CHAPTER-TWO
FINANCIAL ANALYSES AND PLANNING
04/08/2025 By: Adugna T. Arfassa 1
2.1. Financial Analysis
• Financial Analysis is the process of
evaluating businesses, projects, budget
and other finance related transactions to
determine their performance and
suitability.
• Typically financial analysis is used to
analyze whether an entity is stable,
solvent, liquid or profitable enough to
warrant a monetary investment.
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Cont’d
• Financial statements generally consist of two
important statements: (i) The income statement or
profit and loss account. (ii) Balance sheet or the
position statement.
• A part from that, the business concern also
prepares some of the other parts of
statements, which are very useful to the
internal purpose such as: (i) Statement of
changes in owner’s equity. (ii) Statement of
changes in financialBy:position.
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Cont’d
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Income Statement
• Income statement is also called as profit and
loss account, which reflects the operational
position of the firm during a particular period.
• Normally it consists of one accounting year. It
determines the entire operational performance
of the concern like total revenue generated and
expenses incurred for earning that revenue.
• Income statement helps to ascertain the gross
profit and net profit of the concern.
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Position Statement
• Position statement is also called as balance sheet,
which reflects the financial position of the firm at the
end of the financial year.
• Position statement helps to ascertain and understand
the total assets, liabilities and capital of the firm.
• One can understand the strength and weakness of
the concern with the help of the position statement.
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Statement of Changes in Owner’s
Equity
• It is also called as statement of retained earnings.
This statement provides information about the
changes or position of owner’s equity in the
company.
• How the retained earnings are employed in the
business concern. Nowadays, preparation of this
statement is not popular and nobody is going to
prepare the separate statement of changes in
owner’s equity.
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Statement of Changes in Financial
Position
• Statement of changes in financial position helps
to understand the changes in financial position
from one period to another period.
• Statement of changes in financial position
involves two important areas such as fund flow
statement which involves the changes in working
capital position and cash flow statement which
involves the changes in cash position.
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The Need for Financial Analysis
• Financial analysis is needed to:
• Measure the Profitability and Earning
Potential of a Business: It helps to check
whether the profits earned are up to the
expectation or not. After analyzing the financial
statements, the trend of profit can be ascertained
and earning potential of the company can be
checked.
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Measure the Financial
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Strength of the9
Cont’d
• Comparative Study: Financial analysis is helpful
to compare the position of two firms in the market
or compare the growth of a firm.
• Intra-Firm: It is the comparison of the firm’s
profit for the current year and the previous year,
and may also be known as Trend Analysis.
• Inter-Firm: It is also termed as Cross-Sectional
Analysis and is the comparison of one company to
the other in the market.
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Cont’d
• Efficiency of Management: The trend of the benefit and loss of a
business allows us to judge if the business is being managed
efficiently or not.
• Useful to the Management: An insight into the business helps
the management to make very important decisions about the
business.
• Analysis the Short-Term and Long-Term Solvency: It also helps
to analyze whether a business will be able to clear its short-term
and long-term debts or not.
• Reason for Deviation: Financial analysis helps to identify the
reasons for any change in the profitability or financial position of
the firm.
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2. Source of Financial Data
• Financial data can be derived from
traditional sources such as a business’s
balanced sheet, income statement and
cash flow statement as well as alternative
data sources originating outside the
company, also commonly referred to as
external data.
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Cont’d
• An income statement: Is a financial statement that
reports a company’s financial performance over a
specific accounting period.
• Statement of Cash Flow: Reports the cash receipts
and cash payments from operating, investing and
financing activities during a period. Cash comprises
cash on hand and demand deposits with banks.
• Cash equivalents are short term, highly liquid
investments that are readily convertible into known
amounts of cash.
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3. Approaches to Financial Analysis and Interpretation
• Analysis of Financial Statement is also necessary
to understand the financial positions during a
particular period.
• Financial statement analysis is largely a study of
the relationship among the various financial
factors in a business as disclosed by a single set
of statements and a study of the trend of these
factors as shown in a series of statements.
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Ratio Analysis
• Ratio analysis is a commonly used tool of
financial statement analysis.
