Chapter Two

Financial statement
Analysis
 2.1 Financial Analysis
What is statement?
 A financial statement is a formal report that
provides information about the financial
performance and position of a company.
 It typically includes an income statement, balance
sheet, and cash flow statement.
 Which together give investors, creditors, and other
stakeholders a comprehensive view of the
organization's financial health.

6-2
 2.1 Financial Analysis
What is Financial Analysis ?
 Financial analysis is the assessment of firm's
past, present, and anticipated future financial
condition of a business firm.
 Financial analysis is the process of evaluating the financial
health of a company by examining its financial statements,
ratios, and other metrics to gain insights into its performance
and potential risks.

6-3
 2.1 Financial Analysis
The purpose of financial analysis
The main purposes of financial analysis are to:
 Evaluate the company's financial performance and
stability
 Identify strengths and weaknesses in its financial
position
 Forecast future performance and potential risks
 Make informed decisions about investments,
loans, and other financial transactions
 Assess the company's ability to pay debts and
6-4
Users of Financial Analysis
 The identity of the user helps define what
information is needed. The users of financial analysis include:
Investors:
 use financial analysis to assess the financial health and
performance of a company before making investment decisions.
 They analyze financial statements, ratios, and other financial
metrics to determine the company's potential for growth and
profitability.
 An investor attempts to arrive at an estimation of a
company’s future earnings stream in order to attach
a value to the securities being considered for
purchase or liquidation.
6-5
 Cont’d
Lenders:
 Lenders use financial analysis to evaluate the
creditworthiness of a borrower before providing
loans.
 They analyze the borrower's financial statements,
cash flow projections, and credit history to assess
the risk of default.
Management:
 Management uses financial analysis to monitor the
company's financial performance, identify areas of
improvement, and make strategic decisions.
6-6
 Cont’d
Regulators:
 Regulators use financial analysis to monitor
compliance with financial regulations and to detect
any financial irregularities.
 They analyze financial statements and other financial
data to ensure that companies are adhering to
accounting standards and financial reporting
requirements.
Competitors:
 Existing and new entrants have likelihood of their
success or failure in trying to hold in market.

6-7 Their primary interest lies in the business ratios of
 Cont’d
 Overall, financial analysis is an important tool for
anyone interested in understanding the financial
health and performance of a company.
 Considerations in Financial Analysis
1. The financial statements being compared should be
dated at the same point in time during the year.
2. A single analysis does not provide sufficient
information from which to judge the overall
performance of a firm.
3. Use audited financial statements for analysis.
4. Consider different methods used especially for
inventories & depreciation.
5.
6-8 Consider the distortions due to inflation.
 Cont’d
 Types and Tools of Financial Analysis
 Basic Approaches
1. Time-series analysis : Identify financial trends over
time for a single company.
 Present/recent ratios compared with a firm’s own
past ratios.
 Allows a firm to determining whether its progressing
as planned or not

6-9
 Cont’d
2. Cross-sectional analysis: Identify similarities and
differences across companies at a single moment in
time.
 How well a firm performed / positioned in relation to
its competitors.
 To uncover major operating deficiencies.
3. Benchmark comparison: measures a company’s
performance against some predetermined
standard/industry average/.
 Comparison of a particular ratio to the standard
made to isolate any deviation from the norm.
 Too high or too low values reflect symptoms of a
6-10 problem
 Financial ratios analysis
 Probably, the most widely used financial
analysis technique is ratio analysis, the
analysis of relationships between two or
more line items on the financial
statements.
 A ratio: Is the mathematical relationship
between two quantities in the financial
Statement.
 The analysis is used as an indicators of past
performance & a basis for sound decision-
making.
6-11
Types of Financial Ratios & Interpretations

1. Liquidity Ratios:
 Ability to meet current obligations

2. Leverage Ratios:
 shows the degree of a firm’s
indebtedness
3. Activity Ratios:
 Proper & effective use of assets

4. Profitability Ratios:
 Measures management effectiveness

5. Market Value Ratios:

 Indicators of what investors think of
6-12
firm’s past results & future prospects
 Merob Company, Income Statements

Variables 2001 2000

Sales 3,074,000 2,567,000

Less Cost of Goods Sold 2,088,000 1,711,000

Gross Profit 986,000 856,000

Less Operating Expenses

Selling Expenses 100,000 108,000

General and Adm. Expenses 468,000 445,000

Total Operating Expenses 568,000 553,000

Operating Profit 418,000 303,000

Less Interest Expenses 93,000 91,000

Net Profit Before Tax 325,000 212,000

Less Profit Tax (at 29%) 94,250 61,480

Net Income After Tax 230,750 150,520

Less Preferred Stock Dividends 10,000 10,000

Earnings Available to Common Shareholders 220,750 140,520

EPS 2.90 1.81

 Key Financial Ratios:
Liquidity Ratios

Liquidity refers to the company’s short-term

ability to generate cash for working Capital needs
and immediate debt repayment needs.
Liquidity ratios measure a firm’s ability to meet cash
needs as they arise. Liquidity ratios include
 Current ratio Liquidity Ratios: are used to
determine a company’s
 Quick or acid-test ratio ability to
meet its short-term debt obligations
with current assets.
 Key Financial Ratios:
Liquidity Ratios

