Advanced Financial Management

(MBA 532)

Chapter 2
FINANCIAL ANALYSIS AND PLANNING

Master of Business Administration[MBA]

New Global Vision College

1
Financial Analysis

What is financial analysis?

– Evaluating a firm’s financial performance
– Analyzing ratios or numerical calculations
– Comparing a company to its industry and to its
past performance
– A long-run trend analysis over a 5-10 year
period is usually performed by an analyst.
– Ratio analysis may not answer questions, but
leads to further inquiry
Objectives of Financial Analysis

Analysis of financial statements can

examine:
– financial strengths and weaknesses,
– its credit worthiness,
– safety of funds invested in the firm,
– adequacy or otherwise of its earnings,
– ability to meet its obligations of firms.
 Importance of Ratios
Which ratios are most important?
 It depends on your perspective.

– Suppliers and banks (lenders) are most

interested in liquidity ratios.
– Shareholders are most interested in profitability
ratios.
– Bondholders concentrate on debt utilization ratios
– The effective utilization of assets is
management’s responsibility.

4 04/20/21
 Types of Ratios
1. Profitability ratios:
Measures management's overall effectiveness as
shown by returns of the period. Ratios in this group
are:
i. Net Profit Margin
ii. Basic Earning Power (BEP) Ratio
iii. Return on Total Assets
iv. Return on Common Equity
 2. Asset Utilization ratios

Measures the effective use of resources. This

ratio includes:
i. Receivable turnover(RTO)
ii. Daily sales Outstanding (DSO)/ACP
iii. Inventory turnover(ITO)
iv. Fixed Asset turn over(FATO)
v.Total Asset turn over(TATO)
3. Liquidity Ratios

 Measures the firm's ability to meet short

term obligations.
 Current ratio
 Quick or Acid test ratio
4. Debt utilization Ratios:

 Measures the extent of which the firm's

assets are financed by long term debt. It
includes:
i. Total Liabilities to Total Assets
ii. Times -Interest-Earned Ratio
iii. EBITDA Coverage Ratio
5. Market Value ratios

 measures the value of a company’s stock

relative to that of another company.
i. Price /Earnings Ratio
ii. Price/ Cash Flow Ratio
iii. Market/Book Ratio
Financial Analysis
Example

 Let’s see For Mihretab Andualem Inc.:

Balance Sheets and Income statements for
Years ending December 31, 2010 and 2009
respectively (Millions of Dollars. Except for
per share Data).
 Table 2-1a: MA Inc.: Balance Sheets for Years ending
December 31(Millions of Dollars. Except for per share Data).

ASSETS 2010 2009 LIABILITIES AND EQUITY 2010 2009

Cash and cash equivalents $10 $15 Accounts payable $60 30
Short-term investments 0 65 Notes payable 110 60
Account Receivable 375 315 Accruals 140 130
Inventories 615 415 Total current liabilities 310 220
Total current Assets 1000 810 Long-term bonds 754 580
Net Plant and equipment 1000 870 Total debt $106 800
4
Preferred stock (400,000 40 40
shares)
Common stock (50,000,000 130 130
shares)
Retained earnings 766 710
Total common equity 896 840
Total Assets $2000 $1680 Total liabilities and equity $200 1680
0
 Table 2-1b: MA Inc.: Income statements for Years ending
December 31(Millions of Dollars. Except for per share Data).

