CHAPTER 2

FINANCIAL ANALYSES AND

PLANNING

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Contents:

Financial Analysis

The need for financial analysis

Source of financial data

Approaches to financial analysis and
interpretation

Financial planning (forecasting)

The planning process

The importance of sales forecasting

Techniques of determining external
financial requirements.
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 Financial Analysis
 As a manager, you may want to know the answers
for the following questions.

when existing capacity will be expanded and enlarged?

As an investor, how do you predict how well the securities of
one firm will perform relative to that of another?

How can you tell whether one security is riskier than another?

As a lender, how do decide the borrower will be able to pay
back as promised?

 All of these questions can be addressed through

financial analysis.
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What is financial analysis?

Financial analysis is the selection, evaluation,
and interpretation of financial data, along
with other pertinent information, to assist in
investment and financial decision-making.

Financial analysis may be used internally to
evaluate issues such as employee performance,
the efficiency of operations, and credit
policies, and

Financial analysis may be used externally to
evaluate potential investments and the credit-
worthiness of borrowers, among other things

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The need for Financial Analysis

Financial analysis is not an end in itself but is performed
for the purpose of providing information that is useful in
making the right decisions.

Thus, financial statement analysis serves the following
purposes:
1. Measuring the profitability

The main objective of a business is to earn a satisfactory return on
the funds invested in it.
– Financial analysis helps in ascertaining whether adequate profits are
being earned on the capital invested in the business or not.
– It also helps in knowing the capacity to pay the interest and dividend.

2. Indicating the trend of Achievements


Financial statements of the previous years can be compared and
the trend regarding various expenses, purchases, sales, gross profits
and net profit etc. can be ascertained. Value of assets and liabilities
can be compared and the future prospects of the business can be
predicted.
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3. Assessing the growth potential of the
business

The trend and other analysis of the business
provide sufficient information indicating the
growth potential of the business.

4. Comparative position in relation to other

firms

The purpose of financial statements analysis is to
help the management to make a comparative
study of the profitability of various firms engaged
in similar businesses. Such comparison also helps
the management to study the position of their
firm in respect of sales, expenses, profitability
and utilising capital, etc.
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5. Assess overall financial strength

The purpose of financial analysis is to assess the
financial strength of the business. Analysis also
helps in taking decisions, whether funds required
for the purchase of new machines and
equipments are provided from internal sources of
the business or not if yes, how much? And also, to
assess how much funds have been received from
external sources.

6. Assess solvency of the firm


The different tools of an analysis tell us whether
the firm has sufficient funds to meet its short
term and long term liabilities or not.

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Source of Financial data
 Financial data can be obtained from many
sources.
– The primary source is the data provided by the
company itself in its annual report and required
disclosures.
– The annual report includes the income statement,
the balance sheet, and the statement of cash flows,
as well as footnotes to these statements.
– Certain businesses are required by law to disclose
additional information.

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 Besides information that companies are
required to disclose through financial
statements, other information is readily
available for financial analysis.

Like, information such as the market prices of
securities of publicly-traded corporations can be
found in the financial press and the electronic
media daily.

Similarly, information on stock price indices for
industries and for the market as a whole are
available in the financial press.

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 Another source of information is economic
data, such as the Gross Domestic Product and
Consumer Price Index, which may be useful
in assessing the recent performance or future
prospects of a firm or industry.

Suppose you are evaluating a firm that owns a chain of
retail outlets. What information do you need to judge the
firm's performance and financial condition?

You need financial data, but it doesn't tell the whole
story.

You also need information on consumer spending,
producer prices, consumer prices, and the competition.
This is economic data that is readily available from
government and private sources.

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Approaches to financial Analysis and interpretation
 Different techniques are employed for analysing
and interpreting the financial statements.
 Techniques of analysis of financial statements are
mainly classified into three categories.

1. Cross-sectional analysis
It is also known as inter firm comparison. This
analysis helps in analysing financial
characteristics of an enterprise with financial
characteristics of another similar enterprise in
that accounting period.
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2. Time series analysis
– It is also called as intra-firm comparison. According to
this method, the relationship between different items
of financial statement is established, comparisons are
made and results obtained.
– The basis of comparison may be Comparison of the
financial statements of different years of the same
business unit.

