Chapter-2

Financial Statement Analysis

2.1. Financial Statements
In financial accounting, you have learned the process of preparation of financial statements.
Financial statements are the end products of accounting system. The two basic financial
statements required to be prepared for the purpose of external reporting are balance sheet and
income statement. For internal purposes of planning, decision making and control much more
information is contained in Balance sheet and Income statement.
I. Balance Sheet: This is one of the important financial statements. It indicates the financial
position of an accounting entity at a particular, specified movement of time. It is valid only
for a single day, the very next day it will become obsolete. It contains the information
about the resources, obligations of a business entity and the owners’ interest at a specified
point of time.
II. Income statement: This report has greatest importance to the users of financial statements.
It is a performance report recording the changes in income, expenses, profit, and losses as a
result of business operations during the year between two balance sheet dates. The income
statement is valid for the whole year.
2.1.1. Importance of Financial Statements
Financial statements are the index of the financial affairs of a company. To the owners of the
company, they reveal its progress as evidence by earnings and current financial condition; to the
prospective investors they serve as mirror reflecting potential investment opportunity; to the
creditors they reflect the credit worthiness; labor unions are able to know the fair sharing of
bonus; the economist can judge the extent to which the current economic environment has
effecting its business activity; to the government the financial statements offer a basis of
taxation, control of costs, prices and profits and; to the management they reveal the efficiency
with which business affairs are conducted.
2.1.2. Financial Analysis Meaning and Importance
The Financial analysis is the process of identifying and evaluating the firm’s financial strength
and weakness through properly established relationships between the items of balance sheet and
income statement of the firm with a view to getting an insight into the operative activities of a
business concern. It is a technique of investigating the financial positions and progress of the
unit. By establishing some relationship between balance sheet and income statement, analysis
attempts to reveal the meaning and importance of various items contained in the financial

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statements. An analysis of financial statements gives a detailed account of business operations
and their impact on the financial health of the company.
For the purpose of financial analysis, we have to re-organize and re-arrange the data contained in
financial statements. The analysis of financial data i.e., classification of the data into groups and
sub-groups and establishment of relationships among, then is followed by interpretation. The
term interpretation means explaining the meaning and significance of data. It involves drawing
inferences from the analyzed data about the different aspects of the operational and financial
results of the business and its financial health.
Analysis and interpretation are closely inter-linked. They are complementary to each other.
Analysis without interpretation is useless and interpretation without analysis is impossible. But,
generally, the term analysis is used to include interpretation as well since, analysis is always
aimed at interpretation of the relationships that are established in the course of analysis. Thus, it
can be stated that analysis involves compilation, comparison and study of financial and operative
data and preparation, study and interpretation of the same.
2.1.3. Objective of Financial Analysis
The main objective of financial analysis is to reveal the fact and relationships among the
managerial expectations and the efficiency of the business unit. The financial strengths and
weaknesses, its credit worthiness can also be known through such analysis. The safety of funds
invested in the firm, the adequacy or otherwise of its earnings, the ability to meet its obligations
etc. can also be examined through an analysis of their financial statements.
Of course, the financial analysis reveals only what has happened in the past. But, we can predict
future basing on past.
The management of the business unit is concerned; analysis can be used as a means of self-
evaluation. Through analysis the banker can assess the liquidity positions of the client firm and a
creditor can determine the credit worthiness. Analysis of financial statements helps an investor in
knowing the safety of his funds and the possible returns on the same. The bond holders can know
whether the income generated by the firm would provide sufficient margin to pay interest as well
as principal on maturity. Through an analysis of financial statements of firms, an economist can
measure the extent of concentration of economic power and lapses in the financial policies
perused. The employees and trade unions can know how the firm stands in relation to labor and
its welfare. The analysis provides a basis to the government relating to licensing controls, price
fixation, ceiling of profits, dividend freeze, tax subsidy and other concessions.

