Chapter Two

Financial Statement Analysis

2.1 Introduction
The essence of managing risk is making good decisions. Correct decision making depends on
accurate information and proper analysis. Financial statements are summaries of the operating,
investment, and financing activities that provide information for these decisions. But the information
is not enough by themselves and need to be analyzed. Financial analysis is a tool of financial
management. It consists of the evaluation of the financial condition and operating results of a
business firm, an industry, or even the economy, and the forecasting of its future condition and
performance. This Chapter discusses common financial information and performance measures
frequently used by owners and lenders to evaluate financial health and make risk management
decisions. By conducting regular checkups on financial condition and performance, you are more
likely to treat causes rather than address only symptoms of problems.

2.2. Sources of Financial Information

Financial statements help assess the financial well-being of the overall operation. Information about
the financial results of each enterprise and physical asset is important for management decisions, but
by themselves are inadequate for some decisions because they do not describe the whole business. An
understanding of the overall financial situation requires three key financial documents: the balance
sheet, the income statement and the cash flow statement.
1. The Balance Sheet
The balance sheet shows the financial position of a firm at a particular point of time. It also shows
how the assets of a firm are financed. A completed balance sheet shows information such as the total
value of assets, total indebtedness, equity, available cash and value of liquid assets. This
information can then be analyzed to determine the business' current ratio, its borrowing capacity and
opportunities to attract equity capital.
2. Income Statement
Usually income statements are prepared on an annual basis. An income statement often provides a
better measure of the operation's performance and profitability. It shows the operating results of a
firm, flows of revenue and expenses. It focuses on residual earning available to owners after all
financial and operating costs are deducted, claims of government are satisfied.
 3. Cash Flow Statement
Reports the sources and uses of the operation’s cash resources. Such statements not only show the
change in the operation's cash resources throughout the year, but also when the cash was received or
spent. An understanding of the timing of cash receipts and expenditures is critical in managing the
whole operation.

2.3 FINANCIAL ANALYSIS MEANING AND IMPORTANCE

Financial statements analysis is the process of examining relationships among elements of the
company's financial statements and making comparisons with relevant information from the print of
view of all parties interested in the affairs of the business. Analysis and interpretation are closely
inter-linked and they are complementary to each other. Analysis without interpretation is useless and
interpretation without analysis is impossible.
Financial statements analysis is a valuable tool used by investors, creditors, financial analysts,
owners, managers and others in their decision-making process.
Financial analysis is the assessment of firm's past, present, and anticipated future financial
condition. It is the base for intelligent decision making and starting point for planning the future
courses of events for the firm. Its objectives are to determine the firm's financial strength and to
identify its weaknesses. The focus of financial analysis is on key figures in the financial statements
and the significant relationships that exist between them.

2.4 The Need for Financial Analysis

The following stakeholders are interested in financial statement analysis to make their respective
decision at right time. The following are interested in financial statements analysis

1. Investors: Investors fall into two categories, existing and potential. Some seek a takeover, leading to
majority control and shareholding. This usually occurs when a company is losing public confidence
resulting in low market value. Often considered as hostile takeovers, the investors tend to restructure
the business and control it completely, issue shares or sell it off in the open market. The other
category consists of short and long-term investors, both interested in increasing their wealth with the
minimal effort. This may be through either earning dividends or trading shares in the stock exchange.
2. Lenders: These may supply funds to the organization on short and/or long-term basis. There are
several financial institutions and individuals willing to lend to progressive companies but few to
support those with lower earnings levels. The loan carries a charge of interest payable annually or as
agreed, on the principle or compounded principle, over the period that the loan has been issued.
3. The Management: The managers are entrusted with the financial resources contributed by owners
and other suppliers of funds for effective utilization. In their pursuit to make the company achieve its
objectives, the managers should use relevant financial information to make right decision at the right
time.
4. Suppliers: Suppliers of products and services to the company would like their investments sales
made on credit terms - received with surety. A creditor would be reluctant to trade any further if
s/he is not guaranteed a timely payment against the issued invoice.
5. Employees: Many would consider employees the least affected of all when it comes to analyzing
the company's accounts. Think again. The employees will be first to feel the change in
circumstances as they may be promoted, demoted or fired. They would be very much interested in
finding out if the company exhibits any points in their favor, mainly job security and facilities.
6. Government bodies: As a rule, Companies House requires each company, private or public, to
submit their financial statements and accounts annually. The list of registered companies and their
most recent accounts are published in the Companies House official publication, which informs
the public of their performance for the year or period ended. In addition, the government has the
responsibility to ensure that the information is not delusive and the rights of the public are
protected. Furthermore, it bears the responsibility of prosecuting any offender of the law,
including corporate and consumer law.
7. Competitors: It may seem odd, but existing competitors and new entrants have to consider the
likelihood of their success or failure in trying to conquer the market. Their primary interest lies in
the business ratios of efficiency/productivity and cash, debtor and credit management. For the
industry, it acts as a comparative for better performance of firms and companies of varying sizes.
They also help in establishing a trend of the industry that is normally a guide to new entrants to
study, analyze and perform.
2.5 Types of Financial Analysis
Analysis of financial statement may be broadly classified into two important types on the basis of
material used and methods of operations. Financial statement analysis may be classified into two
major types: external analysis and internal analysis.

