Introduction to Financial Accounting.

Page 1 of 15

7 FINANCIAL STATEMENT ANALYSIS

7.1 Introduction

Financial analysis is the assessment of the firm’s past, present and future financial
conditions. It is carried out to find out the firm’s financial strengths and weaknesses
It uses:
 Financial statements (Statement of comprehensive income, Statement of financial
position, Statement of retained earnings, Statement of cash flow, Statement of
changes in equity)
 Comparison of financial ratios (past, industry, sector and all firms)

There are various methods or techniques that are used in analyzing financial
statements such as:

Horizontal analysis
Comparison of two or more year's financial data is known as horizontal analysis, or trend
analysis. Horizontal analysis is facilitated by showing changes between years in both dollar
and percentage form.
Horizontal analysis of financial statements can also be carried out by computing trend
percentages. Trend percentage states several years' financial data in terms of a base year.
The base year equals 100%, with all other years stated in some percentage of this base.

Vertical analysis
Vertical analysis is the procedure of preparing and presenting common size statements.
Common size statement is one that shows the items appearing on it in percentage form as
well as in dollar form. Each item is stated as a percentage of some total of which that item is
a part. Key financial changes and trends can be highlighted by the use of common size
statements.

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Introduction to Financial Accounting. Page 2 of 15

7.2 Ratio analysis

Ratio analysis enables financial users who are not skilled to make sense out of the
statements. With ratio analysis, financial statements can be interpreted and usefully applied
to satisfy the needs of the user.
The main functions of ratios are:
(i) Standardize financial information for comparisons
(ii) Evaluate current operations
(iii) Compare performance with past performance
(iv) Compare performance against other firms or industry standards
(v) Study the efficiency of operations
(vi) Study the risk of operations

7.2.1 Users of ratios

There are a number of people who use ratios to analyze financial statements. These users
are:
Category Users
Profitability ratios Shareholders, management, employees,
creditors, competitors, potential investors
Liquidity ratios Shareholders, suppliers, creditors,
competitors
Efficiency ratios/Activity ratios Shareholders, potential purchasers,
competitors
Capital structure ratios/Gearing or leverage Shareholders, lenders, creditors and
ratios potential investors
Shareholder ratios/Investment or equity Shareholders, potential investors
ratios

7.2.2 Classification of ratios

The following financial statements relate to xyz ltd with an authorised share capital
of shs 225,000 divided into 22,500 shares of shs 10 each. The average market price
of the company’s share was sh 34.50 and sh 29.25 in 2012 and 2013 respectively.

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Introduction to Financial Accounting. Page 3 of 15

XYZ ltd
Statement of comprehensive income
For the year ended 31st December 2013
2012 2013
000 000
Net Sales 2,825.69 3,717.23
Cost of Goods sold 2,322.80 3,053.66
Gross Profit 502.89 663.57

Less: Selling and Administrative expenses 262.10 357.87

Operating income 240.79 305.70

Add: Other income 25.38 36.91

Earnings before interest and taxes (EBIT) 266.17 342.61

Less: Interest 124.98 143.46

Profit before Tax (PBT) 141.19 199.15
Provision for Tax 30.00 64.29
Profit after tax (PAT) 111.19 134.86
Dividend distributed 39.38 45.00
Retained earnings 71.81 89.86

XYZ Ltd
Statement of Cost of goods sold
For the year ended 31st December 2013
2012 2013
000 000
Opening stock 147.12 244.26
Add: Net Purchases (Production cost) 2,419.95 3,271.21
2,567.07 3,515.47
Less Closing stock 244.27 461.81
Cost of goods sold 2,322.80 3,053.66

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Introduction to Financial Accounting. Page 4 of 15

XYZ LTD
STATEMENT OF FINANCIAL POSITION AS AT 31ST DECEMBER 2013
2012 2013
Sh'000 Sh'000
EQUITY
Share Capital 225.00 225.00
Reserve 357.95 447.81
Total Equity 582.95 672.81
Non Current Liabilities
Long term debt 361.65 389.19
Bank borrowings 641.39 839.87
Total Non Current Liabilities 1,003.04 1,229.06

