Chapter 2

Financial
Analysis
1
 Meaning of Financial Analysis
• It is the process of critical evaluation of the
financial information contained in the financial
statements in order to understand and make
decisions regarding the operations of the firm.
• It is the process of identifying the financial
strengths and weaknesses .
• It is concerned with the selection, evaluation,
and interpretation of financial data to assist
investment, financing, and dividend decisions.
2
• The term ‘financial analysis’ includes both
‘analysis and interpretation’.
• The term analysis means simplification of
financial data by methodical classification
given in the financial statements.
• Interpretation means explaining the
meaning and significance of the data.
• These two are complimentary to each other.
• Analysis is useless without interpretation, and
interpretation without analysis is difficult or
even impossible. 3
Purposes of Financial Analysis:
– It is useful to different users in the following ways:
1.Finance manager:
– A finance manager must be well-equipped with the
different tools of analysis to make rational decisions
for the firm.
– It enables the finance manager to make reviews of
the actual financial operations of the firm to
analyze the causes of major deviations, which may
help in corrective action wherever indicated

4
2. Top management:
• The management of the firm uses financial statements
analysis 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 and analyze business and financial
risk
3. Lenders:
– Suppliers of long-term debt are concerned with the firm’s
long-term solvency and survival.
– They analyze the firm’s profitability over a period 5of
 Tools for financial analysis
1. Comparative Statements:
– These are the statements showing the profitability
and financial position of a firm for different periods
of time in a comparative form to give an idea about
the position of two or more periods.
– It usually applies to the two important financial
statements, namely, balance sheet and statement
of profit and loss prepared in a comparative
form. 6
2. Common Size Statements:
• Statements which indicate the relationship of
different items of a financial statement with a
common item by expressing each item as a
percentage of that common item.
• Allow to compare the operating and financing
characteristics of two companies of different sizes
in the same industry.
• Thus, common size statements are useful, both,
in intra-firm comparisons and inter-firm
comparisons for the same year or for several
years. 7
3. Trend Analysis:
• It is a technique of studying the operational results
and financial position over a series of years.
• Using the previous years’ data of a business
enterprise, trend analysis can be done to observe
the percentage changes over time in the selected
data.
• By looking at a trend in a particular ratio, one may
find whether the ratio is falling, rising or
remaining relatively constant. 8
4. Cash Flow Analysis:
• It refers to the analysis of actual movement of
cash into and out of an organization.
• The flow of cash into the business is called as
cash inflow and the flow of cash out of the firm
is called as cash outflow.
• The difference between the inflow and outflow
of cash is the net cash flow.
• Thus, it summarizes the causes for the
changes in cash position of a business
enterprise between dates of two balance sheets.
9
5. Ratio Analysis:
• It describes the significant relationship which
exists between various items of a balance sheet
and a statement of profit and loss of a firm.
• As a technique of financial analysis, which
measure the comparative significance of the
individual items of the income and position
statements.
• It is possible to assess the profitability, solvency
and efficiency of an enterprise through the
technique of ratio analysis.
10
 RATIO ANALYSIS
• Ratio Analysis is an important tool of financial
statements analysis.
• A ratio is a mathematical number
calculated as a reference to relationship
of two or more numbers and can be
expressed as a fraction, proportion,
percentage and a number of times.
• The number is calculated by referring to two
accounting numbers derived from the
financial statements. 11
 Objectives of Ratio Analysis
• To know the areas of the business which need more
attention.
• To know about the potential areas which can be
improved with the effort in the desired direction.
• To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the business;
• To provide information for making cross-sectional
analysis by comparing the performance with the best
industry standards; and
• To provide information derived from financial statements
useful for making projections and estimates for the
future. 12
Major types of Financial Ratios
There is a two way classification of ratios:
(1)Traditional classification
• Statement of Profit and Loss Ratios: A ratio of
two variables from the statement of profit and
loss.
• Balance Sheet Ratios: Both variables are from
the balance sheet, from balance sheet.
• Composite Ratios: If a ratio is computed with
one variable from the statement of profit and loss
and another variable from the balance sheet, it is
13
2. Functional classification:
• Based on the purpose, for which a
ratio is computed, is the most commonly
used classification which is as follows:
– Liquidity ratios
– Long-term solvency ratios
– Asset Management or turnover ratios
– Profitability ratios
– Market Value Ratios
14
The following data pertains to Blue Company for the year
needed December 31, 2020 and 2021:
Income Statement (in thousands)
2020 2021
Net sales (on credit)………………………….. ………….……… 15,00 18,00
Less: Cost of Goods Sold ……………………..………….……… 0 0
Gross profit on sale …………………………..………….………. 5000 6,000
Less: Selling & administrative expenses……….…………. 10,00 12,00
……... 0 0
Earnings before interest and taxes (EBIT) 2,800 3,000
……………………….. 7,200 9,000
Less: Interest expense …………………………...………….…… 1710 1,800
Income before taxes ……………………………………….…….. 5,490 7,200
Less: Income taxes (40%) ………………………………….……. 2,196 2880
Net income ……………………………………….………….…… 3,294 4,320
Less: Common dividends …………………….………….………. 400 600
Increase in retained earnings ……………………..…………. 2,894 3,720
15
 Balance Sheet (in thousands)
Assets: 2020 2021
Cash & marketable securities…………....………….…… 5,000 6,000
Accounts Receivable ……………….………….…………. 4,000 5,000
Inventories ……………………………….………….……… 6,000 8,000
Current Assets ……………………………….………….… 15,000 19,000
Fixed Assets (net)………………………… ………….…… 35,000 41,000
Total assets………………………………..………….…… 50,000 60,000

