FINANCIAL STATEMENT ANALYSIS

(RATIO ANALYSIS)
Financial statements include a profit and loss A/C (income statement) that tells us
the performance of a company throughout the financial period. It also includes a
balance sheet that shows the financial position or status of a company and lastly a
cash flow statement which shows changes in cash position of the entity,
We analyse financial statements by the use of accounting ratios. There are 5
classes of ratios:
 Liquidity
 Leverage/Gearing ratios
 Activity Ratios
 Profitability
 Equity / Investor ratios.

Liquidity ratios.
These measure the firm’s ability to meet its short term maturing obligations.
Leverage/Gearing Ratios – These measure the extent to which a firm has been
financed by non-owner supplied funds.
Activity Ratios – These measure the efficiency with which the firm is using
various assets to generate sales revenue or how active has the firm been.
Profitability Ratios – These measure the efficiency with which the firm uses
various funds to generate profits or returns. They also measure the management’s
ability to control the various expenses in the firm.
Equity Ratios/Investor Ratios – They measure the relative value of the firm and
returns expected by the owners of the firm. They also try to look at the overall
performance of the firm and going concern of the firm.

The following question will be used to illustrate the above classes of ratios
ABC ltd
Profit and Loss A/C for the year ended 31.12.1992
Sh Sh
Sales 850,000
Less: Cost of Sales
Opening stock 99,500
Purchases 559,500
659,000
Less: Closing stocks (149,000) (510,000)
Gross profit 340,000
Less expenses
Selling and distribution 30,000
Depreciation 10,000
Administration expenses 135,000 (175,000)
Earnings before interest & taxes 165,000
Interest (15,000)
Earnings before tax 150,000
Tax @ 50% 75,000
Less ordinary dividend 75,000
(0.75 per share)
Retained profit for the year (15,000)
60,000
ABC
Balance Sheet as at 31 December 1992
Non Current Sh. Issued share Sh.
Assets 250,00 capital 200000
Land and 0 (20000 share of 90000
Buildings 80,000 Sh, 10) 60000
Plant & 330,00 Reserve 100000
Machinery 0 Retained profit 130000
75,000 Long term
Current Assets (4,000) 149,00 Current liabilities.
Inventory 0
Debtors 580,000
Less provision 71,000
Cash 30,000
580,00
0

Additional Note
Cash purchases amount to 14,250.

Required:
Compute the relevant ratios.
LIQUDITY RATIOS
Current Ratio = Current Assets
Current Liabilities

Current Ratio = 250,000 = 1.92 : 1

130,000

The higher the ratio then the more liquid the firm is.

Quick Ratio/Acid Test Ratio

= Current Assets - Inventories
Current Liabilities

= 250,000 – 149,000 = 101,000

130,000 130,000

= 0.78 : 1

this is a more refined ration that tries to recognize the fact that stakes may not be
easily converted into cash. The higher the ratio, the better for the firm as it means
an improved liquidity position.

Cash Ratio
= Cash + Marketable Securities
Current Liabilities
= 30,000 = 0.23 : 1
130,000

= 0.23 : 1

This ratio assumes that stakes may not be converted into cash easily and the
debtors may not pay up their accounts on time. The higher the ratio, the better for
the firm as the Liquidity position is improved.

Net Working Capital Ratio.

= Net Working Capital
Net Assets

Net Working Capital =CA –CL = 250,000-130,000=120,000

Net Working Capital = 120,000 = 0.27 : 1

450,000

= 0.27 : 1

The higher the ratio the better for the firm and therefore the improved Liquidity
position.

GEARING RATIOS
These measure the financial risk of a firm (the probability that a firm will not be
able to pay up its debts). The more debts a business has (non owner supplied
funds) the higher the financial risk.
Debt Ratio
= Total Liabilities
Total Assets

This ratio measures the proportion of total assets financed by non owner supplied
funds. The higher the ratio, the higher the financial risk .

= 230,000 = 0.4
580,000
40% is supplied by non owners

Debt Equity Ratio

= Total Liabilities
Networth (share holders funds)

= 230,000 = 0.66
350,000
40% is supplied by non-owners

This ratio measures how much has been financed by the non-owner supplied funds
in relation to the amount financed by the owners i.e. for every shilling invested in
the business by the owners how much has been financed by the non-owner
supplied funds.
For ABC Ltd, for every 1 shilling contributed in the business by the owner, the
creditor have put in 67 cents.
The higher the financial risk.

Long Term Debt Ratio

= Non Current Liabilities
Net Assets

= 100,000 = 0.2
450,000
This measures the proportion of the total net assets financed by the non-owner
supplied funds.
The higher the ratio, then the higher the financial risk.

