Advanced Financial Management

MBA Program

Chapter II
Financial Statement Analysis
Learning Goals
1. S h o w t h e u s e o f f i n a n c i a l r a t i o s t o g e t u s e f u l
information from financial statements
2. Recognize the diagnostic role of financial ratios
3. Understand who uses financial ratios, and how.
4. Define, calculate, and categorize the major financial
ratios (according to liquidity, financial leverage,
coverage, activity, and profitability) and understand
what they can tell us about the firm.
5. Highlight the utility of financial ratios in credit
analysis and competitive analysis as well as in
determining the financial capability of the firm

2-2
 Con’t…
7. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
8. Use ratios to analyze a firm’s liquidity and activity.
9. Use ratios to analyze a firm’s profitability and its
market value.
10. Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
[Link] the limitations of financial ratios
analysis.
 Con’t…
üThe two basic financial statements required to be prepared
for the purpose of external reporting are
§Balance sheet and
§ Income statement.
Balance Sheet
u A summary of a firm’s financial position on a given
date that shows total assets = total liabilities + owners’
equity.
u It shows the total asset of the firm and how these
assets are financed. The financing portion of the
balance sheet, usually, is funded between contribution
by owners and firm's creditors.
Income Statement:
A summary of a firm’s revenues and expenses over a
specified period, ending with net income or loss for
the period.
 Financial Statement Analysis /FSA/
 Financial analysis is a process of selecting, evaluating,
and interpreting financial data, along with other pertinent
information, in order to formulate an assessment of a
company’s present and future financial condition and
performance.
 Financial analysis refers to an assessment of the viability,
stability and profitability of a business, sub- business or
project.
 Financial analysis is also known as analysis and
interpretation of financial statements.
Need for FSA
 Financial statement analysis is used to identify the
trends and relationships between financial statement
items.
 Both internal management and external users (such as
analysts, creditors, and investors) of the financial
statements need to evaluate a company's profitability,
Efficiency, liquidity, and solvency.
 Nature of Analysis: The nature of the analysis depends
upon their [users] purpose or requirement. They [users]
make the necessary analysis and take the decision,
based on their assessment of the results obtained.
 Con’t…
§In general;
Ø Financial statement analysis is more than just
“crunching numbers”; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing in terms of:
üProfitability,
üOperational efficiency and
ü Growth potential of the business.

oFinancial Analysis facilitate comparison across time in

terms of:
ü Intracompany basis (within the company itself)
ü Intercompany basis (between companies)
ü Industry Averages (against that particular industry’s averages)
i.e. Analysis is the first step to intelligent decision
Users & their interests
I. Lenders (trade creditors): interested in determining
whether they will be repaid money they lent.
II. Shareholders & Investors: are concerned with present
and future profitability.
III. Employees: may want to compare the current
performance or financial status of their employer
with earlier periods.
IV. R e g u l a t o r y a g e n c i e s : often n e e d t o a s s e s s
organizational or industry financial health and
performance.
V. Management: interested in every aspect of financial
analysis.
 Cautions for Doing Ratio Analysis
Before doing specific Analysis we should consider the
following cautions:
Ø Understand the nature of the industry in which the
organisation works. This is an industry factor.
Ø Understand that the overall state of the economy may
also have an impact on the performance of the
organisation.
Ø Ratios must be considered together; a single ratio by
itself means relatively little
Ø The financial statements being compared should be
dated at the same point in time during the year.
 Con’t….
Ø It is preferable to use audited financial statements for
ratio analysis
Ø The financial statement being compared should have
been developed in the same way. The use of different
accounting methods especially related to inventory and
depreciation can distort the result of ratio analysis,
regardless of whether cross sectional or time series analysis
is used.
ØWhen the ratios of one firms are compared with those of
another or with those of the firm it self over time, results can
be distorted due to inflation. Clearly care must be taken in
comparing ratios of older to newer firms or a firm to it self
over a long period of time.
 Techniques of Financial Statement Analysis
The commonly used tools for financial statement analysis are:
• Financial Ratio Analysis
• Comparative financial statements analysis:
ü Horizontal analysis/Trend analysis/Time series
Analysis
ü Vertical analysis/Common size analysis/ Component
Percentages
 RatioAnalysis
 Is a commonly used tool of financial statement
analysis.
 Is a mathematical relationship between one
number to another number.
 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.
 Con’t….

