CHAPTER ONE

OVERVIEW OF FINANCIAL MANAGEMENT

1.1. FINANCE AS AN AREA OF STRUDY
What is exactly managerial finance or finance in general? What are the major responsibilities and duties of
managers of finance? In order to answer these questions, you need to understand the areas that finance cover.
Finance, in general, consists of three interrelated areas:
1. Money and capital markets, which deal with securities markets and financial institutions;
2. Investments, which focus on the decision of investors, both individuals and institutions, as they
choose among securities for their investment portfolios; and
3. Financial management, (or "business finance", "corporate finance", or "managerial finance"),
which involves the actual management of business firms
The career opportunities within each of the above fields are many and varied, but managers of finance must
have knowledge of all three areas if they are to perform their jobs well.
1. Money and Capital Markets
Most of the finance professionals go to work for financial institutions, including banks, insurance companies,
investment companies, credits and savings associations.
♣ For you to succeed in doing such jobs, you need a knowledge of the factors that cause interest rates to
rise and fall, the regulations to which financial institutions are subjected, and the various types of
financial instruments such as bonds, shares, mortgages, certificates of deposits, and so on.
♣ You also need a general knowledge of all aspects of business administration, because the management of
financial institutions involves accounting, marketing, personnel management, computer science as well
as financial management.
♣ An ability to get people to do their job (i.e. people skills) is very critical.
2. Investments
Finance graduates who go into investment areas:
♣ Generally work for brokerage houses in the sales of securities or as security analysts
♣ Others work for banks and insurance companies in the management of investment portfolios, or
♣ The rest work for financial consulting firms, which advise individual investors or pension funds on how
to invest their funds
♣ The three major functions in the investment area are:
 Sales of securities,
 Analysis of individual securities, and
 Determining the optimal mix of securities for a given investor
3. Financial management
Financial management is the focus of this course. The entire discussions in each of the subsequent chapters in
this course are specific to financial management.
♣ It is the broadest area in finance and the one with greatest number of job opportunities.

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♣ Financial management is important in all types of businesses, including banks, and other financial
institutions as well as other form of businesses.(See the chart depicted below)

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 SCOPE OF FINANCIAL MANAGEMENT

ANALYTICAL WAY OF VIEWING THE

FINANCIAL PROBLEMS OF A FIRM

BALANCE SHEET INCOME STATEMENT

PERSPECTIVE PERSPECTIVE
"How Large should an "How Fast should it Grow?"
Enterprise be?"

USES OF SOURCES TARGET CAPITAL

FUNDS OF FUNDS CAPITAL INTENSITY
"In what "What should STRUCTURE "Sales per
form should be the "Leverage, invested capital,
it hold its composition Retention and Investment
Assets?" of its claims?" Dividend turnover"
policy"

SUSTAINABLE
MIX AND GROWTH RATE
TYPE OF DEBT AND "Sales growth rate
ASSETS EQUITY with out increasing
"Current, Long- USAGE leverage or issuing
term, Real, and "Leverage and new shares"
Financial" Equity financing"

INVESTING FINANCING DIVIDEND

DECISION DECISION DECISION

FUNCTIONS OF FINANCE (Decision Areas) (To be dealt in the first part of the course)

PLUS

MANAGEMENT OF FINANCIAL RESOURCES (To be dealt in the second part of the course)

Multi-national Exchange rate (Currency

Cash Receivables Inventory Financial Valuation), Derivatives,
Management Management Management Management issues and Risks

EQUALS

FINANCIAL MANAGEMENT AS A SPECIALISED FIELD OF STUDY

3
♣ Financial management is also important in governmental operations, from schools to hospitals, from
zonal administrative levels to state administrative levels, and even beyond that.
♣ The type of jobs encountered in financial management range from decisions regarding plant expansion
to choosing what types of securities to issue to finance the expansion.

KEY ACTIVITIES OF THE FINANCIAL MANAGER

PERFORM BASIC MAKE DECISIONS MANAGE FINANCIAL

TASKS RESOURCES

Multi-
INVESTME Manage National
FIANAN FINANCIA NT
L
ment of Financial
CIAL DECISION FINANCIN
ANALYSIS S Current Manage
PLANNIN G
G "Transform "Short DECISION Assets ment
(FORCAS financial term and S "Capital Consider
TING) data in to long-term structure ations
"Evaluate usable form investment and
productiv to monitor
s Financing
e capacity financial
condition"
policy
and
determine
financing
requireme
nt"

"Currenc
"Techniq "Increase "Capital "Financia "Manage y
ues or budgeting l leverage ment of Valuation,
(Financia Decrease and and credit Working Derivative
l ratios) capacity; measurem policy Capital, s, Transfer
and additional ent of plus Cash, Pricing,
Interpret funds or expected retention / Receivabl Multinatio
ations" reduction rate of dividend e, nal
of funds" return" policy Inventory netting"
"

Measurem Cost of Capital

ent of Risk (required rate of
return) and
Valuation

4
 ♣ Financial managers also have the responsibility for deciding:
 The credit terms under which customers may buy,
 How much inventory the company should carry,
 How much cash to keep on hand,
 Whether to acquire other company (merger analysis), and
 How much of the firm's earnings to retain in the business versus payout as dividends
Regardless of which specific area of finance you are emphasizing on, you need knowledge of all the three areas
(i.e. money and capital market, investments, and financial management).
♣ For example, a banker lending to businesses cannot do his or her job properly with out a good
understanding of financial management, because he or she must be able to judge how well the
businesses are operating.
♣ In the same way, company financial managers need to know what their bankers consider important and
how investors are likely to judge their company performance and thus, determine their stock prices.
1.2. THE CENTRAL ROLE OF CAPITAL
Capital, as you all know, is essential for the operation of any firm. Financial Management, in this regard, may
be defined in terms of the relationship between capital and the business firm.
♣ A business firm, whether it is a newly established or an existing one, must obtain certain amount of
capital to finance itself in order to produce and sell goods and services to its customers.
♣ Initial capital/funds/ of the newly formed firm consists of funds secured from the owners of the firm in
the form of equity capital and from the creditors in the form of both short-term and long-term loans.
♣ An existing firm may finance itself by retaining part of its earnings in addition to the two sources
indicated.
♣ The capital of the firm, whether it is generated internally from operations or provided by owners and
creditors, constitute the source of the firm's capital and hence, recorded on the right-hand side of the
balance sheet as liabilities and owners' equity.
The acquired capital is used to employ personnel, to obtain offices and other manufacturing facilities,
inventories, and other assets. The capital is also used for producing goods and services to meet customers'
demands.
♣ The acquired assets constitute the uses of the capital of the firm and are listed in the left-hand side of
the balance sheet (i.e. assets).
♣ The balance sheet of the firm, thus, contains both the uses and sources of the capital of the firm.
♣ The balance sheet records these values at the particular point in time.
♣ To complete the balance sheet, the firm records the results of its operations during a given period, such
as a year in its income statement.
♣ The income statement, in this regard, lists the firms revenues generated, expenses incurred, and profit
earned over a span of time and provides a measure of the ability of the firm to manage its capital
sources and uses.
These two financial statements, (balance sheet and incomes statement), picture a firm as an entity that finances
itself with capital from various sources and puts this capital into various uses in order to generate the desired
amount of revenues and profits.

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 1.3. FINANCIAL MANAGEMENT AND CAPITAL
1.3.1. Capital: Sources and Uses
Capital sources and uses must carefully be managed if the firm needs to be profitable for its financiers.
Financial management, in this regard, is the specialized business function that deals with this problem.
♣ In general, financial management can be defined as the management of capital sources and uses so as to
attain the desired goals of the firm (i.e. maximization of shareholders' wealth).
♣ A firm's capital consists of items of value that are owned and used and items that are used but not
owned. For example, the office space that a business firm has rented for doing business and the bank
loans that the firm has taken to finance its operations are items of values that the business firm can use
but does not own. Similarly, inventories and fixed assets purchased by the firm.
♣ Capital sources are those items found on the right-hand side of the balance sheet (i.e., the liabilities and
equity section as stated earlier).
♣ Examples of the uses of capital of the firm are receivables, inventories, and fixed assets.
1.3.2. Financial Management: Basic Functions
As an area of study, financial management is concerned with two distinct functions. These are:
♣ The financing function, and
♣ The investing function
The financing function describes the management of the sources of capital. The investing function, on the other
hand, concentrates on the type, size, and percentage composition of capital uses. It deals with the question
"how much of the total capital provided by the financing sources should be invested in receivables, marketable
securities, inventories, and fixed assets?"
♣ The specialized set of management duties and responsibilities that center around the financing and
investing functions are referred to as financial management.
1.3.3. Goal of the Firm: Profit vs. Wealth Maximization
One additional concept contained in the definition of financial management is concerned with the goal directed
behavior or goral orientation.
♣ The problems and opportunities that financial managers face and the business decisions they are
required to make entirely depend on the purposes or goals of their respective organizations.
♣ Profit seeking organizations should actually behave in a way they maximize the wealth of their
shareholders.
 It is very important for you at this point to distinguish between wealth maximization and profit
maximization as goals of business firms.
1. Profit Maximization
Profit-maximization is a traditional microeconomics theory of business firm, which was historically considered
as the goal of the firm.
 Profit maximization stresses on the efficient use of financial/capital resources of the firm.
 Profit maximization as a goal of the business firm ignores, however, many of the real world
complexities that financial managers try to address in their decisions.
 Profit maximization functions largely as a theoretical goal; economists use it to prove how firms
behave rationally to increase profit.
 When finance was emerged as a separate area of study, it has retained profit maximization, which
is the new concept.

