Chapter-2

Financial Analysis and Planning

Introduction
Management should be particularly interested in knowing financial strengths of the firm
to make their best use and to be able to spot out financial weaknesses of the firm to take suitable
corrective actions. The future plans of the firm should be laid down in view of the firm's
financial strengths and weaknesses. Thus financial analysis is the starting point for making plans.
Understanding the past is a prerequisite for anticipating the future.
Meaning and definition of financial statement analysis
Financial statement analysis is the process of determining the financial strengths and weakness
of a concern. It also establishes the strategic relationship b/n various accounts in the financial
statements.
According to Myers, “financial statement analysis is largely a study of 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 ofstatements”.
Metacalf and tetrad defined as,” financial statement analysis is a process of evaluating the
relation ship b/n component parts of a financial statement toobtain a better understanding of a
firm’s position and performance”.
Objectives of financial statements analysis
i. To find out the operating performance of a company
ii. To findout financial performance of a company
iii. To compare the performance of a company for different periods.
iv. To find out long-term solvency and liquidity of a concern.
v. To compare the performance of the company with other companies in the industry.
Methods or devices of financial statement analysis
1. Comparative statements
2. Trend analysis
3. Common-size statements
4. Fund flow analysis
5. Cash flow analysis

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 6. Ratio analysis
7. Cost-volume –profit analysis.
Comparative statements: dealwith the composition of different items of the profit and
loss account and balance sheet of two or more periods.In the process of comparison, the
good or poor performance of each items for a period can be known in order to take
corrective action for the future.The comparative statements can be prepared separately for
the income statement (profit and loss account) and for balance sheet orfor these two
statements at a time.
Trend analysis: - it is one of the important devices in measuring the financial
performance of a company. In this analysis, the important items of the financial
statements (both profit & loss account and balance sheet)for a long period can be taken
for trend analysis. The period of comparison may be 5 years or more than that. Trend
percentage should be calculated by taking 1 year as base.Normally the 1st year of
comparison is taken as base year. The indexfor thebase year should be 100 and from that
trend % for the subsequent years should be calculated.
From this analysis, it is possible to know whether there is any improvement in the items
of financial statement. Hence, it is easy for the management to identify the weaknesses
for corrective actions for the future.
Common sizestatement
It is concerned with the analysis of the financial statements (income statement and
balance sheet) on % basis.It explains each item of the financial statement in terms of the
% to the total. Hence, the share of each item of expenses or income,assets or liabilities to
total can be known through this analysis.The importance of each item can also beknown
through this analysis.
Nature of Ratio analysis:-
Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “the indicated
quotient of two mathematical expressions” and as the relation ship between two or more things.
In financial analysis ratios are used as bench mark for evaluating the financial position and
performance of a firm.
Normally the ratios are classified on the following basis:
1. profitability ratios

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 2. turnover ratios ( activity /efficiency ratios)
3. liquidity ratios
4. leverage ratios
Profitability ratios:-
It explains the strength of a company with respect to the effective utilization of finance. It
also explains the rate of return on the basis of sales. Here ratios are classified as
(a) Profitability ratios based on investments and (b) Profitability ratios based on sales.
(a) Profitability ratios based on investments:-
Return on capital employed = earnings after tax + interest/total capital employed.
Total capital employed is total of debt and equity. (EAT= earnings after tax)
1. Return on shareholders’ equity= earnings after tax/equity
Equity share holders fund called as equity. It is the total of equity share capital, preference share
capital and reserves and surplus. Fictitious assets should be deducted from this total.
2. Return on equity fund= EAT preference dividend/equity share holders fund.
Equity share holders fund is the difference between the equity and the preference share capital.
3. Return on total assets=EAT+interest/total assets.
Total assets exclude the fictitious assets.
4. Earnings per share (EPS) =EAT preference dividend/number of equity shares.
5. Dividend per share (DPS) =dividend for equity share holders/number of equity
shares.
6. Earnings yield= EPS/market price per share.
7. Dividend yield= DPS/market price per share.
8. Price earning ratio (P/E ratio) =market price per share/EPS.
9. Dividend pay out ratio (D/P ratio) =DPS/EPS.
10. Book value per share= equity share holders fund/number of equity shares.
(b) Profitability ratios based on sales.
1. Gross profit ratio=gross profit/sales (or) total sales.
2. Net profit ratio=net profit/sales (or) total sales.
3. Operating ratio=EBIT (operating profit)/sales.
EBIT=earnings before interest and tax.
4. Expenses ratio:-

