Chapter Two: Financial Analysis and Planning

The need for Analysis

Financial statement analysis involves analyzing the firm’s financial statements to extract
information that can facilitate decision-making.
Analyses of the financial statement can reveal whether;
 the firm will be able to meet its commitments (long-term and short-term)
 the company is using its physical assets efficiently,
 the firm is generating adequate return for its shareholders,
 the firm can sustain its competitive advantage etc;
Who analyzes financial statements?
1. Internal users: to improve company efficiency and effectiveness in providing products and
services.
 to evaluate their overall current performance, identify problem/opportunity areas,
develop budgets and implement strategies for the future
2. External users: to make better and more informed investing and lending decisions.
 Others, such as suppliers, to establish credit terms
Sources of information for Analysis
 Internal sources
- Annual Report
- Management Discussion & Analysis (MD&A)
- Financial Statement
- Balance Sheet
- Income Statement
- Statement of Retained Earnings
- Statement of Cash Flows
- Notes to the Financial Statements
- Others
 External sources
- Database
- Special Report (corporation, industry)
- Governmental Report (industry)
- News
Analysis Tools/Approaches to financial analysis & Interpretation
The three most common financial statement analysis tools are:
1. Horizontal analysis
2. Vertical analysis, and
3. Ratio analysis
1) Horizontal analysis (Trend Analysis)
 A firm’s performance over a period is analyzed from a selected base year.
 Horizontal analysis compares changes in accounts across time.

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For example, assume Company A had the following data available:
2010 2009
Net sales $110,000 $100,000
Cost of goods sold 60,000 51,000
Gross profit 50,000 49,000

A horizontal analysis for this data would be:

Dollar Percent
2010 2009 Change Change
Net sales $110,000 $100,000 $10,000 10.0% (1)
Cost of goods sold 60,000 51,000 9,000 17.6%
Gross profit 50,000 49,000 1,000 2.0%

The percent change is calculated as:

Percent change = Dollar change / older period amount

($10,000 / $100,000 = 10 %)

What does this tell us?

 Even though sales increased by 10% from 2009 to 2010, gross profit only increased by
2%. Why? Such questions need to be directed to management.

2) Vertical Analysis (Common size Analysis)

 Expresses each financial statement item as a dollar amount and a percentage. The ratios
often are expressed as percentages of the reference amount.
 Common size ratios are used to compare financial statements of different-size companies
(Cross-Sectional Analysis) or of the same company over different periods (trend analysis).
 Common size statements usually are prepared for the income statement and balance sheet,
expressing information as follows:
o Income statement items - expressed as a percentage of total revenue
o Balance sheet items - expressed as a percentage of total assets
Using the above example, a vertical analysis would be:

Common-Size Percents
2010 2009 2010 2009
Net sales $110,000 $100,000 100.0% 100.0%
Cost of goods sold 60,000 51, 000 54.5% 51.0%
Gross profit 50,000 49,000 45.5% 49.0%

What does this tell us?

 Even though sales increased, gross profit, as a percentage of net sales decreased.
Limitations of using common size ratios for Cross- sectional Analysis
 Different accounting policies may be used by different firms or within the same firm at
different points in time. Adjustments should be made for such differences.

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  Different firms may use different accounting calendars, so the accounting periods may not
be directly comparable.

3) Ratio Analysis
 Provides the means to analyze the financial statements of a firm from various perspectives:
liquidity, solvency, asset utilization, profitability, and value.
Benchmarks/Standards for Comparison
The Common benchmarks are:
1. Industry Average:
 Represents the average ratio of firms within the same industry (e.g. the average
ratios for all commercial banks)
 Comparing financial analysis data from a company to its industry average lets us
know how a company compares to its competitors.
2. Best Practices (Industry leader’s ratios):
 Firm’s financial ratios could be compared with the industry leader’s ratios.
3. Past ratios (Past Performances)/ Intra-company:
 Comparing data from the current year to the prior years.

2.4 Types of financial ratios

Financial ratio classified into five categories. These are:
1. Liquidity ratios
2. Activity ratios
3. Leverage ratios
4. Profitability ratios
5. Market value ratio

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Example,
ABC Company
Balance sheet
As of December, 31
(In thousands)
yr200 yr2000
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Assets:
Current assets:
Cash 675 450
A/R 1,050 700
Marketable securities 975 650
Inventory 1,900 950
Total current asset 4,600 2,750
Plant assets (net) 3,125 1,250
Total assets 7,725 4,000
Liabilities
Current liability 900 450
Ling term liability 1,800 800
Total liabilities 2,700 1250
Stockholders’ equity
Common stock (100par) 2,000 2,00
0
Retained earning 3,025 75
0
Total liabilities &SHE 7,725 4,000

ABC Company
Income statement
For the year ended, December 31
(in thousands)

yr2001 yr2000
Sales 2250 1800
Sales returns 375 300
Net sales 1875 1500
CGS 1000 850
GP 875 650
Operating expense:

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 Selling expense 300 200
General expense 105 60
Total expense 405 260
Income from operation 470 390
Other income 130 80
Earning before interest and tax (EBIT) 600 470
Interest expense 100 55
Earning before tax (EBT) 500 415
Income tax(40%) 200 166
Net income 300 249

1. Liquidity ratios
 Measure the ability of a firm to meet its short term obligations and reflect the short term
financial strength/solvency of a firm.
Two commonly used ratios are:
A. Current ratio:-
 Measures a firm’s ability to satisfy or cover the claims of short term creditors by using
only current assets.
Current ratio =Current assets
Current liabilities
Current ratio for ABC (for yr2000) = 2750
450
=6.1 times
Interpretation: ABC has birr 6.1 in current assets available for every one birr in current
Liabilities
 Low ratio-suggests that a firm may face difficulty in paying its short term obligations.
 High ratio- indicates that too much capital is tied up in current assets and a firm may
be sacrificing some return.
 A reasonable higher (moderate)the ratio,
- the larger the amount of birr availability in current assets per birr of current liability
- the more the firm’s liquidity position
- the greater the safety of funds of short term creditors (i.e. less risk to creditors)
 A very lower current ratio results opposite from current ratio out lined as above. A low
current ratio could be improved by:
-long term borrowing to increase current assets
-liquidating current liabilities using long term financing
 A very high current ratio may indicate,
-excessive cash due to poor cash management
-excessive A/R due to poor credit management
-excessive inventories due to poor inventory management
- A firm is not making full use of its current borrowing capacity
Therefore, a firm should have a reasonable current ratio.
B. Acid –test or quick – ratio: -
 Measures the short term liquidity by excluding the least liquid assets such as:
- Inventories: because they are not easily and readily convertible in to cash.
Moreover, losses are most likely to occur in the event of selling inventories
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 - Prepaid expenses: because they are not available to pay off current debts.
Quick assets are:
 cash
 marketable securities
 receivables
Quick Ratio = Quick Asset
Current liabilities
or
= Current Assets- (Inventory+ prepaid expenses)
Current liabilities

Quick Ratio for ABC (for yr.2000) = 450+700+650 = 4 times

450
Or
2750.950 = 4 times
450
Interpretation: ABC has birr 4 in quick assets for every birr in current liabilities.
 The current ratio is a crude measure of a firm’s liquidity position as it takes into account all
current assets without any distinction in their composition.

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 2. Activity ratios

These ratios are also called.

 Efficiency ratios or
 Asset- utilization ratios
o Activity ratios are employed to evaluate the efficiency with which the firm manages
and utilizes its assets.
o These ratios are also called turn- over ratios because they indicate the speed with
which assets are being converted or turned over into sales.
i.e Merchandise A/R

Cash

 Overall liquidity ratios generally do not give an adequate picture of company’s real liquidity
due to differences in the kinds of current assets & liabilities the company holds. Thus, it is
necessary to evaluate the activity ratio.

Example:-
ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7000
Marketable security 0 17,000
AIR 0 5,000
Inventories 35,000 6,000
Total current asset 35,000 35,000
Current Liabilities
A/P 0 6,000
N/P 14,000 6,000
Accruals 0 2,000
Total current liability 14,000 14,000
The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR = CA
CL CL
=35000 =35000

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 14,000 14,000
= 2.5 times = 2.5 times

Activity (Asset utilization) Ratios include

a) A/R turnover ratio
b) A/P “ “
c) Inventory “ “
d) FA “ “
e) Total Asset “ “

a) A/R turnover ratio: - measures the liquidity of a firm’s accounts receivable. That is, it indicates how
many times or how rapidly A/R is converted into cash during a year. Financial analysts apply two
tools to judge the quality or liquidity of A/R.

 A/R turnover
 Collection period
A/R turnover = Net credit sales (Total sales)
Average A/R
A/R turnover for ABC (yr 2000) = 1500
700
= 2.14 times

AIR turnover for (yr 2001)= 1875

875*
= 2.14 times
*To compute average A/R sum up the last year A/R ( i.e beginning of this year) and the A/R of
the current year and divide by two .

Interpretation: - ABC’s A/R is converted into cash 2.14 times in year. A reasonably high A/R
turnover is preferable.

A ratio substantially lower than the industry average may suggest that a firm has:
 More liberal credit policy (i.e longer time credit period), poor credit selection, and
inadequate collection effort or policy which could lead.
 A/R to be too high
 Bad debts or uncollectable Receivables
 More restrictive cash discount (i.e no or little cash discount) that could make sales to be too
low.

A/R turnover = Net sales

A/R

Note: - As result of the above factors,

 The firm could have poor profitability position.

