CHAPTER TWOFinancial Analysis and Planning

Financial Statement AnalysisBasic Financial Statements

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 StatementAs you know from you 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 CompanyIncome Statements

For the year ended Sene 30, 1992 and 1993(in thousands of Birrs)

1993 1992Net Sales Birr 120,000 Birr 110,000Cost of goods sold 90,000 83,000Gross Profit 30,000 27,000Operating Expenses:

1993 1992Selling expenses 5,000 4,800General and administrative expenses 8,000 7,600Depreciation expense 1,100 800Lease Payments 1,650 1,600Total operating expenses 15,750 14,800

Earning before interest and taxes 14,250 12,200

Interest expenses:Interest on bank notes 550 700Interest on Other debt 3,600 3,960Total interest expenses 4,150 4,660

Earning before taxes 10,100 7,450Income taxes (34%) 3,434 2,564

Net Income 6,666 4,976

Balance SheetA 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, anidieal business firm, on Sene 30, 1992 E.C. and Sene 30, 1993 E.C.

Addis Manufacturing CompanyComparative Balance Sheet

Sene 30, 1992 and 19931993 1992

Current Assets:Cash 2,500 3,000Marketable securities 1,000 1,300Accounts receivable 16,000 12,000Inventories 20,500 18,700 Total current assets 40,000 35,000

Fixed Assets:Land and buildings 28,700 24,200Machinery and equipment 31,600 29,000

Total fixed assets 60,300 53,200Less accumulated depreciation 18,300 17,200Net fixed assets 42,000 36,000

Total assets 82,000 71,000Liabilities and shareholders' equityCurrent liabilities

Accounts payable 7,200 6,000Notes payable 10% bank 5,500 7,000Accrued liabilities 900 700Current portion of long-term debt 3,000 3,000Other current liabilities 1,400 1,200

Total current liabilities 18,000 17,900 not needed.Long-term liabilities

Long term debt-12% mortgage bond 27,000 30,000Total liabilities 45,000 47,900

Shareholders' equity Common stock, 5Birr par, 2,000,000

shares authorized; 1,300,000 sharesoutstanding in 1993 and 100,000shares outstanding in 1992 6,500 5,000 Capital in excess of par 14,000 5,350 Retained earnings 16,500 12,750

Total shareholders' equity 37,000 23,100Total 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 asset 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:

The individual purchases cost more that ever due to increases in prices and that the physical inventory levels have not increased, or

The company is accumulating that it has been unable to sell, or The company is producing, or purchasing inventories in large quantities in anticipation of

increases is 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 infact, 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, 1993 E.C.

Addis Manufacturing CompanyStatement of retained earnings

For the year ended Sene 30, 1993 E.C.

Retained earnings, Hamle 1, 1992 12,750Net income 6,666

Sub-Total 19,416Less Cash dividends (common stock) 2,916Retained earnings-Sene 30,1993 16,500

As you can see from the statement of retained earning of Addis Manufacturing Company, the retained earnings account has a balance of 12,750 Birr on Hamle 1,1992 which is the ending balance of sene 30, 1992 carried forward. This balance wash shown in the shareholders' equity section of the balance sheet prepared for Addis manufacturing company on sene 30, 1992. In the same way the ending balance of the retained earnings account shown in the statement of retained earning for Addis manufacturing company for the year ending on Sene 30, 1993 (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 nations 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 this king 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 RatiosFinancial ratios can be designed to measure almost any aspect of the performance of the company. In 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:

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.

Management plans - these are financial ratios are 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.

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: liquidity, activity (asset management), debt management (leverage), and profitability ratios.

Liquidity RatiosLiquidity 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 ratios.

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 Ratio =

Current assetsCurrent Liabilities

Current Ratio (for 1992) =

35 , 00017 , 900

= 1 .96 times

Current Ratio (for 1993) =

40 ,00018 , 000

= 2.22 times

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 convert 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 1992 and 2.22 Birr in current assets for each. Birr of current liabilities during 1993. It is very difficult to say this 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 1993 to pay its current liabilities than in 1992.

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 inventories, prepaid expense and supplies from current assets and dividing the remainder by total current liabilities. for Addis Manufacturing Company the quick ratios are:

Quick Ratio =

Current assets − (Pr epaid epense + Supplies + inventories )¿ Current liabiities ¿¿

¿

Quick Ratio (for 1992) =

35 , 000 − (0+0+18700)17 , 900

= 16 ,30017 , 900

= 0 .91 times

Quick Ratio (for 1993) =

40 ,000 − (0+0+20 ,500 )18 , 000

= 19 ,50018 ,000

= 1. 08 times

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 1993, 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 1993 compared to 1992.

