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CHAPTER TWO:
FINANCIAL STATEMENT ANALYSIS
LEARNING OBJECTIVES
After studying this chapter, you will be able to :
 explain the nature and significance of financial analysis;
 identify the objectives of financial analysis;
 describe the various tools of financial analysis;
 state the limitations of financial analysis;
2.1 INTRODUCTION
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. Hence, preparation of the financial statement is
important as much as the financial decisions.
You have learnt about the financial statements (Income Statement and Balance Sheet) of
companies. Basically, these are summarized financial reports which provide the operating results
and financial position of companies, and the detailed information contained therein is useful for
assessing the operational efficiency and financial soundness of a company. This requires proper
analysis and interpretation of such information for which a number of techniques (tools) have
been developed by financial experts. In this chapter we will have an overview of these
techniques.
2.2 MEANING OF ANALYSIS OF FINANCIAL STATEMENTS
Financial statement analysis is the process of analyzing a company’s financial statements to
evaluate its financial performance and condition. It involves reviewing and analyzing financial
reports, such as income statements, balance sheets, and cash flow statements, to gain insights
into a company’s profitability and overall financial situation. In other words financial statement
analysis is defined as the process of identifying financial strengths and weaknesses of the firm by
properly establishing relationship between the items of the balance sheet and the income
statement account
Understanding a company’s financial management and identifying areas that require
improvement are the objectives of financial statement analysis. Also, understanding the meaning
of financial statement analysis is essential for investors to assess the profitability and stability of
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a company before making investment decisions. The term ‘financial analysis’ includes both
analysis and interpretation. The term analysis means simplification of financial data by
methodical classification given in the financial statements.
Interpretation means explaining the meaning and significance of the data. These two are
complimentary to each other. Analysis is useless without interpretation, and interpretation
without analysis is difficult or even impossible.
2.3OBJECTIVES AND USERS OF FINANCIAL STATEMENTS ANALYSIS
Primary objectives of Financial Statement Analysis
Analysis of financial statements reveals important facts concerning managerial performance and
the efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the
information contained in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm thereby, enabling the
analysts to take decisions regarding the operation of, and further investment in the firm. To be
more specific, the analysis is undertaken to serve the following purposes (objectives):
Secondary objectives of Financial Statement Analysis
 To assess the earning capacity or profitability of the firm.
 To assess operational efficiency and managerial effectiveness.
 To assess the short term as well as long term solvency position of the firm.
 To identify the reasons for the change in profitability and financial position of the firm.
 To make the inter-firm comparison.
 To assess the progress of the firm over a period.
 To help in decision making and control.
 To guide or determine the dividend action.
 To provide important information for granting credit.
VARIOUS STAKEHOLDERS AND THEIR INTERESTS
The following are the stakeholders that have interest in performing financial statement analysis
Management, Bankers or financial institution, potential investors, creditors or supplier,
employees, government, trade association, etc all can analyze the Balance Sheet and Statement
of Profit and Loss for taking prudent decisions.
Financial statement analysis is a valuable tool used by investors and creditors, financial
analysts, and others in their decision-making processes related to stocks, bonds, and other
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financial instruments. The goal in analyzing financial statements is to assess past performance
and current financial position and to make predictions about the future performance of a
company. Investors who buy stock are primarily interested in a company’s profitability and their
prospects for earning a return on their investment by receiving dividends and/or increasing the
market value of their stock holdings.
Creditors and investors who buy debt securities, such as bonds, are more interested in
liquidity and solvency: the company’s short and long-run ability to pay its debts. Financial
analysts, who frequently specialize in following certain industries, routinely assess the
profitability, liquidity, and solvency of companies to make recommendations about the purchase
or sale of securities, such as stocks and bonds.
The economists, researchers, etc., analyze the financial statements to study the present
business and economic conditions. The analysis also provides the basis for many governmental
actions relating to price regulations, taxation and other similar purposes.
2.4 TYPES OF FINANCIAL STATEMENTS
Companies produce financial statements to give crucial information about their financial status
and assist stakeholders in making informed decisions. There are three main types of financial
statements: income statement, balance statement, and cash flow statement.
In the below points, we will discuss these types of financial statements.
Income Statement- An income statement, also known as a profit and loss statement, is a
financial report that summarizes a company’s revenue, expenses, and profits or losses
over a specific period, generally for a quarter or a year.
 The income statement provides an overview of a company’s financial performance by
showing how much money the company generated from sales or services, and how much
it spent on expenses like salaries, rent, and taxes. The difference between revenue and
expenses is the company’s net income or profit.
 It is a tool that provides insights into a company’s financial health, profitability, and
operating efficiency. It can also be used to compare a company’s performance to its
competitors.
Balance Sheet- A balance sheet is a financial statement that provides a clear picture of a
company’s financial position at a specific point in time, typically at the end of a quarter
or a year.
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 It provides insights into how the company is financing its operations and investments.
The balance sheet shows a company’s assets, liabilities, and equity.
 Assets are resources that the company owns or controls and can use to generate future
economic benefits, such as cash, investments, inventory, and property.
 Liabilities are the company’s debts to creditors, such as loans, accounts payable, and
taxes owed.
 Equity represents the residual interest in the assets of the company after deducting
liabilities, and it includes the company’s retained earnings and stockholder’s equity.
Cash flow Statement- A cash flow statement is a financial statement that shows the
inflows and outflows of cash and cash equivalents for a company during the quarter or a
financial year.
 The cash flow statement is divided into three main sections: operating activities,
investing activities, and financing activities.
 The operating activities section shows the cash flow from the company’s primary
operations, such as cash received from customers and payments to suppliers and
employees.
 The investing activities section shows the cash flow related to the purchase and sale of
long-term assets, such as property, and land; as well as investments in securities and other
businesses.
 The financing activities section shows the cash flows related to the company’s financing
activities, such as the issuance or repayment of the debt, and the payment of dividends to
shareholders.
 The cash flow statement is an important financial statement that provides insights into a
company’s ability to generate cash and manage its cash flows. Moreover, it is used in
financial analysis and can be compared to analyses from previous years to identify trends
and changes in a company’s cash flow position.
2.5. TOOLS OF FINANCIAL STATEMENTS ANALYSIS
There are several tools used in financial statement analysis. Here in the following points, we will
discuss the most commonly used tools. Two primary types of financial statement analysis are
commonly known as horizontal analysis and vertical analysis based on modes operation. The
most commonly used techniques of financial analysis are as follows:
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TOOLS OF FINANCIAL STATEMENT ANALYSIS

