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FINANCIAL STATEMENT ANALYSIS:

This usually involves the computation of percentage or ratios and then followed by comments on or the
interpretation of ratios. This analysis is usually utilized in the appraisal of the performance of a business entity.

The analysis usually looks at three broad areas.


- Profitability
- Liquidability, and
- Operating efficiency

The ratios are meant to reveal the financial strengths or weaknesses of a business entity, underlying trends and the
causes that have led to these strengths and weaknesses.

Ratios are computed using historical data. It is generally believed that historical ratios will help work out what is
likely to happen in the future.

Ratios need to be interpreted intelligently otherwise they may give information that is not useful.

Interested Persons
1. Owners/shareholders
2. Debenture holders / holders of long term loan capital
3. Banks & Financial Institution
4. Investors & their professional adviser
5. Creditors
6. Tax office (URA)

Areas of Interest
1. Profitability – how much profit is being made in relation to size of investment workforce or other measure.
2. Solvency – are sufficient liquid funds available to meet entity financial obligations.
3. Working capital management
4. capital structure
5. Financial Strength
6. Borrowing potential
7. Divided cover
8. Cost structure – fixed & variable cost
9. Ownership & control
10. Value Added Tax
11. Trends

IMPORTANCE OF RATIOS:
We have so far considered the rules that are utilized in compiling financial statements. We have assumed that their
utility is enhanced by adherence to the generally accepted

Accounting principle and that their comparability will be facilitated by the adherence to accounting standards.

However merely examining figures in the financial statements is not particularly useful but through comparison the
significance of certain figures will be established.

Ratios assist in the comparison of two sets of figures because they highlight the arithmetic relationship between
pairs of figures in the sets of accounts.

A myriad number of ratios can be computed from a set of financial statements but one ought to concentrate only
on the key ones in order to be able to judge the financial health and prospects of an entity.
The utility of ratios computed from a set of accounts will be limited because the accounts may have been drawn up
using different accounting policies.

Ratio analysis should be regarded as part and parcel of the overall exercise of interpreting financial statements. The
others includes scrutiny of accounting policies, funds flow statements, use of intuition etc.

Ratios may be utilized to do the following:-


1. intra – firm comparisons (previous years)
2. inter-firm comparisons (similar business)
3. Current period ratios may be compared with planned ratios established by management.

It should be noted that there are no ideal ratios: they vary over time, from company to company, industry to industry
etc.

Categories of ratios
Ratios are usually categorized into three groups:-
Balance Sheet ratios: `
a) These are derived from B/S figures and give an indication about the financial strengths
and liquidity of a company.
b) Profit and loss account ratios
They are extracted from the P+L a/c and show profitability + growth of the company.
c) Operating or management ratios
These are also known as inter-statement ratios and are computed by comparing related
figures of the B/S + P+L a/c

Types of ratios
1. ROCE (Return on capital employed)
This is sometimes considered to be the most important ratio. It shows how much profit has been made in
relation to the resources employed.

It measures the efficiency with which an entity utilizes funds at its disposal.

ROCE = Profits before interest + taxation


X 100
Capital Employed

Example:
A B
Profit 10,000 10,000
Sales 100,000 100,000
Capital Employed 20,000 40,000
ROCE 50.2 25%
ROCE may be computed in different ways as there is some disagreement about which figures to include in capital
and profit.
e.g
- Assets value – cost or replacement values?
- Depreciation – some say exclusion of depreciation makes the statements more
Comparable.
- intangible assets = should be excluded from capital
- bank drafts – to be included if permanent etc.
2. Profit Margin:
This measures the success of a business in earning profits from its trading operations.
Profit before interest and taxation
X 100
Sales
It may be necessary to exclude investment income and rental income if the margin is only to reflect trading
operations.