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. 1. Inventory turn over ratio: This ratio is meaningful for companies like Addis Manufacturing

Company which hold inventories of different kinds. (if 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 costs of goods sold by the Birr amount of inventory at the closing date of the accounting period. for

Addis Manufacturing Company, the inventory turnover ratios are:

Inventory turnover =

Costs of goods soldInventory balance

Inventory turnover (f0r 1992) =

83 , 00018 , 700

= 4 . 44 times

Inventory turnover (for 1993) =

90 , 00020 , 500

=4 . 39 times

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 4.44 times and 4.39 time during 1992 and 1993 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 indicated 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.

2. 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:

Total assets turnover =

Net SalesTotal assets

Total assets turnover (for 1992) =

110 , 00071 , 000

= 1 . 55 times

Total assets turnover (for 1993) =

120 , 00082 , 000

= 1 . 46 times

The total assets turnover ratio of 1.55 times during 1992 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 1993, on the other hand, the company was able to make a 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 1993, the assets turnover ratios show that the company was efficient in generating higher net sales per birr of investment in asset in 1992 than in 1993. The decrease in the asset turnover ratio in 1993 may indicate a decrease in the utilization of the assets for generating the desired sales revenue.

3. Average Collection Period:- this ratio tries to measure the average number of days it takes for the company to collect its account period. 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:

Step 1: Daily Credit Sales =

total credit sales360 days

Daily Credit Sales (for 1992) =

110 , 00360

= 305 .56 birr

Daily Credit Sales (for 1992) =

120 , 000360

= 333 .33 Birr

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 1992 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 1993 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 1992 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.

Debt Management, or Leverage Ratios:These ratios measure the extent to which a company finance 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? The first question is answered through the use of balance sheet leverage ratios, while the second question is answered through the use of income statement based ratios, or simply through the use of leverage ratios.

Balance sheet leverage ratios:- These ratios provide the basis for answering the question. Where did the company obtain financing for its investments? The balance sheet leverage ratios include:1. Debt ratio, or debt-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:

Debt-asset ratio =

total liabilitiestotal assets

Debt-asset ratio (for 1992) =

47 ,90071 , 000

Debt-asset ratio (for 1993) =

45 ,00082 , 000

= 54 .88 %

At the end of 1992, 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 1993. This leaves 45 percent of the total assets to be financing has declined during 1993 compared to 1992 signaling good condition. To much debt financing risky to the company. Addis manufacturing company can borrow much more money during 1993 than it could do in 1992 because the asset structure of the company was more debt-dominated in 1992 than in 1993. Hence, lenders are willing to give loans to the company during 1993 when debt-asset ratio is less than during 1992 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, 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 will at higher interest rate that commensurate with the high risk they are taking as lenders.

The debit-asset ratio of 67.46 percent for 1992 computed fro 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 1993 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.2. 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:-

Long-term debt - equity ratio =

Lont term debtShareholders equity

Long-term debt-equity, ratio (for 1992)=

30 , 00023 , 000

=1 . 30 or 130%

Long-term debt-equity, ratio (for 1993)=

27 , 00037 , 000

= 0 . 73 , or 73 %

The long-term debt-equity ratio of the company decreased from 130 percent in 1992 to 73 percent in 1993. 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 1992 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 1993. 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.

3. 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:

Debt - equity ratio =

Total debtsShareholders ' equity

Debt-equity ratio (for 1992) =

47 ,90023 , 100

= 2.07

Debt-equity ratio (for 1993) =

45 ,00037 , 000

= 1 .22

The debt-equity ratio of 2.07 for Addis manufacturing company for 1992 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 taken, the debt-equity ratio of 1.22 for 1993 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.

Coverage Ratios:- The ratios are a second category of leverage, and they are used to measure the company’s is ability to cover its financing cost (interest expense) associated with the use of debt financing. These ratios provide the basis for answering the question of whether the company has used to much financial leverage. The coverage ratios, most of the time for most companies, include the following.

1. 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:

Interest coverage ratio =

Earnings before int erest and taxesInterest expenses

Interest coverage ratio for 1992) =

12 ,2004 , 660

= 2.62 times

Interest coverage ratio (for 1993) =

14 , 2504 , 150

= 3 .43 times

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 1992 and 1993 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.

