CHAPTER TWO

2. FINANCIAL ANALYSIS AND PLANNING (FORECASTING)

2.1. Introduction
In the previous accounting courses you have learned that financial statements report both on a
firm’s financial position and financial performance. The four basic financial statements present
about different aspects of financial conditions, operating results, and cash flows. The balance
sheet shows a firm’s assets and claims against assets at a particular point in time. The income
statement, on its part, reports the results of the firm’s operations over a period of time. Similarly,
the statements of retained earnings and cash flows show the change in retained earnings and
cash between two balance sheet dates.
However, financial statements by themselves do not give a complete picture about a company’s
financial condition, operating results, and cash flows. Neither can a real value of financial
statements could be derived in themselves alone. Therefore, to predict the future and to help
anticipate future conditions, financial statements should be analyzed further. This analysis helps
to identify current strengths and weakness of the firm. It facilitates planning the future, and helps
to control the firm’s financial activities better. To have all this benefits, however, a finance
person should perform a financial analysis.
2.1.1. Meaning and Objectives of 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. The focus of financial analysis is
on key figure in the financial statements and the significant relationships that exist between
them. Financial analysis is used by several groups of users like managers, credit analysts, and
investors.
The analysis of financial statements is designed to reveal the relative strengths and weakness of a
firm. This could be achieved by comparing the analysis with other companies in the same
industry, and by showing whether the firm’s position has been improving or deteriorating over
time. Financial analysis helps users to obtain a better understanding of the firm’s financial
conditions and performance. It also helps users understand the numbers presented in the financial
statements and serve as a basis for financial decisions.
2.1.2. Tools and techniques of financial analysis
A number of methods can be used in order to get a better understanding about a firm’s financial
status and operating results. The most frequently used techniques in analyzing financial
statements are:
i) Ratio Analysis – is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages. Like any other financial
analysis, a ratio analysis helps us draw meaningful conclusions and interpretations about a
firm’s financial condition and performance.

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ii) Common Size Analysis – expresses individual financial statement accounts as a percentage of
a base amount. A common size status expresses each item in the balance sheet as a
percentage of total assets and each item of the income statement as a percentage of total
sales. When items in financial statements are expressed as percentages of total assets and
total sales, these statements are called common size statements.
iii) Index Analysis – expresses items in the financial statements as an index relative to the base
year. All items in the base year are assumed to be 100%. Usually, this analysis is most
appropriate for income statement items.
According to users of financial information, there are two techniques of financial analysis. These
are:
i. External Analysis – an analysis performed by outsiders to the firm such as creditors,
investors, suppliers, etc.
ii. Internal Analysis – an analysis performed by corporate finance and accounting
departments for the purpose of planning, evaluating, and controlling operating activities.
2.1.3. Stages in Financial Analysis
Financial analysis consists of the following three major stages.
i) Preparation: The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial statement
analysis focuses primarily on the balance sheet and the income statement. However, data
from statements of retained earnings and cash flows may also be used. So, preparation is
simply objective setting and data collection.
ii) Computation: This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.
iii) Evaluation and Interpretation: Involves the determination of the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm’s
performance and financial condition. This is the most important of all the three stages of
financial analysis.
Although we have briefly seen what is meant by the three most common types of financial
analysis, our focus on this material will be on ratio analysis. So in the section that follows, we
will discuss major types of financial ratios with illustrative examples.
2.2. Types of Financial Ratios
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.
2.2.1. Liquidity Ratios
Liquidity refers to the speed and ease with which an asset can be converted to cash. 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

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to pay its current liabilities as they mature by using current assets. There are two commonly used
liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: Accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800
Zebra Share Company
Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________

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Net sales Br. 196,200,000
Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.
Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2002

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
Common 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000
We can describe a firm’s ability to meet its current obligations in several ways:
i) Current ratio – measures the ability of a firm to satisfy or cover/meet the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities.

Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times

Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in good
position to meet its current obligations. Conversely, relatively low current ratio is interpreted as
an indication that the firm may not be able to easily meet its current obligations. A reasonably
higher current ratio as compared to other firms in the same industry indicates higher liquidity
position. 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. Inventories are removed because they are not readily or easily
convertible into cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities

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by using its most liquid assets into cash. In other words, inventory is often the least liquid current
asset. It’s also the one for which the book values are least reliable as measures of market value,
because the quality of the inventory isn’t considered. Some of the inventory may later turn out to
be damaged, obsolete, or lost. More to the point, relatively large inventories are often a sign of
short-term trouble. The firm may have overestimated sales and overbought or overproduced as a
result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving
inventory. To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the
current ratio, except inventory is omitted:

Zebra’s quick ratio (for 2002) = (Br. 57,600 – Br. 24,900) ÷ Br. 38,100 = 0.86 times

Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term obligations,
and the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more
detailed and penetrating test of a firm’s liquidity position as it considers only the quick asset. The
current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into
account all current assets without distinction.
2.2.2. Asset Management Ratios (Activity Ratios)
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over)
into sales or cost of goods sold. Activity ratios are also called asset management ratios, or asset
utilization ratios, or efficiency ratios. Generally, high turnover ratios are associated with good
asset management and low turnover ratios with poor asset management.
Activity ratios include:
i) Accounts Receivable Turnover – measures how efficiently a firm’s accounts receivable
is being managed. It indicates how many times or how rapidly accounts receivable are
converted into cash during a year.

Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 ÷ Br. 20,700 = 9.48 times
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or inadequate cash collection
efforts.
There are alternate ways to calculate accounts receivable value like average receivables and
ending receivables. Though many analysts prefer the first, in our case we have used the ending

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balances. In computing the accounts receivable turnover ratio, if available, only credit sales
should be used in the numerator as accounts receivable arises only from credit sales.
ii) 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.

Zebra’s days sales outstanding = 365 days ÷ 9.48 = 39 days

Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days.
If Zebra’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.
iii) Inventory turnover: measures how many times per year the inventory level is sold
(turned over).

For Zebra Company (2002) = Br. 159,600 ÷ Br. 24,900 = 6.41 times
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year. In a sense,
Zebra sold off or turned over the entire inventory 6.41 times. As long as we are not running out
of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing
inventory.
In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator
rather than sales. But when cost of goods sold data is not available, we can apply sales. In
general, a high inventory turnover is better than a low turnover. But abnormally high inventory
turnover might result from very low level of inventory. This indicates that stock outs will occur
and sales have been very low. A very low turnover, on the other hand, results from excessive
inventory levels, presence of inferior quality, damaged or obsolete inventory, or unexpectedly
low volume of sales.
iv) Fixed assets turnover:
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 = Net sales ÷ Net fixed assets

Zebra’s fixed assets turnover = Br. 196,200 ÷ Br. 96,300= 2.04X
Interpretation: Zebra 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, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.

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The fixed assets turnover may be deceptively low or high. This is because the book values of
fixed assets may be considerably affected by cost of assets, time elapsed since their acquisition,
or method of depreciation used.
v) 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
Zebra’s total assets turnover = Br. 196,200 ÷ Br. 153, 900 = 1.27X
Interpretation: Zebra 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 low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.
2.2.3. Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, total assets,
and owner’s equity. The following ratios are among the many measures of a firm’s profitability.

i. Profit Margin – shows the percentage of each birr of net sales remaining after deducting
all expenses.

Zebra’s profit margin = Br. 3,900 ÷ Br. 196,200 = 2%

Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.

The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as
well as the amount of all costs and expenses of a firm.

ii. Return on investment (assets) – measures how profitably a firm has used its investment
in total assets.

Zebra’s return on investment = Br. 3,900 ÷ Br. 153,900 = 2.53 %

Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.

iii. Return on equity – indicates the rate of return earned by a firm’s stockholders on
investments made by them.

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Zebra’s return on equity = Br. 3,900 ÷ Br. 55,800= 6.99%
Interpretation: Zebra 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.

A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better offs the owners.
Du Pont System of Analysis
The returns on investment ratios give us a “bottom line” on the performance of a company, but
don’t tell us anything about the “why” behind this performance. For an understanding of the
“why,” the analyst must dig a bit deeper into the financial statements. A method that is useful in
examining the source of performance is the Du Pont system. The Du Pont system is a method of
breaking down return ratios into their components to determine which areas are responsible for a
firm’s performance.
It 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:

Or

2.2.4. Debt Management Ratios (Leverage Ratios)

Leverage ratios are also called debt management or utilization ratios. They 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. While there are many leverage ratios, we will look at only the following three.

i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by
debt.

Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900

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Interpretation: At the end of 2002, 64% of Zebra’s total assets was financed by debt and 36%
(100% - 64%) was financed by equity sources.

A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources. Debt
ratio reflects the capital structure of a firm. The higher the debt ratio, the more the firm’s
financial risk liberal
ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.

Zebra’s times interest earned = Br. 10,500 = 3.50X

Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available
to meet its interest obligations. However, earnings before interest and taxes are an income
concept and not a direct measure of cash. Hence, this ratio provides only an indirect measure of
the firm’s ability to meet its interest payments.
iii) Fixed charges coverage – measures the ability of a firm to meet all fixed obligations
rather than interest payments alone. Fixed payment obligations include loan interest and
principal, lease payments, and preferred stock dividends.

For Zebra Company, the other fixed charge payment in addition to interest is lease payment.
Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700

Interpretation: The fixed charges (interest and lease payments) of Zebra Share Company are
safely covered 2.32 times.

Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.
The fixed charges coverage ratio is required because failure of the firm to meet any financial
obligation will endanger the position of a firm
2.2.5. Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:

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i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s
common stock outstanding. It does not reflect how much is paid as dividends.

Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10

Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.

ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on
each share of its common stock outstanding.

Zebra’s DPs for 2002 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.

iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to
stockholders.

Or

Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
2.3. Comparing financial ratios
To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.
i) Cross – sectional analysis – is the comparison of a firm’s ratios to those other firms in the
same industry at the same point in time. Here, the firm is interested in how well it has performed
in relation to other firms. Generally, cross – sectional analysis is preformed based on industry
averages of different financial ratios.

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ii) Time – series analysis – is an evaluation of a firm’s financial ratios over time. Here, the
current period ratios are compared with those of the past years. The purpose is to determine
whether the firm is progressing or deteriorating.
To obtain the highest possible information about a firm, usually, a combination of both cross –
sectional and time-series analyses are applied.
2.4. Limitations 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.
1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason could
be a single firm may have different divisions operating in different industries. Another
reason could be the financial statements may not be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when they are not
audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. 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.
2.5. Financial Forecasting
2.5.1. Introduction
In the first unit, we discussed that financial management involves planning for raising and
utilizing funds. Financial managers should be able to plan before hand in making investment and
financing decisions. So, financial forecasting helps financial managers to predict events before
they occur. This, particularly, is true when they plan to raise funds externally. Because a firm’s
profit is often insufficient to finance assets in the normal course of business, additional sources
of finance should be considered.
Financial forecasting also forces financial managers to develop financial statements beforehand.
These financial statements are called Pro forma financial statements. They include forecasted
sales and forecasted expenses, forecasted assets, forecasted liabilities, and forecasted
stockholders’ equity. Based on these forecasted items, the financial manager is able to determine
the amount of finance to be obtained from external sources.
2.5.2. Meaning and purpose of financial forecasting
Financial forecasting is one of the four major jobs of a firm’s financial staff, namely performing
financial forecasting and analysis, making investment decisions, and making financing decisions.
It is generally a planning process which involves forecasting of sales, assets, and financial
requirements. In other words, financial forecasting is a process which involves:
 Evaluation of a firm’s need for increased or reduced productive capacity and

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  Evaluation of the firm’s need for additional finance
Generally, financial forecasts are required to run a firm well. Their bases, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects:

 It helps a firm to predict appropriate demand for its products.

 It helps a firm to project its sales and accordingly to predict its assets properly.
 It contributes significantly to the firm’s profitability.
 It plays a crucial role in the value maximization goal of a firm.
Financial forecasts are also means for forecasted financial statements. By their virtue, a firm can
forecast its income statement, balance sheet and other related statements. Besides, key ratios can
be projected. Once financial statements and ratios have been forecasted, the financial forecast
will be analyzed. Finally, the firm’s management will have an opportunity to make some
decisions beforehand.
So, all in all, financial forecasting is a pre requirement for the investment, financing, as well as
dividend policy decisions of a firm.
2.5.3. Procedures in financial 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
The above three procedures are very important in projecting the financial statements and key
financial ratios. However, among the three procedures, the first one, i.e, sales forecast is the most
crucial.
Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is generally
based on recent sales trends and forecast of the economic prospects of the nation, region,
industry and other factors. This procedure starts usually by reviewing the sales of the recent
pasts. The whole crucial point of a financial forecasting process lies in an accurate forecast of
sales. If this procedure is off, the firm’s profitably as well as its value will be negatively affected.
So in forecasting sales, several factors should be considered:
1. The historical sales growth pattern of the firm at both divisional and corporate levels,
2. The level of economic activity in each of the firm’s marketing areas,
3. The firm’s probable market share,
4. The effect of inflation on the firm’s future pricing of products,
5. The effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
6. Individual products’ sales forecasts at each divisional level.