HORIZONTAL ANALYSIS VERTICAL ANALYSIS

Comparative analysis Trend analysis Common size analysis Ratio analysis

HORIZONTAL ANALYSIS
When an analyst compares financial information of certain accounting period with information
of other accounting periods for a single company, the process is referred to as horizontal
analysis. Analysts make use of such an approach to find and analyze historical trends and
changes (increase & decrease) in a company’s performance and position growth over time. It
also helps assess companies’ financial growth and position versus competitors. Is especially
useful for identifying changes in key financial metrics, such as revenue growth, expenses, and
profitability It is also known as “Dynamic Analysis” as it is based on year-to-year data rather
than on any one-year data. There are two primary methods of horizontal financial statement
analysis namely comparative statement analysis and trend analysis.
1. Comparative financial statement analysis:
Comparative statement analysis involves comparing a company’s financial condition and
performance of a particular accounting period with the prior period or any other selected period.
Thus, it involves the analysis of financial statements across time.. Comparative financial
statements will contain items at least for two periods. It allows for a side-by-side comparison of
the company’s financial statements for different periods, such as year-over-year or quarter-over-
quarter. The financial data will be comparative only when same accounting principles are used in
preparing these statements (In the preparation of comparative financial statement uniformity is
essential). If this is not the case, the deviation in the use of accounting principles should be
mentioned as a footnote. Otherwise; comparison will be validated. Comparative figures indicate
the trend and direction of financial position and operating results.
Steps to perform Comparative Statement Analysis:
Step 1: Calculating Change in Birr Amounts
Birr ℎ (Br.) = −
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Notes
If we measure the amount of the change between 2019 and 2020, the a Birr amounts for 2019
become the “base” year figures. Thus, the previous year will become the base year.
Step 2: Calculating Change as a Percentage
ℎ = Birr ℎ × 100

2. Trend analysis:
Trend analysis compares key financial statement values or relationships for the same company
across periods. It generally includes more than three years of data and provides important
information regarding historical performance and growth and, given a sufficiently long history of
accurate seasonal information, can be of great assistance as a planning and forecasting tool for
management and analysts
It involves the calculation of trend percentages which play a significant role in analyzing the
financial stature of the enterprise through base years’ performance ratio computation. Financial
Elements can show upward, downward and sideway (Horizontal) trend. The procedure followed
is to assign the number 100% to items of the base year and to calculate percentage changes in
each item of subsequent year in relation to the base year. That means this analysis sets the base
year at a value of 100% and then shows subsequent years about increases or decreases over the
base year.
This procedure may be called as “trend-percentage method.” This not only reveals the trend
movement of the financial performance of the enterprise but also highlights the strengths and
weaknesses of the enterprise. Financial Elements can show upward, downward and sideway
(Horizontal) trend.
The formula of Calculating Trend percentages:
= × 100

