FM-I Chapte-2

Financial Statement Analysis

2. INTRODUCTION

Financial statement analysis is the process of analyzing a company's financial statements for decision-
making purposes. External stakeholders use it to understand the overall health of an organization and to
evaluate financial performance and business value.

Financial analysis is a process of evaluating firms past, present financial performance and prospect for the
future. It is helpful to analyze the strength and weakness of a business. It is used to establish proper
relationship among the accounts available in financial position and income statement of a business so as
to make them more informative and useful in the decision making process.

2.1. Purpose of Financial Analysis

Individual investors or firms that are interested in investing in small businesses use financial analysis
techniques in evaluating target companies' financial information. By examining past and current
financial statements – financial position, income statements and cash flow statements – potential
investors can form opinions about investment value and expectations of future performance, explains.
Understanding the purpose of financial analysis can help small-business owners as they weigh the
effect of certain decisions, such as borrowing, on their own companies.

If a firm is interested in investing in a small business, its financial analysts will likely examine the
company's past and current financial statements. The objective would be to discover possible
weaknesses and any problem areas that should be discussed with company owners.

The analysts would look for unusual movements in items from year to year and for patterns in revenue
and profits. Steady growth is normally positive, and severe ups and downs might be a sign of not in
agreement. Cash flow statements should indicate how the business normally obtains and uses cash.

By employing expert financial analysis on an ongoing basis, firms are able to make investment
decisions or recommendations based on sound reasoning. Companies might employ their own financial
analysts who would keep watch over the company's strengths and weaknesses and advise upper
management accordingly. Alternatively, some companies might decide to engage the services of
financial consultants who could conduct periodic financial analyses.

Important for Future Projections

A key role of financial analysis is to assist small businesses in their planning. Evaluation of a
company's financial position, financial performance and cash flow statement – interpreting trends and
identifying strengths and weaknesses – might yield enough information to enable management to make
future projection of financial performance.
With knowledge of trends in the general economy and in the company's industry, they can form a
reasonable estimate of how well the company might fare in the coming years. Such analyses can be
helpful to businesses that need to plan equipment purchases and other initiatives.

2.2. Tools of financial Analysis

Financial analysis tools are different ways to evaluate and interpret a company’s financial statements for
various purposes like planning, investment, and performance. Some of the most used financial tools based
on their usage and requirements are common size statements (vertical analysis), comparative financial

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statements (comparison of financial statements), ratio analysis (quantitative analysis), cash flow analysis,
and trend analysis, benchmarking.

1. Comparative Financial Statement

Comparing financial statements of a firm for different accounting periods by looking at it we can
say something about the firm, it has improved, deteriorated or remain unchanged. Comparative
financial statements are used in horizontal analysis or trend analysis. It helps analyze the periodic
change in various components of the financial statements and displays which element has the
maximum impact. It may be prepared in currency amount terms or percentage terms. The comparative
financial statement has advantages like easy comparability, observing the trend, periodic performance
evaluation, etc. However, it has disadvantages like ignoring inflationary impact, high dependability on
financial information that can be manipulated, use of a different method of accounting by various
entities, etc.
2. Vertical Analysis/Common Size Analysis
It is an analysis of financial statement where significant items on financial statement are used as a base
value and evaluate with that value.

The globally acceptable form to disclose the financials for comparison is to bring data in a percentage
format. The organization will prepare main financial statements like financial statements like common
size balance sheet, common size income statement, and common-size cash flow statement.
It will adequately disclose all the items for internal or external analysis with the peer group in percentage
form. For example, the balance sheet can consider the base of total assets. The income statement may
contemplate the base level of net sales, and the cash flow statement can depend on the base level of total
cash flows.
Firm A Firm B
Current ratio 60% 40%
Fixed asset ratio 40% 60%
Which firm do you think more liquid? Reason out?

3. Ratio analysis: It is a mathematical relationship among several numbers, usually stated in the form of
percentage or times. It helps to develop meaningful conclusions and make interpretation about a firm’s
financial condition and performance.

