CHAPTER TWO

Financial Statement Analysis and

Financial Planning
Learning objectives
1. Understand the parties interested in performing financial ratio
analysis and the common types of ration comparisons
2. Use popular ratios to analyze a firm’s liquidity and the activity
of inventory, accounts receivable, accounts payable, fixed
assets and total assets
3. Evaluate a firm’s profitability relative to its sales, asset
investment, owners’ equity investment, and share value. 1
Introduction
Financial analysis help users to evaluate an
organization’s financial performance and condition.
 Financial analysis involves:-
 Comparing the firm’s performance with that of
other firms in the same industry.
Evaluating trends in the financial position and
performance over time.
 Thus, help management to identify deficiencies of
the firm and take actions to improve performance
and maximize shareholders’ wealth.
2
Meaning and concepts of financial analysis

The term ‘Financial Analysis’ also known as

analysis and interpretation of financial statements or
financial statement analysis.
Financial analysis is the process of determining
financial strengths and weaknesses of the firm by
establishing strategic relationship between the items
of the financial statements.
There are different user groups of financial
statements, which include managers, stockholders,
potential investors, creditors and employees.
3
CONT’D

All user groups analyze the financial statements for

their own specific purposes.
Tools of Financial Analysis
 There are three common types of tools of financial
analysis:-
1. Horizontal financial analysis
2. Vertical financial analysis
3. Financial ratio analysis

4
 1. Horizontal financial analysis

 is a technique for evaluating and analyzing a series

of financial statement data over a period of time.
 Its purpose is to determine the increase or decrease
that has taken place, expressed as either an amount
or a percentage
 To illustrate horizontal financial analysis, let’s take
sample financial statements of Sunrise Company.

5
 Sunrise Company
Condensed Balance Sheet
December 31 (In Millions)-Horizontal Analysis
Assets
Increase (decrease)
2006 2005
amount percent

Current assets Br.1,558.6 Br.1,428.8 Br. 129.8 9.0%

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. Br. 4,414.6 Br. 635.4 14.4%
5,050.0
Liabilities and stock holders’ equity
Current liabilities 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 Br.3,767.6 2,823.7 943.9 33.4%
Stockholders’ equity
Common stock 201.8 183.0 18.8 10.3%
Trained earnings 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)
Presented by Bayisa Nigusie(MSC) 6
 Sunrise Company
Condensed income statement
For the year ended December 31 (In Millions)-Horizontal Analysis

Increase (decrease)
During 2006
2006 2005 Amount percent
Net sales………………………….Br.6, 676.6 7,003.7 (327.1) (4.9%)
Cost of goods sold……………….…. 3, 122.9 3,177.7 (54.8) (1.7)
Gross profit…………………………. 3, 553.7 3,826.0 (272.3) (7.1)
Selling and administrative
Expenses…………… …………………2,458.7 2,566.7 (108.0) (4.2)
Nonrecurring charges……………… 136.1 421.8 (285.7) (67.7)
Income rom
f operations………… 958.9 837.5 121.4 14.5
Interestexpense………………….. 65.6 62.6 3.0 4.8
Other income or expense (net)…. (33.4) 21.1 (54.5) NA
Income before income taxes……. . 859.9 796.0 63.9 8.0
Income tax expenses………………… 328.9 305.7 23.2 7.6
Net income……………………………… 531.0 490.3 40.7 8.3
* NA= Not Available 7
2. Vertical financial analysis
 Is a technique of evaluation and analyzing financial
statement data that expresses each item in a
financial statement as a percent of a base amount.
 For example:-
On a balance sheet, total assets being the base
amount).
On an income statement, sales being the base
amount.
 Exhibit2.3 presents a vertical analysis of the
comparative balance sheet of Sunrise Company for
2005 and 2006. 8
 Sunrise company
Condensed Balance-sheet
December 31 (In Millions)-Vertical Analysis

Assets 2006 2005

Amount percent amount percent
Current assets Br.1,528.6 30.3% Br.1,428.8 32.4%
Plant assets(net) 2,932.9 58.1 2,784.8 63.0
Other assets 588.5 11.6 201.0 4.6
Total Assets B r. 5,050.0 100.0% Br. 4,414.6 100.0%
Liabilities and stock holders’ 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 Br.3,767.6 74.6 2,823.7 64.0
Stockholders’ equity
Common stock 201.8 4.0 183.0 4.1
Trained earnings 3,984.0 78.9 3,769.1 85.4
Treasury stock(cost) (2,903.4) (53.5) (2,361.2) (53.5)
Total st ockholders’ 1,282.4 25.4 (1,590.9) 36.0
equity
Total liability & B r. 5,050.0 100.0% Br. 4,414.6 100.0%
stockholders’’ equity
9
 Sunrise company
Condensed Income Statement
For the year ended December 31(In Millions)-Vertical Analysis

