CHAPTER TWO

FINANCIAL STATEMENT ANALYSIS

 Introduction
The essence of managing risk is making good decisions. Correct decision making depends on
accurate information and proper analysis. Financial statements are summaries of the
operating, investment, and financing activities that provide information for these decisions.
But the information is not enough by them selves and need to be analyzed. Financial analysis
is a tool of financial management. It consists of the evaluation of the financial condition and
operating results of a business firm, an industry, or even the economy, and the forecasting of
its future condition and performance. This Chapter discusses common financial information
and performance measures frequently used by owners and lenders to evaluate financial health
and make risk management decisions. By conducting regular checkups on financial condition
and performance, you are more likely to treat causes rather than address only symptoms of
problems.

2.1. Sources of Financial Information

Financial statements help assess the financial well-being of the overall operation. Information
about the financial results of each enterprise and physical asset is important for management
decisions, but by themselves are inadequate for some decisions because they do not describe
the whole business. An understanding of the overall financial situation requires three key
financial documents: the balance sheet, the income statement and the cash flow statement.
1. The 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.
2. 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.
3. 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 when the cash was
received or spent. An understanding of the timing of cash receipts and expenditures is critical
in managing the whole operation.
2.2. Financial Analysis
Financial analysis is the assessment of firm's past, present, and anticipated future financial
condition. It is the base for intelligent decision making and starting point for planning the
future courses of events for the firm. Its objectives are to determine the firm's financial strength
and to identify its weaknesses. The focus of financial analysis is on key figures in the financial
statements and the significant relationships that exist between them.

2.2.1. The Need for Financial Analysis

The following stakeholders are interested in financial statement analysis to make their
respective decision at right time.
The following are interested in financial statements analysis
1. Investors: Investors fall into two categories, existing and potential. Some seek a takeover,
leading to majority control and shareholding. This usually occurs when a company is losing
public confidence resulting in low market value. Often considered as hostile takeovers, the
investors tend to restructure the business and control it completely, issue shares or sell it off
in the open market. The other category consists of short and long-term investors, both
interested in increasing their wealth with the minimal effort. This may be through either
earning dividends or trading shares in the stock exchange.
2. Lenders: These may supply funds to the organization on short and/or long-term basis.
There are several financial institutions and individuals willing to lend to progressive
companies but few to support those with lower earning levels. The loan carries a charge of
interest payable annually or as agreed, on the principle or compounded principle, over the
period that the loan has been issued.
3. The Management: The managers are entrusted with the financial resources contributed
by owners and other suppliers of funds for effective utilization. In their pursuit to make the
company achieve its objectives, the managers should use relevant financial information to
make right decision at the right time.
4. Suppliers: Suppliers of products and services to the company would like their
investments - sales made on credit terms - received with surety. A creditor would be
reluctant to trade any further if s/he is not guaranteed a timely payment against the issued
invoice.
5. Employees: Many would consider employees the least affected of all when it comes to
analyzing the company's accounts. Think again. The employees will be first to feel the
change in circumstances as they may be promoted, demoted or fired. They would be very
much interested in finding out if the company exhibits any points in their favor, mainly job
security and facilities.
6. Government bodies: As a rule, Companies House requires each company, private or
public, to submit their financial statements and accounts annually. The list of registered
companies and their most recent accounts are published in the Companies House official
publication, which informs the public of their performance for the year or period ended. In
addition, the government has the responsibility to ensure that the information is not
delusive and the rights of the public are protected. Furthermore, it bears the responsibility
of prosecuting any offender of the law, including corporate and consumer law.
7. Competitors: It may seem odd, but existing competitors and new entrants have to
consider the likelihood of their success or failure in trying to conquer the market. Their
primary interest lies in the business ratios of efficiency/productivity and cash, debtor and
credit management. For the industry, it acts as a comparative for better performance of
firms and companies of varying sizes. They also help in establishing a trend of the industry
that is normally a guide to new entrants to study, analyze and perform.

2.2.2. Methods/ Domains of Financial Analysis

2.2.2.1. Ratio Analysis

Probably, the most widely used financial analysis technique is ratio analysis, the analysis of
relationships between two or more line items on the financial statements.
A ratio: Is the mathematical relationship between two quantities in the financial Statement.
Ratio analysis: is essentially concerned with the calculation of relationships which, after
proper identification and interpretation, may provide information about the operations and
state of affairs of a business enterprise. The analysis is used to provide indicators of past
performance in terms of critical success factors of a business. This assistance in decision-
making reduces reliance on guesswork and intuition, and establishes a basis for sound
judgment.
2.2.2.2. Horizontal (Trend) Analysis

Horizontal Analysis expresses financial data from two or more accounting periods in terms of
a single designated base period; it compares data in each succeeding period with the amount
for the preceding period. For example, current to past or expected future for the same
company.

2.2.2.3. Vertical (Static) Analysis

In vertical analysis, all the data in a particular financial statement are presented as a
percentage of a single designated line item in that statement. For example, we might report
income statement items as percentage of net sales, balance sheet items as a percentage of total
assets; and items in the statement of cash flows as a fraction or percentage of the change in
cash.

2.2.3. Benchmarks for Evaluation

What is more important in ratio analysis is the through understanding and the interpretation
of the ratio values.To answers the questions as; it is too high or too low? Is good or bad? A
meaningful standard or basis for comparison is needed.
We will calculate a number of ratios. But what shall we do with them? How do you interpret
them? How do you decide whether the Company is healthy or risky? There are three
approaches: Compare the ratios to the rule of thumb, use Cross-sectional analysis or time
series analysis. Comparing a company's ratios to the rule of thumb has the virtue of
simplicity but has little to recommend it conceptually. The appropriate value of ratios for a
company depends too much on the analyst's perspectives and on the Company's specific
circumstances for rules of thumb to be very useful. The most positive thing to be said in their
support is that, over the years, Companies confirming to these rules of thumb tend to go
bankrupt somewhat less frequently than those that do not.
Cross-Sectional Analysis- involves the comparison of different firm's financial ratios at the
same point in time. The typical business is interested in how well it has performed in relation
to its competitors. Often, the firm's performance will be compared to that of the industry
leader, and the firm may uncover major operating deficiencies, if any, which, if changed, will
increase efficiency. Another popular type of comparison is to industry averages; the
comparison of a particular ratio to the standard is made to isolate any deviations from the
norm. Too high or too low values reflect symptoms of a problem. Comparing a Company's
ratios to industry ratios provide a useful feel for how the Company measures up to its
Competitors. But, it is still true that company specific differences can result in entirely
justifiable deviations from industry norms. There is also no guarantee that the industry as a
whole knows what it is doing.

