CHAPTER TWO

Financial Analysis and Planning

The primary goal of financial management is to maximize the stock price, not to maximize accounting
measures such as net income or EPS. However, accounting data do influence stock prices, and to
understand why a company is performing the way it is and to forecast where it is heading, one needs to
evaluate the accounting information reported in the financial statements. Business organizations
survive for two main factors such as profitability (i.e important if the business is to generate revenue
(income) in excess of the expenses incurred in operating that business) and solvency (i.e. important
because it looks at the ability of the business in meeting its financial obligations).
If management is to maximize a firm’s value, improve firm profitability and maintain firm’s solvency,
it must take advantage of the firm’s strengths and correct its weaknesses. Financial statement analysis
involves (1) comparing the firm’s performance with that of other firms in the same industry and (2)
evaluating trends in the firm’s financial position over time. These studies help management identify
deficiencies and then take actions to improve performance. In this chapter, we focus on how financial
managers (and investors) evaluate a firm’s current financial position.
2.1 Concepts of Financial Analysis
Financial analysis is a process of evaluating firms past, present financial performance and prospect for
the future. It is helpful to analyze the strength and weakness of a business. It is used to establish proper
relationship among the accounts available in the balance sheet and income statement of a business so
as to make them more informative and useful in the decision-making process. The focus of financial
analysis is on key figure in the financial statement and the significant relationship that exists among
them which highly support financial decision making
2.2 The need for financial analysis
Financial analysis is one of the many tools useful in analysis because it helps the financial analyst
gauge returns and risks. It is needed for various purposes and is very important for any organization
because:
1. Measure the profitability and earning potential of a business: It helps to check whether the
profits earned are up to the expectations or not. After analyzing the financial statements, the
trend of profit can be ascertained, and earning potential of the company can be checked.
2. Measure the financial strength of the business: It helps to understand how strong a business is
financially and judge its position in the market.
3. Comparative study: Financial Analysis is helpful to compare the position of two firms in the
market or compare the growth of a firm. The comparison can be further of 2 types:
 Intra-Firm: It is the comparison of the firm’s profits for the current year and the previous
year, and may also be known as Trend Analysis.

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  Inter-Firm: It is also termed Cross-Sectional Analysis, and is the comparison of one
company to the other in the market.
4. Efficiency of management: The trend of the profits and losses of a business allows us to judge
if the business is being managed efficiently or not, which means that the resources of a business
are being utilized effectively or not.
5. Useful to the management: An insight into the business helps the management to make very
important decisions about the business.
6. Analyze the short-term and long-term solvency: It also helps to analyze whether a business
will be able to clear its short-term and long-term debts or not.
7. Reasons for deviation: To identify the reasons for any change in the profitability/financial
position of the firm.
2.3 Users of Financial Analysis
Financial analysis can be undertaken by different parties, inside the firm (i.e. management of an
organization) or outside the firm (i.e. owners, creditors, investors and others). The nature of the
analysis will differ depending on the purpose of the uses.
 Creditors: are interested in the firm’s ability to meet their claims over short period of time.
 Supplies of long-term debt: are concerned with the firm’s long-term solvency and survival.
They mostly analyze the firms profitability overtime, its ability to generate cash to be able to pay
interest and repay the principal and relationship among various sources of funds.
 Managements: managements of a firm would be interested in every aspect of the financial
analysis. It is their duty to check whether the financial resource of the firm are used most
effectively and efficiently, and the financial condition is sound
 Investors: they are the one who invested their money in the business, they mostly concerned
with the firms earning.
2.4 Sources of financial data
Financial statements provide the most widely available data on public corporations’ economic
activities, investors and other stakeholders rely on financial reports to assess the plans and
performance of firms and corporate managers.
Financial statement analysis is a valuable activity when managers have complete information on a
firm’s strategies and a variety of institutional factors makes it unlikely that they fully disclose this
information. The financial data reports quarterly or annual from:
 Balance Sheet: the balance sheet shows the financial position of a firm at a particular point of
time. It also shows how the assets of a firm are financed. A completed balance sheet shows
information such as the total value of assets, total indebtedness, equity, available cash and value of
liquid assets. This information can then be analyzed to determine the business' current ratio, its
borrowing capacity and opportunities to attract equity capital.
 Income Statement: Usually income statements are prepared on an annual basis. An income
statement often provides a better measure of the operation's performance and profitability. It
shows the operating results of a firm, flows of revenue and expenses. It focuses on residual earning
available to owners after all financial and operating costs are deducted, claims of government are
satisfied.
 Cash Flow Statement: Reports the sources and uses of the operation’s cash resources. Such
statements not only show the change in the operation's cash resources throughout the year, but also