Total Equity and Liabilities 1,585.99 1,901.87

REPRESENTED BY
NON CURRENT ASSETS
Property, Plant and Equipment at cost 841.64 921.55
Less depreciation 194.46 235.44
647.18 686.11
Other Non Current Assets 16.44 60.72
Total Non current assets 663.62 746.83
Current Assets
Inventories 778.89 1,150.39
Debtors 340.61 483.18
Cash and bank balance 98.84 26.08
Others 186.21 211.27
Total current assets 1,404.55 1,870.92
Current Liabilities
Trade creditors 211.21 339.35
Provision and Others 270.97 376.53
482.18 715.88

Net Current Assets 922.37 1,155.04

Net Assets 1,585.99 1,901.87

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Introduction to Financial Accounting. Page 5 of 15

a) Profitability ratios

Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm.
They include:

(i) Return on capital employed (ROCE)

Return on capital employed establishes the relationship between the profit and the capital
employed. It indicates the percentage of return on capital employed in the business and it
can be used to show the overall profitability and efficiency of the business.
It indicates the efficiency with which a company uses long term funds or permanent assets
to generate returns to shareholders.
ROCE = (PBIT or operating profit/Total capital employed) x 100%
Capital employed = shareholder’s funds (ordinary share capital, preference share capital,
share premium and retained earnings) and long term debts
Capital employed = Non current assets + net current assets

ROCE = 342.61/1901.87 x 100% = 0.18014 x 100% = 18.01%

(ii) Gross profit margin

This ratio shows how well cost of production has been controlled in relation to distribution
and administration costs.
It is given by:
Gross Profit Ratio = (Gross profit /Sales) × 100%]
Example
Gross Profit margin = (663.57/3717.23) × 100%
= 0.1785 x 100% = 17.85%
Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be
reduced without incurring losses on operations.
It reflects the efficiency with which a firm produces its products. The gross profit earned
should be sufficient to recover all operating expenses and to build up reserves after paying
all fixed interest charges and dividends.

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Introduction to Financial Accounting. Page 6 of 15

(iii) Net profit margin

It measures the firm’s ability to control its production, operating and financing costs
It is given by:
Net profit margin = PAT/Sales x 100% (or Net profit/sales) x 100%)
Example
Net profit margin = [(134.86 / 3717.23) × 100]
= 0.0363 x 100% = 3.63%
NP ratio is used to measure the overall profitability and hence it is very useful to proprietors.
The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to
achieve a satisfactory return on its investment.
This ratio also indicates the firm's capacity to face adverse economic conditions such as price
competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But
while interpreting the ratio it should be kept in mind that the performance of profits also be
seen in relation to investments or capital of the firm and not only in relation to sales.

(iv) Net assets turnover

This is used to show the productive efficiency of the firm i.e. how well assets have been used
in generating sales.
It is given by:
Net assets turn over = Sales/Capital employed
NATO = 3717.23/1901.87 x 100% = 1.9545 x 100% = 195.45%

(v) Operating profit/Margin ratio

It indicates the efficiency with which costs have been controlled in generating profits from
sales
Operating profit ratio = (PBIT or operating profit/Sales) x 100%
Example
Operating profit ratio = (342.61/3717.23) × 100%
= 0.0922 x 100% = 9.22%

(vi) Operating expenses ratio

This is used to show a firm’s ability to control production and operating costs to generate a
given level of sales.
Operating expenses ratio = (Operating expenses/Sales) x 100%
Operating expenses ratio = (3053.66 + 357.87/3717.23) × 100%

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Introduction to Financial Accounting. Page 7 of 15

= 3411.53/3717.23 x 100% = 0.9178 x 100% = 91.78%

This means that 8.22% of sales is left to cover interest, taxes and earnings to owners since
91.78% of sales have been consumed together by the cost of goods sold and other operating
expenses.

