Analysis of financial statement

Analysis of Financial Statement
Use of Financial statement
Manager and number of external parties regularly use a firm’s financial statements to evaluate the financial and
operating performance of the business.
Sources of Financial Information
 Published Financial Reports
The firm’s financial Statement contained in the annual report is the end products of the accounting
process. To report on the progress of a firm during the year, most publically held companies also issue
interim reports each quarter. Interim reports focus primarily on the income statement and contain
summary data rather than a full set of financial statements. Still, they provide additional information for
evaluating the financial position and the profitability of the firm’s operations. Unlike the annual reports,
however, interim reports are unaudited.
Annual and interim reports are two of the primary means by which management communicates
information about the firm to interested parties. In addition to the financial statement. These reports
generally contain the auditor’s report. Schedules and explanatory notes. And a discussion and analysis of
the firms operation by management. An analysis of the published reports should include, at a minimum, a
review of these components, for example the auditor’s report tells the reader that the statements were
audited, and whether the statements are fairly presented in accordance with generally accepted
accounting principles .Major concerns of the auditors will also be discussed in the report. A review of the
notes will indicate the accounting policies followed by the company.
 Reports filed With the SEC
Probably the most detailed information available on publicly held companies in contained in the reports
that must be filled with Securities and Exchange Commission (SEC) .these reports include.
Form S-1 A report that must be filed when a firm wishes to offer securities for sale to public. From S-1
contain financial information about the company, its management and management’s plan for the use of
the money received from the sale of the proposed securities.
Form 10-K. An annual report that is more detailed than the published annual report provided to
stockholders.
Form 10-Q. A quarterly report of summarized financial information.
Form 8-k. A special report filed whenever any significant events occur such as a change in top
management.

These reports are available to the public on request.
 Advisory Services And Financial Publications
Financial advisory services, such as Moody’s investors Services and standard and Poor’s Corporation, also
Publish financial data about both publicly and privately owned companies; these are normally not as
detailed as the SEC reports or the Company Reports. The advantages of advisory service reports are their
accessibility since they are found at most public and university libraries.
A comparison of the company under study with firms in a similar line of business and with industry norms
is also useful. Industry data are available from a number of financial services. For examples, Robert Morris
Associates Annual statement studies provide income statement and balance sheet data and 16 financial
ratios for many industries. Dun & Bradstreet publishes an industry Norms and key business Ratios book
that contains typical balance sheet, income statements and 14 selected financial ratios for over 800
different lines of business. The 14 ratios for the most recent year. By industry groups are also published in
key business Ratios by Dun & Bradstreet. Individual company and industry analyses are also available
from stock brokerage firms. An abundance of useful information is found in various economic and
financial newspapers and magazines such as the Wall street Journal, Forbes, Fortune, Business week, and
Barron’s.
In making comparisons with other companies, we must recognize that the company under review may not
be similar to other companies because of diversification into other product lines .Also, because of
diversification; industry data may not clearly resemble the company under study. In such cases, we
attempts to identify the industry that the company best fits and uses that industry data and companies in
that industry group for comparison.
The Need for Analytical Techniques
Information contained in the various sources of financial data is expressed primarily in monetary terms.
When the absolute dollar amounts for most items reported in the financial statements are considered
individually, they are generally of limited usefulness. Significant relationships may not be apparent from a
review of absolute dollar amounts. Because no indication is given whether a particular item is good or bad
for a firm. For example merely knowing that a company reported earnings of $100000 for the current year
is of limited use unless the amount is compared to other information such a last year’s earnings, the
amount is compared to other information, such as last year’s earnings, the amount of capital invested, the
current year’s sales, the earnings of other companies in the same business or some predetermined
amount budgeted by the firm.
To simplify the identification of significant changes and relationships. The dollar amount reported in the
financial statement is frequently converted into the percentages or ratios by the statement user. Some
commonly recognized percentages are sometimes shown in supplementary schedules to the financial
statement as part of the firm’s annual report. The analysis of relationship between dollar amounts of each
item to same base amount is referred to as horizontal analysis and vertical analysis. Ratio analysis is the
interpretation of the relationship between two items. Such as current assets to current liabilities.

