MAFCh 3

CHAPTER - THREE
FINANCIAL ANALYSIS
Financial Analysis
Financial analysis is the process of identifying
the financial strengths and weaknesses of the
firm by properly establishing relationships
between the item of the balance sheet and the
profit and loss account.
Financial Management, Ninth Edition ©

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Vikas Publishing House Pvt. Ltd.
Users of Financial Analysis
• Trade creditors
• Lenders
• Investors
• Management

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Nature of Ratio Analysis
 A financial ratio is a relationship between two
accounting numbers expressed mathematically.
 Ratios help to make a qualitative judgment
about the firm’s financial performance.

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Standards of Comparison
• Time series analysis
• Cross-sectional (Inter-firm analysis)
• Industry analysis
• Proforma financial statement analysis

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Cont’d
1.Time series ratio
It is comparison of present ratios with past
ratios
It reflects the direction of change in financial
performance.
2. Cross-sectional analysis
This is also called inter-firm analysis
It compares the ratio of one firm with the ratio
of some similar selected firms at the same point
in time.
Financial Management, Ninth Edition © I M Pandey 6
Cont’d
3. Industry analysis
This is comparison of one firm’s ratio against
with average industry’s ratio in which the firm is
a member.
4. proforma analysis
This is comparison of present or past financial
ratios with future ratios which is developed from
proforma financial statements
Financial Management, Ninth Edition © I M Pandey 7

Types of Financial Ratios
• Liquidity ratios Strength
• Leverage (capital structure) ratios
• Activity (Turnover) ratios
• Profitability ratios
Weakness

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A. Liquidity Ratios
• Liquidity ratios measure a firm’s ability to meet its
current obligations(current liability). By establishing
r/ship b/n Current Asset & Current Liability
• A firm should insure that it does not suffer from lack
of liquidity, and that it does not have excess liquidity.
The most common are:-
1.Current ratio
2. Quick ratio
3. Cash ratio
4. Interval measure

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1.Current ratio
• Current ratio = current asset
current liability
 Current assets include cash and those assets that can be
converted to cash with in one year.
 It indicates availability of current assets in birr for every one
birr of current liability.
 A ratio of greater than two means that the firm has more
current assets than current liability
How to interpret current ratio?
As a conventional rule, a current ratio of 2 to 1 or more is
considered satisfactory

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Cont’d
• example 1; as the firm’s balance sheet shows,
the current asset and current liability is equal
to 1,870 and 1,555 respectively, calculate and
interpret current ratio.
• Current ratio = 1870/1555
= 1.20 : 1
It can be interpreted as insufficiently liquid

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2. Quick ratio
• Quick ratio, also called acid-test ratio, establishes a relation
ship between quick or liquid assets and current liabilities.
• An asset is liquid if it can be converted to cash immediately or
reasonably soon without a loss of value.
• Cash is the most liquid asset. Other liquid assets include
marketable securities, debtors, and bills receivable. Inventory
is considered to be less liquid.
Quick ratio = current assets - inventory
current liabilities

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Contn’d
• Generally, a quick ratio of 1 to 1 is considered as satisfactory
financial position.
• Example2. If the firm has a current assets of 1,870 from which
inventory constitute of 1,150, and the current liability is equal
to 1,555, calculate quick ratio.
• Quick ratio = 1870 – 1150/1555
= 0.46:1
If the firm do not sell its inventory and it has to pay all its current
obligations, it may be difficult to meet its obligations because
its quick assets are 0.46 times of current liability

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3. Cash ratio
• Since cash is the most liquid asset, a financial
analyst may examine cash ratio which is the
relation ship between cash and cash
equivalents to current liability.
• Cash ratio = cash + marketable securities
current liability

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4. Interval measure
• An other ratio which measure the firm’s ability to meet its
regular daily cash expenses is called interval measure
• Interval measure relates liquid asset to average daily
operating cash outflows.
• Interval measure = current assets – inventory
average daily operating expense

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Cont’d
Example 3
•Assume, current asset = 1,870
•inventory = 1,150, and
• total operating expense excluding depreciation expense =
3,369
•Calculate interval measure
• interval measure = 1,870 – 1,150
3,369/360 days
= 720/ 9.34 =77days
This indicates that the firm has sufficient liquid assets to finance
its operations for 77 days
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B. Leverage ratio
• Leverage ratio indicates the mix of funds provided by
owners and lenders.
• Leverage ratios measure the dependence of a firm on
borrowed funds. Or the extent to which the firm relies
on debt in financing its assets.
• Leverage ratio is used to judge the long term financial
position of the firm.
1. Debt ratio
2. Debt-equity ratio
3. Capital employed to equity ratio
4. Total liability to total asset ratio, and
5. Interest coverage ratio
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1. Debt ratio
• It is the proportion of interest bearing total debt in the capital
structure of the firm.
• Debt ratio can be calculated by dividing total debt by capital
employed or net asset
Debt ratio = Debt
Debt + equity
= Debt
capital employed
Capital employed is equal to net asset (net fixed asset + net
current asset). Accordingly, debt ratio = total debt/ net asset.

