WEEK TWO SLIDES

Introduction To Financial Statement

Analysis:
Lecture Outline
Meaning of Financial Statement
Users of Financial Information
Review of Financial Ratios Analysis
Advantages of Ratio Analysis
Disadvantages of Ratio Analysis

Financial Analysis
Basically, the financial statement by itself
worldwide focuses on the following;
Assessment of the firms past, present and future
financial conditions of firms
To find firms financial strengths and weaknesses
Primary Tool:
Financial Statements
Comparison of financial ratios to past industry, sector and all

firms.

Meaning of Financial Statements

Primarily, financial statement is a just a written report or

document which describes the financial health of a company or

firm quantitatively.

Financial Statements include;

Income Statement / Statement of Comprehensive Income
Statement of Financial Position according to International
Financial Reporting Standard (IFRS)
Cash flow Statements / Statement of Cash flows
Statement of Changes in Equity
Notes to the accounts

Users of Financial Information

The figure below discloses the various categories of users of financial information.
CATEGORY OF USERS

DETAILS OF THE USERS

Owners or Investors
Group

Shareholders or Stockholders, Sole Proprietors,

Partners

Employee Group

Existing employees, Potential employees, Trade

unions, Management, etc

Loan Creditor Group

Debenture holders, loan stockholders, bankers,

other providers of debts.

Business Contact Group

Customers, suppliers, Clients, Bankers,

Takeovers bidders, etc

Advisor or Analyst
Group

Economist, Statisticians, Researchers,

Investment Advisors, Management
Consultants, Credit Rating Agencies, etc

Government

BOG, IRS(now IRA), CEPS, Price and Income

Board (PIB), Local government agencies, SEC,
NIC

General Public

Political parties, Pressure groups, Tax payers,

Environmentalists, General community / Public

Reasons Why Users Must Interpret the Financial

Statement:
To encourage better decision making
For more on-time payment by debtors and to predict the

future cash flow.

To help keep information neatly organized for tax purposes.
To provide proof of business success to both managers and

investors.
To help cut down costly mistakes or errors such as theft,
fraud or illegal activities within the business, etc.

Reasons Why Users Must Interpret the Financial

Statement: (Contds)
To assess the liquidity of the entity.
To estimate the future prospects of the entity (i.e. its

capacity to pay dividends and other cash flows).

To attest to compliance with company law and other legal

obligations
To ascertain the ownership and control of the entity.

Financial Ratios Analysis

The financial analyst needs certain yardsticks to evaluate the
financial condition and performance of a firm.
The yardsticks used is the ratio or index analysis. Here, relevant
ratios can be grouped into the following headings;
Profitability Ratios
Liquidity Ratios
Solvency Ratios
Activity Ratios or Efficiency Ratios
Gearing or Leverage Ratios
Investment Ratios

Profitability Ratios Analysis

There are many measures of profitability. As

a group, these measures enables analysts

to evaluate the firms profits with respect to
a given level of sales, a certain level of
assets or the owners investment.
Without profits, a firm could not attract

outside capital

1. List of Profitability Ratios

RATIOS

FORMULA

Gross Profit Margin

Gross Profit / Sales or Turnover

100%

Net Profit Margin

Net Profit / Sales or Turnover

100%

Return on Capital Employed

(ROCE)

EBIT/ Net Assets 100%

Return on Equity (ROE)

EAT & PD/ Ordinary Share Fund

100%

Return on Asset (ROA)

EAIT / Total Assets 100%

Expenses to Sales Ratio

Expenses / Sales 100%

Interpretation of the Profitability Ratios

a. Gross Profit Margin: Gross profit or sales profit is the difference

between revenue and the cost of making a product or providing a

service, before deducting other payments. This ratio explains how
a firms profit is obtained from it core activities /business. The
higher gross profit margin is desirable in any firm.
b. Net Profit Margin: It measures the relationship between net profit

and sales where the higher the ratio the better amount of money
the firm has.
c. Return on Capital Employed (ROCE): This ratio indicates and

measures the efficiency and profitability of a companys capital

investment.

Interpretation of the Profitability Ratios (contd)

d. Return on Equity: It measures the relationship between net

profit after tax and preference dividend and ordinary share

capital of a company. However, the higher this return the better
off are the owners in terms of earning on the common
stockholders investment in the firm.
e. Return on Assets: It shows how much returns the company has and
the higher the firms return on total assets, the better effectiveness of
management in generating profits with it available assets.
f. Expenses to Sales: this ratio explains the proportion of sales that is
used for the payment of expenses.

