RVU instructor ;Habtamu A

UNIT 2: FINANCIAL ANALYSIS

2.0 AIMS AND OBJECTIVES

The primary purpose of this unit is to enable students understand more and evaluate the financial
statements of a firm. At the end of the unit, students are expected to answer the following questions.

 How do finance people generally begin performing financial analysis? What are the basic
objectives of financial analysis?
 What are some of the common methods used in financial management in order to understand
about a firm’s performance and future conditions?
 Why are financial ratios discussed under major categories? What are the major categories
and what does each category measure about a firm?
 How do you confirm whether a given financial ratio is good or bad?
 What are some of the uses as well as the limitations of ratio analysis?
2.1 INTRODUCTION

In the previous accounting courses you have learned that financial statements report both on a firm’s
financial position and financial performance. The four basic financial statements present about different
aspects of financial conditions, operating results, and cash flows. The balance sheet shows a firm’s assets
and claims against assets at a particular point in time – time. The income statement, on its part, reports the
results of the firm’s operations over a period of time. Similarly, the statements of retained earnings and
cash flows show the change in retained earnings and cash between two balance sheet dates.

However, financial statements by themselves do not give aq complete picture about a company’s financial
condition, operating results, and cash flows. Neither can a real value of financial statements could be
derived in themselves alone. Therefore, to predict the future and to help anticipate future conditions,
financial statements should be analyzed further. This analysis helps to identify current strengths and
weakness of the firm. It facilitates planning the future, and helps to control the firm’s financial activities
better. To have all this benefits, however, a finance person should perform a financial analysis.

2.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS

Financial analysis refers to analysis of financial statements and it is a process of evaluating the
relationships among component parts of financial statements.

The focus of financial analysis is on key figure in the financial statements and the significant relationships
that exist between them. Financial analysis is used by several groups of users like managers, credit
analysts, and investors.

The analysis of financial statements is designed to reveal the relative strengths and weakness of a firm.
This could be achieved by comparing the analysis with other companies in the same industry, and by
showing whether the firm’s position has been improving or deteriorating over time. Financial analysis
helps users obtain a better understanding of he firm’s financial conditions and performance. It also helps
users understand the numbers presented in the financial statements and serve as a basis for financial
decisions.

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2.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS

A number of methods can be used in order to get a better understanding about a firm’s financial status and
operating results. The most frequently used techniques in analyzing financial statements are:

i) Ratio Analysis – is a mathematical relationship among money amounts in the financial statements.
They standardize financial data by converting money figures in the financial statements. Ratios are
usually stated in terms of times or percentages. Like any other financial analysis, a ratio analysis helps
us draw meaningful conclusions and interpretations about a firm’s financial condition and performance.

ii) Common size Analysis – expresses individual financial statement accounts as a percentage of a base
amount. A common size status expresses each item in the balance sheet as a percentage of total assets
and each item of the income statement as a percentage of total sales. When items in financial
statements are expressed as percentages of total assets and total sales, these statements are called
common size statements.

iii) Index Analysis – expresses items in the financial statements as an index relative to the base year. All
items in the base year are assumed to be 100%. Usually, this analysis is most appropriate for income
statement items.

According to users of financial information, there are two techniques of financial analysis. These are:

i) External Analysis – an analysis performed by outsiders to the firm such as creditors, investors,
suppliers etc.

ii) Internal Analysis – an analysis performed by corporate finance and accounting departments for he
purpose of planning, evaluating, and controlling operating activities.

2.4 STAGES IN FINANCIAL ANALYSIS

Financial analysis consists of the following three major stages.

i) Preparation. The preparatory steps include establishing the objectives of the analysis and assembling
the financial statements and other pertinent financial data. Financial statement analysis focuses
primarily on the balance sheet and the income statement. However, data from statements of retained
earnings and cash flows may also be used. So, preparation is simply objective setting and data
collection.

ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial statement
analysis programs can be applied as part of this stage of financial analysis.

iii) Evaluation and Interpretation.

Interpretation. Involves the determination fo the meaningfulness of the analysis and
to develop conclusions, inferences, and recommendations about the firm’s performance and financial
condition. This is the most important of all the three stages of financial analysis.

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Although we have briefly seen what is meant by the three most common types of financial
analysis, our focus on this material will be on ratio analysis. So in the section that follows, we
will discuss major types of financial ratios with illustrative examples.
2.5 TYPES OF FINANCIAL RATIOS

There are several key ratios that reveal about the financial strengths and weaknesses of a firm.
We will look at five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.
2.5.1 Liquidity Ratios

Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets. There are two
commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the necessary ratio
analyses using them, and then evaluate and interpret each analysis.

Zebra Share Company

Comparative Balance Sheet

December 31, 2001 and 2002

(In thousands of Birrs)

Assets 2002 2001

Current assets:

Cash 9,000 7,000

Marketable securities 3,000 2,000

Accounts receivable (net) 20,700 18,300

Inventories 24,900 23,700

Total current assets 57,600 51,000

Fixed assets:

Land and buildings 33,000 27,000

Plant and equipment 130,500 120,000

Total fixed assets 163,500 147,000

Less: accumulated depreciation 67,200 61,200

Net fixed assets 96,300 85,800

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Total assets 153,900 136,800

Liabilities and stockholders’ equity

Current liabilities:

Accounts payable 20,100 17,100

Notes payable 14,700 13,200

Taxes payable 3,300 3,000

Total current liabilities 38,100 33,300

Long-term debt:

Mortgage bonds –5% 60,000 60,000

Total liabilities 98,100 93,300

Stockholders’ equity:

Preferred stock –5% (Br. 100 par) 6,000 -

Common stock (Br. 10 par) 33,000 30,000

Capital in excess of par value 7,500 4,500

Retained earnings 9,300 9,000

Total stockholders’ equity 55,800 43,500

Total liabilities and stockholders’ equity 153,900 136,800

Zebra Share Company

Income Statement

For the Year Ended December 31, 2002

________________________________________________________________________

Net sales Br. 196,200,000

Cost of goods sold 159,600,000

Gross profit Br. 36,600,000

Operating expenses* 26,100,000

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Earnings before interest and taxes (EBIT) Br. 10,500,000

Interest expense 3,000,000

Earnings before taxes (EBT) Br. 7,500,000

Income taxes 3,600,00

Net income Br. 3,900,000

* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease payment.

Zebra Share Company

Statement of Retained Earnings

For the Year Ended December 31, 2002

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000

Sub-total Br. 12,900,000

Less: Cash dividends

Preferred Br. 300,000

Common 3,300,000

Sub-total Br. 3,600,000

Retained earnings at end of year Br. 9,300,000

i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term creditors by
using only current assets. This ratio relates current assets to current liabilities

Current ratio = Current assets

Current liabilities

Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times

Br. 38,100

Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current liabilities.

Relatively high current ratio is interpreted as an indication that the firm is liquid and in good position to
meet its current obligations. Conversely, relatively low current ratio is interpreted as an indication that the
firm may not be able to easily meet its current obligations. A reasonably higher current ratio as compared

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to other firms in the same industry indicates higher liquidity position. A very high current ratio, however,
may indicate excessive inventories and accounts receivable, or a firm is not making full use of its current
borrowing capacity.

ii) Quick ratio (Acid – test ratio)- measures the short-term liquidity by removing the least liquid current
assets such as inventories. Inventories are removed because they are not readily or easily convertible into
cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities by using its most liquid
assets into cash.

Quick ratio = Current assets – Inventory

Current liabilities

Zebra’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900 = 0.86 times

Br. 38,100

Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current liabilities.

Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-tem obligations, and the
higher the quick ratio the more liquid the firm’s position. But the quick ratio is more detailed and
penetrating test of a firm’s liquidity position as it considers only the quick asset. The current ratio, on the
other hand, is a crude measure of the firm’s liquidity position as it takes into account all current assets
without distinction.

