CHAPTER TWO

FINANCIAL ANALYSIS AND PLANNING

Financial analysis is the process of selection, evaluation and interpretation financial data, along
with other pertinent information, to assist in investment and other financial decisions. It is a
diagnostic tool of analysis that can help management to identify the strength and weakness of the
firm so that corrective actions can be taken starting from planning, and also to consider the
strength of the company as a motive for competitiveness and growth. Financial analysis and its
application in business can be viewed from different perspectives .From the investor’s view point
financial analysis is a tool for predicting the future performance of the firm on which the
investment decision related to this firm can be made. For the creditor financial analysis is used to
show the liquidity and solvency of the firm so that dependable credit decisions or making loans
in such firms can be made. But the financial manager’s primary task is the acquisition and use
funds so as to maximize the value of the firm based on right decisions made, and financial
management information are useful to make such critical decisions .

Approaches to financial analysis

Based on the information required for financing and investing decisions, the approaches of
financial analysis include:
 Ratio Analysis - A comparison of the performance of a firm with the performance of
other firms in the same industry
 Trend Analysis - Evaluation of the performance or position of a given firm overtime.
 Common size Analysis - Adjusting the financial statements of a firm to a common size
financial statement.

Financial Statement Analysis

The data used in analyzing financial statements are contained in the financial statements
themselves such as income statement, balance sheet and statement of retained earnings. In
explaining financial statement analysis, financial statements pertaining to Addis Manufacturing
company are used throughout this chapter.

Income Statement
As you know from your previous courses, income statement measures the profitability of
business firm over a period of time. Though the income statements of many multinational
companies cover a European calendar year, Addis Manufacturing Company has adopted fiscal
year that corresponds with the Ethiopian budget year for an accounting purpose. The Ethiopian
budget year runs from Hamle 1 to Sene 30. Income Statement can also be prepared on a
quarterly basis and referred to as interim income statement. Regardless of the starting and
ending dates, or the length of the time covered, the important point is that income statement
summaries the operation of business firm over a given time interval. As it can be seen from the
income statements for Addis Manufacturing Company, the company's operations generated a
flow of revenues (net sales), expenses, and profits (net incomes) during the two reporting years.

Addis Manufacturing Company

 Income Statements
For the year ended Sene 30, 2003 and 2004
(In thousands of Birr)

2004 2003
Net Sales Birr 120,000 Bir110, 000
Cost of goods sold 90,000 83,000
Gross Profit 30,000 27,000
Operating Expenses:

Selling expenses 5,000 4,800

General and administrative expenses 8,000 7,600
Depreciation expense 1,100 800
Lease Payments 1,650 1,600
Total operating expenses 15,750 14,800
Earnings before interest and taxes 14,250 12,200
Interest expenses:
Interest on bank notes 550 700
Interest on Other debt 3,600 3,960
Total interest expenses 4,150 4,660
Earnings before taxes 10,100 7,450
Income taxes (34%) 3,434 2,564
Net Income 6,666 4,976

Balance Sheet
A balance sheet basically summarizes the financial position of the business firm. It usually
contains two sections:
(1) The asset (i.e. uses of funds) section, and
(2) The liabilities and shareholders' equity (i.e. sources of funds) section.
The following is the comparative balance sheet for Addis Manufacturing Company, an ideal
business firm, on Sene 30, 2003 E.C. and Sene 30, 2004 E.C.

Addis Manufacturing Company

Comparative Balance Sheet
Sene 30, 2003 and 2004

2004 2003
Current Assets:
Cash 2,500 3,000
Marketable securities 1,000 1,300
Accounts receivable 16,000 12,000
Inventories 20,500 18,700
Total current assets 40,000 35,000
Fixed Assets:
Land and buildings 28,700 24,200
Machinery and equipment 31,600 29,000
 Total fixed assets 60,300 53,200
Less accumulated depreciation 18,300 17,200
Net fixed assets 42,000 36,000
Total assets 82,000 71,000
Liabilities and shareholders' equity
Current liabilities
Accounts payable 7,200 6,000
Notes payable 10% bank 5,500 7,000
Accrued liabilities 900 700
Current portion of long-term debt 3,000 3,000
Other current liabilities 1,400 1,200
Total current liabilities 18,000 17,900
Long-term liabilities:
Long term debt-12% mortgage bond 27,000 30,000
Total liabilities 45,000 47,900

Shareholders' equity:
1 Common stock, 5Birr par, 2,000,000
shares authorized; 1,300,000 shares
outstanding in 2004 and 100,000
shares outstanding in 2003 6,500 5,000
2 Capital in excess of par 14,000 5,350
3 Retained earnings 16,500 12,750
Total shareholders' equity 37,000 23,100
Total liabilities & shareholder equity 82,000 71,000

As indicated in the above comparative balance sheet prepared for Addis Manufacturing
Company, total assets equal total liabilities and stockholders' equity. This statement shows the
mix of liabilities and equity that is used to finance company's assets. The assets of the company
are the investments it had made in profit-seeking activities. Current assets are the most liquid
assets of the company. There of one year, or less. Hence, the Birr value of current assets is
termed as a gross working capital of the company.
As contrast to current assets, fixed asset division consists of long-term financial claims and
investments in the physical assets such as properties, plants and equipment.