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  The firm’s funds would be tied-up in receivable as payments by customers are delayed.
A ratio substantially higher than the industry average may suggest that a firm has:
 More restrictive credit policy (i.e. short term credit period)
 More liberal cash discount offers (i.e. larger discount and sale increase)
 More restrictive credit selection.
 More rigorous collection effort or policy
Note: the outcomes of a higher A/R turnover could be
 avoidance of the risk of bad debts
 Increase the firm’s profitability position.
 Small funds tied-up in A/R
 Customers pay quickly
A reasonable High ratio is required for a firm to be efficient in converting its A/R into cash.
If available, only credit sales should be used in the numerator as A/R arises only from
credit sales.
Average collocation period (ACP)
Represents the average length of time a firm must wait to receive cash after making a sale.
That is, it indicates how many days a firm takes to convert receivable into cash or number
of days sales are tied up in A/R
ACP= 360 day ACP= Receivables
A/R turnover Average sales per day

= 360 days
Net sales
Average A/R

=360 x Average A/R

Net sales
= 360 x average A/R
Net sales

= 1 X Average A/R
net sales
360
1 X Average A/R
Average sales per day
= Average A/R
Average sales per day

ACP= 360 days Receivable

A/R turnover or Average sales per day
= 360 days = 700 = 700
2.14 1500 4.16
=168 days 360 =168 days

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Assume, the credit term of ABC is 2/10, n/75.
Interpretation: - Customer of ABC, on the average, is not paying their bills on time as the ACP
greater than the credit term (75 days). In general, a reasonably short collection period is
preferable.
ABC takes about 168 days to collect its A/R and this lengthy collection period suggests that the
firm might have potential problems in that:
 It isn’t effective in collecting its A/R
 It may give credit to marginal customers
 Thus, the firm’s profitability is adversely affected.
b) A/P turnover ratio :- measures how rapidly creditors are paid. That is, how rapidly or how many
times A/P are paid during a year.

Example, Assume for XYZ café net purchase (on credit) =150,000
A/P- Dec 31, 2000 30,000
A/P turnover = net purchase
A/P
= 150,000
30,000
=5 times
Interpretation: - Assume that industry average of A/P turnover is 6 times.
XYZ cafe pays its creditors lower times a year (i.e 5 times). Thus, it may be rated a risky
borrower.
 Average payment period (APP):- measures the average length of time creditors must wait to
receive their cash or simply the average time needed by a firm to pay its A/P to creditors’ or
suppliers from which purchase made.

APP= 360 days A/P

A/P turnover over Average purchase per
APP for XYZ cafe = 360 days daday
5 times = 72 days

Assume, suppliers on the average extend, say 60 days credit terms.

Interpretation: - XYZ café would be given a low credit rating (low credit worthiness). That is
XYZ is a risky borrower.
c) Inventory turnover: the frequency at which inventory is converted into sales/ A/R . That is how fast
inventory is sold or turned over?

Inventory turnover= CGS

Average inventory

Inventory turnover for ABC (2001) = 1000

950 + 1900
2
= 0.7 times

Note:- The average inventory is the average of beginning and ending balances of inventory.

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Interpretation:- ABC’s inventory is sold out or turned over 0.7 times per year. It general, a high
inventory turnover ratio is better than a low ratio.
 An Inventory turnover significantly higher than the industry average indicates:
 Superior selling practices
 Improved profitability as less money is tied-up in inventory.

Possible problems of high inventory turnover

 Very low level of inventory (i.e under investment in inventory)
 Lost sales due to insufficient inventory (i.e risk of out of stock)
 Stoppage of production process for manufacturing firms.
A very low inventory turnover suggests:
 Excessive inventory or over investment in anticipation of strike or price decreases.
 Inferior quality goods, stock of un salable / obsolete goods.
Possible problems of a very low inventory turnover
- Cost of funds locked-up or tied up in inventory (opportunely cost)
- Deterioration
- Rental of space
- Insurance cost, properly tax, and other inventory carrying costs.
Average age of inventory (AAI):- The number of days inventory is kept before it is sold to
customers.
AAI = 360 days
Inventory turnover
360 days
0.7
= 514 days
Interpretation: - ABC carries its inventory for 514 days.
The lengthening of the holding period shows a potently greater risk of obsolescence.
Operating Cycle: - is the number of days it takes to convert inventory and receivables to cash.
Inventory A/R Cash
AAI ACP
Operating cycle = AAI + ACP where, AAI, Average Age of Inventory
ACP, Average Collection Period
Operating cycle for ABC= 514 days +168 days
= 682 days

Interpretation :- ABC takes 682 days to convert inventory and receivables to cash.
A short operating cycle is desirable.
d) Fixed Asset turnover: - measures the efficiency of a business firm with which the firm has been using
its fixed assets to generate revenue

Fixed Assert turnover = Net sales

Net fixed asset.
Fixed Asset turnover = 1500
ABC (for 2000) 1250
=1.2 times
Interpretation:-ABC generated birr 1.20 in net sales for every birr invested in fixed assets.

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 Other things being equal, a ratio substantially below the industry average:
 Shows underutilization of available fixed assets. (i.e presence of idle capacity) relative to the
industry.
 Indicates possibility to expand activity level without requiring additional capital investment.
 Shows over investment in fixed assets, low sales, or both.
 helps the financial manager to reject funds requested by production managers for new capital
investments.
 Suggests that sales should be increased, some fixed assets Should be disposed off, or both.
 Citrus Paribas (Other things kept constant), a ratio higher than the industry average:
 Requires the firm to make additional capital investments to operate a higher level of activity.
 Shows more efficiency in managing and utilizing fixed assets.
 A firms fixed asset turnover is affected by:

- The cost of the assets.

