LECTURE EIGHT ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT 8.

1 Introduction
Financial statements are essentially historical and static documents. They tell us what has happened during a particular period or series of periods of time. The most valuable information to most users of financial statements or reports, however, concerns what probably will happen in the future. In this lecture we will discuss how financial statement analysis can assist statement users in predicting the future by means of comparing and evaluating financial trends and cross-sectional positions of firms. Objectives At the end of this lecture you should be able to: 1. 2. 3. Discuss the needs of the users of financial statements. Discuss the types of comparison used in financial statement analysis Compute financial ratios and use them to evaluate financial strengths and weaknesses 4. 5. 6. Use the Dupont system to carry out a complete ratio analysis of the firm Explain common size and index analysis Discuss the limitations of financial statement analysis

8.2 DEFINITION AND OBJECTIVES OF FINANCIAL ANALYSIS

Financial analysis is the process or critically examining in detail, accounting information given in financial statements and reports. It is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of a firms performance. Financial statement analysis involves three basic procedures: Selection This involves the selection from the total information available about an enterprise, the information that is relevant to the decision under consideration. Relation This involves arranging the information in a manner that will bring out a significant relationship(s). Evaluation This involves the study of the relationship and interpretation of the result thereof. The specific objectives of financial statement analysis are to: (a). assess the past, present and future earnings of an enterprise, (b). assess the operational efficiency of the firms a whole and its various divisions or departments (c). asses the short term and tong term solvency of the firm, (d). assess the performance of one firm against another or the industry as whole and the performance of one division against another. (e) Assist in the developing of forecasts and preparing of budgets, (f) Assess the financial stability of the business under review, and (g) Assist in the understanding of the real meaning and significance of financial Information. Financial statements are essentially a record of the past. Business decisions naturally affect the future. Analysts therefore study financial statements as evidence of past performance that may be used in the prediction of future performance. 2

8.3 SOURCES OF INFORMATION

The first procedure in financial statement analysis is to obtain useful information. The main sources of financial information include, but are not limited to, the following; Published reports Quoted companies normally issue both interim and annual reports, which contain comparative financial statements and notes thereto. Supplementary financial information and management discussion as well as analysis of the comparative years' operations and prospects for the future will also be available. These reports are normally made available to the public as well as the shareholders of the company. Registrar of Companies Public companies are required by law to file annual reports with the registrar of companies. These reports are available for perusal upon payment of a minimum fee. Credit and Investment Advisory Agencies Some firms specialize in compiling financial information for investors in annual supplements. Many trade associations also collect and publish financial information for enterprises in various industries. Major stock brokerage firms and investment advisory services compile financial information about public enterprises and make it available to their customers. Some brokerage firms maintain a staff or research analysis department that study business conditions, review published financial statements, meet with chief executives of enterprises to obtain information on new products, industry trends, negative changes and interpret the information for their clients. Audit Reports When an independent auditor performs an audit the audit report-is usually addressed to the shareholders of the audited enterprise. The audit firms frequently also prepare a management report, which deals with a wide variety of Issues encountered in the course of the audit Such a management report is not a public document, however, it is a useful source of financial information. 3

Government Statistics and Market Research Organizations

8.4 COMPARISONS IN FINANCIAL ANALYSIS

The figures in the financial statements are rarely significant or important in themselves. It is their relationships to other quantities, amounts and the direction of change from one point in time to another point in time that is of importance. It is only through comparison of data that one can gain insight and make intelligent judgments. Analysis thus involves establishing significant relationships that points to changes as well as trends. The two comparisons widely used for analytical purpose involve trend and crosssectional analyses.

Trend Analysis
This is also known as time series analysis, horizontal analysis or temporally analysis. It involves the comparison of the present performance with the result of previous periods for the same enterprise. Trend analysis is therefore usually employed when financial data is available for three or more periods. Developing trends can be seen by using multiyear comparisons and knowledge of these trends can assist in controlling current operations and planning for the future. It can be carried out by computing percentages for the element of the financial statement that is under observation. Trend percentage analysis states several years' financial data in terms of a base year, which is set to be equal to 100%. In conducting trend analysis the following need to be taken into account: (i) Accounting principles and policies employed in the preparation of financial statement must be followed consistently for the periods for which an analysis is being made to allow comparability. (ii) (iii) The base year selected must be normal and a representative year. Trend percentages should be calculated only for these items, which

have logical relationship. 4

(iv) (v) Example

Trend percentages should be carefully studied after considering the To make meaningful comparisons, trend percentage should be

absolute figures, otherwise they may lead to misleading conclusions. adjusted in light of price changes to the base year. Assume that the following data is extracted from the books of ABC Ltd.

