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CHAPTER 1

MARKETING EXPENSES AND FINANCIAL

PERFORMANCE

1.1 INTRODUCTION

Holistic marketing incorporates performance marketing and understanding the returns

to the business from marketing programs, as well as addressing broader concerns and

their Legal, ethical, social, and environmental effects. Top management is going

beyond sales revenue to examine the marketing scorecard and interpret what is

happening to market share, customer loss rate, customer satisfaction, products quality,

and other measures.

1.2 PERFORMANCE MARKETING THROUGH ROMI

Return on Marketing Investment (ROMI) and Marketing ROI are defined as the

optimization of marketing spend for the short and long term in support of the brand

strategy by building a market model using valid, objective marketing metrics.

Improving ROMI leads to improved marketing effectiveness, increased revenue,

profit and market share for the same amount of marketing spend. There are two forms

of the Return on Marketing Investment (ROMI) metric. The first, short term ROMI, is

also used as a simple index measuring the dollars of revenue (or market share,

contribution margin or other desired outputs) for every dollar of marketing spend. In a

similar way the second ROMI concept, long term ROMI, can be used to determine

other less tangible aspects of marketing effectiveness. For example, ROMI could be

used to determine the incremental value of marketing as it pertains to increased brand

awareness, consideration or purchase intent. In this way both the longer term value of

marketing activities (incremental brand awareness, etc.) and the shorter term revenue

and profit can be determined. This is a sophisticated metric that balances marketing

and business analytics and is used increasingly by many of the world's leading

organizations (Hewlett-Packard and Procter & Gamble to name two) to measure the

economic (that is, cash-flow derived) benefits created by marketing investments. For

many other organizations, this method offers a way to prioritize investments and

allocate marketing and other resources on a scientific basis.

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1.2.1 Challenge of Return on Marketing Investment

Marketing ROI is critical to any organization, especially business to business and

smaller consumer companies. Without a significant return on marketing investment,

the sales organization will not operate effectively, the company won't meet its'

objectives. How does marketing answer the question when the CEO asks? “Why

should I invest in marketing when I can get better results by hiring more

salespeople?” Is marketing responsible for delivering brand awareness, flashy

graphics and great marketing programs? Or is it responsible to deliver leads and

shorten the sales cycle to generate revenue at a cost and risk in line with other

investments that a company might make?

1.2.2 Metrics Linking Marketing to Financial Performance

Traditionally, marketers concentrated their attention on customer or product-market

results, such as awareness, attitude, sales, market share, brand equity, and customer

satisfaction. They focused on the short-term effects of marketing variables, rather than

long-term effects, and they rarely considered the link to financial outcomes and stock

price. However, changes in the business environment have led to an increased

emphasis on financial accountability for expenditures. Reflecting this shift, the

Marketing Science Institute has designated metrics, or marketing productivity — that

is, the measurement of the impact of marketing on financial outcomes — a first-tier

priority for the past six years.

It is needed to clarify the ways marketing activities build shareholder value. For

example, when we talk of marketing “investment,” we must identify the marketing

assets in which we invest and understand how the assets contribute to profits in the

short run and provide potential for growth and sustained profits in the long run. In this

context, the spotlight is not on underlying products, pricing, or customer relationships

(see Webster 1992) but on marketing expenditures (e.g., marketing communications,

promotions, other activities) and how these expenditures influence marketplace

performance. The firm should have a business model that tracks how marketing

expenditures influence what customers know, believe, and feel, and ultimately how

they behave. These intermediate outcomes are usually measured by nonfinancial

measures such as attitudes and behavioural intentions. The central problem we

address in this article is how nonfinancial measures of marketing effectiveness drive

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conclusions. Although changing customer attitudes, perceptions, and intentions are

important, and achieving improved sales and market share is essential to any

marketing effort, many managers consider financial impact the most crucial measure

of success for any marketing effort. Financial impact involves not only the increase in

revenues but also the expenditure required to produce that increase. Marketing

expenditures are considered investments, and the financial return is measured as ROI.

