Chapter two: Financial Statement Analysis

Introduction
The primary goal of financial management is to maximize the stock price, not to maximize
accounting measures such as net income or EPS (Earnings per share). However, accounting data
do influence stock prices, and to understand why a company is performing the way it is and to
forecast where it is heading, one needs to evaluate the accounting information reported in the
financial statements. If management is to maximize a firm’s value, it must take the advantage of
the firm’s value, the firm’s strengths and, simultaneously, correct its weaknesses.

To make rational decisions in keeping with the objectives of the firm, the financial manager must
have analytical tools. Some of the more useful tools of financial analysis are the subjects of this
chapter.

Definition of Financial Analysis

Financial analysis involves the use of various financial statements. Financial (statement)
analysis refers to the art of transforming data from financial statements into information that is
useful for informed decision making. Financial analysis is the process of identifying the
financial strengths and weaknesses of the firm by properly establishing relationship between
items of financial statements for certain period. Financial analysis is concerned with the
selection, evaluation, and interpretation of financial data to assist investment, financing, and
dividend decisions.

Sources of data for financial analysis

 The sources of data for financial analysis include:
 Financial data (the company’s annual reports)
 Financial statements
 Accompanying notes
 Independent auditor’s report
 Economic data (GDP and Consumer Price Index)
 To assess the recent performance or future prospects of the company or
industry.

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  Available from government and private sources, such as Central Statistics
Authority (CSA).
 Market data (market prices of securities)
 Can be found from financial press and electronic media daily.

Objectives of financial analysis

The firm itself and outside providers of capital – creditors and investors – all undertake
financial statement analysis. The type of analysis varies according to the specific interests of
the party involved.
1) Management of the firm.
Internally, management also employs financial analysis for the purpose of internal control
and to better provide what capital suppliers seek in financial condition and performance from
the firm. From an internal control standpoint, management needs to undertake financial
analysis in order to plan and control effectively. To plan for the future, the financial manager
must assess the firm’s present financial position and evaluate opportunities in relation to this
current position. With respect to internal control, the financial manager is particularly
concerned with the return on investment provided by the various assets of the company, and
with the efficiency of asset management. Finally, to bargain effectively for outside funds, the
financial manager needs to be attuned to all aspects of financial analysis that outside
suppliers of capital use in evaluating the firm. Generally, the objective of financial analysis
by the internal management is to:
 Evaluate whether the resources of the firm are used most efficiently and effectively
 Evaluate whether the financial condition (status) of the firm is sound.
 Analyze funds needed
 Analyze business and financial risk (Business risk is the risk inherent in the operation of
the business whereas financial risk is the probability that the firm fails to meet its
obligations)
2) Trade Creditors (suppliers)/Short-term creditors
 Trade creditors (suppliers’ owed money for goods and services) are primarily interested
in the liquidity of a firm. Their claims are short term, and the ability of the firm to pay
these claims quickly is best judged by an analysis of the firm’s liquidity.

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3) Suppliers of long-term funds
 The claims of bondholders, on the other hand, are long term. Accordingly,
bondholders are more interested in the cash-flow ability of the firm to service
debt over a long period of time. They may evaluate this ability by analyzing the
capital structure of the firm, the major sources and uses of funds, the firm’s
profitability over time, and projections of future profitability. So their objective
is:
 To evaluate the firm’s long term solvency and survival
 To evaluate the firm’s ability to generate profits and cash over time
to pay interest and principal
4) Investors
 Investors in a company’s common stock are principally concerned with present
and expected future earnings as well as with the stability of these earnings about
a trend line. As a result, investors usually focus on analyzing profitability. They
would also be concerned with the firm’s financial condition insofar as it affects
the ability of the firm to pay dividends and avoid bankruptcy. So their interest is:
 To evaluate the overall aspects of the firm’s financial status (financial health)
 To analyze the firm’s present and future profitability.

Approaches in analyzing financial statements

Generally, there are two approaches to financial analysis.
i. Time series analysis
The easiest way to evaluate the performance of a firm is to compare its present performance with
past performance. When financial ratios over a period of time are compared, it is known as the
time series (trend or longitudinal) analysis. Time series (trend) analysis looks for:
 Important trends in the firm’s data
 Shifts in trends
 Data outliers or values that deviate substantially from the other data points.
ii. Cross sectional analysis
- To compare the performance of one firm with the performance of selected firm (key
competitor) in the same industry, or industry average at the same point in time

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 - This kind of comparison indicates the relative financial position and performance of the
firm.