2010 2009
Net sales $3,000 $2850.0
Operating costs excluding depreciation and amortization 2,616.2 2497.0
Earnings before interest, taxes, depreciation, and amortization (EBITDA) $383.8 $353.0
Depreciation 100 90.0
Amortization 0.0 0.0
Depreciation and amortization $100 90.0
Earnings before interest and taxes (EBIT, or operating income) 283.8 263.0
Less interest 88.0 60
Earnings before taxes (EBT) 195.8 203.0
Taxes (40%) 78.3 81.2
Net income before preferred dividends b 117.5 121.80
Preferred dividends 4.0 4.0
Net income $113.5 117.80
Common dividends $57.5 53.0
Addition to retained earnings $56.0 64.80
Per-share data:
Common stock price 23.00 26.00
Earnings per share (EPS) a 2.27 2.36
Dividends per share (DPS) a 1.15 1.06
Book value per share (BVPS) a 17.92 16.80
Cash flow per share (CFPS) a 4.27 4.16
The bonds have a sinking fund requirement of $20 million a year. The costs include lease
payments of $28 million a year. a There are 50,000,000 shares of common stock
outstanding. Note that EPS is based on earnings after preferred dividends — that is, on net
income available to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS for
2001 are as follows:
 1. Profitability ratios:
Measures management's overall effectiveness as shown
by returns of the period. They are:
i. Net Profit Margin
ii. Basic Earning Power (BEP) Ratio
iii. Return on Total Assets
iv. Return on Common Equity
 i. Net Profit Margin

 The net profit margin, which is also called the

profit margin on sales,

 Comments: As we compare with the industry

average the net profit margin is below…..
 ii. Basic Earning power(BEP) ratio
 Basic Earning power(BEP) is:

 Industry average=17%
 Comment:

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iii. Return on Total Assets(Investment)

 The ratio of net income to total assets

measures the return on total assets (ROA)
after interest and taxes.

 Comments:
iv. Return on Common Equity

 The ratio of net income to common equity

measures the return on common equity (ROE):

 Comments:
 2. Asset Utilization ratios

Measures the effective use of resources. They are

five:
i. Receivable turnover(RTO)
ii. Daily sales Outstanding (DSO)/ACP
iii. Inventory turnover(ITO)
iv. Fixed Asset turn over(FATO)
v.Total Asset turn over(TATO)
 i. Receivable Turnover

 Receivable turnover is calculated as sales on

credit divided by account receivable.

Industry average =6times

 Comment: MA collects its receivable faster than
does the industry.

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 ii. The Days Sales Outstanding(DSO):
Evaluating of Receivables
 Days sales outstanding (DSO),also called the “average
collection period” (ACP), is used to appraise accounts
receivable, and it is calculated by dividing accounts receivable
by average daily sales to find the number of days’ sales that are
tied up in receivables.

 Comments:
iii. The Inventory Turnover Ratio:
Evaluating of Inventories
 The inventory turnover ratio is defined as
sales divided by inventories:

 Comments:
iv. The Fixed Assets Turnover
Ratio: Evaluating of Fixed Assets
 The fixed assets turnover ratio measures how
effectively the firm uses its plant and equipment. It
is the ratio of sales to net fixed assets:

 Comments:
v. The Total Assets Turnover
Ratio: Evaluating of Total Assets

 The total assets turnover ratio is calculated

by dividing sales by total assets:

 Comments:
3. Liquidity Ratios

 Measures the firm's ability to meet short

term obligations. They are:
i. Current ratio
ii. Quick or Acid test ratio
 i. The Current Ratio

 The current ratio is calculated by dividing current

assets by current liabilities:

 Comments:
ii.The Quick, or Acid Test,
Ratio
 The quick, or acid test, ratio is calculated by
deducting inventories from current assets and
then dividing the remainder by current liabilities:

 Comments:
4. Debt Utilization Ratios:

 Measures the extent of which the firm's

assets are financed by long term debt. They
are:
i. Total Liabilities to Total Assets
ii. Times -Interest-Earned Ratio
iii. EBITDA Coverage Ratio
i. Total Liabilities to Total Assets:
How the Firm is Financed
 The ratio of total liabilities to total assets is called
the debt ratio, or sometimes the total debt ratio.

 Comments:
Debt-to-equity ratio
 Creditors may be reluctant to lend the firm more
money because a high debt ratio is associated with a
greater risk of bankruptcy. Some sources report the
debt-to-equity ratio, defined as:

 Comments:
Market debt ratio

 MA’s market value of equity is $23(50) = $1,150.

