Chapter Two

IFRS -BASED
FINANCIAL
STATEMENT ANALYSIS
 Purposes of financial analysis

The term ‘Financial Analysis’ also known as

analysis and interpretation of financial statements,
or financial statement analysis, refers to the
process of determining financial strengths and
weaknesses of the firm by establishing strategic
relationship between the items of the financial
statements.
It is prepared to assist investment and financial
decision- making.
It is evaluating relationship between component
parts of financial statements to obtain better
understanding of the firm’s position and performance
is known as analysis of financial statements.
 Financial analysis serves the
following purposes:
Measuring the profitability
Financial analysis helps in ascertaining whether
adequate profits are being earned on the capital
invested in the business or not. It also helps to
know the capacity to pay the interest and
dividend.
Indicating the trend of Achievements
Financial statements of the previous years can
be compared and the trend regarding various
expenses, purchases, sales, gross profits and
net profit etc. can be ascertained.
Assessing the growth potential of the
business
The trend and other analysis of the business
provides sufficient information indicating the
growth potential of the business.
Comparative position in relation to other
firms
Such comparison helps the management to study
the position of their firm in respect of sales,
expenses, profitability and utilizing capital related
to various firms engaged in similar businesses.
Assess overall financial strength
The purpose of financial analysis is to assess
the financial strength of the business.
Assess solvency of the firm
The different tools of an analysis tell us
whether the firm has sufficient funds to meet
its short term and long term liabilities or not.
 Tools for financial analysis

Like a doctor, a financial analyst analyzes

the financial statements using various tools
of analysis before commenting upon the
financial health or weaknesses of an
enterprise. There are three types of tools of
financial analysis that are commonly in use
these include:
 Horizontal financial analysis
 Vertical financial analysis
 Financial ratio analysis
A. Horizontal Financial analysis
Horizontal financial analysis is a technique for
evaluating and analyzing a series of financial
statement data over a period of time.
B. Vertical financial analysis
Vertical financial analysis is a technique of
evaluation and analyzing financial statement
data that expresses each item in a financial
statement as a percent of a base amount. For
example, on a balance sheet, we might say that
current assets are 22% of total assets (total
assets being the base amount).
C. Financial ratio Analysis
The financial ratio analysis is one of the most
powerful types of financial analysis. A ratio is a
simple arithmetical expression of the
relationship of one number to another.
A financial ratio analysis is the process of
establishing and interpreting various financial
ratios for helping in making certain decisions.
However, financial ratio analysis is not an end in
itself. It is only a means of better understanding
of financial strengths and weaknesses of a firm.
The following steps could be very helpful in
ratio analysis:
 Selection of relevant data from the financial
statements depending upon the objective of the
analysis.
 Calculation of appropriate ratios from the above data.
 Comparison of the calculated ratios with the ratios of
the same firm in the past or the ratios of some other
firms or with the ratios of the industry to which the
firm belongs.
 Interpretation of ratios based on the comparison.
There are different parties interested in the
ratio analysis for knowing the financial
position and performance of a firm for
different purposes.
 A supplier of goods of a firm on credit or a bank
advancing a short-term loan to a form’s interested
primarily in the short-term paying capacity of the firm,
or in its liquidity.
 Long-term credit or debt providers to a form will be
primarily interested in the solvency or long-term
financial position of the firm.
 The shareholders are generally interested in the
profitability and dividend position of a firm
 Ratio Analysis
Cautions for making ratio Analysis
1. A single ratio does not generally provide sufficient
information
2. The financial statements being compared should be
dated at the same point in time during the year.
3. It is preferable to use audited FS for ratio analysis.
4. The use of different accounting treatments especially
related to inventory and depreciation can distort the
results of ratio analysis.
5. When the ratios of one form are compared with those of
another or with those of the firm itself over time, results
can be distorted due to inflation.
6. A firm may have some ratios that look “good” and other
that look “bad” making it difficult to tell whether the
company is on average, strong or weak
 Types of financial ratio

