WISCONSIN INTERNATIONAL

UNIVERSITY COLLEGE - MBA

FINANCIAL ANALYSIS AND PLANNING

FEBRUARY 2022
 FINANCIAL STATEMENT ANALYSIS
• A financial statement is an official document of the firm, which explores
the entire financial information of the firm. The main aim of the financial
statement is to provide information and understand the financial aspects of
the firm.

• According to Hamptors John, the financial statement is an organized

collection of data according to logical and consistent accounting
procedures. Its purpose is to convey an understanding of financial aspects
of a business firm.

• It may show a position at a moment of time as in the case of a balance-

sheet or may reveal a service of activities over a given period of time, as in
the case of an income statement.
 Financial Statement Analysis

• John N. Nyer also defines “a financial statements as a summary of the

accounting of a business enterprise, the balance-sheet reflecting the assets,
liabilities and capital as on a certain data and the income statement showing
the results of operations during a certain period”.

• Financial statements generally consist of three important statements:

• a. The income statement or profit and loss account.

• b. Balance sheet or the position statement.
• c. Cash flow statement

• A part from that, the business concern also prepares some of the other parts
of statements, which are very useful to the internal purpose such as:

• Statement of changes in owner’s equity.

• Statement of changes in financial position.
 Annual Report

• The annual report is the most important report that companies issue
to shareholders, and it contains two types of information.

• First, there is a verbal (written) section, often presented as a letter

from the chairperson, which describes the firm’s operating results
during the past year and discusses new developments that will affect
future operations.

• Second, the report provides these four basic financial statements:

 Annual Report

• 1. The balance sheet, which shows what assets the company owns and
who has claims on those assets as of a given date—for example, December
31, 2008.

• 2. The income statement, which shows the firm’s sales and costs (and thus
profits) during some past period—for example, 2008.

• 3. The statement of cash flows, which shows how much cash the firm
began the year with, how much cash it ended up with, and what it did to
increase or decrease its cash.

• 4. The statement of shareholders’ equity, which shows the amount of

equity the shareholders had at the start of the year, the items that increased
or decreased equity, and the equity at the end of the year.
 The Balance Sheet

• The balance sheet is a “snapshot” of a firm’s

position at a specific point in time. Figure 1
shows the layout of a typical balance sheet.

• A firm’s balance sheet shows its assets (what it

owns) and its liabilities (what it owes) at a point
in time. The difference between assets and
liabilities is the firm’s net worth, also called
owners’ equity or shareholder’s equity.

• Assets are divided into two major categories:

current assets and fixed, or long-term, assets.
 The Balance Sheet
• SUMMARISED BALANCE SHEET AT 31 DECEMBER 2008

• GHc’000 GHc’000
•
• Fixed assets 2,600
•
• Current assets
• Stocks 600
• Debtors 900
• Balance at bank 100
• _____
• 1,600
• Trade creditors 800
• _____
• 800
• _____
• 3,400
• Debenture stock 1,400
• _____
• 2,000
• _____
• Capital and reserves
• Ordinary share capital (GHc1shares)
• 1,000
• Preference share capital 200
• Profit and loss account 800
• _____
• 2,000
 The Balance Sheet
• Current assets consist of assets that should be converted to cash
within one year; and they include cash and cash equivalents,
accounts receivable, and inventory (stocks).

• Fixed assets are assets expected to be used for more than one year;
they include land and buildings, plant and equipment in addition to
intellectual property such as patents and copyrights.

• Plant and equipment is generally reported net of accumulated

depreciation. Fixed assets consist entirely of net plant and
equipment, and we often refer to them as “net fixed assets.”
 The Balance Sheet
• The claims against assets are of two basic types:

• Liabilities (or money the company owes to others) and

shareholders’ equity.

• Liabilities consist of claims that must be paid off within one year
(current liabilities), including accounts payable, accruals (total of
accrued wages and accrued taxes), and notes payable to banks that
are due within one year.

• Long-term debt includes bonds that mature in more than a year.

 The Balance Sheet
• Shareholders’ equity can be thought of in two ways.

• First, it is the amount that shareholders paid to the company when

they bought shares the company sold to raise capital, in addition to all
of the earnings the company has retained over the years:

• Shareholders' equity = Paid -in capital + Retained earnings

• The retained earnings are not just the earnings retained in the latest
year—they are the cumulative total of all of the earnings the company
has earned during its life.

• Shareholders’ equity can also be thought of as a residual:

• Shareholders' equity = Total assets - Total liabilities

 The Balance Sheet

• Working capital - Current assets are often

called working capital because these assets “turn
over”; that is, they are used and then replaced
throughout the year. The deference between a
firm’s current assets and its current liabilities is
called net working capital.

• Net working capital

• = Current assets - (Payables + Accruals)

 The Balance Sheet

• Other sources of funds - Most companies finance their assets with a

combination of current liabilities, long-term debt, and common equity.

• Some companies also use “hybrid” securities such as preferred stock,

convertible bonds, and long-term leases.

• Preferred stock is a hybrid between common stock and debt, while

convertible bonds are debt securities that give the bondholder an option to
exchange their bonds for shares of common stock.

• In the event of bankruptcy, debt is paid off first, then preferred stock.

• Common stock is last, receiving a payment only when something remains

after the debt and preferred stock are paid off.
 The Balance Sheet

• 5. Depreciation. Most companies prepare two sets of financial

statements—one is based on Internal Revenue Service (IRS) rules and is
used to calculate taxes; the other is based on generally accepted accounting
principles (GAAP) and is used for reporting to investors. Firms often use
accelerated depreciation for tax purposes but straight line depreciation for
stockholder reporting.