The long-standing recognition of the importance of ROI in evaluating more general

marketing expenditures (Kirpalani and Shapiro 1973) led to early methods for

measuring advertising ROI (Dhalla 1976). The connection between marketing efforts

and financial performance was subsequently reinforced by analysis of the PIMS

company database, which indicated a positive relationship between market share and

the firm’s aggregate return on net assets (Buzzell and Gale 1987), though that

relationship was later challenged on methodological grounds (Jacobson and Aaker

1985). Gale (1994) recanted and later proposed that market share and financial

performance were both driven by product quality, though the link between perceived

and actual quality is itself complex.

More recently, the “return on quality” model has provided a methodology for

projecting a firm’s ROI in service quality (Rust, Zahorik, and Keiningham 1994,

1995). Research has shown that there may be trade-offs between service quality

improvements that increase revenue and those that reduce costs (Anderson, Fornell,

and Rust 1997; Rust, Moorman, and Dickson 2002). Approaches to evaluating

financial return have also begun to consider the element of financial risk (Davis 2002;

Hogan et al. 2002), as is common in corporate finance.

Marketers are thus being increasingly asked to justify their investments to senior

management in financial and profitability terms, as well as in terms of building and

brand and growing the customer base. As a consequence, they are employing a border

variety of financial measures to assess the direct and indirect value their marketing

efforts create. They are also recognizing that much of their firms’ market value comes

from intangible assets, particularly their brands, customers base, employees,

distributor and supplier relations, and intellectual capital.

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WHAT IS METRIC?

A metric is a measuring system that quantifies a trend, dynamic, or characteristics. In

virtually all disciplines, practitioners use metrics to explain phenomena, diagnose

causes, share findings and project the results of future events. Throughout the worlds

of science, business, and government, metrics encourage rigor and objectivity. They

make it possible to compare observations across regions and time periods. They

facilitate understandings and collaboration.

1.4 WHY DO WE NEED METRICS?

Loard Kelvin, a British physicist and the manager of the laying of the first successful

transatlantic cable, was one of history’s great advocates for quantitative investigation.

In his day, however, mathematical rigor had not yet spread widely beyond the worlds

of science, engineering, and finance. Much has changed since then.

Today, numerical fluency is a crucial skill for every business leader. Managers must

quantify market opportunities and competitive threats. They must justify the financial

risk and benefits of their decisions. They must evaluate plans, explain variances,

judge performance, and identify leverage points for improvements- all in numeric

terms. These responsibilities require a strong command of measurements and of the

systems and formulas that generate them. In short, they required metrics. Managers

must select, calculate, and explain key business metrics. They must understand how

each is constructed and how to use it in decisions making.

1.5 MARKETING METRICS: OPPORTUNITIES, PERFORMANCE, AND

ACCOUNTABILITY

Today, marketers must understand their addressable markets quantitatively. They

must measure new opportunities and the investment needed to realize them. Marketers

must quantify the value of products, customers, and distribution channels- all under

various pricing and promotional scenarios. Increasingly, marketers are held

accountable for the financial ramifications of their decisions.

The numeric imperative represents a challenge, however. In business and economics,

many metrics are complex and difficult to master. Some are highly specialized and

best suited to specific analyses. Many require data that may be approximate,

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incomplete, or unavailable.

Under this circumstance, no single metrics is likely to be perfect. For this reason, we

recommend that marketers use a portfolio or “dashboard” of metrics. By doing so,

they can view market dynamics from various perspective and arrive at “triangulated”

strategies and solution. Additionally, with multiple metrics, marketers can use each as

a check on the others. In this way, they can maximize the accuracy of their

knowledge. They can also estimates or project one data point on the basis of others.

Of course, to use multiple metrics effectively, marketers must appreciate the relation

between them and the limitations inherent in each. When this understanding is

achieved, however, metrics can help a firm maintain a productive focus on customers

and markets. They can help managers identify the strengths and weaknesses in both

strategies and execution. Mathematically defined and widely disseminated, metrics

can become part of precise, operational language within a firm. A further challenge in

metrics stems from wide variations in the availability of data between industries and

geographies. Recognizing these variations, we have tried to suggest alternative

sources and procedures for estimating some of the metrics in this book. Fortunately,

although both the range and type of marketing metrics may very between countries,

these differences are shrinking rapidly. Ambler, for example, report that performance

metrics have become a common language marketers, and that they are now used to

rally terms and benchmark efforts internationally.

