CHAPTER TWO

2. FINANCIAL ANALYSIS AND PLANNING (FORECASTING)

2.1. INTRODUCTION
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and
understanding of the financial aspects of the firm. Hence, preparation of the financial
statement is important as much as the financial decisions.
2.1.1. Meaning and definition
According to Hamptors John, the financial statement is an organized collection of
data according to logical and consistent accounting procedures. Its purpose is to
convey an understanding of financial aspects of a business firm. It may show a
position at a moment of time as in the case of a balance-sheet or may reveal a service of
activities over a given period of time, as in the case of an income statement.
Financial statements are the summary of the accounting process, which, provides
useful information to both internal and external parties. John N. Nyer also defines it
“Financial statements provide a summary of the accounting of a business enterprise,
the balance-sheet reflecting the assets, liabilities and capital as on a certain date and the
income statement showing the results of operations during a certain period”. Financial
statements generally consist of two important statements:
i. The income statement or profit and loss account.
ii. Balance sheet or the position statement.
i. Income Statement
Income statement is also called as profit and loss account, which reflects the operational
position of the firm during a particular period. Normally it consists of one accounting
year. It determines the entire operational performance of the concern like total
revenue generated and expenses incurred for earning that revenue. Income
statement helps to ascertain the gross profit and net profit of the concern.
ii. Position Statement
Position statement is also called as balance sheet, which reflects the financial position of
the firm at the end of the financial year. Position statement helps to ascertain and
understand the total assets, liabilities and capital of the firm. One can understand the
strength and weakness of the concern with the help of the position statement.
2.1.2. Meaning and Objectives of Financial Analysis
Financial analysis refers to analysis of financial statements and it is a process of
evaluating the relationships among component parts of financial statements. The
focus of financial analysis is on key figure in the financial statements and the
significant relationships that exist between them. Financial analysis is used by
several groups of users like managers, credit analysts, and investors.
The analysis of financial statements is designed to reveal the relative strengths and
weakness of a firm.
Financial analysis helps users to obtain a better understanding of the firm’s financial
conditions and performance. It also helps users understand the numbers presented
in the financial statements and serve as a basis for financial decisions.

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According to users of financial information, there are two techniques of financial
analysis. These are: External analysis and internal analysis.
A. External Analysis
Outsiders of the business concern do normally external analyses but they are
indirectly involved in the business concern such as investors, creditors, government
organizations and other credit agencies. External analysis is very much useful to
understand the financial and operational position of the business concern. External
analysis mainly depends on the published financial statement of the concern. This
analysis provides only limited information about the business concern.
B. Internal Analysis
The company itself does disclose some of the valuable informations to the business
concern in this type of analysis. This analysis is used to understand the operational
performances of each and every department and unit of the business concern.
Internal analysis helps to take decisions regarding achieving the goals of the
business concern.
2.1.3. Approaches or Tools/techniques of financial analysis
Financial statement analysis is interpreted mainly to determine the financial and
operational performance of the business concern. A number of methods or
techniques are used to analyze the financial statement of the business concern. The
following are the common methods or techniques, which are widely used by the
business concern.
1) Comparative Statement Analysis
Comparative statement analysis is an analysis of financial statement at different
period of time. This statement helps to understand the comparative position of
financial and operational performance at different period of time. Comparative
financial statements again classified into two major parts such as comparative
balance sheet analysis and comparative profit and loss account analysis.
a) Comparative Position Statement Analysis
b) Comparative Income Statement Analysis
a) Comparative Balance Sheet Analysis
Comparative balance sheet analysis concentrates only the balance sheet of the
concern at different period of time. Under this analysis the balance sheets are
compared with previous year’s figures or one-year balance sheet figures are
compared with other years. This type of analysis helps to understand the real
financial position of the concern as well as how the assets, liabilities and capitals are
placed during a particular period.
b) Comparative Profit and Loss Account Analysis
Another comparative financial statement analysis is comparative profit and loss
account analysis. Under this analysis, only profit and loss account is taken to
compare with previous year’s figure or compare within the statement. This analysis
helps to understand the operational performance of the business concern in a given
period.

