CHAPTER TWO

IFRS Based Financial Statement Analysis

2.1. Financial Statement Analysis
o 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.

 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.

 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.
 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.

 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.

2.2. Financial Analysis

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.

2.2.1. 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

 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.
 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.
 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.
 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.
 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.
 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.
 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.
2.3. Methods of Financial Analysis

 Ratio Analysis: Probably, 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. The analysis is used to provide
indicators of past performance in terms of critical success factors of a business. This
assistance in decision making reduces reliance on guesswork and intuition, and establishes
a basis for sound judgment.
 Horizontal (Trend) Analysis
Horizontal Analysis 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.

 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
items in the statement of cash flows as a fraction or percentage of the change in cash.

Benchmarks for Evaluation

What is more important in ratio analysis is the thorough understanding and the interpretation of
the ratio values. To answers the questions as; it is too high or too low? Is good or bad? A
meaningful standard or basis for comparison is needed.

We will calculate a number of ratios. But what shall we do with them? How do you interpret
them? How do you decide whether the Company is healthy or risky? There are three approaches:
Compare the ratios to the rule of thumb, use Cross-sectional analysis or time series analysis.
Comparing a company's ratios to the rule of thumb has the virtue of simplicity but has little to
recommend it conceptually. The appropriate value of ratios for a company depends too much on
the analyst's perspectives and on the Company's specific circumstances for rules of thumb to be
very useful. The most positive thing to be said in their support is that, over the years, Companies
confirming to these rules of thumb tend to go bankrupt somewhat less frequently than those that
do not.
Cross-Sectional Analysis- involves the comparison of different firm's financial ratios at the same
point in time. The typical business is interested in how well it has performed in relation to its
competitors. Often, the firm's performance will be compared to that of the industry leader, and
the firm may uncover major operating deficiencies, if any, which, if changed, will increase
efficiency. Another popular type of comparison is to industry averages; the comparison of a
particular ratio to the standard is made to isolate any deviations from the norm. Too high or too
low values reflect symptoms of a problem. Comparing a Company's ratios to industry ratios
provide a useful feel for how the Company measures up to its Competitors. But, it is still true
that company specific differences can result in entirely justifiable deviations from industry
norms. There is also no guarantee that the industry as a whole knows what it is doing.

Time-Series Analysis – is applied when a financial analyst evaluates performance of a firm over
time. The firm's present or recent ratios are compared with its own past ratios.Comparing of
current to past performance allows the firm to determine whether it is progressing as planned.

2.2. 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. Each category is explained by using an example set
of financial ratios for XYZ Company.
2.3.1. Liquidity Ratios
Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and as
they fall due. Liquidity ratios provide the basis for answering the questions: Does the firm have
sufficient cash and near cash assets to pay its bills on time?

Current liabilities 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 current
assets are the primary source of funds needed to repay current and maturing financial
obligations. Thus, the current ratio 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.
 Let us use the financial statements of XYZ Company, shown below to investigate and explain
ratio analysis.

Xyz Company, Income Statements

Variables 2001 2000
Sales 3,074,000 2,567,000
Less Cost Of Goods Sold 2,088,000 1,711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General And Adm. Expenses 468,000 445,000
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000
Less Interest Expenses 93,000 91,000
Net Profit Before Tax 325,000 212,000
Less Profit Tax (At 29%) 94,250 61,480
Net Income After Tax 230,750 150,520
Less Preferred Stock Dividends 10,000 10,000
Earnings Available To Common Shareholders 220,750 140,520
Eps 2.90 1.81

