Finance is considered to be the foundation of the basic activities of any business. Particularly in production and marketing activities, finance functions in the same way as oil functions in the operation of machines or blood functions in the human body.
In the absence of finance, nobody can imagine either setting up a business or its operations and development. The term finance is derived from the Latin word ‘finis’ which means end/finish.
Finance can also be interpreted in many ways such as fund, money, investment, capital, amount, etc. Finance act as a medium for business which involves the acquisition and usage of funds in various departments such as the production department, purchase department, research, and development, etc.
Finance also refers to the science that describes the management, creation, and study of money, banking, credit, investments, assets, and liabilities. Finance consists of financial systems, which include public, private, and government bodies, and the study of finance and financial instruments, which can relate to countless assets and liabilities.
RATIO ANALYSIS
A ratio is one number expressed in terms of another number to show the relationship between the numbers. For example the relationship between 24 and 6 is 24/6 or 4:1 indicating that the former figure is four times as greater as the letter figure/ a variation is to use a base of 100. This is Called percentage. Using the figure at 24 and 6, the percentage become 24/6 x 100 = 400%.
Financial statements (trading profit and loss A/C and balance sheet) are produced not just for their own sake, but for the use to which they can be put by the various parties interested in different aspects of these statements.
Example
1. The DIRECTORATE – interested in overall figure which show whether the company is profitable and whether it is on a sound financial footing.
2. In a manufacturing business, foremen may be concerned with time taken to complete a job or material usage.
3. Department and general managers are concerned about measurements relating to matters falling within their individual responsibilities.
4. Shareholders (actual and prospectively are interested in their earnings (current & future) out of which dividend can be paid, the security of dividend (dividend cover) return on their investment (yield ) etc.
5. External interested parties include loan creditors, for example debenture holders who are concerned that the company is solvent and there is adequate cover for their interest trade creditors (actual and prospective)
who want to be assured that the company is both solvent and liquid, that is it has adequate cash or cash convertible resources to metal current liabilities as they fall due to financial statement analysis consists of applying any tools and techniques to financial statement (other relevant data to obtain useful information).
This information is shown as significant relationship between data and trends in those data assessing the company, past performance and current financial position.
The information shows the results or consequences of prior management decisions. In addition, the information is used to make predictions that many users of financial statements.
In financial statement analysis, it is drawn that there are certain important relationships. (expressed by means of RATIOS) between items within the trading A/C, the profit & loss A/C and balance sheet between the items of one statement and another, ratio analysis is a further helping hand to the interested parties of accounting information in marking their rational decisions.
CATEGORIES OF ACCOUNTING RATIOS
Normally classified according to the aspects of business they are designed to highlight. These aspect fall under the following categories.-
1. Financial soundness and stability, short & long terms. During the short term, the interest is liquidity and during the long term the interest is solvency.
2. Profitability and return on equity or assets.
3. Activity or efficiency measures.
4. Capital structure and gearing measures.
5. Market based ratios.
A. FINANCIAL SOUNDNESS AND STABILITY
These ratios measure the ability of the firm to meet its:
1. Current of working capital ratio
Working capital is the excess of current assets over current liabilities. The current ratio indicates the ability of a company to pay its current liability from current assets. In this may show the strength of the company’s working positions. It is calculated as:
Current ratio = (Current Assets)/(Current Liabilities).
The current ratio provides a better index of a company’s ability to pay current debts than does the absolute amount of working capital.
N.B:
A number greater than one indicates a firm has the ability ot meet its current liabilities and vice versa. But this is not conclusive evidence.
2.Acid test / Quick Asset ratio
Current ratio assumes that current assets could be turned cash immediately. However not all current assets can be readily converted into cash. The acid test ratio recognizes this limitation and excludes stocks and prepaid expenses on its computation because they might not be readily convertible into cash.
The formula is:-
Acid test ratio = (Quick assets)/(current liabilities)
OR
(current assets-stock-prepaid expenses)/(current liability)
3.Debt service coverage ratio/ time interest came / interest coverage ratio
It measures the ability of a firm to service from operations this ratio is computed as.
Interest coverage ratio = (profit before interest and tax)/(Annual interest payment).
4.Debt repayment coverage ratio.
Gives an indication of the length of time it will take to repay borrowings out of profit of the business.
It is calculated as:-
= (long term liabilities+currentliabilities+current assets)/(Annual profit after interest and income tax)
5. Time preferred dividend earned ratio
This measure the ability of a company to make preferred dividend payments each year.
It given as:-
= (Net profit after interest and tax)/(Annual preferred divided)
B: PROFITABILITY AND RETURN ON EQUITY OR ASSETS
Ratios falling into this group measure the ability of a firm to generate profit’
The ability can be measured according to volume of sales or resources employed in generating the profits. These ratios measure the rate of profitability ratios. Profit is taken to be net profit prior to interest and taxes. Ratios falling under this group are:-
1. Group margin / Gross profit ratio
Specific trades / industries. The sales figure is VAT exclusive. A high gross profit percentage does not result in a large (absolute) figure of gross profit.