(vii) Return on investment (ROI)

It measures the efficiency with which a company uses its total funds in capital employed to
generate returns to owner’s funds.
It is given by:
Return on investment = (Net profit after tax/Capital employed) x 100%
Example
ROI = 134.86/1901.87x 100% = 0.0709 x 100% = 7.09%

This ratio is one of the most important ratios used for measuring the overall efficiency of a
firm. As the primary objective of business is to maximize its earnings, this ratio indicates the
extent to which this primary objective of businesses being achieved. This ratio is of great
importance to the present and prospective shareholders as well as the management of the
company. As the ratio reveals how well the resources of the firm are being used, higher the
ratio, better are the results. The inter firm comparison of this ratio determines whether the
investments in the firm are attractive or not as the investors would like to invest only where
the return is higher

(viii) Return on Equity (ROE)

It measures the efficiency with which a company and other suppliers’ funds have been used
to generate returns to the shareholders.
Return on equity = (Earnings attributable to equity shareholders/Equity) x 100%
Equity = ordinary share capital, share premium and reserves.
ROE = 134.86/672.81 x 100% = 0.2004 x 100% = 20.04%

This ratio is more meaningful to the equity shareholders who are interested to know profits
earned by the company and those profits which can be made available to pay dividends to
them. Interpretation of the ratio is similar to the interpretation of return on shareholder’s
investment and the higher the ration the better.

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Introduction to Financial Accounting. Page 8 of 15

b) Liquidity ratios
They measure the firm’s ability to meet its short term financial obligations as and when they
fall due.
They include:

(i) Current ratio

It is a measure of general liquidity of the firm and is most widely used to make the
analysis for short term financial position or liquidity of a firm.
It is used to check if there are sufficient short term assets to meet the short term
liabilities.
Current ratio = current assets/current liabilities
Example
Current ratio = 1870.92/715.88 = 2.61:1
It represents the margin of safety or cushion available to the creditors. A relatively high
current ratio is an indication that the firm is liquid and has the ability to pay its current
obligations in time and when they become due. A ratio of 2 to 1 is considered
satisfactory.

(ii) Acid test or quick ratio

The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm.
It measures the firm's capacity to pay off current obligations immediately and is more
rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the
current ratio. Quick ratio is more rigorous test of liquidity than the current ratio because
it eliminates inventories as a part of current assets.
Usually high liquid ratios is an indication that the firm is liquid and has the ability to meet
its current or liquid liabilities in time and on the other hand a low liquidity ratio
represents that the firm's liquidity position is not good. As a convention, generally, a
quick ratio of "one to one" (1:1) is considered to be satisfactory.
Acid test ratio = (Current assets – inventory)/Current liabilities
Example
Acid test ratio = 1870.92 – 1150.39/715.88 = 720.53/715.88 = 1:1

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Introduction to Financial Accounting. Page 9 of 15

(iii) Cash ratio

This ratio measures the liquidity of the business by examining cash ratio or cash
equivalents (trade investment or marketable securities) to current liabilities
Cash ratio = Cash + Marketable securities/Current liabilities
Example
Cash ratio = 26.08/715.88 = 0.0364 = 3.64%
This means that the company carries a small amount of cash and if the company has no
borrowing power, there is need to worry.
(iv) Interval measure
It measures a firm’s ability to meet its regular cash expenses and relates liquid assets to
average daily operating cash flows.
The daily operating expenses = (Cost of goods sold + selling, administrative and general
expenses – depreciation and other Non-cash expenditures)/no. of days in a year
Interval measure = Current assets – Inventory/Average daily operating expenses
= 1,870.92 – 1,150.39/(3,053.66 + 357.87 + 143.46 – 235.44) :- 360
= 720.53/(3,319.55 :- 360)
= 720.53/9.22 = 78 days
This means that the company has sufficient liquid assets to finance its operations for 78
days, even if it does not receive any cash.
(v) Net Working capital ratio
This is measure of liquidity that measures a firm’s potential reservoir of funds. A firm
having a larger NWC has a greater ability to meet its current obligations.
NWC ratio = Net working capital (NWC)/Net assets (NA)
Example
NWC ratio = 1,155.04/1,901.87 = 0.6073

c) Efficiency ratios/Activity ratios

These ratios measure the efficiency of the firm in using its assets to generate sales.
They include:

(i) Debtors turn over

It shows the number of times debtors pay within the year. It indicates how efficient the firm
is in management of credit. The higher the ratio, the more efficient management is in
managing the credit policy
Debtors turn over = credit sales/Average debtors

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Introduction to Financial Accounting. Page 10 of 15

Example
Debtors turn over = 3717.23/483.18
= 7.69 times
This means that the company is able to turn over its debtors 7.7 times in a year i.e. debtors
remain outstanding for 12 months/7.7 = 1.56 months or 360/7.7 = 46.8 days

(ii) Debtor’s days or ratio

Is called average collection period. It shows the average period of credit taken by customers
who buy on credit.
Debtors days/ratio = (Average debtors/Credit sales) x number of days in a year
Or = Number of days in a year/Debtors turn over
Example
ACP = (483.18/3717.23) x 360
= 0.13 x 360 = 46.79 or 47 days
This means that debtors remain outstanding for 47 days. This can then be compared with
the company’s credit terms and see if there is efficiency in debt collection.

(iii) Creditors turn over

It indicates the number of times creditors are paid by a company during the year.
Creditors turn over = Credit purchases/Average creditors
Example
Creditors turn over = 3717.23/339.35
= 10.95 = 11 times
This means that the company pays its creditors after 12/11 = 1.09 months or 360/11 = 32.7
days

(iv) Creditor’s days or ratio

It is called the average deferral period. It shows the average time that suppliers allow a
company to settle its dues
Creditor’s days ratio = (Average creditors/Credit purchases) x number of days in a year
Or Number of days in a year/creditors turn over
Example
Creditors days ratio = (339.35/3717.23) x 360
= 0.0913 x 360 = 32.86 or 33 days
This means that suppliers allow the company about 33 days to settle its dues

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Introduction to Financial Accounting. Page 11 of 15

(v) Stock/inventory turn over

It indicates the efficiency of the firm in selling its products so as to generate sales. It
shows the times the stock is turned over or converted into sales within a year. It also
shows how rapidly stock is being turned into cash through sales.
Stock/Inventory turn over = Cost of sales/Average stock
Example
Inventory turnover = 3053.66/(244.26+461.81):-2
= 3053.66/353.04 = 8.65 times
This means that the company turns its inventory of finished goods into sales 8.6 times in
a year (i.e. it holds average inventory for 12 months/8.6 = 1.4 months or 360/8.6 = 42
days)
(vi) Total assets turn over
It shows the firm’s ability to generate sales from all financial resources committed to
total assets
Total assets turn over = Sales/Total assets
Example
TA turn over = 3717.23/(746.83+1870.92)
= 3717.23/2617.75 = 1.42 times
This means that the company is able to generate sales of shs 1.42 for every shilling
investment in Non current assets and current assets
(vii) Non-current assets and current assets turn over
Non-current assets turn-over
This is the firms effectiveness in utilizing non-current assets
NCA turn over = Sales/Net NCA
Example
NCA turn over = 3717.23/746.83 = 4.98 times
Current assets turn over
Current assets turn over = sales/current assets
= 3717.23/1870.92 = 1.98
This means that the company turns over NCA faster as compared to current assets
Other ratios include:
 Stock days/inventory conversion period
 Cash working cycle/Operating cycle
 Cash turn over/ operating turn over

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Introduction to Financial Accounting. Page 12 of 15

d) Capital structure ratios/Gearing or leverage ratios

These ratios measure the extent to which a company uses its assets which have been
financed by non-owner supplied funds. They include:

(i) Debt ratio or capital gearing ratio

It measures the proportion of debt finance to capital employed by a company. If the

ratio is greater than 50%, then a company is highly geared.
Debt ratio = (Total long term debt/Capital employed) x 100%
Example:
Debt ratio = 1,229.06/1901.87
= 0.6462 x 100% = 64.62%
This means that lenders have financed 64.62% of XYZs net assets which means that
owners have only provided 34.38% of the net assets.

