Chapter Two

CH2

Financial Analysis and

Financial Planning
 Meaning of Financial Analysis
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 Financial statement analysis is a process

of evaluating relationships between
component parts of financial statements
to obtain a better understanding of the
firm’s financial condition and
performance.
 Its objective is to identify the firm’s
current strengths and weaknesses and to
suggest actions that the firm might pursue
to take advantage of those strengths and
correct any weaknesses.
 Steps in Financial Analysis
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1. Set objectives of the analysis
Objective depends on the need of the user and the questions to be
answered by the analyst. For example:
 Shareholders (present and prospective) are interested in the firm’s
current and future level of risk and return as these dimensions directly
affect share price.
 Creditors (present and prospective) are primarily concerned with the
short term liquidity of the firm and the firm’s profitability.
 Management uses financial analysis for planning and controlling
decisions.
2. Gather Relevant Data
 Financial statements for at least 3 to 5 years.
 Balance sheets
 Income statements
 Cash flow statements
 Economic and industry data.
 Steps in Financial Analysis…
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3. Select and apply appropriate tools and techniques

to gain a basic understanding of the firm’s financial
status and performance.
Techniques in analyzing financial statements are:
 Ratio analysis,
 Common size statements analysis /vertical analysis/
 Common size income statement
 Common size balance sheet
 percentage change analysis /horizontal analysis/
Ratio and common size statements help standardize
statements of different sizes and currency.
4. Evaluation and interpretation
 Ratio Analysis
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 It is a financial technique that involves

dividing various financial statement
numbers into one another.
 Ratios can be examined to determine
trends and reasons for changes in the
financial statement from month to month.
 Ratios are valuable tools, as they
standardize balance sheet and income
statement numbers.
 Steps in Ratio Analysis
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1. Compute the ratio using appropriate

formula
2. Give an interpretation for the
quotient/result
3. The Implication (strong or weak)
– Use basic standards. Such as
• Industry average, or
• Management plan, or
• Past data/trend
4. Suggestion or recommendation
Copyright © 2011 by Nelson Education Ltd. All rights reserved. 2-6
 Types/Forms of ratio
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comparisons
 Cross-sectional analysis/Peer Group Analysis:
 involves comparison of different firm’s financial ratios at
the same point in time.
 A firm’s ratios may be compared to those of the
industry leader or to industry averages.
 Time series analysis (trend analysis)
 uses ratios to evaluate a firm’s performance over time.
 Any significant year to year changes can be evaluated to assess
whether they are symptomatic of major problem.
 Combined analysis (Use Panel Data):
 the most informative approach that combines cross-
sectional and time-series analyses.
 Types of Financial Ratios
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Liquidity ratios
Asset-management/Activity
ratios
Financial-leverage/Debt
Management ratios
Profitability ratios
Market-value ratios
 1. Liquidity Ratios
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 Liquidity refers to how quickly a firm can

turn its assets into cash.
 Liquidity ratios indicate the ability to meet
short-term obligations to creditors as they
mature or come due.
 Will the firm be able to pay off its debts as
they come due over the next year or so?
 Two commonly used liquidity ratios are:
 Current ratio
 Quick, or Acid Test, Ratio
 1.1. Current ratio
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 It measures a firm’s ability to satisfy the claims of
short term creditors by using all current assets.
 Too high current ratio indicates that too much capital is tied
up in current assets and the firm may be sacrificing some
returns possibilities
 Too low current ratio may suggest that a firm may face
difficulty in paying its short term liabilities., or a firm is not
making full use of its current borrowing capacity (short term
sources are less expensive than long term ones.)
 1.2. Quick, or Acid Test Ratio
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 It measures a firm’s ability to

satisfy the claims of short term
creditors by using quick assets.
 Current assets excluding inventories and
prepaid expenses are usually assumed to be
quick assets
 2. Asset Management Ratios
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 measure how effectively the firm is managing its

assets.
 indicate the extent to which assets are used to
support sales.
 Also called activity or utilization ratios,
 Ratios that analyze the different types of assets
include:-
 Inventory Turnover Ratio (ITO)
 Inventory Period (Average age of inventory)
 Days sales outstanding (DSO)
 Accounts Receivable Turnover
 The Fixed Assets Turnover Ratio
 The Total Assets Turnover Ratio
 Average payment period (APP)
 2.1. Inventory Turnover Ratio (ITO)
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 Indicates how quickly inventory is sold.

 It measures the efficiency of
management in managing sale of
inventory.
 The inventory turnover ratio is calculated as:

 An ITO significantly higher than the industry average may indicate:

 Superior selling practice,
 improved liquidity and profitability,
 fewer cases of damaged or obsolete inventory,
 use of just in time inventory management.
 ITO...

