CHAPTER TWO
FINANCIAL STATEMENT ANALYSIS Chapter Objectives:
After successfully completing this chapter, you will be able to: Explain the concept of financial analysis;
Perform horizontal and vertical financial analysis;
Evaluate the strengths and weaknesses of a firm through financial analysis; Compute and Analyze financial ratios for a particular firm;
Concepts and Use of Financial Statement Analysis
In financial accounting, you have learned the process of preparation of financial statements. Financial statements are the end products of accounting system. The two basic financial statements to be prepared for the purposes of external reporting are balance sheet and income statement. For internal purposes of planning, decision making and control much more information is contained in Balance sheet and Income statement.
Financial statements are used by managers to help improve the firm’s performance, by lenders help evaluate its likelihood of repaying debts, and by stockholders to help forecast future earnings, dividends and stock prices. If management is to maximize a firm’s value, it must take advantage of the firm’s strengths and correct its weakness. Financial analysis is the examination and comparison of financial data in order to draw inferences regarding the current and prospective financial condition of the firm (organization). Financial analysis helps users understand the numbers presented in financial statements and serve as a basis for financial decision making.
The term ‘Financial analysis’, also known as ‘analysis and interpretation of financial statements’, or ‘financial statement analysis’ refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the financial statements. It is the selection, evaluation and interpretations of financial data, along with other pertinent information, to assist investment and financial decision-making. It is a process of evaluating the relationship between items of financial statements to obtain a better understanding of a firm’s position and performance.
Financial analysis is the examination and comparison of financial data in order to draw inferences regarding the current and prospective financial condition of the firm (organization). Financial analysis helps users understand the numbers presented in financial statements and serve as a basis for financial decision making.
2. An evaluation of trends in the firm’s position over time.
Financial statement analysis focuses primarily on the Balance Sheet and Income Statement. However, data from the following two statements may also be used:
The statement of retained earnings, and Statement of changes in financial position.
The purpose of financial analysis is to diagnose the current and past financial condition of a firm and to give some clues about its future condition.
Importance of Financial Analysis
A Financial Manager has to continually utilize financial information. Much of this information is reported in the firm’s financial statements. The purpose of income statements and balance sheets is to inform interested parties about the operations and financial conditions of firms. However, these financial statements merely present the facts; an analysis of those facts is necessary in order to arrive at conclusions.
It is possible for firms to show high profits on their income statements yet be financially weak according to their balance sheets. It is also possible for firms to show low profits or even losses on their income statements yet are financially strong according to their balance sheets. Because the two statements reveal different financial characteristics, both must be analyzed to afford a complete evaluation of the firm’s situation. Financial analysis is of paramount importance to the following groups:
1) Managers: Managers evaluate their firm’s financial statements as a means of monitoring the firm’s operations and identifying the firm’s strengths and weaknesses. The firm’s financial statements can be generated and analyzed as frequently as necessary so that developing problems can be identified and dealt with before they become serious. Managers are also concerned with how the firm’s creditors and owners view the firm’s financial condition as revealed by the financial statements. Constant monitoring of those statements can suggest actions that will improve their appearance.
2) Creditors: Creditors conduct financial analysis of firms to determine the probability that the firms will default on loans. Short-term creditors may be most interested in the firm’s balance sheet, which indicates the level of liquid assets available to repay loans. Long-term lenders, however, may be just as concerned with the income statement as they are with the balance sheet, since the firm must generate sufficient income in future years to pay interest and repay the loan. Additionally, a firm’s balance sheet can deteriorate very quickly if its income statement is not healthy.
the time to analyze the firms in which they invest. Instead they need the advice of financial advisors who analyze firms for them.
4) Others: Government agencies and labor unions will also be interested in the firm’s performance. Many industries are regulated by government agencies and the rate of return allowed by companies in these industries is based on information in the financial statements. Similarly, trade unions frequently use financial statements to show that the firm’s strong profitability position justifies wage increases.
2.2. Types of Financial Statement Analysis
In the process of financial analysis various tools are employed. The most prominent In the process of financial analysis various tools are employed. The most prominent amongst them are listed as below:
amongst them are listed as below: 1. Horizontal Analysis 2. Vertical Analysis 3. Ratio Analysis
Horizontal Analysis
Horizontal Analysis is used to evaluate the trend in the accounts over the accounting periods. It is usually shown on a comparative financial statement. The horizontal analysis stresses the trends in various accounts making it possible to identify areas of wide divergence that require further investigation.
