Chapter Two

Financial statement analysis

Financial analysis is designed to determine the relative strengths and weaknesses of a
company. Investors need this information to estimate both future cash flows from the
firm and the riskiness of those cash flows. Financial managers need the information
provided by analysis both to evaluate the firm’s past performance and to map future
plans. Financial analysis concentrates on financial statement analysis, which highlights
the key aspects of a firm’s operations.
Financial statement analysis: is a process of evaluating relationships between
component parts of financial statements to obtain a better understanding of the firm’s
financial condition and performance. The focus of financial analyses is on key figures in
the financial statements and the significant relationship that exists between them.
Financial analysis helps users understand the numbers presented in the financial
statements and serves as a basis for financial decision making.
Financial analysis consists of three major steps.
1. Preparation involves establishment of objectives of the analysis and assembling the
financial statements and other relevant financial data. Objective depends on the need of
the user and the questions to be answered by the analyst. For example:
• Shareholders (present and prospective) are interested in the firm’s current and future
level of risk and return as these dimensions directly affect share price.
• Creditors (present and prospective) are primarily concerned with the short term liquidity
of the firm i.e. its ability to pay its current liabilities as they come due. A secondary
concern of creditors (esp. long term creditors) is the firm’s profitability. They want
assurance that the business is healthy and will continue to be successful.
• Management: for planning and controlling decisions. Although management, unlike
creditors and stockholders, has internal reports at its disposal, the financial statements do
add considerable information about the strength and weaknesses of the firm. Questions
that can be at least partially assessed from financial statements are:
• How efficiently the firm uses assets; how it finances them?
• How has it performed in the past?
• What changes are needed to improve future performance?
2. Computation: involves the application of tools and techniques to gain a basic
understanding of the firm’s financial status and performance. The most frequently used
techniques in analyzing financial statements are:
a) Ratio analysis: converts figures in the financial statements to ratios.
b) Common size statements: express individual statement accounts as a percentage of
a base amount.
● Common size balance sheet: is one in which each item is expressed as a
percentage of total assets.
● Common size income statement: is one in which each item is expressed as a
percentage of total sales.
N.B. Ratio and common size statements help standardize statements of different sizes and
currency. Example: statements of Ford and GM which are so different in size and GM
and Toyota which use different currency.
3. Evaluation and interpretation: involves the determination of the meaningfulness of
the analysis to develop conclusions and recommendations about the firm’s financial
performance and status. Financial statement is not merely computing ratios or common
size statements but more importantly it involves the interpretation of the analysis results.
RATIO ANALYSIS
“A single figure by it self may have no meaning but when expressed in terms of a related
figure it yields significant inferences.”
Ratio analysis involves the methods of calculating and interpreting financial ratios to
assess financial performance and status. It standardizes financial data by converting birr
figures in the financial statements in to ratios.
Types of ratio comparisons
Ratios as yardsticks or financial flags of a firm’s overall performance are meaningful
only when compared with appropriate standards.
Three types of ratio comparisons
1. Cross-sectional analysis: involves comparison of different firm’s financial ratios at
the same point in time. A firm’s ratios may be compared to those of the industry leader (
to increase efficiency) or to industry averages.
● The comparison of a particular ratio to the standard is made to isolate any
deviation. Thus it is important for the analyst to investigate significant deviations to
either side (positive or negative) of the standard.
● The analyst must also recognize that ratio comparisons resulting in large deviations
from the norm reflect only the symptoms of a problem. Further analysis of the
statements coupled with discussions with key managers is typically required to isolate
the causes of the problem.
2. Time series analysis (trend analysis) is the evaluation of the firm’s financial
performance over time using ratio analysis. Any significant year to year changes can be
evaluated to assess whether they are symptomatic of major problem.
3. Combined analysis: the most informative approach that combines cross-sectional and
time-series analyses. A combined view permits assessment of the trend in the behavior of
the ratio to the trend of the industry.
Some words of caution
1. Single ratio doesn’t generally provide sufficient information. Only when a group of
ratios is used can reasonable judgments be made.
2. Financial statements being compared should be dated at the same point in time during
the year. Otherwise effects of seasonality may produce erroneous conclusions and
decisions. For example inventory turnover may be low at June because of high inventory
level and high at December because of low inventory level.
3. Audited financial statements should be used.
4. The financial data being compared should be prepared in then same way.
5. Inflation and differing asset ages can distort ratio comparisons.
6. Ratio analysis merely directs the analyst to potential areas of concern; it does not
provide conclusive evidence as to the existence of a problem. For example a very high
inventory turn over, the speed with which the firm moves its inventory from raw
materials through production in to finished goods and to the customer as a completed
sale, may be due to low inventory which means excessive stock outs (insufficient
inventory).
Types of ratios
1. liquidity ratio
2. activity ratio
3. debt ratio
4. profitability ratio
5. valuation ratios
• liquidity, activity, and debt ratios primarily measure risk; profitability ratios
primarily measure return
• in the near term, the important elements are liquidity, activity, and profitability,
since these provide information that is critical to the short run operation of the
firm. (If a firm can not survive in the short run we need not be concerned with
its long term prospects.)
• debt ratios are useful primarily when the analyst is sure that the firm will
successfully wither the short run.
Consider the following financial statements to illustrate the computation of the above
ratios.
Alpha Co.
Balance sheet
December 31, 2005
Assets
Current assets
Cash 360
Marketable security 70
Accounts receivable 500
Inventories 290
Total current assets 1220
Fixed assets 4670
Less: accumulated depreciation 2290
Net fixed assets 2380
Total assets 3600
Liabilities and stockholders equity
Current liabilities
Accounts payable 380
Notes payable 80
Accruals 160
Total current liabilities 620
Long term debts 1020
Total liabilities 1640
Stockholders equity
Preferred stock 200
Common stock 620
Retained earnings 1140
Total stockholders equity 1960
Total liabilities and stockholders equity 3600
 Alpha Co
Income statement
For the year ended on Dec. 31, 2005

