TWO: Financial Analyses and Planning

INFO LINK UNIVERSITY COLLEGE
HAWSSA DEP’T OF ACFN FM-I HANDOUT FOR THERED YEAR (R ,W & E) STUDENTS
CHAPTER TWO: Financial Analyses and Planning

Introduction
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. This includes income statement, owner’s equity or statement of retained
earnings, and cash flow statement.The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. Hence, preparation of the financial statement is important as
much as the financial decisions.In previous accounting courses you have learned about the meaning of
financial statements and how to prepare financial statements. Now, in this course Chapter 2, we will see how
financial statements are used by managers to improve performance, by lenders to evaluate the likelihood of
collecting on loans, andby stockholders to forecast earnings, dividends, andstock prices. If the management wants
to maximize a firm’s value, it must take advantage of the firm’s strengths and correct its weaknesses.
2.1. Financial Statement Analysis

2.1.1. The meaning and purpose of financial statement analysis
Financial statement analysis involves the examination of both the relationships among financial
statement numbers and the trends in those numbers over time. By establishing some relationship
between balance sheet and income statement, analysis attempts to reveal the meaning and importance
of various items contained in the financial statements.It helps in:-
1) Use the past performance of a company to predict how it will do in the future.
2) Comparing the firm’s performance with that of other firms in the same industry and
(3) Evaluating trends in the firm’s financial position over time in order to take the corrective action
on the variances.
2.1.2. 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.
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.
Although we have briefly seen what is meant by the three most common types of financial analysis,
our focus on this material will be on ratio analysis. So in the section that follows, we will discuss major
types of financial ratios with illustrative examples.
1 CHAATER TWO (Financial statement analysis) compiled by Ephrem T.(MBA) & Ashenafi
(MSc)October, 2018
2.1.3. Tools&Techniques of Financial Statement Analysis

A number of methods can be used in order to get a better understanding about a firm’s financial status
and operating results. The most frequently used techniques in analyzing financial statements are:
I. Horizontal Analysis
Horizontal analysis is involves using comparative financial statements to calculate dollar or

percentage changes in a financial statement item from one period to the next period.Under this
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.
II. Vertical Analysis
.Under the vertical analysis, financial statements measure the quantities relationship of the various
items in the financial statement on a particular period. For a single financial statement, each item is
expressed as a percentage of a significant total, e.g. all income statement items are expressed as a
percentage of sales.Comparing a company’s financial condition and performance to a base amount. For
example, a sale is assumed as 100 and other items are converted into sales figures.
III. Ratio Analysis – is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages. Like any other
financial analysis, a ratio analysis helps us draw meaningful conclusions and interpretations
about a firm’s financial condition and performance. The following list provides several
possible benchmarks for a financial ratio:
1. The planned ratio for the period.
2. The corresponding ratio during the preceding period for the same firm.
3. The corresponding ratio for a similar firm in the same industry.
4. The average ratio for other firms in the same industry.
IV. 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 aj
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.
V. Index Analysis – expresses items in the financial statements as an index relative to the base
year. All items in the base year are assumed to be 100%. Usually, this analysis is most
appropriate for income statement items. This 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. But in this course our focus is on ratio analysis.
VI. Trend analysis- The study of percentage changes in financial statement items over a
period of time. Trend analysis provides a simple forecasting method.Used to estimate the
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likelihood of improvement or deterioration in its financial conditions. In this chapter our

focus will on horizontal, vertical & ratio analysis. These are disused as follow:
2.3.1. Horizontal Analysis:
Horizontal Analysis Example:The management of Clover Company provides you with comparative
balance sheets of the years ended December 31, 1999 and 1998. Management asks you to prepare a
horizontal analysis based on the information.
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Steps
Totalto calculate horizontal analysis $
assets 315,000 $ 289,700
1) Calculating Change in Dollar Amounts