Ratio analysis compares values within the company from year to year and against other companies and
the industry. Liquidity ratios such as the current ratio (current assets divided by current liabilities) show
the company's ability to pay its short-term obligations on time.
Business owners and small-business management teams might use ratio analysis in their regular
planning, to measure their companies against others in their industry. If ratio analysis shows that a
company has a great deal more debt than other businesses in its industry, the owner might be prompted
to pay off or reduce some loans.
4. Benchmarking is the process of comparing the actuals with the targets set by the top management. It
also refers to the comparison made with the best practices and strives to achieve the same.

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 Types of Ratio Analysis
Liquidity ratio: measure how easily the firm can lay its hands on cash.
Leverage ratio: show how heavily the company is in debt.
Activity ratio: measure how productively the firm is using its assets
Profitability ratio: measure the firm’s return on its investments.
Market value ratio

Types of ratio comparisons

Cross-sectional analysis (inter firm comparison)
Compare ratio of one firm with some selected firms in the same industry at the same point in time. It is
more useful to compare the firm’s ratios with ratios of a few carefully selected competitors, who are
under similar operation. This kind of comparison indicates the relative financial position and performance
of the firm.
Industry Analysis: Determine the financial condition and performance of a firm& its ratio may be
compared with average ratio of the industry in which the firm is a member.

Time Series Analysis

The easiest way to evaluate the performance of a firm is to compare its present ratio with the past ratios. It
is a competition of ratios over a period of time. It gives an indication of the direction of changes and
reflects whether the financial performance has improved, deteriorated or remains unchanging over time.
The analysts should not simply determine the change, but, more importantly he/she should understand
why ratios have changed. It helps us to compare current and past performance of a given firm.
N.B: When both time series and cross-sectional analysis are used together; it is termed as combined
analysis.

Major steps of financial analysis

I. Preparation and selection: establishing the objectives of the analysis and assembling the financial
statement. Depending up on the users of the financial statement and the question to be addressed by the
analysts, selection of financial data differ, mostly analysts used to answer the following questions
 How the firm performs in the past?
 What are the strength and weakness of a firm?
 What corrective action is needed to enhance future performance?
II. Computation and relation: arrange it in the way that will bring about significant relationship. It
involves the application of various tools and techniques in analyzing financial statements. The most
common technique are:
a. Ratio analysis: convert birr amount into ratio.
b. Trend analysis: analyze by computing trends of series of information. Trend analysis is
an analysis of the trend of the company by comparing its financial statements to analyze the trend of
market or analysis of the future on the basis of results of past performance and it's an attempt to make the
best decisions on the basis of results of the analysis done.
c. Comparative statement: an analysis of financial statement at different period of time.
d. Common size analysis: figures reported are converted into percentage to some common base.
e. Fund flow statement: It helps to understand the changes in the financial position of a business
enterprise between the beginning and ending financial statement dates.
III. Evaluation and interpretation: is the determination of evaluations to develop conclusion and
recommendation about the firm’s financial performance and financial condition.

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Types of Financial Ratio Analysis:
One of the major areas of financial analysis is financial statement preparation and selection. At first we
should have a readymade financial statement so as to go through the analysis part. Let’s take the
following financial statements for illustration purpose.
ABC Co.
Financial Position sheet
At December 31, 2014 and 2015
In (000) 2015 2014

Cash 840 760

Marketable securities 1,300 1,200
Account receivable 1,500 1,300
Inventory 2,300 1,900
Total current asset 5,940 5,160
Fixed asset (Net) 6,220 5,630
Total asset 12,160 10,790
A/P 422 304
N/P 458 386
Total Current liability 880 690
Long term liability 3,160 2,945
Total liability 4,040 3,635
Preferred stock 2,455 2,150
Common stock 3,215 2,925
Retained earnings 2,450 2,080
Total liability and owner equity 12,160 10,790

ABC Co.
Income statements
For the year ended, 2014 and 2015
In (000) 2015 2014

Sales 1,870 1,520

Less: Sales return and allowance (250) 210
Net sales 1,620 1,310
Less: Costs of goods sold (820) 760
Gross profit 800 550
Less: Operating expenses
Selling expenses (270) 220
General and administrative expenses (160) 90
Total operating expenses (430) 310
Operating income 370 240
Other income 120 85
EBIT 490 325
Less: Interest expenses (33) (25)
EBT 457 300
Less: Tax (35 %) (160) (105)
Net income after tax 297 195
Less: Preferred stock dividends 112 92
Earnings available to common shareholders 185 103
EPS 74 41.2
N.B: ABC Co has 2,500 outstanding shares (common stockholders) and 1,000 preferred stock shares. Net
purchase for the period is Birr 980. The market price of a share is Birr 500 and the book value is Birr
175. All earnings are paid out as a dividend. The Lease obligation is assumed to be Birr 73.

