BCOM-EVENING TOWN CAMPUS FINANCIAL STATEMENT ANALYSIS

RATIO ANALYSIS
Ratio analysis is among the most popular and widely used tools of financial analysis. A ratio expresses a
mathematical relation between two quantities. While computation of a ratio is easy, its interpretation is
more complex.
Ratios are tools to provide us with insights into underlying conditions. Analysis of a ratio can reveal
important relations and bases of comparison in uncovering conditions and trends difficult to detect the
individual components that make up the ratio. In order to use ratio analysis fairly when evaluating firms,
each company should be evaluated in comparison with its industry peers.
Ratios whose denominator is total assets/ total sales can be read off from vertical common size balance
sheets/income statements.
Summary Table of common Financial Ratios and their interpretation to various stakeholders
Ratio Formula What it measures What it tells you

(A) Owners: Net Income

Return on Average Owners’ Equity Return on owners’ How well is this
Investment (ROI) capital company doing as an
When compared with investment?
return on assets, it
measures the extent to
which financial
leverage is being used
for or against the
owner.

Return on Assets Net Income How well assets have How well has
(ROA) Average Total Assets been employed by management employed
management. company assets? Does
it pay to borrow?

Return on Equity Net Income measures the level How well the mgt are
(ROE) Average total Equity of net income making returns for
realized for every owners
shilling invested by
the owners of the
company.
(B) Managers: Net Income
Net Profit Margin Sales Operating efficiency. Are profits high
The ability to create enough, given the level
sufficient profits from of sales?
operating activities.

Asset Turnover Sales Relative efficiency in How well are assets

Average Total Assets using total resources being used to generate
to product output. sales revenue?

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Return on Assets Net Income x Sales Earning power on all How well has
Sales Total Assets assets; ROA ratio management employed
broken into its logical company assets?
parts: turnover and
margin
.
Average Collection Average A/R x 365 Liquidity of Are receivables
Period Annual Credit Sales receivables in terms of coming in too slowly?
average number of
days receivables are
outstanding.

Inventory Turnover Cost of Goods Sold Expense Liquidity of Is too much cash tied
Average Inventory inventory; the number up in inventories?
of times it turns over
per year.

Average Age of Average A/P x 365 Approximate length How quickly does a
Payables Net Purchases of time a firm takes to prospective customer
pay its bills for trade pay its bills?
purchases.
(C) Short-Term
Creditors Current Assets – Short-term debt- Does this customer
Working Capital Current Liabilities paying ability. have sufficient cash or
other liquid assets to
cover its short-term
obligations?

Current Ratio Current Assets Short-term debt- Does this customer

Current Liabilities paying ability without have sufficient cash or
regard to the liquidity other liquid assets to
of current assets. cover its short-term
obligations?

Quick Ratio Cash+Mktble Sec.+A/R Short-term debt- Does this customer

Current Liabilities paying ability without have sufficient cash or
having to rely on sale other liquid assets to
of inventory. cover its short-term
obligations?

(D) Long-Term Total Debt Amount of assets Is the company’s debt

Creditors: Total Equity provided by creditors load excessive?
Debt-to-Equity for each dollar of
Ratio assets provided by
owner(s)

Times Interest Net Income+(Interest+Taxes) Ability to pay fixed Are earnings and cash
Earned Interest Expense charges for interest flows sufficient to
from operating profits. cover interest payments
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 and some principal
repayments?

Cash Flow to Operating Cash Flow Total debt coverage. Are earnings and cash
Liabilities Total Liabilities General debt-paying flows sufficient to
ability. cover interest payments
and some principal
repayments
Advantages of Financial Ratios
(i) They are used to determine the ability of the company to meet its short term financial
obligations as they fall due i.e. liquidity ratios
(ii) They indicate the extent to which the company has borrowed external fixed charge capital
to finance it assets i.e. Gearing/leverage ratios
(iii) They indicate the efficiency with which the assets of the firm are utilized to generate the
sales revenue i.e. efficiency/activity ratios.
(iv) They are used to compare the performance of the company with that of the industry
average. This is what is known as industrial analysis
(v) They are used to compare the performance of the company with that of its competitors.
This is what is known as cross-sectional analysis.
(vi) They can be used to compare the performance of the company over time. This is what is
known as trend/time series analysis
(vii)Ratios can be used to determine the value of the firm ie valuation/stock exchanges ratios
Disadvantages of Financial Ratios
(i) Ratios ignore the effects of inflation e.g. an increase in sales may be due to the increase in the
selling price and hence it may have nothing to do with the improved performance.
(ii) Differences in sizes of the firms – Firms in the same industry have different sizes, level of
technology and diversification. It is therefore difficult to compares such firms using ratios
(iii) Differences in the accounting policies – Different firms in the same industry use different
accounting policies which make comparison difficult e.g. the use of LIFO and FIFO methods
of stock valuation or the use of the reducing balance method of depreciation and the straight
line method of depreciation.
(iv) Ratios can’t be used to capture the qualitative aspects of the firm – i.e. they only deal with the
quantitative aspects
(v) Ratios are only computed at one point in time. However, the conditions in the firm keep on
changing from one period to another.
(vi) Incase of monopolistic firms i.e. where a firm constitutes the industry then cross sectional
and industrial analysis cannot be carried out.
(vii)Window dressing – This occurs when accountants try to reflect a picture which never existed
during the accounting period.

