CHAPTER TWO

FINANCIAL ANALYSIS
Introduction
Financial analysis is the process of evaluating firm’s financial performance and its prospects for the
future. It is the bases for intelligent decision making and starting point for planning for the future
courses of events for the firm. A better insight about finical strength and weakness of a firm can be
achieved by making financial analysis.

Users of financial analysis

1. Managers of the firm: It is their overall responsibility to say that the resources of a firm are
used most efficiently and effectively. From the view point of managers, financial analysis is
useful both as a way to anticipate future conditions and more important as a starting point for
planning actions that will influence the future course of events for the firm.

2. Shareholders/investors: They are most concerned with the firm’s earnings that are present
and future profitability of the firm.

3. Trade creditors: They are interested to know the ability of the firm to meet their claim over a
very short period of time. Their analysis will, therefore, confine on the evaluation of the firms
liquidity position.

4. Suppliers of long term debt: they are interested with the long solvency and survival of the
firm. They analyze the firm’s profitability over time etc….

The need for financial analysis

Financial analysis is needed by stakeholders of a business firms for the following important points:
Financial analysis assists in identifying the major strengths and weakness of a business firm.
Financial analysis is the bases for intelligent decision making and starting point for planning
the future courses of events for the business firm.
Financial analysis indicates whether a firm has enough cash to meet obligations, a reasonable
accounts receivable collection period.

.Source of financial data

1. Financial statements are the common source of financial data. Those statements may include;
income statement, balance sheet, cash follow statement, retained earnings statement.
2. Publications on industry averages and on financial statements of competitors.

Approaches to financial analysis and interpretation

1. Time series analysis/Trend analysis/horizontal analysis:
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The easiest way to evaluate the performance of firm is to compare its present ratio with the past ration.
It gives an indication of the direction of changes and reflects whether the firm’s financial performance
has improved, deteriorated or remained constant over time.

2. Cross- sectional /Common size/Comparative/Vertical analysis:

It is the comparison of ratio of one firm with some selection firms in the same industry at the same
point in time. It indicates the relative financial passion and performance of the firm in comparison
with a few carefully selected compotators, who have similar operation.
3. Industry analysis:
Determines the financial condition and performance of the firm with average ratios of the industry of
which the firm is a member. It helps to ascertain the financial standing and capacity of the firm vis-a-
vis other firms in the industry. Industry ratios are important standards in view of the fact that each
industry has its characteristics, which influence the financial and operating relationships. But, there are
certain practical difficulties in using industry ratios:
1) Difficult to get average ratios for industry
2) They are averages –averages of the ratios of strong a weak firms
3) Averages will be meaningless and the comparison futile it the firm with the same industry
widely differ in their accounting policies
4. Pro forma analysis:
It shows the firm’s relative strength and weakness in the past and the future by comparing the current
and past ratios with future ratios.

Ratio Analysis
Financial statements report both on a firm’s position at a point in time and on its operations over some
past period. However, the real value of financial statements lies in the fact that they can be used to
help predict future earnings and dividends. From an investor’s standpoint, predicting the future is what
financial statement analysis is all about, while from management’s standpoint, financial statement
analysis is useful both to help anticipate future conditions and, more important, as a starting point for
planning actions that will improve the firm’s future performance. Financial ratios are designed to help
us evaluate a financial statement.

In the paragraphs that follow, we will calculate the Year 2001 financial ratios for Allied Food
Products, using data from the balance sheets and income statements given in Tables 2.1 and 2.2. We
will also evaluate the ratios in relation to the industry averages. Note that all dollar amounts in the
ratio calculations are in millions.

Table 2.1 Allied Food Products: December 31 Balance Sheets (Millions of Dollars)
Assets 2001 2000 Liabilities $ Equity 2001 2000

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Cash $ marketable $10 $80 Accounts payable $60 $30
securities

Accounts Receivable $375 $315 Notes payable $110 $60

Inventories $615 $415 Accruals $140 $130

Total current assets $1,000 $810 Total current liabilities $310 $220

Net plant and Equipment $1,000 $870 Long term bonds $754 $580

Total debt $1,064 $800

Preferred stock (400,000 $40 $40

shares)

Common stock (50,000 shares) $130 $130

Retained earnings $766 $710

Total common equity $896 $840

Total Assets $2,000 $1,680 Total liabilities and equity $2,000 $1,680

NOTE: The bonds have a sinking fund requirement of $20 million a year. A sinking fund simply
involves the repayment of long-term debt. Thus, Allied was required to pay off $20 million of its
mortgage bonds during 2001. The current portion of the long-term debt is included in notes payable
here, although in a more detailed balance sheet it would be shown as a separate item under current
liabilities.