2004 Sh. Million sales 725 Net income 99

2003 Sh. Million 700 97.5

2002 Sh. Million 650 93.75

2001 Sh. Million 575 86.25

2000 Sh. Million 500 75

From the above absolute figures, there appears to be a general increase in safes and income over the years. When expressing the above date in terms of percentages with 2000 being the base year, the following trend percentage is observed.

. Sales Net Income Net income/Sales

2004 145% 132 % 13.7%

2003 140% 130 % 13.9%

2002 130% 125 % 14.4%

2001 115% 115 % 15%

2000 100% 100 % 15%

From the above table it can be observed that: i) ii) Sales and net income have grown over the years but at a 'increasing rate, Net income has not kept pace with growth in sates. When net income is

expressed as a percentage of rates,

iii)

It is further observed that net income as a percentage of sates is decreasing

over the years and this needs to be investigated.

Financial statement analysis is not an end by itself; rather the analyses enable the right questions, for which management has to look for answers.

Graph

percentage 150 140 130 120 110 100 2000 2001 2002 2003 2004 years 6

percentage 150 140 130 120 110 100 2000 2001 2002 2003 2004 years

From the line graph, one can observe that the growth rate for sales has decreased. The same applies is net income as shown by the slope of the curves. One may also conclude from the curves that between 2001 and 2000 sales and income have grown at the same rate. Subsequently, growth in net income failed to keep pace with the growth in sates. Problems of Trend analysis (a). To ensure comparability of figures, the results of each year will have to be adjusted using consistent accounting policies. The task of adjusting statements to bring them to a common basis could be taunting. (b). Comparison becomes difficult when the unit of measurement changes in value due to general inflation. Comparisons become quite difficult over time. 7

(c). If the enterprise's environment changes over time with the result that performance that was considered satisfactory in the past may no longer be considered so. More specific measures rather than general trends may be preferred in such instances.

Cross Sectional Analysis

This involves the comparison of the financial performance of a company against other companies within its industry or industry averages at the same point in time. It may simply involve comparison of the present performance or a trend of the past performance. The idea under this approach is to use bench-marking, whereby areas in which the company excels benchmark companies are identified, and more importantly areas that need improvement highlighted. The typical bench-marks used in cross-sectional analysis may be a comparable company, a leader in the industry, an average firm or industry norms (averages). Problems Of Cross Sectional Analysis (a). It is difficult to find a comparable firm within the same industry. This is because firms may have businesses which are diversified to a greater or lesser extent. Further, industry averages are not particularly useful when analyzing firms with multi-product lines. The choice of the appropriate benchmark industry for such firms is a difficult task. (b). Businesses operating in the same Industry may be substantially different in that, they may manufacture tile same product but one may be using rented equipment while the another uses its own making comparison difficult . (c). Two firms may use accounting policies, which are quite different resulting in difference m financial statements It is usually very difficult for an external user to identify differences in accounting policies yet one must bear them in mind when interpreting two sets of accounts. (d). The analyst must recognize that ratios with large deviations from the norm are only the symptoms of a problem. Once the reason for the problem is known 8

management must develop prescriptive actions for eliminating it. The point to keep in mind is that ratio analysis merely directs attention to potential areas of concern; it does not provide conclusive evidence as to the existence of a problem.

8.4 RATIOS
The most common tools of financial analysis are ratios. A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A ratio may be expressed as a percentage, as a fraction, or a stated comparison between two amounts. The computation of a ratio does not add any information not already existing in the amount or amounts under study. A useful ratio may be computed only when a significant relationship exists between two amounts. A ratio of two unrelated amounts is meaningless. It should be re-emphasized that a ratio by itself is useless, unless compared with the same ratio over a period of time and/or a similar ratio for a different company and the industry. Ratios focus attention on relationships which are significant but the full interpretation of a ratio usually requires, further investigation of the underlying data. Thus ratios are an aid to analysis and interpretation and not a substitute for sound thinking.