- The time elapsed since their acquisition.
- The depreciation methods used
e) Total Asset turnover:- Measures a firm’s efficiency in managing its total assets to generate
sales.
=Net sales
Net total assets
(For year 2000) =1800
4000
= 0.45 times
Net total assets = Net fixed assets + Current Asset.
Depreciation is excluded.
Interpretation: - ABC generates birr 0.45 in net sales for every birr invested in total assets.
 A high ratio suggests greater efficiency in using assets to produce sale
 A low ratio suggests that ABC is not generating a sufficient volume of sales for the size of its
investment in assets. Therefore, ABC should take steps to :-
-increase sales
-Dispose of some of its investment in assets or both.
Caution has to be taken in making comparison between Asset turnover ratio of different
organization because the initial costs of fixed asset differ. Moreover, the method of depreciation
has its own impact on total asset turnover. Inflation has an impact. Comparing an old firm which
had acquired many of its fixed assets at low prices with a new company which had acquired at
high price may be misleading.
Firm A (Meta Brewery) Firm B (Dashen Brewery)
 Old and well established company  New company
 Old fixed assets recorded at lower  New fixed assets purchased at
historical cost higher prices
 Tend to have higher fixed asset turnover  Tend to have lower fixed asset TO

These differences could result from:

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 - Differences in net cost of fixed assets but not from differences
operational efficiencies. Thus, the analyst should consider these facts
while comparing Firm A and Firm B

3. Leverage, solvency and long term debt ratio

Solvency is a firm’s ability to pay long term debt as they come due.
Leverage shows the degree of indebtness of a firm.
There are two debt measurement tools. These are
A. Financial leverage ratio: measures degree of indebtness
B. Coverage ratio: measures ability to pay debt
A) Financial leverage. These ratios examine balance sheet ratios and determine the extent to
which borrowed funds have been used to finance the firm. It is the relationship of borrowed
funds and owner’s capital. This can be:
I. Debt ratio
II. Debt equity ratio
I). Debt ratio: the percentage of assets financed through debt
Debt ratio = Total Liability for ABC (yr 2000) 1250/4000=31.25%
Total Assets
Interpretation: creditors have financed ABC about 31 cents of every birr assets. It is obviously
implies that owners have financed 68.75 percent of total assets.
Higher ratio shows- more of a firm’s asset are provided by creditors relative to owners
- The firm may face some difficulty in raising additional debt.
- Further creditors may require a higher rate of return( interest rate) for
taking higher risk
Creditors prefer moderate or low debt ratio, because low debt ratio provides creditors more
protection in case a firm experiences financial problems.

b) Debt –equity ratio: expresses the relationship between the amounts of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of
creditors and shareholders’ against the asset of the firm/
Debt-equity ratio= Total Liability
Stockholders’ equity
For ABC ( yr 2000)=1250/2750=45.45%
Interpretation: Lenders’ contribution is 0.45 times that of stock holders’ contributions. Debt-
Equity ratio is also the division of debt ratio by equity ratio (i.e 0.3125/0.6875=0.4545)

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 =Debt ratio
Equity ratio

=Total liability = Total liability X Total assets = Total Liability

Total assets Total assets Stockholders equity Stockholders equity
Stock holders equity
Total assets

B) Coverage ratio: these ratio measures the risk of debt by income statement ratios designed
to determine the number of times fixed charges are covered by operating profits. Hence, they
are computed from information available in the income statement. It measures the relationship
between what is normally available from operations of the firm and the claims of outsiders.
The claims of a firm (to outsiders) are normally met from the earnings or operating profits of
the firm. These claims include loan principal and interest, lease payment and preferred stock
dividends. The coverage ratios include:
A. Times Interest Earned Ratio: measures the ability of a firm to pay interest on a timely basis.
= EBIT
Interest expense
For ABC (yr 2001) =600/100= 6 times
Interpretation: ABC earning can cover 6 times its interest expense.
A low ratio suggests:
- Creditors are at more risk in receiving interest due.
-failure to meet interest payment can bring legal action by creditors possibly resulting in
bankruptcy.
- The firm may face difficulty in raising additional financing through debt as it is more than
similar firms.
A high ratio suggests the firm has sufficient margin of safety to cover its interest charges.