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 when the cash was received or spent. An understanding of the timing of cash receipts and
expenditures is critical in managing the whole operation.
 Financial footnotes: Notes explaining accounting methodologies used in financial statements,
including any changes made from the previous reporting period, any required disclosures, and any
upcoming transactions taken into consideration.
2.5 Major areas of financial analysis
A. Preparation and selection: establishing the objectives of the analysis and assembling the
financial statement. depending up on the users of the financial statement and the question to be
addressed by the analysts, selection of financial data differs, mostly analysts used to answer the
following question
 How the firm performs in the past
 What are the strength and weakness of a firm
 What corrective action is needed to enhance future performance
B. Computation and relation: arrange it in the way that will bring about significant relationship. It
involves the application of varies tools and techniques in analyzing financial statements.
C. Evaluation and interpretation: is the determination of evaluations to develop conclusion and
recommendation about the firm’s financial performance and financial condition.
2.6 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 analyze the
financial statement of the business concern. The following are the common methods or techniques,
which are widely used by the business concern.
I. 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.
II. Trend Analysis: The financial statements may be analyzed by computing trends of series of
information. It may be upward or downward directions which involve the percentage relationship
of each and every item of the statement with the common value of 100%. Trend analysis helps to
understand the trend relationship with various items, which appear in the financial statements.
These percentages may also be taken as index number showing relative changes in the financial
information resulting with the various period of time. In this analysis, only major items are
considered for calculating the trend percentage
III. Common Size Analysis: Another important financial statement analysis technique is common size
analysis in which figures reported are converted into percentage to some common base. In the
balance sheet the total assets figures is assumed to be 100 and all figures are expressed as a
percentage of this total. It is one of the simplest methods of financial statement analysis, which
reflects the relationship of each and every item with the base value of 100%.
IV. Ratio Analysis: Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a
mathematical relationship between one numbers to another number. Ratio is used as an index for
evaluating the financial performance of the business concern. An accounting ratio shows the
mathematical relationship between two figures, which have meaningful relation with each other.
Keys terms for ratio analysis
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 a. Ratio: is a numerical or quantitative relationship between two variables
b. Financial statement: Balance sheet: contains assets, liabilities and capital. it is important to
calculate Liquidity ratio, Activity ratio, Leverage ratio,
c. Income statement is used to calculate: Profitability ratio, Activity ratio, Leverage ratio
d. Capital statements: Is important to calculate market value ratio especially important for
prospect investors
Types of ratio comparisons
A. Cross-sectional analysis (inter firm comparison): Compare ratio of one firm with some
selected firms in the same industry at the same point in time. it is more useful to compare the
firm’s ratios with ratios of a few carefully selected competitors, who is under similar operation.
This kind of comparison indicates the relative financial position and performance of the firm.
B. Industry Analysis: Determine the financial condition and performance of a firm, its ratio may
be compared with average ratio of the industry in which the firm is a member.
C. Time Series Analysis: The easiest way to evaluate the performance of a firm is to compare its
present ratio with the past ratios. It is a competition of ratios over a period of time. It gives an
indication of the direction of changes and reflects whether the financial performance has
improved, deteriorated or remains unchanging over time. The analysts should not simply
determine the change, but, more importantly he /she should understand why ratios have
changed. It helps us to compare current and past performance of a given firm.
N.B: When both time series and cross-sectional analysis are used together; it is termed as combined analysis.
D. Common size statement: expressing individual statement in the form of percentage or times
2.6.1.1 Types of Financial Ratio Analysis:
One of the major areas of financial analysis is financial statement preparation and selection. Initially,
we should have a readymade financial statement so as to go through the analysis part. Let’s take the
following financial statements for illustration purpose.
ABC Co.
Balance sheet
At December 31, 2007 and 2008
In (000) 2008 2007
Cash 840 760
Marketable securities 1,300 1,200
Account receivable 1,500 1,300
Inventory 2,300 1,900
Total current asset 5,940 5,160
Fixed asset (Net) 6,220 5,630
Total asset 12,160 10,790
A/P 422 304
N/P 458 386
Total Current liability 880 690
Long term liability 3,160 2,945
Total liability 4,040 3,635
Preferred stock 2,455 2,150
Common stock 3,215 2,925
Retained earnings 2,450 2,080
Total liability and owner equity 12,160 10,790

