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Financial Management-I (AcFn 3041)

By: Wogayehu W/Yesus Tele # 0977-24-44-34 & email :

(Consultant, Trainer & Lecturer) [email protected]
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Chapter 2
IFRS based Financial Statements Analysis
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Overview of IFRS based Financial

Statements
 1. Introduction to IFRS
4

❑ IFRS stands for International Financial Reporting Standards.

➢ They are an existing set of high-quality, country neutral

financial reporting standards to be followed by accountants

to maintain comparable books of accounts across
international boundaries.
➢ They are principle based standards adopted by
International Accounting Standard Board (IASB) where as
IAS (International Accounting Standards) are accounting
standards issued by the International Accounting Standards
Board (IASB) and its predecessor, the International
Accounting Standards Committee (IASC).
 2. Worldwide Adoption of IFRS
5

❑International Accounting Standards (IAS),

now renamed International Financial
Reporting Standards (IFRS), are gaining
acceptance worldwide.
➢ 150 + countries around the world have already

permitted or adopted IFRS. (E.g. European Union,

India, Hongkong, Australia, Pakistan, Russia, South
Africa, Egypt, Kenya, Singapore, Turkey, but not in
the United States.
 3. Key Concepts of IFRS
6

▪ IFRS sets out recognition, measurement, presentation

and disclosure requirements for general purpose
financial statements (GPFS) of profit seeking entities.
a) Recognition - Incorporating in the financial statements
an item that meets the definition and criteria for
recording.
b) Measurement - Determining the monetary amounts at
which the elements of the financial statements are to
be recognized and carried in financial statements.
c) Presentation and Disclosure - Including and providing
a financial information necessary to users.
 4. List of IAS…
7

Standard Standard Name Effective Date

IAS 1 Presentation of Financial Statements Jan.1, 2005

IAS 2 Inventories Jan.1, 2005
IAS 7 Statement of Cash Flows Jan.1, 1994
IAS 8 Accounting Policies, Changes in Accounting Jan.1, 2005
Estimates and Errors
IAS 10 Events After the Reporting Period Jan.1, 2005
IAS 12 Income Taxes Jan.1, 1998
IAS 16 Property, Plant and Equipment Jan.1, 2005
IAS 17 Leases Jan.1, 2005
 4. List of IAS…
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Standard Standard Name Effective Date

IAS 19* Employee Benefits Jan.1, 2013
IAS 20 Accounting for Government Grants and Jan.1, 1984
Disclosure of Government Assistance
IAS 21 The Effects of Changes in Foreign Jan.1, 2005
Exchange Rates
IAS 23 Borrowing Costs Jan.1, 2009
IAS 24 Related Party Disclosures Jan.1, 2011
IAS 26 Accounting and Reporting by Retirement Jan.1, 1988
Benefit Plans
IAS 27* Separate Financial Statements Jan.1, 2013
IAS 28 * Investments in Associates & Joint Ventures Jan.1, 2013
 4. List of IAS…
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Standard Standard Name Effective Date

IAS 29 Financial Reporting in Hyperinflationary Jan.1,2007
Economies
IAS 32 Financial Instruments - Presentation Jan.1, 2005
IAS 33 Earnings per Share Jan. 1, 2005
IAS 34 Interim Financial Reporting Jan.1, 1999
IAS 36 Impairment of Assets Jan.1, 2004
IAS 37 Provisions, Contingent Liabilities and Jan.1, 1999
Contingent Assets
IAS 38 Intangible Assets March 31,2004
IAS 40 Investment Property Jan.1, 2005
IAS 41 Agriculture Jan.1, 2003
 5. List of IFRS…
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Standard Standard Name Effective Date
IFRS 1 First-time Adoption of IFRS July 1, 2009
IFRS 2 Share-based Payment Jan. 1, 2005
IFRS 3 Business Combinations July 1, 2009
IFRS 4* Insurance Contracts (replaced by IFRS 17) March 2004
IFRS 5 Non-current Assets Held for Sale & Jan. 1, 2005
Discontinued Operations
IFRS 6 Exploration for & Evaluation of Mineral Jan. 1, 2006
Resources
IFRS 7 Financial Instruments - Disclosures Jan.1, 2007
IFRS 8 Operating Segments Jan.1, 2009
IFRS 9 Financial Instruments –Recognition & Jan.1, 2015
 5. List of IFRS
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Standard Standard Name Effective Date