Sales 3200
Less: sales returns 130
Net sales 3070
Less: cost of goods sold 2090
Gross profit 980
Less: operating expenses 570
Operating profits 410
Less: interest expense 90
Net profit before taxes 320
Less: taxes 90
Net Profit after taxes 230

1. LIQUIDITY RATIOS
Measure the ability of the firm to meet its short term obligations and reflects its short
term financial strength. Are a firm’s current assets sufficient to pay its current liabilities?
Two commonly used liquidity ratios are:
a) Current ratio: measures a firm’s ability to satisfy the claims of short term creditors by
using all current assets.
current assets
Current ratio =
current liabilities
For Alpha Co. for 2003:
1220
Current ratio = = 1.97
620
Assume industry average of 1.80
Rule thumb (commonly acceptable by creditors) is 2.00
Interpretation: Alpha Co. has $1.97 in current assets for every dollar in current liabilities.
● Too low current ratio may suggest that a firm may face difficulty in paying its short
term liabilities.
● Too high current ratio indicates that too much capital is tied up in current assets and the
firm may be sacrificing some returns possibilities, or a firm is not making full use of its
current borrowing capacity (short term sources are less expensive than long term ones.)
N.B. the acceptability of a ratio depends on the industry in which the firm operates. For
example a current ratio of 1 may be acceptable for a utility but might not be acceptable
for a manufacturing firm. The more predictable a firm’s cash flow the lower the
acceptable ratio.
● While current liabilities must be settled by making payments in full, current assets are
subject to shrinkage in value due to bad debts, obsolescence, or loss of market.
Example: determine the percentage by which Alpha company’s current assets could
shrink or drop out with out making it impossible for the firm to cover its current
liabilities.
 1
Maximum shrinkage = (1 - ) x 100% , CR= current ratio
CR
in value of current assets

=(1- 1 ) x 100%
1.97

= 49%
⇒ The co can still cover the current liabilities even if its current assets shrink by 49%.