1.6 MEASURING ADVERTISING EFFECTIVENESS

There may be disagreement to the statement that all advertising works, whether it is

good or bad, tasteful or vulgar, gentle or browbeating, verbal or visual, written by

professionals or composed by amateurs. This statement will receive the most fervent

nod or approval from people who dislike advertising can manipulate the public. But

all these people are wrong. Individuals who have spent time practicing the advertising

art, especially those who have been concerned with conducting business that depend

on the effectiveness of advertising, know perfectly well that advertising produce very

patchy results-sometimes good, sometimes neutral, sometimes even negative.

Experience of Practitioners indicate that advertising has a high failure rate.

How much advertising works? One can answer this fairly precisely on the basis of

much research carried out in developed advertising markets – the United States,

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Britain, Germany, France, and Scandinavia. The most remarkable conclusion from

this research is the consistency of the patterns of success and failure. There is

evidence of hidden harmonies between how advertising works in different countries—

harmonies that go far beyond the simple and obvious (but sometimes fallacious)

claims made by the proponents of global advertising campaigns. Measurement of the

advertising effectiveness is necessary before to quantify how much of this works. The

difficulty or course is to find out how to include the effects of all the other factors that

influence sales of brand. These include seasonal sales patterns, various types of trade

promotion, display and other distributional stimuli, and-most importantly-the negative

effects of advertising and other activities for competitive brands.

1.7 MARKETING MANAGEMENT

A study of the evolution of marketing brings forth its development into a management

function using various advanced techniques for achieving specific objectives.

Marketing management encompasses the entire range of activities, from the

identification of business opportunities in the customer needs to the customer

satisfaction through consumption of goods or services, leading to fulfillment of the

need.

1.7.1 Definition

"American Management Association" has adopted the following definition of

marketing management: "Marketing (management) is the process of planning and

executing the conception, pricing, promotion and distribution of goods, service, and

ideas to create exchanges with target groups that satisfy customer and organisational

objectives."

1.7.2 Functions of Marketing Management

Marketing management comprises four key functional aspects, viz., Analysis,

Planning, Implementation and Control.

(a) Analysis: There is a need to understand customers, competitors, trends and

changes in the environment and internal strengths and weaknesses for drawing out

effective marketing plans. This requires collection of information related to these

areas using systematic marketing research and marketing information systems, and

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scientific analysis of the data.

(b) Planning: It covers both strategic planning for the long-term marketing direction

of the firm (for example, selection of target markets), and marketing programmes and

tactics to be used to support the strategic plans. The plans should include the goals

and targets in measurable terms, and also the estimates of resources, and the actions

required for their implementation.

(c) Implementation: The implementation of strategic and tactical plans requires

staffing, allocation of tasks and responsibilities, budgeting, and securing financial and

other resources needed.

(d) Control: Measurement and evaluation of progress against the goals and targets

spelt out in the plans is an important function for determining the future course of

action. This may prove to be problematic due to difficulties in measuring the

performance criteria and ascertaining the cause and effect. It is a complex function

requiring use of both qualitative and quantitative techniques including budgetary

control, control of marketing mix, and even marketing audit.

1.8 BANK MARKETING

We define bank marketing as follows: 'Bank marketing is the aggregate of function,

directed at providing services to satisfy customers financial (and other related) needs

and wants, more effectively and efficiently than the competitors keeping in view the

organizational objectives of the bank.” Bank marketing is the 'aggregate of function,'

which signify the totality of the marketing activity. This aggregate of functions

it the sum tool of all individual/ whisks consisting of an integrated effort to

discover, create, arouse and satisfy customer needs. This means, without

exception, that each individual working in the bank is a marketing person who

contributes to the total satisfaction to customers and the bank should ultimately

develop customer orientation among all the personnel of the bank.

Bank marketing deals with providing services to satisfy customers' financial needs

and wants. Banks have to find out the financial needs of the customers and offer

the senior which can satisfy those needs. Banks may also require to satisfy the

customers’ financial and other related needs and wants. The individuals and

corporate bodies have certain needs in relation to money commodity. To satisfy that

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financial needs. Customers want specific serial. Different banks offer different

benefits by offering various schemes which can take care of the wants of the

customers.

