Chapter Two
Chapter Two
Chapter Two
The most widely used financial analysis technique is ratio analysis, the analysis of relationships
between two or more line items on the financial statements.
A ratio: Is the mathematical relationship between two quantities in the financial Statement.
Ratio analysis: is essentially concerned with the calculation of relationships which, after proper
identification and interpretation, may provide information about the operations and state of
affairs of a business enterprise. The analysis is used to provide indicators of past performance in
terms of critical success factors of a business. This assistance in decision-making reduces
reliance on guesswork and intuition, and establishes a basis for sound judgment.
2. Horizontal (Trend) Analysis
Horizontal Analysis expresses financial data from two or more accounting periods in terms of a
single designated base period; it compares data in each succeeding period with the amount for
the preceding period. For example, current to past or expected future for the same company.
3. Vertical (Static) Analysis
In vertical analysis, all the data in a particular financial statement are presented as a percentage
of a single designated line item in that statement. For example, we might report income
statement items as percentage of net sales, balance sheet items as a percentage of total assets; and
items in the statement of cash flows as a fraction or percentage of the change in cash.
4. Cross-Sectional Analysis
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It involves the comparison of different firm's financial ratios at the same point in time. The
typical business 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, and the firm may uncover
major operating deficiencies, if any, which, if changed, will increase efficiency. Another popular
type of comparison is to industry averages; the comparison of a particular ratio to the standard is
made to isolate any deviations from the norm. Too high or too low values reflect symptoms of a
problem. Comparing a Company's ratios to industry ratios provide a useful feel for how the
Company measures up to its Competitors. But, it is still true that company specific differences
can result in entirely justifiable deviations from industry norms. There is also no guarantee that
the industry as a whole knows what it is doing.
Time-Series Analysis – is applied when a financial analyst evaluates performance and positions
of a firm over time. The firm's present or recent ratios are compared with its own past ratios.
Comparing of current to past performance allows the firm to determine whether it is progressing
as planned.
2.1.4. Types of Financial Ratios
There are five basic categories of financial ratios. Each represents important aspects of the firm's
financial conditions. The categories consist of liquidity, activity, leverage, profitability and
market value ratios. Each category is explained by using an example set of financial ratios for
Lakomenza Company.
Let us use the financial statements of Lakomenza Company, shown below to investigate and
explain ratio analysis.
Lakomenza Company
Income Statements
Variables 2001 2000
Sales 3,074,000 2,567,000
Less Cost of Goods Sold 2,088,000 1,711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General and Adm. Expenses 468,000 445,000
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000
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Less Interest Expenses 93,000 91,000
Net Profit Before Tax 325,000 212,000
Less Profit Tax (at 29%) 94,250 61,480
Net Income After Tax 230,750 150,520
Less Preferred Stock Dividends 10,000 10,000
Earning Available to Common Shareholders 220,750 140,520
EPS 2.90 1.81
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Long-Term Debts 1,023,000 967,000
Total Liabilities 1,643,000 1,450,000
Shareholder's Equity
Preferred Stock –Cumulative, 2000 Share issued and Outstanding 200,000 200,000
Common Stock, Shares issued and Outstanding in 2001, 76,262; in 191,000 190,000
2000, 76,244
Current Assets
Current Ratio = Current Liabilities
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liabilities covered 1.97 times from its current liabilities. Current assets get converted in to cash
through the operating cycle and provide the funds needed to pay current liabilities. An ideal
current ratio is 2:1or more. This is because even if the value of the firm's current assets is
reduced by half, it can still meet its obligations.
However, between two firms with the same current ratio, the one with the higher proportion of
current assets in the form of cash and account receivables is more liquid than the one with those
in the form of inventories is liquid.
A very high current ratio than the Standard may indicate: excessive cash due to poor cash
management, excessive accounts receivable due to poor credit management, excessive
inventories due to poor inventory management, or a firm is not making full use of its current
borrowing capacity. A very Low current ratio than the Standard may indicate: difficulty in
paying its short term obligations, under stocking that may cause customer dissatisfaction.
B. Quick (Acid-test) Ratio: This ratio measures the short term liquidity by removing the least
liquid assets such as:
Inventories: are excluded because they are not easily and readily convertible into cash and
moreover, losses are most likely to occur in the event of selling inventories. Because inventories
are generally the least liquid of the firm's assets, it may be desirable to remove them from the
numerator of the current ratio, thus obtaining a more refined liquidity measure.
