Chapter 2

Financial Analysis &

Financial Planning
 Meaning of Financial Analysis
Financial analysis is a process of:
►Selecting, evaluating, and
►interpreting financial data, along with other
pertinent/relevant information,
►in order to formulate an assessment of a company’s present
and future financial condition and performance.

2
 Importance of F/Statement
Analysis
►To obtain a better understanding of the
firm's financial condition and performance.
► The focus is on key figures in the financial statements and the
significant relation ships that exist between them.
►Itserve as a basis for financial decision
making.
►It helps identify a firm’s strengths and
Weaknesses
►In general, it help in measuring
achievement of organization’s objectives
 Steps in Financial Analysis
1. Set objectives of the analysis
Objective depends on the need of the user. For example:
 Shareholders are interested in the firm’s current and future level of
risk and return.
 Creditors are primarily concerned with the short term liquidity of the
firm and the firm’s profitability.
 Management uses financial analysis for planning and controlling
decisions.
2. Gather Relevant Data
 Financial statements for at least 3 to 5 years.
 Balance sheets
 Income statements
 Economic and industry data.
 Steps in Financial Analysis…
3.Select and apply appropriate tools and
techniques to gain a basic understanding of the
firm’s financial status and performance.
 Techniques in analyzing financial statements
include:
Ratio analysis,
Common size /vertical analysis
Trend /Horizontal Analysis
4. Evaluation and interpretation
 Techniques of Financial Analysis
 There are three ways of financial analysis:

1.Horizontal analysis /trend analysis

►Horizontal analysis uses the amounts in accounts in a
specified year as the base, and subsequent years’ amounts
are stated as a percentage of the base value/year.
►Useful when comparing growth of different
accounts over time.
►Compare financial statement of a firm for different
accounting periods.
►Indicate the direction of change (progressing/regressing)
and reflects whether the firm's financial performance has improved , deteriorated or
remained constant over time.
 Example: Horizontal/Trend Analysis
(base year is 2008):
Year 2008 2009 2010 2011 2012 2013

Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%

Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%

Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%

Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%

Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%

Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

Graphically:

8
 2. Vertical /common size
Analysis
►Significant item on a financial statement is
used as a base value and other all items are
compared to it.
►Enable to highlight relationship b/n
components of financial statements
►Enable to disclose the internal structure of
an enterprise
 Common-Size Analysis
restatement of financial
Common-size analysis is the
statement information in a standardized form.
► Vertical common-size analysis uses the aggregate value in a financial
statement for a given year as the base, and each account’s amount is
restated as a percentage of the aggregate.
►Balance sheet: Aggregate amount is total
assets.
►Income statement: Aggregate amount is
revenues or sales.

10
 Example: Common-size analysis
Consider the CS Company, which reports the following financial
information:

Year 2008 2009 2010 2011 2012 2013

Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40

Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65

Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57

Net plant and
equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29

Intangibles 400.00 402.00 404.01 406.03 408.06 410.10

Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

Create the vertical common-size analysis for the CS Company’s assets.

11
 Example: Common-size analysis
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%

12
 C. Ratio analysis
C. Ratio analysis

Standardizes financial data by

converting birr figure into ratios.
►A/B
States mathematical relationship
among several numbers usually in
terms of percentage or times
 Forms of ratio comparisons
1. Cross-sectional analysis/Peer Group Analysis:
 involves comparison of different firm’s financial ratios at the
same point in time.
 A firm’s ratios may be compared to those of the industry leader
or to industry averages.
2. Time series analysis (trend analysis)
 Evaluate a firm’s performance over time.
 Any significant year to year changes can be evaluated to assess whether
they are symptomatic of major problem.
3. Combined analysis (Use Panel Data):
 the most informative approach that combines cross-sectional
and time-series analyses.
4. Management plan : compare the actual ratio against target
 Financial Ratio Analysis
► Financial ratio analysis is the use of relationships among financial statement
accounts to gauge the financial condition and performance of a company.
►We can classify ratios based on the type of information the ratio provides:

16
 Types of Financial Ratios

Liquidity ratios
Asset-management/Activity ratios
Financial-leverage/Debt
Management ratios
Profitability ratios
Market-value ratios
The income statement and balance sheet of Lucy
Construction Company are given below. Calculate financial
ratios for the data provided
Lucy Construction Company
Income Statements
  2009 2008
Net sales $315,000 $259,000
Cost of goods sold -189,000 -154,000

