Department of Business Administration

MBA 806: Corporate Finance

First Semester: 2019/2020

Topic: Financial Statement Analysis

1. Nature of Financial Statement Analysis

Financial statement analysis is the method by which users extract information from accounting
statements to answer their investment or other related questions about a firm. Thus, since the
beginning of business activity, and with it, delegation of responsibility, the owner of the invested
resources requires to monitor and evaluate the stewardship of the operating manager in an
agency relationship. Although merchants began to record transactions some centuries ago, the
fundamental concept of modern financial statements steams from the reaction to the 1929 stock
market crash and the creation of the Securities and Exchange Commissions (SECs) around the
world. Since then, public companies are required to present formal report of their financial
performances in accordance with the provisions of various regulatory bodies, such as the
Company Act provision and other regulatory legislations. Of the various reports that
corporations provide to their stockholders, annual report is arguably the most important. This
reports provides two types of information.

v First, there is a verbal section, often presented as a letter from the chairperson of the
corporation that describes the firm’s operating results during the past year and discusses new
developments that will affect future operations.
v Second, the annual report provides four basic financial statements - the balance sheet, the
income statement, the statement of stockholders’ equity, and the statement of cash flows.

These four statements contain much of the essential historical information about a firm’s
performance and operations. In other words, the statements show where a company has been, so
as to enable users determine where it should go. However, the analysis of these statements is an
essential skill in a variety of occupations including investment management, corporate financing
through commercial lending, and the extension of credit.

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2. Forms and Purpose of Financial Statements

The form of the financial statements is the way in which the statements, and their component
parts relate to each other. Thus, the form is given by a set of accounting relations that express the
various components of financial statements in terms of other components. These four basic
financial statements presented in annual reports are as follows:

a) The Balance Sheet: The balance sheet is the first financial statement of a corporation that
shows what assets the company own and all claims on those assets as of a given date — for
example, December 31, 2018. In other words, it is an accountant’s snapshot of the firm’s
accounting value on a particular date. The balance sheet has two sides: on the left are the
assets, which are things of economic value the company owns and, on the right the liabilities
and stakeholders’ equity. Thus, balance sheet contains three parts, and in accounting
language, the three parts are expressed as:

Total Assets = Total Liabilities + Stockholders’ Equity

Which also means, Shareholders’ equity = Assets – Liabilities

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 Table 1: A typical balance sheet for Miyetti Industries as at December 31, 2018.

Miyetti Industries Ltd Balance Sheets as at December 31 2018 (Millions of Dollars)

ASSETS 2018 2017 LIABILITIES AND EQUITY 2018 2017

Cash and equivalents $10 $15 Accounts payable $60 $30

Short-term investments 0 65 Notes payable 110 60

Accounts receivable 375 315 Accruals 140 130

Inventories 615 415 Total current liabilities $310 $220

Total current assets $1,000 $ 810 Long-term bonds 754 580

Net plant and equipment 1,000 870 Total liabilities $1,064 $800

Preferred stock (400,000 40 40

shares)

Common stock (50,000,000 130 130

shares)

Retained earnings 766 710

Total common equity $ 896 $ 840

Total assets $2,000 $1,680 Total liabilities and equity $2,000 $1,680

In finance perspective, a firm’s balance sheet has six important sections of information, namely:
current assets accounts/cash accounts, working capital accounts, long-term capital assets
accounts, current liabilities accounts, long-term debt/liabilities accounts and ownership
accounts. These six sections are briefly explained as follows:

i. Current Assets – These are the cash account balance available to be spent, marketable and
highly liquid securities, accounts receivable and inventories (work-in-progress, finished stock
and raw materials).
ii. Long-term capital assets accounts - These represents the capital investment of the company
in things such as land, buildings, and machinery. These are assets that provide the basis for

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 producing goods and services. Most companies classified their long-term capital assets under:
§ Plant, property and equipment, and
§ Other long-term assets, such as intangible assets like goodwill, patents, copyrights and
other resources that have value, but are not physical assets.

iii. Current Liabilities: these include: accounts payable, notes payable, and accruals. For
instance, employees’ daily, weekly or monthly wages and the amount the company owes
on these items at any point in time are called “accrual” or “accrued expenses.

iv. Working capital accounts (WCAs) - the working capital accounts are the current assets and
current liabilities of the company. The measure of the relationship between current asset and
current liabilities is net working capital. For Miyetti Industries, the equation to obtain net
working capital for year 2018 is: current assets – current liabilities ($1,000 - $310 = $690).

v. Long-term liabilities/debt accounts – These are debts that a company must pay more than
one year from now. These claims may be from banks and bondholders who have provided
capital to the company, but whose entire repayment is not due during the current operating cycle.

vi. Ownership accounts – the final section in the balance sheet is the ownership accounts or
owners’ equity. Owner’s equity represents the residual value of the company after satisfying all
liabilities. Typically, it is made-up of:

§ Common stock: – Reflects the capital contributed to the firm by the stockholders, and
§ Retained earnings: Are earnings of the company that it reinvests in its core business. Other
long-term assets, such as intangible assets like patents and copyrights that have value, but
are not physical assets.

b) The Income Statement: This is the second financial statement that measures a company’s
financial performance over a specific period of time. It deals with the firm’s sources of income
(coming up from sales) and costs (expenses or value going out in earning revenue) during some
past period—for example, 2018. It is also referred to as profit and loss statement, which
presents the results of business operations during a specified period of time. Corporate owners
use income statement to measure the company’s financial performance over a specific period of

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 time (quarterly or annually for outside distribution, and monthly for internal management). It
summarizes and categorizes company’s revenues and expenses associated with producing those
revenues for that period. Income statement also reports the profits of the company in the form of
net income. The accounting definition of income statement is:

Revenues – operating expenses = Earnings before interest and taxes (EBIT).