2.5.2 Activity Ratios

Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios include
turnover ratios because they show how rapidly assets are being converted (turned over) into sales or cost
of goods sold. Activity ratios are also called asset management ratios, or asset utilization ratios, or
efficiency ratios. Generally, high turnover ratios are associated with good asset management and low
turnover ratios with poor asset management.

Activity ratios include:

i) 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.

Accounts receivable turnover = Net sales

Accounts receivable

Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times

Br. 20,700

Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.

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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 more liberal credit
policy, more restrictive cash discount offers, poor credit selection or in adequate cash collection
efforts.

There are alternate ways to calculate accounts receivable value like average receivables and ending
receivables. Though many analysts prefer the first, in our case we have used the ending balances. In
computing the accounts receivable turnover ratio, if available, only credit sales should be used in the
numerator as accounts receivable arises only from credit sales.

ii) Days sales outstanding (DSO) – also called average collection period. It seeks to measure the average
number of days it takes for a firm to collect its accounts receivable. In other words, it indicates how
many days a firm’s sales are outstanding in accounts receivable.

Days sales outstanding = 365 days

Accounts receivable turnover

Zebra’s days sales outstanding = 365 days = 39 days

9.48

Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days. If
Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve the
collection period.

The average collection period of a firm is directly affected by the accounts receivable turnover
ratio. Generally, a reasonably short-collection period is preferable.

iii) Inventory turnover – measures how many times per year the inventory level is sold (turned over).

Inventory turnover = Cost of good sold

Inventory

For Zebra Company (2002) = Br. 159,600 = 6.41times

Br. 24,900

Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.

In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator
rather than sales. But when cost of goods sold data is not available, we can apply sales. In
general, a high inventory turnover is better than a low turnover. But abnormally high inventory
turnover might result from very low level of inventory. This indicates that stock outs will occur
and sales have been very low. A very low turnover, on the other hand, results from excessive
inventory levels, presence of inferior quality, damaged or obsolete inventory, or unexpectedly
low volume of sales.

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iv) Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows how many birrs
of sales are generated from one birr of fixed assets

Fixed assets turnover = Net sales___

Net fixed assets

Zebra’s fixed assets turnover = Br. 196,200 = 2.04X

Br. 96,300

Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.

A fixed assets turnover ratio substantially lower than other similar firms indicates under
utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low sales
levels. This suggests to the firm possibility of increasing outputs without additional investment in
fixed assets.
The fixed assets turnover may be deceptively 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.
v) Total assets turnover – indicates the amount of net sales generated from each birr of total tangible
assets. It is a measure of the firm’s management efficiency in managing its assets.

Total assets turnover = Net Sales

Total assets

Zebra’s total assets turnover = Br. 196,200 = 1.27X

Br. 153, 900

Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested
in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.
2.5.3 Leverage Ratios
Leverage ratios are also called debt management or utilization ratios. They measure the extent to which a
firm is financed with debt, or the firm’s ability to generate sufficient income to meet its debt obligations.
While there are many leverage ratios, we will look at only the following three.

i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.

Debt ratio = Total liabilities

Total assets

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Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900

Interpretation: At the end of 2002, 64% of Zebra’s total assets was financed by debt and 36% (100% -
64%) was financed by equity sources.

A high debt ratio implies that a firm has liberally used debt sources to finance its assets. Conversely, a
low ratio implies the firm has funded its assets mainly with equity sources. Debt ratio reflects the capital
structure of a firm. The higher the debt ratio, the more the firm’s financial risk.

ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.

Times interest earned = Earnings before interest and taxes (EBIT)

Interest expense

Zebra’s times interest earned = Br. 10,500 = 3.50X

Br. 3,000

Interpretation: Zebra has operating income 3.5 times larger than the interest expense.