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  Profit maximization looks at the total company profit rather than profit per share.
 Profit maximization does not speak about the company's dividends as either a return to
shareholders or the impact of dividend policy on stock prices.
In the more applied discipline of financial management, however, firms must deal every day with two major
factors: These are uncertainty and timing.
A. Uncertainty of Returns
Profit maximization as the goal of business firms ignores uncertainty and risks in order to present the theory
more easily.
 Projects and investment alternatives are compared by examining their expected values or weighted
average profits.
 Whether or not one project is riskier than another doesn't enter these calculations; economists do
discuss risk, but tangentially (or imaginatively).
 In reality, projects differ a great deal with respect to the risk characteristics, and disregarding these
differences can result in incorrect decisions.
To better understand the implication of ignored risks, let us look at two mutually exclusive investment
alternatives (that is, only one of the two can be accepted). The first project involves the use of existing plant to
produce plastic combs, a product with an extremely stable demand. The second project uses existing plant to
produce electric vibrating combs. The latter product may catch on and do well, but it could also fail. The
optimistic, pessimistic, and expected outcomes are given as follows:
Profit Figures
Plastic Comb Electric Com
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
Pessimistic out come 10,000 0
There is no variability associated with the possible outcomes of producing and selling plastic combs because
demand for this product is stable. If things go well (optimistic), poorly (pessimistic), or as expected, the profit
will still be the same, i.e. Birr 10,000. With that of the electric combs, however, the range of possible profit
figures varies from Birr 20,000, if things go well (optimistic), to Birr 10,000, if things go as expected, or to the
profit figure of zero, if things go wrong (pessimistic). Here, if you look at just the expected profit figure of Birr
10,000, it is the same for both projects and you conclude that both projects are equivalent. They are not,
however. The returns (profit figures) associated with electric combs involve a much greater degree of
uncertainty or risk.
 The goal of profit maximization, however, ignores uncertainty (risk) and considers these projects
equivalent in terms of desirability as it refers only to the expected profit figures from the projects.
B. Timing of Returns
Another problem with profit maximization as the goal of business firm is that it ignores the timing of the returns
from projects. To illustrate, let us reexamine our plastic comb versus electric comb investment decisions. This
time let us ignore risk and say that each of these projects is going to return a profit of Birr 10,000. assume that
while the electric comb can go into production after one year, the plastic comb can begin production
immediately. The timing of the profit from these projects is as follows:

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 Profit Figures

Plastic Comb Electric Comb

Year 1 $10,000 $0
Year 2 0 10,000
In this case, the total profit from each project is the same, but the timing of earning the profits differs. As we
will see later in this course, in the chapter dealing with the concept of "Time Value of Money ", money has a
definite time value as people have definite preference for current benefits over future benefits. Thus, the plastic
comb project is the better of the two. Assume that the Birr 10,000 profit from Plastic comb project during year
1is invested in a saving account that earns an interest of 5 percent per annum. This money would have grown to
birr 10,500 at the end of the second year as opposed to the Birr 10,000 profits to be reported by the electric
comb project at the end of the second year.
Since investment opportunities are available for the money on hand, we are not indifferent to the timing of the
returns (profits) from these investment opportunities. In other words, the returns obtained can be re-invested at
the prevailing rate of return.
 Given equivalent cash flows from profits, we want the cash flows to occur sooner rather than later.
 The financial manager must always consider the possible timing of returns (profits) in financial
decision-making.
Therefore, the real-world factors of uncertainty and timing of returns force financial managers to look beyond
simple profit maximization as the goal of the business firm.
 These limitations of profit maximization as the goal of business firms lead us to the maximization of
the more robust goal of the business firm, that is, shareholders' wealth.
2. Wealth Maximization
Wealth maximization, on the other hand, is a more comprehensive model dealing with the goal of the firm.
According to this model, it is made clear that there are two ways in which the wealth of shareholders changes.
These are:
 Through changing dividend payments, and
 Through the change in the market price of common shares
Hence, the change in shareholders' wealth, or change in the value of business firms, may be calculated as
follows:
i. Multiply the dividend per share paid during the period by the number of shares owned.
ii. Multiply the change in shares price during the period by the number of shares owned.
iii. Add the dividends and the change in the market value of shares, computed in step 1 and 2 above,
to obtain the change in the shareholders' wealth during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the larges attainable
combination of dividends per share and stock price appreciation.
 Nevertheless, the problem is that while a business firm may have some degree of freedom in setting its
dividend policy that is in accordance with wealth maximization goal, it cannot influence the share
prices, which are basically set by the interaction of buyers and sellers in the securities/stock markets.
 Stock prices tend to reflect the perception of the stockholders regarding the ability of the business firm
to earn profits and the degree of risks that the business firm assumes in earning its profit.
The ultimate risk that the business firm usually faces is the probability that it will fail or go bankrupt. In such an
event,

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  The owners/shareholders of the business firm would see their investment becoming worthless; and
 The creditors would likely see that at least some portion of their loans go unpaid.
These events have impacts on the market prices of shares, which, in turn, have impacts on the objective/goal of
a business firm, that is, wealth maximization of shareholders.

1.4. MAXIMIZATION OF SHAREHOLDER'S WEALTH

In formulating the goal of maximization of shareholders' wealth, we are doing nothing more than modifying the
goal of profit maximization to deal with the complexities of the operating environment.
 We have chosen maximization of shareholders' wealth, that is, maximization of the total market
value of the existing shareholders' common stock, because the effect of all financial decisions is
reflected through these prices.
 The shareholders (or investors) react to poor investment or dividend decisions by causing the total
value of the firm's stock to fall and they react to good decisions by pushing the price of the stock up.
Obviously, there are some series practical problems in direct use of this goal and evaluating the reaction to
various financial decisions by examining changes in the firm's stock value.
 In reality, different factors/aspects affect stock prices.
 To employ wealth maximization as the goal of your business firm, therefore, you need not consider
every stock price change to be the market interpretation of the worth of your decision.
 Other factors such as economic expectations, also affect stock price movements.
Apparently, what you do focus on is the effect that your decision should have on the stock price if every thing
else where held constant.
 The market price of the business firm’s stock reflects the value of the firm as seen by its owners.
 The wealth maximization as the goal of a business firm takes into account uncertainty or risk, time,
and other factors that are important to the owners of the firm.
 Thus, again, the framework of maximization of shareholders' wealth allows for a decision
environment that includes the complexities and complications of the real world.
1.5. THE AGENCY PROBLEM
While the goal of the business firm is the maximization of shareholders' wealth, in reality the agency problem
may interfere with the implementation of this goal.
 The agency problem is the result of a separation of the management and the ownership of the firm.
For example, a large business firm may run by professional managers, who are agents and have little
or no ownership position/stake in the firm.
 Because of the separation between the decision makers and owners, managers may make decisions
that are not in line with the goal of the business firm, or not consistent with the interests of owners,
that is outlined as maximization of shareholders' wealth.
 Professional managers, being mere agents of owners, may attempt to benefit themselves in terms of
salary and perquisites at the expense of shareholders.
 The exact significance of this problem is difficult to measure.
 However, while it may interfere with the implementation of the goal of maximization of
shareholders' wealth in some firms, it does not affect the goal's validity, however.
 The costs associated with the agency problem are also difficult to measure, but occasionally we can
see the effect of this problem in the marketplace.