XYZ, Balance Sheets

2001 2000
Assets
Current Assets
Cash 363,000 288,000
Marketable Securities 68,000 51,000
Accounts Receivables 503,000 365,000
Inventories 289,000 300,000
Total Current Assets 1,223,000 1,004,000
Gross Fixed Assets (at cost)
Land and Buildings 2,072,000 1,903,000
Machinery and Equipment 1,866,000 1,693,000
Furniture and Fixture 358,000 316,000
Vehicles 275,000 314,000
Others 98,000 96,000
Total Fixed Assets 4,669,000 4,322,000
Less Acc. Depreciation 2,295,000 2,056,000
Net Fixed Assets 2,374,000 2,266,000
 Total Assets 3,597,000 3,270,000
Liabilities and shareholder equity
Current Liabilities
Accounts Payable 382,000 270,000
Notes Payable 79,000 99,000
Accruals 159,000 114,000
Total Current Liabilities 620,000 483,000
Long-Term Debts 1,023,00 967,000
0
Total Liabilities 1,643,000 1,450,000
Shareholder's Equity
Preferred Share –Cumulative, 2000 Share issued and Outstanding 200,000 200,000
Ordinary Share, Shares issued and Outstanding in 2001, 76,262; in 2000, 76,244 191,000 190,000
Share premium-ordinary 428,000 418,000
Retained Earnings 1,135,000 1,012,000
Total Shareholders' Equity 1,954,000 1,820,000
Total Liabilities and Shareholders' Equity 3,597,000 3,270,000
A. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term creditors
by using only current assets. That is, it measures a firm’s short-term solvency or liquidity. The
current ratio is calculated by dividing current assets to current liabilities.

current asset
Current ratio = Therefore, the current ratio for XYZ Company is
curent liabilities

1,223,000
For 2001 = = 1.97
620,000

The unit of measurement is either birr or times. So, we could say that XYZ has Birr 1.97 in
current assets for every 1 birr in current liabilities, or, we could say that XYZ has its current
liabilities covered 1.97 times over. Current assets get converted in to cash through the operating
cycle and provide the funds needed to pay current liabilities. An ideal current ratio is 2:1or more.
This is because even if the value of the firm's current assets is reduced by half, it can still meet
its obligations.

However, between two firms with the same current ratio, the one with the higher proportion of
current assets in the form of cash and account receivables is more liquid than the one with those
in the form of inventories.

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.

B. Quick (Acid-test) Ratio: This ratio 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. Because
inventories 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, prepaid
supplies are excluded because they are not available to pay off current debts.
Acid-Test Ratio is computed as follows.

current asset −inventory

Quick/Acid test Ratio=
cureent liabilities

1223,000−289,000
For 2001, Quick Ration for XYZ Company will be =1.51
620,000

Interpretation: XYZ 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.

C. Cash ratio (Reading assignment)

2.3.2. Activity ratios /Asset Management ratios/

Activity ratios are also known as assets management or turnover ratios. 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.
Let us see the case of ABC and XYZ café having different compositions of current assets but
equal in total amount.
EXERCISE 2.2 ABC CAFÉ XYZ CAFÉ
(Birr) (Birr)
CASH 0 7,000
MARKETABLE 0 17,000
SECURITY
A/R 0 5,000
INVENTORIES 35,000 6,000
TOTAL CURRENT 35,000 35,000
ASSET
CURRENT 0 6,000
LIABILITIES
A/P 14,000 2,000
N/P 0 4,000
ACCRUALS 0 2,000
TOTAL CURRENT 14,000 14,000
LIABILITY
The two cafeterias have the same liquidity (current ratio) but their composition is different.

AC 3500 CA 35000
CR = = = 2.5 times CR= = = 2.5 times
CL 14000 CL 14000

Where: CR is current ratio, CA is current assets, CL is current liability, A/R is accounts

receivables, N/R is notes receivable and A/P is accounts payable.

When you see the two cafes, their current ratios are the same, but XYZ café is more liquid than
ABC café. This differences cause the activity ratio showing the composition of each assets than
the current ratio making activity ratio more important in showing a 'true" liquidity position than
current ratio. Although generalization can be misleading in ratio analysis, generally, high
turnover ratios usually associated with good assets management and lower turnover ratios with
poor assets management.
 Although generalization can be misleading in ratio analysis, 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: The inventory turnover ratio 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.
Cost of Goods Sold
→Inventory Turnover = →For the year of XYZ Company for 2001
Average Inventories

= 2,088,000/294,500*= 7.09 times

Interpretation: - XYZ'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: The number of days inventory is kept before it is sold to customers.
It is calculated by dividing the number of days in the year to the inventory turnover.
No days in year /365 days
Inventory Turnover
Average Age of Inventory =