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 ABC Co.
Income statements
For the year ended, 2007 and 2008
In (000) 2008 2007
Sales 1,870 1,520
Less: Sales return and allowance 250 210
Net sales 1,620 1,310
Less: Costs of goods sold 820 760
Gross profit 800 550
Less: Operating expenses
Selling expenses 270 220
General and administrative expenses 160 90
Total operating expenses 430 310
Operating income 370 240
Other income 120 85
EBIT 490 325
Less: Interest expenses 33 25
EBT 457 300
Less: Tax (35 %) 160 105
Net income after tax 297 195
Less: Preferred stock dividends 112 92
Earnings available to common shareholders 185 103
EPS 74 41.2
N.B: ABC Co has 2,500 outstanding shares (common stockholders) and 1,000 preferred stock shares.
Net purchase for the period is Birr 980. The market price of a share is Birr 500 and the book value is
Birr 175. All earnings are paid out as a dividend. The Lease obligation is assumed to be Birr 73.
TYPES OF RATIOS AS FOLLOWS
1. Liquidity Ratios: It measures the firm’s ability to meet current obligations which is termed as
short-term solvency or liquidity. In other words, whether the firm’s current assets are sufficient
enough to pay its current liability.
A. Current ratio: analyze the firm’s ability to satisfy the short-term creditors’ demand for
repayment by using only current asset. It also indicates the availability of current asset for a
given amount of current liability.

= 6.75times
Current asset: include cash and those assets that can be converted into cash within a year, such as
marketable securities, inventories, prepaid expense etc…
Current liability: include bill payable, accrued expenses, short term bank loans, income tax liability
and long-term debt maturing in the current period (year).
Higher current ratio: indicate that too much capital is tied up in current asset which probably are
idle. (i.e. Firm is suffering opportunity cost of some return. Had the excess (the idle) amount been
invested, there would be a return.)
 It is safety for short term creditors

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  The more the firms liquidity position
A very high current ratio indicates
 Excessive cash due to poor cash management
 Excessive account receivable due to poor credit management
 Poor usage of credit capacity
Low current ratio: suggests that the firm may face difficulty in paying its short-term obligation.
Low ratios can be improved through:
 Long term borrowing, increase current asset without changing current liability
 liquidating current liability through long term equity financing
B. Quick (Acid test) ratio: establishes a relationship between quick assets and current liability.
An asset is liquid if it can be converted in to cash immediately or reasonably soon without a
loss of value. Cash is the most liquid asset and other assets that are considered to be relatively
liquid then included under quick assets are bill receivable and marketable securities (temporary
quoted investment). It is considered to be less liquid. Inventories normally require sometime to
be converted in to cash; their value also has a tendency of fluctuation. Prepaid expenses and
supplies also are treated as less liquid assets

= 4.136times
N.B: Quick ratio is more powerful measure of liquidity than current ratio
C. Net working capital (NWC) ratio: The difference between current assets and current liability
excluding short term bank borrowing is called net working capital or net current asset.

Net asset = Fixed asset + (NWC)

= 0.449
D. Cash ratio:

= 2.432

2. Activity Ratio:
It measures the firm’s efficiency in asset utilization. It also measures how productively the firm is
using its assets. This is why the ratio is termed as asset utilization ratio, efficiency ratio, and turnover
ratio and sometimes it is also called asset management ratio. Funds of creditors and owners are
invested in various assets to generate sales and profit. Under normal circumstance, the better the
management of assets then the larger the amount of sales will be.
A. Account Receivable Turnover ratio: it measures the liquidity of the firm’s account receivable. It
indicates how many times (how rapidly) account receivable is converted into cash in a year. It

