CHAPTER TWO

FINANCIAL ANALYSIS AND PLANNING

In the previous accounting courses you have learned that financial statements report both on a
firm’s financial position and financial performance. The four basic financial statements present
about different aspects of financial conditions, operating results, and cash flows. The balance
sheet shows a firm’s assets and claims against assets at a particular point in time. The income
statement, on its part, reports the results of the firm’s operations over a period of time. Similarly,
the statements of retained earnings and cash flows show the change in retained earnings and cash
between two balance sheet dates. Hence, this chapter will discuss about the different issues
regarding the analysis of financial statement.

2.1. MEANING AND IMPORTANCE OF FINANCIAL ANALYSIS

Financial analysis refers to analysis of financial statements and it is a process of evaluating the
relationships among component parts of financial statements.

The focus of financial analysis is on key figure in the financial statements and the significant
relationships that exist between them. Financial analysis is used by several groups of users like
managers, credit analysts, and investors.

The analysis of financial statements is designed to reveal the relative strengths and weakness of
a firm. This could be achieved by comparing the analysis with other companies in the same
industry, and by showing whether the firm’s position has been improving or deteriorating over
time. Financial analysis helps users obtain a better understanding of the firm’s financial
conditions and performance. It also helps users understand the numbers presented in the financial
statements and serve as a basis for financial decisions.

2.1.1. TYPES OF ANALYSIS

Analysis of financial statement may be broadly classified into two important types on the basis
of material used and methods of operations.
1. Based on Material Used

Based on the material used, financial statement analysis may be classified into two major types
such as External analysis and internal analysis.

A. External Analysis: Outsiders of the business concern do normally external analyses but they
are indirectly involved in the business concern such as investors, creditors, government
organizations and other credit agencies. External analysis is very much useful to understand the
financial and operational position of the business concern. External analysis mainly depends on
the published financial statement of the concern. This analysis provides only limited
information about the business concern.

B. Internal Analysis: The Company itself does disclose some of the valuable information to the
business concern in this type of analysis. This analysis is used to understand the operational
performances of each and every department and unit of the business concern. Internal analysis
helps to take decisions regarding achieving the goals of the business concern.

2. Based on Method of Operation

Based on the methods of operation, financial statement analysis may be classified into two major
types such as horizontal analysis and vertical analysis.

A. Horizontal Analysis: Under the horizontal analysis, financial statements are compared with
several years and based on that, a firm may take decisions. Normally, the current year’s figures
are compared with the base year (base year is consider as 100) and how the financial information
are changed from one year to another. This analysis is also called as dynamic analysis.

B. Vertical Analysis: Under the vertical analysis, financial statements measure the quantitative
relationship of the various items in the financial statement on a particular period. It is also called
as static analysis, because, this analysis helps to determine the relationship with various items
appeared in the financial statement. For example, a sale is assumed as 100 and other items are
converted into sales figures.
2.1.2. TECHNIQUES OF FINANCIAL ANALYSIS
In the process of financial analysis various tools are employed. The most prominent amongst
them are listed as below:

 Comparative statements
 Common size statements
 Trend Analysis
 Ratio Analysis
 Fund flow and cash flow analysis

Comparative Statements: Comparative statements are prepared to provide time perspective to

the consideration of various elements of operations and financial position of the business
embodied in the statement. Here, the figures for two or more periods are placed side by side to
facilitate comparison. In addition to absolute figures the ratios constructed from the financial
statements are also presented in the form of comparative statements. Both, balance sheet and
income statement are presented in the form of comparative statements.

Common Size Statements: Under this technique the individual items of income statement and
balance sheet are expressed as percentages in relation to some common base. In income
statement, sales are usually taken as hundred and all items are expressed as percentage of sales.
Similarly, in balance sheet the total of assets or liabilities treated equivalent to hundred and all
individual assets or liabilities are expressed as percentage of this total.

Trend Analysis: It is highly helpful in making a comparative study of the financial statements
for several years. The calculation of trend percentages involves the calculation of percentage
relationship that each item bears to the same item in the base year. Any year may be taken as
base year. Usually, the first year will be taken as the base year. Any intervening year may also be
taken as the base year. Each item of the base year is taken as 100 and on that basis the percentage
for each of the item for each of the years is calculated. These percentages can also be taken as the
index numbers showing the relative changes in the financial data over a period of time.

Ratio Analysis: Ratio analysis is a tool which establishes a numerical relationship between two
figures normally expressed in terms of percentage.
Fund flow and Cash flow Analysis: The changes that have taken place in the financial position
of a firm between two dates of balance sheets can be ascertained by preparing the fund flow
statement which contains the sources and uses of financial resources. This is a valuable aid to
finance manager, creditors and owners in evaluating the uses of funds by a firm and in
determining how these uses are financed. This statement also helps to assess the growth of the
firm and its resulting financial needs to decide the best way to finance those needs.

Cash flow statement summarizes the causes of changes in cash position between two dates of
balance sheets. It indicates the sources and uses of cash. This statement is similar to statement
prepared on working capital basis, except that it focuses attention on cash instead of working
capital.

2.2. STAGES IN FINANCIAL ANALYSIS

Financial analysis consists of the following three major stages.

i) Preparation. The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial statement
analysis focuses primarily on the balance sheet and the income statement. However, data from
statements of retained earnings and cash flows may also be used. So, preparation is simply
objective setting and data collection.

ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.

iii) Evaluation and Interpretation. This involves the determination of the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm’s
performance and financial condition. This is the most important of all the three stages of
financial analysis.

2.3. RATIO ANALYSIS

The term, ‘ratio’, refers to the numerical or quantitative relationship between items or variables.
It shows an arithmetical relationship between two figures. It is also defined as “the indicated
quotient of two mathematical expressions” and as “the relationship between two or more things”.
The relationship between two accounting figures expressed mathematically is known as
‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are generally expressed
in three ways. It may be a quotient obtained by dividing one value by another. For example, if
the current assets of a business on a particular date are Birr 200, 000 and its current liabilities
Birr 100, 000 the resulting ratio would be Birr 200, 000 divided by 100, 000 i.e., 2:1. The ratio
can be expressed as a percentage as well. Taking the same particulars, it may be stated that the
current assets are 200% of the current liabilities. Sometimes ratios are expressed as so many
‘times’ or ‘fraction’: for example, the current assets may be stated as being double the current
liabilities or current liabilities was half of current assets. Ratio analysis is the process of
computing, determining and interpreting the relationship between the component items of
financial statements.