Prepaid Expenses such as; prepaid rent, prepaid insurance, and prepaid advertising, pre paid
supplies are excluded because they are not available to pay off current debts.
Acid-Test Ratio is computed as follows.
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Activity ratios are also known as assets management or turnover ratios. Turnover ratios measure
the degree to which assets are efficiently employed in the firm. These ratios indicate how well
the firm manages its assets. They provide the basis for assessing how the firm is efficiently or
intensively using its assets to generate sales. These ratios are called turnover ratios because they
show the speed with which assets are being converted into sales.
Measure of liquidity alone is generally inadequate because differences in the composition of a
firm's current assets affect the "true" liquidity of a firm i.e. Overall liquidity ratios generally do
not give an adequate picture of company’s real liquidity due to differences in the kinds of current
assets and liabilities the company holds. Thus, it is necessary to evaluate the activity ratio.
The major activity ratios are the following.
A. Inventory Turnover Ratio
The inventory turnover ratio measures the effectiveness or efficiency with which a firm is
managing its investments in inventories is reflected in the number of times that its inventories are
turned over (replaced) during the year. It is a rough measure of how many times per year the
inventory level is replaced or turned over.
Inventory Turnover = Cost of Goods Sold
Average Inventories
For the year of Lakomenza Company for 2001= 2,088,000/294,500*= 7.09 times
Interpretation: - Lakomenza's inventory is sold out or turned over 7.09 times per year.
In general, a high inventory turnover ratio is better than a low ratio.
An inventory turnover significantly higher than the industry average indicates: Superior selling
practice, improved profitability as less money is tied-up in inventory.
B. Average Age of Inventory
The number of days inventory is kept before it is sold to customers. It is calculated by dividing
the number of days in the year to the inventory turnover.
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This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it is
sold. The longer period indicates that, Lakomenza is keeping much inventory in its custody and,
the company is expected to reassess its marketing mechanisms that can boost its sales because, the
lengthening of the holding periods shows a greater risk of obsolescence and high holding costs.
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365 days
Average Collection period = Re ceivable Turnover
The average Collection period for Lakomenza Company for the year 2001 will be: 365 days/7.08
=51 days or
Average collection period = Average accounts receivables* 365 days/Sales
434,000* 365 days/3,074,000* = 51 days
The higher average collection period is an indication of reluctant collection policy where much
of the firm’s cash is tied up in the form of accounts receivables, whereas, the lower the average
collection period than the standard is also an indication of very aggressive collection policy
which could result in the reduction of sales revenue.
E. Fixed Asset Turnover
Measures the efficiency with which the firm has been using its fixed assets to generate revenue.
The Fixed Assets Turnover for Lakomenza Company for the year 2001 is calculated as follows.
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The Total Assets Turnover for Lakomenza Company for the year 2001 is as follows.
3,074,000 = 0.85
3,597,000
Interpretation: - Lakomenza Company generates birr 0.85 (85 cents) in net sales for every birr
invested in total assets. A high ratio suggests greater efficiency in using assets to produce sales
whereas, a low ratio suggests that Lakomenza is not generating a sufficient volume of sales for
the size of its investment in assets.
Caution- with respect to the use of this ratio, caution is needed as the calculations use historical
cost of fixed assets. Because, of inflation and historically based book values of assets, firms with
newer assets will tend to have lower turnovers than those firms with older assets having lower
book values. The difference in these turnovers results from more costly assets than from
differing operating efficiencies. Therefore, the financial manager should be cautious when using
these ratios for cross-sectional comparisons.
2.2.4.3. Leverage Ratios
Leverage ratios are also called solvency ratio. Solvency is a firm’s ability to pay long term debt
as they come due. Leverage shows the degree of debt of firm.
There are two types of debt measurement tools. These are:
A. Financial Leverage Ratio: These ratios examine balance sheet ratios and determine the
extent to which borrowed funds have been used to finance the firm. It is the relationship of
borrowed funds and owner capital.
B. Coverage Ratio: These ratios measure the risk of debt and calculated by income statement
ratios designed to determine the number of times fixed charges are covered by operating
profits. Hence, they are computed from information available in the income statement. It
measures the relationship between what is normally available from operations of the firm’s
and the claims of outsiders. The claims include loan principal and interest, lease payment and
preferred stock dividends.