Objectives of Financial Statement Analysis
Percentage analysis and ratio analysis have been developed to provide and effective means by which a
statement user can identify.
1. Important relationship between items in the statements and
2. Trends in financial data percentages and ratio simplify the evaluation of financial conditions and
past operating performances.
The information is used primarily to forecast a firm’s ability to pay its debts when due and to operate at a
satisfactory profit level. However because the analytical techniques
Are almost limitless as are the user’s special interests and objectives the choice of
Proper ratio and percentages must fit their specific purposes. For example some users
of financial data are concerned with evaluating the firm’s ability to produce enough cash to pay its short
term debts when they mature and still have sufficient cash left to carry out its other activities. The
concern with a firm’s short-term debt-paying ability is called liquidity. The focus of this type of
investigation is generally on the firm’s current assets and current liabilities.
Other users, such a long-term creditors and stockholders. Want to know about a firm’s liquidity, but are
also interested in the business ability to pay its long-term obligations. This long-term focus deals with a
firm’s solvency. In this analysis the statement user assesses the financial structure of the firm and its use
of financial leverage. The objective is to evaluate the prospects for operating at an earnings level
adequate to provide sufficient cash for the payment of interest. Dividends and debt principal.
Percentage Analysis
1. Horizontal Analysis
An analysis of the change in individual financial statement items from year to year is called
horizontal analysis; Horizontal analysis of the preceding year’s financial statement is generally
performed as a starting point for forecasting future performance. Most firms’ annual reports
include financial statements for the two most recent years and selected summary data for five to
ten year. Financial statements presented for the same company for two or more years are called
Comparative Statements.

In horizontal analysis, the individual items or groups of items on comparative financial statements are
generally first placed side by side, as they are in the first columns of figures. Because it is difficult to
compare absolute dollar amounts, the difference between the dollar amount of one year and the next is
computed in both dollar amounts and percentage change. In computing the increase or decrease the
earlier year is used as the base year. The percentage change is computed as follows:
Percentage Change= 100(Dollar Amount of change )
Dollar amount in previous year
For Example From 1990 to 1991 the cash account of ABC Corporation increased by 90 the percentage
change is 30%.
A percentage change can only be computed when a positive amount is reported in the base year. The
amount of change cannot be stated as a percentage if the item in the base year was reported as a
negative or a zero amount.
We must also be careful when the dollar amount in the base year is small because a small absolute change can result
in a substantial percentage change.For example, assume that net income was $100 last year and increased
to $300 in the current year. This is an increase of only $200 in income. But is a 200% increase in
percentage term such a large percentage change may create a misleading impression.
A review of the percentage increase or decrease will reveal those items that showed the
Most significant change between the periods under study. Important and unusual changes such as a
significant percentage change in sales should be investigated further by the analyst. The objective of the
investigation is:
1) To determine the cause of the change
2) To determine whether the change was favorable or unfavorable.
3) To attempt to assess whether a trend is expected to continue.
WE must also consider changes in other related items. For example when reviewing the percentage changes
in the balance sheet accounts included in figure. Attention is directed to the change is in the plant and
equipment because of the size and direction of the change 44.4% increase the cause of the change is
favorable or unfavorable, We must need to seek further answers to such question as how is the added
investment being financed, is the expansion going to cause severe cash flow problems? Are sales markets
adequate to support the additional output? What is the impact of Expansion on income? Answer To these
questions and announcements made by management, will assist us in determining whether further
expansion is expected to continue and to be effective. We may look to the balance sheet, the income
statement. The statement of cash flow. And supplementary disclosures for additional data in answering
these questions.
Sales in figure increase 7.7% by itself a favorable trend. However the rate of increase in cost of Goods sold
was 10.7% and selling expenses increased by 30.1% thus during the period the firm was unable to maintain
its profit margin percentage. It appears that the increase in sales is a least partially the result of an increased
sales effort. These items warrant further investigation by us if we are concerned with the profitability and
long term future of the firm. in this case the we should try to determine whether inventory cost are
continuing to increase , the extent of competitive pressures on the revenues of the firm and the effect of
the increased selling expenses on future sales.

