Baf4101 Financial Statement and Analysis

DEPARTMENT OF FINANCE AND ACCOUNTING
P.O. Box 342 THIKA, KENYA
Email: [email protected]
Web: www.mku.ac.ke
Course code: BAF4101
COURSE TITLE: FINANCIAL STATEMENT ANALYSIS
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COURSE OUTLINE
MOUNT KENYA UNIVERSITY

SCHOOL OF BUSINESS AND SOCIAL SCIENCES
DEPARTMENT OF FINANCE AND ACOUNTING
Course Objectives and Topics:

Financial reporting systems serve many purposes. They are used to inform both current
and potential investors. The accounting numbers reported in the financial statements are
used in contracting between shareholders, managers, creditors and others. Regulators use
financial reports to make assessments of competitive conditions and financial strength.
At various times, management makes financial reporting and/or transaction design
decisions to obtain some objectives with these various user groups. In this course, we will
examine and analyze the financial accounting model in order to obtain a better
understanding of these decisions and their telltale signs in the financial reports. These
skills will enable us to make assessments of the “quality of reported earnings” and to
make comparative assessments of performance and risk.
The Financial Statement Analysis Course provides many essential tools and concepts for
students contemplating careers in corporate finance, auditing, investment banking, and
equity and fixed income research. The material is covered in a rigorous, analytical
manner.
LESSON 1:
 Definition
 Features of Financial Analysis
 Purpose of Analysis of financial statements
 Procedure of Financial Statement Analysis
 Importance of Financial Statement Analysis:
LESSON 2 and 3
 Users of financial statements
 The need for Financial statements for various users
 Costs associated with disclosures
LESSON 4 and 5
 Tools for financial statement analysis
 Vertical analysis
 Horizontal analysis
LESSON 6 and 7
 Definition
 Objectives of Ratios:
 Pre-Requisites to Ratio Analysis:
 Classification of Ratios
 Calculations
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 Limitations of Rations
 Horizontal analysis
LESSON 8 and 9
 Define financial forecasting

 Importance of financial forecasting
 Methods/Techniques of Financial Forecasting
LESSON10 and11
 Definition
 Effects of Financial Distress
 Indicators of a financially distressed firm
 Market efficiency
 levels and types of market efficiency
 Bankruptcy
LESSON 12: Revision
Course Grading:
Your course grade will be determined as follows:
CAT: 20%
Assignment: 10%
Final Exam: 70 %
References
The Analysis and Use of Financial Statements (3rd edition) by White, Sondi & Fried
(Wiley 2003)
Financial Reporting and Analysis (4th edition) by Revsine, Collins, Johnson, and
Mittelstaedt (McGraw-Hill Irwin 2009)
Financial Statement Analysis & Valuation (2nd edition) by Easton, McAnally, Fairfield,
and Zhang (Cambridge Business Publishers 2009)
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Contents
CHAPTER ONE: INTRODUCTION TO FINANCIAL ANALYSIS ........................................................... 7
1.1 Introduction................................................................................................................................ 7
1.2 Definition.................................................................................................................................... 8
1.3 Features of Financial Analysis .................................................................................................21
1.4 Purpose of Analysis of financial statements ............................................................................21
1.5 Procedure of Financial Statement Analysis..............................................................................21
1.6 Advantages of Financial Statement Analysis:...........................................................................23
1.7 Users of Accounting Information .............................................................................................23
Review Questions ...........................................................................................................................26
TOPIC TWO: BUSINESS ANALYSIS ............................................................................................ 16
2.1 Introduction ..............................................................................................................................16
2.2 Economic Environment ............................................................................................................16
2.3 Industry Analysis ......................................................................................................................18
2.4 Competition..............................................................................................................................18
2.5 Company management ............................................................................................................18
CHAPTER THREE: ANALYSIS OF SHORT TERM LIQUIDITY ........................................................ 20
3.1 Introduction..............................................................................................................................20
3.2Working capital .........................................................................................................................20
3.3 Current Ratio ............................................................................................................................22
3.4 Cash Ratios ...............................................................................................................................24
3.5 Debtor’s turnover ratios ...........................................................................................................24
3.6 Inventory turnover ...................................................................................................................26
3.7 Overview of Cash flow..............................................................................................................27
Review Questions ...........................................................................................................................31

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CHAPTER FOUR: FINANCIAL FORECASTING ............................................................................... 32
4.1 Introduction..............................................................................................................................32
4.2 Methods/Techniques of Financial Forecasting .......................................................................33
Revision Questions .........................................................................................................................41
CHAPTER FIVE: CAPITAL STRUCTURE ANALYSIS ........................................................................ 44
5.1 Introduction ........................................................................................................................44
5.2 Effect of capital structure on long term solvency ....................................................................45
5.3 Financial Distress ......................................................................................................................45
5 . 4 I n d i c a t o r s of Financial distress: ........................................................................................49
5.5Measues of Long term Solvency ...............................................................................................50
5.6 Existence of optimum capital structure ..................................................................................57
5.7 Options in time of financial distress. ..................................................................................60
5.8 Settlements without going through formal bankruptcy .......................................................61
5.9 Managing Financial Distress................................................................................................65
Review questions ...........................................................................................................................72
CHAPTER SIX: ANALYSIS OF OPERATIONS ............................................................................... 76
6.1 Introduction..............................................................................................................................76
6.2 Income statement Analysis ......................................................................................................76
6.3 Analysis of sales and revenues .................................................................................................76
6.4 Analysis of Gross Profit.............................................................................................................77
6.5 Break Even Analysis ..................................................................................................................77
6.6 Expense Analysis ......................................................................................................................80
CHAPTER SEVEN: ANALYSIS OF INVESTMENTS ......................................................................... 82
7.0 Introduction..............................................................................................................................82
7.1 Non quantitative Analysis ........................................................................................................82
7.2 Quantitative Analysis................................................................................................................82

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7.3 Return On Investments (ROI) ...................................................................................................83
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CHAPTER ONE: INTRODUCTION TO FINANCIAL ANALYSIS
Learning Outcome
At the end of this topic, the learner should be able

a) Define financial analysis and Financial statement analysis
b) Identify users of financial statements and their needs
c) Describe the Features of Financial Analysis
d) Determine the Purpose of Analysis of financial statements
e) Outline the Procedure of Financial Statement Analysis
f) Appreciate the importance of Financial Statement Analysis:
1.1 Introduction
Financial statement analysis is the process through which users of financial information
manipulate the presented financial reports for the purpose of extracting information
necessary in decision making. Ordinarily financial information is presented to stake
holders in a standardized manner in line with the recommended reporting standards. This
information is meant for a big group of users and as such may not be able to focus on the
needs of specific categories of users. For this reason further analysis may be necessary to
be able to bring out specific aspects of the financial reports necessary for decision making.
In order to make rational decisions in keeping with objectives of the firm the stakeholders
especially the managers must have at their disposal certain analytical tools. These tools of
financial analysis are important as they give a feedback as to the contents of the financial
statements. These tools are also used by outside suppliers of capital, creditors, investors
and by the firm itself. The firm uses financial analysis not only for internal controls but
also for a better understanding of what capital suppliers seeks in the way of financial
conditions and performance of it.
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1.2 Definition
Financial analysis is a process by which one manipulates the company’s financial
performances by comparing the elements in the balance sheet and those in the profit and
loss account (P&L). This is so because balance sheet elements are usually responsible for
those to be found in the P&L i.e. assets shown in the balance sheet are responsible for
sales, revenue and expenses to be found in the P&L. Financial statement analysis is
defined as the process of identifying financial strengths and weaknesses of the firm by
properly establishing relationship between the items of the balance sheet and the profit
and loss account. Financial statement analysis (or financial analysis) is the process of
understanding the risk and profitability of a firm (business, sub-business or project)
through analysis of reported financial information, particularly annual and quarterly
reports.
Financial statement analysis consists of
1) Reformulating reported financial statements,
2) Analysis and adjustments of measurement errors, and
3) Financial ratio analysis on the basis of reformulated and adjusted financial statements.
The two first steps are often dropped in practice, meaning that financial ratios are just
calculated on the basis of the reported numbers, perhaps with some adjustments. Financial
statement analysis is the foundation for evaluating and pricing credit risk and for doing
fundamental company valuation.
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There are various methods or techniques that are used in analyzing financial statements,
such as comparative statements, schedule of changes in working capital, common size
percentages, funds analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for
decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these statements alone.
However, the information provided in the financial statements is of immense use in
making decisions through analysis and interpretation of financial statements.
By performing financial analysis the analyst seeks to give the user of that information a
better view of the organization especially creating relationships between various elements
of the financial statements so as to bring out the true picture of how the organization is.
The type of analysis to be done depends mainly on the decision at hand but generally the
main types of analysis that can be done in an organization include
a) Common size analysis – This is a type of analysis which seeks to establish the
proportion of each element in a given financial statement or a section of financial
statement. The advantage of this analysis is that it presents clearly the relative
magnitude of each of these elements and this can be compared easily with similar
data from related companies or even over a period of time. Depending on the
relative proportion of the different elements then a decision can be made on how
to manage the different elements or to manage the proportions as they are. In
addition after establishing the relative proportions then it can assist in projections
and preparation of proforma statements.
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Example of Horizontal or Trend Analysis:
Balance Sheet:
Comparative Balance Sheet
December 31, 2002, and 2001 (dollars in thousands)
Increase (Decrease)
2002 2001 Amount Percent
Assets
Current Assets:
Cash Kshs1,200 Kshs2,350 Kshs(1,150)*(48.9)%
Accounts receivable 6,000 4,000 2000 50%
Inventory 8,000 10,000 (2000) (20.0)%
Prepaid Expenses 300 120 180 150.0%
---------- ----------- ---------- ----------
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Total current assets Kshs15,500Kshs16,470 (970) (5.9)%
----------- ----------- ---------- ---------
Property and equipment:
Land 4,000 4,000 0 0%
Building 12,000 8,500 3,500 41.2%
----------- ----------- ----------
Total property and equipment 16,000 12,500 3,500 28%
---------- ----------- ---------- ---------
Total assets 31,500 28,970 2,530 8.7%
====== ====== ====== ======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payables Kshs5,800 Kshs4,000 1800 45%
Accrued payables 900 400 500 125%
Notes payables 300 600 (300) (50%)
---------- ---------- ----------- ---------
Total current liabilities 7,000 5,000 2,000 40%
---------- ---------- ---------- -----------
Long term liabilities:
Bonds payable 8% 7,500 8,000 (500) (6.3)%
---------- ---------- ---------- ----------
Total long term liabilities 7,500 8,000 (500) 6.3%
---------- ---------- ---------- ----------
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Total Liabilities Kshs14,50013,000 1,500 (11.5)%
Stock holders equity:
Preferred stock, 100 par, 6%,Kshs100

Kshs2,000 Kshs2,000 0 0%
liquidation value
Common stock,Kshs12 par 6,000 6,000 0 0%
Additional paid in capital 1,000 1,000 0 0%
---------- ---------- --------- --------
Total paid in capital 9,000 9,000 0 0%
Retained earnings 8,000 6,970 1,030 14.8%
---------- ---------- ---------- ----------
Total stockholders' equity 17,000 15,970 1,030 6.4%
---------- ---------- ---------- ---------
Total liabilities and stockholders' equity Kshs31,500Kshs28,970 Kshs2,530 8.7%
===== ====== ====== ======
*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001
become the base figure for expressing these changes in percentage form. For example,
cash decreased by figuresKshs1,150 between 2001 and 2002. This decrease expressed in
percentage form is computed as follows:
Kshs1,150 ÷Kshs2,350 = 48.9%
Other percentage figures in this example are computed by the same formula.
Income Statement:
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Comparative income statement and reconciliation of retained earnings
For the year ended December 31, 2002, and 2001
(dollars in thousands)
Increase (Decrease)
2002 2001 Amount Percent
Sales Kshs52,000Kshs48,000Kshs4,000 8.3%
Cost of goods sold 36,000 31,500 4,500 14.3%
------------ ------------ ------------ -----------
Gross margin 16,000 16,500 (500) (3.0)%
------------ ------------ ------------ ------------
Operating expenses:
Selling expenses 7,000 6,500 500 7.7%
Administrative expense 5,860 6,100 (240) (3.9)%
------------ ------------ ------------ ------------
Total operating expenses 12,860 12,600 260 2.1%
------------ ------------ ------------ ------------
Net operating income 3,140 3,900 (760) (19.5)%
Interest expense 640 700 (60) (8.6)%
------------ ------------ ------------ ------------
Net income before taxes 2,500 3,200 (700) (21.9)%
Less income taxes (30%) 750 960 (210) (21.9)%
------------ ------------ ------------ ------------
Net income 1,750 2,240 Kshs (490) 21.9%
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======
Dividends to preferred stockholders,Kshs6
per share (see balance sheet above) 120 120
------------ ------------
Net income remaining for common1,630 2,120
stockholders
Dividend to common600 600
stockholders,Kshs1.20 per share
------------ ------------
Net income added to retained earnings 1,030 1,520
Retained earnings, beginning of year 6,970 5,450
------------ ------------
Retained earnings, end of year Kshs 8,000 Kshs 6,970
======= =======
Horizontal analysis of financial statements can also be carried out by computing trend
percentages.
b) Trend analysis – Trend is the movement over a period of time and trend analysis is
the establishment of the movement of the various elements of financial
statements over a period of time. Trend is usually determined by adopting a base
year and then calculating the movement in the subsequent years. The information
so calculated can then be plotted in a graphical format for the purpose of
presenting a visual presentation.
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Illustration a)
The following is a summarized profit statement for a company in the region
2008 2009 2010 2008 2009 2010?
Turnover 24,000,000 22,800,000 22,000,000 100% 95%
COS 17,800,000 15,200,00 14,600,000 100% 85.4%
GP 6,200,000 7,600,000 7,400,000 100% 122.5%
Admin 480,000 390,000 290,000 100% 81.3%