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A.1, Debt Ratio: Shows the percentage of assets financed through debt. It is calculated as:
The debt ratio for Lakomenza Company for the year 2001 is as follows:
= 1,643 = 0.457 or 45.7 %
3,597
This indicates that the firm has financed 45.7 % of its assets with debt. Higher ratio shows more
of a firm’s assets are provided by creditors relative to owners indicating that, the firm may face
some difficulty in raising additional debt as creditors may require a higher rate of return (interest
rate) for taking high-risk. Creditors prefer moderate or low debt ratio, because low debt ratio
provides creditors more protection in case a firm experiences financial problems.
A.2. Debt -Equity Ratio: express the relationship between the amount of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of
creditors and shareholders against the asset of the firm.
The Debt- Equity Ratio for Lakomenza Company for the year 2001 is indicated as follows.
Debt- Equity ratio = 1,643,000 = 0.84 or 84 %
1,954,000
Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.
B. 1. Times Interest Earned Ratio: Measures the ability of a firm to pay interest on a timely
basis. Times Interest Earned Ratio =Earning Before Interest and Tax
Interest Expense
The times interest earned ratio for Lakomenza Company for the year 2001 is:
418,000 = 4.5 times
93,000
This ratio shows the fact that earnings of Lakomenza Company can decline 4.5 times without
causing financial losses to the Company, and creating an inability to meet the interest cost.
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B.2.Coverage Ratio: The problem with the times interest eared ratio is that, it is based on
earnings before interest and tax, which is not really a measure of cash available to pay interest.
One major reason is that, depreciation, a noncash expense has been deducted from earning before
Interest and Tax (EBIT). Since interest is a cash outflow, one way to define the cash coverage
ratio is as follows:
The gross profit margin for Lakomenza Company for the year 2001 is:
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Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: Lakomenza company profit is 32 cents for each birr of sales. A high gross profit
margin ratio is a sign of good management. A gross profit margin ratio may increase by: Higher
sales price, CGS remaining constant, lower CGS, sales prices remains constant. Whereas, a low
gross profit margin may reflect higher CGS due to the firm’s inability to purchase raw materials at
favorable terms, inefficient utilization of plant and machinery, or over investment in plant and
machinery, resulting higher cost of production.
B. Operating Profit Margin: This ratio is calculated by dividing the net operating profits by net
sales. The net operating profit is obtained by deducting depreciation from the gross operating
profit. The operating profit is calculated as:
Operating Profit Margin = Operating Profit
Net Sales
The operating profit margin of Lakomenza Company for the year 2001 is:
418,000 = 13.60
3,074,000
Interpretation: Lakomenza Company generates around 14 cents operating profit for each of birr
sales.
C. Net Profit Margin: This ratio is one of the very important ratios and measures the
profitableness of sales. It is calculated by dividing the net profit to sales. The net profit is
obtained by subtracting operating expenses and income taxes from the gross profit. Generally,
non-operating incomes and expenses are excluded for calculating this ratio. This ratio measures
the ability of the firm to turn each birr of sales in to net profit. A high net profit margin is a
welcome feature to a firm and it enables the firm to accelerate its profits at a faster rate than a
firm with a low profit margin. It is calculated as:
The net profit margin for Lakomenza Company for the year 2001 is:
230,750 = 7.5 %
3,074,000
This means that Lakomenza Company has acquired 7.5 cents profit from each birr of sales.
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D. Return on Investment (ROI): The return on investment also referred to as Return on Assets
measures the overall effectiveness of management in generating profit with its available assets,
i.e. how profitably the firm has used its assets. Income is earned by using the assets of a business
productively. The more efficient the production, the more profitable is the business.
The return on assets is calculated as: Return on Assets (ROA) = Net Income
Total Assets
The return on assets for Lakomenza Company for the year 2001 is:
230,750 = 6.4 %
3,597,000
Interpretation: Lakomenza Company generates only 6 cents for every birr invested in assets.
E. Return on Equity: The shareholders of a company may Comprise Equity share and
preferred shareholders. Preferred shareholders are the shareholders who have a priority in
receiving dividends (and in return of capital at the time of widening up of the Company). The
rate of dividend divided on the preferred shares is fixed. But the ordinary or common
shareholders are the residual claimants of the profits and ultimate beneficiaries of the Company.