8.4.1

Classification of Ratios

Financial ratios may grouped into four basic categories: liquidity ratios, debt ratios, activity ratios and profitability and investment ratios. Liquidity Ratios. Liquidity refers to an enterprise's ability to meet its short-term obligations as and when they fall due. Liquidity ratios are used to assess the adequacy of a firms working capital. Shortfalls in working capital may lead to inability to pay bills and disruptions in operations, which may be the forerunner to bankruptcy. The tree basic measures of liquidity are (1) net working capital, (2) the current ratio, and (3) the quick (acid-test) ratio. As will become clear, for all the three measures, the higher their values the more 9

liquid the firm is. It should however be emphasized that excessive liquidity sacrifices profitability even as inadequate liquidity may lead to insolvency a trade-off exists between profitability and liquidity (risk).

Net Working Capital Net working capital ,although not a ratio is a common measure of a firms overall liquidity it is calculated as follows: Net working capital = current assets current liabilities Net working capital represents current assets that are financed from long term capital resources that do not require repayment in the short-run, implying that the portion is still available for repayment of short-term debts. Example 2004 Sh.000 Current assets 26,400 Current liabilities (13,160) Net working capital 13,240 2003 Sh.000 15,600 (6,400) 9,200.

In the year 2003 Sh.9.2 million of working capital is available to repay Sh.6.4 million of current liabilities and in 2004 Sh.13.24 million is available of working capital to pay sh.l3.16 million of current liabilities. This reflects a strong liquidity position in the years. The figure of net working capital, being an absolute figure requires standardization before its use for comparing performance of different firms. For example net working capital as a percent of sales can be calculated and used for such comparison. A timeseries comparison of the firms net working capital is often helpful in evaluating its operations.

Current ratio The current ratio is one of the most commonly cited financial ratios and tests, in short-term, the debt-paying ability of an enterprise. A high current ratio is assumed to indicate a strong liquidity position while a low current ratio is assumed to indicate a relatively weak liquidity position. The RULE of the thumb is that current-assets 10

should be twice current liabilities. The current ratio is expressed as follows:

Current ratio = Current assets / Current liabilities Example Using the data from the previous example the current ratios for the two years is arrived as follows. 2004 26400 /13,160 = 2: 1 2003 15600/6400 = 2.4: 1

Observation The enterprise appears to nave a strong liquidity position. There has been, however, a slight drop from year 2003 to year 2004. For every shilling that is owed in 2004, the firm has Sh.2 to pay the debt and for every shilling0wed in 2003 , the firm has Sh.2.40 available to meet the liability. If the firms current ratio is divided into 1.0 and the resulting value is subtracted from 1.0, the difference when multiplied by 100 represents the percent by which the firms current assets can shrink without making it impossible for the firm to cover its current liabilities. A current ratio of 2 means that the firm can still cover its current liabilities even if its current assets shrink by 50 percent ([1.0 (1.0/2.0)]* 100). Quick ratio or Acid test ratio. The current ratio has further been refined to Quick ratio or Acid Test Ratio. This ratio tests the short-term debt paying ability of an enterprise without having to rely on inventory and prepayments Inventories are generally the least liquid current asset and prepayments are generally not convertible to cash. Therefore for a company whose inventories include work-in-progress, and slow-moving items the quick ratio is a better indicator of liquidity than the current ratio. The rule of the thumb is for every shilling of

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current liability owed, the enterprise should have a shilling of current quick assets available to meet it i.e. a quick ratio of 1.0. It is given by; (Current assets-inventories-prepayments)/(Current liabilities) Activity Ratios Activity ratios measure the speed with which accounts are converted into sales or cash. Activity ratios can be categorized into two groups: The first group measures the activity of the most i9mportant current accounts, which include inventory, accounts receivable, and accounts payable1. The second group measures the efficiency of utilization of total assets and fixed assets. Inventory Ratios Average sales period ( Age of inventory) This ratio measures the average number of days taken to sell the average inventory carried by a firm. It is given by: (Average inventory x 365 days )/(Cost of sales) Where, average inventory =(Beginning inventory+ Ending inventory)/2