 Current liabilities are the firm's financial

obligations that will mature soon, and the firm's
ability to repay them depends on having enough
cash and other assets.
 The current ratio, which measures the relationship
between current assets and current liabilities, is an
important indicator of liquidity.
 Failure to meet current obligations due to lack of
liquidity can damage the firm's reputation among
suppliers and creditors.
 Credit risk: Short-term liquidity ratios
Current Ratio: total current assets
and divides the remainder by Including Inventory
current liabilities
Current assets
Current ratio =
Current liabilities Very immediate
liquidity
Liquidity
ratios
Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities

Quick (acid test) Ratio: deducts

the least liquid asset from current
assets and divides the remainder
by current liabilities
 A. Current Ratio
• Measures a firm’s ability to satisfy or cover
the claims of short term creditors by using
only current assets. That is, it measures a
firm’s short-term solvency or liquidity.
• The current ratio is calculated by dividing
current assets to current liabilities.
• Current Ratio = current assets/current
liabilities
 Cont…….
• Therefore, the current ratio for Merob
Company is
For 2001 = 1,223,000 = 1.97
620,000
• Merob's current assets are 1.97 times its
current liabilities.
• An ideal current ratio is 2:1 or more, which
ensures a company can still meet obligations
even if current asset values decrease by half.
 Cont……
• Firms with higher cash and account
receivables are more liquid than those
with higher inventories, despite having the
same current ratio.
• High current ratio than the industry
average may indicate poor cash, credit, or
inventory management
• Low current ratio may indicate difficulty in
paying short-term obligations or under
stocking causing customer dissatisfaction.
 B. Quick (Acid-test) Ratio:
• The Acid-Test Ratio is a measure of short-
term liquidity that excludes the least liquid
assets such as inventories and prepaid
expenses.
• It is computed by dividing the sum of cash,
marketable securities, and accounts
receivable by current liabilities.
• This provides a more refined measure of a
firm's ability to pay off its debts quickly.
 Cont…..
Quick/Acid test Ratio =
Current assets- least liquid assets/ current liabilities
For 2001, Quick Ration for Merob Company will
be: 1,223,000- 289,000 /620000= 1.51
• Merob's acid test ratio is 1.51, indicating
that they have 1.51 birr in quick assets for
every birr of current liabilities.
• A moderately high ratio is desirable for the
company, as very high or very low ratios
can indicate problems.
 Key Financial Ratios:
Activity Ratios

• Activity ratios measure a firm's ability to

effectively utilize its assets to generate
revenue or cash flows.
• Activity ratios measure the efficiency of a
firm in managing its assets and generating
revenue.
 Account Receivable turnover
• The major activity ratios are the following.
 Inventory turnover
 Accounts Payable turnover
 Fixed Asset Turnover
 A. Receivables Turnover Ratio and collection
period
Receivables
Turnover = Net Sales
Ratio Average Accounts Receivable

This ratio measures how many

times a company converts its
receivables into cash each year.
Average Collection Period
Average = 365
Collection Receivables Turnover Ratio
Period
This ratio is an approximation of the
number of days the average accounts
receivable balance is outstanding.
 Cont…….
• The accounts receivable turnover for Merob
Company for the year 2001 is computed as
under.
• Accounts receivable turnover ratio
= 3,074,000 = 7.08
434,000*
• Average Accounts Receivable is the accounts
receivable of the year 2000 plus that of the
year 2001 and dividing the result by two.
So, 503,000 + 365,000/ 2 = 434,000*
 Cont…….
• Interpretation: Merob Company collected its
outstanding credit accounts and re-loaned the money
7.08 times during the year.
• Reasonably high accounts receivable turnover is
preferable.
• A ratio substantially lower than the industry average
may suggest that a Company has:
– More liberal credit policy (i.e. longer time credit
period), poor credit selection, and inadequate
collection effort or policy.
• A ratio substantially higher than the industry average
may suggest that a firm has;
• More restrictive credit policy (i.e. short term credit
period), more liberal cash discount offers (i.e. larger
discount and sale increase), more restrictive credit
 Average Collection Period
• The average collection period measures the
number of days it takes for a company to
collect its accounts receivable.
• It's calculated by dividing 365 days by the
accounts receivable turnover.
• The average Collection period for Merob
Company for the year 2001 will be:
365 days/7.08 =51 days
• For Merob Company in 2001, the average
collection period was 51 days based on their
receivable turnover of 7.08.
 Cont……
• The higher average collection period is an
indication of reluctant collection policy
where much of the firm’s cash is tied up in
the form of accounts receivables, whereas,
• the lower the average collection period
than the standard is also an indication of
very aggressive collection policy which
could result in the reduction of sales
revenue.
 B. Inventory Turnover Ratio and Average
Days in Inventory
Inventory
Cost of Goods Sold
Turnover = Average Inventory
Ratio
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.