ACTIVITY RATIO
Stock Turnover
= Cost of Sales
Average Stocks
where
Average Stocks = Opening Stock + Closing Stock
2
= 510,000 = 4.1
124,250

= 4.1 times

This is the number of times stock has been converted to sales in a financial year.
The higher the ratio the more active the firm is.
An alternative formula is

= Sales
Closing Stock

Debtors Turnover

= Credit Sales
Average Debtors
Where
Average Debtors = Opening debtors + Closing debtors
2
Assume the opening debtors was 89,000 and all sales are on credit

Debtor Turnover = 850,000 = 10.625

80,000

The higher the ratio, the more active the firm has been (we had debtors over 10
times to generate the sales)
Note
Average Collection Period = 360
Debtors Turnover

= 360 = 34 days
10.625

This measure the number of days it takes for debtors to pay up. The lesser the
period, the better for the firm as it improves the liquidity position.

Creditors Turnover
= Credit Purchases
Average Creditors
= 545,250
130,000

= 42 times
The ratio tries to measure how many times we have creditors during a financial
period. The lesser the ratio the better.

Non Current Assets Turnover (Fixed Assets Turnover)

= Sales
Average Fixed Assets

A.F.A = 340,000 + 330,000 = 670,000 = 335,000

2 2
= 850,000 = 2.54 times
335,000

The ratio measures the efficiency with which the firm is using its fixed/ Non
Current Assets to generate sales.
The higher the ratio the more active the firm.

Total Assets Turnover

= Sales
Total Assets

= 850,000
580,000

= 1,046 times

Measures the efficiency with which the firm is using its total assets to generate
sales.

PROFITABILITY RATIOS
Profitability in Relation to Sales
Gross Profit Margin
= Gross Profit = 165,000 = 19%
 Sales 850,000

The higher the margin, the more profitable the firm is.

Net Profit Margin

= Net Profit after tax = 75,000 = 9%
Sales 850,000

The higher the margin, the more profitable the firm is.
Margin affected by:
Operating expenses for the period.

Profitability in Relation to investment

Return On Investment
= Net Profit after tax
Total Assets

= 75,000 = 13%
580,000

Shows how efficient the firm has been in using the total assets to generate returns
in the business.

Return On Capital Employed

= Net Profit after tax
Net Assets

= 750,000 = 17%
450,000

How efficient the firm has been in using the net assets to generate returns in the
business.

Return On Equity
= Earnings after tax
Networth

= 75,000
850,000

= 21%

Efficiency of the firm in using the owner’s capital to generate returns.

NOTE
The higher the ratio the more efficient is the firm.

EQUITY RATIOS
Earnings Per Share (Eps)
EPS = Earnings attributable to ordinary shareholders
 No. of ordinary shares outstanding.

= 75,000
20,000

= 3.75

This is the return expected by an investor for every share held in the firm.

Earnings Yield
= Earnings Per Share
Market price per share
Assume that the market price for the ABC’S shares is Sh20/Share.

= 3.75  100%
20
= 19%

This is the return amount expected by a shareholder for every shilling invested in
the business.

Dividend Per Share

= Total Dividend (ordinary shareholders)
Ordinary shares outstanding.

= 15,000
20,000

= 0.75 cts per share

This is the amount expected by an investor for every share held in the firm.

NOTE
The higher the amounts, the better for the firm.

LIMITATIONS ON USE OF RATIOS

 It is difficult to categorise firms in the various industries due to
diversification. This makes inter-company comparison difficult.
 It is difficult to compare one company with others in case of monopolist
firms.
 Different, firms use different accounting policies and methods e.g. on
depreciation, provisions and other estimates so this makes comparison of
companies difficult.
 Ratios are compiled at a point in time and may be affected by short term
changes. Therefore ratios are used for short term planning.
 Ratios are computed from historical data and therefore are not good
indicators of the future.

DEFINITIONS
TREND ANALYSIS – Comparing or assessing a company’s performance over time.
CROSS SECTIONAL ANALYSIS – Comparing two or more companies in the same
industry.

Example 8.6 (ACCA DEC 98)

Beta Ltd is reviewing the financial statements of two companies, Zeta Ltd and
Omega Ltd. The companies trade as wholesalers, selling electrical goods to
retailers on credit. Their most recent financial statements appear below.