Liabilities and Stockholders’ Equity

Liabilities:
Accounts payable …………………….………….…………. 4,000 5,000
Short-term Notes Payable ……………….………….……… 2,600 3,000
Accruals …………………………………..………….……… 3,000 2,000
Long-term debts …………………………..………….…… 14,400 15,000
Total Liabilities…………………………..………….…… 24,000 25,000
Stockholders’ Equity:
Common stock ……………………………… 16,000 23,000
Retained earnings………………………..……… 10,000 12,000
Total stockholders’ equity………… 26,000 35,000
Total Liabilities & stockholders’ equity ….…………. 50,000 60,000

16
Additional Data
• There were 3,000,000 and 4,400,000 shares of
common stock in 2020 and 2021 respectively.
• Selling and administrative expenses include rent of
Br. 200,000 in 2020 and Br. 220,000 in 2021.
• The market prices per share are Br. 10 and Br. 12 in
2020 and 2021 respectively

17
1. Liquidity Ratios:
• Calculated to measure the short-term solvency of
the business, i.e. the firm’s ability to meet its current
obligations.
• These are analyzed by looking at the amounts of
current assets and current liabilities in the
balance sheet.
• The two ratios included in this category are current
ratio and liquidity ratio.
– Current ratio and
– Quick ratio
18
1.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.

• Using the above exercise for a Blue company, current

ratio is computed as follows:

19
• To be desirable, current ratio should be greater than
or equal to the standard.
• As compared to 2020, the current ratio of 2021 is
desirable. Current ratio indicates the availability of
current assets in Birr for every one Birr of current
liability.
• For example, current ratio of 2021 (1.9:1) indicated
that the firm has one Birr and ninety cents current
assets for every one Birr current liability.
• As a conventional rule a ratio of 2:1 (2 to 1) or more
is considered satisfactory.
20
2. Quick (Acid Test) Ratio
• Quick ratio serves the same general purpose as the
current ratio but exclude inventory from current
assets.
• Thus, the quick ratio measures a corporation’s ability
to pay its current liabilities by converting its most
liquid assets into cash.