•A ratio is defined as the indicated quotient of two

mathematical expressions and as the relationship between
two or more items.

•A ratio is a statistical yardstick that provides a measure of

the relationship between two variables or figures.

qF i n a n c i a l r a t i o a n a l y s i s i s t h e c a l c u l a t i o n a n d
comparison of ratios which are derived from the
information in a company's financial statements

qIn financial analysis a ratio is used as yardstick tool to evaluate

financial performances. However; a single ratio in itself does not
indicate favorable or unfavorable conditions performances of a firm.
It should be compared with some standards.
 What can we do with financial ratios?
Standards of Comparisons
§ Ratio calculated from the past financial statement of the
firm/Intra-company
ØComparing data from the current year to the prior years.

§ Best Practices (Industry leader’s ratios):

üFirm’s financial ratios could be compared with the industry
leader’s ratios.
• Ratio of the industry to which the firm belongs/Industry
Average
Represents the average ratio of firms within the same industry (e.g.
the average ratios for all commercial banks)
Comparing financial analysis data from a company to its industry
average lets us know how a company compares to its
competitors.
 Con’t…

Performa Analysis:
Ø sometimes future ratios are used as a standard of
comparison
Ø the comparison of current or past ratios with
future ratios the firms relative strengths and
weaknesses in the past and in the future.
Ratio Analysis: Classification
 From financial management view point, ratios
include:
A. Liquidity Ratio/Short term solvency ratios
B. Activity Ratio
C. Solvency Ratio
D. Profitability Ratio
E. Market Ratio
 A. Liquidity Ratios
 Also called as short-term ratio.
 Help to understand the liquidity in a business which
is the potential ability to meet current obligations.
 This ratio expresses the relationship between
current assets and current liabilities of the
business concern during a particular period.
 Include:
q Current Ratio
q Quick Ratio
 Con’t…

q Liquidity Ratio: Measure the ability of a firm to meet its

short term obligations and reflect the short term
financial strength/solvency of a firm.

qA firm should not suffer from lack of liquidity or should

not be too liquid because:

üLack of liquidity produces loss of confidence in face of

creditors, greater court law suits, bad credit rating, etc. and

üVery high degree of liquidity is also bad, as idle asset earn

nothing, which means, the firms, current fund is tied
unnecessarily by current assets.
A. Liquidity Ratios

 con’t…
q Conventionally (The rule of thumb), a current ratio of 2:1
is considered satisfactory. This rule is based on the logic that
even in the worst situation where the value of current assets
is reduced by fifty percent, the firm will be able to meet its
current obligations.

qCurrent Ratio is a quantitative measure rather than a

qualitative index of liquidity. It takes into account the total
value of current assets without making any distinction
between the various types of current assets like receivables,
stocks and so on. It does not measure the quality of these
assets.
qIf the firm’s current assets include doubtful and slow
paying receivables or slow moving and non-moving (non-
saleable) stock of goods, then the firm’s ability to meet
obligations would be reduced. This aspect is ignored by the
current ratio.

q Conventionally (The rule of thumb), a Quick ratio of 1:1 is

considered satisfactory (sound).
Accounting Measures: Liquidity Ratios
 B. ASSET MANAGEMENT / ACTIVITY/ RATIOS

§ The finances obtained by a firm from its owners and creditors

will be invested in assets.
§ These assets are used by the firm to generate sales and profits.
§ Therefore the amount of sales generated and the obtaining of
the profits depend on the efficient management of these assets
by the firm. i.e.
üAsset management ratios, measures how effectively the
firm is managing its assets to generate sales and profit. That
is why these activity ratios are also known as ‘efficiency
ratios’.
üReflect firm’s efficiency in utilizing assets (the speed with
which various accounts are converted into sales or cash)
 Activity or Efficiency Ratios Analysis

Many activity ratios can be calculated to know the efficiency of

asset utilization. The following are some of the important activity ratios or
turnover ratios:
Con’t…
 1. Fixed Assets Turnover Ratio
§ The fixed assets turnover ratio measures how effectively
the firm uses its plant and equipment to generate sales
and profit.
The fixed assets turnover ratio is the ratio of sales to net
fixed assets:

§The ratio is calculated by dividing the total value of

sales by the amount of net fixed assets invested.