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 Cost of goods sold ratio= cost of goods sold/sales.
COGS= opening stock+purchases+direct expenses-closing stock. (Or)
Sales-gross profit (or) sales+gross loss.
Administrative expenses ratio=administrative expenses/sales.
Selling expenses ratio=selling expenses/sales
Operating expenses ratio=operating expenses/sales.
Operating expenses=administrative expenses+selling expenses.
Operating ratio= COGS+operating expenses/sales.
Turnover ratios
Turnover ratios are otherwise called as Activity ratios or Efficiency ratios. This ratios
explain the efficiency of the company to utilize the resources for production and sales. The
important turnover ratios are explained as follows.
1. stock turnover ratio= COGS/average stock
Average stock=opening stock+closing stock/2
Debtors turnover ratio=credit sales/average debtors.
Average debtors=opening debtors+closing debtors.
2. Debt collection period=365/debtors turnover ratio (or)
12/ debtors turnover ratio.
4. Creditors turnover ratio= credit purchase/average creditors.
Average creditors=opening creditors+closing creditors/2.
Credit payment period= 365 (or) 12/creditors turnover ratio.
6. Assets turnover ratio
Current assets turnover ratio=sales/average current assets.
Fixed assets turnover ratio=sales/average fixed assets.
Total assets turnover ratio=sales/average total assets.
Average total assets=opening balance of assets+closing balance of assets/2.
7. Working capital turnover ratio=sales/average working capital.
Working capital is the difference between current assets and current liabilities.
Liquidity ratios
The ability of a company to meet the short-term obligations is measured through liquidity
ratios. The liquidity ratios are calculated as follows.

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 1. Current ratio=current assets/current liabilities.
Current assets=stock+debtors+cash+bills receivable+expenses paid in advance+outstanding
interest.
Quick assets (or) Liquid assets=debtors+cash+bills receivable.
Current liabilities=creditors+bills payable+outstanding expenses+interest received in advance.
2. Quick ratio (or) Acid test ratio=quick assets/current liabilities.
Quick assets=current assets-stock (or) cash+BR+debtors.
Leverage ratios or capital structure ratios
The long-term solvency of a company is measured through these ratios. This ratio
measures the composition of capital with respect to the own capital and borrowed capital. It also
helps to measure the ability of the company to repay the long term loan and interest from the
earnings. This ratio classified as Debt-Equity ratio and Coverage ratios.
(a) Debt equity ratios
(i) Debt-equity ratio=debt/equity.
Debt =debenture+long-term loans.
Equity =equity share capital+preference share capital+reserves and surpluses-fictious
assets.
(ii) Debt to total capital ratio=debt/capital employed.
Capital employed=debt+equity.
(iii) Debt to total assets ratio=debt/total assets.
(iv)Proprietary ratio=equity/total assets.
(v) Capital gearing ratio=preference share capital+debt/equity.
(b) Coverage ratio
(I) Interest coverage ratio=EBIT/interest.
(II) Dividend coverage ratio=EAT/preference dividend.
EAT excludes interest also.

(III)Debt service coverage ratio= EBIT

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 _____________________________
Interest+principal payment
installment
______________________
1- Tax rate

Financial analysis
As a manager, you may want to reward employees based on their performance. How do
you know how well they have done? How can you determine what departments or divisions have
performed well? As a lender, how do decide the borrower will be able to pay back as promised?
As a manager of a corporation how do you know when existing capacity will be exceeded and
enlarged capacity will be needed? 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 risker
than another? All of these questions can be addressed through 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’s performance, the
efficiency of operations, and credit policies, and externally to evaluate potential investments and
the credit-worthiness of borrowers, among other things.
Sources of Financial data
The analysist draws the financial data needed in financial analysis from many sources.
The primary source is the data provided by the firm itself in its annual report and required
disclosures. The annual report comprises the income statement, the balance sheet, and the
statement of cash flows, as well as footnotes to these statements. Certain business is required by
securities laws to disclose additional information. Besides information that companies are
required to disclose through financial statements, other information is readily available for
financial analysis. For example, 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 does not tell the whole story. You also need information on
consumer spending, producer prices, consumer prices, and the competition. This economic data
that is readily available from government and private sources.
Beside financial statement data, market data, and economic data, in financial analysis you
also need to examine events that may help explain the firm’s present condition and may have a
bearing on its future prospects. For example, did the firm recently incur some extraordinary
losses? Is the firm developing a new product? Or acquiring another firm? Current events can
provide information that may be incorporated in financial analysis.
The financial analyst must select the pertinent information, analyze it, and interpret the
analysis.Enabling judgments on the current and future financial condition and operating
performance of the firm. In this reading, we introduce to you financial ratios- the tool of financial
analysis. In financial ratio analysis we select the relevant information-primarily the financial
statement data- and evaluate it. We show how to incorporate market data and economic data in
the analysis and interpretation of financial ratios.
User of financial analysis:-
Financial analysis is the process of identifying the financial strengths and weaknesses of
the firm by properly establishing relationship between the items of the balance sheet and the
profit and loss account. Financial analysis cab be undertaken by management of the firm or by
parties outside like owners, creditors, investors and others.
Generally the nature of analysis will differ depending on the purpose of the analyst.
Trade creditors are interested in firm's ability to meet their claims over a very short
period of time. Their analysis will confine to the evaluation of the firm's liquidity position.
Suppliers of long-term debt are concerned with firm's long-term solvency and survival.
So they analyze the firm's profitability over time and its ability to generate cash to pay interest
and repay principal. Long-term creditors are also emphasis on financial statements to make
analysis about future solvency and profitability.