In financial analysis the direction of changes over a period of years is of crucial importance.
Time series or trend analysis of ratios indicates the direction of change. Trend analysis is
important because, with its long run view, it may point to basic changes in the nature of the
business. By looking at a trend in a particular ratio, one may find whether the ratio is falling,
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rising or remaining relatively constant. From this observation, a problem is detected or the sign
of good or poor management is detected.
Importance of Horizontal Analysis
Horizontal helps the analyst to examine relationships for detecting strengths and weaknesses of a
business entity such as faster growth in the cost of sales compared to sales. The purpose of
horizontal analysis is primarily to direct attention to the financial elements that require further
investigation. It helps to identify trends in various financial elements and forms the basis of
forecast the future performance and position of a business entity.
VERTICAL ANALYSIS
It is a method of financial statement analysis in which each line item is listed as a percentage of a
base figure within the statement. The most common use of vertical analysis is within a financial
statement for a single reporting period, so that one can see the relative proportions of account
balances. It is also known as Static Analysis. There are two primary methods of vertical financial
statement analysis namely Common size statement analysis and Ratio analysis.
1. Common size financial statement analysis:
Common size analysis involves expressing financial data, including entire financial statements,
in relation to a single financial statement item, or base. Items used most frequently as the bases
are total assets or revenue. In essence, common - size analysis creates a ratio between every
financial statement.
A common size analysis expresses each item in the balance sheet as a percentage of total assets
and each item of the income statement as a percentage of total sales.
To prepare common size statements, the components are translated as a percentage of selected
Key components of the financial statement for analysis and interpretations.
For the Common size Statement of profit & loss, Net sales are considered as a base for the
computation of common size percentages of each financial element present in the Statement of
profit & loss. That is the net sales figures is taken as 100% and all other figures of costs and
expenses are expressed as percentage to net sales.
For the Common size Balance Sheet, Total Assets is considered as a base for the computation
of common size percentages of each financial element present in the Balance sheet.
It is one of the simplest methods of financial statement analysis, which reflects the
relationship of each and every item with the base value of 100%. Such statements also allow an
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analyst to compare the operating and financing characteristics of two companies of different
sizes in the same industry. Thus, common size statements are useful, both, in intra-firm
comparisons over different years and also in making inter-firm comparisons for the same year or
for several years.
For Example:
In the case of the Common Size Balance Sheet, for 2020 common size percentages, all individual
financial elements of the Balance Sheet of 2020 are divided by Total assets of 2020 and then
multiplied by 100.
In the case of Common Size Statement of Profit & Loss, for 2020 common size percentages, all
individual financial elements of Statement of Profit & Loss(income statement) of 2020 are
divided by Revenue from Operations [Net]/Sales of 2020 and then multiplied by 100.
2. Ratio analysis
What is meant by ratio?
The ratio illustrates the relationship between the two related variables.
What is meant by the accounting ratio? The accounting ratios are computed based on available
accounting information extracted from the financial statements.
Ratio analysis is an analysis of financial statements with the help of the 'accounting ratio'. It is a
quantitative method of gaining insight into a company's liquidity, operational efficiency,
profitability, and solvency position by studying its financial statements. Its purpose is to provide
a meaningful understanding of the performance and financial position of an enterprise. Ratio
analysis involves the calculation of financial ratios using data from financial statements. A
financial ratio is a relationship between two accounting numbers. These ratios are used to assess
a company’s financial performance and health, i.e. ratios help to make a qualitative judgment
about the firm’s financial performance. Common ratios include liquidity ratios, profitability
ratios, Activity ratios and solvency ratios. In this chapter, we shall have a brief idea about, ratio
analysis
Ratio analysis is among the most popular and widely used tools of financial statement analysis.
Ratio is a mathematical relationship between one numbers to another number. A ratio of 200 to
100 is expressed as 2:1, or simply 2. Ratio is used as an index for evaluating the financial
performance of the business concern. An accounting ratio shows the mathematical relationship
between two figures, which have meaningful relation with each other. To be meaningful, a ratio
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must refer to an economically important relation. For example, there is a direct and crucial
relation between an item’s sales price and its cost. Accordingly, the ratio of cost of goods sold to
sales is important. In contrast, there is no obvious relation between freight costs and the balance
of marketable securities. It is possible to look at the financial health of a company by looking at
some of its key financial ratios. Ratio analysis can also be used as a diagnostic tool to find the
sources of financial trouble at a company. The example in Illustration 2.1 highlights this point.
2.5 STAGES IN FINANCIAL ANALYSIS
Financial analysis consists of the following three major stages.
i) Preparation. The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial statement
analysis focuses primarily on the balance sheet and the income statement. However, data from
statements of retained earnings and cash flows may also be used. So, preparation is simply
objective setting and data collection.
ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.
iii) Evaluation and Interpretation. Involves the determination of the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm’s
performance and financial condition. This is the most important of all the three stages of
financial analysis.
Although we have briefly seen what is meant by the four most common types of financial
analysis, our focus on this material will be on ratio analysis. So in the section that follows, we
will discuss major types of financial ratios with illustrative examples.
2.6 TYPES OF FINANCIAL RATIOS
There are several key ratios that reveal about the financial strengths and weaknesses of a firm.
We will look at five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.
1) Activity ratios - measure how efficiently a company performs day-to-day tasks, such as
the collection of receivables and management of inventory.
2) Liquidity ratios - measure the company’s ability to meet its short-term obligations.
3) Solvency ratios - measure a company’s ability to meet long-term obligations.
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Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.
4) Profitability ratios - measure the company’s ability to generate profitable sales from its
resources (assets).
5) Market Value Ratios – To estimate the intrinsic value of a company (stock).
Exercise 2.1
Let us use the financial statements of Zebra Share Company, shown below to investigate and
explain ratio analysis.
Zebra Share Company
Profit or loss statement
For the Year Ended December 31, 2001
____________________________________________________
Variables 2001 2000
Sales 3,074,000 2,567,000
Less Cost of Goods Sold 2,088,000 1,711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General and Adm. 468,000 445,000
Expenses
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000
Less Interest Expenses 93,000 91,000
Net Profit Before Tax 325,000 212,000
Less Profit Tax (at 29%) 94,250 61,480
Net Income After Tax 230,750 150,520
Less Preferred Stock 10,000 10,000
Dividends
Earnings Available to 220,750 140,520
Common Shareholders
EPS 2.90 1.8
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Zebra Share Company

