FINANCIAL MANAGEMENT

TOPIC

FINANCIAL PLANNING AND ANALYSIS

BY

MARTIN M. MUSAMALI

JUNE 2008

TABLE OF CONTENTS

1.0 FINANCIAL ANALYSIS...................................................................................................................................3

1.1 INTRODUCTION..................................................................................................................................................31.2 DEFINITION........................................................................................................................................................3

2.0 USERS OF FINANCIAL STATEMENTS.......................................................................................................4

3.0 TOOLS OF FINANCIAL ANALYSIS..............................................................................................................5

3.1 RATIO ANALYSIS...............................................................................................................................................53.2 TYPES OF FINANCIAL RATIOS...........................................................................................................................63.4 UTILITY OF RATIO ANALYSIS.........................................................................................................................123.5 LIMITATIONS IN USING RATIO ANALYSIS.......................................................................................................13

4.0 FINANCIAL PLANNING................................................................................................................................14

4.2 STRATEGIC FINANCIAL PLANNING..................................................................................................................144.3 FINANCIAL PLANNING PROCESS......................................................................................................................144.4 FINANCIAL FORECASTING AND MODELLING...................................................................................................154.5 LONG-TERM FINANCIAL PLAN.......................................................................................................................154.6 STEPS IN FINANCIAL PLANNING......................................................................................................................154.7 CONCLUSION...................................................................................................................................................16

REFERENCES...............................................................................................................................................................17

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1.0 FINANCIAL ANALYSIS

1.1 Introduction

Information contained in Financial Statements that is Balance sheet, profit and loss account or income and expenditure etc is usually used by management, creditors, investors, and others to form judgment about the company’s operating performance and financial position. Users of the financial statements can get better insight about the financial strength and weaknesses of the firm if they properly analyze the information reported in these statements.

A company’s management should be interested in knowing the financial strength to make their best use and be able to spot out financial weaknesses of the firm to take suitable corrective actions. The future plans of the firm should be laid down in view of the firm’s financial strength and weaknesses.

Therefore, financial analysis is the starting point for making plans before forecasting and planning procedures. That understanding the past is a prerequisite for anticipating the future.

1.2 Definition

Financial analysis is the process of identifying a firm’s strength and weaknesses by establishing relationships between the items of the Balance sheet and profit and loss account.

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2.0 USERS OF FINANCIAL STATEMENTS

i) Trade creditors

Trade creditors are interested in the firm’s ability to meet their claims over a short period of time. Their analysis will thus be confined to the evaluation of the firm’s liquidity.

ii) Lenders

Suppliers of long term debt are concerned with the firm’s long term solvency and survival. They analyze the firm’s profitability over time, its ability to generate cash for interest and principal payment and the existing relationship between the various sources of funds. As much as they analyze the historical financial statements they also place more emphasis on the firm’s projected financial statements to make analysis about its future solvency.

iii) Investors

Investors who have invested their funds in the firm’s shares are concerned about the firm’s earnings. Those firms that show steady growth in earnings restore the investor’s confidence. They concentrate o the analysis of the firm’s future and present profitability. They are also interested in the firm’s financial structure to the extent that it influences the firm’s earnings ability and risk.

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iv) Management

Management of the firm would be interested in the entire financial analysis. It is their responsibility to see that the firm’s resources are used effectively and efficiently and that its financial position is sound.

3.0 TOOLS OF FINANCIAL ANALYSIS

a) Ratio Analysis

b) Financial Statements and Cash Flow Analysis

3.1 Ratio Analysis

A firm’s strength and weaknesses is established by viewing the relationship between items in the Balance sheet and profit and loss using ratio analysis.

A ratio is defined as the indicated quotient of two mathematical expressions. It can also be described as the relationship between two or more things. It is used as a benchmark for evaluating the financial position and performance of a firm. Absolute accounting figures reported in the firm’s financial statements do not provide any meaningful understanding of performance and the firm’s financial position.

