CHAPTER TWO

FINANCIAL ANALYSIS AND PLANNING (FORECASTING)

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Chapter objectives

After completing this unit, students will be able to:

 Discuss the concept and objectives of Financial Analysis.
 Explain the stages of Financial Analysis and Interpretation
 Identify the various Approaches or techniques of Financial Analysis
 Identify the types of Financial Ratios
 Discuss the limitations of Financial Ratios
 Explain the meaning and purpose of Financial Forecasting

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Meaning and Objectives of Financial
Analysis
Financial analysis: refers to analysis of financial statements and it is a process of
evaluating the relationships among component parts of financial statements.
The analysis of financial statements is designed to reveal the relative strengths and
weakness of a firm.
It helps users to obtain a better understanding of the firm’s financial conditions and
performance.
Financial statements should provide information useful to both investors and creditors in
making credit, investment, and other business decisions.

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Meaning of Financial Statements

According to Hamptors John, the financial statement is an organized collection of data according to
logical and consistent accounting procedures.
 Its purpose is to convey an understanding of financial aspects of a business firm.
 It may show a position at a moment of time as in the case of a balance-sheet or may reveal a service of
activities over a given period of time, as in the case of an income statement.
John N. Nyer also defines it “Financial statements provide a summary of the accounting of a business
enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain date and the income
statement showing the results of operations during a certain period”.

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Meaning of Financial Statements

Financial statements generally consist of two important statements:

 The Income Statement or Profit and loss account.
 Balance Sheet or the Position Statement.
Income Statement: is also called as profit and loss account, which reflects the operational position of the
firm during a particular period. Normally it consists of one accounting year. It determines the entire
operational performance of the concern like total revenue generated and expenses incurred for earning that
revenue.
Position Statement: is also called as balance sheet, which reflects the financial position of the firm at the
end of the financial year. Position statement helps to ascertain and understand the total assets, liabilities and
capital of the firm. One can understand the strength and weakness of the concern with the help of the
position statement
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The Need for Financial Statement Analysis

Financial statement analysis is needed for the following grounds:

 It is used to measure the relative strengths and weakness of a firm.
 It helps users obtain a better understanding of the firm’s financial conditions and performance.
 Used to make comparative analysis across time in terms of:
 Intra-company basis (within the company itself)
 Intercompany basis (between companies)
 Industry Averages (against that particular industry’s averages)
 It provides information about the organisation’s:
 Past performance
 Present condition
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Approaches or Tools/techniques of Financial
Analysis
Among the number of methods, the following are the common methods or techniques, which are widely used
by the business concern:
1) Comparative Statement Analysis: Comparative statement analysis is an analysis of financial statement at
different period of time. Comparative financial statements again classified into two major parts:
A. Comparative Position Statement Analysis: Under this analysis the balance sheets are compared with
previous year’s figures or one-year balance sheet figures are compared with other years.
B. Comparative Income Statement Analysis: Under this analysis, only profit and loss account is taken to
compare with previous year’s figure or compare within the statement.

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Approaches or Tools/techniques of Financial
Analysis
2) Ratio Analysis: is a commonly used tool of financial statement analysis.
 Ratio is a mathematical relationship between one number to another number.
 Ratio is used as an index for evaluating the financial performance of the business concern. An
accounting ratio shows the mathematical relationship between two figures, which have meaningful
relation with each other. Ratio can be classified into various types. (we will see them later)
3) Common Size Analysis – expresses individual financial statement accounts as a percentage of a base
amount.
 A common size status expresses each item in the balance sheet as a percentage of total assets and each
item of the income statement as a percentage of total sales.

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Stages in Financial Analysis

Financial analysis consists of the following three major stages.

I. Preparation: The preparatory steps include establishing the objectives of the analysis and assembling
the financial statements and other pertinent financial data. So, preparation is simply objective setting
and data collection.
II. Computation: This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial statement
analysis programs can be applied.
III. Evaluation and Interpretation: Involves the determination of the meaningfulness of the analysis and to
develop conclusions, inferences, and recommendations about the firm’s performance and financial
condition.

