances:
 Inventory component. When the current assets figure
includes a large proportion of inventory assets, since
these assets can be difficult to liquidate.
 Paying from debt. When a company is drawing upon its
line of credit to pay bills as they come due.

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Cont’d…
 A reasonably higher current ratio as compared to other
firms in the same industry indicates higher liquidity
position.
 A very high current ratio, however, may indicate excessive

inventories and accounts receivable, or a firm is not

making full use of its current borrowing capacity.

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ii) Quick ratio (Acid – test ratio) (QR): measures the
short-term liquidity by removing the least liquid current
assets such as inventories and prepayments.
Inventories are removed because they are not readily or
easily convertible into cash.
Quick ratio. = Current assets – Inventory--
prepayments
Current liabilities
• Like the current ratio, the quick ratio reflects the firm’s

ability to pay its short-term obligations, and the higher the

quick ratio the more liquid the firm’s position.
• But the quick ratio is more detailed and penetrating test

of a firm’s liquidity position as it considers only the quick

asset.
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 The ratio measures the firm’s ability to meet current
liabilities from its most liquid assets.
 Quick ratio is used as a complementary ratio to the

current ratio.
 Quick ratio is more rigorous test of liquidity than the

current ratio because it eliminates inventories and prepaid

expenses.

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 Cash Ratio
 is an indicator of company's short-term liquidity.
 It measures the ability to use its cash and cash

equivalents to pay its current financial obligations.

 measures the immediate amount of cash available to

satisfy short-term liabilities.

 A cash ratio of 0.5:1 or higher is preferred.

26
 Cash ratio is used by creditors when deciding how
much credit, if any, they would be willing to extend to
the company.
Cash Ratio = cash + Marketable securities

Current liabilities

27
2. Activity Ratios/Asset utilization
ratio
indicate how much a firm has invested in a
particular type of asset (or group of assets)
relative to the revenue the asset is producing.
measure the degree of efficiency a firm
displays in using its assets.
Generally, high turnover ratios are associated
with good asset management and low turnover
ratios with poor asset management.

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 Cont’d…
Activity ratios include:
i. Accounts Receivable turnover
(ART)
ii. Days sales outstanding
(DSO) (AV collection period)
iii. Inventory turnover (ITO)
iv. Fixed assets turnover (FAT)
v. Total assets turnover(TAT)
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 Cont’d…
i) Accounts Receivable turnover (ART)
 Measures Company’s efficiency in collecting its sales on credit
and collection policies.
 Takes in to consideration ONLY the net credit sales.
 Will be affected and may lose its significance if the cash sales are
included.
 It is best to use average accounts receivable to avoid seasonality

effects

Receivables Turnover = Credit sales

accounts receivable

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High receivables turnover ratio

 Implies either that the company operates on a cash

basis or that its extension of credit and collection of
accounts receivable are efficient.
 Indicate reflects a short lapse of time between sales and

the collection of cash,

 Indicate efficiency in the management of receivables and

liquidity
 indicates a combination of conservative credit policy and

aggressive collections department

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A low receivables turnover ratio
 Indicate longer collection period
 Indicate poor receivables collection procedures and

credit policies
 Implies high risk of un-collectibility
 Is an indication of greater collection expenses
 May be caused by a loose or nonexistent credit policy,

or an inadequate collections function

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ii) Days sales outstanding (DSO)
 also called average collection period.
 It seeks to measure the average number of days it takes for a firm
to collect its accounts receivable.
 In other words, it indicates how many days a firm’s sales are
outstanding in accounts receivable.
Days sales outstanding = account receivable
Average credit sales per day
The average collection period of a firm is directly affected by
the accounts receivable turnover ratio.
Average credit sales per day = annual credit sales
360 days

33
Average Collection Period:
 measures the quality of debtors
 can also be evaluated by comparison with the terms on

which the firm sells

 should be the same or lower than the company's credit

terms
 Should not exceed credit terms by more than 10-15 days
 Use average accounts receivable to avoid seasonality

effects

34
Short Collection period:
 Implies prompt payment by debtors.
 Reduces the chances of bad debts.

Longer Collection period:

 Implies too liberal and inefficient credit collection

performance.
 It is difficult to provide a standard collection period of

debtors

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iii) Inventory turnover (ITO)– measures how many times
per year the inventory level is sold (turned over).
Inventory turnover = Cost of good sold
av. Inventory
 Measures the velocity of conversion of stock into sales
 Indicates the number of times stock has been turned into

sales
 Evaluates the efficiency with which a firm is able to

manage its inventory.