365 days
Therefore, the Average Age of Inventory for XYZ Company for the year 2001 is: =51
7.09
days

This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it is
sold. The longer period indicates that, XYZ is keeping much inventory in its custody and, the
company is expected to reassess its marketing mechanisms that can boost its sales because, the
lengthening of the holding periods shows a greater risk of obsolescence and high holding costs.
iii. Accounts Receivable Turnover Ratio: - Measures the liquidity of firm’s accounts receivable.
That is, it indicates how many times or how rapidly accounts receivable is converted into
cash during a year. The accounts receivable turnover 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.

Net Sales
Receivable Turnover =
Average Account
The accounts receivable turnover for XYZ Company for the year 2001 is computed as under.

74000
Accounts receivable turnover ratio = =7.08 → 434,000 =503,000 + 365,000/ 2
434000
Average Accounts Receivable is the accounts receivable of the year 2000 plus that of the year
2001 and dividing the result by two.

Interpretation: XYZ 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: Shows how long it takes for account receivables to be cleared
(collected). The average collection period represents the number of days for which credit
sales are locked in with debtors (accounts receivables).
Assuming 365 days in a year, average collection period is calculated as follows.

365 days
Re ceivable Turnover
Average Collection period =
 The average Collection period for XYZ Company for the year 2001 will be: 365 days/7.08 =51
days or

434,000∗365 days
Average collection period = Average accounts receivables* 365 days/Sales = =
3,074,000
51 days.

The higher average collection period 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 average
collection period 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

The average Payment Period/ Average Age of accounts Payable shows, the time it takes to pay to
its suppliers.

Accounts Payable
The Average Payment Period =
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.

382000
So, Average Payment Period = 0.7 = 95 days this shows that, on average, the firm
2088000×
365
pays its suppliers in 95 days. The longer these days, the more the credit financing the firm obtains
from its suppliers.

vi. Fixed Asset Turnover: Measures the efficiency with which the firm has been using its fixed
assets to generate revenue. The Fixed Assets Turnover for XYZ Company for the year 2001 is
calculated as follows.
Net sales 3074000
Fixed assert turnover = Asset ¿ = = 1.29
Average Net ¿ 2374000
 This means that, XYZ 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. 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 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- Measures a firm’s efficiency in management its total assets to
generate sales.
Net sales
Total Assets Turnover =
Net total assets

The Total Assets Turnover for XYZ Company for the year 2001 is as follows.

3074000
= 0.85
3597000

Interpretation: - XYZ 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 whereas, a low ratio
suggests that XYZ 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. Therefore, the financial manager should be cautious when using
these ratios for cross-sectional comparisons.

2.3.3. Leverage Ratios

The dictionary meaning of the firm leverages refers to “an increase means of accomplishing
drive”. In machines, leverages means the instrument that helps us in lifting heavy objects, which
may not be otherwise possible. This concept of leverage is valid in business too. In financial
management, it is used to describe the firm’s ability to use fixed assets costs funds to satisfy to
magnify the returns of its owners.

Leverage ratios are also called solvency ratio. Solvency is a firm’s ability to pay long term debt
as they come due. Leverage is the ratio of the net rate of return on shareholder’s equity and net
rate of return on total capitalization. Leverage shows the degree of incompetence of firm. There
are three types of debt measurement tools. These are:

A. Financial Leverage Ratio: 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.

i. Debt Ratio: Shows the percentage of assets financed through debt. It is calculated as:
Total Liability
Debt ratio =
Total Assets
The debt ratio for XYZ Company for the year 2001 is as follows:
1643
Debt ratio = = 0.457 or 45.7 %
3597
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.
ii. Debt -Equity Ratio: 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.
Total Liability
Debt -equity ratio =
Stockholders ' Equity

The Debt- Equity Ratio for XYZ Company for the year 2001 is indicated as follows.
 1643000
Debt- Equity ratio = = 0.84 or 84 %
1954000

Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.

iii. Equity Multiplier ratio (Reading Assignment)

iv. Gearing ratio (Reading Assignment)