Average Days in Inventory

Average =
Days in 365
Inventory Inventory Turnover Ratio

This ratio indicates the number

of days it normally takes to sell inventory.
 Cont…….
• Merob Company for For the year 2001
= 2,088,000/ 294,500*= 7.09 times
• Interpretation: - Merob's inventory is sold out or
turned over 7.09 times per year.
• In general, a high inventory turnover ratio is
better than a low ratio.
• An inventory turnover significantly higher than
the industry average indicates: Superior selling
practice, improved profitability as less money is
tied-up in inventory.
 Average Age of Inventory

• The average age of inventory measures how

long a company holds its inventory before
selling it.
• It's calculated by dividing the number of days
in a year by the inventory turnover.
• For Merob Company in 2001, the average age
of inventory was 51 days based on an
inventory turnover of 7.09. (365/7.09)
• A longer period indicates that the company is
holding more inventory, which increases the
risk of obsolescence and higher holding costs.
• It's recommended that Merob reassess its
marketing mechanisms to boost sales.
 C. Fixed Asset Turnover
• The fixed asset turnover measures how
efficiently a company uses its fixed assets
to generate revenue.
• It's calculated by dividing net sales by the
average fixed asset.
• Fixed Assets Turnover = 3,074,000 =
1.29
2,374,000*
• For Merob Company in 2001, the fixed
asset turnover was 1.29, indicating that
the company generated 1.29 birr in net
sales for every birr invested in fixed
assets.
 D. Total Assets Turnover
• Measures a firm’s efficiency in managing
its total assets to generate sales
• Total Assets Turnover = Net sales
Total assets
• So, Total Assets Turnover = 3,074,000 =
0.85
3.597,000
• This means that, Merob Company has
generated 0.85 cent in net sales for every
birr invested in Total assets.
 Key Financial Ratios:
Leverage Ratios
 Leverage ratios measure the extent of a firm’s
financing with debt relative to equity and its
ability to cover interest and other fixed charges.
 measure the degree to which a company uses
debt financing, which can indicate its ability to
meet financial obligations and the potential risk of
default.
 Leverage shows the degree of indebtedness of
firm.
 These ratios include:
1. Debt ratio
2. Debt-equity ratio
3. Times Interest Earned Ratio
 1. Debt Ratio:
• shows the extent of assets financed through debts .
It is calculated as: Debt ratio = Total
Liability
Total Assets
The debt ratio for Merob Company for the year 2001
is as follows:
= 1,643 = 0.457 or 45.7 %
3,597
• This indicates that the firm has financed 45.7 % of
its assets with debt.
• A higher debt-to-equity ratio indicates that a
company has a larger proportion of debt in relation
to equity, which can signal difficulty in raising
additional debt and may result in higher interest
rates demanded by creditors due to increased risk.
 2. Debt -Equity Ratio
• The debt-to-equity ratio compares the
amount of a company's total assets financed
by debt and equity, showing the relative
claims of creditors and shareholders against
the assets of the firm.
• Debt -equity ratio = Total Liability
Stockholders' Equity
 The Debt- Equity Ratio for Merob Company
for the year 2001 is indicated as follows.
Debt- Equity ratio = 1,643,000 = 0.84 or 84
%
1,954,000
• For Merob Company in 2001, the debt-to-equity ratio
was 0.84 or 84%, indicating that lenders'
 3. Times Interest Earned Ratio
• The times interest earned ratio (TIER) measures a
company's ability to pay interest on time.
• TIER= earnings before interest and tax /Interest
expense
• The times interest earned ratio for Merob
Company for the year 2001 is:
TIER = 418,000 = 4.5 times
93,000
• For Merob Company in 2001, the TIER was 4.5
times, indicating that the company's earnings
could decline by 4.5 times before it would be
unable to meet its interest costs and suffer
financial losses.
 4. Cash coverage ratio
• The Cash Coverage Ratio, on the other hand, is a measure
of a company's ability to meet its interest payments with
its cash flow.
• It takes into account both EBIT and the company's
depreciation and amortization expenses.
• Cash coverage ratio = EBIT+ Depreciation