Dollar change = current year figure – base year figure
In our example since we are measuring the amount of the change between 1998 and 1999, the dollar
amounts for 1998 become the “base” year figures.
2) Calculating Change as a Percentage
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Let’s apply it on assets
Interpretation: total asset of Clover Corporation was increased by 8.7 % which implies that the
financial position of the corporation was improved in the year 1999.
Again Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance
sheet.
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Now, let’s apply the procedures to the income statement
Interp
retation: Sales of Glover was increased by 8.3% while net income decreased by 21.9%. Because, there
were increases in both costs of goods sold by (14.3%) and operating expenses by (2.1%). These
increased costs more than sales offset the increase in sales, yielding an overall decrease in net income.
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2.3.2. Vertical Analysis:
In vertical analysis is the analysis based on a single financial statement, each item in the financial
statement is expressed as a percentage of a significant total, and e.g. all income statement items are
expressed as a percentage of sales and that of balance sheet as percentage of total asset.
Example: The management of Sample Company asks you to prepare a vertical analysis for the
comparative balance sheets of the company. Let’s apply this first on asset
Interpretation: In the above table shows, for sample, that in 1998 cash raised from 8 percent of
total assets to 17 percent in year 1999. This shows that the liquidity position of the sample
company was improved by (17-8) = 9 percent.
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From the above table you can see, for example, that the retained earnings of the firm were consisted
from 26 percent of total capital in year 1998 and 32 percent in year 1999. These showsthat retained
earnings was increased in 1999.
2.3.3. Ratio Analysis
Ratioanalysisisacommonlyusedtool (technique) offinancialstatementanalysis.A Financial Ratio is

an index that relates two accounting numbers and is obtained by dividing one number by the other. I t is used
as an indicator for evaluating thefinancial performance of the business concern. It is
expression of logical relationships between items in a financial statement of a single period (e.g.,
percentage relationship between revenue and net income. They have more meaning if compared to the
other ratios.
Two types of comparisonsinternal comparisons&external comparisons, external comparisons involve
comparing the ratios of one firm with those of similar firms or with industry averages. And Similarity
is important as one should compare “apples to apples.”
Ratio can be classified into various types. But, classification from the point of view of financial
management is as follows:
2.3.3.1. Liquidity ratios
2.3.3.2. Asset Management ratios (activity ratios)
2.3.3.3. Profitability ratios
2.3.3.4. Debt management ratios
2.3.3.5. Market value ratios
2.3.3.1. Liquidity ratios
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
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between\current assets and current liabilities of the business concern during a particular
period. The following are the major liquidity ratios:
1. Current Ratio
This ratio is calculated by dividing current assets by current liabilities. Current assets normally
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
other accrued expenses (principally wages). It indicates the extent to which current liabilities are
covered by those assets expected to be converted to cash in the near future. Traditionally, it is
recommended the business should have current ratio of 2:1 in order to have good liquidity position.
2. Quick, Or Acid Test, Ratio
The quick, or acid test, ratio is calculated by deducting inventories from current assets and then
dividing the remainder by current liabilities: Traditionally, it is recommended the business should
have current ratio of 1:1 in order to have good liquidity position. The formula to determine the two
ratios are
Table 2.1: Formula to calculate liquidity ratios
Let’s see the liquidity ratios from the following comparative balance sheet of the Zebra Companyfor the
year 2016?
Zebra Share Company

Comparative Balance Sheet
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December 31, 2015 and 2016
(In thousands of Birr)

Assets 2016 2015
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
Table 2.2: Comparative Balance sheet of Zebra company from 2015-2016
Zebra Share Company

Income Statement
For the Year Ended December 31, 2016
________________________________________________________________________
Net sales Br. 196,200,000

Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
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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, 600,00
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, 2016
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
Required:from the above calculate the financial ratios of year 2016 and compare it with given industry
average?
 Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities
Current ratio = Current assets

Current liabilities
Zebra’s current ratio (for 2016) = Br. 57,600 = 1.51 times but industry average is 4.2 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.When it compared with industry average zebra’s
current ratio is poor but in other sense the industry average is more than the common ratio 2:1
which indicates thatexcessive inventories and accounts receivable, or an industry is not making full use
of its current borrowing capacity.
 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.
(MSc)October, 2018
Quick ratio = Current assets – Inventory

Current liabilities
Zebra’s quick ratio (for 2016) = Br. 57,600 – Br. 24,900 = 0.86 times but industry average is 1.1 times
Br. 38,100
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. The quick ratio of Zebra company (0.86) is less than common
standard (1:1) and also industry average (2.1) this indicates that liquidity position of the firm is poor.
2.3.3.2. Asset Management (Activity) ratio