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2) Ratio Analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a
mathematical relationship between one number to another number. Ratio is used as
an index for evaluating the financial performance of the business concern. An
accounting ratio shows the mathematical relationship between two figures, which
have meaningful relation with each other. Ratio can be classified into various types.
3) Common Size Analysis – expresses individual financial statement accounts as a
percentage of a base amount. A common size status expresses each item in the
balance sheet as a percentage of total assets and each item of the income statement as
a percentage of total sales. When items in financial statements are expressed as
percentages of total assets and total sales, these statements are called common size
statements.
2.1.4. Stages in Financial Analysis
Financial analysis consists of the following three major stages.
i) Preparation: The preparatory steps include establishing the objectives of the
analysis and assembling the financial statements and other pertinent financial
data. Financial statement analysis focuses primarily on the balance sheet and the
income statement. However, data from statements of retained earnings and cash
flows may also be used. So, preparation is simply objective setting and data collection.
ii) Computation: This involves the application of various tools and techniques to
gain a better understanding of the firm’s financial condition and performance.
Computerized financial statement analysis programs can be applied as part of
this stage of financial analysis.
iii) Evaluation and Interpretation: Involves the determination of the meaningfulness
of the analysis and to develop conclusions, inferences, and recommendations
about the firm’s performance and financial condition. This is the most important
of all the three stages of financial analysis.
2.2. Types of Financial Ratios
Several key ratios reveal about the financial strengths and weaknesses of a firm. We
will look at five categories of ratios, each measuring about a particular aspect of the
firm’s financial condition and performance.
2.2.1. Liquidity Ratios
Liquidity refers to the speed and ease with which an asset can be converted into
cash. Liquidity ratios measure the ability of a firm to meet its immediate obligations
and reflect the short–term financial strength or solvency of a firm In other words,
liquidity ratios measure a firm’s ability to pay its current liabilities as they mature by
using current assets. Liquidity has two dimensions: ease of conversion versus loss of
value. Any asset can be converted to cash quickly if we cut the price enough. A
highly liquid asset is therefore one that can be quickly sold without significant loss
of value.
There are two commonly used liquidity ratios: the current ratio and the quick ratio.

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Example: The following financial statements pertain to Zebra Share Company. We
will perform the necessary ratio analyses using them, and then evaluate and
interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2017 and 2018
(In thousands of Birrs)
Assets 2018 2017
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: Accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity:
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800

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 Zebra Share Company
Income Statement
For the Year Ended December 31, 2018
________________________________________________________________________
Net sales Br. 196,200,000
Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,000
Net income Br. 3,900,000
Included in Operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.
Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2018
Retained earnings at beginning of year Br. 9,000,000
Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
Common 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000
We can describe a firm’s ability to meet its current obligations in several ways:
i) Current ratio – measures the ability of a firm to satisfy or cover/meet the claims of
short-term creditors by using only current assets. This ratio relates current assets to
current liabilities

Zebra’s current ratio (for 2018) = Br. 57,600 = 1.51 times

Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and
in good position to meet its current obligations. Conversely, relatively low current
ratio is interpreted as an indication that the firm may not be able to easily meet its
current obligations. A reasonably higher current ratio as compared to other firms in
the same industry indicates higher liquidity position. A very high current ratio,
however, may indicate excessive inventories and accounts receivable, or a firm is not
making full use of its current borrowing capacity.