Comparative Balance Sheet
December 31, 2000 and 2001
(In thousands of Birrs)
2001 2000
Assets
Current Assets
Cash 363,000 288,000
Marketable Securities 68,000 51,000
Accounts Receivables 503,000 365,000
Inventories 289,000 300,000
Total Current Assets 1,223,000 1,004,000
Gross Fixed Assets (at cost)
Land and Buildings 2,072,000 1,903,000
Machinery and Equipment 1,866,000 1,693,000
Furniture and Fixture 358,000 316,000
Vehicles 275,000 314,000
Others 98,000 96,000
Total Fixed Assets 4,669,000 4,322,000
Less Acc. Depreciation 2,295,000 2,056,000
Net Fixed Assets 2,374,000 2,266,000
Total Assets 3,597,000 3,270,000
Liabilities and Owners' Equity
Current Liabilities
Accounts Payable 382,000 270,000
Notes Payable 79,000 99,000
Accruals 159,000 114,000
Total Current Liabilities 620,000 483,000
Long-Term Debts 1,023,000 967,000
Total Liabilities 1,643,000 1,450,000
Shareholder's Equity
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Preferred Stock – 200,000 200,000

Cumulative, 2000 Share
issued and Outstanding
Common Stock, Shares 191,000 190,000
issued and Outstanding in
2001, 76,262; in
2000, 76,244
Paid- in Capital in Excess of 428,000 418,000
Par on Common Stock
Retained Earnings 1,135,000 1,012,000
Total Stockholders' Equity 1,954,000 1,820,000
Total Liabilities and 3,597,000 3,270,000
Stockholders' Equity

2.6.1. LIQUIDITY RATIOS

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due.
Liquidity ratios provide the basis for answering the questions: Does the firm have sufficient cash
and near cash assets to pay its bills on time?
Current liabilities represent the firm's maturing financial obligations. The firm's ability to repay
these obligations when due depends largely on whether it has sufficient cash together with other
assets that can be converted into cash before the current liabilities mature. The firm's current
assets are the primary source of funds needed to repay current and maturing financial
obligations. Thus, the current ratio is the logical measure of liquidity. Lack of liquidity implies
inability to meet its current obligations leading to lack of credibility among suppliers and
creditors. There are two commonly used liquidity ratios: the current ratio and the quick ratio.
A. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term
creditors by using only current assets. That is, it measures a firm’s short-term solvency or
liquidity.

The current ratio is calculated by dividing current assets to current liabilities.

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Current ratio = Current assets

Current liabilities
Zebra’s current ratio (for 2000) = Br. 1,004,000 = 2.08 times
Br. 483,000
Therefore, the current ratio for Zebra Share Company is
For 2001 = 1,223,000 = 1.97
620,000
The unit of measurement is either birr or times. So, we could say that
Interpretation: Zebra share co. has Br. 1.97 in current assets available for every 1 Br. in current
liabilities. An ideal current ratio is 2:1 or more. This is because even if the value of the firm's
current assets is reduced by half, it can still meet its obligations.
However, between two firms with the same current ratio, the one with the higher proportion of
current assets in the form of cash and account receivables is more liquid than the one with those
in the form of inventories.
A very high current ratio than the Standard may indicate: excessive cash due to poor cash
management, excessive accounts receivable due to poor credit management, excessive
inventories due to poor inventory management, or a firm is not making full use of its current
borrowing capacity. A very Low current ratio than the Standard may indicate: difficulty in
paying its short term obligations (the firm may not be able to easily meet its current obligations).
B. Quick (Acid-test) Ratio: This ratio measures the short term liquidity by removing the least
liquid assets such as:
- Inventories: are excluded because they are not easily and readily convertible into cash and
more over, losses are most likely to occur in the event of selling inventories. Because inventories
are generally the least liquid of the firm's assets, it may be desirable to remove them from the
numerator of the current ratio, thus obtaining a more refined liquidity measure.

Acid-Test Ratio is computed as follows.

Quick ratio = Current assets – Inventory
Current liabilities
For 2001, Quick Ration for Zebra Share Company will be: 1,223,000- 289,000 = 1.51
620,000
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Interpretation: Zebra Share has 1birr and 51 cents in quick assets for every 1birr 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. The
current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into
account all current assets without distinction.
As a very high or very low acid test ratio is assign of some problem, a moderately high ratio is
required by the firm.
2.6.2. ACTIVITY RATIOS
Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes
its assets. These ratios are called turnover ratios because they indicate the speed with which
assets are being converted or turned over into sales or cost of goods sold. Activity ratios, thus,
involve a relationship between sales and assets.
Activity ratios are also called asset management ratios, or asset utilization ratios, or efficiency
ratios. These ratios indicate how well the firm manages its assets. They provide the basis for
assessing how the firm is efficiently or intensively using its assets to generate sales. Generally,
high turnover ratios are associated with good asset management and low turnover ratios with
poor asset management
The major activity ratios are the following.
A. Inventory Turnover Ratio
B. Average Age of Inventory
C. Accounts Receivable Turnover Ratio
D. Average Collection Period
E. Average Payment Period
F. Fixed Asset Turnover
G. Total Asset Turnover
A. Inventory Turnover Ratio
The inventory turnover ratio measures the effectiveness or efficiency with which a firm is
managing its investments in inventories is reflected in the number of times that its inventories are
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turned over (replaced) during the year. It is a rough measure of how many times per year the
inventory level is sold or turned over.
Inventory Turnover = Cost of Goods Sold
Average Inventories
For the year of Zebra Share Company for 2001= 2,088,000
(289,000 + 300,000) /2 = 7.09 times
Interpretation: - Zebra Share co. inventory is sold out or turned over 7.09 times per year.
In general, a high inventory turnover ratio is better than a low ratio.
An inventory turnover significantly higher than the industry average indicates: Superior selling
practice, improved profitability as less money is tied-up in inventory.
B. Average Age of Inventory
The number of days inventory is kept before it is sold to customers. It is calculated by
dividing the number of days in the year to the inventory turnover.
Average Age of Inventory =No of days in year /365 days
Turnover Inventory
Therefore, the Average Age of Inventory for Zebra Share Company for the
Year 2001 is:
365 days = 51 days
7.09
Interpretation: This tells us that, roughly speaking, inventory remain in stock for 51 days on
average before it is sold.
The longer period indicates that, Zebra Share is keeping much inventory in its custody and, the
company is expected to reassess its marketing mechanisms that can boost its sales because, the
lengthening of the holding periods shows a greater risk of obsolescence and high holding costs.
C. Accounts Receivable Turnover Ratio: - Measures the liquidity of firm’s accounts
receivable. That is, it indicates how many times or how rapidly accounts receivable is converted
into cash during a year. The accounts receivable turnover is a comparison of the size of the
company’s sales and its uncollected bills from customers. This ratio tells how successful the firm
is in its collection. If the company is having difficulty in collecting its money, it has large
receivable balance and low ratio.
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Receivable Turnover = Net Sales