The liability and shareholders' equity section of the balance sheet shows how the company is
financed. Liabilities are values of assets financed by funds from creditors. Current liabilities, as
stated earlier, are to be paid back in later years in the future. The amount of funds provided by
the shareholders directly for Addis Manufacturing company are represented by the common
stock and additional capital in excess of par portions of the shareholders' equity section of the
balance sheet. Retained earnings are part of shareholders' equity obtained as a result of the board
of directors decision to retain portion, or entire amount of net profits of the company for
reinvestment.

The accounting procedures used to generate financial statements are not primarily designed to
provide data inputs for financial statements analysis. As a consequence of this, the financial
statements may not always provide the information that the financial managers need for various
types of business decisions. For example, the assets are listed in the balance sheet at their
historical costs that do not, most of the time, reflect the current market values, or the replacement
costs of these assets. Moreover, some difficulties can be expected in interpreting financial
statement figures individually. For instance, an increase in a balance of an inventory account
could mean:
1 The individual purchases cost more than ever due to increases in prices and that the
physical inventory levels have not increased, or
2 The company is accumulating that it has been unable to sell, or
3 The company is producing, or purchasing inventories in large quantities in anticipation of
increases in the volume of sales in the future.

These clearly show how it is difficult to interpret the balance of a given account separately as it
could mean different things.

Statement of the Retained Earnings:

The statement of retained earnings lists how much of the net profit/income of the company was
paid out as dividends to the shareholders and how much of it was retained in the company for
reinvestments or further expansion of the company. The statement of retained earnings normally
exhibits one important relationship that exists between the income statement (that summarizes
the operation of the company during a given time period) and the balance sheet (that summarizes
the financial position of the company on the given date). The retained earning account in the
shareholders' equity section of the balance sheet of the company is the accumulation of the net
profit of the company that have been retained over the life time of the company. Every the
retained earnings account is increased by an amount equal to the excess of net profit over
dividend declared and distributed during that year. Hence, the ending balance of the retained
earnings account that is computed in the statement of retained earnings links the income
statement and the balance sheet. There are in fact, many other ways in which all of these
financial statements interact with one another.
The following is the statement of retained earnings for Addis Manufacturing Company, an ideal
company, for the year ended Sene 30, 2004 E.C.
Addis Manufacturing Company
Statement of retained earnings
For the year ended Sene 30, 2004 E.C.

Retained earnings, Hamle 1, 2003 12,750

Net income 6,666
Sub-Total 19,416
Less Cash dividends (common stock) 2,916
Retained earnings-Sene 30, 2004 16,500

As you can see from the statement of retained earnings of Addis Manufacturing Company, the
retained earnings account has a balance of 12,750 Birr on Hamle 1, 2003 which is the ending
balance of sene 30, 2004 carried forward. This balance was shown in the shareholders' equity
section of the balance sheet prepared for Addis manufacturing company on sene 30, 2003. In the
same way the ending balance of the retained earnings account shown in the statement of retained
earnings for Addis manufacturing company for the year ending on Sene 30, 2004 (i.e. 16500
Birr) was reported in the shareholders' equity section of the balance sheet for that year.

Ratio Analysis:
The first step in undertaking financial statements analysis is to read and understand the financial
statement and their accompanying notes with care. This is followed by the computation of ratios
and interpreting what the ratios are to mean (i.e. undertaking ratio analysis). The use of financial
ratios to analyze financial statements is now a common practice to the extent that even
computerized financial statement analysis programs prepare financial ratios as part of their
overall analysis. Both lenders and potential lenders use financial ratios to evaluate loan
applications from borrowing companies. Investors use financial ratios to assess the future tale of
the companies they are thinking to make investment with. Managers make use of financial ratios
in order to judge the performance of their companies and to control the day-to-day operation of
their companies. Owners make use of financial ratios to evaluate whether their companies are
maximizing their wealth or not.

The Basic Financial Ratios

Financial ratios can be designed to measure almost any aspect of the performance of the
company. In general, financial analysts use ratios as one tool in identifying areas of strengths
and weaknesses in the company. Financial ratios, however, tend to identify symptoms rather
than the problems classing symptoms. A financial ratio whose value is judged to be "different"
or usually high or low may help identify a significant event but doesn't provide enough
information that helps to identify the reasons for the occurrence of the event. The financial ratios
are judged to be high, or low, or acceptable when they are compared with standards.

Standard ratios could be:

1 Industry standards, these are standard ratios computed for companies operating in the same
industry. For example, average ratio standards can be developed for textile industry.
2 Management plans - these are financial ratios that the management of a give company set as
goals. These are plans of the company and standards against which actual financial ratios are
compared.
3 Historical standards - these are financial ratios developed from the historical records of the
company over say the last 10 years. Historical standards are, therefore, the average financial
ratios for the company for the last 10 years. These ratios can also be used as standards
against which you compare the computed ratios to judge them of high, low or acceptable.

Types of Financial Ratios:

The most common financial ratios used for financial analysis include: 1) Liquidity; 2) Activity
(asset management), 3) Leverage (debt management); and 4) Profitability ratios.