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ii) Quick ratio (Acid – test ratio) - measures the short-term liquidity by removing
the least liquid current assets such as inventories. Inventories are removed because
they are not readily or easily convertible into cash. Thus, the quick ratio measures a
firm’s ability to pay its current liabilities by using its most liquid assets into cash. In
other words, inventory is often the least liquid current asset. It’s also the one for
which the book values are least reliable as measures of market value, because the quality of
the inventory isn’t considered. Some of the inventory may later turn out to be
damaged, obsolete, or lost. More to the point, relatively large inventories are often a
sign of short-term trouble. The firm may have overestimated sales and overbought or
overproduced as a result. In this case, the firm may have a substantial portion of its
liquidity tied up in slow-moving inventory. To further evaluate liquidity, the quick,
or acid-test, ratio is computed just like the current ratio, except inventory is omitted:

Zebra’s quick ratio (for 2018) = (Br. 57,600 – Br. 24,900) ÷ Br. 38,100 = 0.86 times
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in
current liabilities. Like the current ratio, the quick ratio reflects the firm’s ability to
pay its short-term obligations, and the higher the quick ratio the more liquid the
firm’s position. But the quick ratio is more detailed and penetrating test of a firm’s
liquidity position as it considers only the quick asset. The current ratio, on the other
hand, is a crude measure of the firm’s liquidity position as it takes into account all current
assets without distinction.
2.2.2. Asset Management Ratios (Activity Ratios)
Activity ratios measure the degree of efficiency a firm displays in using its assets.
These ratios include turnover ratios because they show how rapidly assets are being
converted (turned over) into sales or cost of goods sold. Activity ratios are also
called asset management ratios, or asset utilization ratios, or efficiency ratios. Generally,
high turnover ratios are associated with good asset management and low turnover
ratios with poor asset management.
Activity ratios include:
i) Accounts Receivable Turnover – measures how efficiently a firm’s accounts
receivable is being managed. It indicates how many times or how rapidly
accounts receivable are converted into cash during a year.

Zebra’s accounts receivable turnover (for 2018) = Br. 196,200 ÷ Br. 20,700 = 9.48 times
Interpretation: Zebra’s accounts receivable gets converted into cash 9.48 times a
year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A
ratio substantially lower than the industry average may suggest that a firm has more
liberal credit policy, more restrictive cash discount offers, poor credit selection or
inadequate cash collection efforts.

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There are alternate ways to calculate accounts receivable value like average
receivables and ending receivables. Though many analysts prefer the first, in our
case we have used the ending balances. In computing the accounts receivable
turnover ratio, if available, only credit sales should be used in the numerator as
accounts receivable arises only from credit sales.
ii) Days sales outstanding (DSO): also called average collection period. It seeks
to measure the average number of days it takes for a firm to collect its
accounts receivable. In other words, it indicates how many days a firm’s sales
are outstanding in accounts receivable.

Zebra’s days sales outstanding (2018) = 365 days ÷ 9.48 = 39 days

Interpretation: Zebra’s credit customers on the average are paying their bills in
almost 39 days. If Zebra’s credit period is more than 39 days, some corrective actions
should be taken to improve the collection period.
The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover: measures how many times per year the inventory level is
sold (turned over).

For Zebra Company (2018) = Br. 159,600 ÷ Br. 24,900 = 6.41 times
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year. In a
sense, Zebra sold off or turned over the entire inventory 6.41 times. As long as we
are not running out of stock and thereby forgoing sales, the higher this ratio is, the
more efficiently we are managing inventory.
In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we
can apply sales. In general, a high inventory turnover is better than a low turnover.
However, abnormally high inventory turnover might result from very low level of
inventory. This indicates that stock outs will occur and sales have been very low. A
very low turnover, on the other hand, results from excessive inventory levels,
presence of inferior quality, damaged or obsolete inventory, or unexpectedly low
volume of sales.
iv) Fixed assets turnover: measures how efficiently a firm uses its fixed assets. It
shows how many birrs of sales are generated from one birr of fixed assets.
Fixed assets turnover = Net sales ÷ Net fixed assets
Zebra’s fixed assets turnover (2018) = Br. 196,200 ÷ Br. 96,300 = 2.04
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed
assets.
A fixed assets turnover ratio substantially lower than other similar firms indicates
underutilization of fixed assets, i.e., idle capacity, excessive investment in fixed