In a horizontal analysis it is essential to show both the amount of the change and the percentage of the change because either one alone might be misleading. In case where analysis of financial statements of large number of years is to be made, the task will be cumbersome, and in such a case it is recommendable to use trends relative to a certain base year.
To illustrate horizontal financial analysis, let’s take sample financial statements of XYZ Company. Its condensed balance sheets for 2001 and 2002 showing birr and percentage changes are presented in Exhibit 2.1
XYZ Company Comparative Balance sheet
Sene 30, 2001 and 2002
Assets 2002 2001
Increase (Decrease) Amount Percent Current assets Br.
Long-term investment 550,000 Br. 95,000 533,000 Br.177,500 17,000(82,500) 3.2% (46.5%)
Plant assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000
Total assets Br. 1,139,500 Br. 1,230,500 Br. (91,000) (7.4%) Liabilities
Current Liability Br. 210,000 Br. 243,000 Br. (33,000) (13.6%)
Long-term Liabilities 100,000 200,000 (100,000) (50.0%)
Total Liabilities 310,000 443,000 (133,000) (30.0%)
Stockholders’ equity Preferred Stock Common stock
150,000 500,000
150,000 500,000
-Retained earnings 179,500 137,500 42,000 30.5%
Total stockholders’ equity 829,500 787,500 42,000 5.3%
Total Liabilities and
Stockholders’ equity Br. 1,139,500 Br. 1,230,500 Br. (91,000) (7.4%)
Exhibit 2.2 Shows an increase in net sales that may not have a favorable effect on operating performance. The percentage increase in XYZ Company’s net sales is accomplished by a great percentage increase in the cost of goods sold (CGS). This has the effect of reducing gross profit. Selling expenses increased significantly, and administrative expenses increased slightly. Overall, operating expenses increased by 20.7%, whereas gross profit increased by only 19.7%.
The increase in income from operations and in net income is favorable. However, a study of the expenses and additional analyses and compression should be made before reaching a conclusion as to the case.
XYZ Company
Comparative Schedule of Current Assets
Sene 30, 2001 and 2002
Increase (Decrease) 2002 2001 Amount Percent Cash 90,500 64,700 25,800 39.9% Marketable Security 75,000 60,000 15,000 25.0% Accounts Receivable (net) 115,000 120,000 (5,000) (4.2%) Inventory 264,000 283,000 (19,000) (6.7%) Prepaid Expenses 5,500 5300 200 3.8% Total Current Asset 550,000 533,000 17,000 3.2% In Exhibit 2.1.1 the decrease in account receivable may be due to changes in credit terms or improved collection policies. Likewise, a decrease in inventories during a period of increased sales may indicate an improvement in the management of inventory. Generally, the change in the current asset is favorable.
Exhibit 2.2 Horizontal Analysis of Income Statement XYZ Company
Comparative Income statement For the year ended Sene 30 2002 2001
Increase (Decrease) Amount Percent Sales Br.
The measurement of changes in percentages from period to period is relatively straightforward and quite useful. However, complications can result in making the computations. If an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed. And if a negative amount appears in the base or preceding period and a positive amount exists the following year, or vice versa, no percentage change can be computed.
Vertical Analysis
[
Vertical Analysis: Analysis of financial statements where a significant item in a financial statement is used as a base value and all other items are compared against it.
E.g. in balance sheet analysis, all balance sheet items might be expressed as percentage of total assets. In income statement analysis, all income statement items might also be expressed as percentages of net sales.
Vertical financial analysis is a technique of evaluating and analyzing financial statement data that expresses each item in a financial statement as a percent of a base amount. For example, on a balance sheet, we might say that current assets are 22% of total assets (total assets being the base amount). Or on an income statement, we might say that selling expenses are 16% of net sales (net sales being the base amount).
In vertical analyses of the balance sheet, each asset item is stated as a percentage of total assets. Each liability and stockholder’s equity item is stated as a percentage of the total liabilities and stockholder’s equity. Exhibit 2.3 is a condensed comparative balance sheet with vertical analysis for XYZ Company.
