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TOPIC
FINANCIAL PLANNING AND ANALYSIS
BY
MARTIN M. MUSAMALI
JUNE 2008
TABLE OF CONTENTS
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1.0 FINANCIAL ANALYSIS
1.1 Introduction
Information contained in Financial Statements that is Balance sheet, profit and loss account or
income and expenditure etc is usually used by management, creditors, investors, and others to form
judgment about the company’s operating performance and financial position. Users of the financial
statements can get better insight about the financial strength and weaknesses of the firm if they
properly analyze the information reported in these statements.
A company’s management should be interested in knowing the financial strength to make their best
use and be able to spot out financial weaknesses of the firm to take suitable corrective actions. The
future plans of the firm should be laid down in view of the firm’s financial strength and
weaknesses.
Therefore, financial analysis is the starting point for making plans before forecasting and planning
procedures. That understanding the past is a prerequisite for anticipating the future.
1.2 Definition
Financial analysis is the process of identifying a firm’s strength and weaknesses by establishing
relationships between the items of the Balance sheet and profit and loss account.
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2.0 USERS OF FINANCIAL STATEMENTS
i) Trade creditors
Trade creditors are interested in the firm’s ability to meet their claims over a short period of
time. Their analysis will thus be confined to the evaluation of the firm’s liquidity.
ii) Lenders
Suppliers of long term debt are concerned with the firm’s long term solvency and survival.
They analyze the firm’s profitability over time, its ability to generate cash for interest and
principal payment and the existing relationship between the various sources of funds. As
much as they analyze the historical financial statements they also place more emphasis on
the firm’s projected financial statements to make analysis about its future solvency.
iii) Investors
Investors who have invested their funds in the firm’s shares are concerned about the firm’s
earnings. Those firms that show steady growth in earnings restore the investor’s
confidence. They concentrate o the analysis of the firm’s future and present profitability.
They are also interested in the firm’s financial structure to the extent that it influences the
firm’s earnings ability and risk.
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iv) Management
Management of the firm would be interested in the entire financial analysis. It is their
responsibility to see that the firm’s resources are used effectively and efficiently and that its
financial position is sound.
A ratio is defined as the indicated quotient of two mathematical expressions. It can also be
described as the relationship between two or more things. It is used as a benchmark for evaluating
the financial position and performance of a firm. Absolute accounting figures reported in the firm’s
financial statements do not provide any meaningful understanding of performance and the firm’s
financial position.
iii) Projected Ratios –Ratios developed using projected financial statements of the same
firm.
iv) Competitive Ratios –Ratios of some selected firms especially the most progressive and
successful competitors.
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Evaluation of performance of a firm is easily done by comparing its current ratios with past ratios.
When the financial ratios over a period of time are compared, it is called time series analysis or
trend analysis. It gives the indication of direction of change and it reflects whether the firm’s
performance has improved, deteriorated or remained constant over time.
When analyzing, the analyst should not simply determine the change but more importantly
understand why ratios have changed. The change may be affected by changes in the accounting
policies without material change in the firm’s performance.
Comparing ratios of one firm with selected firms in the same industry at the same point in time is
also done. This is called cross-sectional Analysis or inter-firm analysis. It is useful to compare the
firm’s ratios with ratios of a few carefully selected competitors with similar operations. This kind
of a comparison indicates the relative financial position and performance of the firm.
To determine the firm’s financial condition and performance, it is necessary to compare average
ratios of the industry to which the firm is a member. This helps to ascertain the financial standing
and capability of the firm vis a vis other firms in the industry. Industry ratios are important
standards in view of the fact that each industry has its characteristics which influence the financial
and operating relationships.
b) The available industry ratios are only averages. The averages of strong and weak firms
may bear wide variances that may be insignificant and could be meaningless.
c) Averages will be meaningless and comparison futile if firms within the same industry
widely differ in their accounting policies and practices.
That, future ratios could be used as the standard for comparison. They can be developed from
projected or proforma financial statements. The comparisons of the firm’s current and past ratios
show its relative strength and weaknesses in the past and in the future. If the future ratios indicate
weak financial position, then corrective measures could be initiated.
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3.2 Types of Financial Ratios
Ratios can be grouped into the following classes:
a) Liquidity ratios
b) Solvency ratios
c) Turnover ratios
d) Profitability ratios
e) Equity-related ratios
Turnover or activity ratios measure the firm’s efficiency in utilizing its assets.
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3.2.3 Profitability Ratio
Profitability ratios measure a firm’s overall efficiency and effectiveness in generating profit.
h) Market to Book Value = Market Value Per Share/Book Value Per Share
This integrates the important ratios to analyse a firm’s profitability or operating performance. It is
also referred to as Return on Net Assets (RONA) or Return on Capital Employed. (ROCE)
b) ROCE = PAT/Net Worth =[{Sales/Net Assets} x {PBIT/Sales} ]x [{PAT/PBIT}x Net Assets/Net Worth}}
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Illustration 1
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0 0
1,998,70 2,859,00 3,127,30
Long Term Debt 0 0 0
4,429,20 6,413,90 8,398,70
Short Term Debt 0 0 0
6,427,900 10,030,400 12,290,600
11,539,200 15,859,900 19,018,700
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Additional Information :
1. EBIT for 2004, 05 and 06 was KSh. 1,853,800, 2,661,700 and 3,426,100 respectively.
2. COS for 2004, o5 and 06 was KSh. 19, 290,400, 23,228,000 and 30,536,600 respectively.
4. It has been ascertained that both the long and short term debt carry an annual interest rate
of 5%.