EXP
Other Exp 240.000 196,000 220,000 100% 81.7%
EBIT 5,480,000 7,014,000 6,890,000 100% 130%
Illustration b)
2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
Sales 215% 200% 187% 172% 161% 148% 125% 112% 107% 101% 100%
Income 247% 243% 193% 205% 196% 178% 153% 135% 120% 107% 100%
The trend analysis is particularly striking when the data are plotted as
above.
c) Ratio Analysis- A ratio is a mathematical relationship between two variables. By

having those relationships established it becomes possible to make qualitative
judgment on the financial performance of an organization. It is important to note
that a ratio on its own may not be very helpful in decision making and so they need
to be used for comparison with key standards. These standards include the
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industry ratios i.e. average ratios in the industry, competitor ratios, past ratios ad
projected (proforma) ratios. Ratios can be categorized in to various categories
which include
i) Liquidity ratios – These are ratios that give an indication as to a company’s

ability to meet short term financial obligations as they fall due. These ratios
focus on the working capital items seeking to establish the extent of short
term liabilities and how well the current assets are able to cover them. They
include:
a) Current ratio = current assets/current liabilities. A ratio of 2:1 is

considered ideal.
b) Quick ratio- this ratio is borne out of the belief that the current assets
include assets like inventory which are not easy to convert to cash and
so it eliminates the inventory in the calculation hence the ratio is
calculated as
Quick ratio = (Current Assets- Inventory)/ current liabilities
c) Cash ratio – This is a ratio that considers only cash and cash equivalents
which are those highly liquid securities. It is calculated as
Cash ratio – (cash + cash equivalents)/current liabilities
ii) Leverage ratios – These are also referred to as the capital structure ratios
and are used to the long term company solvency and its ability to withstand
financial shocks. These ratios focus on the mix of the sources of long term
finances which are usually debt finance and equity finance. Care should be
taken to ensure there is a balance between the two key sources of finance
as each has its implications to an organization. A high proportion of debt
might place the company at risk especially during the lean times mainly
because debt repayment requires regular repayments despite the hardships
the company could be facing. In addition a highly leveraged company may
find it difficult to raise addition funds when needed. On the other hand a
prudent usage of debt can rapidly magnify the shareholders earnings. The
leverage ratios there for are also mainly used to show the risk associated
with a particular organization. The ratios include:
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a) Debt ratio – This is a ratio that seeks to establish the proportion of debt
out of the totals capital employed.
Debt ratio = Total debt/ capital employed
b) Debt equity ratio – this ratio compares the total debt with the share
holders funds. A high ratio will mean that the lenders have contributed
more to the assets hence it is considered a riskier organization.
Debt equity ratio = Total debt / net worth (share holders funds)
These two ratios represent the key ratios related to the capital structure
and the long term solvency of an organization. The key question on the
ratios relates to the treatment of preference shares which tend to have
characteristics of both debt and equity. The solution depends on the
objective of the ratio being calculated. When the ratio is intended to
show the impact of debt on the shareholders funds then preference
shares can be included in the calculation but if the intention is to show
the level of risk then preference share holders are deemed part of the
owners funds mainly because the risk associated with preference shares
is insignificant.
c) Interest coverage – this is a ratio that seeks to establish the

organization’s ability to meet interest repayments out of the earnings
and is calculated as
Interest coverage = EBIT/ Interest
The higher the proportion of coverage the safer the company. This ratio
however focuses only on the interest repayment hence may not be very
meaning full where the company is repaying both interest and principle.
iii) Activity Ratios – These ratios usually indicate the management performance
in utilizing the shareholders funds to generate profits. Hence the ratios
compare the sales generated to the assets in the organization. They
include:
a) Inventory turnover ratio = cost of sales/ average inventory
This ratio indicates the number of times that the company has
purchased inventory in any particular period. To determine the number
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of days that the company is holding inventory then it is determined as
follows
No of days = 360/ inventory turnover ratio
b) Debtors turnover ratios – This is a ratio that shows the number of times
that credit customers buy from the company in a particular period and
is calculated as
Debtors turnover = Net credit sales/ average debtors
The higher the number shows that debtors buy frequently from the
company which is also an indicator that the credit period is short. To
determine the number of days that the debtors hold company funds
then = 360/ debtors turnover ratio
The ratio so calculated should then be compared to the company credit

period as well as the industry ratios to give an indication on the
adequacy of the credit policy.
c) Assets turnover – This ratio indicates the efficiency of utilizing sales to

earn sales and is calculated as
Sales/ Total assets
The higher the ratio the more efficient the company is in utilizing the
assets
iv) Profitability ratios – These are ratios that seek to establish the extent of
conversion of sales into profits hence they are usually used as indicators on
the level of managerial efficiency. On the other hand profits can be used to
calculate ratios on the ability of the company to use the amounts invested
to earn a profit. These ratios include:
a) Gross profit margin – This is the proportion of the gross margin (profit)
compared to sales. It is used to show efficiency in the production
processes and can be compared to the industry average.
b) Net profit margin – This shows the net profit as a percentage of the
sales. This measures the efficiency in manufacturing, selling and
generally administering the company’s operations.
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c) Operating expenses ratio – This ratio indicates the proportion of
expenses on the sales of the company by comparing the operating
expense to the sales of the company.
d) Return on Investment (ROI) – this ratio shows the efficiency of utilizing

the invested funds to earn a profit. Usually it is calculated as the EBIT
divided by the capital employed ie EBIT/ Capital employed
(shareholders funds + debt)
e) Return on Equity (ROE) – This ratio measures the return attributable to

the owners of the company hence it is calculated as
Net profit/ net worth (share holders funds)
f) Earnings per Share (EPS) – This is a ratio that measures the return for
each share outstanding ie Profit after tax/ number of Out standing
shares
g) Dividend per share = Dividends declared/ no of outstanding shares.
h) Price earnings ratio – This is a ratio that compares the current price of
the share in the market with the return that the share is able to earn.
The smaller the ratio can indicate an undervalued share and vice versa.
P/E ratio = market price per share/ EPS
Limitations of Ratio analysis
Despite their importance in analyzing the performance of an organization it is important

to note that ratios have inherent limitations which one should have in mind when using
them. These include:
a) The ratios are based on the past of the company as they are based
on historical information. The company future conditions may not
be best reflected by its past
b) The ratios can only be meaningful when compared with a realistic

standard
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c) Ratios may not be useful in comparing between companies where
the companies are significantly different in size, and internal
structure
d) Differences in determination of variables making up the ratios
Yard Stick Used In Ratio Analysis
1. Past performance of the company

The company’s past performance (past ratio) is used to measure or gauge the
company’s performance and in particular the change in performance whether good
(favorable), better, same or even worse than the past. Such comparison is then used to
interpret the company’s performance bearing in mind the factors that influenced the
present and past performances.
2. Average industry ratios

These are useful as they indicate the average performance of various companies in a
given industry i.e. it gives the minimum performance of a number of companies in a
given industry. These ratios are useful in so far as to enable the analyst to make a
reasonable comparison of the company’s performance vis-à-vis other companies in the
same industry. However, for this yardstick to be useful the term average should include
those companies which are not extremely. I.e. very strong and very weak companies –
which should be excluded to arrive at industry average figures.
3. Ratio of successful companies

Useful if the company can get figures of competitors who are leading in the market so as
to enable it to gauge its performance against better performance. However this
information is difficult to obtain and sometimes it calls for private investigators e.g. Private
Eyes Ltd.
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4. Ratio of budgeted performance
These are compared with actual performance ratios and investigations are made of any
unfavorable variance which should be explained.
1.3 Features of Financial Analysis

 To present a complex data contained in the financial statement in simple and
understandable form.
 To classify the items contained in the financial statement in convenient and
rational groups.
 To make comparison between various groups to draw various conclusions.
1.4 Purpose of Analysis of financial statements

 To establish the earning capacity or profitability.
 To establish the solvency.
 To establish the financial strengths.
 To know the capability of payment of interest & dividends.
 To make comparative study with other firms.
 To know the trend of business.
 To know the efficiency of mgt.
 To provide useful information to mgt
1.5 Procedure of Financial Statement Analysis

The following procedure is adopted for the analysis and interpretation of financial
statements:-
 The analyst should acquaint himself with principles and principles of accounting
applied in preparing those statements.
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He should know the plans and policies of the managements that he may have a
bearing on the interpretation of the financial statements.
 The extent of analysis should be determined so that the sphere of work may be
decided. If the aim is find out e arning capacity of the enterprise then analysis
of income statement will be undertaken. On the other hand, if financial position is
to be studied then balance sheet analysis will be necessary.
 The financial data be given in statement should be recognized and rearranged. It
will involve the grouping similar data under same heads. Breaking down of
individual components of statement according to their nature. The data is reduced
to a standard form. A relationship is established among financial statements with
the help of tools & techniques of analysis such as ratios, trends, common size,
fund flow etc.
 The information is interpreted in a simple and understandable way. The
significance and utility of financial data is explained for help indecision making.
 The conclusions drawn from interpretation are presented to the management in
the form of reports.
Analyzing financial statements involves evaluating three characteristics of a company:
its liquidity, its profitability, and its insolvency. A short-term creditor, such as a bank, is
primarily interested in the ability of the borrower to pay obligations when they come due.
The liquidity of the borrower is extremely important in evaluating the safety of a loan.
Along-term creditor, such as a bondholder, however, looks to profitability and solvency
measures that indicate the company’s ability to survive over a long period of time. Long-
term creditors consider such measures as the amount of debt in the company’ capital
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structure and its ability to meet interest payments. Similarly, stockholders are interested
in the profitability and solvency of the company. They want to assess the likelihood
of dividends and the growth potential of the stock
1.6 Advantages of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is that
the investors get enough idea to decide about the investments of their funds in the
specific company. Secondly, regulatory authorities like International Accounting
Standards Board can ensure whether the company is following accounting standards or
not. Thirdly, financial statements analysis can help the government agencies to analyze
the taxation due to the company. Moreover, company can analyze its own performance
over the period of time through financial statements analysis.
1.7 Users of Accounting Information

This analysis is important to various parties with a financial stake in the company.
These include:
1. Shareholders – Actual owners are interested in the company’s both short and long
term survival. For this reason they will use ratio’s such as:
a) Profitability ratios – which seek to establish viability.
b) Dividend ratios – which seek to establish return to owners in form of
dividends. The common ratios include earning yield (E/Y), Dividend pay
out ratio (DPO), dividend yield, Price earning ratio, all of which will
measure return to owner.
2. Creditors (trade) – these are interested in the company‟ s ability to meet

