LESSON FOUR

REVIEW/FINANCIAL STATEMENT ANALYSIS

1.1 Introduction
Financial analysis is a process by which an accountant or finance manager or any other
interested party identifies the financial strength or position of a company by comparing the
relationship between items in the balance sheet and those in the profit and loss account.

This is so because balance sheet entities are usually responsible for those to be found in the
P&L i.e. assets shown in the balance sheet are responsible for sales, revenue and expenses to
be found in the P&L.
Thus financial analysis is of paramount importance to all parties with a financial stake in the
company as they will use such analysis to gauge the profitability and safety of their stake in
the company.
The lesson covers:
 Lesson Objectives
 Definition and Users of Financial Statements
 Yard Stick Used In Ratio Analysis
 Classification Computation and interpretation of ratios
 Uses /Applications and limitation of ratios
 Self-test question
 Learning Activities
 Summary
 Further reading.

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1.2 Lesson Objectives
By the end of this lesson you should be able to:

1. Discuss the basis financial statement available in a business

2. Explain the users of financial statements and their information needs
3. Show the importance of ratio analysis
4. Recognize the use and limitations of ratios
5. Understand the classification, computation and interpretation of ratios

1.3 Various Parties with a Financial Stake in the Company

1. Shareholders – Actual owners are interested in the company’s both short and long
term survival. For this reason they will use ratio’s such as:

a) Profitability ratios – which seek to establish viability.

b) Dividend ratios – which seek to establish return to owners in form of dividends. The
common ratios include earning yield (E/Y), Dividend payout ratio (DPO), dividend
yield, Price earning ratio, all of which will measure return to owner.
2. Creditors (trade) – these are interested in the company’s ability to meet their short-
term obligations as and when they fall due. For this reason, they will use ratios such as:
a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by
acid test ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against
current liabilities.
3. Long term lenders – These include finances through loans, mortgages and debenture
holders. These have both short and long term interest in the company and its ability to pay
not only interest on debt but also principal as and when it falls due. These parties are
interested in the following:
a) Liquidity ratios – used to assess short-term liability to meet current obligations.

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b) Profitability ratios – used to ascertain whether the company can pay its principal
back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment of
interest to the lenders of the debt.

4. Directors and management of company – They will therefore be interest in:

a) Efficiency of the company in generating profits.
b) The company’s viability from the investor’s point of view and the company’s ability to
generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.

5. Potential investors – these parties are interested in a company in total both on short- and
long-term basis in particular the company’s ability to generate acceptable return on their
money.
Therefore, they will use:

a) Dividend ratios
b) Return ratios
c) Gearing ratios

6. Government – The Government is interested mostly in utility companies (e.g. KPLC,

KPTC) and those that will provide public services – in this case the government will be
interested in their survival and thus ability to provide those services. It may be interested in
taxation derived from these companies which is used for development. Government may also
be interested in employment level and as such it will use those ratios that can enable it to
achieve such objectives of particular importance are:
a) Profitability ratios
b) Return ratios

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7. Competitors – These are interested in the company’s performance from the market share
point of view and will use the ratios that enable them to ascertain company’s competitive
strength e.g. profitability ratios, sales and returns ratio etc.

8. General public – Customers and potential customers – These are interested in the ability of
the company to provide good services both in the short and long run. To gauge the company’s
ability to provide goods and services on short- and long-term basis. We have:

a) Returns ratio
b) Sales ratio

1.4 YARD STICK USED IN RATIO ANALYSIS

1. Past performance of the company

The company’s past performance (past ratio) is used to measure or gauge the company’s
performance and in particular the change in performance whether good (favourable), better,
same or even worse than the past. Such comparison is then used to interpret the company’s
performance bearing in mind the factors that influenced the present and past performances.

2. Average industry ratios

These are useful as they indicate the average performance of various companies in a given
industry i.e. it gives the minimum performance of a number of companies in a given industry.
These ratios are useful in so far as to enable the analyst to make a reasonable comparison of
the company’s performance vis-à-vis other companies in the same industry. However, for this
yardstick to be useful the term average should include those companies which are not
extremely. I.e. very strong and very weak companies – which should be excluded to arrive at
industry average figures.

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3. Ratio of successful companies
Useful if the company can get figures of competitors who are leading in the market so as to
enable it to gauge its performance against better performance. However this information is
difficult to obtain and sometimes it calls for private investigators e.g. Private Eyes Ltd.