Marketing helps in achieving the organizational objectives of the bank. This

mean, that marketing is equally applicable to achieve commercial and social

objectives of the banks. Indian banks have dual organizational objectives of the

banks. Indian banks have dual organizational objectives-commercial objective

to make profit and social objective which us a development role, particularly in

the rural areas. Service area approach adopted recently by the Indian banks is a

marketing approach whereby a specific mega market is assigned to each bank branch

and after identification of the needs of the customer all efforts of the bank are required

to be concentrated to tacitly the customers to achieve the bank's social objectives.

Hence, the marketing concept is essentially about the following few things which

contribute towards bank's success:

(a) The bank cannot min without the customers

(b) The purse of the bank is to create, win, and keep a customer. The customer is and

should be the central Focus of everything the bank does.

(c) It is alto a way of organizing the bank. The starting point for organizational

design should be the customer and the bank should ensure that the services are

preformed and delivered in the most effective way. Service facilities also should

be designed for customers’ convenience.

(d) Ultimate aim of a bank is to deliver total satisfaction to the customer.

(e) Customer satisfaction is affected by the performance of all the personnel of the

bank.

All the techniques and strategies of marketing are used so that ultimately they induce

the people to do business with a particular bank. To create and keep a customer

means doing all those things so that people would like to do business and continue to

do it with a particular bank rather than with the competitors. It cannot stay in

business if it does not attract and hold enough customers, no matter how efficiently it

operates.

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Marketing is an organizational philosophy. This philosophy demands the satisfaction

of customers’ (consumers) needs as the prerequisite for the existence and survival of

the bank. Marketing is so basic that it cannot be considered as a separate function. It

is the whole business seen from the point of view of its final result that is the

customer’s point of view.

Marketing for service industry like banks is a philosophy to be understood by the

whole organization-from the chief executive to the person waiting at the counter. The

first and most important step in applying the marketing concept is to have a whole

hearted commitment to customer orientation by all the employees. Marketing is an

attitude of mind. This means that the central focus of all the activities of a bank is

customer. Marketing is not a separate function for banks. The marketing function in

Indian bank is required to be integrated with operation.

The potential danger in introducing traditional marketing department as a mean, of

managing services marketing was tested in a study of executives of service firms. The

result of the study clearly indicated that “a separate marketing department may widen

the gap between marketing and operation”.

A traditional marketing department (and officers with marketing designations) usually

cannot be responsible for the total marketing function of a service organisation like

banks. Introduction of such marketing department may easily influence the bank in an

unfavourable direction. Personnel working in other departments like operations and

back of the counters stop worrying about their customers-related responsibilities and

totally concentrate on just handling operations and other ditties mechanically.

The reason for this is clear. They feel that the bank now has marketing specialists and

hence they need not bother about customer related responsibilities any longer. Some

Indian banks have started marketing department which takes are of deposit maim

(deposit mobilisation) function only. In most of the cases it is a new name given to the

old deposit mobilisation department. Functions remain the same with somewhat more

promotional activities. One bank appointed about 50 marketing officer, at branch

level for deposit mobilisation. The experiment is not successful and they are

withdrawn from the branch and position is abolished. Banks may not require this type

of separate positions. Branch manager and counter desks themselves are the

marketing persons.

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Marketing is much more than just advertising and promotion; it is a basic part of total

business operation. What it required for the bank it the market orientation and

customer consciousness among all the personnel of the bank. For developing

marketing philosophy and marketing culture, a bank may require a marketing

coordinator or integrator at the head office reporting directly to the Chief Executive

for effective coordination of different functions, such as marketed research, training,

public relations, advertising and business development to ensure customer

satisfaction. The Executive Director (ED) is the most suitable person to do this

coordination work effectively in the Indian public sector banks though ultimately the

Chief Executive is responsible for the total marketing function. Hence, the total

marketing function involves the following:

(a) Market research i.e., identification of customers' financial needs and wants and

forecasting and researching future financial market needs and competitors' activities.

