FINANCI

AL
MARKET
S
 CONTENTS
1.Vertical Analysis 4.Cash Flow Analysis

CHAPTER 2:
Financial Statement 2.Horizontal Analysis 5.Gross Profit Variance
Analysis

Analysis
3.Financial Ratios 6.Financial Forecasting

7.Operating and
Financial Leverage
 Vertical
Analysis
A method of financial statement
analysis in which each line item is
listed as a percentage of a base figure

01
within the statement.
It shows in the cash flow statement
each cash inflow or outflow as a
percentage of the total cash inflows.

Can become a more potent tool when

used in conjunction with horizontal
analysis, which considers the finances
of a certain period of time.
 Advantag
es Easier to compare the financial
statements of one company with
another, and across industries.
Easier to compare previous periods

01
for time series analysis, in which
quarterly and annual figures are
compared over a number of years.
Easier to understand more the
correlation between single items on a
balance sheet and the bottom line,
expressed in a percentage.
Easier to compare the profitability of a
company with its peers.
 Vertical
Analysis
Important Point: Vertical

01 analysis is used in order to

gain a picture of whether
performance metrics are
improving or
deteriorating.
 Vertical
Analysis
Financial statements that include
vertical analysis clearly show line

01 item percentages in a separate

column. These types of financial
statements, including detailed
vertical analysis, are also known as 
common-size financial statement
s
 and are used by many companies to
provide greater detail on a
company’s financial position.
 Vertical
Analysis
Common-size

01 financial statements
often incorporate
comparative financial
statements that include
columns comparing
each line item to a
previously reported
period.
   %

FORMULA
1 2 3

• INCOME • STATEME
• BALANCE NT OF
STATEME
SHEET CASH
NT
FLOWS

𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡 𝐼𝑡𝑒𝑚 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑆h𝑒𝑒𝑡 𝐼𝑡𝑒𝑚

%
•  ∆ = × 100%
• ∆
  = × 100 % ∆= 𝐶𝑎𝑠h 𝐼𝑛𝑓𝑙𝑜𝑤 𝑜𝑟 𝑂𝑢𝑡𝑓𝑙𝑜𝑤 × 100
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑜𝑟 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 •   𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠h 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

• Line items on an income • Line items on a balance • Vertical analysis of a cash

statement can be stated as a
percentage of gross sales.
sheet can be stated as a
percentage of total assets or
liabilities.
flow statement shows each
cash inflow or outflow as a
percentage of the total cash
inflows.
8
 EXAMPLE
For example, suppose XYZ Corporation has
gross sales of $5 million and cost of goods
sold of $1 million and general and

01 administrative expenses of $2 million and a

25% tax rate, its income statement will look
like this if vertical analysis is used:
 EXAMPLE
Sales 5,000,000 100%

Cost of goods sold 1,000,000 20%

01
Gross profit 4,000,000 80%

General and Administrative Expenses 2,000,000 40%

Operating Income 2,000,000 40%

Taxes (%25) 500,000 10%

Net income 1,500,000 30%

 Horizontal analysis is used
in financial statement analysis
Horizontal to compare historical data,
such as ratios, or line items,
Analysis over a number of accounting
periods. Also known as the
“Trend Analysis”.

02
Horizontal analysis is used in the review of a
i company's financial statements over multiple
periods.

ii It is usually depicted as a percentage

growth over the same line item in the base

USES iii
year.
Horizontal analysis allows financial statement
users to easily spot trends and growth
patterns.
It can be manipulated to make the current
iv period look better if specific historical periods
of poor performance are chosen as a
comparison.
 When the analysis is conducted for all financial statements
at the same time, the complete impact of operational
activities can be seen on the company’s financial condition
during the period under review. This is a clear advantage of
Advantage using horizontal analysis as the company can review its
performance in comparison to the previous periods and

02
gauge how it’s doing based on past results.