B. Fixed Charge coverage ratio: measures the firm’s ability to meet all fixed payment obligation,
such as loan principal, interest, lease payment and preferred stock dividends. It helps to assess
the business organization ability to meet all fixed payments.
Fixed charge coverage ratio= EBIT + Lease payments
Interest+ Lease Payment + (principal pmt+ P/stock dividend)
1-T
Where, T is tax rate.
Note: a firm’s fixed charges are examined on a before tax basis. Interest payments and lease
payments are made on a before tax basis, so no need of adjustment. Principal payments and
preferred stock dividend are not tax deductible and are paid from after tax earnings, a tax
adjustment is necessary. That is, the payment grossed up by dividing (1-T) to find the before
tax income.
Example, assume, Interest expense: 100000
Lease payment: 50,000
Principal payment: 10,000
Preferred stock dividend: 20,000
Tax rate: 40 percent
Fixed charge coverage ratio= 600+50

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 100+50+(10+20/1-0.4)
3.25 times
Interpretation: ABC is able to cover its fixed charges 3.25 times.
If the ratio is lower:
- The firm may be unable to meet its fixed charges if earnings decline
and may be forced into bankruptcy.
- Creditors and preferred stockholders see the firm as more risky.
A high ratio suggests a good protection in the event of worsening financial position

4. Profitability ratio
These ratios are used to measure the management effectiveness. Besides management of the
company, creditors and owners are also interested in the profitability of the company.
Creditors want to get interest and repayment of principal regularly. Owners want to get a
required rate of return on their investment. The ratio includes:
A. Gross profit margin
B. Operating profit margin
C. Net profit margin
D. Return on investment
E. Return on equity
F. Earnings per share

A. Gross profit margin

This ratio indicates management effectiveness in pricing policy, generating sales and
controlling production costs.

Gross profit margin= Gross profit

Net sales

For ABC( yr 2000) = 650/1500=43.3%

Interpretation: The company profit is 0.43 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross margin ratio may
increase by the following factors:
 Higher sales price, CGS remaining constant
 Lower CGS, sales prices remaining constant
A low gross profit margin may reflect higher CGS due to the firm’s:
 Inability to purchase raw materials at favorable terms
 Inefficient utilization of plant and machinery
 Over investment in plant and machinery, resulting higher cost of production
The ratio also low due to a fall in prices in the market or marked reduction in selling by the
firm in an attempt to obtain large sales volume.

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 B. Operating profit margin: measures the percentage of operating profit to sales.

Operating profit margin= EBIT

Net sales

For ABC( yr 2000)=470/1500=31.3%

Interpretation: ABC generates 31 cents operating profits for each of birr sales.

C. Net profit Margin: measures the percentage of net income to sales.

Net profit margin= Net income

Net sales

For ABC (yr 2000) =249/1500=16.6%

Interpretation: ABC generates nearly 17 cents in net income for each of birr net sales.

D. Return on investment (ROI): measures the overall effectiveness of management in

utilizing assets in the process of generating revenue. It reflects how effectively and
efficiently the firm’s assets are used. This ratio is also called Return on Asset (ROA).

Or using Dupont formula: ROA= net profit margin X Total asset turnover
= Net income X Net sales
Net sales Total assets

ROA= Net income

Total assets = 249/4000=6.225% or
=0.06225x0.375=6.225%
Interpretation: ABC generates little more than 6 cents for every birr invested in assets.
E. Return on equity (ROE): measures the rate of return realized by stockholders on their
investment.

ROE= Net income Or ROE= ROA X Leverage

Stockholders’ equity Where, Leverage= Total assets
Stockholder equity

Leverage ratio measures how the firm finances its assets. Basically, firms can finance with either
debt or equity. ROA= ROE, with only equity financing that asset is equal to stockholders equity
and leverage multiplier is 1.
For ABC (yr 20000=249/2750=9.05%
Interpretation: ABC generates about 9 cents for every birr in shareholders’ equity.

F. Earnings per share (EPS): represent the amount of birr earned on behalf of each
outstanding shares of common stock.

EPS= Net income

No. of C/stock shares outstanding

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For ABC (2000) 249/20=12.45
Interpretation: ABC earns birr 12.45 for each shares outstanding.
5. Market Value ratio: these ratio are primarily used for investment decisions and long range
planning and include:
A, Price/ Earnings ratio(P/E ratio): shows the amount investors are willing to pay for each birr
of the firm’s earnings.

P/E ratio= Current Market price per share

Earnings per share
Or
P/E ratio= D1/E1
k-g
Where, D1/E1, is the expected dividend payout ratio
Assume, that ABC year end Dec 31, 2000 market price of common stock is birr 115 per share.
K, is the required rate of return for the stock
P/E ratio=115/12.45=9.24 times.
g, is expected growth rate in dividends.
Interpretation: the market is willing to pay 9.24 birr for every birr in earnings.
A high P/E multiplier often reflects the market’s perception of the firm’s growth prospects. Thus,
if investors believe that a firm’s future earnings potential is good and they may be willing to pay a
higher price for the stock.
B. Book value per share: is the value of each share of common stock based on the firm’s
accounting records.

Book value per share= Total stockholders’ equity- Preferred stock

No. of common shares outstanding

For ABC (yr 2000) =2750-0/20=137.50 birr/share

C. Dividend Ratios. These can be: i) Dividend payout ratio
ii) Dividend yield
i) Dividend Payout ratio: shows the percentage of earnings distributed at the end of the
accounting period. It is the birr amount of dividend paid on a share of common stock outstanding
during the reporting period.