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2.1.4. Techniques of Financial Analysis
In the process of financial analysis various tools are employed. The most prominent amongst
them are listed as below:
1. Trend Analysis
2. Industry/cross-sectional analysis
1. Trend Analysis: It is highly helpful in making a comparative study of the financial
statements for several years. The simplest way to evaluate the performance of a form is
comparing its current year ratios against the past years ratios. The comparison of financial ratios
over a period of time is known as the time serious analysis or trend analysis. Trend analysis gives
an indication the direction of changes and reflect whether the firm financial has improved,
declined or remain constant over time. More importantly understand the reason why ratios have
changed.
2. Industry/cross-sectional analysis: another way of comparison is comparing ratios of one
firm against other firms in the same industry at the same point time. This type of comparison
indicates the relative financial position and performance of the firm.
2.2. Ratio Analysis
For a meaningful and realistic assessment of the position and performance of the firm the
analysis (analyst) should try to establish and evaluate the relationship between different
component items of the basic financial statements, i.e., Balance Sheet and Income Statement.
Ratio analysis will be found useful in this regard. Ratio analysis has become the most widely
used and powerful tool of financial analysis. The importance of ratio analysis is so much that
sometimes ratio analysis is regarded as a synonym to the financial analysis.
2.2.1. Meaning of Ratio and Ratio Analysis
The term, ‘ratio’, refers to the numerical or quantitative relationship between items or variables.
It shows an arithmetical relationship between two figures. It is also defined as “the indicated
quotient of two mathematical expressions” and as “the relationship between two or more things”.
The relationship between two accounting figures expressed mathematically is known as
‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are generally expressed in
three ways. It may be a quotient obtained by dividing one value by another. For example, if the
current assets of a business on a particular date are Birr 200, 000 and its current liabilities Birr
100, 000 the resulting ratio would be Birr 200, 000 divided by 100, 000 i.e., 2:1. The ratio can be
expressed as a percentage as well. Taking the same particulars, it may be stated that the current
assets are 200% of the current liabilities. Sometimes ratios are expressed as so many ‘times’ or

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‘fraction’: for example, the current assets may be stated as being double the current liabilities or
current liabilities was half of current assets.
Ratio analysis is the process of computing, determining and interpreting the relationship between
the component items of financial statements.
2.2.2. Importance of Ratio Analysis
Ratio analysis is an extremely useful and the most widely used tool of financial analysis. It
makes for easy understanding of financial statements. It facilitates intra-and inter-firm
comparison. Ratios act as an index of the efficiency of the enterprise. A study of the trend of
strategic ratios helps the management in planning and forecasting. Ratios help the management
in carrying out its functions of coordination, control and communication. The analysis of ratios
may reveal variability in planning, organizing, coordinating and monitoring different activities of
an organization. It will help to identify the specific weak areas, causes thereof and type of
remedial actions called for. A purposeful ratio analysis helps in identifying problems such as the
following and in finding out suitable course of action.
(a) Whether the financial condition of the firm is basically sound,
(b) Whether the capital structure of the firm is appropriate,
(c) Whether the profitability of the enterprise is satisfactory,
(d) Whether the credit policy of the firm is sound, and
(e) Whether the firm is credit worthy.
In short, through the technique of ratio analysis the firm’s solvency both long and short term
efficiency and profitability can be assessed.
2.2.3. Classification of ratios
The most important and commonly adopted classification of ratios is on the basis of the purpose
or function which the ratios are expected to perform. Such ratios are also called ‘functional
ratios’. They include solvency ratios, liquidity ratios, activity ratios and profitability ratios. In
fact, the entire ratio analysis can be discussed in relation to the orientation of the functional basis
of ratio classification.
 Liquidity ratios bring out the ability of the firm to honor its financial obligations as and when
they mature.
 Activity ratios measure the efficiency with which funds have been employed in the business
operations.
 Profitability ratios measure the profit earnings capacity of the enterprise. The profitability of
the firm can be viewed from the point of view of management, owners and creditors.