CA − CL 1220 − 620
⇒ Margin of safety = = = 97%
CL 620
b) Quick (acid test) ratio:
Measures short term solvency by removing the least liquid assets such as:
⇒ Inventory: excluded because they are not easily and readily convertible in to cash.
Moreover, losses are most likely to occur in the event of selling inventories.
⇒ Prepaid expenses: excluded because they are not available for the payment of debts.
Quick assets: cash, marketable securities, accounts receivable, notes receivable, etc.
quick assets
Quick ratio =
current liabilities
930
For Alpha Co. (2003) = = 1.50
620
Industry average= 1.60
Acceptable ratio = 1
⇒ Alpha co has $ 1.50 in quick assets for every dollar in current liabilities. The ratio
suggests the firm holds more inventory than the industry average.
Summary:
⇒ Current ratio is a crude measure of liquidity as it takes all current assets. It is a
quantitative measure of liquidity.
⇒ The quick ratio is a more regressive and penetrating test of liquidity as it takes only
quick assets. It is a qualitative measure of liquidity.
2. ACTIVITY RATIOS
⇔ These are also called efficiency ratios or asset utililization ratios, or asset
management ratios.
Activity ratios measure how efficiently a company manages its assets. They are also
called turnover ratios as they measure the speed at which various accounts are converted
in to sales or cash.
Activity ratios are important as additional measure of liquidity.
N.B. Though generalization may be misleading, high turnover ratios are usually
associated with good asset management and low turnover ratios with bad asset
management.
a) Inventory turnover ratio
This indicates how quickly inventory is sold. It measures the efficiency of management in
managing sale of inventory.
 cos t of goods sold
ITO =
inventory
N.B. For convenience the activity ratios for current accounts assume that their end-of-
period values are good approximations of the average account balance during the year. If
inventory, accounts receivable, or accounts payable balances vary during the year, an
average balance, calculated by dividing the sum of the beginning of the year and end of
the year balances by 2, should be used instead of the year-end balance.
2090
ITO = = 7.2times
290
⇒ Alpha Co. is converting its inventory to sales 7.2 times in a year. Generally, higher
than average inventory turnovers are suggestive of good inventory management.
⇒ An ITO significantly higher than the industry average indicates:
● Superior selling practice
● improved liquidity and profitability
● fewer cases of damaged or obsolete inventory
● Such problems as:
- very low level of inventory
- lost sales due to insufficient level of inventory
- firm’s policy of buying in small quantities
- production interruptions
⇒ An ITO significantly lower than the average firm in the industry indicates:
● over investment in inventory
● inferior quality goods, stock of unsalable or obsolete inventory
● higher rent of space, insurance cost, property tax, & other inventory carrying
costs
b) Average collection period (days’ sales outstanding)
This 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 its A/R to cash or number of
days sales is tied up in A/R.
365days 365 X A / R 365 x 500
ACP = = = = 59.4days
ARTO net sales 3070
net sales
ARTO= = 6.14 X
A/ R
• On the average it takes 59.4 days for the firm to collect an A/R.
• Industry average = 44.3days
• Credit policy = 30 days
⇒ Alpha’s credit department is not properly managed. Its credit activities are poor as it
takes an average of 59 days to collect an A/R which is greater than both the industry
average and the firm’s credit policy.
Additional information would be required to draw definitive conclusions about the
effectiveness of the firm’s credit and collection policies. E.g. if the firm had extended 60-
days credit terms the 59 days average collection period would be quite acceptable.
N.B. Aging schedule of A/R is an additional tool of financial analysis.
c) Fixed Assets Turnover ( FATO)
Measures the efficiency with which the firm uses its fixed assets to generate sales. It
shows how many birrs of sales are supported by one birr of fixed assets.
net sales 3070
FITO = = = 1.29
net fixed assts 2380
⇒ Alpha company generated $1.29 in net sales for every dollar invested in fixed assets.
However, this is below the industry average indicating that the firm is not using its fixed
assets as high a percentage of capacity as are other firms in the industry. Management
should bear this in mind when its production people request funds for new capital
investments.
⇒ Other things equal a ratio substantially below the industry average shows:
● Underutilization of available fixed assets (i.e. presence of idle capacity relative to
the industry)
● Overinvestment in fixed assets or low sales level, or both, and suggest that net
sales should increase, some fixed assets should be disposed off or both.
⇒ Other things beings equal, a ratio higher than the industry average requires the firm to
make additional capital investment to operate at a higher level of activity as this shows
more efficiency in managing and utilizing fixed assets.
d. Total Assets Turnover (TATO)
TATO indicates the efficiency with which the firm uses all its assets to generate sales.
Generally, the higher a firm’s total asset turnover, the more efficiently its assets have
been used.
This measure is probably of greatest interest to management, since it indicates whether
the firm’s operations have been financially efficient.
net sales 3070
TATO = = = 0.85
total assets 3600
Industry average= 0.75
Alpha generates $0.85 in sales for every dollar invested in total assets. Generally Alpha is
efficient in managing its total assets as compared to the average firm in the industry.
⇒ A relatively high ratio suggests greater efficiency in managing total assets.
⇒ A relatively low ratio suggests the firm is not generating a sufficient volume of sales
for the size of its asset investment. Sales should be increased, some assets should be
disposed of, or both.
NOTE: One caution with respect to use of fixed asset turnover and total asset turnover is
from the fact that the calculations use the historical costs of fixed assets. Since some
firms have significantly newer or older or older assets than others, comparing fixed asset
turnovers of those firms can be misleading. Because of inflation and the historically
based book values of assets, firms with new assets will tend to have lower turnovers than
those with older assets having lower book values. The differences in these turnovers
could result from more costly assets rather than from differing operating efficiencies.
e. Average Payment Period (APP)
APP measures the average length of time creditors must wait to receive their cash. It
indicates the average amount of time needed by the firm to pay its accounts payable.
 A / P x 365 365 x 380
= = 94.81 days
APP = annual credit purchases 1463

