MODULE 2

ANALYZING AND FORECASTING

In every organization, financial statement analysis and forecasting are necessary
elements so that they will know the condition or status of their business. Thus, it can help
them also assess the operation of their business if they are still in good, or not, or if they are
going to expand.
This module contains two lessons that focuses on the financial analysis and forecasting
of an organization. The lesson 1 talks about the assessment of the company’s financial
statements through financial analysis in which it could help the different users to understand the
standing of a company. Further, lesson 2 discusses the concepts and perspective of financial
forecasting for strategic growth of a company.

Lesson 1 Assessment of the Firm’s Operating Efficiency and

Financial Position through Financial Statement Analysis
I -Learning Objectives:
At the end of this lesson, the student will be able to:
1. identify the different financial ratios;
2. discuss the significance of financial analysis to different users;
3. apply the statement of financial position analysis; and describe the purpose of
financial management; and
4. calculate the financial ratios and apply the DuPont equation.
II – Discussions:
Financial Statement Analysis is the process of extracting information from financial
statements to better understand a company’s current and future performance and financial
condition.
ANALYZING THE BROADER BUSINESS ENVIRONMENT
Quality analysis depends on an effective business analysis. The broader business
context in which a company operates must be assessed as its financial statements are read
and interpreted. A review of financial statements which reflect business activities is
contextual and can only be effectively undertaken within the framework of a thorough
understanding of the broader forces that impact company performance. Some of these
questions about a company’s business environment are:

 Life Cycle. At what stage in its life is this company? Is it a startup, experiencing
growing pains? Is it strong and mature, reaping the benefits of competitive
advantages? Is it nearing the end of its life, trying to milk what it can from stagnant
product lines?
 Outputs. What products does it sell? Are its products new, established or dated? Do
its products have substitutes? How complicated are its products to produce?
 Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers have
substantial purchasing power? Can the seller dictate sales terms to buyers?
 Inputs. Who are it suppliers? Are there many supply sources? Does the company
depend on a few supply sources with potential for high input costs?
 Competition. In what kind of markets does it operate? Are markets open? Is the
market competitive? Does the company have a competitive advantage? Can it protect
itself from new entrants? At what cost? How must it compete to survive?
 Financing. Must it seek financing from public markets? Is it going public? Is it seeking
to use its stock to acquire another company? Is it in danger of defaulting on debts
covenants? Are there incentives to tell an overly optimistic story to

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  Labor. Who are its managers? What are their backgrounds? Can they be trusted?
Are they competent? What is the state of employee relations? Is labor unionized?
 Governance. How effective is its corporate governance? Does it have a strong and
independent board of directors? Does a strong audit committee of the board exist,
and is it populated with outsiders? Does management have a large portion of its
wealth tied to the company’s stock?
 Risk. Is it subject to lawsuits from competitors or shareholders? Is it under
investigation by regulators? Has it changed auditors? If so, why? Are its auditors
independent? Does it face environmental and/or political risks?
We must assess the broader business context in which a company operates as we
read and interpret its financial statements. A review of financial statements, which reflect
business activities, cannot be undertaken in a vacuum. It is contextual and can only be
effectively undertaken within the framework of a thorough understanding of the broader
forces that impact company performances.
BASICS OF PROFITABILITY ANALYSIS
The primary goal of financial management is to maximize shareholders’ wealth, not
accounting measures such as net income or earnings per share (EPS). However, accounting
data influence stock prices and this data can be used to see why a company is performing
they way it is and where it is heading.
The previous section described the key financial statements and should how they
change as a firm’s operations change.
In the succeeding section, we shall show the statements are used by managers to
improve the firm’s stock price; by lenders to evaluate the likelihood that borrowers will be
able to pay off loans; and by security analysts to forecast earnings, dividends and stock
prices. If management is to maximize a firm’s value, it must take advantage of the firm’s
strengths and correct its deficiencies and weaknesses.
Financial Analysis involves

 comparing the firm’s performance to that of other firms in the same industry, and
 evaluating trends in the firm’s financial position over time.
These studies help managers identify deficiencies and take corrective actions.
LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS
Although financial statement analysis is highly useful tool, the analyst should consider
its limitations. The limitations involve the comparability of financial data between companies
and the need to look beyond ratios. These limitations are:
1. Information derived by the analysis are not absolute measures of performance in any
and all of the areas of business operations. They are only indicators of degrees of
profitability and financial strength of the firm.
2. Limitations inherent in the accounting data the analysts works with. These are
brought about by among others: (a) variation and lack of consistency in the
application of accounting principles, policies and procedures, (b) too-condensed
presentation of data, and (c) failure to reflect change in purchasing power.
3. Limitations of the performance measures or tools and techniques used in the
analysis. Quantitative measurements are not absolute measures but should be
interpreted relative to the nature of the business and in the light of past, current and
future operations. Timing of transactions and the use of averages can also affect the
results obtained in applying the techniques in financial analysis.
4. Analysts should be alert to the potential for management to influence the outcome of
financial statements in order to appeal to creditors, investors and others.

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 Limitations of analysis may be overcome to some extent by finding appropriate
benchmarks used by most analysts such as the performance of comparable components and
the average performance of several companies in the same industry.
FINANCIAL RATIO ANALYSIS
There are a number of different ways to analyze financial statements. The most
applied is the financial ratio. Financial ratio is a comparison in fraction, proportion, decimal or
percentage of two significant figures taken from financial statements. It expresses the direct
relationship between two or more quantities in the statement of financial position and
statement of comprehensive income of a business firm.
The ratio can be categorized as follows:
1. Liquidity ratio. These ratios gives us an idea of the firm’s ability to pay off debts that
are maturing within a year or within the next operating cycle. Satisfactorily, liquidity
ratios are necessary if the firm is to continue operating.
2. Asset management ratios. These ratios give us an idea of how efficiently the firm is
using its assets. Good asset management ratios are necessary for the firm to keep its
costs low and thus, its net income high.
3. Debt management ratios. These ratios would tell us how the firms has financed its
assets as well as the firm’s ability to repay its long-term debt. Debt management
ratios indicate how risky the firm is and how much of its operating income must be
paid to bondholders rather than stockholders.
4. Profitability. These ratios give us an idea of how profitability the firm is operating and
utilizing its assets. Profitability ratios combine the asset and debt management
categories and show their effects on return on equity.
5. Market book ratios. These ratios which consider the stock price gives an idea of what
investors think about the firm and tis future prospects. Market book ratios tell us what
investors think about the company and its prospects.
All of the ratios are important, but different ones are more important for some
companies than for others. For example, if a firm borrowed too much in the past and its debt
now threatens to drive it into bankruptcy, the debt ratios are the key.
Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and
manufacturing capacity, the asset management ratios take center state. The ROE is always
important, but a high ROE depends on maintaining liquidity, on efficient asset management,
and on the proper use of debt. Managers are, of course, vitally concerned with the stock
price, but managers have little direct control over the stock market’s performance while they
do have control over their firm’s ROE. So ROE tends to be the main focal point.
A summary of the ratios, their formula and significance is presented in Figure 1-1.
I. Ratios Used to Evaluate Short-Term Financial Position (Short-Term
Solvency and Liquidity)

NAME FORMULA SIGNIFICANCE

Primary test of solvency to meet
1. Current Ratio current obligations from current
assets as a going concern; measure
of adequacy of working capital.
2. Acid test ratio or A more severe test of immediate
quick ratio solvency; test of ability to meet
demands from current assets.
3. Working capital Indicates relative liquidity of total
to total assets assets and distribution of resources
employed.
b. Working Capital Current Assets less Current
liabilities
4. Cash Flow Measures short-term liquidity by
Liquidity ratio considering as cash resources

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 (numerator) cash plus cash
equivalents plus cash flow from
operating activities.
5. Defensive Measures length of time in days the
Internal Ratio firm can operate on its present liquid
resources

*Cash +Marketable Securities + Accounts receivable

II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency

NAME FORMULA SIGNIFICANCE

a. Trade Receivable Velocity of collections of trade accounts
and notes; test of efficiency of
collection.

b. Average or
Collection period or Evaluate the liquidity of accounts
number of days’ receivable and the firm’s credit policies.
sales uncollected
Inventory Turnover Measures efficiency of the firm in
a. Merchandise managing and selling inventories.
Turnover

b. Finished goods -do-

inventory

c. Goods in
process Measures efficiency of the firm in
turnover managing and selling inventories.

d. Raw materials
turnover Number of times raw materials
inventory was used and replenished
e. Day supply in during the period.
inventory
Measures the average number of days
to sell or consume the average
inventory.

Working Capital Indicates adequacy and activity of

turnover working capital.
Percent of each current Indicates relative investments in current
asset to total current asset.
assets
Current Assets turnover Measures movement and utilization of
current resources to meet operating
requirements.