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 All these ratios can be grouped into various classes according to the function to be evaluated.
Different persons, as has been pointed out undertake financial statements analysis for different
purposes. For instance, short-term creditors take interest mainly in the short-term solvency or
liquidity position of the firm. Long term creditors are more interested in the long-term solvency
and profitability of the firm and owners’ interest lies in the profitability analysis and financial
condition of the firm. The management of the firm is interested in evaluating every activity of
the firm. In view of the requirements of the various users of financial analysis the functional
classification of ratios becomes important, some important functional ratios are explained here
under:
Illustrations;
ABC cooperative union
Balance sheet
For the date of Sene30,2006

ASSET LIABILITIES AND CAPITAL

Current asset 1999 1998 Liabilities
Cash---------------------------2,500-----------3,000 Current liabilities 1999 1998
Short-term investment-------1,000-----------1,300 Account payable---------------7,200------6,000
Account receivable----------16,000---------12,000 Notes payable------------------5,500------7,000
Inventories-------------------20,500---------18,700 Accrued liabilities---------------900---------700
Total current asset-----------40,000---------35,000 Current portion of L.T.L------3,000------3,000
Fixed asset Other current liabilities--------1,400------1,200
Building ---------------------28,700---------24,200 Total current liabilities-------18,000-----17,900
Equipment’s-----------------31,600---------29,000 Long term debt----------------27,000-----30,000
Total fixed asset’s……….. 60,300---------53,200 Total liabilities-----------------45,000-----47,900
Less: accumulated depr’n---18,300--------17,200 Contributed capital
Net Fixed assets--------------42,000--------36,000 Share capital------------------20,500-----10,350
Total assets------------------82,000--------71,000 Retained earnings-------------16,500-----12,700
Total contributed capital-----37,000------23,100
Total lia. and capital--------82,000-----71,000

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 ABC cooperative union
Income statement
For the month ended Sene 30,2006
Revenue 1999 1998
Net sale------------------------------------------------------ 120,000---------------------110,000
Cost of Goods Sold-------------------------------------------90,000----------------------83,000
Gross profit---------------------------------------------------30,000----------------------27,000
Operating expenses;
Selling expense--------------------------------------5,000------------------------4,800
General and Administrative expense--------------8,000-------------------------7,600
Depreciation expense-------------------------------1,100---------------------------800
Rent expense-----------------------------------------1,650-------------------------1,600
Total operating expense……--…………………………15,750----------------------14,800
Earnings before interest and tax(operating income)……..14,250----------------------12,200
Interest expense---------------------------------------------------4,150-----------------------4,660
Earnings before taxes--------------------------------------------10,100----------------------7,540
Income taxes(coop are exempted from income tax)-----------0.00------------------------0.00
Net Income ……………………………………………….10,100----------------------7,540

1. Liquidity Ratios
Liquidity is the ability of a firm to meet its current or short-term obligations when they become
due. Every firm should maintain adequate liquidity. Liquidity is also known as short-term
solvency of the firm. The liquidity ratios or short-term solvency ratios establish a relationship
between cash and current assets to current liabilities. A firm’s liquidity should neither be too low
nor too high but should be adequate. Low liquidity implies the firm’s inability to meet its
obligations. This will result in bad credit rating, loss of the creditors’ confidence or even
technical insolvency ultimately resulting in the shutting of the firm. A very high liquidity
position is also bad; it means the firm’s current assets are too large in proportion to maturity
obligations. It is obvious that idle assets earn nothing to the firm; and in situations of high
liquidity, the firm’s funds will be unnecessarily tied up in current assets, which, if released, can
be used to generate profits to the firm. Therefore, every firm should strike a balance between
liquidity and lack of liquidity.