• 6. Market values versus book values. Companies generally use GAAP to

determine the values reported on their balance sheets. In most cases, these
accounting numbers (or “book values”) are different from what the assets
would sell for if they were put up for sale (or “market values”).
 Statement of changes in owner’s equity

• It is also called as statement of retained earnings. This statement provides

information about the changes or position of owner’s equity in the
company.

• How the retained earnings are employed in the business concern.

• Nowadays, preparation of this statement is not popular and nobody is going

to prepare the separate statement of changes in owner’s equity.
 Income Statement

• Net sales are shown at the top of the statement; then operating costs,
interest, and taxes are subtracted to obtain the net income available to
common shareholders.

• We also show earnings and dividends per share, in addition to some other
data, at the bottom Earnings per share (EPS) is often called “the bottom
line,” denoting that of all items on the income statement, EPS is the one
that is most important to stockholders.
 Income Statement

• Operating income is derived from the firm’s regular core business.

• Moreover, it is calculated before deducting interest expenses and taxes,

which are considered to be non-operating costs.

• Operating income is also called EBIT, or earnings before interest and taxes.
 Income Statement
• SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2008
• GHc000

• Sales 6,000
• Cost of sales ( including purchases GHc 4,300) 4,500
• _____
• Gross profit 1,500
• Administrative and distribution costs 1,160
• _____
• Trading profit 340
• Debenture interest 74
• _____
• Profit before tax 266
• Taxation 106
• _____
• Profit after tax 60
• Preference dividend 10
• _____
• Profit available for ordinary shareholders 150
• Ordinary dividend 10
• ____
• Retained profit 140
•
 Income Statement

• Operating Income (EBIT) = Sales Revenue – Operating Costs

• Taking a closer look at the income statement, we see that

depreciation and amortization are important components of
operating costs.

• Depreciation is an annual charge against income that reflects the

estimated cedis cost of the capital equipment and other tangible
assets that were used up in the production process.

• Amortization amounts to the same thing except that it represents

the decline in value of intangible assets such as patents,
copyrights, trademarks, and goodwill.
 Income Statement
• Finally, note that the income statement is tied to the balance sheet through
the retained earnings account on the balance sheet.

• Net income as reported on the income statement, less dividends paid, is the
retained earnings for the year .

• Those retained earnings are added to the cumulative retained earnings from
prior years to obtain the year-end 2008 balance for retained earnings.
 Statement of changes in financial position

• Income statement and position statement shows only about the position of
the finance, hence it can’t measure the actual position of the financial
statement.

• Statement of changes in financial position helps to understand the changes

in financial position from one period to another period.
 Statement of cash flow

• Cash flow statement is a statement which shows the sources of cash inflow
and uses of cash out-flow of the business concern during a particular period
of time.

• It is the statement, which involves only short-term financial position of the

business concern.
 Statement of cash flow

• Cash flow statement provides a summary of operating, investment and

financing cash flows and reconciles them with changes in its cash and cash
equivalents such as marketable securities.

• Management’s goal is to maximize the price of the firm’s stock; and the
value of any asset, including a share of stock, is based on the cash flows the
asset is expected to produce.
 statement of cash flow
• Cash flow from Operating Activities GHc’000
• Net Income 23.4
• +depreciation +30.0
• -increase in accounts receivable -10.0
• -increase in inventories -30.0
• +increase in account payables +12.0
• Total cash flow from operations 25.4

• Cash flow from Investing Activities

• -investment in plant and equipment -90.0

• Cash flow from Financing Activities

• -Dividend paid -10.0
• +Increase in short – term debt +94.6

• Total change in cash and marketable securities 20.0

 Statement of cash flow

a. Operating Activities.

• This section deals with items that occur as part of normal ongoing
operations.

• b. Net income.

The first operating activity is net income, which is the first source of cash.
If all sales were for cash, if all costs required immediate cash payments,
and if the firm were in a static situation, net income would equal cash from
operations.

However, these conditions don’t hold; so net income is not equal to cash
from operations. Adjustments shown in the remainder of the statement must
be made.
 Statement of cash flow

• c. Depreciation and amortization

• The first adjustment relates to depreciation and amortization. Depreciation

is a non cash expense deducted from revenue in computing net income. The
cash outlays for the plant and equipment that gave rise to the depreciation
charges occurred when they were originally purchased, but the depreciation
charges are recognised as an expense in each period over their assumed
useful life. Therefore, to get from net income to cash flow from operations,
we have to add back the depreciation charges.

• d. Increase in inventories.

• To make or buy inventory items, the firm must use cash. It may get some of
this cash as loans from its suppliers and workers (payables and accruals);
but ultimately, any increase in inventories requires cash.
 Statement of cash flow

• e. Increase in accounts receivable

• If a firm chooses to sell on credit, when it makes a sale, it will not

immediately get the cash that it would have received had it not extended
credit.

• To stay in business, it must replace the inventory that it sold on credit; but it
won’t yet have received cash from the credit sale. So if the firm’s accounts
receivable increase, this will amount to a use of cash.

• f. Increase in accounts payable

• Accounts payable represent a loan from suppliers. Firms may buy goods on
credit, and its payables would increase.
WISCONSIN INTERNATIONAL
UNIVERSITY COLLEGE - MBA

FINANCIAL ANALYSIS AND

PLANNING

Financial Analysis and

Planning (B)
 Financial Analysis and Planning
• Financial analysis is designed to determine the relative strengths and
weaknesses of a company. Investors need this information to estimate both
future cash flows from the firm and the riskiness of those cash flows.