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 1. Liquidity Ratio: It measures the firm’s ability to meet current obligations which is termed as
short-term solvency or liquidity. In other words, whether the firm’s current assets are sufficient enough to
pay its current liability.
A. Current ratio: analyze the firm’s ability to satisfy the short-term creditors’ demand for
repayment by using only current asset. It also indicates the availability of current asset for a given amount
of current liability.

= 6.75
Current asset: include cash and those assets that can be converted into cash within a year, such as
marketable securities, inventories, prepaid expense etc…
Current liability: include bill payable, accrued expenses, short term bank loans, income tax liability and
long term debt maturing in the current period (year).
Higher current ratio: indicate that too much capital is tied up in current asset which probably are idle.
(i.e., Firm is suffering opportunity cost of some return. Had the excess (the idle) amount been invested,
there would be a return).
 It is safety for short term creditors.
 The more the firm’s liquidity position.
A very high current ratio indicates
 Excessive cash due to poor cash management
 Excessive account receivable due to poor credit management
 Poor usage of credit capacity
Low current ratio: suggests that the firm may face difficulty in paying its short term obligation.
Low ratios can be improved through:
 Long term borrowing, increase current asset without changing current liability
 liquidating current liability through long term equity financing

Generally, even though, there is no single designation point of high or low current ratio, creditors see for
high current ration than industry average. From the perspective of a shareholder, a high current ratio could
mean that the company has a lot of money tied up in non-productive assets, such as excess cash or
marketable securities. Or perhaps the high current ratio is due to large inventory holdings, which might
well become obsolete before they can be sold. Thus, shareholders might not want a high current ratio.
An industry average is not a magic number that all firms should strive to maintain—in fact, some very
well-managed firms will be above the average, while other good firms will be below it. However, if a
firm’s ratios are far removed from the averages for its industry, this is a red flag, and analysts should be
concerned about why the variance occurs.
B. Quick (Acid test) ratio: establishes a relationship between quick assets and current liability. An
asset is liquid if it can be converted in to cash immediately or reasonably soon without a loss of value.
Cash is the most liquid asset and other assets that are considered to be relatively liquid then included
under quick assets are bill receivable and marketable securities (temporary quoted investment).
Inventories are considered to be less liquid. Inventories normally require sometime to be converted in to
cash; their value also has a tendency of fluctuation. Prepaid expenses and supplies also are treated as less
liquid assets.

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 = 4.136
N.B: Quick ratio is more powerful measure of liquidity than current ratio

Net working capital (NWC) ratio: The difference between current assets and current liability excluding
short term bank borrowing is called net working capital or net current asset. It roughly measures the
company’s potential reservoir of cash. Net working capital is usually positive

Net asset = Fixed asset + (NWC)

= 0.449
C. Cash ratio:

= 2.432

A low cash ratio may not matter if the firm can borrow on short notice. Who cares whether the firm has
actually borrowed from the bank or whether it has a guaranteed line of credit that lets it borrow whenever
it chooses? None of the standard liquidity measures takes the firm’s ―reserve borrowing power‖ into
account.

 2. Activity Ratio: measures the firm’s efficiency in asset utilization. It also measures how
productively the firm is using its assets. This is why the ratio is termed as asset utilization ratio, efficiency
ratio, and turnover ratio and sometimes it is also called asset management ratio.
Funds of creditors and owners are invested in various assets to generate sales and profit. Under normal
circumstance, the better the management of assets then the larger the amount of sales will be.
A. Account receivable turnover ratio: Sales of a firm is either cash sell or credit sale. Basically the
credit sell is used as a marketing tool by so many companies. When the firm permits credits sale to its
customers, debtors (A\R) are created in the firms sales. Credit sales are convertible into cash within short
period of time and they are part of the current asset section of business assets. The liquidity position of the
firm depends on the quality of debtors to a large extent.
Account receivable turnover ratio measures the liquidity of the firm’s account receivable. It indicates
how many times (how rapidly) account receivable is converted into cash in a year. It indicates the number
of times debtors turnover each year. Generally, the higher the value of debtors’ turnover, the more
efficient the management is.