Dividend payout ratio= Dividend Per share

Earnings per share

Assume that ABC dividend per share is birr 2.49 Dividend payout ratio = 2.49/12.45=20%
Interpretation: ABC paid 20 percent of its earning as dividend. The higher the ratio may reflect the
firms lower growth opportunities.
ii) Dividend yield: shows the rate earned by shareholders from dividends relative to the current
price of the stock. Dividend yield is part of a stock’s total return.

Dividend yield= Dividend per share

Market price per share
For ABC Dividend yield = 2.49/115=2.17%

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 Limitation of Ratio analysis
The ratio analysis is a widely used technique to evaluate the financial position and performance of
a business. But there are certain problems in using ratios. The analysts should be aware of these
problems. The following are some of the limitations of the ratio analysis.
1. Many large firms operate different divisions in different industries, and for such
enterprises it is difficult to develop a meaningful set industry average.
2. Most firms want to be better than industry average approximations. So merely attains
average performance is not sufficient.
3. Non recognition of inflation in financial statement makes a ratio analysis difficult
4. Firms can employ a “ window dressing” technique to make their financial statement more
stronger
5. Different accounting methods are employed by different enterprises.

Financial Planning/Forecasting

Previously we described what financial statements are and showed how both managers and
investors analyze them to evaluate a firm’s past performance. While this is clearly important, it is
even more important to look ahead and to anticipate what is likely to happen in the future. So,
both managers and investors need to understand how to forecast future results.

Managers make pro forma, or projected, financial statements and then use them in four ways:
(1) By looking at projected statements, they can assess whether the firm’s anticipated performance
is in line with the firm’s own general targets and with investors’ expectations. For example, if the
projected financial statements indicate that the forecasted return on equity is well below the
industry average, managers should investigate the cause and then seek a remedy. (2) Pro forma
statements can be used to estimate the effect of proposed operating changes. Therefore, financial
managers spend a lot of time doing “what if” analyses. (3) Managers use pro forma statements to
anticipate the firm’s future financing needs. (4) Projected financial statements are used to estimate
future free cash flows, which determine the company’s overall value. Thus, managers forecast free
cash flows under different operating plans, forecast their capital requirements, and then choose the
plan that maximizes shareholder value.

Security analysts make the same types of projections, forecasting future earnings, cash flows, and
stock prices. Of course, managers have more information about the company than security
analysts, and managers are the ones who make the decisions that determine the future. However,
analysts influence investors, and investors determine the future of managers. To illustrate, suppose
an influential analyst at a firm such as Goldman Sachs concludes, on the basis of a comparative
financial analysis, that a particular firm’s managers are less effective than others in the industry.
The analyst’s negative report could lead stockholders to revolt and replace management. Or, the
report might lead a firm that specializes in taking over underperforming firms to buy stock in the
company and then launch a hostile takeover designed to change management, improve cash flows,
and make a large capital gain.

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In this part we explain how to create and use pro forma financial statements. We begin with the
strategic plan, which provides a foundation for pro forma statements.

Strategic Plan
Our primary objective in this course, you know, is to explain what managers can do to make their
companies more valuable. Managers must understand how investors determine the values of
stocks and bonds if they are to identify, evaluate, and implement projects that meet or exceed
investor expectations. However, value creation is impossible unless the company has a well-
articulated plan. As Yogi Berra once said, “You’ve got to be careful if you don’t know where
you’re going, because you might not get there.”

Companies begin with a mission statement, which is in many ways a condensed version of their
strategic plan.

CORPORATE PURPOSE
Both mission statements and strategic plans usually begin with a statement of the overall
corporate purpose. Coca-Cola is very clear about its corporate purpose: “. . . maximize share-
owner value over time.”

CORPORATE SCOPE
Its corporate scope defines a firm’s lines of business and geographic area of operations. As Coca-
Cola’s mission statement indicates, the company limits its products to soft drinks, but on a global
geographic scale. Pepsi-Cola recently followed Coke’s lead —it restricted its scope by spinning
off its food service businesses.

CORPORATE OBJECTIVES
The corporate purpose states the general philosophy of the business, but it does not provide
managers with operational objectives. The statement of corporate objectives sets forth specific
goals to guide management. Most organizations have both qualitative and quantitative objectives.
For example, CocaCola’s mission statement lists six corporate objectives, including becoming
“the best marketers in the world” and “leading as a model corporate citizen.” However, these
statements are qualitative, hence hard to measure, so the objectives need to be restated in
quantitative terms, such as attaining a 50 percent market share, a 20 percent ROE, a 10 percent
earnings growth rate, or a $100 million economic value added (EVA). Coca-Cola doesn’t list its
quantitative objectives in its mission statement, but it has them in its detailed strategic plan.
Moreover, executive bonuses are based on achieving the quantitative objectives.
CORPORATE STRATEGIES
Once a firm has defined its purpose, scope, and objectives, it must develop a strategy for achieving
its goals. Corporate strategies are broad approaches rather than detailed plans. For example, one
airline may have a strategy of offering no-frills service between a limited number of cities, while
another’s strategy may be to offer “staterooms in the sky.” Broadly speaking, a company’s
strategy often has several dimensions including whether (1) to invest overseas, (2) to invest in
new lines of business and new technologies, and/or (3) to focus on a broad or narrow portion of

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the customer market. In any event, strategies should be both attainable and compatible with the
firm’s purpose, scope, and objectives.
OPERATING PLANS
Operating plans provide detailed implementation guidance, based on the corporate strategy, to
help meet the corporate objectives. These plans can be developed for any time horizon but most
companies use a five-year horizon. A five-year plan is most detailed for the first year, with each
succeeding year’s plan becoming Less specific. The plan explains in considerable detail who is
responsible for each particular function, when specific tasks are to be accomplished, sales and
profit targets, and the like.

