CHAPTER TWO

FINANCIAL ANALYSIS AND

PLANNING
 2.1. Introduction

 A financial statement is an official document of

the firm, which explores the entire financial
information of the firm.
 The main aim of the financial statement is to
provide information and understand the financial
aspects of the firm.
 2.2. Financial Analysis

 Financial analysis involves the selection, evaluation, and

interpretation of financial data and other pertinent information to
assist in evaluating the operating performance and financial
condition of a company.
 The information that is available for analysis includes economic,
market, and financial information.
 Financial analysis is an evaluation of both a firm’s past financial
performance and its prospects for the future. Typically, it involves
an analysis of the firm’s financial statements and its flow of funds.
 Financial statement analysis involves the calculation of various
ratios. It is used by such interested parties as creditors, investors,
and managers to determine the firm’s financial position relative to
that of others.
 The way in which an entity’s financial position and operating results
are viewed by investors and creditors will have an impact on the
firm’s reputation, price/earnings ratio, and effective interest rate.
 2.3 Financial Statement Analysis

 The financial statements of an enterprise present the summarized

data of its assets, liabilities, and equities in the statements of
financial position and its revenue and expenses in the income
statement.
 If not analyzed, such data may lead one to draw erroneous
conclusions about the firm’s financial condition. Various measuring
instruments may be used to evaluate the financial health of a
business, including horizontal, vertical, and ratio analyses.
A financial analyst uses the ratios to make two types of comparisons:
i. Industry comparison: The ratios of a firm are compared with
those of similar firms or with industry averages or norms to
determine how the company is faring relative to its competitors.
ii. Trend analysis: A firm’s present ratio is compared with its past
and expected future ratios to determine whether the company’s
financial condition is improving or deteriorating over time.
 2.4 Types of Financial Statement Analysis
 According to Myres, “Financial statement analysis is largely a study of the relationship
among the various financial factors in a business as disclosed by a single set of
statements and a study of the trend of these factors as shown in a series of statements”.
 Analysis of financial statement may be broadly classified into two important types on
the basis of material used and methods of operations.
Based on Material Used
 Based on the material used, financial statement analysis may be classified into two
major types such as External analysis and internal analysis.
A. External Analysis: Outsiders of the business concern do normally external analyses
but they are indirectly involved in the business concern such as investors, creditors,
government organizations and other credit agencies.
 External analysis is very much useful to understand the financial and operational
position of the business concern.
 External analysis mainly depends on the published financial statement of the concern.
This analysis provides only limited information about the business concern.
A. Internal Analysis: The company itself does disclose some of the valuable
information to the business concern in this type of analysis.
 This analysis is used to understand the operational performances of each and
every department and unit of the business concern. Internal analysis helps to take
decisions regarding achieving the goals of the business concern.
Based on Method of Operation
 Based on the methods of operation, financial statement analysis
may be classified into two major types such as horizontal
analysis and vertical analysis.
A. Horizontal Analysis: Under the horizontal analysis, financial
statements are compared with several years and based on that, a
firm may take decisions.
 Normally, the current year’s figures are compared with the base
year (base year is consider as 100) and how the financial
information are changed from one year to another. This analysis
is also called as dynamic analysis.
 The statements for two or more periods are used in horizontal
analysis. The earliest period is usually used as the base period
and the items on the statements for all later periods are
compared with items on the statements of the base period. The
changes are generally shown both in dollars and percentage.
A. Vertical Analysis: Under the vertical analysis, financial
statements measure the quantities relationship of the
various items in the financial statement on a particular
period.
 It is also called as static analysis, because, this analysis
helps to determine the relationship with various items
appeared in the financial statement.
 Vertical analysis (Common Size) is a technique used to
identify where a company has applied its resources and
in what proportions those resources are distributed
among the various statements of financial position and
income statement accounts.
 The analysis determines the relative weight of each
account and its share in asset resources or revenue
generation.
Example: Consider the CS Company, which reports
the following financial information:
Year 2008 2009 2010 2011 2012 2013

Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40

Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65

Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57

Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29

Intangibles 400.00 402.00 404.01 406.03 408.06 410.10

Total assets $7, 000.00 $7,215.80 $7,439.12 $7,670.23 $7,909.42 $8,157.01

1.Create the vertical analysis for the CS

Company’s assets.
2.Create the horizontal analysis for CS Company’s
assets, using 2008 as the base year.
Vertical common-size analysis for the CS Company’s assets.