Payable turnover Measure efficiency of the company in

meeting trade payable.
Operating cycle Average conversion period of Measures the length of time required to
inventories + Average Collection convert cash to finished goods; then to
Period of receivable + Days Cash receivable and then back to cash.
Days Cash Measures availability of cash to meet
average daily cash management.
Free cash flow Net cash from operating activities Excess of operating cash flow over
– cash used for investing basic needs.
activities and dividends
Investment or assets Measures efficiency of the firm in
turnover managing all assets.

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Sales to fixed assets Tests roughly the efficiency of
(plant assets turnover) management in keeping plant
properties employed.
Capital intensity ratio Measures efficiency of the firm to
generate sales through employment of
its resources.
*Net Sales if net credit sales figure is not available
II. Ratios Used to Evaluate Long-Term Financial Position or Stability /
Leverage

Name Formula Significance

Debt ratio Shows proportion of all assets that re
financed with debt.
Equity ratio Indicates proportion of assets
provided by owners. Reflects
financial strength and caution to
creditors.
Debt to equity ratio Measures debt relative to amounts of
resources provided by owners.
Fixed assets to long-term Reflects extent of investment in long-
liabilities term assets financed from long-term
debt.
Fixed assets to total equity Measures the proportion of owner’s
capital invested in fixed assets.
Fixed assets to total equity Measures investments in long-term
capital assets.
Book Value per share of Measures recoverable amount in the
ordinary shares event of liquidation if assets are
realized at their book values.
Times interest earned Measures how many times interest
expense is covered by operating
profit.
Times preferred dividend Indicates ability to provide dividends
requirement earned for preference shareholders.
Times fixed charges earned Measures coverage capability more
broadly than times interest earned by
including other fixed charges.

IV. Ratios Used to Measure Profitability and Returns to Investors

NAME FORMULA SIGNIFICANCE

Gross Profit Margin Measures profit generated after
consideration of cost of product sold
Operating profit margin Measures profit generated after
consideration of operating costs.
Net profit margin (rate of Measures profit generated after
return on net sales) consideration of all expenses and
revenues.
Cash Flow Margin Measures ability of the firm to
translate sales to cash.
Rate of return on assets Measures overall efficiency of the firm
(ROA)* Alternative formula: in managing assets and generating
Asset turnover x net profit profits.
margin
Rate of return on equity*** Measures rate of return on resources
provided by owners.
Earnings per share Peso return on each ordinary share.
Indicative of ability to pay dividends.
Price/ earnings ratio Measures relationship between price
of ordinary shares in the open market

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 and profit earned on a per share
basis.
Dividend Payout Shows percentage of earnings paid to
shareholders.
Dividend Yield Shows the rate earned by
shareholders from dividend relative to
current price of stock
Dividend per share Shows portion of income distributed to
shareholders
Rate of return on average Measures the profitability of current
current assets assets invested.
Rate of return per turnover Shows profitability of each turnover of
of current assets current assets

*Sinking fund payment before taxes =

*If there is interest bearing debt, rate of return on assets is computed as follows:
A measure of the productivity of assets regardless of

how the assets are financed.

**May also be computed as follows:

ROE = Return on Assets x Equity Multiplier

Equity multiplier =

Figure 1-1. Summary of Most Commonly Used Ratios: Their Formulas and Basic
Significance

Illustrative Case 1-1.

The financial statements of ABC Enterprises, Inc. will be used to illustrate the use of
financial ratios in analyzing the company’s (1) liquidity, (2) activity or efficiency in managing
resources, (3) leverage, and (4) profitability.
Liquidity ratios are ratios that measures the firm’s ability to meet cash need as they arise
(e.g. payment of accounts payable, bank loans and operating costs).
Activity ratios are ratios that measure the liquidity of specific assets and efficiency in
managing assets such as accounts receivable, inventory and fixed assets.
Leverage ratios are ratios that measure the extent of a firm’s financing, with debt relative to
equity and its ability to cover interest and other fixed charges such as rent and sinking funds
payments.
Profitability ratios are ratios that measure the overall performance of the firm and its
efficiency managing assets, liabilities and equity.
The Statements of Financial Position as of December 31, 20x4 and 20x3, Income
Statements and Statements of Cash flows of ABC Enterprises, Inc. for years 20x4, 20x3 and
20x2 are given below:

ABC Enterprises, Inc.

Statement of Financial Position at December 31, 20x4 and 20x3
(in thousands)

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 20X4 20X3
ASSETS
Current Assets
Cash 2,030.50 1,191.00
Marketable securities 2,636.00 4,002.00
Accounts receivable 4,704.00 4,383.50
Allowance for doubtful accounts (224.00) (208.50)
Inventories 23,520.50 18,384.50
Prepaid expenses 256.00 379.50
Total Current Assets 32,923.00 28,132.00
Property, Plant and Equipment
Land 405.50 405.50
Building and leasehold improvements 9,136.50 5,964.00
Equipment 10,761.50 6,884.00
20,303.50 13,253.50
less: Accumulated depreciation and amortization (5,764.00) (3,765.00)
Net Property, plant and equipment 14,539.50 9,488.50
Other Assets 186.50 334.00
Total Assets 47,649.00 37,954.50

LIABILITIES AND EQUITY

Current Liabilities
Accounts payable 7,147.00 3,795.50
Notes payable –banks 2,807.00 3,006.00
Current maturities of long-term debt 942.00 758.00
Accrued liabilities 2,834.50 2,656.50
Total Current Liabilities 13,730.50 10,216.00
Deferred income taxes 421.50 317.50
Long-term debt 10,529.50 8,487.50
Total liabilities 24,681.50 19,021.00
Equity
Ordinary shares, par value of P1, authorized 10,000
shares; issued, 2,297,000 shares in 20x4 and
2,401,500 shares in 20x3 2,401.50 2,297.00
Additional paid-in capital 478.50 455.00
Retained earnings 20,087.50 16,181.50
Total Equity 22,967.50 18,933.50
Total liabilities and equity 47,649.00 37,954.50

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 ABC Enterprises, Inc.
Income Statement and Retained Earnings
(in thousands)
20x4 20x3 20x2
Net Sales 107,800.00 76,500.00 70,350.00
Cost of good sold (64,682.00) (45,939.50) (40,803.00)
Gross Profit 43,118.00 30,560.50 29,547.00

Selling and administrative expenses 16,332.00 13,191.00 12,749.00

Advertising 7,129.00 5,396.00 4,770.50
Lease payments 6,529.00 3,555.50 3,633.50
Depreciation and amortization 1,999.00 1,492.00 1,250.50
Repairs and maintenance 1,507.50 1,023.00 1,515.50
TOTAL 33,496.50 24,657.50 23,919.00
Operating profit 9,621.50 5,903.00 5,628.00
Other income (expenses)
Interest income 211.00 419.00 369.00
Interest expense (1,292.50) (1,138.50) (637.00)
Earnings before income taxes 8,540.00 5,183.50 5,360.00
Income taxes 3,843.00 2,228.50 2,412.00
Net Income 4,697.00 2,955.00 2,948.00
Earnings per common share 2.00 1.29 1.33
Statements of Retained Earnings
Retained earnings at beginning of yea 16,181.50 14,157.50 12,130.00
Net income 4,697.00 2,955.00 2,948.00
Cash dividend (20x4- P0.33 per share,
20x3 - 0.41 per share) (791.00) (931.00) (920.50)
Retained earnings at end of year 20,087.50 16,181.50 14,157.50

ABC Enterprises, Inc.

Statement of Cash Flows for the Years Ended December 31, 20x4 and 20x3
(in thousands)
20x4 20x3
Cash Flow from Operating Activities - Direct Method
Cash received from customers 107,495.00 74,830.50
Interest received 211.00 419.00
Cash paid to suppliers for inventory (66,466.50) (49,968.00)
Cash paid to employees (S&A expenses) (16,332.00) (13,191.00)

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 Cash paid for other operating expenses (14,864.00) (10,675.00)
Interest paid (1,292.50) (1,138.50)
Taxes paid (3,739.00) (2,160.50)
Net cash provided (used) by operating activities 5,012.00 (1,883.50)
Cash Flow from Investing Activities
Addition to property, plant and equipment (7,050.00) (2,386.50)
Other investing activities 147.50 -
Net cash provided (used) by investing activities (6,902.50) (2,386.50)
Cash Flow from Financing Activities
Sales of ordinary shares 128.00 91.50
Increase (decrease) in short-term borrowing
(includes current maturities of long-term debt) (15.00) 927.00
Addition to long-term borrowings 2,800.00 3,941.00
Reductions of long-term borrowings (758.00) (796.50)
Dividends paid (791.00) (931.00)
Net cash provided (used) by financing activities 1,364.00 3,232.00
Increase (decrease) in cash & marketable securities (526.50) (1,038.00)

Supplemental Schedule
Cash Flow from Operating Activities - Indirect Method
Net Income 4,697.00 2,955.00
Noncash revenue and expense included in net income:
Depreciation 1,999.00 1,492.00
Deferred income taxes 104.00 68.00
Cash provided (used) by current assets and liabilities:
Account Receivable (305.00) (1,669.50)
Inventories (5,136.00) (3,503.00)
Prepaid expenses 123.50 147.50
Account payable 3,351.50 (525.50)
Accrued liabilities 178.00 (848.00)
Net cash provided (used) by operations 5,012.00 (1,883.50)

Additional Information:
Market price share - 20x4: ₱30 ; 20x3: ₱17

REQUIRED:
Using the financial ratios, evaluate the company’s financial position and operating results for
years 20x4 and 20x3.