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They include current ratio, quick ratio or acid test ratio. There is also another measure which is
frequently employed to know the liquidity position of a firm. The measure is the net working
capital which represents excess current assets over current liabilities. The net working capital,
strictly, speaking, is not a ratio.
Current assets include cash and those assets, which in the normal course of business get
converted into cash within a year or the accounting periods: e.g., cash, marketable-securities,
debtors, stock, etc. Prepaid expenses should also be included in the current assets because they
represent the payments which have been made by the firm for the near future.

Current liabilities are those liabilities or obligations which are to be paid within a year. They
include creditors, bills payable, accrued expenses, bank overdraft, income tax liability and long
term debt maturing in the current year.

A. Current Ratio

Current ratio is the ratio of total current assets to total current liabilities. It is calculated by
dividing current assets by current liabilities.
Current assets
Current ratio = Current liabilities
This ratio is also called ‘working capital ratio’ because it is related to the working capital of the
firm. The current ratio is an important and most commonly used ratio to measure the short-term
financial strength or solvency of the firm. It indicates how many Birr of current assets are
available for one Birr of current liability. The higher the current ratio, the more is the firm’s
ability to meet its current obligations and the greater the safety of the funds of the short-term
creditors. Thus the current ratio, in a way, provides a margin of safety to the (short-term)
creditors.
The current ratio for ABC Cooperative Union during 2006 is as follows;
Current assets 35 , 000
Current Ratio 1998 = Current liabilities = 17 , 900 = 1.96:1 or 1.96 times
Current assets 40 ,000
Current Ratio 1999 = Current liabilities = 18 , 000 = 2.22:1 or 2.22 times
Interpretation; In general the larger the current ratio indicates the less difficulty that the firm
faces in paying its current obligation on the right time, other things constant. As indicated above

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the current ratio of the union show that the firm has birr 1.96 in the current asset for each (1) birr
of current liability during 1998 and birr 2.22 during 1999.
Net working capital = Current Assets – Current Liabilities
= Birr 40, 000 – Birr 18,000 = Birr 22,000
B. Quick Ratio or Acid Test Ratio

This ratio measures the relationship between Quick assets (or most liquid assets) and current
liabilities. An asset is considered liquid if it can be converted into cash without loss of time or
value. Cash is the most liquid asset. Other assets which are considered to be relatively liquid and
include in the quick assets are accounts receivable (i.e. debtors and bills receivable) and short
term investments in securities. Stock or inventory is excluded because it is not easily and readily
convertible into cash. Similarly, prepaid expenses, which cannot be converted into cash and be
available to pay off current liabilities, should also be excluded from liquid assets.
The quick ratio is calculated by dividing quick assets by current liabilities:
Quick assets
=CA−(lessliquidassets)/CL
Quick Ratio = Current liabilities
Quick ratio is a more refined and vigorous measure of the firm’s liquidity. It is widely accepted
as the best test for the liquidity of a firm.
Generally, a quick ratio of 1:1 is considered to be satisfactory. But this ratio also should be used
cautiously. It should also be subjected to qualitative tests, i.e., quality of the assets included
should be assessed.
 Taking the same particulars of assets and liabilities given in illustration –1 of the unit,
calculate the quick ratio.
Quick assets Birr (35 , 000−18 ,700 )
=
Quick Ratio 1998 = Current liabilities Birr 17 , 900

Birr 16 ,300
= =0.91:1
Birr 17 ,900

Quick assets Birr (40000−20 , 500)