The income statement usually includes several sections. The operations section reports the firm’s
revenues or sales from where various operating expenses are subtracted, which results to -
earnings before interest and taxes (EBIT). The interest here referred to financing cost, while
taxes are the prevailing corporate tax payable.

Investors often focus on the net income that a firm generates when determining how well the
firm has performed during a particular time period. This is because the net income is the
accounting profit from the operations of the company during the period. However, if investors
are concerned with whether management is pursuing the goal of maximizing the firm’s stock
price, net income might not be the appropriate measure to examine. Financial analysts more
importantly, want to know the cash flow from business operations, and in this case, we use the
framework of the income statement to find the operations of the company (an accounting
measure) and then make adjustments to it to find the cash flow from the operations. A typical
income statement is presented for Miyetti Industries at Table 2 below.

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Table 2: Miyetti Industries Ltd: Income Statements for Year Ending December 31 2018
(All in millions of Dollars, except for per share data).
Miyetti Industries Ltd: Income Statements for Year Ending December 31
(Millions of Dollars, Except for Per Share Data)
2018 2017
Net sales $3,000.0 $2,850.0
Operating costs excluding depreciation and amortization 2,616.2 2,497.7
Earnings before interest, taxes, depreciation and amortization $ 383.8 $ 353.0
(EBITDA)
Depreciation 100.0 90.0
Amortization 0.0 0.0
Depreciation and amortization $ 100.0 $ 90.0
Earnings before interest and taxes (EBIT, or operating income) $ 283.8 $ 203.0
Less interest expenses 78.3 81.2
Earnings before taxes (EBIT) $ 195.8 $ 203.0
Taxes (40%) 78.3 81.2
Net income before preferred dividends $ 117.5 $121.8
Preferred dividends 4.0 4.0
Net income $ 113.5 $ 117.8
Additional Information
Common dividends $ 57.5 $ 53.0
Addition to retained earnings $ 56.0 $ 64.8
Per Share Data
Common stock price $ 23.00 $ 26.00
Earnings per share (EPS) $ 2.27 $ 2.36
Dividends per share (DPS) $ 1.15 $ 1.06
Book value per share (BVPS) $ 17.92 $ 16.80
Cash flow per share (CFPS) $ 4.27 $ 4.16
Note: There are 50,000,000 shares of common stock outstanding and EPS is based on earnings after
preferred dividends — that is, on net income available to common stockholders.

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To achieve this, we must first deal with three fundamental issues that separate net income and
cash flow:
• Accrual-based accounting – the company recognizes and records sales and expenses at a
given point in time, regardless of when the cash transactions occur (both cash and credit
sales)
• Noncash expenses items – We should regard that the annual depreciation expenses
(sometimes includes amortization and bad debt expenses) on the income statement is not an
actual cash outflow during the period. In this case, the accounting profits are adjusted to
reflect it and other noncash expenses.
• Interest expenses – In finance we prefer to classify interest expenses as part of the financing
decisions of the firm, and not as part of the operating decisions. The operating cash flows are
defined as those that arise from normal operations; the difference between cash collections
and cash expenses associated with the manufacture and sale of inventory. Thus, the operating
cash flow is obtained when the net income is adjusted for depreciation and interest expense.
The operating cash flows arise from normal operations; the difference between cash
collections and cash expenses associated with the manufacture and sale of inventory.

For instance, we can find the operating cash flow (OCF) of Miyetti Industries Ltd for the year
ended as follows:
Operating cash flow (OCF) = EBIT + depreciation - taxes
Where EBIT = $283.8 million
Depreciation = $100.0 million
Taxes = 40% = $78.3million
The OCF = ($283.8 million + $100.0 million) – $78.3 million
= 383.8 million – $78.3 million
$305.5 million

Although, apart from operating cash flows arising from the normal operations, there are other
cash flows from borrowing, from sale of fixed assets, or from repurchase of common stock.

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c). The Statement of Stockholders’ Equity: Even though some company regulations require
companies to provide statement of retained earnings which reports the change in the firm’s
retained earnings as a result of the income generated and retained during the year, retained
earnings, as reported on the balance sheet does not represent cash and is not “available” for the
payment of dividends or anything else. More so, the amount reported in the retained earnings
account is not an indication of the amount of cash the firm has, as cash (as of the balance sheet
date) is found in the cash account.