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 ♣ For example, if the market feels that the management of a business firm is damaging
shareholders' wealth, we might see a positive reaction in the stock price to the removal of that
management.
1.6. THE OBJECTIVE OF FINANCIAL MANAGEMENT
The financial manager uses the overall company's goal of shareholders' wealth maximization, which is reflected
through the increased dividend per share and the appreciations of the prices of shares, in formulating financial
policies and evaluating alternative courses of operations. In order to do so, this overall goal of wealth
maximization needs to be related to and/or take the following specific objectives of financial management into
account:
1. Financial management aims at determining how large the business firm should be and how fast
should it grow.
2. Financial management aims at determining the best percentage composition of the firm's assets
(asset part of the decision, or decisions related to capital uses).
3. Financial management also aims at determining the best percentage composition of the firm's
combined liabilities and equity decisions related to capital sources).
1. Determining the Size and Growth Rate
The size of the business firm is measured by the value of its total assets.
♣ If the book values are used, the size of the firm is equal to the total assets as indicated in the balance
sheet.
♣ When this method of size determination is used, the growth rate of the business firm is measured by the
yearly percentage change in the book values of all the items in the assets section of the balance sheet.
As a student of financial management, however, you should be able to understand that a business firm that
is large and growing faster & larger does not necessarily produce increased earnings.
2. Determining Assets Composition (Portfolio)
As indicated earlier, assets represent investments or uses of capital that the business firm makes in seeking to
earn a rate of return for its owners.
♣ The most common asset categories are cash, inventories, and fixed assets.
♣ However, financial institutions, such as banks and insurance companies, have some what different
assets categories. They may list loans, advances, and negotiable securities as assets.
♣ The percentage composition of the assets of the firm is computed as ratio of the book value of each
asset to total book values of all assets.
♣ The choice of the percentage composition of asset items affects the level of business risk.
♣ The asset structure decision relate to what products and services the business firm should produce. The
financial manager is directly involved in decisions related to the assets structure that makes the business
firm more successful in a way it will maximize the wealth of shareholders.
The wealth maximizing assets structure can be described in either of the following ways:
i. The asset structure that yields the larges profit for a given level of exposure to business risk, or
ii. The asset structure that minimizes exposure to business risk that is needed to generate the
desired profit.
In both of the cases, the financial manager should recognize that the asset structure of the business firm is the
major determinant of the overall risk-return profile of the firm.
3. Determining the Composition of Liabilities and Equity
As it was stated earlier in this chapter, liabilities and equity are the sources of capital of business firms.

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 ♣ They are the financing sources that business firms use to make investment in various types of assets.
♣ The most common financing sources are accounts and notes payable; accruals for items such as taxes,
wages, and interests; loans and debt securities of various maturity dates; and common stocks, preferred
stocks, and retained earnings.
♣ Here again, banks and insurance companies might secure funds from liability accounts such as time
deposits, demand deposits, and saving deposits.
♣ As it was done for the percentage composition of assets, the liability and equity percentage
compositions of the business firm is measured by dividing the book value of each liability or equity
item by the total book values of all liabilities and equity.
♣ The mix of liabilities and equity of the business is what is known as the capital structure.
When the business firm finances its investment by using debt capital, ("leverage" being the jargon used in
Finance to refer this), the business firm and its shareholders face added risks along with the possibility of
added returns. This is due to the effects of leverage, which is resulting from using debt capital in financing
investments.
♣ The added risk is the possibility that the firm may face difficulty to repay its debts as they mature. (This
is referred to as a negative leverage)
♣ The added returns come from the ability of the firm to earn the rate of return higher than the interest
payments and related financing costs of using liabilities. (This is referred to as a positive leverage)
♣ The added returns may be paid as dividends and/or re-invested in the firm to generate more profit.
This, in effect, would maximize the wealth of shareholders of the business firm.
Stock prices, therefore, react to the manner of financing of a business firm as well as to the subsequent ability or
inability of the firm to manage its capital structure.
1.7. EVOLUTION OF THE FINANCE FUNCTION
Finance for the first time became a separate area of study around 1900. Since then, the duties and
responsibilities of the financial managers have undergone continuous change, and expected to change in the
future as well.
The two main reasons for the ongoing change in the functions of finance are:
i. The continuous growth and increasing diversity of the national and international economy, and
ii. The time to time development of new analytical tools that have been adopted by financial managers
1. Finance Before 1930
Up to 1900, finance was considered as a part of applied economics.
♣ The 1890s and 1900s were the periods of major corporate mergers and consolidations in the American
economy.
♣ These mergers and consolidations were gradually transmitted to other economics all over the world.
♣ These activities required unprecedented amount of financing.
♣ The management of the capital structure of companies that had been formed due to mergers and
consolidations become an important task. Hence, finance was emerged as distinct functional area of
business management.
The major technological innovations of the 1920s created entirely new industries such as radio and broadcasting
stations.
♣ These new industries produce not only large quantities of output but also earned high profit margin.
♣ Financial management was found to be important in dealing with problems related to planning and
controlling the liquidity of the newly emerged industries of that time.

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The stock market crash of 1929 and the subsequent economic depression occurred in the American economy
resulted in the worst economic conditions that occurred in the 20th century.
♣ Bankruptcy, reorganization, and mere survival become major problems for many corporations.
♣ The capital structure, which was dominated by debt, aggravated the solvency and liquidity problems of
companies.
♣ Financial management is additionally responsible for the planning of the rehabilitation and survival of
the business firm.
2. Finance Since 1950
These days, large number of people is employed and work in manufacturing and service industries that didn't
exist before.
♣ Much of this rapid economic growth occurred because of the increased rate of technological
advancement.
♣ The computerization process in almost all of these industries is an example of the extent to which our
economy has become dependent on new technologies.
♣ As new industries have arisen and as older industries have sought ways to adapt to the rapidly changing
technologies, finance has become increasingly analytical and decision oriented.
♣ This evolution of the finance function has been influenced by the development of computer science,
operations research, and isometrics as tools for financial management functions.
To summarize, the evolution of finance functions contains the following three important points:
1. Finance is relatively new as a separate business management function;
2. Financial management, as it is presently practiced, is decision oriented and uses analytical tools
such as quantitative and computerized techniques, economics, and managerial accounting;
3. The continuing rapid pace of economic development virtually guarantees that the finance function
will not only continue to develop but also have to accelerate its pace of development to keep
up with the complex problems and opportunities that corporate manger are facing.
CHAPTER SUMMARY
This first chapter has provided you an introduction to finance as the area of study and to managerial finance as
an important business function.
The chapter also examined the goal of the business firm; the commonly accepted goal of profit maximization is
contrasted with the more complete goal of the maximization of shareholders' wealth. As the wealth
maximization goal deals with uncertainty and time in a real world environment, it is found to be the proper goal
of the firm. In other words, shareholders' wealth maximization attempts to take into account both risk and
return, and is superior in a number of important ways to that of the traditional economic goal of profit
maximization.
Finance first appeared as a distinct area of study around 1900 and initially focused on capital structure
composition. During the great depression, bankruptcy, and reorganization, finance became an important
consideration. Since 1950, finance became decision oriented with respect to both asset and capital structure
management, and became increasingly analytical in nature. The tools of the financial manager now include
accounting, economics, computer science, and quantitative analysis of operations research.

12
 CHAPTER TWO
FINANCIAL STATEMENT ANALYSIS
2.1. BASIC FINANCIAL STATEMENTS
The data used in analyzing financial statements are contained in financial statements such as income statement,
balance sheet, and statement of retained earnings. In explaining financial statement analysis, financial
statements pertaining to Addis Manufacturing Company are used throughout this chapter, which is an ideal
company considered for an illustrative purpose.
.1. Income Statement
As you know from your previous courses, income statement measures the profitability of a business firm over a
period.
♣ Though the income statements of many multinational companies cover a European calendar year, Addis
Manufacturing Company has adopted fiscal year that corresponds with the Ethiopian budget year for an
accounting purpose.
♣ The Ethiopian budget year runs from Hamle 1 to Sene 30. Income Statement can also be prepared on a
quarterly basis and referred to as interim income statement.
Regardless of the starting and ending dates, or the length of the time covered, the important point is that income
statement summarizes the operations of a business firm over a given time interval.
♣ As it can be seen from the income statement for Addis Manufacturing Company, the company's
operations generated a flow of revenues (net sales), expenses, and profits (net incomes) during the two
reporting years.
Addis Manufacturing Company
Comparative Income Statement
For the Years Ended Sene 30, 1992 and 1993
(Figure in thousands of Birr)
Items 1993 1992
Net Sales Birr 120,000 Birr 110,000
Cost of goods sold 90,000 83,000
Gross Profit 30,000 27,000
Operating Expenses:
Selling expenses 5,000 4,800
General and administrative expenses 8,000 7,600
Depreciation expense 1,100 800
Lease Payments 1,650 1,600
Total operating expenses 15,750 14,800
Earning before interest and taxes 14,250 12,200
Interest expenses:
Interest on bank notes 550 700
Interest on Other debt 3,600 3,960
Total interest expenses 4,150 4,660
Earning before taxes 10,100 7,450
Income taxes (34%) 3,434 2,564

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 Net Income 6,666 4,976
2. Balance Sheet
A balance sheet summarizes the financial position of the business firm. It usually contains two sections:
(1) The asset (i.e. uses of funds) section, and
(2) The liabilities and shareholders' equity (i.e. sources of funds) section
The following is the comparative balance sheet for Addis Manufacturing Company, an ideal business firm, on
Sene 30, 1992 E.C. and Sene 30, 1993 E.C.
Addis Manufacturing Company
Comparative Balance Sheet
Sene 30, 1992 and 1993
Items 1993 1992
Current Assets:
Cash 2,500 3,000
Marketable securities 1,000 1,300
Accounts receivable 16,000 12,000
Inventories 20,500 18,700
Total current assets 40,000 35,000
Fixed Assets:
Land and buildings 28,700 24,200
Machinery and equipment 31,600 29,000
Total fixed assets 60,300 53,200
Less accumulated depreciation 18,300 17,200
Net fixed assets 42,000 36,000
Total assets 82,000 71,000
Liabilities and shareholders' equity
Current liabilities
Accounts payable 7,200 6,000
Notes payable 10% bank 5,500 7,000
Accrued liabilities 900 700
Current portion of long-term debt 3,000 3,000
Other current liabilities 1,400 1,200
Total current liabilities 18,000 17,900
Long-term liabilities
Long term debt-12% mortgage bond 27,000 30,000
Total liabilities 45,000 47,900
Shareholders' equity
Common stock, 5Birr par, 2,000,000
Shares authorized; 1,300,000 shares
outstanding in 1993 and 100,000
shares outstanding in 1992 6,500 5,000
Capital in excess of par 14,000 5,350
Retained earnings 16,500 12,750
Total shareholders' equity 37,000 23,100
Total liabilities & shareholders' equity 82,000 71,000
As indicated in the above comparative balance sheet prepared for Addis Manufacturing Company, total assets
equal total liabilities and stockholders' equity.