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indicates the number of times debtors turnover each year. Generally, the higher the value of debtors’
turnover, the more efficient the management is.
Account Receivable Turnover ratio = Net Sales 1620 = 1.08 times
Accounts receivable 1500
Therefore, ABC co.’s accounts receivable get converted into cash 1.08 times a year.
Reasonable high ratio is preferable; a ratio substantially lower than the industry average may suggests
that the firm has:
 More liberal credit policy (Longer credit period), poor credit selection, inadequate collection effort
which will followed by;
 Account receivable to be too high
 The bad debt expense will be high so sales will be decrease then profit decrease
 More restrictive cash discount (no or little cash discount) that could make sales to low as a result of the
above factors
 The firm could have poor profitability position
 The firms fund would be tied up in receivables as payment by customers are delayed
A ratio substantially higher than the industry average may suggest that a firm has:
 More restrictive credit policy
 More liberal cash discount offers
 More restrictive credit selection
 More serious collection effort
The outcome of higher Account receivable turnover ratio could be:
 Avoidance of the risk of bad debt
 Increase the firms profitability position
 small funds tied up in Account receivable
B. Average Collection Period (Day’s sales Outstanding): the average number of days for which
debtors remain outstanding is called Average collection period. It is the length of time that a firm
must wait to collect cash from credit sell. It tries to measure how rapidly receivables are converted
into cash. The shorter the time, the better the average period because if the time longer the bad
debt expense will rise.
ACP (Days sale outstanding) = Day sales
ARTR
ACP= 365/1.08 = 337.96 days or Receivable/Net Sales/365= 1500/1620/365=337.99
Thus, ABC co.’s credit customers on the average are paying their bills in almost337.96 days

C. Account Payable Turnover ratio: It indicates how rapidly the offset its obligation. It also shows
that hoe often creditors are paid in a year.
Account Payable Turnover ratio= Total Net Purchase = 980 =2.322 times
A/P 422

The higher the APTO, the better for the business operation because the firm can get credit easily
since to lend to this firm is less risky
D. Average Payment Period (APP): Is the average length of time creditors must wait to receive
their cash. A short period is desirable for creditors.

APP = Days Sales =365 =157.2 days

APTR 2.322

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E. Inventory Turnover (Inventory Utilization) ratio: It indicates the efficiency of the firm in
producing and selling its product. The inventory turnover shows how rapidly the inventory is
turning into receivable through sales.

= 0.39times
Interpretation: ABC co.’s inventory is on the average sold out 0.39 times per year.
Generally, a higher inventory turnover is an indication of good inventory management. A low
inventory turnover implies excessive inventory level that warranted by production and sales activities,
or slow moving or obsolete inventory. A high level of sluggish inventory amounts to unnecessary tie-
up of funds reduced profit and increased cost. If the obsolete inventories have to be written off, this
will adversely affect the working capital and liquidity position of the firm. However, a relatively high
inventory turnover may be the result of a very low level of inventory, which results in frequent stock
outs.
If there is, a high inventory turnover ratios
 Stoppage of production process for manufacturing
 Lost sales due to insufficient inventory for merchandise
If inventory turnover is low- there is high inventory due to loss of sales and profit will be lower
 Exposed to deterioration or obsolescence, Inventory may be outdated, exposed to rent
expense, Exposed to insurance expense and Exposed to property tax
F. Average Age of Inventory (AAI) days sales inventory (days of inventory holding)
It shows how long inventory is hold in the warehouse before it is sold for 2008

= 923.08 Days

G. Fixed Asset Turnover ratio (FATO): It is the efficiency of fixed asset to generate sale

= 0.26
FATO substantially lower than industry average shows,
 There is over investment in fixed asset
 Disposal of fixed asset could be there
On the other hand a ratio substantially higher than the industry average shows that
 Requires the firm to make additional capital investment to operate a higher level of activity.
& Shows more efficiency in managing and utilizing financial asset.
Factors that can increase or decrease FATO;
 Depreciation method, The cost of the fixed asset & The time elapsed (dropped) during the
acquisition
H. Total Asset Turnover ratio (TATO): assets are used to generate. Therefore, a firm should
manage its asset efficiently to maximize sales. The relationship between sales and Asset is called
asset turnover. This ratio shows the firm’s ability in generating sales from all financial resources
committed to total assets. thus asset here;