Average Account Receivables
The accounts receivable turnover for Zebra Share Company for the year 2001 is computed as
under.
Accounts receivable turnover ratio = 3,074,000 = 7.08
(503,000 + 365,000)/ 2
Average Accounts Receivable is the accounts receivable of the year 2000 plus that of the year
2001 and dividing the result by two.
So, 503,000 + 365,000/ 2 = 434,000*
Interpretation: Zebra Share Company collected its outstanding credit accounts7.08 times during
the year.
Reasonably high accounts receivable turnover is preferable.
 A ratio substantially lower than the industry average may suggest that a Company has:
More liberal credit policy (i.e. longer time credit period), poor credit selection, and
inadequate collection effort or policy.
 A ratio substantially higher than the industry average may suggest that a firm has;
More restrictive credit policy (i.e. short term credit period), more liberal cash discount
offers (i.e. larger discount and sale increase), more restrictive credit selection
D. Average Collection Period: Shows how long it takes for account receivables to be cleared
(collected). The average collection period represents the number of days for which credit sales
are locked in with debtors (accounts receivables).
Assuming 365 days in a year, average collection period is calculated as follows.
Average Collection period = 365days
Receivable Turnover
The average Collection period for Zebra Share Company for the year 2001 will be:
365 days/7.08 =51 days or
Average collection period = Average accounts receivables* 365 days/Sales
434,000* 365 days/3,074,000* = 51 days
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 51 days.
The average collection period of a firm is directly affected by the accounts receivable turnover
ratio.
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The higher average collection period is an indication of reluctant collection policy where much
of the firm’s cash is tied up in the form of accounts receivables, whereas, the lower the average
collection period than the standard is also an indication of very aggressive collection policy
which could result in the reduction of sales revenue. Generally, a reasonably short-collection
period is preferable
E. Average Payment Period
The average Payment Period/ Average Age of accounts Payable shows, the time it takes to pay to
its suppliers.
The Average Payment Period = Accounts Payable
Average purchase per day
Purchase is estimated as a given percentage of cost of goods sold. Assume purchases were 70%
of the cost of goods sold in 2001.
So, Average Payment Period = 382,000 = 95 days
2,088,000 x .70/365
Interpretation: This shows that, on average, Zebra Share pays its suppliers in 95 days.
The longer these days, the more the credit financing the firm obtains from its suppliers.
F. Fixed Asset Turnover
Measures the efficiency with which the firm has been using its fixed assets to generate revenue.
The Fixed Assets Turnover for Zebra Share Company for the year 2001 is calculated as follows.
Fixed assert turnover = Net sales
Average Net Fixed Asset
Fixed Assets Turnover = 3,074,000 = 1.33
(2,374,000+2,266,000)/2
Interpretation: This means that, Zebra Share Company has generated birr 1.33 in net sales for
every birr invested in fixed assets.
Other things being equal, a ratio substantially below the industry average shows; underutilization
of available fixed assets (i.e. presence of idle capacity) relative to the industry, possibility to
expand activity level without requiring additional capital investment, over investment in fixed
assets, low sales or both. Helps the financial manager to reject funds requested by production
managers for new capital investments
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Other things being equal, a ratio higher than the industry average requires the firm to make
additional capital investment to operate a higher level of activity. It also shows firm's efficiency
in managing and utilizing fixed assets.
G. Total Asset Turnover- Measures a firm’s efficiency in management its total assets to
generate sales.
Total Assets Turnover = Net sales
Average total asset
The Total Assets Turnover for Zebra Share Company for the year 2001 is as follows.
3,074,000 = 0.9
(3,597,000 +3,270,000)2
Interpretation: - Zebra Share Company generates birr 0.9 (90 cents) in net sales for every birr
invested in total assets.
A high ratio suggests greater efficiency in using assets to produce sales whereas; a low ratio
suggests that Zebra Share is not generating a sufficient volume of sales for the size of its
investment in assets.
2.6.3. SOLVENCY RATIOS
Solvency ratios are also called leverage ratio. Solvency is a firm’s ability to pay long term debt
as they come due. Leverage shows the degree of ineptness of firm. This ratio helps to
understand, how the long-term funds are used in the business concern. 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. There are two types of debt measurement tools. These are: financial leverage
ratio and coverage ratio
A. Financial Leverage Ratio: These ratios examine Long-term solvency position of the firm —
Principal repayment. It include the following two ratios
1. Debt Ratio: This ratio measures the long-term debt of a firm in comparison to its total assets.
Shows the percentage of assets financed through debt. A high debt ratio tells you that a company
has more debt than assets and indicates financial leverage. A low debt ratio indicates a
financially stable business. It is calculated as:
Debt ratio = Total Liability
Total Assets
The debt ratio for Zebra Share Company for the year 2001 is as follows:
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= 1,643,000 = 0.457 or 45.7 %