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Types of Financial Ratios

There are several key ratios that reveal about the financial strengths and weaknesses of a firm.
 We will look at Five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.
1. Liquidity Ratios
2. Asset Management Ratios (Activity Ratios)
3. Debt Management Ratios (Long-term solvency or Leverage Ratios)
4. Profitability Ratios
5. Marketability Ratios

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Liquidity Ratios

 Liquidity refers to the speed and ease with which an asset can be converted to cash. Liquidity ratios
measure the ability of a firm to meet its immediate obligations and reflect the short–term financial
strength or solvency of a firm. In other words, liquidity ratios measure a firm’s ability to pay its current
liabilities as they mature by using current assets.
 Liquidity actually has two dimensions: ease of conversion Vs loss of value

 There are two commonly used liquidity ratios: the current ratio and the quick ratio.
Example: The following financial statements pertain to Zebra Share Company for the years 2017 & 18.
We will perform the necessary ratio analysis using them, and then evaluate and interpret each analysis.

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Liquidity Ratios

1. Current ratio – measures the ability of a firm to satisfy or cover/meet the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities.

Zebra’s current ratio (for 2018) = = 1.51 times

 Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current liabilities.
 High current ratio: the firm is liquid and in good position to meet its current obligations.
 Low current ratio: the firm may not be able to easily meet its current obligations. Too low is dangerous
 A very high current ratio: However may indicate excessive inventories and accounts receivable.

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Liquidity Ratios

2. Quick ratio (Acid – test ratio) - measures the short-term liquidity by removing the least liquid current
assets such as inventories. Inventories are removed because they are not readily or easily convertible into
cash.

Zebra’s quick ratio (for 2018) = (Br. 57,600 – Br. 24,900) ÷ Br. 38,100 = 0.86 times
 Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current liabilities.
 Like the current ratio, the higher the quick ratio the more liquid the firm’s position. Too low is dangerous
 But the quick ratio is more detailed and penetrating test of a firm’s liquidity position as it considers only the quick
asset.
 The current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into account all
current assets without distinction.
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Asset Management Ratios (Activity Ratios)

 Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios include
turnover ratios because they show how rapidly assets are being converted (turned over) into sales or
cost of goods sold. Activity ratios are also called asset management ratios, or asset utilization ratios, or
efficiency ratios.
 Generally, high turnover ratios are associated with good asset management and low turnover ratios
with poor asset management.
 There are five commonly used activity ratios: Accounts Receivable Turnover, Days sales Outstanding
(DSO), Inventory Turnover, Fixed Assets Turnover and Total Assets Turnover.

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Asset Management Ratios (Activity Ratios)
1. Accounts Receivable Turnover – measures how efficiently a firm’s accounts receivable is being
managed. It indicates how many times or how rapidly accounts receivable are converted into cash
during a year.

Zebra’s accounts receivable turnover (for 2018) = = 9.48 times

 Interpretation: Zebra’s accounts receivable gets converted into cash 9.48 times a year.
 In general, a reasonably higher accounts receivable turnover ratio is preferable.
 A ratio substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or inadequate cash collection
efforts.

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Asset Management Ratios (Activity Ratios)
2. Days sales outstanding (DSO): also called average collection period. It seeks to measure the average
number of days it takes for a firm to collect its accounts receivable. In other words, it indicates how many
days a firm’s sales are outstanding in accounts receivable.
DSO = 365/Accounts receivable turnover or
DSO = Receivables/Average sales per day = Receivables/ (Annual sales/365)
Zebra’s days sales outstanding = = 39 days
 Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days.
 If Zebra’s credit period is more than 39 days, some corrective actions should be taken to improve the
collection period.
 Generally, a reasonably short-collection period is preferable.

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Asset Management Ratios (Activity Ratios)
3. Inventory turnover: measures how many times per year the inventory level is sold (turned over).

For Zebra Company (2018) = = 6.41 times

 Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
 If cost of goods sold data is not available, we can apply sales (196,200).
 As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more
efficiently we are managing inventory.
 Abnormally high turnover indicates very low inventory (stock out) & low inventory turnover indicates
excessive inventory levels, presence of inferior quality, damaged or obsolete inventory, or unexpectedly low
volume of sales

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Asset Management Ratios (Activity Ratios)
4. Fixed assets turnover: measures how efficiently a firm uses its fixed assets. It shows how many birrs
of sales are generated from one birr of fixed assets.
Fixed assets turnover = Net sales ÷ Net fixed assets
Zebra’s fixed assets turnover = Br. 196,200 ÷ Br. 96,300 = 2.04 times
 Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.
 A fixed assets turnover ratio substantially lower than other similar firms indicates underutilization
of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low sales levels. Suggests
possibility of increasing outputs without additional investment in FA.
 May be deceptively low or high since it is affected by cost of assets, time elapsed since their
acquisition, or method of depreciation used.