B. Coverage Ratio: 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.
i. Times Interest Earned Ratio: Measures the ability of a firm to pay interest on a timely
basis.
Earningsbefore Interest∧Tax
Times Interest Earned Ratio =
Interest Expense

The times interest earned ratio for XYZ Company for the year 2001 is:

418000
Times Interest Earned Ratio = = 4.5 times
93000

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

ii. Coverage Ratio: The problem with the times interest eared ratio is that, it is based on
earnings 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 earnings before Interest and Tax (EBIT). Since interest is a cash outflow, one way
to define the cash coverage ratio is as follows:
EBIT + Depreciation
Cash Coverage Ratio=
interest

So, Cash coverage ratio for XYZ Company for the year 2001 is

(Depreciation for 2000 and 2001 is 223,000 and 239,000 respectively).

 EBIT + Depreciation 18000+29300
Cash Coverage Ratio= = = 7.07 times
interest 93000

This ratio indicates the extent to which earnings may fall without causing any problem to the
firm regarding the payment of the interest charges.

iii) Fixed charge coverage ratio

The fixed-payment coverage ratio measures the firm’s ability to meet all fixed payment
obligations, such as loan interest and principal, lease payments, and preferred stock dividends.
As is true of the times interest earned ratio, the higher this value, the better. The formula for the
fixed-payment coverage ratio is

Fixed charges coverage = Income before fixed charges and taxes

Fixed charges
For Zebra Company case in your worksheet, the other fixed charge payment in addition to
interest is lease payment. Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700
Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are
safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.
The fixed charges coverage ratio is required because failure of the firm to meet any financial
obligation will endanger the position of a firm.
Exercise- Calculate Fixed charge coverage ratio for XYZ Company.

2.3.4. 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. Besides management of the company, creditors
and owners are also interested in the profitability of the company. 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: Gross Profit Margin, Operating Profit Margin, Net Profit
Margin, Return on Investment, and Return on Equity Earnings per Share
i. Gross Profit Margin: This ratio 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. It is calculated as:
Gross Profit
Gross Profit Margin=
net slales

The gross profit margin for XYZ Company for the year 2001 is:

986000
Gross Profit Margin = = 32.08 %
3074000

Interpretation: XYZ 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, a low 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: This ratio 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. The operating profit is calculated as:

Operating Profit
Operating Profit Margin=
net sales

The operating profit margin of XYZ Company for the year 2001 is:

Operating Profit 418000

Operating Profit Margin= = = 13.60
net sales 3074000

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

iii. Net Profit Margin: This ratio 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 interest and income taxes from the gross profit. This ratio 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. It is calculated as:
net income
Net Profit Margin=
nest sales
The net profit margin for XYZ Company for the year 2001 is:
net income 230750
Net Profit Margin= = = 7.5 %
nest sales 3074000
This means that XYZ Company has acquired 7.5 cents profit from each birr of sales

iv. Return on Investment (ROI): The return on investment 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.
The return on assets is calculated as:
net income
Return on Assets (ROA) =
total asset

The return on assets for XYZ Company for the year 2001 is:

net income 230750

Return on Assets (ROA) = = = 6.4 %
total asset 3597000

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

v. Return on Equity: The shareholders of a company may Comprise Equity share and preferred
shareholders. Preferred shareholders are the shareholders who 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 shareholders 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 itself. But the
profit after taxes and after preference shares dividend payments presents the return as equity of
the shareholders.
Net Income
The Return on equity is calculated as: ROE =
Stockholders Equity
The Return on equity of XYZ Company for the year 2001 is:

Net Income 230750

ROE = = = 11.8%
Stockholders Equity 1954000

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

vi. Earnings 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.

Earning Available for Common shareholders

The earning per share is calculated as: EPS=
Number of common shares Outstanding

Therefore, the earning per share of XYZ Company for the year 2001 is:

220750
EPS = = birr 2.90 per share
76262 shares

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

2.3.5. Market value ratios

Market value or valuation ratios are the most significant measures of a firm's performance, since
they measures the performance of the firm's common shares in the capital market. This is known
as the market value of equity and reflects the risk and return associated with the firm's shares.