(b) Product development i.e., appropriate products to meet consume& financial needs.

(c) Pricing atilt service i.e., promotional activities and distribution system in

accordance with the guidelines and rules of the Reserve Bank of India and at the same

time looking for opportunities to satisfy the customers better.

(d) Developing market orientation i.e., marketing culture — among all the customer-

consciousness 'Personnel' of the bank through training.

Thus, it is important to recognise the fundamentally different functions that bank

marketing has to perform. Since the banks have to attract deposits and attract users of

funds and other services, marketing problems are more complex in banks than in other

commercial concerns.

1.9 IMPORTANCE OF MARKETING FOR INDIAN BANKS

Banking organizations are newcomers to marketing. It was the banks in the UK and

US, which were the first to begin applying the marketing concepts during the 1960s.

In India, the banking industry has passed through major transformations during the

twentieth century. At the time of independence, India had 558 commercial banks, of

which 459 were non-scheduled banks. The Imperial Bank of India was converted into

State Bank of India in 1955 and was given the mandate to cover the rural areas, cater

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to the needs of agriculture and small-scale industries, besides serving as agent of

Reserve Bank of India in places, where it did not have offices. In 1967, the number of

banks was reduced to ninety-one, due to several liquidations and amalgamations

followed by nationalization of fourteen major banks of the country in 1969. Indian

banking system transformed itself from class banking to mass banking. The banks

promoted the banking services to inculcate the banking habits among the public. It

indeed was a situation, which illustrated the relevance of marketing in a monopolistic

situation. During the 1970s, the number of bank branches of public sector banks

increased at a very rapid pace. As a result, the banks started feeling the competitive

forces especially in the urban areas. Besides, in the 1980s there were other changes

like development of small savings instruments, corporate sector more tapping the

primary market through public deposit, equity shares and debentures. The bank thus

faced competition both on the assets and liabilities fronts. At that point, the need for

marketing was realised not only by the individual banks but at the banking industry

level. In his statement at the AGM, in April, 1987, the ten chairman of the Indian

Banks’ Association, Mr. M.N. Gopiporia said, “The relevance of aggressive

marketing in banks has come to the fore as never before. The banking system in the

country has built-up a vast infrastructure, at a substantial cost and unless aggressive

efforts are made to market their deposit and credit scheme, as well as the wide range

of facilities and services offered, there could be under-utilization of the banking

infrastructure.”

The following decade saw the Indian banking witness another major transformation

— the emergence of liberalization process that brought about two most eventful

changes. One, the regulatory framework for banks which was highly restrictive, was

changed into a rigorous but broader control system. Two, the banking sector reopened

to the private sector. Hence, while the banks got more freedom, they also had newer

forces to reckon with.

In it retrospect, it is seen that the banks, after nationalization, had the necessity of

catering to a wide spectrum of customers, with different needs. They responded by

developing a new range of services. Although the customer orientation as a marketing

concept was talked about at a much later stage, the bank management displayed

marketing acumen in their practices. The largest bank of the country, State Bank of

India, reorganized itself in 1970s, on the lines of market segments, viz., commercial

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and institutional, small industries and small business, agriculture and personal; and

having a distinct development wing which had the primary function of marketing. As

the economy developed and the customers were exposed to the sophisticated products

offered by the banks abroad, the banks in India were faced with the demand for

similar products. The banks have, therefore, to be continuously acquiring the

capabilities for and have to be innovative in offering new varied services.

One major cause for concern for the banks has been their profitability. The social

responsibilities thrust upon them, which also required them to extend their network in

remote rural areas rendering such branches non-viable, affected their bottom lines

adversely. Evolving suitable strategies for improving the profitability, particularly in

the deregulated and liberalized environment is one major challenge, and it

underscores the need for marketing for banking organizations.

The new generation private sector banks started with technologically superior systems

and took to aggressive marketing of their products. They started segmenting the

customer base and offered products suitable to each segment.