Time-Series Analysis – is applied when a financial analyst evaluates performance of a firm

over time. The firm's present or recent ratios are compared with its own past ratios.
Comparing of current to past performance allows the firm to determine whether it is
progressing as planned.
1.2. 4. Types of Financial Ratios
There are five basic categories of financial ratios. Each represents important aspects of the
firm's financial conditions. The categories consist of liquidity, activity, leverage, profitability
and market value ratios. Each category is explained by using an example set of financial
ratios for Merob Company.

Exercise 2.1

Let us use the financial statements of Merob Company, shown below to investigate and
explain ratio analysis.
Merob Company, Income Statements
2000 2001 Variables
2,567,000 3,074,000 Sales
1,711,000 2,088,000 Less Cost of Goods Sold
856,000 986,000 Gross Profit
Less Operating Expenses
108,000 100,000 Selling Expenses
445,000 468,000 General and Adm. Expenses
553,000 568,000 Total Operating Expenses
303,000 418,000 Operating Profit
91,000 93,000 Less Interest Expenses
212,000 325,000 Net Profit Before Tax
61,480 94,250 Less Profit Tax (at 29%)
150,520 230,750 Net Income After Tax
10,000 10,000 Less Preferred Stock Dividends
140,520 220,750 Earning Available to Common Shareholders
 1.81 2.90 EPS

Merob, Balance Sheets

2000 2001
Assets
Current Assets
288,000 363,000 Cash
51,000 68,000 Marketable Securities
365,000 503,000 Accounts Receivables
300,000 289,000 Inventories
1,004,000 1,223,000 Total Current Assets
Gross Fixed Assets (at cost)
1,903,000 2,072,000 Land and Buildings
1,693,000 1,866,000 Machinery and Equipment
316,000 358,000 Furniture and Fixture
314,000 275,000 Vehicles
96,000 98,000 Others
4,322,000 4,669,000 Total Fixed Assets
2,056,000 2,295,000 Less Acc. Depreciation
2,266,000 2,374,000 Net Fixed Assets
3,270,000 3,597,000 Total Assets
Liabilities and Owners' Equity
Current Liabilities
270,000 382,000 Accounts Payable
99,000 79,000 Notes Payable
114,000 159,000 Accruals
483,000 620,000 Total Current Liabilities
967,000 1,023,000 Long-Term Debts
1,450,000 1,643,000 Total Liabilities
Shareholder's Equity
200,000 200,000 Preferred Stock –Cumulative, 2000 Share issued and Outstanding
190,000 191,000 Common Stock, Shares issued and Outstanding in 2001, 76,262; in
2000, 76,244

418,000 428,000 Paid- in Capita in Excess of Par on Common Stock

1,012,000 1,135,000 Retained Earnings
1,820,000 1,954,000 Total Stockholders' Equity
 3,270,000 3,597,000 Total Liabilities and Stockholders' Equity

2.2.4.1. Liquidity Ratios

Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and
as they fall due.
Liquidity ratios provide the basis for answering the questions: Does the firm have sufficient
cash and near cash assets to pay its bills on time?
Current liabilities represent the firm's maturing financial obligations. The firm's ability to
repay these obligations when due depends largely on whether it has sufficient cash together
with other assets that can be converted into cash before the current liabilities mature. The
firm's current assets are the primary source of funds needed to repay current and maturing
financial obligations. Thus, the current ratio is the logical measure of liquidity. Lack of
liquidity implies inability to meet its current obligations leading to lack of credibility among
suppliers and creditors.
A. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term
creditors by using only current assets. That is, it measures a firm’s short-term solvency or
liquidity.
The current ratio is calculated by dividing current assets to current liabilities.

Current Assets
Current Ratio = Current Liabilities

Therefore, the current ratio for Merob Company is

For 2001 = 1,223,000 = 1.97
620,000
The unit of measurement is either birr or times. So, we could say that Merob has Birr 1.97 in
current assets for every 1 birr in current liabilities, or, we could say that Merob has its current
liabilities covered 1.97 times over. Current assets get converted in to cash through the
operating cycle and provide the funds needed to pay current liabilities. An ideal current ratio
is 2:1or more. This is because even if the value of the firm's current assets is reduced by half,
it can still meet its obligations.
However, between two firms with the same current ratio, the one with the higher proportion
of current assets in the form of cash and account receivables is more liquid than the one with
those in the form of inventories.
A very high current ratio than the Standard may indicate: excessive cash due to poor cash
management, excessive accounts receivable due to poor credit management, excessive
inventories due to poor inventory management, or a firm is not making full use of its current
borrowing capacity. A very Low current ratio than the Standard may indicate: difficulty in
paying its short term obligations, under stocking that may cause customer dissatisfaction.
B. Quick (Acid-test) Ratio: This ratio measures the short term liquidity by removing the
least liquid assets such as:
- Inventories: are excluded because they are not easily and readily convertible into cash and
more over, losses are most likely to occur in the event of selling inventories. Because
inventories are generally the least liquid of the firm's assets, it may be desirable to remove
them from the numerator of the current ratio, thus obtaining a more refined liquidity measure.
- Prepaid Expenses such as; prepaid rent, prepaid insurance, and prepaid advertising, pre
paid supplies are excluded because they are not available to pay off current debts.
Acid-Test Ratio is computed as follows.

Current assets−Inventories
Quick/Acid test Ratio = Current Liabilities

For 2001, Quick Ration for Merob Company will be: 1,223,000- 289,000 = 1.51
620,000
Interpretation: Merob has 1birr and 51 cents in quick assets for every birr current liabilities.
As a very high or very low acid test ratio is assign of some problem, a moderately high ratio
is required by the firm.
2.2.4.2. Activity Ratios
Activity ratios are also known as assets management or turnover ratios. Turnover ratios
measure the degree to which assets are efficiently employed in the firm. These ratios indicate
how well the firm manages its assets. They provide the basis for assessing how the firm is
efficiently or intensively using its assets to generate sales. These ratios are called turnover
ratios because they show the speed with which assets are being converted into sales.
Measure of liquidity alone is generally inadequate because differences in the composition of
a firm's current assets affect the "true" liquidity of a firm i.e. Overall liquidity ratios generally
do not give an adequate picture of company’s real liquidity due to differences in the kinds of
current assets and liabilities the company holds. Thus, it is necessary to evaluate the activity
ratio.
Let us see the case of ABC and XYZ café having different compositions of current assets but
equal in total amount.
Exercise 2.2 ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7,000
Marketable Security 0 17,000
A/R 0 5,000
Inventories 35,000 6,000
Total Current Asset 35,000 35,000
Current Liabilities 0 6,000
A/P 14,000 2,000
N/P 0 4,000
Accruals 0 2,000
Total Current Liability 14,000 14,000