General, selling, and administrative expenses

-54,000 -46,000
EBIT 72,000 59,000
Interest expense -4,000 -4,500
Income before taxes
68,000 54,500
Income tax expense (30%) -20,400 -16,350
Net income 47,600 38,150
 Lucy Construction Company
Statement of Financial Position (Balance sheet)
2009 2008
Cash $6,500 $11,500
Accounts receivable 51,000 49,000
Inventories 155,000 147,500
Total current assets 212,500 208,000
Plant and equipment (net) 187,500 177,000
Total assets 400,000 385,000
Accounts payable 60,000 81,500
Other current liab. 25,000 22,500
Total current liabilities 85,000 104,000
Bonds payable 100,000 100,000
Total liabilities 185,000 204,000
Common stock (1,000 shares) 150,000 150,000
Paid-In capital in excess of par 20,000 20,000
Retained earnings 45,000 11,000
Total stockholders’ equity 215,000 181,000
Total liabilities and stockholders’ equity 400,000 385,000
 1. Liquidity Ratios
 Liquidity refers to how quickly a firm can turn its
assets into cash.
 Liquidity ratios indicate the ability to meet short-term
obligations to creditors as they mature or come due.
Short-term solvency of the firm
 Will the firm be able to pay off its debts as they come
due over the next year or so?
 Two commonly used liquidity ratios are:
 Current ratio
 Quick, or Acid Test, Ratio
 Liquidity
►Liquidity is the ability to satisfy the company’s
short-term obligations using assets that can be
most readily converted into cash.
► Liquidity ratios:

21
 1.1. Current ratio

Rule of thumb: 2 to 1
Discussion Question
What is the implication of having a CR of:
► Higher or
► lower current ratio
 Implications of CR
Too high current ratio indicates that
 too much capital is tied up in current assets and
 Thus, the firm may be sacrificing (opportunity cost) some
returns possibilities, or
 a firm is not making full use of its current borrowing
capacity (short term sources are less expensive than
long term ones.)
 Too low current ratio may suggest that
 a firm may face difficulty in paying its short term
liabilities.
 1.2. Quick, or Acid Test Ratio
9

 It measures a firm’s ability to satisfy the claims

of short term creditors by using quick assets.
 Current assets excluding inventories and prepaid expenses are
usually assumed to be quick assets.

 Rule of thumb: 1 to 1
 Interpretation for CR and QR
►Current and quick ratio:- measures a firm’s ability to
satisfy or cover the claims of short term creditors by using
only current assets.
Interpretation:
 Low ratio-suggests that a firm may face difficulty in
paying its short term obligations.
►Low liquidity ratios can provide indications of impending
bankruptcy.
 High ratio- indicates that too much capital is tied up in
current assets and a firm may be sacrificing some
return.
 2. Asset Management Ratios

 Measure how effectively the firm is managing its

assets.
 indicate the extent to which assets are used to support
sales.
 Also called activity or utilization ratios,
 Ratios that analyze the different types of assets
include:-
 Inventory Turnover Ratio (ITO)
 Inventory Period (Average age of inventory)
 Days sales outstanding (DSO)
 Accounts Receivable Turnover
 The Fixed Assets Turnover Ratio
 The Total Assets Turnover Ratio
 Activity Ratios
► Turnover ratios reflect the number of times assets flow into and out of
the company during the period.
► A turnover is a gauge of the efficiency of putting assets to work. Ratios:

27
 2.1. Inventory Turnover Ratio (ITO)
 Indicates how quickly inventory is sold.
 It measures the efficiency of management in managing sale of
inventory.

Discussion Question
What is the implication of having:
► Higher or
► Lower ratio
 Implication of Inventory
turnover…
 An ITO significantly higher
than the industry average may indicate:
 Superior selling practice,
 Improved liquidity and profitability,
 Fewer cases of damaged or obsolete
inventory,
 Use of just in time (JIT) inventory
management.