A. External Analysis
 Outsiders of the business concern such as investors, creditors, government organizations and
other credit agencies do normally external analyses.
 External analysis is very much useful to understand the financial and operational position of
the business concern.
 External analysis mainly depends on the published financial statement of the concern.
 This analysis provides only limited information about the business concern.
B. Internal Analysis

 The company itself discloses some of the valuable information in this type of analysis.
  This analysis is used to understand the operational performances of each and every
department and unit of the business concern.
 Internal analysis helps to take decisions regarding achieving the goals of the business concern
 They have access to financial data of the company.
2.2 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to analyze the
financial statement of the business. The following are the common methods or techniques, which are
widely used by the business.
1. Comparative Statement Analysis
2. Trend Analysis
3. Common Size Analysis
4. Fund Flow & Cash Flow Statement
5. Ratio Analysis
1. Comparative Statement Analysis
Comparative statements are prepared to provide time perspective to the consideration of various
elements of operations and financial position of the business embodied in the statement. Here, the
figures for two or more periods are placed side by side to facilitate comparison. In addition to
absolute figures the ratios constructed from the financial statements are also presented in the form of
comparative statements. Both, balance sheet and income statement are presented in the form of
comparative statements.
2. Trend Analysis (Horizontal Analysis)
It is used to evaluate the trend in the accounts over the accounting periods. It is usually shown on a
comparative financial statement.
In a horizontal analysis it is essential to show both the amount of the change and the percentage of the change
because either one alone might be misleading.
The calculation of trend percentages involves the calculation of percentage relationship that each item bears to
the same item in the base year. Any year may be taken as base year. Usually, the first year will be taken as the
base year. Each item of the base year is taken as 100 and on that basis the percentage for each of the item of
each of the years is calculated.
To illustrate horizontal financial analysis, let’s take sample financial statements of Biftu Company. Its
condensed balance sheets for 2011 and 2012 showing birr and percentage changes are presented below.
Exhibit 2-1 Horizontal Analysis of Balance Sheet
Biftu Company
Condensed Balance sheet
December 31 (in millions)

Increase (Decrease)
during 2012
Assets 2012 2011 Amount Percent
Current assets Br. 1,528.6 Br. 1,428.8 Br. 99.8 7.0%
Plant assets (net) 2,932.9 2,784.8 148.1 5.3
Other assets 588.5 201.0 387.5 192.8
Total assets Br. 5,050.0 Br. 4,414.6 Br. 635.4 14.4%
Liabilities stock holder’s equity
Current Liability Br. 2,199.0 Br. 1,265.4 Br. 933.6 73.8%
Long-term Liabilities 1,568.6 1,558.3 10.3 0.7
Total Liabilities 3,767.6 2,823.7 943.9 33.4
Stockholders’ equity
Common stock 201.8 183.0 18.8 10.3
Retained earnings & other 3,984.0 3,769.1 214.9 5.7
Treasury stock (cost) (2,903.4) (2,361.2) 542.2 23.0
Total stockholders’ equity 1,282.4 1,590.9 (308.5) (19.4)
Total Liabilities and Stockholders’ Br. 5,050.0 Br.4, 414.6 Br. 635.4 14.4%
equity

The comparative balance sheet above shows that a number of changes occurred in Biftu’s financial
position from 2011 to 2012.
 In the assets section, current assets increased by Br. 99.8 million, or 7.0% (Br. 99.8  Br. 1,428.8),
 plant assets (net of depreciation) increased by Br. 148.1, or 5.3%, and other assets increased by
192.8% (Br. 3875  Br. 201)
 In the liabilities section, current liabilities increased by Br. 933.6, or 73.8%, while long-term
liabilities increased by Br. 10.3, or 0.7%.
 In the stockholders’ equity section, we find that retained earnings increased by Br. 214.9, or 5.7%.