PROFIT AND LOSS ACCOUNTS FOR THE YEAR ENDED 31 MARCH 20X8

Zeta Limited Omega Limited

£’000 £’000 £’000 £’000
Sales 4,000 6,000
Cost of sales
Opening stock 200 800
Purchases 3,200 4,800
3,400 5,600
Less: closing stock 400 800
3,000 4,800
Gross profit 1,000 1,200

Expenses
Distribution costs 200 150
Administrative expenses 290 250
Interest paid 10 400
500 800
Profit before tax 500 400
Taxation 120 90
Net profit for the period 380 310
Balance Sheets As At 31 March 20x8
Zeta Limited Omega Limited
£’000 £’000 £’000 £’000
Fixed assets
Tangible assets
Warehouse and office 1,200 5,000
buildings 600 1,000
Equipment and vehicles 1,800 6,000

Current assets 400 800

Stock 800 900
Debtor – trade 150 80
- sundry - 100
Cash at bank 1,350 1,180

Current liabilities (800) (800)

Creditors – trade (80) (100)
- sundry (200) -
Overdraft (120) (90)
Taxation 150 890
1,950 6,890
- (4,000)
Long-term loan (interest 1,950 2,890
10% pa) 1,000 1,600
- 500
Share capital 950 790
Revaluation reserve 1,950 2,890
Profit and loss account

Required:
a) Calculate for each company a total of eight ratios which will assist in
measuring the three aspects of profitability, liquidity and management of the
elements of working capital. Show all workings.

(8 marks)
b) Based on the ratios you have calculated in (a), compare the two companies
as regards their profitability, liquidity and working capital management.

(8 marks)
c) Omega Ltd is much more highly geared than Zera Ltd. What are the
implications of this for the two companies?

(4 marks)
(20 marks)

Solution:
PROFITABILITY

Gross profit margin

Gross profit  100% 1000  100% = 1200  100% =
Sales 25% 20%
4000 6000
Net profit margin
Net profit  100%
Sales 500  100% = 400  100% =
12.5% 6.7%
Return on capital employed 4000 6000
Profit before interest and tax
Capital employed
510 = 26.2% 800 = 11.6%
Return on shareholders’ capital 1950 6890
Profit before tax
Share capital and reserves
500 = 25.6% 400 = 13.8%
Asset turnover 1950 2890
Sales
Capital employed
4000 = 2.1 6000 = 0.9 times
LIQUIDITY times 6890
Current ratio 1950
Current assets
Current liabilities
1880 = 1.9:1
Quick ratio 1350 = 1.1:1 990
Current assets – stock 1200
Current liabilities
1080 = 1.1:1
Gearing 950 = 0.8:1 990
Long – term loans 1200
Capital
4000 = 58%
Interest cover nil = nil 6890
Profit before interest and tax 1950
Interest charges
800 = 2 times
510 = 51 times 400
10
WORKING CAPITAL
MANAGEMENT
Debtors days
Trade debtors  365 days 900  365 = 55
Sales 800  365 = 73 days
days 6000
Creditor days 4000
Trade creditors  365 days
Purchases
 800  365 = 61
Stock days 800  365 = 91 days
Average stock  365 days days 4800
Cost of sales 3200

800  365 = 61
300  365 = 37 days
days 4800
3000

Note. We have used average stock here. When you have the information use it.

Profitability
Zeta has a higher gross margin than Omega. This may indicate a differing pricing
policy. Omega’s net margin is lower than Zeta’s. Omega’s expenses are therefore
proportionally higher. It should be noted that Omega’s bottom line profit is
reduced significantly by the interest charge.
Return on Omega’s capital is around half of Zeta’s. Omega has a higher fixed asset
base due in part to a revaluation. It may be that a revaluation of Zeta’s assets will
partially close the gap.
Liquidity
Omega has nearly twice as many current assets as current liabilities. Although
both companies’ quick ratios are much closer, Zeta’s liquidity does appear to be an
issue especially as there is no cash at hand. It would be wise to examine projected
cashflows to see how readily Zeta’s profits will improve this situation. As Zeta has
no long-term loans they may be able to borrow in order to improve liquidity.
Working capital management
Zeta is turning stock over more quickly than Omega. This is beneficial in a market
which can be subject to obsolescence.

Zeta’s creditor and debtor days are a cause for concern. Debtors should be
collected within 60 days if not sooner. 60 day collection would improve cash flow
by over £140,000 reducing the debtors balance to £658,000(60/73  £800,000).

Creditors should be paid at least as quickly as Omega pays theirs. Zeta risks
damaging the goodwill it has with its suppliers. Paying creditors within 60 days
would have an adverse effect on cash flow of over £270,000. The creditors balance
would be £527,000 (60/91  £800,000).

Omega is highly geared whereas Zeta has no long-term loans. Omega’s gearing
means that should profits fall they may not be in a position to pay the loan interest.
Zeta’s capital is entirely share capital and so a fixed return is not required.

Omega’s loan appears to be fixed rate. This means that in times of falling interest
rates Omega will have higher interest costs than say, Zeta, if Zeta borrowed the
same amount. The converse is true in times of rising interest rates.