 Indicates whether investment in stock is within proper

limit or not

36
A low inventory turnover ratio:
 Is a signal of inefficiency, either poor sales or excess

inventory
 May indicate poor liquidity, possible overstocking, and

obsolescence,
 May also reflect a planned inventory buildup
 Indicates efficient management of inventory
 Implies a large investment in inventories relative to the

amount needed to service sales

 

37
The following issues can impact the amount of
inventory turnover:

 Seasonal build. Inventory may be built up in advance

of a seasonal selling reason.
 Obsolescence. Some portion of the inventory may be

out-of-date and so cannot be sold.

 Cost accounting. The costing method used, combined

with changes in prices paid for inventory.

 Flow method used. A "pull" system that only

manufactures on demand requires much less inventory

than a "push" system that manufactures based on
estimated demand.
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IV) Fixed assets turnover (FAT) – measures how
efficiently a firm uses it fixed assets. indicate how
intensivly the fixed asset of the firm are being nused
It shows how many birr’s of sales are generated from
one birr of fixed assets.

Fixed assets turnover = sales___

Net fixed assets
 A fixed assets turnover ratio substantially lower than
other similar firms indicates underutilization of
fixed assets, i.e., idle capacity, excessive investment
in fixed assets, or low sales levels.
 This suggests to the firm possibility of increasing
outputs without additional investment in fixed
assets. 39
Cont….
 If fixed assets have changed significantly
during the year, an average fixed asset level
for the year, like inventory, should be used.
 A low ratio implies excessive investment in

plant and equipment relative to the value of

output being produced. In such a case, the
firm might be better off to liquidate some of
the fixed assets and invest the proceeds
productively

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V)Total assets turnover (TAT) – indicates the amount
of net sales generated from each birr of total tangible
assets.
It is a measure of the firm’s management efficiency in
managing its assets.
Total assets turnover = Sales
Total assets
 A high total assets turnover is supposed to indicate

efficient asset management, and low turnover

indicates a firm is not generating a sufficient level of
sales in relation to its investment in assets.

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con…
 Total Assets Turnover helps measure the efficiency with
which firms use their assets.
 It reflects how well the company’s assets are being used to
generate sales
 A low ratio indicates excessive investment in assets.

Generally firms prefer to support a high level of sales with a

small amount of assets, which indicates efficient utilization
of assets.
 High total assets turnover ratio may indicate that the firm is

using old, fully depreciated assets that may be inefficient

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3) Leverage Ratios
 Also known as Financial Leverage Management Ratio)
(FLMR)
 Leverage ratios are also called debt management or
utilization ratios.
 They measure the extent to which a firm is financed with
debt, or the firm’s ability to generate sufficient income to
meet its debt obligations.
 Indicate the ability of the company to survive over a long period of
time
 Indicate the ability of the organization to repay the loan and interest.
 Indicate the extent to which the firm has used debt in financing its
assets.
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 Con..
The most commonly calculated leverage ratios
include:
1. Debt to total asset ratio (Debt Ratio)

2. Debt equity ratio.

3. Times Interest Earned Ratio (TIER)

4. Fixed Charges Coverage Ratio (FCCR)

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i) Debt to total assets (Debt) Ratio – measures the percentage
of total funds provided by debt.
Debt ratio = Total debts
Total assets
◦ A high debt ratio implies that a firm has liberally used debt sources to
finance its assets.
◦ Conversely, a low ratio implies the firm has funded its assets mainly
with equity sources.
◦ Debt ratio reflects the capital structure of a firm.
◦ The higher the debt ratio, the more the firm’s financial risk.
 Creditors usually prefer a low debt ratio since it implies a greater protection of their
position.
 A higher debt ratio generally means that the firm must pay a higher interest rate on its
borrowing; beyond some point, the firm will not be able to borrow at all.
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 ii) )Debt Equity Ratio(DER)

 The Debt-equity ratio indicates the relationship between the total

debts funds provided by creditor and those provided by the
owners of the firm.
 This ratio reflects the relative claim of creditors and shareholders
against the assets of the firm.
 It is computed as:
Debt- Equity Ratio=long term debt
stock holders equity
46
Con…
 Debt to Equity is the ratio of total debt to total equity
 It is one of the measures of the long-term solvency of a firm.
 It measures the relative claims of creditors and owners against the
assets of the firm
 It compares the funds provided by creditors to the funds provided by
shareholders.
 It measures the soundness of the long-term financial policies of the
company
 As more debt is used, the Debt-to-Equity Ratio will increase.
 The use of debt can help improve earnings since deduct interest
expense on the tax return
 For the analysis of capital structure of a firm debt-equity ratio is
important

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Interpretation debt to equity ratio
 Long-term creditors generally prefer to see a modest debt-equity ratio.
 A high debt equity ratio implies that a higher proportion of long-term
financing is from debt.
 A low ratio means the firm has paid for its assets mainly with equity
money
 The D-E ratio indicates the margin of safety to the creditors.
 A very high D-E ratio is unfavorable to the firm and creates inflexibility
in operations.
 During periods of low profits a highly debt financed company will be
under great pressure; it cannot earn enough profits even to pay the interest
charges.
 An ideal D-E ratio is 1:1
 In periods of prosperity and high economic activity, a large proportion of

the debt may be used while the reverse should be done during periods of
adversity

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iii) Times – interest earned ratio
 measures a firm’s ability to pay its interest obligations.

