UNIT 2

FINANCIAL ANALYSES AND PLANNING

2.1. Financial Analysis
2.1.1. The need for financial analysis
2.1.2. Source of financial data
2.1.3. Approaches to financial analysis and interpretation
2.2. Financial planning (forecasting)
2.3. The planning process
2.4. The importance of sales forecasting
2.5. Techniques of determining external financial requirements.
CHAPTER TWO
FINANCIAL ANALYSIS AND PLANNING

What is financial analysis?

Financial analysis is the process of evaluating businesses, projects, budgets and other finance-
related entities to determine their performance and suitability.
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.
Financial analysis is the process of selection, evaluation and interpretation of financial data along
with other pertinent information to assist in investment and other financial decisions.
Financial analysis is a diagnostic tool of analysis that can help management to identify the strength
and weakness of the firm so that corrective actions.
Financial analysis is the tool for predicting the future performance of the firm which the
investment decision related to this firm can be made.
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.
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value. Internal constituents
use it as a monitoring tool for managing the finances.
Source of financial data
 Data internally generated from financial reports of a firm
 Data taken from the external environment for comparison, analysis and
interpretation

Source of internal data for financial analysis

 1. Income Statement

Income statement is also called as profit and loss account, which reflects the operational
position of the firm during a particular period. Normally it consists of one accounting year.
It determines the entire operational performance of the concern like total revenue generated
and expenses incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern.
Gross profit is determined by preparation of trading or manufacturing and net profit is
determined by preparation of profit and loss account.
2. 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.
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.
Statement of changes in financial position involves two important areas such as fund
flow statement which involves the changes in working capital position and cash flow
statement which involves the changes in cash position.
4. Statement of the retained earning

Statement of the retained earning lists how much of the net profit or income of the company was
paid out as dividends to the shareholders and how much of it was retained in the company for
reinvestment or further expansion of the company.
The external source of financial data for analysis
 Financial data source of competitors
 Industry analysis
 Financial data from statistical authorities, chamber of commerce
  Export import data
 Data from other relevant sources

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
 To determine maximization of share holders wealth
 To decide sound financial decision
 To improve the existing financial management system
 Utilization of resources effective

2.2.2. Methods/ Domains of Financial Analysis

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.
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.

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.
Benchmarks for Evaluation

What is more important in ratio analysis is the thorough 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.

2.2.4. Types of Financial ratio:

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 XYZ
Company.

Exercise 2.1

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

Xyz company, Balance Sheets

2001 2000
Assets

Current Assets

Cash 363,000 288,000

Marketable Securities 68,000 51,000

Accounts Receivables 503,000 365,000

Inventories 289,000 300,000

Total Current Assets 1,223,000 1,004,000

Gross Fixed Assets (at cost)

Land and Buildings 2,072,000 1,903,000

Machinery and Equipment 1,866,000 1,693,000

Furniture and Fixture 358,000 316,000

Vehicles 275,000 314,000

Others 98,000 96,000

Total Fixed Assets 4,669,000 4,322,000

Less Acc. Depreciation 2,295,000 2,056,000

Net Fixed Assets 2,374,000 2,266,000

Total Assets 3,597,000 3,270,000

Liabilities and Owners' Equity

Current Liabilities

Accounts Payable 382,000 270,000

Notes Payable 79,000 99,000

Accruals 159,000 114,000

Total Current Liabilities 620,000 483,000

Long-Term Debts 1,023,000 967,000

Total Liabilities 1,643,000 1,450,000

Shareholder's Equity
 Preferred Stock –Cumulative, 2000 Share issued and
Outstanding 200,000 200,000

Common Stock, Shares issued and Outstanding in 2001,

76,262; in 191,000 190,000
2000, 76,244

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

Retained Earnings 1,135,000 1,012,000

Total Stockholders' Equity 1,954,000 1,820,000

Total Liabilities and Stockholders' Equity 3,597,000 3,270,000

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.
The basic measures of liquidity of the companies

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 xyz 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 XYZ has Birr 1.97 in
current assets for every 1 birr in current liabilities, or, we could say that XYZ 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.

Quick/Acid test Ratio = Current assets- Inventories

Current Liabilities

For 2001, Quick Ration for XYZ Company will be: 1,223,000- 289,000 = 1.51
620,000
Interpretation: XYZ 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.
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 xyz Company for 2001= 2,088,000/294,500*= 7.09 times
Interpretation: - xyz 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.

Average Age of Inventory = No days in year / 365days

Inventory Turnover
This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it is
sold. The longer period indicates that, xyz 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 xyz 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: xyz Company collected its outstanding credit accounts and re-loaned the money
7.08 times during the year.
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.