3.1.1 Standards of Comparison

The ratio analysis involves comparison for a useful interpretation of the financial statements. That a single ratio does not indicate either favorable or unfavorable state, rather it should be compared with some standards. Such standards include;

i) Past Ratios- from past financial statements of the same firmii) Industry Ratios- of the industry to which the firm belongsiii) Projected Ratios –Ratios developed using projected financial statements of the same

firm.iv) Competitive Ratios –Ratios of some selected firms especially the most progressive and

successful competitors.

3.1.2 Trend AnalysisEvaluation of performance of a firm is easily done by comparing its current ratios with past ratios. When the financial ratios over a period of time are compared, it is called time series analysis or

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trend analysis. It gives the indication of direction of change and it reflects whether the firm’s performance has improved, deteriorated or remained constant over time. When analyzing, the analyst should not simply determine the change but more importantly understand why ratios have changed. The change may be affected by changes in the accounting policies without material change in the firm’s performance. 3.1.3 Inter-Firm AnalysisComparing ratios of one firm with selected firms in the same industry at the same point in time is also done. This is called cross-sectional Analysis or inter-firm analysis. It is useful to compare the firm’s ratios with ratios of a few carefully selected competitors with similar operations. This kind of a comparison indicates the relative financial position and performance of the firm.

3.1.4 Industry AnalysisTo determine the firm’s financial condition and performance, it is necessary to compare average ratios of the industry to which the firm is a member. This helps to ascertain the financial standing and capability of the firm vis a vis other firms in the industry. Industry ratios are important standards in view of the fact that each industry has its characteristics which influence the financial and operating relationships.

Weaknesses of using industry ratiosa) It becomes difficult to get or establish average ratios for the industryb) The available industry ratios are only averages. The averages of strong and weak firms

may bear wide variances that may be insignificant and could be meaningless.c) Averages will be meaningless and comparison futile if firms within the same industry

widely differ in their accounting policies and practices.

3.1.5 Proforma financial statement analysis

That, future ratios could be used as the standard for comparison. They can be developed from projected or proforma financial statements. The comparisons of the firm’s current and past ratios show its relative strength and weaknesses in the past and in the future. If the future ratios indicate weak financial position, then corrective measures could be initiated.

3.2 Types of Financial Ratios

Ratios can be grouped into the following classes:

a) Liquidity ratios

b) Solvency ratios

c) Turnover ratios

d) Profitability ratios

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e) Equity-related ratios

3.2.1 Liquidity Ratios

Liquidity ratios measure a firm’s ability to meet its current obligations.

a) Current Ratio = {Current Assets/ Current Liabilities}

b) Quick Ratio = {Current Assets – Inventories}/ Current Liabilities

c) Cash Ratio = [Cash + Marketable Securities]/ Current Liabilities

3.3.1 Solvency Ratios

Solvency ratios measure the dependence of a firm on borrowed funds.

a) Debt-Equity Ratio = Debt/Net Worth

b) Debt Ratio = Debt/ Capital Employed

c) Interest Coverage Ratio = IBIT/I

3.2.2 Turnover Ratios

Turnover or activity ratios measure the firm’s efficiency in utilizing its assets.

a) Inventory Turnover = COS/Average (or Closing) inventory

b) Days of inventory holding (DIH) = {Average inventory/COS} x 360

c) Debtor Turnover = Credit Sales/ Average Debtors

d) Collection Period = Average days in year/ Debtors Turnover

3.2.3 Profitability Ratio

Profitability ratios measure a firm’s overall efficiency and effectiveness in generating profit.

a) Gross Profit Margin = PBIT/Net sales

b) Net Profit Margin = PAT/Net Sales

c) Return on Equity (ROE) = PAT/ Net Worth (or Equity)

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3.2.4 Equity-Related Ratios

Equity-related ratios measure the shareholders’ return and value.