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their short-term obligations as and when they fall due. For this reason they
will use ratios such as:
a) Liquidity ratio – a qualitative measure of company‟ s liquidity position
measured by acid test ratio.
b) Current ratio – which is a measure of company‟ s quantity of current assets
against current liabilities.
3. Long term lenders – These include finances through loans, mortgages and
debenture holders. These have both short and long term interest in the company and its
ability to pay not only interest on debt but also principal as and when it falls due. These
parties are interested in the following:
a) Liquidity ratios – used to assess short-term liability to meet current
obligations.
b) Profitability ratios – used to ascertain whether the company can pay its
principal back.
c) Gearing ratio – used to gauge the company‟ s risk in the investment.
d) Investment coverage ratio – shows the company‟ s safety as regards the
payment of interest to the lenders of the debt.
4. Directors and management of company – They will therefore be interest in:
a) Efficiency of the company in generating profits.
b) The company‟ s viability from the investor‟ s point of view and
the company‟ s ability to generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.
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5. Potential investors – these parties are interested in a company in total both on short
and long term basis in particular the company’s ability to generate acceptable
return on their money.
Therefore, they will use:

a) Dividend ratios
b) Return ratios
c) Gearing ratios
6. Government – The Government is interested mostly in utility companies (e.g.
KPLC, KPTC) and those that will provide public services – in this case the
government will be interested in their survival and thus ability to provide those
services. It may be interested in taxation derived from these companies which is
used for development. Government may also be interested in employment level
and as such it will use those ratios that can enable it to achieve such objectives of
particular importance are:
a) Profitability ratios
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b) Return ratios
7. Competitors – These are interested in the company’s performance from the
market share point of view and will use the ratios that enable them to ascertain
company’ competitive strength e.g. profitability ratios, sales and returns ratio etc.
8. General public – Customers and potential customers – These are interested in the
ability of the company to provide good services both in the short and long run.
To gauge the company‟ s ability to provide goods and services on short and
long term basis. We have:
a) L i q u i d i t y ratio
b) solvency ratio
Review Questions
a) Define financial analysis
b) Describe the Features of Financial Analysis
c) Determine the Purpose of Analysis of financial statements
d) Outline the Procedure of Financial Statement Analysis
e) Appreciate the importance of Financial Statement Analysis
f) Outline four limitations of the use of ratios as a basis of financial analysis. (4

marks)
g) What is the need for Financial statements for various users
h) Three years ago, Mrs. Rehema Waziri was retrenched from the Civil Service. She
invested substantially all her terminal benefits in the shares of ABC Ltd., a
company quoted on the stock exchange. The dividend payments from this
investment makes up a significant position of Mrs Waziri‟ s income. She
was alarmed when ABC Ltd. dropped its year 2001 dividend to Sh.1.25 per share
from Sh.1.75 per share which it had paid in the previous two years.Mrs Waziri has
approached you for advice and you have gathered the information given below
regarding the financial condition of ABC Ltd. and the finance sector as a whole.
26
ABC Ltd. Balance Sheets as at 31 October
1999 2000 2001

Sh.’000’ Sh.’000’ Sh.’000’
Cash 15,250 14,400 8,000
Accounts receivable 80,320 87,800 134,400
Inventory 98,600 158,800 254,000
Total current assets 194,170 261,000 396,400
Land and buildings 25,230 27,600 25,000
Machinery 33,800 36,400 30,600
Other fixed assets 14,920 18,200 16,400
Total assets 268,120 343,200 468,400
Accounts and notes payable 34,220 73,760 135,848

Accruals 15,700 34,000 67,000
Total current liabilities 49,920 107,760 202,848
Long term debt 60,850 60,858 81,720
Ordinary share capital 115,000 115,000 115,000
Retained earnings 42,350 59,582 68,832
268,120 343,200 468,400
ABC Ltd. Income Statements for the year ending 31 October
1999 2000 2001

Sh.’000’ Sh.’000’ Sh.’000’
Sales (all on credit) 827,000 858,000 890,000
Cost of sales (661,600) (710,000) (712,000)
Gross profit 165,400 148,000 178,000
General administrative and selling expenses (63,600) (47,264) (51,200)
Other operating expenses (25,400) (31,800) (38,200)
Earnings before interest and tax (EBIT) 76,400 68,936 88,600
Interest expense (12,800) (26,800) (63,600)
Net income before taxes 63,600 42,136 25,000
Taxes (25,400) (16,854) (10,000)
Net income 38,200 25,282 15,000
Number of shares issued 4,600,000 4,600,000 4,600,000
Per share data:

Earnings per share (EPS) Sh. 8.30 Sh. 5.50 Sh. 3.26
Dividend per share Sh. 1.75 Sh. 1.75 Sh. 1.25
27
Market price (average) Sh.48.90 Sh.25.50 Sh.13.25
Industry Financial Ratios

(2001)
Quick ratio 1.0
Current ratio 2.7
Inventory turnover 7 times
Average collection period 32 days
Fixed asset turnover 13.0 times
Total assets turnover 2.6 times
c)
Industry Financial rations
Net income to net worth 1.8%
Net profit margin on sales 3.5%
Price-Earnings (P/E) ratio 6 times
Debt/Equity ratio 50%
28
Notes:
1. Industry ratios have been roughly constant for the past four years.
2. Inventory turnover, total assets turnover and fixed assets turnover are based on the
year-end balance sheet figures.
Required:
(a) The financial ratios for ABC Ltd for the past three years corresponding to
industry ratios given above. (10 marks)
(b) Arrange the ratios calculated in (a) above in columnar form and summarise the
strengths and weaknesses revealed by these ratios based on:
(i) Trends in the firm‟ s ratios (6 marks)
(ii) Comparison with industry averages. (6 marks)
(The summary should focus on the liquidity, profitability and turnover ratios).
(Total: 22 marks)
References
(Wiley 2003)
29
TOPIC TWO: BUSINESS ANALYSIS
Course Objectives
In this topic the student should:

- understand the meaning of business analysis
- Understand the various factors considered under business analysis
- Know how to analyze the competition, industry, business enevironment
etc
2.1 Introduction
Financial analysis is mainly perceived to be quantitative and focusing on the financial
performance of an organization. However it is important to note that analysis would not be
complete unless other non quantitative factors are also analyzed and their possible impact
on an organization determined
2.2 Economic Environment

The economic environment where an organization is operating is a key consideration
especially as it impacts on the organizations future and ability to achieve set objectives.
Under economic factors one should consider the following
a) GDP Growth – The economic growth is an important consideration as it shows by
what extent the economy is expanding. As the economy expands it is expected that
there will be growth in disposable income of the various categories of citizens
which is critical in ensuring that they are able to sustain and increase consumption
which is important for any organization
b) Inflation – Inflation is the rapid rise in prices of commodities which ordinarily has a
negative effect on the disposable income of consumers hence interfering with their
consumption of non core commodities.
c) Interest rates - A high interest rate regime means access to capital may be a
challenge.
16
17
2.3 Industry Analysis
It is important to analyze the industry an organization is operating in as relates to the legal

requirements, trend and future possibilities. It is important to note that there are factors that
affect specific industries on their own despite the general economic trends and there are
possibilities where an industry may experience decline despite the general economy being
in an upward swing and vice versa. It is also good to look at the existing barriers to entry
which determine the possible level of competition in the industry
2.4 Competition
Competition analysis involves generally looking at the strength, severity and general
competition strategies. When an organization is facing stiff competition then it might result
in reduced margins leading to low profits or even losses. When the competing firms are
very strong financially then the level of competition and even the possibility of being forced
out of the market are real. Where the company is facing stiff competition then it would be
important to look at the possibility of diversifying the product portfolio, relocating or even
venturing into other markets. When the analysis shows relatively weak competition then the
company should move to consolidate its leading position by increasing efficiency, market
share and being a leader in innovation otherwise the advantage may be lost over time.
2.5 Company management

Analysis of company management is meant to give indications as to the extent of the
management team qualifications, experience and generally the ability to realize the
company objectives. The analysis helps in giving indication on the strength of the
management team and their ability to execute their mandate and to steer the company
forward. This is an important analysis especially for investors and financiers as it will give
them confidence on the future of the organization depending on the perceived strength of
the management team
18
Review Questions
Using a company of your choice perform a business analysis based on the following
a) The effect of the trend in the economy
b) The management of the organization
c) Competition level and its effect
19
CHAPTER THREE: ANALYSIS OF SHORT TERM LIQUIDITY
Learning Outcome
By the end of this topic the learner should
a) Be able to appreciate the importance of liquidity in an organization
b) Identify tools for examining company liquidity
c) Calculate liquidity ratios and interprete
3.1 Introduction
The short term liquidity of an organization is measured by the degree to which it can meet
its short term obligations. Conventionally short term refers to a span of one year though
some organizations may classify their short term span to equal one business cycle,
meaning the duration of time between purchasing, processing, selling and collecting on
sales.
The importance of liquidity is best gauge by gauging the repercussions that may arise out
of inability to meet the short term obligations which may range from legal suits, to poor
relations with suppliers and in extreme case bankruptcy proceedings against the
organization. For this reasons the creditor’s lenders and all stakeholders in an organization
place a great value in the measures of liquidity. When an organization is not able to meet
its short term financial obligations then its continued existence becomes doubt full.
3.2Working capital
Working capital refers to the excess of the current assets over the current liabilities and a
working capital defic iency exists when the current liabilities exceed the current assets.
Because of the significance of the working capital to an organization it is important to have
a defined measure of what should be considered in determination of the working capital.
Current assets are those assets that would be expected to be converted to cash within the
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companies operating cycle or within one year. On the other hand current liabilities are
those liabilities expected to be settled in a short period of time usually not exceeding one
year.
For the purposes of the definition current assets include
i) Liquid cash either in the company or at the bank

ii) Short term investments
iii) Accounts and notes receivable
iv) Inventories
v) Prepaid expenses
In preparing ratios the analyst should be alert to the possibility of some current assets not
being available within a year. Accounts receivables should only include the collectible
amounts and as such should be net of any bad accounts. In addition the short term
investments and the stock should be properly valued so as to ensure their value is not
overstated. In addition stock should not include any obsolete stocks or slow moving goods
which would distort the ratios.
Current Liabilities include
a) Accounts payable
b) Notes payable
c) Short term loans
d) Taxes and other accrued expenses
e) Current portion of long term loan
Working capital is an important measure for any company but the analyst should be on
the look out for entries in the categories of current assets and liabilities which are mere
accounting entries with no real bearing on the firm’s liquidity. These entries include the
deferred tax liability or tax assets.
21
3.3 Current Ratio
The working capital measures are good indicators of the financial position of the
organization but at the same time they might not bring out some information contained in
the information e.g. the working capital of two firms is presented as follows
A B
Assets 300,000 1,200,000
Liabilities 100,000 1,000,000
Working capital 200,000 200,000
The two firm have a similar capital structure but a keener look can show that firm A can
show that it has a better mix of assets and liabilities as compared to firm B.
For this reason further analysis is necessary to show the financial stability of the
organization. The current ratio is calculated as current assets divided by current liabilities
and for the two firms it would amount to 1.5 for firm A and 1.2 for B and these ratios can
clearly show that firm A is in a better financial position than firm B.
The current ratio is widely preferred in the test of short term liquidity for the following
reasons
a) It measures the degree to which the current assets cover the current liabilities
hence showing the organizations ability to meet the short term liabilities as they
fall due
b) The excess of the current assets over the current liabilities shows the extent to
which the creditors are shielded in case of a reduction in value or inability to collect
on some of the current assets. The bigger the buffer zone the better for the
creditors.
c) The margin of safety represented by the excess of current assets over current
liabilities shows the safety of the company from unusual shocks that might
interfere with the flow of cash to an organization. In case there is a fall in sales,
22
strikes or extraordinary losses can the organization be able to continue meeting its
obligations out of its available funds
d) The method is simple to calculate and interpret and most organizations readily
maintain the information making it easy to extract and apply
Limitations
The main limitation of the ratio is its static nature which means that it measures the
present condition without being able to project how the future will be. To make a decision
on liquidity position of a company one needs also to be able to predict how future inflows
compare to future outflows. The future flows are affected by among others the expected
sales, costs and expenses which are not factored into the measure. The components that
make up the formula actually vary with the level of sales but the components themselves
have no way of helping to predict future outlays for both inflows and outflows.
The use of the ratio also ignores the going concern concept under which the financial
statements are prepared. This is because the ratio looks at the liquidity at a specific time
assuming the organization is dissolved at that point other wise if it was to conform to the
going concern concept then projected cash flows would be an important part in coming up
with the ratio.
Because of the static nature of the ratio it should be used with reservation in that the user
should bear in mind that the ratio only reflects what is possible at present and it does not
relate to the organizations long term liquidity as the ratio to a greater extent envisages a
case of immediate liquidation.
23
3.4 Cash Ratios
Because of the limitations of the current ratio then a more liquid ratio is necessary. Cash is
the most liquid of the current assets combined with cash equivalents which constitute
temporary investments made up of highly marketable and relatively safe temporary
investments. The proportion of the cash and cash equivalents to the total current assets is
called cash ratio and is computed as follows:
Cash + cash equivalents
Total current assets
The higher the ratio the more liquid the assets are and the better for the company. It
should however be noted that the ratio does not show the relation ship between the cash
asset and the liabilities that they are supposed to meet. For this reason the ratio can be
presented in terms of the relation ship between cash and cash equivalents and the current
liabilities. The restated ratio is referred to as the quick ratio or the acid ratio which is
presented as Cash+ cash equivalents
Current liabilities
The omission of inventories from the ratio is because inventories are considered to be the
least liquid asset. It usually takes time to be able to dispose inventory and for this reason
they are omitted.
3.5 Debtor’s turnover ratios