interest expense
In summary, both ratios are used to evaluate a company's
ability to meet its interest payments, but TIER focuses only
on earnings before interest and taxes, while Cash Coverage
Ratio takes into account additional factors such as
depreciation and amortization.
 Cont……
• (Depreciation for 2000 and 2001 is
223,000 and 239,000 respectively).
• So, Cash coverage ratio for Merob
Company for the year 2001 is
418,000 + 239,000 = 7.07 times
93, 000
• This ratio indicates the extent to which
earnings may fall with out causing any
problem to the firm regarding the payment
of the interest charges.
 Key Financial Ratios:
Profitability Ratios:
• Profitability is the ability of a business to
earn profit over a period of time.
• Profitability ratios are used to measure
management effectiveness. Besides
management of the company, creditors and
owners are also interested in the
profitability of the company.
• Creditors want to get interest and
repayment of principal regularly.
• Owners want to get a required rate of return
on their investment. These ratios include:
 Cont……
A. Gross Profit Margin
B. Net Profit Margin
C. Return on Investment
D. Return on Equity
E. Earnings Per Share
 A. Gross Profit Margin
• Gross profit margin ratio that measures a
firm's profitability after accounting for
production or purchasing costs.
• It reflects how well a company manages
pricing, sales, and production expenses.

Gross Profit Margin = Gross Profit

Net Sales
• The gross profit margin for Merob Company
for the year 2001 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
 Cont…..
• Interpretation: Merob company profit is 32
cents for each birr of sales.
• The gross profit margin ratio is a measure
of management's effectiveness in
controlling production costs, generating
sales, and setting prices.
• A high ratio is favorable and indicates
good management, while a low ratio may
reflect higher cost of goods sold due to
various reasons.
 B. Net Profit Margin
• Net profit margin measures the profitability of
sales and is obtained by dividing net profit to
sales.
• It indicates the ability of the firm to turn each
birr of sales into net profit,
• with a higher net profit margin being favorable. It
is calculated as:
Net Profit Margin = Net Income
Net Sales
• The net profit margin for Merob Company for
the year 2001 is: 230,750 = 7.5 %
3,074,000
• This means that Merob Company has acquired
7.5 cents net profit from each birr of sales
 C. Return on Investment (ROI)
 The Return on Investment (ROI) measures the
profitability of a firm's assets and reflects the
effectiveness of management in generating profits.
 It indicates how efficiently the assets are used to
earn income, and the higher the ROI, the more
profitable the business.
Return on Assets (ROA) = Net Income
Total Assets
The return on assets for Merob Company for the year
2001
% is: = 230,750 = 6.4
3,597,000
Interpretation: Merob Company generates little more
than 6 cents for every birr invested in assets.
 D. Return on Equity
• Return on Equity (ROE) is a financial ratio that
measures the profitability of a company in relation to
the equity provided by its shareholders.
• ROE indicates how efficiently a company generates
profits using the money invested by its shareholders.
• It is calculated by dividing the net income (after
taxes and preferred dividends) by the shareholder's
equity.
 Cont…….
• The Return on equity is calculated as:
ROE = Net Income
Stockholders Equity
The Return on equity of Merob Company for the year
2001 is:
230,750 = 11.8%
1,954,000
• Interpretation: Merob generates around 12 cents for
every birr in shareholders equity.
 E. Earning per Share (EPS)
• Earnings per share (EPS) is a financial ratio that
calculates the amount of profit allocated to each
outstanding share of a company's common stock. It is
calculated by dividing the net income of the company by
the number of outstanding shares.
• EPS is an important metric used by investors to
determine a company's profitability on a per-share basis.
EPS = Earning Available for Common Stockholders
No of Shares of Common Stock Outstanding
EPS = 220,750 = birr 2.90 per share
76,262 shares
Interpretation: Merob Company earns birr 2.90 for each
common shares outstanding
 Benefits of Ratio Analysis

 Simplifies the financial statements

 Provides useful information concerning a firm’s
operation and financial conditions
 Helps identify symptoms of problems
 Helps reach to the causes of problems
 Provides a common ground for comparisons
 Helps in comparing companies of different size with
each other
 Helps in trend analysis which involves comparing a
single company over a period
 Highlights important information in simple form
quickly
 Limitations of Ratio Analysis

 Ratios are valuable analytical tools and serve as

screening devices, but they
 do not provide answers in and of themselves
 are not predictive
 should be used with other elements of financial analysis
 Inflation may have badly distorted firm’s balance sheets
- recorded values are often substantially different from
“true” values. Further, because inflation affects both
depreciation charges and inventory costs, profits are
also affected.
 Due to fraud, financial statements are not always
accurate; hence information based on reported data can
be misleading.
 Firms can employ “window dressing” techniques to
make their financial statements look stronger.