It is given by:-
(Gross profit )/Sales X 100
2. Operating margin / Net profit ratio/ Net profit to sales percentage reflects the percentage of each shilling of net sales that becomes net operating profit / Net profit.
The sales figure is VAT exclusive.
It is calculated as:-
Operating margin / Net profit ratio = (Profit before interest and tax)/(Net sales) x 100
Or
(Net operating income)/(Net sales) x 100
3. Return on capital employed (ROCE).
This ratio measures profit per value of net assets. The net assets figure is arrived at by using the following alternative formula:-
Capital employed –
1. Fixed assets + current assets – current liabilities
2.Total assets – current liabilities
It is given by the formula
Return on capital employed =
4. Return on total assets.
This ratio measures the ability of a firm in utilizing its total assets to generate profits
It is given by the formula, Return by total assets = x 100.
5. Return on owner’s equity
This ratio measures the return earned by the company on each shillings of shareholders equity invested.
It is given by:
C. ACTIVITY OR EFFICIENCY RATIOS
Various aspects of the efficiency with which assets can be used, can be derived from turn over ratios
The most important ones are;-
1. Inventory turnover
This ratio shows the number of times a company’s average inventory / stock is sold during a period. If the rate is too low or decreasing this may indicate over – stocking or presence of obsolete merchandise.
If it is too high it may indicate under stocking or other problems, depending on the nature of the business and industry.
It is given as:
2. Accounts receivable turnover
This is the number of times per year that the average amount of receivable – is collected. Amount receivable – debtor. Amount A/C payable – creditor.
It is given as:-
This ratio provides an indication of how quickly the receivable (debtors) are collected.
3. Debtors average collection period/ Average collection period for accounts receivable.
Good credit control is an important aspect of sound financial management. The average length of time.
It is given by:-
Debtors average collection period=
Creditors average payment period.
To put the debtors average collection period in perspective credit period granted to customers should not be out of line with the credit period granted by suppliers. Good financial management should ensure a proper balance. This ratio indicates the average period measured in terms of months, weeks or days for which creditors remain unpaid.
It is given by:-
4. Total assets turn over / sales to total assets ratio
This ratio measures the efficiency with which a company uses its assets to generate sales.
That is it indicates how much does a shilling of an asset generate in terms of sales value. The larger the total asset turn over the larger will be the income on each shilling invested in the assets of the business.
It is given by:-
5. Sales to capital employed ratio
It indicates the efficiency of utilization of capital employed in generating revenue.
It is given by:-
D. CAPITAL STRUCTURE AND GEARING MEASURES
Under this category the following ratios can be looked as equity or longer solvency ratios.
Show the relationship of debt and equity financing in a company. It measure the riskiness of business.
1. Equity or stock holders equity ratio
It indicates the proportion of total assets, that is provided by stock holders (owners ) on any given date.
The formula for the equity ratio is
2. Stock holders’ equity to debt ratio.
This indicates the measure of the relative proportion of stock holders and creditors.
It is given by:-
3. Long term debt to share holders funds
It indicates the extent of cover for fixed liabilities (loans, debentures).
It is given by:-
4. Gearing
This ratio defines the proportion of debt capital and ordinary shares/equity capital. It indicates the degree of vulnerability of earnings available for ordinary shares.
Given by:-
NB.
Some companies use ordinary share holder’s funds as denominator i.e. ordinary share capital plus reserves and some use the book value of loans and shares. Usually a gearing of greater than 1:1 is high and less than 1:1 is low.
In practice greater than 0.6:1 is regarded as high and less than 0.2:1 as low, with the range between these two extremes being regarded as relatively high or relatively low.
E. MARKET BASED RATIOS
These are additional ratios that can be computed when data from stock exchange are incorporated. The most common ones are as follows:-
1. Dividend per share
Indicates the dividend and retention policy of the company when used in line with earnings per share (below)
It is calculated as;
2. Dividend yield (on common stock)
Indicates “current return on investment” that is it measures the real rate of return comparing the dividend paid and the market price of a share or that it measures the return on the shares invested using current market price of the shares.
It is given by:-
It provides the investor with measure of the opportunity cost of his or her investment in terms of yield.
3. Dividend cover
It indicates the ability of a firm to sustain dividend payments out of its distributable profit.
4. Earnings per share (EPS)
It indicates the amounts of the net profit after tax (but before extra ordinary items) attributable to each ordinary share in issue, and racing for dividend during the period.
It is calculated as follows:-
N.B.
Earnings available to common stock holders (ordinary) share holders) is equal to Net profit after tax (net income) minus the current years preferred dividends, whether such dividends have been declared or not. And it presents the fund which supports the distribution of profit by the way of dividend to ordinary share holders.
5. Price earnings ratio(P/E) ratio
It is usually used in establishing the market value of a company. It indicates the number of years purchase of the earnings and is regarded internationally as an indicator of future performance. It acts as the index of whether a stock is relatively cheap or expensive based on ratio.
The price earnings ratio is calculated by using the following formula;-
6. Earning yield
It indicates potential return on investment. It highlights the amount earned on the ordinary share relative to their market price.
