CHAPTER TWO

FINANCIAL ANALYSIS AND PLANNING

2.1 Meanings and Objectives of Financial Analysis

Financial analysis refers to analysis of financial statements and it is a process of

evaluating the relationships among component parts of financial statements. The focus of

financial analysis is on key figure in the financial statements and the significant

relationships that exist between them. Financial analysis is used by several groups of users

like managers, credit analysts, and investors.

The analysis of financial statements is designed to reveal the relative strengths and

weakness of a firm. This could be achieved by comparing the analysis with other

companies in the same industry, and by showing whether the firm’s position has been

improving or deteriorating over time. Financial analysis helps users obtain a better

understanding of t he firm’s financial conditions and performance. It also helps users

understand the numbers presented in the financial statements and serve as a basis for

financial decisions.

2.2 Approaches (Tools) to financial analysis and interpretation

A number of methods can be used in order to get a better understanding about a firm’s

financial status and operating results. The most frequently used techniques in analyzing

financial statements are:

i) Ratio Analysis – is a mathematical relationship among money amounts in the financial

statements. They standardize financial data by converting money figures in the

financial statements. Ratios are usually stated in terms of times or percentages. Like

any other financial analysis, a ratio analysis helps us draw meaningful conclusions and

interpretations about a firm’s financial condition and performance.

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ii) Common size Analysis expresses individual financial statement accounts as a

percentage of a base amount. A common size status expresses each item in the

balance sheet as a percentage of total assets and each item of the income statement as a

percentage of total sales. When items in financial statements are expressed as percentages

of total assets and total sales, these statements are called common size statements.

iii) Index Analysis expresses items in the financial statements as an index relative to

the base year. All items in the base year are assumed to be 100%. Usually, this

analysis is most appropriate for income statement items. According to users of financial

information, there are two techniques of financial analysis. These are:

i) External Analysis an analysis performed by outsiders to the firm such as

creditors, investors, suppliers etc.

ii) Internal Analysis an analysis performed by corporate finance and

accounting departments for the purpose of planning, evaluating, and controlling

operating activities.

2.2.1 Types of Ratio analysis

There are several key ratios that reveal about the financial strengths and weaknesses of a

firm. We will look at five categories of ratios, each measuring about a particular aspect of

the firm’s financial condition and performance

i. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect

the short term financial strength or solvency of a firm. In other words, liquidity ratios

measure a firm’s ability to pay its current liabilities as they mature by using current

assets. There are two commonly used liquidity ratios: the current ratio and the quick ratio.

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 Zebra Share Company
Income Statement
For the Year Ended
December 31, 2

Net sales Br. 196,200,000

Cost of goods sold 159,600,000

Gross profit Br. 36,600,000

Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.

Zebra Share Company

Statement of Retained Earnings

For the Year Ended December 31, 2002

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000

Sub-total Br. 12,900,000

Less: Cash dividends

Preferred stocks Br. 300,000

Common stokes 3,300,000

Sub-total Br. 3,600,000

Retained earnings at end of year Br. 9,300,000

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 Zebra Share Company

Comparative Balance Sheet

December 31, 2001

Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800

i) Current ratio measures the ability of a firm to satisfy or cover the claims of short-
term creditors by using only current assets. This ratio relates current assets to current
liabilities
Current ratio = Current assets
Current liabilities

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Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times

Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in
good position to meet its current obligations. Conversely, relatively low current ratio is
interpreted as an indication that the firm may not be able to easily meet its current
obligations. A reasonably higher current ratio as compared to other firms in the same
industry indicates higher liquidity position. A very high current ratio, however, may
indicate excessive inventories and accounts receivable, or a firm is not making full use of
its current borrowing capacity.

ii) Quick ratio (Acid test ratio)- measures the short-term liquidity by removing the least
liquid current assets such as inventories. Inventories are removed because they are not
readily or easily convertible into cash. Thus, the quick ratio measures a firm’s ability to
pay its current liabilities by using its most liquid assets into cash.