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Asset Management Ratios (Activity Ratios)

5. Total assets turnover: indicates the amount of net sales generated from each birr of total tangible
assets. It is a measure of the firm’s management efficiency in managing its assets.
Total assets turnover = Net Sales ÷ Total assets
Zebra’s total assets turnover = Br. 196,200 ÷ Br. 153, 900 = 1.27 times
 Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested
in total assets.
 A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.

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Debt Management Ratios (Long-term
Solvency or Leverage Ratios)
 Leverage ratios are also called debt management or utilization ratios. They measure the extent to
which a firm is financed with debt, or the firm’s ability to generate sufficient income to meet its debt
obligations.
 While there are many leverage ratios, we will look at only the following three: Debt to total assets
(Debt) Ratio, Times – interest earned, and Fixed charges coverage.
1. Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.
Zebra’s debt ratio = = 64%
Interpretation: At the end of 2018, 64% of Zebra’s total assets was financed by debt and 36% (100% -
64%) was financed by equity sources.
 A high debt ratio implies a firm has liberally used debt sources to finance its assets which means higher
risk.
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Debt Management Ratios (Long-term
Solvency or Leverage Ratios)
2. Times – interest earned - measures a firm’s ability to pay its interest obligations. Categorized under
coverage ratios which is to satisfy fixed financing obligations.

Zebra’s times interest earned = = 3.5 times

 Interpretation: Zebra has operating income 3.5 times greater than its interest expense.
 Generally, The greater the interest coverage ratio, the better able the firm is to pay its interest expenses.
 However, there are other costs that do not arise from debt but which are addressed by fixed charges
coverage ratio.

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Debt Management Ratios (Long-term
Solvency or Leverage Ratios)
3. Fixed charges coverage – measures the ability of a firm to meet all fixed obligations rather than
interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.

Zebra’s fixed charge coverage = = 3.37 times

 Interpretation: The fixed charges (interest and lease payments) of Zebra Share Company are safely
covered 3.37 times.
 Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.

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Profitability Ratios

 Profitability ratios: These ratios measure the earning power of a firm with respect to given level of
sales, total assets, and owner’s equity. It shows the combined effects of liquidity, asset management, and debt on
operating results.
 There are three commonly used Profitability ratios: Profit Margin, Return on investment (assets), and
Return on Equity.
1. Profit Margin – shows the percentage of each birr of net sales remaining after deducting all expenses.

Zebra’s profit margin = Br. 3,900 ÷ Br. 196,200 = 0.02 or 2%

Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
 The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as well as the
amount of all costs and expenses of a firm.
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Profitability Ratios

2. Return on investment (assets) – measures how profitably a firm has used its investment in total
assets.

Zebra’s return on investment = Br. 3,900 ÷ Br. 153,900 = 0.0253 or 2.53 %

 Interpretation: Zebra earned more than 2 cents of profits for each birr it invested on assets.
 Generally, a high return on investment is sought by firms. This can be achieved by increasing sales
levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently utilizing assets.

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Profitability Ratios

3. Return on equity – indicates the rate of return earned by a firm’s stockholders on investments made
by them.
or

Zebra’s return on equity = Br. 3,900 ÷ Br. 55,800 = 6.99%

 Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity.
 Stockholders invest to get a return on their money, and this ratio tells how well they are doing in an
accounting sense.
 Generally, the higher the return on equity, the better offs the owners. Sometimes it may be due to the
company’s greater use of debt.

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Marketability Ratios (Market Value Ratios)

 Marketability ratios A final group of ratios, the market value ratios, relates the firm’s stock price to its
earnings, cash flow, and book value per share.
 These ratios give management an indication of what investors think of the company’s past performance
and future prospects.
 If the liquidity, asset management, debt management, and profitability ratios all look good, then the
market value ratios will be high, and the stock price will probably be as high as can be expected .
 There are three commonly used marketability ratios: Earnings per share (EPS), Dividends Per Share
(DPS), and Dividend pay-out (pay-out) ratio.

