FMA-CH-3_1.ppt

Financial Analysis and Planning
CHAPTER THREE

Introduction
 Most business organizations prepare classified
financial statements, meaning that items with certain
characteristics are placed together in a group, or
classification
 In comparative financial statements, the financial
statement amounts for more than one accounting
period appear side by side in vertical columns. This
assists investors in identifying and evaluating
significant changes and trends.
 Financial statement analysis is used by internal
and external stakeholders to evaluate business
performance and position. 2

 Consolidated financial statements present
the financial position and operating results of
the parent company and its subsidiaries as if
they were a single business organization

Common Size Statements
 Common size, or vertical analysis, is a method
of evaluating financial information by expressing
each item in a financial statement as a
percentage of a base amount for the same time
period.
 A company can use this analysis on its balance
sheet or its income statement.
4

Trend analysis
 Trend analysis refers to the process of
collecting data from multiple different
periods (sometimes referred to as time series
data analysis), before plotting the data on a
horizontal line for review.
 Trend analysis is based on the idea that what has
happened in the past gives traders an idea of what
will happen in the future.
 Trend analysis focuses on three typical time
horizons: short-; intermediate-; and long-term.
6

Trend analysis
 By comparing data over a specific period, you can
spot patterns and project future events
 Trend Ratio Analysis. The comparison of the
successive values of each ratio for a single firm
over a number of years..
7

Tools of Analysis
 Four widely used analytical techniques are
 (1) Dollar and percentage changes,
 (2) Trend percentages,
 (3) Component percentages, and
 (4) Ratios

(1) Dollar and percentage changes
 The dollar amount of any change is the
difference between the amount for a
comparison year and the amount for a base
year.
 The percentage change is computed by
dividing the amount of the dollar change
between years by the amount for the
previous year.

(2) Trend percentages
 show the extent and direction of change.
 Two steps: First, a base year is selected and each item in
the financial statements for the base year is given a weight
of 100 percent. The second step is to express each item in
the financial statements for following years as a
percentage of its base year amount.

3. COMPONENT PERCENTAGES
 Indicate the relative size of each item included in a
total.
 Each item in a balance sheet could be expressed as a
percentage of total assets.
 all items in an income statement as a percentage of net
sales. Such a statement is called a common size
income statement.

4. RATIOS
 A ratio is a mathematical expression of the relationship
of one item to another.
 Every percentage may be viewed as a ratio that is, one
number expressed as a percentage of another.
 Standards of Comparison: Two commonly used
standards are (1) the past performance (comparison of
data over time is sometimes called horizontal analysis,
to express the idea of reviewing data for a number of
consecutive periods. It is distinguished from vertical, or
static, analysis, which refers to the review of the financial
information within a single accounting period) and
(2) the performance of other companies in
the same industry

Types of financial ratios
1. Liquidity ratios
 Liquidity refers to a company’s ability to meet its
continuing obligations as they come due.
A. Current Ratio: measures the ability of the firm
to meet short-term obligations from its current
assets.
Current Ratio = Current Assets
Current Liabilities
 To be desirable, current ratio should be greater than or
equal to the standard
 Working capital is the excess of current assets over
current liabilities

Current Ratio = 180,000 = 1.8 times
100,000
 Industry average is 1.6 times, so this
company is desirable.
 Working capital is the excess of current assets
over current liabilities.
 Current assets . . . . . . . . . . .. . . . $180,000
 Less: Current liabilities . . . . . . . . 100,000
 Working capital . . . . . . . . . . . . . . $ 80,000
B. Quick Ratio
 The quick ratio compares only the most liquid
current assets called quick assets with current
liabilities.

 Quick assets $106,000
 Current liabilities $100,000
 Quick ratio ($106,000 ÷ $100,000) =1.06

Asset Management Ratios
 Measure how effectively the firm is managing it’s assets
A. Inventory Turnover Ratio
 Show how many times inventory is “turned over” during
the year
 Inventory Turnover Ratio = COGS/Average inventory
ITO (2017) = $420,000/$110,000 = 3.8 times
ITO (2018) = 530000/150,000 =3.5 times

B. Average Age of Inventory
 Average number of days to sell inventory = 365/
Inventory Turnover Ratio
 Average number of days to sell inventory 2017 = 365/3.8
= 96 days
 Average number of days to sell inventory 2017 =
365/3.5= 104 days