Required:
i. Current Ratio
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Solution 2004 2005 2006
8,660,8 14,045,5 18,709,2
i Current Ratio CA/CL 00 00 00
2,588,600 4,821,800 7,158,800
3.35:1 2.91:1 2.61:1
(Cash+
Marketable 83,7 988,4 260,8
iii Cash Ratio securities)/CL 00 00 00
2,588,600 4,821,800 7,158,800
0. 0. 0.
03:1 20 :1 04:1
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3.4 Utility of Ratio Analysis
With the help of ratios, one can determine the ability of the firm to meet its current obligations, the
extent to which the firm has used its long term solvency by borrowing funds, the efficiency with
which the firm is utilizing its assets in generating sales revenue and the overall operating efficiency
and performance of the firm.
Management from time to time uses ratio analysis to determine the firm’s strengths and
weaknesses and accordingly takes action to improve the firm’s position.
The credit analyst may use the current ratio or quick acid test ratio to judge the firm’s liquidity of
debt paying ability. He may also use the debt ratio to determine the stake of the owners in the
business and the firm’s capacity to survive in the long run. Return on capital employed may be
used to determine the firm’s earning’s prospects.
The major focus in security analysis is on long term profitability. Profitability is dependent on a
number of factors and therefore the security analyst also uses other ratios to ascertain the
efficiency with which the firm utilizes its assets and the financial risk to which the firm is exposed.
V. Comparative analysis
The ratios of a firm should be compared with the ratios of similar firms and industry for
meaningful interpretation. This comparison will reveal whether the firm is significantly out offline
with its competitors and therefore undertake analysis to spot out the trouble areas.
The ration analysis will reveal the financial condition of the firm or trends in ratios over time are
analyzed. Ratios at a point in time can mislead the analyst because they may be high or low for
some exceptional circumstances at that point of time. Trend analysis of the ratios adds considerable
significance to the financial analysis because it studies ratios of several years and isolates the
exceptional instances occurring in one or two periods.
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3.5 Limitations in Using Ratio Analysis
I. Standards of comparisons
Ratios of a company have meaning only when they are compared with some standards. It is
recommended that ratios should be compared with industry averages however the industry
averages are not easily available.
The situations of two companies are never the same and the factors influencing the performance of
a company in one year may change in another year. Comparison of the ratios of two companies
becomes difficult and meaningless when they are operating in different situations.
The interpretation and comparison of ratios are rendered invalid by the changing value of money.
The accounting figures presented in the financial statements are expressed in the monetary unit
which is assumed to remain constant. This is not true in the real life as we know inflation affects
the value of money and thus the value of the items in the financial statements.
Diversity of views exists as what is to be included in net worth or shareholders equity, current
assets and current liabilities. For instance, whether preference share capital and current liabilities
should be included in debt in calculating the debt equity ratio, should the intangible assets be
excluded to calculate the rate of return on investment, or if included how will they be valued?
Similarly the definition of profit is not uniform to all.
V. Changing situations
The ratios do not have much use if they are not analyzed over years. The ratio at a moment in time
may suffer from temporary changes. This problem can be resolved by analyzing trends of ratios
over years.
The basis to calculate ratios is historical financial statements. The financial analyst is more
interested in what happens in future while the ratios indicate what happened in the past.
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4.0 FINANCIAL PLANNING
4.1 INTRODUCTION
Financial planning indicates a firm’s growth, performance, investments and requirements of funds
during a given period of time, usually three to five years. It involves the preparation of projected or
pro forma profit and loss account, balance sheet and cash flow statement. Financial planning help a
firm’s financial manager to regulate flows of funds which is his primary concern.
The role of a manager is that of an agent and the shareholders are the ultimate owners of the firm.
It is there imperative on the part of the financial manager to make decisions that would increase
thee value of the shareholders’ stake in the firm.
An efficient capital market implies that investors have free access to the market with knowledge,
zero transaction cost and that individual investors are unable to influence prices.
III. Appraising the investment options to achieve the stated growth objective.
VI. Comparing and choosing from alternative growth plans and financing options.
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VII. Measuring actual performance with the planned performance.
A model makes it easy for the financial manager to prepare financial forecasts. It makes financial
forecasting automatic and saves the financial managers time and efforts performing a tedious activity.
Financial planning models help in examining and understanding the consequences of alternative financial
strategies.
I. Inputs
The model builder starts with the firm’s current financial statements and the future growth prospects. The
firm’s growth prospects depend on the market growth rate, firm’s market share and intensity of competition.
II. Model
The model defines the relation between the financial variables and develops appropriate equations.
III. Output
Applying the model equations to the inputs, outputs in the form of projected of proforma financial
statements are obtained.
Analysis of the firm’s past performance to ascertain the relationships between financial variable
and the firm’s financial strength and weaknesses
Analysis of the firm’s operating characteristics which include product, markets, competition,
production and marketing policies, control systems and operating risk to decide about its growth
objectives.
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III. Corporate strategy and investment needs
Determining the firm’s investment needs and choices given its growth objective and overall
strategy.
Forecasting the firms revenue and expenses and need for funds based on its investment and
dividend policies.
V. Financing alternatives
Analyzing financial alternatives within its financial policy and deciding the appropriate means of
raising funds
Analyzing the consequences of its financial plans for the long term health and survival of the firm.
VII. Consistency
Evaluating the consistency of the financial policies with each other, and with the corporate
strategy.
4.7 Conclusion
Financial planning involves the questions of a firm’s long term growth and profitability,
investment and financing decisions. It focuses on aggregative capital expenditure programmes and
debt-equity mix, rather than the individual projects and sources of finance. Financial planning also
involves an interface between the corporate policy and financial planning and the trade off between
financial policy variables.
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REFERENCES
Jae K. Shim, Joel G. Siegel, Financial Management, Barron's Educational Series (2000)
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