Exhibit 2.3 Vertical Analysis of Balance Sheet
XYZ Company Comparative Balance sheet
Sene 30, 2001 and 2002
Assets
2002
Amount Percent
2001 Amount Percent Current assets Br.
Long-term investment
550,000 48.3% 95,000 8.3
533,000 43.3% 177,500 14.4 Plant assets (net) 444,500 39.0 470,000 38.2 Intangible assets 50,000 4.4 50,000 4.1
Total assets
Br.
1,139,500 100% 1,230,500 100% Liabilities
Current Liability Br. 210,000 18.4% 243,000 19.7% Long-term Liabilities 100,000 8.8% 200,000 16.3 Total Liabilities 310,000 27.2% 443,000 36.0% Stockholders’ equity
Preferred Stock Br. Common stock
150,000 13.2% 500,000 43.9
150,000 12.2% 500,000 40.6 Retained earnings 179,500 15.7 137,500 11.2 Total stockholders’ equity 829,500 72.8% 787,500 64.0% Total Liabilities and
Exhibit 2-4 Vertical Analysis of an Income Statement XYZ Company
Comparative Income statement For the year ended Sene 30
2002
Amount Percent
2001 Amount
Percent
Sales Br. Sales return and allowance Net Sales
1,530,500 102.2%
32,500 2.2 1,498,000 100.0%
1,234,000 34,000 1,200,000
102.8% 2.8
100% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross Profit Br. 455,000 30.4% 380,000 31.7% Selling Expenses
Administrative expenses
191,000 12.8% 104,000 6.9
147,000 97,400
12.3% 8.1 Total operating expenses 295,000 19.7% 244,400 20.4% Income from operations 160,000 10.7% 135,600 11.3% Other income
Br.
8,500 0.6 168,500 11.3%
11,000 146,600
0.9 12.2% Other expense 6,000 0.4 12,000 1.0 Income before income taxes 162,500 10.9% 134,600 11.2% Income tax expense 71500 4.8 58,100 4.8 Net income Br. 91,0000 6.1% 76,500 6.4%
3. Ratio Analysis
Horizontal and vertical analyses compare one figure to another within the same category. It is also essential to compare figures from different categories. This is accomplished through ratio analysis. There are many ratios that an analyst can use, depending upon what he or she considers being important relationships.
The financial ratio analysis is one of the most powerful types of financial analysis. A ratio is a simple arithmetical expression of the relationship of one number to another. A financial ratio analysis is the process of establishing and interpreting various financial ratios for helping in making certain decisions. However, financial ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of a firm. Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are analyzed and interpreted. There are a number of ratios, which can be calculated from the information given in the financial statements. But the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same, keeping in mind the objective of analysis. The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature and their interpretation depends upon the caliber and competence of the financial analyst.
Companies that produce the same products generally confront similar problems. Therefore it is reasonable to compare a firm’s ratios with the average ratio levels for the companies in the same industry. The sources of the industry averages may be (1) Trade Associations, (2) Government Agencies, and (3) Private Consulting Firms.
However, industry averages must be used cautiously because of two main reasons. First, using an industry average implies that the industry performance is satisfactory on the average. However, the same forms in the industry may be sick. Second, firms within the industry vary in size and the individual firm’s products are not all exactly the same. This implies possible differences in risk and operating conditions. Therefore the same ratio levels may not be appropriate for all companies in the industry. Thus, it is essential to compute the industry average taking the firm’s size, risk, operation etc in to consideration.
Types of Ratios
Financial ratios can be classified into five groups: A. Liquidity ratios
A) Measures of Liquidity (Liquidity Ratios)
A liquid asset is one that can be easily converted to cash without significant loss of its original value. Converting assets, especially current assets such as inventory and receivables, to cash is the primary means by which a firm obtains the funds needed to pay its current bills. Therefore, a firm’s ‘liquid position’ deals with the question of how well the firm is able to meet its current obligations. So, in general, one firm would be considered more liquid than another firm if it has a greater proportion of its total assets in the firm of current assets.
Liquidity ratios are used to judge a firm’s ability to meet short-term obligations.Liquidity ratios are also called short term solvency ratios. From them, much insight can be obtained into the cash solvency of a company and its ability to remain solvent in the event of adversities.
The most commonly used liquidity ratios are the following: 1) Current Ratio
Like any other liquidity measures, current ratio measures the ability of the firm to meet its short-term obligations with its current assets. The greater the level of a firm’s current assets relative to the current liabilities, the greater the firm’s liquidity is.