(ii) Debt equity ratio

This indicates the relationship between the external equities or outsiders funds (non-
owner supplied funds) and the internal equities or shareholders’ funds.
Debt equity ratio = Long term debt/Equity or net worth
Example
Debt equity ratio = Debt ratio = 1,229.06/672.81
= 1.83
This means that lenders contribution is 1.83 times that of owners contribution.
Debt to equity ratio indicates the proportionate claims of owners and the outsiders
against the firm’s assets. The purpose is to get an idea of the cushion available to
outsiders on the liquidation of the firm.

(iii) Times interest turn over

It shows the number of times earnings by a company cover its current payments (the
firm’s debt servicing capacity). The higher the ratio, the lower the gearing position and
thus the lower the financial risk
Times interest turn over = (EBIT + Depreciation)/Interest charged
Example:
Times interest turn over = (342.61 + 235.44)/143.46
= 4.03

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Introduction to Financial Accounting. Page 13 of 15

(iv) Capital employed to net worth ratio

This looks at the amount of funds being contributed together by lenders and owners for
each shilling of the owners’ contribution.
CE to NW ratio = capital employed/Net worth
Example:
CE to NW ratio = 1901.87/672.81
= 2.83

e) Shareholder ratios/Investment or equity ratios

These ratios are used to evaluate the overall performance of the firm. They include:

(i) Earnings per share (EPS)

It indicates the amount shareholders expect to generate in form of earnings for every share
invested. It shows the profitability of a company per share basis.
EPS = Earnings attributable to equity shareholders/No of ordinary shareholders
Example
EPS = PAT/No. of shares outstanding
EPS = 134.86/22.5 = shs 6

(ii) Dividend per share (DPS)

This represents the amount of cash dividend that shareholders expect to receive for every
share invested in the company.
DPS = Total ordinary dividends/No of ordinary shares
DPS = 45/22.5 = shs 2
This means that out of the shs 6 earned per share, the company distributed shs 2 per share
and retained shs 4 per share

(iii) Dividend pay-out ratio

Dividend per share/Earnings per share) x 100%

Example
Pay out ratio = DPS/EPS = 2/6 = 0.333 or 33.3%
This means that retained earnings is 66.7% of the earnings
What is the impact of this retention on growth of equity?

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 Introduction to Financial Accounting. Page 14 of 15

Growth in equity = retention ratio x ROE

Growth in equity = 0.667 x 0.20 = 0.1334
G = 13.3%

(iv) Price earnings ratio

Shows how much an investor is prepared to pay for a company’s share given its
current earnings per share. It reflects investors’ expectations about the growth of the
firms earnings.
Price earnings ratio = market price per share/earnings per share
Example
PER = MP/EPS
= 29.25/6 = 4.88

(v) Dividend yield

It measures how much an investor expects to receive from cash dividends for every
share purchased or invested in the company.
Dividend yield = (Dividend per share/market price per share) x 100%
DY = DPS/MV = 2/29.25 = 0.0684 = 6.84%

Other ratios
 Dividend retention ratio
(Retained earnings/Earnings attributable to equity shareholders) x 100%
 Dividend cover = EPS/DPS
 Earnings yield = EPS/Market price per share

7.3 Limitations of ratios

(i) Partial information - They only provide partial information mostly on what has happened
in the past (historical). Understanding the present and future conditions may not be easy
from these ratios
(ii) Comparing business from different sectors is not possible - They are only relevant for
businesses that are in the same sector. If the firms are from different sectors, then
comparison becomes difficult.

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 Introduction to Financial Accounting. Page 15 of 15

(iii) Subjectivity (Different accounting practices) - Different organisations use different

accounting policies and hence it is impossible to compare firms/companies that use
different accounting policies. Comparison using ratios therefore becomes impractical.
(iv) Ambiguity - People describe financial information differently and this brings in
ambiguity. For example, others would include preference share capital in equity or
return on capital employed (called gross capital employed) while others would not.
(v) Monopoly - Where a company has no competitors, its impossible to compare its
performance with other companies in the industry.
(vi) Short term measurements - Ratios are computed at a specific point in time and so they
may not be relevant for decision making since circumstances might have changed by the
time the decision is being made.
(vii) Ignores qualitative nature of the firm - Ratios do not consider aspects such as competent
management, experience and motivation of employees.

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