1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its current liabilities and current
portion of long-term debts as they mature. Liquidity ratios assume that current assets are the
principal sources of cash for meeting current liabilities and current portion of long-term loans.
There are two most widely used liquidity ratios. These are the current and quick or acid test
ratios.
 A) Current Ratio:
The current ratio is computed by dividing current assets by current liabilities. The current ratios
for Addis Manufacturing Company for 1992 and 1993 are the following:
Current assets
Current Ratio =
Current Liabilities
35,000
Current Ratio (for 2003) =  1.96 times
17,900
40,000
 2.22 times
Current Ratio (for 2004) = 18 , 000
The larger the current ratio, the less the difficulty that the company faces in paying its
obligations at the right time. In many cases lenders frequently require the current ratio of the
borrowing company to remain at or above 2.0 time as a condition for grading or continuing the
commercial and industrial loans. This standard of 2.0 times is an arbitrarily selected figure and
many financial analysts feel that the liquidity position of the company should be questioned if
the current ratio of the company falls below 2.0 times. This is because of the fact that all current
assets cannot be easily converted back to cash. It is very difficult to collect accounts receivable
is full.

It is very difficult of sell all the inventories. Short-term prepayments are unlikely to be
converting to cash. If the less liquid assets constitute significant portion of the total current asset,
you may need current ratio that is even greater than 2.0 times. The current ratios of Addis
manufacturing Company show that the company has 1.96 Birr in current assets for each Birr of
current liabilities during 2003 and 2.22 Birr in current assets for each Birr of current liabilities
during 2004. It is very difficult to say these ratios are high or low as we don’t have industry
standard, or management plan or historical standard against we compare these current ratios. But
one can say that Addis Company is more capable in 2004 to pay its current liabilities than in
2003.

B) Quick Ratio:
Quick ratio is sometimes called the acid test ratio. It serves the same general purpose as that of
the current ratio but more stringent as it exclude less liquid current assets like inventory from
current assets. It considers only quick current assets such as cash, marketable securities, and
account receivables. This is done because inventories, prepaid expenses and supplies cannot
easily be converted back to cash. Thus the quick (acid-test) ratio measures the ability of the
company to pay its current liabilities by converting its most liquid assets to cash which is easier.
The quick ratio is computed by subtracting less liquid assets such as inventories, prepaid expense
and supplies from current assets and dividing the remainder by total current liabilities. For Addis
Manufacturing Company the quick ratios are:
Current assets  Inventories
Quick Ratio =
Current liabiities

35,000  18700 16,300

Quick Ratio (for 2003) =   0.91 times
17,900 17,900
 40,000  20,500 19,500
Quick Ratio (for 2004) =   1.08 times
18,000 18,000

If the company wants to pay the entire amount of its current liabilities by using its quick assets
(i.e. current assets minus the sum of inventories, prepaid expenses and supplies), its quick assets
should be equal to or greater than its current liabilities. Thus the Company's quick ratio should
be 1.0 times or more than that. In the case of Addis Manufacturing Company, the quick assets of
91 cents are available to meet each Birr or current liabilities. This implies that the quick assets
are not enough to settle all the current obligations. Unless the company converts the non-quick
current assets to the extent they provide cash that is enough to pay the remaining 9 cents for each
Birr of current liabilities, the company will face difficulty in meeting its obligation. The current
ratio of 1.08 times for 2004, on the other hand, implies that the company has 1.08 Birr of quick
assets for each Birr of current liabilities. Again, the company is in good liquidity position during
2004 compared to 2003.

2. Activity Ratios:
Activity ratios measure the degree of efficiency with which the company utilizes its resources.
Efficiency is equated with rapid resource turnovers. Some activity ratios concentrate on
individual assets such as inventory, or accounts receivable while others look at the overall
company performance, or activity. The following activity ratios are discussed for Addis
Manufacturing Company, which is an ideal company considered for an illustrative purpose.

A) Inventory turnover ratio: This ratio is meaningful for companies like Addis
Manufacturing Company which hold inventories of different kinds. (It could be
merchandise, raw material, processed goods and so on). These ratio measures the
number of times per year that the company sells its inventory. It is computed by dividing
the Birr amount of net sales by the Birr amount of inventory at the closing date of the
accounting period. For Addis Manufacturing Company, the inventory turnover ratios are:
Sales
Inventory turnover ratio =
Inventory balance
110,000
Inventory turnover (f0r 2003) =  5.88 times
18,700

120,000
Inventory turnover (for 2004) =  5.85 times
20,500
In general, high inventory turnover may be taken as a sign of good inventory management.
Other things being the same, higher inventory turnover ratios computed for Addis Manufacturing
Company indicate that the company was able to sell its inventories 5.88 times and 5.85 time
during 2003 and 2004 E.C respectively. The performance/efficiency of the company in selling
its inventories was nearly the same during the two years you cannot say the inventory turnover
ratios for Addis Company show good or bad performance, or high efficiency or low efficiency as
long as you don't have standard inventory turnover ratio to compare with.

Inventory turnover ratio, as a measure of efficiency of business activities, suffers from both
conceptual and measurement problems. For example, high inventory turnover ratio could
indicate the inadequacy of inventory to meet customer demands which results in loss of sales. A
low inventory turnover ratio, on the other hand, can be caused by an increased new product
lines each of which requires some minimum inventory balances which in turn raises the balance
of overall inventory level and lowers the inventory turnover ratio. In both of these cases, the
inventory turnover ratio, if it is used alone, may lead to incorrect conclusions. This is to mean
that high inventory turnover ratio may not always be good.

A measurement problem of inventory turnover ratio emanates from the denominator used in
calculating the ratio. Since the purpose of this ratio is to measure the inventory turnover rate, the
denominator should be a measure of the average amount of inventory that the company
maintained during the year. However, in most of the cases, the figure used as the denominator is
the amount of inventory on hand at the end of the reporting period because the average inventory
balance is not easily obtainable. If the balance of inventory at the end of the year is not a good
representative of the average yearly inventory as a result of seasonal and/or cyclical production
and selling patterns, the usefulness of this ratio is greatly limited.