For some of these reasons, recent development in financial theory indicates the significance of
the statement of stockholders’ equity because it provides changes in stockholders’ equity
during the accounting period. This statement presents the distribution of net income for the
past period. It starts with beginning-of-period equity and ends with end-of-period equity, thus
explaining how the equity changed over the period. This can be defined as:

Ending equity = (Beginning equity + Total income) – (Net payout to shareholders)

This is referred to as the stocks and flows equation for equity because it explains how stocks of
equity (at the beginning and end of the period) changed with flows of equity during the period.
Owners’ equity increases from value added in business activities through income and decreases
if there is a net payout to owners. A net payout is amount paid to shareholders less amounts
received from share issues. Just as cash can be paid out in dividends or share repurchases, the
equation for a net payout is expressed as:

Net payout = (Stock repurchase + dividends) – (Proceeds from share issues)

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A typical statement of stockholders’ equity for Miyetti Industries is presented in table 3 below:

Table 3: Miyetti Industries Ltd Statement of Stockholders’ Equity

COMMON STOCK (MILLIONS)

SHARES AMOUNT RETAINED TOTAL

EARNINGS EQUITY

Balances, Dec 31, 2017 50 $130.0 $710.0 $840.0

Net income $113.5 $113.5

Cash dividends (57.5) (57.5)

Issuance of common stock 0 0.0

Balance, Dec 31, 2018 50 $130.0 $766.0 $896.0

From table 3 above, it shows that:

v Miyetti Industries earned $113.5 million during 2018,

v The paid out was $57.5 million in common dividends for the same period
v Reinvested $56 million back into the business ($113.5 million - $57.5 million).

Thus, the balance sheet item “Retained earnings” increased from $710 million at year-end 2017
to $766 million at year-end 2018 (Balance as at 2017 plus Reinvested sum of $56 million). Note
that, in financial parlance, “retained earnings” does not represent assets but instead a claim
against assets.

As indicated in the table 3, in 2017, Miyetti’s stockholders were allowed it to reinvest $56
(being differences of $766 million and $710 million) instead of distributing the money as
dividends, and management spent this money on new assets. Thus, the retained earnings, as
reported on the balance sheet, does not represent cash and is not “available” for the payment of

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 dividends or anything else.

d) The Statement of Cash Flows: A statement of cash flow is a report that shows how things that
affect the balance sheet and income statement affect the firm’s cash flows. The statement shows
how much cash the firm began the year with, how much cash it ended up with, and what it did to
increase or decrease its cash. It is important to note that, the net income as reported on the
income statement is not cash; and in finance, “cash is king.” Management’s goal is to maximize
the price of the firm’s stock; and the value of any asset, including a share of stock, is based on
the cash flows the asset is expected to produce.

For instance, even if a company reports a large net income during a year, the amount of cash
reported on its year-end balance sheet may be the same or even lower than its beginning cash.
The reason is that its net income can be used in a variety of ways, not just kept as cash in the
bank. For example, the firm may use its net income to pay dividends, to increase inventories, to
invest in fixed assets, to reduce debt, or to buy back common stock. Indeed, the company’s cash
position as reported on its balance sheet is affected by many factors, which include the
following:
§ Net income before preferred dividends: Other things held constant, a positive net income
will lead to more cash in the bank.
§ Noncash adjustments to net income: To calculate cash flow, it is necessary to adjust net
income to reflect noncash revenues and expenses, such as depreciation and deferred
taxes, as shown previously in the calculation of net cash flow.
§ Changes in working capital: Increases in current assets other than cash (such as
inventories and accounts receivable) decrease cash, whereas decreases in these accounts
increase cash. For example, if inventories are to increase, then the firm must use some of
its cash to acquire the additional inventory. Conversely, if inventories decrease, this
generally means the firm is selling inventories and not replacing all of them, hence
generating cash. On the other hand, if payables increase then the firm has received
additional credit from its suppliers, which saves cash, but if payables decrease, this means
it has used cash to pay off its suppliers. Therefore, increases in current liabilities such as
accounts payable increase cash, whereas decreases in current liabilities decrease cash.
§ Investments: If a company invests in fixed assets or short-term financial investments, it

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 will reduce its cash position. On the other hand, if it sells some fixed assets or short-term
investments, its cash will increase.
§ Security transactions and dividend payments. If a company issues stock or bonds during
the year, the funds raised will increase its cash position. On the other hand, if the
company uses cash to buy back outstanding stock or to pay off debt, or if it pays
dividends to its shareholders, this will reduce cash. Each of these five factors is reflected
in the statement of cash flows, which summarizes the changes in a company’s cash
position.
For these five reasons, managers must strive to maximize the cash flows available to investors by
designing how the firm’s operations. Unlike in balance sheet and income statement accounts,
where we showed how the cash flow is partitioned into cash from assets, cash flow to creditors,
and cash flow to owners, in the statement of cash flows, it ties back to the cash flow identity.
These cash flows identity are into three sections, namely:
• Cash flows from operating activities,
• Cash flow from investing activities, and
• Cash flow from financing activities.

Therefore, if you are ever analyzing a company and are pressed for time, look first at the trend in
net cash flow provided by operating activities, because it will tell you more than any other
number.