Quick ratio = Current assets Inventory

Current liabilities
Zebra’s quick ratio (for 2002) = Br. 57,600 Br. 24,900 = 0.86 times

Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.

Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-tem
obligations, and the higher the quick ratio the more liquid the firm’s position. But the
quick ratio is more detailed and penetrating test of a firm’s liquidity position as it
considers only the quick asset. The current ratio, on the other hand, is a crude measure of
the firm’s liquidity position as it takes into account all current assets without distinction.

 Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These
ratios include turnover ratios because they show how rapidly assets are being converted

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(turned over) into sales or cost of goods sold. Activity ratios are also called asset
management ratios, or asset utilization ratios, or efficiency ratios. Generally, high
turnover ratios are associated with good asset management and low turnover ratios with
poor asset management. Activity ratios include:

i) Accounts Receivable turnover measures how efficiently a firm’s accounts receivable

is being managed. It indicates how many times or how rapidly accounts receivable are
converted into cash during a year.

Accounts receivable turnover = Net sales

Accounts receivable
Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times

Br. 20,700

Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal
credit policy, more restrictive cash discount offers, poor credit selection or in adequate
cash collection efforts.

ii) Days sales outstanding (DSO) also called average collection period. It seeks to
measure the average number of days it takes for a firm to collect its accounts
receivable. In other words, it indicates how many days a firm’s sales are outstanding
in accounts receivable.

Days sales outstanding = 365 days

Accounts receivable turnover

Zebra’s days sales outstanding = 365 days = 39 days

9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost

39 days. If Zebra’s credit period is less than 39 days, some corrective actions should be
taken to improve the collection period.

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 The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable.

iii) Inventory turnover measures how many times per year the inventory level is sold

(turned over).
Inventory turnover = Cost of good sold
Inventory

For Zebra Company (2002) = Br. 159,600 = 6.41times

Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can
apply sales. In general, a high inventory turnover is better than a low turnover. But
abnormally high inventory turnover might result from very low level of inventory. This
indicates that stock outs will occur and sales have been very low. A very low turnover, on
the other hand, results from excessive inventory levels, presence of inferior quality,
damaged or obsolete inventory, or unexpectedly low volume of sales.

iv) Fixed assets turnover measures how efficiently a firm uses it fixed assets. It shows
how many birrs of sales are generated from one birr of fixed assets

Fixed assets turnover = Net sales___

Net fixed assets

Zebra’s fixed assets turnover = Br. 196,200 = 2.04X

Br. 96,300

Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed
assets.

A fixed assets turnover ratio substantially lower than other similar firms indicates under
utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low

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 sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.

The fixed assets turnover may be deceptively low or high. This is because the book
values of fixed assets may be considerably affected by cost of assets, time elapsed since
their acquisition, or method of depreciation used.

v) Total assets turnover indicates the amount of net sales generated from each birr of
total tangible assets. It is a measure of the firm’s management efficiency in managing its
assets.
Total assets turnover = Net Sales
Total assets

Zebra’s total assets turnover = Br. 196,200 = 1.27X

Br. 153, 900
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr
invested in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low
turnover indicates a firm is not generating a sufficient level of sales in relation to its
investment in assets.

 Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales,
total assets, and owner’s equity. The following ratios are among the many measures of a
firm’s profitability.

i) Profit Margin shows the percentage of each birr of net sales remaining after
deducting all expenses.

Profit margin = Net income

Net Sales
Zebra’s profit margin = Br. 3,900 = 2%
Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing
strategy as well as the amount of all costs and expenses of a firm.
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ii) Return on investment (assets) measures how profitably a firm has used its
investment in total assets.
Return on investment = Net income
Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 %
Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets

Generally, a high return on investment is sought by firms. This can be achieved by

increasing sales levels, increasing sales relative to costs, reducing costs relative to sales,
or efficiently utilizing assets.

iii) Return on equity indicates the rate of return earned by a firm’s stockholders on
investments made by themselves.

