Chapter-One An Overview of Financial Management

1.1. Finance and Financial Management

Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques
and practices related with raising and utilizing of funds (money) by individuals, businesses, and
governments.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments. It is concerned with
the processes, institutions, markets, and instruments involved in the transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the person
making the financial decision. Hence, finance can also be defined as the art and science of
managing money. Finance is one of the important and integral part of business concerns, hence,
it plays a major role in every part of the business activities. It is used in all the area of the
activities under the different names.
Finance is generally divided into three areas: (1) financial management, (2) capital markets, and
(3) investments.
Financial management, also called corporate finance, focuses on decisions relating to how much
and what types of assets to acquire, how to raise the capital needed to buy assets, and how to run
the firm so as to maximize its value. The same principles apply to both for-profit and not-for-
profit organizations; and as the title suggests, much of this course is concerned with financial
management.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
1.2. Financial management decisions
The financial manager must be concerned with three basic types of decisions. Those decisions
are concerned with the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm must
make. These are:
 Investment decisions
 Financing decisions
 Dividend decisions
1.2.1. Investment Decisions
They deal with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
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 i) Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.
iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current assets and
short – term liabilities. The later, on the other hand, involves long – term investment decisions
like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.2.2. Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether
the firm should use equity or debt funds in order to finance its assets. They are also concerned
with determining the most appropriate composition of short – term and long – term financing.
In simple terms, the financing decisions deal with determining the best financing mix or capital
structure of the firm. The financing decisions of a firm are generally concerned with the right
side of the basic accounting equation.
1.2.3. Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong and
healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.
1.3. Basic forms of business organizations
The basics of financial management are the same for all businesses, large or small, regardless of
how they are organized. Still, a firm’s legal structure affects its operations and thus should be
recognized. There are three different legal forms of business organization—sole proprietorship,
partnership, and corporation.
1.3.1. Sole Proprietorship- A sole proprietorship is a business owned by one person. This is
the simplest type of business to start and is the least regulated form of organization.
Depending on where you live, you might be able to start up a proprietorship by doing
little more than getting a business license and opening your doors. For this reason, there
are more proprietorships than any other type of business, and many businesses that later
become large corporations start out as small proprietorships.
The owner of a sole proprietorship keeps all the profits. That’s the good news. The
bad news is that the owner has unlimited liability for business debts. This means that
creditors can look beyond business assets to the proprietor’s personal assets for payment.
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 Similarly, there is no distinction between personal and business income, so all business
income is taxed as personal income.
1.3.2. Partnership
A partnership is similar to a proprietorship, except that there are two or more owners
(partners). In a commonly known general partnership, all the partners share in gains or
losses, and all have unlimited liability for all partnership debts, not just some particular
share. The way partnership gains (and losses) are divided is described in the partnership
agreement.
The advantages and disadvantages of a partnership are basically the same as those of a
proprietorship. Partnerships based on a relatively informal agreement are easy and
inexpensive to form. General partners have unlimited liability for partnership debts, and
the partnership terminates when a general partner wishes to sell out or dies. All income is
taxed as personal income to the partners, and the amount of equity that can be raised is
limited to the partners’ combined wealth. Ownership of a general partnership is not easily
transferred, because a transfer requires that a new partnership be formed.
Based on our discussion, the primary disadvantages of sole proprietorships and
partnerships as forms of business organization are (1) unlimited liability for business
debts on the part of the owners, (2) limited life of the business, and (3) difficulty of
transferring ownership. These three disadvantages add up to a single, central problem:
the ability of such businesses to grow can be seriously limited by an inability to raise
cash for investment.
1.3.3. Corporation
The Corporation is the most important form of business organization. A corporation is a
legal “person” separate and distinct from its owners, and it has many of the rights, duties,
and privileges of an actual person. Corporations can borrow money and own property,
can sue and be sued, and can enter into contracts. A corporation can even be a general
partner or a limited partner in a partnership, and a corporation can own stock in another
corporation.
Not surprisingly, starting a corporation is somewhat more complicated than starting
the other forms of business organization. Forming a corporation involves preparing
articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation
must contain a number of things, including the corporation’s name, its intended life
(which can be forever), its business purpose, and the number of shares that can be issued.
This information must normally be supplied to the state in which the firm will be
incorporated. For most legal purposes, the corporation is a “resident” of that state.
The bylaws are rules describing how the corporation regulates its own existence. For
example, the bylaws describe how directors are elected. These bylaws may be a very
simple statement of a few rules and procedures, or they may be quite extensive for a
large corporation. The bylaws may be amended or extended from time to time by the
stockholders.