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Table 4: Statement of Cash Flows of Miyetti Industries Ltd for 2018

Statement of Cash Flows of Miyetti Industries Ltd for 2018 (Millions of Dollars)
Cash Provided or
Used.
Operating Activities
Net income before preferred dividends $117.7
Adjustments
Non cash adjustments
Depreciation 100.0
Due to changes in working capital
Increase in accounts receivable (60.0)
Increase in inventories (200.0)
Increase in accounts payable 30.0
Increase in accruals 10.0
Net cash provided (used) by operating activities ($2.5)
Investing Activities
Cash used to acquire fixed assets ($230.0)
Sale of short-term investments $ 65.0
Net cash provided (used) by investing activities ($165.0)
Financing Activities
Increase in notes payable $ 50.0
Increase in bonds outstanding 174.0
Payment of preferred and common dividends (61.5)
Net cash provided (used) by financing activities $162.5
Summary
Not change in cash ($5.0)
Cash at beginning of year 15.0
Cash at end of year $10.0

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 The statement of cash flows or the sources and uses of cash in table 4 above also illuminates the
impact of the three basic areas for the year: These areas include:

v Operating activities: This includes net income, depreciation, changes in current assets and
liabilities other than cash, short-term investments, and short-term debt.
v Investing activities: It includes investments in or sales of fixed assets and short-term financial
investments.
v Financing activities: This relates to raising cash by issuing short-term debt, long-term debt, or
stock. But, because dividend payments, stock repurchases, and principal payments on debt
reduce a company’s cash, such transactions are included here.

Note: On the statement of cash flows, sources signify cash inflows (positive amounts), and uses in
parentheses – signify cash outflows (negative amounts).
Therefore: the sources – the uses = changes in the cash account for the year.

Generally, the statement of cash flows offers to answer the question relating to: decrease in cash or
changes in current assets and changes in current liabilities. For instance:
§ Is the firm generating the cash needed to purchase additional fixed assets for its growth?
§ Does the firm generate any extra cash that can be used to repay debt or to invest in new
product?

Understanding these information is useful both for managers and investors, as such an essential part
of the annual report. In addition, the cash flow statement does more than enrich the analysis of
companies encountering risks and opportunities that the income statement and balance sheet are not
designed to portray. It also helps to identify the life-cycle categories into which companies fit. At
all stages of development, and whatever challenges a company faces, financial flexibility is
essential to meeting those challenges. The cash flow statement is the best tool for measuring
flexibility. More so, in the hands of an aggressive but prudent management, a cash flow cushion can
enable a company to sustain essential long-term investment spending when competitors are forced
to cut back.

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For instance, Table 4 shows Miyetti Industries Ltd statement of cash flow, as it would appear in the
company’s annual report. The top section shows cash generated by and used in operations—for
Miyetti Ltd operations provided net cash flows of minus $2.5 million. This subtotal, the minus $2.5
million net cash flow provided by operating activities, is in many respects the most important figure
in any of the financial statements. Profits as reported on the income statement can be “doctored” by
such tactics as depreciating assets too slowly, not recognizing bad debts promptly, and the like.
However, it is far more difficult to simultaneously doctor profits and the working capital accounts.
Therefore, it is not uncommon for a company to report positive net income right up to the day it
declares bankruptcy. In such cases, however, the net cash flow from operations almost always
began to deteriorate much earlier, and analysts who kept an eye on cash flow could have predicted
trouble. Therefore, if you are ever analyzing a company and are pressed for time, look first at the
trend in net cash flow provided by operating activities, because it will tell you more than any other
number.

The second section shows investing activities, and it indicates that Miyetti Industries purchased
fixed assets totaling $230 million and sold $65 million of short-term investments, for a net cash
flow from investing activities of minus $165 million. The third and the financing activities section
include borrowing from banks (notes payable), selling new bonds, and paying dividends on
common and preferred stock. It shows Miyetti Industries raised $224 million by borrowing, but it
paid $61.5 million in preferred and common dividends. Therefore, its net inflow of funds from
financing activities was $162.5 million.

In the summary, when all of these sources and uses of cash are totaled, it suggests that Miyetti
Industries Ltd’s cash outflows exceeded its cash inflows by $5 million during 2018; that is, its net
change in cash was a negative $5 million. To any analysts and managers, Miyetti Industries’
statement of cash flows should be worrisome, because the company had a $2.5 million cash
shortfall from operations, it spent an additional $230 million on new fixed assets, and it paid out
another $61.5 million in dividends. It covered these cash outlays by borrowing heavily and by
liquidating $65 million of short-term investments. Obviously, this situation cannot continue year
after year, so something will have to be done.

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 B: Purpose of Financial Statements

Financial statements are the lenses on a business through which the analyst must understand how
statements need to be appreciated. Although, the primary goal of financial reporting is to
disseminate financial statements that accurately measure the profitability and financial condition
of a company, the main objectives of financial statements includes:

§ To provide information about the reporting entity’s financial performance and financial
position that is useful to a wide range of users for assessing the stewardship of the entity’s
management;
§ To focus exclusively on the information needs of present and potential users;
§ To be adaptable to the environment where it is needed.

So, taking good financial decision requires the understanding and use of information presented in
the financial statements of firms. This understanding helps us in evaluating a firm’s past or
present performance, which in turn, informs our financial decision-making. Nevertheless,
accounting and finance view the numbers from financial statements differently. From finance
perspective, looking at firm’s financial statements help us to decide where to go and the best way
to get there. However, accounting perspective looks back to where a company has been. In other
words, the accountants provide the information and present it from a historical viewpoint, and
the financial group uses it to project into future and make sound financial decisions.

Overall, the four financial statements help to explain many details necessary to gain a more
complete picture of the firm’s performance. For this purpose, the statement must be seen to disclose:
v How specific item was computed
v Additional information on a company’s financial condition
v Special issues concerning its debt or contingent accounts
v Information on the potential effect of a pending lawsuit
v Events regarding a loss or impairment
v Methods used to prepare the financial statements
v Differences between prior estimates and actual results.