IFRS 10 Consolidated Financial Statements Jan.1, 2013
IFRS 11 Joint Arrangements Jan.1, 2013
IFRS 12 Disclosure of Interests in Other Entities Jan.1, 2013
IFRS 13 Fair Value Measurement Jan.1, 2013
IFRS 14 Regulatory Deferral Accounts Jan.1, 2016
IFRS 15 Revenue from Contracts with Customers Jan.1, 2018
IFRS 16 Leases Jan.1, 2019
IFRS 17 Insurance Contract Jan. 1, 2023.
 6. IFRS based Financial Statements
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▪ IAS-1 prescribes the guidelines for the

presentation, structure and content of general
purpose financial statements (GPFS)
➢ General purpose financial statements (financial
statements) - are those intended to meet the
needs of users who are not in a position to
require an entity to prepare reports tailored to
their particular information needs.
 6. IFRS based Financial Statements
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▪ A complete set of IFRS based financial statements

comprise:
1. Statement of profit or loss and other comprehensive income;
2. Statement of changes in equity;
3. Statement of financial position;
4. Statement of cash flows;
5. Notes to the financial statements;
6. comparative information in respect of the preceding period;
7. Statement of financial position as at the beginning of the
preceding period when an entity applies an accounting
policy retrospectively or makes a retrospective restatement
of items in its financial statements, or when it reclassifies items
in its financial statements.
 6.1. Statement of Comprehensive Income
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▪ It is also called Statement of Profit or Loss and

Other Comprehensive Income (SPLOCI).
➢ It comprises :
a) profit or loss;
b) Other comprehensive income;
c) Total comprehensive income.
 Example: Statement of Comprehensive Income ( SPLOCI)
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 6.2. Statement of changes in equity
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▪It is a summary of the changes in the owner’s equity of a

business entity during a specific period of time..
➢ It comprises :

a) total comprehensive income for the period;

b) for each component of equity, the effects of

retrospective application or retrospective restatement
(i.e. the effects of changes in accounting policies and
corrections of errors) ; and
c) for each component of equity, a reconciliation
between the carrying amount at the beginning and
the end of the period.
 Example: Statement of changes in equity
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 6.3. Statement of Financial Position (SFP)
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▪It is a list of Assets, Liabilities and Capital of an

entity at a specific date.
➢ It provides a basis for computing rates of return

and evaluating the capital structure of the

enterprise.
➢ It is used to assess a company’s liquidity,
solvency, efficiency and leverage.
 Example: Statement of Financial Position
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 Example: Statement of Financial Position
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 6.4. Statement of Cash Flows (SCF)
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❑ It provides information to users of financial

statements about the entity's ability to generate
cash and cash equivalents as well as indicating
the cash needs of the entity.
➢ It provides historical information about cash and
cash equivalents classifying cash flows between:
a) Operating activities ;

b) Investing activities ;

c) Financing activities ;
 Example of a SCF: Indirect Method
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 6.5. Notes to Financial Statements
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▪ They are additional disclosures accompanying financial

statements.
➢ The notes shall:

1. present information about the basis of preparation of

the financial statements;

2. present information about specific accounting policies
used in preparation of financial statements ;
3. disclose the information required by IFRSs that is not

presented elsewhere in the financial statements but is

relevant to the user.
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Analyzing IFRS based Financial

Statements
 1. Introduction to Financial Analysis
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❑ Financial Statements Analysis :

