UNIT THREE

Financial analysis
 Financial statements
 The objective of financial statements is to
provide financial information of the business
to all users to help them in their decision
making.
 Financial statements of a company contains a
lot of information about the financial
performance of the company.
 These statements give the overall picture of
the company, but to analyze each and every
aspect of the business extensively, financial
analysis is a must.
 Financial Analysis
 Financial analysis is the examination of a
business from a variety perspectives in order to
fully understand the financial situation and
determine how best to strengthen the business.
 Is the process of identifying the financial
strengths and weaknesses of the firm by
properly establishing a relationship between the
items of balance sheet and income statement.
 A financial analysis looks at many aspects of a
business from its profitability and stability to its
solvency and liquidity.
 Types of ratio comparisons
(standards of comparison)
 Ratios do not reveal by themselves. A single
ratio in it self do not indicate favorable or
unfavorable condition. It should compared
with some standards.
1. Time series analysis:
Is the process of evaluating the performance
of the firm overtime.
2. Cross-sectional analysis:
Involves the comparison of different firms’
financial ratios at the same point in time.
 Cont…
 i.e. Comparing ratio of one firm with some
other selected firms in the same industry at the
same time in time.
Cross sectional analysis can be made:
a. Competitors ratio: Comparing the
ratios of the firm with the ratios of
some selected firms, especially with
the most successful
b. Industry ratio: Comparing the ratio
of the firm with the average ratios
of the industry to which the firm
belongs
 Cont…

3. Performa analysis:
Involves the comparison of the firms ratio
with the future ratios of the firm. Future
ratios can be developed from the projected or
projected financial statements.
 Ratio analysis
 Ratio-analysis is the most common,
comprehensive and powerful tool of the
financial statement analysis.
 It the process of computing, determining and
presenting the relationship of related items and
groups of items of the financial statements.
 Ratio analysis is defined as the systematic use
of ratio to interpret the financial statements so
the strength and weakness of the firm as well as
its historical performance and current financial
condition can be determined.
 Cont…
 The term ratio refers to the numerical/quantitative
relationship between two items or variables. Or
 It is one number expressed in terms of the other
and can be worked out by dividing one number in
to the other.
 This relationship can be expressed as:-
1) Proportion(ratio)
2) Fraction
3) Percentage
 Categories of Financial Ratios

 Financial ratios are often divided into mainly

five categories based on the information that
they provide:
1. Liquidity ratio
2. Asset management ratio
3. Leverage ratio/ debt management ratio
4. Profitability ratio
5. Market value ratio.
1. Liquidity Ratios
 Liquidity ratios describe the ability of a firm
to meet its current obligations as and when
they come due with current assets i.e.The
primary concern is the firm’s ability to pay
its bills over the short run without undue
stress.
 ‘Liquidity’ refers to the speed with which an
asset can be converted to cash.
 Generally, it refers to the short-term of
solvency of the firm
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 Cont…

 There are two common measures of liquidity

ratios:
I. The Current Ratio
II. The Quick Ratio

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 I. The Current Ratio
 It is the most common ratio for measuring the firms short
term solvency.
 It indicates the availability of current asset in birr for
every one birr of current liability.
Current Assets
CR 
Current Liabilities

40,000 = 2.22 times

CR = 18,000
Interpretations: ABC company has $2.22 of current assets for every $1 of
current liabilities.
Suggestion: As compared with the average industry (2:1), ABC is in a
good position to pay its current obligation with out a such big problem.
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 II. The Quick Ratio

 It is often referred to as Acid test ratio. Because it is a

measure of the firms ability to convert current assets
with out a loss of value in to cash in order to meet its
current obligation.
Microsoft
Equation 3.0

Acid-Test Current Assets – Inventory – Prepaid items

Ratio =
Current Liabilities

Acid-Test Ratio = 19,500 = 1.08 times

18,000

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2. Asset Management Ratios

 They are also called efficiency ratios, assets

utilization ratios, activity ratio.
 They are employed to evaluate the efficiency
with which the firm manages and utilizes its
assets. Or
 It measures the speed with which assets can
be converted or turned over in to sales.