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 = 0.133
The current asset here are nonproductive, they use to pay the liability.
The higher the ratio of TATO the better for the firm
Higher ratio suggest that greater efficiency in using the total assets to produce sales
Low ratio suggests that the firm is not generating a sufficient volume of sales for the size of its
investment in assets.
3. Leverage (Debt Management) Ratio
The short-term creditors like bankers and suppliers of raw material are more concerned with the firms’
current debt paying ability. On the hand, long term creditors, like debenture holder, financial
institutions etc. are more concerned with the firm’s long term financial position. To judge the long-
term financial position of the firm, financial leverage or capital structure ratio are calculated. These
ratios indicate mix of funds provided by owners and lenders. As a general rule, there should be an
appropriate mix of debt and owners’ equity in the financing the firm’s assets.
The manner in which assets are financed has a number of implications; let’s look at debt and equity,
debt is more risky from the firm’s point of view. The firm has a legal obligation to pay interest to debt
holders, irrespective of the profit made or losses incurred by the firm. If the firm fails to pay to debt
holders in time, they can take legal action against it to get payments and in extreme cases, can force
the firm into liquidation. On the other hand, the earning of the firm can be magnified, when the firm
earns a rate of return on the total capital employed is higher than the interest rate on the borrowed
fund. Beside the debt holders had limited control over the firm operation. The process of magnifying
the shareholders return through the use of debt is called financial leverage or trading on equity.
Firms with high debt burden could face difficulty while raising funds from owners as well as creditors
for future activities. Creditors consider the owners equity as margin of safety; If the equity base is thin,
the risk of creditors will be very high. Thus, leverage ratios are calculated to measure the financial risk
and the firm’s ability of using debt to the shareholder’s advantage.
Leverage ratios indicate the extent to which the firm has relied on debt in financing debt and it shows
the degree of debt financing in the firm. There are two debt measurement tools.
A. Financial Leverage Ratio: It determines the extent to which borrowed funds have been used
to finance the firm. It is the relationship of borrowed fund and owners’ capital
I. Debt ratio: shows the percentage of assets financed through debt.

= 0.332 = 33.2%
The lower debt ratio is preferable, higher ratios implies more of the firm’s asset are financed by
creditors relative to owners. Creditors may require a higher rate of interest so as to compensate a
higher risk that they taken
The firm may face some difficulty in raising additional funds equity or debt finances.
II. Debt-Equity Ratio: shows the percentage of creditors financed the asset with that of
shareholders equity.

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 = 0.4975= 49.75%
B. Time Interest Earning Ratio (TIE): It measures the ability of firms to pay interest on timely
basis it is also called the interest coverage ratio and determined by dividing earnings before
interest and taxes (EBIT) by the interest expense, Since taxes are computed after interest,
interest coverage is calculated in relation to before tax earnings. Depreciation is a non-cash
expense. Therefore, funds equal to depreciation are also available to pay interest charges. we
can thus calculate the interest coverage ratio as earnings before interest and taxes, depreciation
and amortization divided by interest. Normally a higher ratio is desirable, but too high ratio
indicates that the firm is very conservative in using debt and that it is not using credit to the
best advantage of shareholders. On the other hand, a lower ratio indicates that the excessive
usage of debt or inefficient operations.
Time interest earning Ratio (TEER) = EBIT/Interest Expense
=490/33 = 14.8 times
Interpretation: ABC Co. has operating income 14.5 times larger than the interest expense.
C. Fixed Charge Ratio (EBITDA): it is useful for assessing a company’s ability to meet interest
charges on its debt, but this ratio has two shortcomings:
1. Interest is not the only fixed financial charge companies must also reduce debt on schedule,
and many firms lease assets and thus must make lease payments. If they fail to repay debt or
meet lease payments, they can be forced into bankruptcy.
2. EBIT does not represent all the cash flow available to service debt, especially if a firm has high
depreciation and/or amortization charges.

= 5.311times
4. Profitability Ratios
It measures overall performance and effectiveness of the firm. Profit is the difference between
revenues and expenses over a period of time (usually a year). The profitability ratios are calculated to
measure the operating efficiency of the company. Beside management of the company, creditors and
owners are interested in the profitability of the company. Creditors expect payment of principal and
interest in a regular basis. Owners want to get required rate of return on their investment; this is
possible only when the company earns profits.
Generally, profitability ratio indicates the combined effect of liquidity, asset management and debt
management on operating result. This ratio is used to measure firm’s effectiveness in using the assets
to generate profit.
A. Gross Profit Margin (GPM):
Reflects the efficiency with which management produces each unit of product. This ratio indicates
management effectiveness in pricing policy generating sale and in controlling production cost.