Often it is difficult to estimate the market value
of liabilities; so many analysts define the market
debt ratio as:

 Comments:
 ii. Times -Interest-Earned Ratio:
Ability to Pay Interest

 The times-interest-earned (TIE) ratio, also

called the interest coverage ratio.

 Comments:
 iii. EBITDA Coverage Ratio: Ability to
Service Debt

(1) Interest is not the only fixed financial charge —companies must also reduce
debt on schedule, and many firms lease assets and thus must make lease
payments. If they fail to repay debt or meet lease payments, they can be
forced into bankruptcy. (2) EBIT does not represent all the cash flow avail-
able to service debt, especially if a firm has high depreciation and/or
amortization charges. The EBITDA coverage ratio accounts for these
deficiencies:

Comments:
5. Market Value Ratios
 Market value ratios relate a firm’s stock price
to its earnings, cash flow, and book value per
share. Market value ratios are a way to
measure the value of a company’s stock
relative to that of another company. They
are:
i. Price /Earnings Ratio
ii. Price/ Cash Flow Ratio
iii. Market/Book Ratio
i. Price /Earnings Ratio

 The price/earnings (P/E) ratio shows how much

investors are willing to pay per dollar of reported
profits.

 Comments:
ii. Price/ Cash Flow Ratio
 Stock prices depend on a company’s ability to
generate cash flows. Cash flow is defined as
net income plus depreciation and amortization.

 Comments:
iii. Market/Book Ratio
 The ratio of a stock’s market price to its book value
gives another indication of how investors regard the
company.

 Comments:
 Summary of Financial Ratios

38 04/20/21
Trend Analysis-Example(at least
5years data is needed.

Year ROE(%) Industry ROE(%) MA's

2006 13.2 14.05
2007 14.01 15.9
2008 13.9 13.5
2009 15.3 13.4
2010 15 12.7
Trend Analysis-Example: Rate of
Return on Common Equity, 2006-2010
 THE DUPONT EQUATION

 The return on assets (ROA) can be expressed

as the profit margin multiplied by the total
assets turnover ratio:

For Mihretab, the ROA is

ROA = 3.8% × 1.5 = 5.7%
Return on Equity(ROE)

 To find the return on equity (ROE), multiply the ROA

by the equity multiplier, which is the ratio of assets
to common equity:

 ROE = ROA x Equity multiplier

For MA, we have

ROE = 5.7%X$2,000/$896
=5.7%X2.23
=12.7%
 Return on Equity(ROE)

 Combining Equations 2-1 and 2-3 gives the extended, or

modified, Du Pont equation, which shows how the profit
margin, the total assets turnover ratio, and the equity
multiplier combine to determine the ROE:
 ROE = (profit margin)(Total assets turnover)(Equity
multiplier)

For MA, we have

ROE = (3.8%)(1.5)(2.23)
= 12.7%
 LIMITATIONS OF RATIO ANALYSIS

Some potential problems include the following.

1. Many large firms that operate different divisions in
different industries, and for such companies it is
difficult to develop a meaningful set of industry
averages.
2. To set goals for high-level performance, it is best to
benchmark on the industry leaders’ ratios rather than
the industry average ratios.
3. Inflation may have badly distorted firms’ balance sheets
—reported values are often substantially different from
“true” values.
LIMITATIONS OF RATIO ANALYSIS

4. Seasonal factors can also distort a ratio

analysis.
5. Firms can employ “window dressing”
techniques to make their financial statements
look stronger.
6. Companies’ choices of different accounting
practices can distort comparisons.
 FINANCIAL PLANNING
(FORECASTING):
What is Financial Forecasting?
 Financial forecasting is looking ahead to develop a
financial plan for the future.
 Provides lead time to make necessary adjustments
before actual events occur.
 Helps to plan for significant growth in firm.
 Can be used as a target for measuring
performance.
 Often required by bankers and other lenders.