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assets, or low sales levels. This suggests to the firm possibility of increasing outputs
without additional investment in fixed assets.
The fixed assets turnover may be deceptively low or high. This is because the book
values of fixed assets may be considerably affected by cost of assets, time elapsed
since their acquisition, or method of depreciation used.
v) Total assets turnover: indicates the amount of net sales generated from each
birr of total tangible assets. It is a measure of the firm’s management
efficiency in managing its assets.
Total assets turnover = Net Sales ÷ Total assets
Zebra’s total assets turnover (2018) = Br. 196,200 ÷ Br. 153, 900 = 1.275
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one
birr invested in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and
low turnover indicates a firm is not generating a sufficient level of sales in relation to
its investment in assets.
2.2.3. Debt Management Ratios (Long-term Solvency or Leverage Ratios)
Leverage ratios are also called debt management or utilization ratios. They measure
the extent to which a firm is financed with debt, or the firm’s ability to generate
sufficient income to meet its long-term debt obligations. While there are many
leverage ratios, we will look at only the following three.
i) Debt to total assets (Debt) Ratio – measures the percentage of total funds
provided by debt. It is categorized under Component percentages ratios:
compare a firm’s debt with either its total capital (debt plus equity) or its
equity capital.

Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900
Interpretation: At the end of 2017, 64% of Zebra’s total assets was financed by debt
and 36% (100% - 64%) was financed by equity sources. A high debt ratio implies that
a firm has liberally used debt sources to finance its assets. Conversely, a low ratio
implies the firm has funded its assets mainly with equity sources.
Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more
the firm’s financial risk.
ii) Times – interest earned – measures a firm’s ability to pay its interest
obligations. It is categorized under Coverage ratios: reflect a firm’s ability to
satisfy fixed financing obligations, such as interest, principal repayment, or
lease payments.

Zebra’s times interest earned = Br. 10,500 = 3.50 times

Br. 3,000

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Interpretation: Zebra has operating income 3.5 times larger than the interest
expense.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT)
is available to meet its interest obligations. The greater the interest coverage ratio,
the better able the firm is to pay its interest expense. The interest coverage ratio tells
us about a firm’s ability to cover the interest related to its debt financing. However,
there are other costs that do not arise from debt but which nevertheless must be
considered in the same way we consider the cost of debt in a firm’s financial
obligations. These issues are addressed by fixed charges coverage ratio.
iii) Fixed charges coverage – measures the ability of a firm to meet all fixed
obligations rather than interest payments alone. Fixed payment obligations
include loan interest and principal, lease payments, and preferred stock
dividends. It is also categorized under Coverage ratios: reflect a firm’s ability to
satisfy fixed financing obligations, such as interest, principal repayment, or
lease payments.

For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700
Interpretation: The fixed charges (interest and lease payments) of Zebra Share
Company are safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio
is desirable. The fixed charges coverage ratio is required because failure of the firm
to meet any financial obligation will endanger the position of a firm.
2.2.4. Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales,
total assets, and owner’s equity. Profitability is the net result of a number of policies
and decisions. The ratios examined thus far provide useful clues as to the
effectiveness of a firm’s operations, but the profitability ratios show the combined
effects of liquidity, asset management, and debt on operating results. The following
ratios are among the many measures of a firm’s profitability.

i. Profit Margin – shows the percentage of each birr of net sales remaining after
deducting all expenses.

Zebra’s profit margin = Br. 3,900 ÷ Br. 196,200 = 0.02 or 2%

Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing
strategy as well as the amount of all costs and expenses/ financing strategy of a firm.

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ii. Return on investment (assets) – measures how profitably a firm has used its
investment in total assets.

Zebra’s return on investment = Br. 3,900 ÷ Br. 153,900 = 0.0253 or 2.53 %

Interpretation: Zebra earned more than 2 cents of profits for each birr it invested on
assets.
Generally, a high return on investment is sought by firms. This can be achieved by
increasing sales levels, increasing sales relative to costs, reducing costs relative to
sales, or efficiently utilizing assets.
iii. Return on equity – indicates the rate of return earned by a firm’s stockholders
on investments made by them.

Zebra’s return on equity = Br. 3,900 ÷ Br. 55,800 = 6.99%

Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.