Dakito Alemu (PhD), AAUSC

2-
 Inventory turnover…
Potential problems in higher ITO are:
 Lost sales due to insufficient level of inventory,
 Firm’s policy of buying in small quantities & lost
quantity discount,
 production interruptions because of lack of raw
materials (stock-out)

 An ITO significantly lower than the industry average may

indicate;
 Over investment in inventory,
 Inferior quality goods,
 Stock of un-sellable or obsolete inventory,
 Funds locked up in inventory and higher inventory
carrying costs
 2.2. Inventory Period (Average age of inventory)

 also known as Days in Inventory.

 It measures the average number of days the
inventory is in warehouse before sale.

 The shorter the period, the higher the inventory

turnover and the better the performance is.
 The interpretation is the same to that of
inventory turnover ratio except this is in terms of
days.
 2.3. Days sales outstanding (DSO)

 also called the “average collection period” (ACP),

 the average length of time that the firm must wait
after making a credit sale before receiving cash.
 DSO = 365/RTR
 2.4. Accounts Receivable Turnover (ARTO)

 Measures how many times in average credit sales is made and

collected in a year.

 ARTO and DSO ratios are reciprocals of each other.

Discussion Question
What is the implication of having:
►Higher or
►Lower ratio
2.5. Operating Cycle Formulas

34
Operating Cycle Formulas

35
 3. Debt Management Ratios

 Debt management ratios are used to

measure:
 Degree of indebtedness - measures the
extent to which a firm finances itself with
debt
 Ability to service (pay) debts: measures
the ability of the firm to generate a level of
income sufficient to meet its obligations
(fixed charges)
 Solvency Analysis
► Financial risk is the risk resulting
from a company’s choice of how to
finance the business using debt or
equity.
► We use solvency ratios to assess a
company’s financial risk.
► There are two types of solvency
ratios: component percentages and
coverage ratios.
► Component percentages (financial leverage)
involve comparing the elements in the
capital structure.
► Coverage ratios measure the ability to meet
interest and other fixed financing costs.

39
Solvency ratios

40
 3.1. Measures of Degree of indebtedness

a. Debt Ratio (DR)

 The ratio of total liabilities to total assets.

b. Total-debt-to-equity ratio (DE)

 It shows a firm’s total debt in relation to the total dollar amount owners
have invested in the firm.
 3.2. Measures of Ability to service (pay)
debts/Coverage ratios
 Measure a firm’s ability to meet (cover) fixed charge
obligations such as interest on loans, lease payments,
preferred dividend and repayment of the installment
of loans.
a. Times-Interest-Earned Ratio (interest coverage ratio)
 measures a firm’s ability to pay interest on its
debts using operating profits.
3.2. Measures of Ability to service (pay)
debts/Coverage ratios

b) Fixed Charge Coverage Ratio

measures a firm’s ability to pay all fixed
charges using operating profits.
 4. Profitability Ratios

 Measure a firm’s ability to

generate returns on its sales,
assets, and equity.
 Show the combined effects of
liquidity, asset management,
and debt on operating results.
Profitability ratios: Margins

45
 4.1. Measures of Profitability in terms
of Sales

a. Net Profit Margin /profit margin/

► shows after tax profits per dollar of sales.
 Measures of Profitability in terms of
Sales…
b) Gross profit margin
 Measures the trading effectiveness and basic profit
earning potential of a firm.
 It identifies the gross profit per dollar of sales before any
other expenses are deducted.

 Possible causes for change in gross profit margin:

 changes in selling prices;
 changes in buying policies and practices;
 changes inventory valuation methods.
 Return on Capital Employed
►The most important profitability ratio is return on
capital employed (ROCE).
►Return on capital employed = PBIT/Capital employed
►Capital employed = Shareholders' funds
Plus long-term liabilities
► = Total assets less current liabilities
►ROCE has to be > current market
borrowing rates
 4.2. Measures of Profitability in terms of
investment in total Assets
Return on Investment/ROI/
► Measure of profit per dollar of assets invested.
► It relates earnings to assets invested

 Return on assets=Profit Margin X Total Asset Turnover

4.3. Measures of Profitability in terms of owners’
investment (Return on Equity)

Return on Equity (ROE)

 ROE measures the return the firm is earning on the
equity funds invested by its shareholders—the firm’s
owners
 It is the true bottom-line measure of
performance
 ROE …
 Return on equity=Profit Margin X Total Asset Turnover X Equity multiplier