2.3.1. Importance of ratio analysis

Ratio analysis is an extremely useful and the most widely used tool of financial analysis. It
makes for easy understanding of financial statements. It facilitates intra-and inter-firm
comparison. Ratios act as an index of the efficiency of the enterprise. A purposeful ratio
analysis helps in identifying problems such as the following and in finding out suitable course of
action.

(a) Whether the financial condition of the firm is basically sound,

(b) Whether the capital structure of the firm is appropriate,
(c) Whether the profitability of the enterprise is satisfactory,
(d) Whether the credit policy of the firm is sound, and
(e) Whether the firm is credit worthy.

In short, through the technique of ratio analysis the firm’s solvency both long and short term
efficiency and profitability can be assessed.

2.3.2. Limitations of ratio analysis

At the outset it should be noted that ratio analysis is not an end in itself but a means to the
answering of specific questions which the users of the financial statements have in relation to the
financial condition and results of operations of the firm.
  Ratios are derived from financial statements. The financial statements suffer from a
number of limitations and ratios which are derived from these statements are also subject
to these limitations.
 Ratios are meaningless, if detached from their source.
 Ratios, as they are, are not of much significance. They become useful only when they are
compared with some standards.
 Ratio analysis should be made with caution in the case of inter-firm comparison. Unless
the firms in question follow identical accounting methods for items like depreciation,
inventory valuation, deferred revenue expenditure, the writing off of capital items, etc.,
ratios will not reflect the figures which are truly comparable.
 No ratio may be regarded as good or bad as such. It may be an indication the firm is weak
or strong, not a conclusive proof thereof.
 Ratio analysis may give misleading results if the effect of changes in price level is not
taken into account.
 No ratio analysis can be meaningful unless the questions sought to be answered are
clearly formulated.
 The nature of the business (whether trading or manufacturing) and the industry’s
characteristics which affect the figures in the financial statements and their inter-
relationships should be clearly understood and born in mind in order to made meaningful
ratio analysis.
 The social, economic and political conditions which form the background for the firm’s
operations should be understood so as to make ratio analysis meaningful.

These limitations, to a considerable extent, can be eliminated or corrected:

if the analysis is related to one firm over a period of time;

if the analysis is limited to a few well chosen ratios which can answer specific questions;
if the results of the firm are compared with suitable norms or standards;
if the ratios are used primarily for the identification of areas for further managerial
analysis and formulation of alternatives available to the management in solving such
problems;
 If the ratios are interpreted in the light of social, political, economic, technological and
business conditions under which the firm operates.

If ratio analysis is done mechanically it will be not only misleading but also positively
dangerous. If it is used with a measure of caution, reason, and logic it can be a powerful
management tool not so much for providing answers but for highlighting management issues and
for identifying possible alternatives.

2.3.3. Classification of ratios

Some writers have contended that there are as many as 429 business ratios. But all these ratios
need not be calculated for a particular study. On the basis of the nature of the business concern,
the circumstances in which it is operating, and the particular questions to be answered from the
ratio analysis, certain ratios should only be selected. Every attempt should be made to keep the
number of ratios as far as possible to the minimum. This avoids possible confusion in the
interpretation of ratios.

Financial ratios may be classified in various ways.

On the basis of their importance the ratios may be classified as (1) Primary ratios and (2)
Secondary ratios.
On the basis of the source (i.e., the financial statement(s) from which items are taken to
calculate ratios) ratios may be classified as Balance Sheet ratios or Income Statement
ratios and combined ratios.
On the basis of the nature of items the relationships of which are explained by ratios, the
ratios may also be classified as Financial Ratios and Operating Ratios.
The most important and commonly adopted classification of ratios is on the basis of the
purpose or function which the ratios are expected to perform. Such ratios are also called
‘functional ratios’. They include solvency/debt ratios, liquidity ratios, activity ratios,
market value ratios and profitability ratios. In fact, the entire ratio analysis can be
discussed in relation to the orientation of the functional basis of ratio classification.
  Liquidity Ratios

Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets. There are two
commonly used liquidity ratios: the current ratio and the quick ratio.

i. Current Ratio

Current ratio is the ratio of total current assets to total current liabilities. It is calculated by
dividing current assets by current liabilities.

Current assets
Current ratio = Current liabilities

This ratio is also called ‘working capital ratio’ because it is related to the working capital of the
firm. The current ratio is an important and most commonly used ratio to measure the short-term
financial strength or solvency of the firm. It indicates how many birrs of current assets are
available for one birr of current liability. The higher the current ratio, the more is the firm’s
ability to meet its current obligations and the greater the safety of the funds of the short-term
creditors. Thus the current ratio, in a way, provides a margin of safety to the (short-term)
creditors.

To the question, “What should be the current ratio of a firm?” there is no clear-cut answer, nor is
there any hard and fast rule for deciding it. Conventionally (The rule of thumb), a current ratio of
2:1 is considered satisfactory. This rule is based on the logic that even in the worst situation
where the value of current assets is reduced by fifty percent; the firm will be able to meet its
current obligations. The standard norm for the current ratio (i.e. 2:1) may vary from firm to firm,
industry to industry or for a firm from time to time. As such, this norm of 2:1 should not be
blindly followed.

Also, it should be remembered that this current ratio is a crude measure of liquidity. It is a
quantitative rather than a qualitative index of liquidity. It takes into account the total value of
current assets without making any distinction between the various types of current assets like
receivables, stocks and so on. It does not measure the quality of these assets. If the firm’s current
assets include doubtful and slow paying receivables or slow moving and non-moving (non-
saleable) stock of goods, then the firm’s ability to meet obligations would be reduced. This
aspect is ignored by the current ratio. That is why too much reliance should not be placed on the
current ratio. The ability of the assets also should be ascertained.