=
1999 = Current liabilities Birr 18 ,000
Quick Ratio

Birr 19 ,500
= =1.08 :1
Birr 18 ,000

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Interpretation; in general speaking, if the firm wants to cover its current obligation by using its
current quick assets, the quick assets should be equal or greater than its current obligation. Thus
the firm’s quick ratio should be 1.0 or more. In the case of our example, the quick asset of birr
0.91 was available for each birr of current obligation during 1998. The quick ratio for birr 1.08
for the year 1999 implies that the firm has birr 1.08 in its liquid assets for every birr of its current
obligation.
2. Leverage Ratios/Capital Structure Ratios
These ratios are also known as ‘debt management ratios.’ As stated earlier, the long-term
creditors (debenture holders, financial institutions, etc.) are more concerned with the firm’s long-
term financial position than with others. They judge the financial soundness of the firm in terms
of its ability to pay interest regularly as well as make repayment of the principal either in one
lump sum or in installments. The long-term solvency of the firm can be examined with the help
of the leverage or capital structure ratios. These ratios indicate the funds provided by owners and
creditors. Generally, there should be an appropriate mix of debt and owners’ equity in financing
the firm’s assets. Each of the two sources of funds, viz., creditors and owners depending on
which of them has been used to finance a firm’s assets, has a number of implications. Between
debt and equity (owners’ funds), debt is more risky from the firm’s view point. Irrespective of
the profits made or losses incurred, the firm has a legal obligation to pay interest on debt. If the
firm fails to pay to debt holders in time, they can take legal action against the firm to get
payment and even can force the firm into liquidation. But at the same time the use of debt is
advantageous to the owners of the firm. They can retain the control of the firm without
weakening and their earnings will be enlarged when the firm earns at a rate higher than the
interest rate on the debt. The owners’ equity is created as the margin of safety by the creditors. In
view of the above stated facts, it is relevant to assess the long-term solvency of the firm in terms
of the owner’s and creditor’s contribution to the firm’s total capitalization.
Leverage ratios can be calculated from the Balance Sheet items to determine the proportion of
debt in the total capital of the firm.
Leverage ratios are also calculated from the income statements items to determine the extent to
which operating profits are sufficient to cover the fixed charges.

Balance sheet based ratios

A. Debt-Equity Ratio

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This is one of the measures of the long-term solvency of a firm. This reveals the relationship
between borrowed funds and the owners’ capital of a firm. In other words, it measures the
relative claims of creditors and owners against the assets of the firm. This ratio is calculated as;
Total debt
=47 ,900 /23 ,100=2 .07
Debt-equity ratio 1998 = Shareholders ' equity
Total debt
=45 , 000 /37 ,000=1 .22
Debt-equity ratio 1999 = Shareholders ' equity
Interpretation;
The debt-equity ratio of 2.07 for ABC during 1998 indicates that the creditors of the firm have
provided about birr 2.07 in financing the assets of the firm for every single birr contributed by
shareholders. The figure was declined during 1999 to birr 1.22 for birr one contributed by the
share holders of the firm.
A 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. The D-E ratio indicates the margin
of safety to the creditors. A very high D-E ratio is unfavorable to the firm and introduces an
element of inflexibility in the firm’s operations. During periods of low profits a highly debt
financed company will be under great pressure; it cannot earn enough profits even to pay the
interest charges. A low debt-equity ratio implies a smaller claim of the creditors or a greater
claim of the owners.
B. Debt –Asset Ratio (Debt Ratio)
Measures the extent to which the total assets of the firm have been financed by external
(borrowed) funds. Debt ratio can be defined as total debt divided by net asset
Total liabilties
DR (1998)= = 47,900/71,000=0.6746 or 67.46%
Total net asset
Total liabilties
DR (1999)= = 45,000/82,000=0.5488 or 54.88%
Total net asset
Interpretation:
Generally, creditors prefer a low debt ratio since it implies a high protection of their position. A
higher debt ratio means that the firm must pay a high interest rate on its borrowings and in some
future time, the firm will not be borrow at all. In the case of ABC coop union above, during
1998, 67.46% of the total assets of the firm were financed by borrowed funds. Only 32.54% was
financed by funds contributed by shareholders and retained earnings of the firm. Similarly, debt
financing constitutes about 55% of the total assets of the firm during 1999. The debt ratio has
decline during 1999 compared to 1998 signaling good condition for creditors.
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C. Long Term Debt-Equity Ratio
This ratio measures the extent to which long term debt is used by the firm. It is computed by
dividing long term debt by shareholders equity