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Forecast of sales is a base for forecasting of the firm’s income statement which in turn helps to
project retained earnings. In forecasting the income statement, assumptions about the costs, tax
rates, interest charges and dividends are required.
Sales forecasts are also grounds for determination of the firm’s assets requirement. If sales are
to increase, then assets must also grow. The amount each asset account must increase depends
whether the firm was operating at full capacity or not. If higher sales are projected, more cash
will be needed for transactions, higher sales will create higher receivables. Similarly, higher sales
require higher inventory and higher plant and equipment.
Finally, the firm will face the question of financing its required assets. Some of the required
finance can be covered by the increased retained earnings. The retained earnings increment will
result from increased sales and profit. Still some other portion of the finance can be covered by
some liabilities which will grow by the same proportion with that of sales. The remaining finance
must be obtained from available external sources.
The third procedure of the financial forecasting process, i.e. forecast of financial
requirements, involves again three sub procedures. These are:

1. Determining how much money (finance) the firm will need during the forecasted period.
This will be done based on sales and assets forecast.
2. Determining how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be generated
under normal operations. The first is portion of the net income retained in the firm
(retained earnings). The second one is the increase in the firm’s liabilities as a direct and
automatic result of its decision to increase sales. This finance is called spontaneous
finance. For example, if sales are to increase, inventory must increase. The increase in
inventory requires more purchases which in turn causes the accounts payable to be
increased. The accounts payable will increase spontaneously with the increase in sales.
Other examples include accruals like salaries and wages payable and income tax payable.
3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from external
sources. This finance is called the additional funds needed (AFN).

Additional funds needed (AFN) are funds that a firm must raise externally through borrowing
(bank loans, promissory notes, bonds, etc.) or by issuing new shares of common stock or
preferred stock.
2.5.4. Methods of forecasting financial requirements
There are two methods to determine the additional financial requirements. These are:
1. The proforma financial statements method and
2. The formula method
2.5.4.1. The Pro-Forma Financial Statements Method

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The pro-forma financial statements method is simply a method of forecasting financial
requirements based on forecasted financial statements. As a result, this method is also called the
projected financial statements method. Under this method, the asset requirements are first
projected for the fore coming future period. The forecast of assets helps to determine the total
financial requirements. Then, the liabilities and equity that will be generated under normal
operations are projected. Finally, the additional funds needed will be estimated.
The pro-forma financial statements method of determining additional financial requirements
involves the following steps:
1. Developing the Pro Forma Income statement
The proforma 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. Second, cost of goods sold should be determined. Third, other expenses (operating
and non-operating) should be computed. Next, the net income should be determined. Finally,
based on the amount of dividends, the amount of addition to retained earnings should be
determined.
2. Constructing the Pro Forma Balance Sheet
Higher sales must be supported by higher asset amounts. 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. Next, the spontaneously
increasing liabilities are forecasted. Then, the liability and equity items that are not directly
affected by sales are set. Next, the value of retained earnings for the forecasted period is
obtained. Finally, the AFN will be raised.

For 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.

Assets Liabilities and Equity

Cash ----------------------------Br. 10,000
A/receivable -----------------------70,000
Inventories -----------------------150,000
Current assets -------------Br. 230,000
Net fixed assets -----------------370,000
_________
Total assets ------------------Br. 600,000
A/payable --------------------------Br. 90,000
Accruals --------------------------------40,000
Current liabilities -------------Br. 130,000
Long-term debt -----------------------200,000
Common stock ------------------------120,000
Retained earnings --------------------150,000
Total liabilities and equity ------Br. 600,000

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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 manger estimates that sales will grow at
10%. There are no preferred stocks 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 proforma financial statements method.
Solution
First, we develop the proforma income statement