Trend Analysis
Trend analysis is commonly employed when financial data are presented for three or more years. In this analysis,
the base year is the first year that data are reported. Each financial statement item of the base year is set equal
to 100.In subsequent years statement item are stated as a percentage of their value in the base year as follow:
Index=100(Dollar amount in index year)
Dollar amount in base year
For Example, Assume that sales and net income were reported for the last five years as shown:
It is clear that the dollar amount of both sales and net income are increasing .However, the relationship
between the change in sales and net income can be interpreted more easily. If the changes are expressed in
percentages as shown here
Now it can be seen that net income is increasing more slowly than sales.
The relationship between sales and net income is only one trend to review. The trend in other accounts should
also be investigated, particularly since the level of net income is affected not only by sales but also by the firm’s
expenses. In this case, it is possible that the firms inventory cost are increasing faster than selling prices. Or the
increase in sales may be the result of granting liberal credit terms. Which are resulting in larger bad debt
expenses? The important point is that other related operating data must be also reviewed before drawing a
conclusion about significance of one particular item. The overall objective is to evaluate various related trends and
attempts to assess whether the trends can be expected to continue.
Vertical Analysis
Horizontal analysis compares the proportional changes in a specific item from one period to the next. Vertical
analysis involves restating the dollar amount of each item on the same statement. This item is referred to as the
base amount. For example, on the balance sheet, individual components are stated as a percentage of total assets
or total liabilities and stock holder’s equity. on the income statement , net sales or total revenue are usually set

equal to a base of 100%, with each income statement item expressed as a percentage of the base amount. Such
statements are often called common size statement since all the items are presented as a percentage of some
common base amounts.
Vertical analysis is also an important tool for comparing data to other standards such as the past performance of
the firm. The current performance of competing firms, and averages developed for the industry in which the firm
operates.
Ratio Analysis
A financial statement ratio is computed by dividing the dollar amount of one item reported, the purpose is to
express a relationship between two relevant items that is easy to interpret and compare with other information
.for example the relationship of current assets to current liabilities. Called current ratio. is of interest to most
financial statement users. For a firm reporting current asset of $210000 and current liabilities of $120000 the
current ratio is 1.75. This means that the company has$1.75 in current asset for every $1 of its current liabilities.
The relationship could be converted to a percentage, 175% by multiplying the ratio by 100.in ratio form, or as a
percentage, the relationship between the two items can be more easily compared to other standards, such as the
current ratio of other companies or an industry wide ratio.
Relevant relationship can exist between items in the same financial statement or between items reported in two
different statements; so many ratios can be computed. We must give careful thought to which ratios best express
the relationship relevant to the area of immediate concern. The user must keep in mind that a ratio shows a
significant relationship that may have little significance when used alone. Consequently, to evaluate the adequacy
of a certain relationship, the ratio should be compared to other standards such as an industry average and the
historical record of the company understudy.
Ratios are classified according to their evaluation of a firm’s profitability, liquidity, and solvency.
Ratios To Analyze Profitability
Profitability analysis consists of tests used to evaluate a firm’s earning performance during the year. The result are
combined with other data to forecast the Firm’s potential earning power, which is more important to managers,
long-term creditors, and stock holders because , in the long run, the firm must operate at a satisfactory profit to
survive. Potential earning power is also significant for other statement users. Such as suppliers and labor unions,
who are interested in maintaining a continuing relationship with a financially sound company? A firm’s financial
soundness depends on its future earning power.
Adequacy of earnings is measured in terms of the relationship between earnings and either total assets or
common stockholder’s equity, the relationship between earnings and sales, and the availability of earning to
common stockholders. If earning appears to be inadequate, the next step is to determine why. Is the sales volume
too low? Are the costs of goods sold and or other expenses too high? Is the investment in assets excessive in
relation to the firm’s sales?
Rate of Return on Total Assets
Rate of return on total assets is determined by dividing the sum of net income plus after-tax interest expense by
average total assets for the year:

Return on Total Assets= Net Income + Interest Expense (Net of tax)
Average total Asset
Interest expense (net of tax) is computed as:
Interest Expense X (1.0- income tax rate)
Interest expense is added back to net income in the numerator to derive the total return earned on the total assets
used, Regardless of how they were acquired. In other words, interest expense is a return to the creditors for the
use of their money to finance the acquisition of assets. The net of tax interest expense is used because it is the net
cost to the firm for using borrowed funds; Average total assets are used in the denominator because the earnings
were produced by employing resources throughout the period. The sum of the beginning and ending total assets is
divided by two to compute average total assets. If sufficient information is available, a monthly or quarterly
average would be preferred to minimize the effects of seasonal fluctuations.
The management of XYZ Corporation produced a return on averaging total assets of 11.0% in 1991 and 13.5% in
1990 as computed below assuming the tax rate was 21 and 26% respectively:
1991 1990
558+252(1.00-.21) = 11.0% 690+230(1.00-.26) = 13.5%
(6,300+7,440)/2 (6,400 +6300)/2
During 1991, Management produced approximately 11 cents in profit for every dollar of asset invested, compared
with 13.5 cents for every dollar in 1990.The decrease in the ratios between the two years is significant and result
from decreased net income combined with an increased investment base. Such a decrease highlights the need for
further investigation by us.
Rate of Return on Common Stockholder’s Equity
The return on total assets does not measure the return earned on the assets invested by the common
stockholders. The return to the common stockholders may be greater or less than the return on total assets
because of the firm’s use of financial leverage. Financial leverage is the use of borrowed funds or other financing
sources, such as preferred stock, to earn a return greater than the interest or dividends paid to the creditors or
preferred stockholders, If a firm is able to earn more on these funds than the amount that must to be paid to the
creditors or preferred stockholders, the return to the common stockholders will be greater than the return on total
assets. If the amount earned on the funds is less than the return on total assets. The rate of return to common
stockholders may be computed as:
Return on Common Stockholder’s equity= Net income-Preferred stock dividend Requirements
Average Common Stockholders’ Equity
The preferred dividend requirement is subtracted from net income to yield the portion of net income allocated to
the common stockholder’s equity. The denominator excludes the preferred stockholder’s equity in the firm.

The Computation for ABC Corporation are shown here:
Note that these rates are higher that the corresponding returns computed on total assets because the company
earned a return on the assets financed by the creditors and preferred stockholders greater than the interest or
dividends paid to them. However, the percentage decreased from 26 in 1990 to 17.1 in 1991 a decrease worthy of
further investigation.
Return on sales
Return on sales-also called the profit margin is called during a vertical analysis of income statement, it reflects the
portion of each dollar of sales that represents net income. Return on sales is computed by dividing net income by
net sales.
Return on sales= Net Income
Net Sales
For ABC Corporation the rates are
1991 1990
558
5%
690
7%
10320 9582
For 1991, each Dollar of sales produced 5 cent in net income. Consistent with other ratios computed, this is
measure shows a declining profitability trend for the firm. The ratio should, ofcource, be compared to other
standards to be more useful. If the return on sales for competing firms is 4.5% for example, the 5% appears
favorable. Even so, other data, such as increases in major expenses, should be investigated further because some
problem areas or Poor management practices could be discovered to explain the decline between the two years.

