Financial Performance Analysis: A study on Selected
Private Banks in Ethiopia
By
WESEN LEGESSA TEKATEL
Under the Supervision of
Dr. M. SARADA DEVI
MBA, Ph.D.
PROJECT SUBMITTED TO ANDHRA UNIVERSITY, SCHOOL OF DISTANCE
EDUCATION, VISAKHAPATNAM
FOR THE AWARD OF THE DEGREE OF
EXECUTIVE MASTER
OF
BUSINESS ADMINESTRATION
DECLARATION
I declare that the project entitled “Financial Performance Analysis: A study on Selected Private
Banks in Ethiopia” submitted by me for the award of Executive Master of Business
Administration is original and it has not been submitted previously in part or full to any
university for the award of degree or diploma
_________________________
Wesen Legessa Tekatel
Date: __________________
CERTIFICATE
We certify that this is a bona fide work done by Mr. Wesen Legessa Tekatel, a student of School
of Distance Education for the award of the Degree of Executive Master of Business
Administration in the School of Distance Education, Andhra University, Visakhapatnam under
my guidance.
_________________________
Prof. M. Sarada Devi
Project Supervisor
Date :___________________
ACKNOWLEDGEMENT
First of all, I would like to thank my advisor, Dr. M. Sarada Devi, MBA, Ph. D. Professor
Department
of
Commerce
and
Management
for
her
unreserved
guidance
through the whole period. This research paper would not have been possible without her
technical input and support. Secondly, I would like to thank Commercial Bank of Ethiopia for
providing necessary data and material support during my stay.
My gratitude also goes to my friend Teshome Dula, for his generous assistance and sharing of
knowledge to make this paper a success. Many thanks also go to the staff and management of the
School of Distance Education, Andhra University for your cooperation and support during the
study period.
Thank you all.
Wesen Legessa Tekatel
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Though economic development of a particular country is dependent on a number of factors such
as industrial growth and development, modernization of agriculture, expansion of domestic and
foreign trade, political stability, its dependence to largest extent on the banking sector is
undeniable and/or banks play a key role in improving economic efficiency by channeling funds
from resource surplus unit to those with limited access and/or the needy. Misra & Aspal (2013)
According to Zerayehu et al., (2013) and Ermiase Mengesha(2016) a sound financial system is
indispensable for a healthy and vibrant economy. The financial system in Ethiopia, which is
characterized as highly profitable, concentrated, and moderately competitive is dominated by
banking industry and it is also amongst the major under banked economy in the world (World
Bank, 2013). The development of a vibrant and active private banking system that complements
with the existing public sector work is considered important to Ethiopia’s economic progress
according to the professional advice of group of experts working in well-known financial
organization like WB, AfDB, and IMF. (Keatinge, 2014)
Hence, maximum care should be taken in order to maintain the safety and soundness of private
commercial banks in Ethiopia. Any failure /incident in the banking industry especially in a
country where the commercial banks dominate the financial sector will definitely have a
contagious effect that can lead to bank runs and crises. Hence, it would be mandatory to
scrutinize and take proactive measures to maintain the health of the economy and build up the
public confidence.
When analyzing financial fitness, corporate accountants and investors alike closely examine a
company’s financial statements and balance sheets to get a comprehensive picture of
profitability. The study used to solve the problem explained such as financial statements in their
raw format do not reveal the information as per required by its users. There are a number of
metrics and corresponding financial ratios that are used to measure profitability. Typically,
analysts look to the standardized profitability metrics outlined in the generally accepted
accounting principles (GAAP), because they are easily comparable across business and
industries, but some non- GAAP metrics are widely used.
There is also no performance measurement among the private commercial banks operating in
the country. This undermines the banks financial operations such as profitability, efficiency,
liquidity, and solvency.
The study employs the ratio analysis to compare the financial performance for selected private
Commercial Banks in Ethiopia. Presently there are sixteen private commercial banks and three
state owned banks operating in Ethiopia. From those banks we were select ten private
commercial banks namely: Awash International Bank, Bank of Abyssinia, Cooperative Bank of
Oromia, Dashen Bank, Lion International Bank, Nib International Bank, Oromia International
Bank, United Bank, Wegagen Bank, and Zemen Bank. To do so, fifteen financial ratio analysis
used such as, operating profit margin, net profit margin, return on assets, return on equity, assets
utilization, operating expenses ratio, loans to deposits ratio, loans to assets ratio, debt to equity
ratio, earning per share, price earnings ratio, dividend payout ratio, dividend yield ratio,
inventory turnover ratio and equity multiplier.