The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR= CA
CL CL

=35,000 = 2.5 times =35,000 = 2.5 times

14,000 14, 000

Where: CR is current ratio, CA is current assets, CL is current liability, A/R is accounts

receivables, N/R is notes receivable and A/P is accounts payable.
When you see the two cafes, their current ratios are the same, but XYZ café is more liquid
than ABC café. This differences cause the activity ratio showing the composition of each
assets than the current ratio making activity ratio more important in showing a 'true" liquidity
position than current ratio.
Although generalization can be misleading in ratio analysis, generally, high turnover ratios
usually associated with good assts management and lower turnover ratios with poor assets
management.
The major activity ratios are the following.
A. Inventory Turnover Ratio
The inventory turnover ratio measures the effectiveness or efficiency with which a firm is
managing its investments in inventories is reflected in the number of times that its inventories
are turned over (replaced) during the year. It is a rough measure of how many times per year
the inventory level is replaced or turned over.
Inventory Turnover = Cost of Goods Sold
Average Inventories

For the year of Merob Company for 2001= 2,088,000/294,500*= 7.09 times
Interpretation: - Merob's inventory is sold out or turned over 7.09 times per year.
In general, a high inventory turnover ratio is better than a low ratio.
An inventory turnover significantly higher than the industry average indicates: Superior
selling practice, improved profitability as less money is tied-up in inventory.
B. Average Age of Inventory
The number of days inventory is kept before it is sold to customers. It is calculated by
dividing the number of days in the year to the inventory turnover.

No daysin year/365 days

Average
Therefore, Age ofAge
the Average Inventory =
of Inventory InventoryTurnover
for Merob Company for the year 2001 is:
365 days = 51 days
7.09
This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it
is sold.
The longer period indicates that, Merob is keeping much inventory in its custody and, the
company is expected to reassess its marketing mechanisms that can boost its sales because,
the lengthening of the holding periods shows a greater risk of obsolescence and high holding
costs.

C. Accounts Receivable Turnover Ratio: - Measures the liquidity of firm’s accounts

receivable. That is, it indicates how many times or how rapidly accounts receivable is
converted into cash during a year. The accounts receivable turnover is a comparison of the
size of the company’s sales and its uncollected bills from customers. This ratio tells how
successful the firm is in its collection. If the company is having difficulty in collecting its
money, it has large receivable balance and low ratio.

Receivable Turnover = Net Sales

Average Account Receivables

The accounts receivable turnover for Merob Company for the year 2001 is computed as under.
Accounts receivable turnover ratio = 3,074,000 = 7.08
434,000*
Average Accounts Receivable is the accounts receivable of the year 2000 plus that of the year
2001 and dividing the result by two.
 So, 434 = 503,000 + 365,000/ 2 = 434,000*
Interpretation: Merob Company collected its outstanding credit accounts and re-loaned the
money 7.08 times during the year.
Reasonably high accounts receivable turnover is preferable.
 A ratio substantially lower than the industry average may suggest that a Company has:
 More liberal credit policy (i.e. longer time credit period), poor credit selection, and
inadequate collection effort or policy.
 A ratio substantially higher than the industry average may suggest that a firm has;
 More restrictive credit policy (i.e. short term credit period), more liberal cash discount
offers (i.e. larger discount and sale increase), more restrictive credit selection.
D. Average Collection Period: Shows how long it takes for account receivables to be
cleared (collected). The average collection period represents the number of days for which
credit sales are locked in with debtors (accounts receivables).
Assuming 365 days in a year, average collection period is calculated as follows.

365 days
Average Collection period = Re ceivableTurnover

The average Collection period for Merob Company for the year 2001 will be:
365 days/7.08 =51 days or
Average collection period = Average accounts receivables* 365 days/Sales
434,000* 365 days/3,074,000* = 51 days
The higher average collection period is an indication of reluctant collection policy where
much of the firm’s cash is tied up in the form of accounts receivables, whereas, the lower the
average collection period than the standard is also an indication of very aggressive collection
policy which could result in the reduction of sales revenue.
E. Average Payment Period
The average Payment Period/ Average Age of accounts Payable shows, the time it takes to
pay to its suppliers.

The Average Payment Period = Accounts Payable

Average purchase per day
Purchase is estimated as a given percentage of cost of goods sold. Assume purchases were
70% of the cost of goods sold in 2001.

So, Average Payment Period = 382,000 = 95 days

2,088,000 x .70/365

This shows that, on average, the firm pays its suppliers in 95 days. The longer these days, the
more the credit financing the firm obtains from its suppliers.
F. Fixed Asset Turnover
Measures the efficiency with which the firm has been using its fixed assets to generate revenue.

The Fixed Assets Turnover for Merob Company for the year 2001 is calculated as follows.

Fixed assert turnover = Net sales

Average Net Fixed Asset

Fixed Assets Turnover = 3,074,000 = 1.29

2,374,000*
This means that, Merob Company has generated birr 1.29 in net sales for every birr invested
in fixed assets.
Other things being equal, a ratio substantially below the industry average shows;
underutilization of available fixed assets (i.e. presence of idle capacity) relative to the
industry, possibility to expand activity level without requiring additional capital investment,
over investment in fixed assets, low sales or both. Helps the financial manager to reject funds
requested by production managers for new capital investments.
Other things being equal, a ratio higher than the industry average requires the firm to make
additional capital investment to operate a higher level of activity. It also shows firm's
efficiency in managing and utilizing fixed assets.
G. Total Asset Turnover- Measures a firm’s efficiency in management its total assets to
generate       sales.