Earnings Per Share
The Earning per share (EPS) of common stock is widely used in evaluating a firm’s financial performance; the ratio
is commonly used to compile earning data for the press and for statistical services. It is a well-publicized ratio
because its converts the absolute dollar amount of net income to a per share amount. That is, the EPS ratio is the
amount of net income earned on one share of stock it is computed as follows:
EPS=
Net income -Preferred stock dividend Requirements
Weighted Average Number of Common shares outstanding
In the ABC Corporation illustration, the calculations are
1991 1990
558-30
$3.52
690-30
$5.50
150 120
The average number of common shares outstanding is computed on a weighted average basis. The weighted
average is based on the number of months that the shares were outstanding .The average number of shares for
1990 and 1991 is computed on the assumption that 120000, shares were outstanding during 1990 and that 30000
additional shares were issued at the beginning of 1991.
The EPS ratio means that for 1991 the firm earned $3.52 per share of common stock outstanding .current generally
accepted accounting standards require that the EPS must be disclosed on the face of the income statement.
Price –Earnings Ratio
The price-Earnings Ratio (P/E ratio) indicates how much investors are currently paying for each dollar of earnings.
It enhances a statement user’s ability to compare the market value of one common stock, relative to earnings to
that of other companies. The ratio is computed by dividing the current market price of share of common stock by
the Earning per share.
P/E Ratio = Market Price per share of Common Stock
Earnings per share
Assuming a market price of $40 per share ABC Corporation common stock on December 31, 1991 the P/E ratio is
computed as follows:
40
11.36 times
3.52

The Common stock of ABC Corporation is said to be selling for 11.4 times its earnings.
P/E ratios vary widely since they represent investor’s expectations about the future earnings power of company.
Thus high P/E ratios are associated with companies with prospects of high earning growth. Whereas more stable
firms have lower P/E ratios. For example in the early part of 1988. Companies associated with high technology
generally had high P/E ratios. Apple computer had a P/E of approximately 27. On the other hand, companies in the
auto industry had low P/E ratio-Ford Motor Company and General Motors had P/E ratios of 5 and 7 respectively.
Dividend Yield
The dividend yield is normally computed by investors who are primarily investing in common stock for dividends,
rather than for appreciation in the market price of the stock. The percentage indicates a rate of return on the
dollars invested and permits easier comparison to returns from alternative investment opportunities. The dividend
yield is computed as follows:
Dividend Yield Annual Dividend per share of Common Stock
Market Price Per share of Common Stock
Cash Dividends of $150000 ($1 per share) were paid during 1991 to the common stockholders of ABC Corporation,
Assuming market price of $40 per share, the Dividend yield is computed as follows:
1
2.50%
40
The $150000 can be verified as follows
Retained Earnings 1/1/91 1100000
Add : Net income 558000
Less :Cash dividend
Preferred stock 30000
Common stock 150000 180000
Retained Earning 31/12/1991 $1,478,000
Dividend per share as follows
Dividend Per share Dividends to Common stockholders
Number of Common share outstanding

$150,000
150000 shares
$1 per shares
Dividend Payout
Investors interested in dividend yields may also compute the percentage of common stock earnings distributed as
dividends to the common stock-holders each period. This ratio is referred to as the dividend payout ratio.
Dividend payout= Total dividend to Common Stockholders
Net Income- Preferred Stock Dividend Requirements
For ABC Corporation, The 1991 ratio is computed below:
150
28%
558-30
The Ratio provides an investor with some insights into management’s Policy of distributing dividends as a
percentage of net income available to common stockholders .A low payout ratio would indicate that management
is reinvesting earnings internally. Such a Company would be desirable for someone interested in investing for
growth in the market price of the shares. A Company with a consistently high payout ratio would appeal to an
investor who depends on dividends as a source of current income (e.g. retired individual).
Ratios To Analyze Liquidity
Liquidity- that is, the firm’s ability to meet its short-term obligation-is an important factor in financial statement
analysis, After all, a firm that cannot meet these obligation may be forced into bankruptcy and will not have the
opportunity to operate in the long run. The focus of this type of analysis is on working capital or some components
of working capital.
Current Ratio
Perhaps the most commonly used measure of a firm’s liquidity is the current ratio which is computed as follows:
Current Ratio=
Current Assets
Current Liabilities