The different ratios used in the analysis are grouped/categorized as follows:

1. Liquidity ratios
2. Asset management ratio
3. Debt management ratio
4. Profitability ratios
5. Market value ratios

Table 2.2 Allied Food Products: Income Statements for Years Ending December 31 (Millions
of Dollars, Except for Per-Share Data)
2001 2000

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Net sales $3,000 $2,850.0

Operating costs excluding depreciation and amortization $2,616.2 $2,497.0

Earnings before interest and, taxes, depreciation, and amortization (EBITDA) $383.80 $353.0

Depreciation $100.0 $90.0

Amortization 0.00 0.00

Depreciation and amortization $100.0 $90.0

Earnings before interest and taxes (EBIT or operating income) $283.8 $263.0

Less interest $88.0 $60.0

Earnings before taxes (EBT) $195.8 $203.0

Taxes (40%) $78.3 $81.2

Net income before preferred dividendsb $117.5 $121.8

Preferred dividends $4.0 $4.0

Net income $113.5 $117.8

Common dividends $57.5 $53.0

Addition to retained earnings $56.0 $64.8

Per-share data:

- Common stock price $23.00 $26.00

- Earnings per share (EPS)a $2.27 $2.36

- Dividends per share (DPS)a $1.15 $1.06

- Book value per share (BVPS)a $17.92 $16.80

- Cash flow per share (CFPS)a $4.27 $4.16

a
There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings after
preferred dividends – that is, on net income available to common stockholders. Calculations of EPS,
DPS, BVPS, and CFPS for 2001 are as follows:

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 Net Income $ 113,500,000
Earnings per s h are ratio= = =$ 2.27
Common SHares outstanding $ 50,000,000
¿ $ 57,500,000
Dividends per s h are ratio=Dividends paid ¿ common stockHolders = =$ 1
Common SHares outstanding $ 50,000,000
Total common Equity $ 896,000,000
Book value per s h are ratio= = =$ 17.9
Common SHares o utstanding $ 50,000,000
Net Income + Depreciation+ Amortization $ 213,500,000
Cas h flow per s h are ratio= = =$ 4.27
Common SHares outstanding $ 50,000,000
b
On a typical firm’s income statement, this line would be labelled “net income” rather than “net
income before preferred dividends.” However, when we use the term net income in this text, we mean
net income available to common shareholders. To simplify the terminology, we refer to net income
available to common shareholders as simply net income. Students should understand that when they
review annual reports, firms use the term net income to mean income after taxes but before preferred
and common dividends.

Each of the ratios is discussed in turn as follows:

1. Liquidity Ratio
A liquid asset is one that trades in an active market and hence can be quickly converted to cash at the
going market price, and a firm’s “liquidity position” deals with this question: Will the firm be able to
pay off its debts as they come due over the next year or so? Liquidity ratio includes ratios that show
the relationship of a firm’s cash and other current assets to its current liabilities. The two commonly
used liquidity ratios are current ratio and quick or acid test ratio. Two of the ratios explain the ability
to meet the company’s current obligations.

a) Current Ratio
This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which
current liabilities are covered by those assets expected to be converted to cash in the near future.
Current assets normally include cash, marketable securities, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-
term debt, accrued taxes, and other accrued expenses (principally wages).
Current Assets
Current Ratio=
Current Liabilities
$ 1,000
Current Ratio= =3.2 time s
$ 310
The industry average is = 4.2 times. Allied’s current ratio is well below the average for its industry,
4.2, so its liquidity position is relatively weak. Still, since current assets are scheduled to be converted
to cash in the near future, it is highly probable that they could be liquidated at close to their stated
value. With a current ratio of 3.2, Allied could liquidate current assets at only 31 percent of book value
and still pay off current creditors in full.

b) Quick or Acid Test Ratio

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The quick, or acid test, ratio is calculated by deducting inventories from current assets and then
dividing the remainder by current liabilities. Inventories are typically the least liquid of a firm’s
current assets; hence they are the assets on which losses are most likely to occur in the event of
liquidation. Therefore, a measure of the firm’s ability to pay off short-term obligations without relying
on the sale of inventories is important.
Current Assets−Inventories
Current Ratio=
Current Liabilities
$ 1,000−$ 615
Current Ratio= =1.2׿
$ 310
industry average 2.1׿

The industry average quick ratio is 2.1, so Allied’s 1.2 ratio is low in comparison with other firms in
its industry. Still, if the accounts receivable can be collected, the company can pay off its current
liabilities without having to liquidate its inventory.