 This says that management has only three levers for controlling ROE;
the earnings pressed out of each dollar of sales,
or the profit margin;
the sales generated from each birr of assets
employed, or the asset turnover; and
the amount of equity used to finance the assets,
or the equity multiplier.
 The DuPont Formulas
► The DuPont formula uses the
relationship among financial
statement accounts to
decompose a return into
components.
► Three-factor DuPont for the return on
equity:
► Total asset turnover
► Financial leverage
► Net profit margin
► Five-factor DuPont for the return on
equity:
► Total asset turnover
► Financial leverage
► Operating profit margin
► Effect of nonoperating items
► Tax effect
53
 Example: The DuPont Formula
Suppose that an analyst has noticed that the return on equity )
(ROE) of the 3F Company has declined from FY2012 to
FY2013.
FY2013 Using the DuPont formula, explain the source of this
decline.
decline
(millions) 2013 2012
Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90

Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000
 Example: the DuPont Formula
2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11

Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42

Effect of non-operating items 0.83 0.82

Tax effect 0.76 0.71
56
 5. Market Value Ratios
 Relate a firm’s stock price to its earnings and
book values.
 indicate the willingness of investors to value
a firm in the marketplace relative to financial
statement values.
 A firm’s profitability, risk, quality of
management, and many other factors are
reflected in its stock prices.
 Market value ratios include:-
 Earning per share (EPS)
 Price/Earnings Ratio
 Market/Book Ratio
 Dividend payout
 5.1. Earnings per share (EPS)

 Earning per share represents the amount earned on

common stock.
 It shows the earnings available to the owners of common
stock.
 it specifically reveals how much amount the company is
earning for every share.

EPS= $47,600/1,000 = $47.60 per share

 5.2. Price/Earnings Ratio

 Shows how much investors are willing to pay per dollar of

reported profits.
 Is higher for firms with strong growth prospects, other
things held constant, but it will be lower for riskier firms.
 Assume the price per share is $250 for Lucy Company :
 5.3. Market/Book Ratio

 It gives another indication of how investors regard

the company.
 Companies with relatively high rates of return on
equity generally sell at higher multiples of book
value
 5.4. Dividend Payout

 Shows the percentage of earnings paid to

shareholders.
 It expresses the cash dividend paid per share (DPS)
as a percentage of EPS
 Limitation of ratio analysis
 For firms operating different divisions in different
industries, it is difficult to develop a meaningful set
industry average.
 Merely attaining average performance is not sufficient.
 Non recognition of inflation in financial statement
makes a ratio analysis difficult
 Firms can employ a “ window dressing” technique to
make their financial statement more stronger
 Group Assignment (25%)
► Name of organizations:
► Sainsbury,
► Tesco, and
► Marks & Spencer
► Financial Statements to be used:
► Statement of Financial Position and
► Statement of Profit or Loss and Other Comprehensive Income
► Scope of the study: Year 2013,14,15 and 2016
► Ratios:
► CR, QR,
► Average settlement period for trade receivables;
► Sales Revenue to Capital Employed (SRCE);
► Return on Shareholders’ fund (ROSF);
► Operating profit margin;
► Gearing Ratio; Interest Coverage Ratio; Earnings per share (EPS); Dividend Payout
Ratio (DPOR);
 Financial
Performance of
Bank
 Capital Adequacy Ratio (CAR)
► CAR is also known as capital-to-risk weighted assets ratio (CRAR)
► Capital adequacy ratios (CARs) are a measure of the amount of a
bank's core capital expressed as a percentage of its 
risk-weighted asset.

► Tier one capital is the capital that is permanently and easily available to reduce
losses suffered by a bank without it being required to stop operating.
► A good example of a bank’s tier one capital is its ordinary share capital and RE
► Tier 2 capital is
capital designated as supplementary capital, and is composed of items such as
► revaluation reserves, undisclosed reserves, hybrid instruments (preferred shares) and
subordinated term debt
►