• Financial managers need the information provided by analysis both to

evaluate the firm’s past performance and to map future plans. Financial
analysis concentrates on financial statement analysis, which highlights the
key aspects of a firm’s operations.

• Financial statement analysis involves a study of the relationships between

income statement and balance sheet accounts, how these relationships
change over time (trend analysis), and how a particular firm compares with
other firms in its industry (bench-marking).

• Although financial analysis has limitations, when used with care and
judgment, it can provide some very useful insights into a company’s
operations.
 Financial Analysis and Planning
• Financial statements are used to help predict the firm’s future
earnings and dividends. From an investor’s standpoint, predicting
the future is what financial statement analysis is all about.

• From management’s standpoint, financial statement analysis is

useful both to help anticipate future conditions and, more important,
as a starting point for planning actions that will influence the future
course of events.

• Financial ratios are designed to help one evaluate a firm’s financial

statements. The burden of debt, and the company’s ability to repay,
can be best evaluated

• (1) by comparing the company’s debt to its assets and

• (2) by comparing the interest it must pay to the income it has
available for payment of interest. Such comparisons are made by
ratio analysis.
 Financial Analysis
• Definition
Financial analysis is the process of identifying a firm’s strength and
weaknesses by establishing relationships between the items of the Balance
sheet and profit and loss account (income statement account).

• Users of Financial Statement

• i. Lenders
• ii. Investors
• iii. Trade Creditors
• iv. Management
 Financial Ratio Analysis

• Financial analysis is the selection, evaluation, and interpretation of

financial data, along with other pertinent information, to assist in
investment and financial decision-making.

• Financial analysis may be used internally to evaluate issues such as

employee performance, the efficiency of operations, and credit
policies, and externally to evaluate potential investments and the
credit-worthiness of borrowers.

• Ratio Analysis is a form of financial statement analysis that is used

to obtain a quick indication of a firm's financial performance in
several key areas.

• The ratios are categorized as Short-term Solvency Ratios, Debt

Management Ratios, Activity ratio (Asset Management Ratios),
Profitability Ratios, and Market Value Ratios.
 Tools of financial analysis
• 1.0 Ratio Analysis

• A firm’s strength and weaknesses is established by viewing the relationship

between items in the Balance sheet and profit and loss using ratio analysis.

• A ratio is defined as the indicated quotient of two mathematical

expressions. It can also be described as the relationship between two or
more things. It is used as a benchmark for evaluating the financial position
and performance of a firm.

• Absolute accounting figures reported in the firm’s financial statements do

not provide any meaningful understanding of performance and the firm’s
financial position.
 1.1 Standards of Comparison
• The ratio analysis involves comparison for a useful interpretation of the financial
statements. That a single ratio does not indicate either favourable or unfavourable
state, rather it should be compared with some standards. Such standards include;
•
• i) Past Ratios
• - from past financial statements of the same firm
•
• ii) Industry Ratios
• - of the industry to which the firm belongs
•
• iii) Projected Ratios
• –Ratios developed using projected financial statements of the same firm.
•
• iv) Competitive Ratios
• –Ratios of some selected firms especially the most progressive and successful
competitors
•
 1.2 Trend Analysis

• Evaluation of performance of a firm is easily done by comparing its

current ratios with past ratios. When the financial ratios over a
period of time are compared, it is called time series analysis or trend
analysis.

• It gives the indication of direction of change and it reflects whether

the firm’s performance has improved, deteriorated or remained
constant over time.

• When analyzing, the analyst should not simply determine the change
but more importantly understand why ratios have changed.

• The change may be affected by changes in the accounting policies

without material change in the firm’s performance.
 1.3 Inter-Firm Analysis

• Comparing ratios of one firm with selected firms in the same industry at the
same point in time is also done.

• This is called cross-sectional Analysis or inter-firm analysis.

• It is useful to compare the firm’s ratios with ratios of a few carefully

selected competitors with similar operations.

• This kind of a comparison indicates the relative financial position and

performance of the firm.
 1.4 industry analysis

To determine the firm’s financial condition and performance, it is necessary to

compare average ratios of the industry to which the firm is a member.

This helps to ascertain the financial standing and capability of the firm vis a
vis other firms in the industry.

Industry ratios are important standards in view of the fact that each industry
has its characteristics which influence the financial and operating
relationships.
 Weaknesses of using industry ratios

• a) It becomes difficult to get or establish average ratios for the

industry

• b) The available industry ratios are only averages. The averages of

strong and weak firms may bear wide variances that may be
insignificant and could be meaningless.

• c) Averages will be meaningless and comparison futile if firms

within the same industry widely differ in their accounting policies
and practices.
 1.5 Proforma financial statement analysis

• that, future ratios could be used as the standard for comparison. they
can be developed from projected or proforma financial statements.

• the comparisons of the firm’s current and past ratios show its
relative strength and weaknesses in the past and in the future.

• if the future ratios indicate weak financial position, then corrective

measures could be initiated.
 Classification of ratios

• Ratios are classified according to the way they are constructed and
their general characteristics.

• (i) A coverage ratio – is a measure of a firm’s ability to satisfy

(meet) particular obligations.

• (ii) A return ratio – is a measure of the net benefit, relative to the

resources expended.