Horizontal analysis can also be used to misrepresent results. It can

be manipulated to show comparisons across periods . For instance,
if the profits for this month are only compared with those of last
month, they may appear outstanding but that may not be the case
if compared with the same month the previous year. Using Disadvantage
consistent comparison periods can address this problem.
 FORMULA
02
 Problem Sample
i Example 1:
Assume an investor wishes to invest in company XYZ. The
investor may wish to determine how the company grew over the
past year. Assume that in company XYZ's base year, it reported net
income of 10 million and retained earnings of 50 million. In the

02
current year, company XYZ reported net income of 20 million and
retained earnings of 52 million.

Consequently, it has an increase of 10 million in its net income

and 2 million in its retained earnings year over year.

Therefore, company ABC's net income grew by 100% year over year,
while its retained earnings only grew by 4%.
 Computation

This is a sample text. You can

02
replace this text. Enter your
text here.

i ii
 Problem Sample

02
 Computation

02
 TRY IT!

02
 TRY IT!

02
 DEFINITIO
•
N
Are relationships determined
from a company's financial
information and used for
comparison purposes.
• Financial ratios are
measurements of a business'
financial performance.
• Ratios are also used to
determine profitability,
liquidity, and solvency.
• Ratios identify problem areas
that need attention.
• Comparisons of your
03
company's ratios with
industry standards will
highlight areas that need
improvement to stay
competitive.
• financial ratios can give you
more insight for analyzing
results.
• Trends from changes in
financial ratios could form the
foundation IMPORTAN
for new policies
CE planning.
and strategic
 Liquidity
• Ratios
Liquidity ratios focus on a firm's ability to pay its
short-term debt obligations. 

• Current ratio is found by dividing current assets by

current liabilities. A comfortable ratio is 2:1.

• Quick Ratio (Acid Test)-It measures the ability of the

company to pay current debts with only quick assets
of cash and current receivables. A ratio of 1:1 means
03
that the company has enough quick assets to pay
current liabilities without selling any long-term
assets.
 Liquidity
• Cash Ratio
Ratios
It only takes into account assets that are the easiest to
convert into cash. These assets are cash and cash
equivalents, such as marketable securities, money

03
orders, or money in a checking account
 TURNOVER RATIOS (ASSET
EFFICIENCY RATIOS)
• Turnover ratios measure how efficiently a
business is using its assets. This ratio uses

03
the information found on both the income
statement and the balance sheet.

• The turnover ratios used most commonly are

accounts receivable turnover, accounts
payable turnover, and inventory turnover.
TURNOVER RATIOS (ASSET
EFFICIENCY RATIOS)
a) Accounts receivable turnover indicate how
effective your company is at collecting credit

03
debt.

b) Accounts payable turnover expresses your

efficiency at paying your accounts.

c) Inventory turnover is a measurement of the

amount of time it takes to consume and restock
your inventory.
TURNOVER RATIOS (ASSET
EFFICIENCY RATIOS)

03
 TURNOVER RATIOS (ASSET
EFFICIENCY RATIOS)
 Inventory Turnover
Measures how many times a company’s inventory has been sold

03
during the year.
Formula:
Average Sale Period
Measures the average number of days taken to sell the inventory
one time.
Formula:
 TURNOVER RATIOS (ASSET
EFFICIENCY RATIOS)
 Operating Cycle
Measures the elapsed time from when inventory

03
is received from suppliers to when cash is
received from customers.
Formula:
 FINANCIAL LEVERAGE
• RATIOS
The financial leverage or debt ratios focus on
a firm's ability to meet its long-term debt
obligations.

• They use the firm's long-term liabilities on

the balance sheet such as payable bonds,
long-term loans, or pension funds.
03
 FINANCIAL LEVERAGE
RATIOS
Debt-to-equity is the ratio that lenders will
look at when gauging the risks of extending
more credit. They like to see debt-to-equity
ratios around or less than 1:1.
Debt to equity refers to the amount of money
and retained earnings invested in the
company.
03
Total Debt
Total Equity
 FINANCIAL LEVERAGE
RATIOS
Debt-to-assets indicates the amount of assets
financed by debt instead of owner's equity.