THE FINANCIAL PLAN

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The financial planning process can be broken down into six steps:
1. Project financial statements and use these projections to analyze the effects of the operating plan
on projected profits and various financial ratios. The 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 within the
firm. In essence, this involves making sure that the basic plan is carried 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 just be recognized and reflected in higher production schedules, larger
marketing quotas, and the like, and as rapidly as possible. Thus, Step 5 is really a “feedback loop”
that triggers modifications to the financial plan.
6. Establish a performance-based management compensation system. It is critically important that
such a system rewards managers for doing what stockholders want them to do —maximize share
prices.

In the remainder part, we discuss how firms do the three key components of the financial plan: (1)
the sales forecast, (2) pro forma financial statements, and (3) the external financing plan.

THE PERCENT OF SALES METHOD

Sales Forecast
Sales forecast is the starting point in financial planning. It is a forecast of a firm’s unit and
dollar sales for some future period; it is generally based on recent sales trends (past 5 to 10
years) plus forecasts of the economic prospects for the nation, region, industry, and so forth.

Once sales have been forecasted, we must forecast future balance sheets and income
statements. The most commonly used technique is the percent of sales method, which
begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues.

Many items on the income statement and balance sheet are often assumed to increase
proportionally with sales. For example, the inventories-to-sales ratio might increase 20

21
percent, receivables/sales might increase 15 percent, variable costs might increase 60
percent of sales, and so forth.

Then, as sales increase, items that are tied to sales also increase, and the values of those
items for a particular year are estimated as percentages of the forecasted sales for that year.
The remaining items on the forecasted statements—items that are not tied directly to sales
—are set at “reasonable” levels.
STEP 1: FORECASTED INCOME STATEMENT
First, we forecast the income statement for the coming year. This statement is needed to
estimate both income and the addition to retained earnings. Table 2.1 shows the forecast for
2002. Sales are forecasted to grow by 20 percent. The forecast of sales for 2002, shown in
Row 1 of Column 3, is calculated by multiplying the 2001 sales, shown in Column 1, by (1
+growth rate) = 1.2. The result is a 2002 forecast.
The percent of sales method assumes initially that all costs are a specified percentage of
sales.
STEP 2: FORECAST THE BALANCE SHEET
The assets shown on Lewis’ balance sheet must increase if sales are to increase. It might be
reasonable to assume that cash, accounts receivable, and inventory grow proportionally
with sales, but will the amount of net plant and equipment go up and down as sales go up
and down? The correct answer could be yes or no. When companies acquire plant and
equipment, they often install greater capacity than they currently need, due to economies of
scale. There is not necessarily a close relationship between sales and net plant and
equipment in the short term.
However, for some companies there is a fixed relationship between sales and plant and
equipment, even in the short term. For example, new stores in many retail chains achieve
the same sales during their first year as the chain’s existing stores. The only way these
retailers can grow is by adding new stores, which results in a strong proportional
relationship between fixed assets and sales.
In the long run, there is a relatively close relationship between sales and fixed assets for all
companies: No company can continue to increase sales unless it eventually adds capacity.

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Therefore, as a first approximation it is reasonable to assume that the long-term ratio of net
plant and equipment to sales will be constant.
Once the individual asset accounts have been forecasted, they can be summed to complete
the asset section of the balance sheet.
If Lewis’ assets are to increase, its liabilities and equity must also increase-the additional
assets must be financed. Some items on the liability side can be expected to increase
spontaneously with sales, producing what are called spontaneously generated funds.
Spontaneously generated funds are funds that are obtained automatically from routine
business transactions. For example, as sales increase, so will Lewis’ purchases of raw
materials, and those larger purchases will spontaneously lead to a higher level of accounts
payable.
For example, as sales increase, so will purchases of raw materials, and those larger
purchases will spontaneously lead to a higher level of accounts payable. More sales will
require more labor, and higher sales should also result in higher taxable income and thus
taxes. Therefore, accrued wages and taxes will both increase.
Retained earnings will also increase, but not at the same rate as sales: The new balance for
retained earnings will be the old level plus the addition to retained earnings, which we
calculated in Step 1. Also, notes payable, long-term bonds, preferred stock, and common
stock will not rise spontaneously with sales —rather, the projected levels of these accounts
will depend on financing decisions, as we discuss later.
In summary, (1) higher sales must be supported by additional assets, (2) some of the asset
increases can be financed by spontaneous increases in accounts payable and accruals, and
by retained earnings, but (3) any shortfall must be financed from external sources, using
some combination of debt, preferred stock, and common stock.
Additional Funds Needed (AFN) are Funds that a firm must raise externally through
borrowing or by selling new common or preferred stock. The AFN will be raised by some
combination of borrowing from the bank as notes payable, issuing long-term bonds, and
selling new common stock.
STEP 3: RAISING THE ADDITIONAL FUNDS NEEDED

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The financial staff of a company will raise the needed funds based on several factors,
including the firm’s target capital structure, the effect of short-term borrowing on the
current ratio, conditions in the debt and equity markets, and restrictions imposed by
existing debt agreements.