The ratio is calculated by dividing the credit sales by average debtors ie
Debtors turnover ratio = net credit sales
Average debtors
For most company that sell on credit the accounts receivable make up a significant portion
of the current assets and there is need to establish the quality and liquidity of those
accounts. The ratio above shows how many times the debtors turn over. The average
24
debtors can be found by getting the average between the opening debtors and the closing
debtors.
This ratio is important as an indicator on the number of times that the debtors turn over, it
however does not tell us the number of days that the accounts remain outstanding or the
average collection period. This is shown by calculating the the number of credit days using
the ratio: 360 days
Debtors turnover
Illustration
An organization has credit sales amounting to 1,200,000 with average debtors amounting
to 200,000.
The debtor’s turnover ratio would be = 1,200,000/200,000 = 6
The average collection period = 360/6 = 60 days. Third means that the debts are normally
outstanding for 60 before collection. The decision to use 360 days, i.e. the number of days
in a year (adjusted from 365 for ease of computation) is arbitrary because the sales days
may not add up to that number of days though when used consistently they form a basis
for comparison.
The average collection period measures the quality of the debtors indicating the speed of
their collection and the shorter the period the better the quality of debtors. The computed
collection period should be compared to the company’s credit policy to show how efficient
the company is in collecting on credit accounts. Whereas a long collection period reflects
inefficiency or too much liberalism in the credit policy or even customers in financial
difficulties a very short collection period could indicate restrictive credit policy which only
allows credit to the safe clients only. This could be curtailing sales hence making the
organization to loose.
25
The analyst should also compare the company collection period with the industry average
so as to make a conclusion on how they compare and make a conclusion on how efficient
or inefficient the company is in comparison to the industry.
Ageing schedule
This is a schedule that shows the debtors based on the length of days they have been out
standing. It is also a way of determining the company’s strength when it comes to
collection of credit sales. Ideally most of the outstanding sales should be within the
company allowed credit limit.
3.6 Inventory turnover

Inventories usually form a very big proportion of the current assets. The current ratio
includes inventory as a current assert. There is need to establish the liquidity and quality
of the inventory to se3e how easily it can be transferred to cash.
Inventory turnover ratio = cost of goods sold/ average inventory
Average inventory = (opening inventory +closing inventory)/2
Days to sell inventory – it measures the number of days before inventory could be sold.
= 360 days/ average inventory turnover
ILLUSTRATION
Cost of sales = 1,200,000
Beginning inventory = 200,000
Closing inventory = 400,000
26
Average turnover = (400,000+200,000)/2 = 300,000
Inventory turnover = cost of sales / average inventory = 1,200,000/ 300,000 =4
Days to sell inventory = 360/4 =90
3.7 Overview of Cash flow

Cash flow focuses on movement in cash and cash equivalents trying to predict the
expected income from various sources of cash and how this money is going to be spent
hence helping to determine the adequacy of funds to cover the planned expenditures and
the possibility of need for emergency funding. The main sources of cash include sales,
disposal of assets, returns from investments, tax refunds, owner’s funds and loans. Cash
outflow is as a result of trade purchases, acquisition of assets, investments, loan
repayments, trade expenses, payment of dividends, etc.
A cash flow statement differs from a funds flow statement in that whereas the former
focuses on cash movement the latter takes into consideration the working capital
movements including the shift in creditor position with increase in liabilities being a source
of funds while increase in debtors is represents a negative effect in the cash position.
The ultimate desire for an organization is not to maintain high levels of liquidity but to
maintain an optimal level of liquidity that which allows the organization to meet its
obligations while at the same time earning a return on excess cash. Holding liquid assets
leads to monetary losses under inflationary conditions while value is preserved in assets. It
is however much more risky to hold a fixed assets at a time when you have obligations
requiring spending of cash. This is because it is not easy to convert assets into cash when
you need it and this might plunge the company into financial risks.
Cash flow is also different from profitability in that profits contains revenues that do not
constitute actual cash inflow like gains in disposals while the expenses also contain entries
like depreciation which does not constitute an actual cash outflow. In addition the accrual
system of accounting is different from cash accounting and for this reason the profit
statement needs to be adjusted for all the entries that do not constitute the actual
movement in cash flow.
The relationship between the cash outflows and inflows is actually important in an
organization in that they are interdependent with some categories of expenditures e.g.
advertising determining the amount and quality of inflows that you are going to get as an
organization. For this reason the company does not always have the option of reducing
27
expenditure in a bid to improve the cash position through improved profitability. Profits
are also important in creating steady inflows but at the same time the organizational
policy as relates to credit sales also affects the speed at which sales are converted to cash.
A company with a very strict credit policy might loose sales and hence reduce its
profitability and eventually its cash position while when too lenient again the company
might find itself in financial difficulties because of tying a lot of its funds to creditors.
Cash Forecasting
Cash forecasting is an important activity for any company because it helps in determining
the company’s ability to meet the short term financial obligations as they fall due. This
helps an organization to plan iyts affairs well so as to ensure that funds are available when
needed. Due to the inherent uncertainties in forecasting it should be done for a relatively
short period of time where reasonable assumptions can be made. When the period
involved is too long then the forecast can turn to be unreliable since a lot of factors can
change due to changes in business environment. When a company makes forecasts based
on incorrect assumptions then it might find that the projected funds are not available
when needed since the assumptions do not hold true.
Sales being the main source of inflows should be carefully projected taking into
consideration the past trends, economic growth, industry trend, market share, production
capacity, competition etc. Based on the expected level of sales then it is possible to
estimate the other parameters by use of common size analysis or study of relationships
between sales and expenses for the specific company and come up with the expected
levels of expenditure for any given level of sales.
To check the assumptions made as to how reasonable they are there is need to test the
forecasts using a number of measures. One of measures that one can use is to prepare
pro-forma statements mainly the profit statement and balance sheet from the projections
and then do an analysis of various ratios from the statements to see how well they
compare with those from actual information. Ordinarily an organization develops
gradually and as such where the proforma statements show a jump in performance it
should be checked for the soundness of the assumptions made.
Techniques of cash forecasting
The main technique of forecasting the cash position of a company is to prepare a cash
budget which will show the expected inflows and outflows as well as the remaining cash
balances. Depending on the needs of the organization the cash budget can be done on a
daily or monthly basis. However due to the challenges of projections over a long period of
28
time the cash budgets should be for a relatively short period of time. Preparation of a cash
budget involves the following steps
i) Project the expected sales level taking into consideration the expected business
cycles and credit period
ii) Establish the expected level of expenditure depending on level of sales and taking
into consideration any discounts and credit period granted
iii) Establish any other sources of funds eg sale of assets, income from investments,
loans, owners capital etc
iv) Establish any expenditures other than trade expenditures eg dividends paid, taxes,
loan repayments, capital expenditure etc
v) Ascertain the existence of opening cash balances. Note the closing cash balance for
one period of time forms the opening balance for the next period
January February March
Opening balance XX XXX XXX
Inflows Sales revenue XXXX XXXX XXXX
Dividends XXXX XXXX XXXX
Other sources XXXX XXXX XXXX
Total Inflows XXXXX XXXXX XXXXX
Outflows Trade purchases XXXX XXXX XXXX
Loan repayment XXXX XXXX XXXX
Capital XXXX XXXX XXXX

acquisition
Other outflows XXXX XXXX XXXX
Total Outflows XXXXX XXXXX XXXXX
Net cash flow (inflows- XXX XXX XXX

outflows)
29
In preparing cash analysis the past information helps in determination of the relationship
between sales and the various categories of expenditure. These should however be
adjusted for any out of the ordinary occurrences which might distort performances
depicting extreme levels of sales caused by factors outside the normal trading activities
e.g. post election violence temporarily disrupting sales or fire in a major competitors
premises temporarily boosting sales. In addition it is advisable to consider unique
organizational factors and avoid generalizations since companies may differ even if in the
same industry.
Interpreting the analysis
After the analysis has been done the analyst has a number of things to look out for starting
with the company’s ability to meet its financial obligations as they fall due. Where the
company is perpetually in need of short term financial support in the form of overdrafts
due to excess of outflows over inflows it could be because of loss making, reducing
margins, too much debt, or other factors. The analyst should get to the bottom of the
main cause of the company’s poor financial position. Like wise excessive cash balances
should be discouraged as they show that the company is not gaining from application of
the funds available.
In addition this will show the quality of management decisions as regards to managing the
affairs of the company and the ability to run a company profitably and coming up with
credit and procurement policies that ensure the company maintains its liquidity. It could
also be an indicator of factors that a in existence in the industry or economy where sales
are generally falling or costs rising due to factors outside the managements control.
Cash analysis should be done in combination with other forms of analysis as none can be
able to cover the entire organization while the interpretation of one form of analysis may
be supported or negated by the results of a different analysis hence requiring the insight
of the analyst in interpreting the organizations overall condition.
Illustration
ABC Limited has the following sales projections for the next several months. January
500,000 February 700,000, March 850,000, April 1,000,000 May 1,200,000. Collections
amount to 40% in the first month 30% in the following month with the remainder being
collected in the third month. Purchases form 70% of sales with 60% being payable in the
month of purchase with the remainder being paid a month after. Expenses form 20% of
sales and are paid in the month incurred. Short term financing amounting to 150,000 is
expected in the third month and will be repaid monthly from the month of May at Ksh
18,000 per month for the next one year. Tax arrear amounting to Ksh 140,000 are to be
30
paid in the month of April while assets amounting to Ksh 60,000 are to be acquired in
March.
Required: Prepare a cash budget for the five months and advice the management on the
results of the analysis
Review Questions
a) Differentiate between a cash flow statement and funds flow statement
b) Explain the possible consequences of in optimal cash position
c) Explain the ways through which a company can boost its cash position
d) A company with a debtor’s turnover of 15 times is considering adjusting its credit period
to march the industries 30 days. Clearly explain to the management how this is likely to
affect the liquidity position
e) Choose a company from the NSE and evaluate its liquidity based on the past years
published accounts
31
CHAPTER FOUR: FINANCIAL FORECASTING
Learning outcome
a) Define financial forecasting
b) Determine the importance of financial forecasting
c) Describe and apply Methods/Techniques of Financial Forecasting
4.1 Introduction
There are many measures of an organizations performance and or liquidity position and
long term solvency. These measures however fall short in that in most cases they are back
ward looking meaning that they try to look at the companies future by looking at its past.
The fact on the contrary is that the companies future has little to do with its past but
depends more on the future possibilities, strategies and occurrences. In addition these
measures are actually static giving the company position at a particular point in time and
hence the fail to capture the dynamism and the business cycles that affect the
organizations well being at different times. For this reason there is need to make use of
tools that enable analysts to model the future and make our decisions based on how we
predict the future to be.
The use of analysis tools that allow analysts to project future scenarios is a much more
superior way of analyzing situations and it makes use of the past information not as an
end but as a means and a guide to project possible future patterns. When deciding on the
next course of action especially in financing decisions the future cash flows are much more
relevant in deciding the company’s ability to meet the financial obligations that will arise
out of acquiring debt as compared to the ratios position that the company reflected for
the last accounting period.
The financial planning and forecasting will also determined the activities the firm should
undertake in order to achieve its financial targets.
Financial forecasting is important in the following ways:
1. Facilitate financial planning i.e determination of cash surplus or deficit that are
likely to occur in future.
32
2. Facilitate control of expenditure. This will minimise wastage of financial
resources in order to achieve financial targets.
3. It avoids surprise to the managers e.g any cash deficit is known well in advance
thus the firm can plan for sources of short term funds such as bank drafts or short
term loans.
4. Motivation to the employees – Financial forecasting using budgets and targets
will enhance unity of purpose and objectives among employees who are
determined to achieve the set target.
4.2 Methods/Techniques of Financial Forecasting
1. Use of Cash Budgets

A cash budget is a financial statement indicating:
a) Sources of revenue and capital cash inflows

b) How the inflows are expended to meets revenue and capital expenditure of
the firm.
c) Any anticipated cash deficit/surplus at any point during forecasting period.
2. Regression Analysis
This is a statistical method which involves identification of dependant and independent

variable to form a regression equation *y = a + bx) on which forecasting will be based.
3. Percentage of Sales Method

This method involves expressing various balance sheet items that are directly related to
sales as a percentage of sales. It involves the following steps:
i) Identify various balance sheet items that are directly with sales this items include:
a) Net fixed asset – If the current production capacity of the firm is full an increase
in sales will require acquisition of new assets e.g. machinery to increase
production.
b) Current Asset – An increase in sales due to increased production will lead to
increase in stock of raw materials, finished goods and work in progress.
Increased credit sales will increase debtors while more cash will be required to
buy more raw materials in cash.
c) Current liabilities – Increased sales will lead to purchase of more raw materials
d) Retained earnings – This will increase with sales if and only if, the firm is
operating profitability and all net profits are not paid out as dividend.
Note
The increase in sales does not require an increase in ordinary share capital, preference
share capital and debentures since long term capital is used to finance long term project.
33
ii) Express the various balance sheet items varying with sales as percentage of sales
e.g. assume for year 2002 stock and net fixed assets amount to Sh.12M and 18M
respectively sales amount to Sh.40M. Therefore stock as percentage of sales”
Stock = 12M x100  30%