3,597,00
Interpretation: This indicates that the firm has financed 45.7 % of its assets with debt. Higher
ratio shows more of a firm’s assets are provided by creditors relative to owners indicating that,
the firm may face some difficulty in raising additional debt as creditors may require a higher rate
of return (interest rate) for taking high-risk. Creditors prefer moderate or low debt ratio, because
low debt ratio provides creditors more protection in case a firm experiences financial problems.
2. Debt to Equity Ratio: The debt-to-equity ratio compares a company's total debt to total
equity. A higher debt to equity ratio indicates that more debt financing (long term loans) is used
than investor financing (shareholders).
The debt to equity ratio (also termed as debt-equity ratio) is a long-term solvency ratio that
indicates the soundness of the long-term financial policies of a company. It shows the relation
between the portion of assets financed by creditors and the portion of assets financed by
stockholders. As the debt-to-equity ratio expresses the relationship between external equity
(liabilities) and internal equity (stockholder's equity), it is also known as the "external-internal
equity ratio"..
The Debt- Equity Ratio for Zebra Share Company for the year 2001 is indicated as follows.
Debt -equity ratio = Total Liability
Stockholders' Equity
Debt- Equity ratio = 1,643,000 = 0.84 or 84 %
1,954,000
Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.
B. Coverage Ratio: These ratios are computed to know the solvency of the firm in making the
periodical payment of interest and preference dividends. The interest and preference dividends
are to be paid irrespective of the earnings available in the hands of the firm. In other words, these
are known as fixed commitment charge of the firm. It include the following two ratios:
1. Interest coverage ratio: The firms are expected to make the payment of interest on the
borrowings without fail. This ratio facilitates the prospective lender to study the strength of the
enterprise in making the payment of interest regularly out of the total income. To study the
capacity in making the payment of interest is known as interest coverage ratio or debt service
coverage ratio.
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Interest coverage ratio for Zebra Share Company for the year 2001 is:
Interest coverage Ratio =Earnings before Interest and Tax
Interest Expense
418,000 = 4.5
93,000
Interpretation: Zebra has operating income 4.5 times larger than the interest expense.
The interest coverage ratio implicitly assumes a firm’s operating income (EBIT) is available to
meet its interest obligations. Since the interest coverage ratio is substantially high, it means that
Zebra Share Company has quite a good capacity in making the payment of interest and has high
safety.
2. Dividend Coverage Ratio
It illustrates the firms' ability in making the payment of preference dividend out of the earnings
available in the hands of the firm after the payment of taxation. The greater the size of the profits
after taxation, the greater is the cushion for the payment of preference dividend and vice-versa.
The preference dividends are to be paid without fail irrespective of the profits available in the
hands of the firm after the taxation.
Dividend Interest coverage ratio for Zebra Share Company for the year 2001 is:
Dividend coverage ratio = Earning after tax
Preference dividend
Dividend coverage ratio = 230,750 =23.075
10,000
Interpretation: Since the value of the dividend coverage ratio is quite high, the company has a
strong cushion for the payment of preference dividend.

2.6.4. Profitability Ratios:

Profitability is the ability of a business to earn profit over a period of time. Profitability ratios are
used to measure management effectiveness. Besides management of the company, creditors and
owners are also interested in the profitability of the company. Creditors want to get interest and
repayment of principal regularly. Owners want to get a required rate of return on their
investment. Generally, two major types of profitability ratios are calculated:
1 profitability in relation to sales
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2. Profitability in relation to investment

While discussing the measure of the profitability of the firm, the profits are normally classified
into various categories.
A. Gross Profit Margin
B. Operating Profit Margin
C. Net Profit Margin
D. Return on Investment (ROI)
E. Return on Equity (ROE)
F. Earnings per Share (EPS)
A. Gross Profit Margin: The ratio elucidates the relationship between gross profit and sales
volume. It facilitates the study of the firm's profit-earning capacity out of the manufacturing or
trading operations. This ratio computes the margin earned by the firm after incurring
manufacturing or purchasing costs. It indicates management effectiveness in pricing policy,
generating sales and controlling production costs. A high Gross Profit ratio indicates low
production & high sales cost, whereas a low Gross Profit ratio indicates the high cost of
production & low selling price. It is calculated as:
Gross Profit Margin = Gross Profit
Net Sales
The gross profit margin for Zebra share Company for the year 2001 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: Zebra share company profit is 32 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross profit margin ratio may
increase by: Higher sales price, CGS remaining constant, lower CGS, sales prices remains
constant. Whereas, a low gross profit margin may reflect higher CGS due to the firm’s inability
to purchase raw materials at favorable terms, inefficient utilization of plant and machinery, or
over investment in plant and machinery, resulting higher cost of production.
B. Operating Profit Margin: The operating ratio measures the relationship between operating
profit & net sales. This ratio is calculated by dividing the net operating profits by net sales. The
net operating profit is obtained by deducting operating expense from the gross operating profit.
The operating profit margin is calculated as:
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Operating Profit Margin = Operating Profit