Income statement
30/09/2023 Zewdie Bezabih 21
Items 2014 2015
Net sales(on credit)
Less: Cost of Goods Sold
Gross profit on sale
Less: Selling & administrative expenses
Earning before interest and taxes
Less: Interest expense
Income before taxes
Less: Income taxes (40%)
Net income
Less: Common dividends
Increase in retained earnings
15,000
5000
10,000
2,800
7,200
1710
5,490
2,196
3,294
400
2,894
18,000
6,000
12,000
3,000
9,000
1,800
7,200
2880
4,320
600
3,720

Balance Sheet
Assets:
Cash & marketable securities…………....
Accounts Receivable ……………….
Inventories ……………………………….
Fixed Assets (net)…………………………
Total assets………………………………..
2014 2015
5,000
4,000
6,000
35,000
50,000
6,000
5,000
8,000
41,000
60,000
Liabilities and Stockholders’ Equity
Liabilities:
Accounts payable ……………………….
Short-term Notes Payable ……………….
Accruals …………………………………..
Long-term debts …………………………..
Total Liabilities…………………………..
Stockholders’ Equity:
Common stock …………………………
Retained earnings………………………..
Total stockholders’ equity……………….
Total Liabilities & stockholders’ equity ….
4,000
2,600
3,000
14,400
24,000
16,000
10,000
26,000
50,000
5,000
3,000
2,000
15,000
25,000
23,000
12,000
35,000
60,000

 There were 3,000,000 shares and 4,400,000
shares of common stock in 2014 and 2015
respectively.
 Selling and administrative expenses include
rent of Br. 200,000 in 2014 and Br. 220,000 in
2015.
 The market prices per share are Br. 10 and Br.
12 in 2014 and 2015, respectively

C. Receivables Turn over Ratios
 This ratio tells us the number of times accounts receivable have
been turned over (turned into cash) during the year. This ratio is
calculated by dividing credit sales by ending balance of accounts
receivable.
 Receivable Turn over = Annual Credit Sales
Av. Accounts Receivable
 Grace Company’s Receivable Turnover is computed as follows:
 Receivable Turnover (2014) = 15,000
4,000 = 3.75 times
 Receivable Turnover (2015) = 18,000
4,500 = 4 times
 To be desirable, receivable turnover should be greater than or equal to the
standard. As a result, Grace company’s receivable turnover for 2015 is
desirable as compared to that of 2014.

D. Average Collection period (ACP) or
Receivables turn over in days
 It measures the number of days on average that it will
take to collect its outstanding receivables
 Receivable Turn Over in Days (RTD), Days Sales Outstanding or Average
Collection Period (ACP), is calculated as:
 ACP = _365_________
Receivable turn over
 Using Grace Company data, ACP is computed as follows:
 ACP (2014)= 365__ = 97 days
3.75
 ACP (2015)= 365__ = 91 days
4
 ACP figure tells us the average number of days that receivables are outstanding
before being collected. Generally, a lower ACP is desirable. Grace Company’s
ACP for 2015 is undesirable as compared to that of 2014.

E. Total Assets Turn Over Ratios (TATO)
 This ratio shows the firm’s ability in generating
sales from all financial resources committed to total
assets.
TATO = ____Sales___
Total Assets
Given Grace company’s data, total assets turnover is
computed as follows:
TATO (2014) = 15,000_ = 0.30
50,000
TATO (2015) = 18,000__ = 0.30
60,000
To be desirable, Total Assets Turnover should be
greater than or equal to the standard. Thus, total asset
turnover of Grace Company for 2015 is desirable as
compared to that of 2014.

F. Fixed Assets Turnover (FATO)
 It is used to measure how effectively the firm uses its
plant assets in generating sales. Fixed Assets turnover
is computed as follows:
 FATO = __Sales___
Fixed Assets
 Using Grace Company’s data, fixed assets turnover is
computed as follows:
 FATO (2014) = 15,000_ = 0.43
35,000
FATO (2015) = 18,000_ = 0.44
41,000
To be desirable, fixed assets turnover should be greater
than or equal to the standard. There fore, Grace
Company’s fixed assets turnover for 2015 is desirable as
compared to that of 2014.