Total Debt
Total Assets
03
 FINANCIAL LEVERAGE
RATIOS
Times Interest-Earning Ratio
 

Measures the company’s ability to make

interest payments.
Formula:
03
 FINANCIAL LEVERAGE
  RATIOS
Equity Multiplier
Measures the portion of a company’s assets funded
by equity.
Formula:
03
Profitability
Ratios
 
Gross Margin Percentage
Measures profitability before selling and
administrative expenses.

 
Formula:
03
 Profitability
Ratios
 
Net Profit Margin Percentage
A broad measure of profitability.
Formula:
03
 Profitability
 
Ratios
Return on Total Assets
Measures how well assets have been
employed by management.
Formula:
03
Profitability
Ratios
 
Return on Equity
When compared to the return on total assets,
measure the extent to which financial leverage

03
is working for or against common stockholders.
Formula:
Market Performance
 

Earnings per share

Affects the market price per share, as reflected in the
price-earnings ratio.
Formula:

03
 
  Price-Earnings Ratio
An index of whether a stock is relatively cheap or
relatively expensive in relation to current earnings.
Formula:
Dividend Payout Ratio
 

An index showing whether a company pays out

most of its earnings in dividends or reinvests the
earnings internally.
Formula:
Dividend Yield Ratio
03
Shows the return in terms of cash dividends being
provided by a stock.
Formula:
 
Book Value per Share
 Measures the amount that would be
distributed to common stockholders
if all assets were sold at their

03
balance sheet carrying amounts and
if all creditors were paid off.
Formula:
EXAMPLE
1.Liquidity •  

a.Working Capital

b. Current Ratio

c. Acid-Test Ratio

40
EXAMPLE
• 2. Asset Management •  

• a. Accounts Receivable Turnover

• b. Average Collection Period

• c. Inventory Turnover

41
EXAMPLE
• d. Average sale period •  

• e. Operating Cycle

• f. Total Asset Turnover

42
EXAMPLE
• 3. Debt Management •  

• a. Times Interest-Earned Ration

• b. Debt-to-Equity Ratio

•   c. Equity Multiplier

43
EXAMPLE• 4. Profitability •  

• a. Gross Margin Percentage

• b. Net Profit Margin Percentage

• c. Return on Total Assets

44
EXAMPLE• d. Return on Equity •  

• 5. Market Performance
• a. Earnings per Share

• b. Price-Earnings Ratio

45
EXAMPLE • c. Dividend Payout Ratio •  

• d. Dividend Yield Ratio

• e. Book Value per Share

46
 WHAT IS CASHFLOW
ANALYSIS?

04 The cash flow Analysis refers to

the examination or analysis of the
different inflows of the cash to the
company and the outflow of the
cash from the company during the
period under consideration from
Cash Flow Analysis the different activities which
include operating activities,
investing activities and financing
activities.
 04 Step by Step Cash
Flow Statements
Analysis

Cash Flow Analysis

 OPERATING

04 ACTIVITIES
Cash flow from the operation means taking into
account cash inflows generated from the normal
business operations and its corresponding cash
outflows.
 OPERATING
ACTIVITIES
• Before you start thinking about cash flow statement analysis, have a look
at the income statement first. Now start with net income.

04
• You need to add back non-cash expenses like depreciation, amortization,
etc. The reason behind adding back non-cash expenses is they are not
actually expensed in cash (but in the record).

• This is the same with any sort of sale of assets. If there is any loss on the
sale of assets, we need to add back and if there is any gain on sale of
assets, we need to deduct.

• And then we need to take into account any changes in non-current assets.

• Finally, we need to include changes in current assets and in current

liabilities (in current liabilities we shouldn’t include dividend payable &
notes payable.
 OPERATING
ACTIVITIES
• Before you start thinking about cash flow statement analysis, have a look
at the income statement first. Now start with net income.

04
• You need to add back non-cash expenses like depreciation, amortization,
etc. The reason behind adding back non-cash expenses is they are not
actually expensed in cash (but in the record).

• This is the same with any sort of sale of assets. If there is any loss on the
sale of assets, we need to add back and if there is any gain on sale of
assets, we need to deduct.

• And then we need to take into account any changes in non-current assets.