Total Assets Turnover = Net sales

Net total assets

The Total Assets Turnover for Merob Company for the year 2001 is as follows.
3,074,000 = 0.85
3,597,000
Interpretation: - Merob Company generates birr 0.85 (85 cents) in net sales for every birr
invested in total assets.
A high ratio suggests greater efficiency in using assets to produce sales where as, a low ratio
suggests that Merob is not generating a sufficient volume of sales for the size of its
investment in assets.
Caution- with respect to the use of this ratio, caution is needed as the calculations use
historical cost of fixed assets. Because, of inflation and historically based book values of
assets, firms with newer assets will tend to have lower turnovers than those firms with older
assets having lower book values. The difference in these turnovers results from more costly
assets than from differing operating efficiencies. Therefore, the financial manager should be
cautious when using these ratios for cross-sectional comparisons.
2.2.4.3. Leverage Ratios
Leverage ratios are also called solvency ratio. Solvency is a firm’s ability to pay long term
debt as they come due. Leverage shows the degree of ineptness of firm.
There are two types of debt measurement tools. These are:
A. Financial Leverage Ratio: These ratios examine balance sheet ratios and determine the
extent to which borrowed funds have been used to finance the firm. It is the relationship
of borrowed funds and owner capital.
B. Coverage Ratio: These ratios measure the risk of debt and calculated by income
statement ratios designed to determine the number of times fixed charges are covered by
operating profits. Hence, they are computed from information available in the income
statement. It measures the relationship between what is normally available from
operations of the firm’s and the claims of outsiders. The claims include loan principal and
interest, lease payment and preferred stock dividends.
A.1, Debt Ratio: Shows the percentage of assets financed through debt. It is calculated as:

Debt ratio = Total Liability

Total Assets

The debt ratio for Merob Company for the year 2001 is as follows:
= 1,643 = 0.457 or 45.7 %
3,597
This indicates that the firm has financed 45.7 % of its assets with debt. Higher ratio shows
more of a firm’s assets are provided by creditors relative to owners indicating that, the firm
may face some difficulty in raising additional debt as creditors may require a higher rate of
return (interest rate) for taking high-risk. Creditors prefer moderate or low debt ratio, because
low debt ratio provides creditors more protection in case a firm experiences financial
problems.
A.2. Debt -Equity Ratio: express the relationship between the amount of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims
of creditors and shareholders’ against the asset of the firm.

Debt -equity ratio = Total Liability

Stockholders' Equity

The Debt- Equity Ratio for Merob Company for the year 2001 is indicated as follows.
Debt- Equity ratio = 1,643,000 = 0.84 or 84 %
1,954,000
Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.
B. 1. Times Interest Earned Ratio: Measures the ability of a firm to pay interest on a timely
basis.

Times Interest Earned Ratio =Earning Before Interest and Tax

Interest Expense

The times interest earned ratio for Merob Company for the year 2001 is:
418,000 = 4.5 times
93,000
This ratio shows the fact that earnings of Merob Company can decline 4.5 times without
causing financial losses to the Company, and creating an inability to meet the interest cost.
B.2.Coverage Ratio: The problem with the times interest eared ratio is that, it is based on
earning before interest and tax, which is not really a measure of cash available to pay interest.
One major reason is that, depreciation, a non cash expense has been deducted from earning
before Interest and Tax (EBIT). Since interest is a cash outflow, one way to define the cash
coverage ratio is as follows:

Cash Coverage Ratio= EBIT + Depreciation

Interest

(Depreciation for 2000 and 2001 is 223,000 and 239,000 respectively).

So, Cash coverage ratio for Merob Company for the year 2001 is
418,000 + 239,000 = 7.07 times
93, 000
This ratio indicates the extent to which earnings may fall with out causing any problem to the
firm regarding the payment of the interest charges.
1.2.4.4. Profitability Ratios:
Profitability is the ability of a business to earn profit over a period of time. Profitability
ratios are used to measure management effectiveness. Besides management of the
company, creditors and owners are also interested in the profitability of the company.
Creditors want to get interest and repayment of principal regularly. Owners want to get a
required rate of return on their investment. These ratios include:
A. Gross Profit Margin
B. Operating Profit Margin
C. Net Profit Margin
D. Return on Investment
E. Return on Equity
F. Earning Per Share
A. Gross Profit Margin: This ratio computes the margin earned by the firm after
incurring manufacturing or purchasing costs. It indicates management effectiveness in
pricing policy, generating sales and controlling production costs. It is calculated as:

Gross Profit Margin = Gross Profit

Net Sales

The gross profit margin for Merob Company for the year 2001 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: Merob company profit is 32 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross profit margin ratio
may increase by: Higher sales price, CGS remaining constant, lower CGS, sales prices
remains constant. Whereas, a low gross profit margin may reflect higher CGS due to the
firm’s inability to purchase raw materials at favorable terms, inefficient utilization of plant
and machinery, or over investment in plant and machinery, resulting higher cost of
production.
B. Operating Profit Margin: This ratio is calculated by dividing the net operating profits by
net sales. The net operating profit is obtained by deducting depreciation from the gross
operating profit. The operating profit is calculated as:

Operating Profit Margin = Operating Profit

Net Sales
The operating profit margin of Merob Company for the year 2001 is:
418,000 = 13.60
3,074,000
Interpretation: Merob Company generates around 14 cents operating profit for each of birr
sales.
C. Net Profit Margin: This ratio is one of the very important ratios and measures the
profitableness of sales. It is calculated by dividing the net profit to sales. The net profit is
obtained by subtracting operating expenses and income taxes from the gross profit.
Generally, non operating incomes and expenses are excluded for calculating this ratio. This
ratio measures the ability of the firm to turn each birr of sales in to net profit. A high net
profit margin is a welcome feature to a firm and it enables the firm to accelerate its profits at
a faster rate than a firm with a low profit margin. It is calculated as:

Net Profit Margin = Net Income

Net Sales

The net profit margin for Merob Company for the year 2001 is:
230,750 = 7.5 %
3,074,000
This means that Merob Company has acquired 7.5 cents profit from each birr of sales.

D. Return on Investment (ROI): The return on investment also referred to as Return on

Assets measures the overall effectiveness of management in generating profit with its
available assets, i.e. how profitably the firm has used its assets. Income is earned by using the
assets of a business productively. The more efficient the production, the more profitable is the
business.
The return on assets is calculated as:

Return on Assets (ROA) = Net Income

Total Assets

The return on assets for Merob Company for the year 2001 is:
230,750 = 6.4 %
3,597,000

Interpretation: Merob Company generates little more than 6 cents for every birr invested in
assets.
E. Return on Equity: The shareholders of a company may Comprise Equity share and
preferred share holders. Preferred shareholders are the shareholders who have a priority in
receiving dividends (and in return of capital at the time of widening up of the Company). The
rate of dividend divided on the preferred shares is fixed. But the ordinary or common share
holders are the residual claimants of the profits and ultimate beneficiaries of the Company.
The rate of dividends on these shares is not fixed. When the company earns profit it may
distribute all or part of the profits as dividends to the equity shareholders or retain them in the
business it self. But the profit after taxes and after preference shares dividend payments
presents the return as equity of the shareholders.
The Return on equity is calculated as:

ROE = Net Income

Stockholders Equity

The Return on equity of Merob Company for the year 2001 is:
230,750 = 11.8%
1,954,000
Interpretation: Merob generates around12 cents for every birr in shareholders equity.
F. Earning per Share (EPS): EPS is another measure of profitability of a firm from the
point of view of the ordinary shareholders. It reveals the profit available to each ordinary
share. It is calculated by dividing the profits available to ordinary shareholders (i.e. profit
after tax minus preference dividend) by the number of outstanding equity shares.
The earning per share is calculated as:

EPS = Earning Available for Common Stockholders

Number of Shares of Common Stock Outstanding

Therefore, the earning per share of Merob Company for the year 2001 is:
EPS = 220,750 = birr 2.90 per share
76,262 shares
Interpretation: Merob Company earns birr 2.90 for each common shares outstanding.
Market Value Ratio:
Market value or valuation ratios are the most significant measures of a firm's performance,
since they measures the performance of the firm's common stocks in the capital market. This
is known as the market value of equity and reflects the risk and return associated with the
firm's stocks.
These measures are based, in part, on information that is not necessarily contained in
financial statements – the market price per share of the stock. Obviously, these measures can
only be calculated directly for publicly traded companies.

The following are the important valuation ratios:

A. Price- Earnings (P/E) Ratio: The price earning ratio is an indicator of the firm's growth
prospects, risk characteristics, shareholders orientation corporate reputation, and the firm's
level of liquidity.
The P/E ratio can be calculated as:

P/E Ratio = Market Price per Share

Earning per Share

The price per share could be the price of the share on a particular day or the average price for
a certain period.

Assume that Merob Company's common stock at the end of 2001 was selling at birr 32.25,
using its EPS of birr 2.90, the P/E ratio at the end of 2001 is:
= 32.25/ 2.90 = 11.10
This figure indicates that, investors were paying birr 11.10 for each 1.00 of earnings.

Though not a true measure of profitability, the P/E ratio is commonly used to assess the
owners' appraisal of shares value. The P/E ratio represents the amount investors are willing to
pay for each birr of the firm's earnings. The level of P/E ratio indicates the degree of
confidence (or Certainty) that investors have in the firm's future performance. The higher the
P/E ratio, the greater the investor confidence on the firm's future. It is a means of
standardizing stock prices to facilitate comparison among companies with different earnings.
B. Market Value to Book Value (Market-to-Book) Ratios
The market value to book value ratio is a measure of the firm's contributing to wealth creation
in the society. It is calculated as:

Market-Book Ratio = Market Value pre Share

Book Value per Share

The book value per share can be calculated as:

Book value per share = Total Stockholders Equity

No. of Common Shares Outstanding
Book Value per Share for 2001 = 1,954,000 = 25.62
76,262
Therefore, the Market-Book Ratio for Merob Company for the year 2001 is:
32.25 = 1.26
25.62
The market –to-book value ratio is a relative measure of how the growth option for a
company is being valued via-a vis- its physical assets. The greater the expected growth and
value placed on such, the greater this ratio.
2.2.4. Limitations of Ratio Analysis

While ratio analysis can provide useful information concerning a company’s operations and
financial condition, it does have limitations that necessitate care and judgments. Some
potential problems are listed below:
1. Many large firms operate different divisions in different industries, and for such
companies it is difficult to develop a meaningful set of industry averages. Therefore, ratio
analysis is more useful for small, narrowly focused firms than for large, multi divisional
ones.
2. Most firms want to be better than average, so merely attaining average performance is not
necessarily good as a target for high-level performance, it is best to focus on the industry
leader’ ratios. Benchmarking helps in this regard.
3. Inflation may have badly distorted firm’s balance sheets - recorded values are often
substantially different from “true” values. Further, because inflation affects both
depreciation charges and inventory costs, profits are also affected. Thus, a ratio analysis
for one firm over time, or a comparative analysis of firms of different ages, must be
interpreted with judgment.
4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio
for a food processor will be radically different if the balance sheet figure used for
inventory is the one just before versus just after the close of the coming season.
5. Firms can employ “window dressing” techniques to make their financial statements look
stronger.
6. Different accounting practices can distort comparisons. As noted earlier, inventory
valuation and depreciation methods can affect financial statements and thus distort
comparisons among firms. Also, if one firm leases a substantial amount of its productive
equipment, then its assets may appear on the balance sheet. At the same time, the ability
 associated with the lease obligation may not be shown as a debt. Therefore, leasing can
artificially improve both the turnover and the debt ratios.
7. It is difficult to generalize about whether a particular ratio is “good” or “bad”. For example,
a high current ratio may indicate a strong liquidity position, which is good or excessive
cash, which is bad (because excess cash in the bank is a non-earning asset).
Similarly, a high fixed asset turnover ratio may denote either that a firm uses its assets
efficiently or that it is undercapitalized and cannot afford to buy enough assets.
8. A firm may have some ratios that look “good” and other that look “bad”, making it difficult
to tell whether the company is, on balance, strong or weak. However, statistical procedures
can be used to analyze the net effects of a set of ratios. Many banks and other lending
organizations use discriminate analysis, a statistical technique, to analyze firm’s financial
ratios, and then classify the firms according to their probability of getting into financial
trouble.
9. Effective use of financial ratios requires that the financial statements upon which they are
based are accurate. Due to fraud, financial statements are not always accurate; hence
information based on reported data can be misleading. Ratio analysis is useful, but
analysts should be aware of these problems and make adjustments as necessary.
2.2.6. Common size and Index Analysis

It is often useful to express balance sheet and income statement items as percentages. The
percentages can be related to totals, such as total assets or total sales, or to some base year.
Called Common size analysis and Index analysis, respectively, the evaluation of trends in
financial statements percentages over time affords the analyst insight in to the underlying
improvement or deterioration in financial condition and performance. While a good portion
of this insight is revealed on the analysis of financial ratios, a broader understanding of the
trends is possible when the analysis is extended to include the foregoing considerations.
To illustrate these two types of analysis, let us use the balance sheet and income statements
of JAMBO Electronics Corporation for the year 1999 through 2001 E.C.
Exercise 2.3 the following table illustrates the balance sheet and income statement for
JAMBO Electronics Corporation. You are required to analyze it using vertical and
horizontal analysis methods of the financial statement.