2. Asset Management Ratio

The second group of ratios, the asset management ratios, measures how effectively the firm is
managing its assets. These ratios are designed to answer this question: Does the total amount of each
type of asset as reported on the balance sheet seem reasonable, too high, or too low in view of current
and projected sales levels?

THE INVENTORY TURNOVER RATIO

The inventory turnover ratio is defined as sales divided by inventories. It is about evaluating
inventories.
Sales
Inventory Turnover Ratio=
Inventories
$ 3,000
Inventory Turnover Ratio= =4.9×; industry average is 9.0׿
$ 615
As a rough approximation, each item of Allied’s inventory is sold out and restocked, or “turned over,”
4.9 times per year. Allied’s turnover of 4.9 times is much lower than the industry average of 9 times.
This suggests that Allied is holding too much inventory. Excess inventory is, of course, unproductive,
and it represents an investment with a low or zero rate of return. Allied’s low inventory turnover ratio
also makes us question the current ratio. With such a low turnover, we must wonder whether the firm
is actually holding obsolete goods not worth their stated value. Note that sales occur over the entire
year, whereas the inventory figure is for one point in time. For this reason, it is better to use an average
inventory measure.

THE DAYS SALES OUTSTANDING

Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to appraise
accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to find
the number of days’ sales that are tied up in receivables. It is about evaluating inventories. Thus, the

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DSO represents the average length of time that the firm must wait after making a sale before receiving
cash, which is the average collection period.
Recievables Recievables
Days Sales Outstanding ( DSO )= =
Average sales per day Annual Sales
365
Annual Sales $ 3,000
i .e . Average sales per day= = =$ 8.2192
365 days 365 days
$ 375
Days Sales Outstanding ( DSO )= =45.625 days=46 days
$ 8.2192
Industry average = 36 days. Allied has 46 days sales outstanding, well above the 36-day industry
average. The DSO can also be evaluated by comparison with the terms on which the firm sells its
goods. For example, Allied’s sales terms call for payment within 30 days, so the fact that 46 days’
sales, not 30 days’, are outstanding indicates that customers, on the average, are not paying their bills
on time. This deprives Allied of funds that it could use to invest in productive assets. Moreover, in
some instances the fact that a customer is paying late may signal that the customer is in financial
trouble, in which case Allied may have a hard time ever collecting the receivable.

THE FIXED ASSETS TURNOVER RATIO

The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. So it
is about evaluating fixed assets. It is the ratio of sales to net fixed assets as follows:
Sales
¿ AssetsTurnover Ratio= Assets¿
Net ¿
$ 3,000
¿ AssetsTurnover Ratio= =3.0׿
$ 1,000
The industry average is 3.0 times. Allied’s ratio of 3.0 times is equal to the industry average,
indicating that the firm is using its fixed assets about as intensively as are other firms in its industry.
Therefore, Allied seems to have about the right amount of fixed assets in relation to other firms. A
potential problem can exist when interpreting the fixed assets turnover ratio. Recall from accounting
that fixed assets reflect the historical costs of the assets. Inflation has caused the value of many assets
that were purchased in the past to be seriously understated. Therefore, if we were comparing an old
firm that had acquired many of its fixed assets years ago at low prices with a new company that had
acquired its fixed assets only recently, we would probably find that the old firm had the higher fixed
assets turnover ratio. However, this would be more reflective of the difficulty accountants have in
dealing with inflation than of any inefficiency on the part of the new firm. The accounting profession
is trying to devise ways of making financial statements reflect current values rather than historical
values. If balance sheets were actually stated on a current value basis, this would help us make better
comparisons, but at the moment the problem still exists.