Return on equity = Net income___

Stockholders’ equity

Zebra’s return on equity = Br. 3,900 = 6.99%

Br. 55,800

Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.

Return on equity = Return on investment

1 Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance.
On the contrary, a low ratio may indicate greater owner’s capital contribution as compared
to debt contribution. Generally, the higher the return on equity, the better off the owners.

2.3 Meanings and purposes of financial forecasting (Planning)

Financial forecasting is one of the four major jobs of a firm’s financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making

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 financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process
which involves:
- Evaluation of a firm’s need for increased or reduced productive capacity and
- Evaluation of the firm’s need for additional finance
Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, is forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects:
- It helps a firm to predict appropriate demand for its products.
- It helps a firm to project its sales and accordingly to predict its assets properly.
- It contributes significantly to the firm’s profitability.
- It plays a crucial role in the value maximization goal of a firm.

Financial forecasts are also meanses for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast will be analyzed. Finally, the firm’s management will have
an opportunity to make some decisions before hand

So, all in all, financial forecasting is a pre requirement for the investment, financing, as
well as dividend policy decisions of a firm

 Procedures in sales forecasting

The financial forecasting process generally involves the following procedures:

i) Forecasting of sales for the future period

ii) Determining the assets required to meet the sales targets, and
iii) Deciding on how to finance the required assets.

The above three procedures are very important in projecting the financial statements and
key financial ratios. However, among the three procedures, the first one, i.e, sales
forecast is the most crucial.

Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by reviewing the
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 sales of the recent pasts. The whole crucial points of a financial forecasting process lies in
an accurate forecast of sales. If this procedure is off, the firm’s profitably as well as its
value will be negatively affected. So in forecasting sales, several factors should be
considered:

1. The historical sales growth pattern of the firm at both divisional and corporate levels,
2. The level of economic activity in each of the firm’s marketing areas,
3. The firm’s probable market share,
4. The effect of inflation on the firm’s future pricing of products,
5. The effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
6. Individual products’ sales forecasts at each divisional level.

2.4 Techniques of determining external financial requirement

There are two methods to determine the additional financial requirements. These are:
1. The pro-forma financial statements method and
2. The formula method

1. The Pro-Forma Financial Statement Method

The pro-forma financial statements method is simply a method of forecasting financial
requirements based on forecasted financial statements. As a result, this method is also
called the projected financial statements method. Under this method, the asset
requirements are first projected for the fore coming future period. The forecast of assets
helps to determine the total financial requirements. Then, the liabilities and equity that
will be generated under normal operations are projected. Finally, the additional funds
needed will be estimated.
The pro-forma financial statements method of determining additional financial
requirements involves the following steps.
1. Developing the Pro Forma Income statement
The pro-forma income statement provides a projection of the firm’s net income for the
forecasted period. This enables the firm to estimate the amount of retained earnings it
will generate during the period. In developing the projected income statement, first, a
forecast of sales should be established. Second, cost of goods sold should be determined.
Third, other expenses (operating and non-operating) should be computed. Next, the net
income should be determined. Finally, based on the amount of dividends, the amount of
addition to retained earnings should be determined.
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2. Constructing the Pro Forma Balance Sheet

Higher sales must be supported by higher asset amounts. Some of the assets increase can
be financed by retained earnings, and spontaneous finance. The remaining blanc must be
financed from external sources. In the forecast of the firm’s balance sheet, first, those
balance sheet items that are expected to increase directly with sales are forecasted. Next,
the spontaneously increasing liabilities are forecasted. Then, the liability and equity items
that are not directly affected by sales are set. Next, the value of retained earnings for the
forecasted period is obtained. Finally, the AFN will be raised.

Example

Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the
following year. At the end of the year just completed, the condensed balance sheet of the
company has contained the following items.

