CHAPTER-TWO

1.1
 FINANCIAL ANALYSIS
◦ Ratio analysis
A. Liquidity ratios
B. Activity ratios
C. Leverage ratios
D. Profitability ratios
E. Market value ratios
◦ Vertical analysis
◦ Horizontal analysis
 FINANCIAL PLANNING

1.2
2.1 FINANCIAL ANALYSIS
 Financial analysis is an evaluation of both a
firm’s past financial performance and its
prospects for the future.
 Typically, it involves an analysis of the firm’s
financial statements and its flow of funds.
 Financial statement analysis involves the
calculation of various ratios. It is used by
such interested parties such as :
◦ creditors,
◦ investors,
◦ and managers to determine the firm’s financial
position relative to that of others.

3
 A creditor is ultimately concerned with
the ability of an existing or prospective
borrower to make interest and principal
payments on borrowed funds.
 Questions raised in a credit analysis
should include:
◦ What is the borrowing cause?
◦ What is the firm’s capital structure?
◦ What will be the source of debt repayment?

6-4
 An investor attempts to arrive at an estimation
of a company’s future earnings stream in
order to attach a value to the securities being
considered for purchase or liquidation.
 The investment analyst poses questions such
as:
◦ What is the company’s performance record?
◦ What are the future expectations?
◦ How much risk is inherent in the existing capital
structure?
◦ What are expected returns?
◦ What is firm’s competitive position?

6-5
• Management relates to all questions raised by
creditors and investors.
• Management must also consider its
employees, the general public, regulators, and
the financial press.
• Looks to financial statement data to determine
• How well has the firm performed and why?
• What operating areas have contributed to
success and which have not?
• What are strengths and weaknesses of the
company’s financial position?
• What changes should be implemented to
improve future performance?
• 6-6
FINANCIAL STATMENT ANALYSIS
 The financial statements of an enterprise
present the summarized data of its assets,
liabilities, and equities in the balance sheet
and its revenue and expenses in the income
statement.
 Various measuring instruments may be used to
evaluate the financial health of a business, including
horizontal, vertical, and ratio analyses.
 financial analyst uses the ratios to make two types of
comparisons:
(a) Industry comparison:- The ratios of a firm are
compared with those of similar firms or with industry
averages or norms to determine how the company is
faring relative to its competitors.

7
 Trend analysis:-A firm’s present ratio is
compared with its past and expected future
ratios to determine whether the company’s
financial condition is improving or
deteriorating over time.

8
 2.1.1. RATIO ANALYSIS
•It
is essential to compare figures from different
categories.

•Ratios are tools, and their value is limited when used

alone. The more tools used, the better the analysis.
•So to, we need to be skilled with the financial tools we

use.
•Thereare many ratios that an analyst can use, depending
upon what the user considers to be important relationships.

6-9
RATIO TYPES
 Financial ratios can be classified into five
groups:
A. Liquidity ratios
B. Activity ratios
C. Leverage ratios
D. Profitability ratios
E. Market value ratios

10
Liquidityratios measure a firm’s ability
to meet cash needs as they arise-ability
of a firm to meet near-term demands for
cash
Should include analysis of selected

financial ratios and a comparison with

industry averages
Analyzing corporate liquidity is especially

important to creditors.
 Liquidity ratios include:
• current ratio
• quick or acid-test ratio
6-11
12
Current Ratio

Measures the ability of a firm to meet debt

requirements as they come due-Short-
Term Solvency.
Current assets
Current liabilities

current ratio is well below the average for its industry, 4.2, so its liquidity position is relatively weak.
•If a company is getting into financial difficulty, it begins paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on.
If current liabilities are rising faster than current assets, the current
ratio will fall, and

• this could spell trouble. Because the current ratio provides the best
single indicator of the extent to which the claims of short-term creditors
are covered by assets that are expected to be converted to cash fairly
quickly,

• it is the most commonly used measure of short-term solvency.

14
15
Quick or Acid-Test Ratio
Measures ability to meet short-term cash
needs more rigorously by eliminating
inventory
Current assets - Inventory

Current liabilities

- Inventories are typically the least liquid of a firm’s current

assets, hence they are the assets on which losses are most
likely to occur in the event of liquidation.

-Therefore, a measure of the firm’s ability to pay off short-term

obligations without relying on the sale of inventories is
important.

6-16
Quick or Acid-Test Ratio

The industry average quick ratio is 2.1, so 1.2

ratio is low in comparison with other firms in its
industry.