2. Fixed Charge Coverage ratio:- This ratio is similar to that of the time-interest-earned ratio, but it is more inclusive as it recognize other fixed assets such as lease payments, principal payments of debts, and preferred stock dividend payments. Since principal payments of debts and preferred stock dividend payments are not tax deductibles and paid from after tax earnings unlike interest expenses, a tax adjustment should be made for these payments.For example the company that is required to effect principal payments amounting to 100 birr from its earnings after taxes (assuming a tax rate of 40 percent) needs its earnings

before taxes to be (100/1−0.4 ) , or 166.67 birr.The fixed charges obviously include interest expenses, annual long-term lease obligations, principal payments of long-term debts, and dividend payments for preferred stockholders and the fixed charge coverage ratio is defined as:

Fixed charge coverage ration =

EBIT + Lease paymentsint erest + lease Payment + ¿¿

¿¿

As you can observe from the above equation, interest expenses and lease payments are not adjusted for taxes because they are paid from earning before tax, while principal and preferred dividend payments are adjusted for taxes because they are paid from the after tax earnings (net income)Considering the given income tax rate of 34 percent and the principal payments of 2500 birr and 3000 birr during 1992 and 1993 respectively, the fixed charge coverage ratios for Addis Manufacturing Company can be computed by using the above mathematical equation as follows:

Fixed charge coverage ratio (for 1992) =

12 ,200 + 1 , 600

4 ,660 + 1 ,600 + (2500+01−0 . 34 )

=

13 , 8004 ,660 + 1 ,600 + 3 , 789

=

13 , 80010 , 049

= 1. 37 times

Fixed charge coverage ratio (for 1993) =

14 , 250+ 1 ,650

4 ,150+1 ,650+(3000+01−0. 34 )

=

15 , 9004150 + 1650 + 4 , 545

=15 , 90010 ,345

= 1. 45 times

Addis manufacturing company is able to cover its fixed charges (interest, lease payments, and principal payments) 1.37 times and 1.54 times using its earnings before interest and taxes during

1992 and 1993 respectively. In other words, the earnings before interest and taxes of the company are equal to 1.37 times the fixed charges during 1992 and 1.54 time the fixed charges during 1993.

Profit Ability 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 average ratios on the operating result of the company. The several ratios falling under this category are discussed in the following paragraphs.

1. Gross profit margin:- the gross profit margin ratio is calculated as follows:Gross profit margin = Gross profit

Net salesGross profit margin of Addis co. (for 1992) = 27,000 = 0.2455, or 110,000 24.55%Gross profit margin of Addis co. (for 1993) = 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 1992 and 1993 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.

2. Operating profit margin:- moving down in the income statements, the next profit figure following gross profit is the operating income (or EBIT). This operating profit figure serves as the basis for computing the operating profit margin. The operating profit, as you know, is the excess of gross profit over the total operating expenses. For Addis manufacturing ocmpnay the operating profit margins are found as follows:

Operating profit margin = Operating Income Net salesOperating profit margin (for 1992) = 12,200 = 0.1109, or 11.09%

110,000Operating profit margin (for 1993) =14,250 = 0.1188, or 11.88%

120,000

The operating profit margins reflect the company’s operating expenses as well as its costs of goods sold. Addis manufacturing company remained with 11.09 percent and 11.88 percent of its net sales after covering its cost of goods sold and all operating expenses during 1992 and 1993 respectively.

2. 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 taxesNet sales

Net profit margin (for 1992) = 4,976 = 0.0452, or 4.52%110,000

Net profit margin (for 1993) = 6.666 = 0.0556 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 1992 and 5.56 percent or nearly 6 cents per birr of sales it made during 1993. 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).

3. 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 (netincome )Total assets

ROI (for 1992) = 4,976 = 0.0701, or 7.01% 71,000ROI (for 1993) = 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 1992, 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 1993. 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 1993 compared to that of 1992.

You can also use a her 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 1993, for instance, is:ROI for 1993 =6,666 = 0.1802, or 18.02% 37,000

As it can be deducted form 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 1992 and 1993 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.