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 In a large corporation, the stockholders and the managers are usually separate groups.
The stockholders elect the board of directors, who then select the managers. Management
is charged with running the corporation’s affairs in the stockholders’ interests. In
principle, stockholders control the corporation because they elect the directors. As a
result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and
the life of the corporation is therefore not limited. The corporation borrows money in its
own name. As a result, the stockholders in a corporation have limited liability for
corporate debts. The most they can lose is what they have invested.
The relative ease of transferring ownership, the limited liability for business debts,
and the unlimited life of the business are the reasons why the corporate form is superior
when it comes to raising cash.
1.4. Goal of the firm
Assuming that we restrict ourselves to for-profit businesses, the goal of financial
management is to make money or add value for the owners. This goal is a little vague, of
course, so we examine some different ways of formulating it in order to come up with a more
precise definition. Such a definition is important because it leads to an objective basis for
making and evaluating financial decisions.
Possible Goals
If we were to consider possible financial goals, we might come up with some ideas like the
following:
o Survive.
o Avoid financial distress and bankruptcy.
o Beat the competition.
o Maximize sales or market share.
o Minimize costs.
o Maximize profits.
o Maintain steady earnings growth.
These are only a few of the goals we could list. Furthermore, each of these possibilities
presents problems as a goal for the financial manager. For example, it’s easy to increase
market share or unit sales; all we have to do is lower our prices or relax our credit terms.
Similarly, we can always cut costs simply by doing away with things such as research and
development. We can avoid bankruptcy by never borrowing any money or never taking any
risks, and so on. It’s not clear that any of these actions are in the stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a
very precise objective. Do we mean profits this year? If so, then we should note that actions
such as deferring maintenance, letting inventories run down, and taking other short-run cost-
cutting measures will tend to increase profits now, but these activities aren’t necessarily
desirable.

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The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but
it’s still unclear exactly what this means. First, do we mean something like accounting net
income or earnings per share? Second, what do we mean by the long run? As a famous
economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t
tell us what the appropriate trade-off is between current and future profits. The goals we’ve
listed here are all different, but they do tend to fall into two classes.
The first of these relates to profitability. The goals involving sales, market share, and
cost control all relate, at least potentially, to different ways of earning or increasing profits.
The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in
some way to controlling risk. Unfortunately, these two types of goals are somewhat
contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really
possible to maximize both safety and profit. What we need, therefore, is a
goal that encompasses both factors

The Goal of Financial Management

The financial manager in a corporation makes decisions for the stockholders of the firm.
Given this, instead of listing possible goals for the financial manager, we really need to
answer a more fundamental question: From the stockholders’ point of view, what is a good
financial management decision? If we assume that stockholders buy stock because they seek
to gain financially, then the answer is obvious: good decisions increase the value of the stock,
and poor decisions decrease the value of the stock. Given our observations, it follows that the
financial manager acts in the shareholders’ best interests by making decisions that increase
the value of the stock. The appropriate goal for the financial manager can thus be stated quite
easily:

The goal of maximizing the value of the stock avoids the problems associated with the
different goals we listed earlier. There is no ambiguity in the criterion, and there is no short-
run versus long-run issue. We explicitly mean that our goal is to maximize the current stock
value. If this goal seems a little strong or one-dimensional to you, keep in mind that the
stockholders in a firm are residual owners. By this we mean that they are only entitled to
what is left after employees, suppliers, and creditors (and anyone else with a legitimate
claim) are paid their due. If any of these groups go unpaid, the stockholders get nothing. So,
if the stockholders are winning in the sense that the leftover, residual, portion is growing, it
must be true that everyone else is winning also. Because the goal of financial management is
to maximize the value of the stock, we need to learn how to identify those investments and
financing arrangements that favorably impact the value of the stock. This is precisely what