Current Ratio = Example: Current Ratio of XYZ Company:
2002 2001
Current Asset 550,000 533,000
Current Liabilities 210,000 243,000
Current Ratio 2.62 2.19
The higher the ratio, the more liquid the firm is. However, if the ratio is too high, the firm may have an excessive investment in current assets. It may also indicate an underutilization of short-term credit. A low current ratio indicates that the firm is having difficulty in meeting short-term commitments and the liquidity position of the firm is not safe.
2) Quick Ratio (Acid Test Ratio)
The Quick Ratio uses all current assets except inventory for measuring the liquidity of the firm. The ratio measures the firm’s ability to meet short-term obligations from its most liquid assets. Inventory is the least liquid of the current assets and may not be easily converted into cash. Similarly, prepaid expenses, which cannot be converted into cash and be available to pay off current liabilities, should also be excluded from liquid assets.
Quick Ratio =
Current Asset - Inventory 286,000 250,000
Current Liabilities 210,000 243,000
Quick Ratio 1.36 1.03
The greater the value of the quick ratio of a firm, the greater is the firm’s liquidity. If the ratio is too low, it shows that the firm is not able to pay obligations as they come due. B) Measures of Efficiency (Asset Utilization Ratios)
These ratios are also called Activity Ratios. They show the intensity with which the firm uses its assets in generating sales. These ratios indicate whether the firm’s investments in current and long-term assets are too small or too large. If investment is too large, it could be that the funds tied up in that asset should be used for more productive purposes.
The following are the most important asset utilization ratios: 1) Inventory Turnover
This ratio indicates the efficiency of the firm’s inventory management. It is calculated bydividing the cost of goods sold by the average inventory.
Generally, firms prefer to support a high level of sales with a low level of inventory. The reason is that the expense of maintaining inventory is directly related to the level of inventory. A low inventory turnover implies a large investment in inventories relative to the amount needed to service sales. Excess inventory indicates unproductive resources. If the inventory turnover is too high, inventories are too small and the firm may be running short of inventory. Inventory level must be relative to sales that are not excessive but sufficient to meet customers’ needs.
Inventory Turnover =
Cost of goods sold = Sales – Gross Profit or
= Opening Stock + Purchases + Mfg. Costs – Closing Stock. Average Stock = (Opening Stock + Closing Stock) 2.
If the particulars of cost of goods sold and average stock are not available in the published financial statements the stock turnover can be calculated by dividing sales by the stock at the end, i.e.,
Inventory Turnover =
Between the two formulae given above for calculating the stock turnover the former is more logical and more appropriate than the latter.
Inventory 264,000 283,000
Inventory Turnover 3.95 2.90
The inventory turnover ratio indicates how quickly a firm has used inventory to generate the goods and services that are sold.
Average Collection Period (Days sales outstanding)
Each Average Collection Period represents an expense to the selling firm, since it has invested its money in, but has not received payment for the product. Therefore, a high level of Average Collection Period can be costly to the firm.
The Average Collection period is a measure of how long it takes from the time sale is made to the time the cash is collected.
Average Collection Period =
Average Credit Sales per Day =
The average collection period indicates the firm’s efficiency in collecting on its sales. A high average collection period indicates that the firm allows the customers more time to pay or it receives the payment from its sales too slowly. Though a long collection period is not necessarily bad, a longer time in collecting on sales is a cost to the firm. A shorter collection period is not always better. Credit sales that can be collected within the firm’s credit policies are necessary for promoting sales.
2. Receivables Turnover
Receivables Turnover =
The debtors’ turnover indicates the number of times on the average that debtor’s turnover each year. Generally, the higher the value of the debtors’ turnover, the more efficient is the management of credit.
3) Fixed Assets Turnover
It indicates how intensively the fixed assets of the firm are being used. Fixed Assets Turnover =
E.g. 2002 2001
Sales 1,530,500 1,234,000
Fixed Asset 444,500 470,000
Fixed Asset Turnover 3.44 2.63
If fixed assets have changed significantly during the year, an average fixed asset level for the year, like inventory, should be used. A low ratio implies excessive investment in plant and equipment relative to the value of output being produced. In such a case, the firm might be better off to liquidate some of the fixed assets and invest the proceeds productively.