1
 Cont…

The Commonly used measures of asset management

ratio are:

I. Inventory Turnover Ratio

II. Days of holding inventory
III. Accounts Receivable Turnover Ratio
IV. Average Collection Period
V. Fixed Asset Turnover Ratio
VI. Total Asset Turnover Ratio

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 I. The Inventory Turnover Ratio

 This ratio indicates how fast inventory is sold. Simply,

it measures the liquidity of a firm’s inventory.

 A high ITR, indicates a high sales; where as

A low ITR indicates low sale

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory 90,000 = 4.70 times

=
Turnover (18,244+20,000)/2

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II. Days of holding inventory

ITR, can be also expressed in days of holding

inventory. It measures the average age of
inventory.

DHI = Average Inventory X 360

CGS Or

DHI = 360
ITR
1
 Cont…

 The higher DHI is bad, the lower DHI is good.

 The higher ITR, the lower DHI.

DHI 360 = 77 days

=
4.7

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 III. The A/R Turnover Ratio
It Measures how rapidly receivables are collected.

Accounts Receivable = Sales on Account ( net credit sales)

Turnover Average Accounts Receivable

A high ARTR indicates a shorter time lag between credit

sales and cash collection.
Which indicates efficiency in credit management. But a low
ratio shows that receivables are not being collected rapidly.
Accounts
72,000
Receivable = = 5.14 times
(12,000 + 16,000)/2
Turnover
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IV. The Average Collection Period
It is also called days sales out standing.

it indicates that the average length of time that the firm

must wait to receive cash after making sales.

ACP = 360 Days Or = Average Receivable

ARTR Net credit sales/360

360 = 70 days
ACP = 5.15

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 V. The Fixed Asset Turnover Ratio
It measures the efficiency with which the firm uses its
fixed assets to generate sales.

FATO = Net sales

Net fixed asset

The higher FATO is preferable, ant it reflects greater

efficiency of fixed assets utilization.

120,0000 = 2.86 time

FATO =
42,000

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 VI. The Total Asset Turnover Ratio

 It measures the efficiency with which the firm uses its

assets to generate sales. I.e. It shows the firms ability in
generating sales from all financial resources committed
to total assets.

 A high TATO ratio indicates efficient asset

management since it generates a lot of sales per birr of
asset.

TATO = Net sales

Total asset

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 TATO = 120,0000 = 1.46 times
82,000

A low turnover shows that a company is not generating a

sufficient volume of business for the size of the asset base.

This may be remedied by increasing sales or by disposing

of some of the assets or both.

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 3. Leverage Ratios
 Are also called debt management ratio, capital
structure ratio, solvency ratio.
 As a general rule there should be an appropriate mix of
debt and owners’ equity in financing the firm’s asset.

Debt management ratio measures :

1. the extent to which the firm is financed with debt

2. its likelihood of defaulting on its debt obligation.
i.e. it measures the degree of financial risk.

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 Financial leverage has 3 important
implications:

1.By raising funds through debt, stock holder can

maintain control of a firm with out increasing
equity.
2. If the firm earns more on investments financed with
borrowed funds than it pays in interests, then its
stock holders return are magnified, or levered. But
their risk also magnified.
3. Creditor look to the equity, or owners supplied fund,
to provide margin of safety. I.e. the higher the
proportion of funding supplied by stock holders, the
less risk creditors face.

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 The use of debt is advantageous for
shareholders in three ways

1. They can retain control of the firm with a limited

stake
2. Their earnings will be magnified when the firm
earns a rate of return higher than the interest
rate.
3. Interest expense is tax deductible but dividend
is not.