17
 Activity ratios measure how effectively a
firm is utilizing its assets.
Turnover ratios measure the operating
efficiency of a firm.
Activity ratios include
i. inventory turnover
ii. Average Collection Period
iii. fixed asset turnover
iv. total asset turnover

6-18
i. Inventory Turnover

Measures firm’s efficiency in managing its

inventory.
It measures how fast the inventory is

turned over to produce the years sales.

SALE
Inventory

6-19
 inventory is sold out and
restocked, or “turned over,” 4.9
times per year.

Financial Management, Ninth Edition

© I M Pandey
Vikas Publishing House Pvt. Ltd. 20
 ii. Average Collection Period
Also called Accounts Receivable Turnover or Days
Sales Outstanding.
Shows the average length of time that a firm must
wait after making a sale, but before receiving cash.
Measures efficiency of firm’s collection and credit
policies.
Average Receivable = Average Receivable

Av Sale Per Day Annual Sale

360

6-21
Financial Management, Ninth Edition
© I M Pandey
Vikas Publishing House Pvt. Ltd. 22
iii. Fixed Asset Turnover
Assesseshow effectively a firm uses its plant
and equipment to generate sales.

Net sales
Net property, plant, equipment

6-23
iv. Total Asset Turnover
Assesses effectiveness in generating sales
from investments in all assets.

Net sales
Total assets

It is somewhat below the industry average, indicating that the

company is not generating a sufficient volume of business given
its total assets investment.

6-24
Leverage ratios measure the extent of a firm’s
financing with debt relative to equity and its
ability to cover interest and other fixed charge.
Common Leverage ratios include:
• Debt ratio
• Times interest earned

6-25
i. Debt Ratio

Considers the proportion of all assets that

are financed with debt.
Calculated as:

Total liabilities
Total assets

6-26
 ii. Times Interest Earned (TIE)
Indicates how well operating earnings
cover fixed interest expenses

Earning Before Interest and Tax (EBIT)

Interest expense

Since the industry average is 6 times, its interest charges by a relatively

low margin of safety. 6-27
 D. PROFITABILITY RATIOS

Profitability ratios measure the overall

performance of a firm and its efficiency in
managing assets, liabilities, and equity.

6-28
Profitability ratios include
• gross profit margin
• net profit margin
• return on total assets (ROA) or return on
investment (ROI)
• return on equity (ROE)

6-29
i. Net Profit Margin
Measures Percentage of income from a
birr amount of sale.
Net Income is computed considering all

revenue and expense, including interest,

taxes, and non-operating items.

Net Income available to

Common stockholders
Net sales

6-30
Net Profit Margin

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. However, it’s low profit margin is also a result
of its heavy use of debt.

31
 ii. Basic Earning Power (BEP)
Measures the raw earning power of the
firm’s asset before the influence of tax and
leverage.
Is useful for comparing firms with different

tax situations and different degrees of

financial leverage.

EBIT
Total assets
6-32
Basic earning power

Basic Earning Power (BEP)

This ratio shows the raw earning power of the firm’s assets, before
the influence of taxes and leverage,
it is useful for comparing firms with different tax situations and
different degrees of financial leverage.
iii. Return on Equity (ROA)
•Measures rate of return on total asset after interest and taxes.

Net Income available to

Common stockholders
Total Asset

6-34
 Return on Asset

Return on Equity (ROA)

The 5.7 percent return is well below the 9 percent average

for the industry.
This low return results from
(1)the company’s low basic earning power
(2)high interest costs resulting from its above-average use of
debt,
iv. Return on Equity (ROE)
Measures rate of return on stockholders’
investment

Net Income available to

Common stockholders
Stockholders’ equity

6-36
 Return on Equity (ROE)

Return on Equity (ROE)

This ratio tells how well shareholders are doing in an accounting

sense. Allied’s 12.7 percent return is below the15 percent industry
average, but not as far below as the return on total assets.
This somewhat better result is due to the company’s greater use of
debt, a point that is analyzed in detail later in the chapter.
Market ratios measure returns to
stockholders and the value the market
place puts on a company’s stock.
Common Market ratios include:
• price-to-earnings ratio
• Market to Book value ratio

6-38
i. Price Per Earnings(P/E) Ratio
 Shows how much investors are willing
to pay per birr of reported profit (Current
earnings).
Relates earnings per common share to

the market price at which the stock

trades, expressing the “multiple” that the
stock market places on a firm’s earnings

6-39
Market price per Share (PPS)
Earnings Per Share (EPS)
Where:

EPS = Net income Available to Common Stockholders

Number of Common shares Outstanding

6-40
 Price Per Earnings(P/E) Ratio

• The price/earnings (P/E) ratio shows how much investors are willing
to pay per dollar of reported profits.
• Allied’s stock sells for $23, so with an EPS of $2.27 its P/E ratio is
10.1:
Price Per Earnings(P/E) Ratio
i. Market Per Book value(M/B) Ratio
• Shows how much investors are
willing to pay for Book value of a
firm.
Market price per Share (PPS)
Book Value Per Share (BPS)
Where:

BPS = Common Equity

Number of Common shares Outstanding

6-42
Market Per Book value(M/B) Ratio

Book Value Per Share (BPS)

Market Per Book value(M/B) Ratio

Investors are willing to pay less for a dollar of Allied’s

book value than for one of an average food-
processing company.
USES AND LIMITATION OF RATIOS
A. Strengths:
(a) Easier to understand than absolute
measures.
(b) Easier to look at changes over time.
(c) Puts performance into context.
(d) Can be used as targets.
(e) Summarise results.
B. USES
Used for decision making by
 Managers
 Creditors
 Stockholders
6-44
c. Limitations
1. it is difficult to develop meaningful industry
average for multi-industry firms.
2. Most firms want to be better than averages.
3. Inflation may distort firm’s balance sheets.
4. Seasonal factors can distort ratio analysis.
5. Firms can employ “window dressing”
technique.
6. it is difficult to generalize whether a
particular ratio is good or bad.
7. A firm may have some good ratios and
another bad ratios making difficult to tell
whether a company is good or bad in
balance.

6-45
 Are used to have a good insight of trends of
financial statement items or ratios.
 Are useful for comparing firms with
different sizes.
A. Common size Analysis
 Expresses each item in the balance sheet as
a percentage of total net assets and each
item in the income statement as a
percentage of total net sales.
 Eg. Comparative financial statements.

6-46
B. Index Analysis
 items in the financial statement are
expressed as an index relative to the base
year.
 All items of the base year are assigned a

100% index.
 All items in the subsequent to the base

year valued relative to the base year items.

 Eg. Indexed financial statements.

6-47
Financial Planning :
1.Is a process of deciding on a firm’s future
financial position by predicting results under
various alternative ways of achieving goals and
deciding the desired goals.
2.Helps for guiding and coordinating a firm’s
action to achieve its objectives.
3.Results in pro-forma (forecasted/budgeted )
financial statements and additional fund need
(AFN).
 Additional finance requirement or need
(AFN) is the fund needed from external
sources to meet targeted performance.
 Financial requirement planning allows
financial managers to make an intelligent
guess about the future financial condition
of their firms.
 It involves:
a) Determining how much money a firm will need
during a given period,
b) Determining how much money a firm will
generate during the same period, and
c) Determining financial requirements(a-b).
49
 Two methods:
◦ Projected or pro-forma financial statements
method
◦ Formula Method
A. pro-forma financial statements method
 Uses constant sales growth rate to forecast
accounts.
 is a simple technique of forecasting financial
statements.
 It forecasts assets , liabilities and equity
needed and subtracts projected liabilities
and equity from projected assets to
determine additional fund needed (AFN).
6-50
1. Forecast income statement
2. Forecast balance sheet
3. Raise Additional fund needed
4. Financing feed back
5. Prepare pro-forma financial statements

6-51
 The Purpose is to determine how much
income the company will earn and retain
for reinvestment during the forecast year.
 Begin with sales forecast, based a sales
growth (g) forecast.
 assumes that all costs will increase at the
same rate as sales. In more complicated
situations, however, specific costs will be
forecasted separately.

6-52
 Steps –B.I/S
◦ Forecast sales for next period (S1) = So x(1+g).
◦ Forecast costs for next period (C1) = Co x(1+g).
◦ Carry over interest expense and preferred dividend.
 I1 = Io , df = df
◦ Forecast common dividends for next period based
on dividend growth rate:
 (Dividend Per Share1) = Dividend Per Share o x(1+d).
 total Dividend 1 = Dividend Per Share1 x(no of
53

shares).
◦ Determine additions to retained earnings (R/E).
 Additions to R/E = NI- Dividends
NOTE: This forecast overstates states actual R/Es as
interest & dividend payments growth are overlooked.
So, go to the next step.
 Growth in sales projections will necessarily
lead to:
◦ demand for more cash
◦ Higher receivables
◦ Stocking of additional inventory
◦ Acquisition of new plant and equipment
 Assumptions in balance sheet forecast:
◦ Assets will increase in proportion to sales
◦ Increase in assets will be financed by one of the
following methods
 spontaneous liabilities
 Formal borrowing and/or
 Issuance of common stock: and/or
 Retained earnings.
6-54
 Steps- B. B/S
◦ Forecast assets for next period (A1) = Ao x(1+g).
◦ Forecast spontaneous generated funds for next
period (CL1) = CLo x(1+g).
◦ Set an initial values of equities that requires mgt
decision.
 N/P1 = N/Po , LTD1 = LTD1, CK1= CK0
◦ Determine Projected retained earnings (R/E).
 R/E1 = R/E0 +Forecasted additions to R/E
◦ Determine AFN.
 AFN= projected Assets – Projected
Equities
NOTE: AFN will be raised by borrowing or selling stocks
or a combination of these. So, go to the next step.