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.
Accounts receivable turnover = Net sales
Accounts receivable
Zebra’s accounts receivable turnover (for 2016) = Br. 196,200 = 9.48 times but industry average is 8X
Br. 20,700
Interpretation: Zebra’s accounts receivable get 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 in adequate cash collection efforts.
When it compared to industry average 8 times, Zebra Company’s has higher accounts receivable
turnover ratio (9.48 times).
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.
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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.
Days sales outstanding = 365 days
Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days and industry average is also 39 days.
9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days which
similar to industry average 39 days. If Zebra’s credit period is less than 39 days, some corrective actions
should be taken to improve the collection period. Generally, a reasonably short-collection period is
preferable.
iii) Inventory turnover – measures how many times per year inventory level is sold (turned over).
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 our case we have
CGS therefore ITO can be calculated as:
Inventory turnover = Cost of goods sold

Inventory
For Zebra Company (2016) = Br. 159,600 = 6.41times but industry average is 9 times
Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year. When it compared to
industry average (9 times) zebra’s ITO is twice lower that of industry. This indicates that Zebra’s
inventory position is weak and need some improvements. In general, a high inventory turnover is
better than a low turnover. But abnormally high inventory turnover might result from very low level
of inventory. 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 it fixed assets. It shows how many
birr of sales are generated from one birr of fixed assets.
Fixed assets turnover = Net sales___
Net fixed assets
Zebra’s fixed assets turnover = Br. 196,200 = 2.04X but industry average is 3 times.
Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets but industry
average is Br. 3. This indicates that A Zebra’s fixed assets turnover ratio substantially lower than other
similar firms shows underutilization of fixed assets, i.e., idle capacity, excessive investment in fixed
assets, or low sales levels. This suggests to the firm possibility of increasing outputs without
additional investment in fixed assets.
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.
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Total assets turnover = Net Sales

Total assets
Zebra’s total assets turnover = Br. 196,200 = 1.27X but industry average is 1.8X
Br. 153, 900
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. When it compared to industry average (1.8X), it has lower TATO (1.27X) this indicate that the
firm’s management efficiency in managing its assets is poor.
2.3.3.3 Leverage (Debt management) 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
debt obligations. While there are many leverage ratios, we will look at only the following three.
i) Debt to total assets (Debt) Ratio – measurespercentage of total funds provided by debt.
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.
Debt ratio = Total liabilities
Total assets
Zebra’s debt ratio = Br. 98,100 = 64% but industry average is 40%
Br. 153,900
Interpretation: At the end of 2016, 64% of Zebra’s total assets were financed by debt and 36% (100%
- 64%) was financed by equity sources. When it compared with industry average, Zebra Company has
high debt ratio. This indicates that firm’s financial risk is higher than industry average.
ii) Times – interest earned – measures a firm’s ability to pay its interest obligations. The times
interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available to meet its
interest obligations. However, earnings before interest and taxes are an income concept and not a direct
measure of cash. Hence, this ratio provides only an indirect measure of the firm’s ability to meet its
interest payments. Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50X but industry average is 6X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense. Which indicates
that the can fully pay interest expense out of its current operating income but needs some
improvements to industry average since it lower than 6X.
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iii) Fixed charges coverage – measures the ability of firms to meet all fixed obligations rather than
interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes
Fixed charges
For Zebra Company in 2016, 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 but industry average 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.
2.3.3.4. Profitability ratios
Profitability is the net result of a number of policies and decisions. These ratios measure the earning
power of a firm with respect to given level of sales, total assets, and owner’s equity. They 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.
Profit margin = Net income Zebra’s profit margin = Br. 3,900 = 2% but industry average is 5%
Net Sales 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales. When it compared
with industry it low. This indicates that the profit margin of the firm is lower than industry average.
In order to be commutative, Zebra should improve its profit margin to industry average.
ii) Return on investment (assets) – measures how profitably a firm has used its investment in total
assets. Return on investment = Net income
Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 % but industry average is 9%

Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets. When it compared
with industry average it is three times lower than it. Generally, a high return on investment is
required by firm to the level of the industry average. This can be achieved by increasing sales
levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently utilizing
assets.
(MSc)October, 2018
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments made
by them. Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99% but industry average is 9.05%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity. When compared
with industry average, Zebra has low ROE and needs improvement.
2.3.3.5. Marketvalue (Marketability) ratio
Marketability ratios are used primarily for investment decisions and long range planning. 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.
Earnings per share = Net income – Preferred stock dividend
Number of common shares outstanding
Zebra’s Eps for 2016 = 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 2016.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each share of its
common stock outstanding.
Dividends per Share = Total cash dividends on common shares
Number of common shares outstanding
Zebra’s DPs for 2016 = Br. 3,300 _ = Br. 1.00
Br. 33,000
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Price earnings ratio = Provides some measure of whether the stock is under or overpriced.
Price-earnings ratio A measure of growth potential, earnings stability, and management
capabilities; computed by dividing market value of a company by net income. Note that the PE
ratio is different from the other ratios in that it is not the ratio of two financial statement
numbers. Instead, the PE ratio is a comparison of a financial statement number to a market value
number.
 Indicates the amount investors are willing to pay for each Brr.1 of a firm’s earnings.
PER = Market Price Per Share
EPS
Suppose price per share of 2016 is Br 12, the price earring ratio of Zebra Company can be calculated as
Br.12 = Br 11. 00 but industry average is Br 8.3
Br. 1.09
Interpretation:Amount investors are willing to pay for each Birr of earnings of Zebra Companyis Birr
11. When it is compared to industry average, the price of Zebra Company is overvalued.
v) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.
Dividends pay-out = Dividends per share
Earnings per share
Zebra’s pay-out ratio = Br. 1.00 = 92%
Br. 1.09
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends but industry average is 87%.
This indicates the firm pays more cash dividend than industry average which is good for its
shareholders.
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Table 2.3.The summary of 2016 Zebra Company’sin comparison with industry average
Type of ratio Formula Calculation Ratio Industry average Comment
Liquidity ratio
Current ratio 57,600 1.51x 4.2x Poor
38,100
Quick ratio 57,600 0.86x 2.1x Poor

-24,900
38,100
Activity ratio
365 365 39 days 39 days Good
RTO 9.48
159,600 6.4x 9.0x Good
24,900
Fixed asset turnover 196,200 2.04x 3.0x Poor

96,300
Total assets turnover 196, 200 1.27x 1.8x Poor

153,900
Leverage ratio
Debt to asset ratio Total debt 98,100 64% 40% Risky
Total assets 153,900
Times-interest earned (TIE) EBIT 10,500 3.5x Less risky
Interest charge 3, 000
Profitability ratio
Profit margin on Net income 3,900 2% Poor
Sales Net sale 196,200
Return on total Net income 3,900 2.53% 9.0% Poor
assets (ROA) Total asset 196,200
(ROE) Net income 3,900 6.99% 9.05% Poor
Common stock 55,000
Marketability ratio
Price/earnings Price per share Br12 11. 01 10 Good
(P/E) Earnings per share 1.09
Dividend pay-out (pay-out) ratio Dividend per share Br 1 92% 87% Good
EPS 1.09
Exercises 2.1. From the above comparative balance sheet and income statement of year 2015 and 2016,
calculate Horizontal and vertical analysis?
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.
(MSc)October, 2018
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 a stationery materials selling company will be different at different time
periods of a year.
2.5. Financial planning
In financial analysis helping in how both managers and investors analyze them to evaluate a firm’s past
performance. While this is clearly important, it is even more important to look ahead and to anticipate
what is likely to happen in the future. The financial plan is the final element of the overall corporate
plan. A separate plan is set forth for each unit, and those plans are then consolidated to show the
projected results for the entire corporation. The effective financial planning and forecasting helps
management make the right decisions.So, both managers and investors need to understand how to
forecast future results. Managers make pro forma, or projected, financial statements and then use them
in five ways:
(1) By looking at projected statements, they can assess whether the firm’s anticipated performance is in
line with the firm’s own general targets and with investors’ expectations. For example, if the projected
financial statements indicate that the forecasted return on equity is well below the industry average,
managers should investigate the cause and then seek a remedy.
(2) Performa statements can be used to estimate the effect of proposed operating changes.
(3) Managers use preform statements to anticipate the firm’s future financing needs.
(4)Projected financial statements are used to estimate future free cash flows, which determine the
company’s overall value. Thus, managers forecast free cash flows under different operating plans,
forecast their capital requirements, and then choose the plan that maximizes shareholder value.
Pro Forma (Projected) Financial Statements are financial statements that forecast the company’s
financial position and performance over period of years. Managers make pro forma, or projected,
financial statements and then use them in five ways:
(5) The pro forma results can be analyzed, individual problem areas can be identified, and then
corrective actions can be taken. With these issues in mind, we explain how to create and use forecasted
financial statements.
Commonly prepared Performa statements are sale, income statement and balance sheet forecasts
1. THE SALES FORECAST
Financial planning requires us to forecast and then analyze a set of financial statements. We begin with
the sales forecast, which starts with a review of sales during the past 5 to 10 years.
For example: Allied Foods, our illustrative company has the following sale forecasts of 2006 based on
five years past sale data. The data below the table show five years of historical sales, which Allied
thinks are most relevant for planning purposes.
(MSc)October, 2018
Year Sales in Birr