This horizontal analysis suggests that the company expanded its asset base during 2012 and
financed this expansion primarily by retaining income in the business and incurring short-term debts.
In addition, the company reduced its stockholders’ equity by 19.4% by buying treasury stock.
Presented in exhibit 2.2 is a comparative income statement of Biftu Company for 2011 and 2012 in a
condensed format. Horizontal analysis of the income statement shows these changes:
Exhibit 2-2 Horizontal Analysis of Income Statement (in Millions)
Biftu Company
Condensed Income statement
For the year ended December 31
Increase (Decrease) during
2012
2012 2011 Amount Percent
Net Sales Br.6,676.6 Br.7,003.7 Br.(327.1) (4.7%)
Cost of goods sold 3,122.9 3,177.7 (54.8) (1.7)
Gross Profit 3,553.7 3,826.0 (272.3) (7.1)
Selling & administrative expenses 2,458.7 2,566.7 (108.0) (4.2)
Nonrecurring charges 136.1 421.8 (285.7) (67.7)
Income from operations 958.9 837.5 121.4 14.5
Interest expense 65.6 62.6 3.0 4.8
Other income (expense), net (33.4) 21.1 (54.5) NA*
Income before income taxes 859.9 796.0 63.9 8.0
Income tax expense 328.9 305.7 23.2 7.6
Net income Br. 531.0 Br. 490.3 Br. 40.7 8.3
* NA = Not Available
 Net sales decreased by Br. 327.1, or 4.7% (Br. 327.1 Br. 7003.7).
 Cost of goods sold increased by Br. 54.8, or 1.7% (Br. 54.8  Br. 3,177.7).
 Selling and administrative expenses decreased by Br. 108.0, or 4.2% (Br. 108.0  Br. 2,566.7).
 Overall, gross profit decreased by 7.1% and net income increased by 8.3%.
 The increase in net income can be attributed nearly to the 67.7% decrease from 2011 to 2012
in the nonrecurring charges.
The measurement of changes in percentages from period to period is relatively straightforward and
quite useful. However, complications can result in making the computations. If an item has no value
in a base year or preceding year and a value in the next year, no percentage change can be computed.
And if a negative amount appears in the base or preceding period and a positive amount exists the
following year, or vice versa, no percentage change can be computed. For example, no percentage
could be calculated for the “other income (expense)” category in Biftu’s condensed income statement.
Common Size Analysis (Vertical Analysis)
 It is analysis of financial statements where a significant item in a financial statement is used as
a base value and all other items are compared against it. For example, in balance sheet
analysis, all balance sheet items might be expressed as percentages of total assets. In income
statement analysis, all income statement items might be expressed as percentages of net sales..
 Vertical financial statement analysis is a technique of evaluating and analyzing financial
statement data that expresses each item in a financial statement as a percent of the base
amount. For example, on a balance sheet, we might say that current assets are 22% of total
assets (total assets being the base amount). Or in an income statement, we might say that
selling expenses are 16% of net sales (net sales being the base amount).
Exhibit 2.3 presents a vertical analysis of the comparative balance sheet of Biftu Company for
2011 and 2012
 The base for the asset items is total asset, and
  The base for the liability and stockholders' equity items is total liabilities and stockholders'
equity.
 In addition to showing the relative size of each category on the balance sheet, vertical analysis
may show the %age change in the individual asset, liability and stockholders' equity items.
Exhibit 2-3 Vertical Analysis of Balance Sheet (in Millions)
Biftu Company
Condensed Balance sheet
December 31
2012 2011
Assets Amount Percent Amount Percent
Current assets Br.1,528.6 30.3% Br. 1,428.8 32.4
Plant Assets (net) 2,932.9 58.0 2,784.8 63.0
Other assets 588.5 11.7 201.0 4. 6
Total assets Br. 5,050.0 100.0% Br. 4,414.6 100.0%
Liabilities & Stockholders' equity
Current liabilities Br. 2,199.0 43.5% Br. 1,265.4 28.7
Long-term liabilities 1,568.6 31.1 1,558.3 35.3
Total Liabilities 3,767.6 74.6 2,823.7 64.0

Stockholders' equity:
Common stock 201.8 4.0 183.0 4.1
Retained earnings & other 3,984. 78.9 3,769.1 85.4
Treasury stock cost) (2,903.4) (57.5) (2,361.2) (53.5)
Total stockholders' equity Br. 1,282.4 25.4 Br. 1,590.9 36.0
Total liabilities & Stockholders'
equity Br 5,050.0 100.0% Br. 4,414.6 100.0%
 In this case, even though current assets increased by Br. 99.8 million from 2011 to 2012, they
decreased from 32.4% to 30.3% of total assets.
 Plant assets (net) decreased from 63.1% to 58.1% of total assets. Also, even though retained
earnings increased by Br. 214.9 million from 2011 to 2012, they decreased from 85.4% to
78.9% of total liabilities and stockholders' equity. This indicates that there is a shift to a
higher percentage of debt financing. This is because current liabilities increase by Br. 933.6
million, going from 53.3% to 57.5% of total liabilities and stockholders' equity. Thus, the
company shifted toward a heavier reliance on debt financing both by using more short-term
debt and by reducing the amount of outstanding equity.
Exhibit 2-4 Vertical Analysis of an Income Statement (in Millions)
ABC Company
Condensed Income Statement
For the years Ended December 31
2012 2011
Amount Percent Amount Percent
Net Sale Br. 676.6 100.0% Br. 7,003.7 100.0%
Cost of goods sold 3,122.9 46.8 3,177.7 45.4
Gross Profit 3,553.7 53.2 3,826.0 54.6
Selling & administrative Expenses 2,458.7 36.8 2,566.7 36.6
Non-recurring charges 136.1 2.0 421.8 6.0
Income from operations 958.9 14.4 837.5 12.0
Interest expense 65.6 1.0 62.6 0.9
Other income (expense), net (33.4) 0.5 21.1 0.3
Income before income taxes 859.9 12.9 796.0 11.4
Income tax expense 328.9 4.9 305.7 4.4
Net Income Br. 531.0 8.0% Br. 490.3 7.0%

