Chapter: 2

FIRMS FINANCIAL OPERATION

3.1 financial statements

Are a technique prepared by accountant and they show the financial

position and financial performance of the given organization. Among those different financial statement
income statement and balance sheet are important.

A. INCOME STATEMENT
- Usually income statements are prepared on an annual basis.
- An income statement often provides a better measure of the operation's performance and profitability.
- The information obtains from income statement helps to perform financial analysis on the company
profitability.
- The purpose of income statement is to show whether or not the company generate profit.
B. BALANCE SHEET
- shows the financial position of a firm at a particular point of time,
- How the assets of a firm are financed, A total value of assets, total indebtedness, equity, available cash and
value of liquid assets.
- This information can then be analyzed to determine the business' current ratio, its borrowing capacity and
opportunities to attract equity capital.
3.2 FINANCIAL ANALYSES OF CONSTRUCTION COMPANY

Financial analysis is a tool of financial management. It consists of the evaluation of the financial
condition and operating results of a business firm, an industry, or even the economy, and the forecasting
of its future condition and performance.
Financial statement analysis involves:
(1) A comparison of the firm’s performance with that of other firms in the same industry.
(2) An evaluation of trends in the firm’s position over time.
The purpose of financial analysis is to diagnose the current and past financial condition of a firm
and to give some clues about its future condition.
3.2.1 Stakeholders of financial analysis
The following stakeholders are interested in financial statement analysis to make their respective decision at
right time.

1. Investors: - Financial analysis is very important to shareholders (and prospective shareholders)

who need to know how well their investment (the firm) is performing. Financial analysis may
signal to existing shareholders that it is time to replace the board of directors or time to sell their

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stock in the company. Some shareholders do not take the time to analyze the firms in which they
invest. Instead they need the advice of financial advisors who analyze firms for them.
2. Lenders Creditors conduct financial analysis of firms to determine the probability that the
firms will default on loans. Short-term creditors may be most interested in the firm’s balance
sheet, which indicates the level of liquid assets available to repay loans. Long-term lenders,
however, may be just as concerned with the income statements as they are with the balance
sheet, since the firm must generate sufficient income in future years to pay interest and repay the
loan. Additionally, a firm’s balance sheet can deteriorate very quickly it its income statements is
not healthy.
3. The Management:- The managers are entrusted with the financial resources contributed by
owners and other suppliers of funds for effective utilization. In their pursuit to make the
company achieve its objectives, the managers should use relevant financial information to make
right decision at the right time.
4. Others: - Government agencies and labor unions will also be interested in the firm’s
performance. Many industries are regulated by government agencies and the rate of return
allowed by companies in these industries is based on information in the financial statements.
Similarly, trade unions frequently use financial statement to show that the firm’s strong
profitability position justifies wage increases.
3.2.2 Ratio analysis
An analysis that considers the relationships between financial statement variables is called
Ration Analysis. Ration analysis provides a current picture of the firm’s position.
Comparisons of financial ratio analysis
Ratio analysis is not merely the application of a formula to financial data to calculate a given
ratio. More important is the interpretation of the ratio value. To answer such questions: is too
high or too how? It is good or bad? A meaningful standard or basis for comparison is needed.
1. Time series (Trend) Analysis: Time series analysis is applied when a financial analyst
evaluates performance over time. Comparison of current to past performance, using ratio
analysis, allows the firm to determine whether it is progressing as planned. Developing trends
can be seen by using multiyear comparisons. Time series analysis is always often helpful in
checking the reasonableness of a firm's projected (Performa) financial statements. A
comparison of current and past ratios to those resulting from an analysis of projected
statements may reveal discrepancies on over optimism.
In general using time series analysis: Comparing a firm's present ratios with the past ratios to
evaluate financial position and performance of the firm is important. It gives an indication of the
direction of change and reflects whether the firm's financial performance has: Improved,
Deteriorated, or remained constant over time. The analyst: i) should determine the change ii)
Should understand why ratios have changed. This is because the change in ratios may be affected
by changes in the accounting policies without a material change in the firm's performance.