• Finally, we need to include changes in current assets and in current

liabilities (in current liabilities we shouldn’t include dividend payable &
notes payable.
 OPERATING
ACTIVITIES
CASH CASH
OPERATING ACTIVITIES
INFLOWS OUTFLOWS
Collecting cash from customers through sale

04
x  
of goods or services rendered.
Paying suppliers for inventory purchase   X
Paying bills to insurers, utility providers, etc.   X
Paying wages and salaries to employees   X
Paying taxes to government bodies   X
Paying interest to lenders   X
 FINANCING
ACTIVITIES
 First, if there is any buying back or issuing stocks, it will
come under financing activities in cash flow analysis.

04  Borrowing and repaying loans on a short term or long term

issuing notes and bonds etc.) will also be included under
financing activities.
 We also need to include dividend paid (if any). However, we
need to make sure that we don’t include accounts payable
or accrued liabilities (because they would be taken into
account in net cash flow from operating activities).
 FINANCING
ACTIVITIES
CASH
CASH
FINANCING ACTIVITIES OUTFLOW
INFLOWS

04
S
Borrowing money from creditor X  
Repaying the principal amount of   X
debt
Collecting cash from the sale of X  
common stock
Paying cash to repurchase your   X
own common stock
 INVESTING
ACTIVITIES
Other than operations, the company also invests in assets that

04
can provide them with greater returns. We need to find out how
many cashless (loss or gain) activities are done during the period
so that we can take them into account while ascertaining the net
cash inflow. Cash Inflow from investing activities would include
activities like purchasing long-term assets or securities or selling
them (except cash) and also providing and taking loans.
 INVESTING
ACTIVITIES
Though there is nothing much to be talked about here;

04
there are two things to be taken into account.
 First, we need to add back losses (if any) while selling any
long term assets or marketable securities. These losses
should be added back as there is no cash outflow for the
losses.
 Second, we need to deduct profits (if any) while selling any
long term assets or marketable securities. These profits
should be deducted because there is no cash inflow for the
profits the company has made.
 INVESTING
ACTIVITIES
CASH
CASH
INVESTING ACTIVITIES INFLOW

04 Buying property, plant, and

equipment
Selling property, plant, and
 

X
S
OUTFLOWS

 
equipment
Buying stock and bonds as a long-   X
term investment
Selling stock and bonds held for long- X  
term investment
A change in gross profit can be caused
by any of the following events:

Sales prices have changed

The unit volume of items

sold have changed

The mix of products sold

has changed (which alters
the gross profit if different
products have different
gross margins)
05 Gross Profit
Variance
Analysis
is designed to pick apart the
The purchase price of reasons why the gross profit
direct materials have margin changes from period to
changed period, so that management
can take steps to bring the
gross margin in line with
expectations.
A change in gross profit can be caused
by any of the following events:

The amount of direct

materials required has
changed

The amount of direct labor

has changed

The cost of direct labor has

changed

The amount of fixed overhead

incurred has changed
05 Gross Profit
Variance
Analysis
is designed to pick apart the
The amount of variable overhead reasons why the gross profit
incurred has changed margin changes from period to
period, so that management
can take steps to bring the
gross margin in line with
expectations.
 FORMUL
A
= Sales
- direct materials
- direct labor
- manufacturing overhead
05
Gross Profit
Variance
Analysis
• In first step, the sales price
variance and the sales
volume variance are
computed.

• In second step, the cost

05
price variance and cost
volume variance are
computed. Gross Profit
• In third step, the sales Variance
volume variance and cost
volume variance are
further analyzed by
Analysis
Variances involved in gross profit analysis:
For performing a gross profit analysis, the standard
computing sales mix sales and cost figures are used as the basis.
variance and a final sales The analysis is performed in three steps.
volume variance.
PROFIT VARIANCES FOR SINGLE-PRODUCT
FIRMS An unfavorable profit variance can be broken down into four
components: a sales price variance, a cost price variance, a
sales volume variance, and a cost volume variance.

SALES PRICE VARIANCE COST PRICE VARIANCE

It measures the impact of It is simply the summary of
changes in the unit selling price variances forSALES VOLUME
materials,
price in the firm’s contribution labor, and overhead. VARIANCE
margin (or gross profit).
CPV= (Actual cost – Budget
IT indicates the impac
SPV= (Actual price – Budget cost) firm’s profit of change
price) unit sales volume.