Year 2008 2009 2010 2011 2012 2013

Cash 6% 6% 5% 5% 5% 5%

Inventory 23% 23% 23% 23% 22% 22%

Accounts receivable 16% 16% 16% 15% 15% 15%

Net plant and equipment 50% 50% 51% 51% 52% 52%

Intangibles 6% 6% 5% 5% 5% 5%

Total assets 100% 100% 100% 100% 100% 100%

 Vertical analysis also refers to the review of
financial information for only one accounting
period.
 It indicates the relative size of each item in the
financial statements as a percentage of the total of
that statement.
 i.e total assets or total liabilities and share holders
equity in statement of financial position and sales
in income statement such a statement then called
common size financial statement.
 Horizontal analysis for CS Company’s assets, using 2008 as the
base year.

Year 2008 2009 2010 2011 2012 2013

Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%

Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%

Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%

Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%

Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%

Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

2.5 Techniques of Financial Statement Analysis
 Financial statement analysis is interpreted mainly to
determine the financial and operational performance of the
business concern.
 A number of methods or techniques are used to analyse
the financial statement of the business concern.
The following are the common methods or techniques,
which are widely used by the business concern.
a. Comparative Statement Analysis
b. Trend Analysis
c. Common Size Analysis
d. Fund Flow Statement
e. Cash Flow Statement
f. Ratio Analysis
A. Comparative Statement Analysis
 Comparative statement analysis is an analysis of financial
statement at different period of time. This statement helps to
understand the comparative position of financial and operational
performance at different period of time.
B. Trend Analysis
 The financial statements may be analysed by computing trends of
series of information.
 It may be upward or downward directions which involve the
percentage relationship of each and every item of the statement
with the common value of 100%.
 Trend analysis helps to understand the trend relationship with
various items, which appear in the financial statements.
 These percentages may also be taken as index number showing
relative changes in the financial information resulting with the
various period of time. In this analysis, only major items are
considered for calculating the trend percentage.
 The main differences b/n Trend analysis and comparative
statement analysis is that:
 Trend analysis designed to look for trends, where as
comparative analysis simply compares changes from period
to period.
 Trend analysis actually a form of comparative analysis and
generally uses %ages or ratios to compare information,
where as comparative analysis takes several periods of
information and compares them from period to period.
 Trend analysis is a procedure in financial analysis where the
amounts in financial statements over a certain period of
time is compared line by line in order to make related
decisions whereas comparative analysis is the method that
compares current year’s financial statement with prior
period statements or with the statement of another
C. Common Size Analysis
 Another important financial statement analysis technique is
common size analysis in which figures reported are converted
into percentage to some common base.
 In the statement of financial position the total assets figures is
assumed to be 100 and all figures are expressed as a
percentage of this total. It is one of the simplest methods of
financial statement analysis, which reflects the relationship of
each and every item with the base value of 100%.
D. Fund Flow Statement
 Funds flow statement is one of the important tools, which is
used in many ways. It helps to understand the changes in the
financial position of a business enterprise between the
beginning and ending financial statement dates.
 It is also called as statement of sources and uses of funds.
Con……………………………………..
E. Ratio Analysis
 A ratio is defined as the indicated quotient of two
mathematical expressions and as the relationship between two
or more items. In financial analysis a ratio is used as yardstick
to evaluate financial performances.
 A ratio analysis involves comparison. A single ratio in itself does
not indicate favorable or unfavorable conditions performances
of a firm. It should be compared with some standards.
Standards of comparison may be obtained from:
 Ratio calculated from the past financial statement of the firm,
 Ratio developed from the Performa financial statements,
 Ratio of the most successful and profitable firm in the industry,
 Ratio of the industry to which the firm belongs.
 Dozens of ratios can be computed from a single set of financial
statement.
 Ratio is a mathematical relationship between one
numbers to another number. Ratio is used as an index for
evaluating the financial performance of the business
concern.
 An accounting ratio shows the mathematical relationship
between two figures, which have meaningful relation
with each other. Ratio can be classified into various types.
The following different and commonly used ratios will
be considered under four major categories.
 Liquidity Ratio
 Activity Ratio/ Asset Management ratios
 Leverage or long-term solvency ratios
 Profitability ratios
 Market value ratios
Liquidity Ratio
 Liquidity is extremely essential for a firm to be able to meet its
obligation as they become due.
 Liquidity ratio, therefore, measures the ability of a firm to
meet is current obligation.
 Analysis of liquidity demands preparation of cash budget and
cash flow statements; but liquidity ratios can be calculated, by
establishing relationship between current liabilities and
current assets.
 A firm should not suffer from lack of liquidity or should not be
too liquid.
 Lack of liquidity produces loss of confidence in face of
creditors, greater court law suits, bad credit rating, etc. and
very high degree liquidity is also bad, as idle asset earn
nothing, which means, the firms, current fund is tied
unnecessarily by current assets.
TYPES OF LIQUIDITY RATIO
1. CURRENT RATIO: It is the most important ratio
among liquidity ratios. It is essentially an attempt
to measure and compare the current assets with
current liabilities.
 This ratio is extensively used by financial
analysts, bankers, credit institution with the view
to find out whether the current liabilities, which
are required to be met in the short run, are
adequately covered by current assets which may
be expected to be realized over a similar period
of time.
2. QUICK OR ACID TEST RATIO: Since current ratio
includes inventories which might not be easily realizable,
financial analysts have developed another indicator for
liquidity.
 This is a more refined measure of liquidity; it establishes
a relationship between quick or liquid assets and current
liabilities.
 An asset is liquid if it can be converted into cash
immediately or reasonably soon without a loss of value.
 Cash is the most liquid asset. Receivables and securities
are relatively liquid. Inventories and prepaid expenses
considered to be less liquid. They need some more time
to be converted into cash and have a tendency to
fluctuate in value.
ASSET MANAGEMENT RATIO
 The second group of ratios, the asset management
ratios, measures how effectively the firm is managing its
assets.
 These ratios are designed to answer this question: Does
the total amount of each type of asset as reported on
the balance sheet seem reasonable, too high, or too low
in view of current and projected sales levels?
 When they acquire assets, Allied and other companies
must borrow or obtain capital from other sources. If a
firm has too many assets, its cost of capital will be too
high, hence its profits will be depressed.
 On the other hand, if assets are too low, profitable sales
will be lost. Ratios that analyze the different types of
assets are described in this section.
 1. INVENTORY TURNOVER RATIO