Dakito Alemu
 Risk Weighted Assets
► Risk weighted assets -mean fund based assets such as cash, loans,
investments and other assets.
► Degrees of credit risk expressed as percentage weights have been
assigned by the national regulator to each such assets.
►Bank "A" has assets totaling 100 Br, consisting of:
► Cash: 10 br
► Government bonds: 15 Br
► Mortgage loans: 20 Br
► Other loans: 50 Br
► Other assets: 5 Br
► Bank "A" has debt of 95 Br, all of which are deposits. By definition, equity
 is equal to assets minus debt, or 5 Br.
►Bank A's risk-weighted assets are calculated as follows
Cash 10*0%=0
Government securities 15*0%=0
Mortgage loans 20*50%=10
Other loans 50*100%=50
Other assets 5*100%=5
Total risk
Weighted assets 65
Equity 5
CAR (Equity/RWA) 7.69%
Even
Eventhough 
though Bank
BankAA would
 wouldappear
appeartotohave
haveaadebt-to-equity
debt-to-equity
ratio
ratioof
of95:5,
95:5,or
orequity-to-assets
equity-to-assetsof
ofonly
only5%,
5%,
its
itsCAR
CARis
issubstantially
substantiallyhigher.
higher.
ItIt isis considered
considered less
less risky
risky because
because some
some of
of its
its assets
assets are
are
less
lessrisky
riskythan
thanothers.
others.10%
10%
 Economic Value Added (EVA)
►EVA measures the net value added by a company
during a period.
►It equals net operating profit after tax minus
average cost of capital employed.

►If EVA is positive, it means the management has

increased the company's total worth.
►If EVA is negative it means that the cost of capital
employed is greater than the profit generated and
this means a decline in value over the period.
 Example:
►Starbuck Company‘s earnings before interest and
taxes for the year 2014 amounted to $5,130
million.
►Applicable tax rate is 30%.
►The company financed 60% of the company's
assets by debt with before tax cost of 6% and
40% is financed by equity with a cost of 9.8%.
►Starbuck’s average total capital employed over
the period amounted to $50,420 million.
►Find the company‘s economic value added.
 FP

Financial Planning
92
 Financial Planning

 Financial planning -the process of estimating

the funds requirement (additional fund
needed (AFN) of a firm and determining the
sources of funds
 It involves
 Forecasting financial statements under
alternative versions
 Allocating financial resources to meet
strategic goals and objectives.
 Intrinsic Value: Financial Forecasting

Forecasting: Forecasting:
Operating Financial policy
assumptions assumptions

Projected
Projected Projected
additional
income balance
financing
statements sheets
needed (AFN)

Weighted average
Free cash flow
cost of capital
(FCF)
(WACC)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
 Financial planning
• The planning process involves :
1. Forecasting financial results (Sales) under alternative
versions of the operating plan
2. Determines the amount of capital (Assets) that will be
needed to support the plan
3. Estimate internal generated funds and determine funds
needed from external sources (EFN)
4. Establishes a performance-based management
compensation system that rewards employees
5. Monitor operations after implementing the plan
 Financial planning…
• If firm’s sales are to increase, then
its asset must also grow.
• When the company operates at full capacity, higher
sales must be supported by
▫ higher asset levels
▫ some of the asset increases can be financed by
spontaneous/unstructured increases in
▫ accounts payable and
▫ accruals and by retained earnings, and
▫ Any short fall must be financed from external
sources,
 Borrowing
 Selling new common or preferred stock
 External Financial/fund Requirement (EFR)

 After forecasting sales,

sales a firm shall determine
 how much new capital (AFN) will be
needed to fund the increased sales
• There are two ways to estimate EFR:
1.Percentage of sales method (AFN
model)
2.Forecasted Financial statement
methods (FFS)
 Additional Fund Needed (AFN) Model
of estimating/calculating EFR
▫ Establish relation between
▫ sales and
▫ balance sheet items that change with sales
▫ Find-out the level of
▫ current asset,
▫ fixed asset,
▫ current liability and
▫ stockholders equity needed to support the forecast sales.
▫ Inputs used in this method are the
▫ previous year and
▫ sale forecast for the next period.