Illustration:
The 2001 balance sheet and income statement for the Lewis Company are shown below.
Lewis Company
Income Statement
For the Year ended on December 31, 2001 (Thousands of Dollars)

Lewis Company

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 Balance Sheet
As of December 31, 2001 (Thousands of Dollars)

Additional Information:
The firm operated at full capacity in 2001. It expects sales to increase by 20 percent during
2002 and expects 2002 dividends per share to increase to $1.10.
Required:
a. Use the projected financial statement method to determine how much outside
financing is required, developing the firm’s pro forma balance sheet and income
statement, and use AFN as the balancing item.
b. The financial staff of Lewis Company, after considering all of the relevant factors,
decided on the following financing mix to raise the additionally needed fund:
SOURCE OF CAPITAL PERCENTAGE AMOUNT INTEREST RATE
OF NEW CAPITAL
Notes payable 25% 8%
Long-term debt 25 10
Common stock 50
Total 100%

c. How will your answer in section (b) change, if the firm must maintain a current ratio

Total Curren Assets

[ Current ratio=
Total Current Liabilities ] of 2.3 and a debt ratio

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 Total Debt
[ Debt ratio=
Total Assets]of 40 percent? In other words, how much financing will be

obtained using notes payable, long-term debt, and common stock under the new
restrictions?
Solution:
a. AFN = $667.
Table 2.1 Forecasted Income Statements
Particulars Actual Forecast Basis 2002
2001 Forecast
Sales 8,000 1.2x2001 Sales 9,600
Operating Costs 7,450 1.2x2001 operating costs 8,940
EBIT 550 660
Interest 150 150
EBT 400 510
Taxes 160 204
Net Income 240 306
Common Dividends 156 165
(150x$1.
1)
Retained Earnings 84 141

Table 2.2 Forecasted Balance Sheet

Particulars Actual Forecast Basis 2002 Forecast
2001 First AFN Second
Pass Pass
Cash 80 1.2x2001 Cash 96 96
Accounts Receivables 240 1.2x2001 A/R 288 288
Inventories 720 1.2x2001 Inv. 864 864
Total Current Assets 1,040 1,248 1,248
Fixed Assets 3,200 1.2x2001 FA 3,840 3,840
Total Assets 4,240 5,088 5,088
Accounts Payables 160 1.2x2001 A/P 192 192
Accruals 40 1.2x2001 Accruals 48 48
Notes Payables 252 252 +166.75 418.75
Total Current Liabilities 452 492 658.75
Long Term liabilities 1,244 1,244 +166.75 1410.75
Total Debt 1,696 1,736 2069.50

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 Common Stock 1,605 1,605 +333.50 1938.50
Retained Earnings 939 +141 1,080 1080
Total liabilities and Equity 4,240 4,421 + 667 5088
Additional Funds Needed (AFN) 5,088 - 4,421 = 667
b. The financial staff of Lewis Company, after considering all of the relevant factors,
decided on the following financing mix to raise the additionally needed fund:
SOURCE OF CAPITAL PERCENTAGE AMOUNT AFN from each source
OF NEW CAPITAL
Notes payable 25% 166.75
Long-term debt 25 166.75
Common stock 50 333.5
Total 100% 667
c. Given target current ratio of 2.3 and target debt ratio of 405, the Increase in notes
payable will be $50.60; increase in Long-term Debt becomes $248.60 and Increase in
C/S $367.80 which will be computed as follows.
Total Curren Assets 1,248
Current ratio= =2.3=
Total Current Liabilities Total Current Liabilities
1,248
Total Current Liabilities= =542.60
2.3
Total Current Liabilities= Accruals+ Accounts Payable+ Notes Payable
192+48+ Notes Payable=542.60
Notes Payable=542.60−240
Notes Payable=302.60
Additional Notes Payable=302.60−252=$ 50.60

Total Debt Total Debt

Debt ratio= = =.40
Total Assets 5,088
Total Debt =.40 ×5,088=2,035.20
Total Debt =Total Current Liabiliti es + Long Term debt
2,035.20=542.60+ LongTerm debt
Long Term debt=1,492.60
Additional Long Term debt=1,492.60−1,244=248.60
AFN =Additional Notes Payable+ Additional LongTerm debt+ Additional Common Stock
667=50.60+248.60+ Additional Common Stock
Additional Common Stock=667−299.20=367.80

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