3. Combination of Cross-sectional & time series

analysis
– This analysis is intended to compare the financial
characteristics of two or more enterprises for a
defined accounting period. It is possible to extend such
a comparison over the year. This approach is most
effective in analysing of financial statements.
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 Tools of Financial Statement
Analysis
 A number of tools or methods or devices are used to

study the relationship between financial statements.

 The most important tools which are commonly used

for analysing and interpreting financial statements
are the following:
Dollar & Percentage Changes


Trend Percentages


Component Percentages


Ratios


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Dollar and Percentage Changes

 The dollar amount of any change is the

difference between the amount for a
comparison year and the amount for a
base year.
 The percentage change is computed by
dividing the amount of the dollar change
between years by the amount for the
base year.

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Dollar and Percentage Changes
Dollar Change:

Dollar Analysis Period Base Period

Change = Amount – Amount

Percentage Change:
Percent Base Period
Change = Dollar Change
÷ Amount

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Trend Analysis
 The change in financial statement items
from a base year to following years are
often expressed as trend percentages to
show the extent and direction of change.
 Two steps are necessary to compute trend
percentages.
1. Select base year and assign a weight of 100%
for each item in the base year
2. Express each item following years as a
percentage of its base year amount.

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Ratio
 A ratio is a mathematical relation
between one quantity and another.

 A financial ratio is a comparison between

one bit of financial information and
another.

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The use of Ratio
 Ratios are used to

compare results over a period of time


measure performance against other
organisations


compare results with a target


compare against industry averages

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 Ratios can be grouped into the following
ways
1. A liquidity ratio: provides information on a firm's ability to meet
its short-term obligations.
2. A profitability ratio: provides information on the amount of
income from each dollar of sales.
3. An activity ratio: provides information on a firm's ability to
manage its resources (that is, its assets) efficiently.
4. A financial leverage ratio: provides information on the degree of a
firm's fixed financing obligations and its
ability to satisfy these financing obligations.
5. A shareholder ratio: describes the firm's financial condition in terms of
amounts per share of stock.

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 Liquidity

Liquidity reflects the ability of a firm to meet its short-
term obligations using assets that are most readily
converted into cash.

Assets that may be converted into cash in a short period
of time are referred to as liquid assets; they are listed in
financial statements as current assets.

Current assets are often referred to as working capital,
since they represent the resources needed for the day-to-
day operations of the firm's.

Current assets are used to satisfy short- term
obligations, or current liabilities.

The amount by which current assets exceed current
liabilities is referred to as the net working capital.

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 Measures of liquidity

There are three commonly used liquidity ratios:
1. The current ratio is the ratio of current assets
to current liabilities; Indicates a firm's ability
to satisfy its current liabilities with its current
assets:

Current ratio = Current assets

Current liabilities

A current ratio of 2:1 or 2 means that we have

twice as much in current assets as we need to
satisfy obligations due in the near future.
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2. Quick ratio: it is the ratio of quick
assets (generally current assets less
inventory) to current liabilities;
Indicates a firm's ability to satisfy
current liabilities with its most liquid
assets

Quick ratio = Current assets – Inventory

Current liabilities

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3. The net working capital to sales ratio
is the ratio of net working capital
(current assets minus current
liabilities) to sales; Indicates a firm's
liquid assets (after meeting short-term
obligations) relative to its need for
sales (represented by sales)

Net working capital Current assets - Current liabilities

to sales ratio =
Sales

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 Generally, the larger these liquidity ratios
the better the ability of the company to
satisfy its immediate obligations.
 Consider the current ratio.

A large amount of current assets relative to current
liabilities provides assurance that the company will be
able to satisfy its immediate obligations.

– However, if there are more current assets than the

company needs to provide this assurance, the
company may be investing too heavily in these
non- or low-earning assets and therefore not
putting the assets to the most productive use

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Profitability Ratios

Profitability ratios compare components of
income with sales.
– It gives us an idea of what makes up a firm's
income and are usually expressed as a portion of
each dollar of sales.


Gross profit margin:- This ratio indicates how
much of every dollar of sales is left after costs
of goods sold:

– Gross profit margin = Gross Profit

Sales
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
Operating profit margin:- The
operating profit margin is the ratio of
operating profit (EBIT, operating
income or income before interest and
taxes) to sales.