• Ratio is a mathematical relationship
between one numbers to another number.
Ratio is used as an index for evaluating
the financial performance of the business
concern.
• An accounting ratio shows the
mathematical relationship between two
figures, which have meaningful relation
with each other. Ratio can be classified
into various types.
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Cont’d
• Classification from the point of view of
financial management is as follows:
1.Liquidity Ratio
2.Activity Ratio
3.Solvency Ratio
4.Profitability Ratio
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Cont’d
• Liquidity Ratio: It is also called as short-term
ratio. This ratio helps to understand the
liquidity in a business which is the potential
ability to meet current obligations.
• This ratio expresses the relationship between
current assets and current assets of the
business concern during a particular period.
•The following are the major liquidity ratio:
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Cont’d
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Cont’d
• Activity Ratio: It is also called as turnover
ratio. This ratio measures the efficiency of
the current assets and liabilities in the
business concern during a particular period.
• This ratio is helpful to understand the
performance of the business concern. Some
of the activity ratios are given below:
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Cont’d
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Cont’d
• Solvency Ratio: It is also called as
leverage ratio, which measures the long-
term obligation of the business concern.
• This ratio helps to understand, how the
long-term funds are used in the business
concern. Some of the solvency ratios are
given below:
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Cont’d
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Cont’d
• Profitability Ratio: Profitability ratio
helps to measure the profitability position
of the business concern. Some of the
major profitability ratios are given below.
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Cont’d
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Cont’d
• Exercise-6: From the following balance sheet of
Mr. Arvind Industries Ltd., as 31st March 2007.
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Cont’d
•Other information:
1. Net sales Rs. 60,000
2. Cost of goods sold Rs. 51,600
3. Net income before tax Rs. 4,000
4. Net income after tax Rs. 2,000
5. Fixed interest charges = 6% on debentures of Rs.14, 000 = Rs.
840
•Calculate appropriate ratios
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Solution
•Short-term solvency ratios
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Cont’d
•Long-term solvency ratios
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Activity Ratio
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Cont’d
• In absence of purchases, cost of goods
sold – gross profit treated as credit
purchases and in the absence of opening
creditors, closing creditors are treated as
average creditors.
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Profitability Ratios
In the absence of non-operating income, operating profit ratio is equal to net profit ratio.
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Group Assignment
• Discuss the following topics
• Illustrate your discussion supporting by
examples.
1. External analysis
2. Internal analysis
3. Horizontal analysis
4. Vertical analysis
5. Trend analysis
6. Common size analysis
7. Comparative Statement Analysis
8. Comparative Balance Sheet
Analysis
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2. Financial Planning (Forecasting)
• Financial planning is the process of setting,
planning, achieving and reviewing your life
goals through the proper management of your
finances.
• Planning is a systematic way of deciding about
and doing things in a purposeful manner. When
this approach is applied exclusively for financial
matter, it is termed as financial planning.
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Cont’d
• Thus, financial planning involves:
1.Estimating the amount of capital to be raised;
2.Determining the pattern of financing i.e.,
deciding on the form and proportion of capital
to be raised;
3.Formulating the financial policies and
procedures for procurement, allocation and
effective utilization of funds.
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3. The Planning Processes
• Establishing Objectives: Financial planning
should establish both short-term and long run
objectives. The concern should take
advantage of prevailing economic situation.
Formulating Financial Policies: Financial
policies are guides to all action which deals with
procuring, administrating and distributing the
funds of business firms.
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Cont’d
• These policies may be classified into several broad
categories:
Policies governing the amount of capital required by
the firm to achieve their financial objectives.
Policies to achieve and determine control by the
parties who furnish the capital.
Policies which act as a guide in the use of debt or
equity capital.
Policies which guide management in the selection of
sources of funds.
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Cont’d
Forecasting: Financial management is required to
forecast the future in order to predict the variability of
factors influencing the type of policies the enterprise
formulates.
Formulation of Procedures: Financial planning are
broad guides which to be executed properly, must be
translated into detailed procedures.
Providing for Flexibility: The financial planning
should ensure proper flexibility in objectives, policies
and procedures to adjust according to the changing
economic situations.