Table 1
JAMBO Electronic Corporation Balance Sheet
 Year
2001 2000 1999 Items
Assets
11,310,000 4,749,000 2,507,000 Cash
85,147,000 72,934,000 70,360,000 Accounts Receivables
91,378,000 86,100,000 77,380,000 Inventory
6,082,000 5,637,000 6,316,000 Other Current Assets
193,917,000 169,420,000 156,563,000 Total Current Assets
94,652,000 91,868,000 79,187,000 Fixed Assets (Net)
5,899,000 5,017,000 4,695,000 Other Long-Term Assets
294,468,000 266,305,000 240,445,000 Total Assets
Liabilities and Shareholders' Equity
37,460,000 31,857,000 35,661,000 Accounts Payable
14,680,000 25,623,000 20,501,000 Notes Payable
8,132,000 7,330,000 11,054,000 Other Current Liabilities
60,272,000 64,810,000 67,216,000 Total Current Liabilities
1,276,000 979,000 888,000 Long -Term Debt
61,548,000 65,789,000 68,104,000 Total Liabilities
0 0 0 Preferred Stock
26,038,000 25,649,000 12,650,000 Common Stock
45,883,000 33,297,000 36,134,000 Additional Paid in Capital
160,999,000 141,570,000 123,557,000 Retained Earnings
132,920,000 200,516,000 172,341,000 Shareholders' Equity
294,468,000 266,305,000 240,445,000 Total Liabilities and Equity

Table 2
JAMBO Electronic Corporation Income Statement

Year Items

2001 2000 1999

375,088,000 347,322,000 323,780,000 Sales
184,507,000 161,478,000 148,127,000 Cost of Goods Sold
190,581,000 185,844,000 175,653,000 Gross Profit
103,975,000 98,628,000 79,399,000 Selling Expenses
45,275,000 45,667,000 43,573,000 General and Adm. Expenses
149,250,000 144,295,000 122,972,000 Total Expenses
41,331,000 41,549,000 52,681,000 Earning Before Interest and Tax
2,963,000 4,204,000 1,757,000 Other Income
44,294,000 45,753,000 54,438,000 Earning Before Tax
20,413,000 22,650,000 28,853,000 Taxes
23,881,000 23,103,000 25,585,000 Earning After Tax

Solutions to exercise 2.3

Table 3
JAMBO Corporation Common size Balance Sheet
Year
2001 2000 1999 Items
Assets
3.80 1.80 1.00 Cash
28.90 27.40 29.30 Accounts Receivables
31.00 32.30 32.20 Inventory
2.10 2.10 2.60 Other Current Assets
65.90 63.60 65.10 Total Current Assets
32.10 34.50 32.90 Fixed Assets (Net)
2.00 1.90 2.00 Other Long-Term Assets
100.00 100.00 100.00 Total Assets
Liabilities and Shareholders' Equity
12.70 12.00 14.80 Accounts Payable
5.00 9.60 8.50 Notes Payable
2.80 2.80 4.60 Other Current Liabilities
20.50 24.30 28.00 Total Current Liabilities
.40 .40 0.40 Long-Term Debt
20.90 24.70 28.30 Total Liabilities
0 0 0 Preferred Stock
8.80 9.60 5.30 Common Stock
15.60 12.50 15.00 Additional Paid in Capital
54.70 53.20 51.40 Retained Earnings
79.10 75.30 71.70 Shareholders' Equity
100.00 100.00 100.00 Total Liabilities and Equity
 Table 4
JAMBO Electronic Corporation Common size Income Statement
Year Items

2001 2000 1999

100.00 100.00 100.00 Sales
49.20 46.50 45.70 Cost of goods sold
50.80 53.50 54.30 Gross Profit
27.70 28.40 24.50 Selling Expenses
12.10 13.10 13.50 General and Adm. Expenses
39.80 41.50 38.00 Total Expenses
11.00 12.00 16.30 Earning Before Interest and Tax
.80 1.20 .50 Other Income
11.80 13.20 16.80 Earning Before Tax
5.40 6.50 8.90 Taxes
6.40 6.70 7.90 Earning After Tax

2.2.6.1. Statement Items as Percentage of Totals

In Common size analysis, we express the various components of a balance sheet as

percentages of the total assets of the company. In addition, this can be done for the income
statements, but here items are related to sales. The expression of individual financial items as
percentage of totals usually permits insights not possible from a review of raw figures by
themselves.
In the table for JAMBO Company we can see that, over the three years the percentage of
current assets increased and that this was particularly true for cash. In addition we see that
account receivables showed a decrease from the year 1999 to 2000 and showed a relative
increase from the year 2000 to 2001. On the liability and shareholders' equity side, of the
balance sheets, the debt of the company declined on a relative basis from 1999 to 2001. The
accounts payable increased substantially 1999 to the year 2001.
The Common size income statement on table 4 shows the gross profit margin is constantly
decreasing from the year 1999 to 2001. When this is combined with the fluctuating selling
expenses and constantly decreasing general and administrative expenses, the end result gives
the constantly decreasing net profit margin.

Table 5
JAMBO Electronic Indexed Balance Sheet

Year
2001 2000 1999 Items
Assets
451.10 189.40 100.00 Cash
121.00 103.70 100.00 Accounts Receivables
118.10 111.30 100.00 Inventory
96.30 89.20 100.00 Other Current Assets
123.90 108.20 100.00 Total Current Assets
119.50 116.00 100.00 Fixed Assets (Net)
125.60 106.90 100.00 Other Long-Term Assets
122.50 110.80 100.00 Total Assets
Liabilities and Shareholders' Equity
105.00 89.30 100.00 Accounts Payable
71.60 125.00 100.00 Notes Payable
73.60 66.30 100.00 Other Current Liabilities
89.70 96.40 100.00 Total Current Liabilities
143.70 110.20 100.00 Long-Term Debt
90.40 96.60 100.00 Total Liabilities
0.00 0.00 0.00 Preferred Stock
205.80 202.80 100.00 Common Stock
127.00 92.10 100.00 Additional Paid in Capital
130.30 114.60 100.00 Retained Earnings
135.20 116.30 100.00 Shareholders' Equity
122.50 110.80 100.00 Total Liabilities and Equity
 Table 6
JAMBO Electronic Indexed Income Statement

Year Items

2001 2000 1999

115.80 107.30 100.00 Sales
124.60 109.00 100.00 Cost of Goods Sold
108.50 105.80 100.00 Gross Profit
131.00 124.20 100.00 Selling Expenses
103.90 104.80 100.00 General and Adm. Expenses
121.40 117.30 100.00 Total Expenses
78.50 78.90 100.00 Earning Before Interest and Tax
168.60 239.30 100.00 Other Income
81.40 84.00 100.00 Earning Before Tax
70.70 78.50 100.00 Taxes
93.30 90.30 100.00 Earning After Tax