= 1.157
Reasonable high ratio is preferable; a ratio substantially lower than the industry average may suggests that
the firm has:
 more liberal credit policy (Longer credit period), poor credit selection, inadequate collection
effort which will followed by;
 Account receivable to be too high
 The bad debt expense will be high so sales will be decrease then profit decrease

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  More restrictive cash discount ( no or little cash discount) that could make sales
to low as a result of the above factors
 The firm could have poor profitability position
 The firms fund would be tied up in receivables as payment by customers are
delayed
A ratio substantially higher than the industry average may suggest that a firm has:
 More restrictive credit policy
 More liberal cash discount offers
 More restrictive credit selection
 More serious collection effort

The outcome of higher Account receivable turnover ratio could be:

 Avoidance of the risk of bad debt

 Increase the firms profitability position
 small funds tied up in Account receivable

Average Collection Period (Day’s sales Outstanding): the average number of days for which debtors
remain outstanding is called Average collection period. It is the length of time that a firm must wait to
collect cash from credit sell. It tries to measure how rapidly receivables are converted into cash. The
shorter the time, the better the average period because if the time longer the bad debt expense will rise.

Or

Solution:

= 311.15 Days

O
Account Payable Turnover ratio: It indicates how rapidly the offset its obligation. It also shows that
hoe often creditors are paid in a year.

= 2.7
The higher the APTO, the better for the business operation because the firm can get credit easily since to
lend to this firm is less risky.
Average Payment Period (APP): Is the average length of time creditors must wait to receive their cash.
A short period is desirable for creditors.

= 133.33 Days
B. Inventory Turnover (Inventory Utilization) ratio: It indicates the efficiency of the firm in
producing and selling its product. The inventory turnover shows how rapidly the inventory is turning into
receivable through sales.

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= 0.39
Generally, a higher inventory turnover is an indication of good inventory management. A low inventory
turnover implies excessive inventory level that warranted by production and sales activities, or slow
moving or obsolete inventory. A high level of sluggish inventory amounts to unnecessary tie-up of funds
reduced profit and increased cost. If the obsolete inventories have to be written off, this will adversely
affect the working capital and liquidity position of the firm. However, a relatively high inventory turnover
may be the result of a very low level of inventory, which results in frequent stock outs.

A high inventory turnover show Superior selling practice Improved profitability as less capital is tied up
in inventory

Disadvantage of high inventory turnover

Stoppage of production process for manufacturing

Lost sales due to insufficient inventory for merchandise
If inventory turnover is low- there is high inventory due to loss of sales and profit will be lower
 Exposed to  Rent expense
deterioration or  Exposed to insurance
obsolescence expense
 Inventory may be  Exposed to property tax
outdated
Average Age of Inventory (AAI) days sales inventory (days of inventory holding)
It shows how long inventory is hold in the warehouse before it is sold

= 923.08 Days

Fixed asset turnover ratio (FATO): It is the efficiency of fixed asset to generate sale

= 0.26
FATO substantially lower than industry average shows,
 There is over investment in fixed asset
 Disposal of fixed asset could be there
On the other hand a ratio substantially higher than the industry average shows that
 Requires the firm to make additional capital investment to operate a higher level of activity.
 Shows more efficiency in managing and utilizing financial asset.
Factors that can increase or decrease FATO;
 Depreciation method
 The cost of the fixed asset
 The time elapsed (dropped) during the acquisition

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C. Total asset turnover ratio (TATO): assets are used to generate sales. Therefore, a firm should
manage its asset efficiently to maximize sales. The relationship between sales and Asset is called asset
turnover. This ratio shows the firm’s ability in generating sales from all financial resources committed to
total assets. thus asset here;

= 0.133

The current asset here are non-productive, they use to pay the liability.