➢ It also called Financial analysis/ Accounting analysis
/ Analysis of finance.
➢ It is the process of identifying the financial strengths
and weaknesses of the firm by properly establishing
relationship between finical statement items for
certain period.
➢ It is concerned with the selection, evaluation, and
interpretation of financial data to assist business
decisions/finance decisions/functions.
 2. Objectives of Financial Analysis
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▪ The goal of financial analysis is to analyze

whether an entity is stable, solvent, liquid, or
profitable enough to warrant a monetary
investment. It is used to :
a) evaluate economic trends;
b) set financial policy;
c) build long-term plans for business activity, and
d) identify projects or companies for investment.
 2. Objectives of Financial Analysis
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▪ More specifically, financial analysis has the

following objectives.
a) Assessment of Past Performance: Past performance is a good
indicator of future performance.
b) Assessment of current position: to assess the current position of
the firm.
c) Prediction of profitability and growth prospects: to assess and
predict the earning prospects and growth rates.
d) Assessment of the operational efficiency: to assess the
operational efficiency of the management of a company.
e) Prediction of bankruptcy and failure: to assess and predict
bankruptcy and probability of business failure.
 3. Limitations of Financial Analysis
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▪ Although financial analysis is essential to

obtain relevant information for making several business
decisions/functions , it should be carefully performed as it
suffers from a number of the following limitations.
➢ The users and analysts must understand the limitations
before analyzing the financial statements of the
company.
➢ The limitations make it clear that the analysis is a means

to an end and not an end to itself.

 3. Limitations of Financial Analysis
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a) Mislead the user : The accuracy of financial information

largely depends on how accurately financial statements
are prepared. If their preparation is wrong the
information obtained from their analysis will also be
wrong which may mislead the user in making decisions.
b) Wrong judgment : The skills used in the analysis without
adequate knowledge of the subject matter may lead to
negative direction. Similarly, biased attitude of
the analyst may also lead to wrong judgment and
conclusion.
 3. Limitations of Financial Analysis
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C) Qualitative aspects : financial analysis provides

only quantitative information about the
company’s financial affairs. However, it fails to
provide qualitative information such as
management labor relation, customer’s
satisfaction, and management’s skills and so on
which are also equally important for decision
making.
 3. Limitations of Financial Analysis
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d) Comparison not possible : The financial statements

are based on historical data. There fore comparative
analysis of financial statements of different years
cannot be done as inflation distorts the view
presented by the statements of different years.
e) Not useful for planning : since financial statements
are prepared by using historical financial data,
therefore, the information derived from such
statements may not be effective in corporate
planning, if the previous situation does not prevail.
 4. Data for Financial Analysis
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1) Financial data – the entity’s annual reports;

a) Financial statements;
b) Accompanying notes;
c) Independent auditor’s report;
2) Economic data - GDP , GNP, Price Index, BP, BOT, etc;
a) It helps to assess the recent performance or future prospects of
the company or industry.
b) It is available from government and private sources such as
Central Statistics Authority.
3) Market data - Market prices of securities;
a) It can be found from financial press and electronic media.
 5. Approaches of Financial analysis
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❑ There are several approaches of financial

analysis. The most common approaches
include :
1) Vertical Analysis;
2) Horizontal Analysis ;
3) Cross-sectional Analysis ;

4) Ratio Analysis ;
 5.1. Vertical Analysis
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❑ It is also called common-size analysis;

➢ It is a type of financial analysis that evaluates financial
performance of an entity by expressing each line item as a
percentage of the base amount for that period;
a) Common size Balance Sheet (SFP) – Each item in the Balance

Sheet (SFP) is expressed as a percentage of total assets.

b) Common-size Income Statements (SPLOCI) – Each item in the

Income Statement (SPLOCI) is expressed as a percentage of net

sales.
➢ The analysis helps to understand the impact of each item in the
financial statement and its contribution to the resulting figure.
 5.1. Vertical Analysis
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 5.1. Vertical Analysis
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➢ Formula for Common Size Analysis :

5.1.1. Balance Sheet (SFP)Vertical Analysis

Sample Company
Balance Sheet (Assets)
At December 31, 2020 and 2019
% of Total Assets
2020 2019 2020 2019
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
$82,000
Inventory ÷ $483,000
87,000 = 17% rounded
82,000 18% 21%
Land 101,000 90,000 21% 23%
$30,000
Equipment
÷ $387,000
110,000
= 100,000
8% rounded 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
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5.1.1. Balance Sheet (SFP)Vertical Analysis

