Chapter Two Financial Analysis and Planning Part One-Financial Analysis 2.1
Chapter Two Financial Analysis and Planning Part One-Financial Analysis 2.1
Chapter Two Financial Analysis and Planning Part One-Financial Analysis 2.1
CHAPTER TWO
FINANCIAL ANALYSIS AND PLANNING
Part One- FINANCIAL ANALYSIS
2.1. Introduction
In the previous accounting courses you have learned that financial statements report both on
a firm’s financial position and financial performance. The four basic financial statements
present about different aspects of financial conditions, operating results, and cash flows.
The balance sheet shows a firm’s assets and claims against assets at a particular point in
time. The income statement, on its part, reports the results of the firm’s operations over a
period of time. Similarly, the statements of retained earnings and cash flows show the
change in retained earnings and cash between two balance sheet dates.
However, financial statements by themselves do not give a complete picture about a
company’s financial condition, operating results, and cash flows. Neither can a real value of
financial statements could be derived in themselves alone. Therefore, to predict the future
and to help anticipate future conditions, financial statements should be analyzed further.
This analysis helps to identify current strengths and weakness of the firm. It facilitates
planning the future, and helps to control the firm’s financial activities better. To have all
this benefits, however, a finance person should perform a financial analysis.
2.2. Meaning and objectives of financial analysis
The analysis of financial statements is designed to reveal the relative strengths and weakness of
a firm. This could be achieved by comparing the analysis with other companies in the same
industry, and by showing whether the firm’s position has been improving or deteriorating over
time. Financial analysis helps users obtain a better understanding of he firm’s financial
conditions and performance. It also helps users understand the numbers presented in the
financial statements and serve as a basis for financial decisions.
2.3.Tools and Techniques of Financial Analysis
A number of methods can be used in order to get a better understanding about a firm’s
financial status and operating results. The most frequently used techniques in analyzing
financial statements are:
i) Preparation. The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial
statement analysis focuses primarily on the balance sheet and the income statement.
However, data from statements of retained earnings and cash flows may also be used.
So, preparation is simply objective setting and data collection.
ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.
iii) Evaluation and Interpretation. Involves the determination fo the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm’s
performance and financial condition. This is the most important of all the three stages of
financial analysis.
Although we have briefly seen what is meant by the three most common types of financial
analysis, our focus on this material will be on ratio analysis. So in the section that follows, we
will discuss major types of financial ratios with illustrative examples.
2.5. Types of Financial Ratios
There are several key ratios that reveal about the financial strengths and weaknesses of a
firm. We will look at five categories of ratios, each measuring about a particular aspect of the
firm’s financial condition and performance.
2.5.1. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure
a firm’s ability to pay its current liabilities as they mature by using current assets. There are
two commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
inventories and accounts receivable, or a firm is not making full use of its current
borrowing capacity.
ii) Quick ratio (Acid – test ratio)- measures the short-term liquidity by removing the least
liquid current assets such as inventories. Inventories are removed because they are not readily
or easily convertible into cash. Thus, the quick ratio measures a firm’s ability to pay its
current liabilities by using its most liquid assets into cash. Quick ratio = Current assets –
Inventory
Current liabilities
Zebra’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term
obligations, and the higher the quick ratio the more liquid the firm’s position. But the quick
ratio is more detailed and penetrating test of a firm’s liquidity position as it considers only
the quick asset. The current ratio, on the other hand, is a crude measure of the firm’s
liquidity position as it takes into account all current assets without distinction.
2.5.2. Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These
ratios include turnover ratios because they show how rapidly assets are being converted
(turned over) into sales or cost of goods sold. Activity ratios are also called asset
management ratios, or asset utilization ratios, or efficiency ratios. Generally, high turnover
ratios are associated with good asset management and low turnover ratios with poor asset
management. Activity ratios include:
i) Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is
being managed. It indicates how many times or how rapidly accounts receivable are
converted into cash during a year.
Accounts receivable turnover = Net sales
Accounts receivable
Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or in adequate cash
collection efforts.
There are alternate ways to calculate accounts receivable value like average receivables and
ending receivables. Though many analysts prefer the first, in our case we have used the ending
balances. In computing the accounts receivable turnover ratio, if available, only credit sales
should be used in the numerator as accounts receivable arises only from credit sales.
ii) Days sales outstanding (DSO) – also called average collection period. It seeks to measure
the average number of days it takes for a firm to collect its accounts receivable. In other
words, it indicates how many days a firm’s sales are outstanding in accounts receivable.
Days sales outstanding = 365 days
Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days
9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39
days. If Zebra’s credit period is less than 39 days, some corrective actions should be taken
to improve the collection period.
The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover – measures how many times per year the inventory level is sold
(turned over).