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 we will be studying. In fact, we could have defined corporate finance as the study of the
relationship between business decisions and the value of the stock in the business.
A More General Goal
Given our goal as stated in the preceding section (maximize the value of the stock), an
obvious question comes up: What is the appropriate goal when the firm has no traded stock?
Corporations are certainly not the only type of business; and the stock in many corporations
rarely changes hands, so it’s difficult to say what the value per share is at any given time.
As long as we are dealing with for-profit businesses, only a slight modification is needed.
The total value of the stock in a corporation is simply equal to the value of the owners’
equity. Therefore, a more general way of stating our goal is as follows: maximize the market
value of the existing owners’ equity. With this in mind, it doesn’t matter whether the
business is a proprietorship, a partnership, or a corporation. For each of these, good financial
decisions increase the market value of the owners’ equity and poor financial decisions
decrease it. In fact, although we choose to focus on corporations in the chapters ahead, the
principles we develop apply to all forms of business. Many of them even apply to the not-for-
profit sector. Finally, our goal does not imply that the financial manager should take illegal
or unethical actions in the hope of increasing the value of the equity in the firm. What we
mean is that the financial manager best serves the owners of the business by identifying
goods and services that add value to the firm because they are desired and valued in the free
marketplace.
1.5. Financial Markets and Institutions
We’ve seen that the primary advantages of the corporate form of organization are that ownership
can be transferred more quickly and easily than with other forms and that money can be raised
more readily. Both of these advantages are significantly enhanced by the existence of financial
markets, and financial markets play an extremely important role in corporate finance.
A financial market, like any market, is just a way of bringing buyers and sellers together. In
financial markets, it is debt and equity securities that are bought and sold. Financial markets
differ in detail, however. The most important differences concern the types of securities that are
traded, how trading is conducted, and who the buyers and sellers are. Some of these differences
are discussed next.
✓ Primary versus Secondary Markets
Financial markets function as both primary and secondary markets for debt and equity securities.
The term primary market refers to the original sale of securities by governments and
corporations. The secondary markets are those in which these securities are bought and sold after
the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued
by both governments and corporations. In the discussion that follows, we focus on corporate
securities only.
Primary Markets In a primary market transaction, the corporation is the seller, and the
transaction raises money for the corporation. Corporations engage in two types of primary
market transactions: public offerings and private placements. A public offering, as the name

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suggests, involves selling securities to the general public, whereas a private placement is a
negotiated sale involving a specific buyer. By law, public offerings of debt and equity must be
registered with the Securities and Exchange Commission (SEC). Registration requires the firm to
disclose a great deal of information before selling any securities. The accounting, legal, and
selling costs of public offerings can be considerable. Partly to avoid the various regulatory
requirements and the expense of public offerings, debt and equity are often sold privately to large
financial institutions such as life insurance companies or mutual funds. Such private placements
do not have to be registered with the SEC and do not require the involvement of underwriters
(investment banks that specialize in selling securities to the public).
Secondary Markets A secondary market transaction involves one owner or creditor selling to
another. It is therefore the secondary markets that provide the means for transferring ownership
of corporate securities. Although a corporation is only directly involved in a primary market
transaction (when it sells securities to raise cash), the secondary markets are still critical to large
corporations. The reason is that investors are much more willing to purchase securities in a
primary market transaction when they know that those securities can later be resold if desired.
Dealer versus Auction Markets There are two kinds of secondary markets: auction markets and
dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car
dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers
and sellers, but they do not actually own the commodity that is bought or sold. A real estate
agent, for example, does not normally buy and sell houses.
Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most
trading in debt securities takes place over the counter. The expression over the counter refers to
days of old when securities were literally bought and sold at counters in offices around the
country. Today, a significant fraction of the market for stocks and almost all of the market for
long-term debt have no central location; the many dealers are connected electronically.
Auction markets differ from dealer markets in two ways. First, an auction market or exchange
has a physical location (like Wall Street). Second, in a dealer market, most of the buying and
selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to
match those who wish to sell with those who wish to buy. Dealers play a limited role.