= 0.4938

High ratio: implies that the firm is able to produce at relatively lower cost. It is considered as a sign of
good management.
Factors that lift up the GPM
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  Higher sales prices, CGS remain unchanged
 Lower CGS, sales price remain unchanged
 A combination of variations in sales prices and CGS, the margin widening, and
 An increase in the proportionate volume of higher margin items.
Low ratios: may reflect a higher CGS due to the firm’s inability to purchase raw materials at
favorable terms. It also could be inefficient utilization of plant and machinery, resulting in higher cost
of production. The fall of price in the market or marked reduction in selling price by a firm in an
attempt to obtain large sales volume, the CGS remain unchanged.
B. Operating Profit Margin (OPM):

= 0.3025
C. Net Profit Margin (NPM)
This ratio is the overall measure of the firm’s ability to turn each amount of sales in to net profit. It
also indicates the firms’ capacity to withstand adverse economic conditions. A firm with a high net
margin ratio would be in advantageous position to survive in the face of falling selling prices, rising
cost of production or declining demand for the product. Similarly, a firm with high net profit margin
can make better use of favorable conditions, such as rising selling prices, falling costs of production or
increasing demand for the product such a firm will be able to accelerate its profits at a faster rate than a firm
with

= 0.183
D. Return on Investment/ Asset (ROI/ ROA):
The term investment may refer to total assets or net assets. ROI measures the overall efficiency of
management in utilizing assets in the process of generating income.

OR ROA (ROI) = Net profit margin * Total asset turn over

= 0.0244
E. Return on Equity (ROE):
A return on shareholders’ equity is calculated to see the profitability of owners’ investment. It
measures the rate of return realized by stockholders on their investment.

, = 0.037
ROE indicates how well the firm has used the resources of owners.
F. Earnings per Share(EPS):
It indicates whether the firm earning power on per share basis has changed over that period. It
represents the amount of Birr earned on behalf of each outstanding share of common stock.

= 0.1188
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5. Market Value Ratio:
Market value ratios relate a firm’s stock price to its earnings, cash flow, and book value per share.
Market value ratios are a way to measure the value of a company’s stock relative to that of another
company. These ratios are primarily used for investment decision and long range planning. There are
two ratios.
A. Price earnings ratio: The price/earnings (P/E) ratio shows how much investor is willing to
pay per dollar of reported profits. It indicates investors’ judgment or expectations about the
firm’s performance and reflects investors’ expectations about the growth in the firm’s earnings.

= 6.757
A higher price (earning multiplier) often reflects the market perception of the firm’s growth
perspectives. Thus, if investors believe that a firm’s future earnings potential is good enough and they
may be willing to pay a higher price for the stock.
 Book value per share: It is the value of each shares of common stock based on the accounting
records.
 Dividend ratio: Under this issue we do have two classes i.e. Dividend payout ratio and
Dividend yield ratio.
B. Dividend payout ratio: shows the percentage of earnings distributed at the end of the accounting
period. It is the Birr amount of dividend paid on share of common stock outstanding during the
reported period.

= 0.0849

= 0.0011
Higher ratio: Reflects firm’s lower growth opportunity
Lower ratio: reflect the firms higher growth opportunity

C. Dividend yield ratio: shows the rate earned by shareholders from dividends relative to the current
price of the stock.