Inventory turnover = Cost of goods sold
Inventory
For Zebra Company (2002) = Br. 159,600 = 6.41times
Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can apply
sales. In general, a high inventory turnover is better than a low turnover. But abnormally
high inventory turnover might result from very low level of inventory. This indicates that
stock outs will occur and sales have been very low. A very low turnover, on the other hand,
results from excessive inventory levels, presence of inferior quality, damaged or obsolete
inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows
how many Birr of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales___
Net fixed assets
A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources.
Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more the
firm’s financial risk.
ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.
Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is
available to meet its interest obligations. However, earnings before interest and taxes are an
income concept and not a direct measure of cash. Hence, this ratio provides only an indirect
measure of the firm’s ability to meet its interest payments.
iii) Fixed charges coverage – measures the ability of firms to meet all fixed obligations
rather than interest payments alone. Fixed payment obligations include loan interest and
principal, lease payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and
taxes Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700
Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company
are safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is
desirable. The fixed charges coverage ratio is required because failure of the firm to meet
any financial obligation will endanger the position of a firm.
2.5.4. Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, total
assets, and owner’s equity. The following ratios are among the many measures of a firm’s
profitability.
i) Profit Margin – shows the percentage of each birr of net sales remaining after deducting
all expenses.
Profit margin = Net income
Net Sales
Zebra’s profit margin = Br. 3,900 = 2%
Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing strategy
as well as the amount of all costs and expenses of a firm.
ii) Return on investment (assets) – measures how profitably a firm has used its investment
in total assets.
Return on investment = Net income
Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 %
Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on
investments made by them.
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s
equity We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment
1 – Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance. On
the contrary, a low ratio may indicate greater owner’s capital contribution as compared to
debt contribution. Generally, the higher the return on equity, the better offs the owners.
2.5.5. Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning.
They include:
i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s
common stock outstanding. It does not reflect how much is paid as dividends.
Earnings per share = Net income – Preferred stock dividend
Number of common shares outstanding
Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000 Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on
each share of its common stock outstanding.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For
example, the inventory turnover ratio for a stationery materials selling company will be
different at different time periods of a year.
Exercises
1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br. 200,000,
and long-term bond of Br. 225,000. If the total stockholders’ equity of the company
amounts to Br. 750,000, what is the debt ratio?
2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between inventories
and current liabilities for this firm?
3. ABC company’s return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The firm’s
annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%.
What is XYZ Company’s times interest earned ratio?
5. Complete the balance sheet and sales information in the following table for Abay
Transport Ltd. Using the financial ratios that follow.
BALANCE SHEET
_______________________________________________________________________________________________________
Cash Accounts payable
Accounts receivable Long-term debt 120,000
Inventories Common stock
Fixed assets ________ Retained earnings 195,000
Total assets Br. 1,000,000 Total liabilities and equity _______
Sales Cost of goods sold
Debt ratio: 50% Days sales outstanding: 36days
Quick ratio: 0.80X Cost of goods sold/sales: 75%
Total assets turnover: 1.5X Inventory turnover: 5X
A lack of effective planning is a commonly cited reason for financial distress and failure.
Planning is a means of systematically thinking about the future and anticipating possible
problems before they arrive. Financial planning forces the corporation to think about goals.
Financial planning formulates the way in which financial goals are to be achieved. A
financial plan is thus a statement of what is to be done in the future.
Every of resource allocation decision embodies a forecast of future. These forecasts mainly
fall under two broader classifications, namely, short run and long run forecasts. Short run
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Financial Management-I [CHAPTER 2]
forecasts time span coverage is usually one year or less while long term forecasts are seeing
several years into the future.
Financial planning, usually the term is related to long term, indicates a firm’s growth,
performance, investment and requirement of funds (which includes Internal and External
Financing ) during a given period of time, usually three to five years.
Most financial planning models require the user to specify some assumptions about the
future. Based on those assumptions, the model generates predicted values for a large
number of variables. Almost all financial plans require an externally supplied sales forecast.
A financial plan will have a forecasted balance sheet, income statement, and statement of
cash flows. These are called pro forma statements, which are the output from the financial
planning model.
A financial plan is a serious of continuous actions or process which can be broken down
into the following basic ingredients:
1. Forecast sales
In order to develop financial plan, we will start with a forecast of what drives much of our
financial activity; namely sales. Therefore, the first forecast we will prepare is the Sales
Forecast. In order to estimate sales, we will look at past sales histories and various factors
that influence sales. For example, marketing research may reveal that future sales are
expected to stabilize. Maybe we cannot meet growing sales because of limited production
capacities or maybe there will be a general economic slowdown resulting in falling sales.
Considerations also must be given to marketing efforts to be done, credit policy etc.
Therefore, we need to look at several factors in arriving at our sales forecast.
After we have collected and analyzed all of the relevant information, we can estimate sales
volumes for the planning period. It is very important that we arrive at a good estimate since
this estimate will be used for several other estimates in our budgets. The Sales Forecast has
to take into account what we expect to sell at what sales price. Most of the time it will be
given as the growth rate in sales rather than explicit sales figure.
