Say True or False

1. Liquidity ratios, that look at the availability of cash for operations.

2. Asset management ratios evaluate the efficient utilization of the resources.

3. Debt management ratios keep track of debt to be within reasonable bounds, and keep the debt level
at its optimal level.

4. Profitability ratios measure the degree of accounting profits.

5. Market value ratios help investors discriminate between overvalued and undervalued securities while
making investment decisions.

12.2.2. Methods/ Domains of Financial Analysis

1.Horizontal (Trend) Analysis

2.Vertical (Static) Analysis

3.Ratio Analysis

4.Profitability Analysis

5.Market Value Analysis

1.Horizontal (Trend) Analysis

-It expresses financial data from two or more accounting periods in terms of a single designated base
period;

-It compares data in each succeeding period with the amount for the preceding period. For example,
current to past or expected future for the same company.

2. Vertical (Static) Analysis

In vertical analysis, all the data in a particular financial statement are presented as a percentage of a
single designated line item in that statement. For example, we might report

-Income statement items as percentage of net sales,

- Balance sheet items as a percentage of total assets; and

- Statement of cash flows items as a fraction or percentage of the change in cash.

3.Ratio Analysis

-The most widely used financial analysis technique is ratio analysis, the analysis of relationships
between two or more line items on the financial statements.
A ratio: Is the mathematical relationship between two quantities in the financial Statement. Ratio
analysis: is essentially concerned with the calculation of relationships which, after proper identification
and interpretation, may provide information about the operations and state of affairs of a business
enterprise

Types of Financial Ratios

There are five basic categories of financial ratios. Each represents important aspects of the firm's
financial conditions. The categories consist of liquidity, activity, leverage, profitability and market value
ratios.

1. Liquidity Ratios

-Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and as they
fall due.

-CL-represent the firm's maturing financial obligations. The firm's ability to repay these obligations when
due depends largely on whether it has sufficient cash together with other assets that can be converted
into cash before the current liabilities mature.

- The firm's CA are the primary source of funds needed to repay current and maturing financial
obligations.

-CR-is the logical measure of liquidity. Lack of liquidity implies inability to meet its current obligations
leading to lack of credibility among suppliers and creditors.

i.Current Ratio:- Measures a firm’s ability to satisfy or cover the claims of short term creditors by using
only current assets. i.e,it measures a firm’s short-term solvency or liquidity.

CR=cA÷CL

The unit of measurement is either birr or times. So, we could say that Merob has Birr 1.97 in current
assets for every 1 birr in current liabilities, or, we could say that Merob has its current liabilities covered
1.97 times over. An ideal current ratio is 2:1or more.

A very high current ratio than the Standard may indicate:

 excessive cash due to poor cash management,

 excessive accounts receivable due to poor credit management,
 excessive inventories due to poor inventory management, or a firm is not making full use
of its current borrowing capacity.
A very Low current ratio than the Standard may indicate:

 difficulty in paying its short term obligations,

 under stocking that may cause customer dissatisfaction.
ii.Quick (Acid-test) Ratio: It measures the short term liquidity by removing the least liquid assets such
as:

 Inventories: are excluded because

 They are not easily and readily convertible into cash and moreover, losses are most likely to
occur in the event of selling inventories.

 They are generally the least liquid of the firm's assets, it may be desirable to remove them from
the numerator of the current ratio, thus obtaining a more refined liquidity measure.

 Prepaid Expenses such as;

 prepaid rent,

 prepaid insurance, and

 prepaid advertising,

 pre paid supplies are excluded because they are not available to pay off current debts.

Q/ATR=CA-Inv÷CL

Interpretation: Merob has 1birr and 51 cents in quick assets for every birr current liabilities.As a very
high or very low acid test ratio is assign of some problem, a moderately high ratio is required by the
firm.

2. Activity Ratios

Activity ratios are also known as assets management or turnover ratios.

Measure the degree to which assets are efficiently employed in the firm. These ratios indicate how
well the firm manages its assets. They provide the basis for assessing how the firm is efficiently or
intensively using its assets to generate sales. These ratios are called turnover ratios because they show
the speed with which assets are being converted into sales.

Measure of liquidity alone is generally inadequate because differences in the composition of a firm's
current assets affect the "true" liquidity of a firm i.e.Overall liquidity ratios generally do not give an
adequate picture of company’s real liquidity due to differences in the kinds of current assets and
liabilities the company holds. Thus, it is necessary to evaluate the activity ratio.

Generally, high turnover ratios usually associated with good assets management and lower turnover
ratios with poor assets management.