A/ P
Or APP = average purchases per day

Industry average = 80 days

Suppliers give 75 days
Interpretation: Alpha Co. would be given a low credit rating as the it presents prospective
lenders and suppliers of trade credit with risk.
N.B. If the company’s suppliers on average have extended 90-day credit terms its credit
would be acceptable. Prospective lenders and suppliers of trade credit are especially
interested in the average payment period since it provides them with a sense of the bill-
paying patterns of the firm.
III. DEBT MGT RATIOS
Also called solvency ratios, leverage ratios, or capital structure ratios.
These are of two general types: those which show:
1. Degree of indebtedness - the extent to which a firm finances itself with debt as
opposed to equity, using balance sheet items
2. Ability to service (pay) debts- the ability of the firm to generate a level of
income sufficient to meet its obligations (fixed charges) such as interest, and
principal payments on loans, preferred dividends, etc.
The manner in which assets are financed has a number of implications:
► from debt and equity, debt is more risky.
► Employment of debt is advantageous in two ways: 1) owners can retain the firm with a
limited stake (investment) i.e. high EPS 2) their earnings ( EPS) will be magnified, when
the firm earns a rate of return on capital is higher than interest rate on borrowed funds.
The process of magnifying shareholders return through debt is called financial leverage.
High leverage also means high risk if firm’s rate of return is less than cost of debt also
bankruptcy incase of insolvency.
► A highly debt-burdened firm will find difficulty in raising funds from creditors and
owners in future.
⇒ Generally, leverage ratios are calculated to measure financial risk of a firm and its
ability to use debts to shareholders’ advantage.
To illustrate the leverage concept consider the following case. A firm is considering two
financing options for its $50,000 assets.
1. No debt plan- under which 200 shares of $250 per share are to be sold
2. Debt plan – issuance of 100 shares at $250 and borrowing $25,000 at 12% annual
interest rate.
Regardless of which option is taken, the Co. expects sales to average $30,000, costs and
operating expenses to average $18,000, tax of 40%.
30000 − 18000 − 4800
● EPS under the first plan = = 37.50
200
 12000 − .12 x 25000 − .4 x9000
● EPS under the second plan = = 54
100
Since the second plan has a higher leverage its earnings per share is magnified.
i. Leverage Ratios
a) Debt-Asset ratio (Debt Ratio)
- Debt Ratio measures the proportion of total assets financed by the firm’s creditors.
total liabilities 1640
DR = = = 0.456 = 45.6%
total assets 3600
Industry average = 40%
Interpretation: 45.6% of the company’s total assets is financed by debt funds. The
remaining 54.4% is obtained from equity. Since the average debt ratio for the industry is
about 40% Alpha would find it difficult to borrow additional funds with out first raising
equity capital. Creditors would be reluctant to lend the firm more money, and
management would probably be subjecting the firm to the risk of bankruptcy if it sought
to increase the debt ratio any further by borrowing additional funds.
N.B. Creditors prefer low debt ratios, because the lower the ratio the greater the cushion
against creditors’ losses in the event of liquidation. Stockholders’, on the other hand, can
benefit from leverage because it magnifies earnings.
b) Debt Equity Ratio
Measures the extent to which debt financing sources are used relative to equity. i.e.
relative claims of creditors and shareholders against the assets of the firm.
Total Debt 1640
Debt equity ratio= = = 0.84
stockholders ' equity 1960