365days
Average Collection period =
Receivable Turnover

The average Collection period for xyz 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 xyz 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, xyz 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. 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 xyz Company for the year 2001 is as follows.
3,074,000 = 0.85
3,597,000
Interpretation: - xyz 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 whereas; a low ratio
suggests that xyz 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.
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 xyz 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 xyz 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 =Earnings Before Interest and

Tax Interest Expense

The times interest earned ratio for xyz Company for the year 2001 is:
418,000 = 4.5 times
93,000
This ratio shows the fact that earnings of xyz Company can decline 4.5 times without causing
financial losses to the Company, and creating an inability to meet the interest cost. Coverage
Ratio: The problem with the times interest eared ratio is that, it is based on earnings 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 xyz 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 without causing any problem to the
firm regarding the payment of the interest charges.

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. Earnings 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 xyz Company for the year 2001 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: xyz 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 xyz Company for the year 2001 is:
418,000 = 13.60
3,074,000
Interpretation: xyz 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 xyz Company for the year 2001 is:
230,750 =7.5%
3,074,000
This means that xyz 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 xyz Company for the year 2001 is:
230,750 =6.4%
3,597,000

Interpretation: xyz 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 Xyz Company for the year 2001 is:
230,750 = 11.8%
1,954,000
Interpretation: Xyz generates around12 cents for every birr in shareholders’ equity.
F. Earnings 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 earnings per share is calculated as:

EPS = Earnings Available for Common Stockholders

Number of Shares of Common Stock Outstanding

Therefore, the earning per share of xyz Company for the year 2001 is:
EPS = 220,750 = birr 2.90 per share
76,262 shares
Interpretation: Xyz 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 earnings 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

Earnings 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 xyz 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 per 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 XYZ 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:
 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.
 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.
 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.
 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.
 Firms can employ “window dressing” techniques to make their financial statements look
stronger.
 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.
 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.
 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.
 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.Comparative Profit and Loss Account Analysis

Another comparative financial statement analysis is comparative profit and loss account
analysis. Under this analysis, only profit and loss account is taken to compare with previous
year’s figure or compare within the statement. This analysis helps to understand the
operational performance of the business concern in a given period. It may be analyzed on
horizontal basis or vertical basis.

3. Common Size Analysis

Another important financial statement analysis technique is common size analysis in

which figures reported are converted into percentage to some common base. In the balance
sheet the total assets figures is assumed to be 100 and all figures are expressed as a percentage
of this total. It is one of the simplest methods of financial statement analysis, which reflects
the relationship of each and every item with the base value of 100%.
Example: Common size balance sheet of ABC Bank Ltd., as on 31st March 2003
and 2004.
 4. Trend Analysis

The financial statements may be analyzed by computing trends of series of information. It

may be upward or downward directions which involve the percentage relationship of each
and every item of the statement with the common value of 100%. Trend analysis helps to
understand the trend relationship with various items, which appear in the financial
statements. These percentages may also be taken as index number showing relative changes
in the financial information resulting with the various period of time. In this analysis, only
major items are considered for calculating the trend percentage.
Exercise 2
Calculate the Trend Analysis from the following information of ABC
Bank Ltd., taking 1999 as a base year and interpret them (in thousands).

Solution
Trend Analysis (Base year 1999=100
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 planned 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.
CHAPTER THREE
THE TIME VALUE OF MONEY

3.1. The Concept of Time Value of Money

3.2. Simple Interest versus Compound Interest
3.3. Future Values vs. Present Values
3.3.1. Future Value of Single Amount
3.3.2. Present Value of Single Amount
3.4. Annuities
3.4.1. Future Value of Ordinary Annuity
3.4.2. Future Value of Annuity Due
3.4.3. Present Value of Ordinary Annuity
3.4.4. Present Value of Annuity Due
3.1. The Concept of Time Value of Money

The value of money depends on time. The value of a given amount of money at one point in time
is not the same as the value of the same face amount at another time. Thus, the value of money is
dependent on the point of time it occurs at payment or receipt. It is the expression of the fact that,
if the rate of interest is positive, the money in hand now is worth more than money to be received
at a date in the future. It refers to the value derived from the use of money over time as a result of
investment and reinvestment. It is the concept that an amount in hand today is worth more than
the same amount that will be received in future year. This is because; the amount could be
deposited in an interest-bearing bank account (or otherwise invested) from now to time "t" and
yield interest. Similarly, it means that, cash paid out later is worth less than a similar sum paid at
an earlier date.
3.2. Simple Interest versus Compound Interest
Interest is the growth in a principal amount representing the fee charged for the use of money for
specified time period.
3.2.1. Simple Interest: is the return on a principal amount for one period time. It is based on the
assumption that interest itself does not earn a return, but this kind of situation occurs rarely in the
business world.
Simple interest I= principal x rate x time
3.2.2. Compound Interest: is the return on a principal amount for two or more time periods,
assuming that the interest for each time is added to the principal amount at the end of each period
and earns interest in all subsequent periods.
Exercise 3.1
Suppose that Br. 200,000 is invested at 20% simple interest per annum. The following table
shows the state of the investment, year by year.