THE TOTAL ASSETS TURNOVER RATIO

The final asset management ratio, the total assets turnover ratio, measures the turnover of all the
firm’s assets; it is calculated by dividing sales by total assets.

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 Sales
Total Assets Turnover Ratio=
Total Assets
$ 3,000
Total Assets Turnover Ratio= =1.5׿
$ 2,000
Industry average is 1.8 times. Allied’s ratio is somewhat below the industry average, indicating that
the company is not generating a sufficient volume of business given its total assets investment. Sales
should be increased, some assets should be disposed of, or a combination of these steps should be
taken.

3. Debt Management Ratios

The extent to which a firm uses debt financing, or financial leverage, has three important
implications: (1) By raising funds through debt, stockholders can maintain control of a firm while
limiting their investment. (2) Creditors look to the equity, or owner-supplied funds, to provide a
margin of safety, so the higher the proportion of the total capital that was provided by stockholders,
the less the risk faced by creditors. (3) If the firm earns more on investments financed with borrowed
funds than it pays in interest, the return on the owners’ capital is magnified, or “leveraged.”

Debt Ratio or Total Debt to Total Assets

The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of funds
provided by creditors. It is about how the firm is financed. Total debt includes both current liabilities
and long-term debt. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion
against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want more
leverage because it magnifies expected earnings.
Total Debt
Debt Ratio=
Total Assets
$ 310+ $ 754 $ 1,064
Debt Ratio= = =53.2 %
$ 2,000 $ 2,000
Industry average is 40%. Allied’s debt ratio is 53.2 percent, which means that its creditors have
supplied more than half the total financing. The fact that Allied’s debt ratio exceeds the industry
average raises a red flag and may make it costly for Allied to borrow additional funds without first
raising more equity capital. Creditors may be reluctant to lend the firm more money, and management
would probably be subjecting the firm to the risk of bankruptcy if it sought to increase the debt ratio
any further by borrowing additional funds.

TIMES-INTEREST-EARNED RATIO
The ability to pay interest or times-interest-earned (TIE) ratio is determined by dividing earnings
before interest and taxes (EBIT) by the interest charges. The TIE ratio measures the extent to which
operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet
this obligation can bring legal action by the firm’s creditors, possibly resulting in bankruptcy. Note
that earnings before interest and taxes, rather than net income, is used in the numerator. Because
interest is paid with pre-tax dollars, the firm’s ability to pay current interest is not affected by taxes.

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 EBIT
¿ Interest Earned (TIE)Ratio=
Interest cHarges
$ 283.8
¿ Interest Earned ( TIE ) Ratio= =3.2׿
$ 88
Industry average is 6.0 times. Allied’s interest is covered 3.2 times. Since the industry average is 6
times, Allied is covering its interest charges by a relatively low margin of safety. Thus, the TIE ratio
reinforces the conclusion from our analysis of the debt ratio that Allied would face difficulties if it
attempted to borrow additional funds.

ABILITY TO SERVICE DEBT: EBITDA COVERAGE RATIO

A ratio whose numerator includes all cash flows available to meet fixed financial charges and whose
denominator includes all fixed financial charges. The TIE ratio is useful for assessing a company’s
ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the
only fixed financial charge — companies must also reduce debt on schedule, and many firms lease
assets and thus must make lease payments. If they fail to repay debt or meet lease payments, they can
be forced into bankruptcy. (2) EBIT does not represent all the cash flow available to service debt,
especially if a firm has high depreciation and/or amortization charges. To account for these
deficiencies, bankers and others have developed the EBITDA coverage ratio, defined as follows:
EBITDA + Lease Payment
EBITDA Coverage Ratio=
Interest + Principa l Payments+ Lease Payments