Net Sales
The operating profit margin of Zebra share Company for the year 2001 is:
418,000 = 13.60
3,074,000
Interpretation: Zebra share Company generates around 14 cents operating profit for each of birr
sales. The higher the ratio, the better it is for the firm. A higher operating profit ratio suggests a
high operating margin used to pay other non-operating expenses, finance cost, and taxes.
C. Net Profit Margin: This ratio is one of the very important ratios and measures the
profitableness of sales. It is calculated by dividing the net profit to sales. The net profit is
obtained by subtracting operating expenses and income taxes from the gross profit. Generally,
non operating incomes and expenses are excluded for calculating this ratio. This ratio measures
the ability of the firm to turn each birr of sales in to net profit.
The ratio expresses the relationship between the net profit and sales volume. It facilitates the
portrayal of the overall operating efficiency of the firm. The net profit ratio is an indicator of the
firm's overall earning capacity in terms of return out of sales volume A high net profit margin is
a welcome feature to a firm and it enables the firm to accelerate its profits at a faster rate than a
firm with a low profit margin. It is calculated as:
The net profit margin for Zebra share Company for the year 2001 is:
Net Profit Margin = Net Income
Net Sales
230,750 = 7.5 %
3,074,000
Interpretation: This means that Zebra share Company has acquired 7.5 cents profit from each
birr of sales.
Total Revenues = Revenue from operations + Other Income
Total expenses = Cost of goods sold + Office expenses + Administrative expenses + Selling
expenses + Distribution expenses + Interest on loans + Tax
Net profit = Total revenues – Total expenses
The higher the ratio, the better the firm's position is which means that the firm earns greater
profits out of the sales and vice-versa.
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D. Return on Investment (ROI): The return on investment also referred to as Return on Assets
measures the overall effectiveness of management in generating profit with its available assets,
i.e. how profitably the firm has used its assets. Income is earned by using the assets of a business
productively. The more efficient the production, the more profitable is the business. This ratio
indicates the 'overall efficiency' of the firm. The return on assets is calculated as:
Return on Assets (ROA) = Net Income
Total Assets
The return on assets for Zebra share Company for the year 2001 is:
230,750 = 6.4 %
3,597,000
Interpretation: Zebra share Company generates little more than 6 cents for every birr invested
in assets. The higher the ratio, the better it is.
E. Return on Equity Capital /Shareholders Fund: indicates the rate of return earned by a
firm’s stockholders on investments made by them. The shareholders of a company may
Comprise Equity share and preferred share holders. Preferred shareholders are the shareholders
who have a priority in receiving dividends (and in return of capital at the time of widening up of
the Company). The rate of dividend divided on the preferred shares is fixed. But the ordinary or
common share holders are the residual claimants of the profits and ultimate beneficiaries of the
Company. The rate of dividends on these shares is not fixed. When the company earns profit it
may distribute all or part of the profits as dividends to the equity shareholders or retains them in
the business itself. But the profit after taxes and after preference shares dividend payments
presents the return as equity of the shareholders. This ratio is also known as 'Return on Net
Worth. The profitability & performance of the company is judged using this ratio. Equity
shareholders use this ratio to take their investment decisions.
The Return on equity is calculated as:
ROE = Net Income
Stockholders’ Equity
The Return on equity of Zebra share Company for the year 2001 is:
230,750 = 11.8%
1,954,000
Interpretation: Zebra share Co. generates around12 cents for every birr in shareholder’s equity.
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Shareholder equity = Equity share capital + Reserves and Surplus – Accumulated losses
• High ROEC will satisfy the shareholders (or owners).
• Low ROEC indicates the low profitability of the company.
F. Earnings per Share (EPS): EPS is another measure of profitability of a firm from the point
of view of the ordinary shareholders. It reveals the profit available to each ordinary share. It is
calculated by dividing the profits available to ordinary shareholders (i.e. profit after tax minus
preference dividend) by the number of outstanding equity shares.
The earnings per share is calculated as follows:
Common EPS = Earnings Available for Common Stockholders
Number of Shares of Common Stock Outstanding
Therefore, the earning per share of Zebra share Company for the year 2001 is:
EPS = 220,750 = birr 2.90 per share
76,262 shares
We can also use the following alternative way to calculate EPS.
EPS = Net income after tax – preferred dividend 230,750- 10,000 = 2.90
Number of Shares of Common Stock Outstanding 76,262
Interpretation: Zebra share Company earns birr 2.90 for each common shares outstanding.
The higher the ratio, the better it is, as it means
• The company is more profitable and
• The company has more profits to distribute to its shareholders.
• The company has a strong financial position.
• It is a reliable company to invest money
2.6.5. Market Value Ratio:
Market value also called valuation ratios are the most significant measures of a firm's
performance, since they measure the performance of the firm's common stocks in the capital
market. This is known as the market value of equity and reflects the risk and return associated
with the firm's stocks.
These measures are based, in part, on information that is not necessarily contained in financial
statements – the market price per share of the stock. Obviously, these measures can only be
calculated directly for publicly traded companies.
The following are the important valuation ratios:
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A. Price- Earnings (P/E) Ratio: It shows the relationship between the stock price and the
earnings of the company. It indicates how much an investor is willing to pay to buy one share
based on its' earnings. A high P/E ratio indicates that the company's share is sold in the stock
market at a high price, and the investors have high expectations. At the same time, it indicates
the low profits of the company as the EPS (denominator) is less.
The P/E ratio can be calculated as:
P/E Ratio = Market Price per Share
Earnings per Share
The price per share could be the price of the share on a particular day or the average price for a
certain period.
Assume that Zebra share Company's common stock at the end of 2001 was selling at birr 32.25,
using its EPS of birr 2.90, the P/E ratio at the end of 2001 is:
= 32.25/ 2.90 = 11.10
Interpretation: This figure indicates that, investors were paying birr 11.10 for each 1.00 of
earnings. Though not a true measures of profitability, the P/E ratio is commonly used to assess
the owners' appraisal of shares value. The P/E ratio represents the amount investors are willing to
pay for each birr of the firm's earnings. The level of P/E ratio indicates the degree of confidence
(or Certainty) that investors have in the firm's future performance. The higher the P/E ratio, the
greater the investor confidence on the firm's future. It is a means of standardize stock prices to
facilitate comparison among companies with different earnings.
B. Market Value to Book Value (Market-to-Book) Ratios
The market value to book value ratio is a measure of the firm's contributing to wealth creation in
the society. It is calculated as:
Market-Book Ratio = Market Value pre Share
Book Value per Share
The book value per share can be calculated as:
Book value per share = Total Stockholders’ Equity
No. of Common Shares Outstanding
Book Value per Share for 2001 = 1,954,000 = 25.62
76,262
Therefore, the Market-Book Ratio for Zebra share Company for the year 2001 is:
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32.25 = 1.26
25.62
The market –to-book value ratio is a relative measure of how the growth option for a company is
being valued via-a vis- its physical assets. The greater the expected growth and value placed on
such, the greater this ratio.
2.7 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.
2.8 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS
Financial ratios are used almost universally by companies of all sizes to provide numerical
information on the profitability, health and direction of the business. Financial ratios provide
useful analysis and can help drive management toward making better decisions if they are
interpreted correctly. At face value, ratio analysis is the measure of strength and weakness of the
firm; however, there are some drawbacks to relying on these metrics. Even though ratio analysis
can provide useful information about a firm’s financial conditions and operations, it has the
following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason could
be a single firm may have different divisions operating in different industries. Another
reason could be the financial statements may not be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when they are not
audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
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5. Inflation badly distorts comparison of ratios of a firm over time.