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 In deed, there are several tools used in evaluating corporate performance. These include ration
analysis, credit analysis, Economic value added, market value added, and several others.

3. Financial Ratio Analysis?

Financial ratios are the relationships between different accounts from financial statements and these
include the income statement and the balance sheet that serve as performance indicators. Ratio
analysis is one of the main tools used to measure financial performance of an organization or a
division of an organization by investors, shareholders, and other stakeholders. In other words, these
tools provide a quick and relatively simple means of examining the health and financial condition of
a business. The nature of analysis and recommendations will of course differ depending on the
purpose of the analyst and the type of company or industry. For example:
v Current and prospective shareholders are interested in the firm’s present and projected level of
earnings or profitability.
v Other investors may focus on measuring the liquidity and leverage in order to determine the
likelihood of the firm’s continued existence and to evaluate the probability of receiving any
distribution of the firm’s earnings or growth in earnings.
v Trade creditors (short-term creditors) and the suppliers of long-term debt have different and
essential concerns on the information provided in financial statements of corporations.
v The firm’s management is to use ratios in order to monitor the performance of the entity from
period to period. For instance, the management are often concerned with the likelihood of any
unexpected changes, with a view to isolating them from developing future problems.

Other users of ratio analysis are the stakeholders in finance and investment, and these include the
following:
v Managers: The management of a company employs ratios to help analyse, control, and thus
improve the firm’s operations.
v Credit analyst: This group include bank loan officers and bond rating analysts, they analyse
ratios to help ascertain a company’s ability to pay its debts
v Security analysts or investors: They include stock analysts who are interested in the company’s
efficiency and growth prospects, and bond analysts, who are concerned with a company’s ability

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 to pay interest on its bonds and liquidation value of the firm’s assets in the event that the
company fails.
v Investors/prospective shareholders: They are concerned with likely return on investment (ability
to generate acceptable dividend, growth and bankruptcy).

Types of Ratios
There are many types of ratios used in answering pertinent performance questions using accounting
numbers in the balance sheet and income statements. These include:
i. Liquidity Ratios
ii. Asset Management or Activity Ratios
iii. Debt Management/Financial Leverage or Gearing Ratios
iv. Profitability Ratios
v. Market Value Ratios

a) Liquidity ratios (Short-term solvency): These are ratios, which give us an idea of the firm’s
ability to pay off debts that are maturing within a year. In other words, liquidity ratios measure a
company’s ability to meet its short-term debt obligations in a timely fashion. It deals with the
firm’s current assets and current liabilities accounts. These accounts track the assets that the
company expects to turn into cash in the near future and the liabilities that are expected to become
due in the near future. This is because, if the company is unable to meet its short-term cash
obligations, it may find itself in bankruptcy. However, in determining the liquidity of a company,
we use current ratio and quick (acid test) ratio in assessing its liquidity.
i. Current ratio is defined as: current assets/current liabilities
Therefore, Miyetti’s current ratio = $1000/$310 = 3.2 times

As a conventional rule, a current ratio greater than 1 tells us the current assets can generate
enough cash to cover the current liabilities becoming due and still keep the company out of
short-term cash problems. This is because the basic source from which to pay these debts are
current assets. Based on this principle, Miyetti’s current ratio of 3.2 times is adequate enough to
offset its current liabilities. However, where the industry average of the type of Miyetti
operations is 4.2 times, then the 3.2 times is insufficient to redeem the short-term liabilities.

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ii. Quick (Acid Test) ratio = The ratio is calculated by deducting inventories from current
assets and then dividing the remainder by current liabilities:
(Current assets – Inventory)/Current liabilities
For Miyetti: ($1,000 - $615)/310

= $385/$310 = 1.2 times

Note that, inventories are typically the least liquid of a firm’s current assets; and if sales slow
down, they might not be converted to cash as quickly as expected. Also, inventories are the
assets on which losses are most likely to occur in the event of liquidation. Therefore, the quick
ratio, which measures the firm’s ability to pay off short-term obligations without relying on the
sale of inventories, is important. However, if the industry average quick ratio is 2.2, so Miyetti’s
1.2 times ratio is relatively low. Still, if the accounts receivable can be collected, the company
can pay off its current liabilities even if it has trouble disposing of its inventories.

b) Asset Management/Activity Ratios: The asset management ratios, measure how effectively the
firm is managing its assets. These ratios answer this question: Does the amount of each type of
asset seem reasonable, too high, or too low in view of current and projected sales? These ratios
are important because when Miyetti acquire assets, they must obtain capital from banks or other
sources and capital is expensive. Therefore, if Miyetti has too many assets, its cost of capital will
be too high, which will depress its profits. On the other hand, if its assets are too low, profitable
sales will be lost. So Miyetti must strike a balance between too many and too few assets, and
the asset management ratios will help it strike this proper balance.
i. Inventory/Stock Turnover Ratio: Turnover ratios show how many times the particular
asset is “turned over” during the year. It is calculated by dividing the sales by inventories.