B) Days Sales Outstanding (DSO): Also called Average Collection Period (ACP) tries to
measure the average number of days it takes for the company to collect its account
receivable. The shorter the average collection period, the better the company's activities.
As you know, account receivable is resulted from credit sales. Hence, this ratio relates
the daily credit sales to its account receivable balance at the end of the reporting period.
Net sales may be used in the absence of credit sales, though it reduces the quality of the
ratio in measuring the number of days that receivables do take before their collection.
The average collection period is computed in a two-step procedure. First, you compute
the average daily credit sales (in the absence of credit sales you computed the average
daily sales) by dividing the 360 days into the total credit sales, or total sales. Second, you
compute the average collection period by dividing the account receivable balance at the
end of the accounting period (preferably the average account receivable if available) by
daily credit sales, or daily sales in the absence of the former. Assuming that all sales are
made on account by Addis manufacturing company, the average collection periods are:

DSO = Account receivable

Average Daily credit sale

total credit sales

Daily Credit Sales = 360 days
110,00
 305.56 birr
Daily Credit Sales (for 2003) = 360
120,000
 333.33 Birr
Daily Credit Sales (for 2004) = 360
When total sales are used instead of credit sales in the formula, the average collection period will
face the measurement problem because the cash sales included in the total sales do not have any
link with average collection period.

Moreover, the use of the account receivable balance at the end of the may not represent the
month average of accounts receivable when there are seasonal fluctuations. In this case, the
average collection period again suffers from the measurement problem. The average collection
period requires the analyst to provide careful interpretation even when these measurement
problems are overcome, are at least recognized. An increase, or decrease in the values of
average collection period should not be used to evaluate the effort the company puts in collecting
its receivables. For example the average collection period during that year. If the shorter
average collection period during 2003 was caused by the very tight credit policy adopted during
that year, it may not be more desirable than the average collection period of 48 days achieved
during 2004 under, say a liberal credit policy. This is because the credit policies themselves can
bring changes to the average collection period. Stringent credit policy definitely reduces the
average collection period. If the small average collection period of Addis Manufacturing
Company during 2003 was caused by reduced volume of credit sales, it may not be a good
indication of good credit collection condition.

Credit granting and the structuring of credit terms are major competitive tools used by the
marketing manager rather than the financial manager. Many companies are forced to set credit
policies which are comparable with the credit policy of the dominant company in the same
industry. The average collection period has to be interpreted in relation the credit term provide
to customers.

C) Total Assets Turnover Ratio:- It measures the relationship between a birr of sales and a
birr of assets, usually on the yearly basis. Basically the company wants to generate as
much birr as possible in the form of sales per a birr of an investment it made in assets.
The asset turnover ratio is a measure of the overall activity of the company. It is
computed by dividing the total net sales of the company by its total assets on the closing
date of the accounting period. For Addis Manufacturing co-the total turnover ratios are:
Net Sales
Total assets turnover = Total assets
110,000
 1.55 times
Total assets turnover (for 2003) = 71, 000
120,000
 1.46 times
Total assets turnover (for 2004) = 82, 000
The total assets turnover ratio of 1.55 times during 2003 implies that the company was able to
generate 1.55 Birr for a single birr it has invested in its assets during the year. During 2004, on
the other hand, the company was able to make net sales of 1.46 birr for each birr it has invested
in the total assets. Though the total volume of sales is greater during 2004, the assets turnover
ratios show that the company was efficient in generating higher net sales per birr of investment
in asset in 2003 than in 2004. The decrease in the asset turnover ratio in 2004 may indicate a
decrease in the utilization of the assets for generating the desired sales revenue.

.
3. Leverage (Debt Management) Ratios:

These ratios measure the extent to which a company finances itself with debt as opposed to
equity financing. These ratios are also called solvency or capital structure ratios. They are also
termed as financial leverage ratios. Financial ratios provide the basis for answering two basic
questions: How has the company finance its assets? And can the company afford the level of
fixed charges associated with the use non-owners-supplied funds such as bond interest and
principal payments?

A) Debt ratio or debt-to-asset ratio: it measures the extent to which the total assets of the
company have been financed using borrowed funds.
For Addis Manufacturing Company, the ratios are computed as follows:
total liabilities
Debt-asset ratio = total assets
47 ,900
Debt-asset ratio (for 2003) = 71, 000 =67.46%
45 , 000
 54 . 88 %
82 , 000
Debt-asset ratio (for 2004) =
At the end of 2003, 67.46 percent of the total assets of Addis Manufacturing Company was
financed by funds secured in the form of current and long-term liabilities. The remaining 32.54
percent was financed by funds contributed by shareholders and retained from the profits earned
by the company. Similarly, debt financing constitutes about 55 percent of the total assets of the
company during 2004. This leaves 45 percent of the total assets to be financing has declined
during 2004 compared to 2003 signaling good condition. To much debt financing risky to the
company. Addis manufacturing company can borrow much more money during 2004 than it
could do in 2003 because the asset structure of the company was more debt-dominated in 2003
than in 2004. Hence, lenders are willing to give loans to the company during 2004 when debt-
asset ratio is less than during 2003 when debt-asset ratio is high.