40M
Fixed asset = 18M x100  45%

40M
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iii) Determine the increase in total asset as a result of increase in sales e.g suppose
sales increases from Sh.40 M to Sh.60 M during year 2003. The additional stock
and net fixed asset required would be determined as follows:
Increase in stock = % of sales x increase in sales
= 30% (60 – 40) = Sh.6M
Increase in fixed asset = % of sales x increase in sales
= 45%(60 – 40) = Sh.9 M
iv) Determine the total increase in assets which will be financed by:
a) Spontaneous source of finance i.e increase in current liabilities

Where Increase = % of sales x increase in sales
b) Retained earnings for the forecasting period

Retained earnings = Net profit – Dividend paid
Net profit margin = Net profit

Sales
Therefore: Net profit = Net profit margin (%) x sales
Note
Generally Net profit margin is called after tax return on sales.
 Out of the total assets that are required as a result of increase in sales, the financing
will come from the two sources identified. Any amount that cannot be met from the
two sources will be borrowed externally on short term basis which will be a current
liability.
Assumptions underlying % of sales method

The fundamental assumption underlying the use of % of sales method is that, there is no
inflation in the economy i.e the increase in sales is caused by increase in production and
not increase in selling price.
Other assumptions include:
1. The firm is operating at full or 100% capacity. Therefore the increase in

production will require acquisition of new fixed assets.
2. The firm will not issue new ordinary shares or debenture or preference shares thus
35
this capital will remain constant during the forecasting period.
3. The relationship between balance sheet item and sales i.e balance sheet items as
% of sales will be maintained during forecasting period.
4. The after tax, profit on sale or net profit margin will be achieved and shall remain
constant during the forecasting period.
Illustration
The following is the balance sheet of XYZ Ltd as at 31st December
2002:
Sh.‟ 000‟
Net fixed asset 300
Current assets 100
400
Financed by:
36
Ordinary share capital 100
Retained earnings 70
10% debentures 150
Trade creditors 50
Accrued expenses 30
400
Additional Information
1. The sales for year 2002 amounted to Sh.500,000. The sales will increase by 15%
during year 2003 and 10% during year 2004.
2. The after tax return on sales is 12% which shall be maintained in future.
3. The company‟ s dividend payout ratio is 80%. This will be maintained during
forecasting period.
4. Any additional financing from external sources will be affected through the issue
of commercial paper by company.
Required
a) Determine the amount of external finance for 2 years upto 31st December
2004. b) Prepare a proforma balance as at 31 December 2004
Solution
Identify various items in balance sheet directly with sales:
 Fixed Asset
 Current Asset
 Trade creditors
 Accrued expenses
Net fixed assets = 300M x 100 = 60%

500M
Current Assets = 100M x 100 = 20%

500M
Trade creditors = 50 x 100 = 10%

500
Accrued expenses = 30 x 100 = 6%

500
c) Compute the increase in sales over the 2 years.
37
115
Year 2002 sales = 500x 
575M
10
0
Year 2003 sales = 575x 115  632.5M

100
38
Increase in sales in 2003-03-26= 632.5 – 500 = 132.5M
d) Compute the amount of external requirement of the firm over the 2 years of
forecasting period.
i) Increase in F. Assets = % of sales x increase in sales

= 60% x 132.5 = 79.5M
ii) Increase in C. Assets = % of sales x increase in sales
= 20% of 132.5 = 26.5M
Total additional investment/asset required 106M
Interpretation
For the company to earn increase in sales of 132.5M it will have to acquire additional
assets costing 106M.
Sh.’000’
Additional investment/asset required 106,000
Less: Spontaneous source of finance
Increase in creditors = % of sales x increase in sales
= 132,500 x 10% (13,250)
Increase in accrued expenses = % of sales x increase in sales
= 132,500 x 6%
(7,950)
Less: Retained earnings during 2 years of operation (initial sources)
Net profit for 2003 = Net profit margin x sales of 2003
= 12% of 575,000 = 69,000
Less: Dividend payable 80% of 69,000 = 55,200
(13,800)
Net profit for 2004 = Net profit margin x sales of 2004
= 12% of 632,500 = 75,900
Less: dividend payable 80% of 75,900 = 60,720
(15,180)
External financial needs (commercial paper) 55,820
Proforma Balance Sheet
This refers to the projected balance sheet at the end of forecasting period. The items in
the proforma balance which vary with sales would be determined in any of the following
two ways:
i) % of sales x sales at last year of forecasting (2004); or

ii) Balance sheet item before forecasting plus increase in balance sheet item as a
result of increase in sales. 39
Proforma balance sheet as at 31st December 2004
Shs.
Net fixed assets 60% x 632.5 or 300 + 79.5 379.50
Current Assets 20% x 632.5 or 100 + 26.5 126.50
506.00
Ordinary shares (will remain constant) 100.00
Retained earning 70 + 13.8 + 15.18 98.98
10% debenture (remain constant) 150.00
Trade creditor 10% x 632.5 or 50 + 13.25 63.25
Accrued expenses 6% x 632.5 or 30 + 7.95 37.95
External borrowing – commercial 55.82
506.00
40
Revision Questions
QUESTION ONE
Madawa Chemicals Ltd. is in the process of forecasting its financial needs for the coming
year ending 31 October 2003. The company attained a turnover ofSh.300 million for the
current year ended 31 October 2002.
The following are the summarized financial statements of the company for the year ended
31 October 2001:
Profit and Loss

Account
Sh.’million’
Turnover 300
Profit before tax 54
Taxation 18
Profit after tax 36
Dividend 9
Retained profit 27
Balance Sheet
Sh.’million’ Sh.’million’
Net Assets:
Fixed assets (net) 190
Current assets 146
Current liabilities 103 43
233
Financed by:
Issued ordinary shares 50
Reserves 90
140
Medium and long-term 93
debt 233
From past experience, it has been disclosed that each additional Sh.1 of sales made by the
company requires, on average, a total investment in fixed assets, stocks and debtors of
Sh.1.50. The Sh.1 additional sales also results in the generation of automatic financing of
40 cents as various creditors spontaneously arise with the increase in sales.
41
The net profit margin after tax and the dividends payout ratio which apply for the year
ended 31 October 2002 will also be relevant into the foreseeable future.
Required:
(a) The amount of external finance that will be needed during the year ending 31
October 2003 if sales are expected to increase by 15% in the year.
(4 marks)
(b) The maximum expected sales growth that can be achieved in the year ending 31
October 2003 if only internally generated funds are used. (6
marks)
(c) The maximum growth in sales that can be achieved in the year ending 31 October
2003 if the company wishes to maintain its current level of financial gearing.
(6 marks)
(d) Briefly comment upon the weaknesses of the method of forecasting used above.
(4 marks)
(Total: 20 marks)
QUESTION THREE
Explain the limitations of using ratios
QUESTION THREE
The following information has been extracted from the published accounts of Pesa
Corporation Limited, a company quoted on the Nairobi Stock Exchange.
Shs.
Net profit after tax and interest 990,000

Less: dividends for the period 740,000
Transfer to reserves 250,000
Accumulated reserves brought forward 810,000
Reserves carried forward 1,060,000
Share capital (Sh.10 par value) Sh.8,000,000
Mar02ket price per share now 12%
Required
42
a) What is meant by a company quoted on the Nairobi Stock Exchange?
(6 marks)
b) Calculate for Pesa Corposation Limited the following ratios and indicate
the importance of each to Miss Hisa, a Shareholder:
i) Earnings per share. (4 marks)

ii) Price earnings ratio (4 marks)
iii) Dividend yield (4 marks)
iv) Dividend cover (4
marks)
(Total: 22 marks)
References
(Wiley 2003)
43
CHAPTER FIVE: CAPITAL STRUCTURE ANALYSIS
Learning Outcome
a) Define financial distress
b) Describe the Effects of Financial Distress c)
Outline the reasons for financial distress
d) Identify the indicators of a financially distressed firm
e) predict Bankruptcy
5.1 Introduction
The capital structure refers to the mix of sources of long term finance used in an organization and it
includes long term debt, common equity, preferred stock, and reserves. The capital structure is a
good indicator of the long term solvency of an organization and its financial stability depending on
the sources of its funds.
In addition the capital structure affects the cost of capital and eventually the long term value of a
firm and the question on existence of an optimal capital structure is a hotly debated issue in
finance. Several theories have been advanced on the question of relevance of the capital structure
in the value of the firm. Some of the theories on the issue include the net income approach, Net
operating income approach and the traditional approach to cost of capital and value of the firm.
The significance of the capital structure is derived mainly from the difference between debt and
equity. The outstanding characteristic of equity finance is that it is permanent and can be expected
to remain even in times of adversity without and has no mandatory requirement for dividends.
Unlike equity debt has to be repaid at certain specified times regardless of the organizations
financial situation. For this reason the higher the proportion of debt in the capital structure the
higher the repayment commitment and the higher the possibility of default. Despite the risk that
44
may be associated with debt when applied to a certain point it is a less expensive source of funds
because interest is fixed and as long as it is lower than the rate of return the difference goes to
benefit the equity owner. In addition interest is an expense that is tax deductible as opposed to
dividends which are distributions of profits.
5.2 Effect of capital structure on long term solvency

In a leveraged capital structure one of the risks envisaged include running out of cash to meet the
expected debt repayments. To address this situation an organization can prepare a statement of
cash flow to predict the availability of cash when needed. This statement needs to be prepared with
the worst case scenario in mind. These statements however are only useful in the short term due to
the inability to make long term projections accurately.
For the above reason a better measure of long term solvency needs to be done and this is mainly
achieved by using measures that are more static based on measures of capital structure as well as
assets and earnings coverage tests.
5.3 Financial Distress
Financial distress is a condition where firms‟ obligations are not met or meet with difficulty.
The disadvantage of a firm taking on higher debt ratio is that it increases the risk of financial
distress which is detrimental to equity and debt holders The extreme form of financial distress
is insolvency, which could be very expensive for it involves legal costs and may force a firm to
sell its assets at distress prices.
Rose et al (1996) linked financial distress to insolvency and defined it as: “Inability to
pay one’s debt and lack of means of paying one‟ s debts. Such as a condition of a
women (or man’s) assets and liabilities, the farmer needs immediately available would be
insufficient to discharge the later”.
Altman (1983) distinguished between stock-based insolvency and flow-based insolvency all of
which leads to financial distress. The former occurs when a firm has negative net- worth causing
45
the value of its assets to be less than the value of its debts.
A major disadvantage for a firm taking on higher levels of debt is that it increases the risk of
financial distress, and ultimately liquidation. This may have detrimental effect on both the equity
and debt holders
5.3.1 Effects of Financial Distress
(i) The risk of incurring the costs of financial distress has a negative effect on a firm's
value, which offsets the value of tax relief of increasing debt levels.
(ii) These costs become considerable with very high gearing. Even if a firm manages
to avoid liquidation its relationships with suppliers, customers, employees and creditors
may be seriously damaged.
(iii) Suppliers providing goods and services on credit are likely to reduce the generosity of their
terms, or even stop supplying altogether, if they believe that there is an increased chance
of the firm not being in existence in a few months' time.
(iv) Customers may develop close relationships with their suppliers, and plan their own
production on the assumption of a continuance of that relationship. If there is any doubt
about the longevity of a firm it will not be able to secure high- quality contracts. In the
consumer markets customers often need assurance that firms are sufficiently stable to
deliver on promises.
46
5.3.2 Reasons for financial distress:
The principal factors influencing the probability of bankruptcy, ceteris peribus, could be
associated with the (1) Asset mix (2) financial structure (3) corporate governance.
(i) The first cause of financial distress is the inappropriate allocation of assets. Assets are
usually industry specific a firm may be driven to bankruptcy if the resources are not allocated
efficiently. The resources mix between the long and short-term assets is crucial in an efficient
market.
(ii) A firm bankruptcy might be financial. The firm has the right assets structure but its
financial structure is inappropriate hence liquidity constraints.
(iii) Whereas the firm is viable in the long run, due to liquidity constraints it is has to go to
bankruptcy in the short run.
(iv) Corporate governance may drive a firm into bankruptcy if the problem is not resolved.
Conflict of interest of the management and the owners. The owners of a firm provide fund
to be put the best use and managers utilize the resources as the agents of the owners.
5.3.3 Indirect costs of Financial Distress:
(i) Management attitude
It has a great effect on the attitude of the management. The shareholders may like the
management to invest in risky, marginal projects so that debt holder‟ s wealth is transferred.
Management may also avoid investing in profitable projects since under an insolvency or
financial distress debt holders are likely to benefit more from such investments.
(ii) Creditor relationships

47
Creditors lose their patience when a firm faces financial problems. They force the firm into
liquidation to realize their claims.
(iii) Sub-optimization
A financially distressed firm also has a tendency to emphasize short-term profitability at the
cost of long-term sustainability and profitability.
(iv) Staff morale and turnover
There is a tendency of staff considering alternative employment, as a result of a loss in staff
morale.
(v) Realizable values
If assets have to be sold quickly, the price may be very low.