Long tem debt

Long term Debt-Equity Ratio 1998 = =30,000/23,100= 1.3 or 130%
Shareholders equity
Long tem debt
Long term Debt-Equity Ratio 1999 = =27,000/37,000 = 0.73 or 73%
Shareholders equity
Interpretation;
A higher debt-equity ratio implies that a higher portion of long term financing come from debt
sources. In general creditors prefer minimum debt-equity ratio since it means lower risk for the
interest, in the case of ABC above the ratio (130%) was extremely high during 1998 which can
evidence the riskiness of the firm for its creditors. However, the decrease to 73% during the year
1999 may be signals an improvement of the risk factor.

Income statement based ratios

A. Time-Interest Coverage Ratio: measures the extent to which the operating income can
cover its annual interest costs. The ratio equals earnings before interest and taxes divided by
interest expense.
EBIT
TICR 1998 = = 12,200/4,660 = 2.62 times
Interest expenses
EBIT
TICR 1999 = = 14,250/4,150 = 3.43 times
Interest expenses
Interpretation: the ratios computed for ABC reveals that the firm earnings before interest and
taxes are 2.62 times and 3.43 times during 1998 and 1999 respectively. In other words, the ratios
are 2.62 times and 3.43 times higher than the respective interest expenses of the firm during 1998
and 1999 respectively. In general, creditors prefer the higher time interest coverage ratio.

3. Turn Over (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. The amount of sales generated and the
obtaining of the profits depend on the efficient management of these assets by the firm. Activity
ratios indicate the efficiency with which the firm manages and used its assets. That is why these
activity ratios are also known as ‘efficiency ratios’. They are also called ‘turnover ratios’ because
they indicate the speed with which assets are being converted or turned over into sales. Thus the

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activity or turnover ratio measures the relationship between sales on one side and various assets
on the other. The underlying assumption here is that there exists an appropriate balance between
sales and different assets. A proper balance between sales and different assets generally indicates
the efficient management and use of the assets. 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:
A. Total Assets Turnover Ratio
This ratio measures the overall performance and efficiency of the business enterprise. It points
out the extent of efficiency in the use of assets by the firm. This ratio is calculated by dividing
the annual sales value by the value of total assets. Normally, the value of sales should be
considered to be twice that of the assets. A lower ratio indicates that the assets are lying idle
while a higher ratio may mean that there is overtrading. Sometimes, intangible assets (goodwill,
patents, etc.) are excluded from the total assets and the total tangible assets-turnover ratio is
calculated as;
Net Sales
TATR 1998 = = 110,000/71,000 = 1.55 times
Net Assets
Net Sales
TATR 1999 = = 120000/82,000 = 1.46 times
Net Assets
Interpretation: the total asset turnover ratio of 1.55 times during 1998 and 1.46 times during
1999 implies the firm was able to generate birr 1.55 and 1.46 for a single birr it has invested in
its assets during 1998 and 1999 respectively.
Even though, the total volume of sales was greater during the year 1999, the ratio shows that the
firm was more efficient in total assets utilization during 1998. Thus, the decline in the ratio
during 1999 may indicate a decrease in the efficiency of asset utilization in generating sales.
B. Inventory Turnover Ratio
This ratio indicates the efficiency of the firm’s inventory management. It measures the number
of times per year the firm sales its inventories. This ratio indicates the rapidity with which the
stock is turning into receivables through sales. Generally, a high inventory turnover is an index
of good inventory management and a low inventory turnover indicates an inefficient inventory
management. Low stock turnover implies the maintenance of excessive stocks which are not
warranted by production and sales activities. It also may be taken as an indication of slow
moving or non-moving and obsolete inventory. A too high inventory turnover also is not good. It
may be the result of a very low level of stocks which may result in frequent stock-outs. The stock
turnover should be neither too high nor too low.