Most of the studies on bank profitability have categorized the determinants of profitability into
endogenous and exogenous factors. The endogenous factors are those firm specific factors that
result from the decision and policies of management. Hence, efficiency, profitability, liquidity,
capital structure, and asset quality ratios are among the endogenous factors. On the other hand,
market concentration, ownership, and other macroeconomic factors such as economic growth
and inflation are classified as exogenous factors. Unlike in Ethiopia, there are many literatures
and arguments as to which factors determine commercial banks profitability in the developed
world.
Hence, owing to existence of very limited literature in the subject matter and inspired by ratio
analysis we explored the performance among selected private commercial banks in Ethiopia. The
rationale behind focusing on bank specific variables only is owing to the existing less
competitive and highly protected Ethiopian banking environment. Moreover, the exogenous
factors are not expected to differ among the target banks that are selected for this particular study
since all are operating under the same financial system, same regulatory organ and are within the
same geographic area.
Therefore, this work solely seeks to examine the effect of bank specific variables to rank the
overall financial performance of selected private commercial banks. The project used seven
years of secondary data in the industry so as to systematically analyze the effects of banks
specific performance analysis. Hence, all the target banks selected for this particular study are
classified under the medium category since all of them have stayed seven or more years in the
business.
1.2 Overview of Ethiopian Private Financial Sector
The financial sector in Ethiopia is composed of the banking industry, insurance companies,
microfinance institutions, saving and credit cooperatives and the informal financial sector. The
banking industry accounts about 95% of the total financial sector assets, implying that the
financial sector is under developed, and activities that banks could perform are legally limited,
which in turn contribute to lesser contestability. (Zerayehu et al., 2013)
Ethiopia’s banking industry is closed and generally less developed than its regional peers. The
industry comprise one state owned development bank and 18 commercial banks, two of which
are state-owned including the dominant commercial bank of Ethiopia (CBE), with assets
accounting for approximately 70 percent of the industry’s total holdings. As per the information
disclosed in the NBE’s Second Quarter Report (2014/15), the Ethiopian financial system is
comprised of one central bank (NBE), 19 commercial banks of which three are owned by the
government, 32 micro-finance institutions’ (MFIs), 17 insurance companies of which 16 are
privately owned, two pension funds namely: Social Security Authority and Private Sector Social
Welfare Agency and numerous savings and microcredit associations. It contrasts with regional
and international peer countries where banking industries have a much higher share of private
sector and foreign participation. (Keatinge , 2014)
Financial intermediation is relatively low in Ethiopia and it is in declining trend. Financial
intermediation is a driving force for economic development. In 2011, credit to private sector was
around 14 percent of the gross domestic product (GDP). This indicates that it is falling behind its
sub-Saharan African peers, which was compared to be 23 percent on average. Despite the overall
disintermediation trend, the Ethiopian financial sector continues to have the potential to be a
driver of economic growth. The banking sector remains, stable, well capitalized and continues to
be highly profitable. The Ethiopian banking sector ranks higher than the SSA average in terms of
profitability measured on the basis of Return on Equity (ROE).
Modern banking in Ethiopia was introduced in 1905 by an agreement between the then Ethiopian
Emperor Menelik II and a representative of the British owned National Bank of Egypt. The
stated agreement has led to the establishment of Bank of Abyssinia and it has been inaugurated
in Feb16, 1906. Later on in the 1930’s, the bank was bought by the Ethiopian government and
the State Bank of Ethiopia was established by a proclamation issued in August 1942. This bank
was later disintegrated into two different banks forming the National Bank of Ethiopia and the
Commercial Bank of Ethiopia. (Leulseged 2005; Alemayehu 2006)
In the history of Ethiopian banking industry, Addis Ababa Bank Share Company was the first
private Ethiopian bank that had been established by the Ethiopian citizens’ initiative and with the
collaboration of National and Grandly bank London which had a possession of 40 percent of the
total share holdings. The stated company had started its operation in 1964 with a paid up capital
of two million. In the pre-1974 era, there hardly was any banking competitive environment, since
the banking industry was dominated by a single government owned State Bank of Ethiopia.
(Zerayehu et al., 2013)
After the termination of fragile and inefficient state-dominated banking sector that has existed in
Ethiopia from 1974-1991, the current government restructured and introduced a new Banking
and Monetary proclamation that gave more autonomy and further clarified the National Bank of
Ethiopia’s activities as a regulator and supervisor of the banking sector. Moreover, the reform
has legalized investment in the domestic private banking sector in 1994 under proclamation no.
