Unit Three Financial Analysis
Unit Three Financial Analysis
Unit Three Financial Analysis
Financial analysis
1
Financial statements
The objective of financial statements is to
provide financial information of the business
to all users to help them in their decision
making.
Financial statements of a company contains a
lot of information about the financial
performance of the company.
These statements give the overall picture of
the company, but to analyze each and every
aspect of the business extensively, financial
analysis is a must. 2
Financial Analysis
Financial analysis is the examination of a
business from a variety perspectives in order to
fully understand the financial situation and
determine how best to strengthen the business.
Is the process of identifying the financial
strengths and weaknesses of the firm by
properly establishing a relationship between the
items of balance sheet and income statement.
A financial analysis looks at many aspects of a
business from its profitability and stability to its
solvency and liquidity. 3
Types of ratio comparisons
(standard of comparison)
Ratios do not reveal by themselves. A single
ratio in it self do not indicate favorable or
unfavorable condition. It should compared
with some standards.
1. Time series analysis:
Is the process of evaluating the performance
of the firm overtime.
2. Cross-sectional analysis:
Involves the comparison of different firms’
financial ratios at the same point in time. 4
Cont…
i.e. Comparing ratio of one firm with some
other selected firms in the same industry at the
same time in time.
Cross sectional analysis can be made:
a. Competitors ratio: Comparing the
ratios of the firm with the ratios of
some selected firms, especially with
the most successful
b. Industry ratio: Comparing the ratio
of the firm with the average ratios
of the industry to which the firm
belongs
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Cont…
3. Performa analysis:
Involves the comparison of the firms ratio
with the future ratios of the firm. Future
ratios can be developed from the projected or
projected financial statements.
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Ratio analysis
Ratio-analysis is the most common,
comprehensive and powerful tool of the
financial statement analysis. It the process of
computing, determining and presenting the
relationship of related items and groups of
items of the financial statements.
Ratio analysis is defined as the systematic use
of ratio to interpret the financial statements so
the strength and weakness of the firm as well
as its historical performance and current
financial condition can be determined.
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Cont…
The term ratio refers to the numerical or
quantitative relationship between two items
or variables. Or
It is one number expressed in terms of the
other and can be worked out by dividing one
number in to the other.
This relationship can be expressed as:-
1) Proportion(ratio)
2) Fraction
3) Percentage
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Categories of Financial Ratios
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1. Liquidity Ratios
Liquidity ratios describe the ability of a firm
to meet its current obligations as and when
they come due with current assets i.e.
The primary concern is the firm’s ability to
pay its bills over the short run without undue
stress.
‘Liquidity’ refers to the speed with which an
asset can be converted to cash
Generally, it refers to the short-term of
solvency of the firm
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There are three common measures of liquidity
ratios:
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I. The Current Ratio
It is the most common ratio for measuring the firms short
term solvency.
It indicates the availability of current asset in birr for
every one birr of current liability.
Current Assets
CR
Current Liabilities
40,000 = 2.22 times
CR = 18,000
Interpretations: ABC company has $2.22 of current assets for every $1 of
current liabilities.
Suggestion: As compared with the average industry (2:1), ABC is in a
good position to pay its current obligation with out a such big problem.
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II. The Quick Ratio
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2. Asset Management Ratios
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Cont…
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I. The Inventory Turnover Ratio
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II. Days of holding inventory
DHI 360
=
ITR
17
The higher DHI is bad, the lower DHI is good.
The higher ITR, the lower DHI.
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III. The A/R Turnover Ratio
It Measures how rapidly receivables are collected.
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V. The Fixed Asset Turnover Ratio
It measures the efficiency with which the firm uses its
fixed assets to generate sales.
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VI. The Total Asset Turnover Ratio
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TATO = 120,0000 = 1.46 times
82,000
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3. Leverage Ratios
Are also called debt management ratio, capital
structure ratio, solvency ratio.