Assets Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000

A/receivable -----------------------70,000 Accruals --------------------------------40,000
Inventories -----------------------150,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
Retained earnings --------------------150,000
Total assets ------------- Br. 600,000 Total laibilities. and equity ------Br. 600,000

During the year just completed the firm had sales of Br. 1,800,000. In the following year,
due to increased demand to the firm’s products the financial manger estimates that sales
will grow at 10%. There are no preferred stock outstanding during the year. The firm’s
dividend pay-out ratio is 60%. It is also known that the firm’s assets have been operating
at full capacity. During the same year, Blue Nile’s operating costs were Br. 1,620,000
and are estimated to increase proportionately with sales. Assume the company’s interest
expense will be Br. 40,000 during the next year and its tax rate is 40%.

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Required: Determine the additional funds needed (AFN) of Blue Nile Share Company
for the next year using the proforma financial statements method.
Solution
First, we develop the proforma income statement

Pro Forma Income Statement

____________________________________________________________________________________________________________
Sales (Br. 1,800,000 x 1.10) 1,980,000
Operating costs (Br. 1,620,000 x 1.10) ----------------------------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) 198,000
Interest expense -----------------------------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) 158,000
Taxes (Br. 158,000 x 40%) ---------------------------------------------------------------------------------------63,200
Net income 94,800
Dividends to common stock (Br. 94,800 x 60%) 56,880
Addition to retained earnings (Br. 94,800 Br. 56,880) 37,920

Then, we construct the proforma balance sheet

Pro Forma Balance Sheet
____________________________________________________________________________________________________________
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------Br.
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10)
Inventories (Br. 150,000 x 1.10) ----------165,000 Current liabilities ----------------------------Br.
Current assets ---------------------------Br. 253,000 Long-term debt (the increase is
Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt)
Retained earnings (Br. 150,000 + Br. 37,920) 187,920
Total assets -----------------------Br. 660,000 Total liabilities and equity -------------Br. 650,920

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Blue Nile’s forecasted total assets as shown above are Br. 660,000. However, the
forecasted total liabilities and equity amount to only Br. 650,920. Since the balance sheet
must balance, i.e. A = L + OE, the difference must be covered by additional funds.

Therefore, AFN = Br. 660,000 Br. 650,920 = Br. 9,080.

Or AFN = increase in Increase in normally

assets generated funds
= [Br. 660,000 Br. 600,000] [(Br. 99,000 Br. 90,000) + (Br. 44,000
Br.40,000) + Br. 37,920]

= Br. 60,000 Br. 50,920 = Br. 9,080

ii) The Formula Method
This is a much easier method of determining additional financial requirements than the
pro forma method. The formula method is a shortcut to financial forecasting. However,
many companies use the pro forma method of forecasting their financial requirements
because the output of the formula method is less meaningful. Under the shortcut method,
we make the following assumptions.

1. Each asset maintains a direct proportionate relationship with sales

2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant.
The formula that can be used as a shortcut to determine external capital requirements is
given as:

Additional Required Spontaneous Increase in

Funds = increase increase in retained

needed S
AFN = (A/S) (L/S) inS assets
MS1 (1liabilities
d) earnings

Where
AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S1 S0 = S0 x g
S1 = Total Sales projected for the next period
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 S0 = Total sales of the current period
L/S = Percentage relationship of variable (spontaneous) liabilities to sales
M = Net profit margin
d = Dividend payout ratio
g = The expected sales growth rate
To illustrate the formula method, consider the example given for the previous method.
But assume that Blue Nile’s net profit margin is 5%.

= Br. 60,000 Br. 13,000 Br. 39,600

= Br. 7,400
To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must
increase its assets by 60,000. In other words, the firm will require a Br. 60,000 more fund
for the forecasted year. Out of this, Br. 13,000 will come from spontaneous increase in
liabilities. Another Br. 39,600 will be obtained from retained earnings. The remaining Br.
7,400 must be raised from external sources like by issuing new shares of stocks or by
borrowing.
* S = S1 S0 = S0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br.
180,000
** S1 = S0 + S0g = S0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br.
1,980,000.

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