A high return on equity may indicate that it is due to greater use of debt. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared
to debt contribution. Stockholders invest to get a return on their money, and this
ratio tells how well they are doing in an accounting sense. Generally, the higher the
return on equity, the better offs the owners.
2.2.5. Marketability/Market Value Ratios
A final group of ratios, the market value ratios, relates the firm’s stock price to its
earnings, cash flow, and book value per share. Marketability ratios are used
primarily for investment decisions and long-range planning. These ratios give
management an indication of what investors think of the company’s past
performance and future prospects. If the liquidity, asset management, debt
management, and profitability ratios all look good, then the market value ratios will
be high, and the stock price will probably be as high as can be expected. They
include:
i) Earnings per share (EPS) – expresses the profits earned on each share of a
firm’s common stock outstanding. It does not reflect how much is paid as
dividends. It shows how much investors are willing to pay per dollar of
reported profits.

Zebra’s Eps for 2018 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2017.

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ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm
paid on each share of its common stock outstanding.

Zebra’s DPs for 2017 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to
stockholders.

Or

Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
2.3. Ratios and Standard of Comparisons for Financial Ratios
A ratio analysis involves a standard of comparison for a useful interpretation of the
financial statement. To address whether a given ratio is high or low, good or bad, a
meaningful basis is needed for comparison. A single ratio in itself does not indicate
favorable or unfavorable condition. Thus, one of the following might serve as
standard of comparison:
 Time series or Past ratio analysis, i.e. ratios calculated from the past financial
statements of the same firm,
 Projected or Proforma ratio analysis, i.e. ratios developed using the
projected, or pro forma, financial statement of the same firm,
 Cross sectional or Competitor’s ratio analysis, i.e. ratios of some selected
firms, especially the most progressive successful competitor, at the same point
in time,
 Industry ratio analysis, i.e. ratios of the industry to which the firm belongs.
2.4. Limitations of ratio analysis
Even though ratio analysis can provide useful information about a firm’s financial
conditions and operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information
by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One
reason could be a single firm may have different divisions operating in
different industries. Another reason could be the financial statements may not
be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when
they are not audited.

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4. Different accounting principles and methods employed by different
companies can distort comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive
conclusion. For example, the inventory turnover ratio for stationery materials
selling company will be different at different time periods of a year.

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Financial Forecasting
2.4.1. Introduction
In the first unit, we discussed that financial management involves planning for
raising and utilizing funds. Financial managers should be able to plan before hand in
making investment and financing decisions. Therefore, financial forecasting helps
financial managers to predict events before they occur. This, particularly, is true
when they plan to raise funds externally. Because a firm’s profit is often insufficient
to finance assets in the normal course of business, additional sources of finance
should be considered.
Financial forecasting also forces financial managers to develop financial statements
beforehand. These financial statements are called Pro forma financial statements. They
include forecasted sales and forecasted expenses, forecasted assets, forecasted
liabilities, and forecasted stockholders’ equity. Based on these forecasted items, the
financial manager is able to determine the amount of finance to be obtained from
external sources.
2.4.2. Meaning and purpose of financial forecasting
Financial forecasting is one of the three major jobs of a firm’s financial staff, namely
performing financial forecasting and analysis, making investment decisions, and
making financing decisions. It is generally a planning process which involves
forecasting of sales, assets, and financial requirements. In other words, financial
forecasting is a process which involves:
 Evaluation of a firm’s need for increased or reduced productive capacity and
 Evaluation of the firm’s need for additional finance
Generally, financial forecasts are required to run a firm well. Their bases, in almost
all circumstances, are forecasted financial statements. An accurate financial forecast
is very important to any firm in several aspects:
 It helps a firm to predict appropriate demand for its products.
 It helps a firm to project its sales and accordingly to predict its assets
properly.
 It contributes significantly to the firm’s profitability.
 It plays a crucial role in the value maximization goal of a firm.
Financial forecasts are also means for forecasted financial statements. By their
virtue, a firm can forecast its income statement, balance sheet and other related
statements. Besides, key ratios can be projected. Once financial statements and ratios
have been forecasted, the financial forecast will be analyzed. Finally, the firm’s
management will have an opportunity to make some decisions beforehand.
So, all in all, financial forecasting is a pre- requirement for the investment, financing,
as well as dividend policy decisions of a firm.
2.4.3. Procedures in financial forecasting
The financial forecasting process generally involves the following procedures:
i. Forecasting of sales for the future period
ii. Determining the assets required to meet the sales targets, and
iii. Deciding on how to finance the required assets