This is a ratio that indicates how much
of each dollar of sales is left over after
operating expenses:

– Operating profit margin =

Operating
income
Sales
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 Net profit margin:- The net profit
margin is the ratio of net income (net
profit) to sales, and indicates how much
of each dollar of sales is left over after
all expenses:

 Net profit margin = Net income .

Sales

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 Activity ratios
 Activity ratios are measures of how well assets are
used.
 This can be used to evaluate the benefits produced by
specific assets, such as inventory or accounts
receivable or by all a firm's assets collectively.
 The most common turnover ratios are:
1. Inventory turnover ratio;- is the ratio of cost of goods
sold to inventory.

This ratio indicates how many times inventory
is created and sold during the period:
Inventory turnover = Cost of goods sold
Inventory
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2. Accounts receivable turnover ratio: is
the ratio of net credit sales to accounts
receivable.

This ratio indicates how many times in the
period credit sales have been created and
collected on:

Accounts receivable turnover = Sales on credit

Account receivable

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3. Total asset turnover ratio: is the ratio of sales to total
assets.

This ratio indicates the extent that the
investment in total assets results in sales.
Total asset turnover = Sales
Total assets

4. Fixed asset turnover: is the ratio of sales to fixed

assets.

This ratio indicates the ability of the firm's
management to put the fixed assets to work to
generate sales:

Fixed asset turnover = Sales

Fixed assets
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 Financial Leverage Ratios

A firm can finance its assets either with equity or
debt.

Financing through debt involves risk because
debt legally obligates the firm to pay interest and
to repay the principal as promised.

Equity financing does not obligate the firm to
pay anything -- dividends are paid at the
discretion of the board of directors.

Financial leverage ratios are used to assess how
much financial risk the firm has taken on.

There are two types of financial leverage ratios:
component percentages and coverage ratios.
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Component-percentage financial leverage
ratios
 These ratios compare the amount of debt
to either the total capital of the firm or to
the equity capital.

1. The total debt to assets ratio: indicates

the proportion of assets that are financed
with debt (both short-term and long-term
debt):
Total debt to assets ratio = Total debt
Total assets

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2. The long-term debt to assets ratio: indicates
the proportion of the firm's assets that are
financed with long-term debt.

– Long - term debt to assets ratio = Long - term debt

Total assets

3. The debt to equity ratio: indicates the relative

uses of debt and equity as sources of capital to
finance the firm's assets, evaluated using book
values of the capital sources:

– Total debt to equity ratio = Total debt

Total shareholders' equity
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 Coverage financial leverage ratios

In addition to the leverage ratios that are used
information about how debt is related to either
assets or equity, there are two most commonly used
ratios: the times interest coverage ratio and the
fixed charge coverage ratio.


The times-interest-coverage ratio, also referred to
as the interest coverage ratio, this ratio tells us how
well the firm can cover or meet the interest payments
associated with debt. The ratio compares the funds
available to pay interest (that is, earnings before interest
and taxes) with the interest expense:
Times - interest = Earnings before interest and taxes
coverage ratio Interest
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 The fixed charge coverage ratio: expands
on the obligations covered and can be
specified to include any fixed charges,
such as lease payments and preferred
dividends.
 For example, to measure a company’s
ability to cover its interest and lease
payments, you could use the following
ratio:
Fixed - charge
= Earnings before interest and taxes + Lease payment
coverage ratio
Interest + Lease payment

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Shareholder ratios
 These ratios translate the overall results
of operations so that they can be
compared in terms of a share of stock:
 Earnings per share (EPS) is the amount
of income earned during a period per
share of common stock.

Earnings per share = Net income available to shareholders

Number of shares
outstanding

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
The price earnings ratio (P/E or PE ratio) is
the ratio of the price per share of common
stock to the earnings per share of common
stock:

– Price-earnings ratio = Market price per share

Earnings per share


The P/E ratio is sometimes used as a proxy for
investors' assessment of the firm's ability to
generate cash flows in the future.

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 Dividends per share (DPS) is the dollar amount
of cash dividends paid during a period, per
share of common stock:

– Dividends per share = Dividends paid to shareholders

Number of shares
outstanding

 The dividend payout ratio is the ratio of cash

dividends paid to earnings for a period:

– Dividend payout ratio = Dividends

Earnings
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