ChapterII:Financial Analyses And Planning

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.
 Cont…
• Financial statements generally consist of two important
statements:
• (i) The income statement or profit and loss account.
• (ii) Balance sheet or the position statement.
• A part from that, the business concern also prepares some of the
other parts of
• statements, which are very useful to the internal purpose such as:
• (i) Statement of changes in owner’s equity.
• (ii) Statement of changes in financial position.
 Cont..
• 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. Gross profit is determined by preparation
of trading or manufacturing a/c and net profit is determined by
preparation of profit and loss account.
 Cont…
• 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.
 Cont…
• Statement of Changes in Owner’s Equity
• It is also called as statement of retained earnings. This statement
provides information about the changes or position of owner’s
equity in the company. How the retained earnings are employed
in the business concern.
 2.2.Approaches to financial analysis and interpretation
• “Financial statement analysis is largely a study of the relationship
among the various financial factors in a business as disclosed by a
single set of statements and a study of the trend of these factors as
shown in a series of statements”. Analysis of financial statement
may be broadly classified into two important types on the basis of
material used and methods of operations.
Cont…
 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.
 Internal Analysis

• The company itself does disclose some of the valuable

information's 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.
 Cont…
• Based on the methods of operation, financial statement analysis
may be classified into two major types such as horizontal
analysis and vertical analysis.
• A. Horizontal Analysis
• Under the horizontal analysis, financial statements are compared
with several years and based on that, a firm may take decisions.
Normally, the current
• year’s figures are compared with the base year (base year is
consider as 100) and how the financial information are changed
from one year to another. This analysis is also called as dynamic
analysis.
Example
Cont…
Cont…
Complete horizontal Analysis
 Cont…
• B. Vertical Analysis
• Under the vertical analysis, financial statements measure the
quantities relationship of the various items in the financial
statement on a particular period.
• It is also called as static analysis, because, this analysis helps
to determine the relationship with various items appeared in
the financial statement. For example, a sale is assumed as 100
and other items are converted into sales figures.
 Cont…

• As we have seen, horizontal analysis and trend analysis percentages

highlight changes in an item from year to year, or over time. But no
single technique gives a complete picture of a business, so we also
need vertical analysis. Vertical analysis of a financial statement shows
the relationship of each item to its base amount, which is the 100%
figure. Every other item on the statement is then reported as a
percentage of that base. For the income statement, net sales are the
base.
Vertical analysis%= each income statement item x100
Revenue (net sale)
Cont…
 Trend Analysis
• Trend analysis is a form of horizontal analysis. Trend percentages indicate
the direction a business is taking. How have sales changed over a five-year
period? What trend does net income show? These questions can be answered
by trend analysis over a period, such as three to five years. Trend analysis
percentages are computed by selecting a base year (the earliest year). The
base year amounts are set equal to 100%. The amounts for each subsequent
year are expressed as a percentage of the base amount. To compute trend
analysis percentages, we divide each item for the following years by the base
year amount. Trend analysis is widely used to predict the future health of a
company.
Trend%= any year birr amount /base year birr amount x100
 Cont…
• Assume Smart Touch’s total revenues were $1,000 million in 2010 and rose
to $3,189 million in 2014. To illustrate trend analysis, review the trend of net
sales during 2010–2014, with dollars in millions. The base year is 2010, so
that year’s percentage is set equal to 100.
 common size analysis

• Horizontal analysis and vertical analysis provide much useful data

about a company. As we have seen, Smart Touch’s percentages
depict a very successful company. But the data apply only to one
business.
• To compare Smart Touch to another company we can use a
common-size statement. A common-size statement reports only
percentages—the same percentages that appear in a vertical
analysis. By only reporting percentages, it removes dollar value
bias when comparing one company to another company. Dollar
value bias is the bias one sees from comparing numbers in
absolute (dollars) rather than relative (percentage) terms.
Cont …
 2.3.Techniques Of Financial Statement Analysis