84/1994 that marked the beginning of a new era in the Ethiopian banking sector. (Admasu &
Asayehegn 2014) In the Ethiopian banking industry, there exist only two forms of bank
ownership: fully government owned or fully privately owned. No hybrid form of the two forms
of ownership or the involvement of foreign ownership exists. (Tesfaye, 2014). Ethiopian law
prohibits non-Ethiopian citizens from investing in Ethiopian Financial Institutions (NBE,
Guideline No.FIS/01/2016). So almost all share holders of Ethiopian private banks are Ethiopian
citizens.
To sum up, the banking industry in Ethiopia is highly regulated and closed from foreign
competition. Banks operate extremely in conservative lending policies and require physical
collateral for virtually all loans constrain inclusive growth. Key risks to financial stability and
inclusive growth include: Unpredictable inflation; foreign exchange shortage exacerbated by
unstable export performance; lack of skilled manpower in the banking industry; collateral based
lending is constraining private sector lending and alternative financing mechanism is lacking;
ineffective ICT infrastructure on account of very weak internet connectivity; regulatory burden
and/or tightening of regulations (the 27% NBE bill and entry barrier for new private banks by
increasing the capital requirement can be mentioned ); restriction of foreign bank entry; lack of
standardized accounting practices, and very weak and less organized risk management practices.
Getnet(2012) and Ermiase(2016).
1.3 Statement of the problem
Competition in the Ethiopian banking industry is labeled as incontestable and difficult to enter
owing to legal, technological and economic policy factors. Zerayehu et al. (2013) As a matter of
fact, the Ethiopian government has implemented a number of reforms in the banking sector since
it took power. However, all the measures taken to improve the banking sector significantly fall
short. Hence, the existing Ethiopian financial sector is not able to offer adequate and competitive
services on the scale required and it is not yet competitive and efficient. Admassu & Asayehgn
(2014), Ermiase(2016).
Moreover, the Ethiopian banking sector has been known for supplying limited financial products,
expensive branch expansions, low levels of technology utilization, huge reliance on manual
work, and concentration on urban areas over the past two decades. Therefore, private commercial
banks cannot continue doing business using traditional business models in this very competitive
industry and need to upgrade their overall competitiveness. As a matter of fact, it has alerted the
need for frequent bank examinations all over the world. Thus, Ethiopian private commercial
banks need to learn timely on how to stay healthy, competent and profitable in a very
competitive and dynamic business environment. In this study we will alert the private
commercial banking sector to take necessary measures based on the recommended analysis. And
also we have shown the position of selected banks in the industry. Hence, this particular research
is meant to fill the gap in this regard.
1.4 Research Objectives
1.4.1 General Objective
The general objective of the study is to analyze the performance of private commercial banks in
Ethiopia and to rank the respective private commercial banks based on their performances.
1.4.2 Specific Objectives:
Specific objectives that are derived from the general objective and needed to be addressed in the
studies are:
To identify the key bank performance.
To measure the significance level of performance drivers in Ethiopian private
commercial banks
To examine the performance of private commercial banks by rating each bank specific
proxy (in a multi -dimensional way)
1.5 Significance of the study
This study assists investors in understanding the current situation (strength & weaknesses) of
Private commercial banks in Ethiopia which in turn will help investors to make information
based decisions. The outputs of the study are expected to have the following importance:
It assists the government body to rank the private banks based on results.
It helps for decision making of the new investors in the private banking industry.
To be used as a spring board for other advanced researchers.
1.6 Scope of the study
The study is going to use the data’s of ten private commercial banks for the years 2009-
2015 (7 years) ; however, results can be generalized to cover all private commercial banks.
1.7 Limitations of the study
The study is limited to the performance analysis of private commercial banks by applying
financial ratio analysis only.
1.8 Organization of the Study
Introduction
Literature Review
Research Method
Quantitative
Research(using secondary data, books, journals, working papers , internet sources, etc. )
Empirical research
Analysis of finding
Conclusion.
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
A healthy and vibrant economy requires a financial system that moves funds from people who
save to people who have productive investment opportunities. The financial system is complex in
both structure and function throughout the world. It includes many different types of
institutions’: banks, insurance companies, mutual funds, stock and bond markets, etc.