Year Principal Interest Earned Amount Cumulative Amount

1 200,000 40,000 (20% of 200,000) 240,000
2 200,000 40,000 (20% of 200,000) 280,000
3 200,000 40,000 (20% of 200,000) 320,000

Assuming the above case, the compounded amount would be as indicated on the following table.

Year Principal Interest Earned Amount Cumulative Amount

1 200,000 40,000 (20% of 200,000) 240,000
2 240,000 48,000 (20% of 240,000) 288,000
3 288,000 57,600 (20% of 288,000) 345,600

3.3. Future Values versus Present Values

When correctly applied, both techniques will result in the same decisions but they view the
decision from opposite angles. Future value techniques are used to find the future values of the
amount (s) involved at some future time, usually at the end of the life of the project whereas,
present value techniques are used to find the today's equivalent (present values) of amounts
expected at some time in the future. Present values are measured at the start of the project's life
(time zero). Future value computation techniques use compounding to find the future value of each
cash flow at the end of the investment's life and then sums them to find the investment's future
value, on the other hand, the present value techniques uses discounting to find the present value of
each cash flow at time zero and then sums them to find the present value of the investments.

3.3.1. Future Value of Single Amount

The accumulated amount of a single amount invested, at compound interest may be
computed period by period by a serious of multiplications.
Exercise 3.2
Suppose your father gives you 10,000 on your eighteenth birthday. You deposited this amount in a
bank at 8 per cent compounded quarterly for one year. How much future sum would you receive
after one year?
Solution
If n is used to represent the number of periods that interest is to be compounded, i is used to
represent the interest per period, and p is the principal amount invested, the series of
multiplications to compute the amount is:
n
a = P (1+i)
4
a= birr 10,000 (1 + 0.02)
a= 10,824.32

3.3.2. Present Value of Single Amount

It is a method of assessing the worth of an investment by investing the compounding process to
give the present value of future cash flows. This process is "discounting".
The present value of "P" of the amount "A" due at the end of "n" conversion periods at the rate
"i" per conversion period. The value of "P" is obtained as follows:
-n
P= A or P= A (1+i)
n
(1+i)

Exercise 3.3
Ato Megersa has been given the opportunity to receive birr 10,000 four years from now. If he
can earn 6 % on his investment, what is the amount that would make him indifferent if he is to
receive the amount as of today?
Solution
P=A= 10,000 = 10,000 = 7,921
n 4
(1+i) (1+0.06) 1.26428
This means that, if Megersa deposited birr 7,921 in to the bank at interest rate of 6 per cent, he
will get birr 10,000 at the end of 4 years.
Exercise 3.4: Determining the Interest Rate
If birr 1,000 is deposited at compound interest on January 1 year 1, and the amount on deposit on
December 31,year 10, is birr 1,806.11, what is the semiannual interest rate accruing on the
deposit?
Solution
The amount of 1 for 20 periods at the unstated rate of interest is birr 1.80611 (birr 1,806.11÷birr
1,000 = birr 1.80611). Referring the future value table, 1.80611 is the amount of 1 for 20 periods
at 3 %.
Therefore, the semiannual interest rate is 3%.

3.4. Annuities

An annuity is a bunch of structured payments or equal payments made regularly, like every
month or every week.
Many measurement situations involve periodic deposits, receipts, withdrawals, or payments
(called rents), with interest at a stated rate compounded at the time that each rent is paid or
received. These situations are considered annuities if all the following conditions met:
1. The periodic rents are equal in amount.
2. The time period between rents is constant, such as a year a quarter of a year, or a month.
 3. The interest rate per time period remains constant.
4. The interest is compounded at the end of each time period.
When rents are paid or received at the end of each period and the total amount on deposit is
determined at the final rent is made, the annuity is an ordinary annuity (or annuity in arrears).
The other type of annuity is an annuity due in which payments or receipts occur at the beginning
of each period.
3.4.1. Future Value of Ordinary Annuity

The future value of an ordinary annuity is the aggregate sum of the future value of each
individual payment on the final rent is made.
If we assume an investor who wants to know how much is the value of just birr 1 deposit to be
made at the end of each of the coming five years at 10 % compounded annually, the first
payment earns an interest for four years ( n-1) years because, it is made at the end of the first
year. So, it is late to earn anything in the first year. The second payment earns interest for 3 (n-2)
years. And the last payment does not earn anything because it is made just at the end of the last
year. Thus, for ordinary annuity of n payments, there is n-1 compounding periods. The Future
value of Ordinary Annuity is calculated by the following formula:
n
FVOA= R [(1+i) -1]
i
Where:
FVOA = is the future value of ordinary annuity
R = Periodic payments
i = Interest rate
n = Periods for which rent is made