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Example 4
• Assume that short term debt and long term debt = 389, and
839 respectively, owners equity equal to 672. calculate debt
ratio.
• Debt ratio = 389 + 839
389 + 839 + 672
= 1,228/1900 = 0.646
The debt ratio of 0.646 means that the lenders have financed
64.6% of net asset (capital employed). The remaining is
financed by owners (35.4%).

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2.Debt – equity ratio
• This relationship describes the lenders’ contribution for
each birr of the owners’ contribution (owners’ equity).
• Debt-equity ratio is directly computed by dividing total
debt by owners equity.
Debt-equity ratio = total debt
owners equity
Example 5: using information provided in example 4,
calculate debt-equity ratio.
debt-equity ratio = 1,228/672 = 1.83
(Or) lenders’ contribution/ owners’ contribution 0.646/0.354
= 1.83

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3. Capital employed to equity ratio
• This is yet another alternative way of expressing the basic
relation ship between debt & equity.
• One may want to know: how much funds are being contributed
by lenders and owners for each birr of the owners’ equity.
• This can be calculated by dividing capital employed by owners’
equity.
• This can be calculated by dividing capital employed by owners
equity.
Capital employed to equity ratio = capital employed
owners equity
Example 6
• Assume again information provided in the above example 4, in
which capital employed and owners equity is equal to 1,900, and
672 respectively, calculate capital employed to equity ratio.
• Capital employed to equity ratio = 1,900/672
= 2.83
4. Total liability to total asset ratio

 So far, non-interest bearing current liabilities are excluded from
the computation of leverage ratios.
 However, some times the firm may like to include them in the
calculation of leverage ratio.
• This relationship assess the proportion of total funds (short and
long term ) provided by outsiders to finance total assets.
Total liability to total asset ratio = Total liability (TL)
I M Pandey Total asset (TA)
22
5. Interest coverage ratio
• Interest coverage ratio shows the ability of
the firm to meet interest obligation.
• It is used to test debt-servicing capacity of
the firm.
• It is calculated as dividing earnings before
interest, tax, depreciation, and amortization
(EBITDA).
Interest coverage = EBITDA
interest
C. Turnover Ratios/asset management
ratio
• Turnover or activity ratios measure the firm’s efficiency and
effectiveness in utilizing its assets. Or
• Ability of the management in utilizing the assets of the firm. The
management may use the following ratios:-
1. Total asset turnover ratio

2. Current asset turnover ratio
3. Fixed assets turnover ratio
4. Inventory turnover ratio
5. Average collection period, etc.
Contn’d
1. Total asset turnover:- this shows the effectiveness of all assets to
generate revenue. Or shows how hard the firm’s assets are being put to use. it is
calculated by dividing sales by total assets
•Total asset turnover = Net Sales
Average total assets
Notice that since the assets are likely to change over the year, we use the
average of the assets at the beginning and end of the year.
•Example: if the firm has net sales of 22,348, and beginning and ending balance
of the total asset is equal to 22,660, and 20,101 respectively, calculate total asset
turn over ratio.
Total asset turnover = 22,348
(22,660 + 20,101)/2 = 1.05
•Each dollar of total assets produced $1.05 of sales:
•A high ratio compared with other firms in the same industry or industry average could
indicate that the firm is working effectively.
If industry ratio = 1 25
Contn’d
2. Current asset turnover: this ratio measures how effectively
the firm uses its current asset to generate revenue. It is the ratio of net sales to
average current assets:
Current ratio = net sales
average current asset
3. Fixed assets turnover ratio: this ratio measures how

effectively the firm uses its fixed assets to generate revenue. It is the ratio of net
sales to average fixed assets:
Fixed asset turnover = net Sales
Average fixed assets
•example, if the firm has 22,348 net sales, and 7,318,and 6,261 fixed assets
(beginning & ending), FATO ratio = 22,348
(7,318 + 6,261)/2
= 3.29
26
contn’d
4. Inventory turnover ratio:- indicates the efficiency of

the firm in producing and selling its product.
•Shows the number of times inventory replenishment is required
during an accounting period to achieve a given level of sales.
•It is calculated by dividing cost of good sold by an average
inventory.
Inventory turnover = cost of goods sold
Average inventory
•Efficient firms turn over their inventory rapidly and don’t tie up
more capital than they need in raw materials or finished goods.