Financial ratios can be divided for convenience

into five basic groups or categories
1. Short term solvency or liquidity measures
2. Long-term solvency measures
3. Asset Management or turnover measures
4. Profitability Measures
5. Market Value Ratios (Measures)
For illustrative purposes, we shall use data
taken from balance sheet and income
statement of a simple company called EMC
manufacturing company.
 EMC manufacturing company
Comparative balance sheets
December 31, 2005 and 2006(in thousands of dollars)

Assets 2006 2005 Liabilities 2006 2005

Current assets Current Liabilities
Cash 2,500 3,000 Account Payable 7200 6,000
Notes payble-10% bank 5,500 7,000
Marketable Securities 1,000 1,300
Accrued liabilities 900 700
Accounts receivable 16,000 12,000
Current maturity of long-term 3,000 3,000
Inventories 20,500 18.700 debt
Other liabilities 1,400 1,200
Total Current Assets 40,000 35,000 Total current liabilities 18,00 17,90
0 0
Fixed Assets Long –term liabilities Long-
term debt-12% mortgage 27,00 30,00
bond… 0 0
Land and building 28,700 24,200 Total liabilities 45,00 47,90
0 0
Machinery and Stockholders’’ Equity
equipment 31,600 29,000 Share capital $5par,2,000,000
Total fixed assets 60,300 53,200 shares authorized;1,300,000
share outstanding in 2006 and
Less accumulated depr. (18,300) (17,200) 1,000,000
Net fixed assets…… 42,000 36000 shares outstanding in 6,500 5,000
2005………
Total assets……… 82,000 71,000 Paid up Capital in excess of 14,00 5,350
 EMC manufacturing company
Comparative income statements
For the years ended December 31, 2005 and 2006 (in thousands of
dollars)

2006 2005
Net sales……………………………………………………. 120,000 110,00
Cost of goods sold…………………………………….. 90,000 0
Gross profit……………………………………………….. 30,000 83,000
Operating expenses 27,000
Selling………………………………………………………. 5,000
General and administrative……………………… 8,000 4,800
Depreciation………………………………………………… 1,100 7,600
Lease payments…………………………………………. 1,650 800
Total operating expenses…………………………… 15,750 1,600
Earnings before interest and taxes (EBIT)…… 14,250 14,800
Interest expenses 12,200
Interest on bank notes…………………………….. (550)
Interest on other debt…………………………… (3,600) (700)
Earnings before taxes………………………………. 10,100 (3,960)
Taxes (34%)…………………………………………. 3,434 7,450
Net Income…………………………………………………. 6,666 2,560
4,975
 EMC manufacturing company
Statement of retained Earnings
December 31, 2005 and 2006(In thousands of dollars)

2006

Retained earnings-January 1……………………….. 12,750

Net 6,666
income………………………………………………….. 19,416
Total…………………………………………………………..
Less cash dividends 2,600
Common stock $2.00 per share………………….. 16,816
Retained earnings-December 31………………..
Assume that EMC’ year end (i.e., Dec.31 2006), market price of common
stock is birr 35 per share.
The industry average of different ratios is given below for
comparison purpose with EMC Company.
Ratios
Averages (standards)
Industry
1. Liquidity ratios
a. Current ratio………………………………………………………. 2.00x
b. Quick ratio…………………………………………………………… 1.08x
2. Assets management ratio(activity ratio)
a. Accounts Receivable turnover…………………………… 10.40x
b. Average collection period………………………………… 35.00days
c. Inventory turnover………………………………………….. 6.00x
d. Fixed asset turnover……………………………………….. 3.50x
e. Total assets turnover………………………………………. 2.00x
3. Debt Management ratios(debt ratios)
a. Debt ratio…………………………………………………………. 45.00%
b. Debt –equity ratio……………………………………………… 81.81%
c. Time-interest-earned………………………………………… 5.50x
d. Fixed-charge-coverage………………………………………. 2.50x
4. Profitability ratios
a. Gross profit margin……………………………………………….. 26.00%
b. Operating profit margin………………………………………… 15.50%
c. Net profit Margin……………………………………………….. 6.00%
d. Return on investment……………………………………….. 12.00%
e. Return on equity………………………………………………… 21,82%
5. Market /Book ratio
a. Earning s per share…………………………………………. $ 15.50
b. Price/earnings ratio………………………………………. 12.00
c. Book value per share………………………………………. $46.50
d. Dividend per share………………………………………… . 1.10
e. Dividend pay out…………………………………………….... 20.00%
f. Dividend per yield…………………………………………….. 1.67%
Industry averages are assured to remain constant for 2005 and 2006
1. Short term solvency or liquidity measures