$ 283.8+ $ 100+ $ 28 $ 411.8

EBITDA Coverage Ratio = = =3.0׿
$ 88+ $ 20+ $ 28 $ 136

The industry average is 4.3 times. Allied had $283.8 million of operating income (EBIT), presumably
all cash. Noncash charges of $100 million for depreciation and amortization (the DA part of EBITDA)
were deducted in the calculation of EBIT, so they must be added back to find the cash flow available
to service debt. Also, lease payments of $28 million were deducted before getting the $283.8 million
of EBIT. That $28 million was available to meet financial charges, hence it must be added back,
bringing the total available to cover fixed financial charges to $411.8 million. Fixed financial charges
consisted of $88 million of interest, $20 million of sinking fund payments, and $28 million for lease
payments, for a total of $136 million.10 Therefore, Allied covered its fixed financial charges by 3.0
times. However, if operating income declines, the coverage will fall, and operating income certainly
can decline. Moreover, Allied’s ratio is well below the industry average, so again, the company seems
to have a relatively high level of debt. The EBITDA coverage ratio is most useful for relatively short-
term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than
about five years. Over a relatively short period, depreciation generated funds can be used to service
debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else
the company cannot remain in business. Therefore, banks and other relatively short-term lenders focus
on the EBITDA coverage ratio, whereas long-term bondholders focus on the TIE ratio.

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 4. Profitability Ratio
Profitability is the net result of a number of policies and decisions. The ratios examined thus far
provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios show the
combined effects of liquidity, asset management, and debt on operating results.

PROFIT MARGIN ON SALES

The profit margin on sales, calculated by dividing net income by sales, gives the profit per dollar of
sales:
Profit Margin on Sales=Net Income available ¿ Common StockHolders ¿
Sales
$ 113.5
Profit Margin on Sales= =3.8 %
$ 3,000
The industry average is 5.0%. Allied’s profit margin is below the industry average of 5 percent. This
sub-par result occurs because costs are too high. High costs, in turn, generally occur because of
inefficient operations. However, Allied’s low profit margin is also a result of its heavy use of debt.
Recall that net income is income after interest. Therefore, if two firms have identical operations in the
sense that their sales, operating costs, and EBIT are the same, but if one firm uses more debt than the
other, it will have higher interest charges. Those interest charges will pull net income down, and since
sales are constant, the result will be a relatively low profit margin. In such a case, the low profit
margin would not indicate an operating problem, just a difference in financing strategies. Thus, the
firm with the low profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage.

Basic Earning Power (BEP) Ratio

This ratio indicates the ability of the firm’s assets to generate operating income; calculated by dividing
EBIT by total assets.
EBIT
Basic Earning Power ( BEP)=
Total Assets

$ 283.8
Basic Earning Power ( BEP )= =14.2%
$ 2,000
Industry average is 17.2%. This ratio shows the raw earning power of the firm’s assets, before the
influence of taxes and leverage, and it is useful for comparing firms with different tax situations and
different degrees of financial leverage. Because of its low turnover ratios and low profit margin on
sales, Allied is not earning as high a return on its assets as is the average food-processing company.

RETURN ON TOTAL ASSETS

The ratio of net income to total assets measures the return on total assets (ROA) after interest and
taxes:
Return on Total Assets=Net Income available¿ Common StockHolders ¿
Total Assets

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 $ 113.5
Return on Total Assets= =5.7 %
$ 2,000
Industry average is 9.0%. Allied’s 5.7 percent return is well below the 9 percent average for the
industry. This low return results from (1) the company’s low basic earning power plus (2) high interest
costs resulting from its above-average use of debt, both of which cause its net income to be relatively
low.

RETURN ON COMMON EQUITY

Ultimately, the most important, or “bottom line,” accounting ratio is the ratio of net income to
common equity, which measures the return on common equity (ROE):
Return on Common Equity=Net Income available ¿ Common StockHolders ¿
Common Equity
$ 113.5
Return on Common Equity= =12.7 %
$ 896
The industry average is 15.0%. Stockholders invest to get a return on their money, and this ratio tells
how well they are doing in an accounting sense. Allied’s 12.7 percent return is below the 15 percent
industry average, but not as far below as the return on total assets. This somewhat better result is due
to the company’s greater use of debt.

5. Market Value Ratios

A final group of ratios, the market value ratios, relates the firm’s stock price to its earnings, cash
flow, and book value per share. These ratios give management an indication of what investors think
of the company’s past performance and future prospects.
If the liquidity, asset management, debt management, and profitability ratios all look good, then
the market value ratios will be high, and the stock price will probably be as high as can be
expected.