Methods for analyzing financial statements

Generally, there are four methods of analyzing financial statements.
a. Ratio analysis
b. Common size statement analysis
c. Trend analysis
d. Index analysis

Ratio analysis
To evaluate a firm’s financial condition and performance, the financial analyst needs to perform
“checkups” on various aspects of a firm’s financial health. A tool frequently used during these
checkups is a financial ratio, or index, which relates two pieces of financial data by dividing one
quantity by the other. Financial ratio is an index that relates two accounting numbers and is
obtained by dividing one number by the other.
Ratio is defined as the indicated quotient of two mathematical expressions. Ratio analysis is an
analytical technique that typically involves a comparison of the relationship between two
financial statement items.

Types of standards/benchmarks used in Ratio analyses

Ratios are more meaningful if there is standard of measurement or comparison. When computing
and interpreting the financial ratio results, we need to decide whether these ratio results suggest
well, bad or average performance about a particular company. The most commonly used
standards are as discussed below:
a. Historical standards (intra company)
 Ratios computed from the company’s own past experience. The company under
analysis provides standards for comparison based on prior year’s performance and
relation between the financial statement items.
 For example, A company’s current year NI can be compared with prior year’s NI
and its relations to revenues.
b. Horizontal standards (Competitor)

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  Use of key competitor’s ratios or industry averages. One or more direct competitors
of the company under analysis can provide standards for comparisons. A company’s
Profit margin for instance, can be compared with the profit margin of another
company.
c. Budgeted standards
 Use of budgeted performance
d. Absolute standards
 Ratios generally recognized as being desirable regardless of the type of company, the
time, stage of business cycle, or objective of the analyst

Financial ratios can be designed to measure almost any aspect of a firm’s performance. In
general, analysts use ratios as one tool in identifying areas of strength or weakness in an
enterprise. Ratios, however, tend to identify symptoms rather than problems. A ratio whose value
is judge to be “different” or unusually high or low may help identify a significant event but will
seldom provide enough information, in and of itself, to identify the reasons for an event’s
occurrence.

Major types of financial ratios

Generally, financial ratios can be classified in to five categories; namely,
 Liquidity ratios.
 Asset management (Activity, or turnover) Ratios
 Debt management (leverage or gearing) ratios
 Profitability and
 Marketability ratios
1. Liquidity ratios
Liquidity ratios are used to measure a firm’s ability to meet short-term obligations (or current
liabilities). Short-term obligations include accounts payable, short-term notes payable, accruals
(e.g. salaries payable, rent payable, interest payable etc), and currently maturing portion of long-
term debts. They compare short-term obligations to short-term (or current) resources on the
assumption that current assets are primarily available for the payment of shot-term obligations.
Current assets include cash, marketable securities, receivables, and inventories. From these

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ratios, much insight can be obtained into the present cash solvency of the firm and the firm’s
ability to remain solvent in the event of adversity. The most common ratios which indicate the
extent of liquidity are:
 Current ratio and
 Quick ratio
Current Ratio
Current ratio measures the ability of the firm to meet short-term obligations from its current
assets. Current ratio is a measure of a firm’s short-term solvency. It is computed by dividing
current assets by current liabilities.
Current Ratio = Current Assets
Current Liabilities

Quick /Acid Test/ Ratio

Quick ratio serves the same general purpose as the current ratio but exclude inventory from
current assets. This is done because inventories are typically a firm’s least liquid current assets.
Thus, the quick ratio measures a corporation’s ability to pay its current liabilities by converting
its most liquid assets into cash.

It is computed by subtracting inventories from current assets and dividing the remainder by
current liabilities.

If the company seeks to pay its current liabilities by using only its quick assets, then its quick
assets must equal or exceed its current liabilities. Thus its quick ratio must be 1 or more. This is
the reasoning behind the quick ratio’s standard to be 1.0 that many analysts use as the dividing
line between sufficient and insufficient liquidity.
2. Asset management /activity/ ratio
Activity ratios, also known as efficiency or turnover ratios, measure how effectively the firm is
using its assets in generating revenues or sales. Efficiency is equated with rapid turnover, hence,
these ratios are referred to collectively as activity ratios. Some activity ratios concentrate on
individual assets such as inventory or accounts receivable. Others look at overall corporate
activity. Some of the major activity ratios are discussed as follows:
i. Inventory Turnover (ITO)

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Inventory turnover measures the number of time per year, on average, that a corporation sells, or
turns over, its inventory.

 Inventory Turnover = Cost of Goods sold

(Average) Inventory
Or
 Inventory Turnover = Sales
(Average)Inventory If there is no CGS
data

In general, high inventory turnover ratios are taken as a sign of efficient management of
inventory. Relatively low inventory turnover is often a sign of excessive, slow moving, or
obsolete items in inventory.