2006 2005
Amount percent Amount percent

Net sales………………...………..… Br.6,676.6 100.0% 7,003.7 100.0%

Cost of goods sold……………….……… 3,122.9 46.8 3,177.7 45.4
Gross profit………………………….…. 3,553.7 53.2 3,826.0 54.6
Selling and administrative
Expenses………………………………….2, 458.7 36.8 2,566.7 36.6
Nonrecurringcharges……………………... 136.1 2.0 421.8 6.0
Incomefrom operations………………….. 958.9 14.4 837.5 12.0
Interest expense……………… ……………65.6 1.0 62.6 0.9
Other income or expense (net)……………(33.4) 0 .5 21.1 0.3
Incomebefore income taxes……………... 859.9 12.9 796.0 11.4
Income tax expenses…………………….. 328.9 4.9 305.7 4.4
Net income………………………………. 531.0 8.0% 490.3 7.0%
10
3. Financial ratio Analysis

A ratio is a simple arithmetical expression of the

relationship of one number to another.
Ratio analysis is not merely the application of a
formula to financial data to calculate a given ratio.
More important is the interpretation of the ratio
value.
Types of ratio comparisons:-
a) Cross-sectional analysis
b) Time-series Analysis.
c) Combined analysis
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CONT’D
a)Cross-sectional analysis
 The typical business is interested in how well it has
performed in relation to other firms in the industry.
b)Time-series Analysis
 Comparison of current to past performance, using
ratio analysis allows the firm to determine whether
it is progressing as planned.
c)Combined analysis
 combines cross-sectional and time series analysis.

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Types of financial ratio
Financial ratios can be divided into five basic
groups or categories:
1. Liquidity Ratios
2. Activity Ratios
3. Debt Ratios
4. Profitability Ratios
5. Market value Ratios
 The necessary inputs to an effective financial ratio
analysis include at least the income statement and
the balance sheet. 13
CONT’D
 We also evaluate the ratios in relation to the industry
averages or standards.
 Industry averages are ratios that are computed by
taking the balance sheet and income statement
figures of firms operating in the same industry.
 They are taken as norms for firms operating within
the industry.
 By comparing the firm’s ratio to the industry
average you will be able to know whether the firm
is performing below or above the industry average.
14
 1) LIQUIDITY RATIOS
 Liquidity refers to the ability of a firm to meet its
short-term obligations as and when they become due.
 The short term obligations are met by realizing
amounts from current assets.
 If the current assets can pay off current liabilities, then
liquidity position of the firm will be satisfactory.
 The three basic measures of liquidity are :
a) Net working capital
b) Current Ratio
c) Quick(Acid-Test)Ratios

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a) Net working capital(NWC)

 NWC, is commonly used to measure a firm’s

overall liquidity.
 It is calculated as follows:
NWC = Current assets – current liabilities
 NWC is really not a ratio, it is frequently employed
as a measure of a company’s liquidity position.
 The greater is the amount of NWC, the greater is the
liquidity of the firm.

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b) Current Ratio
 Is commonly cited financial ratios, which measures firm’s ability
to meet its short-term obligations.
 It indicates the extent to which those assets that are expected to
be converted to cash in the near future can cover current
liabilities.
Current Ratio = Current assets
Current liabilities
 Assume EMC company has 40,000&18,000 current assets
and liabilities respectively.(industry Average current ratio=2
times)
Current ratio for EMC for 2006 40,000 = 2.22 times

