FINANCIAL STATEMENT ANALYSIS: RATIO ANALYSIS

This topic deals with tools of financial analysis and interpretation

CONTENTS

 Definitions and user of financial statements

 Yard Stick Used In Ratio Analysis
 Classification, Computation and interpretation of ratios
 Uses/ Application and limitation of ratios

Introduction
The purpose of financial statement i.e. revenue statement (statement of comprehensive income)
and balance sheet (statement of financial position) is first o show the result of the operation for
the period under review and secondly the financial position of the enterprise as at the relevant
date. It is difficult to get any meaning given out of figure includes in the financial statement. To
give a better information and understanding of the statement to users, the figure are compared in
terms of ration. This is what financial analysis entails.
Definition
Financial statement analysis is a process by which finance identifies the company’s financial
performance by comparing the entries in the balance sheet and those in the profit and loss
account (P*L). In other words, financial statement analysis involve the examination of both the
relationship among financial statement number and the trend in the number over time. This is so
because balance sheet entities are usually responsible for those to be found in the P & L i.e. asset
shown in the balance sheet are responsible for sales, revenue and expenses to be found in the P &
L.
Purpose of financial statement analysis
Financial analysis is the process of examining a company’s performance in the context of its
industry and economic environment in order to arrive at a decision making or recommendation.
Often, the decision and recommendation addressed by financial analysts pertain to providing
capital to the companies especially, whether to invest in the company’s debt or equity securities
and at what price. An investor in debt securities is concerned about company’s ability to pay
interest and to repay principal lent. An investor in equity securities is an owner with a residual
interest in the company and is concern about company ability to pay dividends and the likelihood
that its share price will increase. Overall, a central focus of financial analysis is evaluating the
company’s ability to earn a return on its capital that is at least equal to the cost of capital, to
profitably grow its operations, and generate enough cash to meet obligation and pursue
opportunities. Fundamental financial analysis starts with the information found in a company’s
financial reports. These financial report include audited financial statement, additional

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disclosures required by regulatory authorities and any accompanying (unaudited) commentary by
management
So in a nutshell the main purpose includes:
o The use past performance of a company to predict how will it be in the future
o To evaluate the performance of a company with an eye towards identifying problem
areas. Thus, financial statement analysis is both diagnostic- identifying where a firm has
problem and prognostic- predicting how a firm will perform in the future
This analysis is important to various parties with financial stake I the company. These includes
1. Shareholders- actual owner are interested in the company’s both short and long term
survival. For this reason they will use ratios such as :

a) Profitability ratios – which seek to establish viability

b) Dividend ratios – which seek to establish return to owner in the form of
dividends. The common ratios include earning yield (E/Y). Dividend payout ratio
(DPO), Dividend yield, Earning per share, price earning ration, all of which will
measure return to owner.

2. Creditors ( trade) – these are interested in the company’s ability to meet their short term
obligation and when they fall du. For this reason they will use ratios such as:

a) Liquidity ratios – a qualitative measure of company’s liquidity position measured

by acid test ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against
current liabilities.
3. Long term lenders – these includes finances through loans, mortgages and debenture
holder. These have both short and long term interest in in the company and its ability to
pay not only interest on debt but also principal and when it fall due. These parties are
interested in the following:

a) Liquidity ratios – used to assess short-term liability to meet current obligations

b) Profitability ratios – used to ascertain whether the company can pay its principal
back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment
of interest to the lender of the debt.

4. Directors and management of the company – they will therefore be interest in:
a) Efficiency of the company in generating profit.

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 b) The company’s viability from the investor’s point of view and the company’s
ability to generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.
5. Potential investors – these parties are interested in a company in total both on short and
long term basis in particular the company’s ability to generate return on their money.
Therefore they will use

a) Dividend ratios
b) Return ratios
c) Gearing ratios

6. Government – the government is interested mostly in utility companies (e.g TANESCO)

and those that will provide public services – in this case the government will be interest
in their survival and thus ability to provide those services. It may be interest in taxation
derived from these companies which is used for development. Government may also be
interest in employment level and as such it will use those ratios that can enable it to
achieve such objectives of particular importance are:

a) Profitability ratios
b) Return ratios

7. Competitors – These are interested in the company’s performance from the market share
point of view and will use the ratios that enable them to ascertain company’s competitive
strength e.g. profitability ratios, sales and return ratios.