Liquidity refers to the ability of a firm to meet its

short-term obligations as and when they become
due. Liquidity also refers to the solvency of the
firm’s overall financial position the ease with
which it can pay its bills.
The short term obligations are met by realizing
amounts from current assets. These current assets
should be quickly converted to cash at the going
market price.
The sufficiency or insufficiency of current assets
should be assessed by comparing them with short-
term (current) liabilities.
If the current assets can pay off current
liabilities, then liquidity position of the firm
will be satisfactory. on the other hand, if
current liabilities are not easily met out of
current assets then liquidity position of the
firm will be bad.
The liquidity ratios indicate whether a firm
has enough cash or other liquid assets to
meet its short-term obligations (current
liabilities
The three basic measures of liquidity are:
a. Net working capital (NWC) :
 Net working capital, although not actually a
ratio, is commonly used to measure a firm’s
overall liquidity. It is calculated as follows
Net working capital = Current assets – current liabilities
NWC represents the excess of current asset over
current liabilities.
Although NWC is really not a ratio, it is
frequently employed as a measure of a
company’s liquidity position.
The greater is the amount of NWC, the greater is
the liquidity of the firm.
b. Current Ratio:
This is one of the most commonly cited financial ratios,
which measures firm’s ability to meet its short-term
obligations.
Current Ratio = Current assets
Current liabilities
A current ratio of 2.0 is occasionally cited as acceptable,
but a value’s acceptability depends on the industry in
which the firm operation.
Example:
Current ratio for EMC for 2006 40,000 = 2.22
times
18,000
 Interpretation: EMC has 2.22 birr in current assets
available for every birr in current liabilities.
This ratio slightly exceeds the industry average (i.e., 2
times).
 A very high current ratio may indicate
 Excessive cash due to poor cash management
 Excessive accounts receivable due to poor credit management
 Excessive inventory due to poor inventory management
 The result of very high current ratio is to have an
improved liquidity greater safety of funds of short- term
creditors
 A low current ratio could be improved by
 Long-term borrowing and sale of stock to increase current assets.
 Liquidating current liabilities using long-term financing.
c. Quick(Acid-Test)Ratios
This is more conservative measure of liquidity. The
quick (acid-test) ratio is similar to the current ratio
except that it excludes inventory, which is generally
the least liquid current asset, and prepaid expenses.
1. Generally low liquidity of inventory results from two
primary factor.
 Many types of inventory cannot be sold easily, and
 The items are typically sold on credit which means that they
become accounts receivable before being converted into cash.
2. Prepaid expenses are excluded because they are not
available to pay current debts.
Quick Ratio = Current Assets – Inventory –Prepaid Expenses
Current Liabilities
A quick ratio of 1.0 or greater is occasionally recommended, but as
with the current ratio, an expectable value depends on the industry
Example: quick ratio for EMC (2006) = 19,500 = 1.08
18,000
Interpretation;: EMC has 1.08 birr in quick asset of
every birr in current liabilities. Recall that current ratio of
EMC (2.22 times) was greater than the industry average
(2times). But the quick ratio (measure of liquidity by
excluding inventory and prepaid expense) of EMC (1.08
times) is less than the industry average. This suggests
that the firm has more inventories and /or prepayments
than the industry average.
 2. Long-term solvency measures