a) Earnings Per Share = PAT/Number of ordinary shares

b) Dividend Per Share = Total Dividends/Number of ordinary Shares

c) Payout Ratio = Dividend Per Share/Earnings Per Share

d) Divided Yield = Dividend Per Share/Market Price Share

e) Earnings Yield = Earnings Per Share/Market Price Share

f) Price Earning Ratio = Market Price Share/Earnings Per Share

g) Book Value Per Share = Net worth / Number of ordinary Shares

h) Market to Book Value = Market Value Per Share/Book Value Per Share

I) Tobin’s q = Market Value of Assets/ Replacement Cost (or Economic V Value) of assets

3.2.5 DuPont Analysis

This integrates the important ratios to analyse a firm’s profitability or operating performance. It is also referred to as Return on Net Assets (RONA) or Return on Capital Employed. (ROCE)

a) RONA = {PBIT/Net Assets}= [{Sales/Net Assets} x {PBIT/Sales} ]

b) ROCE = PAT/Net Worth =[{Sales/Net Assets} x {PBIT/Sales} ]x [{PAT/PBIT}x Net Assets/Net Worth}}

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Illustration 1

RM Patel & Partners Limited

Balance sheet

As at 31 December

2004 2005 2006

KShs. KShs. KShs.

Non Current Assets

Land and Buildings 527,60

0 164,40

0 607,20

0

Property Plant and Machinery 6,534,90

0 8,416,40

0 9,215,50

0

Less Depreciation (1,595,50

0) (1,944,60

0) (2,354,40

0)

5,467,000 6,636,200 7,468,300

Current Assets

Inventories 4,762,80

0 7,788,90

0 11,503,90

0

Receivables 2,531,60

0 3,406,10

0 4,831,80

0

cash and Bank 83,70

0 988,40

0 260,80

0

Others 1,282,70

0 1,862,10

0 2,112,70

0

8,660,800 14,045,500 18,709,200

Current Liabilities

Payables 359,90

0 2,112,10

0 3,393,50

0

Provisions and others 2,228,70

0 2,709,70

0 3,765,30

0

2,588,600 4,821,800 7,158,800

Net Current Assets 6,072,200 9,223,700 11,550,400

11,539,200 15,859,900 19,018,700

Financed By

Share Capital of Sh. 10 each 2,250,00

0 2,250,00

0 2,250,00

0

Reserves 2,861,30

0 3,579,50

0 4,478,10

0

5,111,300 5,829,500 6,728,100

10% Debentures - 757,50

0 764,60

0

Long Term Debt 1,998,70

0 2,859,00

0 3,127,30

0

Short Term Debt 4,429,20

0 6,413,90

0 8,398,70

0

6,427,900 10,030,400 12,290,600

11,539,200 15,859,900 19,018,700

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Additional Information :

1. EBIT for 2004, 05 and 06 was KSh. 1,853,800, 2,661,700 and 3,426,100 respectively.

2. COS for 2004, o5 and 06 was KSh. 19, 290,400, 23,228,000 and 30,536,600 respectively.

3. There was no opening stock for year 2004.

4. It has been ascertained that both the long and short term debt carry an annual interest rate of 5%.

Required:

a) Compute the following :

i. Current Ratio

ii. Quick Ratio

iii. Cash Ratio

iv. Debt Ratio

v. Debt Equity Ratio

vi. Interest Coverage Ratio

vii. Inventory Turnover

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Solution 2004 2005 2006

i Current Ratio CA/CL 8,660,8

00 14,045,5

00 18,709,2

00 2,588,600 4,821,800 7,158,800

3.35:1 2.91:1 2.61:1

ii Quick RatioCA-Inventories/CL

3,898,000

6,256,600

7,205,300

2,588,600 4,821,800 7,158,800 1.

51:1 1.

30 :1 1.