14
 ♣ This statement shows the mix of liabilities and equity that is used to finance company's assets.
♣ The assets of the company are the investments it had made in profit-seeking activities.
 Current assets are most liquid assets of the company, which can be used or converted in to cash
with in a period of one year or less. Hence, the Birr value of current assets is termed as a gross
working capital of the company.
 In contrast to current assets, fixed assets division consists of long-term financial claims and
investments in the physical assets such as properties, plants and equipment.
♣ The liability and shareholders' equity section of the balance sheet shows how the company is financed.
♣ Liabilities are values of assets financed by funds from creditors. Current liabilities, as stated earlier, are
to be paid back in less than one year.
♣ The amount of funds provided by the shareholders' directly for Addis Manufacturing company are
represented by the common stock and additional capital in excess of par portions of the shareholders'
equity section of the balance sheet.
♣ Retained earnings are part of shareholders' equity obtained as a result of the board of directors decision
to retain portion, or entire amount of net profits of the company for reinvestment.
The accounting procedures used to generate financial statements are not primarily designed to provide data
inputs for financial statements analysis.
♣ As a consequence of this, the financial statements may not always provide the information that the
financial managers need for various types of business decisions.
♣ For example, the assets are listed in the balance sheet at their historical costs that do not, most of the
time, reflect the current market values, or the replacement costs of these assets.
♣ Moreover, some difficulties can be expected in interpreting financial statement figures individually.
♣ For instance, an increase in a balance of an inventory account could mean:
 The individual purchases cost more that ever due to increases in prices and that the physical
inventory levels have not increased, or
 The company is accumulating that it has been unable to sell, or
 The company is producing, or purchasing inventories in large quantities in anticipation of
increases is the volume of sales in the future.
This clearly shows that it is difficult to interpret the balance of a given account separately as it could mean
different things.

3. Statement of the Retained Earnings

The statement of retained earnings lists how much of the net profit/income of the company was paid out as
dividends to the shareholders and how much of it was retained in the company for reinvestments or further
expansion of the company.
♣ The statement of retained earnings normally exhibits one important relationship that exists between the
income statement (that summarizes the operation of the company during a given time period) and the
balance sheet (that summarizes the financial position of the company on the given date).
♣ The retained earning account in the shareholders' equity section of the balance sheet of the company is
the accumulation of the net profit of the company that has been retained over the life time of the
company.
♣ Every the retained earnings account is increased by an amount equal to the excess of net profit over
dividend declared and distributed during that year.

15
 ♣ Hence, the ending balance of the retained earnings account that is computed in the statement of retained
earnings links the income statement and the balance sheet.
♣ There are in fact, many other ways in which all of these financial statements interact with one another.
The following is the statement of retained earnings for Addis Manufacturing Company, an ideal company, for
the year ended Sene 30, 1993 E.C.
Addis Manufacturing Company
Statement of retained earnings
For the Year ended Sene 30, 1993 E.C.
Retained Earnings, Hamle 1, 1993 12,750
Net income 6,666
Sub-Total 19,416
Less: Cash dividends (Common stock) 2,916
Retained Earnings, Sene 30, 1993 16,500
As you can see from the statement of retained earning of Addis Manufacturing Company, the retained earnings
account has a balance of Birr 12,750 on Hamle 1, 1993 that is the ending balance of Sene 30, 1992 carried
forward. This balance wash shown in the shareholders' equity section of the balance sheet prepared for Addis
manufacturing company on Sene 30, 1992. In the same way, the ending balance of the retained earnings
account shown in the statement of retained earning for Addis manufacturing company for the year ending on
Sene 30, 1993 (i.e. 16500 Birr) was reported in the shareholders' equity section of the balance sheet for that
year.
2.2. RATIO ANALYSIS
The first step in undertaking financial statements analysis is to read and understand the financial statement and
their accompanying notes with care. This is followed by the computation of ratios (i.e. undertaking ratio
analysis) and interpreting what the ratios is to mean.
♣ The use of financial ratios to analyze financial statements is now a common practice to the extent that
even computerized financial statement analysis programs prepare financial ratios as part of their overall
analysis.
♣ Both lenders and potential lenders use financial ratios to evaluate loan applications from borrowing
companies.
♣ Investors use financial ratios to assess the future tale of the companies in which they are contemplating
to make investment.
♣ Managers make use of financial ratios in order to judge the performance of their companies and to
control the day-to-day operation of their companies.
♣ Owners make use of financial ratios to evaluate whether their companies are maximizing their wealth or
not.
2.2.1. Financial Ratios: General
Financial ratios can be designed to measure almost any aspect of the performance of the company.
♣ In general, financial analysts use ratios as one tool in identifying areas of strengths and weaknesses in
the company.
♣ Financial ratios, however, tend to identify symptoms rather than the problems classing symptoms.
♣ A financial ratio whose value is judged"different" or usually high or low may help identify a significant
event but it does not provide enough information that helps to identify the reasons for the occurrence of
the event.
♣ The financial ratios are judged high, low, or acceptable when they are compared with standards.
♣ Standard ratios could be:

16
  Industry standards: These are standard ratios computed for companies operating in the same
industry. For example, average ratio standards can be developed for textile industry.
 Management plans: These are financial ratios are ratios that the management of a give company
set as goals. These are plans of the company and standards against which actual financial ratios
are compared.
 Historical standards: These are financial ratios developed from the historical records of the
company over say the last 10 years. Historical standards are, therefore, the average financial
ratios for the company for the last 10 years. These ratios can also be used as standards against
which you compare the computed ratios to judge them of high, low or acceptable.
2.2.2. Types of Financial Ratios
The most common financial ratios used for financial analysis include Liquidity, Activity (Asset Management),
Debt Management (Leverage), and Profitability ratios.
1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its current liabilities and current portion of long-term
debts as they mature. Liquidity ratios assume that current assets are the principal sources of cash for meeting
current liabilities and current portion of long-term loans. There are two most widely used liquidity ratios.
These are the current and quick or acid ratios.
A. Current Ratio
The current ratio is computed by dividing current assets by current liabilities. The current ratios for Addis
Manufacturing Company for 1992 and 1993 are the following:
Current assets
Current Ratio =
Current Liabilities
35,000
Current Ratio (for 1992) =  1.96 times
17,900
40,000
Current Ratio (for 1993) =  2.22 times
18,000
The larger the current ratio, the less the difficulty the company faces in paying its obligations at the right time.
In many cases, lenders frequently require the current ratio of the borrowing company to remain at or above 2.0
times as a condition for grading or continuing the commercial and industrial loans.
♣ This standard of 2.0 times is an arbitrarily selected figure and many financial analysts feel that the
liquidity position of the company should be questioned if the current ratio of the company falls below
2.0 times.
♣ This is because of the fact that all current assets cannot be easily converted back to cash
♣ It is very difficult to collect accounts receivable in full.
♣ It is very difficult of sell all the inventories.
♣ Short-term prepayments are unlikely to be converted to cash.
♣ If the less liquid assets constitute significant portion of the total current asset, you may need current
ratio that is even greater than 2.0 times.
The current ratios of Addis manufacturing Company show that the company has Birr 1.96 in current assets for
each Birr of current liabilities during 1992 and Birr 2.22 in current assets for each Birr of current liabilities
during 1993. It is very difficult to say this ratios are high or low as we don’t have industry standard, or
management plan, or historical standard against we compare these current ratios.
♣ However, one can say that Addis Company is more capable in 1993 to pay its current liabilities than in
1992.
B. Quick Ratio
Quick ratio is sometimes called "acid test ratio". It serves the same general purpose as that of the current ratio
but more stringent as it exclude less liquid current assets like inventory from current assets.