The major activity ratios are the following.

I.Inventory Turnover Ratio(ITOR)

II.Average Age of Inventory(AAI)

III.Accounts Receivable Turnover Ratio(A/R TOR)

IV.Average Collection Period(ACP)

V.Average Payment Period(APP)

VI.Fixed Asset Turnover(FATO)

VII.Total Asset Turnover(TATO)

I.Inventory Turnover Ratio(ITOR)

 It measures the effectiveness or efficiency with which a firm is managing its investments
in inventories is reflected in the number of times that its inventories are turned over
(replaced) during the year.
 It is a rough measure of how many times per year the inventory level is replaced or
turned over.
ITO= CGS÷A.Inv

Interpretation: - Merob's inventory is sold out or turned over 7.09 times per year.

In general, a high inventory turnover ratio is better than a low ratio.

An inventory turnover significantly higher than the industry average indicates:

 Superior selling practice,

 Improved profitability as less money is tied-up in inventory.
II.Average Age of Inventory(AAI)

 The number of days inventory is kept before it is sold to customers.

AAI=365 days ÷ITO

Interpretation: Inventory remain in stock for 51 days on average before it is sold.

III.Accounts Receivable Turnover Ratio(A/R TOR)

 Measures the liquidity of firm’s accounts receivable. I.e, it indicates how many times
or how rapidly accounts receivable is converted into cash during a year. The A/RTO
is a comparison of the size of the company’s sales and its uncollected bills from
customers. This ratio tells how successful the firm is in its collection. If the
company is having difficulty in collecting its money, it has large receivable balance
and low ratio.
A/RTO=NS÷A A/R
Interpretation: Merob Company collected its outstanding credit accounts and re-loaned the money
7.08 times during the year. Reasonably high accounts receivable turnover is preferable.

A ratio substantially lower than the industry average may suggest that a Company has:

 More liberal credit policy (i.e. longer time credit period),

 Poor credit selection, and
 Inadequate collection effort or policy.
A ratio substantially higher than the industry average may suggest that a firm has;

 More restrictive credit policy (i.e. short term credit period),

 More liberal cash discount offers (i.e. larger discount and sale increase),
 More restrictive credit selection.
IV.Average Collection Period(ACP)

 Shows how long it takes for account receivables to be cleared (collected).

 The ACP represents the number of days for which credit sales are locked in with
debtors (accounts receivables).
ACP=365 days ÷A/R TO

Or

ACP = AA/R* 365 days÷Sales

The higher ACP is an indication of

 Reluctant collection policy where much of the firm’s cash is tied up in the form of
accounts receivables, whereas,
The lower the ACP than the standard is also an indication of

 Very aggressive collection policy which could result in the reduction of sales revenue.
V.Average Payment Period(APP/AA.A/P)

 The average Payment Period/ Average Age of accounts Payable shows, the time it takes
to pay to its suppliers.
APP= A/P÷ Average Purchase per day

Purchase is estimated as a given percentage of cost of goods sold. Assume purchases were 70% of the
cost of goods sold in 2001.

So, Average Payment Period = 382,000 = 95 days

2,088,000 x .70/365
This shows that, on average, the firm pays its suppliers in 95 days.

VI.Fixed Asset Turnover(FATO)

 Measures the efficiency with which the firm has been using its fixed assets to generate
revenue.
FATO=NS÷Average Net Fixed Asset

This means that, Merob Company has generated birr 1.29 in net sales for every birr invested in fixed
assets.

Other things being equal, a ratio substantially below the industry average shows;

 Underutilization of available fixed assets (i.e. presence of idle capacity) relative to the
industry,
 Possibility to expand activity level without requiring additional capital investment,
 Over investment in fixed assets,
 Low sales or both. It helps the financial manager to reject funds requested by production
managers for new capital investments.
Other things being equal, a ratio higher than the industry average

 It requires the firm to make additional capital investment to operate a higher level of
activity.
 It also shows firm's efficiency in managing and utilizing fixed assets.
VII.Total Asset Turnover(TATO)

 Measures a firm’s efficiency in management its total assets to generate sales.

TATO= NS÷ Net Total Asset

Interpretation: - Merob Company generates birr 0.85 (85 cents) in net sales for every birr invested in
total assets.