18,000
17
CONT’D
 A very high current ratio may indicate
Excessive cash due to poor cash management
Excessive accounts receivable due to poor credit
management
Excessive inventory due to poor inventory management
 A very lower current ratio indicates opposite from the
higher current ratio stated above.
 A low current ratio could be improved by
Long-term borrowing and sale of stock to increase
current assets.
Liquidating current liabilities using long-term financing.
18
c) Quick(Acid-Test)Ratios
This is more conservative measure of liquidity.
The quick (acid-test) ratio is similar to the current
ratio except that it excludes inventory, which is
generally the least liquid current asset, and prepaid
expenses.
Quick Ratio = Current Assets – Inventory –Prepaid Expenses
Current Liabilities
 Assume EMC company has 40,000&20,500 current assets and
inventory respectively with no prepaid expenses & 18,000
current liabilities.(Industry Average quick ratio=1.08) Thus:
quick ratio for EMC = 19,500 = 1.08
18,000 19
2) ACTIVITY RATIOS.
 are also called efficiency ratios, or asset management
ratios or asset utilization ratios.
 it measures how effectively the firm is managing its
assets, and how well a firm’s funds are utilized?
 Activity ratios includes:
A)Inventory turn over ratio
B)Accounts receivable turn over
C)Average collection period
D)Accounts payable turn over
E)Average payable period
F)Fixed assets turn over ratio
G)Total assets turn over ratio. 20
A. Inventory turnover ratio
 commonly measures liquidity of a firm’s inventory.
 It measures how quickly inventory is sold.
 A high inventory turnover indicates that the firm is rapidly receiving
cash and or more able to pay its liabilities as they come due or may be
used for some other profitable venture.
Inventory turn over = cost of goods sold
Inventory
“Or” Inventory turnover = Sales
Inventory
Assume EMC company has 90,000&20,500 cost of goods sold and inventories
respectively.(with Industry average 6 times)
inventory turn over = 90,000
20,500 = 4.39 times
 But inventory turn over of EMC is blow the industry average of 6
21
B. Accounts Receivable Turn
over(ARTO)
 measure the liquidity of firm’s accounts receivable.
 This is the ratio of net credit sale to accounts receivable.
 It tells us the number of times accounts receivable have been
turned over (turned into cash) during the year.
 This ratio is calculated as follows
ARTO = Net sales
Accounts Receivable
 EMC company has 120,000&16,000 net sales and Account receivables
respectively(Industry Average ARTO=10.4 times)
ARTO (EMC) = 120,000
16,000 = 7.5 times
 But this is considerably below the industry average of 10.4
times. 22
CONT’D
 A ratiosubstantially lower than the industry average
may suggest that a firm has
More liberal credit policy: (i.e., longer times credit
period), poor credit selection, and inadequate
collection effort or policy which could lead to
Accounts receivable to be high and higher bad debt
or uncollectible receivable
More restricted cash discount (no or little cash
discount) that could make sales to be too low

23
C. Average Collection Period(ACP)
It represents the average length of time a firm must wait to
receive cash after making sales
it indicates how many days a firm takes to convert receivables
into cash
It is the average number of days that accounts receivable are
outstanding before being collected.
Generally, the lower the average collection period, the more
efficiently the credit sales are being managed.
ACP = 360(365) days a year
ARTO
 Thus: ACP for EMC company if industry ACP=35 days.
ACP = 360
7.5 times =48 days
24

D. Accounts payable turn over (APTO)
Measures how rapidly creditors are paid.
That is, how rapidly or how many times accounts
payable are paid during a year
APTO = Net purchase
Accounts payable
 EMC company has 150,000&30,000 net purchase and Account
payable(Industry average APTO=7times) Thus:
APTO of EMC = 150,000
30,000 = 5 times
 But industry average of APTO is 7 times. Therefore it
25
E. Average payment period
The average payment period or average age
accounts payable is calculated in the same manner
as average collection period.
It measures the average length of time creditors
must wait to receive their cash.
Average payable period = Accounts payable
Average purchase per
day
Or = Accounts payable
Annual purchase
26
CONT’D
Example: EMC company has 30,000&150,000 Annual
purchase(Industry Average APP=45 days)
APP for EMC = 30,000 = 72days
(150,000/360)
Or APP = 360 = 72 days
5 times
Interpretation: Assume suppliers on the average
extend 45 days credit term.
 That is, EMC Company is a risky borrower.

27
F. Fixed Asset turn Over (FATO)
The fixed asset turns over measures the efficiency with
which the firm has been using its fixed assets to generate
sales.
This ratio indicates management’s efficiency in
managing fixed assets.
Fixed Asset Turn Over = sales (Net)
Net Fixed Assets
Example: EMC company has 120,000& 42,000 net sales and net
fixed assets respectively.(Industry average FATO=3.5 times)
FATO (EMC, for 2006) = 120,000
42,000 = 2.86 times
 However, this is below the industry average of 3.5 times.
28
CONT’D
 Other things being equal, a ratio substantially below
the industry average
Shows under utilization of available fixed asset.
Indicates possibility to expand activity levels with
out requiring additional capital investment.
Shows over investment in fixed assets, low sales or
both.
Helps the manager to reject funds requested by
production mangers for new capital investment.
Suggests that sales should be increased, some fixed
29
G. Total Assets Turnover
This measures the efficiency with which the firm uses all its
assets to generate sales.
How much sales birr is generate per birr of investment in
asset?
Total Asset Turnover = sales
Total Assets
Example: EMC company has 120,000 & 82,000 net sales and total
assets respectively.(Industry Average 2 times)
total Assets Turn over (EMC for 2006)
= 120,000
82,000 = 1.46 times
 However, this is below the industry average of 2 times
30
CONT’D
A high ration suggests greater efficiency in using
assets to produce sales.
A low ratio suggests that EMC is not generating
sufficient value sales for the size of the investment
in assets.
EMC should take steps to increase sales (asset
remains the same), dispose of its investment in
assets or both.