Sample Company
Balance Sheet (Assets)
At December 31, 2020 and 2019
% of Total Assets
2020 2019 2020 2019
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
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 5.1.1. Balance Sheet (SFP)Vertical Analysis

Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 2020 and 2019
% of Total Assets
2020 2019 2020 2019
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
$76,000 ÷ $483,000
Notes Payable 50,000 = 16% rounded
50,000 10% 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%

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 5.1.2. Income Statement (SPLOCI) Vertical Analysis
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 5.2. Horizontal Analysis
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❑It is also called time series analysis or trend

analysis or longitudinal analysis.
➢ It is a type of financial analysis that evaluates
the historical trends of financial performance of
an entity over a period of time.
➢ This will help an analyst to identify :
a) Important trends in the firm’s performance - growing
or declining or no change;
b) Shifts in trends ;

c) Outliers or values that deviate substantially from the

other data points.
 5.2. Horizontal Analysis
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❑ In horizontal analysis, the changes in specific

financial statement values are expressed as a
percentage and in amount ($) .
5.2.1. Balance Sheet (SFP)Horizontal Analysis

ABC CORPORATION
Comparative Balance Sheets
December 31, 2020 and 2019
I
2020 2019
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 303,000 $ 23,500

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 5.2.1. Balance Sheet (SFP)Horizontal Analysis

ABC CORPORATION
Comparative Balance Sheets
December 31,2020 and 2019
Increase (Decrease)
2020 2019 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 – $23,500
155,000 = $(11,500)
164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

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 5.2.1. Balance Sheet (SFP) Horizontal Analysis

Increase (Decrease)
2020 2019 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets ($11,500155,000
÷ $23,500) × 100% = 48.9%
164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

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 5.2.1. Balance Sheet (SFP)Horizontal Analysis

ABC CORPORATION
Comparative Balance Sheets
December 31, 2020 and 2019
Increase (Decrease)
2020 2019 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
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5.2.2. Income Statement (SPLOCI )Horizontal Analysis

ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2020 and 2019
Increase (Decrease)
20120 2019 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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 5.2.2. Income Statement (SPLOCI )Horizontal Analysis

ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2020 and 2019
Increase (Decrease)
2020 2019 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Sales increased by 8.3% while net income
Net operating income by 21.9%. 31,400
decreased 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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 5.2.2. Income Statement (SPLOCI )Horizontal Analysis

ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2020 and 2019
Increase (Decrease)
2020 2019 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of There were increases in both cost of360,000
goods sold goods sold (14.3%)
315,000and 45,000 14.3
operating expenses (2.1%). These increased costs more than
Gross margin 160,000 165,000 (5,000) (3.0)
offset the increase in sales, yielding an overall decrease in net
Operating expenses
income. 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
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 5.3. Cross-sectional Analysis
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❑ It is also called comparative analysis.

➢ It is a type of financial analysis that compares a
particular company to its competitor or its industry.
➢ It indicates the relative financial position and
performance of the firm and may focus on :
a) head-to-head analysis - selected company (key
competitor) in the same industry ; or
b) industry-wide analysis - industry average at the
same point in time to identify companies with a
particular strength.
 5.4. Ratio Analysis…
51

❑ It is the quantitative method of evaluating the company’s

financial performance.
➢ It provides valuable information about the organization’s :

i. Liquidity
ii. Solvency

iii. Operational efficiency

iv. Profitability

v. Marketability

➢ It requires some standards against which the ratios are

compared.
 5.4. Ratio Analysis…
52

▪ The common standards of comparison are :

1) Historical standards : Ratios computed from the
company’s own past experience.
2) Budgeted standards : Use of budgeted performance.
3) Absolute standards: Ratios generally recognized as
being desirable regardless of the type of company,
the time, stage of business cycle, or objective of the
analyst.
4) Horizontal (peer or industry) standards : Use of key
competitor’s ratios or industry averages.
 5.4. Ratio Analysis..
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 5.4. Ratio Analysis
54

❑ Five major categories:

1. Liquidity Ratios.
2. Asset Management (Activity) Ratios
3. Debt Management (Leverage) Ratios
4. Profitability Ratios
5. Marketability Ratios
 5.4.1. Liquidity Ratios
55

a) Current Ratio :
➢ It measures the ability of the firm to meet short-term
obligations from its current assets.
➢ It is a measure of a firm’s short-term solvency.
➢ Generally, the Current ratio greater than or equal the
standard is desirable.
➢ Thus it must be 1 or more.
 5.4.1 Liquidity Ratios
56

b) Quick/Acid Test Ratio :

➢ It measures an entity's ability to pay its current liabilities
by using its most liquid assets excluding least liquid
inventories.
➢ Generally, Quick ratio greater than or equal to the
standard is desirable.
➢ Thus its quick ratio must be 1 or more.
 5.4.2 Asset Management Ratios
57

❑ They are called Activity Ratios

/Efficiency Ratios / Turnover Ratios.
➢ They measure how effectively the firm

is using its assets in generating revenues.

 5.4.2 Asset Management Ratios
58

Ratio Formula 2014 2015

Inventory COGS =15,000 = 18,000
Turnover Inventory 5,000 8,000
= 3 times = 2,25 times

a) Inventory Turnover (ITO):

➢ It measures the average number time per year that an entity
sells, or turns over, its inventory.
➢ High inventory turnover ratios are taken as a sign of efficient
management of inventory where as low inventory turnover is
a sign of slow moving or obsolete items in inventory.
➢ Generally, higher ITO is desirable.
 5.4.2 Asset Management Ratios
59

Ratio Formula 2014 2015

Inventory 360 = 360 = 360
Period Inventory Turnover 3 2.25
or Alternatively = 120 days = 160 days
360*Inventory
COGS
b)Inventory Period:
➢ It is called Inventory turnover in days (ITD)

➢ It is an alternative measure of inventory activity.

➢ Generally, inventory period less than or equal to the

standard is desirable.
 5.4.2 Asset Management Ratios
60

c) Receivable Turn over (RTO) :

➢ It tells us the number of times A/R have been turned

over/ turned into cash during the year.

➢ Generally, RTO greater than or equal to the standard
is desirable.
 5.4.2 Asset Management Ratios
61

d) Average Collection Period (ACP):

➢ It is called Receivable Turn Over in Days (RTD) or Days
Sales Outstanding.
➢ It tells us the average number of days that receivables are
outstanding before being collected.
➢ Generally, a lower ACP is desirable.
 5.4.2 Asset Management Ratios
62

e) Fixed Assets Turnover (FATO)

➢ It is used to measure how effectively the firm uses its
plant assets in generating sales.
➢ Generally, FATO greater than or equal to the
standard is desirable.
 5.4.2 Asset Management Ratios
63

f) Total Assets turn over (TATO)

➢ It shows the firm’s ability in generating sales from all
financial resources committed to total assets.
➢ Generally, TATO greater than or equal to the standard
is desirable.
 5.4.3. Debt Management Ratios
64

❑They are called Leverage/Gearing Ratios.

➢ They are used to evaluate the extent to which the firm
uses debt financing / debt burden of the firm.
➢ Leverage refers to the use of fixed costs in an attempt
to increase profitability.
➢ There are two types of leverages :

1) Operating leverage refers to the extent to which the

firm uses fixed operating costs &
2) Financial leverage refers to the extent to which the
firm uses debts in financing its assets.
 5.4.3. Debt Management Ratios
65

a)Debt (D/A) Ratio :

➢ It measures the extent to which the firm is using
borrowed money.
➢ Generally, creditors would like a lower debt ratio.
 5.4.3. Debt Management Ratios
66

b) Debt-Equity (D/E) Ratio :

➢ It measures the proportion of debt capital in
terms of equity capital.
➢ Generally, creditors would like a lower D/E
ratio.
 5.4.3. Debt Management Ratios
67

Debt-Equity (D/E) Ratio :

➢ Debt-to- Equity ratio may also be computed as :
 5.4.3. Debt Management Ratios
68

c) Equity Multiplier (Financial Leverage) :

