Financial Management
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Mashal Institute of Higher Education
Financial Management
Source person: Kamran Khan
M.Com, B.Com…
Lecturer at Mashal Institute of Higher Education
Mashal institute of Higher Education, Shar-e-new Park, Kabul
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_2
Chapter No. 03
Analysis of Financial Statements
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_3
Chapter No.03 Analysis of Financial Statements
Ratio Analysis
Financial managers use ratios to check the financial statements or to come to know about the
business position.
What is ratio?
A ratio is a relationship between two numbers, for every amount of one thing, how much there
is of another thing. For example, supposing one has 8 oranges and 6 lemons in a bowl of fruit,
the ratio of oranges to lemons would be 4:3 (which is equivalent to 8:6). Or a business having
current assets of value $10000 and current liabilities of $5000, so the ratio of current assets and
liabilities is 2:1 is.
Financial ratio:
Financial ratio is a ratio in terms of finance which shows the existence of one number into
another. It is getting by dividing one number by another.
Classification of financial ratios:
We have 5 groups of financial ratios. These are:
1. Profitability ratios
2. Liquidity ratios
3. Debt ratios
4. Assets activity ratios
5. Market value ratios
1. Profitability ratios: these are the ratios which show the organizational operating
performance of profit earnings.
Ratios in this group are:
a. Gross profit margin
This ratio shows how much profit remains out of each sales dollar after the cost of goods sold.
Formula:
Gross profit margin = Gross profit / Sales * 100
b. Operating profit Margin
This ratio shows how much profit remains out of each sales dollar after the cost of goods sold
and operative expenses.
Formula:
Operating profit Margin = Earnings before Interest and Taxes / Sales * 100
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_4
c. Net profit Margin Ratio
This ratio shows how much profit remains out of each sales dollar after all expenses.
Formula:
Net profit Margin = Net profit available to common stockholders / Sales * 100
d. Return on assets
This ratio shows how much profit each dollar of assets produces.
Formula:
Return on asset = Net profit available to common stockholders / Total Assets * 100
e. Return on equity
This ratio shows how much profit each dollar of owners’ equity produces.
Formula
Return on Equity = Net profit available to common stockholders / common stock equity * 100
2. Liquidity ratios
Liquidity means the ability of quick conversion into cash.
Liquidity ratios show the ability of a firm to meet its short term obligations.
Ratios in this group:
a. The current ratio
This ratio shows for each current liability how much current assets we are having.
Formula:
Current ration = Current Assets / Current Liabilities
b. Quick ratio
This ratio shows a more liquid form of the business.
Formula:
Quick ratio = Current Assets-inventory / current liability
3. Debt ratio
Debt ratios show the debt load on the business and the firm’s ability to pay off the debt.
Ratios in this group:
a. Debt to total assets
This ratio shows the assets available for the debt to pay.
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_5
Formula:
Debt to asset ratio = Total Debt / Total Assets
b. Times interest earned ratio
This ratio shows the ability of a company to pay the interest on its debt with operating income
from the current period.
Formula:
Times interest earned ratio: EBIT / Interest expense
4. Assets activity ratios
These ratios show how efficiently the firm using its assets.
Ratios in this group:
a. Average collection period ratio
This ratio shows in how many days we collect cash from our accounts receivables.
Formula:
Average collection period ratio: Accounts receivable / average credit sale per day
b. Inventory turnover ratio
This ratio shows us how many times a firm converts its inventory into sales.
Formula:
Inventory turnover ratio = Sales / Inventory
c. Total assets turnover ratio
This ratio shows us what is the percentage of sales on total assets? Means how efficiently the
firm using its assets?
Formula:
Total assets turnover ratio = Sales / Total Assets
5. Market Ratios
These are the ratios which show the price in the market and the value in the financial
statements.
Ratios in this group:
a. Price to earnings ratio = Market Price per Share / Earnings per share
b. Market to Book Value = Market Price per Share / Book value per Share
Book value per share = Common stock equity / No. of common shares outstanding
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_6
Topic- Economic value added and Market value added
Economic value added and market value added are the new financial indicators. These
indicators introduced by Stern Stewart & Company, a consulting firm in New York City. These
concepts are discussed as below:
1. Market value added
The primary goal of most of the firms is to maximize the shareholder’s wealth. Shareholder’s
wealth is maximized by maximizing the difference between the market value of the firm‘s stock
and the amount of equity capital that was supplied by the shareholders. This difference is called
the Market Value Added (MVA). It is calculated as:
MVA = Market value of stock – Equity capital supplied by shareholders
= (shares outstanding)(Stock price) - total common equity
Sometimes, MVA is defined as the total market value of the firm minus the total amount of
investors’ supplied capital.
MVA = Total market value – total investor supplied capital
= (market value of stock + market value of debt) – total investor supplied capital
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education
Financial Management
Page_7
2. Economic value added
Whereas market value added measures the effects of managerial actions since the very
inception of the business. Economic value added focuses on the managerial effectiveness in a
given year. It is calculated as:
EVA = Net profit after taxes (NOPAT) – After-tax dollar cost of capital used to support
operations
= EBIT (1 – Tax rate) – (Total net operating capital) (WACC)
Topic- Trend analysis and Industry Comparisons
Ratios are used to compare a firm’s past and present performance and its industry
performance. Here we will discuss the two methods to know the firm’s performance.
a. Trend analysis
Trend analysis is the process of comparing a ratio for one year with the same ratio for other
years of the same firm. Trend analysis helps financial managers and analysts see whether a
company’s current financial situation is improving or deteriorating. Example on trend analysis is
as follows.
Ratio name
ROA
Net profit margin ratio
2010
2%
9%
2011
3%
7%
2012
5%
12%
b. Industry comparison
Industry comparison is the process of comparing a firm’s ratios with that of the other firms’
ratios in the same industry. Example on industry comparison is as follows.
Company’s Name
Ratio
Our company-ABC Company
A Company
B Company
C Company
D Company
Industry average:
ABC+A+B+C+D
5+3+2+5+2/5 = 3%
ROA-----------------------------5%
3%
2%
5%
2%
Lecturer: Mr. Kamran Khan
M.Com, B.Com, D.Com………..
MIHE
Mashal Institute of Higher Education