The entry of new generation private sector banks in India has inter-alia brought to the

fore two major aspects. One, the use of information technology for delivery of

banking services, which has not only affected the banking products but also facilitated

new outlets, for example, ATMs, Internet, etc. Two, it renewed focus on the high net

worth customer, which has created a different type of private banking in the Indian

banks. This proved to be a catalyst, which brought into play a rapid reaction across

the entire banking sector. The computerization of bank branches took place at fast

pace thereafter not only among the public sector banks, but even among the old

private sector banks and cooperative banks. These developments have underlined the

marketing orientation of banks. The banks are now not only conscious of the customer

needs but are focused on customer relations management.

1.10 CUSTOMER SATISFACTION

The number of customers or percentage of total customers, whose reported experience

with a firm, its products, or its services (ratings) exceeds specified satisfaction goals.

Within organization, customer satisfaction rating can have powerful effects. They

focus employees on the importance of fulfilling customers’ expectations.

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Furthermore, when ‘these ratings dip, they warn of problems that can affect sales and

profitability.

A second important metric related to satisfaction is willingness to recommend. When

a customer is satisfied with a product, he or she might recommend it to friends,

relatives, and colleagues. This can be a powerful marketing advantage.

Customer satisfaction data are among the most frequently collected indicators of

market perceptions. Their principal uses it twofold.

1. Within organizations, the collections, analysis, and dissemination of these data

send a message about the importance of tending to customers and ensuring

that they have a positive experience with the company’s good and services.

2. Although sales or market share can indicate how well a firm is performing

currently, satisfaction is perhaps the best indicator of how likely it is that the

firm’s customer will make further purchases in the future. Much research has

focused on the relationship between customer satisfaction and relation.

Studies indicate that the ramifications of satisfaction are most strongly realized

at the extremes. On the scale in figure 1. Individual who rate their satisfaction

level as”5”are likely to become return customer and might even evangelize for

the firm. Individuals who rate their satisfaction level as “1”, by contrast, are

unlikely to return. Further they can hurt the firm by making negative.

Comments about it to prospective customers. Willingness or recommended is

a key metrics relating to customer satisfaction.

These metrics quantify an important dynamic. When a brand has loyal customers, it

gains positive word-of-mouth marketing, which is both free and highly effective.

Customer satisfaction is measured at the individual level, but it is almost always

reported at an aggregate level. It can be, and often is, measured along various

dimensions. A hotel, for example, might ask customers to rate their experience with

its front desk and check-in service, with the room, with the amenities in the room,

with the restaurants, and so on. Additionally, in a holistic sense, the hotel might ask

about overall satisfaction “with your stay”.

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1.11 INTRODUCTION OF FINANCIAL PERFORMANCE

There are many different ways to measure financial performance, but all measures

should be taken in aggregation. Line items such as revenue from operations, operating

income or cash flow from operations can be used, as well as total unit sales.

Furthermore, the analyst or investor may wish to look deeper into financial

statements and seek out margin growth rates or any declining debt, measuring the

results of a firm's policies and operations in monetary terms. These results are

reflected in the firm's return on investment, return on assets, value added, etc.

Financial analysis also refers to the financial statement analysis or accounting

analysis. Therefore, the knowledge about financial statement is necessary.

1.12 FINANCIAL STATEMENTS

A financial statement is an organized collection of date according to logical and

consistent accounting procedures. Its purpose is to convey an understanding of some

financial aspects of a business firm. It may show a position at a moment, of time as in

the case of balance sheet, or may reveal a series of activities over a given period of

time, as in the case of an income statement.

Accounting is the process of identifying, measuring and communicating economic

information to permit informed judgments and decision by users of the information. It

involves recording, classifying and summarizing various business transactions. The

end products of business transactions are the financial statements comprising

primarily the position statement or the balance sheet and the income statement or the

profit and loss account. These statements are the outcome of summarizing process of

accounting and the financial position of a concern. Financial statements are the basis

for decision making by the management as well as other outsiders who are invested in

the affairs of the firm such as investors, creditors, customers, suppliers, financial

institutions, employees, potential investors, government and the general public. The

analysis and interpretation of financial statements depend up on the nature and type of

information available in these statements.

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1.13 TYPES AND SIGNIFICANCE OF FINANCIAL STATEMENTS

Financial statements are broadly groped in to two statements. 1. Income statements (trading, profit and loss account)

2. Balance Sheets.

In addition to above financial statements supported by the following statement are

prepared to meet the needs of the business concern.