Illustration: assume the following balance sheet, income statement and other supporting data for
Ethio-Metals Manufacturing Company as of December 31, 2013. Figures are in millions
Ethio-Metals Manufacturing Company
Balance Sheet
As of December 31, 2013
(Figure in thousands of Birr)
Assets (000) Liabilities and Equity (000)

Current Assets: Liabilities and shareholders' equity

Cash Birr 2,500 Current liabilities
Marketable securities 1,000  Accounts payable Birr 7,200
Accounts receivable 16,000  Notes payable 10% bank 5,500
Inventories 20,500  Accrued liabilities 900
Total current assets 40,000  Current portion of long-term debt 3,000
Fixed Assets: 1,400
 Other current liabilities
Land and buildings 28,700 18,000
Total current liabilities
Machinery and equipment 31,600
Long-term liabilities
Total fixed assets 60,300 27,000
 Long term debt-12% mortgage bond
Less accumulated depreciation (18,300) 45,000
Total liabilities
Net fixed assets 42,000
Shareholders' equity
Total assets 82,000
 Common stock, 5 Birr par, 2,000,000
Shares authorized; 1,300,000 shares
6,500
outstanding in 2013
14,000
 Paid-in-capital in excess of par
16,500
 Retained earnings
37,000
Total shareholders' equity
82,000
 Total liabilities & shareholder equity
Ethio-Metals Manufacturing Company
Income Statements
For the year ended December 31, 2013
(Figure in thousands of Birr)
Net Sales Birr 120,000
Cost of goods sold 90,000
Gross Profit 30,000
Operating Expenses:
Selling expenses 5,000
General and administrative expenses 8,000
Depreciation expense 1,100
Lease Payments 1,650
Total operating expenses 15,750
Earnings before interest and taxes 14,250
Interest expenses:
Interest on bank notes 550
Interest on Other debt 3,600
Total interest expenses 4,150
Earnings before taxes 10,100
Income taxes (34%) 3,434
Net Income 6,666

Additional Information:
i. The company paid principal payments of 2,500,000 birr on its outstanding debts during 2013.
ii. Common share of Ethio Metals manufacturing company has market prices of 30 Birr at the
end of 2013.
iii. The company distributed a cash dividend to common shareholders of 1,900,000 Birr during
2013.
iv. The tax rate applicable to the firm is 34 percent.
v. The industry averages for the year 2013 is provided below:
 Types of Ratios Industry Average (in 2013)
Current ratio ……………………………. 2 times
Quick ratio ……………………………… 1.1 times
Inventory turnover ……………………… 6 times
Total assets turnover …………….……..... 2 times
Fixed assets turnover ……………………. 3 times
Average collection period ………………. 35 days
Total debt to assets …………………….... 50%
Long term debt to equity ………………... 80%
Total debt-to-equity ……………………… 1
Time interest earned ……………………... 5 times
Fixed charges coverage …………………... 2.5 times
Gross profit margin ………………………. 30%
Operating profit margin ……………….… 13%
Net profit margin …………………………. 7%
Return on investment (ROI) …………….... 10%
Return on shareholders’ equity (ROE) …… 20%
Earnings per share (EPS) ……………..….. Birr 6/share
Price-to-earnings ratio (P/E) ……………... 7 times
Book value per share ……………………… Birr 25/share
Dividends per share (DPS) ……………….. Birr 2.50
Dividend payout ratio …………………….. 40%
Dividend yield ……………………………... 7.50
Current assets birr 40,000,000
Current Ratio = Current liabilities = birr 18,000,000 = 2.22:1

Interpretation: the company has birr 2.22 current assets for one birr current liability. Ethio-
Metals Manufacturing’s current ratio is above the average for its industry, 2, so its liquidity
position is relatively strong.
ii. Quick Ratio or Acid Test Ratio

This ratio measures the relationship between Quick assets (or liquid assets) and current
liabilities. An asset is considered liquid if it can be converted into cash without loss of time or
value. Cash is the most liquid asset. Other assets which are considered to be relatively liquid and
include in the quick assets are accounts receivable (i.e. debtors and bills receivable) and short
term investments in securities. Stock or inventory is excluded because it is not easily and readily
convertible into cash. Similarly, prepaid expenses, which cannot be converted into cash and be
available to pay off current liabilities, should also be excluded from liquid assets.

The quick ratio is calculated by dividing quick assets by current liabilities:

Quick assets
Quick Ratio = Current liabilities

= birr 19,500,000/18,000,000 = 1.083:1

Interpretation: The industry average quick ratio is 1.1, so Ethio-Metals Manufacturing’s 1.083
ratio is slightly low in comparison with other firms in its industry. Still, if the accounts receivable
can be collected, the company can pay off its current liabilities without having to liquidate its
inventory.

Note: Quick ratio is a more refined and vigorous measure of the firm’s liquidity. It is widely
accepted as the best test for the liquidity of a firm. Generally, a quick ratio of 1:1 is considered to
be satisfactory. But this ratio also should be used cautiously. It should also be subjected to
qualitative tests, i.e., quality of the assets included should be assessed.

 Asset Management/Activity Ratios

The finances obtained by a firm from its owners and creditors will be invested in assets. These
assets are used by the firm to generate sales and profits. The amount of sales generated and the
obtaining of the profits depend on the efficient management of these assets by the firm. Activity
ratios indicate the efficiency with which the firm manages and used its assets. That is why these
activity ratios are also known as ‘efficiency ratios’. They are also called ‘turnover ratios’
because they indicate the speed with which assets are being converted or turned over into sales.
Thus the activity or turnover ratio measures the relationship between sales on one side and
various assets on the other. The underlying assumption here is that there exists an appropriate
balance between sales and different assets. A proper balance between sales and different assets
generally indicates the efficient management and use of the assets. Many activity ratios can be
calculated to know the efficiency of asset utilization. The following are some of the important
activity ratios or turnover ratios:

i. Total Assets Turnover Ratio

This ratio measures the overall performance and efficiency of the business enterprise. It points
out the extent of efficiency in the use of assets by the firm. This ratio is calculated by dividing
the annual sales value by the value of total assets.

turn total sales value

total asset = = birr 120,000,000/birr 82,000,000 = 1.5 times
ratio total asset value

Interpretation: Ethio-Metals Manufacturing’s ratio is somewhat below the industry average (2

times), indicating that the company is not generating a sufficient volume of sales given its total
asset investment. Sales should be increased, some assets should be sold, or a combination of
these steps should be taken.
ii. Fixed Assets – Turnover Ratio