2.2.6.2. Statement of Items as Indexes Relative to a Base Year

The common size balance sheets and income statements can be supplemented by the
expression of items as trends from the base year. For JAMBO electronic Corporation, the
base year is 1999 and all the financial statement items are 100.00 for that year. Items for the
two subsequent years are expressed as an index relative to that year. If the statement item
were birr 22,500 compared with birr 15,000 in the base year, the index would be 150. Table 5
and 6 are an indexed balance sheet and an income statement. In table 5, the increase in cash
is apparent. Note also the large increase in cash and inventories are also increasing from the
base year to 2001. There is also a sizable increase in fixed assets.
On the liability side of the balance sheet, we note the fluctuating trend in accounts payable,
notes payable and other current liabilities which resulted in constantly decreasing total
current liabilities.
Where as there is an increasing trend in long term debt from base year to the year 2001 the
aggregate effect of which is the decreasing trend in total liability from base year to the 2001.
The common stock and retained earning shows an increasing trend from the base year to the
year 2001 which resulted in the increase in total liability and equity from the base year to the
year 2001.

When we consider the indexed income statement in table 6 we see the increase in sales, cost
of goods sold and gross profits from the base year to the year 2001. Earning before taxation
and taxes are decreasing from the base year to the final year. Finally, the earnings after
taxation show the fluctuating trend.

DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont Model or
the

DuPont Method) is an expression which breaks ROE (Return on Equity) into three parts.
The name comes from the DuPont Corporation that started using this formula in the 1920s.

The DuPont Model developed in 1914 by F. Donaldson Brown of chemical company

DuPont de Nemours & DuPont Corporation. It is a set of financial ratios and key figures
relating to the Return on Investment (ROI). It is a technique that can be used to analyze the
profitability of a company using traditional performance figures. It integrates elements of the
Income Statement with those of the Balance Sheet.

ROI = Net Profit Margin x Total Assets Turnover

The DuPont Model

2.3. Financial Planning
Forecasting in financial management is needed when the firm is ready to estimate its future
financial needs. Forecasting uses past data as a base and then planned and expected
circumstances are incorporated in order to estimate the future financial requirements.

2.3.1. Steps in Planning Process

The basic steps involved in predicting those financial needs are the following.
Step1: Project the firm's sales revenues and expenses over the planning period.
Step2: Estimate the levels of investment in current and fixed assets that are necessary to
support the projected sales.
Step3: Determine the firm's financial needs throughout the planning period.

2.3.2. Ingredients of Financial Planning

 Assumptions- The user needs to specify some assumptions as to the future. The financial
plan should explicitly specify the environment in which the firm expects to operate over
the life of the plan. A plan that is prepared under one assumption or a set of assumptions
will be different from a plan prepared under another assumption. Among the more
 important assumptions that will have to be made are the level interest rate and the firm's
tax rate.
 Sales Forecast- almost all financial plans require a sales forecast. Most other values in
the financial plan will be calculated based on the sales forecast.
 Performance Statements- a financial plan will have a forecasted balance sheets, income
statement, and statement of cash flows. These are called pro forma statements.
 Assets Requirements – the plan should state the planed investments and the changes in
the firm's assets.
 Financial Requirements- the plan should also describe the necessary financing
arrangements needed to finance the planned investments. Financing policy issues such as
debt policy, debt-equity ratio, and dividend should be discussed.
2.3.2.1. Sales Forecasting
The most important element in financial planning is the sales forecast. Because such forecast
are critical for production scheduling, for plant design, for financial planning, and so on, the
entire management team participate in its preparation. Companies must project the state of
the national economy, economic conditions within their own geographic areas, and
conditions in the product markets they serve. Further, they must consider their own pricing
strategies, credit policies, advertising programs, capacity limitations, and the like. If sales
forecast is off, the consequence can be series. First, if the market expands more than the firm
has expected, and geared up for, the company will not be able to meet its customers' needs.
Orders will back up, delivery times will lengthen, repair and installations will be harder to
schedule and customer dissatisfaction will increase. On the other hand, if its projections are
overly optimistic, the firm could end up with too much plant, equipment and inventory. This
could mean, low turnover ratios, high cost for depreciation and storage, and, possibly write
offs of obsolete inventory and equipment. Therefore, accurate sales forecast is critical to the
well-being of the firm.

2.3.3. Techniques of Determining External Financial Requirements

2.3.3.1. 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.
2.3.3.2. 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
Solutions to Exercise 2.4
The Projected Balance Sheet Method

The first task is to identify those balance sheet items that vary directly and proportionately
with sales; those are called spontaneous assets. Because Kekot has been operating at full
capacity (it has no excess manufacturing capacity), each assets item, including plant and
equipment, must increase if the higher level of sales is to be attained. More cash will be
needed for transactions; receivables will be higher, as sales increase by 50% (from 400,000 to
600,000) and credit policy is assumed unchanged; additional inventory must be stocked; and
new fixed assets must be added. If Kekot assets are to increase, its liabilities and/or equity
must likewise rise: the balance sheet must balance and any increase in assets must be
financed in some manner. Some of the required funds will come spontaneously from routine
business transactions, whereas, other funds must be raised from outside sources.
Spontaneously generated funds will come from such sources as accounts payable and
accruals, which are assumed to increase spontaneously and proportionately with sales. As
sales increase, so will Kekot's purchase and larger purchase will automatically result in
higher level of accounts payable. Similarly because a higher level of operations will require
more labor, accrued wages will increase, and, assuming profit margins are maintained, an
increase in profits will pull up accrued taxes. Retained earnings will also increase but not in
direct proportion to the increase in sales. Neither notes payable, mortgage bonds, nor
common stocks will increases spontaneously with sales, so management must obtain funds
from these sources by taking some specific planned action. The spontaneous assets include:
cash, accounts receivable, inventories and net fixed assets. Similarly, accounts payable,
accrued wages and taxes are the spontaneous liabilities. No other balance sheet items are
spontaneous, but all entries in the income statement are assumed (for simplicity) to vary
directly and spontaneously with sales.