2. List of Liquidity or Short-Term Solvency Ratio

RATIOS

FORMULA

Current Ratio

Current Assets/
Current Liabilities : 1

Quick Ratio

Current Assets Stock/

Current Liabilities : 1

Cash Ratio

Cash & Cash

Equivalent/ Current
Liabilities : 1

Interpretation of the Liquidity Ratios

a.

Current Ratio: This ratio expresses the number of times

currents assets can be used to settle current liabilities. The
higher the current ratio, the more capable the
company is of paying its obligations.

b. Quick (Acid Test) Ratio: The quick ratio is more conservative

than the current ratio because it excludes inventories from

current assets to cover its immediate liabilities.
c.

Cash Ratio: This ratio to determine how quickly, the company

can repay its short-term debt. It is useful to creditors when
deciding how much debt, if any they would be willing to extend
to the asking party.

3. List of Activity or Efficiency (Assets Utilization) Ratios;

These ratios are important in determining whether a company's
management is doing a good enough job of generating revenues, cash,
etc. from its resources.
RATIOS

FORMULA

Fixed Assets
Turnover
Turnover Ratio

Sales/ Fixed Assets 100%

Stock Turnover

Cost of Sales/ Average Stock

:1

Debtors Collection
Period

Debtors/ Credit Sales

365days

Creditors Payment
Period

Creditors / Credit Purchases

365days

Turnover/ Total Assets

100%

Interpretation of the Activity Ratios

a.

b.
c.

d.
e.

Fixed Assets Turnover: this ratio simply measures how effectively

fixed assets are being used to generate sales. A low fixed assets
turnover implies that a firm has too much investment in fixed assets
relative to sales.
Turnover Ratio: It measures the number of times a companys
inventory is replaced during a given time period.
Stock Turnover: This ratio measures the number of times a
company's investment in inventory is turned over during a given year.
The higher the turnover ratio, the better, because a high turnover
requires a smaller investment in inventory than one producing the
same level of sales with a low turnover rate
Debtors Collection Period: It shows how efficient a company is in
collecting it debts.
Creditors Payment Period: This ratio indicates how a company
uses short-term finances to fund its debts or goods bought on credit.

List of Gearing or Leverage or Long-Term

Solvency Ratios
RATIOS

FORMULA

Debt Ratio

Total Debt/ Equity +

Debt(Total Assets)
100%

Debt to Equity Ratio

Total Debt / Equity

(Net Worth) 100%

Interpretation of the Gearing Ratios

a. Debt Ratio: A debt ratio is a measure of how risky it would

be for a bank to extend a loan to a company, with a higher

ratio indicating great risk.
b. Debt-to-Equity Ratio: The debt to equity ratio shows the

percentage of company financing that comes from creditors

and investors. A higher debt to equity ratio indicates that
more creditor financing (bank loans) is used than investor
financing (shareholders).

4. List

of Investment Ratios

RATIOS

FORMULA

Earnings per Share

Profit after Tax & Preference

Dividends/ Number of Ordinary
Shares

Dividend per Share

Total Dividend/ Number of

Ordinary Shares

Dividend Cover

Profit after Tax & Preference

Dividends/ Total Equity Dividend
or DPS

Price/ Earnings
Ratio(P/E Ratio)
Earnings Yield

Market Price Per Ordinary Share/

Earnings per Share

Dividend Yield

Dividend per Share/ Market

Price per Share

Earnings per Share / Market

Price per Share

Interpretations of the Investment Ratios

a. Earnings Per Share (EPS): Is the portion of a companys profit

that is allocated to each outstanding share of common stock,

serving as an indicator of the companys profitability.
b. Dividend Per Share (DPS): Dividends are a form of profit

distribution to the shareholder. Having a growing dividend per

share can be a sign that the company's management believes that
the growth can be sustained in a particular accounting year.
c.

Dividend Cover: Dividend cover is the ratio of company's net

income over the dividend paid to shareholders. It helps indicate
how sustainable a dividend payment is within a given period.

d. Price Earning Ratio: The P/E is sometimes referred to as the

"multiple", because it shows how much investors are willing

to pay per dollar of earnings.
e. Earnings Yield: this ratio usually indicates the potential

return on investment. Again, this ratio is used by many

investment managers to determine optimal asset allocations.
f. Dividend Yield: Dividend yield is a way to measure how

much cash flow you are getting for each dollar invested in an
equity position

Advantages of Ratio Analysis

Limitations of Ratio Analysis