According to Spong(2000), efficiency and competition are closely linked. In a competitive
banking system, banks must operate efficiently and utilize their resources wisely if they are to
keep their customers and remain in business. Zerayehu et al., (2013) also argued that survival in
today’s competitive environment totally depends on performance and growth. Competition has
implications for efficiency, innovation, pricing, availability of choice, consumer welfare, and the
allocation of resources in the economy.
2.2 Theories of Bank Profitability
According to literatures, bank performance studies have been started in the late 1980s and/or
early 1990s. These studies revolve on different theories. For Instance, the signaling theory,
which elaborates the relationship between capital and profitability, suggests that higher capital is
a
positive
signal
to
the
market
of
the
value
of
bank.
(Berger,
1995)
By the same token, a lower leverage indicates that banks perform better than their competitors
who can’t raise their equity without further deteriorating the profitability (Ommeren, 2011).
Bankruptcy cost hypothesis on the other hand, argues that in case where bankruptcy costs are
unexpectedly high , a bank holds more equity to avoid period of distress (Berger, 1995). Hence,
both the signaling theory and bankruptcy cost hypothesis support the existence of a positive
relationship between capital and profitability. However, the risk-return hypothesis suggests that
increasing risks, by increasing leverage of the firm, leads to higher expected return (profitability)
on one hand and it will definitely reduce the equity to asset ratio (represented by capital) on the
other hand. Thus, risk-return hypothesis predicts a negative relationship between capital and
profitability. (Obamuyi, 2013)
Contrary to the above argument, Modigliani – Miller theorem conclude that no relationship exists
between the capital structure (debt or equity financing) and the market value of the bank
(Modigliani and Miller, 1958). In other words, no relationship exists between equity to asset
ratio and funding costs or profitability under perfect market. However, when the concept of
Money Market’s perfect market is scrutinized there is no such a thing in the real world owing to
agency problem, information asymmetry problem, existence of transaction costs, etc. Thus, when
the perfect market does not hold there could be a possible negative relationship between capital
and profitability. Ommeren, (2011), Olweny and Shipho (2011) argued that the Market Power
theory (MP) assumes bank profitability is a function of external market factors, while the
Efficiency Structure (ES) theories and the balanced portfolio theory largely assume that bank
performance is influenced by internal efficiencies and managerial decisions. Despite the
existence of several models to deal with bank specific aspects, none of the models are believed to
be sufficient to express all bank specific behaviors in a holistic manner, the researchers asserted.
2.3 Performance Measurement in Banks
According to Aburime (2009), the importance of bank profitability can be appraised at the micro
and macro level of the economy. At the micro level, profit is the essential prerequisite of a
competitive banking institutions and the cheapest source of funds. It is not merely a result, but
also a necessity for successful banking in a period of growing competition on financial markets.
Hence, the basic aim of every bank management is to maximize profit, as an essential
requirement for conducting business.
Various literatures written by academicians also assert that profitability is the bottom line or
ultimate performance result showing the net effects of bank policies and activities in a financial
year. As a matter of fact, numerous factors such as inflation, accounting policy, high level of
competition, etc., may have an influence on a bank’s profitability. In due course, wide varieties
of ratios are discussed and different measures of profitability of commercial banks have been
suggested.
For instance, Net Interest Margin (NIM), Return on Assets (ROA), and Return on Equity were
identified by Ahmed (2003) are in use in the literature since then. Profitability measures
according to Akinola (2008) include Profit before Tax (PBT), Profit after Tax (PAT), ROE, Rate
of Return on Capital (ROC). Some other, studies on profitability have also used returns
on average bank assets (ROAA), net interest margin (NIM) and return on average equity
(ROAE) to measure profitability according to Francis (2013). However, owing to divergent
views among scholars on the superiority of one indicator over the others as measures of
profitability, there is no clear cut stand as to which best fits. Nonetheless, most literatures confine
the profitability measure only to the three widely used measures namely Return on Assets
(ROA), Return on Equity (ROE), and Net Interest Margin (NIM). Accordingly, some scholars
select either of the three and some others preach to select three of them at once.
In line with the above discussion, the researcher has used ROA as measure of profitability for
this particular study owing to the limitations of NIM & ROE. NIM is reported to have two major
limitations. First, it doesn’t measure the total profitability of the bank as most of them earn fees
and other non-interest income through service like brokerage and deposit account services
without taking account operating expenses, such as personnel and facilities costs, or credit costs.