2002 Projections
 2nd approximations 1st approximation As of June 30 Balance Sheet Items
Includes financings 2001
15 15 10 Cash
135 135 90 Accounts Receivables
300 300 200 Inventories
450 450 300 Total Current Assets
450 450 300 Net Fixed Assets
900 900 600 Total Assets
60 60 40 Accounts Payable
15d 10a 10 Notes Payable
75 75 50 Accrued Wages & Taxes
150 145 100 Total Current Liabilities
300 e
150 a
150 Mortgage Bonds
126f 50a 50 Common Stocks
324 324b 300 Retained Earnings
900 669 600 Total Liability and Equity
231c Additional Fund Needed

Forecasted 2002 For the year ended June 30 2001 Income Statement Items
600 400 Sales
500 333 Total Costs
100 67 Taxable Income
40 27 Taxes (40%)
60 40 Net Income
36 24 Dividends
24 16 Additions to Retained Earnings
Foot Notes
a
This account does not increase with sales, so for the first- appropriation projection, the 2001 balance is carried foreword. Latter decisions
could change the figure shown
b
2001 retained earnings plus 2002addition=birr 300,000+24,000= birr 324,000
c
AFN is a balancing item found by subtracting projected total liabilities and equity from projected total assets
d
Birr 5,000 of the new notes payable has been added to the first approximation balance. This is the maximum addition based on the limitation
on total current liabilities
e
Birr 150,000 of new bonds has been added to the first approximations balance. This is the maximum additional debt due to total liabilities
limitations
f
The addition to common equity is determined as a residual ;it is that amount of AFN that still remains after the additions to notes payable and
mortgage bonds
We will begin our analysis by constructing first- approximation projected financial statements
for June 2002, proceeding as follows.
Step 1: Project balance sheet and income statement items: spontaneous assets, liabilities and
all the income statement items are multiplied by (1+g) or 1.50 and items such as notes payable
that does not vary directly with sale is simply carried forward from column one to column two
to develop the first approximation balance sheet. We also carry forward figures for mortgage
bonds and for common stock from 2001 to 2002.
Step 2: Project cumulative retained earnings: we next combine the additions to retained
earnings estimate for 2002 and the June 30 2001 balance sheet figures to obtain June 30 2002
projected retained earnings. Kekot will have a net income of birr 60,000 in the year 2002. If
the firm continues to pay out 60 percent of its income as dividend, the dividend payment will
be birr 36,000, leaving birr 60,000- 36,000 = birr 24,000 of new retained earnings. Thus, the
2002 balance sheet account retained earnings is projected to be birr 300,000 + 24,000 =
324,000.
Step 3: Calculations of Additional fund Needed (AFN):Next, we sum the balance sheet asset
accounts obtaining a projected total assets figure of birr 900,000, and we also sum the
projected liability and equity items to obtain birr 669,000. At this point, the 2002 balance
sheet does not balance. Thus, we have a shortfall, or additional funds needed (AFN) of birr
231,000.

Raising the Additional Funds Needed

Additions could use short-term bank loans (notes payable), mortgage bonds, common stock,
or a combination of these securities to make up the shortfall. It would make this choice on the
relative costs of these different types of securities, subject to certain constraints. Assume here
Kekot has a contractual agreement with its bondholders to keep debt at or below 50 percent
of total assets and also to keep the current ratio at a level of 3.0 or greater. These provisions
restrict the financing choices as follows.

A. Restrictions to Additional Debt

Maximum Debt Permitted = 0.5 x Total assets
= 0.5 x 900,000 = 450,000
Less: debt already projected for June 2002:
 Current liabilities 145,000
Mortgage bonds 150,000 = 295,000
Maximum additional current liabilities 155,000
B. Restrictions on Additional Current Liabilities
Maximum current liabilities = Current assets ÷ 3.0
= 450,000 ÷ 3 = 150,000
Current liabilities already projected…………….. 145,000
Maximum additional current liabilities……….…… 5,000
C. Common Equity Requirements
Total additional funds needed………………. 231,000
Maximum additional debt permitted…………155,000
Common Equity funds required……………… 76,000
Here is a summary of its projected non spontaneous external financings:

Short-term debt (notes payable) ………………… 5,000

Long-term debt……………………………....… 150,000
New Common stock…………………………….. 76,000
Total ……………..…………………………….. 231,000

The Formula Method for Forecasting AFN

AFN = A*/S (S) - L*/S (S) - MS1 (1-d)

= 1.5 (200,000) - 0.225 (200,000) – 0.1(600,000) (0.4)
= 300,000 – 45,000- 24,000 = 231,000

So the total assets = 250,000/2 = 125,000 and we are given that 95 % of these assets are
fixed. Hence, the fixed assets = 95 % (125,000) = 118,750
So, the fixed assets turnover = 250,000/ 118,750 = 2.10
When we compare the industry average (2.50) with the actual result (2.10), the
implication is that, MITU Manufacturing Company has less FATO than the industry. This
further indicates that it is under utilizing its existing fixed assets to generate sales. So no
need of purchasing additional fixed assets to boost sales revenue. Hence, the proposal
should be rejected.
4. Calculation of ratios for Omega Company
 Net income = 5 % (2,000,000) = 100,000
 Let X be income before taxation so, (X- 50% * X= 100,000)
So, the income before taxation is birr 200,000 implying that income tax is birr 100,000
 Current ratio= 1.50, as current liabilities are birr 60,000, total current assets will be
1.50x 60,000 = birr 90,000
Inventory turnover ratio= 15 times = Cost of goods sold/ closing inventory= 15
As cost of goods sold is birr 600,000, closing inventory will be 600,000/15= 40,000
Out of the total current assets of birr 90,000, stock is birr 40,000 and the debtors are birr
35,000. Therefore, the remaining balance is cash.
Hence, cash= 90,000- 75,000 = 15,000
Return on net worth = Net profit/ net worth= 20 % and as net profit is birr 100,000. Hence,
the      net worth is birr 500,000.
 Share to reserve ratio is 4:1 and as share capital + reserve = net worth= 500,000
Hence, share capital is birr 400,000 and reserve is birr 100,000.
 As total liabilities and equity 660,000 is equal to total assets, the fixed assets portion is the
difference of total assets and current assets (660,000- 90,000) = 570,000
Omega Company, Income Statement, for June 30, 2001
2,000,000 Sales
600,000 Cost of Goods Sold
1,400,000 Gross Profit
1,190,000 Operating Expenses
210,000 Earning Before Interest and Tax
10,000 Debenture Interest
100,000 Income Tax
100,000 Net Profit

Omega Company, Balance Sheet, for June 30, 2001

Liabilities Assets
60,000 Sundry creditors 15,000 Cash
100,000 10% Debentures 40,000 Stocks
160,000 Total liabilities 35,000 Debtors
100,00 Reserve and Surplus 90,000 Total Current Assets
400,000 Share Capital 570,000 Fixed Assets
 660,000 Total Liability and Equity 660,000 Total Assets

Multiple choice questions

1. C 2. B 3. B 4. B 5. C 6. A