It is also called Debt utilization ratio or

financial leverage ratios.
These ratios provide information on the degree
of a firm’s fixed financing obligations (debt
financing) and its ability to pay these financing
obligations.
Financial leverage ratios convey how a firm is
dependent on debt financing and indicate its
ability to meet fixed charge obligations.
They provide insight into how much debt the
firm is employing relative to equity finance.
Financing assets through debt involves more
risk than financing assets with equity.
Debt usually forces the firm to pay interest
and repay the principal amount whether the
firm is profitable or not.
However, equity financing does not oblige the
firm to pay dividends ever year.
A. Debt-ratio:
 This measures the proportion of total assets financed by the
firm’s creditors
 The higher this ratio the greater the amount of other people
money being used in an attempt to generate profit and the
higher the financial cost and restrictions from creditors.
Debit ratio = Total liabilities
Total assets
Example: Debt-asset ratio for EMC (2006) = 45,000= 55%
82,000

 Interpretation: Creditors have supplied EMC about 55% of every

dollar in assets. This is quite above the industry average of 45%.
Thus EMC has leverage more than the industry average.
b. Debit-equity ratio:
 This indicates the relationship between the long-term funds
provided by creditors and those provided by the firm’s owners.
 This ratio reflects the relative claim of creditors and
shareholder’s against the assets of the firm.
Debt-equity ratio = Total liabilities
Stockholder’s equity
Example:
debt –equity ratio for EMC (3006) = 45,000 = 1.2162
37,000
 Interpretation: creditors of EMC provided about birr 1.21 in
financing for every birr contributed by owners. Therefore, EMC
has more financial leverage than average for the industry
(81.82%) and, consequently, may have greater financial charges
(interest)
A high debt-equity ratio shows
 A large share of financing by creditors relative to the

owners.
 A large creditor’s claim to the assets of the firm.

 Little margin of safety to creditors

 High risk to creditors

 Less flexible in the firm’s operation as creditors would

exercise pressure and interfering management of the firm

 If this high financial leverage is favorable, shareholders

return will be magnified and if it is unfavorable

shareholders return will decrease
A low debt equity ratio has just the opposite
implication.
c. Times-interest earned ratio:
 The times-interest earned ratio measures the firm’s ability to make
contractual interest payments from operating profit.
 The higher the value of this ratio, the better able the firm is to fulfill its
interest obligation.
 Failure to meet his obligation can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
Time-Interest earned = Earnings before interest and tax (EBIT)
Interest expenses
 As rule, the times-interest earned ratio of a least 3.0 and preferably
closed to 5.0 is suggested.
Example:
Time interest earned ratio (EMC 2006) = 14,250 = 3.43 times
4,150
Interpretation: EMC earns 3.43 times more than its interest charges
However, EMC times interest earned ratio is below the industry average of
5.5times showing that EMC is making extensive use of credit of financial
operations.
d. Fixed-Payment Coverage Ratio
The fixed-payment coverage ratio measures
the firm’s ability to meet all fixed payment
obligations, such as loan interest principal,
lease payments, and preferred stock
dividends. Like the times-interest earned
ratio, the higher this value is better.
Fixed payment coverage ratio =
________________EBIT + lease payment__________________
Interest + lease payments + (principal payments + preferred
stock dividends)x (1/1-T)
Example:
Fixed charge coverage = 14,250 + 1,650 = 15,900 = 1.54
times
4,150 + 1,650 + (3000/ (1/1-.34) 10345
 Interpretation: EMC is able to cover its fixed charges only 1.54
times compared with the industry average of 2.5 times. This means
EMC earns birr 1.54 profits for every birr of fixed charge payment.
The low ratio gives creditors a small margin of safety in case EMC
experiences lower earnings.
 Note that EMC does not have any preferred stockholders, but the
firm did repay part of its long-term debt during the accounting period
(i.e., 3,000 birr principal of 2005 less birr 27,000 principal in 2006).
 If the ratio is lower, creditors and preferred stockholders view the
firm as more risky and the firm may be unable to meet its fixed
charges of earnings decline and may be forced into bankruptcy. A
high ratio suggests a larger cushion of protection in the events of
worsening financial position.
 1. Activity (utilization, efficiency or asset
management) ratios.