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The above three procedures are very important in projecting the financial statements
and key financial ratios. However, among the three procedures, the first one, i.e,
sales forecast is the most crucial.
Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by
reviewing the sales of the recent pasts. The whole crucial point of a financial
forecasting process lies in an accurate forecast of sales. If this procedure is off, the
firm’s profitably as well as its value will be negatively affected. So, in forecasting
sales, several factors should be considered:
1. The historical sales growth pattern of the firm at both divisional and corporate
levels,
2. The level of economic activity in each of the firm’s marketing areas,
3. The firm’s probable market share,
4. The effect of inflation on the firm’s future pricing of products,
5. The effect of advertising campaigns, cash and trade discounts, credit terms,
and other similar factors alike on future sales,
6. Individual products’ sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firm’s income statement which in
turn helps to project retained earnings. In forecasting the income statement,
assumptions about the costs, tax rates, interest charges and dividends are required.
Sales forecasts are also grounds for determination of the firm’s assets requirement.
If sales are to increase, then assets must also grow. The amount each asset account
must increase depends whether the firm was operating at full capacity or not. If
higher sales are projected, more cash will be needed for transactions, higher sales
will create higher receivables. Similarly, higher sales require higher inventory and
higher plant and equipment.
Finally, the firm will face the question of financing its required assets. Some of the
required finance can be covered by the increased retained earnings. The retained
earnings increment will result from increased sales and profit. Still some other
portion of the finance can be covered by some liabilities which will grow by the same
proportion with that of sales. The remaining finance must be obtained from available
external sources.
The third procedure of the financial forecasting process, i.e. forecast of financial
requirements, involves again three sub procedures. These are:
1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast.
2. Determining how much of the total required finance, the firm will be able to
generate internally during the same period. There are two types of finance that
will be generated under normal operations. The first is portion of the net income
retained in the firm (retained earnings). The second one is the increase in the
firm’s liabilities as a direct and automatic result of its decision to increase sales.
This finance is called spontaneous finance. For example, if sales are to increase,

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 inventory must increase. The increase in inventory requires more purchases
which in turn causes the accounts payable to be increased. The accounts payable
will increase spontaneously with the increase in sales. Other examples include
accruals like salaries and wages payable and income tax payable.
3. Determining the additional external financial requirements. Any balance of the
total finance that cannot be met with normally generated funds must be obtained
from external sources. This finance is called the additional funds needed (AFN).

Additional funds needed (AFN) are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock.

2.4.4. Methods of forecasting financial requirements

There are two methods to determine the additional financial requirements. These
are:
1. The proforma financial statements method and
2. The formula method
2.5.4.1. The Pro-Forma Financial Statements Method
The pro-forma financial statements method is simply a method of forecasting
financial requirements based on forecasted financial statements. As a result, this method
is also called the projected financial statements method. Under this method, the
asset requirements are first projected for the fore coming future period. The forecast
of assets helps to determine the total financial requirements. Then, the liabilities and
equity that will be generated under normal operations are projected. Finally, the
additional funds needed will be estimated.
The pro-forma financial statements method of determining additional financial
requirements involves the following steps:
1. Developing the Pro Forma Income statement
The proforma income statement provides a projection of the firm’s net income for
the forecasted period. This enables the firm to estimate the amount of retained
earnings it will generate during the period. In developing the projected income
statement, first, a forecast of sales should be established. Second, cost of goods sold
should be determined. Third, other expenses (operating and non-operating) should
be computed. Next, the net income should be determined. Finally, based on the
amount of dividends, the amount of addition to retained earnings should be
determined.
2. Constructing the Pro Forma Balance Sheet
Higher sales must be supported by higher asset amounts. Some of the assets increase
can be financed by retained earnings, and spontaneous finance. The remaining
balance must be financed from external sources. In the forecast of the firm’s balance
sheet, first, those balance sheet items that are expected to increase directly with sales