31
 3. Debt (leverage) ratios
It is also called Debt utilization ratio or financial leverage
ratios.
These ratios provide information on the degree of a firm’s
fixed financing obligations (debt financing) and its ability
to pay these financing obligations.
Financial leverage ratios convey how a firm is dependent
on debt financing and indicate its ability to meet fixed
charge obligations.
Leverage (debt) ratios include
A. Debt-ratio
B. Debit-equity ratio
C. Times-interest-earned ratio
32
A. Debt-ratio:
This measures the proportion of total assets
financed by the firm’s creditors.
It measures the percentage of funds provided by
creditors.
It is the ratio of total debt to total assets.
The higher this ratio the greater the amount of other
people money being used in an attempt to generate
profit and the higher the financial cost and
restrictions from creditors.
Debt ratio = Total liabilities
Total assets
33
CONT’D
 Example: EMC company has 45,000&82,000 total liabilities and
total assets respectively.(Industry Average Debt-asset ratio=45%)
Debt-asset ratio for EMC
= 45,000
82,000 = 55%
 the industry average of is 45%. Thus EMC has leverage
more than the industry average.
 Creditors prefer low debt ratio because creditors’ losses in
the event of firm liquidation will be lesser.
 Stockholders, on the other hand may want a larger debt
ratio because it magnifies expected earnings available to
them. 34
B. Debit-equity ratio:
This indicates the relationship between the long-term funds
provided by creditors and those provided by the firm’s owners.
Example: EMC company has 45,000&37,000 total liabilities and
stockholders equity.(Industry Average=81.82%)
Debt-equity ratio = Total liabilities
Stockholder’s equity
An alternative formula of to calculate debt-equity ratio: Debt-
equity ratio = Long- term debt
Stockholder’s equity
debt –equity ratio for EMC,If long-term liability is 45,000
&stockholders equity is 37,000:
= 45,000
37,000 = 1.2162
35
CONT’D
 A high debt-equity ratio shows
A large share of financing by creditors relative to
the owners.
A large creditor’s claim to the assets of the firm.
Little margin of safety to creditors
High risk to creditors
Less flexible in the firm’s operation
If this high financial leverage is favorable,
shareholders return will be magnified and if it is
unfavorable shareholders return will decrease
36
C. Times-interest earned ratio
measures the firm’s ability to make contractual interest
payments from operating profit.
The higher the value of this ratio, the better able the firm
is to fulfill its interest obligation.
Time-Interest earned = EBIT
Interest
Example: EMC company has 14,250& 4,150 EBIT and Interest
respectively.(Industry average 5.5 times)
Time interest earned ratio of EMC
= 14,250 = 3.43 times
4,150
 37
D. Fixed-Payment Coverage Ratio
The fixed-payment coverage ratio measures the
firm’s ability to meet all fixed payment obligations,
such as loan interest principal, lease payments, and
preferred stock dividends.
Like the times-interest earned ratio, the higher this
value the is better.
Fixed payment coverage ratio=
EBIT + lease payment
Interest + lease payments+(Principal payments + Preferred
stock dividends/1-T)
38
CONT’D
Example: EMC company has 14,250,1,650,4,150 and 3,000 EBIT,
lease payment, Interest ,preferred stock dividend respectively.
(Industry average 2.5 times, Tax rate 34%)
Fixed charge coverage = 14,250 + 1,650
4,150 + 1,650 + 3000/ 1-.34)
= 15,900 = 1.54 times
10,345
 The industry average of 2.5 times.
 The low ratio gives creditors a small margin of
safety
39
4. Profitability ratios
It measures operating efficiency and ability to ensure
adequate return to shareholders.
used to evaluate the overall management effectiveness and
efficiency in generating profit on sales, total assets and
owners’ equity.
Profitability ratio include;

A. Gross Profit Margin

B. Operating Profit Margin
C. Net Profit Margin
D. Return On Investment (ROI)
E. Return On Equity(ROE) 40
A. Gross Profit Margin
The gross profit margin measures the percentage of each sales
birr remaining after the firm has paid for its goods.
The higher the gross profit margin, the better and the lower the
relative cost of merchandise sold.
Gross profit margin = sales – cost of good sold

Sales
= Gross profit
Sales
Example: EMC company has 30,000 and 120,000 gross profit and sales
respectively.(Industry average 26%)
= 30,000 = 25%
120,000
41
CONT’D
 This
ratio indicates management’s effectiveness in
Product pricing
Generating sales
Controlling production costs.