These ratios are also called efficiency ratios, or

asset management ratios or asset utilization
ratios. Asset management ratios usually compare
the leveled sales or cost of goods sold with the
level of investment in various asset accounts. It
measures how effectively the firm is managing its
assets, and how well a firm’s funds are utilized?
Does the total amount of each type of asset as
reported on the balance sheet seem reasonable,
too high or too low in relation total sales? If a firm
has too many assets, its cost of capital will be too
high; hence its profits will be reduced. The
reverse is true
A. Inventory turnover ratio
 Inventory turnover commonly measures the activity or
liquidity of a firm’s inventory. It measures how quickly
inventory is sold. That is it indicates the efficiency of the
firm in management and selling inventory.
 A high inventory turnover ratio is better than a low ratio as
a high ratio implies good inventory management.
Inventory turnover = cost of goods sold
Inventory
Example:
inventory turnover (for EMC 2006) = 90,000 = 4.39 times
20,500
Interpretation: EMC’s inventory is sold out or
turned over 4.39 times per year. But inventory
turnover of EMC is below the industry average
of 6 times. Inventory turnover can also be
calculated using the follow ing formula.
But this will be used if the cost of goods sold
figure is not available.
Inventory turnover = Sales__
Inventory
b. Accounts Receivable Turn Over(ARTO)
 Accounts receivable turn over measure the
liquidity of firm’s accounts receivable.
 This turnover ratio provides insight into the quality
of the firm’s receivable and how successful the firm
is in its collections.
 The higher the receivables turnover, the shorter
will be the time between the typical credit sale and
cash collection.
 Generally it indicates how many times or how
rapidly accounts receivable are converted into cash
during a year.
Accounts Receivable Turnover (ARTO) = Net sales
Accounts
Receivable
Example: ARTO (EMC2006) = 120,000 = 7.5 times
16,000
Interpretations: EMC accounts receivable are converted into cash
7.5 times in a year. But this is considerably below the industry average
of 10.4 times. In general, a reasonable high ARTO is preferable.
A ratio substantially lower than the industry average may suggest that
a firm has
More liberal credit policy: (i.e., longer times credit period), poor
credit selection, and inadequate collection effort or policy which could
lead to
Accounts receivable to be high and higher bad debit or uncollectible
receivable
More restricted cash discount (i.e., no or little cash discount) that
could make sales to be too low
Accounts payable turn over (APTO)
Measures how rapidly creditors are paid. That is,
how rapidly or how many times accounts payable
are paid during a year

Example: Data of ABC Company for 2000

Net purchase (on credit) ………………………..Br150,
000
Accounts payable Dec.31.2000………………..Br.
30,000
APTO = Net purchase = 150,000 =5
times
Accounts payable 30,000
c. Fixed Asset turn Over (FATO)
The fixed asset turns over measures the efficiency with
which the firm has been using its fixed assets to generate
sales. This ratio indicates management’s efficiency in
managing fixed assets.
Fixed Asset Turn Over = sales (Net)
Net Fixed Assets
A net fixed asset means cost of fixed assets net of
depreciation. Generally, higher fixed asset turnover are
preferred, because they reflect greater efficiency of fixed
asset utilization. Because of inflation and the historically
based book values of assets, firm with the newer asset will
tend to have lower turnovers tan those with older assets
having lower book values.
The difference in this turnover could result from
more costly assets rather tan from differing
operating efficiencies. Therefore, the financial
manager should be cautious when using those
ratios for cross- section comparisons.
Examples: FATO (EMC, for 2006) = Net sales = 120,000= 2.86 times
Net fixed assets 42,000

Interpretation: EMC generates birr 2.86 in net

sales for ever birr invested in its fixed assets.
However, this is below the industry average of
3.5 times.
Interpretation: EMC generates birr 2.86 in net
sales for ever birr invested in its fixed assets.
However, this is below the industry average of
3.5 times.
Other things being equal, a ratio substantially
below the industry average
 Shows under utilization of available fixed asset
 Indicates possibility to expand activity levels without
requiring additional capital investment.
 Shows over investment in fixed assets, low sales or
both.
 Suggests that sales should be increased, some fixed
asset should be disposed of or both.
c. Total Assets Turnover(refers to return on investment)
 This measures the efficiency with which the firm uses all its
assets to generate sales.
 How much sales birr is generate per birr of investment in
asset? It is the ratio of sales to total assets.
Total Asset Turnover = sales
Total
Assets
 Generally, the higher a firm’s total assets turnover, the more
efficiently its assets have been used.
Example:
total Assets Turn over (EMC for 2006) = 120,000 = 1.46
times 82,000
Interpretation:
 EMC generates birr 1.46 in net sales for