The vertical analysis of the comparative income statements for Biftu Company, shown in Exhibit 2.4
reveals that;
 cost of goods sold as a percentage of net sales increased by 1.4% (from 45.4% to 46.8%) and
 Selling and administrative expenses increased by 0.2% (from 36.6% to 36.8%). Despite these
negative changes, net income as a percentage of net sales increased from 7.0% to 8.0%.
The vertical analysis is, therefore, used to gain insight into the relative importance or magnitude
of various items in the financial statements. Again an associated benefit of vertical analysis is that
it enables you to compare companies of different sizes, because each item in the financial
statements is expressed in relation to a certain item of the financial statements, regardless of the
absolute amounts of the items.

Fund flow and Cash flow Analysis

The changes that have taken place in the financial position of a firm between two dates of balance
sheets can be ascertained by preparing the fund flow statement which contains the sources and uses of
financial resources. This is a valuable aid to finance manager, creditors and owners in evaluating the
uses of funds by a firm and in determining how these uses are financed. This statement also helps to
assess the growth of the firm and its resulting financial needs to decide the best way to finance those
needs..
Cash flow statement summaries the causes of changes in cash position between two dates of two
balance sheets. It indicates the sources and uses of cash. This statement is similar to statement
prepared on working capital basis, except that it focuses attention on cash instead of working capital
RATIO ANALYSIS
Horizontal and vertical analyses compare one figure with another within the same category. It is also
essential to compare figures from different categories and this is accomplished through ratio analysis.
Ratio analysis is the process of determining and interpreting numerical relationship based on financial
statements. It is the technique of interpretation of financial statements with the help of accounting
ratios derived from the Balance Sheet and Income Statement.

 Ratio shows the mathematical relationship between two figures, which have meaningful relation
with each other
 Financial ratio analysis is the most common form of financial statements analysis
 Financial ratio:
Is used as an index for evaluating the financial performance of the business.
Compare items on a single financial statement or examine the relationships between items
on two financial statements
Generally hold no meaning unless they are compared against something else, like past
performance, another company/competitor or industry average
Are also used by bankers, investors, and business analysts to assess various attributes of a
company's financial strength or operating results.
Can be classified into various types
Objectives of Ratio Analysis
 To standardize financial information for comparisons
 To evaluate current operations
 To compare current performance with past performance
 To compare performance against other firms or industry standards
 To study the efficiency of operations
 To study the risk of operations
 To find out the ability of the firm to meet its debts (liquidity).
 To help investors in evaluating sustainability of returns on their investment
Advantages of Ratios Analysis:
Ratio analysis is an important and age-old technique of financial analysis. The following are some of
the advantages / Benefits of ratio analysis:
1. Simplifies financial statements: Ratios tell the whole story of changes in the financial condition
of the business
2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight
the factors associated with successful and unsuccessful firm. They also reveal strong firms and
weak firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic
functions of forecasting. Planning, co-ordination, control and communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the
performance of different divisions of the firm. The ratios are helpful in deciding about their
efficiency or otherwise in the past and likely performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of investors and lending
decisions in the case of bankers etc
Limitations of Ratios Analysis:
The ratios analysis is one of the most powerful tools of financial management. Though ratios are
simple to calculate and easy to understand, they suffer from serious limitations.

1. Limitations of financial statements: Ratios are based only on the information which has been
recorded in the financial statements. Financial statements themselves are subject to several
limitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-
financial changes though important for the business are not relevant by the financial statements.
Financial statements are affected to a very great extent by accounting conventions and concepts.
Personal judgment plays a great part in determining the figures for financial statements.
2. Comparative study required: Ratios are useful in judging the efficiency of the business only
when they are compared with past results of the business. However, such a comparison only
provide glimpse of the past performance and forecasts for future may not prove correct since
several other factors like market conditions, management policies, etc. may affect the future
operations.
3. Ratios alone are not adequate: Ratios are only indicators; they cannot be taken as final regarding
good or bad financial position of the business. Other things have also to be seen.
4. Problems of price level changes: A change in price level can affect the validity of ratios
calculated for different time periods. In such a case the ratio analysis may not clearly indicate the
trend in solvency and profitability of the company. The financial statements, therefore, be adjusted
keeping in view the price level changes if a meaningful comparison is to be made through
accounting ratios.
5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no
well accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders
interpretation of the ratios difficult
6. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To make a
better interpretation, a number of ratios have to be calculated which is likely to confuse the analyst
than help him in making any good decision.
7. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have to
be interpreted and different people may interpret the same ratio in different way.
8. Incomparable: Not only industries differ in their nature, but also the firms of the similar business
widely differ in their size and accounting procedures etc. It makes comparison of ratios difficult
and misleading

Classification of Ratio
 Classification from the point of view of financial management is as follows:
A. Liquidity Ratio
B. Activity Ratio
C. Solvency Ratio
D. Profitability Ratio
E. Market value ratios