This ratio measures the firm’s efficiency in utilizing its fixed assets. Firms which have large
investments in fixed assets usually consider this ratio important. It indicates the extent of
capacity utilization in the firm. The ratio is calculated by dividing the total value of sales by the
amount of fixed assets invested. A high ratio is an indicator of overtrading while a low ratio
suggests idle capacity or excessive investment in fixed assets. Normally, a ratio of five times is
taken as a standard. Some analysts suggest the exclusion of intangible assets like goodwill,
patents, etc., for calculating this ratio. For calculating this ratio, the gross fixed assets figure is
preferred to the net value figure.
 total sales value
¿ asset turnover ratio= assets value ¿ = birr 120,000,000/birr 60,300,000 = 1.99
total ¿
times

Interpretation: Ethio-Metals Manufacturing’s ratio of 1.99 times is below to the industry

average (3 times), indicating that the firm is using its fixed assets less intensively than other
firms in its industry. Hence, the firm should undertake additional decisions regarding to the
utilization of its fixed assets and/or sales should be increased.
iii. Stock Turnover or Inventory Turnover

This ratio indicates the efficiency of the firm’s inventory management. It is calculated by
dividing the sales by inventory. This ratio indicates the rapidity with which the stock is turning
into receivables through sales. Generally, a high inventory turnover is an index of good inventory
management and a low inventory turnover indicates an inefficient inventory management. Low
stock turnover implies the maintenance of excessive stocks which are not warranted by
production and sales activities. It also may be taken as an indication of slow moving or non-
moving and obsolete inventory. A too high inventory turnover also is not good. It may be the
result of a very low level of stocks which may result in frequent stock-outs. The stock turnover
should be neither too high nor too low.

total sales
Stock Turnover = = birr 120,000,000/birr 20,500,000 = 5.85 times
inventory

Interpretation: each item of Ethio-Metals Manufacturing’s inventory is sold out and restocked,
or “turned over,” 5.85 times per year. Ethio-Metals Manufacturing’s turnover of 5.85 times is
approximately equal to the industry average of 6 times. This suggests that Ethio-Metals
Manufacturing’s is holding fewer inventories.
iv. The Days Sales Outstanding

Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to
appraise accounts receivable, and it is calculated by dividing accounts receivable by average
daily sales to find the number of days’ sales that are tied up in receivables. Thus, the DSO
represents the average length of time that the firm must wait after making a sale before receiving
cash, which is the average collection period.
 Receivables Recievables
DSO=Days sales outstanding= =
Average sales per year Annual Sales
365 ¿
¿

Days in a year /12 months

Average Collection Period = Re ceivables ' Turnover

= birr 16,000,000/ birr 120,000,000/365 = 48 days

Interpretation: For Ethio-Metals Manufacturing’s it takes 48 days to collect its receivable

which is above the average collection period for the industry (35 days). The company is slower
in collecting its receivables relative to its competitors. DSO can be affected by the credit policy
of the firm.

 Profitability Ratios

Every firm should earn adequate profits in order to survive in the immediate present and grow
over a long period of time. In fact, the profit is what makes the business firm run. It is described
as the magic eye that mirrors all aspects of the business operations of the firm. Profit is also
stated as the primary and final objective of a business enterprise. It is also an indicator of the
firm’s efficiency of operations. There are different persons interested in knowing the profits of
the firm. The management of the firm regards profits as an indication of efficiency and as a
measure of control. Owners take it as a measure of the worth of their investment in the business.
To the creditors profits are a measure of the margin of safety. Employees look at profits as a
source of fringe benefits. To the government they act as a measure of the firm’s tax paying
ability and a basis for legislative action. To the customers they are a hint for demanding price
cuts. To the firm they constitute a less cumbersome and low cost source of finance for existence
and growth. Finally, to the country profits are an index of the economic progress, the national
income generated and the rise in the standard of living of the people. Therefore, every firm
should earn sufficient profits in order to discharge its obligations to the various persons
concerned.

Profitability means the ability to make profits. Profitability ratios are calculated to measure the
profitability of the firm and its operating efficiency. They relate profits earned by a firm to
different parameters like sales, capital employed and net worth. But while making financial ratio
analysis relating to profits, it should be noted that there are different concepts of profits such as
contribution (sales revenue minus variable costs), gross profit, profit before tax, profit after tax,
profit before interest and taxes, operating profit, profit has to be used for making the profitability
analysis suitable for analyzing specific problems. Profitability ratios can be calculated with
reference to the different concepts of profit mentioned earlier.

Profitability of the firm can be measured by calculating several interrelated ratios demanded by
the aims of the analyst. The profitability of a firm can be measured and analyzed from the point
of view of management, owners (i.e., shareholders in the case of companies) and creditors.

i. Gross Profit margin or Gross Profit to Sales

This ratio is calculated by dividing gross profit by sales value. This ratio is usually expressed as a
percentage. It indicates the efficiency with which management produces each unit of product or
service. It reveals the spread (difference) between sales value and cost of goods sold. A high
gross profit margin (compared to the industry average) indicates relating lower cost of
production of the firm concerned. It is an index of good management. A lower gross margin
indicates higher cost of goods sold (which might be due to purchase of an unfavorable items
inefficient utilization of plant and machinery or over-investment in plant, machinery and
equipment), or lower sales values (which could be due to fall in prices in the market, reduction in
selling price, less volume of sales, etc.)

Gross profit Sales−Cost of goods sold

=
Gross profit margin = Sales Sales

= birr 30,000,000/ birr 120,000,000 = 0.25 = 25%

Interpretation: Ethio-Metals Manufacturing’s gross profit margin is below the industry average
of 30 percent. This sub-par result occurs because costs of production are high. High costs, in
turn, generally occur because of inefficient operations, use of excessive fixed assets, purchase of
unfavorable items or lower sales value.
ii. Operating profit Margin

This ratio is calculated by dividing gross operating margin by sales.

Operating profit or earnings before interest and taxes = Gross profit minus operating expenses.

This ratio indicates the extent to which the selling price per unit may decline without incurring
any loss in the business operations. It is rather difficult to evolve a standard norm for this ratio.
But it should not be lower than that of similar concerns.

Operating profit
Gross operating profit margin=
total sales

= birr 14,250,000 /birr 120,000,000 = 0.11875 = 11.9%

Interpretation: Ethio-Metals Manufacturing’s operating profit margin is below the industry

average of 13 percent. This sub-par result occurs because costs of operation are high. High costs,
in turn, generally occur because of inefficient operations. The Company is not getting as high a
return on its assets as is the average company in its industry.

iii. Net Profit Margins or Net Profit to Sales

This is one of the very important ratios and measures the profitableness of sales. It is calculated
by dividing the net profit by sales. This ratio measures the ability of the firm to turn each Birr of
sales into net profit. It also indicates the firm’s capacity to withstand adverse economic
conditions. A high net profit margin is a welcome feature to a firm and it enables the firm to
accelerate its profit at a faster rate than a firm with a low net profit margin.