§A high ratio is an indicator of overtrading while a

low ratio suggests idle capacity or excessive
investment in fixed assets. Normally, a ratio of five
times is taken as a standard.
Con’t….

• how many birrs of sales are generated from one

birr of fixed assets.
• Fixed assets turnover = Net sales___
Net fixed assets
Net Fixed assets= Total Fixed Assets minus Depreciation Expense
 Con’t…
Note:
• A fixed assets turnover ratio substantially lower than other
similar firms indicates under utilization of fixed assets, i.e.,
üidle capacity,
ü excessive investment in fixed assets, or
ü low sales levels.
• The fixed assets turnover may be misleadingly low or high.

• This is because the book values of fixed assets may be

considerably affected by cost of assets, time elapsed since their
acquisition, or method of depreciation used.
 2. Accounts Receivable Turnover Ratio

§ Credit sales are not an uncommon feature. When the firm

sells goods on credit, book debts (receivables) are created.
Debtors are expected to be converted into cash over a short
period and hence are included in current assets.

§ To a great extent the quality of debtors determines the

liquidity position of the firm. The quality of debtors can be
judged on the basis of debtors turnover and average collection
period.
§ Accounts Receivable turnover – measures how efficiently a
firm’s accounts receivable is being managed. It indicates how
many times or how rapidly accounts receivable are converted
into cash during a year.
B. Activity Ratios

Con’t…
 Con’t…
Note:
In general, a reasonably higher accounts receivable
turnover ratio is preferable.
A ratio substantially lower than the industry average
may suggest that a firm has:
ØMore liberal credit policy,
ØMore restrictive cash discount offers (i.e no or
little cash discount) that could make sales to
be too low.
ØPoor credit selection or
ØInadequate cash collection efforts or policy
which could lead:
qA/R to be too high
qBad debts or uncollectable Receivables
 Con’t…
Note: - As result of the above factors,
üThe firm could have poor profitability position.
üThe firm’s funds would be tied-up in receivable as
payments by customers are delayed.

A ratio substantially higher than the industry average

may suggest that a firm has:
üMore restrictive credit policy (i.e. short term credit
period)
üMore liberal cash discount offers (i.e. larger discount and
sale increase)
üMore restrictive credit selection.
üMore rigorous collection effort or policy
Con’t…
Note: the outcomes of a higher A/R turnover could be
üAvoidance of the risk of bad debts
üIncrease the firm’s profitability position.
üSmall funds tied-up in A/R
üCustomers pay quickly
 Con’t..

Note:
üThe average collection period of a firm is directly affected by
the accounts receivable turnover ratio. Generally, a reasonably
short-collection period is preferable.
üAverage Collection Period for firm “ X ” is = 365/11.4 =32
days.
Interpretation: firm” X” customers on the average are paying
their bills in almost 32 days. If firm “X”s credit period is less
than 32 days, some corrective actions should be taken to
improve the collection period
 4. Inventory Turn Over Ratio
• Inventory turnover ratio indicates the efficiency of the
firm’s inventory management.

• Inventory Turnover (ITO): is the frequency at which

inventory is converted into sales/ A/R . That is how fast
inventory is sold or turned over?

• If the particulars of cost of goods sold and average stock are

not available in the published financial statements the stock
turnover can be calculated by dividing sales by the stock at
the end, i.e.,
Inventory Turnover = Sales/closing stock or inventory
Con’t….


Cost of goods Sold = Net Sales – Gross Profit

 Con’t….
In general, a high inventory turnover ratio is better than a
low inventory turnover ratio.
üAn Inventory turnover significantly higher than the
industry average indicates:
üSuperior selling practices
üImproved profitability as less money is tied-up
in inventory.
Possible problems of high inventory turnover
üVery low level of inventory (i.e under investment in
inventory)
üLost sales due to insufficient inventory (i.e risk of out
of stock)
üStoppage of production process for manufacturing
firms.
 Con’t….
A very low inventory turn over suggests:
§ Excessive inventory or over investment in anticipation
of strike or price decreases.
§ Inferior quality goods, stock of un salable / obsolete
goods.