An alternative measure of inventory activity is Inventory turnover in days (ITD), Average age of
Inventory (AAI) or inventory period, which is computed as follows:

 Inventory Period = 360_____

Inventory turn over
 Or equivalently
Average Inventory × 360
Cost of Goods Sold
ii. Receivable Turn over (RTO)
Receivable turnover ratio provides insight into the quality of the firm’s receivables and how
successful the firm is in its collection. This ratio tells us the number of times accounts receivable
have been turned over (turned into cash) during the year. This ratio is calculated by dividing
credit sales by ending balance of accounts receivable.
Receivable Turn over = Annual Credit Sales
Average As/Receivable

 ACP = 360 days

Receivable turn over
Or Alternatively,

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  ACP = Accounts receivable × 360
Total annual credit Sales

iii. Total Assets Turn over (TATO)

This ratio shows the firm’s ability in generating sales from all financial resources committed to
total assets. Thus’
TATO = ____Sales___
Total Assets

iv. Fixed Assets Turnover (FATO)

It is used to measure how effectively the firm uses its plant assets in generating sales. Fixed
Assets turnover is computed as follows:
 FATO = __Sales___
Fixed Assets

3. DEBT MANAGEMENT (LEVERAGE) RATIOS

Leverage refers to the use of fixed costs in an attempt to increase profitability. There are two
types of leverages; namely, operating leverage and financial leverage. Operating leverage refers
to the extent to which the firm uses fixed operating costs. On the other hand, financial leverage
refers to the extent to which the firm uses debts in financing its assets.

Debt management ratios are used to evaluate the extent to which the firm uses debt financing.
They indicate the debt burden of the firm. Different debt management ratios are used to evaluate
the debt burden of the firm. Generally, the leverage ratios are grouped into two: Balance sheet
leverage ratios and Coverage ratios. Balance sheet leverage ratios include: Debt ratio,
Shareholders ratio, Debt-to-Equity (D/E) ratio, and Equity Multiplier and Debt Multiplier ratios
as discussed hereunder:
i. Debt Ratio
Debt ratio, also called total debt-to-total assets (D/A) ratio, measures the extent to which the
firm is using borrowed money. It may be calculated as follows:

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  Debt ratio = Total Liabilities
Total Assets
ii. Debt- to- Equity (D/E) ratio
Debt-Equity ratio measures the proportion of debt capital in terms of equity capital. Debt-to-
equity ratio is computed by simply dividing the total debt of the firm (including current
liabilities) by shareholders’ equity.
Debt-to-Equity Ratio = Total Liabilities
Shareholders’ Equity
Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of
the firm’s financing that is being provided by shareholders and the larger the creditor cushion
(margin of protection) in the event of shrinking asset values or outright losses.

Depending on the purpose for which the ratio is used, preferred stock is sometimes included as
debt rather than as equity when debt ratios are calculated. Preferred stock represents a prior claim
from the standpoint of the investors in common stock; consequently, investors might include
preferred stock as debt when analyzing a firm. The ratio of debt to equity will vary according to
the nature of the business and the variability of cash flows.
Debt-to- Equity ratio may also be computed as follows:
D/E = D/A where, D = Debts A = Assets
1 – D/A E = Stockholders’ equity

iii. Equity Multiplier

The role of equity multiplier is the same as that of debt ratio. It measures the extent to which the
firm uses debt financing in its capital structure. It may be obtained by dividing total assets by
total stockholders’ equity.
 Equity Multiplier = Total Assets
Total stockholders’ Equity

A lower equity multiplier is desirable.

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iv) Shareholders ratio (SHR)
It shows the percentage of assets financed by the share holders’ equity. It is calculated using the
following formula:
Shareholders’ ratio= Total Shareholders’ equity
Total Assets
Or SHs Ratio= 1-D/R
v) Deb Multiplier
It measures the number of times that the firm’s total assets can cover its outstanding total debt. It
is computed as follows:
DM= Total Assets
Total Debts
Note that DM= it is the reciprocal of Debt Ratio (DM= 1/D/R)