Interpretation: For each dollar supplied by stockholders, creditors have supplied $0.84.
N.B. Debt to assets and debt to equity ratios are simply transformations of each other.
Both of the two indicate the same thing – the extent to which the firm has relied in
financing its assets.
TD
⇒ DE =
TA − TD
⇒ DE(TA) – DE(TD) =TD

⇒ DE(TA) = TD + DE(TD)
DE DR
⇒ DR = AND DE =
1 + DE 1 − DR
ii. COVERAGE RATIOS
Measure a firm’s ability to meet (cover) fixed charge obligations such as:
⇒ Interest on loans
⇒ Lease payments
⇒ Preferred dividend
⇒ Repayment of the installment of loans or redemption of preferred capital on maturity
a) Times Interest Earned (interest coverage) ratio
TIE measures a firm’s ability to pay interest on its debt using operating profits. It shows
the extent to which operating income can decline before the firm is unable to meet its
annual interest costs. Failure to meet these obligations can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
Earnings Before Interest and Taxes 410
TIE = = = 4.56 x
Interst Expense 90
Interpretation: Alpha generates $4.56 in operating income for each dollar of interest
expense that is far below the average for the industry. Thus alpha is covering its interest
charges by a relatively low margin of safety which reinforces our conclusion that it may
face difficulties if it attempts to borrow additional funds. A high TIE ratio implies the firm
has sufficient margin of safety to cover its interest charges. That is the firm’s earnings
could decline with out jeopardizing its ability to make interest payments.