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It is calculated as;
Cost of Goods Sold
ITR 1998 = = 83,000/18,700 = 4.44 times
Ending Inventory Balance
360
Average Age of Inventory = = = 360/4.44 = 81 days
ITR
Cost of Goods Sold
ITR 1998 = = 90,000/20,500=4.39 times
Ending Inventory Balance
360
Average Age of Inventory = = = 360/4.39=82 days
ITR
Interpretation; in general high inventory turnover ratio may be taken as a sign of good
inventory management and efficiency.
C. Average Collection Period
This ratio measures the average collection period or the average number of days it takes for the
firm to collect its account receivables, it is computed in two-step procedures. The first step is
computing the average daily credit sale and the second step is computing the average collection
period as shown below;
Total credit sale
Daily Credit Sale =
360 days
Acc . Receivable ending
ACP = Daily credit sale
Assume that the firm in our example makes its all sales on credit; the average collection period
of the firm can be calculated in the following manner,
Daily Credit Sales = 110,000/360 = 305.56 Br/day
ACP (1998) = 12,000/305.56 = 39.27 days
Daily Credit Sales = 120,000/360 = 333.33 Br/day
ACP (1998) = 16,000/333.33 = 48 days
Interpretation: in general, the shorter is the average collection period is the better the firm’s
efficiency. For ABC, it was relatively better receivable collection period during 1998 than 1999.
4. Profitability ratios
Every firm should earn adequate profits in order to survive in the immediate present and grow
over a long period of time. In fact, the profit is what makes the business firm run. Profit is also
stated as the primary and final objective of a business enterprise. It is also an indicator of the
firm’s efficiency of operations. There are different persons interested in knowing the profits of
the firm. The management of the firm regards profits as an indication of efficiency and as a
measure of control. Owners take it as a measure of the worth of their investment in the business.

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To the creditors profits are a measure of the margin of safety. Employees look at profits as a
source of fringe benefits. To the government they act as a measure of the firm’s tax paying
ability and a basis for legislative action. To the customers they are a hint for demanding price
cuts. To the firm they constitute a less cumbersome and low cost source of finance for existence
and growth. Finally, to the country profits are an index of the economic progress, the national
income generated and the rise in the standard of living of the people. Therefore, every firm
should earn sufficient profits in order to discharge its obligations to the various persons
concerned.
From the management point of view, profitability ratios are calculated for measuring the
efficiency of operations. There are two types of profitability ratios calculated for this purpose.
They are:
I. Profitability in relation to sales, and
II. Profitability in relation to investment.
1. Profitability in relation to sales
Under this category many profitability ratios are calculated relating different concepts of profit to
the sales value. Some such ratios are:
I. Gross Profit margin ratio
It measures the relationship between the firm’s sale and its gross profit. It is calculated by
dividing gross profit by sale.
Gross profit Sales−Cost of goods sold
=
Gross profit margin ratio 1998 = Sales Sales
= 27,000/110,000 = 0.2455 or 24.55%
Gross profit Sales−Cost of goods sold
=
Gross profit margin ratio 1999 = Sales Sales
= 30,000/120,000 = 0.25 or 25%
Interpretation: the gross profit margin ratios of the firm constitute 24.55% and 25% of the
firm’s net sales during the respective periods. This ratio indicate the firms mark ups on its cost of
goods sold as well as the ability of the firm’s management to minimize the cost of goods sold in
relation to net sales. Generally, larger gross profit margin ratio implies lower costs of goods sold
and higher efficiency.
II. Operating Profit Margin Ratio
Operating profit margin is the excess of gross profit over operating expenses. It is calculated by
dividing operating profit by net sales.