42
 B. Operating profit Margin.
measures the percentage of each birr remaining after all cost
and expenses other than interest and taxes are deducted.
It represents the pure profit earned on each sales birr.

Operating profit margin = Operating profit

Sales
 Example: EMC company has 14,250 and 120,000 EBIT and sales
respectively (Industry average of 15.5% )

=14,250 = 11.88%
120,000
 The industry average of 15.50% 43
 C. Net profit margin
The net profit margin measures the percentage of each sales
birr remaining after all costs and expenses, including interest
and taxes have been deducted.
Net profit margin = net profit after tax
Sales
 Example: EMC company has 7,000 and 120,000 NPAT and sales
respectively (Industry average of 5 )

Net profit margin = 7,000 = 5.83%

120,000
 This lower profit margin occurs because costs and expenses
44
D. Return on Investment (ROI) or
Return on total asset (ROA)
This measures the overall effectiveness of management
in generating profit with its available assets.
The higher the firm’s return on total assets, the better its
total assets is used in generating profits.
ROA = Net profit after taxes
Total Assets

 Example: EMC company has 7,000 and 82,000 NPAT and total assets
respectively (Industry average of 5% )
 ROA = 7,000 = 8.54%
 82,000 45
E. Return on Equity (ROE)
measures the return earned on the owners’ (preferred and common
stockholders’) as an indicator of management’s performance.
Generally, the higher this return, the better for the owners.

ROE = Net profit after tax

Stockholders’ equity
High ROE indicates effective management performance
Low ROE indicates ineffective management performance.
 Example: EMC company has 7,000 and 37,000 NPAT and stockholders’
equity respectively (Industry average of 21.82% )

ROE = 7,000 = 18.92%

37,000
 The industry average of 21.82%. 46
 DuPont system of analysis
The DuPont system merges the income statement
and balance sheet into two summary measure of
profitability; return on total assets (ROA) and return
on equity (ROE) with its total asset turn over.
ROA =Net profit margin*total asset turn over
ROA = Net profit after tax x Sales
Sales Total assets
ROA = Net profit after tax
Total assets

47
 5. MARKET / BOOK RATIOS
These ratios are primarily used for investment
decisions and long-range planning and include
the following ratio.
1. Earnings per share (EPS)
2. Price / earning ratio(P/E)
3. Book-value per share
4. Dividend per share (DPS)
5. Dividend payout ratio.
6. Dividend Yield
48
1. Earnings per share (EPS)
Expresses the profit earned per common share
outstanding during the reporting period.
It provides a measure of overall performance and is
an indicator of the possible amount of dividends that
may be expected.
EPS =NIAT – preferred stock dividend
Number of common shares outstanding.

49
 2. Price/ Earning ratio(P/E)
Show how much investors are willing to pay per
birr of reported profit.
The price currently paid by market for each birr
(dollar) currently reported EPS
Measures investors’ expectation and the market
appraisal of performance of the firm
indicates the degree of confidence that investors
have in the firm’s future performance.
P/E ratio = market price per common share
EPS 50
 3. Book-Value Per Share
Itis the value of each share of common stock based
the firm’s accounting records.
BVPS = total stock equity – preferred stock
Number of common shares outstanding
Where ,BVPS:- is Book-Value Per Share

51
 4. Dividend per share (DPS)
This shows the dollar amount of dividends paid on a
share of common stock outstanding during the
reporting period.
DPS = total cash dividends on common shares
Number of common shares outstanding

52
 5. Dividend payout ratio.
This shows the percentage of earnings paid to
shareholders.
It expresses the cash dividends paid per share as a
percentage of EPS.
DPR = cash dividends per share
EPS
or
Total dividends to common stock
Total earnings available or common stockholders
53
 6. Dividend Yield
This shows the ratio earned by shareholders from
dividends relative to the current price of the stock.
Dividend yield is part of a stock’s total return.
Dividend Yield = Cash Dividends Per Share
Current Market Price per Share.

54
END

END OF CHAPTER TWO

55