ever birr invested in total assets.. However,

this is below the industry average of 2
times
 A high ration suggests greater efficiency in

using assets to produce sales. The reverse

is true
 EMC should take steps to increase sales

(asset remains the same), dispose of its

investment in assets or both.
 4. PROFITABILITY RATIOS

It measures operating efficiency and ability to

ensure adequate return to shareholders.
In other words, they are used to evaluate the
overall management effectiveness and
efficiency in generating profit on sales, total
assets and owners’ equity.
Profitability ratio indicates the firm’s
effectiveness in terms of profit margins and
rate of return on investment. These groups of
ratio include;
a. Gross Profit Margin
 The gross profit margin measures the percentage of each sales birr remaining
after the firm has paid for its goods. The higher the gross profit margin, the
better and the lower the relative cost of merchandise sold.
Gross profit margin = sales – cost of good sold = gross profit
Sales
Sales
 This ratio indicates management’s effectiveness in
 Product pricing
 Generating sales
 Controlling production costs.
 Example: Gross profit margin for EMC (2006) = 30,000 = 25%
120,000
Interpretation: In EMC 25% remain from each birr sales after
deducting cost of goods sold from net sales. EMC’s gross profit
margin is slightly lower than the industry average of 26%
suggesting that the firm is similar to other companies in it
industry with regard to pricing policies and production costs.
b. Operating profit Margin.
 Operating profit margin measures the percentage of each birr remaining
after all cost and expenses other than interest and taxes are deducted.
 It represents the pure profit earned on each sales birr.
Operating profit margin = Operating profit
Sales
Example:
operating profit margin (for EMC 2006)
= EBIT = 14,250 = 11.88%
Net sales 120,000
Interpretation: EMC generates 11.88% or approximately
12 cents in operating profits per birr of net sales. This ratio
is below the industry average of 15.50% and may suggest
that relative to the average firm in the industry. EMC has
higher operating cost, and/ or lower selling prices.
c. Net profit margin
The net profit margin measures the percentage of
each sales birr remaining after all costs and expenses,
including interest and taxes have been deducted.
Net profit margin = net profit after tax = 6666 = 5.56%
Sales 120,000

This lower profit margin occurs because costs and

expenses are too high. High cost and expenses, in
turn, generally occur because of inefficient operations.
A low net profit margin is also a result of its heavy use
of debt, which brought high interest cost.
d. Return on Investment (ROI) or Return on total asset (ROA)
 This measures the overall effectiveness of management in
generating profit with its available assets. The higher the
firm’s return on total assets, the better its total assets is
used in generating profits.
Return on investment (total assets) ROA = Net profit after taxes

Total Assets

Example; ROI (ROA) for EMC 2006 = Net income = 6,666 = 8.13%
Total Assets 82,00 0

Interpretation: EMC generates little more than 8 cents for

every birr invested in assets EMC’s 8.13% ROI is
substantially below the industry average of the 12%. To
improve its profit margin EMC should increase its sales
relative to its cost or reduce costs relative to sales.
e. Return on Equity (ROE)
The return of equity measures the return earned on the
owners’ (preferred and common stockholders’) as an
indicator of management’s performance. Generally, the
higher this return, the better off is the owners.
ROE = Net profit after tax
Stockholders’ equity
Example: ROE = 6,666 = 18.02
37,000
Interpretation: EMC generates about 18 cents for every birr
in shareholders’ equity. This is below the industry average of
21.82%. A substantially high ROE may indicate that a firm is
more risky due to higher financial leverage. A substantially low
ROE may indicate more conservative financing.
 5. MARKET / BOOK RATIOS