The rate of dividends on these shares is not fixed. When the company earns profit it may
distribute all or part of the profits as dividends to the equity shareholders or retain them in the
business it self. But the profit after taxes and after preference shares dividend payments presents
the return as equity of the shareholders. The Return on equity is calculated as:
ROE = Net Income
Stockholders’ Equity
The Return on equity of Lakomenza Company for the year 2001 is:
230,750 = 11.8%
1,954,000
Interpretation: Lakomenza generates around12 cents for every birr in shareholder’s equity.
F. Earnings per Share (EPS): EPS is another measure of profitability of a firm from the point
of view of the ordinary shareholders. It reveals the profit available to each ordinary share. It is
calculated by dividing the profits available to ordinary shareholders (i.e. profit after tax minus
preference dividend) by the number of outstanding equity shares.
The earning per share is calculated as follows:
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EPS = Earning Available for Common Stockholders
Number of Shares of Common Stock Outstanding
Therefore, the earning per share of Lakomenza Company for the year 2001 is:
EPS = 220,750 = birr 2.90 per share
76,262 shares
Interpretation: Lakomenza Company earns birr 2.90 for each common shares outstanding.
Market Value Ratio:
Market value or valuation ratios are the most significant measures of a firm's performance, since
they measure the performance of the firm's common stocks in the capital market. This is known
as the market value of equity and reflects the risk and return associated with the firm's stocks.
These measures are based, in part, on information that is not necessarily contained in financial
statements – the market price per share of the stock. Obviously, these measures can only be
calculated directly for publicly traded companies.
The following are the important valuation ratios:
A. Price- Earnings (P/E) Ratio: The price earnings ratio is an indicator of the firm's growth
prospects, risk characteristics, shareholders orientation corporate reputation, and the firm's level
of liquidity. The P/E ratio can be calculated as:
The price per share could be the price of the share on a particular day or the average price for a
certain period.
Assume that Lakomenza Company's common stock at the end of 2001 was selling at birr 32.25,
using its EPS of birr 2.90, the P/E ratio at the end of 2001 is:
= 32.25/ 2.90 = 11.10
This figure indicates that, investors were paying birr 11.10 for each 1.00 of earnings.
Though there no a true measure of market value, the P/E ratio is commonly used to assess the
owners' appraisal of shares value. The P/E ratio represents the amount investors are willing to
pay for each birr of the firm's earnings. The level of P/E ratio indicates the degree of confidence
(or Certainty) that investors have in the firm's future performance. The higher the P/E ratio, the
greater the investor confidence on firms’ future prospects. It is a means of standardizing stock
prices to facilitate comparison among companies with different earnings.
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B. Market Value to Book Value (Market-to-Book) Ratios
The market value to book value ratio is a measure of the firm's contributing to wealth creation in
the society. It is calculated as:
Market-Book Ratio = Market Value per Share
Book Value per Share
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one just before versus just after the close of the coming season.
5. Firms can employ “window dressing” techniques to make their financial statements look
stronger.
6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation
and depreciation methods can affect financial statements and thus distort comparisons among
firms. Also, if one firm leases a substantial amount of its productive equipment, then its assets
may appear on the balance sheet. At the same time, the ability associated with the lease
obligation may not be shown as a debt. Therefore, leasing can artificially improve both the
turnover and the debt ratios.
7. It is difficult to generalize about whether a particular ratio is “good” or “bad”. For example, a
high current ratio may indicate a strong liquidity position, which is good or excessive cash,
which is bad (because excess cash in the bank is a non-earning asset).
Similarly, a high fixed asset turnover ratio may denote either that a firm uses its assets
efficiently or that it is undercapitalized and cannot afford to buy enough assets.
8. A firm may have some ratios that look “good” and other that look “bad”, making it difficult to
tell whether the company is, on balance, strong or weak. However, statistical procedures can
be used to analyze the net effects of a set of ratios. Many banks and other lending
organizations use discriminate analysis, a statistical technique, to analyze firm’s financial
ratios, and then classify the firms according to their probability of getting into financial
trouble.
9. Effective use of financial ratios requires that the financial statements upon which they are
based are accurate. Due to fraud, financial statements are not always accurate; hence
information based on reported data can be misleading. Ratio analysis is useful, but analysts
should be aware of these problems and make adjustments as necessary.
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