q Possible problems of a very low inventory turnover

o Cost of funds locked-up or tied up in inventory (opportunely cost)
o Deterioration
o Rental of space
o Insurance cost, properly tax, and other inventory carrying costs.
 Con’t…
Illustration:
The sales of a firm amounted to Birr 600, 000 in a particular
period on which it had a gross margin of 20%. The stock at the
beginning of the period was worth Birr 70, 000 and at the end
of the period of Birr 90, 000. Calculate the inventory turnover
ratio.
Inventory turnover = Cost of good sold
Average Inventory
Inventory Turnover = 600,000 – 120,000 = 6 times
(70,000 + 90,000)/2
Interpretation: the company’s inventory are on the average
sold out 6 times per year.
 5. Inventory Holding Period (IHP)
vInventory holding period (IHP) represents the period of
time that the company holds the average inventory balance in
store before sales.
vThe shorter inventory holding period implies that good
inventory management.
IHP in days= 365 days
Inventory Turnover Ratio
IHP in months = 12 months
Inventory Turnover Ratio
From the above example:
IHP = 365 days or 12 months/6 times = 60.83 days or 2 months
So the company holds its average inventory in store for 60.83
days or for 2 months before each conversion point in sales.
 6. Account Payable Turn over ratio
A/P turnover ratio :- measures how rapidly creditors are paid. That is,
how rapidly or how many times A/P are paid during a year.
A/P turnover Ratio= Net Credit Purchase
Average A/Payable
Average A/P= Beginning A/P + Ending A/P
2
Example, Assume for XYZ café net purchase (on credit) =150,000
A/P- Dec 31, 2000 30,000
A/P turnover = net purchase
Average A/P
= 150,000
30,000
=5 times
  Interpretation :- Assume that industry average of A/P turnover is 6
times.
XYZ cafe pays its creditors lower times a year (i.e 5 times). Thus, it may be
rated a risky borrower.
7. Average Payment Period (APP)
Average payment period (APP):- measures the average length of time
creditors must wait to receive their cash or simply the average time needed
by a firm to pay its A/P to creditors or suppliers from which purchase is
made.
APP= 360 days
A/P turnover over
Or
A/P
Average purchase per day

APP for XYZ cafe = 360 days

5 times = 72 days
Assume, suppliers on the average extend, say 60 days credit terms.
Interpretation: - XYZ café would be given a low credit rating (low credit
worthiness). That is XYZ is a risky borrower.
 8. Net Working Capital Turnover Ratio
üThe Net working capital turnover ratio measures how well a
company is utilizing its working capital to support a given level
of sales.
üNet Working capital is current assets minus current liabilities.
Net Working capital turnover ratio is computed by dividing
the net sales by Net working capital.
ü A high turnover ratio indicates that management is being
extremely efficient in using a firm's short-term assets and
liabilities to support sales.

ü Conversely, a low ratio indicates that a business is investing

in too many accounts receivable and inventory assets to
support its sales, which could eventually lead to an excessive
amount of bad debts and obsolete inventory.
 Con’t…

•Note:::::::::::::::::::::::::::::::
• Generally, a high working capital turnover ratio is
better. A low ratio indicates inefficient utilization of
working capital during the period.

§The ratio should be compared with the previous years’

ratio, competitors’ or industry’s average ratio to have a
meaningful idea of the company’s efficiency in using its
working capital.

• The working capital turnover ratio should be carefully

interpreted because a very high ratio may also be a sign of
insufficient quantity of working capital in the business.
Con’t…

 9. Total Asset Turnover Ratio
üTotal assets turnover – indicates the amount of net sales
generated from each birr of total tangible assets invested.

üT o t a l A s s e t T u r n o v e r r a t i o m e a s u r e s t h e o v e r a l l
performance and efficiency of the business enterprise. It points
out the extent of efficiency in the use of assets by the firm.
Assets turnover = Net Sales
Total assets
Total Assets = Net Fixed Assets + Current Assets

q Note: A high total assets turnover is supposed to indicate

efficient asset management, and low total asset turnover
indicates a firm is not generating a sufficient level of sales in
relation to its investment in assets.
Con’t…


3. Leverage Ratios or Capital Structure Ratios
 3. Leverage Ratios, Solvency or Debt Ratio
Short term creditors, such as, bankers, suppliers of raw
materials, etc., are interested with the firm's current debt
paying ability. This will be known by liquidity ratios.