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2. Cross-Sectional Analysis: Cross-Sectional analysis involves the comparison of different
firm's financial ratios at the same point in time. The typical business is interested in how well
it has performed in relation to other firms in the industry. This type of cross-sectional
analysis called bench marking, has become very /popular during recent years. By comparing
the firm's ratios to those of the bench mark company (or companies),
3. Combined Analysis: The most informative approach to ratio analysis is one that combines
cross-sectional and time-series analysis. A combined view permits assessment of the trend in
the behavior of the ratio in relation to the trend for the industry.
4. Performa Analysis: The whole essence of this analysis of that: Some times future ratios are
used as the standard of comparison. Future ratios can be developed from the projected or
Performa financial statements. The comparison of current or past ratios with future ratios
shows the firm's relative strengths and weaknesses in the past and the future. If the future
ratios indicate weak financial position, corrective action should be taken
When using ratio analysis one should bear in mind the following cautions:
(1) A single ratio does not provide sufficient information from which to judge the overall
performance of the firm. Only when group of ratios are used can reasonable judgments be made.
(2)The financial statements being compared should be dated at the same point in time during the
year. If not, the effects of seasonality may produce erroneous conclusions and decisions. (3)In
order to increase users confidence and enhance the reliability of information presented in the
financial statements, it is preferable to use audited financial statements for ratio analysis. (4)The
financial data being compared should be developed in the same accounting way. Different
methods used especially for inventories and depreciation can distort the results of ratio analysis.
2.1.3.3 Types of Financial Ratios and interpretations
Financial ratios can be divided for convenience into five basic groups or categories:

1. Liquidity ratios 2. leverage,

3. Activity ratios 4. profitability ratios and
5 Market value ratios
Liquidity ratios measure the firm’s ability to meet current obligations, leverage ratios show the
proportions of debt and equity in financing the firm’s assets; activity ratios reflect the firm’s
efficiency in utilizing its assets; profitability ratios measure overall performance and
effectiveness of the firm, and market ratios show the performance of the firm’s common stock in the
capital market.

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 Dear Students! Let us use the financial statements of Merob construction Company, shown below to
investigate and explain ratio analysis.

Merob Construction Company, Income Statements

Variables 2001 2000
Revenue 3,074,000 2,567,000
Less Cost OF revenue
Material cost 1,000,000 826000
Labor 488,000 340000
Subcontracts 600,000 550000
Total direct cost 2,088000 1711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General and Adm. Expenses 468,000 445,000
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000

Less Interest Expenses 93,000 91,000

Net Profit Before Tax 325,000 212,000
Less Profit Tax (at 29%) 94,250 61,480
Net Income After Tax 230,750 150,520
Less Preferred Stock Dividends 10,000 10,000
Earnings Available to Common Shareholders 220,750 140,520
EPS 2.90 1.81

Merob, Balance Sheets

2001 2000
Assets
Current Assets
Cash 363,000 288,000
Marketable Securities 68,000 51,000
Accounts Receivables 503,000 365,000
Material Inventories 289,000 300,000
Cost and estimated earnings in excess of billing on work in progress 547,000 450,000
Total Current Assets 1,770,000 1,454,000
Gross Fixed Assets (at cost)
Construction plant 2,072,000 1,903,000
Machinery and Equipment 1,866,000 1,693,000
Furniture and Fixture 358,000 316,000
Vehicles 275,000 314,000
Others 98,000 96,000
Total Fixed Assets 4,669,000 4,322,000
Less Acc. Depreciation 2,295,000 2,056,000