4. Ratio of budgeted performance

These are compared with actual performance ratios and investigations are made of any
unfavorable variance which should be explained.

1.5 Classification of Ratios

Ratios are broadly classified into 5 categories:
1. Liquidity ratios
2. Turnover ratios
3. Gearing ratios
4. Profitability ratios
5. Growth and valuation ratios

1. Liquidity Ratios
Also called working capital ratios. They indicate ability of the firm to meet its short-term
maturing financial obligation/current liabilities as and when they fall due.

The ratios are concerned with current assets and current liabilities. They include:

a) Current ratio = Current Assets

Current liabilities

This ratio indicates the No. of times the current liabilities can be paid from current assets
before these assets are exhausted.

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The most recommended ratio is 2.0 i.e. the current asset must at least be twice as high as
current liabilities

b) Quick/acid test ratios = Current Asset - Stock

Current liabilities
Is a more refined current ratio which exclude amount of stock of the firm. Stocks are
excluded for two basic reasons.
i) They are valued on historical cost basis
ii) They may not be converted into cash very quickly
The ratio therefore indicates the ability of the firm to pay its current liabilities from the more
liquid assets of the firm.
c) Cash ratio = Cash in hand/bank + short term marketable securities
Current liabilities
This is a refinement of the acid test ratio indicating the ability of the firm to meet its current
liabilities from its most liquid resources.
Short term marketable securities refer to short term investment of the firm which can be
converted into cash within a very short period e.g commercial paper and treasury bills.
d) Net working capital Ratio = Networking Capital x 100
Net Assets
Where Net Assets or Capital employed = Total Assets – Current liability
This ratio indicates the proportions of total net assets which is liquid enough to meet the
current liabilities of the firm.
It is expressed in % term.
2. Turnover Ratios/efficiency/asset management ratio
Turnover ratio indicates the efficiency with which the firm utilized the asset or resources at
its disposal to generate sales revenue or turnover.
This ratio includes:

a) Stock/inventory turnover = Cost of Sales

Average stock

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The ratio indicates number of times the stock was turned into sales in a year i.e how many
times did the ‘buy-sell’ process occur during the year. The higher the stock turnover, the
better the firm and more likely the higher the sales.
b) Stock holding period = 365 days
Stock turnover

= 365 x Average stock i.e 365

Cost of sales Stock turnover

The ratio indicates number of days the stock was held in the warehouse before being sold.
The higher the stock turnover, the lower the stock holding period and vice versa.
c) Debtors/accounts receiver turnover = Annual credit sales
Average debtor
The ratio indicate the number of times/frequency with which credit customers or debtors
were turned into sale i.e the number of times they come to buy on credit per year after paying
their dues to the firm.
The higher the debtors turnover the better the firm indicating that customers came to buy on
credit many times thus they paid within a short period.

d) Debtors collection period = 365

Debtors turnover
or 365 x Average debtors
Annual credit sales
This refers to credit period that was granted to the debtors on the period within which they
were supposed to pay their dues to the firm.
The shorter the collection period/credit period the higher the debtors turnover and vice versa.
If no opening debtors are given use the closing debtors to represent average debtors.

e) Creditors/accounts payable turnover = Annual credit purchases

Average creditors
The firm buy goods on credit from suppliers.

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The ratio indicate number of times p.a. the firm bought goods on credit after paying the
suppliers.
If the creditors turnover is high, this indicates that the payment was made
within a short period of time.
f) Creditors payment period = 365
Creditors turnover
= 365 x Average creditors
Annual credit purchases
The ratio indicate the credit period granted by the suppliers i.e. the period
within which the firm should pay its liabilities to the suppliers.
The shorter the period the higher the creditors turnover and vice-versa.
g) Fixed asset turnover = Annual Sales
Fixed Assets
This ratio indicate the efficiency with which, the fixed assets were utilised to generate sales
revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilised to generate Sh.1.4 of
sales.
h) Total asset turnover = Annual sales
Total assets
The ratio indicate amount of sales revenue generated from utilisation of one shilling of total
asset.
The Concept of Working Capital/Cash Operating Cycle
Working capital cycle refers to period that elapses between the payment for raw materials
bought on credit (cash outflows) and the receipts of cash from finished goods sold on credit
(cash inflows).
The working capital cycle will involve the following:
a) Purchase of raw materials on credit from suppliers
b) Payment of raw materials after the lapse of credit period
c) Conversion of raw materials into finished goods
d) Sale of finished goods to creditors
e) Receipt of cash from debtors.
Other leverage or gearing ratios are

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a) Debt ratio = Total debts
Total assets

Where total debt = fixed charge capital + liabilities.