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 Operatingincome
Operating Profit Margin Ratio 1998 =
Net sale
OPMR = 12,200/110,000 = 0.1109 or 11.09%

Operatingincome
Operating Profit Margin Ratio 1999 =
Net sale
OPMR = 14,250/120,000 = 0.1188 or 11.88%
Interpretation: operating income is an income from the firms operation. This ratio reflects the
firm’s operating expenses as well as its cost of goods sold. The above ratio of ABC indicates that
the firm left with 11.09% and 11.88% of its net sells after covering its cost of goods sold and all
operating expenses during 1998 and 1999 respectively. Generally, the higher ratio indicates
higher efficiency.
III. Net Profit Margins Ratio
This is one of the very important ratios and measures the profitableness of sales. It is calculated
by dividing the net profit by sales. The Net profit is obtained by subtracting operating expenses
and income tax from the gross profit. This ratio measures the ability of the firm to turn each Birr
of sales into net profit. It also indicates the firm’s capacity to withstand adverse economic
conditions. A high net profit margin is a welcome feature to a firm and it enables the firm to
accelerate its profit at a faster rate than a firm with a low net profit margin.
NPMR (1998) = net income /net sale
= 7,540/120,000 = 0.0685 or 6.58%
NPMR (1999) = net income /net sale
= 10,100/120,000 = 0.0842 or 8.42%
Interpretation: ABC union has earned 6.85% net income per birr of net sales it made during
1998; and nearly 8.42% net income per birr of net sales during 1999. Generally, the higher the
net profit margin ratio points out the higher the efficiency of the firm.
2. Profitability in Relation to Investment
A. Return on Investment (ROI):
Also known as return on assets (ROA). This ratio measures the firm’s profitability per birr of
investment in total assets. ROA/ROI is calculated by dividing net income by total assets of the
firm.
Net Income
ROI (1998) =
Total Net Sale
= 7,540/71,000 = 0.1062 or 10.62%

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 Net Income
ROI (1999) =
Total Net Sale
= 10,100/82,000 = 0.1232 or 12.32%
Interpretation: this ratio evidenced that the union generates 10.62% or birr about 0.1062 in
1998 and 12.32% or about birr 0.1232 in 1999 in the form of net income out of each birr invested
in its total assets during the years. Generally, the higher ROI in 1999 indicates that the
improvement in the efficiency of the firms overall performance.

2.2.4. Limitations Of Ratio Analysis

At the outset it should be noted that ratio analysis is not an end in itself but a means to the
answering of specific questions which the users of the financial statements have in relation to the
financial condition and results of operations of the firm.
Ratios are derived from financial statements. The financial statements suffer from a number of
limitations and ratios which are derived from these statements are also subject to these
limitations.
 Ratios are meaningless, if detached from their source.
 Ratios, as they are, are not of much significance. They become useful only when they are
compared with some standards.
 Ratio analysis should be made with care in the case of inter-firm comparison. Unless the
firms in question follow identical accounting methods for items like depreciation, stock
valuation, deferred revenue expenditure, the writing off of capital items, etc., ratios will not
reflect the figures which are truly comparable.
 No ratio may be regarded as good or bad as such. It may be an indication the firm is weak or
strong, not a conclusive proof thereof.
 Ratio analysis may give misleading results if the effect of changes in price level is not taken
into account.
The nature of the business (whether trading or manufacturing) and the industry’s characteristics
which affect the figures in the financial statements and their inter-relationships should be clearly
understood and born in mind in order to make meaningful ratio analysis.

The social, economic and political conditions which form the background for the firm’s
operations should be understood so as to make ratio analysis meaningful.
These limitations, to a considerable extent, can be eliminated or corrected:

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 1) if the analysis is related to one firm over a period of time;
2) if the analysis is limited to a few well-chosen ratios which can answer specific questions;
3) if the results of the firm are compared with suitable norms or standards;
4) if the ratios are used primarily for the identification of areas for further managerial
analysis and formulation of alternatives available to the management in solving such
problems;
5) If the ratios are interpreted in the light of social, political, economic, technological and
business conditions under which the firm operates.
If ratio analysis is done unconsciously it will be not only misleading but also positively
dangerous. If it is used with a measure of caution, reason, and logic it can be a powerful
management tool not so much for providing answers but for highlighting management issues and
for identifying possible alternatives.

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