It is given by:-
LIMITATIONS OF RATIO ANALYSIS
In using ratios, the analyst must keep a few general limitations in mind. The main limitations attached to it are:-
1.It lacks standard values for the ratio, therefore scientific analysis is not possible.
2.As there are no standard with to compare, it fails to throw light on the efficiency of any activity of the business.
3.It gives only the relationship between different variables and the actual magnitudes are not known through ratio.
4.Ratio are derived from the financial statement and naturally reflect their drawbacks.
5.If fails to indicate immediately where the mistake or error lies
6.It does not take into consideration the market and other changes.
7.Seasonal factors can upset ratio analysis.
8.The basis of asset valuation can be misleading.
9.A set of account never shows a complete picture of a company’s activates.
10.Ratios vary enormously between different industries.
PROBLEM
The trading stock of Joan street, retailer, has been reduced during the year ended 31st march 2008 by Tshs 6000 from its commencing figure of Tshs 21000. A number of financial ratios and related statistics have been compiled relating to the business of Joan street for the year ended 31st march 2008 these are shown below:-
Net profit as % net capital employed (see below)
Net profit 15
Sales 9
Sales 166 2/3
Net capital employed
Fixed assets 45%
Working capital ratios
Current assets 400%
Current liabilities
Acid test ratio
Bank + Debtors 275%
Current liabilities
Gross profit 25%
Sales
Debtor’s collection period:
Debtors x 365days 36 ½ days
Sales
Stock turn over (based on average stock for the year 10 times
Prepare the trading and profit and loss account for the year ended 31st 2008 and balance sheet as at that date of Joan Street in as much detail as possible.
Note:
Take the closing figure at 31st march 2008.
Solution
Opening stock 21000
Closing stock = 21000 – 6000 = 15000
Cost of goods sold = 18000 x 10 = 180,000
Open stock + purchases – closing stock = cost of goods sold
21000 + purchases – 15000 = 180000
Purchases = 180,000 + 15000 – 21000
= 174,000/=
Gross profit = 25%
Sales = 25/100 = ¼-1 = 1/3 x 60,000
Sales = GP + Cost of goods sold
= 60,000 + 180,000
= 240,000
Net capital employed
Current assets = 400
Current liabilities 100
Current assets = 4 current liabilities
Working capital = CA – CL
But CA = 4CL
WC = 4CL – CL
WC = 3CL
Working capital = capital employed – fixed assets
WC = 144,000 – 108,000
WC = 3600
WC = 3C.L
36000 = 3C.L
3 3
C.L =12000
Debtors x 365 = 36 ½
Debtors x 365 = 36 ½
Sales 240,000
365 debtors = 36 ½x 240000
Debtors = 24,000
| Trading and profit & loss A/C for the year ended 31/3/2008 | ||||||
| opening stock | 21000 | sales | 240,000 | |||
| add: purchases | 174000 | |||||
| cost of goods available or sale | 195000 | |||||
| less: closing stock | 15000 | |||||
| cost of goods sold | 180000 | |||||
| gross profit c/d | 60000 | |||||
| 240,000 | 240,000 | |||||
| expenses | 38400 | gross profit b/d | 60,000 | |||
| net profit | 21600 | |||||
| 60,000 | 60,000 | |||||
| BALANCE SHEET AS AT 31 DECEMBER 2008 | ||||||
| Capital | 122,400 | fixed assets | 108,000 | |||
| Add; Net profit | 21600 | current assets | ||||
| 144,000 | stock | 15000 | ||||
| current liabilities | 12000 | debtors | 24,000 | |||
| bank | 9000 | |||||
| 156,000 | 156,000 | |||||
EXERCISE
The balance sheet and supplementary data for the KWABWANYENYE LTD.
Are shown below:
Kwabwanyenye ltd
Balance sheet December 31, 1997
Assets Tshs
Cash in hand a/c 50,000
Marketable securities 80,000
Accounts receivable, net C.A 70,000
Inventory A.C 150,000
Building F.A 400,000
Less: accumulated depreciation 100,000 300,000
600,000
Liabilities and stock holders equity TSHS
Accounts payable C.L 30,000
Bank payable C.L 10,000
Mortgage notes payable due in 2000 L.K 40,000
Bonds payable 10% due Dec 31,2002 L.L 100,000
Common stock, Tshs 100 par value capture 300,000
Retained earnings reserve 120,000
Total liabilities and stock holders equity 600,000
Supplementary data:
1997 net income Tshs 60,000
1997 cost of goods sold Tshs. 540,000
1997 sales Tshs. 900,000
Inventory January 1, 1997 Tshs 100,000
Interest expenses Tshs 15000
1997 net income before interest and taxes Tshs 130,000
Net accounts receivable on January 1, 1997 Tshs 50,000
Total assets on January 1, 1997 Tshs 540,000
1997 divided paid Tshs 240,000
Current market price per share Tshs 150
Require: compute the following ratios:
Current ratio
Acid test ratio
Accounts receivable turn over
Inventory turn over
Total assets turn over
Equity ratio
EPs of common stock
P/E ratio
Dividend yield
Gearing
Earnings yield
Debtors days
...
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