In order to have a more meaningful interpretation of the profitability of a firm, both gross margin
and net margin should jointly be evaluated. If the gross margin has been on the increase without
a corresponding increase in net margin, it indicates that the operating expenses relating to sales
have been increasing. The analyst should further analyze in order to find out the expenses which
are increasing. The net profit margin can remain constant or increase with a fall in gross margin
only if the operating expenses decrease sufficiently.

Net Profit Margin=net income available ¿ common stock h olders ¿

total sales

= birr 6,666,000/birr 120,000,000 = 0.0555 = 5.5%

Interpretation: Ethio-Metals Manufacturing’s profit margin is below the industry average of 7
percent. This sub-par result occurs because costs are high. High costs, in turn, generally occur
because of inefficient operations. However, Ethio-Metals Manufacturing’s low profit margin is
also as a result of its heavy use of debt (shown on its debt ratio). Recall that net income is
income after interest. Therefore, if two firms have identical operations in the sense that their
sales, operating costs, and EBIT are the same, but if one firm uses more debt than the other, it
will have higher interest charges. Those interest charges will pull net income down, and since
sales are constant, the result will be a relatively low profit margin. In such a case, the low profit
margin would not indicate an operating problem—rather; it would indicate a difference in
financing strategies. Thus, the firm with the low profit margin might end up with a higher rate of
return on its stockholders’ investment due to its use of financial leverage.
iv. Return on assets/investment (ROA)

This ratio is calculated by dividing net profit after tax by total assets:

Net Profit After Tax

Return on Assets (ROA) = Total Assets

There are many variations on the return on assets ratio mix depending on the particular concept
of net profit and assets used. The different concepts of net profit used include net profit after tax,
net profit after tax plus interest (on loans), net operating profit, and net profit after taxes plus
interests minus tax savings.

Similarly, the concept ‘assets’ may indicate total assets, fixed assets, tangible assets, operating
assets, etc.

Returnon Total Assets ( ROA )=Net income available ¿ common stock h olders ¿
Total Assets

= birr 6,666,000/birr 82,000,000 = 0.0813 =8.13%

Interpretation: Ethio-Metals Manufacturing’s 8.13 percent return is below the 10 percent

average for the industry. This low return results from (1) the company’s low operating profit
margin (2) high interest costs resulting from its above-average use of debt, both of which cause
its net income to be relatively low.
Note: This Return on Assets ratio measures the profitability of the total assets (or investment) of
a firm. But this ratio does not throw any light on the profitability of the different sources of funds
which have financed the total assets. This aspect of profitability is covered by Return on capital
employed.

v. Return on Shareholders’ Equity (ROE)

The shareholders of a company may comprise equity shareholders and Preference shareholders.
Preference shareholders are the shareholders who have a priority in receiving dividends (and in
the return of capital at the time of winding up of the company). The rate of dividend on the
preference shares is fixed. But the ordinary or common shareholders are the residual claimants of
the profits and ultimate beneficiaries of the company. The rate of dividend on these shares is not
fixed. When the company earns profits it may distribute all or a part of the profits as dividends to
the equity shareholders or retain them in the business itself. But the profits after taxes and after
Preference Shares dividend payment presents the return as equity of the shareholders.

A return on shareholders’ equity is calculated to assess the profitability of the owners’

investment. The shareholders’ equity is ascertained by adding up equity Share capital, Preference
share capital, share premium, reserves and surplus. If any accumulated losses are there, they
should be deducted from this amount. The shareholder’s equity is also called net worth.

Return on shareholders’ equity or return on net worth is calculated by dividing the net profit after
tax by the total shareholders’ equity or net worth.

Net Profit After Taxes

Shareholders ' Equity
Return on shareholders’ equity =

= birr 6,666,000/ birr 37,000,000 = 0.18016 =18%

Interpretation: Ethio-Metals Manufacturing’s 18 percent return is below the 20 percent industry

average. This is because of the low net income of the firm due to high operating and non
operating costs.
  Debt Management Ratio

These ratios are also known as ‘long term solvency ratios’ or ‘capital gearing ratios.’ As stated
earlier, the long-term creditors (debenture holders, financial institutions, etc) are more concerned
with the firm’s long-term financial position than with others. They judge the financial soundness
of the firm in terms of its ability to pay interest regularly as well as make repayment of the
principal either in one lump sum or in installments. The long-term solvency of the firm can be
examined with the help of the leverage or capital structure ratios. These ratios indicate the funds
provided by owners and creditors. Generally, there should be an appropriate mix of debt and
owners’ equity in financing the firm’s assets. Each of the two sources of funds, viz., creditors
and owners depending on which of them has been used to finance a firm’s assets, has a number
of implications. Between debt and equity (owners’ funds) debt is more risky from the firm’s
view point. Irrespective of the profits made or losses incurred, the firm has a legal obligation to
pay interest on debt. If the firm fails to pay to debt holders in time, they can take legal action
against the firm to get payment and even can force the firm into liquidation. But at the same time
the use of debt is advantageous to the owners of the firm. They can retain the control of the firm
without dilution and their earnings will be enlarged when the firm earns at a rate higher than the
interest rate on the debt. The owner’s equity is created as the margin of safety by the creditors. In
view of the above stated facts, it is relevant to assess the long-term solvency of the firm in terms
of the owner’s and creditor’s contribution to the firm’s total capitalization.

Leverage ratios can be calculated from the Balance Sheet items to determine the proportion of
debt in the total capital of the firm. Though there are many variations of these ratios all of them
indicate the extent to which the firm has used debt in financing its assets.