55
 AFN will be financed by borrowing or selling
stocks or a combination of these.
 Decide the finance mix.
 Add additional fund needed to initially
forecasted amounts.
NOTE: This results in additional interest and
dividend payments. So, go to the next step.

6-56
 Forecast additional interest expense due to
financing action.
 Interest exp= interest rate x borrowing
 Forecast additional dividends due to
financing action.
 No new shares = money raised/stock price
 Additional = No new shares x forecasted
dividend per dividend
share
 Add additional interest expense and
dividend payments .
 This reduces the original Additions to R/E determined in
step 1 and results shortfalls.
 Decide the financing mix to cover this short
fall.
6-57
 This requires additional interest and dividend
payments which in turn results shortfalls.
 After about five iteration, the shortfall will be
small and the forecast is considered
complete.
 Finally, prepare forecasted financial
statements.

Example: assume the following financial

statement for 2004 and forecast financial
statement for 2005.

6-58
Alex Corporation Balance Sheets (in million Birr)
December, 31 LIAB. & EQUITY
ASSETS 2004 Accounts Payable 60
Cash and Notes Payable 110
marketable Accruals 140
securities 10 Total Current Liabilities 310
Accounts Long-term bonds
receivable 375 payable 754
Inventories 615 Total Debt 1064
Total Current A. 1000 Preferred stock 40
Plant Assets(net) Common stock 130
Retained earnings 766
1000 Total Common Equity 896
Total Assets 2000 Total Liab. &
Equity
6-59 2000
 Alex Corporation Income Statements( in million Birr)

December, 31 2004
Net sales 3000.0
Costs excluding depreciation 2616.2
Depreciation costs 100.0
Total Operating costs 2716.2
Earnings before interest and taxes (EBIT) 283.8
Les interest expense 88.0
Earnings before tax 195.8
Income tax (40%) 78.3
Net income before referred dividend 117.5
Preferred dividend 4.0
Net income available to common stockholders 113.5
Common dividends 57.5
Addition to retained earnings 6-60
56.0
Per-share data
Common stock price 23.00
Earnings per-share (EPS) 2.27
Dividends per-share (DPS) 1.15
 There
Book areper-share
value 50 million common stock shares
(BVPS) 17.92in
2004.
 There are 400,000 preferred stock shares in
2004.
 Estimated Sales growth for 2005 = 10%.
 Estimated dividend growth for 2005 = 8%.
 Additional financing mix:
 Notes payable 25% @ 8%
 Bonds payable 25% @ 10%
 Common stock issuance 50%
6-61
 Amount in million Birr
Increase in sales 300.00
Increase in asset 200.00
From: external
N/P 29.53
B/P 29.53
Common Stock 59.06
Total AFN 118.12
R/e 62.00
spont liab 20.00

Total fund increase 200.12

6-62
 It is possible to obtain an initial rough estimate
of financial requirements through the following
formula.
Additional Required spontaneous
increase Funds = Increase in - increase
in - in retained Needed Assets
assets earnings
 AFN = (A */S0) ΔS0 - (L*/S0) ΔS0 - MS1 (1-
d)
Where
 AFN = Additional funds needed

 A*/S= Required Birr increase in assets per 1 Birr

increase in sales. 6-63

 L*/S =Liabilities that increase spontaneously
with sales as a percentage.
 S = last year's sales.
o
 S1= Total sales projected for next year.
 ΔS = Changes in Sales = Sl - So
 M =Profit margin or rate of profit per 1 birr
 d = Fraction of earnings paid out in common

dividends (the dividend pay out ratio).

 d = earning retention ratio.

Question: Calculate AFN using the Formula

Method.
6-64
solution
 AFN = 0.667 (ΔS )-O.067 (ΔS )-0.038(3300)* (1-
0 0
0.509) =0.667 (300)-0.067 (300)-0.038(3300)
(0.491)
=200 million-20million-62 million = 118
million.
 The total increase (Fund) required financing the
increase in assets. 200 million and is financed as
follows:
1. From spontaneous liabilities 20 million
2. From Retained earnings 62 million
3. from External financing:
◦ Notes payable 25% at 8 % 29.5 million
◦ Long-term debt 25% at 10% 29.5 million
◦ Common stock issue 50% 59.0 million
Total fund to finance increase in Assets = 200
million
6-65