Besides, net interest margin of two banks can’t be contrasted as both the banks are poles apart in
their own way in the nature of their activities, composition of customer base, etc. http: //
www.readyratios.com
ROE is also indicated to have a lot of limitations. First, it is not risk sensitive. A decomposition
of ROE shows that a risk component represented by leverage can boost ROE in a substantial
manner. Second, ROE is unable to indicate risky assets and their solvency situation. Third, ROE
failed to discriminate the best performing banks from the others in terms of sustainability of their
results especially in the 2008 banking crises. Fourth, ROE is a short term indicator and must be
interpreted as a snapshot of the current health of institutions. It does not take into account either
institution’s long term strategy or the long term damages caused by the crisis. Its weaknesses are
even more obvious in times of stress, when there is a climate of uncertainty surrounding the
medium term profitability of institutions. (ECB, 2010)
Flamini et al., (2009) has also argued that analysis of ROE disregards financial leverage and the
risk associated with it. Hence, for the reasons stated above, ROA is considered as key proxy for
bank profitability, instead of the alternative return on equity (ROE) & net interest margin (NIM).
ROA measurement includes all of a business’s assets including those which arise out of
contribution by investors. Moreover, the inclusion of liabilities makes ROA even more valuable
as an internal measurement tool, particularly in evaluating the performance of different
departments or divisions of a company.
2.4 Financial Statements Analysis
Analysis of financial statements is the process of evaluating the relationship between
component parts of financial statements to obtain a better understanding of the firm’s position
and performance. The focus of financial analysis is on key figures in the financial statements and
the significant relationship that exists between them. The first task of the financial analyst is to
select the information relevant to the decision under consideration from the total information
contained in the financial statements .The second step is to arrange the information in a way to
highlight significant relationships. The final step is interpretation and drawing of inferences and
conclusions. In brief, financial analysis is the process of selection, relation and evaluation.(Khan,
M Y, 2007).
Financial performance analysis is, therefore, the process of identifying the financial strengths
and weakness of a firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account. Financial performance analysis involves careful selection
of data from financial statements for the purpose of forecasting the financial health of the firm.
This is accomplished by examining trends in key financial data, comparing financial data
across firms, and analyzing key financial ratios. It also involves the assessment of firm’s past,
present and anticipated future financial condition.
2.4.1 Types of Financial Analysis
Financial analysis can be both internal and external.
Internal financial analysis:
Internal financial analysis (also known as managerial financial analysis) is necessary for meeting
the own requirements of a company. It is aimed on determination of liquidity or results
estimation of a last fiscal period. Usual output of internal analysis is a set of administrative
decisions – combination of various measures intended for optimization of certain issue within the
business. The internal analysis is typically performed inside a company by its financial
department and constantly revised because of changes in macro- and microeconomic
environment. Due to the nature of data sources using for the internal analysis (internal
accounting books and reports), its results are always precise.
External financial analysis:
An external analyst does not have access to internal financial data and, hence, has to carry out
so-called external financial analysis, when initiative does not belong to a company’s
management, but to a third party. The main goal and objectives of external analysis may differ
from its managerial analogue. The defining a creditworthiness and investment possibilities by an
investor, may serve purposes of an external financial analysis. In similar way, financial liquidity
or solvency can be of interest for a bank. To make a better decision, potential business partners
wish to know maximum available information about a firm and amount of risk involved in
respect of investments profitability and possible gains and losses. External financial analysis is
based on published accounting statements and aimed on prediction of a possible bankruptcy,
assessment
of
business
performance
and
financial
sustainability
of
a
company.
Irrespective of type of the analysis, its methods are very similar in their determination and
interpretation of various financial ratios, studying of changes over time and structural changes of
articles. Correct application of financial analysis allows answering many questions concerning
financial health of a business. (Pandey, 2006)
2.4.2 Basics of financial statements
Financial reporting system of a company utilizes its specially determined accounting statements
and rules of their application. Regulation and use of financial reports is coordinated by national
or (and) international accounting standards. There are four main financial statements:
A balance sheet
An income statement
Cash flow statement and
Statement of shareholders’ equity
2.4.3 Common-size statements
Common size statement is a statement in which all items are expressed as a percentage of a base
figure, useful for purposes of analyzing trends and changing relationship among financial
statement items. These percentage figures bring out clearly the relative significance of each
group of item in the aggregative position of the company.
Common size ratios are used to compare financial statements of different size companies or of
the same company over different periods. By expressing the items in proportion to some size
related measure, standardized financial statements can be created, revealing trends and providing
insight into how the different companies compare. A common size analysis scales the financials
into a percentage of sales for the income statement and a percentage of total assets on the balance
sheet. The scaling effect highlights the most important expense areas and can reveal problem
areas that may not have been noticed before.