• Financial statement analysis is interpreted mainly to determine the

financial and operational performance of the business concern. A
number of methods or techniques are used to analyse the financial
statement of the business concern. The following are the common
methods or techniques, which are widely used by the business
concern.
Cont…
 2.4.Using financial ratio for decision making
• relationship between one number to another number. Ratio is
used as an index for evaluating the financial performance of the
business concern. Ratio can be classified into various types.
Classification from the point of view of financial management is
as follows:
• Liquidity Ratio
• Activity Ratio
• Solvency Ratio
• Profitability Ratio
 Liquidity Ratio

• It is also called as short-term ratio. This ratio helps to

understand the liquidity in a business which is the potential
ability to meet current obligations. This ratio expresses the
relationship between current assets and current liability of the
business concern during a particular period.
 Activity Ratio

• It is also called as turnover ratio. This ratio measures the

efficiency of the current assets and liabilities in the business
concern during a particular period. This ratio is helpful to
understand the performance of the business concern.
• Stock Turnover Ratio=Cost of Sales/Average Inventory
• Debtors Turnover Ratio=CreditSales/AverageDebtors
• Creditors Turnover Ratio=CreditPurchase/AverageCredit
• Working Capital Turnover Ratio=Sales/NetWorkingCapital
 Solvency Ratio
• It is also called as leverage ratio, which measures the long-
term obligation of the business concern. This ratio helps to
understand, how the long-term funds are used in the business
concern.
 Profitability Ratio
• Profitability ratio helps to measure the profitability position of
the business concern.
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 Ratio Analysis Practices
• Financial statements report both a firm’s position at a point in time
and its operations over some past period. However, their real value
lies in the fact that they can be used to help predict future earnings
and dividends.
• From an investor’s standpoint, predicting the future is what
financial statement analysis is all about, while from
management’s standpoint, financial statement analysis is useful
both to help anticipate future conditions and, more important, as a
starting point for planning actions that will improve future
performance. 31
 1. Liquidity Management Ratios

• Liquidity Ratios: Ratios that show the relationship of a firm’s cash

and other current assets to its current liabilities.
• A liquid asset is one that trades in an active market and hence can
be quickly
• converted to cash at the going market price, and a firm’s “liquidity
position” deals with this question: Will the firm be able to pay off
its debts as they come due in the coming year? Will it have trouble
meeting those obligations?
• Two of the most commonly used liquidity ratios are discussed
here.
A. Current Ratio=Current Asset/Current Liabilities
• The primary liquidity ratio is the current ratio, which is calculated
by dividing current assets by current liabilities:
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 Cont…
• Current assets include cash, marketable securities, accounts
receivable, and inventories. current liabilities consist of
accounts payable, short-term notes payable, current maturities
of long-term debt, accrued taxes, and accrued wages. If a
company is getting into financial difficulty, it begins paying its
bills (accounts payable) more slowly, borrowing from its bank,
and so on, all of which increase current liabilities. If current
liabilities are rising faster than current assets, the current ratio
will fall, and this is a sign of possible trouble.

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 B. Quick, or Acid Test, Ratio

• The second most used liquidity ratio is the quick, or acid test,
ratio, which is calculated by deducting inventories from current
assets and then dividing the remainder by current liabilities:
• Quick ratio= Current Asset-Inventories
• Current Liabilities
• The higher the ratio, the better the liquidity position