• Using the above exercise for a Blue company, Quick

ratio is computed as follows:

21
• To be desirable, quick ratio should be greater than
or equal to the standard.
• Thus, Blue Company’s quick ratio of 2021 is desirable
as compared to that of 2020.
• If a company seeks to pay its current liabilities by
using its quick assets, then its quick assets must
equal or exceed its current liabilities.
• This is the reasoning behind the quick ratio standard
of 1.0 that many analysts use as the dividing line
between sufficient and insufficient liquidity.

22
2.Debt Management (Leverage) Ratios
• 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.
• Some of them are discussed in the following
section:

23
1. 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.

• For Blue Company, debt ratio is computed as follows:

• Generally, creditors would like a lower debt ratio to

be desirable.
• When compared with 2020, Blue Company’s debt
ratio is desirable in 2021. 24
2. Debt- to- Equity (D/E) ratio
• Debt-Equity ratio measures the proportion of debt
capital in terms of equity capital.

• 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. 25
Debt-to- Equity ratio may also be computed as follows:

26
3. Equity Multiplier Ratio
• It measures the extent to which the firm uses debt
financing in its capital structure.

• For Blue Company, Equity Multiplier ratio is

computed as follows:

• Generally, a lower Equity Multiplier Ratio is

desirable.

27
4. Times Interest Earned (TIE) ratio
• It is used to measure the ability of the firm to meet
interest obligations from its profits.
• It indicates the number of times EBIT is available
to cover interest obligations. It is computed as
follows:

• For Blue Company, Times Interest Earned (TIE) ratio is

computed as follows:

• To be desirable TIE ratio should be greater than or28

 3. Asset Management (turnover) ratios
• Asset Management 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 of the major activity ratios are discussed
as follows:
29
1.Inventory Turnover (ITO)
• Inventory turnover measures the number of
time per year, on average, that a
corporation sells, or turns over, its
inventory.

• Using Blue Company data, inventory turnover is

computed as follows:

30
• In general, high inventory turnover may be
taken as a sign of good inventory
management.
• Other things being the same, higher inventory
turnover ratios computed for Blue Company
indicate that the company was able to sell its
inventories 0.833 times and 0.75 time during 2020
and 2021 respectively.
• For Blue Company show good or bad performance,
or high efficiency or low efficiency as long as you
don't have standard inventory turnover ratio to
compare with. 31
• An alternative measure of inventory activity is
inventory turnover in days (ITD), or inventory period,
which is computed as follows:

32
• Alternatively, you may also use the following formula

• Generally, to be desirable, inventory period

should be less than or equal to the standard.
• Accordingly, Blue Company’s inventory period is
undesirable in 2021 as compared to 2020.

33
2.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.

34
• Blue Company’s Receivable Turnover is computed as
follows:

• To be desirable, receivable turnover should be

greater than or equal to the standard.
• As a result, Blue Company’s receivable turnover for
2021 is undesirable as compared to that of 2020.
• The higher the turnover, the shorter will be the
time between the typical sales and cash
collection.
35
• Receivable Turn Over in Days (RTD), Days Sales
Outstanding or Average Collection Period (ACP), is
calculated as:

• ACP figure tells us the average number of days

that receivables are outstanding before being
collected.
• Generally, a lower ACP is desirable. Blue
Company’s ACP for 2021 is undesirable as
compared to that of 2020. 36
Or Alternatively,

37
3. Total Assets Turn over (TATO): This ratio shows
the firm’s ability in generating sales from all financial
resources committed to total assets.

• To be desirable, Total Assets Turnover should be greater

than or equal to the standard.
• TATO of 0.33 implies that the company was able to generate
sales of Birr 0.33 for a single birr it has invested in its assets
during the year.

38
4. Fixed Assets Turnover (FATO)
• It is used to measure how effectively the firm uses its
plant assets in generating sales.

• To be desirable, Fixed Assets turnover should be

greater than or equal to the standard.
• The company generated birr 0.43 in sales for every birr
invested in fixed assets in the year 2020 and birr 0.44 in
the year 2021.
• Therefore, Blue Company’s fixed assets turnover for 2021
is somehow desirable as compared to that of 2020. 39
 PROFITABILITY RATIOS
• 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.
• They measure the combined effect of asset management,
debt management, and liquidity on the profitability of the
firm.
• 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 40
1. 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).