The ratio indicate the proportion of total assets that has been financed using long term and
current liabilities e.g a debt ratio of 0.45 mean 45% of total asset has been financed with debt
while the remaining 55% was financed with owners equity/capital.
b) Times interest earned ratio = Operating profit (earning before interest and tax
Interest Charges
TIER also called interest coverage ratio.

This ratio indicate the number of times interest charges can be paid from operating profit.
The higher the TIER, the better the firm indicating that either the firm has high operating
profits or its interest charges are low.
If TIER is high due to low interest charges, this indicates low level of gearing/debt capital of
the firm.
4. Profitability Ratio

This ratio indicate the performance of the firm in relation to its ability to derive returns or
profit from investment or from sale of goods i.e profit margin or sales.
1. Profitability in relation to sales
The ratio indicate the ability of the firm to control its cost of sales, operating and financing
expenses.
They include:
a) Gross profit margin = Gross profit x 100
Sales
The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit
margin of 40% means 60% of sales revenue was taken up by cost of sales while 40% was the
gross profit.
b) Operating profit margin = Operating profit/Earning before interest & tax
Sales

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The ratio indicates ability of the firm to control its operating expenses such as distribution
cost, salaries and wages, travelling, telephone and electricity charges etc. e.g a ratio of 20%
means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit

c) Net profit margin = Net profit x 100 (earning after tax) + interest
Sales
This ratio indicates the ability of the firm to control financing expenses in particular interest
charges e.g. Net profit margin of 10% indicate that:
i) 90% of sales were taken up by cost of sales, operating and financing expenses
ii) 10% remained as net profits.
2. Profitability in relation to investment

a) Return on Investment (ROI) = Net profit x 100

or return on total asset (ROTA) Total asset
The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of 20%
means Sh.10 of total asset generated Sh.2 of net profit.
b) Return on equity (ROE) = Net profit x 100
or Return on net worth (RONW) equity
or Return on shareholders equity (ROSE)

The ratio indicate the return of profitability for every one shilling of equity capital
contributed by the shareholders e.g a ratio of 25% means one shilling of equity generates
Sh.0.25 profit attributable to ordinary shareholders.
c) Return on capital employed ROCE = Net profit x 100
or Return on net asset (RONA) Net Asset (Capital employed)
This ratio indicate the returns of profitability for every one shilling of capital employed in the
firm.

5. The Growth and Valuation Ratio

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This ratio indicates the growth potential of the firm in addition to determining the value of
the firm and investment made by various investors. They include the following:
a) Earnings per share EPS = Earnings to Ordinary shareholders
No. of ordinary shares
This ratio indicate earnings power of the firm i.e how much earnings or profits are attributed
to every share held by an investor. The higher the ratio the better the firm.
b) Earnings yield (EY) = Earnings per share x 100
Market price per share
The market price per share (MPS) is the price at which new shares can be bought from the
stock market.
These ratios therefore indicate the returns or earnings for every one shilling invested in the
firm.
c) Dividends per share (DPS) = Dividend paid
No. of ordinary shares
This indicates the cash dividend received for every share held by an investor. If all the
earnings attributable to ordinary shareholders were paid out as dividend, then EPS = DPS.
d) Dividend Yield (DY) = Dividend per share x 100
Market price per share

Or Dividend paid
Market value of equity

Where market value of equity = No. of shares x MPS

This ratio indicates the cash dividend returns for every one shilling invested in the firm.
e) Price earnings (P/E) = Market price per share (MPS)
Ratio Earning per share
OR
= Market value of equity
Earning to Ord. Shareholders

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P/E ratio is a reciprocal of earning yield (EY). The MPS is the price at which a new share can
be bought i.e investment per share. The EPS is the annual income/earnings from each share.
PE therefore indicate the payback period i.e number of years it will take to recover MPS from
the annual earnings per share of the firm.
f) Dividend cover = EPS = Earning to ordinary shares
DPS Dividend paid