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Net Fixed Assets 2,374,000 2,266,000
Total Assets 3,597,000 3,270,000
Liabilities and Owners' Equity
Current Liabilities
Accounts Payable 382,000 270,000
Notes Payable 79,000 99,000
Billing in excess of cost and estimated earning on work in progress 159,000 114,000
Total Current Liabilities 620,000 483,000
Long-Term Debts 1,023,000 967,000
Total Liabilities 1,643,000 1,450,000
Shareholder's Equity
Preferred Stock –Cumulative, 2000 Share issued and Outstanding 200,000 200,000
Common Stock, Shares issued and Outstanding in 2001, 76,262; in 191,000 190,000
2000, 76,244
Paid- in Capital in Excess of Par on Common Stock 428,000 418,000
Retained Earnings 1,135,000 1,012,000
Total Stockholders' Equity 1,954,000 1,820,000
Total Liabilities and Stockholders' Equity 3,597,000 3,270,000
A) Liquidity Ratios
Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and as they
fall due.
1. Networking Capital: Networking capital, although not actually a ratio, is commonly used to
measure a firm's overall liquidity. It is calculated as follows:

NWC= CA-CL.
Therefore, Networking capital of Merob Company is
For 2001 = 1,770,000-14540000 = 316000
This figure is not useful for comparing the performance of different firms, but it is quite useful for
internal control. Often the contract under which a long-term debt is incurred specifically states a
minimum level of networking capital that the firm must maintain. This requirement is intended to
force the firm to maintain sufficient operating liquidity and helps to protect the creditor. A time-
series comparison of the firm's networking capital is often helpful in evaluating its operations.
2. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term creditors
by using only current assets. That is, it measures a firm’s short-term solvency or liquidity. An ideal
current ratio is 2:1or more. This is because even if the value of the firm's current assets is reduced
by half, it can still meet its obligations.
The current ratio is calculated by dividing current assets to current liabilities.
Therefore, the current ratio for Merob Company is
Current Ratio =
For 2001 = 1,770,000 = 1.22
Current Assets 1454,000
Current Liabilities

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Interpretation :-The unit of measurement is either birr or times. So, we could say that Merob has
Birr 1.22 in current assets for every 1 birr in current liabilities, or, we could say that Merob has its
current liabilities covered 1.22 times over
3. Quick (Acid-test) Ratio:- This ratio measures the short term liquidity by removing the least
liquid assets such as: Inventories, Prepaid Expenses.This ratio should be in the range of
1.0-1.5 An Acid Test Ratio greater than 1.5 indicates the company is covercapitalized and
should consider investing the excess in other profit producing ventures or attempt to
maximize cash turnover through an increased sales volume.

Current assets−Inventories
Quick/Acid test Ratio = Current Liabilities

For 2001, Quick Ration for Merob Company will be: 1,770,000- 289,000 = 2.38
620,000
Interpretation: Merob has 2birr and 38 cents in quick assets for every birr current liabilities.As a
very high or very low acid test ratio is assign of some problem, a moderately high ratio is required
by the firm.
B) Activity Ratios:-
Activity ratios are also known as assets management or turnover ratios. Turnover ratios measure
the degree to which assets are efficiently employed in the given construction firm. They provide
the basis for assessing how the firm is efficiently or intensively using its assets to generate sales.
These ratios are called turnover ratios because they show the speed with which assets are being
converted into sales. generally, high turnover ratios usually associated with good assts
management and lower turnover ratios with poor assets management.
1. Inventory Turnover Ratio:-The inventory turnover ratio measures the effectiveness or
efficiency with which a firm is managing its investments in inventories is reflected in the
number of times that its inventories are turned over (replaced) during the year. In general, a
high inventory turnover ratio is better than a low ratio.
Inventory Turnover = Material cost
Material Inventories
For the year of Merob Company for 2001= 1000, 000/289,000= 3.46 times
Interpretation: - Merob's inventory is sold out or turned over 3.46 times per year.
2. Average Age of Inventory
The number of days inventory is kept before it is used for construction of the company project. It is
calculated by dividing the number of days in the year to the inventory turnover.