These measures are based, in part, on information that is not necessarily contained in financial
statements – the market price per share of the shares. Obviously, these measures can only be
calculated directly for publicly traded companies.

The following are the important valuation ratios:

i. Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each
share of its common stock outstanding.
Dividends per Share = Total cash dividends on common shares
Number of common shares outstanding
 Zebra’s DPs for 2018 = Br. 3,300 = Br. 1.00
Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
ii. Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.
Dividends pay-out = Dividends per share
Earnings per share
= Total dividends to common shareholders
Total earnings to common shareholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%
Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
Exercise-Calculate DPS and DPO ratio for XYZ company.
iii. Price- Earnings (P/E) Ratio: The price earnings ratio is an indicator of the firm's growth
prospects, risk characteristics, shareholders orientation corporate reputation, and the firm's level
of liquidity.

The P/E ratio can be calculated as:

Market Price per Share

P/E Ratio =
earnining pershare

The price per share could be the price of the share on a particular day or the average price for a
certain period.

Assume that XYZ Company's common shares at the end of 2001 was selling at birr 32.25, using its
EPS of birr 2.90, the P/E ratio at the end of 2001 is:

Market Price per Share 32.25

P/E Ratio = = = 11.10
earnining pershare 2.90

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 shares prices to
facilitate comparison among companies with different earnings.

iv. 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:

Market Value per Share

Market-Book Ratio =
Book Value per Share

The book value per share can be calculated as:

Total Shareholders’ Equity

Book value per share =
No . of Common Shares Outstanding

1954000
Book Value per Share for 2001 = = 25.62
76,262

Therefore, the Market-Book Ratio for XYZ Company for the year 2001 is:

32.25
= 1.26
25.62

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

v. Enterprize Value Multiplier Ratio (Reading assignment)

2.3.6. Limitations of Ratio Analysis

While ratio analysis can provide useful information concerning a company’s operations and
financial condition, it does have limitations that necessitate care and judgments. Some potential
problems are listed below:

1. Many large firms operate different divisions in different industries, and for such companies
it is difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is
more useful for small, narrowly focused firms than for large, multi-divisional ones.
2. Most firms want to be better than average, so merely attaining average performance is not
necessarily good as a target for high-level performance, it is best to focus on the industry
leader’ ratios. Benchmarking helps in this regard.

3. Inflation may have badly distorted firm’s balance sheets - recorded values are often
substantially different from “true” values. Further, because inflation affects both depreciation
charges and inventory costs, profits are also affected. Thus, a ratio analysis for one firm over
time, or a comparative analysis of firms of different ages, must be interpreted with judgment.

4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for
a food processor will be radically different if the balance sheet figure used for inventory is
the one just before versus just after the close of the coming season.

5. Firms can employ “window dressing” techniques to make their financial statements look
stronger.

6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation
and depreciation methods can affect financial statements and thus distort comparisons among
firms. Also, if one firm leases a substantial amount of its productive equipment, then its
assets may appear on the balance sheet. At the same time, the ability associated with the lease
obligation may not be shown as a debt. Therefore, leasing can artificially improve both the
turnover and the debt ratios.

7. It is difficult to generalize about whether a particular ratio is “good” or “bad”. For example, a
high current ratio may indicate a strong liquidity position, which is good or excessive cash,
which is bad (because excess cash on hand is a non-earning asset).

Similarly, a high fixed asset turnover ratio may denote either that a firm uses its assets
efficiently or that it is undercapitalized and cannot afford to buy enough assets.

8. A firm may have some ratios that look “good” and other that look “bad”, making it difficult to
tell whether the company is, on balance, strong or weak. However, statistical procedures can
be used to analyze the net effects of a set of ratios. Many banks and other lending
organizations use discriminate analysis, a statistical technique, to analyze firm’s financial
ratios, and then classify the firms according to their probability of getting into financial
 trouble.

9. Effective use of financial ratios requires that the financial statements upon which they are
based are accurate. Due to fraud, financial statements are not always accurate; hence
information based on reported data can be misleading. Ratio analysis is useful, but analysts
should be aware of these problems and make adjustments as necessary.