 A high ratio suggests greater efficiency in using assets to produce sales where as,
 A low ratio suggests that is not generating a sufficient volume of sales for the size of its
investment in assets.
Caution-with respect to the use of this ratio, caution is needed as the calculations use historical cost of
fixed assets. Because, of inflation and historically based book values of assets, firms with newer assets
will tend to have lower turnovers than those firms with older assets having lower book values.The
difference in these turnovers results from more costly assets than from differing operating efficiencies.

3. Leverage Ratios

 Leverage ratios are also called solvency ratio.

 Solvency is a firm’s ability to pay long term debt as they come due.
 Leverage shows the degree of ineptness of firm.
There are two types of debt measurement tools. These are:

I.Financial Leverage Ratio(FLR):

II.Coverage Ratio(CR):

I.Financial Leverage Ratio(FLR): These ratios

 Examine balance sheet ratios and

 Determine the extent to which borrowed funds have been used to finance the firm.
 It is the relationship of borrowed funds and owner capital.
II Coverage Ratio(CR): These ratios

 Measure the risk of debt and calculated by income statement ratios designed to
determine the number of times fixed charges are covered by operating profits. Hence,
they are computed from information available in the income statement.
 It measures the relationship between what is normally available from operations of the
firm’s and the claims of outsiders. The claims include loan principal and interest,
lease payment and preferred stock dividends.

A.1, Debt Ratio(DR):

 It Shows the percentage of assets financed through debt. It is calculated as:

DR=TL÷TA

This indicates that the firm has financed 45.7 % of its assets with debt.

Higher ratio shows more of a firm’s assets are provided by creditors relative to owners indicating that,

 The firm may face some difficulty in raising additional debt as creditors may require a
higher rate of return (interest rate) for taking high-risk.
Creditors prefer moderate or low debt ratio,

 Because low debt ratio provides creditors more protection in case a firm experiences
financial problems.
A.2. Debt -Equity Ratio(DER):


Express the relationship between the amount of a firm’s total assets financed by
creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of
creditors and shareholders’ against the asset of the firm.
DER=TL÷SHE
Interpretation: lenders’contribution is 0.84 times of stock holders’ contributions.

B. 1. Times Interest Earned Ratio(TIER):

  Measures the ability of a firm to pay interest on a timely basis.

TIER=Earning Before Interest &Tax ÷ Interest Expense

This ratio shows the fact that earnings of Merob Company can decline 4.5 times without causing
financial losses to the Company, and creating an inability to meet the interest cost.

B.2.Coverage Ratio(CR):


The problem with TEIR is that, it is based on earning before interest and tax, which is not
really a measure of cash available to pay interest. One major reason is that, depreciation,
a non cash expense has been deducted from earning before Interest and Tax (EBIT).
Since interest is a cash outflow, one way to define the cash coverage ratio is as follows:
CCR=EBIT+Depreciation ÷Interest
This ratio indicates the extent to which earnings may fall with out causing any problem to the firm
regarding the payment of the interest charges.

4.Profitability Ratios:

 Profitability is the ability of a business to earn profit over a period of time.

 Profitability ratios are used to measure management effectiveness.
 Creditors want to get interest and repayment of principal regularly.
 Owners want to get a required rate of return on their investment.

These ratios include:and

I.Gross Profit Margin(GPM)

II.Operating Profit Margin(OPM)

III.Net Profit Margin(NPM)

IV.Return on Investment (ROI)

V.Return on Equity (ROE)

VI.Earning Per Share(EPS)

I.Gross Profit Margin(GPM)

 It computes the margin earned by the firm after incurring manufacturing or

purchasing costs.
 It indicates management effectiveness in
 pricing policy,
 generating sales and
 controlling production costs.
GPM=GP÷NS

Interpretation: Merob company profit is 32 cents for each birr of sales.

A high gross profit margin ratio is a sign of good management.

A gross profit margin ratio may increase by:

 Higher sales price,

 CGS remaining constant,
 lower CGS,
 sales prices remains constant. Whereas,
Alow gross profit margin may reflect

 Higher CGS due to the firm’s inability to purchase raw materials at favorable
terms,
 Inefficient utilization of plant and machinery, or
 Over investment in plant and machinery,
 Resulting higher cost of production.
II.Operating Profit Margin(OPM)

 It is calculated by dividing the net operating profits by net sales.

 The net operating profit is obtained by deducting depreciation from the gross
operating profit.
OPM=OP÷NS

Interpretation: Merob Company generates around 14 cents operating profit for each of birr sales.