2.6.5 LIMITATIONS OF RATIO ANALYSIS

Even though ratio analysis can provide useful information about a firm’s financial condition 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.
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 led us to deceptive conclusion.
II.7 Financial planning
Planning includes attempting to make optimal decisions, projecting the consequence of these decisions
for the firm in the form of a financial plan and then comparing future performance against that plan. It
is the task of determining how a business will afford to achieve its strategic goals and objectives.
Usually, a company creates a financial plan immediately after the vision and objectives have been set.
The financial plan describes each of the activities, resources, equipment and materials that are needed
to achieve these objectives, as well as the timeframes involved.
The financial planning activity involves the following task:
1. Assess the business environment,
2. Confirm the business vision and objectives,
3. Identify the types of resources needed to achieve these objectives,
4. Quantify the amount of resource (labor, equipment, materials)
5. Calculate the total cost to create a budget,
6. Identify any risk and issues with the budget set.
II.8 Scope of financial planning
Financial planning should cover all areas of the client’s financial needs and should result in the
achievement of each of the client’s goals. The scope of financial planning would usually include the
following:
1. Risk management and insurance planning: managing cash flow risks through sound risk
management and insurance techniques.
2. Investment and planning issues: Planning, creating and managing capital accumulation to
generate future capital and cash flows for reinvestment and spending.
3. Retirement planning: planning to ensure financial independence at retirement.
4. Tax planning: planning for the reduction of tax liabilities and the freeing-up of cash flows for
other purposes.
5. Estate planning: planning for the creation, accumulation, conservation and distribution of assets.
6. Cash flow and liability management: maintaining and enhancing personal cash flows through
debt and life style management.
7. Relationship management: Moving beyond pure product selling to understand and service the
core needs of the client.
8. Education planning for kids and the family members.
II.9 Types of financial plan
Financial planning is an important aspect of the firm’s operations because it provides road maps for
guiding, coordinating and controlling the firm’s actions to achieve its objectives. Financial planning

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begins with long term or strategic financial plans. These, in turn, guide the formulation of short-term
plans.
1. Long-term (strategic) financial plans:
plans: long term financial plans lay out a company’s planned
financial actions and the anticipated impact of those actions over periods ranging from 2 to 10
years.
2. Short-term (operating) financial plans:
plans: Short- term financial plans specify short term financial
actions and the anticipated impact of those actions. These plans most often cover a 1-to-2-year
period. Key inputs include the sales forecast and various forms of operating and financial data.
Key output includes a number of operating budgets, the cash budget and proforma financial
statements.
II.10 Procedure of financial planning
For the purposes of financial planning, an organization should take the following steps:
1. Laying down financial objectives:
objectives: In order to make an effective financial planning first of all
the financial objectives of the corporation should be laid down. The financial objectives of a
business help in determining policies and procedures. In the changing circumstances, the
business must determine its short term and long-term objectives in present times. Short term
objectives should be determined in a manner that they help in the achievement of long-term
objectives.
2. Formulating financial polices:polices: The formulation of policies is the second step in financial
planning. These policies act as guidelines for the procurement of funds, their utilization and
control.
3. Developing financial procedures:
procedures: To implement the policies, it is necessary that detailed
financial procedures be determined which explains all rules and sub rules. The subordinates
will come to know what work they have to do and how they have to do it.
4. Preparation of financial plan: plan: Under this process, total capital requirement is determined. It
is called capitalization. To determine the capitalization, fixed assets, current assets, preliminary
expenses and other expenses are determined to make correct estimate of necessary funds.
5. Reviewing of financial planning:
planning: Financial planning is a continuous process of business. The
financial objectives, policies, procedures, capitalization and capital structure should be
modified according to the changing internal and external circumstances.
Benefits of financial planning
1. Identifies advance actions to be taken in various areas.
2. Seeks to develop a number of options in various areas that can be exercised under
different conditions.
3. Facilitates a systematic exploration of interaction between investment and financing
decisions.
4. Clarifies the links between present and future decisions.
5. Forecasts what is likely to happen in future and hence helps in avoiding surprises.
6. Ensures that the strategic plan of the firm is financially viable.
7. Provides benchmarks against which future performance may be measured.