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How?????
 Potential problems in higher ITO are:
 lost sales due to insufficient level of inventory,
 firm’s policy of buying in small quantities & lost
quantity discount,
 production interruptions because of lack of raw
materials.
 An ITO significantly lower than the industry
average may indicate;
 over investment in inventory,
 inferior quality goods,
 stock of un-sellable or obsolete inventory,
 funds locked up in inventory and higher
inventory carrying costs
 2.2. Inventory Period (Average age of inventory)
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 also known as Days in Inventory.

 It measures the average number of days
the inventory is in warehouse before
sale.

 The shorter the period, the higher the inventory

turnover and the better the performance is.
 The interpretation is the same to that of
inventory turnover ratio except this is in terms
of days.
 2.3. Days sales outstanding (DSO)
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 also called the “average collection period”

(ACP),
 the average length of time that the firm must
wait after making a credit sale before
receiving cash.
 DSO = 365/RTR
 2.4. Accounts Receivable Turnover (ARTO)
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Measures how many times in

average credit sales is made in a
year.
 It is calculated as:

 ARTO and DSO ratios are reciprocals

of each other.
 2.5. The Fixed Assets Turnover Ratio/FATO/

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 Measures how effectively the firm uses its

plant and equipment.
 unused or idle capacity is very costly and
often represents a major factor in a firm’s
poor operating performance.
 It is the ratio of sales to net fixed assets:

 A potential problem when interpreting

FATO are comparing an old firm with a
new company.
 b/s of Inflation and depreciation
 2.6. The Total Assets Turnover Ratio
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 Measures the turnover of, the

entire firm’s assets;
 it is calculated by dividing sales by
total assets:
 2.7. Average payment period (APP)
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 Measures the average length of time the
creditors must wait to receive their cash.
 It indicates the average amount of time needed
by the firm to pay its accounts payable.

 effect payments as late as possible, without

jeopardizing the relationship with the suppliers
and lenders.
 lenders and suppliers of trade credit are
especially interested in the average payment
period since it provides them with a sense of
the bill-paying patterns of the firm.
 3. Debt Management Ratios
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 Debt management ratios are used to measure:

 Degree of indebtedness - measures the extent
to which a firm finances itself with debt- we us
B/Sheet
 Ability to service (pay) debts: measures the
ability of the firm to generate a level of income
sufficient to meet its obligations (fixed charges)
– I/Statement
 The extent to which a firm uses debt financing, or
financial leverage, has three important
implications:
 control
 returns
 risk
 3.1. Measures of Degree of indebtedness
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a. Debt Ratio (DR)

 The ratio of total liabilities to total assets.

b. Total-debt-to-equity ratio (DE)

 It shows a firm’s total debt in relation to the total dollar
amount owners have invested in the firm.
 Measures of Degree of indebtedness…
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 Debt to assets and debt to equity ratios are simply

transformations/alterations /change of each other.

c. The equity multiplier ratio

 The equity multiplier ratio is calculated by dividing total
assets by the firm’s total equity.
 3.2. Measures of Ability to service (pay)
debts/Coverage ratios
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 Measure a firm’s ability to meet (cover) fixed charge obligations

such as interest on loans, lease payments, preferred dividend
and repayment of the installment of loans.

a. Times-Interest-Earned Ratio
 also called the interest coverage ratio,
 measures a firm’s ability to pay interest on its debts using
operating profits.

b. Cash coverage ratio: is a measure of cash available to pay

interest.
 Fixed Charge Coverage Ratio
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c. Fixed Charge Coverage Ratio

measures a firm’s ability to pay
fixed charges using operating
profits.
 4. Profitability Ratios
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 Measure a firm’s ability to

generate returns on its
sales, assets, and equity.
 show the combined effects
of liquidity, asset
management, and debt on
operating results.
 4.1. Measures of Profitability in
terms of Sales
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a. Net Profit Margin /profit margin/

a. shows after tax profits per dollar of sales.

b. Operating profit margin

 identifies how a company is performing with respect to its
operations before the impact of interest expenses and taxes
are considered.
 It gives operating profit per birr of sales:
 Measures of Profitability in terms
of Sales…
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C. Gross profit margin

 measures the trading effectiveness and basic profit
earning potential of a firm.
 It identifies the gross profit per dollar of sales before
any other expenses are deducted.
 It gives gross profit per birr of sales:

 Possible causes for change in gross profit margin:

 changes in selling prices;
 changes in buying policies and practices;
 changes in sales mix, that is, the respective
proportions of the range of products sold;
 changes inventory valuation methods.
 4.2. Measures of Profitability in terms
of investment in total Assets
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a. Basic Earning Power (BEP) Ratio
 shows the raw earning power of the firm’s assets before the
influence of taxes and leverage

b. Return on Total Assets /ROA/

 measures the return on total assets after interest and taxes.
 It is also known as return on investment (ROI).