SVV= (Actual sales – B

PROFIT VARIANCES FOR SINGLE-PRODUCT
FIRMS An unfavorable profit variance can be broken down into four
components: a sales price variance, a cost price variance, a
sales volume variance, and a cost volume variance.
SALES VOLUME COST VOLUME
VARIANCE VARIANCE
IT indicates the impact on the
It has the same
firm’s profit of changes in the
interpretation with the sales
unit sales volume.
volume variance.

SVV= (Actual sales – Budget

CVV=(Actual sales – Budget
sales) x Budget price
Sales) x Budget cost per unit
 EXAMPLE S
S
S
a le s (units)
e lling Pric e
a le s Re ve nue
2019
97,500
9.00
877,500
2020
110,000
8.80
968,000

• The controller of the ABC Co. prepared the

C OG S 585,000 704,000
G ro ss Pro fit: 292,500 264,000

Ana lyze the d e c line in g ro ss p ro fit b e twe e n

2019 a nd 2020 by c a lc ula ting :
a. Sa le s Pric e Va ria nc e

following comparative statement of

2020 Ac tua l Sa le s 968,000
2020 Budg e te d 990,000
22,000
b. C o st Pric e Va ria nc e
2020 C O G S 704,000
2020 Ac tua l Sa le s

operations in 2019 and 2020.

@ 2019 c o st p e r unit 660,000
44,000

*2019 c o st p e r unit = 585,000/ 97,500

c. Sa le s Vo lume Va ria nc e
2020 a c tua l vo lume
@ 2019 p ric e 990,000
2019 a c tua l vo lume
@ 2019 p ric e 877,500
112,500

d. C o st Vo lume Va ria nc e
2020 a c tua l vo lume
2019 2020 @ 2019 c o st
Sa les (units) 97,500 110,000 2019 a c tua l vo lume 660,000
@ 2019 c o st 585,000
Selling Pric e 9.00 8.80
75,000
Sa les Revenue 877,500 968,000
C OGS 585,000 704,000
G ross Pro fit: 292,500 264,000 Sale s (u nits )
2
9
0
7
1 9
, 5 00
2
1
0
1
2
0
0
,000
Selling Pric e 9. 0 0 8.80
Sale s R ev en ue 87 7 , 500 96 8,000
C O G S 58 5 , 000 70 4,000
G ros s Pro fi
t: 29 2 , 500 26 4,000

A nal yze th e d ec l in e in g ros s profit b e t wee n

20 19 an d 2 02 0 b y c al c u la tin g :
a. Sal e s Pric e V a ria n c e

Ana lyze the d ec line in gro ss profit between

20 2 0 A c tu al S al es 968 ,00 0
20 2 0 B u d g et ed 990 ,00 0
22,0 00
b. C o st Pric e V a ria nc e
20 2 0 C O G S 704 ,00 0
20 2 0 A c tu al Sa les
@ 2 01 9 c o s t p e r u n it 660 ,00 0

2019 a nd 2020 by c alc ula ting:

44 , 000

*2019 c ost per un it =585,000/ 97,500

c . Sale s V olu m e V a r
ia nc e
202 0 ac tu al v olu m e
@ 2 01 9 p ric e 990,000

a . Sa les Pric e Va ria nc e

2019 ac tu al v olu m e
@ 2 01 9 p ric e 877,500
112,500

d. C o st Vo lu m e Va ria nc e
20 20 ac tu al v olum e

2020 Ac tua l Sa les 968,000

@ 201 9 c os t
2019 ac tu al v olum e 660 ,000
@ 201 9 c os t 585 ,000
75,0 00

2020 Budgeted 990,000

22,000
2019 2020
b. C o st Pric e Va ria nc e
Sa le s (units) 97,500 110,000
2020 C O G S 704,000
Selling Pric e 9.00 8.80
2020 Ac tua l Sa les Sa le s Reve nue 877,500 968,000
@ 2019 c ost p er unit 660,000 C OGS 585,000 704,000
44,000 G ro ss Profit: 292,500 264,000