PRICE/EARNINGS RATIO
The ratio of the price per share to earnings per share; shows the dollar amount investors will pay for
$1 of current earnings. The price/earnings (P/E) ratio shows how much investor is willing to pay
per dollar of reported profits. Allied’s stock sells for $23, so with an EPS of $2.27 its P/E ratio is
10.1:
Price per SHare
Price earnings ( PE ) ratio=
Earnings per SHare
$ 23.00
Price earnings ( PE ) ratio= =10.1׿
$ 2.27
The industry average is 12.5 times. P/E ratios are higher for firms with strong growth prospects,
other things held constant, but they are lower for riskier firms. Since Allied’s P/E ratio is below the
average for other food processors, this suggests that the company is regarded as being somewhat
riskier than most, as having poorer growth prospects, or both.

PRICE/CASH FLOW RATIO

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The ratio of price per share divided by cash flow per share; shows the dollar amount investors will pay
for $1 of cash flow. In some industries, stock price is tied more closely to cash flow rather than net
income. Consequently, investors often look at the price/cash flow ratio:
Price per SHare
Price per Cas h flow ratio=
CasH flow per SHare
$ 23.00
Price per Cas h flow ratio= =5.4׿
$ 4.27
The industry average is 6.8 times. Cash flow per share is calculated as net income plus depreciation
and amortization divided by common shares outstanding. Allied’s price/cash flow ratio is also below
the industry average, once again suggesting that its growth prospects are below average, its risk is
above average, or both.

MARKET/BOOK RATIO
The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies with relatively high rates of return on equity generally sell at higher
multiples of book value than those with low returns. First, we find Allied’s book value per share:
Common Equity
Book value per s h are ratio=
SHares Outstanding
$ 896
Book value per s h are ratio= =$ 17.92
50
Now we divide the market price per share by the book value to get a market/book (M/B) ratio of 1.3 times:
Market Price per SHare
Maket Book ( MB) ratio=
Book Value per SHares
$ 23.00
Maket Book ( MB ) ratio= =1.3׿
$ 17.92
The industry average is 1.7 times. Investors are willing to pay less for a dollar of Allied’s book value
than for one of an average food-processing company. The average company followed by the Value
Line Investment Survey had a market/book ratio of about 4.28 in early 2001. Since M/B ratios typically
exceed 1.0, this means that investors are willing to pay more for stocks than their accounting book
values. This situation occurs primarily because asset values, as reported by accountants on corporate
balance sheets, do not reflect either inflation or “goodwill.” Thus, assets purchased years ago at pre-
inflation prices are carried at their original costs, even though inflation might have caused their actual
values to rise substantially, and successful going concerns have a value greater than their historical
costs. If a company earns a low rate of return on its assets, then its M/B ratio will be relatively low
versus an average company.
Vertical and Horizontal Analysis Technique
The overall objective of financial statement analysis is the examination of a firm’s financial
position and returns in relation to risk. This must be done with a view to forecasting the firm’s
future prospective.

For the purpose of understanding, the following statement of financial position for hypothetical
company, Xyz, is used.
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 Xyz Manufacturing Company
Balance Sheet
December 31,

2001 2002 2003

Assets
Cash 4,700 4,200 7,970
Marketable securities 3,680 3,500 3,380
Account receivables 710 1,080 1,130
Inventories 14,000 20,860 23,190
Total current assets 23,090 29,640 35,670
Fixed assets
Machinery 8,220 10,600 10,980
Equipment and vehicles 9,130 9,750 9,550
Other fixed assets 1,920 1,870 1,920
Total fixed assets 19,270 22,220 22,450
Total Assets 42,360 51,860 58,120
Liabilities and owners’ equity
Account payables 23,360 28,720 31,910
Salaries payables 2,500 4,340 4,850
Dividend payables 1,380 1,640 2,030
Total current liabilities 27,240 34,700 38,790
Long term liabilities 1,210 1,180 700
Total liabilities 28,450 35,880 39,490
Stock holders’ equity
Share capital 1,200 1,200 1,200
Share premium 1,080 1,080 1,080
Retained earnings 11,630 13,700 16,350
Share holders’ interest 13,910 15,980 18,630
Total liabilities and equity 42,360 51,860 58,120
A: Horizontal Financial Statement Analysis
A comparison of statements over several years reveals direction, speed and extent of a trend(s).
The horizontal financial statements analysis is done by restating amount of each item or group of
items as a percentage.
Such percentages are calculated by selecting a base year and assign a weight of 100 to the amount
of each item in the base year statement. Thereafter, the amounts of similar items or groups of items
in prior or subsequent financial statements are expressed as a percentage of the base year amount.
The resulting figures are called index numbers or trend ratios.
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From balance sheet given above, we can produce the following indexed balance sheet:
Xyz Manufacturing Company
Balance Sheet
December 31,
2001 2002 2003
Assets
Cash 100 89.4 169.6
Marketable securities 100 95.1 91.8
Account receivables 100 152.1 159.2
Inventories 100 149.0 165.6
Total current assets 100 128.4 154.5
Fixed assets
Machinery 100 129.0 133.6
Equipment and vehicles 100 106.8 104.6
Other fixed assets 100 97.4 100.0
Total fixed assets 100 115.3 116.5
Total Assets 100 122.4 137.2
Liabilities and owners’ equity
Account payables 100 122.9 136.6
Salaries payables 100 173.6 194.0
Dividend payables 100 118.8 147.1
Total current liabilities 100 127.4 142.4
Long term liabilities 100 97.5 57.9
Total liabilities 100 126.1 138.8
Stock holders’ equity
Share capital 100 100.0 100.0
Share premium 100 100.0 100.0
Retained earnings 100 117.8 140.6
Share holders’ interest 100 114.9 133.9
Total liabilities and equity 100 122.4 137.2