8. General public – customer and potential customer – these are interested in the ability of
the company’s ability to provide goods and services on short and long term basis. We
have:
a) Return ratio
b) Sales ratio

YARD STICK USED IN RATIO ANALYSIS

1. Past performance of the company
The company’s past performance (past ratio) s used to measure of gauge the company’s
performance and particular the change in performance whether good (favorable), better, same or
even worse than the past. Such comparison is then used to interpret the company’s performance
bearing in mind the factor that influenced the present and past performances.
2. Average industry ratios

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These are useful as they indicate the average performance of various companies in a given
industry i.e. it’s given the minimum performance of a number of companies in a given industry.
These ratio are useful in so far as enable the analyst to make a reasonable comparison of the
company’s performance vis-à-vis other companies in the same industry. However, for this i.e
very strong and very weak companies – which should be excluded to arrive at industry average
figures
3. Ratio of successful companies
Useful if the company can bet figures of competitor who are leading in the market so as to enable
it to gauge it performance against better performance. However this information difficult to
obtain and sometimes it calls for private investigators.
4. Ratio of budgeted performance
These are the compared with actual performance ratios and investigations are made of any
unfavorable variance which should be explained.

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Classification of ratios:
Ratios are broadly classified into different categories:
1. Liquidity ratios
2. Turnover ratios
3. Gearing ratios
4. Profitability ratios
1. Liquidity Ratios
Also called working capital ratios. They indicate ability of the firm to meet its short term
maturity financial obligation/ current liabilities as and when they fall due.
The ratios are concerned with current assets and current liabilities. They include:
a) Current ratio = Current Assets
Current liabilities
This ratio indicate the No. of times the current liabilities can be paid from current assets before
these assets are exhausted.
The most recommended ratio is 2.0 i.e. the current asset must at least be twice as high as current
liabilities.
b) Quick/ acid test ratios = Current Asset – Stock
Current liabilities
Is a more refined current ratio which exclude amount of stock of the firm. Stocks are excluded
for two basic reasons.
i) They are valued on historical cost basis
ii) They may not be converted into cash very quickly
The ratio therefore indicates the ability of the firm to pay its current liabilities from the more
liquid assets of the firm
c) Cash ratio = Cash in hand/bank + Short marketable securities
Current liabilities
This is refinement of the acid test ratio indicate the ability of the firm to meet its current
liabilities from its most liquid resources.
Short term marketable securities refers to short term investment of the firm which can be
converted into cash within a very short period e.g. commercial paper and treasury bills.

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 d) Net working capital Ratio = Net working capital X 100
Net Assets
Where Net Asset or Capital employed = Total Assets – Current liabilities
This ratio indicates the proportions of total net assets which is liquid enough to meet the current
liabilities of the firm.
It is expressed in % term.
2. Turnover Ratio/ efficiency/ asset management ratio
Turnover ratio indicate the efficiency with which the firm utilized the asset or resources at its
disposal to generate sales revenue or turnover.
This ratio includes:
a) Stock/ inventory turnover = Cost of sale
Average stock
The ratio indicate number of times the stock was turned into sales in a year i.e. how many times
did the ‘buy-sell’ process occur during the year. The higher the stock turnover, the better the firm
and more likely the higher the sales.
b) Stock holding period = 365 days
Stock turnover

= 365 X Average stock i.e 365 days

Cost of sales Stock turnover
The ratio indicates number of days the stock was held in the warehouse before being sold.
The higher the stock turnover, the lower the stock holding period and vice versa.
c) Debtors/ accounts receiver turnover = Annual credit sales
Average debtor
The ratio indicates the number of times / frequency with which credit customer or debtors were
turned into sale i.e. the number of times they come to buy on credit per year after paying their
dues to the firm.
The higher the debtors turnover the better the firm indicating that customer came to buy credit
many times thus they paid within a short period.

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 d) Debtors collection period = 365 days
Debtors turnover

OR = 365 days X Average debtors

Annual credit sales
This refers to credit period that was granted to the debtors on the period within they were
supposed to pay their dues to the firm.
The shorter the collection period/ credit period the higher the debtors turnover and vice versa
If no opening debtors are given use the closing debtor to represent average debtors.
e) Creditors / accounts payable turnover = Annual credit purchases
Average creditors
o The firm buy goods on credit from suppliers.
o The ratio indicate number of times p.a. the firm bought goods on credit after the
suppliers.
o If the creditors turnover is high, this indicates that the payment was made within a short
period of time.

f) Creditors payment period 365 days

Creditor turnover

= 365 days x Average creditors

Annual credit purchases

o The ratio indicate the credit period granted by the supplier i.e. the period within which
the firm should pay its liabilities to the suppliers.
o The shorter the period the higher the creditors turnover and vice versa.

g) Fixed asset turnover = Annual sales

Fixed assets
o This ratio indicates the efficiency with which, the fixed assets were utilized to generate
sales revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilized to generate
sh 1.4 of sales

h) Total asset turnover = Annual sales

Total assets
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 o The ratio indicate amount of sales revenue generated from utilization of one shilling of
total asset.