(vi) Quick fix measures
Temptation to sell healthy businesses as this will receive the most cash.
The direct costs include:
 Lawyers fees
 Accountants fees
 Court fees
 Management time.
5.3.4 Factors Influencing the Risk of Financial Distress Costs

The susceptibility to financial distress varies from company to company. Here are some
influences:
(i) The sensitivity of the company's revenues to the general level of economic activity.
If a company is highly responsive to the ups and downs in the economy, shareholders and lenders
may perceive a greater risk of liquidation and/or distress and demand a higher return in
compensation for gearing compared with that demanded for a firm which is less sensitive to
economic events.
48
(ii) The proportion of fixed to variable costs. A firm which is highly operationally geared,
and which also takes on high borrowing, may find that equity and debt holders demand a high
return for the increased risk
(iii) The liquidity and marketability of the firm's assets. Some firms invest in a type of asset
which can easily be sold at a reasonably high and certain value should they go into liquidation.
This is beneficial to the financial security holders and so they may not demand such a high-risk
premium.
(iv) The cash-generative ability of the business. Some firms produce a high regular flow of cash
and so can reasonably accept a higher gearing level than a firm with lumpy and delayed cash
inflows.
5 . 4 I n d i c a t o r s of Financial distress:
a) Financial analysis (Balance sheet and Income statement data) may be used to view some of
financial distress. The most important ratios are liquidity ratio, debt management ratio and asset
utilization ratio. The ratios indicate whether the firm is facing financial problems in meeting its
current and long term obligations
b) Statistical prediction models are more generally better known as measures of financial
distress. Altman’s Z-score model –multiple discriminant analysis is commonly used to predict
bankruptcy.
c) Sensitivity of the firms‟ revenue to general economic condition. If a company is highly
responsive to ups and downs in the economy the fund providers would demand higher return for
compensation.
d) Bankruptcy Court, Investment Advisors and Registrar of Companies are sources which can
provide information on financial healthy of a company.

49
5.5Measues of Long term Solvency
a) Common size statements
One of the measures of financial risk in an organization is the composition of the capital structure.
This is achieved by constructing a common size statement of the equity section focusing on the
longer term capital funds. The advantage of this is that it presents clearly the relative magnitude of
the sources of funds of an organization and this can be compared easily with similar data from
related companies.
Example
The following is the capital structure of a company in the region
Long term debt ------------------------------------------ 500,000 18.5%
Preferred stock ------------------------------------------- 400,000 14.8%
Retained earnings ---------------------------------------- 600,000 22.0%
Common stock -------------------------------------------1,200,000 44.7%
2,700,000 100%
b) Capital Structure Ratios
a) Debt equity ratio = Total debt/ Total Equity

This is a ratio whose purpose is to compare the amount of debt employed in an organization to the
owner’s contribution. The total debt should include all liabilities including the short term liabilities,
long term debts, redeemable preference stock and any other category of debt. Owner’s equity
should be made up of the paid up capital and any reserves. A slightly different measure is the long
term to equity ratio which is measured by the ratio
50
Long term debt/owners equity
Where by the long term debt excludes the short term liabilities.
Which ever way a debt ratio is calculated it shows the extent to which a company is using debt
financing with a high ratio meaning that the creditors have a higher claim than the owners. A high
level of debt means that the company lacks flexibility in its operations because of increasing
pressure from the creditors. In addition the company finds it difficult to raise more funds for
operations as it is considered to too risky.
On the other hand when the ratio of debt to owners equity it symbolizes a stable firm which is
comfortably able to meet its entire financial obligation even during lean times. When the
proportion of debt is too low it might also indicate a firm that is not able to earn extra return during
good times. For this reason the decision on the amount of debt to employ needs caution so that the
organization does not loose out on opportunities to make a good return for the share holders
b) Interest coverage ratios

These are ratios that show how well a company is able to meet its interest payments out of the
profits earned.
EBIT/Interest
Where the ratio is more than one then the company is able to comfortably meet its interest
payments
c) Altman’s Z-score
Analysts make use of ratio analysis to measure the level of various risks associated with the
financial well being of a company. However questions still abound on the suitability of the ratio
analysis in predicting long term solvency of an organization. Among the studies done it can be
concluded that ratios have a predictive power on the possibility of organizational failure
(bankruptcy) up to a number of years before the actual collapse. In general ratios relating to
profitability, liquidity and solvency emerged as the most significant indicators of impending
corporate failure.
51
Although the studies done established certain important generalizations regarding the performance
and trends of particular measurements, the interpretation was found to be a challenge on the level
of importance of each measure with some measures not being explicit in their interpretation. For
this reason there was need to enhance the usefulness of ratio analysis by finding a model that
would combine the individual ratios so that the challenges of interpreting individual ratios can be
mitigated.
This led to the development of the Z score analysis which seeks to predict the possibility of
bankruptcy in financially distressed companies.
Z=1.2X1+1.4 X2+3.3X3+0.6X4+1.0X5
Where X1 = Working capital/Total assets
This is a measure of the level of the working capital in comparison to the total assets. A company
that makes losses over a long period of time has a low level of working capital in comparison to the
total assets.
X2= Retained earnings /total assets
This is a ratio that seeks to look at how much an organization has retained from the profits that it
has made in its operations. An organization that is continually making losses will have no retained
earnings while a young company will also have a low level or no retained earnings. This scenario
would mean the organization will use a high level of debt and is likely to be in a bad financial
situation.
X3 = EBIT/Total assets
This is a ratio that measures the productivity of assets employed by an organization. Where an
organization is not able to earn an adequate return from its assets this is a company which is likely
to have low profitability and consequently financial problems.
X4 = Equity/ total liabilities
The liabilities are made of both the short term and long term liabilities and the ratio measures the
extent of claims by outsiders in comparison to the owner’s equity. In a situation where the liabilities
exceed the equity (common and preferred) then the company is likely to find itself in financial
distress since this indicates high levels of gearing.
X5 = Sales/ Total Assets
This ratio shows the assets ability to generate sales and also the management’s ability to deal with
competition at the market place.
52
In calculating the ratios the figures used should be calculated as absolute figures i.e. 10% should not
be converted to 0.1but should be used as calculated
Interpretation
The score is interpreted as follows
Z<1 The company is insolvent and winding up is a matter of course
1<Z>2.9 this is a gray area. The company may slip into insolvency if care is not taken
Z>3 the company is sound financially and there is no threat of insolvency
Illustration
A company with sales turnover of 262,451,000 and EBIT of (47,503,000) has the following balances
in the balance sheet
KSH KSH
Non current Assets 160,492,000
Current Assets 52,880,000
Less current liab 93,146,000 (40,266,000)
Total Assets 120,226,000
Financed By
Share Capital 117,812,000
Revenue reserve (150,694,000)
Revaluation reserve 79,193,000
Non current Loans 73,915,000
Total Liabilities 120,226,000
Calculate the Z score.
53
WorldCom Test
To demonstrate the power of the Z-score, let‟ s look at how it holds up with a tricky test case.
Consider the infamous collapse of telecommunications giant WorldCom. Declared bankrupt in
2002, WorldCom lost investors more thanKshs100billion in value after management falsely
recorded billions of dollars as capital expenditure rather than operating costs.
Here we calculate Z-scores for WorldCom using annual financial reports for years ending
December 31 1999, 2000, and 2001. Indeed, WorldCom‟ s Z-score in 2000 and 2001,
before declaring bankruptcy in2002.
Input Financial Ratio 2000 2001
1999
X1 Working capital/total Assets - -0.08 0
0.09
X2 Retained earnings/Total - 0.03 0.04
Assets 0/02
X3 EBIT/Total Assets .08 .02
.09
X4 Market value/ Total Liabilities 1.2 .50
3.7
X5 Sales/Total Assets 0.42 0.3
0.51
Z-Score 2.5 1.4 .85
54
But WorldCom management cooked the books, inflating the company’s earnings and
assets in the financial statements. What impact do these creative accountings have on the Z-
score? Overstated earnings likely increase the EBIT/Total assets ratio in the Z- score model,
but overstated assets would actually shrink three of the other ratios with total assets in the
denominator. So the overall impact of the false accounting on the company‟ s Z-score is
likely to be downward.
Enron
In 2001/2, Enron was a market darling worth overKshs80 billion. Today it is worth nothing
more than a penny stock with a market capitalization of less thanKshs800 million. This
recent happenings of listed companies brought several questions to investors. These
included:
 Who protects the interest of investors?
 Do existing securities have value when, and if, the company is reo-organized?
Altman subsequently developed a revised Z-Score model (with revised coefficients and
Z-Score cut-offs) which dropped variables X4 and X5 (above) and replaced them with a new
variable X4 = net worth (book value)/total liabilities. The X5 variable was allegedly dropped to
minimize potential industry effects related to asset turnover.
Around 1977, Altman developed jointly with a private financial firm (ZETA Services, Inc.) a
revised seven-variable ZETA model based on a combined sample of 113 manufacturers and
retailers. The ZETA model is allegedly "far more accurate in bankruptcy classification in years 2
through 5 with the initial year's accuracy about equal." However, the coefficients of the model
are not specified (without retaining ZETA Services). The ZETA model is based on the following
variables:
55
 Return on assets
 Stability of earnings
 Debt service
 Cumulative profitability
 Liquidity/current ratio
 Capitalization (five year average of total market value)
 Size (total tangible assets)
Where Z score falls short

Alas, the Z-Score is not perfect, and needs to be calculated and interpreted with care. For starters,
the Z-Score is not immune to false accounting practices as seen above.
Companies in trouble may be tempted to misrepresent financials. The Z-Score is only as accurate
as the data that goes into it.
The Z-Score also isn‟ t of much use for new companies with little or no earnings. These
companies, regardless of their financial health, will score low. Moreover, the Z-Score doesn‟ t
address the issue of cash flows directly, only hinting at it through the use of the net working
capital-to-asset ratio. After all, it takes cash to pay the bills.
Finally, Z-Scores can swing from quarter to quarter when a company records one-time write
offs. These can change the final score, suggesting that a company that‟ s really not at risk is on
the brink of bankruptcy. Sometimes off balance sheet events are used to achieve financial
smoothening.
To keep an eye on their investments, investors should consider checking their companies Z-Score
on a regular basis and over time. A deteriorating Z-Score can signal trouble ahead and provide
56
a simpler conclusion than the mass of ratios. Given its shortcomings, the Z-Score is probably better
used as a gauge of relative financial health rather than as a predictor. Arguably, it‟ s best to use
the model as a quick check of financial health, but if the score indicates a problem, it‟ s a good
idea to conduct a more detailed analysis.
5.6 Existence of optimum capital structure