4) Total Assets Turnover
Total Assets Turnover =
E.g. 2002 2001
Sales 1,530,500 1,234,000
Total Asset 1,139,500 1,230,000
Total Asset Turnover 1.34 1.003
A low ratio indicates excessive investment in assets. Generally, firms prefer to support a high level of sales with a small amount of assets, which indicates efficient utilization of assets. Firms maintaining excess capacity may be needlessly spending money to maintain those assets. Conversely, an exceptionally high total assets turnover ratio may indicate that the firm is using old, fully depreciated assets that may be inefficient.
C) Measures of Financial Leverage (Debt Utilization Ratios)
Financial leverage refers to the use of borrowed funds to finance a firm’s assets. They indicate the company’s capacity to meet its long-term and short-term debt obligations. Leverage Ratios are important to creditors, since they indicate whether or not there are sufficient assets to pay off the debt if the firm liquidates. They evaluate the overall debt position in light of its asset base and earning power. Firms that borrow a large proportion of their funds, as opposed to financing with common equity, have fewer owners of common stock sharing the firm’s earnings. However, these same firms incur higher fixed financing costs, which must be paid regardless of the level of firm sales.
There are two types of leverage measures: those that measure the amount of debt used by the firm and those that measure the ability of the firm to service its debt (pay principal and interest when due).
The most important leverage ratios are the following: 1) Debt to Total Assets Ratio (D/A) (Debt Ratio)
The debt ratio indicates the percentages of a firm’s total assets that are financed with borrowed funds.
Debt Ratio = = = 27.2% D/R (D/A) = D/E
1+D/E
Creditors usually prefer a low debt ratio since it implies a greater protection of their position. A higher debt ratio generally means that the firm must pay a higher interest rate on its borrowing; beyond some point, the firm will not be able to borrow at all.
2) Debt to Equity Ratio
Debt to Equity Ratio = = = 37.4% D/E = D/A
1 – D/A
For XYZ Company, at year-end 2002 this ratio is 37.4%. The ratio tells us that creditors are providing 37 cents of financing for each $1 being provided by shareholders. Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of the firm’s financing that is being provided by shareholders and the larger the creditor cushion (margin of protection) in the event of shrinking asset values or outright losses.
It is used to measure the amount of long-term financing provided by debt relative to equity. This is similar to the debt ratio in term of its interpretation except the debt to equity ratio considers only long-term financing. Long-term creditors generally prefer to see a modest debt-equity ratio since it means greater has paid for its assets mainly with shareholder’s equity. A high debt equity ratio implies that a higher proportion of long-term financing is from debt sources. A low ratio means the firm has paid for its assets mainly with equity money (Preferred stock, common stock, and retained earnings).
3) Equity Multiplier (EM)
Equity multiplier is a measure of financial leverage. Calculated as: Equity Multiplier = Total Assets
Total Stockholders' Equity
EM = 1_____ or D/A = 1 –1 1 – D/A EM
Like all debt management ratios, the equity multiplier is a way of examining how a company uses debt to finance its assets. Also known as the financial leverage ratio or leverage ratio.
In other words, this ratio shows a company's total assets per dollar of stockholders' equity. A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets.
4) Times Interest Earned Ratio (TIER)
Interest Expense
The creditors may not like a low ratio on the ground that the company uses more debt or doesn’t generate sufficient income to cover the interest expense. The higher the ratio, the stronger is the interest paying ability of the firm. If it is too high, stockholders may feel that the firm is not taking advantage of the benefits provided by financial leverage, i.e. the firm doesn’t use enough debt to finance its operations.
5) Fixed Charges Coverage Ratio (FCCR)
Fixed charges coverage ratio is used to measure the ability of the firm to meet all fixed obligations such as interest, lease payments (rent), and sinking fund payments. It is computed as the ratio of earnings before fixed obligations and fixed charges or obligations.
FCCR = Income available for meeting fixed charges Fixed charges
FCC = EBIT + Lease Payments_______________ Interest + Lease + Sinking Fund Payments
1 – tax rate
The lease payments are added to EBIT because we want to determine the firm’s ability to cover its fixed charges from the income generated before any fixed charges are deducted.It is assumed that profits are used to pay fixed charges. Sinking fund payments are made with after tax Birr whereas interest and lease payments are made with pre-tax Birr. As a result, the sinking fund payments must be grossed up by dividing by (1- tax rate) to find the before tax income required to pay taxes and still have enough money left to make the sinking fund payment.