A. Measures of Liquidity (Liquidity Ratios)

Liquidity ratios measure a firm’s ability to meet short term obligations with short-term assets. It is
essential for a firm to be able to meet its obligations as they become due. Liquidity ratios are highly
useful to creditors and commercial banks that provide short-term credit. A firm should ensure that it
does not suffer from lack of liquidity, and does not have excess liquidity. Both B inadequate and
excess liquidity are not desirable. Therefore, it is necessary for the firm to strike a proper balance
between high liquidity and lack of liquidity
Higher the liquidity ratios, higher will be the liquidity position.
Higher the liquidity ratios, higher will be the amount of Working Capital (WC).
Working capital means excess of Current Assets (CA) over Current Liabilities (CL).
The most commonly used liquidity ratios are the following::
1) Current Ratio
It is the relationship between current assets and current liabilities. Current ratio measures the
ability of the firm to meet its short-term obligations with its current assets.
 It is the most commonly used measure of short-term solvency
 It is determined by dividing current assets by current liabilities.
 The higher the ratio, the more liquid the firm is
 However, if the ratio is too high, the firm may have an excessive investment in current assets
 It may also indicate an underutilization of short-term credit..
 A low current ratio indicates that the firm is having difficulty in meeting short-term
commitments and the liquidity position of the firm is not safe

Current Ratio =

As an example, the current ratio for Biftu Co. can be computed from Exhibit 2.1 for year 2012 as:
 Current Ratio= = implying that for each Birr of
current liability the Company owes others, it has only seventy cents of current assets available..
Interpretation of Current Ratio
Acceptable current ratio values vary from industry to industry
As a conventional rule, current ratio of 2:1 is considered satisfactory for merchandising firms.
However, the arbitrary ratio of 2:1 should not be, blindly, followed.
Firms with less than 2:1 ratio may become meeting the liabilities without difficulties, though
firms with a ratio of more than 2:1 may have difficulty to meet their obligation
High ratio indicates under trading and over capitalization and vice-versa for low ratio.
Current ratio is a test of quantity, not test of quality. It is essential to verify the composition and
quality of assets before, finally, taking a decision about the adequacy of the ratio.
Limitations of Current Ratio::
It is a measure of liquidity and should be used very carefully because it suffers from many
limitations. It is, therefore, suggested that it should not be used as the sole index of short term
solvency.
1. It is crude ratio because it measures only the quantity and not the quality of the current assets.
2. Even if the ratio is favorable, the firm may be in financial trouble, because of more stock and
work in process which is not easily convertible into cash, and, therefore firm may have less
cash to pay off current liabilities.

3. Window dressing: It can be very easily manipulated by overvaluing the current assets.

4. An equal increase in both current assets and current liabilities would decrease the ratio and
similarly equal decrease in current assets and current liabilities would increase current ratio.

5. Current ratio is also affected by seasonality.

The current ratio can yield misleading results under the following circumstances:
 Inventory component. When the current assets figure includes a large proportion of inventory
assets, since these assets can be difficult to liquidate.
 Paying from debt. When a company is drawing upon its line of credit to pay bills as they
come due, this means the cash balance is near zero. Hence, the current ratio could be fairly
low, and yet the presence of a line of credit still allows the business to pay in a timely manner
2) Quick Ratio (Acid Test Ratio)
 Quick Ratio uses all current assets except inventory for measuring the liquidity of the firm.
 The ratio measures the firm’s ability to meet current liabilities from its most liquid assets.
 Inventory is the least liquid of the current assets and may not be easily converted into cash.
 Quick ratio is used as a complementary ratio to the current ratio.
 Quick ratio is more rigorous test of liquidity than the current ratio because it eliminates
inventories and prepaid expenses.
 Usually high quick ratios indicate the firm’s ability to meet its current liabilities in time.
 On the other hand a low liquidity ratio represents that the firm's liquidity position is not good.
 As a convention, generally, a quick ratio of "one to one" (1:1) is considered to be satisfactory.

Quick Ratio =
For Biftu Company, assuming that inventories and prepayments respectively are Br. 600 and Br. 250
(in millions), the quick ratio for the year 2012 can be shown as::

Quick Ratio = = . This

shows that for each Birr of current liability the Company owes, there are only thirty cents in fast
converting assets to settle the obligations. Both measures of liquidity reveal that Biftu Company is
not in good posture in terms of liquidity.
Interpretation of Quick Ratio
 Quick ratio of 1:1 is generally considered satisfactory.
 However, firms with the ratio of more than 1:1 need not be liquid and those having less than
the standard need not, necessarily, be illiquid.
 It depends more on the composition of liquid assets.
 Debtors, normally, constitute a major part in liquid assets. If debtors are slow paying, doubtful
and long outstanding, they may not be totally liquid.
 A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position if all the debtors
cannot be realized.
 In the same manner, a low liquid ratio does not necessarily mean a bad liquidity position as
inventories are not absolutely non-liquid.
 Hence, a firm having a high liquidity ratio may not have a satisfactory liquidity position if it
has slow-paying debtors.
 On the other hand, a firm having a low liquid ratio may have a good liquidity position if it has
fast moving inventories