An optimum capital structure exists and it occurs when the cost of capital is at the minimum or the
value of the firm is at the maximum. This optimum position should be the one that allows maximum
returns for the shareholders, room for the management to execute corporate programs as well as
having the lowest risk to the long term solvency of the company
Graph
PV of FD
and
agency
costs
Actual
Value of a firm
value of
a firm
57
PV of
interest
tax
shield
Optimal leverage Capital Structure
The present value of the interest tax shield (PVINTS) increases with borrowing but so
does the present value of the costs of financial distress. However, the costs of financial
distress are quite insignificant with moderate level of debt and therefore the value of the
firm increases with debt. With more and more debt, the costs of financial distress
increases and so the tax benefits shrinks. The optimum point is reached when the present
58
value of the tax benefit becomes equal to the present value of the costs of financial
distress. The value of the firm is maximum at this point.
Financial distress runs across the whole range; from a vague uneasiness about future
profitability to complete disintegration of the firm. It can be defined in the following
terms:
(i) Economic failure – failure in an economic sense signifies that firm‟ s revenues
don‟ t cover its total costs including its cost of capital. Businesses that are economic
failures can continue operating as long as:
 Creditors are willing to provide capital
 The owners are willing to accept below market rates of return
Such firms run the danger that no new capital will be provided when assets wear out
and need to be replaced. So such firms either close or contract to a point where their
smaller level of output provides a “normal” return.
(ii) Business failure – refers to any business that has terminated operations with a
resultant loss to creditors. Thus a business can be classified as a failure even though it
never enters into a formal winding process. A business can also close and not be
counted as a failure (Discontinued Operations under International Accounting
Standards (IAS) 14.
59
(iii) Technical insolvency – A firm is considered technically insolvent if it cannot
meet its obligations as they fall due.
(iv) Insolvency in bankruptcy – A firm is insolvent in bankruptcy when the book
value of its total liabilities exceeds the market value of its assets. This is a sign of
economic failure and often leads to liquidation of the business.
(v) Legal bankruptcy – Although many people use the term Bankruptcy to refer to
any firm that has “failed”, a firm is not legally bankrupt unless it has filed for
liquidation under the Companies Act (Cap 486).
5.7 Options in time of financial distress.
Business firms can deal with financial distress, that is, when they are in a Z score of
between 1 and 1.8, in several ways, which include:
(i) Disposing of real property: A company may opt for this to get money to pay its
creditors and meet other operating costs- (a sale and leaseback). We witnessed Uchumi
Supermarkets Ltd disposing off some of their property in order to stay a float.
(ii) Merging with other firms: Mergers and alliances, such as that between Bamburi
Cement and Athi River Mining, can put a distressed company back on good financial
footing.
(iii) Reducing capital spending on research and development: This option may make a
firm „survive‟ . In the long run, research is critical in the light of dynamic
business environment.
(iv) Issuing new shares: This depends on whether a company has exhausted its
60
authorized share capital.
(v) Negotiating with creditors: An organization may negotiate with creditors to
extend the duration of debt servicing. This may involve new negotiations on interest
rates and paying period. A successful negotiation may save a company from liquidation.
(vi) Liquidation: A situation in which a firm is terminated as a going concern involves
selling its assets to salvage is value.
(vii) Lay offs: Reducing staff levels in an option adopted by some organizations. Other
firms are right sizing their labour force.
5.8 Settlements without going through formal bankruptcy
When a firm experiences financial distress its managers must decide whether: -
 The problem is temporary and the firm is really financially viable or
 A permanent problem exists that endangers the firm‟ s life.
 Try to solve the problem informally or under the direction of a bankruptcy court.
Because costs associated with formal bankruptcy (e.g. disruptions that occur when
customers, suppliers and employees learn about bankruptcy) it is desirable if possible to
reorganize or liquidate a firm outside formal bankruptcy.
Informal Re-organization:
In case of economically viable companies, whose financial difficulties appear to be
temporary, creditors are directly working with the company in order to help it recover
and re-establish itself on a sound financial basis (workout plans). These plans involve
debt restructuring whereby extensions and or composition is extended by creditors.
 Extensions are instances where creditors postpone the dates of required interest or
principal payments.
61
 Composition are instances where creditors voluntarily reduce their fixed claims
on the debtor by ;
a) Accepting a lower principal amount,
b) Reducing the interest rates on the debt,
c) Accepting equity in place of debt i.e. National Bank and N.S.S.F.
d) accepting a combination of the two.
It is worth noting that as a result of the reality of financial distress, most banks in Kenya
have developed loan products to address this sector, for instance Barclays Bank has come
up with a product called „Top up’ to assist firms during financial distress. The basis of
„Top up‟ is basically to extend the credit period and reduce the fixed rate of payments
to the bank.
Banks also engage in restructuring of loan facilities extended to both retail and corporate
clients, to enable them put their businesses on track before they can finally classify the
account and embark on recovery of debt, for instance we have seen Housing Finance
(HF) restructuring the mortgage product when its clients are encountering financial
difficulties, such as a loss of employment, death of the principal loaner and even
transferring the loan to a nominated beneficiary.
Assignment:-
For a firm that is obviously viable and valuable, informal procedures can also be used to
liquidate the firm as they usually yield creditors larger amounts than they would receive
in formal bankruptcy/liquidation. However, assignments are only feasible; if a firm is
small and its affairs are not complex e.g. Supreme Furnishers and its sister company
Barnetts. An assignment involves the transfer of title to assets of a debtor to be
62
transferred to a third party.
Illustration:
The Altman formula for prediction of bankruptcy is as follows.
1.2(A) + 1.4 (B) + 3.3 (C) + 1 (D) + 0.6(E)
Where:
A= Working capital/assets.
B= Retained earnings/assets
C=Pretax earnings/assets
D= Sales/assets
E= Market value of equity/liabilities.
A company that has a Z-score of less than 1.81 is regarded as being at risk
You are given the following information in respect of four listed companies.
Company Workings Retained Pre-tax MV of
Capital earnings earnings equity Assets Liabilities
Sales
63
A Ltd 4,000 60,000 10,000 20,000 200,000 120,000
200,000
B Ltd 200,000 20,000 0 5,000 100,000 80,000
120,000
C Ltd 60,000 200,000 (30,000) 480,000 800,000 740,000
900,000
D Ltd 40,000 200,000 30,000 100,000 1,800,000 1,000,000
2,000,000 All figures are in Shs. „000‟
Required:
a) Calculate the Z-score for each of the companies and comment on your results.
b) Briefly explain the possible reasons for selection of each of the five variables
included in the formula.
c) Discuss the argument that other ratios ought to be regarded as better predictors of
bankruptcy.
A B C D E
Solution: A Ltd factor 0.02 0.30 0.05 1.00 0.167
Z score = 1.2(0.02) + 1.4(0.30) + 3.3(0.05) + 1(1) + 0.6(0.167) = 1.709 etc.
Others
64
5.9 Managing Financial Distress
Many bankruptcies can be avoided by practicing good money management. For example,
avoid impulse spending, don‟ t use a credit card unless you have cash to pay it off, tear up
credit card offers you receive in the mail, stick to a realistic budget, don‟ t buy more house
than you can comfortably afford, make sure you are adequately covered by insurance
(medical, homeowners, auto), don‟ t make speculative or high - risk investments,
don‟ t incur joint debts with others who have questionable financial habits.
If you do find yourself behind your bills, call your creditors before you get in too deep.
Most creditors will work with you if circumstances (job loss, divorce, illness, etc.) have
made it temporarily difficult for you to meet your financial obligations. Suggest a
temporary reduction in your payment, a waiver of late fees or penalties, skipping several
payments now and increasing future payments to make up for it, or skipping several
payments and adding them to the end of the loan. Some people successfully use credit
counseling services to help negotiate with creditors, but make sure the business is
legitimate and reputable.
5.10 Summary
We have discussed the main issues involved in bankruptcy and financial distress in
general. The key concepts are listed below:
65
 There are several definitions of financial distress; (1) economic failure, (2)
business failure, (3) technical insolvency, (4) insolvency in bankruptcy and (5)
legal bankruptcy.
 The proportion of businesses that fail fluctuates with the economy, but the
average liability per failure has tended to increase over time due to inflation and
to an increase in the number of billion – dollar bankruptcies in recent years.
 The fundamental issue to be addressed with a company encountering financial
distress is whether the company is “worth more dead than alive”, that is, would
the business be more valuable if it continued in operation or if it were liquidated
and sold off in pieces?
 In the case of a fundamentally sound company whose financial difficulties appear
to be temporary, creditors will frequently work with the company, helping it to
recover and re-establish itself on a sound financial basis. Such voluntary
reorganization plans are called workouts.
 Reorganization plans usually require some type of restructuring of the
firm‟ s debts, involving either an extension, which postpones the date of required
date of payment of past due date obligations, or a composition, by which the
creditors voluntarily reduce their claims on the debtor or the interest rate on their
claims.
 When it is obvious that a firm is worth more dead than alive, informal procedures
can sometimes be used to liquidate the firm. Assignment is an informal procedure
for liquidating a firm and it usually yields creditors a larger amount than they
would receive in formal bankruptcy liquidation. However, assignments are
66
feasible only if the firm is small and its affairs are not too complex.
 Since the first bankruptcy laws, most formal reorganization plan have been
guided by absolute priority doctrine. This doctrine holds that creditors should be
compensated for their claims in a rigid hierarchical order, and that senior claims
must be paid in full before junior claims can receive even a dime.
 Another position, the relatively priority doctrine holds that more flexibility should
be allowed in a reorganization and that a balanced consideration should be given
to all claimants. In the recent years, there has been a shift away from absolute
priority towards relative priority. The primary effect of this shift has been to delay
liquidation so as to give management more time to rehabilitate companies in an
effort to provide value to junior claimants.
 The primary role of the bankruptcy court in reorganization is to determine the
fairness and the feasibility of proposed plans of reorganization.
 Even if some creditors or stockholders dissent and do not accept a reorganization
plan, the plan may still be approved by the court if the plan is deemed vital.
Illustration.
High Pitch Entertainment started operation on, 1st September 2007. It raised the
required equity capital of Shs.130m and the debt at an annual rate of interest of 18%
before commencing the business. Given below are some statistics extracted from the
books of the company in respect of the firm‟ s statement prepared to 31st August 2007.
67
Total fixed assets (NBV) 150,000
Operating profit (excluding debt interest) 78,300
Dividend declared and paid 8,440
Cash and bank balances 6,250
80% of sales were on credit

The current assets on 31.08.07 consisted of only stock, debtors and cash and bank
balances as given above while the current liabilities consists of creditors and tax
provision in respect of the year to 31.08.07. Taxation was provided for at a rate of 30%.
You are provided with the following ratios which have been determined from the
financial statement of High Pitch Entertainment.
Fixed assets turnover 1.8times
G P margin 45%
Stock turnover 4.4times
Interest cover 4 times
Average debt collection period (360days) 84 days
Current ration 2.5:1
In respect of the year, ended 31.08.07 you are required to prepare the company‟ s
i. Income statement
ii. Balance sheet
68
Solution
Fixed asset turn over = Sales Interest cover =EBIT
ratio F. A Interest expenses
1.8 = Sales
75,000
Sales = 75,000 x 1.8
= 135,000
Credit sales = 80% x 135,000
=108,000
Average collection period = Number of days x Av. Debtors
Credit sales
84 x 360 = 360/84 =4.286
Average debtors =108,000=25,198
4.286
Gross profit margin =GP X 100
Sales
69
45 = GP x 100 Interest cover =EBIT
70
135,000 Interest
45 x 1350 =GP 4=21,600
60,750=GP x
GP = Sales – COGS
60750 = 135,000 – COGS Interest expense> x =21,600/4 = 5400
COGS = 135,000 -60,750 = 74,250 Debt= 5400/.18 = 30,000
MWANCHI TRADING P X L ACCOUNT FOR THE YEAR ENDING 31.08.03
Sales 135,000
Loss: COGs (74,250)
GP 60,750
Less: Expenses
Operating costs 39,150
EBIT 21,600
Less: Interest cover (5,400)
EBT 16,200
Less: Tax (30% x 16,200) 4,860
Earnings attributable to shoulder 11,340
Ordinary share paid (DVD) (4,220)
Retained earnings 7,120
Average stock =COGS =4.4
Av. Stock
71
135,000 – 6,075 =4.4
Av. Stock =16,875
EBIT = 4 60750 -39,150 =5400-Interest exp
Int. exp 4
Current ratio 2.25.1 = C.A = 2.5
C.L 1
CA =16875 +25200 + 3125 – 2.5
x 1
x =18,080
Review questions
1) The following information has been extracted from the published accounts
of Pesa Corporation Limited, a company quoted on the Nairobi Stock
Exchange.
Shs.
Net profit after tax and interest 990,000

Less: dividends for the period 740,000
Transfer to reserves 250,000
Accumulated reserves brought forward 810,000
Reserves carried forward 1,060,000
Share capital (Sh.10 par value) Sh.8,000,000
Market price per share now 12%

72
Required
a) What is meant by a company quoted on the Nairobi Stock Exchange?
(6 marks)
b) Calculate for Pesa Corposation Limited the following ratios and indicate
the importance of each to Miss Hisa, a Shareholder:
i) Earnings per share. (4 marks)

ii) Price earnings ratio (4 marks)
iii) Dividend yield (4 marks)
iv) Dividend cover (4
marks)
2)
The Altman formula for prediction of bankruptcy is given as follows:
Z score= 1.2X1 + 1.4X2 + 3.3X3 + 1X4 +

0.6X5
Where: X1 = Working capital/Total assets

X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Sales/Total assets
X5 = Market value of Equity/Liabilities
In this model, a Z-score of 2.7 or more indicates non-failure and a Z-score of 1.8
or less indicates failure.
You are provided with the following information in respect of four listed
companies.
C Ltd Working Retained Earning Market Total Liabilities

D capital earnings s before value of assets
interest equity
and tax
Sh.’000’
Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’
A 4,000 60,000 10,000 20,000 200,000 120,000
Ltd 2,000 20,000 0 5,000 100,000 80,000
B 6,000 20,000 -30,000 48,000 800,000 740,000
Ltd 40,000 200,000 30,000 100,000 1,800,000 1,000,000
73
Sales
Sh.’000’
20,000
120,000
900,000
2,000,000
74
Required
a) The Z-Score for each of the companies. Comment on the results obtained. (10
marks)
b) It has been suggested that other ratios ought to be incorporated into Altman‟ s
bankruptcy prediction model. What is your opinion on this? (5
marks)
c) List the indicators of possible business failure. (5
marks)
References
(Wiley 2003)
75
CHAPTER SIX: ANALYSIS OF OPERATIONS
6.1 Introduction
An organizations operation is of significant importance to a financial analyst as they give
insight on the company’s earnings, cost structure and profitability and their implication
for the organization. The operations of an organization can be presented using different
formats where for external users they are presented using the profit and loss statement
and the balance sheet while for internal purposes they can be presented using any format
that would meet the management’s information requirements.
6.2 Income statement Analysis