The FCCR is identical to the TIER. A higher ratio will indicate that the company is able to pay the fixed charges and will satisfy the creditors.
D) Measures of Profitability (Profitability Ratios)
Measuring the firm’s profitability is important to the analyst since it provides summary information on the success of the firm’s operations during a given period. Profitability Ratios indicate the success of the firm in earning a net return on sales, total assets, and invested capital and also show the combined effects of liquidity, asset management and debt management on operating results. Many of the problems related to profitability can be explained, in whole or in part, by the firm’s ability to effectively employ its resources. Profitability ratios are of two types.Those showing profitability in relation to sales and those showing profitability in relation to investment. Togtheer these ratios indicate the firm’s overall effectivness of operations.
i. Profitability in relation to sales
Gross Profit Margin = Net Sales – Cost of goods sold Net Sales = 1,498,000 – 1,043,000 = 3 0 . 37 %
1,498,000
Firms like their gross profit margin to be as high as possible. Gross Margin should be monitored over time to assure that the cost of goods sold does not become excessive. If the Gross Margin is increased by raising the price, the product may become noncompetitive, producing a fall off in sales.
2) Operating Margin: The net operating margin indicates the profitability of sales before taxes and interest expenses. This ratio measures the effectiveness of production and sales of the company’s product in generating pretax income for the firm.
Operating Margin = Operating Income = 160,000 = 10. 68 % Net Sales 1,498,000
The higher the net operating margin the better the company is
3) Net Profit Margin: Net profit margin is a measure of the percent of each dollar of sales that flows through to the stockholders as net income. It shows what percent of every sales dollar the firm was able to convert into net income. Firms with a low volume of sales may need a higher profit margin to generate a satisfactory return for its shareholders.
Net Profit Margin = Net Income = 91,000 = 6 .1 % Net Sales 1,498,000
The stockholders always like to have a higher net profit margin. ii. Profitability in relation to Investment
4) Return on Investment (Return on Assets): It is also referred to as Return on Assets. It measures the return to the firm as a percentage of the total amount invested in the firm or how profitable the firm used its assets.
ROI(ROA) = Net Income = 91,000 = 8% Total Assets 1,139,500
ROA (ROI) = NPM X Total assets turnover
ROI = (Net Income + Interest Expense) = (91,000 + 35,000) = 11.06% Total Assets 1,139,500
NB: the amount in the interest expense is taken for this example only, not from XYZ companies Income statement.
5) Return on Equity (ROE): This ratio measures the return earned on the owners' (both preferred and common stockholders) investment in the firm. Generally, the higher this return, the better off is the owners. Return on equity is calculated as follows:
Return on equity (ROE) = Net Profits after Taxes Stockholders' Equity
ROE = ROA 1 – D/A
It is the duty and objective of the management to generate maximum return on shareholders’ investments in the firm. Common Stockholders prefer ROE to be very high, since it indicates high returns relative to their investment. However, if the return is abnormally high, it may increase the risk and therefore the reasons must be determined. The Du Pont Identity
Du Pont is the name of a person who managed a corporation named Du Pont Corporation. Du Pont was very much interested in ROE as an important measure of the performance of his corporation. He developed ROE model based on three major factors. These are:
1. Net profit margin
2. Total asset turnover, and 3. Equity Multiplier
Based on the above factors, he developed ROE model and called it Du Pont Identity. The Du Pont identity is shown below:
ROE = Net Profit X Total Assets X Equity Margin Turnover Multiplier 6) Earnings Per share (EPS)
It expresses the profit earned per common share by a corporation during the reporting period. It provides a measure of over all performance and is an indicator of the possible amount of dividends that may be expected. The earning per share calculations made over years indicates whether or not the firm’s earning power on per share basis has changed over that period. The earning per share is generally of interest to present or prospective shareholders and management. Hence, they are closely watched by the investing public and are considered an important indicator of corporate success.
Earning per share simply shows the profitability of the firm on a per share basis, it does not reflect how much is paid as dividend and how much is retained in the business. But as a profitability index, it is a valuable and widely used ratio.
Earning per share is computed on common stock by dividing dividend on common stock by number of common stock outstanding.