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 Analysis

 Current ratio matches current assets with current liabilities and tells
us whether the current assets are enough to settle current liabilities.
 A current ratio of 1 or more means that current assets are more than
current liabilities and the company should not face any liquidity
problem.
 A current ratio below 1 means that current liabilities are more than
current assets, which may indicate liquidity problems.
 In general, higher current ratio is better.
 Current ratios should be analyzed in the context of relevant
industry. Some industries for example retail, have very high current
ratios. Others, for example service providers such as accounting
firms, have relatively low current ratios because they do not have
any significant current assets.
 An abnormally high value of current ratio may indicate existence of
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idle or underutilized resources in the company.
 Cont …
• Quick ratio is particularly useful in assessing liquidity
situation of companies in a crunch situation, i.e. when they
find it difficult to sell inventories.
• Quick ratio should be analysed in the context of other liquidity
ratios such as current ratio, cash ratio, etc., the relevant
industry of the company, its competitors and the ratio’s trend
over time.
• A quick ratio lower than the industry average might indicate
that the company may face difficulty honouring its current
obligations.
• Alternatively, a quick ratio significantly higher than the
industry average highlights inefficiency as it indicates that the
company has parked too much cash in low-return assets.
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 2. Asset Management Ratios
• Asset Management Ratios: A set of ratios that measure how
effectively a firm is managing its assets.

A. Inventory Turnover Ratio

• “Turnover ratios” are ratios where sales are divided by some asset,
and as the name implies, they show how many times the item is
“turned over” during the year. Thus, the inventory turnover ratio
is defined as sales divided by inventories:
• Inventory Turn-over ratio= Sales /Inventories

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 Cont…

B. Fixed Assets Turnover Ratio

• The fixed assets turnover ratio measures how effectively the firm
uses its plant and equipment. It is the ratio of sales to net fixed
assets:
• Fixed Asset Turnover = Sales /Net Fixed Asset
C. Total Assets Turnover Ratio
• The final asset management ratio, the total assets turnover ratio,
measures the turnover of all the firm’s assets, and it is calculated
by dividing sales by total assets:
• Total Asset Turnover ratio= Sales /Total Asset

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 3. Debt Management Ratios
• Financial Leverage: The use of debt financing.
• The extent to which a firm uses debt financing, or financial
leverage, has three important implications: (1) By raising funds
through debt, stockholders can control a firm with a limited
amount of equity investment. (2) Creditors look to the equity, or
owner-supplied funds, to provide a margin of safety, so the higher
the proportion of the total capital provided by stockholders, the
less the risk faced by creditors. (3) If the firm earns more on its
assets than the interest rate it pays on debt, then using debt
“leverages,” or magnifies, the return on equity, ROE.
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 Cont…
A. Total Debt to Total Assets
• The ratio of total debt to total assets, generally called the debt
ratio and it measures the percentage of funds provided by
creditors:
• Debt Ratio= Total Debrt/tptal Liablity
• Another ratio that looks at the ability of a company to pay its
interest when due is its interest coverage ratio, or times interest
earned. This is defined as
B. Interestcoverage(Timesinterestearned) =EBIT/Interest Expenses

• If this ratio is 4, then for each dollar of interest due, the company
has $4 available. This is a fairly safe ratio, and the probability of
default is quite low.
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 Analysis

• Debt ratio is a measure of a business’s financial risk, the risk that

the business’ total assets may not be sufficient to pay off its debts
and interest thereon.
• While a very low debt ratio is good, it may indicate
underutilization of a major source of finance which may result in
restricted growth.
• While debt ratio indicates total debt exposure relative to total
assets, times interest earned (TIE) ratio assesses whether the
company is earning enough to pay off the associated interest
expense.
• Higher value of times interest earned (TIE) ratio is favourable as it
shows that the company has sufficient earnings to pay off interest
expense and hence its debt obligations.
• Lower values highlight that the company may not be in a position
to meet its debt obligations. 41
 3. Profitability Management Ratios
A. Profit Margin on Sales
• The profit margin on sales, calculated by dividing net income by
sales, gives the profit per dollar of sales:
• Profit Margin on sales = Net income /Sales
• suppose that profit margin ratio=3.9% where as the
industry average profit margin is 5%. In such cases, profit margin
is below the industry average of 5 percent. This sub-par result
occurs because costs are too high. High costs, in turn, generally
occur because of inefficient operations.