3. Asset Turnover
This indicate the efficiency with which the business is utilizing its assets
Asset turnover = Sales

Capital employed

4. Fixed Asset Turnover


This measures the ability of the fixed assets to generate sales
Fixed Asset turnover = Sales

Fixed Assets

5. Working Capital Ratios


These assess whether or not the investment in working capital (current assets- current liabilities) is
reasonable. These are further broken into two: turnover ratios.
Examples are:-
a) stock turnover:-
This indicates whether the level of stock is reasonable in relation to the volume of sales.
Stock turnover = Sales

Average Stock

b) Stock turnover period:-


Stock turnover period = Average Stock
X 12 months
Sales per annum

c) Debtors turnover period:


Debtors turnover period = Average Debtors
X 12 months
Sales per annum
The average collection period in excess of an entity’s normal credit term suggested bad credit control.
d) Creditors turnover period:
This shows the average credit period taken in respect of purchases.
Creditors turnover period = Average Creditors

Purchaser per annum

e) Stocks to net current assets


Stocks high ratio would indicate
- bad stock control; and / or
- Obsolete stocks; and/or
- tight control of cash & debtors

The above were turnover ratios. The following are liquidity ratios
f) Current ratio/working capital ratio
Current ratio = Current assets

Current liabilities
A figure of 2 & 3 is considered reasonable

g) Quick ratio
It is a test of the immediate solvency of a business
Quick ratio = liquid assets

Current liabilities

Capital Ratios
Liquid assets include cash and those assets that can quickly be turned into cash such as debtors and short-time
investments. Stock are usually excluded because they may first have to be sold on credit and some of them may
end up being bad debts.

The following are capital ratios: Capital of a company can be divided into two groups:-
- share capital, and
- loan capital

Striking an adequate capital mix is a complex business because enough capital should be raised to cater for both
fixed assets and working capital and at the same time be sufficient to enable a company to produce/sell enough
goods and service to be able to make a satisfactory return.

Over capitalization occurs when the level of capital is too large in relation to a business and undercapitalization is
when there is inadequate working capital.

h) Gearing ratio
This is the ratio between share capital and fixed interest bearing securities.
Fixed Interest Capital

Equity capital/ Gearing capital

Fixed interest capital usually consists of preferences shares, loan capital, bank overdrafts and short
term loans.

a) Debt Ratio
This ratio used to indicate the acceptable limits borrowing.

Total Debt

Total Assets
Total assets normally exclude intangible assets. Total debt includes long-term borrowing short-term loans,
overdrafts and all other liabilities excluding short-term dividends.
b) Borrowing Ratio
The ratio also measures debt capacity:

Long term borrowing plus overdrafts


Capital employed

The following are ratios that assist analysis, + existing and potential investors to compare alternative investments.

6. a) Investors’ Ratio
This gives an indication about how efficiently a business is run – its profitability.

Net profit accruing to equity shareholders

Equity capital and reserves

b) Dividend Yield

Gross dividends per share

market price per share

c) Earnings per share (EPS)


This is a very popular ratio which measures a company’s performance by comparing results over several
year.

Profit available for equity shareholders

Equity shares in issue ranking for dividends


d) Price earnings ratio) P/E ratio)
The ratio shows the relative worth of a share.

Total Market Value of Equity

Total Average on the net basis

e) Dividend cover
Shows the number of times the actual dividend could be paid out of current profits
Dividend Cover = Maximum possible dividend that could be
Paid out of current profit

Actual dividends

f) Earnings Yield
Grossed up equivalent EPS Calculated on net basis x 100

Market price per share

There are other useful ratios


7. Value added ratio – to judge company and employee performance
- Profit to added value
- Added value per employee

8. Employee ratios – to measure relative efficiency between firms


- Sales per employee
- Profit per employee
- Wages per employee

Examination questions on ratio analysis


These will normally require you to prepare a report for a particular user of accounts e.g shareholders, creditors,
management or employees.

The approach should be to:


- Calculate the relevant ratios
- Interpret the ratios for the benefit of the users.

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