17
 ♣ It considers only quick current assets such as cash, marketable securities, and account receivables.
♣ This is done because inventories, prepaid expenses and supplies cannot easily be converted back to
cash.
♣ Thus, the quick (acid test) ratio measures the ability of the company to pay its current liabilities by
converting its most liquid assets to cash, which is easier.
♣ The quick ratio is computed by subtracting inventories, prepaid expense, and supplies from current
assets and dividing the remainder by total current liabilities.
For Addis Manufacturing Company, the quick ratios are:
Quick Ratio =
Current assets  (Pr epaid epense  Supplies  inventories )
Current liabiities

35,000  (0  0  18700) 16,300

Quick Ratio (for 1992) =   0.91 times
17,900 17,900
40,000  (0  0  20,500) 19,500
Quick Ratio (for 1993) =   1.08 times
18,000 18,000
If the company wants to pay the entire amount of its current liabilities by using its quick assets (i.e. current
assets minus the sum of inventories, prepaid expenses, and supplies), its quick assets should be equal to or
greater than its current liabilities.
♣ Thus, the Company's quick ratio should be 1.0 times or more than that.
In the case of Addis Manufacturing Company, the quick assets of 91 cents are available to meet each Birr of
current liabilities.
♣ This implies that the quick assets are not enough to settle all the current obligations.
♣ Unless the company converts the non-quick current assets to the extent they provide cash that is enough
to pay the remaining 9 cents for each Birr of current liabilities, the company will face difficulty in
meeting its short-term obligations.
The quick ratio of 1.08 times for 1993, on the other hand, implies that the company has Birr 1.08 of quick assets
for each Birr of current liabilities. Again, the company is in good liquidity position during 1993 compared to
1992.
2. Activity Ratios (Asset Management Ratio)
Activity ratios measure the degree of efficiency with which the company utilizes its resources (assets).
♣ Efficiency is equated with rapid resource turnovers.
♣ Some activity ratios concentrate on individual assets such as inventory, or accounts receivable while
others look at the overall company performance, or activity.
The following activity ratios are discussed for Addis Manufacturing Company:
A. Inventory Turnover Ratio
This ratio is meaningful for companies like Addis Manufacturing Company, which hold inventories of different
kinds. (it could be merchandise, raw material, processed goods, and so on).
♣ This ratio measures the number of times per year that the company sells its inventory.
♣ It is computed by dividing the Birr amount of costs of goods sold by the Birr amount of inventory at
the closing date of the accounting period.
For Addis Manufacturing Company, the inventory turnover ratios are:
Costs of goods sold
Inventory turnover =
Inventory balance

18
 83,000
Inventory turnover (f0r 1992) =  4.44 times
18,700

90,000
Inventory turnover (for 1993) =  4.39 times
20,500
In general, high inventory turnover may be taken as a sign of good inventory management. Other things being
the same, inventory turnover ratios computed for Addis Manufacturing Company indicate that the company was
able to sell its inventories 4.44 times and 4.39 time during 1992 and 1993 E.C. respectively.
♣ The performance/efficiency of the company in selling its inventories was nearly the same during the
two years.
♣ However, you cannot say the inventory turnover ratios for Addis Company show good or bad
performance, or high efficiency or low efficiency as long as you do not have standard inventory
turnover ratio to compare with.
Inventory turnover ratio, as a measure of efficiency of business activities, suffers from both conceptual and
measurement problems.
♣ For example, high inventory turnover ratio could indicated the inadequacy of inventory to meet
customer demands which results in loss of sales.
♣ A low inventory turnover ratio, on the other hand, can be caused by an increased line of new products
each of which require some minimum inventory balances, which, in turn, raises the balance of overall
inventory level and lowers the inventory turnover ratio.
♣ In both of these cases, the inventory turnover ratio, if it is used alone, may lead to incorrect conclusions.
♣ This is to mean that high inventory turnover ratio may not always be good.

A measurement problem of inventory turnover ratio emanates from the denominator used in calculating the
ratio.
♣ Since the purpose of this ratio is to measure the inventory turnover rate, the denominator should be a
measure of the average amount of inventory that the company maintained during the year.
♣ However, in most of the cases, the figure used as the denominator is the amount of inventory on hand at
the end of the reporting period because the average inventory balance is not easily obtainable.
♣ If the balance of inventory at the end of the year is not a good representative of the average yearly
inventory because of seasonal and/or cyclical production and selling patterns, the usefulness of this
ratio is greatly limited.
B. Total Assets Turnover Ratio
It measures the relationship between a birr of sales and a birr of assets, usually on a yearly basis.
♣ A firm wants to generate as much birr as possible in the form of sales per a birr of an investment it
made in assets.
♣ The asset turnover ratio is a measure of the overall activity of the company.
♣ It is computed by dividing the total net sales of the company by its total assets on the closing date of the
accounting period.
For Addis Manufacturing co-the total turnover ratios are:
Net Sales
Total assets turnover =
Total assets
110,000
Total assets turnover (for 1992) =  1.55 times
71,000

19
 120,000
Total assets turnover (for 1993) =  1.46 times
82,000
The total assets turnover ratio of 1.55 times during 1992 implies that the company was able to generate Birr
1.55 for a single birr it has invested in its assets during the year. During 1993, on the other hand, the company
was able to make net sales of birr 1.46 for each birr it has invested in the total assets.
♣ Though the total volume of sales is greater during 1993, the assets turnover ratios show that the
company was efficient in generating higher net sales per birr of investment in asset in 1992 than in
1993.
♣ The decrease in the asset turnover ratio in 1993 may indicate a decrease in the utilization of the assets
for generating the desired sales revenue.
C. Average Collection Period
This ratio tries to measure the average number of days it takes the company to collect its account receivables.
♣ The shorter the average collection period, the better the company's activities are.
As you know, account receivable is resulted from credit sales.
♣ Hence, this ratio relates the daily credit sales to its account receivable balance at the end of the
reporting period.
♣ Net sales may be used in the absence of credit sales, though it reduces the quality of the ratio in
measuring the number of days that receivables do take before their collection.
The average collection period is computed in a two-step procedure.
♣ First, you compute the average daily credit sales (in the absence of credit sales you computed the
average daily sales) by dividing the 360 days into the total credit sales, or total sales.
♣ Second, you compute the average collection period by dividing the account receivable balance at the
end of the accounting period (preferably the average account receivable if available) by daily credit
sales, or daily sales in the absence of the former.
Assuming that all sales are made on account by Addis manufacturing company, the average collection periods
are:
Total credit sales
Step 1: Daily Credit Sales =
360 days
110,00
Daily Credit Sales (for 1992) =  305.56 birr
360
120,000
Daily Credit Sales (for 1992) =  333.33 Birr
360
When total sales used instead of credit sales in the formula, the average collection period will face measurement
problem because the cash sales included in the total sales do not have any link with average collection period.
Moreover, the use of the account receivable balance at the end of the may not represent the month average of
accounts receivable when there are seasonal fluctuations. In this case, the average collection period again
suffers from the measurement problem.
Account Re cievables
Step 2: Average Collection Period (ACP) =
DailyCredi tsalss
12,000
ACP (for 1992) =  39.27 Days
305.56

20
 16,000
ACP (for 1992) =  48 Days
333.33
The average collection period requires the analyst to provide careful interpretation even when these
measurement problems are overcame, or at least recognized.
♣ An increase, or decrease in the values of average collection period should not be used to evaluate the
effort the company puts in collecting its receivables.
For example, the average collection period during the year 1992 is nearly 40 days, which is shorter than that of
the year 1993.
♣ If the shorter average collection period during 1992 was caused by the very tight credit policy adopted
during that year, it may not be more desirable than the average collection period of 48 days achieved
during 1993 under, say a liberal credit policy.
♣ This is because the credit policies themselves can bring changes to the average collection period.
♣ Stringent credit policy definitely reduces the average collection period.
♣ If the small average collection period of Addis Manufacturing Company during 1992 was caused by
reduced volume of credit sales, it may not be a good indication of good credit collection condition.
Furthermore, credit granting and the structuring of credit terms are major competitive tools used by the
marketing managers rather than the financial managers.
♣ Many companies are forced to set credit policies that are comparable with the credit policy of the
dominant company in the same industry.
♣ The average collection period, in this regard, has to be interpreted in relation to the credit terms
provided to customers.
3. Debt Management or Leverage Ratios
These ratios measure the extent to which a company finances itself with debt as opposed to equity financing.
♣ These ratios are also called solvency or capital structure ratios.
♣ They are also termed as financial leverage ratios.
Financial ratios provide the basis for answering two basic questions:
i. How has the company finance its assets using debts?
ii. Can the company afford the level of fixed charges associated with the use of non-owners-
supplied funds such as bond interests and principal payments?
The first question is answered using balance sheet leverage ratios, while the second question is answered
through the use of income statement based ratios, or simply through the use of leverage ratios.
A. Balance Sheet Leverage Ratios
These ratios provide the basis for answering the question "Where did the company obtain financing for its
investments? The balance sheet leverage ratios include:
i. Debt Ratio or Debt-Asset Ratio
It measures the extent to which the total assets of the company have been financed using borrowed funds. For
Addis Manufacturing Company, the ratios are computed as follows:
Total liabilitie s
Debt-Asset Ratio =
Total assets
47,900
Debt-Asset Ratio (for 1992) = = 67.46%
71,000