3. Gearing/ Leverage/ Capital Structure Ratio

The ratio indicate the extent in which the firm has borrowed fixed charge capital to finance the
acquisition of assets or resources of the firm.
The two basic gearing ratios are:

a) Debt/ equity ratio = Fixed charge capital

Equity (net worth)

This ratio indicate the amount of fixed charge capital in the capital structure of the firm for every
one shilling of owner capital or equity e.g. ratio of 0.78 means for every sh. 1 of equity there is
Sh 0.78 fixed charge capital.

b) Fixed charge to total capital ratio = Fixed charge capital X 100

Total capital employed

Where total capital employed = fixed charge capital + equity relative to total capital employed
by the firm e.g. a ratio of 0.38 means that, 38% of the capital employed is fixed charge capital

Other leverage or gearing ratio are

a) Debt ratio = Total debt

Total assets

Where total debt = fixed charge capital + liabilities

The ratio indicate the proportion of total assets that has been financed using long term and
current liabilities e.g. a debt ratio of 0.45 mean 45% of total asset has been financed with debt
while the remaining 55% was financed with owner equity/capital

b) Times interest earned ratio = Operating profit (earnings before interest and tax)
Interest charges
TIER also called interest coverage ratio

This ratio indicate the number of time interest charges can be paid from operating profit. The
higher the TIER, the better the firm indicating that either the firm has high operating profit of its
interest charges are below.
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If TIER is high due to low interest charges, this indicates low level of gearing/ debt capital of the
firm.

5. Profitability Ratio

This ratio indicate the performance of the firm in relation to its ability to derive returns or profit
from investment or from sale of goods i.e profit margin or sales.

1. Profitability in relation to sales

The ratio indicate the ability of the firm to control its cost of sale, operating and financing
expenses:
They include:

a) Gross profit margin = Gross profit X 100

Sales

The ratio indicate the ability of the firm to control cost of sale expenses e.g gross profit margin
of 40% means 60% of sales revenue was taken up by cost of sales while 40% was the gross
profit.

b) Operating profit margin = Operating profit/ Earnings before interest & tax
Sales

The ratio indicates ability of the firm to control its operation expenses such as distribution cost,
salaries and wages, travelling, telephone and electricity charges etc. e.g. a ratio of 20% means:
i) 80% of sales relate to both operating and cost of sales expenses
ii) 20% of sales remained as operating margin profit

c) Net profit margin = Net profit (earning after tax) + interest X 100
Sales

This ratio indicates the ability of the firm to control financing expenses in particular interest
charges e.g. Net profit margin pf 10% indicate that:

 90% of sales were taken up by cost of sales, operating and financing

 10% remained as net profits.

Profitability in relation to investment

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 a) Return on Investment (ROI) = Net profit x 100
Or Return on Total Asset (ROTA) Total asset

The ratio indicates the return on profit from investment of sh. 1 in total assets e.g a ratio
of 20% means sh. 10 of total asset generate sh. 2 of net profit.

b) Return on Equity (ROE) = Net profit x 100

Or Return in Net Worth (RONW) Equity
Or Return on shareholders’ equity (ROSE)

The ratio indicate the return of profitability for every one shillings of equity capital contributed
by the shareholders e.g. a ratio of 25% means one shilling of equity generates sh. 0.25 profit
attributable to ordinary shareholders

c) Return on capital employed (ROCE) = Net profit x 100

Or Return in net Asset (RONA) Net asset (capital employed)

This ratio indicate the returns of profitability for every one shilling of capital employed in the
firm.

Uses/ application of Ratios

Ratios are used in the following ways by managers in various firms.

1. Evaluating the efficiency of assets utilization to generate sales revenue i.e. turnover ratio.
2. Evaluating the ability of the firm to meet its short term financial obligation as and when they
fall due (liquidity ratios).
3. To carry out industrial analysis i.e. compare the firm’s performance with the average
industrial performance of the firm with that of individual competitors in the same industry.
4. For cross section analysis i.e. compare the firm’s performance with that of individual
competitors in the same industry.
5. For trend/ time series analysis i.e. evaluate the performance of the firm over time.
6. To establish the extent which the assets of the firm has been financed by fixed charge capital
i.e. use of gearing ratio.
7. To predict the bankruptcy of the firm i.e. use of selected ratios to determine the overall ratio
usually called a Z- scored will indicate the probability of the bankruptcy of the firm in future

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Limitation of Ratios

Ratios have the following weakness:

1. They ignore the size of the firm being compared e.g. in cross-section analysis, the firm being
compared might be of different size, technology and product diversification.
2. Effect of inflation:
3. Ratio ignores the effect of inflation in performance e.g. increase in sales might be due to
increase in selling price caused by inflationary pressure in the economy.
4. Ratios ignores qualitative or non-qualitative aspects of the firm e.g. important assets such as
corporate image, efficient management team, customer loyalty, quality of product,
technological innovation etc are not captured in ratio analysis.
5. Ratios are computed only at one point in time i.e. they are subject to frequent changes after
computation e.g. liquidity ratios will constantly change as the cash, debtors and stock level
changes.
6. Monopolistic
7. It is difficult to carry out industrial and cross-sectional analysis for monopolistic firms since
they do not have competitors and they are the only firms in the whole industry e.g. East
Africa Brewery etc.
8. Historical Data – Ratios are computed in historical information or financial statement thus
may be irrelevant in future decision-making.
9. Computation and interpretation
10. Generally some ratios do not have an acceptance standard of computation. This may differ
from one industry to another. E.g. the return on investment may be computed as:

Return on investment = EBIT or EAT

Total assets Total assets

Different accounting policies – different firms in the same industry use different accounting
policies e.g. methods of depreciation and stock valuation. This makes comparison difficult.

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QUESTION ONE

a) The following financial statements relate to the ABC Company:

Statement of financial position as at 31st March 2014

Asset Shs. Liabilities

Shs.
Cash 28,500 Trade creditor 116,250
Debtors 270,000 Notes payable (9%)
54,000
Stock 649,500 Other current liabilities
100,500
Total current assets 948,000 Long term debt (10%)
300,000
Net fixed assets 285,750 Net worth
663,000
1,233,750
1,233,750

Income statement for the year ended 31st March 2014

Shs.
Sales 1,972,500
Less: cost of sales 1,368,000
Gross profit 604,500
Selling and distribution expenses 498,750
Earning before interest and tax 105,750
Interest expenses 34,500
71,250
Estimated taxation (40%) 28,500
Earning after interest and tax 42,750

Required:

Calculate

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 i) Inventory turnover ratio
ii) Times interest earned ratio
iii) Total assets ratio
iv) Net profit margin

(Note: Round your ratio to one decimal place)

b) The ABC Company operates in an industry whose norms are a follow

Ratio Industry norm
Inventory turnover 6.2 times
Times earned interest ratio 5.3 times
Total assets turnover ratio 2.2 times
Net profit margin 4.5%

Required:

Comment on the revelation made by the ratio you have computed in part (a) above when
compared with the industry average.

QUESTION TWO:

The following data are taken from the record of Emmanuel Company Ltd. In Dar es Salaam

Emmanuel Company Ltd. Statement of financial Position as at 31st December

Assets 2015 2014
Sh “000” Sh “000”
Non-Current Assets
Property plant and Equipment 50,000 50,000
Other non-current assets 8,000 10,000

Total Non-Current Assets 58,000 60,000

Current Assets
Inventory 20,000 10,000
Trade Debtors 8,000 7,000
Cash 2,000 3,000
Total Current Asset 30,000 20,000
Total Assets 88,000 80,000

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Liabilities & Equity
Long term Liabilities 12,000 5,000
Current Liabilities 22,000 25,000
Total Liabilities 34,000 30,000

Equity shareholder’s Equity 30,000 30,000

Retained profit 24,000 20,000
Total Shareholder’s equity 54,000 50,000
Total liabilities & equity 88,000 80,000
Emmanuel company Ltd Income Statement for the years ended December

2015 2014
Sh “000”
Sh”000”
Sales 265,000 224,000
Cost of goods sold 186,000 169,000
Gross profit 79,000 55,000
Operating expenses 51,000 34,000
Operating profit (PBIT) 28,000 21,000
Interest Expenses 2,000 1,000
Profit before Taxes 26,000 20,000
Income Taxes 6,500 6,000
Net profit 19,500 14,000

Required:
1. Compute the following ratios for 2014 and 2015
i) Current ratio
ii) Debt-to-Equity ratio (gearing ratio)
iii) Asset Turnover
iv) Average Collection Period (use the trade debtors balance at the end of the year)
v) Number of day’s Sales in inventory (use the inventory balance at the end of the
year)
vi) Times Interest Earned
vii) Return on Assets
viii) Return on Equity

2. Discuss the firm’s performance and financial position for 2015 and 2014.

3. Assume you are a Loan Officer in one of the bank in Dar es Salaam. In January 2016 you
were asked to recommend whether Emmanuel Company Ltd should be given a loan of

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Sh. 15,000,000 for the purpose of acquiring additional Property, Plant and Equipment.
Explain what will you recommend and explain the basis of your recommendation.

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