46 04/20/21
FINANCIAL PLANNING
(FORECASTING):

 Planning: is a desire of future state of an entity

and of effective ways of bringing its about, in a
quantitative ways.
 Some of the major steps are:

i. Establishing objectives: Objectives are

statements of broad and long range desired
state or position of an enterprise in the future.
This represents the purpose. (e.g. weather or not
to maximize profit).
 FINANCIAL PLANNING
(FORECASTING):

ii. Determining goals: Goals are operational

specifications of the broad objectives with time and
quantity dimensions. They are quantified targets to be
attained within specific period (e.g. target of 20% rate
of return on the total investment at the end of 2017).
iii. Developing strategies: Strategies lay down the
foundation for attaining the objectives and goals of an
enterprise. They specify the ways to achieve the goals
operationally (e.g. increasing sales volume through
price reduction).
FINANCIAL PLANNING
(FORECASTING):

iv. Formulating Profit Plan (Budgets): A profit

plan or budget is the formal expression of the
company's plans and objectives, stated in
financial terms, for specific future period of
time.
 It is a plan because it explicitly states the goals
in terms of time expectations and expected
financial results for each major segment of the
entity (e.g. proforma income statement).
FINANCIAL PLANNING
(FORECASTING):
 The three components of an overall budget are:
i. Operating Budgets
 relates to the planning of the activities or
operations of the enterprise; such as,
production sales and purchase.
ii. Financial Budgets
 concerned with the financial implications of the
operative budgets - the expected cash inflows,
outflows, financial position and operating
results.
FINANCIAL PLANNING
(FORECASTING):

 Components of financial budgets are:

– Cash Budget
– Proforma Balance Sheet & Income Statement
– Statement of changes in Financial position (fund
flow statement)
FINANCIAL PLANNING
(FORECASTING):
iii. Capital Budgets
 It involves planning to acquire worthwhile
projects, together with timing of the
estimated cost and cash flow of each
project.
FINANCIAL STATEMENT FORECASTING:
1. THE PERCENT OF SALES METHOD

Step 1. Forecast Income Statement

Step 2. Forecast the Balance Sheet
Step 3. Raising the Additional Funds
Step 4. Funds Needed Financing Feedbacks
Step 5. Analysis of The Forecast
Illustration: Percentage of sales
method of sales forecasting

 A firm expects to grow by 30% of last year

and believes it can maintain cost of goods sold
at 85% of sales and to pay out 1/3 of
income as dividend. Following is the
condensed version of last year income
statement.
Percentage of sales method of
sales forecasting

Sales $2,000
Cost of goods sold 1,700 85% of sales
EBT $300
Taxes (34%) 102
Net. Income $198
Dividend 66 1/3 of income
Retained Earning $132
Percentage of sales method of
sales forecasting
 Assume currently there are 3,000 shares
outstanding, which result dividend per share
(DPS) of $0.02 [$66/3000 shares
outstanding=$0.02].The dividend per share is
projected to grow to $0.0286.
 Assume further that the current fair
market value of a stock is $4.416 per
share.
 Balance sheet for the previous year in
absolute terms and as a percent of sales is
given below:

% of % of
sales sales
Cash $100 0.05 Accounts payable $60 0.03
Accounts 120 0.06 Notes payable 140
receivable
Inventories 140 0.07 Long term debt 200
Total Current $360 0.18 Common stock 10
Assets
Net Fixed Assets 640 0.32 Retained Earning 590
Total assets $1,000 0.50 $1,000
 Required:
1. Given the above data how much
additional earning can be expected?

Last Projection Proforma

year
Sales $2,000 1.3 $2,600.00
Cost of goods 1,700 85% * projected $2,210.00
sold sales
EBT $300 390.00
Taxes (34%) 102 132.60
Net. Income $198 257.40
Dividend 66 [$0.0286*3,000] or 85.80
[ 1/3*257.4]
Retained Earning $132 171.60
2. What assets are needed to support
sales growth?

% of Projec % of Projected Projected L

sales ted sales sales and C
assets
Cash 0.05 $130 A/P 0.03 $2,600 78
Accounts 0.06 156 N/P 140
Receivable
Inventories 0.07 182 LTD 200
Total Current 0.18 468 CS 10
Assets
Net Fixed Assets 0.32 832 RE 761.60
Total assets 0.50 $1,300 $1,189.60
 2. What assets are needed to support
sales growth?