21
 45,000
Debt-Asset Ratio (for 1993) =  54.88%
82,000
At the end of 1992, 67.46 percent of the total assets of Addis Manufacturing Company were financed by funds
secured in the form of current and long-term liabilities. The remaining 32.54 percent was financed by funds
contributed by shareholders and retained from the profits earned by the company. Similarly, debt financing
constitutes about 55 percent of the total assets of the company during 1993. This leaves 45 percent of the total
assets to be financed with equity sources.
♣ The level of debt financing has declined during 1993 compared to 1992 signaling good condition.
♣ Too much debt financing is riskier to the company.
♣ Addis manufacturing company can borrow much more money during 1993 than it could do in 1992
because the asset structure of the company was more debt-dominated in 1992 than in 1993.
♣ Hence, lenders are willing to give loans to the company during 1993, when the debt-asset ratio is less,
than during 1992, when debt-asset ratio is high.
You cannot say much about the capital structure of Addis manufacturing company on the basis of the debt-asset
ratios computed above as you don't have any standard debt-asset ratio to be used as a bench mark.
♣ In general, creditors prefer low debt-asset ratios, because the lower the ratios, because the lower the
ratios, the lower the chance of losing their money upon maturity, or liquidation.
♣ The owners, on the other hand, may want higher debt (leverage) ratios because the cost of borrowed
money is usually less than the cost of owners' funds.
The debt-asset ratios calculated above for Addis manufacturing company show that more than half of the
company's assets were financed with funds form creditors during the two years.
♣ As a result, the company may find it difficult borrow additional funds without first raising more equity.
♣ Otherwise, creditors would be reluctant to lend more money to the company with its debt-dominated
capital structure.
Though creditors are willing to give loans to debt dominated borrower they are will at higher interest rate that
commensurate with the high risk they are taking as lenders.
The debit-asset ratio of 67.46 percent for 1992 computed fro Addis manufacturing company can also be
interpreted as one birr of investment in the company's assets was made up of the combination of about 67 cents
of the creditors' funds and the remaining 33 cents of the shareholders' funds. During 1993, a birr of investment
in the company's assets was made with about 55 cents of creditors' funds and shareholders contributed the
remaining 45 cents.
ii. Long-Term Debt- Equity Ratio
This ratio measures the extent to which creditors (debt-holders) provided long-term financing relative to
shareholders' financing.
♣ The ratio is computed by dividing long-term debts by stockholders' equity.
The long-term debt to equity ratios for Addis manufacturing company are computed as follows:-
Lont term debt
Long-Term Debt-Equity Ratio =
Shareholders equity
30,000
Long-Term Debt-Equity Ratio (for 1992) =  1.30 or 130%
23,000
27,000
Long-Term Debt-Equity Ratio (for 1993) =  0.73, or 73%
37,000
The long-term debt-equity ratio of the company decreased from 130% in 1992 to 73% in 1993. This decrease
may be caused by several factors some of which are:

22
  Some long-term debts might be matured and paid out, which reduce the balance of long-term debts,
 Addis manufacturing company might increase the level of its shareholders' equity either by issuing
additional shares at premium, and
 Some amount might be added to the company's retained earnings due to retention of the portion of full
amount of net income.
Your interpretation for the long-term debt-equity ratio of 130 percent achieved during 1992 can be that for a
single birr of shareholders' equity in the long-term financing there is birr 1.30 of long-term debt in the long-term
financing.
 In other words, the long-term financing of birr 2.30 was made in a way that birr 1 from
shareholders' equity and birr 1.30 from long-term debt.
 In the same way, a single birr in the long-term equity financing is combined with 73 cents of long-
term debt financing to form a total long-term financing of birr 1.73 during 1993.
 In other words, for each birr obtained from shareholders' equity, the long-term debt holders
contributed 73 cents in the long-term financing during the year.
Again, it is very difficult to conclude that the long-term debt-equity ratios computed for Addis Manufacturing
Company show good or bad capital structure of the company as long as you do not have standard long-term
debt-equity ratio to be used as a point of reference.
iii. Debt-Equity Ratio
This ratio expresses the relationship between the amount of the total assets of the company financed by
creditors (debt) and owners (equity).
 Thus, this ratio reflects the relative claims of creditors and shareholders against the total assets
of the company.
 The debt-equity ratio is computed by dividing the total debts by the total shareholders' equity.
This ratio provides answer to the question: What are the proportions of debts and equity in financing the total
assets of the company?
The debt-to-equity ratios for Addis manufacturing company are the following:
Total debts
Debt - Equity Ratio =
Shareholders ' equity
47,900
Debt- Equity Ratio (for 1992) =  2.07
23,100
45,000
Debt- Equity Ratio (for 1993) =  1.22
37,000
The debt-equity ratio of 2.07 for Addis manufacturing company for 1992 indicates that the creditors of the
company have provided about birr 2.07 in financing the assets of the company for every single birr contributed
from shareholders’ equity. In the same token, the debt-equity ratio of 1.22 for 1993 shows that the creditors
have provided birr 1.22 in financing the assets of the firm for each birr contributed by shareholders’ equity.
 Whether these types of capital structure (debt and equity mix) are good or bad depends on the standard
set for the debt-to-equity ratio.
 Unless you are told this standard, still you cannot say the debt and equity mix of Addis manufacturing
company is good or bad.
B. Coverage Ratios
These ratios are the second category, i.e. Income Statement-Based, leverage ratios.
 They are used to measure the company’s ability to cover its financing costs (interest expenses)
associated with the use of debt financing.

23
  These ratios provide the basis for answering the question of whether the company has used too much
financial leverage. The coverage ratios, most of the time for most companies, include the following.
i. Times Interest Earned Ratio (Interest Coverage Ratio)
This ratio measures the extent to which operating income can decline before the company is unable to meet its
annual interest costs.
♣ Failure to meet this obligation can bring legal action by the company’s creditors, possibly resulting in
bankruptcy.
♣ This ratio is determined by dividing earnings before interest and taxes (EBIT) by the interest charges
during the year.
♣ Note that earnings before interest and taxes (EBIT), rather than net income, is used as a numerator in
the formula because interest is paid with the pre-tax income and the company’s ability of paying
interest charges is not affected by taxes.
The times interest earned ratios (interest coverage ratios) for Addis manufacturing company during 1992 and
1993 are:
Earnings before int erest and taxes
Interest Coverage Ratio =
Interest exp enses
12,200
Interest Coverage Ratio (for 1992) =  2.62 times
4,660
14,250
Interest Coverage Ratio (for 1993) =  3.43 times
4,150
The times interest earned (interest coverage) ratios computed for Addis manufacturing company reveals that the
company’s earnings before interest and taxes are 2.62 times and 3.43 times higher than the respective interest
expenses of the company during 1992 and 1993 respectively.
♣ As long as you do not have the industry average, you cannot categorize these ratios as high or as low.
But, generally speaking,
♣ Lower times interest earned ratio suggests that creditors are at risk in receiving the interest payments
that are due; the creditors may take legal action that may result in bankrupting the company; and the
company may face difficulty in raising additional financing through debt issues as the company is under
risk of paying interest charges.
♣ A larger interest coverage ratio, on the other hand, suggests that the company has sufficient margin of
safety to cover its interest expenses; and the earnings before interest and taxes (EBIT) of the company
could decline without jeopardizing the company’s ability to make interest payments.
ii. Fixed Charge Coverage Ratio
This ratio is similar to that of the times-interest-earned ratio, but it is more inclusive as it recognizes other fixed
obligations such as lease payments, principal payments of debts, and dividend payments on preferred stocks.
♣ Unlike interest expenses and lease payments, the principal payments of debts and dividend payments on
preferred stocks are not tax deductibles, i.e. they are paid from after tax earnings.
♣ Thus, a tax adjustment should be made for these payments.
For example, the company that is required to effect principal payments amounting to birr 100 from its earnings
after taxes (assuming a tax rate of 40 percent) needs its earnings before taxes to be ( 100 1  0.4), or birr
166.67.
The fixed charges obviously include interest expenses, annual long-term lease obligations, principal payments
of long-term debts, and dividend payments for preferred stockholders.
The formula for fixed charge coverage ratio is, therefore, defined as follows:

24
 EBIT  Lease payments
 Pr inciple preferred 
Fixed Charge Coverage Ratio = 
 payment  dividend


Interest  Lease Payment   
1  tax rate

 

 

As you can observe from the above equation, interest expenses and lease payments are not adjusted for taxes
because they are paid from earning before tax, while principal and preferred dividend payments are adjusted for
taxes because they are paid from the after tax earnings (net income)
Considering the given income tax rate of 34 percent and the principal payments of 2500 birr and 3000 birr
during 1992 and 1993 respectively, the fixed charge coverage ratios for Addis Manufacturing Company can be
computed by using the above mathematical equation as follows:
12,200  1,600
Fixed Charge Coverage Ratio (for 1992) =  2500  0 
4,660  1,600   
 1  0.34 
13,800
=
4,660  1,600  3,789
13,800
= 1.37 times
10,049

14,250 1,650
Fixed Charge Coverage Ratio (for 1993) =  3000  0 
4,150  1,650   
 1  0.34 
15,900 15,900
=  1.45times
4150  1650  4,545 10,345

Addis manufacturing company is able to cover its fixed charges, (interests, lease payments, and principal
payments), 1.37 times and 1.54 times using its earnings before interest and taxes during 1992 and 1993
respectively.
♣ In other words, the earnings before interest and taxes of the company are equal to 1.37 times the fixed
charges during 1992 and 1.54 times the fixed charges during 1993.