Solution: ABC Enterprises, Inc.

I. Analysis of Liquidity or Short-term Solvency

Current Ratio
Formula:

20x4: = 2.40 times

20x3: = 2.75 times
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 Current ratio is widely regarded as measure of short-term debt paying ability. Current
liabilities are used as the denominator because they are considered to represent the most
urgent debts requiring retirement within one year or one operating cycle. A declining ratio
could indicate a deteriorating financial condition or it might be the result of paring of obsolete
inventories or other stagnant current assets. An increasing ratio might be the result of an
unwise stock piling of inventory or it might indicate an improving financial situation. The
current ratio is useful but tricky to interpret and therefore, the analysts must look closely at
the individual assets and liabilities involved.
Some analysts eliminate prepaid expenses from the numerator because they are not
potential sources of cash but, rather, represent future obligations that have already been
satisfied.
ABC’s current ratio indicates that at year-end 20x4 current assets covered current
liabilities 2.4 times down from 20x3. Its significance could be best evaluated by comparing
this with industry competitors or the company’s trend of liquidity over a longer period.
As a measure of short-term liquidity, the current ratio is limited by the nature of the
component. The liquidity of the assets may vary considerably from the date on which the
statement of financial position is prepared. Furthermore, it could have a relatively high
current ratio but not be able to meet the demands for cash because the accounts receivable
are of inferior quality or the inventory is saleable only at discounted price.

Quick or Acid test ratio

Formula:

20x4: = 0.67 times

20x3: = 0.92 times

The acid-test (quick) ratio is much more rigorous test of a company’s ability to meet
its shor-term debt. Inventories and prepaid expenses are excluded from total current assets
leaving only the more liquid assets to be divided by current liabilities. This is designed to
measure how well as company can meet its obligations without having to liquidate or depend
too heavily on its inventory. Since inventory is not an immediate source of cash and may not
even be saleable in times of economic stress, it is generally felt that to be properly protected;
each peso of liabilities should be backed by at least ₱1 of quick assets.
ABC’s quick ratio indicates deterioration between year 20x4 and year 20x3. An
analyst might be quite concerned about several disquieting trends revealed in rising short-
term debts and increasing inventories. The acid-test ratio must also be examined in relation
to other firms in the same industry.
Cash Flow Liquidity Ratio
Formula:

20x4: = 0.70 times

20x3: = 0.32 times
The cash flow liquidity ratio considers cash flow from operating activities (from
the statements of cash flows) in addition to the truly liquid assets, cash and
marketable securities.

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 ABC’s current ratio and acid-test ratio both decreased between 20x3 and 20x4
which could be interpreted as a deterioration of liquidity. But the cash flow ratio
increased indicating an improvement in short-term solvency. Furthermore, the reason
for the decline in the current ratio and acid-test ratio could be traced to the 88%
increase in accounts payable which could actually be a plus if its means that ABC,
Inc. strengthen its ability to obtain supplier credit. Also, the firm’s cash flow from
operating activities turned around from negative to positive amount which contributed
to the stronger shor-term solvency in 20x4.
II. Analysis of Asset Liquidity and Asset Management Efficiency
Accounts Receivable Turnover
Formula:

20x4: = 24.90 times

20x3: = 18.32 times

*When available, credit sales can be submitted for net sales since credit sales
produce receivable.
**Assumed average for 20x3.
The accounts receivable turnover roughly measures how many times a company’s
account receivable have been turned into cash during the year. ABC, Inc. converted
accounts receivable into cash 24.90 times in 20x4, up from 18times in 20x3. The turnover if
receivable has improved and this indicate efficiency in the collection of receivable, but a very
high turnover may not be favorable because it may indicate that credit and collection policies
are overly restrictive.

Average Collection Period

Formula: or

20x4: = 14.60 days or 15 days

20x3: = 19.90 days or 20 days
The average collection period helps evaluate the liquidity of accounts receivable and
the firm’s credit policies. The long collection period may be a result of the presence of many
old accounts of doubtful collectability, or it may be the result of poor day-to-day credit
management such as inadequate checks on customers or perhaps no follow-ups are being
made on slow account. There could be other explanations such as temporary problem
caused by a depressed economy.
The average collection period of accounts receivable is the average number of days
required to convert receivable into cash. The ratios for ABC, Inc. indicate that during 20x4,
the firm collected its accounts in 15 days on average, an improvement over the 20 day
collection period in 20x3. Whether the average of 15 days taken to collect an account is good
or bad depends on the credit terms ABC is offering its customers. If the credit terms are 10
days, then a 15 day average collection period would be viewed as good. Most customers will
tend to withhold payment for as long as the credit terms will allow and may even go over a

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few days. This factor, added to ever-present problems with a few slow- paying customers,
can cause the average collection period to exceed normal credit terms by a week or so and
should not cause great alarm.
Inventory Turnover
Formula:

20x4: = 3.09 times

20x3: = 2.50 times
*Assumed average of 20x3.
The inventory turnover measures the efficiency of the firm in managing and selling
inventory. It is computed by dividing the cost of goods sold by the average level of inventory
on hand. The ratio is sometimes calculated with net sales as the numerator and the average
level of inventory as the denominator. The inventory turnover of ABC, Inc. was 3.09 times in
20x4, an improvement over 20x3’s 2.50 times.
Generally a high turnover is preferred because it is a sign of efficient inventory
management and profit for the firm. But a high turnover could also mean underinvestment in
inventory and lost orders, a decrease in prices, a shortage of materials or more sales than
planned. A relatively low turnover could mean that the company is carrying too much
inventory or it has obsolete, slow-moving or inferior inventory stock.
The inventory turnover varies, from industry to industry. Flowers and vegetable sellers
would have a relatively high inventory turnover because they deal with perishable products
but a jewelry store would have lower turnover but high profit margin.
Average Sale Period
Formula:

20x4: = 118 days

20x3: = 146 days
The number of days being taken to sell the entire inventory one time (called the
average sale or conversion period) is computed by dividing 365 days by the inventory
turnover period. Generally, the faster inventory sells, the fewer funds are tied up in inventory
and more profits are generated. ABC’s average sale or conversion period decreased from
146 days in 20x3 to 118 days in 20x4. This is evidence of efficiency in managing the
inventories in 20x4.
Fixed Asset Turnover
Formula:

20x4: = 8.97 times

20x3: = 8.06 times
*Assumed average of 20x3.
The fixed asset turnover is another approach to assessing management’s
effectiveness in generating sales from investments in fixed assets particularly for a capital-
intensive firm. For ABC, Inc. the fixed asset turnover improved slightly because of the 41% in
sales as compared with 26% increase in average fixed assets. This occurrence however

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should be further examined within the framework of the overall analysis of the company as
well as that of the industry.
Total Asset Turnover
Formula:

20x4: = 2.52 times

20x3: = 2.02 times
*Assumed average of 20x3.
The total asset turnover is a measure of the efficiency of management to
generate sales and thus earn more profit for the firm. When the asset turnover ratios
are low relative to the industry or the firm’s historical record, it could mean that either
the investment in assets is too heavy or sales are sluggish. There may however be
justification for the low turnover. For example, the firm may have undertaken an
extensive plant modernization or placed in assets is service at year-end which will
generate positive results in the long-term.
For ABC, Inc. the total asset turnover has improved primarily because of the
improvement in fixed assets, inventory and accounts receivable turnover.