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 The use debt is more risky from the firm’s
point of view
This is because :
1. The firm has a legal obligation to pay interest to
debt holders, irrespective of the profits made or
losses incurred by the firm.
2. When the firm fails to pay to debt holders in
time, they can take a legal action and can force
the firm into liquidation.
3. Highly debt-burdened firm will find difficulty in
raising funds from creditors and owners in
future.
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 Types of debt management ratio

I. Debt ratio
II. Debt-equity ratio
III. Equity multiplier
IV. Interest coverage ratio
V. Cash ratio
VI. Fixed payment coverage ratio

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 Financial leverage

 Financial leverage or financial gearing or trading

on equity is the process of magnifying the
shareholders’ return through the use of debt.

 However, leverage can work in opposite direction

when the cost of debt is higher than the firm’s
overall rate of return—there is threat of insolvency
and the worst sufferers will be shareholders.

2
 I. The Total Debt Ratio
It measures the proportion of total assets financed by
the firm’s creditors.

Debt = Total liability

ratio Total net asset
High debt ratio means the greater amount of other peoples’
money being used to generate profit.

Debt = 45,000 = 0.5488 or 54.88%

ratio 82,000

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 II. The Debt to Equity Ratio

It indicates that how much of the company is levered by

comparing what is owed to what is owned.

This relationship describes the lenders contribution for

each birr of the owner’s contribution.

D-E = Total liability

ratio equity

D-E = 45,000 = 1.2162 times

ratio 37,000
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 III. The Equity multiplier ratio
Equity multiplier is a financial leverage ratio that
evaluates a company's use of debt to purchase assets.
Equity = Total asset
multiplier equity
OR

Equity multiplier = 1 + debt equity ratio

Equity = 82,000
multiplier 37,000

OR

Equity multiplier = 1 + 1.2162 = 2.2162

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 IV. The Times Interest Earned Ratio
Are also called interest coverage ratio. It measures the firms
ability to make contractual interest payments.

It is used to test the firms debt–servicing capacity.

The higher the ratio, the better able the firm to fulfill its
interest obligation.
EBIT
TIE 
Interest Expense

TIE 14,250 = 3.43 times

ratio = 4,150
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 Cont…

 Interest coverage ratio also indicates the extent to

which operating income can decline before the
firm is unable to meet its annual interest costs.
 Generally, the higher the ratio, the more safe are
creditors because even if earning of the firm fall,
the firm shall be able to meet its commitment of
fixed interest charges.
 The earning can decline by 70.85 % but still the
company has the ability to pay its obligation.

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 V. The Cash Coverage Ratio
EBIT  Non cash Expenses
Cash Coverage Ratio 
Interest Expense

Cash = 14,250 + 1,100 = 3.70 times

coverag 4,150
e ration

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 VI. The Fixed Charge Coverage Ratio
It measures the firm's ability to meet all fixed payment
obligations such as interest, principal amt, lease payments,
and preferred stock dividends.

FCCR = EBIT + lease payment

Interest +LP +[RP +PSD] *[1/(1 -T)

 Note: the term 1/(1-T) is included to adjust the after

tax principal and preferred dividend payments back
to a before tax equivalent.

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 14,250 + 1,650
FCCR = 4,150 +1,650 +[3000 +0] *[1/(1 -0.34)

1.54 times

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4. Profitability Ratios
 Profitability ratios refers to a company
abilities to generate revenue in excess of the
costs incurred in producing these revenues.
I.e. Are calculated to measure the over all
operating efficiency of a company.

 It enables the analyst to evaluate the firm’s

profits with respect to the given level of
sales, certain level of assets or the owners’
investment.

3
 Cont….

The Commonly used types of profitability ratio:

I. Gross Profit Margin
II. Operating Profit Margin
III. Net Profit Margin
IV. Return on Total Assets
V. Return on Equity
VI. Return on Common Equity

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 I. The Gross Profit Margin
 Measures the percentage of each sales birr remaining after
the firm has paid for its manufacturing cost.

 It reflects the efficiency in which management produces

each unit of product.
Gross Pr ofit
GPM 
Sales

High ratio indicates, high gross profit per dollar of sales

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 Cont…
30,000
GP = = 0.25 = 25%
120,000

A high ratio of gross profit to sales indicates a sign of good

management as it implies that the cost of production of the
firm is relatively low, or it may also be an indicative of a
high sales price.