 Return on assets=Profit Margin X Total Asset Turnover

 4.3. Measures of Profitability in terms of owners’
investment (Return on Equity)
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 ROE measures the return the firm is earning on

the equity funds invested by its shareholders—
the firm’s owners
 It is a measure of return on stockholders’
investment in the enterprise.
 ROE …
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 Return on equity=Profit Margin X Total Asset Turnover X Equity multiplier

 This says that management has only three levers for

controlling ROE;
 the earnings pressed out of each dollar of
sales, or the profit margin;
 the sales generated from each birr of assets
employed, or the asset turnover; and
 the amount of equity used to finance the
assets, or the equity multiplier.
 Earnings per share (EPS)
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 Earning per share represents the number of

dollars earned on common stock.
 It shows the earnings available to the owners
of common stock.
 it specifically reveals how much money the
company is earning for every share.
 5. Market Value Ratios
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 relate a firm’s stock price to its earnings,

cash flow, and book value per share.
 indicate the willingness of investors to
value a firm in the marketplace relative to
financial statement values.
 A firm’s profitability, risk, quality of
management, and many other factors are
reflected in its stock prices.
 indicate the market’s assessment of
the value of the firm’s securities.
 Types:-
 Price/Earnings Ratio
 Price/Cash Flow Ratio
 Market/Book Ratio
 5.1. Price/Earnings Ratio
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 shows how much investors are willing to

pay per dollar of reported profits.
 Is higher for firms with strong growth
prospects, other things held constant,
but they are lower for riskier firms.
 5.2. Market/Book Ratio
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 It gives another indication of how

investors regard the company.
 Companies with relatively high rates of
return on equity generally sell at higher
multiples of book value
 Evaluating Bank Performance Using
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CAMEL Approach
CAMEL Ratios   Formula

1 Capital & reserve/Risk

 
Capital Adequacy CAR Weighted Asset
2
ROA
Asset Quality   NI/Total Assets
ROE NI/Equity
3
Management
Efficiency Net Sales/Total Assets
  Asset Turnover Ratio

4
Earning Quality NI/Net Sales
Net Profit Margin
 
Current Ratio CA/CL
5 Liquidity Investment to Deposit ratio Investment/Deposit
  Copyright © 2011 by Nelson Education Ltd. All rights reserved. 2-36
 Financial Planning and
Forecasting
CH2

 Financial planning is a continuous

process of directing and allocating
financial resources to meet strategic
goals and objectives.
 Financial planning -the process of
estimating the funds requirement of
a firm and determining the sources
of funds
 Forecasting-predicting future values
using different techniques
 Techniques of determining AFN
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 The Percent of Sales Method

(constant ratio method or Performa
method),
 Additional Funds Needed (AFN
formula), and
 Judgmental analysis.

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 Percent of Sales Method
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 is the most common method,

which begins with the sales
forecast expressed as an annual
growth rate in sale revenue.
 Many items on the balance sheet
and income statement are
assumed to change
proportionally with sales.
 Percent of Sales Steps:
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 Express balance sheet items that vary directly with
sales as a percentage of sales
 Multiply the percentage determined in step one by sales
forecast.
 Insert balance sheet item that don’t vary with sales as
they are. Example, long term liability, common stock.
 Compute the projected retained earnings of the following
accounting period.
Projected retained earning= retained earning+
projected net income-dividend
  Determine the amount of excess of total asset over the
sum of total liability and stockholders’ equity.
 Forecast the balance sheet items
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 higher sales must be supported by higher asset levels

 Some assets are increased proportional with sales
others are not.
 When the company operates at full capacity, each
asset account must increase if the higher sales level
is to be attained
 if the firm’s assets are to increase, its liabilities and
equity must also increase
 Spontaneously generated funds will be provided by
accounts payable and accruals
 AFN Formula
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Additional funds needed(AFN) = Required increase

in assets – Spontaneous increase in liabilities –
Increase in retained earnings.
AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

A*/S0: assets required to support sales; called capital intensity ratio.

 ΔS: increase in sales.
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
RR: retention ratio; percent of net income not paid as dividend.
 S0: Actual sales
 S1: Projected sales
 Implications of AFN
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 If AFN is positive, then you must

secure additional financing.
 If AFN is negative, then you have
more financing than is needed.
 Pay off debt.
 Buy back stock.
 Buy short-term investments.
 Pay additional dividend