III. ANALYSIS OF LEVERAGE: DEBT FINANCING AND COVERAGE

Debt Ratio
Formula:

20x4: = 51.8%
20x3: = 50.1%

The debt ratio measures the proportion of all assets that are financed with debt.
Generally, the higher the proportion of debt the greater the risk because creditors must be
satisfied before owners in the event of bankruptcy.
The use of debt involves risk because debt carries a fixed obligation in the form of
interest charges and principal repayment. Failure to satisfy the fixed charges associated with
debt will ultimately result in bankruptcy.
ABC, Inc. debt ratios in 20x4 and 20x3 indicate relatively heavy reliance on borrowed
capital and they have reached the generally considered maximum ratio of 50% debt and 50%
equity. Too much debt would pose difficulty in obtaining additional debt financing when
needed or that credit is available only at extremely high rates of interest and most onerous
terms.
Debt to Equity Ratio
Formula:

20x4: = 107.46%
20x3: = 100.46%

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 The amount and proportion of debt and equity in a company’s capital structure are
extremely important to the financial analyst because of the trade-off between risk and return.
While debt implies risk, it also provides the potential for increased benefits to the firm’s
owners. When debt is used successfully, operating earnings exceed the fixed charges
associated with debt, the return to the stockholders are magnified through financial leverage
or “trading on the equity.”
The debt to equity ratio measures the riskiness of the firm’s capital structure in terms
of relationship between the funds supplied by creditors (debt) and investor (equity). ABC’s
debt to equity has increased between 20x4 and 20x3, implying a slightly riskier capital
structure.

Times Interest Earned

Formula:

20x4: = 7.44 times

20x3: = 5.18 times
Times interest earned ratio is the most common measure of the ability of a firm’s
operations to provide protection to long-term creditors. The more times a company can cover
its annual interest expense from operating earnings, the better off will be the firm’s investors.
While ABC, Inc., increased its use of debt in 20x4, the company improved its ability to
cover interest payment from operating profits.
Fixed Charge Coverage
Formula:

20x4: = 2.06 times

20x3: = 2 times
The fixed charge coverage measures the firm’s coverage capability to cover not only
interest payments but also the fixed payment associated with leasing which must be met
annually. This ratio is particularly important for firms that operate extensively with leasing
arrangements, whether operating leases or capital leases.
ABC, Inc. experienced a significant increase in the amount of annual lease payment
in 20x4 but was still able to improve its fixed charge coverage.
IV.OPERATING EFFICIENCY AND PROFITABILY
Gross Profit Margin
Formula:

20x4: = 40%
20x3: = 39.95%
Gross profit margin which shows the relationship between sales and the cost of
products sold, measures the ability of a company both to control costs and inventories or
manufacturing of products and to pass along price increases through sales to customers.

14
 ABC’s gross profit margin for both 20x4 and 20x3 have been stable which is
considered to a positive sign even if the company had to offer probably discounted items to
attract customers or feature “sale” to hasten up inventory turnover.

Operating Profit Margin

Formula:

20x4: = 8.9%
20x3: = 7.7%
The operating profit margin is a measure of overall operating efficiency and
incorporates all of the expenses associated with ordinary or normal business activities.
ABC’s operating profit margin improved from 7.7 % in 20x3 to 8.9% in 20x4. This is
favorable because it indicates ability of the company to control its operating expenses while
sharply increasing sales.

Net Profit Margin

Formula:

20x4: = 4.36%
20x3: = 3.87%
Net profit margin measures profitability after considering all revenue and expenses,
including interest, taxes and non-operating items such as extraordinary items, cumulative
effect of accounting change, etc.
ABC’s net profit margin slightly increased despite increased interest and tax
expenses and a reduction in interest revenue for marketable security investment.
Cash Flow Margin
Formula:

20x4: = 4.65%
20x3: = (2.5%)
Cash flow margin is another measure or perspective on operating performance. This
measures the ability of the firm to translate sales to cash to enable it to service debt, pay
dividends or invest in new capital assets.
ABC’s cash flow margin in 20x4 was higher than the operating margin. This indicates
a strong positive generation of cash. The performance in 20x4 represents a solid and
impressive improvement over 20x3 when the firm failed to generate cash from operations
and had a negative cash flow margin.

Return on Investment on Assets (ROA)

Formula:

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 or Net Profit Margin x Total Asset Turnover
If the firm has interest-bearing debt, ROA is computed using the following formula:

20x4: = 10.88%
20x3: = 9.02%
Return on Equity (ROE)

Formula:

or Return on Assets x Financial Leverage or Equity Multiplier

Equity Multiplier =

20x4: = 22.42%
20x3: = 15.60%
Return on assets and return on equity are two ratios that measure the overall
efficiency of the firm in managing its total investment in assets and in generating return to
shareholders. These ratios indicate the amount of profit earned relative to the level of
investment in total assets and investment of common shareholders.
These ratios will also measure how effectively the company is using financial
leverage. The financial leverage Index (FLI) is computed as follows:

If the FLI is greater than 1 indicating the return on equity exceeds return on assets,
the firm is using debt effectively. If the FLI is less than 1, the financial leverage is negative
which means that the firm is not using debt successfully.
ABC’s registered a solid improvement in 20x4 of both return ratios. Financial
Leverage Index is calculated as follows:

20x4: = 2.06
20x3: = 1.73
ABC’s FLI of 2.06 in 20x4 and 1.73 in 20x3 indicates a successful use of financial
leverage although borrowing increased. The firm has generated sufficient operating returns
to more than cover the interest payments on borrowed funds.

OTHER RATIOS USED TO MEASURE RETURNS TO INVESTORS

a. Earnings per Share (EPS)
Formula:

Basic EPS =

Diluted EPS =

Basic EPS
20x4: = ₱2

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 20x3: = ₱1.29
The Diluted EPS need not be computed because there are no potential diluters (e.g.
convertible bonds, convertible preference shares or stock options and warrants) outstanding.
PAS 33 issued by the ASC in 2008 is used to compute the Earnings per share.
ABC’s earning per ordinary share increased form ₱1.29 in 20x3 to ₱2.00 in 20x4
which is a clear indication in the improvement on the investment return of ordinary
shareholders.
b. Price Earnings Ratio (P/E)

Formula:
20x4: = ₱15
20x3: = ₱13.39
The P/E ratio relates earnings per ordinary share to market price at which the stock
trades, expressing the “multiple” which the stock market places on a firm’s earning. It is a
combination of a number of factors such as the quality of earnings, future earnings, potential
and performance history of the company.
ABC’s price to earnings ratios is higher in 20x4 than in 20x3. This could be because
the market is reacting favorably to the firm’s good year.
c. Dividend payout ratio

Formula:
20x4: = 16.5%
20x3: = 31.78%
ABC, Inc. reduced its cash dividend payment in 20x4. It is particularly unusual for a firm
to reduce dividends during a good year. A possible explanation for this though may be the
adoption of a new policy that will lower dividend payments in order to increase the availability
of funds that may be reinvested for expansion purposes

d. Dividend Yield

Formula:
20x4: = 1.1%
20x3: = 2.41%
A low dividend yield would indicate that an investor would choose ABC, Inc. as an
investment more for its long-term capital appreciation than for its dividend yield.
Summary of Financial Statements Analysis of ABC, Inc.
Short-term Liquidity and Activity
Short-term liquidity analysis is of particular significance to trade and short-term
creditors, management and other parties concerned with the ability of a firm to meet near-
term demands for cash.
ABC’s current and quick ratios decreased indicating a deterioration of short-term
liquidity. However, the cash flow liquidity ratio improved in 20x4 after a negative cash
generation in 20x3.
The average collection period for accounts receivable and the inventory turnover
improved in 20x4 which could indicate improvement in the quality of accounts receivable and
liquidity of inventory. The increase in inventory level has been accomplished by reducing

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holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for
potentially less liquid assets. The efficient management of inventories is critical for the firm’s
ongoing liquidity.
Presently, there appears to be no major problems with the firm’s short-term liquidity
position.
Long-Term Solvency
The debt ratios for ABC show a steady increase in the use of borrowed funds. Total
debt has increased relative to total assets, long-term debt has increased as a proportion of
the firm’s permanent financing and external or debt financing has risen relative to internal
financing.
Why has debt increased? The statement of cash flows shows that ABC has
substantially increased its investment in capital or fixed assets and their investments have
been financed largely by borrowing especially in 2013 when the firm had a rather sluggish
operating performance and no internal cash generation.
Given the increased level of borrowing, the times interest earned and fixed charge
coverage improved slightly in 20x4. These ratios should however be monitored closely in the
future particularly if ABC continues to expand.
Operating Efficiency and Profitability
As noted earlier, ABC has increased its investment in fixed asset as a result of store
expansion. The asset turnover increased in 20x4, the progress traceable to improved
management of inventories and receivable. There has been substantial sales growth which
suggests future performance potential.
The gross profit margin was stable, a positive sign in the light of new store openings
featuring discounted and “sale” items to attract customers. The firm also managed to improve
it operating profit in 20x4 principally due to the firm’s ability to control operating costs. The
net profit margin also improved despite increased interest and tax expenses and a reduction
in interest income from marketable security investment.
Return on assets and return on equity increased considerably in 20x4. These ratios
measure the overall success of the firm in generating profits from its investment and
management strategies.
CONCLUSION:
It appears the ABC Enterprise, Inc. is well positioned for future growth. Close
monitoring the firm’s management of inventories is important considering the size of the
company’s capital tied up in it. The expansion in their operation may necessitate a sustained
effort to advertise more, to attract customers to both new and old areas. ABC has financed
much of its expansion with debt, and so far, its shareholders have benefited from the use of
debt through financial leverage. The company should however be cautious of the increased
risk associated with debt financing.
THE DUPONT DISAGGREGATION ANALYSIS
DuPont Equation is the formula that shows that the rate of return on equity can be
found as the product of profit margin, total assets turnover and the equity multiplier. It shows
the relationships among asset management, financial leverage management and profitability.
Disaggregation of return on equity (ROE) was initially introduced by E.I. DuPont de
Nemours and Company to help its managers in performance evaluation.
The basic DuPont model disaggregates ROE as follows:

ROE= = x x

Profit Asset Financial

Margin Turnover Leverage
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These three components are described as follows:
1. Profit Margin is the amount of profit that the company earns from each peso of sales.
A company can increase its profit margin by increasing its gross profit margin (Gross
profit ÷ Sales) and/ or by reducing its expenses (other than cost of sales) as
percentage of sales.
2. Asset Turnover is a productivity measure that reflects the volumes of sales that a
company generates from each peso invested in assets. A company can increase it
asset turnover by increasing sales volume with no increase in assets and/or by
reducing asset investment without reducing sales.
3. Financial Leverage measures the degree to which the company finances its assets
with debt rather than equity. Increasing the percentage of debt relative to equity
increases the financial leverage. Although financial leverage increases ROE (when
performance is positive), debt must be used with care as it increases the company’s
relative riskiness.
The profit margin and asset turnover relates the company operations and combine to
yield on assets (ROA) as follows:

ROA = = x

Profit Asset
Margin Turnover

Return on Assets
(ROA)

Return on assets measures the return on investment for the company without regard
to how it financed (relative proportion of debt and equity in its capital structure). Operating
managers of a company typically grasp the income statement. They readily understand the
pricing of products, the management of production costs and importance of controlling
overhead costs. However, many managers do not appreciate the importance of managing
the statement of financial position.
The ROA approach to performance measurement encourages managers to also
focus on the returns that they achieve from the invested capital under their control. Those
returns are maximized by a joint focus on both profitability and productivity.
1. Profitability. It is measured by the profit margin (Gross profit ÷ Sales). Analysis of
profitability typically examines performance over time relative to benchmarks such
as competitors’ or industry performance, which highlight trends and abnormalities.
When abnormal performance is discovered, managers either correct suboptimal
performance or protect superior performance. The two general areas of
profitability analysis are:
 Gross profit margin. It measures the gross profit (Sales less Cost of
Goods Sold) for each sale. Gross profit margin (Gross profit ÷ Sales) is
affected by both the selling prices of products and their manufacturing
cost.
 Expense management. Managers focus on reducing manufacturing and
administrative overhead expenses to increase profitability. Manufacturing
overhead refers to all production expenses (e.g. utilities, depreciation and

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 administrative costs) other than labor and materials. Administrative
overhead refers to all expenses not in costs of goods sold (e.g.
administrative salaries and benefits, research and development,
marketing, legal and accounting).
2. Productivity. It refers to the volume of sales resulting from invested in assets.
When a decline in productivity is observed, managers have to avenues of attack:
 Increase in sales volume from the existing asset base, and
 Decrease the investment in assets without reducing sales volume.
Illustrative Case 1-2.
AL Company is a subsidiary of Honest Business Sense, Inc. and was acquired several years
ago as explained in the following note to the Honest Business Sense, Inc. annual report:
On May 23, 20x2, AL Company acquired Honest Business Sense, Inc. a distributor of
grocery and food products to retailers, convenience stores and restaurants. Result of Honest
Business Sense, Inc. operations are included in AL Company’s consolidated results
beginning on that date. Honest Business Sense, Inc. revenues in 20x4 totaled ₱24.1 million
compared to ₱23.4 million in 20x3 and approximately ₱22.0 million for the full year of 20x2.
Sales of grocery products increased about 5% in 20x4 and were partially offset by lower
sales to foodservice customers. Honest Business Sense, Inc. business is marked by high
sales volumes and very low profit margins. Pretax earnings in 20x4 of 217 million declined
11million in 20x3. The gross margin percentage was relatively unchanged between years.
However, the resulting increased gross profit was more than offset by higher payroll, fuel and
insurance expenses. Approximately, 33% of Honest Business Sense, Inc. annual revenues
currently derive from sales to Savemore. Loss or curtailment of purchasing by Savemore
could have a material adverse impact on revenues and pre-tax earnings of Honest Business
Sense, Inc.
Analysis
Honest Business Sense, Inc. is a wholesaler of food products; it purchases food
products in finished and semi-finished form from agricultural and food-related business and
resells them to grocery and convenience food stores. The extensive distribution network
required in this business entails considerable investments. The business analysis of Honest
Business Sense, Inc. financial results includes the following observations:

 Industry competitors: Honest Business Sense, Inc. has many competitors with food
products that are difficult to differentiate.
 Bargaining power of buyers. The note above reveals that 33% of Honest Business
Sense, Inc. sales are to Savemore, which has considerable buying power that limits
seller profits; also, the food industry is characterized by high turnover and low profit
margins, which implies that cost control is key to success.
 Bargaining power of suppliers. Honest Business, Sense Inc. is large (24million in
annual sales), which implies its suppliers are unlikely to exert forces to increase its
cost of sales.
 Threat of substitution. Grocery items are usually not well differentiated; this means
the threat of substitution is high, which inhibits its ability to raise selling prices.
 Threat of entry. High investment costs, such as warehousing, and logistics, are a
barrier to entry in Honest Business Sense, Inc. business; this means the threat of
entry is relatively low.
Our analysis reveals the Honest Business Sense, Inc. is a high volume, low-margin
company. Its ability to control costs is crucial to its financial performance, including its ability
to fully utilize its assets. Evaluation of Honest Business Sense, Inc. financial statements
should focus on that dimension.

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 Name: _____________________________Course Code/ Course Title_____________
Major/Year Level:__________________ Date:______________Score:_____________
Instructor: John Albert A. Alzate

Exercise 1.1
Test I- Identification
Directions: Identify the following concept by writing your answer on the space provided.

1. _________________________. Indicates relative investments in current asset.

2. _________________________. Measures overall efficiency of the firm in managing assets and
generating profits.
3. _________________________.Measures rate of return on resources provided by owners.
4. _________________________.Peso return on each ordinary share. Indicative of ability to pay
dividends.
5. _________________________.Measures relationship between price of ordinary shares in the open
market and profit earned on a per share basis.
6. _________________________.Shows percentage of earnings paid to shareholders.
7. _________________________.Shows the rate earned by shareholders from dividend relative to
current price of stock.
8. _________________________.Primary test of solvency to meet current obligations from current
assets as a going concern; measure of adequacy of working capital.
9. _________________________.A more severe test of immediate solvency; test of ability to meet
demands from current assets.
10. _________________________.Indicates relative liquidity of total assets and distribution of resources
employed.
11. _________________________.Velocity of collections of trade accounts and notes; test of efficiency
of collection.
12. _________________________.Evaluate the liquidity of accounts receivable and the firm’s credit
policies.
13. _________________________. Shows the rate earned by shareholders from dividend relative to
current price of stock.
14. _________________________.Shows portion of income distributed to shareholders.
15. _________________________. Measures the profitability of current assets invested.

Test II. Questions

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 1. Financial ratio analysis is conducted by three main groups of analyst: credit analysts,
stock analysts and managers. What is the primary emphasis of each group, and how
would that emphasis affects the ratios they focus on?
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Name: _____________________________Course Code/ Course Title_____________

Major/Year Level:__________________ Date:______________Score:_____________
Instructor: John Albert A. Alzate

Exercise 1.2
Problem-Solving
Directions: Read the following problems and answer on the space provided on what is being
required.
Problem I (Statement of Financial Position Analysis)
Complete the statement of financial position and sales information using the following
financial data.
Debt-to-assets ratio : 50%
Current Ratio : 1.8x
Total asset turnover : 1.5x
Day sales outstanding : 36.5 days (calculation is based on a 365-day year)
Gross Profit Margin on Sales : (Sales-Cost of goods sold)/ Sales = 25%
Inventory turnover ratio : 5x

Statement of Financial Position

Assets Liabilities and Owner's Equity

Cash Accounts Payable
Accounts Receivable Long-term debt ₱ 60,000
Inventories Common Stock
Fixed Assets Retained Earnings ₱ 97,500
Total Assets ₱ 300,000 Total Liabilities & Equities

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Problem 2 (Ratio Analysis)
Data for Barry Company and its industry averages is as follow.