✓ Money markets versus Capital markets

Money markets versus capital markets. Money markets are the markets for short-term, highly
liquid debt securities. The New York, London, and Tokyo money markets are among the worlds
largest. Capital markets are the markets for intermediate- or long-term debt and corporate stocks.
The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a
prime example of a capital market. There is no hard-and-fast rule, but in
a description of debt markets, short-term generally means less than 1 year, intermediate-term
means 1 to 10 years, and long-term means more than 10 years.

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.
 Chapter – 2: Financial Statement Analysis
2.1. Financial Statement Analysis
Financial statement information is used by both external and internal users, including investors,
creditors, managers, and executives. Financial statements by themselves do not give a complete
picture about a company’s financial condition, operating results, and cash flows. Neither can a
real value of financial statements could be derived in themselves alone. Therefore, to predict the
future and to help anticipate future conditions, financial statements should be analyzed further.
This analysis helps to identify current strengths and weakness of the firm. It facilitates planning
the future, and helps to control the firm’s financial activities better. To have all this benefits,
however, a finance person should perform a financial analysis. These users must analyze the
information in order to make business decisions, so understanding financial statements is of great
importance. There are three methods of performing financial statement analysis: Horizontal
analysis, Vertical analysis, and Ratio analysis.
2.1.1. Horizontal and Vertical Analysis
2.1.1.1. Horizontal Analysis
Methods of financial statement analysis generally involve comparing certain information. The
horizontal analysis compares specific items over a number of accounting periods. For example,
accounts payable may be compared over a period of months within a fiscal year, or revenue may
be compared over a period of several years. These comparisons are performed in one of two
different ways.
A) Absolute Dollars
One method of performing a horizontal financial statement analysis compares the absolute dollar
amounts of certain items over a period of time. For example, this method would compare the
actual dollar amount of operating expenses over a period of several accounting periods. This
method is valuable when trying to determine whether a company is conservative or excessive in
spending on certain items. This method also aids in determining the effects of outside influences
on the company, such as increasing gas prices or a reduction in the cost of materials.

B) Percentage
The other method of performing horizontal financial statement analysis compares the percentage
difference in certain items over a period of time. The dollar amount of the change is converted to
a percentage change. For example, a change in operating expenses from $1,000 in period one to
$1,050 in period two would be reported as a 5% increase. This method is particularly useful
when comparing small companies to large companies.
2.1.1.2. Vertical Analysis
The vertical analysis compares each separate figure to one specific figure in the financial
statement. The comparison is reported as a percentage. This method compares several items to
one certain item in the same accounting period. Users often expand upon vertical analysis by
comparing the analyses of several periods to one another. This can reveal trends that may be
helpful in decision making. An explanation of Vertical analysis of the income statement and
vertical analysis of the balance sheet follows.
A) Income Statement

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Performing vertical analysis of the income statement involves comparing each income statement
item to sales. Each item is then reported as a percentage of sales. For example, if sales equals
$10,000 and operating expenses equals $1,000, then operating expenses would be reported as
10% of sales.
B) Statements of Financial position /Balance Sheet
Performing vertical analysis of the statements of financial position /balance sheet involves
comparing each balance sheet item to total assets. Each item is then reported as a percentage of
total assets. For example, if cash equals $5,000 and total assets equals $25,000, then cash would
be reported as 20% of total assets.
2.1.2. Ratio Analysis
Ratio Analysis – is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages.
Like any other financial analysis, a ratio analysis helps us draw meaningful conclusions and
interpretations about a firm’s financial condition and performance..
There are several key ratios that reveal about the financial strengths and weaknesses of a firm.
We will look at five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.
2.1.2.1. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets. There are two
commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Statements of Financial position
December 31, 2017 and 2018
(In thousands of Birrs)
A s s e t s 2 0 1 8 2 0 1 7
C u r r e n t a s s e t s :
C a s h 9 , 0 0 0 7 , 0 0 0
M a r k e t a b l e s e c u r i t i e s 3 , 0 0 0 2 , 0 0 0
A c c o u n t s r e c e i v a b l e ( n e t ) 20,700 1 8 ,3 0 0
I n v e n t o r i e s 24,900 2 3 ,7 0 0
T o t a l c u r r e n t a s s e t s 57,600 5 1 ,0 0 0
F i x e d a s s e t s :
L a n d a n d b u i l d i n g s 33,000 2 7 ,0 0 0
P l a n t a n d e q u i p m e n t 130,500 1 2 0 , 0 0 0
T o t a l f i x e d a s s e t s 163,500 1 4 7 , 0 0 0
Less: accumulated depreciation 67,200 6 1 ,2 0 0
N e t f i x e d a s s e t s 96,300 8 5 ,8 0 0