The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available to meet
its interest obligations. However, earnings before interest and taxes is an income concept and not a direct
measure of cash. Hence, this ratio provides only an indirect measure of the firm’s ability to meet its
interest payments.

iii) Fixed charges coverage – measures the ability of a firms to meet all fixed obligations rather than
interest payments alone. Fixed payment obligations include loan interest and principal, lease payments,
and preferred stock dividends.

Fixed charges coverage = Income before fixed charges and taxes

Fixed charges

For Zebra Company, the other fixed charge payment in addition to interest is lease payment. Therefore,

Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X

Br. 3,000 + Br. 2,700

Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are safely
covered 2.32 times.

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Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable. The
fixed charges coverage ratio is required because failure of the firm to meet any financial obligation will
endanger the position of a firm.

2.5.4 Profitability Ratios

These ratios measure the earning power of a firm with respect to given level of sales, total assets, and
owner’s equity. The following ratios are among the many measures of a firm’s profitability.

i) Profit Margin – shows the percentage of each birr of net sales remaining after deducting all expenses.

Profit margin = Net income

Net Sales

Zebra’s profit margin = Br. 3,900 = 2%

Br. 196,200

Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.

The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as well as the
amount of all costs and expenses of a firm.

ii) Return on investment (assets) – measures how profitably a firm has used its investment in total assets.

Return on investment = Net income

Total assets

Zebra’s return on investment = Br. 3,900 = 2.53 %

Br. 153,900

Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.

Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments made
by themselves.

Return on equity = Net income___

Stockholders’ equity

Zebra’s return on equity = Br. 3,900 = 6.99%

Br. 55,800

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Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity

We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment

1 – Debt ratio

A high return on equity may indicate that a firm is more risky due to higher debt balance. On the contrary,
a low ratio may indicate greater owners capital contribution as compared to debt contribution. Generally,
the higher the return on equity, the better off the owners.

Dupont System of Analysis

It is an approach to assess that a firm’s return on assets and return on equity show not only the firm’s
earning power but also efficiency and leverage. This analysis breaks down these two ratios as follows:

Return on assets = Profit margin X Total assets turnover

Return on equity =Profit margin X Total assets turnover X Total assets/equity

= Profit Margin X Total assets turnover X Equity Multiplier

2.5.5 Marketability Ratios

Marketability ratios are used primarily for investment decisions and long range planning. They include:

i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common stock
outstanding. It does not reflect how much is paid as dividends.

Earnings per share = Net income – Preferred stock dividend

Number of common shares outstanding

Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09

Br. 33,000  Br. 10

Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.

ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each
share of its common stock outstanding.
Dividends Per Share = Total cash dividends on common shares

Number of common shares outstanding

Zebra’s DPs for 2002 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10

Interpretation: Zebra distributed Br. 1 per share in dividends.

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iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.

Dividends pay-out = Dividends per share

Earnings per share

= Total dividends to common stockholders

Total earnings to common stockholders

Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600

Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.

2.6 COMPARING FINANCIAL RATIOS

To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.

i) Cross – sectional analysis – is the comparison of a firm’s ratios to those other firms in the same
industry at the same point in time. Here, the firm is interested in how well it has performed in relation to
other firms. Generally, cross – sectional analysis is preformed based on industry averages of different
financial ratios.

ii) Time – series analysis – is an evaluation of a firm’s financial ratios over time. Here, the current period
ratios are compared with those of the past years. The purpose is to determine whether the firm is
progressing or deteriorating.

To obtain the highest possible information about a firm, usually, a combination of both cross – sectional
and time-series analyses are applied.

2.7 LIMITATIONS OF RATIO ANALYSIS

Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.

1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason could be a
single firm may have different divisions operating in different industries. Another reason could
be the financial statements may not be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when they are not
audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.

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5. Inflation badly distorts comparison of ratios of a firm over time.

6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example,
the inventory turnover ratio for a stationery materials selling company will be different at
different time periods of a year.

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