On the other hand, long term creditors, like bond holders,

financial institutions, etc., are more concerned with firm's
long term financial strength.
ØThey judge the financial soundness of the firm in terms
of:
üIts ability to pay interest regularly as well as
üMake repayment of the principal either in one lump
sum or in installments.
In fact, a firm should be strong both in the short run and
in the long run.
To judge the long run financial position of the firm, leverage, or
capital structure ratios are calculated.

These ratio shows the mix of funds provided by owners and

creditors. As a general rule, there should be an appropriate mix
of funds in the capital structure of a firm.

§The manner in which assets have been financed has a number

of implications:
I. Debt is more risky from the firms point of view. The firm
has legal obligation to pay to its bond holders at stipulated
time interest and principal, irrespective of the profits made
or losses incurred. If it fails, an action may be taken on
firm's assets.
II. Highly burdened, or highly geared firms will find difficulty
in raising additional funds from creditors and owners in
the future.
Con’t…
 Leverage or Solvency or Debt Ratios
 It is also called as solvency ratio
 Measures the long-term obligation of the
business.
 Helps to understand, how the long-term funds
are used in the business
 Indicates the amount of other people’s money
being used to generate profits.
 Con’t…
While there are many leverage ratios, we will look at
some of the following which are given below:
q Debt-Equity Ratio

q Debt Ratio

q Interest Coverage Ratio/Times interest earned ratio

1. Debt-Equity (D-E) Ratio
This ratio reveals the relationship between borrowed
funds and the owners’ capital of a firm.
Thus, this ratio reflects the relative claims of creditors and
shareholders’ against the asset of the firm.
 Con’t….
üA high debt-equity ratio indicates a large share of
financing by the creditors in relation to the owners or a
larger claim of the creditors than those of owners.
üA low debt-equity ratio implies a smaller claim of the
creditors or a greater claim of the owners.

2. Debt to total assets Ratio –which is also said to be

the debt ratio; measures the percentage of total funds provided
by debt or creditors.
üShows the percentage of the firm’s assets that are supported
by debt financing.

Debt ratio = Total liabilities

Total assets
 Con’t….
Note:
ØA high debt ratio implies that:
vMore of a firm’s asset are provided by creditors
relative to owners
vThe firm may face some difficulty in raising additional
debt.
vFurther creditors may require a higher required rate of
return for taking higher risk
ØConversely, a low ratio implies the firm has funded
its assets mainly with equity sources.
ØCreditors prefer moderate or low debt ratio, because low
debt ratio provides creditors more protection in case a firm
experiences financial problems.
 3. Times – interest earned Ratios
Times – interest earned ratios are also known as Interest
Coverage Ratio-measures the extent to which the operating
income can cover its annual interest costs.

Times – interest earned ratio – measures a firm’s ability to pay

its interest obligations from operating income.

Times Interest Earned Ratio: measures the ability of a firm to

pay interest on a timely basis.

The times-interest-earned (TIE) ratio is determined by

dividing earnings before interest and taxes (EBIT) by the
interest charges:
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
 Con’t…
Note:
A low TIE ratio suggests:
- Creditors are at more risk in receiving interest due.
-failure to meet interest payment can bring legal action by
creditors possibly resulting in bankruptcy.
-The firm may face difficulty in raising additional
financing through debt as it is more than similar firms.

A high TIE ratio suggests the firm has sufficient margin

of safety to cover its interest charges.
3. Summary for Solvency Ratio DE Ratio indicates how much
debt a company is using to
finance its assets relative to the
amount of value represented in
 SHE
qProfitability means the ability to make profits.
qProfitability ratio measures the overall performance of a
company.
qProfitability ratios measure the earning power of a firm
with respect to given level of sales, total assets, and
owner’s equity.
q The profitability ratios show the combined effects of
liquidity, asset management, and debt management on
operating results.