Number of common shares outstanding 7) Dividend per share (DPS)
It represents the Birr amount of cash dividends a corporation paid on each share of its common stock outstanding during the reporting period.
DPS = Cash Dividends on Common stock Number of Common shares outstanding 8) Payout ratio
It shows the percentage of earnings paid to stockholders. That is, the payout ratio expresses the cash dividend paid per share as a percentage of EPS.
Pay Out Ratio = Dividend per Share Earnings per Share
[[
E) Marketability ( Market value) Ratios
If the firm’s liqudity, asset managemnt, debt management, and profitability ratios are all good, then its market value ratios will be high and its stock price will be as high as can be expected. These ratios measure the perception of the future earning power of the firm by the market. The ratios are used for investment decisions and long range planning.
1) Price Earnings (P/E) Ratio: It expresses the multiple that the market places on a firm’s earnings per share and is commonly used to assess the owners’ appraisal of share value. The level of the P/E ratio indicates the degree of confidence (or certainty) that investors have in the firm’s future performance.
The P/E ratio represents the amount investors are willing to pay for each dollar of the firm’s earnings. A high P/E multiple reflects the market’s perception of the firm’s growth prospects (i.e. the higher the P/E ratio, the greater investors confidence in firm’s future). If investors believe that a firm’s future earnings potential is good, they may be willing to pay a higher price for the stock and thus boost its P/E. The level of P/E ratio indicates the degree of confidence that investors have in the firm’s future performance.
A rise in the price earnings ratio could be seen as a signal of increase in the market value of the firm’s stocks.
2) Market / Book (M/B) Ratio
has declined.M/B ratio is computed as the ratio of Market price per share to book value per share. Book value per share is determined by dividing total stockholders’ equity by Number of common stock outstanding.
Book value per share = Common Equity Share Outstanding Limitations of Ratio Analysis
Even though ratio analysis can provide useful information regarding a company’s operations and financial condition, it does have limitations that necessitate care and judgment. These are:
The basic data arise from the accounting process and therefore based on historical costs. Because one of the main purposes of financial accounting is to match revenues ad expense in the appropriate period there may be little or no direct relationship to the firm’s cash flows, especially in the short run.
The accounting process allows for alternative treatment of numerous transactions. Thus, two identical firms my report substantially different data by employing alternative GAAP treatments.
Windows dressing many appear in accounting statements. For instance, by taking out a long-term loan before the end of its fiscal year and holding the proceeds as cash, a firm could significantly improve its current and quick ratios. Once the fiscal year has ended the firm could turn around and pay the loan- but the transaction has already served its purpose.
Inflation and disinflation can have material effects on the firm, especially on inventories and long-term assets, which may be seriously understated when inflation is present. The comparability of data within a firm over time, and also between firms, is therefore limited.
Industry averages are generally not where the successful firm wants to operate; rather, it wants to be the top end of the performance ladder. Also, finding an appropriate industry for comparison is not as simple as it sounds.
For firms with substantial international operations, other reporting problems exist in addition to those faced by domestic firms.
Many firms are multi divisional, and sufficient data are generally are not reported so that outsiders can examine the performance of the various divisions. Also, it is often difficult to find comparable industry data for multi divisional firms.
Work sheet on chapter Two (Ratio Analysis)
1. ABC Company has produced the following balance sheet and income statement for the year ended 2004 (in thousands):
A. Balance sheet Assets :
Cash ...$.400
Inventories ...2100
Total current Assets ...3800
Liabilities & Capital
As/P ...$.320
Accruals ...260
Short -tern loans ...1100
Total current liabilities...1680
Long term Debts ...2000
Equity ...3440
Total liabilities & Equity $7120 B. Income statement Net sales (all credit ... $12,680 Cost of goods sold ... 8930
Gross profit ... 3750
Selling & administrative expenses ... 2230
Operating income ... 1520
Interest expense ... 460
Income before tax ... 1060
Taxes ... 390
Net income ... $ 670 Additional information:
The ending inventory for the year 2003 is $ 1,800 There is no preferred stock
Number of common stock outstanding is 10,000
Market price per share as of December 31, 2004 is Br. 120 Required: Compute the following:
a. Current ratio b. Quick ratio
c. Receivable turnover d. Average collection period e. Inventory turnover f. Days sales in inventory g. Total Asset turnover h. Fixed asset turnover i. Debt ratio
2. D and H Share Company has earned net income of Br. 47500 during the year ended December 31, 2005. There are currently 20 days sales outstanding (DSO) in receivables with 360 operating days in a year. Total assets and receivables are Br. 527,000 and Br. 60,000 respectively. Debt to equity ratio is 0.85. All sales are on credit.