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 Investors are most concerned about firm's earnings. They restore more confidence in
those firms that show steady growth in earnings. So they concentrate on the analysis of the firm's
present and future profitability.
Management of the firm would be interested in every aspect of the financial analysis. It
is their overall responsibility to see the resources of the firm are used effectively and efficiently,
and firm's financial condition is sound.
Introduction to Financial Planning:-
A firm should be managed effectively and efficiently. This implies that the firm should be
able to achieve its objectives by minimizing the use of resources. One systematic approach for
attaining effective management performance is financial planning and budgeting. Financial
planning indicates firm's growth, performance, investments and requirements of funds during a
given period of time. It involves the preparation of projected profit and loss account, balance
sheet and funds flow statement. Financial planning and profit planning help a firm's financial
manager to regulate flow of funds.
Financial planning process:-
The financial planning process can be broken into 6 steps;-
1. Project financial statements and use these projections to analyze the effects of the
operating plan on projected profits and various financial ratios. These projections can
also be used to monitor operations after the plan has been finalized and put into
effect. Rapid awareness of deviations from the plan is essential in a good control
system, which, in turn is essential to corporate success in a changing world.
2. Determine the funds needed to support the five –year plan. This includes funds for
plant and equipment as well as for inventories and receivables, for R&D programs,
and for major advertising campaigns.
3. Forecast funds availability over the next five years. This involves estimating the
funds to be generated internally as well as those to be obtained from external
sources. Any constraints on operating plans imposed by financial restrictions must be
incorporated into the plan, constraints include restrictions on the debt ratio, the
current ratio and the coverage ratios.
4. Establish and maintain a system of controls to govern the allocation and use of funds
with in the firm. In essence, this involves making sure that the basic plan is carried

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 out properly.
5. Develop procedures for adjusting the basic plan if the economic forecasts upon
which the plan was based do not materialize. For example, if the economy turns out
to be stronger than was forecasted, then these new conditions must be reorganized.
This step is a feed back loop.
6. Establish a performance-based management compensation system. It is critical
important that such a system rewards managers for doing what stock-holders want
them to do-maximize share prices.
Sales forecast:-
The sales forecast is typically the starting point of the financial forecasting exercise. Most of the
financial variables are projected in relation to the estimated level of sales. Hence the accuracy of
the financial forecast depends critically on the accuracy of the sales forecast.
Although the financial manager may participate in the process of developing the sales forecast,
the primary responsibility for it typically vests with the marketing department or the planning
group.
Sales forecasts may be prepared for varying planning horizons to serve different purposes. A
sales forecast for a period of 3-5 years or for even longer durations, may be developed mainly to
aid investment planning. A sales forecast for a period of one year is the primary basis for the
financial forecasting exercise. Sales forecasts for shorter durations (six, three, one months) may
be prepared for facilitating working capital planning and cash budgeting.
A wide range of sales forecasting techniques and methods are available. They may be divided
into three broad categories.
. Qualitative techniques: - These techniques rely essentially on the judgment of
experts to translate qualitative information into quantitative estimates.
. Time series projection methods: - These methods generate forecasts on the basis of
an analysis of the past behavior of time series.
. Casual models: - These techniques seek to develop forecasts based on cause –effect
relationships expressed in explicit, quantitative manner.
Characteristics of financial planning