Average Age of Inventory =

No daysin year/365 days
InventoryTurnover 6
Therefore, the Average Age of Inventory for Merob Company for the year 2001 is:
365 days = 105 days
3.46
Interpretation: inventory remains in stock for 105days on average before it is used for construction.
Merob is keeping much inventory in its custody and, the company is expected to reassess its
marketing mechanisms that can boost its sales because, the lengthening of the holding periods shows
a greater risk of obsolescence and high holding costs.
3. Accounts Receivable Turnover Ratio : - It indicates how many times or how rapidly accounts
receivable is converted into cash during a year. The accounts receivable turnover is a comparison of
the size of the company’s sales and its uncollected bills from customers. If the company is having
difficulty in collecting its money, it has large receivable balance and low ratio. Reasonably high
accounts receivable turnover is preferable.
Receivable Turnover = Net Sales

Average Account Receivables

The accounts receivable turnover for Merob Company for the year 2001 is computed as under.
Accounts receivable turnover ratio = 3,074,000 = 7.08 higher
434,000*
Average Accounts Receivable is the accounts receivable of the year 2000 plus that of the year
2001 and dividing the result by two.
So, 434 = 503,000 + 365,000/ 2 = 434,000*
Interpretation: Merob Company collected its outstanding credit accounts and re-loaned the money
7.08 times during the year.
4. Average Collection Period: Shows how long it takes for account receivables to be cleared
(Collected). The average collection period represents the number of days for which credit sales
are locked in with debtors (accounts receivables). Assuming 365 days in a year, average
collection period is calculated as follows.

365 days
Average Collection period (ACP)= Re ceivable Turnover

The average Collection period for Merob Company for the year 2001 will be:
365 days/7.08 =51 days or

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 A c p = Average accounts receivables* 365 days/Sales
434,000* 365 days/3,074,000* = 51 days
The higher average collection period is an indication of reluctant collection policy where much
of the firm’s cash is tied up in the form of accounts receivables, whereas, the lower the average
collection period than the standard is also an indication of very aggressive collection policy
which could result in the reduction of sales revenue.
5. Average age of under billing: this ratio measures the number of days the given construction
company takes to collect under billed asset. the lower the ratio is the better for the firm.
For the year of Merob Company for 2001,
Average age of under billing = (under billing /revenue)*365
= (547,000/3,074,000)*365
=65 days
Interpretation;-the company takes 65 days to collect the under billed asset.
6. Average Payment Period ;- The average Payment Period/ Average Age of accounts Payable
shows, the time it takes to pay to its suppliers.

The Average Payment Period (APP)= Accounts Payable

Average purchase per day

Purchase is estimated as a given percentage of cost of goods sold. Assume purchases were 70%
of the cost of goods sold in 2001.

So, A PP = 382,000 = 95 days

2,088,000 x .70/365
This shows that, on average, the firm pays its suppliers in 95 days. The longer these days, the
more the credit financing the firm obtains from its suppliers.
6. Average age of overbilling: this ratio measures the number of days the given construction
company takes to pay over billed cost. The higher the ratio is the better for the firm.
(Over billing /revenue)*365
= (159000/3,074,000)*365
=19 days
C. Leverage Ratios:-Leverage ratios are also called solvency ratio. Solvency is a firm’s ability
to pay long term debt as they come due. Leverage shows the degree of indebtedness of firm.
1, Debt Ratio: Shows the percentage of assets financed through debt. It is calculated as:

Debt ratio = Total Liability

Total Assets 8
 The debt ratio for Merob Company for the year 2001 is as follows:

= 1,643 = 0.457 or 45.7 %

3,597
Interpretation:-This indicates that the firm has financed 45.7 % of its assets with debt. Higher
ratio shows more of a firm’s assets are provided by creditors relative to owners indicating that,
the firm may face some difficulty in raising additional debt as creditors may require a higher rate
of return (interest rate) for taking high-risk.
2. Debt -Equity Ratio: express the relationship between the amount of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of
creditors and shareholders’ against the asset of the firm.