Inventory turnover ratio. Inventory turnover ratio measure the number of times a company's inventory has been sold during the year. Inventory turnover = Cost of sales/Average Inventory

Accounts Receivable Ratios Average Collection Period (Age of accounts receivable or days sales outstanding) The ratio measures the average number of days taken by an enterprise to collect its trade receivables. The ratio is computed as follows
1

In order to calculate activity ratios using current accounts the averages of these amounts during the year are preferred.. These averages can be approximated by summing the beginning-of-year and the-end-of year account balances and dividing by 2. When data needed to find the averages are unavailable, year-end values may be used to calculate activity ratios for current accounts.

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(Average trade receivables X 365 days)/ (Credit sales) Or, 365 days/(Accounts receivable turnover ratio) Where, average trade receivables = (Beginning + Ending trade receivables)/2 The average collection period should only be judged in relation to a firms credit terms. Only then can one draw definitive conclusions about the effectiveness of a firms credit and collection policies. Accounts receivable turnover ratio The accounts receivable turnover ratio measures the number of times an enterprise has turned accounts receivable into cash during the year. The higher the times the more efficient a company will be assumed to be in collecting its debts. The ratio is computed as follows: Accounts receivable turnover = Annual Credit sates/Average trade receivables Trade Creditors Ratios (vi) Average payment period (Age of trade payable) ratio. This ratio measures the average number of days taken to pay an accounts payable. It is computed as follows:(Average trade payables X 365 days)/Credit purchases Or 365 days/(Accounts payable turnover ratio) Where average accounts payable=(Beginning + Ending accounts payable)/2

Accounts payable turnover ratio. The accounts payable turnover ratio measures the efficiency with which firms pay their trade creditors. The higher the number of times, the

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more efficient the enterprise is assumed to be in paying its creditors. It is calculated as follows; Accounts payable turnover ratio = Annual Credit purchases/Average trade payables Leverage ratios A firm is said to be financially leveraged whenever it finances a portion of its assets by debts. Debts commit a firm to payment of interest and repayment of capital. Borrowing increases the risk of default and it is only advantageous to shareholders if the return earned on the funds borrowed is greater than the cost of the funds. There two classifications of measures of debt: (1) Measures of the degree of indebtedness measure the amount of debt relative to other significant balance sheet amounts. Common measure of the degree of indebtedness include the debt ratio, the debt/equity ratio, and the debt to-total capitalization, (2) Measures of the ability to service debt assesses a firms ability to make the contractual payments required on a scheduled basis over the life of the debt. Commonly referred to as coverage ratios, they include times-interest earned, and the fixed charge coverage ratios. Debt to equity ratio This ratio measures the proportion of assets provided by providers of long-term debt funds for each shilling of assets provided by the shareholders. It is computed as follows: Total long term debt/Total stockholders funds Debt to total assets ratio (Debt ratio) This ratio measures the proportion of assets financed by outsiders. It is calculated as follows; Total liabilities / Total assets Debt/total capitalization ratio Indicates the proportion of capital provided by outsiders. The formula for Debt/Total capitalization ratio is; Long-term debt/(Long-term debt + Shareholders funds) The times interest earned ratio This is also known as the interest cover ratio. This ratio measures the ability of a firm to meet its interest payment out of the current earnings. It reflects the likelihood that creditors will continue to receive their interest payments. 14

It is It is computed as follows:Earning before interest and tax/Interest expense Fixed charge coverage ratio The fixed payment coverage ratio measures the firms ability to meet all fixed payment obligations. Loan interest, principal payments, on debt, scheduled lease payments, and preferred stock dividends are commonly included in this ratio. The formula for the fixed charge coverage ratio is as follows: (Earnings before interest and tax + lease payments)/(interest + lease payments + {(principal payments + preferred stock dividends)*[1/(1-T)]} Where T is the corporate tax rate applicable to the firms income. The term [1/(1-T)] is included to adjust the after tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-tax values of all other terms. The fixed payment coverage ratio measures the risk the firm will be unable to meet scheduled fixed payments and thus be driven into bankruptcy. The lower the ratio the greater the risk to both lender and owners.

