CHAPTER SIX

FINANCIAL STATEMENTS AND BANK PERFORMANCE EVALUATION

6.1 Introduction
 Financial analysis is the process of evaluating relationship between component parts of financial
statements to obtain a better understanding of firm’s position and performance.
 Financial analysis is process of identifying the financial strength and weakness of the firms by properly
establishing relationship between the items of the financial analysis assist in identifying and indicating.
 Whether a firm has enough cash to meet its obligation
 A reasonable accounts receivable collection period
 An efficient plant, property management policy;
 Sufficient plant, property, and equipment;
 An adequate capital structure all of which are necessary if that is to maximizing shareholder
wealth;
 To assess a firm’s viability as an ongoing enterprise and
 To determine whether a satisfactory return is being earned for the risk taken
 Analysis to financial statement is an attempt to assess the efficiency and performance of an enterprise.
Thus, the analysis and interpretation of financial statement is very essential to measure the efficiency,
profitability, financial soundness and future prospects of the business unit.
 Financial analysis serves the following purposes;
i. Measuring the profitability; the main objective of a business is to earn a satisfactory return on the
funds invest in it. Financial analysis helps in ascertaining whether adequate profits are being earned on
the capital invested in the business or not. It also helps in knowing the capacity to pay the interest and
dividend.
ii. Indicating the trend of achievements: - financial statements of the previous years can be compared
and the trend regarding various expenses, purchases, sales, gross profit and net profit etc. can be
ascertained. Value of asset and liabilities can be compared and the future prospects of the business can
be envisaged.
iii. Assessing the gross potential of the business; the trend and other analysis of the business provide
sufficient information indicating the growth potential of the business.
iv. Comparative position in relation to other firms: the purpose of financial statements analysis is to
help the management to make a comparative study of profitability of various firms engaged in similar
businesses. Such comparison also helps the management to study the position of their firm in respect
of sales expenses profitability and utilizing capital, etc.

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 v. Assess overall financial strength: the purpose of financial analysis is to assess the financial strength
of the business. Analysis also helps in taking decisions, whether funds required for the purchase of
new machines and equipment’s are provided from internal sources of the business or not if yes, how
much? And also to assess how much funds have been received from external sources.
vi. Assess solvency of the firm: the different tools of an analysis tell us whether the firm has sufficient
funds to meet its short term and long term liabilities or not.
Source;
 Note that, the objectives of financial analysis differ among various groups (creditors, shareholders,
management, potential investors, labor union, and so on) interested in the results and relationship
reported in the statements. These are
 Internal users (managers, officers, internal auditors, consultants, budget officers and market
researchers) make a company strategic and operating decisions. The purpose of financial analysis for
these users is to provide information helpful in improving the company’s efficiency and
effectiveness in providing products and services.
 Short-term creditors interested in judging the firm’s ability to pay its current debt.
 Bondholders (long-term creditors) concerned with examining the capital structure, past and projected
earning and change in financial position. That is they assess company prospects for lending
decisions.
 Shareholders interested in earning per share and dividend pay-out ratio which are likely to have a
significant bearing on the market price of share i.e. they assess company prospects for investing
decisions.
 Board of directors analyzes financial statements in monitoring management’s decisions.
 Customers and suppliers analyze financial statements in deciding whether to establish the purchase
and supple relationships.
6.2 Techniques of financial analysis
 When computing and interpreting analysis measures as part of a financial analysis, we need to decide
whether these measures suggested good, bad, or average performance. To make these judgments, we
need standards (benchmarks/techniques) for comparison, in general, standards for comparison may
include;
i. Intra-company- the company under analysis can provide its own standards for comparison based on
prior performance and relations between its financial items. In other word, it was use past ratios, ratios
calculated from the earlier period financial statements of same firms.