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Marketability Ratios (Market Value Ratios)

1. Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common stock
outstanding. It shows how much investors are willing to pay per dollar of reported profits. It does not
reflect how much is paid as dividends.

Zebra’s Earning per share (EPS for 2018) = = Br. 1.09

Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2018.
 In general, higher for firms with strong growth prospects, other things held constant. But they are lower for
riskier firms.

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Marketability Ratios (Market Value Ratios)

2. Dividends per share (DPS) – represents the amount of cash dividends a firm paid on each share of its
common stock outstanding.

Zebra’s Dividends per share (DPS for 2018) = = Br. 1.00

Interpretation: Zebra distributed Br. 1 per share in dividends in 2018.

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Marketability Ratios (Market Value Ratios)

3. Dividend pay-out (pay-out) ratio – shows the percentage of earnings or Net Income paid to common
stockholders.

Or

Zebra’s Earning per share (EPS for 2018) = = 92%

Interpretation: Zebra paid its common stockholders nearly 92% of its earnings in cash dividends in 2018 .

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Ratios and Standard of Comparisons

A ratio analysis involves a standard of comparison for a useful interpretation of the financial statement. To
address whether a given ratio is high or low, good or bad, a meaningful basis is needed for comparison. A
single ratio in itself does not indicate favorable or unfavorable condition.
 Time series or Past ratio analysis, i.e. ratios calculated from the past financial statements of the same
firm,
 Projected or Proforma ratio analysis, i.e. ratios developed using the projected, or pro forma, financial
statement of the same firm,
 Cross sectional or Competitor’s ratio analysis, i.e. ratios of some selected firms, especially the most
progressive successful competitor, at the same point in time,
 Industry ratio analysis, i.e. ratios of the industry to which the firm belongs.

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Limitations of ratio analysis

1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. Ex. a firm with different
divisions operating in different industries.
3. The financial statements of firms are not always reliable, particularly, when they are not audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. Ex. Stationary
firm

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Financial Forecasting
Introduction
 Financial managers should be able to plan before hand in making investment and
financing decisions.
 So, financial forecasting helps financial managers to predict events before they occur.
This, particularly, is true when they plan to raise funds externally.
 Financial forecasting also forces financial managers to develop financial statements
beforehand.

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Financial Forecasting
Meaning & Purpose

It is generally a planning process which involves forecasting of sales, assets, and

financial requirements. In other words, financial forecasting is a process which
involves:
 Evaluation of a firm’s need for increased or reduced productive capacity and
 Evaluation of the firm’s need for additional finance.
Their bases, in almost all circumstances, are forecasted financial statements.
These financial statements are called Pro forma financial statements.

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Financial Forecasting
Meaning & Purpose

An accurate financial forecast is very important to any firm in several aspects:

 It helps a firm to predict appropriate demand for its products.
 It helps a firm to project its sales and accordingly to predict its assets properly.
 It contributes significantly to the firm’s profitability.
 It plays a crucial role in the value maximization goal of a firm.
So, all in all, financial forecasting is a pre- requirement for the investment, financing, as
well as dividend policy decisions of a firm.

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Procedures in Financial Forecasting

The financial forecasting process generally involves the following procedures:

1. Forecasting of sales for the future period.
2. Determining the assets required to meet the sales targets, and
3. Deciding on how to finance the required assets.

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Procedures in Financial Forecasting
Sales Forecast:
This procedure starts usually by reviewing the sales of the recent pasts.
So, in forecasting sales, several factors should be considered:
 The historical sales growth pattern of the firm at both divisional and corporate levels,
 The level of economic activity in each of the firm’s marketing areas,
 The firm’s probable market share,
 The effect of inflation on the firm’s future pricing of products,
 The effect of advertising campaigns, cash and trade discounts, credit terms, and other similar factors
alike on future sales,
 Individual products’ sales forecasts at each divisional level.
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Procedures in Financial Forecasting

Sales Forecast:
 Forecast of sales is a base for forecasting of the firm’s income statement which in
turn helps to project retained earnings.
 They are also grounds for determination of the firm’s assets requirement. i.e. If sales
are to increase, then assets (cash, receivables, Inventories & Plant/equip.) must also
grow depending on whether the firm was operating at full capacity or not.
 Finally, the firm will face the question of financing its required assets.