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Simplicity of purpose:-
The planning schedule should be organized and should be as simple as possible so that
the understanding of it becomes easier.
Intensive use:-
A wasteful use of capital is almost as bad as inadequate capital. A financial plan should
be such that it will provide for an intensive use of funds. Funds should not remain idle, nor there
any paucity of funds. Moreover, they should be made available for the optimal utilization of
projects.
Financial contingency:-
In fact, planning, as it is commonly practiced today, tends to build in rigidities, which
work against a quick and effective response to the unexpected event. Contingency planning or a
strategy for financial mobility should be brought into the open for a careful review. Every
business has objectives that guide policy in their most basic form and include survival, profit-
ability and growth. Growth objectives that are central to our philosophy of successful
management may be expressed in a variety of ways – sales, profits, market share, geographical
coverage and product line, but they are all contingent on a continuous flow of funds which make
it possible for the management to implement decisions. Financial contingency planning is a
strategy, which a firm adopts in situations of adversity.
Objectivity:-
The figures and reports to be used for a financial plan should be free from partiality,
prejudice and personal bias. A lapse from objectivity is undesirable as it may mislead and make
it difficult if not impossible for a firm to prepare a fact-finding plan.
Financial planning process involves the following

i. Evaluating the current financial condition of the firm.

ii. Analyzing the future growth prospects and options.
iii. Appraising the investment options to achieve the stated growth objective.
iv. Projecting the future growth and profitability.
v. Estimating funds requirement and considering alternative financing options.
vi. Comparing and choosing from alternative growth plans and financing options.

Measuring actual performance with the planned one.

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Work sheet: on financial analysis and planning

Comparative
1. Prepare a comparative income statement of K ltd fort the following profit and loss
account for the year ended 31st march 2006 and 2007.

Profit and loss account for the year ended 31st march 2006 and 2007.
Particulars 2006 2007 particulars 2006 2007
To cost of goods sold 690,000 810,000 By sales 1,200,000 1,400,000
To operating expenses
Adminexp 150,000 120,000
Sellingexp 180,000 230,000
to net profit 180,000 240,000
____________________ ________________________
1,200,000 1,400,000 1,200,000 1,400,000

Provided the balance sheet for the year ended 31st march 2006 and 2007
Particulars 2006 2007 particulars 2006 2007
Share capital 400,000 400,000 land 400,000 300,000
Preference capital 100,000 200,000 building 300,000350,000
Reserve and surplus 125,000 190,000 plant 320,000 270,000
Debentures 250,000 50,000 stock 31,000 20,000
Loan 200,000 130,000 debtors 42,000 53,000
Sundry creditors 40,000 50,000 cash 35,000 22,000
Bills payable 25,000 10,000 outstanding int 12,000 15,000
__________________ __________________ 1,
1140,000 1,030,000 1,140,000 1,030,000
Trend analysis
2. The following are the information related to sales and profit of G ltd. Calculate the trend
percentages by taking 2003 as a base. Also interpret the result.
Year sales stock profit before tax
2003 4,500 340 420
2004 5,300 450 370
2005 6,000 700 510
2006 6,500 550 300
2007 7,000 400 750
___________________________________________________________________________

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Common size statement
3. The income statement of a manufacturing company for 31st march 2006 and 2007 are stated as
follows
Particulars 2006 2007
Sales 2,900,000 3,400,000
Non-operating income (dividend received) 150,000 100,000
____________________________
3,050,000 3,500,000
_____________________________
Expenses
Cost of production 1,640,000 1,885,000

Admin expense 540,000 620,000

Selling expenses 210,000 275,000

Interest 370,000 390,000

Total expenses 2,760,000 3,170,000

Net profit 290,000 330,000

4. The balance sheet of N ltd and H ltd as on 31st march 2007 are stated as follows.

Particulars Nltd Hltd

Assets

Cash 75,000 95,000

Sundry debtors 70,000 77,000

Stock 79,000 85,000

Outstanding income 26,000 23,000

Prepaid expenses 20,000 10,000

Fixed assets 1,020,000 1,210,000

Total assets 1,290,000 1,500,000

Liabilities

Sundry creditors 45,000 32,000

Bills payable 25,000 13,000

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Long-term loan 400,000 555,000

Capital 820,000 900,000

Total liabilities 1,290,000 1,500,000

Prepare a commonsize balance sheet

5. Calculate (i) sales (ii) closing stock (iii) sundry debtors (iv) sundry creditors from the
following

Gross profit ratio-20%, stock velocity-5 times, debtors velocity-3 months,

Creditors velocity-2 months, gross profit as on 31st march 2007 is $140,000 and operating stock
is $80,000.

6. Prepare the trading and profit and loss account and balance sheet as on 31st march 2007 from
the following information.

a. Gross profit ratio 20%

b. net profit ratio 16%

c. stock turnover ratio 5

d. net profit to capital1/8

e.fixed assets to capital 6/5

f. fixed assets to current assets 4

g. capital to total liabilities 2/3

h. closing stock $140,000

i. fixed assets $1,200,000

j. sundry debtors $70,000

k. current ratio 3:1

l. long term loan $275,000

m. operating expenses $20,000 and non-operating expenses $11,250.

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