Barry Company
Statement of Financial Position as of December 31, 20x4
(in thousands)

Assets Liabilities and Owner's Equity

Cash 77,500 Accounts Payable 129,000
Receivables 336,000 Notes Payable 84,000
Inventories 241,500 Other Current liabilities 117,000
Total current assets 655,000 Total current liabilities 330,000
Net fixed assets 292,500 Long-term debt 256,500
Common equity 361,000
Total Assets ₱ 947,500 Total Liabilities & Equities ₱ 947,500

Barry Company
Income Statement for the Years Ended December 31, 20x4
(in thousands)

Sales ₱ 1,607,500
Cost of Goods Sold
Materials 717,000
Labor 453,000
Heat,light, power 68,000
Indirect labor 113,000
Depreciation 41,500 (1,392,500)
Gross profit ₱ 215,000
Selling Expenses (115,000)
General and administrative expenses (30,000)
Earnings before interest and taxes (EBIT) 70,000
Interest expense (24,500)
Earnings before taxes (EBT) 45,500
Federal and state income taxes (40%) (18,200)
Net income ₱ 27,300

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 Industry
RATIO BARRY COMPANY Average
Current 2.0x
Quick 1.3x
Day sales outstanding 35 days
Inventory turnover 6.7x
Total assets turnover 3.0x
Profit Margin 1.20%
ROA 3.60%
ROE 9.00%
Total debt/total assets 60.00%

Required:
a. Calculate the indicated ratios for Barry.
b. Construct the DuPont equation for both Barry and the industry.
c. Outline Barry Company’s strength and weaknesses as revealed by your analysis.

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Lesson 2 Financial Forecasting for Strategic Growth

I - Learning Objectives:
After studying this lesson, the students are expected to:
1. discuss financial planning and control;
2. explain the benefits that can be derived from financial planning; and
3. apply the financial planning process using the Projected Financial Statement Method
(Percent of Sales Method); and
4. show appreciation on the importance of financial planning and control.
II- Discussions:
A lack of effective long-range planning is commonly cited reason for financial distress
and failure. Long-range planning is a means of systematically thinking about the future and
anticipating possible problems before they occur. Planning is said to be process that at best
helps the firm avoid stumbling into the future backward.
Financial planning establishes guidelines for change and growth in a firm. It focuses
on the big picture, which means that it is concerned with the major elements of a firm’s
financial and investment policies without dealing with the individual components of those
policies in detail.
WHAT IS FINANCIAL PLANNING?

25
 Financial planning formulates the way in which financial goals are to be achieved. A
financial plan is thus, a statement of what is to be done in the future. Many decisions have a
long lead time which means they take a long time to implement. In an uncertain world, this
requires that decisions made far in advance of their implementation. For instance, if a firm
wants to build a factory in 2018, it might have to begin lining up contractors and financing in
2016 or even earlier.
GROWTH AS FINANCIAL MANAGEMENT GOAL
As discussed in the earlier lessons, the appropriate goal is for the financial manager
is increasing the market value of the owners’ equity and not just growth by itself. If the firm is
successful in doing this, then growth will usually result. Growth may thus be a desirable
consequence of good decision making but it is not an end unto itself. However, while growth
is used in the planning process, it is considered a convenient means of summarizing various
aspects of a firm’s financial and investment policies. Likewise, if we think of growth in the
market value of the equity in the firm, then goals of growth and increasing the market value
of the equity in the firm are not all that different.
PERSPECTIVE OF FINANCIAL PLANNING
For planning purposes, it is often useful to think of the future as having a short-run
and a long-run. The short-run planning, in practice, usually covers the coming 12 months
while financial planning over the long run is takes to be the coming two to five years. This
time period is referred to as the planning horizon and this is the first dimension of the
planning process that must be established.
The second dimension of the planning process that needs to be determined is the
level of aggregation. Aggregation involves the determination of all of the individual projects
together with the investment required that the firm will undertake and adding up these
investment proposals to determine the total needed investments which is treated as one big
project.
After planning horizon and level of aggregation are established, a financial plan
requires inputs in the form of alternative sets of assumptions about important variables. This
type of planning is particularly important for cyclical businesses or business firms whose
sales are strongly affected by the overall state of the economy or business cycles.

WHAT ARE THE BENEFITS THAT CAN DERIVED FROM FINANCIAL PLANNING?
Due to the amount spent in examining the different scenarios and variable that will
eventually become the basis for a company’s financial plan, it seems reasonable to ask what
planning process will accomplish.
Among the more significant benefits of derived from financial planning are the
following.
1. Provides a rational way of planning options or alternatives.
The financial plan allows the firm to develop, analyze and compare many different
business scenarios in an organized and consisted way. Various investment and financing
options can be explored, and their impact on the firm’s shareholders can be evaluated.
Questions concerning the firm’s future lines of business and optimal financing arrangements
are addressed. Options such as introducing new products or closing plants might be
evaluated.
2. Interactions or linkages between investment proposals are carefully
examined.
The financial plan enables the proponents to show explicitly the linkages between
investment proposal for the different operating activities of the firm and its available financing
choices. For example, if the firm is planning on expanding or undertaking new investments

26
and projects, all other relevant variables such as source, terms and timing of financing are
thoroughly examined.
3. Possible problems related to the proposal projects are identified actions to
address them are studied.
Financial planning should identify what may happen to the firm if different events take
place. Specifically, it should address what actions the firm will take if expectations do not
materialized and more generally, if assumptions made today about the future are seriously in
error. Thus, one objective of financial planning is to avoid surprises and develop contingency
plans.
4. Feasibility and internal consistency are ensured.
Financial planning is a way of verifying that the goals and plans made for specific
area of a firm’s operations are feasible and internally consistent. The financial plan makes
explicit the linkages between different aspects of a firm’s business such as the market share,
return on equity, financial leverages, and so on. It also imposes a unified structure for
reconciling goals and objectives.
5. Managers are forced to think about goals and establish priorities.
Through financial planning, directions that the firm would take are established, risks
are calculated and educated alternative course of action are considered thoroughly.
FINANCIAL PLANNING MODELS
Financial planning process will differ from the firm to firm, just as companies differ in
size and products. However, a basic financial planning model will have the following common
elements; (a) economic environment assumptions, (b) sales forecasts, (c) pro forma
statements, (d) asset requirements, (e) financial requirement, and (f) additional funds
needed.
1. Economic Environment Assumption. The plan will have to state explicitly the
economic environment in which the firm expects to reside over the life of the plan.
Among the more important economic assumption that will have to be made are the
inflation rates, level of interest rates and the firm’s tax rate.
2. Sales Forecast. An externally supplied sales forecast considered the “driver” shall be
the “heart” of all financial plans. The user of the planning model will supply this value
and most other values will be calculated based on it. Planning will focus on projected
future sales and the assets and financing needed to support those sales.

Oftentimes, the sales forecast will be given as the growth rate in sales rather
than as an explicit sales figure. Perfect sales forecast are not possible, of course,
because sales depend on the uncertain future state of the economy. To come up with
its projections, firms could consult with some businesses which specialize in
macroeconomic and industry projections. Also, evaluating alternative scenarios does
not require sales forecast to be very accurate because the financial planner’s goal is
to examine the interplay between investment and financing needs at different
possible sales level, not to pinpoint what we expect to happen.

Determinants of Growth Rates

A firm’s ability to sustain growth depends explicitly on the following factors:
 Profit Margin. An increase in profit margin will increase the firm’s ability to
generate funds internally and thereby increase its sustainable growth.
 Dividend policy. A decrease in the percentage of net income paid out as
dividends will increase the retention ratio. This increases internally
generated equity and thus increases sustainable growth.
 Financial Policy. An increase in the debt-equity ratio increases the firm’s
financial leverage. Because this make additional debt financing available, it
increases the sustainable growth rate.

27
  Total Asset Turnover. An increase in the firm’s total asset turnover
increases the sales generated for each peso in assets. This decreases the
firm’s need for new assets as sales grow and thereby increases the
sustainable growth rate. Notice that total asset turnover is the same thing
as decreasing capital intensity.
The sustainable growth rate is a very useful planning number. What it
illustrate is the explicit relationship between the firm’s four major areas of
concern: (a) its operating efficiency as measured by profit margin, (b) its
asset use efficiency as measured by total asset turnover, (c) its dividend
policy as measured by the retention ratio, and (d) its financial policy as
measured by the debt-equity ratio.
3. Pro forma Statements. A financial plan will have a forecast statement of financial
position, income statement, statement of cash flows and statement of stockholders’
equity. These are called pro forma or projected statements which will summarize the
different events projected for the future.
4. Asset Requirements. The financial plan will describe projected capital spending. At a
minimum, the projected statement of financial position will contain changes in total
fixed assets and net working capital. These changes are effectively the firm’s total
capital budget. Proposed capital spending in different areas must thus be reconciled
with the overall increases contained in the long-range plan.
5. Financial Requirements. The financial plan will include a section about the necessary
financing arrangements. This part of the plan should discuss dividend policy and debt
policy. Sometimes firms will expect to raise cash by selling new shares of stock or by
borrowing. In this case, the plan will have to consider what kinds of securities have to
be sold and what methods of issuance are most appropriate.
6. Additional Funds Needed (AFN). After the firm has a sales forecast and an estimate
of the required spending on assets some amount of new financing will often be
necessary because projected total assets will exceed projected total liabilities and
equity. In other words, the statement of financial position will no longer balance.