It also provides a way to compare year-to-year variations in financials. The common size ratio
for each line on the financial statement is calculated as follows:
reference
item
interest
of
item
ratio
size
Common
The ratios often are expressed as percentages of the reference amount. Common size statements
usually are prepared for the income statement and balance sheet, expressing information as
follows:
Income statement items- expressed as a percentage of total revenue
Balance sheet items-expressed as a percentage of total assets Hettihewa, Samantala (
1997).
CHAPTER THREE
METHODOLOGY
3.1 Data collection
Main data for our project are the annual financial reports of each concerned bank included in our
studies. When we measurement the ratio analysis for any company, we must be used in annual
financial report. We have also used four main financial statements for ratio analysis of selected
private commercial banks such as balance sheets, an income statement, cash flow statement,
statement of shareholder’s equity.
3.2 Sample Size
The sample size consists of ten Ethiopian private commercial Banks listed on National Bank of
Ethiopia. Annual Time Series data for both independent and dependent variables were extracted
from the respective banks’ annual audited financial statements from the period 2009-2015.
3.3 Data analysis
We used the model for performance evaluation of selected private commercial banks. In this
work by using the data from financial report such as balance sheet, income statement and cash
flow statement of the respected private banks, and using ratio analysis method we investigated
the performance of private banks in Ethiopia.
3.4 Formula and Basic Concepts on Ratio analysis
Ratio analysis involves the methods of calculating and interpreting financial ratios to assess the
firm’s performance and status. It is a widely used tool of financial analysis. It can be used to
compare the risk and return relationships of firms of different sizes. Ratio analysis is defined as
the systematic use of ratio to interpret the financial statements so that the strengths and
weaknesses of a firm as well as its historical performance and current financial condition can
be determined.
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 as is it
too high or too low? Is it good or bad? , a meaningful standard or basis for comparison is
needed (Gitman, 2004).
Ratio analysis studies levels and changes of relative measurements of financial performance.
This method is the most commonly used in the world practices of financial analysis because of
its relative simplicity and availability of data sources. When using the ratio analysis one can tell
how profitable a business is: to show if it has enough capital to meet its obligations and even
suggest whether its shareholders satisfied by an increasing value of the company or not.
Ratio analysis can also help to confirm whether a company is doing better this year than it was
last year; and it can tell how a firm is performing comparing with similar firms in industry.
The proper application of a ratio depends on correct economical and financial meaning of that
ratio. To be useful, both the meaning and limitations of a chosen ratio have to be understood.
Meaningful ratio analysis must conform to the following elements:
1. The viewpoint of the analysis taken;
2. The objectives of the analysis;
3. The potential standards of comparison.
The information contained in the main financial statements has major significance to various
interested parties who regularly need to have relative measures of the company’s business
efficiency. Financial analysis conducted for the need of third parties is external by its nature and
often called “analysis of financial statements”. The analysis of financial statements is based on
the use of ratios. The only data sources to ratio analysis are the firm’s financial statements.
(Gitman, 2004)
Frank J. Fabozzi and Pamela P. Peterson in their “Financial Management and Analysis” propose
following classification of financial ratios according to the way they are constructed. They define
four types of ratios:
Coverage ratios: A coverage ratio is a measure of a firm’s ability to “cover” certain
financial obligations. The denominator is an obligation and the numerator is the amount
of the funds available to satisfy that obligation.
Return ratios: A return ratio indicates a net benefit gained from particular investment of
resources or any other similar activity. The numerator is the net result of an operation and
the denominator is the resources spent for that operation.
Turnover ratios: A turnover ratio is a measure of how much a firm gets out of its assets. It
compares the gross benefit from an activity with the resources employed in it.
Component percentage: A component percentage is the ratio of one amount in a financial
statement, such as sales, to the total of amounts in that financial statement.(Fabozzi, et al.,
2003)
To make correct conclusions on ratio analysis, two types of ratio comparisons should be made:
cross-sectional approach and trend-analyzing method.
Cross-Sectional Analysis: involves comparison of different firms’ financial ratios over the
same period in time. It usually concerns two or more companies in similar lines of business.
The typical business is interested in how well it has performed in relation to other firms in its
industry.
Trend Analysis (or Time-Series Analysis): In trend analysis, ratios are compared over
periods, typically years. Year-to-year comparisons can highlight trends and point up possible
need for action. Trend analysis works best with three to five years of ratios.