Thus, inventory ratio for Miyetti = Sales/Inventories

= $3,000/$615
4.9 times

Industry average is 10.9 times

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 As a rough approximation, each item of Miyetti’s inventory is sold and restocked, or “turned
over,” 4.9 times per year. However, Miyetti’s inventory turnover of 4.9 is much lower than the
industry average of 10.9. This suggests that it is holding too much inventory. Excess inventory
is, of course, unproductive and represents an investment with a low or zero rate of return.

ii. Days Sales Outstanding (DSO): This ratio also called the average collection period (ACP) is
calculated by dividing accounts receivable by average sales per day to find out how many
day’s sales are tied up in receivables. Thus, the DSO represents the average length of time the
firm must wait after making a sale before receiving cash.

For Miyetti, the DSO = Receivables/Average sales per day

= Receivables/(Annual sales/365)

= $375/($3,000/365)

= $375/$8.2192

= 45.625 days = Approx. = 46 days

Industry average = 36 days

The DSO can be compared with the industry average of 36 days, but it is also evaluated by
comparing it with Myetti’s credit terms. However, the high average DSO indicates that if some
customers are paying on time, quite a few must be paying very late. Late- paying customers often
default, so their receivables may end up as bad debts that can never be collected. This suggests
that, Miyetti’s credit manager should take steps to collect receivables faster.

iii. Total Assets Turnover/Efficiency Ratio: This ratio measures the turnover of all of the
firm’s assets; and it is calculated by dividing sales by total assets.
This means, Miyetti’s total assets turnover ratio = Sales/ Total Assets
= $3,000/$2,000 = 1.5 times
Industry average = 1.8

Miyetti’s ratio is somewhat below the industry average, indicating that it is not generating

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enough sales given its total assets. Since we earlier found Miyetti’s fixed assets turnover
is in line with the industry average; so the problem is with its current assets, such as
inventories and accounts receivable, whose ratios were below the industry standards. It is
therefore advisable that, inventories should be reduced and receivables collected faster,
which would improve operations.

c) Debt Management/Financial Leverage or Gearing Ratios: A set of ratios that measure

how effectively a firm manages its debt. In other words, it gives us an idea of how the firm
has financed its assets as well as the firm’s ability to repay its long-term debt. It also helps to
know whether a company can handle interest expenses from debt with normal operations or
will need to seek additional capital to meet the debt. The ratios includes:

v Total Debt to Total Assets Ratio: This measures the percentage of funds provided by

creditors. It includes all current liabilities and long-term debt. Creditors prefer

low debt ratios because the lower the ratio, the greater the cushion against
creditors’ losses in the event of liquidation. Stockholders, on the other hand, may
want more
Total Debt to Total Assets Ratio is calculated as: Total debt/Total assets
For Miyetti’s ratio = (total current liability + Long-term Debt/Total Assets
= $310 + $754)/$2,000
=$1,064/$2,000 = 53.2%
Industry average = 40.0%

Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against
creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want more
leverage because it can magnify expected earnings. Miyetti’s debt ratio is 53.2%, which means
that its creditors have supplied more than half of its total funds. It also suggest that Miyetti’s debt
ratio exceeds the industry average by a fairly large amount. In this case, it will make it relatively
costly for Miyetti to borrow additional funds without first raising more equity. Creditors will also
be reluctant to lend the firm more money, and management would probably be subjecting the

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 firm to too high a risk of bankruptcy if it sought to borrow a substantial amount of additional
funds.

v Times-Interest-Earned (TIE) Ratio: The ratio of earnings before interest and taxes (EBIT)
to interest charges. This is a measure of the firm’s ability to meet its annual interest payments.
In other words, the ratio measures the extent to which operating income can decline before the
firm is unable to meet its annual interest costs. Failure to pay interest will bring legal action
by the firm’s creditors and probably result in bankruptcy. Note that, earnings before interest
and taxes, rather than net income, are used in the numerator. Because interest is paid with
pretax dollars, the firm’s ability to pay current interest is not affected by taxes.
Times-interest - earned (TIE) ratio = EBIT/Interest charges or Interest expenses

Time-interest earned ratio for Miyetti = $283.8/$78.3 = 3.6 times

Industry average = 6.0 time

Miyetti’s interest is covered 3.6 times. The industry average is 6 times, so Miyetti is covering its
interest charges by a relatively low margin of safety. Thus, the TIE ratio reinforces our
conclusion from the debt ratio, namely, that Miyetti would face difficulties if it attempted to
borrow additional funds.

d) Profitability Ratios: Is a group of ratios that measures how effective a company is turning sales
or assets into income. The ratios indicate how well the company has performed overall. By
calculating profitability ratios, it shows the combined effects of liquidity management, asset
management, and debt management on operating results. There are a large number of
profitability ratios; each relates the return of the firm to its sales, its assets, or its equity. This is
because without profits, a firm could not attract outside investors or capital. Often, company’s
creditors and owners would become concerned about the company’s future if its profitability
ratios are not greater than what investors can achieve on their own in capital markets. The
profitability ratios commonly used include:
v Net Profit Margin Ratio: This ratio measures net income per dollar of sales and is
calculated by dividing net income by sales.
Therefore, Net profit margin for Miyetti = Net Income /Sales.

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 = $113.5/$3,000 = 0.0378 or 3.78%
Net Profit margin for Miyetti = 3.8%
If the Industry average is given as = 5.0%

Then, Miyetti’s 3.8% profit margin is below the industry average of 5.0%, and this result
occurred for two reasons.