➢ It measures the extent to which the firm uses debt
financing in its capital structure.
➢ Generally, creditors would like a lower Equity
Multiplier.
 5.4.3. Debt Management Ratios
69

d) Times Interest Earned (TIE) Ratio:

➢ It is used to measure the ability of the firm to meet
interest obligations from its profits.
➢ It indicates the number of times Earnings before Interest
and Taxes (EBIT) is available to cover interest obligations.
➢ Generally, TIE ratio greater than or equal to the
standard is desirable.
 5.4.4. Profitability Ratios
71

❑ They measure the combined effect of :

a) Liquidity

b) asset management;

c) debt management on the profitability of the firm.

➢ They allow the analyst to evaluate the earning power

of the firm with respect to given level of sales, total
assets, and owner’s equity.
➢ They measure the operating efficiency of the entity
because they give final answers about how the firm is
being managed.
 5.4.4. Profitability Ratios
72

a) Gross Profit Margin :

➢ It reflects management’s effectiveness in pricing policy,
generating sales, and production efficiency.
➢ Generally, gross profit margin ratio greater than or
equal to the standard is desirable.
 5.4.4. Profitability Ratios
73

b)Net Profit Margin :

➢ It indicates management’s efficiency in manufacturing,
administering, selling, financing, pricing and tax
management.
➢ Generally, net profit margin ratio greater than or
equal to the standard is desirable.
 5.4.4. Profitability Ratios
74

c) Return on Investment (ROI):

➢ It is also called Return on Assets (ROA)
➢ It measures the amount of profit generated on
investments in assets.
➢ Generally, a higher ROA is desirable.
 5.4.4. Profitability Ratios
75

 .

d) Return of Equity (ROE) :

➢ It is also called the Return on Stockholders’ Equity or
Return on Net Worth.
➢ It measures the return earned by stockholders’ on their
investment and serves as an indicator of management
performance.
➢ Generally, a higher ROE is desirable
 5.4.4. Profitability Ratios
76

e) Earnings per Share (EPS):

➢ It simply shows the profitability of the firm on a per

share basis during the reporting period.

➢ Generally, higher EPS is desirable.
 5.4.4. Profitability Ratios
77

f) Dividend per Share (DPS) :

➢ It represents the Birr amount of cash dividends a
corporation paid on each share of its common stock
outstanding during the reporting period.
➢ Generally, higher DPS is desirable.
 5.4.4. Profitability Ratios
78

g) Payout (P/O) Ratio :

➢ It shows the percentage of earnings paid to stockholders.
➢ That is, the payout ratio expresses the cash dividend
paid per share as a percentage of EPS.
➢ Generally, higher P/O is desirable.
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❑ They measure the perception of the future

earning power of the company by the
market.
➢ These are ratios used primarily for :
i. investment decisions and
ii. long-range planning.
➢ They rely on financial market data, such
as the market price of securities.
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a) Price- Earning (P/E) Ratio

➢ It indicates the degree of confidence (or certainty)
that investors have in the firm’s future performance.
➢ The higher the P/E ratio, the greater investors
confidence in firm’s future and thus boost its P/E.
➢ Generally, higher P/E is desirable.
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b) Market-to Book (M/B) Ratio:

➢ It measures whether the firm has created value for its
shareholders.
➢ Generally, higher M/B ratio is desirable

i. If M/B ratio is greater than 1, it is said that the firm has

created value for its shareholders.
ii. If M/B ratio is less than 1, the value of the firm has
declined.
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❑In the 1920s, the management at DuPont

Corporation has developed a model called
DuPont Analysis for a detailed assessment of the
company’s profitability.
➢ DuPont Analysis is a tool that may help us to
avoid misleading conclusions regarding a
company’s profitability.
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❑The analysis of a company’s profitability

involves some hints.
➢ For example, in the ROE formula, we use
the book value of the company’s common
equity.
➢ To avoid erroneous conclusions based on

the ROE analysis, we can use a more in-

depth analysis of this measure.
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 Question or Comment ?
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