 These ratios are primarily used for investment decisions

and long-range planning
a. Earnings per share (EPS)
 Expresses the profit earned per common share
outstanding during the reporting period.
EPS = Net income after tax – preferred stock dividend
Number of common shares outstanding.
Example: EPS for EMC for 2006 = Birr 6,666 = 5.127 =
5.13
1,300 shares
Interpretation: EMC’s EPS of birr 5.13 is below the
industry average of birr 15.50. This may deter prospective
investors from investing in the company and existing
investors could present challenge of management. Note –
EPS doesn’t show how much is paid as dividend and how
much is retained.
b. Price/ Earnings ratio(P/E) ;
Expresses the multiple that the market places on a firm’s
EPS and is commonly used to assess the owner’s appraisal
of share value
P/E ratio = market price per common share
EPS
Show how much investor is willing to pay per birr of
reported profit.
The price currently paid by market for each birr (dollar)
currently reported EPS
Measures investors’ expectation and the market appraisal
of performance of the firm
The higher P/E ratio, the greater the investors’ confidence
in the firm’s future
P/E for EMC for 2006 = 35/5.13 = 6.82 times
Interpretation: the market is willing to pay
about 7 for every birr in earnings. However,
the market is willing to pay 12 for every birr in
earnings for other firms in the industry. EMC’s
lower P/E, suggests that investors don’t value
EMC as highly as other firms
Note: a high P/E multiple often reflects the
market’s perception of the firm’s growth
prospects. Thus, if investors believe that a
firm’s future earnings potential is good, they
may be willing to pay a higher price of the
stock and boost its P/E multiple.
c. Book-Value Per Share:
It is the value of each share of common stock based the firm’s accounting
records.
Book-value per share = total stock equity – preferred stock
Number of common shares outstanding
Example: Book-value per share = 37,000 = 28.46
1,300
d. Dividend per share (DPS)
This shows the dollar amount of dividends paid on a share of common stock
outstanding during the reporting period.

DPS = total cash dividends on common shares

Number of common shares outstanding

Example: DPS for EMC for 2006 = 2600= Birr. 2

1,300 shares
Interpretation: EMC pays birr 2 in dividends for each
share of common stock outstanding that is more than the
industry average of birr 1.10 per share.
EMC pays more cash dividends than the industry
average
EMC retains fewer earnings than the industry average.
Increase in Retained Earnings = (EPS – DPS)
(number of common shares outstanding)
= (5.13 -2) (1.300) = birr 4,066 = (5.1277 -2)1300 = 4,066
Check: Retained Earnings Ending – Retained Earning Beginning
= 16,816 -12,750 = 4,066
Net income – common dividend = 6,666 – 2,600 = Br.4, 066
e. Dividend payout ratio.
This shows the percentage of earnings paid to shareholders. It
expresses the cash dividends paid per share as a percentage of EPS.
Dividend Payout Ratio = cash dividends per share
EPS
Or = total dividends to common stock
Total earnings available for common stockholders

Example: Dividend Payout Ratio for EMC for 2006 = 2 / 5.13 =

39% or 2,600 / 6,666 = 39%
Interpretation: EMC paid 39% of its earnings in dividends that are
higher tan the 20% industry average. This higher ratio may reflect
EMC’s lower growth opportunities than the average for other firms
in its industry.
f. Dividend Yield
This shows the ratio earned by shareholders
from dividends relative to the current price of
the stock. Dividend yield is part of a stock’s
total return.
Dividend Yield = Cash Dividends Per Share
Current Market Price per
Share.
Example:
Dividend yield for EMC for 2006 = 2 / 35
= 5.71.
Problems with financial statement Analysis

One particularly severe problem is that many

firms are conglomerates, owning more or less
unrelated lines of business.
The consolidated financial statements for
such firms don’t fit any neat industry
category.
The existence of different standards and
procedures makes it difficult to compare
financial statements across national borders.
Different firms use different accounting
procedures—for inventory, for example. This
makes it difficult to compare statements.
Different firms end their fiscal years at
different times.
For firms in seasonal businesses (such as a
retailer with a large Christmas season), this
can lead to difficulties in comparing balance
sheets because of fluctuations in accounts
during the year.