Ø First, because of the firm’s high operating costs.

Ø Second, the profit margin is negatively impacted by Miyetti’s heavy use of debt.

v Return on Total Assets or Return on Assets (ROA) or Return on Investment (ROI

Ratio: The ROA or ROI indicates how well the assets (investment in plant, property,
equipment, and so fort) are generating income. The ROA is calculated as follows:
Return on assets (ROA or ROI) = Net income/Total assets
The ROA of Miyetti is thus: $113.5/$2,000 = 0.0567 or 5.7%
Industry average = 9.0%

Miyetti’s 5.7% return is well below the 9.0% industry average. This is not good, and it is
obviously better to have a higher than a lower return on assets. A major reason for the low ROA
is the decision to use a great deal of debt. It thus suggests that, the high interest expenses or
payments causes net income to be relatively low.

v Return on Common Equity (ROE) Ratio: The most important, or bottom-line, accounting
ratio is the return on common equity (ROE).
ROE is calculated as: Net income/Total Common Equity
Miyetti’s ROE = $113.5/$896 = 0.1267 or 12.7%
Industry average = 15.0%

Stockholders expect to earn a return on their money, and this ratio tells how well they are doing
in an accounting sense. Miyetti’s 12.7% return is below the 15.0% industry average, but not as
far below as the return on total assets. This somewhat better ROE results from the company’s

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 greater use of debt.

e) Market Value Ratios: The market value ratios relate the firm’s stock price to its earnings and
book value per share. They give management an indication of what investors think of the
company’s future prospects based on its past performance. In this case, if the firm’s liquidity
ratios, debt management ratios, profitability ratios, and asset management ratios are all good, then
its market value ratios will be high, and its stock price will probably be as high as can be
expected. Of course, where the other ratios show otherwise, the opposite is also true. The market
value ratios are used in three primary ways: (1) by investors when they are deciding to buy
or sell a stock, (2) by investment bankers when they are setting the share price for a new
stock issue (an IPO), and (3) by firms when they are deciding how much to offer for
another firm in a potential merger. Some of the market value ratios commonly used includes:

v Price/Earnings (P/E) Ratio: The P/E ratio shows how much investors are willing to
pay per dollar of reported profits. In other words, it is the dollar amount investors will
pay for $1 of current earnings.
The P/E ratio is = Price per share/ or Price of common stock/Earnings per share
The P/E ratio for Miyetti = $23/$2.27 = 10.13 times
Where the industry average = 11.3 times

Miyetti’s P/E ratio is below its industry average, so this suggests that the company is regarded as
being relatively risky, as having poor growth prospects, or both. This because, P/E ratios are
relatively high for firms with strong growth prospects and little risk but low for slowly growing
and risky firms.

v Market to- Book Value Ratio: The ratio of a stock’s market price to its book value gives
another indication of how investors regard the company. The stocks of companies with
relatively high rates of return on equity generally sell at higher multiple of book value than
those with low returns.
To find the market/book value ratio:
First Step: Determine book value per share as:
Book value per share = Owners’ equity/ Number of common shares outstanding

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 For Miyetti = $896/50 = $17.92

Second Step: Determine the Market – to - Book Value Ratio as:

Market price per share/Book value per share

Miyetti’s Market to Book Value = $23./$17.92 = 1.28 times

Industry average: 1.7 times

There are also other ratios that investors often use in measuring company performance, and these
include:
• Dividend per share (DPS): earnings paid to shareholders/number of shares outstanding.
• Payout ratio: dividend per share/earning per share.
• Dividend yield as: dividend per share/share price

TREND ANALYSES

Trend Analysis: This is an analysis of a firm’s financial ratios over time used to estimate the
likelihood of improvement or deterioration in its financial condition. In other words, trends give
clue as to whether a firm’s financial condition is likely to improve or deteriorate. To determine
the financial performance using trend analysis, it starts with the analysis of trends in ratios as
well as their absolute levels. We can do this by plotting a ratio over time. All the other ratios
could be analyzed similarly. This would, for instance allow us to gain insights as to why the
ROE behaved as it did as against the industry average. Graphs are used in trend analysis
activities.

INDUSTRY RATIOS AND BENCHMARKING:

Industry Ratios: Although used often by financial analysts, financial ratios can vary across
industries. For instance, Airlines, Automobile, Pharmaceuticals, oil and gas, retail, computer
hardware, foods and beverages, financial institutions, all have different industrial basis. These
differences are partly informed by their differences in operations in terms of:

Ø Borrowing capacity and terms,

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 Ø Cash management (including rationale),
Ø Capital intensity (some required more fixed assets investment),
Ø Labor intensity, (both skilled and unskilled),
Ø Competition (extend and within a given environment),
Ø Regulations (within and across boarders)
Ø Timing (in terms of seasonal growth and decline, such as services industries like
school, newspaper advertisement etc.), and,
Ø Differences between indivudal companies in a given industry.

For example, if one were to compare Pfizer, a leading pharmaceutical firm) Exxon Mobile (a
large oil and gas company) in terms of profit margin, the assumption would be different from
what might likely be obtained. This suggest that ratios are just starting point.