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Procedures in Financial Forecasting

Sales Forecast:
The third procedure of the financial forecasting process involves again three sub procedures. These are:
1. Determining how much money (finance) the firm will need during the forecasted period.
2. Determining how much of the total required finance, the firm will be able to generate internally. They
are of two types: Retained earning & Spontaneous finance (A/P, salaries & wages payable & income
tax payable)
3. Determining the additional external financial requirements. They are called additional funds
needed (AFN)

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Methods of forecasting Financial Req’ts

There are two methods to determine the additional financial requirements. These are:
1. The proforma financial statements method and
2. The formula method
The pro-forma (Projected) financial statements method: is simply a method of forecasting financial
requirements based on forecasted financial statements.
 Under this method, the asset requirements are first projected for the fore coming future period.
 Then, the liabilities and equity that will be generated under normal operations are projected.
 Finally, the additional funds needed will be estimated.

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Methods of forecasting Financial Req’ts
The pro-forma financial statements method of determining additional financial requirements involves the
following steps:
1. Developing the Pro Forma Income statement
 Sales CGS Other expenses Net Income Finally, based on the amount
of dividends, the amount of addition to retained earnings should be determined.
2. Constructing the Pro Forma Balance Sheet
 Those balance sheet items that are expected to increase directly with sales are forecasted the
spontaneously increasing liabilities are forecasted the liability and equity items that are
not directly affected by sales are set the value of retained earnings for the forecasted
period is obtained Finally, the AFN will be raised

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Pro-forma financial statements method
Example, Blue Nile S.C is a medium sized firm engaged in manufacturing of various household utensils.
The financial manager is preparing the financial forecast of the following year. At the end of the year just
completed, the condensed balance sheet of the company has contained the following items.

Assets Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000
A/receivable -----------------------70,000 Accruals --------------------------------40,000
Inventories -----------------------150,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
_________ Retained earnings --------------------150,000
Total assets ------------------Br. 600,000 Total liabilities and equity ------Br. 600,000
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Pro-forma financial statements method
 During the year just completed, the firm had sales of Br. 1,800,000. In the following year, due to
increased demand to the firm’s products the financial manger estimates that sales will grow at 10%.
 There are no preferred stocks outstanding during the year. The firm’s dividend pay-out ratio is 60%. It
is also known that the firm’s assets have been operating at full capacity.
 During the same year, Blue Nile’s operating costs were Br. 1,620,000 and are estimated to increase
proportionately with sales.
 Assume the company’s interest expense will be Br. 40,000 during the next year and its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile S.C for the next year using the
proforma financial statements method.

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Solution
Pro Forma Income Statement
______________________________________________________________________________
Sales (Br. 1,800,000 x 1.10) -------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) -----------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) -----------------------------------------------Br. 198,000
Interest expense ------------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) ---------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) -----------------------------------------------------------------------63,200
Net income -------------------------------------------------------------------------------------Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) -----------------------------------------Br. 56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) --------------------------------Br. 37,920

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Solution
Pro Forma Balance Sheet
______________________________________________________________________________
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) -------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) --- Br. 99,000
A./receivable (Br. 70,000 x 1.10) -------77,000 Accruals (Br. 40,000 x 1.10) --------- 44,000
Inventories (Br. 150,000 x 1.10) -------165,000 Current liabilities ----------------- Br. 143,000
Current assets ----------------------- Br. 253,000 LT debt (the increase is unknown) ------ 200,000
Net fixed assets (Br. 370,000 x 1.10) -407,000 Common stock (as long-term debt) -120,000
Retained earnings (150,000 + 37,920) --187,920
Total assets ----------Br. 660,000 Total liabilities and equity -------------Br. 650,920

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Solution
 Blue Nile’s forecasted total assets as shown above are Br. 660,000. However, the forecasted total
liabilities and equity amount to only Br. 650,920.
 Since the balance sheet must balance, i.e. A = L + OE, the difference must be covered by additional
funds.
 Therefore, AFN = Br. 660,000 – Br. 650,920 = Br. 9,080 or
AFN = Increase in Assets - Increase in normally generated funds
= [Br. 660,000 – Br. 600,000] – [(Br. 99,000 – Br. 90,000) + (Br. 44,000 – Br. 40,000) + Br. 37,920]
= Br. 60,000 – Br. 50,920
= Br. 9,080