3) Cash Ratio interpretation

 Cash Ratio is an indicator of company's short-term liquidity. It measures the ability to use its
cash and cash equivalents to pay its current financial obligations.
 Cash ratio measures the immediate amount of cash available to satisfy short-term liabilities. A
cash ratio of 0.5:1 or higher is preferred.
 Cash ratio is the most conservative look at a company's liquidity since is taking in the
consideration only the cash and cash equivalents.
 Cash ratio is used by creditors when deciding how much credit, if any, they would be willing
to extend to the company.
Cash Ratio =

For Biftu Company, assuming that cash and marketable securities respectively are Br. 100 and Br.
150 (in millions), the quick ratio for the year 2012 can be shown as::

Cash Ratio = =

This shows that for each Birr of current liability the Company owes, there are only eleven cents in
absolute assets to settle its obligations
B. ACTIVITY RATIO(Asset Utilization Ratios)
These ratios are also called measures of Efficiency ratios. They show the intensity with which the
firm uses its assets in generating sales. These ratios indicate whether the firm’s investments in current
and long-term assets are too small or too large. If investment is too large, it could be that the funds
tied up in that asset should be used for more productive purposes.
The following are the most important asset utilization ratios::
1) Inventory Turnover Ratio (ITOR)
It is a relationship between the cost of goods sold and average inventory. Inventory turnover ratio:
 Measures the velocity of conversion of stock into sales
 Indicates the number of times stock has been turned into sales
 Is expressed in number of times
 Evaluates the efficiency with which a firm is able to manage its inventory.
 Indicates whether investment in stock is within proper limit or not
 Can be judged only after comparing it with some standard figure such as industry average or
the Company’s past values for this figure
Inventory Turnover =
Assuming the inventory value of Br. 600 (in millions) as in the quick ratio, Biftu Company’s
inventory turnover for 2012 is computed as:
Inventory Turnover = = .
A low inventory turnover ratio:
 Is a signal of inefficiency, either poor sales or excess inventory
 May indicate poor liquidity, possible overstocking, and obsolescence,
 May also reflect a planned inventory buildup
 Indicates efficient management of inventory
 Signifies more profit
 Implies a large investment in inventories relative to the amount needed to service sales
A high inventory turnover ratio:
 Implies either strong sales or ineffective buying
 Indicates an inefficient management of inventory
 May be due to under-investment in inventories
 May indicate better liquidity, but it can also indicate a shortage inventory levels, which may
lead to a loss in business.
 Implies over-investment in inventories, dull business, poor quality of goods, stock
accumulation, accumulation of obsolete and slow moving goods and low profits as compared
to total investment
 Implies that the purchasing function is tightly managed
 Inventory level must be relative to sales that are not excessive but sufficient to meet
customers’ needs
The following issues can impact the amount of inventory turnover:
 Seasonal build. Inventory may be built up in advance of a seasonal selling reason.
 Obsolescence. Some portion of the inventory may be out-of-date and so cannot be sold.

 Cost accounting. The costing method used, combined with changes in prices paid for
inventory, can result in significant swings in the reported amount of inventory.
  Flow method used. A "pull" system that only manufactures on demand requires much less
inventory than a "push" system that manufactures based on estimated demand.
2) Receivables Turnover Ratio (RTOR)
Accounts receivable represents the indirect interest free loans that the company is providing to its
customer. Therefore, it is very important to know how "costly" these loans are for the company.
Accounts Receivable Turnover Ratio is one of the efficiency ratios and measures the number of times
receivables are collected, on average, during the fiscal year.

Receivables turnover ratio:

 Measures Company’s efficiency in collecting its sales on credit and collection policies.
 Takes in to consideration ONLY the net credit sales.
 Will be affected and may lose its significance if the cash sales are included.
 It is best to use average accounts receivable to avoid seasonality effects.
Receivables Turnover = .

For Biftu Company, this ratio for 2012 would be times

A high receivables turnover ratio:

 Implies either that the company operates on a cash basis or that its extension of credit and
collection of accounts receivable are efficient.
 Indicate reflects a short lapse of time between sales and the collection of cash,
 Indicate efficiency in the management of receivables and liquidity
 indicates a combination of conservative credit policy and aggressive collections department

A low receivables turnover ratio:

 Indicate longer collection period
 Indicate poor receivables collection procedures and credit policies
 Implies high risk of uncollectibility
 Is an indication of greater collection expenses
 May be caused by a loose or nonexistent credit policy, or an inadequate collections function
If the ratio is going up, either collection efforts may be improving, sales may be raising or
receivables are being reduced.