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Contn’d
• Example ;assume cost of goods sold is equal to birr 3,000, and
cost of average inventory is equal to birr 615. calculate inventory
turnover ratio and comment the result if industry average is equal
to 9.0
Inventory turnover = cost of goods sold
Average inventory
= $3,000 = 4.9 times
$615
• This result shows that, each item of inventory is sold out and
restocked, or replenished or “turned over,” 4.9 times per year.
• Comment: the firm is inefficient in turning inventory to sale
compared to average industry. Because, 4.9 times is much lower
than the industry average of 9 times.
Contn’d
• Managers sometimes also look at average inventory holding days
per year. The reciprocal of inventory turnover gives days of
inventory holdings (DIH).
• This is equal to the average inventory divided by the daily cost of
goods sold:
DIH = average inventory X 360
Cost of goods sold
OR 360 days = 360 = 73.8 days
Inventory turnover 4.9
29
Contn’d
5. Average Collection Period- The average collection period

measures the speed with which customers pay their bills. It expresses accounts
receivable in terms of daily sales:
•Example, if annual sale is 22,348, beginning and ending inventory is equal to
2,453 and 2,150 respectively, calculate ACP
•Average collection period (ACP) = average receivables
Average daily sales
= (2,453 + 2,150)/2
22,348/360
= 37 days
This indicates that on average, accounts receivables remain outstanding for 37
days. Financial Management, Ninth Edition ©
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D. Profitability Ratios
1. Cost of good sold ratio
2. Gross profit margin ratio:
3. Operating margin ratio
4. Net profit margin ratio
5. Post tax margin ratio
6. Return on investment (ROI)
7. Return on Equity (ROE)
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Profitability Ratios
• Profitability ratios measure a firm’s overall
efficiency and effectiveness in generating profit.
1. Cost of good sold ratio = CGS x100
Net sales
 Lower cost of good sold is advised to produce a given sales.
2. Gross profit margin ratio: provides an idea of gross margin
which in turn depends up on relation ship between
price ,volume and costs.
Gross profit margin ratio = Net sales – CGS X100
Net sales
 Higher gross profit margion ratio is here accepteble.
3. Operating margin ratio : provides a view of operating
efficiency.
Operating margin ratio = EBIT x 100
net sales
 Higher operating margin ratio is here also accepteble 32
cont’d
4. Net profit margin ratio: reflects management ability to
operate business to earn all its costs and expenses, and able to
provide a compensation to owners.
Net profit margin ratio = net profit x 100
net sales
Higher net profit margin ratio is accepteble
5. Post tax margin ratio: shows after tax margin to both
creditors and owners.
Post tax margin ratio = net profit after tax but before interest
net sales
Note that the numerator for post tax margin can be obtained by
adding back to net income the after tax cost of interest.
So, net profit after tax but before interest = NI + I (1-tax rate)
Financial Management,
I M Pandey Ninth Edition © 33
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Cont’d
6. Return on investment (ROI) or Net assets (RONA) -
Managers often measures the performance of a firm by the
ratio of net income to net assets.
•It is better to use net income plus interest because we are
measuring the return on all the firm’s net assets, not just the
equity investment.
ROI = RONA = EBIT(1-T)
Net asset
7. Return on Equity (ROE) - Another measure of
profitability focuses on the return on the shareholders’ equity:
it is used to see the profitability of owners’ investment. ROE
= Net income (NI)
owners’ equity
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Utility of Ratio Analysis
• Assessment of the firm’s financial
conditions and capabilities.
• Diagnosis of the firm’s problems,
weaknesses and strengths.
• Credit analysis
• Security analysis
• Comparative analysis
• Time series analysis
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Cautions in Using Ratio Analysis
• Standards of comparisons
• Company differences
• Price level
• Different definition
• Changing situations
• Past data

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END OF CHAPTER

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CHAPTER - THREE

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition © I M Pandey 7

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

4. Total liability to total asset ratio

1. Total asset turnover ratio

3. Fixed assets turnover ratio: this ratio measures how

4. Inventory turnover ratio:- indicates the efficiency of

Financial Management, Ninth Edition ©

5. Average Collection Period- The average collection period

Financial Management, Ninth Edition ©

Financial Management, Ninth Edition ©

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