

Understand purposes of financial analysis


Understand the tools for financial analysis
 Common size financial statements
 Comparative financial statements
 Trend analysis
 Ratio analysis
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Calculate and interpret key measures of operating efficiency, leverage, liquidity,
profitability, and market value.
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Show how profitability depends on the efficient use of assets and on profits as a fraction of
sales.
 Definition
 financial reports providing information about financial performance & financial position
 contain information useful to make investment/credit decisions
 Types
 annual (yearly) versus interim (covering less than a year e.g., quarterly)
 consolidated, unconsolidated versus combined

 Accrual accounting = revenues and expenses are booked when they are incurred, regardless
of when they are actually received or paid.
 Components of basic financial statements/annual report
1. Statement of comprehensive income .
o It tells you whether a company is making a profit or
o It indicates how much profit or loss a company generates over a period of time
2. Statement of financial position .
o It gives a snapshot of the company’s financial situation.
o It tells you how efficiently the company is utilizing its assets and how well it is managing its
liabilities in pursuit of profit.
3. Statement of changes in owners’ equity
4. Statement of cash flows .
o Tells where the company’s cash comes from and where it goes.
• i.e the flow of cash in, through, and out of the company.
o It tells you whether a company is turning profits into cash.
5. Notes to financial statements
 are a required, integral part of a company's external financial statements.
 are used to explain the assumptions used to prepare the numbers in the financial statements as well
as the accounting policies adopted by the company.
6. Audit report

Financial analysis refers to an assessment of the viability, stability, and profitability of a
business, sub-business or project.

The primary purpose of financial analysis is
……..to determine how a business is performing in specific areas, such as:
o Efficient utilization of assets,
o Managing liquidity,
o Managing debt,
o managing cash flow, and
o collecting accounts receivable in a timely fashion

Individual investors or firms that are interested in investing in businesses use financial
analysis techniques in evaluating target companies' financial information.

Financial statements, by themselves, tells you quite a bit:
 How much profit the company made, where it spend its money, how large its debts are….and so on.

But, how do you interpret all the numbers these statements provide?
 Is the company’s profit small or large?
 Is the level of debt healthy or not?

That is why we employ the financial analysis tools.
 Definition
 gathering and examining financial data to evaluate health of a firm
o liquidity – ability to meet current financial obligations
o financial flexibility – ability to exploit business opportunities
o solvency – confidence that the entity will survive/sustain doing business
o profitability/earning power – ability to earn return on investment
o efficiency – ability to efficiently utilize economic resources/assets
o market value – firm’s value relative to the market
 used as bases for investment/credit decisions, firm valuation and regulation
 Lenders (trade creditors) – interested to determine ability of a firm to pay its debts
 Shareholders/investors – concerned with present and future profitability of a firm
 Employees – concerned with financial status of their employer/firm
 Regulatory agencies – concerned with financial health and performance of a
firm/industry
 Management – interested in every aspect of financial analysis/a firm
 Horizontal – analysis
o relationships between elements of financial statements over multiple periods
o [changes] in elements of financial statements over multiple periods
 Vertical – analysis
o relationships between elements of financial statements within a give period
 Ratio analysis
 establishing meaningful relationship between two/more elements of financial
statements
 Comparative analysis
 comparing elements of financial statements over multiple periods
 Common-size analysis
 expressing each item on statement of financial position as a % of total assets
 expressing each item on statement of financial performance as a % of sales
 Trend analysis
 analyzing financial ratios over time to estimate likelihood of improvement or
deterioration
 Cash flow analysis
 analyzing inflows and outflows of actual cash (cash and cash equivalents)
 summarizing operating, investment and financing cash flows
 shows short-term position of a firm
 Fund flow analysis
 analyzing changes in working capital
 shows long-term position of a firm
 Definition
 Provides a means of digging deeper into the information contained in the financial
statements.
 establishing relationship among elements of FS to evaluate performance by comparing
ratios of a firm
 over several years (a time-series comparison/trend/horizontal analysis)
 to that of other firms in the industry (cross-sectional comparison)
 to some absolute benchmark/industry norms assessing relationship among elements
of financial reports
 with its planned/budgeted amounts
 Definition, purpose and implications
 relationship between current assets and current liabilities
 measures ability of a firm to meet its current financial obligations
 lower ratios imply liquidity problems while higher ratios may imply inefficiency
in using assets (see activity ratio)
 Types and formula
a) current ratio
 the prime measure of how solvent a company is.
 it’s so popular with lenders……called banker’s ratio.
 the higher the ratio, the better financial condition a company is in.
Total current assets – prepaid expenses
Current ratio = CR=?
Total current liabilities
b) quick/acid test
 Measures the ratio of a company’s assets that can be quickly liquidated and used to pay debts.
 Called acid-test ratio because it measure’s a company’s ability to deal instantly with its liabilities
 Ability to pay obligations without relying on sales of inventories
o excludes inventory because they are least liquid

QR=?

c) Cash ratio
 Definition, purpose and implications
 also called asset management ratios
 measures efficiency of a firm in using and managing its resources to generate
maximum possible income
 higher ratios imply efficiency while lower ratios imply inefficiency
 Types and formula
a) accounts receivable/debtors turnover ratio (efficiency)
 number of times accounts receivable are generated and collected
 higher ratio imply efficiency in managing receivable (e.g., strict credit
follow-up) and/or strict credit policy adversely affecting sales

ARToR=?
b) receivable collection period/Days receivables
 number of days it takes to covert accounts receivable into cash
 How long it actually takes a company to collect what it’s owed?