• (iii) A turnover ratio – is a measure of the gross benefit, relative to

the resources expended.
 Aspects of operating performance and financial
condition

• (i) A liquidity ratio – provides information on a firm’s ability to meet its

short-term, immediate obligations.

• (ii) A profitability ratio – provides information on the amount of income

from each cedi of sales.

• (iii) An activity ratio – relates information on a firm’s ability to manage its

resources (that is, its assets) efficiently.
 Aspects of operating performance and financial
condition

• (iv) A financial leverage ratio – provides information on the degree of a

firm’s fixed financial obligations and its ability to satisfy these financing
obligations.

• (v) A shareholder ratio – describes the firm’s financial condition in terms

of amounts per share of stock.

• (vi) A return on investment ratio – provides information on the amount of

profit, relative to the assets employed to produce that profit.
 Short-term Solvency or Liquidity Ratios

• Liquidity reflects the ability of a firm to meet its short-term

obligations using assets that are most readily converted into cash.

• Assets that may be converted into cash in the short period of time
are referred to as liquid assets, which are listed in the financial
statements as current assets.

• Current assets are used to satisfy short-term obligations or current

liabilities.
 Measures of liquidity

• Liquidity Ratios attempt to measure the ability of a firm to meet its short-
term financial obligations. In other words, these ratios seek to determine
the ability of a firm to avoid financial distress in the short-run.

• The two most important Short-term Solvency Ratios are the Current Ratio
and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test
Ratio.)

• Liquidity provides a measure of a firm’s ability to generate cash to meet its

immediate needs.

• Generally, the larger the liquidity ratio the better the ability of the firm to
satisfy its immediate obligations. There are three commonly used liquidity
ratios:
 The current ratio
• The current ratio – is the ratio of current assets to current liabilities. It
indicates a firm’s ability to satisfy its current liabilities with its current
assets.

• Current Assets are the assets that the firm expects to convert into cash in
the coming year and Current Liabilities represent the liabilities which have
to be paid in cash in the coming year.

• The appropriate value for this ratio depends on the characteristics of the
firm's industry and the composition of its Current Assets. However, at a
minimum, the Current Ratio should be greater than one.

• Current ratio = current assets

current liabilities
 Quick Ratio/Acid Test Ratio
• The quick/acid test ratio is the ratio of quick assets (generally current assets less
stocks) to current liabilities. It indicates a firm’s ability to satisfy current liabilities
with most liquid assets.

• The Quick Ratio recognizes that, for many firms, stocks (inventories) can be rather
illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the
firm might have difficulty in finding a buyer and the inventory items would likely
have to be sold at a substantial discount from their fair market value.

• This ratio attempts to measure the ability of the firm to meet its obligations relying
solely on its more liquid current asset accounts such as cash and accounts
receivable. This ratio is calculated by dividing current assets less stocks
(inventories) by current liabilities.

• Quick ratio = current assets – stocks

current liabilities

• Quick ratio = cash + marketable securities + receivable

Current liabilities
 Cash Ratio

• Cash Ratio: A company’s most liquid assets are its holdings of cash and
marketable securities. That is why analysts also look at the cash ratio:

• Cash ratio = cash + marketable securities

Current Liabilities
 Net Working Capital to Sales Ratio

• Net working capital to sales ratio is the ratio of net working capital (current
assets minus current liabilities) to sales.

• It indicates a firm’s liquid assets (after meeting short term obligations)

relative to its need for liquidity (represented by sales).

• Net working capital to sales ratio =

current assets – current liabilities

sales
 The Operating Cycle

• The operating cycle is the length of time it takes to convert an investment

of cash in stocks (inventory) back into cash (through collection of sales).

• The net operating cycle is the length of time it takes to convert an

investment of cash in stocks and back into cash considering that some
purchases are made on credit.

• The number of days a company ties up funds in stocks is determined by:

• (i) the total amount of money represented in stocks

• (ii) the average day’s cost of goods are sold
 Profitability Ratios
• Profitability Ratios attempt to measure the firm's success in generating income.
These ratios reflect the combined effects of the firm's asset and debt management.

• a. Gross profit margin – is the ratio of gross income or profit to sales. This ratio
indicates how much of every cedi of sales is left after costs of goods sold.

• Gross profit margin = Gross Income

sales

• b. Operating profit margin

Is the ratio of operating profit (ie: Earnings before interest and taxes, EBIT) to sales.
This is a ratio that indicates how much of each cedi of sales is left over after
operating expenses.

• Operating profit margin = Operating income

sales

• Operating profit margin = Operating income (EBIT)

Sales
 Profitability Ratios

c. Net Profit Margin

The Net Profit Margin indicates the cedi in income that the firm earns on each
cedi of sales.

This ratio is calculated by dividing Net Income by Sales.

• Profit margin = Net Income

sales

d. Return in Investment

• Net Profit after tax × 100

• Shareholder Fund
 Return on Assets (ROA), and Return on Equity (ROE)
Return on Sales (ROS)

• The Return on Assets Ratio indicates the cedis in income earned by the firm on its
assets and the Return on Equity Ratio indicates the cedis of income earned by the
firm on its shareholders' equity.

• It is important to remember that these ratios are based on Accounting book values
and not on market values. Thus, it is not appropriate to compare these ratios with
market rates of return such as the interest rate on Treasury bonds or the return
earned on an investment in a stock.