The income statement is of great importance to any person interested in an organizations
performance. From credit evaluation to security analysis, the ability of an organization to
generate income and the quality of that income is of great importance. While analyzing
the income statement of an organization the analyst should be conscious of the various
factors that may affect the preparation of the statements including the accounting
principles applied as well as the degree of objectivity of the accountant and the auditors
involved. Cases of manipulation of accounts are common and as such the analyst should
be able to rise above any such schemes and based on his insight be able to adjust the
accounts to bring out the true financial condition of an organization.
6.3 Analysis of sales and revenues

This analysis is supposed to give insight into the major sources of revenues the stability
and trend. The source of revenue is important especially where the organization is
operating in diverse markets and having a variety of products. Each of these regions and
product lines is likely to have its own growth pattern and direction. The best way to
analyze the revenues is by doing a common size analysis to see what product line forms
what proportion of the total income or the proportions per regions. A lot of times it is
common to find that some product lines or regions actually do not add to the profitability
of the organization and they may actually be pulling the organization backwards through
loss making. Unless the loss making or negative margins is part of corporate strategy then
such products or regions should be noted for action.
It is important for the analyst to understand the industry, markets and economies where
the organization is operating. Are they growing or shrinking? How is competition,
availability of substitutes? What the government’s policy is as relates to the business that
the organization is involved in? What is the key markets and customers? What market
segment is the company serving and what are the implications? All these questions will
76
and others focused on the business environment will help the analyst be able to
determine the likely trend of the revenues and their continuity.
After doing the analysis the analyst should compare the results with those of the other
industry players so as to be able to make an impression on how well the company is doing
in comparison to the competition.
6.4 Analysis of Gross Profit

The gross profit represents the excess of sales over the cost of goods sold. When
compared over a period of time the trend that emerges should indicate a growing gross
margin constant or declining margin. It is important for the analyst to be able to explain
the causes of the movement if the accounts are to be properly interpreted. The following
scenarios are likely to cause positive movements in the gross margin
a) Growth in per unit price without a corresponding growth in the unit costs – This is
possible due to aspect of fixed costs which do not rise with the volume of
transactions
b) Reduction in operational costs reflecting greater efficiency
c) Growth in volumes leading reduced cost per unit
6.5 Break Even Analysis

This is an equally important analysis for the management of an organization especially for
a newly formed organization since it helps establish the volumes at which the company is
expected to break even. In addition the analysis prods the management to make a
decision on the level of operating leverage they will prefer to maintain as the analysis
shows the interplay between the fixed and the variable costs in an organization.
The formula for break even (Fixed Costs/ contribution per unit) indicates that the
management has to be conscious of the trade off between high capitalization and high
proportion of variable costs. The more than proportional increase in profitability courtesy
of use of fixed costs in operations of the organization is referred to as operational
leverage. For a highly leveraged company there is a huge increase in profitability for a
small change in profits. At the same time the organization with high leverage would suffer
77
huge losses when sales fall as compared to a firm with low leverage. Thus it is the role of
the management to make a decision in view of expected volatility of sales.
For a company operating in a volatile market the level of the fixed costs should be low
meaning that the company will break even at low volumes and that its cost structure will
be flexible such that as sales come down some costs are avoided as they are variable. On
the other hand when the company is operating in a stable market use of higher levels of
fixed costs due to automation will mean that the company breaks even at a higher output
level but it makes a greater return when the sales are high as the fixed costs will be used
over a larger volume of output.
Illustration
Two firms X and Y operate in the same market with similar products. The following
information is relevant to the two
X Y
Selling price 100 100
Variable costs 60 40
Fixed costs 400,000 700,000
BEP X = 400,000/ 40 = 10,000
BEP Y = 720,000/ 60 = 12,000
From the BEP analysis the organization with a higher leverage needs a higher volume of
sales to be able to break even compared to the one with a low leverage. The following
table shows the level of profitability as sales volumes rise
Company X
UNITS REVENUE V.COSTS F.COSTS PROFIT
78
5,000 500,000 300,000 400,000 -200,000
10,000 1,000,000 600,000 400,000 0
15,000 1,500,000 900,000 400,000 200,000
20,000 2,000,000 1,200,000 400,000 400,000
25,000 2,500,000 1,500,000 400,000 600,000
Company Y
UNITS REVENUE V.COSTS F.COSTS PROFIT
5,000 500,000 200,000 700,000 -400,000
10,000 1,000,000 400,000 700,000 -100,000
15,000 1,500,000 600,000 700,000 200,000
20,000 2,000,000 800,000 700,000 500,000
25,000 2,500,000 1,000,000 700,000 800,000
From the tables above the highly leveraged organization is more profitable when the sales
are high while it is susceptible to losses when sales fall. The management needs to make a
decision especially as relates to investments in the production process depending on the
industry trends. When making a decision for or against automation the management
needs to take cognizance of the effect of high automation in a turbulent market.
79
6.6 Expense Analysis
It is important for the analyst to also carry out an analysis on the other categories of
assets mainly to see the proportion they form of the total expenses. By carrying out a
common size analysis one can be able to compare the proportion of expenses to sales
with those of a similar company. Among the key expenses to be analyzed include:
a) Sales and marketing expenses- The analysis for this category of assets is meant to
establish the impact of expenditure in this category on the sales of the company.
Where the impact is significant then it means that the organization stands to gain
by increasing the proportion of advertising costs. Where there is no significant
impact it could indicate a saturated market or a product that has no appeal to the
consumers hence need for reengineering.
b) Maintenance expenses – where these are excessive it would indicate old machines
that need replacement to boost operational efficiency. On the other hand it could
indicate misuse by enterprise mainly out of failure to understand how they should
be used hence need for training.
c) Finance costs – where these are high they indicate high levels of gearing and could
indicate presence of financial risk should the company be unable to generate
adequate returns to meet the financial costs
Other relevant ratios
i) Operating ratio –This ratio measures the proportion of the operating

expenses on the sales of the company i.e. operating expenses/ net sales
ii) Gross margin ratio – The ratio measures the level of gross margin on the
net sales i.e. Gross margin/ Net sales
iii) Net income ratio – This ratio establishes the relation ship between net
income and sales i.e. Net Income/ Net sales
80
These ratios are important especially for projection purposes where the management
wants to project the expected level of net sales, and gross margin out of targeted sales
volumes. They can also be compared to similar companies to indicate the level of
efficiency compared to the peers.
81
CHAPTER SEVEN: ANALYSIS OF INVESTMENTS
Chapter objectives
By the end of the chapter the student should:
a) Appreciate the need to perform analysis of investments
b) Identify the tools to use in analyzing investments
c) Use the identified tools practically
7.0 Introduction
Companies engage in investments either as a core activity or out of a desire to utilize
excess funds or take advantage of an opportunity. Whatever the reason for the
investment it is important to ensure that the company is getting maximum returns out of
its investment. In analyzing an investment there are both quantitative and non
quantitative factors to consider
7.1 Non quantitative Analysis

It is not always that a company will invest for the purpose of earning a profit. There are
investments that are done whose main objective is to achieve desired non profit
objectives such as a just society, gender parity, poverty eradication, improving quality of
life etc. For such investments the level of returns may have to be based on factors that are
more qualitative than quantitative.
7.2 Quantitative Analysis

This involves use of quantitative methods to determine the extent to which an investment
is meeting the desired objectives. To be able to do this one needs to have quantitative
objectives which can then be compared to the results after a given period of time. Most of
the commercial investments are profit oriented and for that reason they are quantitative
in nature. Analysis may be done by use of comparative analysis where the results of one
investment may be compared to another similar investment. However the main tool of
analyzing investments that are profit oriented is the ROI (Return on investments)
82
7.3 Return On Investments (ROI)
This is a common tool of analysis for investments which focuses on comparing the returns
from an investment to the amount that has been investments done in that investment. By
using that kind of an analysis it is easier to compare among different investments hence
choosing the investment with the highest return on investment.
Formula ROI = Net profit/ Total Investment
The formula above helps to discriminate among investments under similar conditions
though many arguments exist on the suitability of the ROI. One of the questions relates to
the value of net profit to use i.e. whether it should be profit before interest and tax or
after. The main concern is that the management should not be blamed for the tax and
interest payments which are not under their control.
Where the ROI is for the purpose of measuring the management efficiency then it would
be right to consider using the profit before tax and interest but only if the management is
totally not in control of the financing costs and taxes. It should however be noted that the
management has options to avoid paying some taxes by taking advantage of
opportunities provided by the tax policies of the government. For this reason Profit after
tax is normally used to calculate the ROI.
Uses of ROI
- Measure of management efficiency – For similar organizations the

difference in ROI can only be attributed to management efficiency with
the more efficient organization reflecting a higher ROI.
- Tool to discriminate between projects – Where two projects are

involved the project with a higher return should be preferred.
Advantages of ROI
- Easy to calculate and interpret
- Allows ranking of companies
- Widely accepted as a measure of performance
83
Disadvantages of ROI
- It relies on accounting information which may at times not be very

accurate
- Does not consider other non quantitative factors
Review Questions
Using any two similar companies in the stock exchange compare the returns on
investment over a period of three years and comment on
- Trend
- Comparison between the two companies
- Factors contributing to the differences in the ROI
- Your preferred company
84

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DEPARTMENT OF FINANCE AND ACCOUNTING

P.O. Box 342 THIKA, KENYA

Course code: BAF4101

COURSE TITLE: FINANCIAL STATEMENT ANALYSIS

MOUNT KENYA UNIVERSITY

DEPARTMENT OF FINANCE AND ACOUNTING

Course Objectives and Topics:

 Define financial forecasting

LESSON 12: Revision

CHAPTER ONE: INTRODUCTION TO FINANCIAL ANALYSIS ........................................................... 7

1.3 Features of Financial Analysis .................................................................................................21

1.4 Purpose of Analysis of financial statements ............................................................................21

1.5 Procedure of Financial Statement Analysis..............................................................................21

1.6 Advantages of Financial Statement Analysis:...........................................................................23

1.7 Users of Accounting Information .............................................................................................23

Review Questions ...........................................................................................................................26

TOPIC TWO: BUSINESS ANALYSIS ............................................................................................ 16

2.1 Introduction ..............................................................................................................................16

2.2 Economic Environment ............................................................................................................16

2.3 Industry Analysis ......................................................................................................................18

2.5 Company management ............................................................................................................18

CHAPTER THREE: ANALYSIS OF SHORT TERM LIQUIDITY ........................................................ 20

3.2Working capital .........................................................................................................................20

3.3 Current Ratio ............................................................................................................................22

3.4 Cash Ratios ...............................................................................................................................24

3.5 Debtor’s turnover ratios ...........................................................................................................24

3.6 Inventory turnover ...................................................................................................................26

3.7 Overview of Cash flow..............................................................................................................27

Review Questions ...........................................................................................................................31

4.2 Methods/Techniques of Financial Forecasting .......................................................................33

Revision Questions .........................................................................................................................41

CHAPTER FIVE: CAPITAL STRUCTURE ANALYSIS ........................................................................ 44

5.1 Introduction ........................................................................................................................44

5.2 Effect of capital structure on long term solvency ....................................................................45

5.3 Financial Distress ......................................................................................................................45

5 . 4 I n d i c a t o r s of Financial distress: ........................................................................................49

5.5Measues of Long term Solvency ...............................................................................................50

5.6 Existence of optimum capital structure ..................................................................................57

5.7 Options in time of financial distress. ..................................................................................60

5.8 Settlements without going through formal bankruptcy .......................................................61

5.9 Managing Financial Distress................................................................................................65

Review questions ...........................................................................................................................72

CHAPTER SIX: ANALYSIS OF OPERATIONS ............................................................................... 76

6.2 Income statement Analysis ......................................................................................................76

6.3 Analysis of sales and revenues .................................................................................................76

6.4 Analysis of Gross Profit.............................................................................................................77

6.5 Break Even Analysis ..................................................................................................................77

6.6 Expense Analysis ......................................................................................................................80

CHAPTER SEVEN: ANALYSIS OF INVESTMENTS ......................................................................... 82

7.1 Non quantitative Analysis ........................................................................................................82

7.2 Quantitative Analysis................................................................................................................82

At the end of this topic, the learner should be able

conditions and performance of it.

Financial analysis is a process by which one manipulates the company’s financial

understanding the risk and profitability of a firm (business, sub-business or project)

through analysis of reported financial information, particularly annual and quarterly

Financial statement analysis consists of

1) Reformulating reported financial statements,