B: Vertical/Cross-Sectional/Common Size Analysis Techniques

Vertical/Cross-sectional/Common size statements came from the problems in comparing the financial
statements of firms that differ in size.
 In the balance sheet, for example, the assets as well as the liabilities and equity are each
expressed as a 100% and each item in these categories is expressed as a percentage of the
respective totals.
 In the common size income statement, turnover is expressed as 100% and every item in the
income statement is expressed as a percentage of turnover (sales).

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 Xyz Manufacturing Company
Balance Sheet
December 31,
2001 2002 2003
Assets
Cash 11.1 8.1 13.7
Marketable securities 8.7 6.7 5.8
Account receivables 1.7 2.1 1.9
Inventories 33.1 40.2 39.9
Total current assets 54.5 57.2 61.4
Fixed assets
Machinery 19.4 20.4 18.9
Equipment and vehicles 21.6 18.8 16.4
Other fixed assets 4.5 3.6 3.3
Total fixed assets 45.5 42.8 38.6
Total Assets 100.0 100.0 100.0
Liabilities and owners’ equity
Account payables 55.1 55.4 54.9
Salaries payables 5.9 8.4 8.3
Dividend payables 3.3 3.2 3.5
Total current liabilities 64.3 66.9 66.7
Long term liabilities 2.9 2.3 1.2
Total liabilities 67.2 69.2 67.9
Stock holders’ equity
Share capital 2.8 2.3 2.1
Share premium 2.5 2.1 1.9
Retained earnings 27.5 26.4 28.1
Share holders’ interest 32.8 30.8 32.1
Total liabilities and equity 100.0 100.0 100.0

C: Percentage of sales forecast (pro forma) analysis

The importance of sales forecasting
When constructing a financial forecast, the sales forecast is used traditionally to estimate various
expenses, assets, and liabilities. The most widely used method for making these projections is the
percent-of-sales method (pro forma), in which the various expenses, assets, and liabilities for a future
period are estimated as a percentage of sales. These percentages, together with the projected sales, are
then used to construct pro forma (planned of projected) balance sheets.

Illustrative Example:
See the following data for xyz flour factory for the year 2004.
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 Xyz Company
Balance Sheet
December 30, 2004
Cash 500,000
Account Receivables 200,000
Inventory 4,000,000
Total current assets 6,500,000
Fixed assets 1,000,000
Total assets 7,500,000
Liabilities and owners equity
Account Payables 1,500,000
Notes Payables 1,000,000
Total current liabilities 2,500,000
Long term liabilities 500,000
Total liabilities 3,000,000
Total owners equity 4,500,000
Total liabilities and owners equity 7,500,000

Xyz Company
Income Statement
For the Month Ended December 30, 2004
Sales 15,000,000
Cost of goods sold (14,250,000)
Net income 750,000
Dividend payable (250,000)
Retained earnings 500,000
Assume that sales have increased by 25%. All the balance sheet items except for long term debt and
owners equity has increased by proportion of sales increases. The expenses and interest and tax are
expected to increase to between 17,750,000.
Required: prepare balance pro forma balance sheet and income statement by using percentage of
sales method
Solution:
Xyz Company
Pro forma balance sheet
December 30, 2004
Cash 625,000
Account Receivables 2500,000
Inventory 5,000,000
Total current assets 8,125,000
Fixed assets 1,250,000