Receivables Turnover =
3) Average Collection Period (Days Sales Outstanding)
Average Collection Period represents the average number of days it takes the company to convert
receivables into cash. The DSO represents the average length of time that the firm must wait after
making a sale before receiving cash.
Average Collection Period:
 measures the quality of debtors
 can also be evaluated by comparison with the terms on which the firm sells
 should be the same or lower than the company's credit terms
 Should not exceed credit terms by more than 10-15 days
 Use average accounts receivable to avoid seasonality effects
 Is computed by dividing the receivables turnover ratio into 365 days
Short Collection period:
  Implies prompt payment by debtors.
 Reduces the chances of bad debts..
Longer Collection period:
 Implies too liberal and inefficient credit collection performance.
 It is difficult to provide a standard collection period of debtors
If the trend in average collection period over the past few years has been rising, but the credit
policy has not been changed, this would be strong evidence that steps should be taken to speed up
the collection of accounts receivable.

Average Collection Period =

Average Credit Sales per Day =

For Biftu Company, the average collection period, assuming accounts receivable of Br. 259 and credit
sales of Br. 600 (both in millions), can be computed as:
Average Collection Period = = days

4) Fixed Assets Turnover

It indicates how intensively the fixed assets of the firm are being used.
Fixed Assets Turnover = . The value of this ratio for Biftu Company for the year

2012 is times
 If fixed assets have changed significantly during the year, an average fixed asset level for the
year, like inventory, should be used.
 A low ratio implies excessive investment in plant and equipment relative to the value of
output being produced. In such a case, the firm might be better off to liquidate some of the
fixed assets and invest the proceeds productively.

5) Total Assets Turnover

 Total Assets Turnover helps measure the efficiency with which firms use their assets.
 It reflects how well the company’s assets are being used to generate sales
Total Assets Turnover = . For Biftu Company, this ratio for the year 2012 stands as

times
 A low ratio indicates excessive investment in assets. Generally firms prefer to support a high
level of sales with a small amount of assets, which indicates efficient utilization of assets.
 High total assets turnover ratio may indicate that the firm is using old, fully depreciated assets
that may be inefficient.
C. LEVERAGE RATIOS OR CAPITAL STRUCTURE RATIOS
These ratios are also known as ‘long term solvency ratios’ or ‘capital gearing ratios.’ Long-term
creditors are more concerned with the firm’s long-term financial position than with others. They
judge the financial soundness of the firm in terms of its ability to pay interest regularly as well as
make repayment of the principal either in one lump sum or in installments. These ratios:
  Indicate the ability of the company to survive over a long period of time
 Indicate the ability of the organization to repay the loan and interest..
 Indicate the extent to which the firm has used debt in financing its assets.
The most commonly calculated leverage ratios include:
1. Debt to total asset ratio (Debt Ratio)
2. Debt equity ratio.
3. Times Interest Earned Ratio (TIER)
4. Fixed Charges Coverage Ratio (FCCR)
1. Debt to total asset ratio (Debt Ratio)
The debt ratio indicates the percentages of a firm’s total assets that are financed with borrowed funds.
Debt Ratio =

For Biftu Company, the debt ratio for the year 2012 appears as or 75%.
 Creditors usually prefer a low debt ratio since it implies a greater protection of their position.
 A higher debt ratio generally means that the firm must pay a higher interest rate on its
borrowing; beyond some point, the firm will not be able to borrow at all.
2. Debt-Equity Ratio
 Debt to Equity is the ratio of total debt to total equity
 Ii is one of the measures of the long-term solvency of a firm.
 It measures the relative claims of creditors and owners against the assets of the firm
 It compares the funds provided by creditors to the funds provided by shareholders.
 It measures the soundness of the long term financial policies of the company
 As more debt is used, the Debt to Equity Ratio will increase.
 The use of debt can help improve earnings since deduct interest expense on the tax return
 For the analysis of capital structure of a firm debt-equity ratio is important
NB:
NB: The outsiders’ funds include all debts / liabilities to outsiders, whether long term or short term
or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of
equity share capital, preference share capital, capital reserves, revenue reserves, and reserves
representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc
Debt-Equity Ratio = .

For Biftu Company, this ratio for 2012 is .

Interpretation of Debt-Equity ratio
 Long-term creditors generally prefer to see a modest debt-equity ratio.
 A high debt equity ratio implies that a higher proportion of long-term financing is from debt.
 A low ratio means the firm has paid for its assets mainly with equity money
 The D-E ratio indicates the margin of safety to the creditors.
 A very high D-E ratio is unfavorable to the firm and creates inflexibility in operations.
 During periods of low profits a highly debt financed company will be under great pressure; it
cannot earn enough profits even to pay the interest charges.
 An ideal D-E ratio is 1:1
  In periods of prosperity and high economic activity, a large proportion of the debt may be
used while the reverse should be done during periods of adversity.
3. Times Interest Earned Ratio (TIER)
The TIER measures the ability of the firm to service its debt. In other words, it measures the ability to
pay interest out of its earnings. It shows how many times the interest payments are covered by funds
that are normally available to pay interest expense.
TIER = .

For Biftu Company, the TIER will be times for 2012.