• Return on Assets (ROA) = Net Income

• Total Assets

• Return on Equity (ROE) = Net Income

• Total Owners Equity

• Return on Sales (ROS) = EBIT

• Sales
 Activity Ratio (Asset Management Ratios)

• Activity ratios attempt to measure the firm's success in managing its assets
to generate sales.

• For example, these ratios can provide insight into the success of the firm's
credit policy and inventory management.

• These ratios are also known as Asset management or Turnover Ratios.

 Receivables Turnover
• The Receivables Turnover and Days' Receivables Ratios assess the firm's
management of its accounts receivables and, thus, its credit policy.

• In general, the higher the receivables turnover ratio the better, since this
implies that the firm is collecting on its accounts receivables sooner.

• However, if the ratio is too high then the firm may be offering too large of a
discount for early payment or may have too restrictive credit terms.

• The receivables turnover ratio is calculated by dividing sales by accounts

receivables. (Note: since accounts receivables arise from credit sales it is
more meaningful to use credit sales in the numerator if the data is
available) .

• Receivables Turnover = Sales

Accounts receivables

• Debtors Turnover Ratio = Credit Sales

Average Debtors
 Days' Receivables
• The Days' Receivables Ratio is calculated by dividing the number of days
in a year, 365, by the receivables turnover ratio.

• Therefore, the days' receivables indicates how long, on average, it takes for
the firm to collect on its sales to customers on credit.

• This ratio is also known as the days' sales outstanding (DSO) or average
collection period (ACP).

• Days receivables = Receivables * 365

Sales
 Debtors ratio
• This is computed by dividing the debtors by the average daily sales to
determine the number of days sales held in debtors.

• A long average collection period probably indicates poor credit control.

• Average collection period = Trade Debtors × 365 days

• Credit Sales

• Average collection period = Account Receivable

• Average Daily Sales
 Creditors Turnover Ratio

• Creditors Turnover Ratio = Credit Purchase

• Average Credit
 Creditors ratio
• This is computed by dividing the creditors by the average daily credit
purchases to determine the number of days purchases are held in creditors.

• Average payment period = Trade Creditors × 365 days

• Credit Purchases

• Average payment period = Account payable

• Average Daily Purchases
 Inventory Turnover and Days' Inventory
• The Inventory Turnover and Days' Inventory Ratios measure the firm's
management of its Inventory.

• In general, a higher inventory turnover ratio is indicative of better

performance since this indicates that the firm's inventories are being sold
more quickly.

• However, if the ratio is too high then the firm may be losing sales to
competitors due to inventory shortages. The Inventory Turnover Ratio is
calculated by dividing cost of goods sold by inventory.

• When comparing one firm's Inventory Turnover ratio with that of another
firm it is important to consider the inventory valuation method used by the
firms. Some firms use a FIFO (first-in-first-out) method, others use a LIFO
(last-in-first-out) method, while still others use a weighted average method.

• Inventory turnover = Cost of goods sold

• Inventory
 Days' Inventory Ratio
• The Days' Inventory Ratio is calculated by dividing the number of days in a
year, 365, by the Inventory Turnover Ratio.

• Therefore, the Days' Inventory indicates how long, on average, an

inventory item sits on the shelf until it is sold.

• Days stock = 365

stocks turnover
 Stock turnover
• This ratio indicates whether stock levels are justified in relation to sales.
The higher the ratio, the healthier the cash flow position.

• Stock turnover = Stocks

• Cost of sales

• Stock turnover can also be calculated in days as:

• Stockholding period = Cost of sales × 365 days

• Stock
 Fixed Assets Turnover
• The Fixed Assets Turnover Ratio measures how productively the
firm is managing its Fixed Assets to generate Sales.

• This ratio is calculated by dividing sales by net fixed assets.

• When comparing fixed assets turnover ratios of different firms it is

important to keep in mind that the values for net fixed assets
reported on the firms' balance sheets are book values which can be
very different from market values.

• Fixed Assets Turnover = sales

Net fixed assets
 Total Assets Turnover
• The Total Assets Turnover Ratio measures how productively the firm is
managing all of its assets to generate sales.

• This ratio is calculated by dividing sales by total assets.

• Total Assets Turnover Ratio = Sales

Total Assets
 Investor ratios
• Earnings per share

• Earnings available for ordinary shareholders’ means profits after

interest, taxation and preference dividends.

• Earnings per share = Earnings available for ordinary

shareholders
• Number of ordinary shares in issue

• Earnings per share is used by investors in calculating the price–

earnings ratio or PE ratio. This is simply calculated as follows:
 Investor ratios

• PE ratio = Market price of share

Earnings per share

• A high PE ratio means that the shares are seen as an attractive investment.

• For example, if the PE ratio is 20, it means that investors are prepared to
pay 20 times the annual level of earnings in order to acquire the shares.
 Investor ratios
• Dividend cover = Profit available to ordinary shareholders
Dividend

• This gives an indication of the security of future dividends.

• A high dividend cover ratio means that available profits comfortably cover
the amount being paid out in dividends.
 Risk
• Gearing

• Gearing measures the extent to which a business is

dependent on borrowed funds, as opposed to equity funding.
Gearing gives an indication of long–term liquidity and the
risk inherent within the business.

• Highly geared companies have to meet interest

commitments before paying dividends and may have
problems raising further finance if expansion is necessary.

• Gearing = Long - term debt and preference share capital × 100%

• Shareholder funds and long - term debt and preference share capital
 Interest cover

• Interest cover = Profit before interest

• Interest paid

• Interest on debt has to be paid before shareholders can receive dividends.

