CHAPTER-TWO
FINANCIAL ANALYSES AND
PLANNING
Mulugeta A.
Mulugeta.ak@wldu.edu.et
02-DEC-2023
1
Chapter Outline
2.1. Financial Analysis
• The Need or purpose of financial Analysis
• Source of financial data
• Financial Analysis Steps
• Approaches to financial analysis and interpretation
2.2. Financial planning (forecasting)
• The planning process
• The procedures and importance of sales forecasting
• Methods of determining external financial requirements.
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2.1. 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.
• It is the assessment of firm’s past, present and anticipated future
financial condition.
• The focus of financial analysis is on key figure in the financial statements
and the significant relationships that exist between them.
• Its objectives are to determine the firm’s financial strength and identify it’s
weaknesses.
• It helps users obtain a better understanding of the firm’s financial
conditions and performance
• Users of Financial Analysis are Lenders, Investors, Management,
Suppliers, Employees, and Government bodies.
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The Need/ Purposes of Financial Analysis
• To evaluate an organisation’s;
– Financial performance
– Financial position.
• To have a means of comparative analysis across time in terms of:
– Intracompany basis (within the company itself)
– Intercompany basis (between companies)
– Industry Averages (against that particular industry’s averages)
• to obtain useful information to aid decision making by applying
analytical tools and techniques to financial statements.
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Source of financial data
• Financial data are the base for financial analysis and
financial decision making of a firm
• Among these financial statements,
Balance Sheet,
Income Statements,,
Cash flow and
Retained Earnings statements are the core components.
• The financial manager, investor or any responsible
financial analyst could get the financial data from
these component parts of the financial statements of
the firm
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Financial Analysis Steps
1. Identify the economic characteristics
2. Identify the corporate strategies
3. Understand the financial statements
4. Assess the profitability and risk
5. Value the particular firm
Benchmarks for evaluation
• To answers the question as; it too high or too low, is good or bad? A
meaningful standard or basis is needed.
• There are three approaches;
– Rule of thumb
– Cross sectional analysis or industry average
– Time series analysis
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Approaches to financial analysis and interpretation
• According to users of financial information, there are
two techniques of financial analysis. These are
Internal Analysis, and External Analysis
• The most frequently used tools/techniques in
analyzing financial statements are:-
I.
Financial Ratio Analysis/ Ratio analysis
II. Common size analysis/
Component Percentages
III. Horizontal
Analysis
analysis/Trend
Vertical
analysis/
analysis/
Index
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Chapter Two: Financial Analysis and Planning
Illustration: Financial statement analysis
• The following financial statements of XYZ Ltd were prepared
in accordance with Ethiopian GAAPs. XYZ Ltd is a
diversified enterprise with its main interests in the
manufacture and retail of alcoholic products.
• The financial statements of XYZ Ltd need to be analysed. An
investor is considering purchasing shares in the company.
Relevant ratios need to be selected and calculated and a
report needs to be written for the investor. The report should
evaluate the company’s performance and position.
• See the XYZ Ltd.'s Financial
Statements on the given Sheet!
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I. Financial 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.
• A. 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
• We will perform the necessary ratio analyses using them, and then
evaluate and interpret each analysis
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I.
Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets.
Current ratio = Current assets/ Current liabilities
• XYZ’s current ratio (for 2002) = Br. 57,600/ Br. 38,100 = 1.51 times
• Interpretation: XYZ has Br. 1.51 in current assets available for every 1 Br. in current liabilities.
N.B: Relatively high current ratio is interpreted as an indication that the firm is liquid and in good
position to meet its current obligations; the reverse is true. 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.
Quick ratio = Current assets – Inventory/Current liabilities
XYZ’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900/ Br. 38,100 = 0.86 times
• Interpretation: XYZ has Br. 0.86 in quick assets available for every one birr in current liabilities.
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B. Activity Ratios/Asset Management Ratios/ asset
utilization ratios, or efficiency ratios
• Efficiency of asset usage
– How well assets are used to generate revenues (income) will impact on the overall
profitability of the business.
– How the firm efficiently or intensively use its assets to generate sales.
– These ratios measure the degree to which assets are efficiently employed in the firm.
• For Example:1. Accounts Receivable Turnover – measures how efficiently a firm’s accounts receivable
is being managed.