2-
 Steps in computing financial
requirements
1. Express balance sheet items that vary directly with sales
as a percentage of sales
2. Determine the additional investment in assets .
3. Determine additional spontaneous/ financing amount.
4. Compute the internally generated funds (projected
retained earning of the following accounting period).
Projected RE= RE beg+ projected NI - dividend
5. Determine the external fund needed.
EFN/AFN = Additional assets – Internally generated funds –
additional spontaneous financing
 Example
►In 2011, sales for Ethiopian Pulp and Paper were $60
million.
►In 2012, management believes that sales will increase
by 20%, with a continued profit margin expected to
be 5% and dividend payout ratio of 40%.
►No excess capacity exists. Given the following
balance sheet (in millions),
►what is the fund added to retained earning during
2012.
AFN - Problem Ethiopian Pulp and
Paper Co.
►Cash $ 3.0
►A/R 3.0
►Inventory 5.0
►C/Assets $ 11.0
►Fixed Assets 3.0
►Total Assets $ 14.0
 Ethiopian Pulp and Paper

►A/P $ 2.0
►Notes Payable 1.5
►C/Liabs $ 3.5
►L/T Debt 3.0
►Common Equity 7.5
►Total Liabs & Cmn Equity$ 14.0
 Ethiopian Pulp and Paper

►Sales $ 60.0
►X Profit Margin x .05
►= Profit (NI) $ =3.0
►- Div Payout (40%) - 1.2
►= Addts to RE =1.8
 External Financial Requirement (EFR)…

Additional funds needed(AFN) = Required increase in assets –

Spontaneous increase in liabilities – Increase in retained
earnings.
AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

A*/S0: assets required to support sales; called capital intensity ratio.

 ΔS: increase in sales.
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
RR: retention ratio; percent of net income not paid as dividend.
 S0: Actual sales
 S1: Projected sales
 Key Factors in AFN Equation

►Sales growth (g): The higher g is, the larger AFN

will be—other things held constant.
►Capital intensity ratio (A0*/S0): The higher the
capital intensity ratio, the larger AFN will be—
other things held constant.
►Spontaneous-liabilities-to-sales ratio (L0*/S0):
The higher the firm’s spontaneous liabilities, the
smaller AFN will be—other things held constant.

105
 AFN Key Factors (Continued)

►Profit margin (Net income/Sales): The higher

the profit margin, the smaller AFN will be—other
things held constant.
►Payout ratio (DPS/EPS): The lower the payout
ratio, the smaller AFN will be—other things held
constant.

106
 Example for ABC Co. AFN

►Operating at full capacity in 2010.

►So and Ao are 2000 and 1,200 respectively
►Sales are expected to increase by 15% ($300
million).
►Asset-to-sales ratios remain the same.
►Spontaneous-liabilities-to-sales ratio remains
the same, 100.
►2010 profit margin ($24/$2,000 = 1.2% (0.012)
and payout ratio (35%) will be maintained.
107
 Definitions of Variables in AFN

►A0*/S0: Assets required to support sales: called

capital intensity ratio.
►S: Increase in sales.
►L0*/S0: Spontaneous liabilities ratio.
►M: Profit margin (Net income/Sales)
►POR: Payout ratio (Dividends/Net income)

108
ABC’s AFN Using AFN Equation

AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)(1−POR)

AFN = ($1,200/$2,000)($300)
− ($100/$2,000)($300)
− 0.012($2,300)(1 - 0.375)
AFN = $180 − $15 − $17.25
AFN = $147.75 million.
 External Financial Requirement (EFR)…

Implication of AFN
 If AFN is positive, then you must
secure additional financing.
 If AFN is negative, then you have more financing
than is needed.
Pay-off debt.
Buy back stock/Treasury stock.
Pay additional dividend
 Self-Supporting Growth Rate

Self-Supporting growth rate is the maximum growth

rate the firm could achieve if it had no access to
external capital.
M(1 − POR)S
Self-supporting g = 0
______________________________

A0* − L0* − M(1 − POR)S0

(0.012)(1−0.35)($2,000)
g= ______________________________________________

$1,200 − $100 − (.012)(1−0.35)($2,000)

$15.60
g= ____________
= 1.44%
$1,084
111
 Self-Supporting Growth Rate

►If ABC’s sales grow less than 1.44%, the firm will
not need any external capital.
►The firm’s self-supporting growth rate is
influenced by the firm’s capital intensity ratio.
►The more assets the firm requires to achieve a
certain sales level, the lower its sustainable
growth rate will be.

112
 2. Forecasted Financial Statements (FFS)
approach of calculating EFR/AFN

 Project a complete set of financial statements

Forecast each element (account) in the financial
statements
 Too detail and need application of computer
software such as excel
THANK YOU for your Attention!
End of the chapter.

If you have any

question….