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 II. The Operating Profit Margin
 It measures the percentage of each sales birr remaining
after all costs and expenses other than interest and taxes
are deducted.

 It represents the pure profit earned on each sales birr.

Net Operating Income

OPM 
Sales

4
 Cont…

14,250
OPM= = 0.1188 = 11.88%
120,000

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 III. The Net Profit Margin
 It measures the percentage of each sales birr remaining
after all costs and expenses, including interest and taxes
have been deducted.

 This ratio is the over all measure of the firm’s ability to

turn each sales in to net profit.

Net Income
NPM 
Sales

4
 Cont…

6,666
NPM= = 0.0556 = 5.56%
120,000

 It expresses the cost - price effectiveness of the

operation.

 A high net profit margin would ensure adequate

return to the owners.

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IV. The Return on Total Assets
 It is also called return on investment.

 It measures the over all operating efficiency or

earning power of the company with its available
assets/investments.
Net Income
ROA 
Total Assets

6,666
ROA = 82,000 = 0.0813 = 8.13%
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V. The Return on Equity
Measures the return earned on the shareholders
investment in the firm.
Net Income
ROE 
Total Equity

ROE = 6,666 = .18 = 18%

37,000

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VI. The Return on Common Equity
 It measures the return earned on common stock holders
investment in the firm.

 It measures the rate of return on common stockholders

investment.

ROCE = NI available to common stockholders

common stockholders equity

ROCE = 6,666 = 0.18 = 18%

37,000

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 5. Market Value Ratios
 The market valuation ratios provide an indication of
the relative under- or over-pricing of a firm’s stock:
I.e. They relate the firms market value, as measured
by its current share price , to certain accounting
values like its earning, cash flow and book value per
share.
 Those ratios give management an indication of what
investors think of the past performance and future
prospects. If the liquidity, asset management, debt
management and profitability ratios all look good ,
then the market value ratios will be high and the
stock price would probability be as high as can be
expected. 4
 I. The earning per share(EPS)
 It measures the return available to common
stockholders on a per share basis.
 Represents the amount of birr earned during the
period on the behalf of each common stock
outstanding.

EPS = Net income – preferred stock dividend

Number of common shares outstanding

EPS = NI available to common stockholders = 6,666,000 = 5.128

number of common shares outstanding 1,300,000
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II. The dividend per share(DPS)
 It is the dividend paid to share holders on a
per share basis. In other words, DPS is the net
distributed profit belongs to shareholders
divided by the number of ordinary share
holders outstanding.
DPS = Total cash dividend on common share
Number of outstanding common shares
Assume , BOD has declared that 39% of net
profit available to common stock holders
should be distributed as a dividend.
DPS = 2,600,000 = 2 birr /share
1,300,000 5
 III. The dividend pay out ratio

 Measures the relationship between the

earnings belong to ordinary share holders
and the dividend paid to them.

DPOR = total dividend to common stockholders

NI available to c/s holders outstanding

DPOR = cash dividend per share/DPS = 2 = 39 %

EPS 5.128
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IV. The Price/Earnings Ratio
Measures the amount that investors are willing to
pay for each birr of the firm's earning. i.e. it
indicates how much investors are willing to pay
per birr of the reported profits.
Stock Pr ice
P/ E
Earnings per Share

Assume the current stock price is birr 21

21
P/E = = 4.0952
5.128 5
 V. Dividend yield
 Dividend yield is a stock’s dividend as a
percentage of the stock price.
 Dividend yields are a measure of an investment’s
productivity, and some even view it like an
"interest rate" earned on an investment.
 Dividend yield = cash dividend per share
Current market price per share

= 2 = .0952 = 9.52%
21
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 VI. The book value per share

 it measures the book value on a per share basis. It is

an accounting number it reflects historical cost.

BVPS = Common stock equity

Number of common shares outstanding

37,000,000 = 28.46/share
=
1,300,000

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