The current ratio measure the Creditors Margin of safety in being paid. It indicates the relationship of current
assets to current liabilities on a dollar per dollar basis. A low ratio may mean that the firm would be unable to
meet its short-term debt in an emergency. A high ratio is considered favorable to creditors, but may indicate
excessive investment in working capital items, such as holding slow selling inventory. That may not be producing
income.
Analysts often contended that the current ratio should be at least two to one. In other words, a firm should
maintain $2 of current asset for every $1 of current liabilities. Although such a rule is one standard of comparison,
it is arbitrary and subject to exception and numerous qualifications in the modern approach to statement analysis.
Deviations from 2:1 rule nevertheless indicate an area in which additional tests are needed to evaluate the time
meeting its shot-term commitment therefore, to assess its liquidity the quick ratio and turnover ratios discussed
below and the company’s cash flow should be carefully investigated.
The current ratios for ABC Corporation for 1991 and 1990 are:
1991 1990
4340
2.47
3900
2.44
1760 1600
ABC Corporation shows a slight improvement in the relationship between current assets and current liabilities and,
in the absence of other information, would be considered liquid, at least in the short run. However, a ratio of 2.4
or higher may signify excessive investment in current assets that is a high ratio may indicate that the company is
holding too many assets that are not producing revenue.
Quick Ratio
One of the limitations of the current ratio is that it include inventory and prepaid expenses in the numerator,
however, these items are not as liquid as cash, marketable securities, notes receivable, or accounts receivables. In
the normal course of business. Inventories must first be sold and the cash must be collected before its is available,
also most prepaid expenses, such as prepaid insurance, are to be consumed and cannot be readily converted into
cash’s ratio used to supplement the current ratio that provides a more rigorous measure of liquidity is the quick
ratio or acid test ratio. As it is sometimes called. The quick ratio is computed by dividing the sum of the most liquid
current assets-generally cash, short-term marketable securities and net current receivable-by the current liabilities
as follows:
Quick Ratio=
Cash +Marketable Securities + Net Receivables
Current liabilities
The higher the ratio, the more liquid the firm is considered, A lower ratio may indicate that, in an emergency, the
company would be unable to meet its immediate obligations.

The Quick ratios for ABC Corporation are computed as follows:
1991 1990
Cash $390 $300
Marketable Securities 380 440
Account Receivable (Net) 1460 1290
Total quick Assets $2,230 $2,030
1991 1990
2230
1.27
2030
1.27
1760 1600
A Ratio of 1.27:1 in both years shows that the firm is highly liquid. However, this observation is somewhat
dependent on the collectability of the receivables included in the numerator.
The current ratio and quick ratio measure the adequacy of the firm’s current assets to satisfy its current obligations
as of the balance sheet date.However, these ratios ignore how long it takes for a firm to collect cash-an important
aspect of the firm’s liquidity, since receivables and inventories normally makeup a large percentage of a firm’s
current assets, The quick ratio and current ratio may be misleading if there is an extended interval between
purchasing inventory, selling it, and collecting cash from the sale. Thus, the receivable turnover and inventory
turnover ratios are two other liquidity measures that often yield additional information. These turnover ratios are
sometimes called activity ratios.
Receivable Turnover
The receivable turnover ratio is a measure of how many times the average receivable balance was converted into
cash during the year. It is also considered a measure of the efficiency of the firm’s credit-granting and collection
policies it is computed as follows:
Receivable Turnover= Net sales
Average Receivable Balance
The higher the receivable turnover ratio, the shorter the time period between recording a sale and collecting the
cash. To be competitive, the firm’s credit policies are influenced by industry practicing. Comparison of this ratio to
industry norms can reveal deviations from competitors operating results.