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 ii. Competitors ratios- one or more direct especially the most progressive and successful competitors of
the company being analyzed can provide standards for comparisons. For example Coca Colas profit
margin, for instance, can be compared with PepsiCo’s profit margin.
iii. Industry ratios– industry statistics can provide standards for comparisons. Published industry
statistics are available from several services such as Dun and Bradstreet, Standards and Poor’s and
Moody’s.
iv. Projected ratios- ratios developed using the projected or pro-forma financial statements of the same
firms.
v. Guidelines (rules of thumb) - general standards of comparisons can developed from experiences.
Examples are 2:1 level of the current ratio or 1:1 for the acid-test ratio. These guidelines, or rules of
thumb, must be carefully applied since their context is often critical.
6.3 Basic Financial Ratio

A. Liquidity Ratios
 Liquidity ratios are used to judge the firm's ability to moot short-term obligation. These ratios give
insights into the present cash solvency of the firms and its ability to remain solvent in the event of
adversities. It is the comparison between short-term obligation and the short –term resources available to
meet these obligations. These ratios are calculated to find the ability of banks to meet their short-term
obligation, which are likely to mature in the short period. The following ratios are developed and used for
our purpose to find the liquidity positions of the two banks.
 Under this group following ratios were used for liquid position of the banks:
 Current Ratio
 Cash and Bank Balance to Total Deposit Ratio

 Fixed Deposit to Total Deposit Ratio

i. Current Ratio
 This ratio indicated the current short-term solvency position of a current ratio is the relationship between
current assets and current liabilities. It is calculated by dividing the current liabilities by current assets,
which is expressed as follows:
Current Ratio = Current Asset
Current Liability

 Current assets refer in those assets, which are convertible in cash within a year or so. They includes, cash
and Bank Balance, investment in treasury bills, money at short call, or placement, loans and advances,
bills purchased and discounted, overdrafts, other short-term loans, foreign currency loans, bills for

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 collection, customer's acceptance liabilities, pre-payment expenses, and other receivable. Similarly,
current- liabilities refer to those obligations maturing within a year. It includes, current account deposits,
saving account deposits, margin deposits, call deposits, intra- bank reconciliation A/c, bills payable, bank
over-draft, provisions, accrued expenses, bill for collection, and customer's acceptance liabilities etc. A
higher ratio indicates better liquidity position. However, "A very high ratio of current assets to current
liabilities may be indicative of slack management practice, as it might signals excessive inventories for
the current requirement and poor credit management in terms of over-expanded account receivable.
 Current ratio is a measure of firm's solvency. It indicates the availability of the current assets in birr or
every one birr of current liability. As a conventional rule, a current ratio of 2 to 1 in considered
satisfactory. However, these rules should not be blindly followed, as it is the test of quantity not quality.
In spite of its shortcoming, it is a crude and quick measure of the firm's liquidity.

ii. Cash and Bank Balance to Total Deposit Ratio

 The ratio is calculated using following formula,
Cash and Bank Balance
=
Total Deposit
 Total deposit consists of current deposit, saving deposit, fixed deposit, money at call and short notice and
other deposits. The ratio shows the proportion of total deposits held as most liquid assets. High ratio
shows the strong liquidity position of the bank. Too high ratio is not favorable for the bank because it
produces adverse effect on profitability due to idleness of high-interest bearing fund.
iii. Fixed Deposit to Total Deposit Ratio
 It is calculated as follow:
Fixed Deposit
= Total Deposit
 The ratio shows what percentage of total deposit has been collected in form of fixed deposit. High ratio
indicates better opportunity available to the bank to invest in sufficient profit generating long-term loans.
Low ratio means bank should invest the fund of low cost in short- term loans.