The theory behind time-series analysis is that the company must be evaluated in relation to its
past performance ,developing trends must be isolated ,and appropriate action must be taken to
direct the firm towards immediate long term goals .Time-series analysis is often helpful in
checking the reasonableness of a firm’s projected financial statements. Certainly, the most
informative approach to ratio analysis combines both cross-sectional and trend analyses. A
combined view makes it possible to assess the trend in the behavior of the ratio in relation to the
trend for the industry.
We can use Financial ratios to evaluate five aspects of operating performance and financial
conditions:
Return on investment
Liquidity
Profitability
Activity
Financial leverage
There are several ratios revealing each of the five aspects of firm’s operating performance and
financial condition and more details about it will follow in the next section.
3.4.1 Liquidity Ratios
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come
due (Gitman, 2004). Liquidity also stands for ability of a company to convert its assets into cash
quickly and with lower costs as possible. Such liquid assets are necessary to cover any “financial
emergencies” and play as a buffer in company’s operations. Liquidity ratios reflect the short term
financial strength/solvency of a company.
The liquidity of a business firm is usually of particular interest to its short-term creditors since
the liquidity of the firm measures its ability to pay those creditors. Several financial ratios
measure the liquidity of the firm. Those ratios are the current ratio, the quick ratio or acid test,
cash ratio and net working capital.
Current Ratio: The current ratio, one of the most commonly cited financial ratios, measures the
company’s ability to meet its short-term obligations by using only current assets. The current
assets consist of cash and assets that can easily be turned into cash and the current liabilities
consist of payments that a company expects to make in the near future. Thus, the ratio of the
current assets to the current liabilities measures the margin of liquidity. It is known as the current
ratio. The current ratio is probably the best known and most often used of the liquidity ratios.
s
Liabilitie
Current
Asset
Current
Ratio
Current
A satisfactory current ratio would enable a company to meet its obligations even when the value
of the current assets declines. The higher the current ratio, the larger is the amount of birr
available per birr of current liability, the more is the company’s ability to meet current
obligations and the greater is the safety of funds of short-term creditors. Thus, current ratio, in a
way, is a measure of margin of safety to the creditors.
It is important to note that a very high ratio of current assets to current liabilities may be
indicative of slack management practices, as it might signal excessive inventories for the current
requirements due to poor inventory management, excessive cash due to poor cash management
and poor credit management in terms of overextended accounts receivable. At the same time, the
company may not be making full use of its current borrowing capacity. Therefore, a company
should have a reasonable current ratio (Khan, M Y, 2007).
The result of very high current ratio is to have an improved liquidity and greater safety of funds
of short-term creditors thereby reduced risk to creditors but a sacrifice of profitability because
current assets are less profitable than fixed assets. A very lower current ratio indicates opposite
from the higher current ratio stated above.
Quick (Acid-Test) Ratio: Measures liquidity by considering only quick assets. Differences in
structure of assets may require calculating the quick ratio. Some assets are more liquid than
others are. For example, inventories have relatively low liquidity since selling of them may
require lowering prices and a business has to find a buyer if it wants to liquidate the inventory, or
turn it into cash. Finding a buyer is not always easy. On the other side, cash, short-term
securities,
and
bills
that
customers
have
not
yet
paid,
are
more
liquid.
The quick ratio provides, in a sense, a check on the liquidity of a company as shown by its
current ratio. The quick ratio is a more rigorous and penetrating test of the liquidity position of a
company.
s
Liabilitie
Current
receivable
notes
and
accounts
Securities
Cash
Ratio
Quick
)
(
Generally, a quick ratio of 1:1 is considered satisfactory as a company can easily meet all current
claims. (Khan, M Y, 2007)
Cash Ratio (Absolute liquidity ratio): The most liquid assets of the company’s are cash and
financial instruments. These assets have an absolute liquidity and allow redeeming all
obligations in no time. The recommended value of this ratio is 0.2 to 0.5.
s
Liabilitie
Current
Securities
term
short
Securities
Cash
Ratio
Quick
)
(
Operating Cash Flow Ratio: is focused on the ability of a company’s operations to generate the
resources needed to repay its current liabilities. Current maturities of long-term debts along with
notes payable comprise of current debt obligations.
s
Liabilitie
Current
Operations
from
Flow
Cash
Ratio
Flow
Cash
Operating
These measures of liquidity are just indicators of a problem financial situation and aimed to
attract attention of an involved party. They are no substitutes for a detailed financial plan
ensuring that a company can pay its bills. Liquidity ratios also have a negative characteristic.