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are forecasted. Next, the spontaneously increasing liabilities are forecasted. Then, the
liability and equity items that are not directly affected by sales are set. Next, the
value of retained earnings for the forecasted period is obtained. Finally, the AFN will
be raised.
For Example, Blue Nile Share Company is a medium sized firm engaged in
manufacturing of various household utensils. The financial manager is preparing the
financial forecast of the following year. At the end of the year just completed, the
condensed balance sheet of the company has contained the following items.

Assets Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------- Br. 90,000
A/receivable -----------------------70,000 Accruals ----------------------------------40,000
Inventories -----------------------150,000 Current liabilities -------------Br. 130,000
Current assets ------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
___________ Retained earnings --------------------150,000
Total assets ------------------Br. 600,000 Total liabilities and equity -----Br. 600,000

During the year just completed, the firm had sales of Br. 1,800,000. In the following
year, due to increased demand to the firm’s products the financial manger estimates
that sales will grow at 10%. There are no preferred stocks outstanding during the
year. The firm’s dividend pay-out ratio is 60%. It is also known that the firm’s assets
have been operating at full capacity. During the same year, Blue Nile’s operating
costs were Br. 1,620,000 and are estimated to increase proportionately with sales.
Assume the company’s interest expense will be Br. 40,000 during the next year and
its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile Share
Company for the next year using the proforma financial statements method.
Solution
First, we develop the proforma income statement
Pro Forma Income Statement
Sales (Br. 1,800,000 x 1.10) -------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) ---------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) -------------------------------------------Br. 198,000
Interest expense ----------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) -------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) ----------------------------------------------------------------------63,200
Net income -----------------------------------------------------------------------------------Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) -------------------------------------Br. 56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) ----------------------------Br. 37,920
Then, we construct the proforma balance sheet

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 Pro Forma Balance Sheet
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) --------------Br. 11,000 A/Payable (90,000 x 1.10) -------99,000
A/receivable (Br. 70,000 x 1.10) --------77,000 Accruals (Br. 40,000 x 1.10) ---- 44,000
Inventories (Br. 150,000 x 1.10) -------165,000 Current liabilities ----------------143,000
Current assets ----------------------- Br. 253,000 LT debt (increase is unknown)--200,000
Net fixed assets (Br. 370,000 x 1.10)--407,000 Common stock--------------------
120,000
Retained earnings (150,000+37,920) 187,920
Total assets -------------------------- Br. 660,000 Total liabilities and equity Br. 650,920
Blue Nile’s forecasted total assets as shown above are Br. 660,000. However, the
forecasted total liabilities and equity amount to only Br. 650,920. Since the balance
sheet must balance, i.e. A = L + OE, the difference must be covered by additional
funds.
Therefore, AFN = Br. 660,000 – Br. 650,920 = Br. 9,080.
Or AFN = Increase in assets - Increase in normally generated funds
= [Br. 660,000 – Br. 600,000] – [(Br. 99,000 – Br. 90,000) + (Br. 44,000 – Br.
40,000) + Br. 37,920]
= Br. 60,000 – Br. 50,920
= Br. 9,080
2.5.4.2. The Formula Method
This is a much easier method of determining additional financial requirements than
the pro forma method. The formula method is a shortcut to financial forecasting.
However, many companies use the pro forma method of forecasting to their
financial requirements because the output of the formula method is less meaningful.
Under the shortcut method, we make the following assumptions:
1. Each asset maintains a direct proportionate relationship with sales
2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant.
The formula that can be used as a shortcut to determine external capital
requirements is given as:
Additional Required Spontaneous Increase in
Funds = increase – increase in – retained
Needed in assets liabilities earnings
AFN = (A/S) S – (L/S) S – MS1 (1 – d)
Where: AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = Change in sales = S1 – S0 = S0 x g
S1 = Total Sales projected for the next period
S0 = Total sales of the current period
L/S = Percentage relationship of variable liabilities to sales
M = Net profit margin
d = Dividend payout ratio