• Therefore a good measure of risk is to compare available profit with the

amount of interest to be paid.
 GLORYLAND COMPANY LIMITED – BALANCE SHEET

• Now calculate all of the above ratios on the following profit and loss account and balance sheet for a company
called Gloryland Company Limited.
•
• SUMMARISED BALANCE SHEET AT 31 DECEMBER 2008
• GHc000 GHc000
•
• Fixed assets 2,600
•
• Current assets
• Stocks 600
• Debtors 900
• Balance at bank 100
• _____
• 1,600
• Trade creditors 800
• _____
• 800
• _____
• 3,400
• Debenture stock 1,400
• _____
• 2,000
• _____
• Capital and reserves
• Ordinary share capital (GHc1shares)
• 1,000
• Preference share capital 200
• Profit and loss account 800
• _____
• 2,000
•
 GLORYLAND COMPANY LIMITED – INCOME STATEMENT
• SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2008
• GHc000

• Sales 6,000
• Cost of sales (including purchases GHc 4,300) 4,500
• _____
• Gross profit 1,500
• Administrative and distribution costs 1,160
• _____
• Trading profit 340
• Debenture interest 74
• _____
• Profit before tax 266
• Taxation 106
• _____
• Profit after tax 60
• Preference dividend 10
• _____
• Profit available for ordinary shareholders 150
• Ordinary dividend 10
• _____
• Retained profit 140
•
 Solution

• ROCE = 10% 340/3,400 × 100%

• Profit margin = 5.7% 340/6,000 × 100%
• Asset turnover = 1.8 times 6,000/3,400
• Gross profit margin = 25% 1,500/6,000 × 100%
• Return on owners’ equity = 14.2% (266 – 10)/(1,000 + 800) × 100%
• Current ratio = 2 times 1,600/800
• Acid test ratio = 1.25 times (900 + 100)/800
• Debtors ratio = 55 days 900/6,000 × 365 days
• Creditors ratio = 68 days 800/4,300 × 365 days
• Stock turnover = 7.5 times 4,500/600
• Earnings per share = 15p 150/1,000
• Dividend cover = 15 times 150/10
• Gearing = 47% (1,400 + 200)/3,400 × 100%
• Interest cover = 4.6 times 340/74
 Interpretation
• The first stage of answering questions on
interpretation is to calculate the ratios; the second
is to draw conclusions about the company based
on those ratios.

• A study of the trend of ratios for several years is

desirable before drawing firm conclusions about
many aspects of a company’s position.

• Let us consider what conclusions we may draw

from the illustrative accounts of Gloryland
Company Limited above.
 Profitability
•

• 1. Return on capital employed – The company shows a return on total capital

employed of 10%: not dramatically good, but satisfactory. Note that it exceeds the
rate of interest being paid on the debentures (5.3%).
•
• 2. Net profit as percentage of sales – This is fairly low at 5.7%. The net profit as a
percentage of sales varies greatly from industry to industry: more information is
needed about the performance of other companies to draw useful conclusions about
the level of this ratio.
•
• 3. Asset turnover ratio – The overall efficiency may be judged by asset turnover.
This is 1.8 times for Gloryland Company Limited.
•
• 4. Gross profit margin – This is a more respectable 25% but again comparison to
the industry average would indicate whether it is acceptable.
•
• 5. Return on owners’ equity – The level of acceptability of 14.2% will depend on
three things.
•
• _ The investors’ anticipated return.
• _ The industry average or that of competitors.
• _ The return available in other forms of investment, eg building society
 Liquidity
• A quick ratio of about 1:1 is normally regarded as indicating a reasonable
level of liquidity.

• The current ratio is often more variable, because of variations in a

company’s need to hold stocks.

• We may deduce either that the nature of Gloryland Company Limited

business is such that above–average stock levels are needed, or that its
stock control procedures leave something to be desired.

• More information is clearly needed. The stock turnover ratio may throw
more light on this aspect: see ‘asset utilisation’ below.
 Asset utilisation
• Several ratios give some idea of management efficiency.

• 1. Asset turnover ratio – Unfortunately we can draw no conclusions

whatsoever about the company and the efficiency of its management
without more information to compare it with the ratios for Gloryland
Company Limited in past years and the ratios for other similar companies
in the current year.
•
• 2. Debtors ratio – Gloryland Company Limited figure of 55 days is
probably acceptable, since 60 days is often regarded as ‘par’ for a company
offering normal credit terms of monthly settlement for all its sales.
•
• 3. Creditors ratio – Gloryland Company Limited is paying its creditors on
average in 68 days. This is after the period from which it collects its
debtors (55 days) so it will help cash flow overall.
•
• 4. Stock turnover ratio – This comes to 7.5 times for Gloryland Company
Limited. It is again difficult to draw conclusions about this figure in
isolation. It needs to be compared with other years for Gloryland Company
Limited and with other companies.
 Investor ratios

• 1. Earnings per share – Gloryland Company Limited earnings per

share is GHc0.15p.

• This should be compared to Gloryland Company Limited earnings

per share achieved in prior years to determine whether the trend is
favourable or not.

• 2. Dividend cover – This is fifteen times, a very secure profit to

dividend ratio.
 Risk

1. The gearing ratio for Gloryland Company

Limited is 47%. Anything over 50% would
probably be regarded as fairly high.