• Accounts receivable turnover = Net sales/ Accounts receivable
• XYZ’s A/R turnover (for 2002) = Br. 196,200/ Br. 20,700 = 9.48 times
• Interpretation: XYZ’s accounts receivable get converted into cash 9.48 times a year.
• In general, a reasonably higher accounts receivable turnover ratio is preferable.
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2. 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
XYZ’s days sales outstanding = 365 days/ 9.48 = 39 days
• Interpretation: XYZ’s credit customers on the average are paying their bills in
almost 39 days. If XYZ’s credit period is less than 39 days, some corrective actions
should be taken to improve the collection period.
• The average collection period of a firm is directly affected by the accounts receivable
turnover ratio.
• Generally, a reasonably short-collection period is preferable.
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3. Inventory turnovermeasures how many times per year the inventory level is sold (turned over).
Inventory turnover = Cost of goods sold/ Inventory
For XYZ Company (2002) = Br. 159,600/ Br. 24,900 = 6.41times
Interpretation: XYZ’s inventory is on the average sold out 6.41 times per year.
In general, a relative high inventory turnover is better than a low turnover.
4. Fixed assets turnover
– measures how efficiently a firm uses its fixed
assets. It shows how many birrs of sales are generated from one birr of fixed assets
Fixed assets turnover =
XYZ’s fixed assets turnover =
Net sales/ Net fixed assets
Br. 196,200/ Br. 96,300 = 2.04X
Interpretation: XYZ 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
underutilization of fixed assets
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5. 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
• XYZ’s total assets turnover = Br. 196,200/ Br. 153, 900 = 1.27X
• Interpretation: XYZ 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 vis versa.
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C. Leverage Ratios
• Also called debt management or utilization ratios, Long term funds management
• measure the extent to which a firm is financed with debt, or the firm’s ability to
generate sufficient income to meet its debt obligations.
• The types of debt measurement tools are:I. Financial Leverage Ratio: These ratios examine balance sheet ratios and determine
the extent to which borrowed funds have been used to finance the firm.
1. Debt to total assets (Debt) Ratio – measures the percentage of total funds
provided by debt.
Debt ratio =
Total liabilities/Total asset
XYZ’s debt ratio = Br. 98,100/ Br. 153,900 = 64%
Interpretation: At the end of 2002, 64% of XYZ’s total assets were financed by debt
and 36% (100% - 64%) was financed by equity sources.
The higher the debt ratio is the more the firm’s financial risk.
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II. Coverage Ratios
These ratios measure the risk of debt and calculated by
income statement ratios designed to determine the number
of times fixed charges are covered by operating profits.
1. Times – interest earned – measures a firm’s ability to
pay its interest obligations.
Times interest earned = Earnings before interest and taxes
(EBIT) / Interest expense
XYZ’s times interest earned = Br. 10,500Br. 3,000 = 3.50X
Interpretation: XYZ has operating income 3.5 times larger
than the interest expense.
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2. Fixed charges coverage
• Measures the ability of firms to meet all fixed obligations rather than
interest payments alone.
• Fixed payment obligations include
Interest on debt, Principal
repayment on debt, Lease payment, and Preferred-share dividend
payments.
• Fixed charges coverage = Income before fixed charges and taxes/ Fixed
charges
• For XYZ Company, the other fixed charge payment in addition to
interest is lease payment. Therefore,
• XYZ’s FCC = Br. 10,500 + Br. 2,700 / Br. 3,000 + Br. 2,700 = 2.32X
• Interpretation: the fixed charges (interest and lease payments) of XYZ
Share Company are safely covered 2.32 times.
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3. Cash Coverage Ratio
Cash Coverage Ratio= EBIT + Depreciation/ Interest
XYZ’s cash coverage ratio = Br. 10,500+ Br. 6,000/ Br.
3,000 = 5.5x
Interpretation: the cash coverage ratio of XYZ Share
Company are safely covered 5.5 times.
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D. Profitability Ratios
 Profitability is the ability of an entity to earn profits.
 This ability to earn profits depends on the effectiveness and
efficiency of operations as well as resources available.
 Profitability analysis focuses primarily on the relationship
between operating results reported in the income statement and
resources reported in the balance sheet.