 It is an efficiency/activity ratio which estimates the

number of times per period a business sales and replaces
its entire batch of inventories.

 Allieds inventory turn over of 4.9 times is much lower

than the industry average 9 times which suggests that,
the co. is holding excessive stock of inventory which is
unproductive (investment with zero rate of return).
 With such low turn over we must wonder whether the
firm is holding damaged or obsolete goods not actually
worth their stated value, since low inventory turn over
compared to the industry average and competitors
means poor inventories management.
 Limitation of this ratio is sales are stated at
market price while inventories are stated at cost
(different measurement unit) to have more
meaning full result. Therefore, it is better to use
cost of good sold instead of sales.
 Low turn over of inventory may be due to bad
buying , obsolete inventory and results in
increased inventory holding costs and is a danger
signal.
 High turn over is good but it must be carefully
interpreted as it may be due to buying in small
lots or selling quickly at low margin to realize
cash.
 2. DAYS SALES OUTSTANDING (DSO)
 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.
 It represents the average length of time that the firm must wait
after making a sale before receiving cash, which is the average
collection period.

 Allied has 46 days sales outstanding, well above the

36-day industry average:
 If the co. sales terms call for payment within 30 days,
so the fact that 45 DSO indicates that customers on
average are not paying their bills on time.
 The average collection period ratio measures the
quality of debtors since it indicates the rapidity or
slowness of their collectability.
 The shorter the average collection period, the better
the quality of debtors.
 The higher the Turnover Ratio and the shorter the
average collection period, the better the trade credit
management and the better the liquidity of debtors.
 That is, high Turnover Ratio and short collection
period imply prompt payment on the part of debtors.
 On the other hand, low Turnover Ratio and long
collection period reflects that payments by debtors
are delayed.
 3. FIXED ASSETS TURNOVER RATIO
 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:

Industry average =3.0 times

 Allied’s ratio of 3.0 times is equal to the industry
average, indicating that the firm is using its fixed
assets about as intensively as are other firms in its
industry.
 Therefore, allied seems to have about the right
amount of fixed assets in relation to other firms.
 A potential problem can exist when interpreting
the fixed assets the historical costs of the assets.
 Inflation has caused the current value of many
assets that were purchased in the past to be
seriously under stated.
 Therefore, if we were comparing an old firm that
had acquired many of its fixed assets years ago at
low prices with a new Company that had acquired
its fixed assets only recently we would probably
find that the old firm had the higher fixed assets
turn over ratio.
 4. TOTAL ASSETS TURNOVER RATIO
 The total assets turnover ratio, measures the turnover
of the entire firm’s assets indicates how efficiently
utilizing total assets. Higher turn over indicates better
activity and profitability.