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 Cont …
B. Return on Total Asset=Net Income /Total Asset
The return on total assets ratio indicates how well a company's
investments generate value, making it an important measure of
productivity for a business. It is calculated by dividing the
company's earnings after taxes (EAT) by its total assets, and
multiplying the result by 100%.
As a general rule, the higher the percentage, the better. Business
owners and other analysts will usually want to compare the return
on total assets ratio for a specific company with others in the
same industry to get a true picture of how well the business is
performing.

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 Cont…
C. Return on Equity =Net income/outstanding common stock
Similar to the metric Return On Assets (ROA), Return on Equity
(ROE) helps investors understand how well a company generates
return on investment.
• What’s the Importance of Return on Equity?
1. Understanding a Company’s Efficiency and Profitability
• If a company has a high ROE relative to its industry peers, that
means that it is likely operating more efficiently. That could
translate into better future performance.
2. Comparisons Over Time
• If a company’s ROE is increasing, they are becoming more
profitable. If a company’s ROE is decreasing, they are becoming
less profitable.
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 Cont…
• 3. Return on Equity and a Sustainable Growth Rate
• ROE can be used to determine a company’s sustainable growth
rate. To calculate this, take a company’s earnings retention rate
and multiply it by its return on equity. It can also be calculated by
taking the company’s historical earnings retention rate and ROE
performance and averaging it to determine what its growth rate
has been over time.
• Retention Ratio = (Net Income – Dividends Distributed) /
Net Income.
• Sustainable growth rates can be used by creditors to determine a
company’s credit risk. However, a high growth rate often means
that a company is likely expanding and innovating which can
increase risk since it could have greater volatility.
• The SGR can be calculated using the sustainable growth
rate formula: SGR = retention ratio * ROE
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 Cont…
4. Finding The Dividend Growth Rate Using ROE
• ROE can be used to predict a company’s dividend growth rate,
which is useful in anticipating how much a company’s dividend
might increase in the future.
• To calculate this, multiply ROE by one minus the pay-out ratio a
company uses to determine its dividends. Here is an examples of a
company that pays out 20% of its earnings in dividends and has a
10% ROE.
• Dividend Growth Rate = 10% x (1 - .20)
• Dividend Growth Rate = 8%

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 2.5. Financial Planning And Control
• The information derived from financial statement analysis can be
used to establish future operating goals (financial planning) and
to determine how to meet established goals (financial control).
• Developing pro forma (forecasted) financial statements is an
important part of the planning and control processes.

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 Sales Forecasts
• Sales Forecasts—probably the most important part of financial
planning is the sales forecast; this forecast generally is based on the
trend in sales in recent periods, perhaps the last five to 10 years;
inaccurate sales forecasts can have serious repercussions if the firm
is too optimistic, such assets as inventory will be built up too
much, but if the firm is too conservative, it might miss valuable
opportunities in the market because demand cannot be met with
existing production capabilities.

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 Cont…

• Projected (Pro Forma) Financial Statements—projected financial

statements help the firm determine the amount that is needed to
finance expected future activities; the information from these
statements indicates how much financing will be generated by the
firm internally and how much must be generated externally (called
additional funds needed) by borrowing or by selling stock;
following are the steps necessary to construct a pro forma balance
sheet and a pro forma income statement, which must be completed
to determine the additional funds needed (AFN):

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 Cont…

• Step 1: Forecast next period’s income statement—estimate the

percentage growth (increase or decrease) in sales, cost of goods
sold, and other revenues and expenses, and then change the
current values by the estimates; one of the easiest ways to
approach this task is to apply a single growth rate, such as 8
percent, to all revenue and expense categories that change when
production changes; to be more accurate, however, each category
should be examined individually to determine the impact of any
forecasted change; a projected income statement might be as
simple as the following:

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Cont…

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 Cont…

• According to this forecast, the firm expects to grow by 8 percent

next year. Notice that, in addition to the variable revenues and
expenses, the fixed costs and depreciation amounts are increased
by 8. This assumes the firm is currently operating at full capacity;
if the firm is not operating at full capacity, the forecasted amounts
for fixed costs and depreciation either would be about the same as
the most recent figures (if the amount of existing plant and
equipment is sufficient to satisfy the increased production) or
would change by a percent different than 8 percent (if there is some
free capacity, but not enough to meet all new production
requirements).