You can't say much about the capital structure of Addis manufacturing company on the basis of
the debt-asset ratios computed above as you don't have any standard debt-asset ratio to be used
as a bench mark. In general, creditors prefer low debt-asset ratios, because the lower the ratios,
the lower the chance of losing their money upon maturity, or liquidation. The owners, on the
other hand, may want higher debt (leverage) ratios because the cost of borrowed money is
usually less than the cost of owners' funds. The debt-asset ratios calculated above for Addis
manufacturing company show that more than half of the company's assets were financed with
funds form creditors during the two years. As a result, the company may find it difficult borrow
additional funds without first raising more equity otherwise, creditors would be reluctant to lend
more money to the company with its debt-dominated capital structure.

Though creditors are willing to give loans to debt dominated borrower they are willing at higher
interest rate that commensurate with the high risk they are taking as lenders.

The debit-asset ratio of 67.46 percent for 2003 computed for Addis manufacturing company can
also be interpreted as one birr of investment in the company's assets was made up of the
combination of about 67 cents of the creditors' funds and the remaining 33 cents of the
shareholders' funds. During 2004 a birr of investment in the company's assets was made with
about 55 cents of creditors' funds and the remaining 45 cents was contributed by shareholders.
 B) Long-Term Debt- Equity Ratio:- This ratio measures the extent to which long-term
financing sources are provided by creditors (debt-holders). The ratio is computed by
dividing long-term debts by stockholders' equity. The long-term debt to equity ratios for
Addis manufacturing company are computed as follows:-
Lont term debt
Long-term debt - equity ratio = Shareholders equity
30,000
 1.30 or 130%
Long-term debt-equity, ratio (for 2003) = 23, 000
27,000
 0.73, or 73%
Long-term debt-equity, ratio (for 2004) = 37,000

The long-term debt-equity ratio of the company decreased from 130 percent in 2003 to 73
percent in 2004. This decrease may be caused by several factors some of which are:
(1) Some long-term debts might be matured and paid out, which reduce the balance
of long-term debts,
(2) Addis manufacturing company might increase the level of its shareholders'
equity either by issuing additional shares at premium, and
(3) Some amount might be added to the company's retained earnings due to
retention of the portion of full amount of net income.
Your interpretation for the long-term debt-equity ratio of 130 percent achieved during 2003 can
be for a single birr of share holders' equity in the long-term financing there is 1.30 birr of long-
term debt in the long-term financing. In other words the long-term financing 2.30 birr was made
1 birr from share holders' equity and 1.30 birr from long-term debt. In the same way, a single
birr in the long-term equity financing is combined with 73 cents of long-term debt financing to
form a total long-term financing of 1.73 birr during 2004. In other words, for each birr obtained
from shareholders' equity, the long-term debt holders contributed 73 cents in the long-term
financing during the year. Again, it is very difficult to conclude that the long term debt-equity
ratios computed for Addis Manufacturing Company show good or bad capital structure of the
company as long as you don't have standard long-term debt-equity ratio to be used as a point of
reference.

C) Debt-equity ratio: This ratio expresses the relationship between the amount of the total
assets of the company financed by creditors (debt) and owners (equity). Thus, this ratio
reflects the relative claims of creditors and shareholders against the total assets of the
company. This ratio provides answer to the question: What are the proportions of debts
and equity in financing in the total assets of the company?

The debt-equity ratio is computed by dividing the total debts by the total shareholders' equity.
The debt-to-equity ratios for Addis manufacturing company are the following:
Total debts
Debt - equity ratio = Shareholders ' equity
47,900
 2.07
Debt-equity ratio (for 2003) = 23,100
 45,000
 1.22
Debt-equity ratio (for 2004) = 37 , 000
The debt-equity ratio of 2.07 for Addis manufacturing company for 2003 indicates that the
creditors of the company have provided about 2.07 birr in financing the assets of the company
for every single birr contributed from shareholders’ equity. In the same token, the debt-equity
ratio of 1.22 for 2004 shows that the creditors have provided 1.22 birr for each birr assets
financed by shareholders’ equity. Whether these types of capital structure (debt and equity mix)
are good or bad depends on the standard set for the debt-to-equity ratio. Unless you are told this
standard, you can’t say the debt and equity mix of Addis manufacturing company is good or bad.

D) Time interest earned ratio (Interest coverage ratio): This ratio measures the extent to
which operating income can decline before the company is unable to meet its annual
interest costs. Failure to meet this obligation can bring legal action by the company’s
creditors, possibly resulting in bankruptcy. This ratio is determined by dividing earnings
before interest and taxes (EBIT) by the interest charges during the year. Note that
earnings before interest and taxes (EBIT), rather than net income, is used as a numerator
in the formula because interest is paid with the pre-tax income and company’s ability of
paying interest charges is not affected by taxes.

The time interest earned ratios (interest coverage ratios) for Addis manufacturing company
during 1992 and 1993 are:
Earnings before int erest and taxes
Interest coverage ratio =
Interest exp enses
12,200
 2.62 times
Interest coverage ratio for 2003) = 4,660
14,250
 3.43 times
Interest coverage ratio (for 2004) = 4,150

The time interest earned (interest coverage) ratios computed for Addis manufacturing company
reveals that the company’s earnings before interest and taxes are 2.62 times and 3.43 times
higher than the respective interest expenses of the company during 2003 and 2004 respectively.
As long as you don’t have the industry average, you cannot categorize these ratios as high or as
low. But generally speaking, the lower time interest earned ratio suggests that creditors are at
risk in receiving the interest payments that are due; the creditors may take legal action that may
result in bankrupting the company; and the company may face difficulty in raising additional
financing through debt issues as the company is under risk of paying interest charges. A larger
interest coverage ratio, on the other hand, suggests that the company has sufficient margin of
safety to cover its interest expenses; and the earnings before interest and taxes (EBIT) of the
company could decline without jeopardizing the company’s ability to make interest payments.