01:1

iii Cash Ratio

(Cash+ Marketable securities)/CL

83,700

988,400

260,800

2,588,600 4,821,800 7,158,800 0.

03:1 0.

20 :1 0.

04:1

iv Debt RatioDebt/Capital Employed

6,427,900

10,030,400

12,290,600

11,539,200 15,859,900 19,018,700 0.

56 0.

63 0.

65

vDebt Equity Ratio

debt/Net Worth

6,427,900

10,030,400

12,290,600

5,111,300 5,829,500 6,728,100 1.

26 1.

72 1.

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viInterest Coverage EBIT/INT

1,853,800

2,661,700

3,426,100

321,395 539,395 652,760 5.

77 times 4.

93 times 5.

25 times

viInventory Turnover

COS/Ave. Inventory 19,290,400 23,228,000

30,536,600

2,381,400 6,275,850 9,646,400 8.

10 times 3.

70 times 3.

17 times

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3.4 Utility of Ratio Analysis

I. Assessment of the firm’s financial conditions and capabilities.

With the help of ratios, one can determine the ability of the firm to meet its current obligations, the extent to which the firm has used its long term solvency by borrowing funds, the efficiency with which the firm is utilizing its assets in generating sales revenue and the overall operating efficiency and performance of the firm.

II. Diagnosis of the firm’s problems, weaknesses and strengths.

Management from time to time uses ratio analysis to determine the firm’s strengths and weaknesses and accordingly takes action to improve the firm’s position.

III. Credit analysis

The credit analyst may use the current ratio or quick acid test ratio to judge the firm’s liquidity of debt paying ability. He may also use the debt ratio to determine the stake of the owners in the business and the firm’s capacity to survive in the long run. Return on capital employed may be used to determine the firm’s earning’s prospects.

IV. Security analysis

The major focus in security analysis is on long term profitability. Profitability is dependent on a number of factors and therefore the security analyst also uses other ratios to ascertain the efficiency with which the firm utilizes its assets and the financial risk to which the firm is exposed.

V. Comparative analysis

The ratios of a firm should be compared with the ratios of similar firms and industry for meaningful interpretation. This comparison will reveal whether the firm is significantly out offline with its competitors and therefore undertake analysis to spot out the trouble areas.

VI. Time series analysis

The ration analysis will reveal the financial condition of the firm or trends in ratios over time are analyzed. Ratios at a point in time can mislead the analyst because they may be high or low for some exceptional circumstances at that point of time. Trend analysis of the ratios adds considerable significance to the financial analysis because it studies ratios of several years and isolates the exceptional instances occurring in one or two periods.

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3.5 Limitations in Using Ratio Analysis

I. Standards of comparisons

Ratios of a company have meaning only when they are compared with some standards. It is recommended that ratios should be compared with industry averages however the industry averages are not easily available.

II. Company differences

The situations of two companies are never the same and the factors influencing the performance of a company in one year may change in another year. Comparison of the ratios of two companies becomes difficult and meaningless when they are operating in different situations.

III. Price level

The interpretation and comparison of ratios are rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in the monetary unit which is assumed to remain constant. This is not true in the real life as we know inflation affects the value of money and thus the value of the items in the financial statements.

IV. Different definition

Diversity of views exists as what is to be included in net worth or shareholders equity, current assets and current liabilities. For instance, whether preference share capital and current liabilities should be included in debt in calculating the debt equity ratio, should the intangible assets be excluded to calculate the rate of return on investment, or if included how will they be valued? Similarly the definition of profit is not uniform to all.

V. Changing situations

The ratios do not have much use if they are not analyzed over years. The ratio at a moment in time may suffer from temporary changes. This problem can be resolved by analyzing trends of ratios over years.

VI. Past data

The basis to calculate ratios is historical financial statements. The financial analyst is more interested in what happens in future while the ratios indicate what happened in the past.