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 Step 2: Forecast next period’s balance sheet
• some accounts on the balance sheet, such as inventories,
receivables, payables, and other operating accounts, change
“spontaneously” as production changes (movements in these
accounts generally result from day-to-day business activities),
while other accounts, such as long-term financing arrangements
(bonds and equity), remain constant until management makes
decisions to raise new funds (movements in these accounts require
specific decisions and actions to be made).

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 Cont…
• To determine the estimated amounts in each balance sheet
account, change the amount (balance) of each account that you
• expect to be directly affected by any change in operating
activities. In the current example, all of the current assets and
all of the current liabilities except notes payable should
increase by 8 percent next year. notes payable is not a
“spontaneous,” or operating, account in the sense that the firm
must make a deliberate, or conscious, decision to apply for
such loans.

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 Cont…

• Payables do, however, represent spontaneous financing because the

amount in payables increases or decreases as the firm increases or
decreases production (demand for products) rather than as the
result of a deliberate application for funds. Also, because the firm
in our example currently operates at full capacity, plant and
equipment will have to increase to satisfy the expected sales
increase.

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Cont…

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Cont…

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 Step 3: Raising the additional funds needed
• how the additional funds needed ($8.5 million) are raised depends
on the firm’s preference for, and its ability to handle, additional
debt relative to equity; Its combination of debt and equity and the
type of debt that is preferred; perhaps the firm decides to raise the
funds as described earlier or perhaps it prefers to issue a greater
amount of bonds than equity.

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 Step 4: Financing feedbacks

• because decisions to raise more funds via new debt issues and new
stock issues affect the expected total amount of interest and
dividends paid by the firm, which, in turn, affects the amount of
income that is expected to be added to retained earnings, the
process of constructing pro forma statements is iterative that is,
you must repeat the steps described here to construct financial
statements until the amount of additional funds needed equals
zero; financing feedbacks indicate the overall effects of raising the
additional funds needed, AFN.

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 Other Considerations in Forecasting

• Excess capacity:if the firm has excess capacity, it might not

have to add more plant and equipment (i.e., build) to reach its
growth expectations, or it might have to increase plant and
equipment by some percent less than the growth rate. To
determine the level of sales current plant capacity can handle,
use the following equation:
• Full capacity sales =Current sales level/Percent of capacity
used to generate current sales level

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 Cont…
• Example: If the firm in our example was operating at 90
percent capacity rather than full capacity, the level of sales it
could generate with existing assets would be:
• Full capacity sales = $500/0.90 = $555.6
• In this situation, the firm would not need to add additional fixed
assets to support its forecasted 8 percent growth next year. In
fact, it would not need to raise additional external funds,
because the funds generated internally (spontaneously) would
be sufficient to support the forecasted growth.

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 Economies of scale
• due to economies of scale, the variable cost ratio might change
with changes in production activity for example, if the firm
increases its production significantly, its variable cost ratio might
decrease from 80 percent, which is its current level, to much less
than 80 percent.
• Financial Control--Budgeting and Leverage:proper planning and
control helps ensure the firm meets its expectations, and, when
results fall short of expectations, helps management determine the
reasons.

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 Cont…

• Operating breakeven analysis: operating breakeven is defined

as the level of operations where the net operating income,
NOI, which is the same as earnings before interest and taxes,
EBIT, equals zero that is, total operating costs, both fixed and
variable, are just covered by sales revenues

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cont

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Cont …

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