41
• Using Blue company data, gross profit margin ratio is
computed as follows:

• Generally, a higher gross profit margin ratio is

desirable.
• These ratios reflect the company’s mark ups on costs
of goods sold as well as the ability of the company’s
management to minimize the costs of goods sold in
relation to sales.
• Larger gross margin ratio implies lower costs of
goods sold rate and vice versa. 42
2. 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.

43
• For Blue company, net profit margin is calculated as
follows:

• To be desirable, net profit margin ratio should be

greater than or equal to the standard.
• Accordingly, since net profit margin ratio of 2021 is
greater than that of 2020, it is considered desirable.

44
3. Return on investment (ROI) or Return on
Assets (ROA)
• It measures the amount of profit generated on
investments in assets.

• Blue Company’s return on investments is computed as

follows

• Generally, a higher ROA is desirable.

45
• Thus, Blue Company generated about 6.6 cents in
the form of net income out of each birr it
invested in its total assets during 2020, and about
7.20 cents in the form of net income out of each birr
of investment in its total assets during 2021.

• Whether the indicated returns on investments are

good or bad depends on the industry standards,
or the management plans.
• The company’s return on investment has shown slight
improvement in 2021 compared to that of 2020.
46
4. 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.
• 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.
47
• 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.
For Blue Company, ROE is computed as follows:

48
Return on Equity (ROE) may also be computed using
the following formula:

49
5. 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.
• EPS simply shows 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.
50
• For Blue Company, Earning per share on common
stock is computed as follows:

• Generally, higher earnings per share are

desirable.

51
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:
1. Price / Earning (P/E) Ratio
2. Market-to-Book (M/B)ratio
52
1. Price- Earning (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.

53
• Blue Company’s P/E ratio is computed as follows:

• The market is willing to pay about 9.11 birr in 2020 and

about 12.24 birr in 2021 for every birr in the company’s
earnings.
• Since the industry standard or management plan is lacking,
it is very difficult to categorize Blue Company as highly
valued or own valued company.
• But we can say that a high P/E ratio reflects the market’s
perception of the company’s growth prospects.
• The problem with P/E ratio is that the market price for a
share of common stock may not be available when there is
54
2. 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.
• For Blue Company, book value per share and M/B
ratio are determined as follows:

55
• According to the above analysis, Blue Company has
created value for its shareholders in both years since
M/B ratio is greater than 1.

56
Advantages of Financial Ratio Analysis:
– Ratios are easy to compute
– Ratios provide standards of comparison at a point in
time and comparisons to be made with industry average, if
available.
– Ratios can be used to analyze company’s time series in
order to discover trends, shifts in trends, and values that
deviate from other similar values.
– Ratios are useful in identifying problem areas of a
company.
– When combined with other tools, financial ratios analysis
makes an important contribution to the task of evaluating
the company’s financial performance.
57
Limitations of Financial ratio analysis:
• Taken by themselves, financial ratios provide very little
information that is useful.
• Ratios seldom provide answers to questions they raise
because generally they do not identify the causes for the
difficulties that the company faced.
• Ratios can easily be misinterpreted for instance; a decrease
in the value of a given ratio doesn’t necessarily mean that
something undesirable has happened.
• Very few standards exist that can be used to judge the
adequacy of a ratio or a set of ratios.
– In some cases, the industry average ratios may not be
available at all that is the problem we encounter in the case
of Ethiopian industries. 58
• Ratio analysis more useful for smaller and narrowly
focused companies than for large and multi
divisional ones.
• Ratios do not take the time value of money effects
unless balance sheet and income statement figures
are adjusted for the effect of inflation.
• Seasonal fluctuations can also distort the analysis of
financial statements through the use of ratios.
– These problems can be minimized by using monthly
averages for inventories and receivables when calculating
turnover ratios.

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 END OF
CHAPTER
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