4) Profitability Ratios

Profitability is the net result of a number of policies and decisions. The profitability ratios
provide the overall evaluation of performance of the company and its management. These ratios
show the combined effects of liquidity, activity and leverage ratios on the operating result of the
company. The several ratios falling under this category are discussed in the following
paragraphs.
A) Gross profit margin:- the gross profit margin ratio is calculated as follows:
Gross profit margin = Gross profit
Net sales
Gross profit margin of Addis co. (for 2003) = 27,000 = 0.2455, or
110,000 24.55%
Gross profit margin of Addis co. (for 2004) = 30,000 = 0.25, or
120,000 25%

Thus, Addis manufacturing company’s gross profit constitutes 24.55 percent and 25 percent of
the company’s net sales during 2003 and 2004 respectively. These ratios reflect the company’s
mark ups on costs of goods sold as well as the ability of the company’s management to minimize
the costs of goods sold in relation to net sales. Larger gross margin ratio implies lower costs of
goods sold rate and vice versa.

B) Net profit margin ratio: - the net profit margin on net sales measures the profitability of
the company on a per birr basis of net sales. This ratio is calculated by dividing net
income by net sale of the company for a given accounting period. The net profit margin
ratios for Addis manufacturing company are:
Net profit margin = Earnings after taxes
Net sales
Net profit margin (for 2003) = 4,976 = 0.0452, or 4.52%
110,000
Net profit margin (for 2004) = 6.666 = 0.0556 or 5.56%
120,000
These net profit margin ratios can be interpreted in such a way that Addis manufacturing
company had earned 4.52 percent, or nearly 5 cents net income per birr of net sales it made
during 2003 and 5.56 percent or nearly 6 cents per birr of sales it made during 2004. Make sure
also that the net profit margin of the company is influenced by the amount of interest
expenses/charges and income tax expense because net profit is an earning after interest and taxes
(EBIT).

C) Return on Investment (ROI) – It is also known as return on Assets (ROA). This ratio
measures the company’s profitability per birr of investment in the total assets. The ROI
or ROA is calculated by dividing earnings after taxes by total assets. The ROIs for Addis
manufacturing company are:
Return on Investment (ROI) = earnings after taxes (net income )
Total assets
ROI (for 2003) = 4,976 = 0.0701, or 7.01%
71,000
ROI (for 2004) = 6,666 = 0.0813, or 8.13%
82,000
Thus, Addis manufacturing company generated 7.01 percent, or about 7 cents in the form of net
income out of each birr it invested in its total assets during 2003, and 8.13 percent, or about 8
cents in the form of net income out of each birr of investment in its total assets during 2004.
Whether the indicated returns on investments are good or bad depends on the industry standards,
or the management plans. But what you can say at this point is that the company’s return on
investment has shown slight improvement in 2004 compared to that of 2003.

You can also use a native formula to compute the return on investments (ROI). That is:
Return on investment (ROI) = net profit margin x Total asset turn over

= Net income x Net sales

Net sales total investment

The ROI for Addis Manufacturing Company during 2004, for instance, is:
ROI for 2004 = 6,666 = 0.1802 or 18.02%
37,000
As it can be deducted from the computed ROES, Addis manufacturing company has generated
21.54 percent, or about 22 cents and 18.02 percent, or about 18 cents for every birr of
shareholders’ equity during 2003 and 2004 respectively. Since earnings after taxes are the net
earnings after covering both interest charges and tax liabilities, they are available only for the
shareholders of the equity capital of the firm, or company.
D) Return on Equity (ROE): It earned the return on the owners (both preferred and common
shareholders) investment in the firm. It shows what rate of return was earned on the book
value of the owners equity

ROE = Earning After tax

Total shareholder equity
The ROE for Addis Manufacturing company during 2003 and 2004 is computed as
follows
ROE (for 2003) = 4,976 = 0.2154 or 21.54%
23,100

ROE (for 2004) = 6,666 = 0.1802 or 18.02%

37,000

E) Earnings per share (EPS): Expresses the profit earned per common share outstanding
during the reporting period. It provides a measure of overall performance and is an
indicator of the possible amount of dividends that may be expected. The earnings per
share for Addis manufacturing company are computed as follows:
Earnings per share (EPS) = Earnings after tax (net income) – Preferred dividend
Number of common shares out standing
Or (EPS) = Earnings available for common stock holders
Number of common shares outstanding
EPS (for 2003) = 4,976-0 = 4,976 = 4.98 Birr/share
1000 shares 1000 shares
EPS (for 2004) = 6,666 - 0 =6,666 = 5.13 birr/share
1,300 1,300
 Addis manufacturing company has earned 4.98 Birr per share during 2003 and 5.13 Birr per
share during 2004. The earnings per share have shown an increase during 2004 which shows
improved performance of the company during the year. Though the earnings per share were 4.98
Birr and 5.13 Birr per share during 2003 and 2004 respectively. These ratios do not tell you how
much of these earnings per share is paid as dividend and how much is retained in the business.
Moreover, since you don’t have the industry average or the management plan you cannot
conclude that these earnings per share are indicators of good or bad performance.