*2019 c o st per unit = 585,000/ 97,500 Ana lyze the d ec line in gross pro fit b etwee n
2019 a nd 2020 by c a lc ula ting:
a . Sale s Pric e Va ria nc e
c. Sa les Volume Va ria nc e
2020 Ac tua l Sa les 968,000
2020 a c tua l volume 2020 Bud gete d 990,000
@ 2019 p ric e 990,000 22,000
2019 a c tua l volume b . C o st Pric e Va ria nc e
@ 2019 p ric e 877,500 2020 C O G S 704,000
112,500 2020 Ac tua l Sa les
@ 2019 c ost p er unit 660,000
44,000

d. C o st Vo lume Va ria nc e
*2019 c o st p er unit = 585,000/ 97,500
2020 a c tua l volume
@ 2019 c ost c. Sale s Volume Va ria nc e
2019 a c tua l volume 660,000 2020 a c tua l volume
@ 2019 c ost 585,000 @ 2019 p ric e 990,000
75,000 2019 a c tua l volume
@ 2019 p ric e 877,500
112,500

2019 2020 d. C o st Volume Va ria nc e

Sa le s (units) 97,500 110,000 2020 a c tua l volume
Selling Pric e 9.00 8.80 @ 2019 c o st
Sa le s Reve nue 877,500 968,000 2019 a c tua l volume 660,000
C OGS 585,000 704,000 @ 2019 c o st 585,000
G ro ss Profit: 292,500 264,000 2019 7
205,000
20
Sa les (units) 97,500 110,000
Ana lyze the d e c line in gross pro fit b e twee n Selling Pric e 9.00 8.80
2019 a nd 2020 b y c a lc ula ting : Sa les Re ve nue 877,500 968,000
C OGS 585,000 704,000
a . Sa le s Pric e Va ria nc e
G ro ss Pro fit: 292,500 264,000
2020 Ac tua l Sa les 968,000
2020 Bud ge ted 990,000
A na lyze the d e c line in gro ss p ro fit be twe e n
22,000 2019 a nd 2020 by c a lc ula ting :
b . C ost Pric e Va ria nc e a . Sa le s Pric e Va ria nc e
2020 C O G S 704,000 2020 A c tua l Sa le s 968,000
2020 Ac tua l Sa le s 2020 Bud geted 990,000
@ 2019 c o st p er unit 660,000 22,000
44,000 b . C o st Pric e Va ria nc e
2020 C O G S 704,000
*2019 c o st p er unit = 585,000/ 97,500 2020 Ac tua l Sa le s
@ 2019 c o st p e r unit 660,000
44,000
c. Sa le s Volume Va ria nc e
2020 a c tua l vo lume
*2019 c o st p er unit = 585,000/ 97,500
@ 2019 p ric e 990,000
2019 a c tua l vo lume
c. Sa le s Volume Va ria nc e
@ 2019 p ric e 877,500 2020 a c tua l volume
112,500 @ 2019 p ric e 990,000
2019 a c tua l volume
@ 2019 p ric e 877,500
d. C ost Vo lume Va ria nc e 112,500
2020 a c tua l vo lume
@ 2019 c o st
2019 a c tua l vo lume 660,000 d. C o st Vo lume Va ria nc e
@ 2019 c o st 585,000 2020 a c tua l volume

75,000
@ 2019 c o st
2019 a c tua l volume
@ 2019 c o st
660,000
585,000
68
75,000
 EXAMPLE
• e. Total Volume Variance
• Sales Volume Variance 112,500
• Cost Volume Variance 75,000 • The decline in gross profit of Php 28,500 can be
• 37, 500 explained as:

• f. Sales Mix Variance = 0 since the company • Gain due to favorable sales
only produces one product • volume variance 112,500

• Losses due to:

• g. Sales Quantity Variance • Unfavorable Sales Price variance 22,000
• 2020 Avolume 110,000 • Unfavorable Cost price variance 44,000
• 2019 Bvolume 97,500 • Unfavorable cost volume variance 75,000
• Difference 12,500 • 28,500
• 2019 GP/u *3
• Variance 37,500 • The decrease in gross profit is thus accounted
for: 112,500 - 141,000 = 28,500
• *SP – Cost = Php9 – Php6 = Php3

69
 06
Refers to the
additional resources
that will be needed for
a company to expand
its operations.

