Slide 1
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 USERSDETAILS OF THE USERSOwners or Investors GroupShareholders or Stockholders, Sole Proprietors, PartnersEmployee GroupExisting employees, Potential employees, Trade unions, Management, etcLoan Creditor GroupDebenture holders, loan stockholders, bankers, other providers of debts.Business Contact GroupCustomers, suppliers, Clients, Bankers, Takeovers bidders, etcAdvisor or Analyst GroupEconomist, Statisticians, Researchers, Investment Advisors, Management Consultants, Credit Rating Agencies, etcGovernment BOG, IRS(now IRA), CEPS, Price and Income Board (PIB), Local government agencies, SEC, NICGeneral PublicPolitical parties, Pressure groups, Tax payers, Environmentalists, General community / PublicReasons 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
RATIOSFORMULAGross Profit MarginGross Profit / Sales or Turnover 100%Net Profit MarginNet 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 RatioExpenses / Sales 100%Interpretation of the Profitability Ratios
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.
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.
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
RATIOSFORMULACurrent RatioCurrent Assets/ Current Liabilities : 1Quick RatioCurrent Assets Stock/ Current Liabilities : 1Cash RatioCash & Cash Equivalent/ Current Liabilities : 1Interpretation of the Liquidity Ratios
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.
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.
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.
RATIOSFORMULAFixed Assets TurnoverSales/ Fixed Assets 100%Turnover Ratio Turnover/ Total Assets 100%Stock TurnoverCost of Sales/ Average Stock : 1Debtors Collection PeriodDebtors/ Credit Sales 365daysCreditors Payment PeriodCreditors / Credit Purchases 365daysInterpretation of the Activity Ratios
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
RATIOSFORMULADebt RatioTotal Debt/ Equity + Debt(Total Assets) 100%Debt to Equity RatioTotal Debt / Equity (Net Worth) 100%Interpretation of the Gearing Ratios
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.
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
RATIOSFORMULAEarnings per ShareProfit after Tax & Preference Dividends/ Number of Ordinary SharesDividend per ShareTotal Dividend/ Number of Ordinary SharesDividend CoverProfit after Tax & Preference Dividends/ Total Equity Dividend or DPSPrice/ Earnings Ratio(P/E Ratio)Market Price Per Ordinary Share/ Earnings per ShareEarnings YieldEarnings per Share / Market Price per ShareDividend YieldDividend per Share/ Market Price per ShareInterpretations of the Investment Ratios
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.
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.
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.
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.
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.
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
It simplifies the financial statements for easy understating.
It helps in financial planning and forecasting for businesses.
Facilitates inter-firm comparison to assess ones business performance relative to competitors.
It helps in investment decisions making.
Helps in trend analysis which involves comparing a single firm over a period.
Limitations of Ratio Analysis
Ratios are subject to the limitations of accounting methods.
It explains relationships between past information while users are more concerned about current and future information.
Financial accounting information is affected by estimates and assumptions, etc.
Seasonal Variations and economic