2001 2,058
2002 2,534
2003 2,472
2004 2,850
2005 3,000
2006 3,300 (Projected)
Fig 2.1 Allied food products 2006 sale forecast
Interpretation; Allied had its ups and downs during the per iod from 2001 to 2005. In 2003, poor weather in
California’s fruit-producing regi ons resulted in low production, which caused 2003 sales to fall below the 2002
level. Then a bumper crop in 2004 pushed sales up by 15 percent, an unusually hig h growth rate for a mature
food processor. As shown in the chapter Excel mo del, the compound annual growth rate over the four-year
period was 9.88 percent. However, due to planned newproduct introductions, the firm’s production and
distribution capacity, its competitors’ capacities and new-product introductions, pricing strategies, inflation,
advertising campaigns, credit terms, and the lik e, management projects that the growth rate will increase to 10
percent in 2006, so sales should rise from $3,000 million to $3,300 million.
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TWO
(MSc)October, 2018

TWO: Financial Analyses and Planning

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CHAPTER TWO: Financial Analyses and Planning

2.1. Financial Statement Analysis

2.1.3. Tools&Techniques of Financial Statement Analysis

Horizontal analysis is involves using comparative financial statements to calculate dollar or

IV. Common size Analysis – expresses individual financial statement accounts as a

likelihood of improvement or deterioration in its financial conditions. In this chapter our

2.3.1. Horizontal Analysis:

1) Calculating Change in Dollar Amounts

2) Calculating Change as a Percentage

Let’s apply it on assets

Now, let’s apply the procedures to the income statement

2.3.2. Vertical Analysis:

2.3.3. Ratio Analysis

Ratioanalysisisacommonlyusedtool (technique) offinancialstatementanalysis.A Financial Ratio is

2.3.3.1. Liquidity ratios

2. Quick, Or Acid Test, Ratio

Table 2.1: Formula to calculate liquidity ratios

Zebra Share Company

December 31, 2015 and 2016

(In thousands of Birr)

Table 2.2: Comparative Balance sheet of Zebra company from 2015-2016

Zebra Share Company

Net sales Br. 196,200,000

Operating expenses* 26,100,000

Retained earnings at beginning of year Br. 9,000,000

Current ratio = Current assets

Quick ratio = Current assets – Inventory

2.3.3.2. Asset Management (Activity) ratio

Inventory turnover = Cost of goods sold

Total assets turnover = Net Sales

2.3.3.3 Leverage (Debt management) ratios

2.3.3.4. Profitability ratios

Zebra’s return on investment = Br. 3,900 = 2.53 % but industry average is 9%

Quick ratio 57,600 0.86x 2.1x Poor

Fixed asset turnover 196,200 2.04x 3.0x Poor

Total assets turnover 196, 200 1.27x 1.8x Poor

2.4. Limitations of ratio analysis

1. THE SALES FORECAST

Year Sales in Birr

Fig 2.1 Allied food products 2006 sale forecast

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