ARCP= ?
c) inventory turnover (efficiency)
 number of times inventory is sold/consumed
 higher ratio implies efficiency in managing inventories, lost sales
opportunities due to inadequate inventory caused by production
problems/poor sales forecasting/weak coordination between sales and
production activities within a firm
 lower/declining ratio suggests a firm has continued to build up inventory,
weakening demand or may be carrying/reporting outdated/obsolete
inventory
IToR=?
d) inventory period/Days inventory
 Measures how long it takes a company to sell the average amount of inventory on hand
during a given period of time.
 The longer it takes to sell inventory, the more the company’s cash gets tied up and the
greater the likelihood that the inventory will not be sold at full-value.

IP=? days
e) accounts payable/creditors turnover
 number of times accounts payable are generated and paid
 lower ratio is better given that the firm timely pays its bills and satisfies its
financial obligations to its supplier

APToR=?
f) Working capital turnover ratio
 measures how effective a firm is at generating sales for every dollar of working
capital put to use

WCR=?
g) accounts payable payment period
 tells you how many days it takes to pay its suppliers
o number of days it takes to settle accounts payable
o The more days it takes, the longer a company has the cash to work with.
 longer payment period is preferred because accounts payable are cheaper source of
funds

APPP=? days
h) fixed asset turnover ratio
 indicates management’s effectiveness in using net fixed assets to generate sale
 fixed assets refer to property, plant and equipment

FAToR=?

i) total asset turnover ratio

 Shows how efficiently a company uses its assets

TAToR=?
 Definition, purpose and implications
 also called debt management/leverage ratio
 leverage = use of debt in financial structure
 This ratio tell you how, and how extensively, a company uses debt.
 indicates the relative mix of debt and equity financing
 measures long-term debt paying ability & financial viability of a firm
 increases potential reward to shareholders and potential for financial distress and
business failure
 Types and formula
a) debt ratio
 indicates percentage of total assets financed by debt
 affects financial flexibility (i.e., operating/investing/financing decision)

DR=?

b) debt-equity ratio

D-ER=?
c) interest coverage ratio/Times interest earned
 Measures a company’s margin of safety
o How many times over the company can make its interest payments
 indicates ability of a firm to make contractual interest payments

c) equity multiplier
 measures how much of a firm’s assets are financed through stockholders' equity

EM=?
 measures a company’s level of profitability by expressing sales and profits as a
percentage of various other items.
 measure earning power of a firm
 measure how efficiently a firm uses its assets and manages its operations
 measure management’s ability to control expenses in relation to sales
 the combined effects of liquidity, asset management, and debt management on operating
results
 reflect a firm’s operating performance, riskiness, and leverage
 Types and formula
a) gross profit margin
 measures gross profit earned from each birr/dollar sales
 shows relationship between sales and cost of sales
 percentage of each birr/dollar sales remaining after covering cost of sales

GPM=?
c) Operating profit margin
 is a way to measure how sales translate into bottom-line profit.
 measures income earned from operating activities of a firm
 income left after covering all costs and expenses excluding non-operating income and
expenses (e.g., interest, taxes, gains, losses, etc.)

OPM=?
d) Return on assets (ROA)/return on investment (ROI)
 provides quantitative description of how well a company has invested in its assets
 measures income earned per each birr/dollar asset
 shows net profit generated from each dollar invested in total assets
 product of ability to generate net income per each dollar sale and effective use of total
assets to generate net sales
e) Return on equity (ROE)
 an accounting measure of maximization of wealth of shareholders
 shows the return on the portion of the company’s financing that is provided by
shareholders
 product of how profitability a firm employs its assets and the extent of which the assets
are financed through shareholders' equity
f) Earnings per share (EPS)
 shows profitability of a firm relative to its outstanding shares
 A breakdown of ROA and ROE into component ratios.
 management efficiency in generating income from total assets
 financial leverage – use of equity to finance assets
 net profit margin – profit generated as a percentage of revenue/sales
 total assets turnover ratio – measures effective use of assets to generate revenue/sales
 Definition, purpose and implications
 provide information on value of a firm relative to market
 assumes a publicly traded stock
 Types and formula
a) price-earnings ratio
 indicates how much investors are willing to pay per dollar of earnings for shares
of the firm’s
 indicates how the market perceives firm’s growth/profit opportunity
b) market-to-book value ratio
 Ratio of market value of equity to book value of equity.
 measures how much value a firm has created for its shareholders.
c) dividend yield/dividend-price ratio
 shows how much a firm pays out in dividends each year relative to its share
price

d) dividend payout ratio

 shows percentage of a firm’s per share earnings paid out as cash dividends
 lack of meaningful industry average – e.g., firms operating different divisions in
different industries
 use of industry average ratios as benchmarks – setting goals for high-level
performance needs benchmarking on industry leaders’ ratios
 inflation – ratio analysis for one firm over time or a comparative analysis of firms
of different ages can be distorted by inflation
 seasonal factors – can distort a ratio analysis making comparison difficult
 uses of different accounting practices – can distort comparisons
 employing “window dressing” techniques – to make financial statements look
stronger
 e.g., a company
 takes out a 2-year Birr10,000,000 loan towards end of its fiscal year (Dec 25)
 total current asset before loan = Birr100,000,000
 total current liabilities before loan = Birr58,000,000
 compute current ratio before and after taking the loan
 if the company pays the loan back in January, then the transaction was strictly
window dressing
 Qualitative factors
 Revenues per key customers/key product
 Supplies of goods/services per key supplier
 Reliance on single customers, products, or suppliers increases risk
 Percentage of the company’s overseas business
 Exposure to risk of currency exchange volatility and political instability
 Probable actions of current competitors and likelihood of additional new
competitors
 Do prospects of the firm depend critically on the success of products currently in
the pipeline or on existing products?
 How does the legal and regulatory environment affect the company?