The creditors may not like a low ratio on the ground that the company uses more debt or doesn’t
generate sufficient income to cover the interest expense. The higher the ratio, the stronger is the
interest paying ability of the firm. If it is too high, stockholders may feel that the firm is not taking
advantage of the benefits provided by financial leverage, i.e. the firm doesn’t use enough debt to
finance its operations..
4. Fixed Charges Coverage Ratio (FCCR)
Like the TIER, the FCCR is a measure of the ability of the firm to pay its fixed financing costs. It
indicates how much income is available to pay for all the firm’s fixed charges..
FCCR =

FCCR =

The FCCR is similar to the TIER. A higher ratio will indicate that the company is able to pay the
fixed charges and will satisfy the creditors.
D. MEASURES OF PROFITABILITY (PROFITABILITY RATIOS)
Profitability Ratios indicate the success of the firm in earning a net return on sales, total assets, and
invested capital and also show the combined effects of liquidity, asset management and debt
management on operating results.
There are different users interested in knowing the profits of the firm..
 The management of the firm regards profits as an indication of efficiency
 Owners take it as a measure of the worth of their investment in the business.
 To the creditors profits are a measure of the margin of safety.
 Employees look at profits as a source of fringe benefits.
 To the government, measures of the firm’s tax paying ability and a basis for legislative action.
 To the customers they are a hint for demanding price cuts.
The following are the main profitability ratios:
1. Gross Profit Margin
 Gross Profit Margin indicates the percent of each sales dollar remaining after cost of goods
sold has been subtracted.
 It also reflects the effectiveness of pricing policy and of production efficiency..
Gross Profit Margin = .
For Biftu Company, gross profit margin for 2012 is or 53%.

2. Operating Margin
 The net operating margin indicates the profitability of sales before taxes and interest expenses.
 This ratio measures the effectiveness of production and sales of the company’s product in
generating pretax income for the firm..
Operating Margin = .

For Biftu Company, this ratio would amount to or 14%.

 Generally the higher the net operating margin the better the company is..
3. Net Profit Margin
 Net profit margin is a measure of the percent of each dollar of sales that flows through to the
stockholders as net income.
 It shows what percent of every sales dollar the firm was able to convert into net income.
 Firms with a low volume of sales may need a higher profit margin to generate a satisfactory
return for its shareholders.
Net Profit Margin = .

For Biftu Company, this ratio for 2012 is or 8%.

 Generally the stockholders always like to have a higher net profit margin..

4. Return on Investment
 It is also referred to as Return on Assets. It measures the return to the firm as a percentage of
the total amount invested in the firm or how profitable the firm used its assets.
ROI = .

The value of this ratio for Biftu Company for the year 2012 is or 10.5%.

 Managers generally prefer this ratio to be very high for their firms. However, a high ratio can
also mean that the firm is failing to replace worn-out assets.
 A low return on assets shows that the firm is not utilizing its assets profitably.

5. Return on Equity (ROE)

This ratio measures the return earned on the owners' (both preferred and common stockholders)
investment in the firm. Generally, the higher this return, the better off is the owners. Return on
equity is calculated as follows:
Return on Equity (ROE)=
This ratio for Biftu Company for 2012 is or 41%.
 It is the duty and objective of the management to generate maximum return on shareholders’
investments in the firm. Common
 Stockholders prefer ROE to be very high, since it indicates high returns relative to their
investment. However, if the return is abnormally high, it may increase the risk and therefore
the reasons must be determined..

(E) Market Value Ratios

These ratios relate the firm’s stock price with its earnings and book value per share..
1) Price Earnings Ratio:
Ratio:
 Used to assess the owner’s appraisal of share value.
 It also measures the amount investors are willing to pay for each Birr of the firm’s earnings.
 The level of P/E ratio indicates the degree of confidence that investors have in the firm’s
future performance.

 A rise in the price earnings ratio could be seen as a signal of increase in the market value of
the firm’s stocks..

2) Market/Book Ratio:
 The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company.
 Firms with relatively high rates of return on equity generally sell at higher multiples of book
value than those with low return.
Market/Book Ratio

Book Value per Share

1) Dividend Ratios: The primary interest of stockholders on a company’s operation is to see
whether it pays a good amount of dividend or not. The two ratios relative to dividends are::
Dividend Yield

Dividend payout
Determining the Market Value Ratios
Stockholders’ equity: 2009 2008
Preferred stock (Br. 1 par) 200 200
Common stock 4,822 3311
Retained earnings 18,355 15784
Total stockholders’ equity 23,377 19,295
Additional Information:
1) The total number of common shares outstanding on December 31, 2009 and 2008 were Br.
3,375 and Br. 3,796 shares respectively.
2) The preferred stocks pay a dividend of Br. 0.5 per share out of total net profits of Br. 4,572;
(i.e., earnings per share = 4,472/3,375 = Br. 1.325, assume dividend per share = Br. 0.9).
3) Capital’s shares are currently trading for Br. 9/share
Required:
Required: Compute price Earnings ratio and dividend yield ratio for 2009.

Key: P/E ratio = = 6.79 per share

Dividend yield= = 0.1= 10%