Industry average =1.8 times.

 Allied’s ratio is somewhat below the industry average,
indicating that the company is not generating a sufficient
volume of business given its total assets investment.
 Sales should be increased, some assets should be
disposed of, or a combination of these steps should be
taken.
DEBT MANAGEMENT RATIO
 Short term creditors, such as, bankers, suppliers of raw
materials, etc., are interested with the firm's current debt
paying ability.
 This will be known by liquidity ratios. On the other hand,
long term creditors, like bond holders, financial institutions,
etc., are more concerned with firm's long term financial
strength.
 In fact, a firm should be strong both in the short run and in
the long run.
 To judge the long run financial position of the firm, leverage,
or capital structure ratios are calculated. These ratios show
the mix of funds provided by owners and creditors.
 As a general rule, there should be an appropriate mix of
funds in the capital structure of a firm. The manner in which
assets have been financed has a number of implications:
1. Debt is more risky from the firm’s point of view: The firm has
legal obligation to pay to its bond holders at stipulated time
interest and principal, irrespective of the year's performance.
If it fails, an action may be taken on firm's assets.
2. Highly burdened or highly geared firms will find difficulty in
raising additional funds from creditors and owners in the
future. Always the owners' equity is assumed as margin of
safety for the investment by creditors. If the base is thin, the
creditor's risk will be high.
 Leverage ratios are many, but all these ratios indicate more or
less the same thing: the extent of which the firm has relied on
debt in financing its assets.
 It may be calculated from balance sheet items to determine
the proportion of debt in total financing or from income
statement items to know the extent to which operating profits
are sufficient to cover fixed charges.
Some of these ratios are:
1. FINANCIAL LEVERAGE
 The extent to which a firm uses debt financing, or financial leverage, has three
important implications:
a. By raising funds through debt, stockholders can maintain control of a firm while
limiting their investment.
b. Creditors look to the equity, or owner-supplied funds, to provide a margin of
safety, so the higher the proportion of the total capital that was provided by
stockholders, the less the risk faced by creditors.
c. If the firm earns more on investments financed with borrowed funds than it pays
in interest, the return on the owners’ capital is magnified, or “leveraged.”
 To understand better how financial leverage affects risk and return, consider the
following . Here we analyze two companies that are identical except for the way
they are financed.
 Firm U (for “unleveraged”) has no debt, whereas Firm L (for “leveraged”) is
financed with half equity and half debt that costs 15 percent.
 Both companies have $100 of assets and $100 of sales, and their expected
operating income (also called earnings before interest and taxes, or EBIT) is $30.
Thus, both firms expect to earn $30, before taxes, on their assets. Of course, things
could turn out badly, in which case EBIT would be lower.
Table 1. Effects of Financial Leverage on
Stockholders’ Returns Firm U (Unleveraged)
Current Assets $50 Debt $0

Fixed Assets 50 Common Equity $100

Total Assets $100 Total liabilities and equity $100

Expected conditions Bad conditions

Sales $100.00 $82.50

Operating costs 70.00 80.00

Operating income (EBIT) $30.00 2.50

Interest 0.00 0.00

Earnings before taxes (EBT) $30.00 2.50

Taxes (40%) 12.00 1.00

Net income (NI) 18.00 1.50

ROE =NI/ Common Equity= NI/100 18% 1.5%

Firm L (Leveraged)
Current Assets $50 Debt $50
Fixed Assets 50 Common Equity $50
Total Assets $100 Total liabilities and equity $100

Expected conditions Bad conditions

Sales $100.00 $82.50

Operating costs 70.00 80.00
Operating income (EBIT) $30.00 2.50
Interest (15%) 7.50 7.5
Earnings before taxes (EBT) $22.5 ($5.00)
Taxes (40%) 9.00 (2.00)
Net income (NI) 13.50 (3.00)
ROE= NI/Common equity =NI/50 27.00% (6.00%)
2. DEBT RATIO
 The ratio of total debt to total assets, generally called the debt ratio,
measures the percentage of funds provided by creditors:

 Creditors prefer low debt ratios because the lower the ratio, the
greater the cushion against creditors’ losses in the event of liquidation.
Stockholders, on the other hand, may want more leverage because it
magnifies expected earnings.
 Allied’s debt ratio is 53.2 percent, which means that its creditors have
supplied more than half the total financing.
 Nevertheless, the fact that Allied’s debt ratio exceeds the industry
average raises a red flag and may make it costly for Allied to borrow
additional funds without first raising more equity capital.
 Creditors may be reluctant to lend the firm more money, and
management would probably be subjecting the firm to the risk of
bankruptcy if it sought to increase the debt ratio any further by
borrowing additional funds.
3. TIMES-INTEREST-EARNED (TIE) RATIO
 It measures the extent to which a firm’s earnings can decline
before the firm cannot make its interest payments.

 The TIE ratio measures the extent to which operating income can
decline before the firm is unable to meet its annual interest costs.
 Failure to meet this obligation can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy. Note that earnings
before interest and taxes, rather than net income, are used in the
numerator. Because interest is paid with pre-tax dollars, the firm’s
ability to pay current interest is not affected by taxes.
 Thus, the TIE ratio reinforces the conclusion from our analysis of
the debt ratio that Allied would face difficulties if it attempted to
borrow additional funds.
 If Debt increases TIE ratio Falls.
4. EBITDA COVERAGE RATIO
 The TIE ratio is useful for assessing a company’s ability to
meet interest charges on its debt, but this ratio has two
shortcomings:
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.
1. EBIT does not represent all the cash flow available to
service debt, especially if a firm has high depreciation
and/or amortization charges.
 To account for these deficiencies, bankers and others
have developed the EBITDA coverage ratio, expressed as
follows:
 if operating income declines, the coverage will
fall, and operating income certainly can decline.
 Moreover, Allied’s ratio is well below the industry
average, so again, the company seems to have a
relatively high level of debt.
 EBITDA coverage ratio is most useful for relatively
short term lenders, long term bond holders
focuses on TIE ratio.
PROFITABILITY RATIOS
 Profitability is the net result of a number of policies
and decisions.
 Margins and profit ratios provide information on the
profitability of a company and the efficiency of the
company.
 Margin is a portion of revenues that is a profit,
where as return is a comparison of a profit with the
investment necessary to generate the profit.
 The ratios examined thus far provide useful clues as to
the effectiveness of a firm’s operations, but the
profitability ratios show the combined effects of
liquidity, asset management, and debt on operating
results.
1. PROFIT MARGIN ON SALES
 The profit margin on sales, calculated by dividing
net income by sales, gives the profit per dollar of
sales:

 Allied’s low profit margin is also a result of its

heavy use of debt. Recall that net income is
income after interest.
 Therefore, if two firms have identical operations in
the sense that their sales, operating costs, and
EBIT are the same, but if one firm uses more debt
than the other, it will have higher interest charges.
 Those interest charges will pull net income down,
and since sales are constant, the result will be a
relatively low profit margin.
 In such a case, the low profit margin would not
indicate an operating problem, just a difference in
financing strategies.
 Thus, the firm with the low profit margin might
end up with a higher rate of return on its
stockholders’ investment due to its use of
financial leverage.
2. BASIC EARNING POWER (BEP)
 The basic earning power (BEP) ratio used to determine
how efficiently a firm uses its assets to generate income

 This ratio also shows the raw earning power of the

firm’s assets, before the influence of taxes and
leverage, and it is useful for comparing firms with
different tax situations and different degrees of
financial leverage.
 Because of its low turnover ratios and low profit
margin on sales, Allied is not earning as high a return
on its assets as is the average food-processing company.
3. RETURN ON TOTAL ASSETS
 The ratio of net income to total assets measures the
return on total assets (ROA) after interest and taxes:

 Allied’s 5.7 percent return is well below the 9 percent

average for the industry. This low return results from
a. The company’s low basic earning power plus
b. High interest costs resulting from its above-average use
of debt, both of which cause its net income to be
relatively low.
 The higher ratio is more favorable to investors, since it
shows that the co. is more effectively managing its
assets to produce greater amount of net income.
4. RETURN ON COMMON EQUITY
 Ultimately, the most important, or “bottom line,”
accounting ratio is the ratio of net income to
common equity, which measures the return on
common equity (ROE):

 Allied’s 12.7 percent return is below the 15 percent

industry average, but not as far below as the return
on total assets.
 This somewhat better result is due to the
company’s greater use of debt, a point that is
analyzed in detail later in the chapter.