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 Total assets 9,375,000
Liabilities and owners equity
Account Payables 1,875,000
Notes Payables 1,250,000
Total current liabilities 3,125,000
Long term liabilities 500,000
Total liabilities 3,125,000
Additional fund needed 500,000
Total owners equity 5,250,000
Total liabilities and owners equity 9,375,000
Xyz Company
Pro forma Income Statement
For the Month Ended December 30, 2004
Sales 18,750,000
Cost of goods sold (17,750,000)
Net income 1,000,000
Dividend payable (250,000)
Retained earnings 750,000
Total fund needed = Total liability + Owners equity + additional fund needed
Total fund needed = 9,375,000 = 3,625,000 + 5,250,000+ additional fund needed
Additional fund needed =9,375,000 - 8,875,000
Additional fund needed = 500,000
Utility of Ratio analysis
With the help of ratios, one can determine:
a. The ability of the firm to meet its current obligation
b. The extent to which the firm has used its long term solvency by barrowing funds.
c. The efficiency with which the firm is utilizing its assets in generating sales revenue and
d. The overall operating efficiency and performance of the firm
Limitations of Ratio Analysis
Even though ratio analysis is a widely used technique to evaluate the financial position and performance of a
firm, there are certain problems that the analysis should be aware of some of the limitations, which are listed
below
1. Accounting Information
Different Accounting Policies: The choices of accounting policies may distort intercompany
comparisons.
Creative accounting: The businesses apply creative accounting in trying to show the better
financial performance or position which can be misleading to the users of financial
accounting.
2. Information problems
Ratios are not definitive measures: Ratios need to be interpreted carefully. They can provide

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 clues to the company’s performance or financial situation. But on their own, they cannot
show whether performance is good or bad. Ratios require some quantitative information for
an informed analysis to be made.
Outdated information in financial statement: The figures in a set of accounts are likely to be
at least several months out of date, and so might not give a proper indication of the
company’s current financial position.
Historical costs not suitable for decision making: IASB Conceptual framework recommends
businesses to use historical cost of accounting. Where historical cost convention is used, asset
valuations in the balance sheet could be misleading. Ratios based on this information will not
be very useful for decision making.
Financial statements certain summarized information: Ratios are based on financial
statements which are summaries of the accounting records. The ratios are based on the
summarized year end information which may not be a true reflection of the overall year’s
results.
Interpretation of the ratio: It is difficult to generalize about whether a particular ratio is
‘good’ or ‘bad’.
3. Comparison of performance over time
Price changes: Inflation renders comparisons of results over time misleading as financial
figures will not be within the same levels of purchasing power. Changes in results over time
may show as if the enterprise has improved its performance and position when in fact after
adjusting for inflationary changes it will show the different picture.
Technology changes: When comparing performance over time, there is need to consider the
changes in technology. For ratios to be more meaningful the enterprise should compare its
results with another of the same level of technology as this will be a good basis measurement
of efficiency.
Changes in accounting policy: Changes in accounting policy may affect the comparison of
results between different accounting years as misleading. The problem with this situation is
that the directors may be able to manipulate the results through the changes in accounting
policy.
Changes in Accounting standard: Accounting standards offers standard ways of recognizing,
measuring and presenting financial transactions. Any change in standards will affect the
reporting of an enterprise and its comparison of results over a number of years.
Impact of seasons on trading: As stated above, the financial statements are based on year end
results which may not be true reflection of results year round. Businesses which are affected
by seasons can choose the best time to produce financial statements so as to show better
results.
4. Inter-firm comparison
Different financial and business risk profile: No two companies are the same, even when they
are competitors in the same industry or market. Using ratios to compare one company with
another could provide misleading information.

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 Different capital structures and size: Companies may have different capital structures and to
make comparison of performance when one is all equity financed and another is a geared
company it may not be a good analysis.
Impact of Government influence: Selective applications of government incentives to various
companies may also distort intercompany comparison. One company may be given a tax
holiday while the other within the same line of business not, comparing the performance of
these two enterprises may be misleading.
Window dressing: These are techniques applied by an entity in order to show a strong
financial position.

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