N.B. Earnings before interest and taxes, rather than net income, is used in the
numerator. This is because interest is paid with pretax dollars; the firm’s ability to pay
current interest is not affected by taxes.
⇒ The Times-Interest-Earned ratio implicitly assumes that remaining income (after
subtracting production, operating, and administrative expenses from sales) is available to
meet interest expense. However, Earnings–Before-Interest–and-Taxes is an income
concept not a direct measure of cash. Consequently, this ratio provides only an indirect
measure of the firm’s ability to meet its interest payments.
b) Fixed Charge Coverage ratio: measures the firm’s ability to meet all fixed payment
obligations, such as loan interest and principal, lease payments, and preferred stock
dividends.
EBIT + Lease payments
FCCR =
Pr eferred dividend + Pr incipal payments
Interest + Lease payments +
1− T
Where T = income tax rate
Additional information:
⇒ Alpha Co. has a 4- year financial lease requiring annual beginning of year payment of
35.
⇒ Annual principal repayment of the firm’s total outstanding debt amount to $71
⇒ The annual preferred stock dividend would total $10
⇒ Tax rate is 40%
410 + 35
FCCR = = 1.71x
71 + 10
90 + 35 +
1 − 0.4
⇒ Interpretation: Fixed charges of Alpha Company are covered 1.71 times using its
earnings. This relatively low ratio gives creditors and preferred stockholders small
margins of safety incase Alpha Company experiences lower earnings.
⇒ A high ratio suggests greater protection incase of worsening of financial position.
c) Cash Coverage ratio:
- is a measure of cash available to pay interest.
A problem with TIE ratio is that it is based on EBIT that is not a real measure of Cash
available to pay interest as it excludes non cash expenses.
EBIT + depreciation 410 + 150
Cash coverage ratio = = = 6.22
int erest 90
Alpha Co. is able to generate cash from operation of 6.22 times its obligation for interest.
4. PROFITABILITY RATIOS
Profitability ratios provide an overall evaluation of performance of a firm and its
management. The ratios examined thus far provide some information about how the firm
operates, but profitability ratios show the combined effects of liquidity, asset
management, and debt management on operating results. i.e. they give final answers
about how effectively the firm is managed.
Profitability ratios measure the returns generated by the firm from several aspects: a) on
a per share basis b) on a per dollar basis c) on per dollar of asset basis d) on per dollar
of stockholders’ equity basis.
Profitability ratios measure the over all management effectiveness in generating profit on
sales, total assets and owners equity.
a) Gross profit margin: measures the percentage of each sales dollar remaining after the
firm has paid for its goods. It indicates management’s effectiveness in pricing its
products, generating sales and in controlling production costs.
gross profit 980
Gross profit margin = = = 0.3192 = 31.92%
net sales 3070
Industry average = 30%
Interpretation: alpha company generates gross margin of $0.32 from each dollar sale.
This is slightly beyond the industry average indicating that the pricing policy and
production cost control of the company is in a good position.
b) Operating profit margin: measures the percentage of profits earned on each sales
dollar before interest and taxes. It measures pure profits earned on each dollar as it
ignores any financial or government charges (interest and taxes) and measures only the
profits earned on operations. A high operating profit margin is generally preferred.
operating profits EBIT 410
Operating profit margin = = = = 13.30
netsales net sales 3070
Industry average = 11%
Interpretation: alpha company generates 13.3% or 13.3 cents in operating profit per dollar
f net sales. This is above the industry average indicating that the firm incurs relatively
lower operating costs and has high selling prices or high volume of sales. That is, it gets
better profit from its operating activities.

c) Net profit margin (or profit margin)

► measures the percentage of each sales dollar remaining after deducting all expenses,
including taxes. Profit margin is a function of three factors: sales generating capacity
(sales volume), pricing strategy, and cost controlling strategy.
net income 230
Net profit margin = = = 0.075 = 7.5%
net sales 3070
Industry average: Alpha xo generates 7.5 cents in profit for every dollar in sales. This is
slightly above the average for the industry indicating that alpha has a relatively higher
sales and/or lower expenses i.e. better selling practices and cost reduction management.

d) Return on investment (return on assets)

► ROI measures the overall effectiveness of management in generating profits with its
available assets. Profit margin measures profitability per sales dollar, and total assets turn
over ratio measures how well assets are managed. Thus ROI can be understood as
occurring from a combination of profit margin and activity.

net income 230

ROI = = = 0.064 = 6.4%
total assets 3600
Du Pont formula:
net income net sales
ROI = × = profit m arg in × total assets turnover
net sales total assets

= .075 × 0.85 = 6.4%

Industry average = 4.8%
Interpretation: Alpha generates a return of 6.4 cents on each dollar invested in its assets
which is well above the industry average. This positive result is both from better
management of assets and a better profit margin.
N.B. ► To increase ROI companies should work for better rate of profitability and
better rate of asset turnover.
. ► ROI relates size to profits. If a corporation increases in size (as measured by
total assets) but does not increase its earnings after taxes proportionately; then its
ROI will decrease.
e) Return on equity (Return on net worth)
This ratio measures the return earned on the owners’ (both common and preferred)
investment in the firm. It indicates management’s performance for owners.
net income 230
ROE = = =11.73%
stockholders ' equity 1960
Industry average: alpha generates about 12 cents for every dollar in stockholders’ equity.
This is well above the industry average indicating that management is performing
relatively more effectively to provide owners an above average return on their
investment.