• 2. Interest cover – For Gloryland Company

Limited this is 4.6 times. This may be
considered reasonable.
 PEC Manufacturing Company - Balance Sheet as at Dec 31, 2011
•

• 2010 2011

• Cash 10,000 750

• Account Receivables 12,750 17,200
• Inventory 31,200 46,250
• Total Current Assets 53,950 64,250
• Land 22,500 27,120
• Plant and Equipment 71,250 100,000
• Less accumulated depreciation (31,200) (32,000)
• Total fixed assets 62,550 94,920
• 116,500 159,120

• Accounts payable 11,500 24,000

• Bank overdraft 18,250 49,500
• Total current liabilities 29,750 73,500
• Term loan 33,700 27,500
• Shareholders’ funds 53,050 58,120
• 116,500 159,120
 PEC Manufacturing Company – Income Statement for the year ended
Dec 31, 2011
• 2010 2011
• Sales 129,000 163,000
• Cost of goods sold 77,400 97,800
• Gross Profit 51,600 65,200

• Expenses:

• Administrative 21,750 21,750

• Operating 12,900 16,300
• Depreciation 4,700 10,000
• Total expenses 39,350 48,050
• Earnings before Int. & Tax 12,250 17,150
• Interest 3,500 6,250
• Earnings before taxes 8,750 10,900
• Tax 4,200 5,232
• 4,550 5,668
 Questions
• a. Based on the financial statements for PEC Manufacturing Company, compute the
following ratios:
• Industry Actual (2010) Actual (2011)
• Current Ratio 1.84
• Acid test ratio 0.66
• Average collection period 37 days
• Inventory turnover 2.6 times
• Times interest earned 3.6
• Debt to total assets 55%
• Gross profit margin 39%
• Net profit margin 3.4%
• Total asset turnover 1.2 times
• Fixed asset turnover 1.5 times
• Return on total assets 4.3%
• Return on shareholders’ funds 10%

b. Write a brief report to the bank manager outlining the reasons why the loan
should or should not be granted.
 The Dupont equation

• The DuPONT EQUATION – is a formula that shows that the rate of return
on equity can be found as the product of profit margin, total assets turnover,
and the equity multiplier.

• It shows the relationships among assets management, debt management,

and profitability ratios
 The Dupont equation
• ROE = Profit margin x Total asset turnover x Equity multiplier

= Net income x Sales x Total assets

Sales Total assets Total common equity

= 317.50 5,000 4,000

5,000 4,000 1,140

= 6.35% 1.25 times 3.51 = 27.86%

Industry = 8.0% x 1.9 times x 1.85 = 28.12%

 A Dupont equation
• The first term, the profit margin, tells us how much the firm earns on its
sales. This ratio depends primarily on costs and sales prices. If a firm can
command a premium price and hold down its costs, its profit margin will be
high, which will help its ROE.

• The second term is the total assets turnover. It is a ‘multiplier’ that tells us
how many times the profit margin is earned each year. ABC Limited earned
6.35% on each cedi of sales, and its assets were turned over 1.25 times each
year; so its return on assets was 6.35% x 1.25 = 7.94%

• The equity multiplier, which is the adjustment factor. ABC Limited assets
are 3.51 times its equity. Thus we must multiply the 5.9% return on assets
by the 3.51 x equity multiplier to arrive at its ROE of 27.86%
 A Dupont equation
• Why the use of DuPont equation :

• DuPont equation helps us see why ABC Limited’s ROE is only 27.86%
versus 28.12% for the industry.

• First, its profit margin is below average, which indicates that its costs are
not being controlled as well as they should be and that it cannot charge
premium prices. In addition, because it uses more debt than most
companies, its high interest charges also reduce the net profit margin.
• Second, its total assets turnover is below the industry average, which
indicates that it has more assets than it needs.

• Finally, because its equity multiplier is relatively high, its heavy use of debt
offsets to some extent its low profit margin and turnover.
 Question
• Box Computer Limited – Balance Sheet as at December 31, 2010

• GHc’000 GHc’000
• Cash 77,500 Accounts payable 129,000
• Receivables 336,000 Notes payable 84,000
• Inventories 241,500 Others current liabilities 117,000
• Total current assets 655,000 Total current liabilities 330,000

• Long-term debt 256,500

• Net fixed assets 292,500 Common equity 361,000
• Total assets 947,500 Total liabilities and equity 947,500
 Question
Box Computer Limited- income Statement for year ended December 31, 2010
GHc’000 GHc’000
• Sales 1,607,500
• Cost of goods sold,
• Material 717,000
• Labour 453,000
• Heat, light and power 68,000
• Indirect labour 113,000
• Depreciation 41,500 1,392,500
• Gross Profit 215,000
• Selling expenses 115,000
• General and administrative exp 30,000
• EBIT 70,000
• Interest expenses 24,500
• Earnings before taxes 45,500
• Tax (40%) 18,200
• Net Income 27,300
 Question

• Ratio Box Industry Average

• Current - 2.0x
• Quick - 1.3x
• Days sales outstanding (365) - 35.0 days
• Inventory turnover - 6.7x
• Total asset turnover - 3.0x
• Profit margin - 1.2%
• ROA - 3.6%
• ROE - 9.0%
• Total debt/total assets - 60.0%
 Question

• Data for Box Computer Limited and its industry average

follow.

• a. Calculate the indicated ratio for Box Computer Limited.

• b. Construct the DuPont equation for both Box and the

industry.

• c. Outline Box’s strength and weaknesses as revealed by your

analysis.
 Question

• Given the following financial statements, historical ratios, and industry

averages, calculate Ocean Ventures Limited financial ratio for 2014.