The second groups of leverage ratios are coverage ratios, which includes interest coverage ratios,
fixed charge coverage ratios and dividend coverage ratios as discussed below:
i. Times Interest Earned (TIE) ratio/Interest Coverage ratio (ICR)
It is used to measure the ability of the firm to meet interest obligations from its profits. It
indicates the number of times that the Earnings before Interest and Taxes (EBIT) are available to
cover interest obligations. It is computed as follows:
TIE =Earning before interest and taxes
Interest Expense

ii. Fixed Charges Coverage (FCC) ratio

Fixed charges coverage ratio is used to measure the ability of the firm to meet all fixed
obligations such as interest, lease payments (rent), and sinking fund payments. It is computed as
the ratio of earnings before fixed obligations and fixed charges or obligations.
 FCC = EBIT + Lease Payments_______________
Interest + Lease + Sinking Fund Payments
1 – tax rate
It is assumed that profits are used to pay fixed charges. Sinking fund payments are made with
after tax Birr whereas interest and lease payments are made with pre-tax Birr. As a result, the
sinking fund payments must be grossed up by dividing by (1- tax rate) to find the before tax
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income required to pay taxes and still have enough money left to make the sinking fund
payment.
To be desirable, fixed charges coverage ratio should be greater than or equal to the standard.
Comparing with 2016, the fixed charges coverage ratio of 2017 is desirable. XYZ Company does
not have sinking fund payment in both years.
ii. Dividend Coverage (FCC) ratio
It measures the ability of the firm to meet fixed obligations related with the preferred stock
investors using the net income. The dividend coverage ratio is calculated using the following
formula:
 Dividend coverage ratio= Net income
Annual Dividend for Preferred stocks

4. Profitability ratios
As a group, these ratios allow the analyst to evaluate the earning power of the firm with respect
to given level of sales, total assets, and owner’s equity.
Profits are essential; however it would be wrong to assume that every action initiated by
management of a company should be aimed at maximizing profits, irrespective of social
consequences. It is unfortunate that the word “profit” is looked upon as a term of business since
some firms always act to maximize profits at the cost of employees, customers, and society at
large. Except such infrequent cases, it is a fact that sufficient profits must be earned due to the
following reasons:
 to attract outside capital for expansion
 to cover operating expenses, interest expense, and other fixed charges
 to earn profits for owners
 to contribute–towards social welfare
 for survival and growth of the firm over the long-run & etc.

Thus, the financial managers should continuously evaluate the efficiency of its company in terms
of profits. To this end, profitability ratios are calculated to measure the operating efficiency of
the company because they give final answers about how the firm is being managed. They
measure the combined effect of asset management, debt management, and liquidity on the
profitability of the firm.

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i. Gross Profit Margin
This ratio indicates the percentage of each sale Birr remaining after deducting the cost of goods
sold. The ratio reflects management’s effectiveness in pricing policy, generating sales, and
production efficiency (i.e. how well the purchase or production cost of goods is controlled).
Gross Profit Margin = Gross Profit
Net Sales
Generally, a higher gross profit margin ratio is desirable.
ii. Net Profit Margin
It measures the percentage of each sale Birr remaining after deducting all expenses. This ratio
shows the earnings left for shareholders (both common & preferred) as a percentage of net sales.
This ratio establishes a relationship between net income and net sales and indicates
management’s efficiency in manufacturing, administering, selling, financing, pricing and tax
management.
Net Profit Margin = Net Income
Net Sales
iii. Return on investment (ROI) also called Return on Assets (ROA)
It measures the amount of profit generated on investments in assets.
ROI (ROA) = Net Income
Total Assets
Generally, a higher ROA is desirable.

iv. Return of Equity (ROE)

It measures the rate of return realized by a firm’s stockholders on their investment and serves as
an indicator of management performance. ROE measures the return earned on the owners’
investment. ROE also called the Return on Stockholders Equity or Return on Net Worth. It
measures corporate profitability per Birr of equity capital. The shareholders equity will include
common stock, preferred stock, premium on common, & preferred stock, and retained earnings.
 Return on equity (ROE) = Net Income____
Stockholders equity
This ratio indicates how well the firm has used the resources of the owners. Thus, this ratio is of
great interest to present as well as prospective shareholders and also of great concern to
management, which has the responsibility of maximizing the owners’ welfare.

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The formula for ROE includes preferred dividends in the net income figure and preferred stock
in the shareholders’ equity. However, because the amount of preferred stock & its impact on a
firm are generally quite small, or non-existent, this formula is a reasonably good approximation
of the true owns (i.e. the common stockholders return).
Return on Equity (ROE) may also be computed using the following formula:
ROE = ROA
1 – D/A

v. Earnings Per share (EPS)

It expresses the profit earned per common share by a corporation during the reporting period. It
provides a measure of over all performance and is an indicator of the possible amount of
dividends that may be expected. The earning per share calculations made over years indicates
whether or not the firm’s earning power on per share basis has changed over that period. The
earning per share is generally of interest to present or prospective shareholders and management.
Hence, they are closely watched by the investing public and are considered an important
indicator of corporate success.