III.Net Profit Margin(NPM)

 It is one of the very important ratios and measures the profitableness of sales.
 It is calculated by dividing the net profit to sales.
 The net profit is obtained by subtracting operating expenses and income taxes from the
gross profit.
 It measures the ability of the firm to turn each birr of sales in to net profit.
 A high net profit margin is a welcome feature to a firm and it enables the firm to
accelerate its profits at a faster rate than a firm with a low profit margin.
NPM=NI÷NS

This means that Merob Company has acquired 7.5 cents profit from each birr of sales

IV.Return on Investment (ROI)

  It is also referred to as Return on Assets measures the overall effectiveness of
management in generating profit with its available assets, i.e. how profitably the
firm has used its assets.
 Income is earned by using the assets of a business productively.
 The more efficient the production, the more profitable is the business.
ROI=NI÷TA

Interpretation: Merob Company generates little more than 6 cents for every birr invested in assets.

V.Return on Equity (ROE)

 The shareholders of a company may Comprise Equity share and preferred share holders.
 Preferred shareholders are the shareholderswho have a priority in receiving dividends
(and in return of capital at the time of widening up of the Company).
 The rate of dividend divided on the preferred shares is fixed.
 But the ordinary or common share holders are the residual claimants of the profits and
ultimate beneficiaries of the Company.
 The rate of dividends on these shares is not fixed.
 When the company earns profit it may distribute all or part of the profits as dividends to
the equity shareholders or retain them in the business it self.
 But the profit after taxes and after preference shares dividend payments presents the
return as equity of the shareholders.

ROE=NI÷SHE

Interpretation: Merob generates around12 cents for every birr in shareholders’ equity.

VI.Earning Per Share(EPS)

 EPS is another measure of profitability of a firm from the point of view of the ordinary
shareholders.
 It reveals the profit available to each ordinary share.
 It is calculated by dividing the profits available to ordinary shareholders (i.e. profit
after tax minus preference dividend) by the number of outstanding equity shares.
EPS =Earning Available for Common Stockholders

Number of Shares of Common Stock Outstanding

Interpretation: Merob Company earns birr 2.90 for each common shares outstanding.

Interpretation: Merob Company earns birr 2.90 for each common shares outstanding.

5.Market Value Ratio:

  Market value or valuation ratios are the most significant measures of a firm's performance,
 Market Value to Book Value (Market-to-Book) Ratios
 The market value to book value ratio is a measure of the firm's contributing to wealth
creation in the society. It is calculated as:
 They measures the performance of the firm's common stocks in the capital market.
 This is known as
 the market value of equity and
 reflects the risk and return associated with the firm's stocks.
 These measures are based, in part, on information that is not necessarily contained in
financial statements – the market price per share of the stock.
 These measures can only be calculated directly for publicly traded companies.
I. Price- Earnings (P/E) Ratio:

 It is an indicator of the firm's growth prospects, risk characteristics, shareholders

orientation corporate reputation, and the firm's level of liquidity.
P/E Ratio = Market Price per Share÷Earning per Share

This figure indicates that, investors were paying birr 11.10 for each 1.00 of earnings.

 Though not a true measure of profitability, the P/E ratio is commonly used to assess the
owners' appraisal of shares value.
 The P/E ratio represents 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 (or Certainty) that investors have
in the firm's future performance.
 The higher the P/E ratio, the greater the investor confidence on the firm's future. It is a
means of standardizing stock prices to facilitate comparison among companies with
different earnings.
II.Market Value to Book Value (Market-to-Book) Ratios

 It is a measure of the firm's contributing to wealth creation in the firm's contributing to

wealth creation in the society.
Market-Book Ratio = Market Value pre Share ÷ Book Value per Share
Book value per share = Total Stockholders Equity

No. of Common Shares Outstanding

 The market –to-book value ratio is a relative measure of how the growth option for a
company is being valued via-a vis- its physical assets.
 The greater the expected growth and value placed on such, the greater this ratio.
Multiple Choice Questions

1. Travel Air emerging regional air line, earns 6 percent on total assets but has a turnover on equity of 24
percent. What percent of the air line’s assets are financed with debt?

A. 30 % C. 75 %

B. 25 % D. 70 %

2. Chara Company has current ratio of 2.2 times, acid test ratio of 1.4 times and inventories of birr 55,000.
What will be its current assets?

A. 90,000 C. 155,000

B. 151,250 D. 68,750

3. Which of the following ratio indicate the most liquidity position of the company?

A. Liquidity ratio C. Profitability ratio

B. Activity ratio D. Dent management ratio

4. Which of these are concerned with financial statement analysis to assure the protection of the rights of
the public?

A. Investors C managers

B. Government D. All of the foregoing