Required: Compute the following: a. Net profit margin
b. Total assets turnover ratio c. Return on Equity (ROE)
3. The following information is available on the balance sheet and income statement of ABC Corporation for the year ended December 2005 (in thousands):
Balance sheet
Assets Liabilities & Share holder’s Equity Cash &Marketable
securities
500 Accounts payable 400
Accounts Receivable ? Bank loan ?
Inventories ? Accruals 200
Total current assets ?? Current liabilities ??
Net Fixed assets, ? Long term debts 2650
Total liabilities ?
Equity (common stock &Retained
Earning) 3750
Total Assets ?? Total liability & Shareholders’ equity ??
Income Statement Net Sales ... ..8000 Cost of goods sold ... ? Gross profit ... ? Selling & administrative expenses... ? Interest expense ... 400 Operating Profit……… ? Profit before tax ... ? Taxes (44%) ... ? Profit After taxes ... ??
Additional Information: All sales are on credit
Current ratio 3:1
Net profit margin ... 7%
Required: Assuming that sales and production are steady throughout a 360-day year, complete the balance sheet and income statement for ABC Corporation.
4. Complete the balance sheet and income statement information in the following table for XYZ Company (in thousands)
Balance sheet
Cash &Marketable securities ... $? As/P & Accruals $? Accounts Receivable ... ? Long term debts ...300 Inventories ... ? Common stock ... ? Total current assets ...?? Retained earnings ...390 Fixed assets( net )... ? _______ Total Assets ... …...2,000 Total liability.& equity..…?? Income Statement
Net Sales (on credit )...$? Cost of goods sold ... ? Gross profit ... ? Operating expenses... 300 EBIT ... ? Interest expense ... 20 Profit before tax ... ? Taxes (40%) ... ? Profit After taxes (Net income)... ?? Additional Information:
Current ratio ... 2 Quick ratio ... 1
ACP (Average Collection Period)... 36 days ROE(Return on Equity) ... 8% Equity multiplier ... 1.67
Net profit margin ... 3.2%
5. Alem Company’s return on assets was 20% last year and the net profit margin was 10%.What was the total sales for the year if total assets are $500,0000.
6. XYZ Company has Br. 1,000,000 debt outstanding at 10% interest rate. The firm's annual net sales are Br. 4,000,000. Its tax rate is 40%. Net profit margin is 6%. If there is no preferred stock, determine times interest earned ratio.
a. What was the times interest earned ratio assume interest expense and tax rate for the period were Br.10, 000 and 40% respectively.
b. What was the net income and earnings per share (EPS) for the period.
8. ABC has a net profit margin of 10.5%, TATO (Total Asset turnover ratio) of 1.75, and ROE (Return on equity) of 24.50%. Determine its debt to equity ratio.
9. Consider the following data:
Additions to retained earnings for the year just ended ... 160,000 Cash dividends paid ... 100,000 Total equity (no preferred stock)... 5 million Common stock outstanding ... 100,000 shares Current market price per share ... Br. 65
Required: Determine the following: a. Earnings per share
b. Dividend per share c. Book value per share d. Market to book ratio e. Price-earnings ratio
10.XYZ Corporation has sales of Br. 25 million, total assets of Br. 36 million and total debt of Br. 7 million. If the net profit margin is 6%, what is net income? What is ROE? What is ROA?
11.ABC Company has a current Accounts Receivable balance of Br. 425,000 and credit sales for the year of Br. 2,553,000.
Required:
a. What is receivable turnover? b. Determine ACP
c. If the credit period is 30 days, judge the desirability of the company's ACP. 12.A firm has debt ratio of 35%. Determine Debt to equity ratio and equity multiplier.
13.If a firm has an equity multiplier of 1.80, TATO (Total Asset turnover ratio) of 1.10, and a net profit margin of 11%, what is its ROE (Return on equity)?
14.Assume you are given the following relationships for the XY’ Corporation: Sales/total assets 1.5X
Return on assets (ROA) 3% Return on equity (ROE) 5%
Calculate XY’s profit margin and debt ratio.