Profitability ratios are calculated to measure the

profitability of the firm and its operating efficiency.
 Con’t…..
The following ratios are among the many measures of a firm’s
profitability.
1. Gross Profit Margin = Gross Profit
Net Sales
2. Operating Profit Margin = Net Operating Income
Net Sales
3. Net Profit Margin = Net Income
Net Sales
4. Return on Total Assets = Net Income
Total Assets
5. Return on Equity = Net Income
Total Equity
6. Return on Common Equity (EPS)= Net Income Available to Common Equity
Common Equity
1. Gross Profit Margin
 2. Operating Profit Margin
üOperating profit margin: measures the percentage of
operating profit to net sales.
Operating profit margin= EBIT
Net sales
3. Net Profit Margin or Net profit margin on sales
üThe net profit margin on sales, calculated by dividing net
income by net sales, gives the profit per dollar of net sales:

üProfit Margin – shows the percentage of each birr of net sales

remaining after deducting all expenses.
Profit margin = Net income on Available common stocks
Net Sales
The net profit margin ratio is affected generally by factor as:
v sales volume,
vpricing strategy as well as
vthe amount of all costs and expenses of a firm.
 4. Return on investment (ROI):
Return on investment (ROI): measures the overall
effectiveness of management in utilizing assets in the
process of generating revenue.
It reflects how effectively and efficiently the firm’s assets
are used to generate profit. This ratio is also called Return
on Asset (ROA).

vUsing Dupont formula:

ROA= Net profit margin X Total asset turnover
= Net income X Net sales
Net sales Total assets
 5. Return on equity (ROE)
ü Return on equity (ROE): measures the rate of return realized by
stockholders on their investment.
ROE= Net income
Stockholders’ equity
Or
ROE= ROA X Leverage factor
Where, Leverage= Total assets
Stockholder equity
Leverage ratio measures how the firm finances its assets. Basically, firms

can finance with either debt or equity.

So ROA= ROE, with only equity financing that asset is equal to stockholders

equity and leverage multiplier is 1.

 
 DuPont System of Analysis
üThe Du Pont system is a method of breaking down return
ratios into their components to determine which areas are
responsible for a firm’s performance.
üThe DuPont system of analysis is used to dissect the firm’s
financial statements and to assess its financial condition.
üIt merges the income statement and balance sheet into two
summary measures of profitability.
üThe Modified DuPont Formula relates the firm’s ROA to its
ROE using the financial leverage multiplier (FLM), which is
the ratio of total assets to common stock equity:
üROA and ROE as shown in the series of equations on the
following slide.
DuPont System of Analysis
 Con’t…
6. Earnings per share (EPS): represent the amount of birr
earned on behalf of each outstanding shares of common stock.
EPS= Net income available for common stock holders
No. of C/stock shares outstanding
Or
Return on Common Equity = Net Income Available to Common Equity
Common Equity
Con’t….

Con’t…

Con’t…

5. Market Ratios:
§Reading Assignment
 Uses and limitations of Ratio Analysis
A. Uses
ØFinancial ratio analysis is essentially an attempt to
develop meaning full relationship between individual
items or group of items in the balance sheet or income
statement.
ØA purpose full financial ratio analysis could lead to
highlight management issues and problems, and this
will aid the management in identifying alternative
courses of action to respond to such issues and
problems.
 Con’t…
ØHelp managers analyze, control, and thus improve their
firms’ operations;
ØHelp credit analysts ascertain a company’s ability to pay its
debts;
ØTo compare different firms is the same industry
ØTo know whether the firm's financial position is basically
sound. I.e.
v capital structure
v profitability
v credit policy
 Limitations of ratio analysis
Some of the problems in the application of ratio analysis are:
a) Difficulty to decide the proper basis of comparison. The
problem of standards of comparison is usually an
important case. And impossible to compile an industry
wide averages or ratios that serves as a useful standard to
measure all firms.

b) The standard of comparison do not consider the different

technological, social, market, etc., conditions of a firms.
c) The change in the general price level makes the analysis
invalid (problem of inflation).
d) Different firms may use different accounting calendars, so
the accounting periods may not be directly comparable.
 Con’t…
d) The greatest constraint to meaning full analysis comes from
different accounting treatments reflected in annual
financial statements; such differences as in:
ØDepreciation methods
ØMethods of inventory valuation
ØCost classification
ØTreatment of intangible assets
ØUse of different accounting periods, etc. Adjustments
should be made for such differences.
e) The ratios are calculated from past data and are not
representative of the current which cannot be used as
indicator of the future.
f) Seasonal factors can also distort a ratio analysis. Example ,
the inventory turnover ratio for food processor will
be radically different periodically.
Exercise
 Balance Sheet
Assets Liabilities
Current Assets Current Liabilities
Cash 1,000 Accounts Payable 2,000
Investments 3,000 Miscellaneous Payable 2,000
Accounts Receivables 4,000 Accrued Payables 1,200
Inventories 6,000 Tax Payable 800
Fixed Assets (Net Depr.) 26,000 6% Mortgage Payable 14,000
Equities
Share Capital 12,000
Retained Earnings 8,000
Total Assets 40,000 Total Liab. & Equities 40,000
 Other Information:
q Net Sales …………………………….. Br. 60,000
q Cost of Goods Sold …………………. 51,600
q EBIT………………………………....... 4,000
q Net Income After Tax ……………..... 2,000
 Calculate
q Short-term solvency ratios (liquidity ratios)
§ Current Ratio