Profitability Ratios Profitability ratios evaluate the firms earnings with respect to a given level of sales, a certain level of assets, the owners investment, or share value. Evaluating the future profitability potential of the firm is crucial since in the long run, the firm has to operate profitably in order to survive. The ratios are of importance to long term creditors, shareholders, suppliers, employees and their representative groups. All these parties are interested in the financial soundness of an enterprise. The ratios commonly used to measure profitability include: Gross Profit Margin This ratio measures the percentage of each shilling of sales remaining after the firm has paid for its goods. The higher the gross profit margin the better, and the lower the relative cost of merchandise sold. The formula for calculating the gross profit margin is as follows: 15

Gross profit margin = (Sales cost of goods sold)/ Net Sales = Gross profits/ Net Sales Operating Profit Margin This ratio measures the percentage of each shilling of sales that remains after paying of for the goods sold and the operating expenses. This is a measure of pure profits because they measure only the profits earned on operations ignoring any financial charges and government taxes. The operating profit margin is calculated as follows: Operating profit margin = Operating profits/Net Sales = Earnings before interest and taxes/Net Sales Net Profit Margin The net profit margin measures the percentage of each shilling of sales remaining to the owners of the firm after paying off all expenses, including financing charges and taxes. The higher the firms net profit margin the better for the owners. The ratio is calculated as follows: Net profit margin = Profit after taxes/Net Sales Return on Total Assets (ROA) This ratio is also called the return on investment (ROI) and measures how well management has employed available assets in generating profits from its assets. The return on total assets is calculated as follows: Return on total assets = Profit after taxes/ Total assets Return on Equity (ROE) The return on equity measures the return earned on the owners investment in the firm. This ratio measures the ability of an enterprise to generate income for its owners. Return on equity is calculated as follows: Return on equity = (Profits after taxes preference dividend)/Ordinary Shareholders funds Where, ordinary shareholders equity =Total shareholders funds less preference share capital. Investment Ratios 16

Investment ratios help equity shareholders and other investors to assess the value of an investment in the ordinary shares of a company, The value of an investment in the ordinary shares in a listed company is its market value, and so investment ratios must have regard not only to information in the company published accounts, but also to the current price. The following are the common investment ratios. Earnings per Shape (EPS) This ratio represents or reflects the amount of shillings or cents earned per ordinary share. It is considered so critical that the accounting profession requires its disclosure on the face of the income statement for quoted companies(IAS 33). It is given by EPS = (Profit after taxes -Preference dividends)/The number of ordinary Shares outstanding Dividend pay-out ratio. This ratio reflects a company's dividend policy. It indicates the proportion of earnings per share paid out to ordinary shareholders as divided. It is computed as follows: Dividend pay-out ratio = Dividends per ordinary share / Earnings per share

Where ordinary dividends per share = Ordinary dividends/ Number of ordinary shares

Dividend Yield Ratio This shows the dividend return being provided by the share. It is given by Dividend yield = Dividends per share / Market price per share Price Earnings Ratio (The P/E Ratio) This ratio is used in comparing stock investment opportunity. It is an index of determining whether shares are relatively cheap or relatively expensive. It measures the amount investors are willing to pay for each shilling of the firms earnings. 17

It is given by PER=Market price per ordinary share/Earnings per share

This price earnings ratio reflects the consideration that investors are willing to pay for a stream of a shillings of earnings in the future. The price-earnings ratio is widely used by investors as a general guideline in gauging stock values. Investors increase or decrease the price-earnings ratio that they are willing to accept for a share of stock according to how they view its future prospects. Companies with ample opportunity for growth generally have high price-earnings ratio, with the opposite being for companies with limited growth.

LIMITATIONS OF RATIOS 1. Ratios are insufficient in themselves as a basis of judgment about the future. They are simply indicators or what to investigate. Therefore, they should not be viewed as an end but as a starting point. 2. They are useless when used in isolation. They have to be compared over time for the same firm or across firms with the industry's average. 3. Ratios are based on financial statements. Any weaknesses of the financial statements are also captured within the ratios. 4. Comparing ratios across firms may be difficult because the firms may not be comparable. Data among companies may not provide meaningful comparisons because of factors such as use of different accounting policies and the size of the company.

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