Debt -equity ratio = Total Liability The Debt- Equity Ratio for Merob Company for

Stockholders' Equity the year 2001 is indicated as follows.

Debt- Equity ratio = 1,643,000 = 0.84 or 84 %
1,954,000
Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.
3. Times Interest Earned Ratio: Measures the ability of a firm to pay interest on a timely basis.

Times Interest Earned Ratio =Earning Before Interest and Tax

Interest Expense

The times interest earned ratio for Merob Company for the year 2001 is:
418,000 = 4.5 times
93,000
Interpretation;- earnings of Merob Company can decline 4.5 times without causing financial losses
to the Company, and creating an inability to meet the interest cost.
D. Profitability Ratios:
Profitability is the ability of a business to earn profit over a period of time. Profitability ratios are
used to measure management effectiveness. These ratios include:
A. Gross Profit Margin D. Net Profit Margin
B. Return on Investment
C. Return on Equity

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 A. Gross Profit Margin: This ratio computes the margin earned by the firm after incurring
manufacturing or purchasing costs. It indicates management effectiveness in pricing policy,
generating sales and controlling production costs. It is calculated as: A high gross profit margin
ratio is a sign of good management.
Gross Profit Margin = Gross Profit The gross profit margin for Merob Company for the year

Net Sales
2001is: Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: Merob company profit is 32 cents for each birr of sales.
B. Net Profit Margin: This ratio is one of the very important ratios and measures the
profitableness of sales. It is calculated by dividing the net profit to sales. The net profit is
obtained by subtracting operating expenses and income taxes from the gross profit. Generally,
non operating incomes and expenses are excluded for calculating this ratio. This ratio measures
the ability of the firm to turn each birr of sales in to net profit. A high net profit margin is a
welcome feature to a firm and it enables the firm to accelerate its profits at a faster rate than a
firm with a low profit margin. It is calculated as:
Net Profit Margin = Net Income The net profit margin for Merob Company for the year 2001 is:
Net Sales 230,750 = 7.5 %
3,074,000
This means that Merob Company has acquired 7.5 cents profit from each birr of sales.
C . Return on Investment (ROI): The return on investment also referred to as Return on Assets
measures the overall effectiveness of management in generating profit with its available assets,
i.e. how profitably the firm has used its assets. Income is earned by using the assets of a business
productively. The more efficient the production, the more profitable is the business.
The return on assets is calculated as:
Return on Assets (ROA) = Net Income The return on assets for Merob Company for the year 2001 is:

Total Assets 230,750 = 6.4 %

3,597,000

Interpretation: Merob Company generates little more than 6 cents for every birr invested in assets.

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 D. Return on Equity: The shareholders of a company may Comprise Equity share and
preferred share holders. Preferred shareholders are the shareholders who have a priority in
receiving dividends (and in return of capital at the time of widening up of the Company).
The rate of dividend divided on the preferred shares is fixed. But the ordinary or common
share holders are the residual claimants of the profits and ultimate beneficiaries of the
Company. The rate of dividends on these shares is not fixed. When the company earns profit
it may distribute all or part of the profits as dividends to the equity shareholders or retain
them in the business it self. But the profit after taxes and after preference shares dividend
payments presents the return as equity of the shareholders.
The Return on equity is calculated as:

ROE = Net Income The Return on equity of Merob Company for the year 2001 is:

Stockholders Equity 230,750 = 11.8%

1,954,000
Interpretation: Merob generates around12 cents for every birr in shareholders equity.
E. Market Value Ratio: Market value or valuation ratios are the most significant measures
of a firm's performance, since they measures the performance of the firm's common stocks in the
capital market. This is known as the market value of equity and reflects the risk and return
associated with the firm's stocks.
I. Price- Earnings (P/E) Ratio: The price earning ratio is an indicator of the firm's growth
prospects, risk characteristics, shareholders orientation corporate reputation, and the firm's level
of liquidity.