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Cont’d
• The financial planning process is a logical,
six-step procedure:
Step-1: Determine Current Financial Situation
Step-2: Develop Financial Goals
Step-3: Identify Alternative Courses of Action
Step-4: Evaluate Alternatives
Step-5: Create and Implement a Financial
Action Plan
Step-6: Reevaluate and Revise Plan
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4. The Importance of Sales Forecasting
• The types of forecasts used by businesses
and other organizations may be classified
in several categories, depending on the
objective and the situation for which a
forecast is to be used. Four types are
discussed below.
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Cont’d
• Sales Forecasts: The sales forecast gives
the expected level of sales for the company's
goods or services throughout some future
period and is instrumental in the company's
planning and budgeting functions. It is the
key to other forecasts and plans.
• Economic Forecasts: Economic forecasts
cover a variety of topics including GDP, levels
of employment, interest
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rates, and foreign40
Cont’d
• Financial Forecasts: This includes forecasts of
financial variables such as the amount of external
financing needed, earnings, and cash flows and
prediction of corporate bankruptcy.
• Technological Forecasts: A technological
forecast is an estimate of rates of technological
progress. Technological forecasting is probably
best performed by experts in the particular
technology.
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Importance of Sales Forecasting
1. Regular supply is facilitated: Supply and demand for the
products can easily be adjusted, by overcoming temporary
demand, in the light of the anticipated estimate;
2. A good Inventory control is advantageously benefited by
avoiding the weakness of under stocking and overstocking.
3. Allocation and reallocation of sales territories are facilitated.
4. It is a forward planner as all other requirements of raw
materials, labor, plant layout, financial needs, warehousing,
transport facility etc., depend in accordance with the sales
volume expected in advance.
5. Sales opportunities are searched out on the basis of
forecast;
6. Advertisement programmes are beneficially adjusted with
full advantage to the firm.
7. It is an indicator to the department of finance as to how
much and when finance
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is needed; and it helps to
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5. Techniques of Determining
External Financial Requirements
• Forecasting is the basis for budgeting activities and
estimating future financing needs. It begins with
forecasting sales and the related expense. Basic steps
involved in projecting financing needs are:
1. Project the firm’s sales
2. Project variable expenses
3. Estimate level of investment in current and fixed assets
4. Calculate firm’s financing needs
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Percent to Sales Method of Financial
Forecasting
• It is the most widely used method. In this
method, the variable expenses, assets and
liabilities for future period are estimated as
percentages of sales.
• Percentages together with the projected sales
are used to construct preforma or planned or
projected balance sheet. Calculation for
preforma balance sheet is as follow:
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Cont’d
a. Express balance sheet in terms that vary directly with
sales as a percentage of sales. Any interims that does
not vary directly with sales activity such as long-term
debts is designated as not applicable (n.a).
b. Multiply the percentages determined in step “a” by
the sales projected to obtain the amounts of the future
period.
c. Where no percentages applies such as for long-term
debt, common stock and capital surplus, simply insert
the figures from theBy: Adugna
04/08/2025 presentT. Arfassa balance sheet in the
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Cont’d
• Sum the asset account to obtain a total
projected asset figures and add the
projected liabilities and equity accounts to
determine the total financing provided.
• Since liability plus equity must balance the
asset when totaled, any difference is a
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is the T. Arfassa amount of external
46
Example
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Cont’d
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Where:
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Example:
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Cont’d
• Therefore, $80,000 ($0.08 x 1,000,000)
can be raised from external sources by
issuing notes payable, bonds, stocks singly
or in combination.
• Limitation of the percentage of sales
method is that firm is assumed to be
operating at full capacity. The major
advantage is it is simple and inexpensive
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The Budget of Financial Plan
• Budget is company’s annual financial plan. A
set of formal (Written statement of manager’s
expectation regarding sales, expenses,
production volume and various financial
transactions).
• It is a set of preforma statement about
company’s finance and operations. Tools for
both controlling and planning and at the
beginning of the period, budget is the
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plan or standard and at the end of the
Operational Budget
• Operating budget consists of: sales budget,
including computation of cash receipts, production
budget, ending inventory budget, direct material
budget, direct labor budget and factor overhead
budget, selling and administrative expense budget.