 Asset requirements are $1,300 but

internally generated financing is only
$1,189.60. The difference $110.40 (1300-
1189.60=110.40) is to be externally
generated.
 3. How will the needed funds be
financed?

 Let us assume that it is determined to raise

60% of it from debt market and the rest
through issuance of ordinary shares.
Financing source % of EFR Proportion
total EFR
Debt 0.60 $110.40 $66.24
Equity 0.40 $110.40 $44.16
Total 1.00 $110.40
 4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend.

Cost of debt[$66.24*0.05*0.66] 2.18592

Dividend [ ] 0.286
Total deduction 2.47192
 4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend:

 Now this will reduce retained earnings and it

has to be raised again.
Financing % of total EFR Proportion
source financing
Debt 0.60 $2.47192 $1.483152
Equity 0.40 $2.47192 $0.988768
Total 1.00 $2.47192
 4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend:

Cost of debt[$1.483152*0.05*0.66] 0.048944016

Dividend [ ] 0.006403706
Total deduction 0.055347722
 4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend:

 Now this amount still reduces retained earnings

therefore it has to be raised again.
Financing source % of total financing EFR Proportion
Debt 0.60 $0.055347722 $0.033208633
Equity 0.40 $0.055347722 $0.022139089
Total 1.00 $0.055347722
4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend:

Cost of debt [$0.033208633*0.05*0.66] $0.001095885

Dividend [ ] 0.000143383
Total deduction $0.001239268
 4. The above analysis of EFR has to be
adjusted because both have costs, debt
interest and equity dividend:

 Let us stop here assuming that the cost became

insignificant.
 Therefore, debt, equity, and retained earnings after
these iterations will become:
 Debt [66.24+1.483152+0.033208633]= 67.756361
 Equity [44.16+0.988768+0.022139089]= 45.170907
 Retained Earnings [171.60-2.47192-0.055347722]=
169.07273
 2. AFN method

 Identifying the funds which must be raised in

order to support the forecasted sales level is
one of the key outputs of the forecasting
process. This amount is known as the External
Financing Needed (EFN) or Additional Funds
Needed (AFN).
 Most firms forecast their capital requirements
by constructing pro forma income statements
and balance sheets as described above.
 AFN method:

 However, if the ratios are expected to remain

constant, then the following formula can be
used to forecast financial requirements.
Additional Funds Needed = (Required increase in assets)-
(Spontaneous increase in liabilities)-(increase in Retained
Earnings)
The calculations presented are based on the
Balance Sheet and Income Statement below.

Balance Sheet ($ in Millions)

Assets 1999 Liabilities & Owners' Equity 1999
Current Assets   Current Liabilities  
Cash 200 Accounts Payable 400
Accounts Receivable 400 Notes Payable 400
Inventory 600 Total Current Liabilities 800
Total Current Assets 1200 Long-Term Liabilities  
    Long-Term Debt 500
Fixed Assets   Total Long-Term Liabilities 500
Net Fixed Assets 800 Owners' Equity  
    Common Stock 300
    Retained Earnings 400
    Total Owners' Equity 700
Total Assets 2000 Total Liab.& O.Equity 2000
 Income Statement ($ in Millions)

Income Statement ($ in Millions)

  1999
Sales 1200
Cost of Goods Sold 900
Taxable Income 300
Taxes 90
Net Income 210
Dividends 70
Addition to Retained 140
Earnings
 Full Capacity

 The equation used to calculate EFN when fixed assets are being
utilized at full capacity is given below. (Please note that this
equation is based on the same assumptions that underlay the
Percentage of Sales Method. Namely that the Profit Margin and
the Retention Ratio are constant.)