Because of short-term assets and liabilities are easily changed, measures of liquidity can rapidly
become outdated. (Khan, M Y, 2007).
3.4.2 Profitability ratios
Profitability is a relative term. It is hard to say what percentage of profits represents a profitable
firm, as profits depend on such factors as the position of the company and its products on the
competitive life cycle (for example profits will be lower in the initial years when investment is
high),
on
competitive
conditions
in
the
industry,
and
on
borrowing
costs.
For decision-making, it is concerned only with the present value of expected future profits. Past
or current profits are important only as they help to identify likely future profits, by identifying
historical and forecasted trends of profits and sales. Profitability ratios measure operating
efficiency and ability to ensure adequate return to shareholders.
In other words, they are used to evaluate the overall management effectiveness and efficiency in
generating profit on sales, total assets and owners’ equity.
Profitability ratios help to measure how well a company is managing its expenses. These
measurements allow evaluating the company’s profits with respect to a given level of sales, a
certain level of assets, or the owner’s investment. It is related to the effectiveness with which
management has employed both the total assets and the net assets as recorded on the balance
sheet. These ratios are usually created by relating net profit, defined in a variety of ways, to the
resources utilized in generating that profit. (Khan, M Y, 2007).
Gross Profit Margin: This ratio measures the percentage of sales money remaining after the
firm has paid for its goods. The higher the gross profit margin, the better and the lower the
relative cost of sales.
A company should have a reasonable gross margin to ensure adequate coverage for operating
expenses of the company and sufficient return to the owners of the business, which is reflected in
the net profit margin.
The gross profit margin ratio is calculated as follows:
Gross proit margin = Sales −Cost of goods sold
Sales
= Gross proit
Sales
In general, a company’s gross profit margin should be stable. It should not fluctuate much from
one period to another, unless the industry it is in has been undergoing drastic changes, which will
affect the costs of goods sold or pricing policies.
Operating Profit Margin: It measures the percentage of each monetary unit from sales
remaining after all costs and expenses other than interest, taxes, and preferred stock dividends
are deducted (Gitman, 2004).It represents the pure profit earned on each sales Birr. Operating
profits are pure because they ignore any financial and government charges and measures only the
profit earned on operations. If a company’s margin is increasing, it is earning more per 1
monetary unit of sales. A high operating profit margin is preferred.
! ” = !#
$%#
Net Profit Margin: The net profit margin measures the percentage of each monetary unit from
sales remaining after all costs and expenses, including interest, taxes, and preferred stock
dividends, have been deducted.
Return on Assets (ROA): Measures the overall effectiveness of management in generating
profits with its available assets. A company is efficient if it can generate an adequate return while
using the minimum amount of assets. Efficiently working company does not require too much
cash for everyday operations and can shift its excesses to investments in new spheres.
Consequently, the ROA is considered a critical ratio for determining a company’s overall level
of operating efficiency and it shows how much profit was earned on the total capital used to
make that profit. Here, the profitability ratio is measured in terms of the relationship between net
profits and assets. The ROA may also be called profit-to-asset ratio. The formula is as follows:
(Khan, M Y, 2007).
&’ (### = ) !#
* % (###
Return on Equity (ROE): The return on equity ratio or ROE is a profitability ratio that
measures the ability of a firm to generate profits from its shareholders investments in the
company. In other words, the return on equity ratio shows how much profit each rupees of
common stockholders’ equity generates.
The return on equity measures the return earned on the owners’ capital (both preferred and
common stockholders’) as an indicator of management’s performance.
High return on equity indicates effective management performance but low return on equity
indicates ineffective management performance. (Khan, M Y, 2007).
&’ +,’- =
) . /
$ℎℎ %1# +,’-
Return on Capital Employed (ROCE): This ratio indicates the efficiency and profitability of a
company’s capital investments. This ratio provides sufficient insight into how efficiently the
long-term funds of owners and lenders are being used. The higher the ratio, the more efficient is
the use of capital employed. (Khan, M Y, 2007).
&’ 2% +/% -1 =
+34*
* % (## −2′ 56%#
3.4.3 Activity (Utilization) Ratios
This is another set of ratios to estimate how efficiently a company uses its working capital.
Efficiency (or activity) ratios measure the speed with which various accounts are converted into
sales or cash – inflows or outflows. Asset management ratios usually compare the level of sales
or cost of goods sold with the level of investment in various asset accounts. They measure how