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 T o t a l a s s e t s 153,900 1 3 6 , 8 0 0
Liabilities and stockholders’ equity
C u r r e n t l i a b i l i t i e s :
A c c o u n t s p a y a b l e 20,100 1 7 ,1 0 0
N o t e s p a y a b l e 14,700 1 3 ,2 0 0
T a x e s p a y a b l e 3 , 3 0 0 3 , 0 0 0
Total current liabilities 38,100 3 3 ,3 0 0
L o n g - t e r m d e b t :
M o r t g a g e b o n d s – 5 % 60,000 6 0 ,0 0 0
T o t a l l i a b i l i t i e s 98,100 9 3 ,3 0 0
S t o c k h o l d e r s ’ e q u i t y :
Share C apital —P reference–5% (B r. 100 par ) 6 , 0 0 0 -
Share Capital—Ordinary (Br. 10 par) 3 3 , 0 0 0 3 0 , 0 0 0
S h a r e P r e m i u m — O r d i n a r y 7 , 5 0 0 4 , 5 0 0
R e t a i n e d e a r n i n g s 9 , 3 0 0 9 , 0 0 0
Total stockholders’ equity 55,800 4 3 ,5 0 0
Total li abilities and stockholders’ equity 1 5 3 , 9 0 0 1 3 6 , 8 0 0
Zebra Share Company
Income Statement
For the Year Ended December 31, 2018
________________________________________________________________________

Net sales Br. 196,200,000

Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.
Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2018

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preference Br. 300,000

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 Ordinary 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000

i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
Zebra’s current ratio (for 2018) = Br. 57,600 = 1.51 times
Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in good
position to meet its current obligations. Conversely, relatively low current ratio is interpreted as
an indication that the firm may not be able to easily meet its current obligations.
A reasonably higher current ratio as compared to other firms in the same industry indicates
higher liquidity position. A very high current ratio, however, may indicate excessive inventories
and accounts receivable, or a firm is not making full use of its current borrowing capacity.
ii) Quick ratio (Acid – test ratio) - measures the short-term liquidity by removing the least liquid
current assets such as inventories. Inventories are removed because they are not readily or easily
convertible into cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities
by using its most liquid assets into cash.
Quick ratio = Current assets – Inventory
Current liabilities
Zebra’s quick ratio (for 2018) = Br. 57,600 – Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term obligations,
and the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more
detailed and penetrating test of a firm’s liquidity position as it considers only the quick asset. The
current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into
account all current assets without distinction.
2.1.2.2 Assets Management Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over)
into sales or cost of goods sold. Assets Management Ratios are also called Activity ratios, or
asset utilization ratios, or efficiency ratios. Generally, high turnover ratios are associated with
good asset management and low turnover ratios with poor asset management.
Asset management ratios include:
i) Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is
being managed. It indicates how many times or how rapidly accounts receivable are converted
into cash during a year.