 Where,
– S0 = Current Sales,
– S1 = Forecasted Sales = S0(1 + g),
– g = the forecasted growth rate is Sales,
– A*0 = Assets (at time 0) which vary directly with Sales,
– L*0 = Liabilities (at time 0) which vary directly with Sales,
– PM = Profit Margin = (Net Income)/(Sales), and
– b = Retention Ratio = (Addition to Retained Earnings)/(Net Income).
 Full Capacity

 When the firm is utilizing its assets at full capacity,

A*0 will equal Total Assets. L*0 typically consists of
Accounts Payable (and if present Accruals). The logic of
underlying this equation can be explained as follows.
 = the required increase in Assets,
 = the "spontaneous" increase in Liabilities, and

 = the "spontaneous" increase in Retained Earnings.

 Full Capacity

 The increased in Liabilities and Retained Earnings in

the equation are considered "spontaneous" because
they occur essentially automatically as a consequence
of the firm conducting its business.
 Full Capacity- Example
Example: Use the Balance Sheet and Income Statement above to
determine the EFN given that Fixed Assets are being utilized at full
capacity and the forecasted growth rate in Sales is 25%.
Solution:
First calculate the Forecasted Sales.
S1 = 1200(1 + .25) = $1500

A*=$2000
L*=400(A/P)

Next, solve using the EFN equation. Note that we are substituting (Net Income)/(Sales) for
Profit Margin and (Addition to Retained Earnings)/(Net Income) for the Retention Ratio.
 Excess Capacity

 If the firm has excess capacity in its Fixed

Assets then the Fixed Assets may not have
to increase in order to support the
forecasted sales level(Case 1).
 Moreover, if the Fixed Assets do need to
increase in order to support the forecasted
sales level(Case 2).
 Excess Capacity
 When a firm has excess capacity in its Fixed
Assets the first step is to determine the sales level
that the existing Fixed Assets can support. This can
be determined by dividing Current Sales by the
percentage of capacity at which the Fixed Assets
are presently being utilized. This sales level is called
Full Capacity Sales, SFC.
 Excess Capacity

 If Forecasted Sales are less than Full Capacity

Sales(S1 < SFC), then fixed assets do not need to
increase to support the forecasted sales level.
 On the other hand, if Forecasted Sales are greater
than Full Capacity Sales (S1 > SFC), then Fixed
Assets will have to increase.
 We shall consider these two cases below:
 Case 1: S1 Less Than SFC

 When the Forecasted Sales are less than or equal

to Full Capacity Sales, EFN can be determined in one
step using the above equation.
 The only adjustment is that A*0 now only consists of
Total Current Assets since Fixed Assets do not
need to increase to support the forecasted sales
level.
Excess Capacity Example: S1 < SFC

Use the Balance Sheet and Income Statement above to

determine the EFN given that Fixed Assets are currently being
utilized at 60% of capacity and the forecasted growth rate in
Sales is 25%.
Solution:
First calculate the Forecasted Sales and Full Capacity Sales.
S1 = 1200(1 + .25) = $1500
SFC = 1200/.60 = $2000
Since Forecasted Sales are less than Full Capacity Sales the EFN can
be found in one step. Here A*0 is equal to Total Current Assets which
equals $1200.
 Case 2: S1 Greater Than SFC
 When the Forecasted Sales are greater than Full
Capacity Sales, EFN can be determined in two
steps:
 The first step, illustrated by the equation for EFN1
below, finds the EFN needed to get to Full Capacity
Sales.
 The second step, illustrated by the equation for
EFN2 below, finds the additional EFN to get from
Full Capacity Sales to the Forecasted Sales.
 The total EFN is calculated as EFN1 plus EFN2.
Case 2: S1 Greater Than SFC
Excess Capacity Example: S1 > SFC

Use the Balance Sheet and Income Statement above to determine the
EFN given that Fixed Assets are currently being utilized at 90% of
capacity and the forecasted growth rate in Sales is 25%.
Solution:
First calculate the Forecasted Sales and Full Capacity Sales.
S1 = 1200(1 + .25) = $1500
SFC = 1200/.90 = $1333.33
Since Forecasted Sales are greater than Full Capacity Sales the EFN
has to be found in two steps.
 End of Chapter

Have a nice time!