Financial Management-I [CHAPTER 2]

CHAPTER TWO
FINANCIAL 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. 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 a 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 the 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.
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:

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

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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
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:

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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
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 to other firms in the same industry indicates
higher liquidity position. A very high current ratio, however, may indicate excessive

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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-term
obligations, and the higher the quick ratio the more liquid the firm’s position. But the quick
ratio is more detailed and penetrating test of a firm’s liquidity position as it considers only
the quick asset. The current ratio, on the other hand, is a crude measure of the firm’s
liquidity position as it takes into account all current assets without distinction.
2.5.2. Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. 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.
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

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

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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
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.

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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.

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 are 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 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.
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

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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 them.
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%
Br. 55,800
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 owner’s capital contribution as compared to
debt contribution. Generally, the higher the return on equity, the better offs the owners.
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.

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

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

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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.
Exercises
1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br. 200,000,
and long-term bond of Br. 225,000. If the total stockholders’ equity of the company
amounts to Br. 750,000, what is the debt ratio?
2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between inventories
and current liabilities for this firm?
3. ABC company’s return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The firm’s
annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%.
What is XYZ Company’s times interest earned ratio?
5. Complete the balance sheet and sales information in the following table for Abay
Transport Ltd. Using the financial ratios that follow.

BALANCE SHEET
______________________________________________________________________________________
_________________
Cash Accounts payable
Accounts receivable Long-term debt 120,000
Inventories Common stock
Fixed assets ________ Retained earnings 195,000
Total assets Br. 1,000,000 Total liabilities and equity _______
Sales Cost of goods sold
Debt ratio: 50% Days sales outstanding: 36days
Quick ratio: 0.80X Cost of goods sold/sales: 75%
Total assets turnover: 1.5X Inventory turnover: 5X