Leverage ratios are also calculated from the income statements items to determine the extent to
which operating profits are sufficient to cover the fixed charges. This type of leverage ratios are
popularly known as ‘coverage ratios’

The most commonly calculated leverage ratios include: (1) debt to asset ratio. (2) debt to equity
ratio, and (3) gross fixed assets to shareholders funds.

i. Total Debt to Asset ratio

The ratio of total liabilities to total assets is called the debt ratio, or sometimes the total debt
ratio. It measures the percentage of funds provided by sources other than equity: Creditors prefer
low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the
event of liquidation. Stockholders, on the other hand, may want more leverage because it
magnifies expected earnings.

total liabilities
Debt Ratio=
total assets

= birr 45,000,000/birr 82,000,000 = 0.55 = 55%

Interpretation: Ethio-Metals Manufacturing’s debt ratio is 55 percent, which means that its
creditors have supplied more than half the total financing. Ethio-Metals Manufacturing’s debt
ratio exceeds the industry average (50%) raises a red flag and may make it costly for Ethio-
Metals Manufacturing’s to borrow additional funds without first raising more equity capital.

ii. Total debt to equity ratio

The debt-to-equity ratio tells us how the firm finances its operations with debt relative to the
book value of its shareholders’ equity:

Total liability
Debt ¿ Equity ratio=
book vale of s h are h olders equity

For Ethio-Metals Manufacturing’s = birr 45,000,000/birr 37,000,000 = 1.22 =122%

Interpretation: For every one dollar of book value of shareholders’ equity, Ethio-Metals
Manufacturing’s uses 1.22 birr of debt.

iii. Time –interest-earned Ratio

The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and
taxes (EBIT) by the interest charges: The TIE ratio measures the extent to which operating
income can decline before the firm is unable to meet its annual interest costs. Failure to meet this
obligation can bring legal action by the firm’s creditors, possibly resulting in bankruptcy. Note
that earnings before interest and taxes, rather than net income, is used in the numerator. Because
interest is paid with pre-tax birr, the firm’s ability to pay current interest is not affected by taxes.

EBIT
Time−interest −earned ( TIE ) ratio=
interest c h arges

= birr 14,250,000/birr 4,150,000 = 3.43 times

Interpretation: Ethio-Metals Manufacturing’s interest is covered 3.4 times. Since the industry
average is 5 times, Ethio-Metals Manufacturing’s is covering its interest charges by a relatively
low margin of safety. Thus, the TIE ratio reinforces the conclusion from our analysis of the debt
ratio that Ethio-Metals Manufacturing’s would face difficulties if it attempted to borrow
additional funds.

iv. Fixed charges coverage ratio

The TIE ratio is useful for assessing a company’s ability to meet interest charges on its debt, but
this ratio has two shortcomings: (1) Interest is not the only fixed financial charge—companies
must also reduce debt on schedule, and many firms lease assets and thus must make lease
payments. If they fail to repay debt or meet lease payments, they can be forced into bankruptcy.
(2) EBIT does not represent all the cash flow available to service debt, especially if a firm has
high depreciation and/or amortization charges. To account for these deficiencies, bankers and
others have developed the EBITDA (earnings before interest, taxes, depreciation and
amortization) coverage ratio or fixed charges coverage ratio, defined as follows:

EBITDA +lease payment

EBITDA coverage ratio=
interest+ principal payment +lease payment

EBITDA = EBIT + depreciation and amortization

For Ethio-Metals Manufacturing’s EBITDA coverage ratio =

14,250,000+1,100,000+1,650,000
4,150,000+2,500,000+1,650,000

17,000,000
¿ = 2.05 times
8,300,000
Interpretation: Ethio-Metals Manufacturing’s had birr 14.25 million of operating income
(EBIT), presumably all cash. Noncash charges of birr 1.1 million for depreciation and
amortization (the DA part of EBITDA) were deducted in the calculation of EBIT, so they must
be added back to find the cash flow available to service debt. Also, lease payments of birr 1.65
million were deducted before getting the birr 14.25 million of EBIT. That birr 1.65 million was
available to meet financial charges, hence it must be added back, bringing the total available to
cover fixed financial charges to birr 17 million. Fixed financial charges consisted of birr 4.15
million of interest, birr 2.5 million of principal payments, and birr 1.65 million for lease
payments, for a total of birr 8.3 million. Therefore, Ethio-Metals Manufacturing’s covered its
fixed financial charges by 2.05 times. However, if operating income declines, the coverage will
fall, and operating income certainly can decline. And Ethio-Metals Manufacturing’s ratio is
below the industry average (2.5 times), so again, the company seems to have a relatively high
level of debt.
 Market value ratios
i. 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
profit available to ordinary shareholders, (i.e., profit after tax minus Preference dividend) by the
number of outstanding equity shares.

Profit After Tax - Pref . Dividend

EPS = No . of Equity Share Outs tan ding

The EPS of the firm the particulars of which are given in Illustration –1 is calculated as under: in
Ethio-Metals Manufacturing’s case there is no preferred dividend.

6,666,000
EPS=birr = birr 5.13 per share
1,300,000

The EPS of a firm studied over years indicates whether or not the earnings per share basis has
changed over the period. To assess the relative profitability of the firm its EPS should be
compared with that of similar concerns and the industry average.
Interpretation: income per common equity share is birr 5.13 which is below the industry
average of birr 6. This is due to the less profitability and high debt ratio of the firm relative to the
industry.

ii. Price to earnings ratio

The price/earnings (P/E) ratio shows how much investor’s are willing to pay per birr of
reported profits. P/E ratios are higher for firms with strong growth prospects, other things held
constant, but they are lower for riskier firms. Ethio-Metals Manufacturing’s stock sells for birr
30, so with an EPS of birr 5.13 its P/E ratio is 5.85:

price per s h are

price ¿ earnings(PE)ratio=
earnings per s h are

= birr 30 per share/birr 5.13 per share = 5.85 times

Interpretation: Because Ethio-Metals Manufacturing’s P/E ratio is below the average (7 times),
this suggests that the company is regarded as being somewhat riskier than most, as having poorer
growth prospects, or both.

iii. Book value per share

The ratio of a stock’s book value to its shares outstanding gives another indication of how
investors regard the company. Companies with relatively high rates of return on equity generally
sell at higher multiples of book value than those with low returns.

common equity
book value per s h are=
s h ares outstanding

= birr 6,500,000/1,300,000 shares = birr 5 per share

Interpretation: the book value per share of the company is far below the average (i.e. birr 25
per share).This could be due to less profitability of the firm over long period of time.

iv. Dividend Per Share (DPS)

The net profits after taxes and Preference dividend belong to the equity shareholders and EPS
reveals how much of it is it per share. But no company is under the obligation to distribute all the
profits as dividends to the shareholders. In pursuance of the policy which the company has
evolved it may retain all or some profits and distribute the balance as dividends. A large number
of potential or prospective investors are interested in knowing the dividends which the company
distributes per share. The Dividend Per Share (DPS) is calculated by dividing the profits
distributed as dividend by the number of equity share outstanding.