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4.0 FINANCIAL PLANNING

4.1 INTRODUCTION

Financial planning indicates a firm’s growth, performance, investments and requirements of funds during a given period of time, usually three to five years. It involves the preparation of projected or pro forma profit and loss account, balance sheet and cash flow statement. Financial planning help a firm’s financial manager to regulate flows of funds which is his primary concern.

4.2 Strategic Financial Planning

Two important tasks of the financial manager are:

a) Allocation of funds also called investment decision.

b) Generation of funds also called financial decision.

The theory of finance makes two crucial assumptions:

I. The objective of the firm is to maximise the wealth of shareholders.

The role of a manager is that of an agent and the shareholders are the ultimate owners of the firm. It is there imperative on the part of the financial manager to make decisions that would increase thee value of the shareholders’ stake in the firm.

II. Capital markets are efficient.

An efficient capital market implies that investors have free access to the market with knowledge, zero transaction cost and that individual investors are unable to influence prices.

4.3 Financial Planning Process

Financing planning process involves the following facets:

I. Evaluating the current financial condition of the firm.

II. Analysing the future growth prospects and options.

III. Appraising the investment options to achieve the stated growth objective.

IV. Projecting the future growth and profitability.

V. Estimating funds requirement and considering alternative financing options.

VI. Comparing and choosing from alternative growth plans and financing options.

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VII. Measuring actual performance with the planned performance.

4.4 Financial Forecasting and modelling

Financial forecasting is an integral part of financial planning. It uses past data to estimate the future financial requirements. A financial planning model establishes the relationship between financial variables and targets, and facilitates the financial forecasting and planning process.

A model makes it easy for the financial manager to prepare financial forecasts. It makes financial forecasting automatic and saves the financial managers time and efforts performing a tedious activity. Financial planning models help in examining and understanding the consequences of alternative financial strategies.

A financial planning model has the following three components:

I. Inputs

The model builder starts with the firm’s current financial statements and the future growth prospects. The firm’s growth prospects depend on the market growth rate, firm’s market share and intensity of competition.

II. Model

The model defines the relation between the financial variables and develops appropriate equations.

III. Output

Applying the model equations to the inputs, outputs in the form of projected of proforma financial statements are obtained.

4.5 Long-term Financial Plan

In practice, long-term financial forecasts are prepared by relating the items of profit and loss account and balance sheet to sales. This is called the percentage to sales method.

4.6 Steps in Financial Planning

I. Past performance

Analysis of the firm’s past performance to ascertain the relationships between financial variable and the firm’s financial strength and weaknesses

II. Operating characteristics

Analysis of the firm’s operating characteristics which include product, markets, competition, production and marketing policies, control systems and operating risk to decide about its growth objectives.

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III. Corporate strategy and investment needs

Determining the firm’s investment needs and choices given its growth objective and overall strategy.

IV. Cash flow from operations

Forecasting the firms revenue and expenses and need for funds based on its investment and dividend policies.

V. Financing alternatives

Analyzing financial alternatives within its financial policy and deciding the appropriate means of raising funds

VI. Consequences of financial plans

Analyzing the consequences of its financial plans for the long term health and survival of the firm.

VII. Consistency

Evaluating the consistency of the financial policies with each other, and with the corporate strategy.

4.7 Conclusion

Financial planning involves the questions of a firm’s long term growth and profitability, investment and financing decisions. It focuses on aggregative capital expenditure programmes and debt-equity mix, rather than the individual projects and sources of finance. Financial planning also involves an interface between the corporate policy and financial planning and the trade off between financial policy variables.

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REFERENCES

I M Pandey, Financial Management, Ninth Edition, (Vikas Publication House), 2006

Andrew Gallagher and Timothy J. Gallaghe, Financial Management , - Academic Internet Publishers Incorporated (2006)

Jae K. Shim, Joel G. Siegel, Financial Management, Barron's Educational Series (2000) 

P. Manasseh, Business Finance, (McMore Accounting Books), Nairobi, 2004

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