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:

1. Earning per share (EPS): Expresses the profit earned per common shop out standing 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 earning per share for Addis manufacturing company are computed as follows:

Earning per share (EPS) = Earnings after tax (net income) – Preferred dividendNumber of common shares out standing

Or (EPS) =Earnings available for common stock holdersNumber of common shares outstanding

EPS (for 1992) =4,976-0 = 4,976 = 4.98 Birr/share1000 shares 1000 shares

EPS (for 1993) = 6,666 - 0 =6,666 = 5.13 birr/share 1,300 1,300

Addis manufacturing company has earned 4.98 Birr per share during 1992 and 5.13 Birr per share during 1993. The earning per share has shown an increase during 1993 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 1992 and 1993 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.

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 1992 and 1993 the common share of Addis manufacturing company has a marke t 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 1992 ) = 30 = 6.02 times 4.98 P/E ratio (for 1992) =35 = 6.82 times

5.13

You can interpret these ratios?Like this: the market is willing to pay about 6 birr in 1992 and about 7 birr in 1993 for every birr in the company’s earnings. Again the P/E ratio has shown a slight improvement during 1993. Since the industry standard or management plan is lacking, it is very difficult for you to categorize Addis manufacturing company as highly valued or ow 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 perspects. 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 value 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 1992) =23, 100 – 0 = 23,100 = 23.10 1,000 shares 1000 shares

Book value per share (for 1993) =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 1992 and 28.46 Birr during 1993. 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 dividending 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 1992 and 2,600,000 Birr during 1993. The dividend per share for the two years are:

Dividend per share = Total dividends on common share Number of common shares outstanding

Dividend per shae (for 1992) =1,900 = 1.9 Birr1000 Shares share

Dividend per share (for 1993) =2600 = 2 Birr 1,300 shares share

Addis manufacturing company paid 1.9 Birr dividend per common share during 1992 and 2 Birr per common share during 1993.

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 share , or Earning per share

= Total dividend to common stock Total earnings available for common stock hold

Dividend payout ratio (for 1992) = 1.90 = 38.15%4.98

Dividend payout ratio (for 1993) = 2.0 = 39% 5.13

or elseDividend payout ratio (for 1992) =1900 = 38.18%

4,976Dividend payout ratio (for 1993) =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 1992 and 39 percent of its earnings was paid in the form of dividends during 1993.

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 pershare. The dividend yields for Addis manufacturing company for 1992 and 1993 are:-

Dividend yield =Cash dividend per share Market price per share

Dividend yield (for 1992) =1.9 = 6.33 % 30

Dividend yield (for 1993) =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 1992 and 1993 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 AnalysisThese 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 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 1993. 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 1992 and 1993 which are summarized in the following table.

Summary of Financial Ratios of Addis manufacturing company.

Ratio 1992 1993Liquidity:Current ratio ------------------------------------ 1.96 2.22Quick ratio ------------------------------------ 0.91 1.08

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

Leverage:Total debt to assets --------------------------- 67.46% 54.88%Long term debt to equity --------------------- 130% 73%Total debt-to-equity --------------------------- 2.07 1.22Time interest earned --------------------------- 2.62 times 2.26 timesFixed charges coverage ----------------------- 1.37 times 1.54 times

Profitability:Gross profit margin ---------------------------- 24.55% 25%Operating profit margin ----------------------- 11.09% 11.88%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 1992 and 1993 of Addis manufacturing company, both the current ratio and quick ratio show improvement during 1993.

The activity ratios of Addis manufacturing company imply that the company was less efficient in utilizing its assets in 1993 compared to what it had done during 1993.

The leverage (debt management) ratios of Addis manufacturing company show that the capital structure has been improved during 1993 compared to that of 1992 where the capital structure had been a debt-dominated one.

The profitability ratios also suggest that the company’s performance was more profitable during 1993 than it had been in 1992.

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 evaluates 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 compute2. 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 analyse 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

contributions 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 which 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.

Chapter SummaryFinancial analysis of the financial data contained in the company’s income statements and balance sheets is aided by the use of ratios analysis.

Ratio analysis is used to obtain measures of company’s liquidly, activity, debt and profitability. The cross-sectional approach to ratio analysis, supplemented with industry averages, can help in evaluating the financial position of a company at a given point in time. The time series approach, together with the preparation of common size income statements, can help is late financial trends, shifts in trends, and values that deviate fro other data.

The use of financial ratios cannot do adequate job of financial statement analysis. The use of financial ratios alone will not provide a complete understanding of the company’s activities. Rather the use of financial ratios will raise question that, When pursued, will provide the information needed to reach an informed judgment about the financial condition of the company.