Exercise 3.5: Ato Mohammed wish to determine the sum of money he will have in his saving
account at the end of 6 years by depositing birr 1,000 at the end of each year for the next 6 years
at an annual interest rate of 8 per cent .
Required: 1. Determine the amount
2. Prepare fund accumulation table
Solution
n
1. FVoA= R [(1+i) -
1] i
6
= 1000 [(1+ 0.08) -1] = 7,336
0.08
2. Fund accumulation table
Annual
Date Deposit Interest earned Increase in fun Fund balance
December 31 balance
Year 1 1,000 - 1,000.00 1,000.00
Year 2 1,000 80.00 1,080.00 2,080.00
Year 3 1,000 166.40 1,166.40 3,246.40
Year 4 1,000 259.70 1,259.70 4,506.10
Year 5 1,000 360.50 1,360.50 5,866.60
Year 6 1,000 469.33 1,469.30 7,336.00

3.4.2. Future Value of Annuity Due

The future value of annuity due is the total amount on deposit one period after the final rent is
made. It assumes periodic rents occur at the beginning of the period. The future value of annuity
due can be given by either of the following formulas:
n
1. FVAD= R [(1+i) -1 ] (1+i) or
i
n+1
2. FVAD= R [(1+i) - 1] -
Ri
Where: FVAD- Future Value of Annuity Due
R= Periodic payments
i=Interest rate
n=Periods for which rent is made

Exercise 3.6: Tewodros deposits birr 5,000 on January 1 of each year for the coming eight years
in to an account paying 9 % compounded annually. How much will be in his account by the end
of the year 8?
Solution
8
FVAD= 5,000 [(1.09) -1] * (1.09)
0.09
= 5,000 (11.0285) *(1.09) = 60,105.00 or
8+1
FVAD = 5,000 [(1.09) -1] - 5,000
0.09

= 5,000 [13.021] – 5,000 65,105- 5,000 = 60,105.00

3.4.3. Present Value of Ordinary Annuity

The present value of ordinary annuity is the discounted value of a series of future rents on the date
one period before the first rent is made.
It can be calculated by using the following formula:
-n
PVOA = R [1- (1+i) ]
i
Where: PVOA = Present Value of Ordinary
Annuity R= Periodic Payments
i = Interest Rate
n= Periods for which Rent is Made
Exercise 3.7
XYZ Corporation purchased Machinery on January 1 2001 and agreed to pay for the purchase
payment of birr 5,000 each including principal and interest on December 31 of each of the next
five year beginning December 31, 2001. The agreed interest rate is 6 per cent compounded
annually.
Required: 1. Compute the price of the machinery excluding interest charge
2. Prepare liability table for the purchase showing periodic interest charges
Solution
-n
PVOA= R [1- (1+i) ]
i
-5
= 5,000 [1-(1.06) ] = 21,061.82
0.06
Therefore, the price of the machinery is birr 21,061.82
 2. Debt Payment Program

Interest Payment at Net Reduction in Debt

Date 6 %/Year End of the year Debt Balance
Jan 1,01 - - - 21,061.82
Dec 31,01 1,263.71 5,000 3,736.29 17,325.53
Dec 31,02 1,039.53 5,000 3,960.47 13,365.06
Dec 31,03 801.90 5,000 4,198.10 9,166.96
Dec 31,04 550.02 5,000 4,449.98 4,716.98
Dec 31,05 283.02 5,000 4,716.98 0

3.4.4. Present Value of Annuity Due

The present value of annuity due is the discounted value of a series of future rents on the date
the first rent is received or paid. It can be calculated by using either of the following formulas:
-n
PVAD= R [1- (1+i) ] (1+i) or
i
– (n-1)
PVAD= R [1- (1+i) ] +R
i
Where: PVAD= Present Value of annuity Due
R= Periodic payments
i = Interest rate
n= Periods for which rent is made
Exercise 3.8
XYZ Company acquired office equipment on January 1, 1999 and agreed to pay for the purchase
with three installments of birr 5,000 each including principal and interest, every year beginning
January 1, 1999. The interest rate was 12 per cent compounded annually.

Required: 1. Compute the acquisition cost of the equipment excluding interest charges.
2. Prepare a liability table showing periodic interest charges and payment
-n
1. PVAD= R [1- (1+i) ] (1+i)
i
-3
= 5,000 [(1- (1.12) ] (1.12)
0.12 = 13,450.26
2. Liability Table

Lear Beginning Debt Payment at Balance Accruing Interest Ending Dent

Balance Beginning Interest Balance
1999 13,450.26 5,000 8,450.26 1,014.03 9,464.29
2000 9,464.29 5,000 4,464.29 535.71 5,000
2001 5,000 5,000 0 0 0