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 g = The expected sales growth rate
To illustrate the formula method, consider the example given for the previous
method. But assume that Blue Nile’s net profit margin is 5%.
* S = S1 – S0 = S0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000
** S1 = S0 + S0g = S0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000.
AFN = (Br. 180,000) – 5% x Br
1,980,000** (1 – 60%)
= Br. 60,000 – Br. 13,000 – Br. 39,600
= Br. 7,400
To increase sales by 10% (Br. 180,000), the formula method suggests that Blue Nile
must increase its assets by 60,000. In other words, the firm will require a Br. 60,000
more fund for the forecasted year. Out of this, Br. 13,000 will come from
spontaneous increase in liabilities. Another Br. 39,600 will be obtained from retained
earnings. The remaining Br. 7,400 must be raised from external sources like by
issuing new shares of stocks or by borrowing.
2.4.5. Factors that affect additional financial requirements
The external financial requirements of a firm during any given period are affected by
several factors.
1. Financial Planning: Refers to the growth rates of sales a firm has projected.
Sales growth rates and additional funds needed are positively related. At low
growth rates of a sale, a firm needs small or no external financing. The firm
might even generate surplus funds at low growth rates. As the growth rates
increase, the AFN will also increase. So other factors being constant, the higher
the sales growth rates, the higher the AFN.
2. Capital Intensity: This is the amount of assets required to support each birr of
sales. In the formula, this is designated as A/S. Generally, firms with higher
capital intensity ratios are with greater capital requirements. Capital-intensive
firms generally require more external funds than labor intensive firms.
3. Profit Margin: Profit margin is the net income per each birr of net sales. It is
evident from the very formula of computing AFN that external capital
requirements and net profit margin are related in opposite directions. Other
factors held constant, the higher the profit margin, the lower the external funds
requirements.
4. Dividends policy: Dividend policy refers to the percentage of a firm’s net
earnings paid out as cash dividends. It is reflected in the firm’s payout ratio.
The higher the dividend payout ratio, the smaller the addition to retrained
earnings, and hence the greater the requirements for external finance.
2.4.6. Excess capacity and additional financial requirements
Previously, when we were dealing with Blue Nile’s financial forecast, our
assumption had been that assets were operating at full capacity (100% capacity).
Now let’s relax this assumption that excess capacity exists in the firm’s fixed assets.

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 In fact, theoretically excess capacity exists with all types of assets. But as a practical
matter, excess capacity normally exists primarily with respect to fixed assets.
Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does
this affect the firm’s AFN? Some procedures are involved to see the effect.
i. Determine the full capacity sales, i.e., sales that could have been produced had
fixed assets been utilized 100%.
Full capacity sales = _____ Actual sales_______________
Percentage of capacity at which fixed assets were operated
= Br. 1,800,000 = Br. 1,836,735
98%
ii. Determine the target fixed assets/sales ratio
Target fixed assets/sales ratio = Actual fixed assets = Br. 370,000 = 20%
Full capacity sales Br. 1,836,735
iii. Determine the new required level of fixed assets.
Required level of fixed assets = (Target fixed assets/sales ratio) X (Projected sales)
= 20% X Br. 1,980,000 = Br. 396,000
Previously Blue Nile forecasted it would need to increase fixed assets at the same
rate as sales or by 10%. That means, the firm forecasted an increase from Br. 370,000
to Br. 407,000. Now we see that the actual required increase is only from Br. 370,000
to Br. 396,000. Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,000 – Br.
396,000) less than the earlier forecast. Therefore, the projected AFN would decline
from an estimated Br. 9,080 to Br. -1,920 (Br. 9,080 – Br. 11,000). The negative AFN
indicates the firm would even produce excess funds of Br. 1,920 than it requires.

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