Earnings per share simply show the profitability of the firm on a per share basis, it does not
reflect how much is paid as dividend and how much is retained in the business. But as a
profitability index, it is a valuable and widely used ratio.
Earning per share is computed on common stock by dividing dividend on common stock by
number of common stock outstanding.
EPS = Earnings Available to common stock
Number of common stock outstanding
Or
EPS =Net Income - Preferred stock dividend
Number of common shares outstanding

Generally, a higher earnings per share is desirable.

vi. Dividend per share (DPS)
It represents the Birr amount of cash dividends a corporation paid on each share of its common
stock outstanding during the reporting period.

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DPS =Cash Dividends on Common stock
Number of Common shares outstanding
vii. Payout ratio (Dividend payout ratio)
It shows the percentage of earnings paid to stockholders. That is, the payout ratio expresses the
cash dividend paid per share as a percentage of EPS.
Pay Out Ratio = Dividend per Share
Earnings Per Share

5. MARKETABILITY RATIOS
They measure the perception of the future earning power of the company by the market. These
are ratios used primarily for investment decisions and long-range planning. They rely on
financial market data, such as the market price of securities. The major marketability ratios are:
a. Price / Earning (P/E) Ratio
b. Market-to-Book (M/B)ratio
a. Price- Earning (P/E) Ratio
It expresses the multiple that the market places on a firm’s earnings per share and is commonly
used to assess the owners’ appraisal of share value. The level of the P/E ratio indicates the degree
of confidence (or certainty) that investors have in the firm’s future performance. The P/E ratio
represents the amount investors are willing to pay for each dollar of the firm’s earnings. A high
P/E multiple reflects the market’s perception of the firm’s growth prospects (i.e. the higher the
P/E ratio, the greater investors confidence in firm’s future). If investors believe that a firm’s
future earnings potential is good, they may be willing to pay a higher price for the stock and thus
boost its P/E.
Price Earnings Ratio = Market Price per share
Earning per share
** P/E ratio has to be interpreted with caution because it may rise if earnings dropped while the
market price of stock rises.
b. Market-to Book ratio
It measures whether the firm has created value for its shareholders. If M/B ratio is greater than 1,
it is said that the firm has created value for its shareholders.
If M/B ratio is less than 1, the value of the firm has declined.

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M/B ratio is computed as the ratio of Market price per share to book value per share. Book value
per share is determined by dividing total stockholders’ equity by Number of common stock
outstanding.
The Du Pont Identity
Du Pont is the name of a person who managed a corporation named Du Pont Corporation. Du
Pont was very much interested in ROE as an important measure of the performance of his
corporation. He developed ROE model based on three major factors. These are:
1. Net profit margin
2. Total asset turnover, and
3. Equity Multiplier
Based on the above factors, he developed ROE model and called it Du Pont Identity. The Du
Pont identity is shown below:

ROE = Net Profit X Total Assets X Equity

Margin Turnover Multiplier

Evaluation of ratio analysis& other analysis techniques

Evaluation of ratio analysis

The intelligent use of ratio analysis requires an understanding of the advantages & limitations of
this technique.
Advantages of Ratio Analysis
1. Ratios are easy to compute
2. Ratios provide a standard of comparison at a point in time and allow comparisons to be made
with industry averages.
3. Ratios can be used to analyze a corporation’s financial time series in order to discover trends,
shifts in trends and data outliers.
4. Ratios are useful in identifying problem areas of a firm.
5. When combined with other tools, ratio analysis makes an important contribution to the task of
evaluating a corporation’s financial performance.

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Limitations of Ratio Analysis
1. It is difficult to develop meaningful set of industry averages for comparative purposes,
especially for a firm, which operates a number of different divisions.
2. Inflation has badly distorted the firm’s financial statements
3. Seasonal factors can distort a ratio analysis.
4. Firms can employ “window dressing” techniques to make their financial statements look
stronger.
5. Different accounting practices can distort comparisons.
6. It is difficult to generalize about whether a particular ratio is ”good” or “bad”
7. It is historical in nature.
Common-Size Statement Analysis, Trend Analysis, & Index Analysis
1. Common-Size Statement Analysis
 Each item in the balance sheet is expressed as a percentage of total assets.
 Each item in the income statement is expressed as a percentage of net sales.
2. Trend Analysis
 Deals the study of the percentage change in financial statement items over time
3. Index Analysis
 Deals financial statement items are expressed as a percentage relative to the base year

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