B. Leverage Ratios
 Leverage or capital structure ratios are used to judge the long-term financial position of the firm. It
evaluates the financial risk of long-term creditors greater the proportion of the owner's capital structure,
lesser will be the financial risk borne by supplier of credit funds.
 Debt is more risky from the firm's point of view. The firm has legal obligation to pay interest to deft
holders irrespective of the profit made or losses incurred by the firm. However, use of debt is
advantageous to shareholders in two ways:

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  They can retain control on the firm with a limited stake
 Their earning in magnified when rate of return of the firm on total capital is higher than the cost of
debt.
 However, the earning of shareholders reduces if the cost of debt becomes more than the overall rate of
return. In case, there is the threat of insolvency. Thus, the debt has two folded impact- increases
shareholder earning-increase risk. Therefore, a firm should maintain optimal mix of investors and
outsiders fund for the benefit owners and its stability.
 Under this group, following ratios are calculated to test the optimality capital structure;
 Debt-Equity ratio
 Debt-Asset ratio

i. Debt –Equity Ratio

 It is the most widely used leverage ratio to evaluate the long-term solvency of the firm. This ratio
expresses the relationship between debt capital and equity capital. The ratio is calculated by dividing total
debt by shareholder's equity. It is calculated as,
Total Debt
=
Shareholder’s equity
 Total debt consists of all interest bearing long-term and short-term debts. These include loans and
advances taken from other financial institutions, deposits, carrying interest etc. Shareholder's equity
includes paid-up capital, reserves and surplus and undistributed profit.
 The ratio shows the mix of debt and equity in capital. It measures creditors' claims against owners. A
high ratio shows that the creditors' claims are greater than those of owners are. Such a situation
introduces inflexibility in the firms operation due to the increasing interference and pressures from
creditors' low ratio imply a greater claim of owners than creditors. In such a situation, shareholders are
less benefited if economic activities are good enough. Therefore, the ratio should be neither too high nor
too low.
ii. Debt-Asset Ratio
 It represents the relationships between the debt and total assets of the firm. It is calculated as:
Total Debt
=
Total Assets
 The ratio shows the contribution of creditors in financing the assets of the bank. High ratio indicates that
the greater portion of the bank's assets has been financed through outsider's fund. The ratio should be too
high per too low.

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C. Turnover Ratio
 Turnover ratios, also known as utilization ratios or activity ratios are employed to evaluate the efficiency
with which the firm manages and utilizes its assets. They measure how effectively the firm uses
investment and economic resources at its command. Investments are made in order to produce profitable
sales. Unlike other manufacturing concerns, the bank produces loans, advance and other innovation. So,
high ratio depicts the managerial efficiency in utilizing the resources which shows the sound and
profitability position of the bank and the low ratio is the result of insufficient utilization of resources.
However, too high ratio is also not good enough as it may be due to the insufficient liquidity.
 Depending upon special nature of assets and sales made by the bank, following ratios are tested;
 Loans and advances total deposits ratio
 Investment to total deposit ratio
 Performing assets to total assets ratio

i. Loans and Advances to Total Deposit Ratio

 The ratio is computed by dividing total loans and advances by total deposit liabilities.
Loans and advances
=
Total deposit
 Loan and advances consist of loans, advances, cash credit overdraft, foreign bills purchased and
discounted. The ratio indicates the proportion of total deposits invested in loans and advances. High ratio
means the greater use of deposits for investing in loans and advances. However, very high ratio shows
poor liquidity position and risk in loans on the contrary; too low ratio may be the causes of idle cash or
use of fund in less productive sector.

ii. Investment to Total Deposit Ratio

 The ratio obtained by dividing investment by total deposits collection in the bank.
Investment
=
Total Deposit
 Investment comprises investment in treasury bills, development bonds, company shares and other type of
investment. The ratio shows how efficiently the major resources of the bank have been mobilized. High
ratio indicates managerial efficiency regarding the utilization of deposits. Low ratio is the result of less
efficiency in use of funds.

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iii. Performing Assets to Total Assets Ratio
 It is calculated by dividing performing assets by total assets.
Performing Assets
=
Total Assets
 Performing assets to total assets include those assets, which are invested for income generating purpose.
These consist of loans and advances, bills purchased and discounted investment and money at call or
short notice. The ratio measures what percentage of the assets has been funded for income generation.
High ratio indicates greater utilization of assets and hence sound profitability position.