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

Then, we construct the proforma balance sheet

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 Common stock (as long-term debt) ------------120,000
_______ Retained earnings (Br. 150,000 + Br. 37,920)-187,920
Total assets -----------------------Br. 660,000 Total liabilities and equity -------------Br. 650,920

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 Increase in normally
assets – generated funds

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 = [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
2.5.4.2. The Formula Method
This is a much easier method of determining additional financial requirements than the pro forma
method. The formula method is a shortcut to financial forecasting. However, many companies
use the pro forma method of forecasting their financial requirements because the output of the
formula method is less meaningful. Under the shortcut method, we make the following
assumptions:
1. Each asset maintains a direct proportionate relationship with sales
2. Accounts payable and accruals increase in direct proportion to sales increase.
3. 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 Required Spontaneous Increase in
Funds = increase – increase in – retained
Needed in assets liabilities earnings

AFN = (A/S) S – (L/S) S – MS1 (1 – d)

Where
AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S1 – S0 = S0 x g
S1 = Total Sales projected for the next period
S0 = Total sales of the current period
L/S = Percentage relationship of variable (spontaneous) liabilities to sales
M = Net profit margin
d = Dividend payout ratio
g = The expected sales growth rate

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. 180,000) – 5% x Br 1,980,000** (1 –

60%)
= Br. 60,000 – Br. 13,000 – Br. 39,600
= Br. 7,400

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 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.

2.5.5. Factors that affect additional financial requirements

The external financial requirements of a firm during any given period are affected by several
factors.
1. Financial Planning: Refers to the growth rates of sales a firm has projected. Sales growth
rates and additional funds needed are positively related. At low growth rates of a sale, a
firm needs small or no external financing. The firm might even generate surplus funds at
low growth rates. As the growth rates increase, the AFN will also increase. So other factors
being constant, the higher the sales growth rates, the higher the AFN.
2. Capital Intensity: This is the amount of assets required to support each birr of sales. In the
formula, this is designated as A/S. Generally, firms with higher capital intensity ratios are
with greater capital requirements. Highly capital-intensive firms generally require more
external funds than labor intensive firms.
3. Profit Margin: Profit margin is the net income per each birr of net sales. It is evident from
the very formula of computing AFN that external capital requirements and net profit
margin are related in opposite directions. Other factors held constant, the higher the profit
margin, the lower the external funds requirements.
4. Dividends policy: Dividend policy refers to the percentage of a firm’s net earnings paid
out as cash dividends. It is reflected in the firm’s payout ratio. The higher the dividend
payout ratio, the smaller the addition to retrained earnings, and hence the greater the
requirements for external finance.

2.5.6. Excess capacity and additional financial requirements

Previously, when we were dealing with Blue Nile’s financial forecast, our assumption had been
that assets were operating at full capacity (100% capacity). Now let’s relax this assumption that
excess capacity exists in the firm’s fixed assets. In fact, theoretically excess capacity exists with
all types of assets. But as a practical matter, excess capacity normally exists primarily with
respect to fixed assets.
Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does this affect
the firm’s AFN? Some procedures are involved to see the effect.
i. Determine the full capacity sales, i.e., sales that could have been produced had fixed assets
been utilized 100%.
Full Actual sales______________

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 capacity = Percentage of capacity at which
sales fixed assets were operated

= Br. 1,800,000 = Br. 1,836,735

98%
ii. Determine the target fixed assets/sales ratio
Target fixed assets/sales ratio = Actual fixed assets
Full capacity sales
= Br. 370,000 = 20%
Br. 1,836,735
iii. Determine the new required level of fixed assets.
Required level of fixed assets = (Target fixed assets/sales ratio) X (Projected sales)
= 20% X Br. 1,980,000 = Br. 396,000
Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as sales or
by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br. 407,000. Now we
see that the actual required increase is only from Br. 370,000 to Br. 396,000. Thus, the capacity
adjust forecast is Br. 11,000 (Br. 407,000 – Br. 396,000) less than the earlier forecast. Therefore,
the projected AFN would decline from an estimated Br. 9,080 to Br. -1,920 (Br. 9,080 – Br.
11,000). The negative AFN indicates the firm would even produce excess funds of Br. 1,920
than it requires.
“End of Chapter Two”

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