4. Profit Ability Ratios

Profitability is the net result of a number of policies and decisions.
♣ The profitability ratios provide the overall evaluation of performance of the company and its
management.
♣ These ratios show the combined effects of liquidity, activity, and leverage ratios on the operating result
of the company.
The several ratios falling under this category are discussed in the following paragraphs.
i. Gross Profit Margin
The gross profit margin ratio is calculated as follows:

Gross Profit Margin = Gross profit

Net sales
Gross profit margin of Addis co. (for 1992) = 27,000 = 0.2455, or 24.55%
110,000

Gross profit margin of Addis co. (for 1993) = 30,000 = 0.25, or 25%
120,000

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Thus, Addis manufacturing company’s gross profit constitutes 24.55% and 25% of the company’s net sales
during 1992 and 1993 respectively.
♣ These ratios reflect the company’s mark-ups on costs of goods sold as well as the ability of the
company’s management to minimize the costs of goods sold in relation to net sales.
♣ Larger gross margin ratio implies lower costs of goods sold rate and vice versa.
ii. Operating Profit Margin
Moving down in the income statements, the next profit figure following gross profit is the operating income (or
EBIT).
♣ This operating profit figure serves as the basis for computing the operating profit margin.
♣ The operating profit, as you know, is the excess of gross profit over the total operating expenses.
For Addis manufacturing company, the operating profit margins are found as follows:

Operating profit margin = Operating Income

Net sales
Operating profit margin (for 1992) = 12,200 = 0.1109, or 11.09%
110,000
Operating profit margin (for 1993) = 14,250 = 0.1188, or 11.88%
120,000
The operating profit margins reflect the company’s operating expenses as well as its costs of goods sold. Addis
manufacturing company remained with 11.09 percent and 11.88 percent of its net sales after covering its cost of
goods sold and all operating expenses during 1992 and 1993 respectively.

iii. Net Profit Margin Ratio

The net profit margin on net sales measures the profitability of the company on a per birr basis of net sales.
♣ This ratio is calculated by dividing net income by net sale of the company for a given accounting
period.
The net profit margin ratios for Addis manufacturing company are:

Net profit margin = Earnings after taxes

Net sales
Net profit margin (for 1992) = 4,976 = 0.0452, or 4.52%
110,000
Net profit margin (for 1993) = 6.666 = 0.0556
120,000
These net profit margin ratios can be interpreted in such a way that Addis manufacturing company had earned
4.52 percent, or nearly 5 cents, net income per birr of net sales it made during 1992 and 5.56 percent, or nearly
6 cents, per birr of sales it made during 1993.
♣ The net profit margin of the company is influenced by the amount of interest expenses/charges and
income tax expenses because net profit is an earning after interest and taxes (EBIT).
iv. Return on Investment (ROI)
It is also known as return on Assets (ROA).
♣ This ratio measures the company’s profitability per birr of investment in the total assets.
♣ The ROI, or ROA is calculated by dividing earnings after taxes by total assets.
The ROI for Addis manufacturing company for the two years are:

Return on Investment (ROI) = Earnings After Taxes (Net Income )

Total assets
ROI (for 1992) = 4,976 = 0.0701, or 7.01%
71,000
ROI (for 1993) = 6,666 = 0.0813, or 8.13%

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 82,000
Thus, Addis manufacturing company generated 7.01 percent, or about 7 cents, in the form of net income out of
each birr it invested in its total assets during 1992, and 8.13 percent, or about 8 cents, in the form of net income
out of each birr of investment in its total assets during 1993.
♣ Whether the indicated returns on investments are good or bad depends on the industry standards, or the
management plans.
♣ What you can say at this point is that the company’s return on investment has shown slight
improvement in 1993 compared to that of 1992.
You can also use a native formula to compute the return on investments (ROI). That is:
Return on investment (ROI) = Net Profit Margin x Total Asset Turnover
= Net Income x Net Sales
Net Sales Total Investment

The ROI for Addis Manufacturing Company during 1993, for instance, is:

ROI for 1993 = 6,666 = 0.1802 or 18.02%

37,000
As it can be deduced form the computed ROE, Addis manufacturing company has generated 21.54 percent, or
about 22 cents, and 18.02 percent, or about 18 cents, for every birr of shareholders’ equity during 1992 and
1993 respectively.
♣ Since earnings after taxes are the net earnings after covering both interest charges and tax liabilities,
they are available only for the shareholders of the equity capital of the firm, or company.
5. Market/Book Ratios
These are ratios recently introduced into the ratio analysis.
♣ They are primarily used for investment decisions and long-range planning
Included in these ratios are the following:
i. Earning Per Share (EPS)
Earning per share (EPS) expresses the profit earned per common stock outstanding during the reporting period.
♣ It provides a measure of overall performance and is an indicator of the possible amount of dividends
that may be expected.
The earning per share for Addis manufacturing company are computed as follows:
Earning per share (EPS) = Earnings after tax (net income) – Preferred dividend
Number of common shares outstanding
Or (EPS) = Earnings available for common stock holders
Number of common shares outstanding
EPS (for 1992) = 4,976-0 = 4,976 = 4.98 Birr/share
1000 shares 1000 shares
EPS (for 1993) = 6,666 - 0 = 6,666 = 5.13 birr/share
1,300 1,300
Addis Manufacturing Company has earned Birr 4.98 per share during 1992 and Birr 5.13 per share during 1993.
The earning per share has shown an increase during 1993, which shows improved performance of the company
during the year.
♣ Though the earnings per share were Birr 4.98 and Birr 5.13 per share during 1992 and 1993
respectively, these ratios do not tell you how much of these earnings per share are paid as dividend
and how much is retained in the business.

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 ♣ Moreover, since you do not have the industry average or the management plan, you cannot conclude
that these earnings per share are indicators of good or bad performance.
ii. Price -to-Earnings Ratio (P/E)
The price-earning ratio expresses the multiple that the market prices on the company’s earnings per share and
is commonly used to assess the owner’s appraisal of share value.
♣ The price-to-earnings ratio is computed by dividing the market price of a share by the earning per share
computed above.
Assuming the common share of Addis manufacturing company has market prices of Birr 30 and Birr 35 at the
end of 1992 and 1993 respectively, compute the P/E ratio of the company.

P/E ratio = Current market price per share

EPS
P/E ratio (for 1992) = 30 = 6.02 times
4.98
P/E ratio (for 1992) = 35 = 6.82 times
5.13
You can interpret these ratios like this:
♣ The market is willing to pay about birr 6 in 1992 and about birr 7 in 1993 for every birr in the
company’s earnings. Again, the P/E ratio has shown a slight improvement during 1993.
Since the industry standard or management plan is lacking, it is very difficult for you to categorize
Addis manufacturing company as highly valued or low valued company.
♣ However, you can say, in general, that a high P/E ratio reflects the market’s perception of the
company’s growth prospects.
♣ Thus, if the investors in the stock markets believe that a company’s future earnings potential is
good, they are willing to pay higher prices for the stock and further boast the P/E ratio.
♣ The problem with P/E ratio is that the market price for a share of common stock may not be
available when there is no’ stock market.
iii. Book Value Per Share
It is the value of each share of common stock based on the company’s accounting records.
♣ It is computed by dividing the excess of total stockholders' equity over preferred stock to the number of
common shares outstanding.
The book values per share ratios for Addis manufacturing company are computed as follows:
Book value per share = Total stockholders' equity – preferred stock
Number of common shares outstanding

Book value per share (for 1992) = 23, 100 – 0

1,000 shares
= 23,100 = 23.10
1000 shares
Book value per share (for 1993) = 37,000 – 0
1,300 shares
= 37,000 = 28.46
1,300 shares
The book value of a share of common stock of Addis manufacturing company is Birr 23.10 in 1992 and Birr
28.46 during 1993.