Times interest earned = EBIT

Interest expense
 The times interest earned ratio implicitly assumes a firm’s

operating income (EBIT) is available to meet its interest

obligations.
 However, earnings before interest and taxes are an income

concept and not a direct measure of cash.

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IV Fixed charge coverage ratio
 Like the TIER, the FCCR is a measure of the ability of the firm
to pay its fixed financing costs. It indicates how much income
is available to pay for all the firm’s fixed charges

50
 4) Profitability Ratios

 These ratios measure the earning power of a firm with

respect to given level of sales, total assets, and
owner’s equity.
There are different users interested in knowing the profits of the firm.
 The management of the firm regards profits as an indication of efficiency
 Owners take it as a measure of the worth of their investment in the business.
 To the creditors profits are a measure of the margin of safety.
 Employees look at profits as a source of fringe benefits.
 To the government, measures of the firm’s tax paying ability and a basis for
legislative action.
 To the customers they are a hint for demanding price cuts.

51
 Con..
The following are the main profitability ratios
1. Gross Profit Margin
 Gross Profit Margin indicates the percent of each sales dollar
remaining after cost of goods sold has been subtracted.
 It also reflects the effectiveness of pricing policy and of

production efficiency

Gross profit margin = Sales – Cost of good sold

Sales

52
2. Operating margin
 The net operating margin indicates the profitability of sales
before taxes and interest expenses.
 This ratio measures the effectiveness of production and sales of

the company’s product in generating pretax income for the firm

Operating margin = operating Income

Sales
Generally the higher the net operating margin the better the
company is

53
 Con…
3. Net Profit Margin
 Net profit margin is a measure of the percent of each dollar of
sales that flows through to the stockholders as net income.
 It shows what percent of every sales dollar the firm was able to
convert into net income.
 Firms with a low volume of sales may need a higher profit

margin to generate a satisfactory return for its shareholders

Net profit margin = Net income
Sales
Generally the stockholders always like to have a higher net profit
margin.

54
4) Return on equity – indicates the rate of return earned by
a firm’s stockholders on investments made by themselves.
Return on equity = Net income __
Stockholders’ equity
OR
Return on equity = Total asset
share holders equity
• A high return on equity may indicate that a firm is more risky
due to higher debt balance.
• On the contrary, a low ratio may indicate greater owner’s capital
contribution as compared to debt contribution .

55
 Con..
5. Return on Investment
It is also referred to as Return on Assets. It measures the return
to the firm as a percentage of the total amount invested in the
firm or how profitable the firm used its assets
ROI = Net Income
Total assets
 Managers generally prefer this ratio to be very high for their
firms. However, a high ratio can also mean that the firm is
failing to replace worn-out assets.
 A low return on assets shows that the firm is not utilizing its

assets profitably

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 5. Market value ratios
These ratio relate with firms stock price with its
earning and book value per share.
I ) price earning ratio – used to asses the owners
appraisal of share value. measure the amount of
investors are willing to pay for each Birr of the
firms earning.
the degree of confidence that investors have in
the firms future performance.

price earning ratio = market price per share of common stock

earning per share

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2) market/ book ratio
the ratio of stock market price to its book value gives another indication of
how investors regard the company.

market /book ratio = market price per share .

book value per share
book value per share = common equity
common share outstanding
dividend ratio :- the primary interest of stockholders on company
operations to see whether it pay a good amount of dividend or not.

Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid

to stockholders.
Dividends pay-out = Dividends per share
Earnings per share

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 COMPARING FINANCIAL RATIOS
 To address whether a given ratio is high or low, good or
bad, a meaningful basis is needed for comparison. Two types of
ratio comparisons can be made.
I ) Cross – sectional analysis – is the comparison of a firm’s ratios
to those other firms in the same industry at the same point in time.
Here, the firm is interested in how well it has performed in relation
to other firms. Generally, cross – sectional analysis is preformed
based on industry averages of different financial ratios.
ii) Time – series analysis – is an evaluation of a firm’s financial
ratios over time. Here, the current period ratios are compared
with those of the past years. The purpose is to determine whether
the firm is progressing or deteriorating.

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PROCEDURES IN FINANCIAL FORECASTING

 The financial forecasting process generally

involves the following procedures:
I. Forecasting of sales for the future period
II. Determining the assets required to meet the
sales targets, and
III. Deciding on how to finance the required assets.
 Sales forecast is a forecast of a firm’s unit and birr
sales for some future period.
 It is generally based on recent sales trends and
forecast of the economic prospects of the nation,
region, industry and other factors.

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