This indicate the number of times dividend can be paid from earnings to ordinary
shareholders. The higher the DPS the lower the dividend cover and vice-versa e.g consider
the following two firms X and Y
X Y
EPS 12/= 12/=
DPS 3/= 5/=
Dividend cover 12 = 4 12 = 2.4 times
3 5

g) Dividend pay out ratio = DPS x 100 = Dividend paid

EPS Earning to ordinary shareholder

This is the reciprocal of dividend cover. It indicates the proportion of earnings that was paid
out as dividend e.g a payout ratio of 40% means 60% of earnings were retained while 40%
was paid out as dividend, therefore retention ratio = 1 – dividend payout ratio
h) Book value per share = Networth Equity
(BVPS) No. of ordinary shares
This is also called liquidity ratio which indicates the amount attributable to each share if the
firm was liquidated and all asset sold at their book value.
The ratio is based on the residual amount which would remain after paying all liabilities from
the sales proceeds of the assets.
i) Market to book value per share =MPS
BVPS

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This ratio indicates the amount of goodwill attached to the firm i.e the price in excess of the
sales value of the assets of the firm. If the ratio is greater 1(MBVPS >1) this indicate a positive
goodwill while if less than 1 a –ve goodwill.

1.6 Uses/Application of Ratios

Ratios are used in the following ways by managers in various firms.

1. Evaluating the efficiency of assets utilisation to generate sales revenue i.e turnover
ratio.
2. Evaluating the ability of the firm to meet its short term financial obligation as and
when they fall due (liquidity ratios).
3. To carry out industrial analysis i.e compare the firm’s performance with the average
industrial performance of the firm with that of individual competitors in the same
industry.
4. For cross sectional analysis i.e compare the performance of the firm with that of
individual competitors in the same industry.
5. For trend/time series analysis i.e evaluate the performance of the firm over time.
6. To establish the extent which the assets of the firm has been financed by fixed charge
capital i.e use of gearing ratio
7. To predict the bankruptcy of the firm i.e use of selected ratios to determine the overall
ratio usually called Z-score. The Z-score when compared with a pre-determined
acceptable a Z-score will indicate the probability of the bankruptcy of the firm in
future.
Limitations of Ratios
Ratios have the following weaknesses:

1. They ignore the size of the firm being compared e.g in cross-sectional analysis, the
firm being compared might be of different size, technology and product
diversification.

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2. Effect of inflation: Ratio ignores the effect of inflation in performance e.g increase in
sales might be due to increase in selling price caused by inflationary pressure in the
economy.
3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g important assets
such as corporate image, efficient management team, customer loyalty, quality of
product, technological innovation etc are not captured in ratio analysis.
4. Ratios are computed only at one point in time i.e they are subject to frequent changes
after computation e.g liquidity ratios will constantly change as the cash, debtors and
stock level changes.
5. Monopolistic firms: It is difficult to carry out industrial and cross-sectional analysis
for monopolistic firms since they do not have competitors and they are the only firms
in the whole industry e.g Telkom-Kenya, East Africa Brewery etc.
6. Historical Data – Ratios are computed in historical information or financial statement
thus may be irrelevant in future decision-making of
7. Computation and interpretation: Generally, some ratios do not have an acceptable
standard of computation. This may differ from one industry to another. E.g the return
on investment may be computed as:

Return on investment = EBIT or EAT

Total assets Total assets

8. Different accounting policies – Different firms in the same industry use different
accounting policies e.g methods of depreciation and stock valuation. This makes
comparison difficult.

1.6 Self-Test Question

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1.7 Learning Activities

(i) Discuss the need for financial statement to different stakeholders

(ii) Highlight types and calculation of rations
(iii) Computation of key ratios in a firm

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1.7 Summary

Financial statement are key financial indicators on the performance of a firm, hence the
computation and analysis of the key rations within a firm helps gauge the current
performance and helps projects the future performance of the firm

1.8 Further Reading

1. Financial Management, 10 edition I M Pandey

2. Fundamentals of Financial Management, Concise Edition, By Eugene F. Brigham, Joel F.

Houston.

3. Stice, E., Stice, J., & Diamond, M. A. (2005). Financial accounting: Reporting & analysis.
Florence, SC:. Cengage Learning.

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