The higher the ratio of TATO the better for the firm

Higher ratio suggest that greater efficiency in using in using the total assets to produce sales

Low ratio suggests that the firm is not generating a sufficient volume of sales for the size of its investment
in assets.

 3. Leverage ( Debt Management ) Ratio

The short term creditors like bankers and suppliers of raw material are more concerned with the firms’
current debt paying ability. On the hand, long term creditors, like debenture holder, financial institutions
etc… are more concerned with the firm’s long term financial position. To judge the long term financial
position of the firm, financial leverage or capital structure ratio are calculated. These ratios indicate mix
of funds provided by owners and lenders. As a general rule, there should be an appropriate mix of debt
and owners’ equity in financing the firm’s assets.

The manner in which assets are financed has a number of implications; let’s look at debt and equity, debt
is more risky from the firm’s point of view. The firm has a legal obligation to pay interest to debt holders,
irrespective of the profit made or losses incurred by the firm. If the firm fails to pay to debt holders in
time, they can take legal action against it to get payments and in extreme cases, can force the firm into
liquidation. On the other hand, the earning of the firm can be magnified, when the firm earns a rate of
return on the total capital employed is higher than the interest rate on the borrowed fund. Beside the debt
holders had limited control over the firm operation. The process of magnifying the shareholders return
through the use of debt is called financial leverage or trading on equity.

However, leverage can work in opposite direction as well. If the cost of debt is higher than the firms
overall rate of return, the earning of shareholders will be reduced. In addition, there is interest of
insolvency. If the firm is actually liquidated for non-payment of debt holders’ dues, the worst losers will
be shareholders who claim the residual funds. Thus, use of debt could magnify the shareholders earnings
as well as increase their risks.

Firms with high debt burden could face difficulty while raising funds from owners as well as creditors for
future activities. Creditors consider the owners’ equity as margin of safety; If the equity base is thin, the
risk of creditors will be very high. Thus, leverage ratios are calculated to measure the financial risk and
the firm’s ability of using debt to the shareholders advantage.

Leverage ratios indicate the extent to which the firm has relied on debt in financing debt and it shows the
degree of debt financing in the firm. There are two debt measurement tools.

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 A. Financial Leverage Ratio: It determines the extent to which borrowed funds have been used to
finance the firm. It is the relationship of borrowed funds and owners' capital
I. Debt Ratio:
II. Debt-Equity Ratio:
1. Debt ratio: shows the percentage of assets financed through debt.

= 0.332
The lower debt ratio is preferable, higher ratios imply more of the firm's assets are financed by creditors
relative to owners. Creditors may require a higher rate of interest so as to compensate a higher risk that
they take.

The firm may face some difficulty in raising additional funds equity or debt finances.

2. Debt-Equity Ratio: shows the percentage of creditors financed the asset with that of
shareholders equity.

= 0.4975
Generally Debt-equity ratio describes the lenders contribution for each Birr of owners’ contribution.
B. Coverage ratio: Use to test the firms debt-servicing capacity. This ratio measures the risk of debt
by income statement ratios designed to develop the number of times fixed charges are covered by
operating profit.
a. Time Interest Earning Ratio: shows the number of times the interest charges are covered by
funds that are ordinarily available for their payment. Since taxes are computed after interest, interest
coverage is calculated in relation to before tax earnings. Depreciation is a non-cash expense. Therefore,
funds equal to depreciation are also available to pay interest charges we can thus calculate the interest
coverage ratio as earnings before interest and taxes, depreciation and amortization divided by interest. It
measures the ability of firms to pay interest on timely basis.
Normally a higher ratio is desirable, but too high ratio indicates that the firm is very conservative in using
debt and that it is not using credit to the best advantage of shareholders. On the other hand, a lower ratio
indicates that the excessive usage of debt or inefficient operations. The firm should make efforts to
improve the operating efficiency or retire debt to have a comfortable coverage ratio.
The limitation of interest coverage ratio is that it does not consider repayment of loan
 A low ratio suggest that creditors are at more risk in receiving interest due
 Failure to meet interest payment can bring legal action by creditors possibly resulting in
bankruptcy.
 The firm is facing difficulty in raising additional debt and forced to borrow many at higher
interest rate.