P/E Ratio = Market Price per Share

Earning per Share

The price per share could be the price of the share on a particular day or the average price for a
certain period.

Assume that Merob Company's common stock at the end of 2001 was selling at birr 32.25, using its
EPS of birr 2.90, the P/E ratio at the end of 2001 is:

= 32.25/ 2.90 = 11.10

Interpretation:- This figure indicates that, investors were paying birr 11.10 for each 1.00 of earnings.
Though not a true measure of profitability, the P/E ratio is commonly used to assess the owners'
appraisal of shares value. The P/E ratio represents the amount investors are willing to pay for each
birr of the firm's earnings. The level of P/E ratio indicates the degree of confidence (or Certainty)

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 that investors have in the firm's future performance. The higher the P/E ratio, the greater the
investor confidence on the firm's future. It is a means of standardizing stock prices to facilitate
comparison among companies with different earnings.
II. Market Value to Book Value (Market-to-Book) Ratios:-The market value to book value ratio is
a measure of the firm's contributing to wealth creation in the society.

Market-Book Ratio = Market Value pre Share

Book Value per Share

The book value per share can be calculated as:

Book value per share = Total Stockholders Equity

No. of Common Shares Outstanding

Book Value per Share for 2001 = 1,954,000 = 25.62

76,262
Therefore, the Market-Book Ratio for Merob Company for the year 2001 is:
32.25 = 1.26
25.62
The market –to-book value ratio is a relative measure of how the growth option for a company is being
valued via-a vis- its physical assets. The greater the expected growth and value placed on such, the greater
this ratio.
Limitations of Ratio Analysis
1. Many large firms operate different divisions in different industries, and for such companies it is
difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more useful
for small, narrowly focused firms than for large, multi divisional ones.

2. Most firms want to be better than average, so merely attaining average performance is not
necessarily good as a target for high-level performance, it is best to focus on the industry leader’
ratios. Benchmarking helps in this regard.

3. Inflation may have badly distorted firm’s balance sheets - recorded values are often substantially
different from “true” values. Further, because inflation affects both depreciation charges and
inventory costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a
comparative analysis of firms of different ages, must be interpreted with judgment.

4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a
food processor will be radically different if the balance sheet figure used for inventory is the one
just before versus just after the close of the coming season.

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5. Firms can employ “window dressing” techniques to make their financial statements look stronger.

6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among firms.
Also, if one firm leases a substantial amount of its productive equipment, then its assets may
appear on the balance sheet. At the same time, the ability associated with the lease obligation
may not be shown as a debt. Therefore, leasing can artificially improve both the turnover and the
debt ratios.

7. It is difficult to generalize about whether a particular ratio is “good” or “bad”. For example, a high
current ratio may indicate a strong liquidity position, which is good or excessive cash, which is
bad (because excess cash in the bank is a non-earning asset).

Similarly, a high fixed asset turnover ratio may denote either that a firm uses its assets efficiently
or that it is undercapitalized and cannot afford to buy enough assets.

8. A firm may have some ratios that look “good” and other that look “bad”, making it difficult to tell
whether the company is, on balance, strong or weak. However, statistical procedures can be used
to analyze the net effects of a set of ratios. Many banks and other lending organizations use
discriminate analysis, a statistical technique, to analyze firm’s financial ratios, and then classify
the firms according to their probability of getting into financial trouble.

9. Effective use of financial ratios requires that the financial statements upon which they are based
are accurate. Due to fraud, financial statements are not always accurate; hence information
based on reported data can be misleading. Ratio analysis is useful, but analysts should be aware
of these problems and make adjustments as necessary.

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