As a general rule there should be an appropriate mix of
debt and owners’ equity in financing the firm’s asset.
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Financial leverage has 3 important
implications:
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The use of debt is advantageous for
shareholders in three ways
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The use debt is more risky from the firm’s
point of view
This is because :
1. The firm has a legal obligation to pay interest to
debt holders, irrespective of the profits made or
losses incurred by the firm.
2. When the firm fails to pay to debt holders in
time, they can take a legal action and can force
the firm into liquidation.
3. Highly debt-burdened firm will find difficulty in
raising funds from creditors and owners in
future.
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Types of debt management ratio
I. Debt ratio
II. Debt-equity ratio
III. Equity multiplier
IV. Interest coverage ratio
V. Cash ratio
VI. Fixed payment coverage ratio
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Financial leverage
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I. The Total Debt Ratio
It measures the proportion of total assets financed by
the firm’s creditors.
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II. The Debt to Equity Ratio
Equity = 82,000
multiplier 37,000
OR
The higher the ratio, the better able the firm to fulfill its
interest obligation.
EBIT
TIE
Interest Expense
TIE 14,250 = 3.43 times
ratio = 4,150
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Cont…
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V. The Cash Coverage Ratio
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VI. The Fixed Charge Coverage Ratio
It measures the firm's ability to meet all fixed payment
obligations such as interest, principal amt, lease payments,
and preferred stock dividends.
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14,250 + 1,650
FCCR = 4,150 +1,650 +[3000 +0] *[1/(1 -0.34)
1.54 times
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4. Profitability Ratios
Profitability ratios refers to a company
abilities to generate revenue in excess of the
costs incurred in producing these revenues.
I.e. Are calculated to measure the over all
operating efficiency of a company.
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I. The Gross Profit Margin
Measures the percentage of each sales birr remaining after
the firm has paid for its manufacturing cost.
Gross Profit
GPM
Sales
40
Cont…
30,000
GP = = 0.25 = 25%
120,000
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II. The Operating Profit Margin
It measures the percentage of each sales birr remaining
after all costs and expenses other than interest and taxes
are deducted.
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Cont…
14,250
OPM= = 0.1188 = 11.88%
120,000
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III. The Net Profit Margin
It measures the percentage of each sales birr remaining
after all costs and expenses, including interest and taxes
have been deducted.
Net Income
NPM
Sales
44
Cont…
6,666
NPM= = 0.0556 = 5.56%
120,000
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IV. The Return on Total Assets
It is also called return on investment.
Net Income
ROA
Total Assets
6,666
ROA = 82,000 = 0.0813 = 8.13%
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V. The Return on Equity
Measures the return earned on the shareholders
investment in the firm.
Net Income
ROE
Total Equity
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VI. The Return on Common Equity
It measures the return earned on common stock holders
investment in the firm.
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5. Market Value Ratios
The market valuation ratios provide an indication of
the relative under- or over-pricing of a firm’s stock:
I.e. They relate the firms market value, as measured
by its current share price , to certain accounting
values like its earning, cash flow and book value per
share.
Those ratios give management an indication of what
investors think of the past performance and future
prospects. If the liquidity, asset management, debt
management and profitability ratios all look good ,
then the market value ratios will be high and the
stock price would probability be as high as can be
expected. 49
I. The earning per share(EPS)
It measures the return available to common
stockholders on a per share basis.
Represents the amount of birr earned during the
period on the behalf of each common stock
outstanding.
Stock Pr ice
P/E
Earnings per Share
21
P/E = = 4.0952
5.128 53
V. Dividend yield
Dividend yield is a stock’s dividend as a
percentage of the stock price.
Dividend yields are a measure of an investment’s
productivity, and some even view it like an
"interest rate" earned on an investment.
Dividend yield = cash dividend per share
Current market price per share
= 2 = .0952 = 9.52%
21
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VI. The book value per share
37,000,000 = 28.46/share
=
1,300,000
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