Because new financing may be necessary to cover all of the projected capital
spending, a financial “plug” variable must be selected. The plug is the designated
source (s) of external financial needed to deal with any shortfall (or surplus) in
financing and thereby bring the statement of financial position into balance.

For example, a firm with a great number of investment opportunities and limited cash
flow may have raise to new equity. Other firms with few growth opportunities and
ample cash flow will have a surplus and thus might pay an extra dividend. In the first
case, external equity is the plug variable; and the second, the dividend is used.
FINANCIAL PLANNING PROCESS
Well run companies generally base their operating plans on a set of forecasted
financial statements. The planning process begins with a sales forecast for the next five or so
years. Then the assets required to meet the sales targets are determined, and decision is
made concerning how to finance the required assets. At that point, income statements and
statement of financial position can be projected, and earnings per share, as well the key
ratios can be forecasted.
Once the “base-case” forecasted statements and ratios have been prepared, top managers
will ask questions such as:

 Are the forecasted results as good as we can realistically expect, and if not, how
might we change our operating plans to produce better earnings and a higher stock
price?
 How sure are we that we will be able to achieve the projected results? For example, if
our base-case forecast assumes a reasonably strong economy but a recessions
occurs, would we be better off under an alternative operating plan?

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THE PROJECTED FINANCIAL STATEMENT METHOD
Any forecast of financial requirements involves (a) determining how much money the
firm will need during a given period, (b) determining how much money the firm will generate
internally during the same period, and (c) subtracting the funds generated from the funds
required to determine the external financial requirements.
The projected financial statement method is straightforward, one simple projects the
asset requirements for the coming period, then projects the liabilities and equity that will be
generated under normal operations, and subtracts the projected liabilities/capital from the
required assets to estimate the additional funds needed (AFN).
The steps in the procedure are as follows:
Step 1. Forecast the Income Statement.
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding production costs;
direct materials, direct labor and overhead.
c. Estimate selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.

Step 2. Forecast the Statement of Financial Position

a. Project the assets that will be needed to support projected sales.
b. Project funds that will be spontaneously generated (through accounts payable and
accruals) and by retained earnings.
c. Project liability and stockholders’ equity accounts that will not rise spontaneously with
sales (e.g. notes payable, long-term bonds, preferred stock and common stock) but
may change due to financing decisions that will be made later.
d. Determine if additional funds will be needed by using the following formula:

Additional Required Increase - Spontaneous Increase – Increase in

Funds Needed in Assets in Liabilities Retained Earnings

The additional financing needed will be raised by borrowing from the bank as notes
payable, by issuing long-term bonds, be selling new common stocks or by some
combination of these actions.
Step 3. Raising the additional funds needed.
The financing decision will consider the following factors:
a. Target capital structure;
b. Effect of short-term borrowing on its current ratio;
c. Conditions in the debt and equity markers; or
d. Restrictions imposed by existing debt agreements.
Step 4. Consider financing feedbacks.
Depending on whether additional funds will be borrowed or will be raised through
common stocks, consideration should be given on additional interest expense in the income
statement or dividends, thus decreasing the retained earnings.
Apply the iteration process using the available financing mix until the AFN would
become so small that the forecast can be considered complete.

ILLUSTRATIVE CASE 2-1. Financing Forecasting (Percent of Sales Method)

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The Jana Company has the following statements which are representative of the company’s
historical average.

Income Statement

Sales 2,000,000.00
Cost of Sales (1,200,000.00)
Gross Profit 800,000.00
Operating expenses (380,000.00)
Earnings before interest and taxes 420,000.00
Interest Expense (70,000.00)
Earnings before taxes 350,000.00
Taxes (35%) (122,500.00)
Earnings after taxes 227,500.00

Dividends 136,500.00

Statement of Financial Position

ASSETS
Cash 50,000.00
Accounts receivable 400,000.00
Inventory 750,000.00
Current Assets 1,200,000.00
Fixed Assets (net) 800,000.00
Total Assets 2,000,000.00

LIABILITIES AND EQUITY

Accounts Payable 250,000.00
Accrued wages 10,000.00
Acrrued Taxes 20,000.00
Current Liabilities 280,000.00
Notes payable - bank 70,000.00
Long-term debt 150,000.00
Ordinary shares 1,200,000.00
Retained earnings 300,000.00
Total liabilities and equity 2,000,000.00

The firm is expecting a 20 percent increase in sales next year, and management is
concerned about the company’s need for external funds. The increase in sales is expected to
be carried out without any expansion of fixed assets, but rather through more efficient asset
utilization in the existing store. Among liabilities, only current liabilities vary directly with
sales.
Using the percent-of-sales method, determine whether the company has external
financing needs or a surplus of funds.
Solution:
Step 1. Forecast the Income Statement
The projected income statement will show the following:

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 Income Statement

Sales 2,400,000.00
Cost of Sales (1,440,000.00)
Gross Profit 960,000.00
Operating expenses (456,000.00)
Earnings before interest and 504,000.00
Interest Expense (70,000.00)
Earnings before taxes 434,000.00
Taxes (35%) (151,900.00)
Earnings after taxes 282,100.00

Dividends (36% payment) 101,600.00

Step 2. Forecast the Statement of Financial Position

The projected statement of financial position will show the following:

Statement of Financial Position

ASSETS
Cash (1) 60,000.00
Accounts receivable (2) 480,000.00
Inventory (3) 900,000.00
Current Assets 1,440,000.00
Fixed Assets (net) (4) 800,000.00
Total Assets 2,240,000.00

LIABILITIES AND EQUITY

Accounts Payable (5) 300,000.00
Accrued wages (6) 12,000.00
Acrrued Taxes (7) 24,000.00
Current Liabilities 336,000.00
Notes payable - bank (4) 70,000.00
Long-term debt (4) 150,000.00
Ordinary shares (4) 1,200,000.00
Retained earnings (8) 480,500.00
Total 2,236,500.00
Additional financing required 3,500.00
Total liabilities and equity 2,240,000.00

Supporting Computations:

(1) Cash = 2.5% x ₱2.4M sales

(2) Accounts receivable = 20% of ₱2.4 M
(3) Inventory = 37.50 % x ₱2.4M
(4) No percentages are computed for fixed assets, notes payable, long-term debt,
ordinary shares and retained earnings because they are not assumed to maintain
a direct relationship with sales volume. For simplicity, depreciation is not explicitly
considered.
(5) Accounts Payable = 12.5% of ₱2.4M
(6) Accrued expenses = 0.5 % of ₱2.4M

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 (7) Accrued Taxes = 1% of ₱2.4M
(8) Retained Earnings = 300,000 + 282,100 – 101,600
Formula Method
*Additional financing needed (AFN) may also be computed as follows:
Additional Required Increase - Spontaneous Increase – Increase in
Funds Needed in Assets in Liabilities Retained Earnings

Where:
Required increase in Assets = Change in Sales x
Spontaneous increases in liabilities = Change in Sales x
Increase in Retained Earnings = Earnings after taxes – Dividend payment

Applied to Jana Company, AFN is computed as follows:

AFN = - – 282,100 – 101,600
= 240,000 – 56,000 – 180,500
= 3,500
Illustrative Case 2-2. Projected Financial Statements with Financing
For Leo Company, the following data have been made available:

LEO COMPANY
Income Statement
Year 20x4
(Thousand of Pesos)

Sales 6,000
Operating Cost (inclusive of 200 depreciation) (5,432)
Earnings before interest and taxes 568
Less: interest expense (176)
Earnings before taxes 392
Taxes (40%) (157)
Net income before preference dividend 235
Dividend to preference (8)
Net income available to ordinary 227
Dividend to ordinary 114

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 LEO COMPANY
Statement of Financial Position
December 31, 20x4
(Thousand of Pesos)

ASSETS
Cash 20
Accounts receivable 750
Inventory 1,230
Current Assets 2,000
Net plant and equipment 2,000
Total Assets 4,000

LIABILITIES AND EQUITY

Accounts payable 120
Notes payable 220
Acrrued Taxes 280
Total Current Liabilities 620
Long-term bonds 1,508
Total liabilities 2,128

Preferences shares 80
Ordinary shares (50,000 shares) 260
Retained earnings 1,532
Total Equity 1,872
Total Liabilities and Equity 4,000

Additional information follows:

1. Historical sales for the last five years (in thousand pesos).

YEAR SALES
20X0 4,116
20X1 5,068
20X2 4,944
20X3 5,700
20X4 6,000
20X5 6,600 (projected*)
2. Assets and spontaneous liabilities will increase by 10%.
3. Ordinary shares outstanding, 50,000.
4. Ordinary shares dividends are projected at ₱2.5 per share.
5. Market value per share at the end of 20x2 is ₱46.67.