§ Quick Ratio
q Long-term solvency (Activity) Ratios
§ D-E Ratio

§ Fixed Interest Charge (interest coverage ratio)

Exercise

Exercise

 BALANCE SHEET ANALYSIS Complete the balance sheet
and sales information using the following financial data:
 Debt ratio: 50%
 Current ratio: 1.8×
 Total assets turnover: 1.5×
 Days sales outstanding: 36.5 days*
 Gross profit margin on sales: (Sales − Cost of goods sold)/Sales ¼ 25%

 Inventory turnover ratio: 5×

* Calculation is based on a 365-day year.
Balance Sheet
 Cash Accounts payable
 Accounts receivable Long-term debt 60,000
 Inventories Common stock
 Fixed assets Retained earnings 97,500
 Total assets $300,000 Total liabilities and equity
 Sales Cost of goods sold
 A. Trend Analysis/Horizontal Analysis/Time
series Analysis
Horizontal Analysis:
Here financial statements are compared with
several years.
In general using time series analysis:
v Comparing a firm’s present ratios with the past
ratios to evaluate financial position and
performance of the firm is important.
vIt gives an indication of the direction of change
and reflects whether the firm’s financial
performance has:
v Improved
vDeteriorated
vRemained constant
Time series (trend analysis)

 Helps to understand the trend relationship with

various items, which appear in the financial
statements.
 These percentages may also be taken as index
number showing relative changes in the financial
information resulting with the various period of
time.
For example, assume Company A had the following data
available:
Description 2010 2009
Net sales $110,000 $100,000
Cost of goods sold 60,000 51,000
Gross profit 50,000 49,000
Dollar Change Percent Change
2010 2009
Net sales $110,000 $100,000 $10,000 10.0% (1)

Cost of goods 60,000 51,000 9,000 17.6%

sold
Gross profit 50,000 49,000 1,000 2.0%
Con’t….

The percent change is calculated as:

Percent change = Dollar change / older period amount
($10,000 / $100,000 = 10 %)
What does this tell us?
Even though sales increased by 10% from 2009 to 2010,
gross profit only increased by 2%. Why? Such questions
need to be directed to management.
 
 Con’t….
Cross Sectional/Common Size
Analysis/Vertical Analysis/ static analysis.

ü Here, financial statements measure the quantities

relationship of the various items in the financial
statement on a particular period.
üAll Income statement items - expressed as a
percentage of total revenue/net sales
üA l l B a l a n c e s h e e t i t e m s - e x p r e s s e d a s a
percentage of total assets/net assets
Cross Sectional/Common size/vertical analysis

 Here, figures reported are converted into

percentage to some common base.
 In the balance sheet the total assets figures is
assumed to be 100 and all figures are expressed as
a percentage of this total.

 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%.
 Cross Sectional/Common size/vertical analysis

Cross sectional analysis involves the comparison of different

firm’s financial ratio at the same point in time.

Common size ratios are used to compare financial statements

of different-size companies (Cross-Sectional Analysis) or of
the same company over different periods.
Common size statements usually are prepared for the income
statement and balance sheet, expressing information as
follows:
üAll Income statement items - expressed as a percentage of
total revenue/net sales
üAll Balance sheet items - expressed as a percentage of
total assets/net assets
 Cross sectional analysis
Common-Size Percents
2010 2009 2010 2009
Net sales $110,000 $100,000 100.0% 100.0%
Cost of goods sold 60,000 51, 000 54.5% 51.0%
Gross profit 50,000 49,000 45.5% 49.0%

What does this tell us?

üEven though sales increased, gross profit, as a
percentage of net sales decreased. Why???????????
End of Chapter

Wish You Good Work

and Luck!!