Modified Du pont formula:

NI total assets
ROE = ×
total assets stockholders ' equity
But, SHE = (1 – Debt Ratio) × Total Assets
NI total assets
ROE = ×
total assets (1 − debt ratio)total assets
 1 ROI
ROE = ROI x =
(1 − debt ratio) (1 − debt ratio)

NI
ROE = × equity multiplier
total assets

N.B. ►Too high ROE might indicate greater use of debt (higher leverage) which might
be risky. i.e. the ROE ratio might decrease if the firm is unable to earn a rate of
return that exceeds its cost of debt financing.
► Too low ROE might suggest a more conservative financing policy.

5. Market Value Ratios

These ratios relate the firm’s stock price to its earnings and book value per share.
If a firm’s liquidity, asset management, debt management, and profitability ratios are all
good, then its market value ratios will be high, its stock price will probably be as high as
can be expected.
a) Earnings per share
Earning per share represents the number of dollars earned common stock. It is generally
of interest to present and prospective owners and management and is considered as
important indicator of corporate success.
earning available to common share
EPS =
number of common shares outs tan ding

net income − preferred dividend 230 − 10

EPS = = = 2.75
number of common shares outs tan ding 80
Industry average: 2.26
Interpretation: Alpha earns $2.75 on behalf of each share outstanding, a higher one as
compared to the industry average.
b) Price/ earnings ratio
This ratio reflects the amount investors are willing to pay for each dollar of the firm’s
earnings. It measures the degree of confidence (or certainty) that investors have in the
firm’s future performance. i.e. The higher the P/E ratio, the greater the investors’
confidence in the firm. P/E ratios are higher for firms with higher growth prospects, other
things held constant, but they are lower for riskier firms.
market price per share of common stock
P/E ratio =
earning per share

1
Assume for Alpha that its common stock was selling at 32 (or 32.25) and it has 80
4
shares of common stock outstanding.
 32.25
P/E = = 11.73
2.75
Industry average = 12.50
Interpretation: investors were paying $11.73 for each dollar of earnings. This is below the
industry average indicating poor performance by management and high risk. (Use of a
relatively higher debt.).This suggests that the firm is regarded as being some what riskier
than most, as having poorer growth prospects, or both.

c) Market/ Book ratio

This ratio indicates how equity investors regard the company. Companies with relatively
high rates of return on equity generally sell at higher multiples of book value than those
with low returns.
market price per share
Market/ book ratio =
book value per share

common equity 620

Book value per share = = = 7.75
sahres outs tan ding 80

32.25
Market/ book value ratio = = 4.16
7.75
Industry average = 5
Interpretation: investors are willing to pay less for Alpha’s book value than for that of an
average firm in the industry reinforcing the above conclusion.

Evaluation of ratio analysis

Financial statement analysis has limitations but if used with care and judgment, it can be
very helpful.

Advantages
1. Ratios are easy to compute.
2. Ratios provide a standard of comparison at a point in time and allow comparisons
to be made with industry averages.
3. Ratios can be used to analyze a corporation’s financial time series in order to
discover trends, shifts in trends, and data outliers.
4. Ratios are useful in identifying problem area of firm.
5. When combined with other tools, ratio analysis makes an important contribution
to the task of evaluating a firm’s financial performance. While it is important to
understand and interpret financial statements, sound financial analysis involves
more than just calculating and interpreting numbers. Good analysts recognize that
certain qualitative factors must be considered when evaluating a company. Some
of these factors are:

► The extent to which the company’s revenues are tied to one key customer.
► The extent to which the company’s revenues are tied to one key product.
► The extent to which the company relies on a single supplier.
 ► The percentage of the company’s business generated overseas.
► Competition.
► Future prospects.
► Legal and regulatory environment.

Limitations
1. Taken by itself, a ratio provides little useful information
2. Ratios seldom provide the answers to the question they raise because generally
they do not identify the causes of a firm’s problems.
3. Ratios can be easily misinterpreted. For example a decrease in the value of a ratio
does not necessarily mean that something undesirable has happened. E.g. high
inventory turn over does not necessarily indicate good management.
4. Industry averages can not be relied up on exclusively to evaluate a corporation’s
performance because generally half the firms in an industry perform worse than
the industry average.
5. They are based on accounting data which are subject to different interpretations
and manipulation such as different depreciation methods, inventory valuation
methods, bad debts, different fiscal years, seasonal impacts etc.