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 II.11 Financial forecasting
Financial forecasting describes the process by which firms think about and prepare for the future. The
forecasting process provides the means for a firm to express its goal and priorities and to ensure that
they are internally consistent. It also assists the firm in identifying the asset requirements and needs for
external financing.
Financial forecasting is that process in which the future financial condition of the firm is shown on the
basis of past accounts, funds flow statements, financial ratios and economic conditions of the firm and
industry. The projection of future plan of management in terms of finance is financial forecasting.
Advantages of financial forecasting: Financial forecasting can:
 Serve as an advance warning system:
 Improve the policy development and budget preparation process
 Evaluate alternative financial plans.
Tools of financial forecasting
1. Sales forecast: the sales forecast is typically the starting point of the financial forecasting
exercise. Most of the financial variables are projected in relation to the estimated level of sales.
Hence, the accuracy of the financial forecast depends critically on the accuracy of the sales
forecast.
2. Proforma income statement:
statement: the proforma income statement is a projection of income for a
period of time in the future.
3. Proforma or projected balance sheet: sheet proforma balance sheet is forecasting of flow of funds
and according to this the estimation of every item should be made and checked. The
preparation of proforma balance sheet is made on the basis of proforma income statement and
supporting schedules and budgets.
II.12 Techniques of Determining External Financial Requirements
1. Percent-of-Sales Method of Financial Forecasting
When constructing a financial forecast, the sales forecast is used traditionally to estimate various
expenses, assets, and liabilities. The most widely used method for making these projections is the
percent-of-sales method, in which the various expenses, assets, and liabilities for a future period are
estimated as a percentage of sales. These percentages, together with the projected sales, are then used
to construct pro forma (planned of projected) balance sheets.
The calculations for a pro forma balance sheet are as follows:
1. Express balance sheet items that vary directly with sales. That means multiply those balance sheet
items that vary directly with sales by (1 + sales growth rate).
2. Multiply the income statement items by (1+ Sales Growth Rate). Thus, we are assuming that each
income statement item increases at the same rate as sales, which means that we are assuming
constant returns to scale.
3. Where no percentage applies (such as for long-term debt, common stock, and capital surplus),
simply insert the figures from the present balance sheet in the column for the future period.
4. Compute the projected retained earnings as follows:
Projected Retained Earnings = Present Retained Earnings + Projected Net Income – Cash Dividends
Paid. (You will need to know the percentage of sales that constitutes net income and the dividend
payout ratio).
5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected liabilities
and equity accounts to determine the total financing provided. Since liability plus equity must
balance the assets when totaled, any difference is a shortfall, which is the amount of external
financing needed.
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2. Formula Method for Forecasting AFN
A simple forecasting formula provides a short cut to projecting additional funds needed (AFN) and can
be used to clarify the relationship between sales growth and financial requirements, as well as the
influence of other relevant variables on (AFN).
Additional
Fund = [Required Increase] – [Spontaneous Increase] - [Increase in Retained]
`Needed in Assets in liabilities Earnings
AFN = A*/S (S) - L*/S (S) - MS1 (1-d)
Where
AFN= Additional or External Fund Needed
A*/S= Assets that increase spontaneously with sales as a percentage of sales
L*/S= Liabilities that increase spontaneously with sales as a percentage of sales
S1= Total sales Projected for next year
S = Change in sales = S1- So
M= Profit margin or rate of profit per a birr of sales
D= Percentage of earnings paid out in dividends or Dividend Payout Ratio
Exercise 2.4
Kekot Products Company is a highly capital-intensive Manufacturing Company, whose June 30,
2001 balance sheet and summary of income statement are given below. Kekot operated its fixed
assets at full capacity in 2001 to support its birr 400,000 of sales and it had no unnecessary current
assets. Its profit margin on sales was 10 percent, and it paid out 60 percent of its net income to
stockholders as dividends. If Kekot's sales increase to birr 600,000 in 2002, what will be its pro
forma June 30 2002 balance sheet, and how much additional financing will the company required
during 2002?

Kekot Product Company Balance sheet on June 30, 2001 (In Thousands of Birr)
Cash …………………….. 10 Accounts Payable ……………..…..... 40
Accounts Receivables……90 Notes Payable ………………………..10
Inventories……………... 200 Accrued Wages and Taxes…………. 50
Total Current Assets…. 300 Total Current Liabilities…................ 100
Net Fixed Assets ……….300 Mortgage Bonds…….…………....... 150
Total Assets…………... 600 Common Stock….……………...….. 50
Retained Earnings……………...…. 300
Total Liabilities and Equity……….. 600
Kekot Product Company Income Statement for 2001 (In Thousands of Birr)
Sales ………………………………………………….… 400
Total Costs……………………………………………... 333
Taxable Income………………………………………….. 67
Taxes (40%)…………………………………………… 27
Net income…………………………………………….… 40
Dividends………………………………………………….24
Additions to retained earnings……………………………16

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