REQUIRED:
1. Construct the pro forma financial statements using the projected financial statement
method. How much additional capital will be required? Assume the firm operated at
full capacity in year 20x4. Do not include financing feedback.
SOLUTION:
Based on the data and assumptions given, the following projections are made and the
additional financing needed determined.

Figure 2-1

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 Projected Income Statement (First Pass)
(Thousands of Pesos)
20x4 20x5 Forecast
Actual Basis First Pass
Sales 6,000 x110% 6,600
Operating Cost (inclusive of 200 depreciation) (5,432) x110% (5,975)
Earnings before interest and taxes 568 x110% 625
Less: interest expense (176) (176)
Earnings before taxes 392 449
Taxes (40%) (157) (180)
Net income before preference dividend 235 269
Dividend to preference (8) (8)
Net income available to ordinary 227 261
Dividend to ordinary 114 125
Addition to retained earnings 136

Figure 2-2.

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 Projected Statement of Financial Position (First Pass)
(Thousands of Pesos)
20x4 20x5 Forecast
Actual Basis First Pass
ASSETS
Cash 20 x110 % 22
Accounts receivable 750 x110 % 825
Inventory 1,230 x110 % 1,353
Current Assets 2,000 2,200
Net plant and equipment 2,000 x110 % 2,200
Total Assets 4,000 4,400

LIABILITIES AND EQUITY

Accounts payable 120 x110 % 132
Notes payable 220 220
Acrrued Taxes 280 x110 % 308
Total Current Liabilities 620 660
Long-term bonds 1,508 1,508
Total liabilities 2,128 2,168

Preferences shares 80 80
Ordinary shares (50,000 shares) 260 260
Retained earnings 1,532 ₊136 1,668
Total Equity 1,872 2,008
Total Liabilities and Equity 4,000 4,176
Additional funds needed (AFN) 224
Cumulative AFN 224

DISCUSSION:
Figure 2-1 shows Leo Company actual 20x4 and forecasted 20x5 income statement. For
year 20x5 earnings before interest and taxes are projected at 625,000 and earnings after
taxes of 629,000. Dividends to preferences shares and ordinary shares are projected at
8,000 and 125,000, respectively.
Figure 2-2 contains Leo Company 20x4 actual and its projected 20x5 statement of position.
Total assets are projected 4,400,000 while the forecasted liability and equity accounts total to
only 4,176,000. Since the resources or assets required to support the higher sales level
exceed the available resources, it means that additional funds will have to be obtained. The
AFN of 224,000 will be raised by borrowing from the bank as notes payable or by issuing
long-term bonds or by selling new ordinary shares, or by some combination of these actions.
II.Assume that after considering all the relevant factors, Leo decided on the following funds
financing mix to raise the AFN of 224,000.
Percent Amount Interest Rate
Notes Payable 25% 56,000 8%
Long-term Debt 25% 56,000 10%
Ordinary shares* 50% 112,000 -
Total 100% 224,000
*2400shares

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REQUIRED:
Construct the pro-forma income statement and statement of financial position to
incorporate the financing feedback which results from adopting the financing mix given
above.
SOLUTION:
Figure 2-3

Projected Income Statement (Second Pass)

For 20x5
(Thousands of Pesos)
20x4 20x5 Forecast
Actual First Pass Feedback Second Pass
Sales 6,000 6,600 6,600
Operating Cost (inclusive of 200 depreciation) (5,432) (5,975) (5,975)
Earnings before interest and taxes 568 625 625
Less: interest expense (176) (176) ⁺10 (186)
Earnings before taxes 392 449 439
Taxes (40%) (157) (180) ⁻4 (176)
Net income before preference dividend 235 269 263
Dividend to preference (8) (8) (8)
Net income available to ordinary 227 261 255
Dividend to ordinary 114 125 ⁺6 131
Additional to retained earnings 136 124

Figure 2-4
Projected Statement of Financial Position (Second Pass)
(Thousands of Pesos)
20x4 20x5 Forecast
Actual First Pass Feedback Second Pass
ASSETS
Cash 20 22 22
Accounts receivable 750 825 825
Inventory 1,230 1,353 1,353
Current Assets 2,000 2,200 2,200
Net plant and equipment 2,000 2,200 2,200
Total Assets 4,000 4,400 4,400

LIABILITIES AND EQUITY

Accounts payable 120 132 132
Notes payable 220 220 ⁺ 56 276
Acrrued Taxes 280 308 308
Total Current Liabilities 620 660 716
Long-term bonds 1,508 1,508 ⁺56 1,564
Total liabilities 2,128 2,168 2,280

Preferences shares 80 80 80
Ordinary shares (50,000 shares) 260 260 ⁺ 112 372
Retained earnings 1,532 1,668 1,656
Total Equity 1,872 2,008 2,108
Total Liabilities and Equity Before AFN 4,000 4,176 4,388

Additional funds needed (AFN) 12

Total Liabilities and Equity 4,400
Cumulative AFN 236

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 In figure 2-4 the second pass 20x5 Statement of Financial Position shows that a
shortfall of 12,000 will still exist as a result of financing feedback effects due to the additional
interest (net of taxes) and dividend payments that reduced the projected retained earnings.
This amount raises the cumulative AFN from 224,000 to 236,000.
If additional iterations are done (i.e. 3rd, 4th, 5th, etc.), the additional financing needed
would become smaller and smaller until the forecast would be considered to be completed.
Making a spreadsheet using Lotus 1-2-3 or other program can facilitate the iteration process
and arrive at the final forecast.
ANALYSIS OF THE FORECAST
Next year’s forecast as developed above is only the first part of total forecasting
process. Forecasting is an iterative process, both in the way the financial statements are
generated and in that way the financial plan is developed. For planning purposes, the
consultant or financial staff develops a preliminary forecast based on a combination of past
policies and trends. This will serve as a starting point or “baseline” forecast. The model is
then modified to see what effects alternative operating plans would have on the firm’s
earnings and financial condition. Likewise, alternative operating plans are examined under
different sales growth rate scenarios and linked to the firm’s dividend policy and capital
structure decisions. The revised forecast or model can also be used to analyze alternative
working capital policies.

Name: _____________________________Course Code/ Course Title_____________

Major/Year Level:__________________ Date:______________Score:_____________

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Instructor: John Albert A. Alzate

Exercise 2.1
Directions: Answer the following questions on the space provided.
1. What are the main purpose of financial planning and control?
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2. Why do you think most long-term financial planning begins with sales forecasts? Put
differently, why are future sales the key input?
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3. Certain liability and net worth items generally increase spontaneously with increases
in sales. Put a cross (x) by those items that typically increase spontaneously.

Accounts Payable __________

Notes Payable to banks __________
Accrued wages __________
Accrued taxes __________
Mortgage bonds __________
Common Stocks __________
Retained Earnings __________

4. Assume that an average firm in the office supply business has a 6 percent after-tax
profit margin, a 40 percent debt/assets ratio, a total assets turnover of 2 times, and a
dividend payout ratio of 40 percent. Is it true that if such a firm is to have any sales
growth, it will be forced either to borrow or sell common stock?
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Name: _____________________________Course Code/ Course Title_____________

Major/Year Level:__________________ Date:______________Score:_____________

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Instructor: John Albert A. Alzate

Exercise 2.2
Problem Solving
Directions: Read the following problems and answer on the space provided on what is being
required.
Problem 1 (Pro Forma Statements)
Consider the following simplified financial statements for the Philip Corporation assuming no
income taxes.
Income Statement Statement of Financial Position
Sales ₱23,000 Asset 15,800 Debt 5,200
Costs 16,700 Equity 10,600
Net income 6,300 Total 15,800 Total 15,800

Philips has predicted a sales increase of 15 percent. It has predicted that every item
on the statement of financial position will increase by 15 percent as well. Create the pro
forma statements and reconcile them. What is the additional financing needed here?
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Problem 2 (Calculating the Retained Earnings from Pro Forma Income)

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Consider the following income statement for JL Corporation.

JL CORPORATION
Income Statement

Sales ₱ 38,000
Costs (18,400)
Taxable income 19,600
Taxes (34%) (6,664)
Net income ₱ 12,936
Dividends 5,200
Additional to retained earnings 7,736

A 20 percent growth rate in sales is projected. Prepare a pro forma income statement
assuming cost vary with sales and the dividend payout is constant. What is the projected
additional to retained earnings?
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