3. Leverage (Debt Management) Ratios
 used to evaluate the extent to which the firm uses debt financing.
 They indicate the debt burden of the firm. Different debt
management ratios are used to evaluate the debt burden of the firm.
i. Debt Ratio
 also called total debt-to-total assets (D/A) ratio, measures the
extent to which the firm is using borrowed money. It may be
calculated as follows:
Debt ratio = Total Liabilities
Total Assets
For Grace company, debt ratio is computed as follows:
Debt ratio (2014) = 24,000 = 0.48
50,000
Debt ratio (2015) = 25,000 = 0.42
60,000
Generally, creditors would like a lower debt ratio to be desirable.
When compared with 2014, Grace Company’s debt ratio is desirable
in 2015.

ii. Debt- to- Equity (D/E) ratio
 measures the proportion of debt capital in terms of
equity capital.
Debt-to-Equity Ratio = Total Liabilities
Shareholders’ Equity
 Creditors would generally like this ratio to be low. The lower
the ratio, the higher the level of the firm’s financing that is
being provided by shareholders and the larger the creditor
cushion (margin of protection) in the event of shrinking asset
values or outright losses.
Debt-to- Equity ratio may also be computed as follows:
D/E = D/A D = Debts A = Assets
1 – D/A E = Stockholders’ equity
From Grace company example, debt ratio for 2014 is
48% and D/E ratio is Equal to:
D/E = 0.48_ = 0.92
1 – 0.48

III. Equity Multiplier
It measures the extent to which the
firm uses debt financing in its capital
structure.
 Equity Multiplier = Total Assets________
Total stockholders’ Equity
Equity Multiplier (2014) = 50,000 = 1.92
26,000
Equity Multiplier (2015) = 60,000 = 1.71
35,000
 A lower equity multiplier is desirable

IV. Times Interest Earned (TIE) ratio
 measure the ability of the firm to meet interest
obligations from its profits.
TIE = Earning before interest and taxes
Interest Expense
Using Grace company’s data, times interest earned ratio is
calculated as follows:
TIE (2014) = 7200 = 4.21 times
1710
TIE (2015) = 9000 = 5 times
1800
To be desirable, times interest earned ratio should be
greater than or equal to the standard. Is Times Interest
Earned ratio for Grace Company for 2015 desirable as
compared to that 2014?

4. PROFITABILITY RATIOS
 Used to evaluate the earning power of the firm with
respect to given level of sales, total assets, and owner’s
equity.
 They measure the combined effect of asset
management, debt management, and liquidity on the
profitability of the firm.
 It includes:
 Gross profit margin
 Net profit margin
 Return on Investment (ROI)
 Return on Equity (ROE)
 Earning Per share (EPS)
 Dividend Per Share (DPS) and Dividend pay out ratio (DPO)

A. Gross Profit Margin
 This ratio indicates the percentage of each sale Birr
remaining after deducting the cost of goods sold.
The ratio reflects management’s effectiveness in
pricing policy, generating sales, and production
efficiency (i.e. how well the purchase or production
cost of goods is controlled).
 Gross Profit Margin = Gross Profit
Net Sales
Using Grace company data, gross profit margin ratio is computed
as follows:
 Gross Profit Margin (2014) = 10,000 = 0.67
15,000
 Gross Profit Margin (2015) = 12,000 = 0.67
18,000

B. Net Profit Margin
 It measures the percentage of each sale Birr remaining after
deducting all expenses.
 Shows the earnings left for shareholders (both common &
preferred) as a percentage of net sales.
Net Profit Margin = Net Income
Net Sales
For Grace company, net profit margin is calculated as
follows:
Net Profit margin (2014) = 3294 = 21.96%
15,000
Net Profit margin (2015) = 4320 = 24%
18,000
To be desirable, net profit margin ratio should be greater than or
equal to the standard. Accordingly, since net profit margin ratio of
2015 is greater than that of 2014, it is considered desirable.

C. Return on investment (ROI)
 Also called Return on Assets (ROA)
It measures the amount of profit generated on
investments in assets.
ROI (ROA) = Net Income
Total Assets
Grace Company’s return on investments is computed as
follows:
ROI (2014) = 3294 = 6.6%
50,000
ROI (2015) = 4320 = 7.2%
60,000
Generally, a higher ROA is desirable.

D. Return on Equity (ROE)
 It measures the rate of return realized by a firm’s
stockholders on their investment and serves as an
indicator of management performance.
 ROE measures the return earned on the owners’
investment.
 ROE also called the Return on Stockholders Equity
or Return on Net Worth. It measures corporate
profitability per Birr of equity capital. The
shareholders equity will include common stock,
preferred stock, premium on common, & preferred
stock, and retained earnings.
 Return on equity (ROE) = Net Income____
Stockholders equity
 ROE (2014) = 3294 = 12.7%
26,000
 ROE (2015) = 4320 = 12.3%
35,000

E. Earnings Per share (EPS)
 It expresses the profit earned per common share by a
corporation during the reporting period. It provides a measure of
over all performance.
 It shows the profitability of the firm on a per share basis, it
does not reflect how much is paid as dividend and how much is
retained in the business..
 EPS = Earnings Available to common stock
Number of common stock outstanding
EPS = Net Income - Preferred stock dividend
Number of common shares outstanding
EPS (2014) = 3294 - 0 = 1.098
3000
EPS (2015) = 4320 - 0 = 0.98
4400
Generally, a higher earning per share is desirable.