• 1. Profit Margin
– shows the percentage of each birr of
net sales remaining after deducting all expenses.
• Profit margin = Net income/Net Sale
• XYZ’s profit margin = Br. 3,900/ Br. 196,200 = 2%
• Interpretation: XYZ generated 2 cents in profits for every one
birr in net sales.
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2. Return on Investment (Assets)
Measures how profitably a firm has used its investment in total
assets.
Return on investment =
Net income / Total assets
XYZ’s return on investment = Br. 3,900 / Br. 153,900 = 2.53 %
Interpretation: XYZ earned more than 2 cents of profits for each
birr in assets.
Generally, a high return on investment is sought by firms
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3. Return on equity
indicates the rate of return earned by a firm’s stockholders on
investments made by them selves.
Return on equity =
Net income/ Stockholders’ equity
XYZ’s return on equity = Br. 3,900/ Br. 55,800 = 6.99%
• Interpretation: XYZ 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 = ROI / 1 – Debt ratio
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E. DuPont System of Analysis
• Is an approach to assess that a firm’s return on assets and return
on equity show not only the firm’s earning power but also
efficiency and leverage.
• This analysis breaks down these two ratios as follows:
ROA= Profit margin X Total assets turnover
XYZ’s ROA (2002) = 0.02 X1.27 = 0.0254 ≈ 0.03
ROE= PM X Total assets turnover X Total assets/equity
= PM X Total assets turnover X Equity Multiplier*
XYZ’s Equity Multiplier (2002) = 153,900/55,800 = 2.76X
XYZ’s ROE (2002) = 0.02X1.27X2.76* ≈ 0.07
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F. Marketability Ratios
• Marketability ratios are used primarily for investment decisions and long
range planning. They include:
1. Earnings per share (EPS)-
expresses the profits earned on each
share of a firm’s common stock outstanding.
Earnings per share = Net income – Preferred stock dividend
Number of common shares outstanding
• XYZ’s Eps for 2002 = Br. 3,900 – Br. 300 / Br. 33,000  Br. 10 = Br. 1.09
2. Dividends Per Share (DPS)-
represents the amount of cash dividends
a firm paid on each share of its common stock outstanding.
Dividends per Share = Total cash dividends on common shares
Number of common shares outstanding
• XYZ’s DPs for 2002 =
Br. 3,300
/ Br. 33,000  Br. 10
= Br. 1.00
• Interpretation: XYZ distributed Br. 1 per share in dividends.
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3. Dividend pay-out (pay-out) ratio
Shows the percentage of earnings paid to stockholders.
• Dividends pay-out = Dividends per share
Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
XYZ’s pay-out ratio = Br. 1.00
Br. 1.09
= Br. 3,300 = 92%
Br. 3,600
Interpretation: XYZ paid nearly 92% of its earnings in
cash dividends.
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Comparing Financial Ratios
• Cross – sectional analysis: The comparison
of a firm’s ratios to those other firms in the
same industry at the same point in time
• Time – series analysis: an evaluation of a
firm’s financial ratios over time.
 The purpose is to determine whether the
firm is progressing or deteriorating.
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Limitation of Ratio Analysis
• Even though ratio analysis can provide useful information
about a firm’s financial conditions and operations, it has the
following problems and limitations.
 Any single financial ratio does not provide sufficient
information by itself.
 Sometimes a comparison of ratios between different firms is
difficult due to the following two reasons
 A single firm may have different divisions operating in
different industries.
 The financial statements may not be dated at the same
point in time.
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Con…
The financial statements of firms are not always
reliable, particularly, when they are not audited.
 Different accounting principles and methods employed
by different companies can distort comparisons.
 Inflation badly distorts comparison of ratios of a firm
over time.
 Seasonal factors inherent in a business can also lead
us to deceptive conclusion.
For example, the inventory turnover ratio for a
stationery materials selling company will be different at
different time periods of a year.
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2.2. Financial planning (Forecasting)
• It is the process of estimating the capital required and determining it's
competition.
• Financial planning is the process of assessing the current financial
situation of a business to identify future financial goals and how to achieve
them.
• It indicates a firm’s growth, performance, investments and requirements of
funds during a given period of time, usually three to five years.