2. Prepare a pro forma statements
These statements then serve as means of measuring the effect of operating plans on
projected profits and other financial ratios. It also serves as a means of standard from which
deviations are to be calculated for control purpose. The basic statements usually prepared
are: forecasted balance sheet, income statement and statement of cash flow.
Pro forma F/S simply means the forecast or estimate of what the statement will be in the
future, such as the Income Statement for given future months or the coming year, and the
balance sheet at the end of those periods.
1. The Cash Forecast/ Cash Budget
The cash forecast is the estimate of what will happen to the firm's cash account as a result
of planned activities. It uses to forecast the cash inflows from operations and non-operating
activities and the uses of cash for these purposes. It is, simply, a forecast of a firm's cash
inflows and outflows over a designated planning period. It helps identify periods of cash
surpluses, as well as periods during which additional financing will be needed. The
preparation of cash budget is divided into four steps:
1. Forecasting sales
2. Estimating cash inflows
3. Estimating cash outflows
4. Estimating end of month cash and loan balances
Sales forecast: -Estimates of cash inflows and outflows are based primarily on sales
forecasts. This sales forecast could be made using either internally or externally obtained
information. Frequently, the sales forecast will be given as the growth rate in sales rather
than an explicit sales figure. These two approaches are essentially the same because we can
calculate projected sales once we know the growth rate.
The cash inflow section of the cash budget includes two types of cash inflows:
1. Receipt on cash and credit sales; and
2. Other cash inflows not tied directly to sales.
Each type of cash inflow is computed separately. Cash sales occur when payment by check
or currency is made at the time of purchase. These sales are recorded as cash inflow in the
month when the sales are made. The accounts receivable generated from credit sales are
recorded as cash inflows in the months when the receivables are collected.
In addition to cash inflows generated from sales, other cash inflows can occur during the
planning period. Examples of cash inflows not directly related to sales include tax refunds;
proceed from sale of marketable securities, and proceeds from the sale of other assets.
The cash outflow portion of the cash budget includes five types of payments:
1. Payments for purchases
2. Payments for salaries and wages
3. Payments for other operating costs
4. tax payments
5. Other payments.
Each type of payment is estimated separately.
Payments for purchases:- purchases are often made on credit basis, thus creating accounts
payable. Purchase payments are recorded as cash outflows in the months when payments are
made by cash or check. When estimating purchase payments on the basis of sales forecast, it is
necessary to estimate the percentage that purchases are contained in each dollar of sale.
Previous year income statements can be a good first estimate of this. This is done by taking the
purchases contained in the cost of goods sold and dividing it by net sales. This percentage is
then multiplied by the sales forecast in order to estimate the required purchase payment.
Payments for salaries and wages:- these are recognized as cash out flows in the month
they are paid to employees. A firm typically incurs a minimum amount of payroll expense
that is independent of sales volume. Once the sales volume exceeds a minimum amount,
wages and salaries tend to increase proportionally with sales.
Other payments: - there are several types of cash outflows that are not directly related to
sales. These include dividend payments, payments for the purchase of real estate, property,
plant and equipment, and the payments of principal and interest on long term debt.
Computing cash and loan balances: - to compute cash balances, total cash inflows and
outflows are combined with (1) the estimate of cash on hand at the start of the period and (2)
the minimum cash balance desired at the end of each month. Setting minimum cash balance is
one way of allowing for the forecasting errors that occur in the cash budget estimate.
To compute loan balances, the loan and repayment schedule for each month must
contain the following:
1. The amount borrowed:- this will be determined by comparing the net cash available
with the minimum cash balance required. If the net cash is more than the minimum
amount no loan is needed. On the other hand if the net cash is lower than the
minimum cash balance additional financing (loan) is needed.
2. The interest cost: this will be included in the cash budget in the month it will be paid.
3. The maximum loan size- the maximum value of unpaid principal and interest that
occurs in each month. It is computed by adding the following items:(a) the amount
borrowed during the month (b) the loan interest (c)the end of month loan from the
previous month.
4. The amount of loan repaid during the month. Loan will be repaid if there is
positive net cash that exceeded the minimum cash balance for the month.
5. The end of month loan size
To prepare a pro forma Income Statement using the percent of sales method, the following
information is needed:
1. Sales forecast for the year in question
2. Identification of Those Income Statement items that vary proportionately with sales
3. Estimates for those items that do not vary with sales; and
4. The dividend policy for the year in question
A. Economic of scale: it is when a firm does have advantage over size. In this cases then
relationship between items would become non-linear.
B. Lumpy assets: These are productive assets, which increase or decrease in their production
capacity in large quantum and therefore resulting non-linear relationship.
C. Non-optimal starting ratios: this is an interval in which a certain level of increase in sales is
possible without any increase in the corresponding inputs because the previously
forecasted sales level is not reached.
D. Excess capacity adjustment: this is adjusting for unutilized or untapped assets at hand to the
projected amount of sales