D. Asset Quality Ratios

 As explained earlier, turnover ratios measure the turnover of economic resource in terms of quantity.
Only the investment is not of great significance, but the return from them with minimum default in
payment by debtors is significant. A firm may be in a state of enough profit and though unable to meet
liability. Therefore, asset quality ratios are intended to measure the quality of assets contained by the
bank. Following ratios are computed in this group:
 Loan loss coverage ratio

 Loan loss provision to total income ratio

 Loan loss provision to total deposit ratio

i. Loan Loss Coverage Ratio

 The ratio is calculated by dividing provision for loans loss by total risk assets.
Loan loss Provision
=
Total Risk Assets
 For the purpose, risk assets constitute loans and advances, bills purchased and discounted. The ratio,
therefore, measures whether the provision is sufficient to meet the possible loss created by defaulted in
payment of loan or not. High ratio indicates that the major portion of loan is risky.

ii. Loan Loss Provision to Total Income Ratio

 The ratio is obtained by dividing loan loss provision by total income.
Loan loss Provision
=
Total Income
 The ratio shows what portion of total income has been held as safety cushion against the possible bad
loan. Higher ratio indicates that the greater portion of loan advanced by the bank is inferior in quality.
Low ratio means that the bank has provided most of its loans and advance in secured sector.

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Loan Loss Provision to Total Deposit Ratio
 The ratio is obtained by dividing the provision for loan loss by total deposit in the bank.
Loan Loss Provision
= Total Deposit
 It shows the proportion of bank's income held as loan loss provision in relation to the total deposit
collected. Higher ratio means quality of assets contained by the bank in form of loan is not much
satisfactory. Low ratio is the index of utilization of resources in healthy sector.
E. Profitability Ratio
 Profitability ratios are designed to highlight the end-result of the business activities, which in the
imperfect world of ours, is the sole criterion of cover all efficiency of business unit. A company should
earn profit to survive and grow over a long period. It is a fact that sufficient profit must be earned to
sustain the operations of the business, to able to obtain funds from investors for expansion and growth;
and to contribute towards the social overheads for the welfare of society. The profitability ratios are
calculated to measure the operating efficiency of the company. Management of the company, creditors
and owners are interested in the profitability of the firm. Creditors want to get interest and repayment of
principal regularly. Owners want to get a reasonable return from their investment.
 To meet the objective of study, following ratios are calculated in this group;
 Return on total assets
 Return on total equity
 Return on net worth

 Total interest expenses to total interest income ratio

i. Return on Total Asset

 The ratio is calculated by dividing net profit after tax by total on asset of the bank.
Net profit after tax
=
Total assets
 Net profit refers to the profit deduction of interest and tax. A total asset means the assets that appear in
asset of balance sheet. It measures the efficiency of bank in utilization of the overall assets. High ratio
indicates the success of management in overall operation. Lower ratio means insufficient operation of the
bank.

ii. Return on Equity

 The ratio is calculated by dividing net profit after tax by total equity of the bank.
Net profit after tax
=
Total Equity

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 Total equity refers to the sum of equity which is gained from common shareholders as well as the paid
up capital which is used for formation of capital. Higher ratio means the effective utilization of the
resources and it is better for the investor.

iii. Return on Net Worth

 The ratio is computed by dividing net profit after tax by net worth.
Net profit after tax
=
Net Worth
 The ratio is tested to see the profitability of the owner's investment "reflects the extent to which the
objective of business is accomplished". The ratio is of great interest to present as well as prospective
shareholders and of great significance to management, which has the responsibility of maximizing the
owner's welfare, so higher ratio is desirable.

iv. Total Interest Expenses to Total Interest Income Ratio

 The ratio is obtained by dividing total interest expenses by total interest income.
Total Interest Expenses
=
Total Interest Income
 Total interest expenses consist of interest expense incurred for deposit, borrowing and loans taken by the
bank. Total interest income includes interest income received from loans, advance, cash credit, overdrafts
and government securities, interbank and other investment. The ratio shows the percentage of interest
expenses incurred in relation to the interest income realized. Lower ratio is favorable from profitability
point of view.

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