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Accounts receivable turnover = Net sales
Accounts receivable
Zebra’s accounts receivable turnover (for 2018) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or in adequate cash collection
efforts.
There are alternate ways to calculate accounts receivable value like average receivables and
ending receivables. Though many analysts prefer the first, in our case we have used the ending
balances. In computing the accounts receivable turnover ratio, if available, only credit sales
should be used in the numerator as accounts receivable arises only from credit sales.
ii) Days sales outstanding (DSO) – also called average collection period. It seeks to measure the
average number of days it takes for a firm to collect its accounts receivable. In other words, it
indicates how many days a firm’s sales are outstanding in accounts receivable.
Days sales outstanding = 365 days
Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days
9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days.
If Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve
the collection period.
The average collection period of a firm is directly affected by the accounts receivable turnover
ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover – measures how many times per year the inventory level is sold (turned
over).
Inventory turnover = Cost of goods sold
Inventory
For Zebra Company (2018) = Br. 159,600 = 6.41times
Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator
rather than sales. But when cost of goods sold data is not available, we can apply sales.
In general, a high inventory turnover is better than a low turnover. But abnormally high
inventory turnover might result from very low level of inventory. This indicates that stock outs
will occur and sales have been very low.
A very low turnover, on the other hand, results from excessive inventory levels, presence of
inferior quality, damaged or obsolete inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows how
many birrs of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales
Net fixed assets

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.
Zebra’s fixed assets turnover =Br. 196,200= 2.04X
Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.
A fixed assets turnover ratio substantially lower than other similar firms indicates
underutilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.
The fixed assets turnover may be deceptively low or high. This is because the book values of
fixed assets may be considerably affected by cost of assets, time elapsed since their acquisition,
or method of depreciation used.
v) Total assets turnover – indicates the amount of net sales generated from each birr of total
tangible assets. It is a measure of the firm’s management efficiency in managing its assets.
Total assets turnover = Net Sales
Total assets
Zebra’s total assets turnover = Br. 196,200 = 1.27X
Br. 153, 900
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested
in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.
2.1.2.3. Debt Management Ratios
Debt Management Ratios are also called Leverage ratios or utilization ratios. They measure the
extent to which a firm is financed with debt, or the firm’s ability to generate sufficient income to
meet its debt obligations. While there are many leverage ratios, we will look at only the
following three.
i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.
Debt ratio = Total liabilities
Total assets
Zebra’s debt ratio = Br. 98,100 = 64%
Br. 153,900
Interpretation: At the end of 2018, 64% of Zebra’s total assets was financed by debt and 36%
(100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources. Debt
ratio reflects the capital structure of a firm. The higher the debt ratio, the more the firm’s
financial risk.
ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available
to meet its interest obligations. However, earnings before interest and taxes is an income concept
and not a direct measure of cash. Hence, this ratio provides only an indirect measure of the
firm’s ability to meet its interest payments.
iii) Fixed charges coverage – measures the ability of a firms to meet all fixed obligations rather
than interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.

Fixed charges coverage = Income before fixed charges and taxes

Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease payment.
Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700

Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are
safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.
The fixed charges coverage ratio is required because failure of the firm to meet any financial
obligation will endanger the position of a firm.
2.1.2.4. Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, total assets,
and owner’s equity. The following ratios are among the many measures of a firm’s profitability.
i) Profit Margin – shows the percentage of each birr of net sales remaining after deducting all
expenses.
Profit margin = Net income
Net Sales
Zebra’s profit margin = Br. 3,900 = 2%
Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as
well as the amount of all costs and expenses of a firm.
ii) Return on investment (assets) – measures how profitably a firm has used its investment in
total assets.
Return on investment = Net income
Total assets

Zebra’s return on investment = Br. 3,900 = 2.53 %

Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments
made by themselves.
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment
1 – Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better off the owners.
2.1.2.5. Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:
i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common
stock outstanding. It does not reflect how much is paid as dividends.
Earnings per share = Net income – Preferred stock dividend
Number of common shares outstanding
Zebra’s Eps for 2018 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2018.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each
share of its common stock outstanding.
Dividends per Share =Total cash dividends on common shares
Number of common shares outstanding
Zebra’s DPs for 2018 =Br. 3,300 = Br. 1.00
Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.
Dividends pay-out = Dividends per share
Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%
Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
1. Problems/ Limitations of ratio analysis
Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.
2. Sometimes a comparison of ratios between different firms is difficult. One reason could be a
single firm may have different divisions operating in different industries. Another reason could
be the financial statements may not be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when they are not
audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example,
the inventory turnover ratio for a stationery materials selling company will be different at
different time periods of a year.

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Lecture Notes/Financial Management -I, AcFn3041, Chapter One and Two.