Earnings distributed as dividend to equity shareholders

D.P.S. = No. of equity shares outstanding

= birr 1,900,000/1,300,000 shares = birr 1.46 per share

Interpretation: the amount of income distributed to common stockholders per share is below
the industry average (birr 2.5 per share). This could be due to the less profitability of the firm
relative to its competitors and also may be due to its dividend policy.

v. Dividend Payout Ratio

This is calculated by dividing the DPS by the EPS or by dividing the total dividends paid by total
earnings made.

DPS
Dividend Payout Ratio = EPS

This shows the percentage of profit after taxes and Preference dividend distributed as dividends.

If the DPR ratio is subtracted from 100, it will give the retention ratio, i.e., percentage of profits
retained in the business.

= birr 1.46 per share/birr 5 per share = 0.292 = 29.2%

Interpretation: 29.2% of the total net income available to common stockholders is distributed as
dividend leaving 70.8% as retained earnings. This is far below the average (40%) due to the less
profitability and may be due to the dividend policy of the Company.

vi. Dividend Yield

The dividend yield is the DPS divided by the market price per share. This indicates the
shareholder’s return (dividend) in relation to the market value per share.

Dividend per share

Market price per share
Dividend yield =

= birr 1.46 per share/birr 30 per share = 0.049 = 4.9%

Interpretation: dividend yield of the company is far below the industry average (7.5%). This is
because of the low profit and low dividend per share of the company relative to the same firms
operating in its industry.

2.4. Financial planning/forecasting

Financial forecasting is one of the four major jobs of a firm’s financial staff, namely performing
financial forecasting and analysis, making investment decisions, and making financing decisions.
It is generally a planning process which involves forecasting of sales, assets, and financial
requirements. In other words, financial forecasting is a process which involves:

 evaluation of a firm’s need for increased or reduced productive capacity and

 evaluation of the firm’s need for additional finance

Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, is forecasted financial statements. An accurate financial forecast is very important
to any firm in several aspects:

 It helps a firm to predict appropriate demand for its products.

 It helps a firm to project its sales and accordingly to predict its assets properly.
 It contributes significantly to the firm’s profitability.
 It plays a crucial role in the value maximization goal of a firm.

Financial forecasts are also meanses for forecasted financial statements. By their virtue, a firm
can forecast its income statement, balance sheet and other related statements. Besides, key ratios
can be projected. Once financial statements and ratios have been forecasted, the financial
forecast will be analyzed. Finally, the firm’s management will have an opportunity to make some
decisions beforehand.

So, all in all, financial forecasting is a pre-requisite for the investment, financing, as well as
dividend policy decisions of a firm.

Procedures in financial forecasting

The financial forecasting process generally involves the following procedures:

i) Forecasting of sales for the future period

ii) Determining the assets required to meet the sales targets, and

iii) Deciding on how to finance the required assets.

The above three procedures are very important in projecting the financial statements and key
financial ratios. However, among the three procedures, the first one, i.e, sales forecast is the most
crucial.

Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is generally
based on recent sales trends and forecast of the economic prospects of the nation, region,
industry and other factors. This procedure starts usually by reviewing the sales of the recent
pasts. The whole crucial points of financial forecasting process are lies in an accurate forecast of
sales. If this procedure is off, the firm’s profitably as well as its value will be negatively affected.
So in forecasting sales, several factors should be considered:

 The historical sales growth pattern of the firm at both divisional and corporate levels,
 The level of economic activity in each of the firm’s marketing areas,
 The firm’s probable market share,
 The effect of inflation on the firm’s future pricing of products,
 The effect of advertising campaigns, cash and trade discounts, credit terms, and other similar
factors alike on future sales, individual products’ sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firm’s income statement which in turn helps to
project retained earnings. In forecasting the income statement assumptions about the costs, tax
rates, interest charges and dividends are required.

Sales forecasts are also grounds for determination of the firm’s assets requirement.

If sales are to increase, then assets must also grow. The amount each asset account must increase
depends whether the firm was operating at full capacity or not. If higher sales are projected, more
cash will be needed for transactions, higher sales will create higher receivables. Similarly, higher
sales require higher inventory and higher plant and equipment.

Finally, the firm will face the question of financing its required assets. Some of the required
finance can be covered by the increased retained earnings. The retained earnings increment will
result from increased sales and profit. Still some other portion of the finance can be covered by
some liabilities which will grow by the same proportion with that of sales. The remaining finance
must be obtained from available external sources.

The third procedure of the financial forecasting process, i.e. forecast of financial requirements
involves again three sub procedures such as:

- Determining how much money (finance) the firm will need during the forecasted period. This
will be done based on sales and assets forecast.
- Determining how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be generated under
normal operations. The first is portion of the net income retained in the firm (retained
earnings). The second one is the increase in the firm’s liabilities as a direct and automatic
result of its decision to increase sales. This finance is called spontaneous finance. For
example, if sales are to increase, inventory must increase. The increase in inventory requires
more purchases which in turn cause the accounts payable to be increased. The accounts
payable will increase spontaneously with the increase in sales. Other examples include
accruals like salaries and wages payable and income tax payable.
- Determining the additional external financial requirements. Any balance of the total finance
that cannot be met with normally generated funds must be obtained from external sources.
This finance is called the additional funds needed (AFN).
 AFN =required increase∈assets−required increase∈normally generated funds

Additional funds needed (AFN) are funds that a firm must raise externally through borrowing
(bank loans, promissory notes, bonds, etc.) or by issuing new shares of common stock or
preferred stock.

Methods of forecasting financial requirements

There are two methods to determine the additional financial requirements. These are:

1. The pro-forma financial statements method and

2. The formula method

The Pro-Forma Financial Statements Method

The pro-forma financial statements method is simply a method of forecasting financial

requirements based on forecasted financial statements. As a result, this method is also called the
projected financial statements method. Under this method, the asset requirements are first
projected for the fore coming future period. The forecast of assets helps to determine the total
financial requirements. Then, the liabilities and equity that will be generated under normal
operations are projected. Finally, the additional funds needed will be estimated. The pro-forma
financial statements method of determining additional financial requirements involves the
following steps.