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The Formula Method
 This is a much easier method of determining additional financial requirements than the pro forma
method. The formula method is a shortcut to financial forecasting.
Under the shortcut method, we make the following assumptions:
 Each asset maintains a direct proportionate relationship with sales
 Accounts payable and accruals increase in direct proportion to sales increase.
 The profit margin and the dividend pay-out ratios are constant.
The formula that can be used as a shortcut to determine external capital requirements is given as:
Additional Required Spontaneous Increase in
Funds = increase – increase in – retained
Needed in assets liabilities earnings
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The Formula Method
AFN = (A/S) S – (L/S) S – MS1 (1 – d)

Where
AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S1 – S0 = S0 x g

S1 = Total Sales projected for the next period = S0 (1+g)

S0 = Total sales of the current period

L/S = Percentage relationship of variable liabilities to sales
M = Net profit margin
d = Dividend payout ratio 12/23/2022
g = The expected sales growth rate
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The Formula Method

 To illustrate the formula method, assume that Blue Nile’s net profit margin is 5%.
AFN = (Br. 180,000) - (Br. 180,000) - 5% x Br 1,980,000** (1 – 60%)
= Br. 60,000 – Br. 13,000 – Br. 39,600
= Br. 7,400
 To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must increase its assets by
60,000. In other words, the firm will require a Br. 60,000 more fund for the forecasted year.
 Out of this, Br. 13,000 will come from spontaneous increase in liabilities. Another Br. 39,600 will be
obtained from retained earnings.
 The remaining Br. 7,400 must be raised from external sources like by issuing new shares of stocks or by
borrowing.

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Factors that affect additional financial
requirements
 Financial Planning: At low growth rates of a sale, a firm needs small or no external financing. The
firm might even generate surplus funds at low growth rates. As the growth rates increase, the AFN will
also increase.
 Capital Intensity: Generally, firms with higher capital intensity ratios are with greater capital
requirements. Highly capital-intensive firms generally require more external funds than labor intensive
firms.
 Profit Margin: Profit margin is the net income per each birr of net sales. It is evident from the very
formula of computing AFN that external capital requirements and net profit margin are related in
opposite directions
 Dividends policy: Dividend policy refers to the percentage of a firm’s net earnings paid out as cash
dividends. The higher the dividend payout ratio, the smaller the addition to retrained earnings, and
hence the greater the requirements for external finance.
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Excess capacity and additional financial
requirements
 Previously, when we were dealing with Blue Nile’s financial forecast, our assumption
had been that assets were operating at full capacity (100% capacity).
 Now let’s relax this assumption that excess capacity exists in the firm’s fixed assets.
 In fact, theoretically excess capacity exists with all types of assets. But as a practical
matter, excess capacity normally exists primarily with respect to fixed assets.
 Assume that Blue Nile was operating at only 98% of its fixed asset capacity. How
does this affect the firm’s AFN? Some procedures are involved to see the effect.

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Excess capacity and additional financial
requirements
1. Determine the full capacity sales, i.e., sales that could have been produced had fixed assets been
utilized 100%.
 Full capacity sales = Actual sales/Percentage of capacity at which fixed assets were operated
= Br. 1,800,000/98% = Br. 1,836,735
2. Determine the target fixed assets/sales ratio
 Target fixed assets/sales ratio = Actual fixed assets/Full capacity sales
= Br. 370,000/Br. 1,836,735 = 20%
3. Determine the new required level of fixed assets
 Required level of fixed assets = (Target fixed assets/sales ratio) X (Projected sales)
= 20% X Br. 1,980,000 = Br. 396,000
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Conclusion

 Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as sales
or by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br. 407,000. Now
we see that the actual required increase is only from Br. 370,000 to Br. 396,000.
 Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,000 – Br. 396,000) less than the
earlier forecast.
 Therefore, the projected AFN would decline from an estimated Br. 9,080 to Br. -1,920
(Br. 9,080 – Br. 11,000).
 The negative AFN indicates the firm would even produce excess funds of Br. 1,920 than it
requires.

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