Benchmarking: This is the process of comparing a particular company with a set of benchmark
companies. Ratio analysis involves comparison for useful interpretation of the firm’ performance.
A single ratio in itself does not indicate favorable or unfavorable conditions, until it is compared
with some standards consisting of the following:

i. Ratios calculated from the past financial statements of the same firm,
ii. Ratios developed using the projected or performance financial statement of the same
firm,
iii. Ratios of some selected firms, especially, the most progressive and successful,
iv. Ratios of the industry to which the firm belongs.

However, there are two ways or types of comparison in which financial ratios are used:
a) The cross-sectional approach: This involves the comparison of different firm’s financial
ratios at the same point in time. The typical business firm is interested in how well it has
performed in relation to its competitors. Often the firm’s performance will be compared to
that of the industry leader. This comparison may allow the firm to uncover major operating
differences, which if changed, will increase efficiency. In addition, the firm’s ratios can be
compared to industry averages.

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b) Time-series analysis: This is done when the financial analyst measures a firm’s performance
over time. Comparison of the firm’s current performance to past performance utilizing ratio
analysis allows the firm to determine whether it is progressing as planned. Generally, the
theory behind time-series analysis is that the firm must be evaluated in relation to its past
performances, and any developing trends must be isolated and appropriate action taken.
Time-series is therefore helpful in checking the reasonableness of a firm’s projected financial
statements.

Limitations of Ratio Analysis

Although ratio analysis can provide useful information concerning a company’s operations and
financial condition, it does have inherent problems and limitations that necessitate care and
judgment. Some of these potential problems include the following:

Ø Many large firms operate a number of divisions in very different industries. In such cases, it
is difficult to develop a meaningful set of industry averages for comparative purposes. More
so, ratio analysis tends to be more useful for small, narrowly focused firms than for large,
multidivisional firms.
Ø Most firms want to be better than average, so merely attaining average performance is not
necessarily good. As a target for high-level performance, it is best to focus on the industry
leaders’ ratios.
Ø Inflation might distort firm’s balance sheets. For example, if recorded values are historical,
they could be substantially different from the “true” values. Again, because inflation affects
both depreciation charges and inventory costs, it also affects profits. For these reasons, a ratio
analysis for one firm over time, or a comparative analysis of firms of different ages, must be
interpreted using judgment.

Ø Seasonal factors can distort a ratio analysis. For instance, the inventory turnover ratio for a
textile firm will be radically different if the balance sheet figure used for inventory is the one
just before the fall of fashion season (festival seasons) versus the one just after the close of
the season. You can minimize this problem by using monthly averages for inventory (and
receivables) when calculating ratios such as turnover.

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 Ø Firms can employ “window dressing” techniques to make their financial statements look
stronger. This often happens with some financial statements, especially financial
institutions.

Ø Differences in accounting practice can distort comparison. Since we know that inventory
valuation and depreciation methods can affect financial statements, and thus, the fact that
different methods can be used makes comparisons among firms difficult.

Ø It is difficult to generalize about whether a particular ratio is ‘good or bad.’ For example, a
high current ratio might indicate a strong liquidity position, which is good, or excessive
cash, which is bad (because excess cash in the bank is a nonearning asset). Similarly, a high
fixed asset turnover ratio might denote either a firm that uses it assets efficiently or one that
is undercapitalized and cannot afford to buy enough assets.
Ø A firm might have some ratios that look ‘good’ and others that look ‘bad’ making it difficult
to tell whether the company is, on balance, strong or weak.

Even through ratio analysis is still useful in determining financial performance of firms,
investors/analysts should be aware of these problems and make adjustments where necessary.
This is because, where ratios are used intelligently, and with good judgment, it can provide
useful insights into a firm’s operations. Probably, the most important and difficult input to
successful financial statement analysis, apart from the qualities of the statements, is the judgment
used when interpreting the results to reach an overall conclusion about the firm’s financial
position. Recently, many companies use statistical procedures to analyse firm’s financial ratios
and, on the basis of their analyses, classify companies according to their probability of getting
into financial trouble. Analysts are also encouraged to use reasonable judgment when
interpreting the results to reach an overall conclusion about the firm’s financial position.

LOOKING BEYOND THE NUMBERS

Sound financial analysis involves more than just number. A good analysis requires that certain
qualitative factors also be considered. These factors include the following:

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 § Are the company’s revenues tied to one key customer? If so, the company’s performance
may decline dramatically if that customer goes elsewhere. On the other hand, if the
customer has no alternative to the company’s products, this might actually stabilize sales.
§ To what extent are the company’s revenues tied to one key product? Firms that focus on a
single product are often efficient, but a lack of diversification also increases risk because
having revenues from several products stabilizes profits and cash flows in a volatile
world.
§ To what extent does the company rely on a single supplier? Depending on a single
supplier may lead to an unanticipated shortage and a hit to sales and profits.
§ What percentage of the company’s business is generated overseas? Companies with a
large percentage of overseas business are often able to realize higher growth and larger
profit margins. However, overseas operations may expose the firm to political risks and
exchange rate problems.
§ How much competition does the firm face? Increases in competition tend to lower prices
and profit margins; so when forecasting future performance, it is important to assess the
likely actions of current competitors and the entry of new ones.
§ Is it necessary for the company to continually invest in research and development? If so,
its future prospects will depend critically on the success of new products in the pipeline.
For example, investors in a pharmaceutical company want to know whether the company
has a strong pipeline of potential block- buster drugs and whether those products are
doing well in the required tests.

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