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 ♣ This shows that the book value of a share is less than the market value of a share during the two years,
assuming the market prices used earlier in the example.
♣ Hence, the value of a share in the market during the two years is better than the book value.
Since we don’t have industry average or management goal, we cannot say the book values per share ratios are
above or below the industry average, or management plan, however.
iv. Dividends Per Share (DPS)
It shows the birr amount of dividends paid on a share of common stock outstanding during the reporting period.
♣ It is determined by dividing the total cash dividends on common shares by the number of common
shares outstanding.
Assuming Addis manufacturing company distributed a cash dividend to common shareholders of Birr 1,900,000
during 1992 and Birr 2,600,000 during 1993, the dividend per share for the two years are:

Dividend per share = Total dividends on common share

Number of common shares outstanding

Dividend per share (for 1992) = 1,900 = Birr 1.9/ share

1000 Shares

Dividend per share (for 1993) = 2600 = Birr 2/ share

1,300 shares

Addis manufacturing company paid Birr 1.9 dividend per common share during 1992 and Birr 2 per common
share during 1993.
v. Dividend Payout Ratio
It shows the percentage of earnings paid to shareholders.
♣ It expresses the cash dividend paid per share as a percentage of EPS.
♣ Dividend payout ratio is computed by dividing cash dividend per share by earnings per share.
The dividend payout ratios of Addis manufacturing company are computed as follows:

Dividend payout ratio = Cash dividend per share , or

Earning per share
= Total dividend to common stock
Total earnings available for common stock hold

Dividend payout ratio (for 1992) = 1.90 = 38.15%

4.98

Dividend payout ratio (for 1993) = 2.0 = 39%

5.13
Or else
Dividend payout ratio (for 1992) = 1900 = 38.18%
4,976
Dividend payout ratio (for 1993) = 2,600 = 39%
6,666

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The dividend payout ratios indicate that Addis manufacturing company paid about 38 percent of its earnings in
the form of dividends for its common shareholders during 1992 and paid 39 percent of its earnings in the form
of dividends during 1993.
vi. Dividend Yield
It shows the rate earned by shareholders from dividends relative to the current market price of shares.
♣ Dividend yield is computed by dividing cash dividend per share by current market price per share.
The dividend yields for Addis manufacturing company for 1992 and 1993 are:

Dividend yield = Cash dividend per share

Market price per share

Dividend yield (for 1992) = 1.9 = 6.33 %

30
Dividend yield (for 1993) = 2 = 5.71%
35
Addis manufacturing company paid 6.33 percent and 5.71 percent in the form of dividends to common
shareholders per birr of the current market prices of its shares during 1992 and 1993 respectively.
♣ Unless we do have industry average, it is difficult to say these ratios indicate good or bad situation.
However, what we can say, in general, is that the higher dividend rate (yield) may reflect fewer
investment opportunities on the part of Addis manufacturing company.
2.3. APPROACHES TO USING RATIOS IN THE FINANCIAL STATEMENTS ANALYSIS
These are two basic approaches in analyzing a set of financial statements using financial ratios. These are the
cross sectional analysis and the time series analysis. These two approaches complement each other and both
should be used as part of the analysis of financial statements.
2.3.1 Cross-Sectional Analysis
This approach enables you to evaluate company’s financial conditions at a given point in time and compare
company’s current performance against that of the previous year.
♣ Under cross-sectional analysis, you compare the ratios of your company against those of its
competitors.
♣ The first step in cross-sectional analysis of Addis manufacturing company is to evaluate its financial
position at the end of 1993. In order to do so, the company’s financial statements are needed.
♣The second step is to compare the current performance of the company against that of the previous year
by comparing the financial ratios computed for 1992 and 1993, which are summarized in the following
table.
Summary of Financial Ratios of Addis manufacturing company:

Ratio 1992 1993

Liquidity:
Current ratio ------------------------------------ 1.96 2.22
Quick ratio ------------------------------------ 0.91 1.08
Activity:
Inventory turnover --------------------------- 4.44 4.39
Total assets turnover -------------------------- 1.55 1.46
Average collection period -------------------- 39 days 48 days
Leverage:
Total debt to assets --------------------------- 67.46% 54.88%
Long term debt to equity --------------------- 130% 73%

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 Total debt-to-equity --------------------------- 2.07 1.22
Time interest earned --------------------------- 2.62 times 2.26 times
Fixed charges coverage ----------------------- 1.37 times 1.54 times
Profitability:
Gross profit margin ---------------------------- 24.55% 25%
Operating profit margin ----------------------- 11.09% 11.88%
Net profit margin ------------------------------ 4.52 % 5.56%
Return on investment (ROI) ------------------ 7.01 % 8.13%
Return on shareholders’ equity (ROE) ------- 21.54% 18.02%
 Comparing the liquidity ratios of 1992 and 1993 of Addis manufacturing company, both the current ratio
and quick ratio show improvement during 1993.
 The activity ratios of Addis manufacturing company imply that the company was less efficient in
utilizing its assets in 1993 compared to what it had done during 1993.
 The leverage (debt management) ratios of Addis manufacturing company show that the capital structure
has been improved during 1993 compared to that of 1992, where the capital structure had been a debt-
dominated one.
 The profitability ratios also suggest that the company’s performance was more profitable during 1993
than it had been in 1992.
 The final step in the cross-sectional analysis is comparing the financial ratios computed for Addis
manufacturing company against the average financial ratios computed for all competing companies in
the industry.
The result of this comparison tells you the position of Addis manufacturing company regarding its liquidity,
activity, leverage and profitability.
 Unfortunately, we do not have industry averages in our country to use for comparison purposes.
2.3.2. Time series Analysis
This approach is used to evaluate the performance of the company over several years. It looks for three factors:
 Important trends in the data of the company
 Shifts in trends, and
 Values that deviate substantially form the other data
2.4. ADVANTAGES AND LIMITATIONS OF RATIO ANALYSIS
2.4.1. Advantages of Financial Ratio Analysis:
The following are the major advantages of financial ratio analysis:
1. Ratios are easy to compute
2. Ratios provide standards of comparison at a point in time and comparisons to be made with industry
average, if available.
3. Ratios can be used to analyze company’s time series in order to discover trends, shifts in trends, and
values that deviate form other similar values.
4. Ratios are useful in identifying problem areas of a company.
5. When combined with other tools, financial ratios analysis makes important contributions to the task of
evaluating the company’s financial performance.

2.4.2. Limitations of Ratio Analysis

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The following are the major limitations of financial ratio analysis:
1. Taken by themselves, financial ratios provide information very little in its use.
2. Ratios seldom provide answers to questions they raise because generally they do not identify the causes
for the difficulties that the company faced.
3. Ratios can easily be misinterpreted for instance; a decrease in the value of a given ratio does not
necessarily mean that something undesirable has happened.
4. Very few standards exist that can be used to judge the adequacy of a ratio or set of ratios.
5. Industry average cannot be relied upon exclusively to evaluate a company’s performance because most
of the companies in an industry may perform far below the acceptable level of performance, which
lowers the industry average.
6. In some cases, the industry average ratios may not be available at all, which is the problem we
encounter in the case of Ethiopian industries.
7. Many large companies operate a number of different industries and in such cases, it is difficult to
develop a meaningful set of ratios to compare against industry average. This makes ratio analysis more
useful for smaller and narrowly focused companies than for large and multi divisional ones.
8. Inflation severely distorts balance sheets of companies (recorded values are usually different from
’true’, or ‘market’ value). Again, since inflation affects both depreciation charges and inventory costs,
profits are also affected. Ratios do not consider these distortions unless balance sheet and income
statement figures are adjusted for the effect of inflation.
9. Seasonal fluctuations can also distort the analysis of financial statements through the use of ratios.
These problems can be minimized by using monthly averages for inventories and receivables when
calculating turnover ratios.
10. Companies can employ ‘window dressing’ techniques to make the financial statements look stronger.
For instance, the company might borrow on a long-term basis huge amount of cash to wards the end of
the accounting period for few days but back paid in the first week of the subsequent accounting period.
This action did improve the company’s current and quick ratios and made the balance sheet of the
company look good. However, as you clearly understand, the improvement was strictly due to the
“window dressing” technique the company had employed. Under such situation, it is highly likely to
misinterpret both the current and quick ratio as they signal good liquidity position of the company,
which in fact is not.
11. It is difficult to generalize whether a particular ratio is ‘good’ or ‘bad’. For example, a high current
ratio may indicate a strong liquidity position, which is good, or the availability of excess cash, which is
obviously bad as the excess cash is a non-earning (idle) asset. Similarly, a high fixed asset turnover
ratio may denote either a company that uses its fixed assets efficiently, or one that is under capitalized
and cannot afford to buy enough fixed asset whose value is used as a denominator when calculating the
ratios.
CHAPTER SUMMARY
Analysis of the financial data contained in the company’s income statements and balance sheets is aided by the
use of ratios analysis. Ratio analysis is used to obtain measures of company’s liquidly, activity, debt, and
profitability.
The cross-sectional approach to ratio analysis, supplemented with industry averages, can help in evaluating the
financial position of a company at a given point in time. The time series approach, together with the
preparation of common size income statements, can help in showing recent financial trends, shifts in trends, and
values that deviate from other data.
The use of financial ratios cannot do adequate job of financial statement analysis. The use of financial ratios
alone will not provide a complete understanding of the company’s activities. Rather the use of financial ratios

32
will raise question that, when pursued, will provide the information needed to reach an informed judgment
about the financial condition of the company.

33