 MARKET/BOOK RATIOS:
These ratios are recently introduced into the ratio analysis. They are primarily used for
investment decisions and long-range planning and include:

 Price-to-earnings ratio (P/E): expresses the multiple that the market prices on the
company’s earnings per share and is commonly used to assess the owner’s appraisal of share
value. The price-to-earnings ratio is computed by dividing the market price of a share by the
earning per share computed above.
Assuming that at the end of 2003 and 2004 the common share of Addis manufacturing company
has market prices of 30 Birr and 35 Birr respectively, compute the P/E ratio of the company.

P/E ratio = Current market price per share

EPS
P/E ratio (for 2003) = 30 = 6.02 times
4.98
P/E ratio (for 2004) = 35 = 6.82 times
5.13

You can interpret these ratios Like this: the market is willing to pay about 6 birr in 2003 and
about 7 birr in 2004 for every birr in the company’s earnings. Again the P/E ratio has shown a
slight improvement during 2004. Since the industry standard or management plan is lacking, it
is very difficult for you to categorize Addis manufacturing company as highly valued or low
valued company. But what you can say in general is that a high P/E ratio reflects the market’s
perception of the company’s growth prospects. Thus, if the investors in the stock markets
believe that a company’s future earnings potential is good, they are willing to pay higher prices
for the stock and further boast the P/E ratio. The problem with P/E ratio is that the market price
for a share of common stock may not be available when there is no’ stock market.

3. Book value per share:- is the value of each share of common stock based on the company’s
accounting records. It is computed by dividing the number of common shares outstanding into
the excess of total stock holders; equity over preferred stock. The book values per share ratios
for Addis manufacturing company are computed as follows:

Book value per share = Total stock holder equity – preferred stock
Number of common shares outstanding
 Book value per share (for 2003) = 23, 100 – 0 = 23,100 = 23.10
1,000 shares 1000 shares
Book value per share (for 2004) = 37,000 – 0 = 37,000 = 28.46
1,300 shares 1,300 shares
The book value of a share of common stock of Addis manufacturing company is 23 – 10 Birr in
2003 and 28.46 Birr during 2004. This shows that the book value of a share is less than the
market value of a share during the two years. Hence, the value of a share during the two years.
Hence, the value of a share in the market during the two years is better than the book value.
Since we don’t have industry average or management goal, we cannot say the book values per
share ratios are above or below the industry average, or management plan.

4. Dividends per share (DPS): it shows the birr amount of dividends paid on a share of common
stock outstanding during the reporting period. It is determined by dividing the total cash
dividends on common shares by the number of common shares outstanding. Assuming that
Addis manufacturing company distributed a cash dividend to common shareholders of
1,900,000 Birr during 2003 and 2,600,000 Birr during 2004. The dividend per share for the
two years are:

Dividend per share = Total dividends on common share

Number of common shares outstanding

Dividend per share (for 2003) = 1,900 = 1.9 Birr

1000 Shares share

Dividend per share (for 2004) = 2600 = 2 Birr

1,300 s+hares share

Addis manufacturing company paid 1.9 Birr dividend per common share during 2003 and 2 Birr
per common share during 2004.

5. Dividend payout ratio – It shows the percentage of earnings paid to shareholders. It

expresses the cash dividend paid per share as a percentage of EPS. Dividend payout ratio is
computed by dividing cash dividend per share by earnings per share. The dividend payout
ratios of Addis manufacturing company are computed as follows:

Dividend payout ratio = Cash dividend per common share , or

Earning per share
= Total dividend to common stock
Total earnings available for common stock hold

Dividend payout ratio (for 2003) = 1.90 = 38.15%

4.98

Dividend payout ratio (for 2004) = 2.0 = 39%

5.13
 or else
Dividend payout ratio (for 2003) = 1900 = 38.18%
4,976
Dividend payout ratio (for 2004) = 2,600 = 39%
6,666

The dividend payout ratios indicate that Addis manufacturing company paid about 38 percent of
its earnings in the form of dividends for its common shareholders during 2003 and 39 percent of
its earnings was paid in the form of dividends during 2004.

6. Dividend yield: it shows the rate earned by shareholders from dividends relative to the
current market price of shares. Dividend yield is computed by dividing cash dividend per
share by current market price per share. The dividend yields for Addis manufacturing
company for 2003 and 2004 are:-

Dividend yield = Cash dividend per share

Market price per share

Dividend yield (for 2003) = 1.9 = 6.33 %

30
Dividend yield (for 2004) = 2 = 5.71%
35
Addis manufacturing company paid 6.33 percent and 5.71 percent of the current market prices in
the form of dividends to common shareholders during 2003 and 2004 respectively. Unless we do
have industry average, it is difficult of say these ratios indicate good or bad situation. But what
we can say, in general, is that the higher dividend rate (yield) may reflect fewer investment
opportunities on the part of Addis manufacturing company.

Approaches to use Financial Ratios in the Financial Statements Analysis

These are two basic approaches in analyzing a set of financial statements through the use of
financial ratios. These are the cross sectional analysis and the time series analysis. These two
approaches complement each other and both should be used as part of the analysis of financial
statements.