• Analyse its overall financial situation both in comparison with industry

averages and over the period 2012 – 2013.

• Break your analysis into an evaluation of the firm’s liquidity, activity, debt,
profitability, and market value.
Question
Question
Question
Solution
Solution
Solution
Solution
Solution
 Question
Qu 1.
First Creation Company Limited Balance Sheet , December 31, 2015

Assets GHc
Cash 1,000,000
Account Receivable 5,000,000
Inventory 7,000,000
Fixed Assets, net 17,000,000

• Total Assets 30,000,000

Liabilities and Shareholder’s Equity

GHc
Notes payable, bank 4,000,000
Account payable 2,000,000
Accrued wages and taxes 2,000,000
Long-term debt 12,000,000
Preferred stock 4,000,000
Common stock 2,000,000
Retained earnings 4,000,000
Total liabilities & Shareholders equity 30,000,000
 Question
First Creation Company Limited Statement of Income and Retain Earnings Year Ended December 31, 2015

GHc
Net Sales
Credit 16,000,000
Cash 4,000,000
Total 20,000,000

Cost and Expenses

Cost of goods sold 12,000,000
Selling, General and Admin expenses 2,200,000
Depreciation 1,400,000
Interest 1,200,000 16,800,000
Net income before taxes 3,200,000
Taxes on income 1,200,000
Net Income after Taxes 2,000,000
Less: Dividend on preferred stocks 240,000
Net income available to common shareholders 1,760,000
Add: Retained Earning at 1/1/2015 2,600,000
Subtotal 4,360,000
Less; Dividend paid on common stock 360,000
Retained earnings 31/12/2015 4,000,000
 Question

a. Fill in the 2015 column in the table below

• Ratio 2013 2014 2015 Industry Norms

• 1. current ratio 250% 200% 225%

• 2. Acid - test ratio 100% 90% 110%
• 3. Receivable turnover 5.0x 4.5x 6.0x
• 4. Inventory turnover 4.0x 3.0x 4.0x
• 5. long-term debt/total capitalization 35% 40% 33%
• 6. Gross profit margin 39% 41% 40%
• 7. Net profit margin 17% 15% 15%
• 8. Return on equity 15% 20% 20%
• 9. Return on investment 15% 12% 12%
• 10. Total asset turnover 0.9x 0.8x 1.0x
• 11. Interest cover ratio 5.5x 4.5x 5.0x

b. Comment on the specific trend analysis

 Question
Qu 2. Great Plumbing Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statements over the last three
years are as follows:
•
• 2011 2012 2013
• GHc GHc GHc
• Cash 30,000 20,000 5,000
• Accounts receivable 200,000 260,000 290,000
• Inventory 400,000 480,000 600,000
• Net fixed assets 800,000 800,000 800,000
1,430,000 1,560,000 1,695,000
• Accounts payable 230,000 300,000 380,000
• Accruals 200,000 210,000 225,000
• Bank loan, short term 100,000 100,000 140,000
• Long-term debt 300,000 300,000 300,000
• Common stock 100,000 100,000 100,000
• Retained earnings 500,000 550,000 550,000
• 1,430,000 1,560,000 1,695,000
•
• Sales 4,000,000 4,300,000 3,800,000
• Cost of goods sold 3,200,000 3,600,000 3,300,000
• Net profit 300,000 200,000 100,000
•
• Using the ratios discussed in the chapter, analyze the company’s financial condition and performance over the last three
years. Are there any problems?
 Question

Qu. 3 Super Computer Company: Balance Sheet as of December 31, 2015 (In Thousands)

• Assets GHc Liabilities GHc

Cash 77,500 Accounts payable 129,000

Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities 117,000
Total current assets 655,000 Total current liabilities 330,000
Net fixed assets 292,500 Long-term debt 256,500
Common equity 361,000
• Total assets 947,500 Total liabilities and equity 947,500
 Question
• Super Computer Company: Income Statement for Year Ended December 31, 2015
• (In Thousands)
• GHc GHc
• Sales 1,607,500
• Cost of goods sold
• Materials 717,000
• Labor 453,000
• Heat, light, and power 68,000
• Indirect labor 113,000
• Depreciation 41,500 1,392,500
• Gross profit 215,000
• Selling expenses 115,000
• General and administrative expenses 30,000
• Earnings before interest and taxes (EBIT) 70,000
• Interest expense 24,500
• Earnings before taxes (EBT) 45,500
• National income taxes (40%) 18,200
• Net income 27,300
 Question

• RATIO SUPPER INDUSTRY AVERAGE

•
• Current assets/current liabilities _____________ 2.0x
• Days sales outstanding a _____________ 35 days
• Sales/inventories _____________ 6.7x
• Sales/total assets ______________ 3.0x
• Net income/sales ______________ 1.2%
• Net income/total assets ______________ 3.6%
• Net income/common equity ________________ 9.0%
• Total debt/total assets ________________ 60.0%
•
• a Calculation is based on a 365-day year.
 Question

• Data for Supper Computer Company and its industry averages follow.

• a. Calculate the indicated ratios for Super Computers

• b. Construct the extended Du Pont equation for both Supper and the
industry.
• c. Outline Supper’s strengths and weaknesses as revealed by your analysis.
• d. Suppose Supper had doubled its sales as well as its inventories, accounts
receivable, and common equity during 2015. How would that information
affect the validity of your ratio analysis?

• (Hint: Think about averages and the effects of rapid growth on ratios if
averages are not used. No calculations are needed.)