• An operating budget is a comprehensive estimate
of an organization, company or an institution’s
revenue and expenses over a specified period of
time.
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1. Sales Budget
• Sales budget is the starting point in preparing the
operating budget. It gives the quantity of each
product expected to be sold. After sales volume has
been estimated, the sales budget is constructed by
multiplying the estimated number of units by the
expected unit price.
• Sales budget includes computation of cash collection
anticipated from credit sales, which will be used later
for cash budget.
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Cont’d
Example:
• Assume that of each quantity’s sales, 70%
is collected in the first quarter of the sale,
28% is collected in the following quarter
and 2% is uncollectable.
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Cont’d
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Schedule of Expected Cash Collection
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2. The Production Budget
• The production budget is a number of units
expected to be manufactured to meet
budgeted sales and inventories.
• It can be determined by subtracting
the estimated inventories at the
beginning of the period from the sum
of units to be sold plus desired ending
inventory.
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Cont’d
Example:
• Assume that ending inventory is 10% of
the next quarter’s sales and that the
ending inventory for the 4th quarter is 100
units.
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Cont’d
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3. The Direct Material Budget
• It is constructed to show how much material will be
required and how much of it must be purchased to meet
the production requirements. The purchase will depend
on both the expected usage of materials and the
inventory levels.
• Amount of materials to be purchased = Materials
needed for production + Desired ending materials
inventory – Beginning material inventory in unit
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Cont’d
Example:
• Assume that ending inventory is 10% of the
next quarter’s production needed, the ending
materials for the 4th quarter is 250 units, and
50% of each quarter purchases are paid in that
quarter, with the remaining being paid the
following quarter. Also 3 units of materials are
needed per unit of product at cost of $2 per
pound.
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Cont’d
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Expected Cash Disbursement
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4. The Direct Labor Budget
• Direct labor hour is necessary to meet
production requirements multiplied by the
estimated hourly yields the total direct
labor.
Example:
• Assume that 5 hours of labor are required
per unit of product and that the hourly rate
is $5.
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Cont’d
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5. The Factor Overhead Budget
• It is all manufacturing costs other than direct
materials and direct labors.
Example:
• For the following factor overhead budget,
assume that total factory overhead is
budgeted as $6,000 per quarter plus $2 per
hour of direct labor. Depreciation expenses
are $3,250 per quarter. All overhead costs
involving cash outlays are paid in the quarter
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Cont’d
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6. The Ending Inventory Budget
• The ending inventory budget provides the information
required for constructing budgeted financial
statements. It is use full for comparing the cost of
goods sold on the budgeted income statement.
Example:
• For the ending inventory budget, we first need to
compute the unit variable cost for finished goods as
follows:
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Cont’d
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7. Selling and Administrative
Expense Budget
• They list the operating expenses involved in selling the
products and in manufacturing the business.
Example:
• The variable selling and administrative expenses
amount of $4 per unit of sale, including commissions,
shipping and supplies, expenses are paid in the same
quarter in which they are incurred, with the exception of
$1,200 in income tax which is paid in the third quarter.
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Cont’d
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8. Cash Budget
• Cash budget can avoid the problem of either
having idle cash on hand or suffering a cash
shortage. The cash budget consists of four major
sections:
1.The Receipt Section: Lists all cash inflows
excluding cash received from financing the firm’s
operation.
2.The Disbursement Section: Consists of all cash
payments excluding repayments of principal and
interest.
3.The Cash Surplus or Deficit Section:
Determines if the company will need to borrow
money or if it will be able to repay funds
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previously borrowed.
Everson Manufacturing Cash Budget
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Cont’d
• The example shows that an unordinary large dividend
payment in the second week of the cash budget,
coupled with a large asset purchase in the following
week places the company in a negative cash position.
• Paying out such a large dividend can be a problem for
lenders, who do not like to issue loans so that
companies can use the funds to pay their ability to
pay back the loans. Thus, it may be wiser for the
company to consider a small dividend payment and
avoid a negative cash position.
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