6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For
example, the inventory turnover ratio for a stationery materials selling company will be
different at different time periods of a year.
7. Financial Statements only provide historical data for a company’s performance and it
may not reflect its future performance or potential. Market conditions, economic trends,
and other factors Financial may change in the future. All of these factors can impact a
company’s financial position and performance.
8. Financial statements may not provide a complete picture of a company’s financial
position. This happens because the statements may not include information on non-
financial factors such as the quality of management, intellectual property, or brand
recognition.
9. Financial statements can be impacted by external factors such as changes in economic
conditions, industry trends, or changes in business requirements. These factors may not
be reflected in the financial statements and might require some additional analysis to
understand the impact.
2.9 SUMMARY
The primary purpose of this unit was to learn how to analyze financial statements.
The basic points discussed are:
- There are several techniques of financial analysis; but ratio analysis is common.
- Financial ratios are classified into different categories, measuring about a firm’s liquidity,
activity, leverage, earning powers, and other related aspects.
- Current and quick ratios are the two commonly used liquidity ratios.
- Activity ratios include turnover ratios like accounts receivable turnover, inventory
turnover, fixed assets turnover, and total assets turnover.
- Leverage ratios reveal two information associated with debt of a firm. These ratios
include debt ratio, times interest earned, and fixed charges coverage.
- Profitability ratios indicate the earning power of a firm. Ratios under this category
include profit margin, return on assets, and return on investment.
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- Marketability ratios, unlike the other categories, do not measure specific aspect of a firm.
Earnings per share, dividends per share and pay-out ratio are among the most common
types.
- To compare ratios, cross – sectional or time – series analyses can be employed.
- Financial ratios, though are important and useful analyses, have many problems and
limitations
2.11. MODEL EXAMINATION QUESTIONS
Part I: essay
1. What is financial statement?
2. What is financial statement analysis?
3. Explain various techniques of financial statement analysis.
4. What is ratio analysis? Explain its types.
Part II. Multiple choices
1. Identify the factor that contributes for shorter days sales outstanding
A. Longer credit periods C) Strong cash collection policy
B. Limited cash discount offers D) Poor credit selection
2. If new shares of common stock are issued in exchange for the existing debt of a firm,
then
A. Return on investment increases.
B. Times interest earned ratio will decrease.
C. Return on stockholders’ equity will decrease.
D. Current and quick ratios will increase.
3. A relatively lower return on assets is always an indicator of poor asset management.
A. True B) False

Part III. Exercises

1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br. 200,000,
and long-term bond of Br. 225,000. If the total stockholders’ equity of the company
amounts to Br. 750,000, what is the debt ratio?
 29

2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between inventories
and current liabilities for this firm?
3. ABC company’s return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The firm’s
annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%.
What is XYZ Company’s times interest earned ratio?