Additional Funds Needed A way of calculating how much

(External Financing Needed) new funding will be required, so
that the firm can realistically look
Financial at whether or not they will be able
Forecasting to generate the additional funding
and therefore be able to achieve
Is the amount of money a higher sales.
company must raise from
external sources to finance the
increase in assets required to
support the increase level of
sales.
 AFN
Formula
:AFN = A * ΔS/S

06
0 0 – L0 * ΔS/S0 – S1 *
PM * b
A0 – current level of
assets
L0 – current level of
liabilities
ΔS/S0 – percentage
Financial increase in sales
Forecasting S1 -new level of sales
Additional Funds PM – profit margin
b – retention rate = (1 –
Needed (External payout rate)
Financing Needed) AFN Simplified Formula:
AFN = Projected increase in asset –
spontaneous increase in liabilities –
any increase in retained earnings
 Operating and

07 Financial
Leverage
• Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is
used to evaluate the breakeven point of a business, as well as the likely profit levels on
individual sales.

• The degree of operating leverage (DOL) is used to measure the extent of the change in
operating income resulting from change in sales.

• It measures the sensitivity of the change in operating income (or EBIT, earnings before
interest and taxes) to the change in sales revenue.

OPERATING
LEVERAGE
 Operating
Leverage
FORMULA
It can be calculated in several different ways. First, we can use the formula from the definition of the
ratio:
Degree of operating leverage= %Change in Operating Income
%Change in Sales

Next, we can calculate it using its contribution margin. The contribution margin is the difference
between total sales and total variable costs.
Degree of operating leverage= Contribution Margin
Operating Income

Finally, if there is available information about the cost structure of a company, we can use the
following formula:
Degree of operating leverage= Q(P- V)
Q(P-V)-F
WHERE:
Q- THE NUMBER OF UNITS V- THE VARIABLE COST PER UNIT
 Operating
Leverage
EXAMPLE
The management of ABC corp. Wants to determine the company’s current degree of
operating leverage. The company sells 10,000 product units at an average price of $50.
The variable cost per unit is $12 while the total fixed costs are $100,000.
The company’s DOL is:

Therefore, every 1% change in the company’s sales will change the company’s operating
income by 1.38%.
 Operating and

07 Financial
Leverage
• A financial ratio that measures the sensitivity in fluctuations of the company’s
overall profitability to the volatility of its operating income.

• The degree of financial leverage is a financial ratio that measures the sensitivity
in fluctuations of the company’s overall profitability to the volatility of its
operating income caused by changes in its capital structure. The degree of
financial leverage is one of the methods used to quantify a company’s financial
risk (the risk associated with how the company finances its operations).

FINANCIAL
LEVERAGE
 Financial
Leverage
FORMULA
There are several ways on how to calculate the financial leverage.

The company’s management often wants to decide whether it should or

should not issue more debt. Net income would be an appropriate
measure of the company’s profitability:

Degree of Financial Leverage= % Change in Net Income

%Change in Ebit
 Financial
Leverage
FORMULA
If an investor wants to determine the effects of the company’s decision to
incur additional leverage, the earnings per share (EPS) is a more
appropriate figure because of metric’s strong relationship with the share
price.
Degree of Financial Leverage= % Change in EPS
%Change in EBIT

Finally, there is a formula that allows calculating the degree of financial

leverage in a particular time period:
Degree of Financial Leverage=EBIT
EBIT-INTEREST
 Financial
Leverage
EXAMPLE

ABC Corp. is preparing to launch a new project that will require substantial external
financing. The company’s management wants to determine whether it can safely issue
a significant amount of debt to finance the new project. Currently, the company’s EBIT is
$500,000, and interest payments are $100,000.

In order to make the decision, the company’s management wants to examine the
degree of financial leverage ratio:

It shows that a 1% change in the company’s leverage will change the company’s
operating income by 1.25%.