1. Cross-Sectional (Horizontal) Analysis

This approach enables you to evaluate company’s financial conditions at a given point in time
and compare company’s current performance against that of the previous year. Under cross-
sectional analysis, you compare the ratios of your company against those of its competitors. The
first step in cross-sectional analysis of Addis manufacturing company is to evaluate its financial
position at the end of 2004. In order to do so, the company’s financial statements are needs. The
second step is to compare the current performance of the company against that of the previous
year by comparing the financial ratios computed for 2003 and 2004 which are summarized in the
following table.
 Summary of the Financial Ratios of Addis manufacturing company.

Ratio 2003 2004

Liquidity:
Current ratio ------------------------------------ 1.96 2.22
Quick ratio ------------------------------------ 0.91 1.08

Activity:
Inventory turnover --------------------------- 4.44 4.39
Average collection period -------------------- 39 days 48 days
Total assets turnover -------------------------- 1.55 1.46

Leverage:
Total debt to assets --------------------------- 67.46% 54.88%
Long term debt to equity --------------------- 130% 73%
Total debt-to-equity --------------------------- 2.07 1.22
Time interest earned --------------------------- 2.62 times 2.26 times

Profitability:
Gross profit margin ---------------------------- 24.55% 25%
Net profit margin ------------------------------ 4.52 % 5.56%
Return on investment (ROI) ------------------ 7.01 % 8.13%
Return on shareholders’ equity (ROE) ------- 21.54% 18.02%

Comparing the liquidity ratios of 2003 and 2004 of Addis manufacturing company, both the
current ratio and quick ratio show improvement during 2004.

The activity ratios of Addis manufacturing company imply that the company was less efficient in
utilizing its assets in 2003 compared to what it had done during 2004.

The leverage (debt management) ratios of Addis manufacturing company show that the capital
structure has been improved during 2004 compared to that of 2003 where the capital structure
had been a debt-dominated one.

The profitability ratios also suggest that the company’s performance was more profitable during
2004 than it had been in 2003.

The final step in the cross-sectional analysis is comparing the financial ratios computed for
Addis manufacturing company against the average financial ratios computed for all competing
companies in the industry. The result of this comparison tells you the position of Addis
manufacturing company regarding its liquidity, activity, leverage and profitability.
Unfortunately we don’t have industry averages in our country to use for comparison purposes.
 2. Time series Analysis

It is the approach that is used to evaluate the performance of the company over several years.
This approach looks for three factors: (1) important trends in the data of the company. (2) Shifts
in trends, and (3) values that deviate substantially form the other data.

Advantages of Financial Ratio Analysis:

The following are the major advantages financial ratio analysis:

1. Ratios are easy to compute

2. Ratios provide standards of comparison at a point in time and comparisons to be made
with industry average, if available.
3. Ratios can be used to analyze company’s time series in order to discover trends, shifts in
trends, and values that deviate form other similar values.
4. Ratios are useful in identifying problem areas of a company.
5. When combined with other tools, financial ratios analysis makes an important
contribution to the task of evaluating the company’s financial performance.

The following are the major limitations of financial ratio analysis:

1. Taken by themselves, financial ratios provide very little information that is useful.
2. Ratios seldom provide answers to questions they raise because generally they do not
identify the causes for the difficulties that the company faced.
3. Ratios can easily be misinterpreted for instance; a decrease in the value of a given ratio
doesn’t necessarily mean that something undesirable has happened.
4. Very few standards exist that can be used to judge the adequacy of a ratio or a set of
ratios. Industry average cannot be relied upon exclusively to evaluate a company’s
performance because most of the companies in an industry may perform far below the
acceptable level of performance which lowers the industry average. In some cases, the
industry average ratios may not be available at all that is the problem we encounter in the
case of Ethiopian industries.
5. Many large companies operate a number of different industries and in such cases it is
difficult to develop a meaningful set of ratios to compare against industry average. This
makes ratio analysis more useful for smaller and narrowly focused companies than for
large and multi divisional ones.
6. Inflation has severely distorted balance sheets of companies (recorded values are usually
different from ’true’, or ‘market’ value.) Again since inflation affects both depreciation
charges and inventory costs, profits are also affected. But ratios do not take these
distortions into account unless balance sheet and income statement figures are adjusted
for the effect of inflation.
7. Seasonal fluctuations can also distort the analysis of financial statements through the use
of ratios. These problems can be minimized by using monthly averages for inventories
and receivables when calculating turnover ratios.
8. Companies can employ ‘window dressing’ techniques to make the financial statements
look stronger. For instance, the company might borrow on a long-term basis huge
amount of cash to wards the end of the accounting period for few days but back paid in
 the first week of the subsequent accounting period. This action did improve the
company’s current and quick ratios and made the balance sheet of the company look
good. However, as you clearly understand, the improvement was strictly due to the
“window dressing” technique the company had employed. Under such situation, it is
highly likely to misinterpret both the current and quick ratio as they signal good liquidity
position of the company which in fact is not.
9. It is difficult to generalize whether a particular ratio is ‘good’ or ‘bad’. For example, a
high current ratio may indicate a strong liquidity position which is good, or the
availability of excess cash which is obviously bad as the excess cash is a non-earning
(idle) asset. Similarly, a high fixed asset turnover ratio may denote either a company that
uses its fixed assets efficiently, or one that is under capitalized and can’t afford to buy
enough fixed asset whose value is used as a denominator when calculating the ratios.