1. Developing the Pro Forma Income statement

The pro-forma income statement provides a projection of the firm’s net income for the forecasted
period. This enables the firm to estimate the amount of retained earnings it will generate during
the period. In developing the projected income statement, first, a forecast of sales should be
established. Second, cost of goods sold should be determined. Third, other expenses (operating
and non-operating) should be computed. Next, the net income should be determined. Finally,
based on the amount of dividends, the amount of addition to retained earnings should be
determined.

2. Constructing the Pro Forma Balance Sheet

Higher sales must be supported by higher asset amounts. Some of the assets increase can be
financed by retained earnings, and spontaneous finance. The remaining blanc must be financed
from external sources. In the forecast of the firm’s balance sheet, first, those balance sheet items
that are expected to increase directly with sales are forecasted. Next, the spontaneously
increasing liabilities are forecasted. Then, the liability and equity items that are not directly
affected by sales are set. Next, the value of retained earnings for the forecasted period is
obtained. Finally, the AFN will be raised.

Illustration

Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the following
year. At the end of the year just completed, the condensed balance sheet of the company has
contained the following items.

Assets Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000

A/receivable -----------------------70,000 Accruals --------------------------------40,000

Inventories -----------------------150,000 Current liabilities -------------Br. 130,000

Current assets -------------Br. 230,000 Long-term debt -----------------------200,000

Net fixed assets -----------------370,000 Common stock ------------------------120,000

_________ Retained earnings --------------------150,000

Total assets -------------Br. 600,000 Total laibs. and equity ------Br. 600,000

During the year just completed the firm had sales of Br. 1,800,000. In the following year, due to
increased demand to the firm’s products the financial manger estimates that sales will grow at
10%. There is no preferred stock outstanding during the year. The firm’s dividend pay-out ratio
is 60%. It is also known that the firm’s assets have been operating at full capacity. During the
same year, Blue Nile’s operating costs were Br. 1,620,000 and are estimated to increase
proportionately with sales. Assume the company’s interest expense will be Br. 40,000 during the
next year and its tax rate is 40%.

Required: Determine the additional funds needed (AFN) of Blue Nile Share Company for the
next year using the pro-forma financial statements method.

Solution

First, we develop the pro-forma income statement

Pro Forma Income Statement

Sales (Br. 1,800,000 x 1.10) ----------------------------------------------------------Br. 1,980,000

Operating costs (Br. 1,620,000 x 1.10) ---------------------------------------------------1,782,000

Earnings before interest and taxes (EBIT) --------------------------------------------Br. 198,000

Interest expense --------------------------------------------------------------------------------40,000

Earnings before taxes (EBT) ----------------------------------------------------------Br. 158,000

Taxes (Br. 158,000 x 40%) ------------------------------------------------------------------63,200

Net income ----------------------------------------------------------------------------------Br. 94,800

Dividends to common stock (Br. 94,800 x 60%) --------------------------------------Br. 56,880

Addition to retained earnings (Br. 94,800 – Br. 56,880) -----------------------------Br. 37,920

Pro Forma Balance Sheet

Assets Liabilities and Equity

Cash (Br. 10,000 x 1.10) ---------Br. 11,000 A/Payable (Br. 90,000 x 1.10) --------Br. 99,000

A./receivable (Br. 70,000 x 1.10) -----77,000 Accruals (Br. 40,000 x 1.10) -----------44,000

Inventories (Br. 150,000 x 1.10) ----165,000 Current liabilities --------------------Br. 143,000

Current assets --------------Br. 253,000 Long-term debt (the increase is unknown)----200,000

Net fixed assets (Br. 370,000 x 1.10) --407,000 Common stock (as long-term debt) ---120,000

_______ RE (Br. 150,000 + Br. 37,920)---- 187,920

Total assets -----------------------Br. 660,000 Total liabilities and equity ----------Br. 650,920

Blue Nile’s forecasted total assets as shown above are Br. 660,000. However, the forecasted total
liabilities and equity amount to only Br. 650,920. Since the balance sheet must balance, i.e. A =
L + OE, the difference must be covered by additional funds.

Therefore, AFN = Br. 660,000 – Br. 650,920 = Br. 9,080.

Or AFN = increase in Increase in normally

Assets – generated funds

= [Br. 660,000 – Br. 600,000] – [(Br. 99,000 – Br. 90,000) + (Br. 44,000 – Br. 40,000) + Br.
37,920]

= Br. 60,000 – Br. 50,920 = Br. 9,080

The Formula Method

This is a much easier method of determining additional financial requirements than the pro forma
method. The formula method is a shortcut to financial forecasting. However, many companies
use the pro forma method of forecasting their financial requirements because the output of the
formula method is less meaningful. Under the shortcut method, we make the following
assumptions.

1. Each asset maintains a direct proportionate relationship with sales

2. Accounts payable and accruals increase in direct proportion to sales increase.

3. The profit margin and the dividend pay-out ratios are constant.

The formula that can be used as a shortcut to determine external capital requirements is given as:

Additional funds needed=required increase∈assets−( spontaneous increase∈liabilities +increase∈retained earn

AFN = (A/S) S – (L/S) S – MS1 (1 – d)

Where

AFN = Additional funds needed

A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.

S = change in sales = S1 – S0 = S0 x g

S1 = Total Sales projected for the next period

S0 = Total sales of the current period

L/S = Percentage relationship of variable (spontaneous) liabilities to sales

M = Net profit margin

d = Dividend payout ratio

g = the expected sales growth rate

To illustrate the formula method, consider the example given for the previous method. But
assume that Blue Nile’s net profit margin is 5%.

AFN =
( BrBr. 1,.600,800,000000 ) (Br .180,000 ) − ( BrBr. 1. 130,000
¿
,800,000 ) (Br. 180,000) – 5% x Br 1,980,000**
(1 – 60%)

= Br. 60,000 – Br. 13,000 – Br. 39,600 = Br. 7,400

To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must increase its
assets by 60,000. In other words, the firm will require a Br. 60,000 more fund for the forecasted
year. Out of this, Br. 13,000 will come from spontaneous increase in liabilities. Another Br.
39,600 will be obtained from retained earnings. The remaining Br. 7,400 must be raised from
external sources like by issuing new shares of stocks or by borrowing.

* S = S1 – S0 = S0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000

** S1 = S0 + S0g = S0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000.