Higher ratio represents the firm has sufficient margin of safety for creditors.

b. Fixed Charge Ratio: this ratio is more inclusive ratio

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 = 5.311
 Profitability Ratios:

It measures overall performance and effectiveness of the firm. Profit is the difference between revenues
and expenses over a period of time (usually a year). The profitability ratios are calculated to measure the
operating efficiency of the company. Beside management of the company, creditors and owners are
interested in the profitability of the company. Creditors expect payment of principal and interest in a
regular basis. Owners want to get required rate of return on their investment; this is possible only when
the company earns profits.

Generally, profitability ratio indicates the combined effect of liquidity, asset management and debt
management on operating result. This ratio is used to measure firm’s effectiveness in using the assets to
generate profit.

a. Gross Profit Margin (GPM):

Reflects the efficiency with which management produces each unit of product. This ratio indicates
management effectiveness in pricing policy generating sales and in controlling production cost.

= 0.4938

High ratio: implies that the firm is able to produce at relatively lower cost. It is considered as a sign of
good management.

Factors that lift up the GPM

 Higher sales prices, CGS remain unchanged

 Lower CGS, sales price remain unchanged
 A combination of variations in sales prices and CGS, the margin widening, and
 An increase in the proportionate volume of higher margin items.

Low ratios: may reflect a higher CGS due to the firm’s inability to purchase raw materials at favorable
terms. It also could be inefficient utilization of plant and machinery, resulting in higher cost of
production. The fall of price in the market or marked reduction in selling price by a firm in an attempt to
obtain large sales volume, the CGS remain unchanged.
Operating Profit Margin (OPM):

= 0.3025

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b. Net Profit Margin (NPM)
This ratio is the overall measure of the firm’s ability to turn each amount of sales in to net profit. It also
indicates the firms’ capacity to withstand adverse economic conditions. A firm with a high net margin
ratio would be in advantageous position to survive in the face of falling selling prices, rising cost of
production or declining demand for the product. Similarly, a firm with high net profit margin can make
better use of favorable conditions, such as rising selling prices, falling costs of production or increasing
demand for the product such a firm will be able to accelerate its profits at a faster rate than a firm with a

= 0.183

c. Return on Investment/ Asset (ROI/ ROA):

The term investment may refer to total assets or net assets. ROI measures the overall efficiency of
management in utilizing assets in the process of generating income.

OR ROA (ROI) = Net profit margin * Total asset turn over

= 0.0244
d. Return on Equity (ROE):

A return on shareholders’ equity is calculated to see the profitability of owners’ investment. It measures
the rate of return realized by stockholders on their investment.

= 0.037

ROE indicates how well the firm has used the resources of owners.

e. Earnings per Share(EPS):

It indicates whether the firm earning power on per share basis has changed over that period. It represents
the amount of Birr earned on behalf of each outstanding share of common stock.

= 0.1188
 Market Value Ratio:

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 These ratios are primarily used for investment decision and long range planning. There are two ratios.

i. Price earnings ratio: it indicates investors’ judgment or expectations about the firms
performance and reflects investors’ expectations about the growth in the firms earnings.

= 6.757
A higher price (earning multiplier) often reflects the market perception of the firm’s growth perspectives.
Thus, if investors believe that a firm’s future earnings potential is good enough and they may be willing
to pay a higher price for the stock.

ii. Book value per share: It is the value of each shares of common stock based on the accounting
records.
iii. Dividend ratio: Under this issue we do have two classes i.e. Dividend payout ratio and Dividend
yield ratio.
1. Dividend payout ratio: shows the percentage of earnings distributed at the end of the accounting
period. It is the Birr amount of dividend paid on share of common stock outstanding during the reported
period.

= 0.0849

= 0.0011
Higher ratio: Reflects firm’s lower growth opportunity
Lower ratio: reflect the firms higher growth opportunity

2. Dividend yield ratio: shows the rate earned by shareholders from dividends relative to the
current price of the stock.

Limitation of Ratio Analysis

1. Many large firms operate different divisions in different industries so that it is difficult to develop
meaningful industry average.
2. Non consideration of inflation and deflation in financial statement
3. Different accounting methods are employed by different enterprise.

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