• It is generally a planning process which involves forecasting of sales,
assets, and financial requirements
• Financial forecasting is an integral part of financial planning. It uses past
data to estimate the future financial requirements.
• It 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
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Con…
• Financing planning process involves the following facets:
– Evaluating the current financial condition of the firm.
– Analysing the future growth prospects and options.
– Appraising the investment options to achieve the stated
growth objective.
– Projecting the future growth and profitability.
– Estimating funds requirement and considering alternative
financing options.
– Comparing and choosing from alternative growth plans and
financing options.
– Measuring actual performance with the planned performance
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The procedures and importance of 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.
 Determining how much money (finance) the firm will need during the
forecasted period. This will be done based on sales and assets forecast.
 Determining how much of the total required finance, the firm will be able
to generate internally during the same period.
 Determining the additional external financial requirements
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The planning process
1)Preparation-
Includes
establishing
the
objectives of the analysis and assembling the
financial statements and other pertinent financial
data
2) Computation-
an application of various
tools and techniques to gain a better understanding
of the firm’s financial condition and performance.
3) Evaluation and InterpretationDeveloping
conclusions,
inferences
and
recommendations about the firm’s performance and
financial condition.
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Methods of determining
external financial
requirements
(Additional funds needed
(AFN))
1) The pro-forma financial
statements method
2) The formula method
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1) The Pro-Forma Financial Statements Method
• is also called the projected financial statements method
• The pro-forma financial statements method is simply a method
of forecasting financial requirements based on forecasted
financial statements
• It involves the following steps
i. 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.
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ii. Constructing the Pro Forma Balance Sheet
• Some of the assets increase can be financed by retained
earnings, and spontaneous finance
• The remaining balance 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
Example
Blue Nile Share Company is a medium sized firm engaged in
manufacturing of various household utensils. The financial
manager 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.
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Blue Nile Share Company
Comparative Balance Sheet
August 30, 2015
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
_________
Total assets -------------Br. 600,000
Chapter Two: Financial Analysis and Planning
Retained earnings --------------------150,000
Total liabilities and equity ------Br. 600,000
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Con…
• 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
manager estimates that sales will grow at 10%. There is 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%.
• Required: Determine the additional funds needed (AFN) of Blue Nile Share
Company for the next year using the pro-forma financial statements method
and Formula Method.
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Solution
1st . Develop Pro Forma Income Statement
Sales (Br. 1,800,000 x 1.10) ----------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) --------------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) -----------------------------------------------------Br. 198,000
Interest expense -----------------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) ------------------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) -------------------------------------------------------------------------------63,200
Net income -----------------------------------------------------------------------------------------------Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) ---------------------------------------------------Br. 56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) ----------------------------------------Br. 37,920
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Con…
2. Then, construct the 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. 99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000
Accruals (Br. 40,000 x 1.10) --------------------44,000
Inventories (Br. 150,000 x 1.10) ----------165,000
Current liabilities ----------------------------Br. 143,000
Current assets ---------------------------Br. 253,000
Long-term debt (the increase is unknown)----200,000
Net fixed assets (Br. 370,000 x 1.10) ----407,000
_______
Total assets -----------------------Br. 660,000
Chapter Two: Financial Analysis and Planning
Common stock (as long-term debt) ------------120,000
Retained earnings (Br. 150,000 + Br. 37,920) 187,920
Total liabilities and equity -------------Br. 650,920
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Con…
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
Assets
Increase in normally
–
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
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2. The Formula Method
• is a much easier method of determining additional financial requirements than the pro
forma method; and it’s a shortcut to financial forecasting.
Assumption of the formula method.
 Each asset maintains a direct proportionate relationship with sales
 Accounts payable and accruals increase in direct proportion to sales increase.
 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
• funds
• needed
Required
=
increase
Spontaneous
–
in assets
increase in
liabilities
Increase in
–
retained
earnings
• AFN = (A/S) S – (L/S) S – MS1 (1 – d)
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Con…
To illustrate the formula method, consider the example given for the previous method. But assume that
Blue Nile’s net profit margin is 5%.
AFN =
 Br.600,000 
 Br.130,000 

 Br.180,000*  

 Br.1,800,000 
 Br.1,800,000 


(Br. 180,000) – 5% x Br 1,980,000** (1 – 60%)
= 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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The End!
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