F. Dividend per share (DPS)
 It represents the Birr amount of cash dividends a
corporation paid on each share of its common stock
outstanding during the reporting period.
DPS = Cash Dividends on Common stock
Number of Common shares outstanding
DPS (2014) = 400 = 0.13
3000
DPS (2015) = 600 = 0.14
4400
G. Payout ratio
It shows the percentage of earnings paid to stockholders. That
is, the payout ratio expresses the cash dividend paid per share
as a percentage of EPS.
Pay Out Ratio = Dividend Per Share
Earnings Per Share
Payout ratio (2014) = 0.13/1.098 = 0.12
Payout ratio (2015) = 0.14/0.98 = 0.14

5. Marketability Ratios
 They measure the perception of the future
earning power of the company by the market.
 Used primarily for investment decisions and
long-range planning.
 They rely on financial market data, such as
the market price of securities. The major
marketability ratios are:
 Price / Earning (P/E) Ratio
 Market-to-Book (M/B)ratio

A. Price- Earning (P/E) Ratio
 The level of the P/E ratio indicates the degree of
confidence (or certainty) that investors have in the firm’s
future performance.
 The P/E ratio represents the amount investors are willing
to pay for each dollar of the firm’s earnings. If investors
believe that a firm’s future earnings potential is good, they
may be willing to pay a higher price for the stock and thus
boost its P/E.
Price Earnings Ratio = Market Price per share
Earning per share
P/E ratio (2014) = 10/1.098 = 9.12
P/E ratio (2015) = 12/0.98 = 12.24
** P/E ratio has to be interpreted with caution because it may
rise if earnings dropped while the market price of stock rises.

B. Market-to Book ratio
 It measures whether the firm has created value for its
shareholders. If M/B ratio is greater than 1, it is said that the
firm has created value for its shareholders.
 If M/B ratio is less than 1, the value of the firm has declined.
 M/B ratio is computed as the ratio of Market price per
share to book value per share. Book value per share is
determined by dividing total stockholders’ equity by Number
of common stock outstanding.
 Book value per share (2014) = 26,000/3000 = 8.67
 M/B ratio (2014) = 10/8.67 = 1.15
 Book value per share (2015) = 35,000/4400 = 7.95
 M/B ratio (2015) = 12/7.95 = 1.51
 Grace Company has created value for its shareholders in both
years since M/B ratio is greater than 1.

Limitations of Ratio Analysis
 It is difficult to develop meaningful set of industry
averages for comparative purposes, especially for a
firm, which operates a number of different divisions.
 Inflation has badly distorted the firm’s financial
statements
 Seasonal factors can distort a ratio analysis.
 Firms can employ “window dressing” techniques to
make their financial statements look stronger.
 Different accounting practices can distort
comparisons.
 It is difficult to generalize about whether a particular
ratio is ”good” or “bad”
 it is based on historical data

Z-score
 Altman developed to estimate the chances of a
company going bankrupt.
 The formula looks at working capital, retained
earnings, and EBIT, all relative to a firm's total
assets.
 A Z-score above 3.0 signals good financial health,
while a score below 1.8 suggests a high risk of
bankruptcy

Z-score=(1.2×A)+(1.4×B)+(3.3×C)+(0.6×D) +(1.0×E)
where:
A=Working Capital ÷ Total Assets (15,000,000 –
9,600,000) /50,000,000 = 0.108
B=Retained Earnings ÷ Total Assets
26,000,000/50,000,000 = 0.52
C=Earnings Before Interest & Tax ÷ Total Assets
(7,200,000/50,000,000 = 0.144
D =Market Value of Equity ÷ Total Liabilities (3,000,000
/50,000,000 = 0.06
E=Sales ÷ Total Assets (15,000,000 /50,000,000 = 0.3
Z-score=(1.2×0.108)+(1.4×0.52)+(3.3×0.144) +(0.6×0.6) +(1.0×0.3) =
5.23 So, the company has no risk of bankruptcy

End of the chapter

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