In computing this ratio, credit sales should be used in the numerator whenever the amount is available, however,
such information is normally not found in financial statements, and so net sales are substituted. An average of
monthly receivable balance should be used in the denominator. In the absence of monthly information, the year-
end balance, an average of the beginning of the year and end of the year balances, or averages of quarterly
balances are used in the calculation. The average of the receivable balance is used because net sales earned over a
period of time. Therefore the denominator should approximate what the receivable balance was throughout the
period.
The computation for ABC Corporation is:
1991 1990
10320 7.51
times
9582
7.34 times
(1290+1460)/2 (1320+1290)/2
Frequently, the receivable turnover is divided into 360 days to derive the average number of days its takes to
collect receivables from sales on account.
1991 1990
360 days 48.0
days
360 days
49.0 days
7.51 7.34
During 1991, the corporation collected the average account receivables balance 7.51 times. Expressed another
ways, it took an average of 48.0 days to collect sales on account, an improvement of one day over 1990.these
measures are particularly useful if one knows the credit terms granted by the firm. Assuming credit terms of 60
days, the average 48-to -49 day collection period shows that the firm’s credit policy is effective and firm probably is
not burdened by excessive amounts of uncollectible accounts that have not been written off. A collection period
significantly in excess of 60 days indicates a problem with either the granting of credit, collection policies or both.
Inventory Turnover
The control of the amount invested in inventory is an important aspect of managing a business, the size of
investment in inventory and inventory turnover depend on such factors as type of business and time of year, A
grocery store has higher turnover that an automobile dealership. The inventory level of a seasonal business is
higher at certain times in the operating cycle that at others. The inventory turnover ratio is a measure of the
adequacy of inventory and how efficiently it is being managed. The ratio is an expression of the number of times
the average inventory balance was sold and then replaced during the year. The ratio is computed as follows:
Inventory Turnover=
Cost of Goods Sold
Average Inventory Balance
Cost of Goods sold, rather than sales, is used in the numerator because (1) it is a measure of the cost of inventory
sold during the year and (2) the cost measure is consistent with the cost basis of the denominator. Ideally, an
average monthly inventory balances should be computed. But this information is generally not available to

external parties in published reports. A quarterly average can be computed if quarterly interim reports are
published by the firm.
The inventory turnover ratios for ABC Corporation using the average of beginning and ending inventories are:
1991 1990
7719 4.08
times
6975 3.84
times(1770+2010)/2 (1860+1770)/2
The average days per turnover can be computed by dividing 360 days by the turnover ratio.
1991 1990
360 days 88.2
days
360 days
93.8 days
4.08 3.84
The turnover ratio indicates that the average inventory was sold 4.08 times during the year, as compared to 3.84
times in 1990.in terms of days the firm held its inventory approximately 88 days in 1991 before it was sold,
compared to about 94 days in 1990.
The increased turnover in 1991 is generally considered a favorable trend. Inventory with a high turnover is less
likely to become obsolete and decline in price before it is sold. A higher turnover also demonstrates greater
liquidity, since the inventory will be converted into cash in a shorter period.Howerver, given the nature of the
firm’s business, a very high turnover may indicate that the company in carrying insufficient inventory and is losing
a significant amount of sales.
Ratios to Analyze Solvency
Another important use of financial statement analysis is to evaluate a firm’s solvency, or its ability to meet
commitments arising from utilizing financial leverage, in the long run. A firm uses financial leverage whenever its
finances a portion of its assets by borrowing or by issuing preferred stock. Issuing bonds to finance the purchase of
plant assets is an example of using financial leverage. Debt of the firm carries two obligations: one to make interest
payments on specified dates and the other to repay the principal when it matures. If a firm fails to meet these
commitments, the bondholders can force the firm into bankruptcy, thus, borrowing increases the risk of default.
The advantage to the common stockholders is that their return may be increased if the return earned on the funds
borrowed is greater than the cost of the debt.AS a result, managers, long-term creditors, short term creditors and
stockholders are all concerned with the amount of financial leverage a firm employs.
Several ratios are used to analyze a firm’s solvency; one approach focuses on the firm’s ability to meet its interest
commitments as indicated by the income statement, while second ratio considers the firm’s ability to carry debts
as indicated by the balance sheet.
Debt to Total Assets
The percentage of total assets financed by creditors indicates the extent to which the firm uses debt financing .The
ratio of debt to total assets, also called the debt ratio. Measures the relationship between total liabilities and total
assets and is computed as follows:

Debt to Total Asset=
Total Liabilities
Total Assets
A high debt to total assets ratio indicates a greater risk of default and less protection for the creditors, this
percentage is important to long-term creditor and stockholders, since the creditor have a prior claim to assets in
the event of liquidation. That is the creditors must be paid in full before assets are distributed to stockholders, the
greater the percentage of assets invested by stockholders, the greater the protection to the creditors.
1991 1990
3660
49.20%
3300
52.40%
7440 6300
Thus, for both years, approximately 49 to 52% of the assets were provided by the firm’s creditors.
Because of the trade-off between increased risks for potentially greater returns to common stockholders, no single
percentage is considered best in all cases. Other things being equal, firms with stable income can issue a greater
percentage of debt than firms with volatile income. Stable income levels enable a statement user to better predict
from period to period the level of debt costs that can be paid with cash generated by operation.
Times Interest Earned
The times interest earned ratio is an indication of the firm’s ability to satisfy periodic interest payments from
current earnings. The rough rule of thumb is that the company should earn three to four times its interest
requirement. Since current interest charges are normally paid from funds provided by current operations, we
frequently compute the relationship between earning and interest.
Times Interest Earned=
Net Income+ Interest Expense+ Income Tax Expense
Interest Expense
Interest expense and income tax expense are added back to net income in the numerator because the ratio is a
measure of income available to pay the interest charges for ABC Corporation, the ratios are shown below:
1991 1990
Net income $558 $690
Interest Expense 252 230
Income Tax Expense 144 237
Totals $954 $1,157

1991 1990
954
=3.79
1157
=5.03
252 230
In 1990, earnings before interest and income taxes were 5.03 times interest expense. This ratio declined to 3.79 in
1991.the 1991 result is Marginal, but it is still an adequate coverage according to the rule of Thumb, However, the
result should be considered in relation to other trends in the company’s financial status, especially the trend in this
ratio, and in comparison with other standards, such as industry averages.
Limitations of Financial Analysis
The analytical techniques introduced in this are useful for providing insights into the financial position and results
of operations of a particular firm. Statement users must be careful in interpreting trends and ratios computed from
reported financial statements, certain basis limitations and an explanation of each follow:
1. Financial analysis is performed on historical data primarily for the purpose of forecasting future
performance. The historical relationship may not continue because of changes in:
a) The general state of economy
b) The business environment in which the firm must operate
c) Management
d) The Policies established by management
2. The measurement base used in computing the analytical measures in historical cost. Failure to
adjust for inflation or for changes in fair value may result in some computations providing
misleading analysis of trends and comparisons between companies. For example, the return on
total asset includes net income in the numerator, which is affected by the current year’s sales
and current operating expenses measured in current dollars. However, fixed assets and other
nonmonetary items are measured in historical dollars, which are not adjusted to reflect current
price levels, thus the ratio divides items primarily measured in current dollar amounts by a total
measured primarily in terms of historical dollars.
3. Year-end data may not be typical of the firm’s position during the year. Knowing that certain
ratios are computed at year-end, management may improve a ratio by entering into certain
types of transactions near the end of the year, for example, the current ratio can be improved by
using cash to pay off short-term debt. To illustrate, assume that a firm reported current assets of
$200000 and current liabilities of $100000 before paying $50,000 on account payable. The
payment will increase the current ratio as shown here:
Before Payment Payment
After
Payment
Current assets $200,000 $50,000 $150,000
Current Liabilities 100,000 50,000 50,000

Also, a firm usually establishes a fiscal year-end that coincides with the low point of activity in its
operating cycle. Therefore, account balances such as receivables, payables, and inventory may
not be representative of the balances carried in these accounts during the year.
4. Companies may not be comparable. Data among companies may not provide meaningful
comparisons because of such factors as the use of different accounting methods, estimates made
by company management the size of the companies, and diversification of product lines.
The selection of a particular accounting method or estimate can have significant effect on net income and financial
position of a firm. Using accounting methods or making estimates that result in reporting the lowest net income In
the current period is considered a conservative approach to income measurement. For example, in a period of
increasing inventory prices, the last in, first out (LIFO) inventory method results in the lowest net income, so it is
conservative. First in, first out (FIFO) is the least conservative inventory method when prices are increasing .To use
a 5 year period to amortize an intangible asset rather than a 40-year period is another example of conservatism. As
Financial analysts we carefully review such policies to assess what is called the quality of earnings. A firm that
follows more conservative policies is considered to have a high quality of earnings.
Current Ratio 200,000
2
Current Ratio 150,000
3
100,000 50,000

Analysis of financial statement

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