ILLUSTRATION ONE
Munyah Ltd. is an expanding company and the following accounts relate to its operations for the year
2016 and 2017:

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 Statement of profit or Loss account for the year
ended 30 June
2016 2017
Sh. Sh.
Sales 3,000,000 4,800,000
Less: cost of goods sold 1,650,000 2,700,000
Gross profit 1,150,000 2,100,000
Less: trading expenses 675,000 825,000
Trading profit 675,000 1,275,000
Less: Debenture interest 37,500 37,500
Net profit before taxation 637,500 1,275,000
Less: Corporation tax 240,000 480,000
Net profit after taxation 397,500 757,500
Less: Ordinary share dividend 187,500 262,500
Undistributed profit for the year 210,000 495,000

Statement of Financial Position as at 30 June

2016 2017
Sh. Sh. Sh. Sh.
Fixed assets at cost 1,500,000 2,100,000
Less: Depreciation 300,000 1,200,000 375,000 1,725,000
Current assets:
Stock 600,000 825,000
Debtors 375,000 525,000
Cash 120,000 1,350,000
Less: current liabilities 1,095,000
Creditors 217,500 300,000
Taxation 240,000 480,000
Proposed dividend 187,500 262,500
Bank overdraft _______ 97,500
(645,000) (1,140,000)
1,650,000 1,935,000
Financed by:
Ordinary share capital 750,000 750,000
(Authorised and issued)
Undistributed profits 525,000 1,020,000
10% debentures 375,000 165,000
1,650,000 1,935,000
Required:
(i) Compute six accounting ratios for both 2015 and 2016 ( which you feel would be of particular value
in assessing the Profitability and Liquidity of Munyah Ltd. (12 marks)

(ii) Comment on the current position of the company with the aid of the accounting ratios computed
in (i) above and any other information that you consider to be relevant.
(3marks)
Illustration Two
The summarized financial statements of Baraka Enterprises Ltd. are as follows:

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 Statement of profit or loss for the year ended 30 September
2016 2017
Sh.’000 Sh.’000
Sales 20,000 28,000
Cost of sales (15,000) (21,000)
Gross profit 5,000 7,000
Administrative expenses (3,800) (4,600)
Debenture interest _(400)
Net profit 1,200 2,000

Statement of financial position as at 30 September

2016 2017
Sh.’000 Sh.’000
Assets:
Non-current assets (net book value) 11,000 14,000
Current assets:
Inventories 2,000 3,000
Trade and other receivables 2,500 2,800
Balance at bank ___- _500
4,500 6,300
Total assets 15,500 20,300
Equity and liabilities:
Capital and reserves:
Issued and fully paid
1,000,000 ordinary shares of Sh.10 each 10,000 10,000
Revenue reserves _3,000 _4,100
13,000 14,100
Non-current liabilities
8% debentures ____- 5,000
Current liabilities
Trade and other payables 1,500 1,200
Bank overdraft _1,000 ____-
_2,500 _1,200
Total equity and liabilities 15,500 20,300

Stock as at 1 October 2015 was Sh.5,000,000

Required:
For each year, calculate the following:
(a) Gross profit margin (2 marks)
(b) Inventory turnover (2 marks)
(c) Return on equity (2 marks)
(d) Return on assets (2 marks)
(e) Acid test ratio (2 marks)
(f) Current ratio (2 marks)
(g) Financial leverage (2 marks)

(a) Comment on the liquidity position of the company giving possible reasons for the change.
(3 marks)
(Total: 20 marks)
Assignment
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The financial statements of Ng’ombe Ltd for the years ended 30 April 2016 and 30 April 2017 are
given below:
Income statements for the years ended 30 April:
2017 2016
Shs.’000’ Shs.’000’
Revenue 396,900 378,000
Cost of sales (217,140) (219,240)
Gross profit 179,760 158,760
Administrative expenses (31,563) (29,589)
Distribution costs (35,070) (32,865)
Profits from operations 113,127 96,306
Finance costs (17,115) (14,784)
Profit before tax 96,012 81,522
Income tax expense (42,000) (28,980)
Net profit for the year 54,012 52,542

Statements of financial position as at 30 April:

2017 2016
Shs.’000’ Shs.’000’
Non-current assets:
Plant, property and equipment 443,961 427,476

Current assets:
Inventory 55,923 37,275
Trade receivables 47,460 30,240
Bank balances 1,113 1,050
104,496 68,565
Total assets 548,457 496,041

Equity and liabilities:

Equity and reserves:
Called up share capital 168,000 168,000
Retained profits 153,573 135,114
321,573 303,114

Non-current liabilities:
12% loan notes 105,000 105,000

Current liabilities:
Trade payables 8,148 8,190
Bank overdraft 48,800 27,300
Tax payable 64,936 52,437
121,884 87,927
Equity and liabilities 548,457 496,041
Required
a) For each year, compute the following ratios:
i. Gross profit margin. (2 marks)
ii. Profit margin. (2 marks)
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 iii. Return on capital employed. (2 marks)
iv. Current ratio. (2 marks)
v. Acid test ratio. (2 marks)
vi. Inventory turnover. (2 marks)
vii. Trade receivables collection period. (2 marks)

b) Citing relevant ratios computed in (a) above, briefly comment on the performance of
Savannah Ltd using the following criteria:
i. Profitability. (2 marks)
ii. Liquidity (2 marks)
iii. Efficiency (2 marks)
(Total: 20 marks)

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stronger than your feelings. Stop waiting for the perfect moment. Take the moment you have and
make it perfect. Live your vision and demand your success. Have a great and successive
Revision.

Sporta Fred