3. Statement of retained earnings.

4. Statement of changes in financial position.

Figure 1.1: Financial Statements

1.14 OBJECTIVES OF FINANCIAL STATEMENTS

The following are the important objectives of the financial statements:

1. To provide adequate information about the source of finance and obligation of the

finance firm.

2. To provide reliable information about the financial performance and financial

soundness of the concern.

3. To provide sufficient information about results of operation of business over a

period of time.

4. To provide useful information about the financial conditions of the business and

movement of resources in and out of business.

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5. To provide necessary to enable the users to evaluate the earning performance of

resources or management performance in forecasting the earning potentials of

business.

1.15 ANALYSIS AND INTERPRETATION OF FINANCIAL

STATEMENTS

Preparation of financial statement is the important part of accounting process. To

provide more meaningful information to enables to owners, investors, creditors or

users of financial statements to evaluate the operational efficiency of the concern

during the particular period.

Analysis and interpretation of financial statements, therefore, refers to such a

treatment of the information contained in the Income Statement and the Balance Sheet

so as to afford full diagnosis of the profitability and financial soundness of the

business. In order to fulfill the need of above, it is essential to consider analysis and

interpretation of financial statements.

The term “Analysis” refers to rearrangement of the data given in the financial

statements. In other words, simplification of data by methodical classification of the

data given in the financial statements.

The term “Interpretation” refers to “explaining the meaning and significance of the

data so simplified.”

However, both ‘Analysis’ and ‘Interpretation’ are complementary to each other.

Interpretation requires Analysis, while Analysis is useless without interpretation.

Financial statement analysis and interpretation refer to the process of establishing the

meaningful relationship between the items of two financial statements with the

objective of identifying the financial and operational strengths and weakness.

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1.16 TECHNIQUES OF FINANCIAL ANALYSIS

There are many technique of financial analysis which is as under:

Figure 1.2: Techniques of Financial Analysis

1.16.1 Comparative Financial Statements

Comparative financial statements are those statements which have been designed in a

way so to provide time perspective to the consideration of various elements of

financial position embodied in such statements. In these statement figures for two or

more periods are placed side by side to facilitate comparison. Both the Income

Statement and Balance Sheet can prepared in from of comparative financial

statements.

1.16.2 Common Size Financial Statements

Common size financial statements are those in which figures reported are converted in

to percentages to some common base. The comparative common size financial

statements show the percentage of each item to the total in each period but not

variations in respective items form period to period. However, common size financial

statements are useful for studying the comparative financial position of two or more

business.

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1.16.3 Trend Percentages

Trend percentages are immensely helpful in making a comparative study of the

financial statements for several years The method of trend percentages is a useful

analytical device analytical device for the several the management since by

substituting percentages for large amounts, the brevity and readability are achieved.

There are usually calculated only for major items since propose is to highlight

important changes.

1.16.4 Fund Flow Analysis

Funds flows analysis has become an important tool in the analytical kit of financial

analysts, credit granting institutions and financial manager Funds flow analysis revel

the changes in working capital position. It tells about the sources from which the

working capital was obtained and the purpose for which it was used. It brings out in

open the changes which have taken place behind the balance sheet.

1.16.5 Cost Volume Profit Analysis

Cost volume profit analysis is an important tool of profit planning. It is an important

tool for the management for decision making. It tells the volume of sales at which the

firm will break even, selling price and cost, and finally, the quality to be produced and

sold to reach the target profit level.

1.16.6 Ratio Analysis

Ratio analysis used to determine the financial soundness of a business concern.

Alexander Wall designed a system of ratio analysis and presented it in useful form in

the year 1909. Ratio simply means one number expressed in terms of another. A ratio

is a statistical yardstick by means of which relationship between two or various

figures can be compared or measured.

1.17 DEFINITION OF ACCOUNTING RATIO

The term "accounting ratios" is used to describe significant relationship between

figures shown on a balance sheet, in a profit and loss account, in a budgetary control

system or in any other part of accounting organization. Accounting ratios thus shows

the relationship between accounting data.

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Ratios can be found out by dividing one number by another number. Ratios show how

one number is related to another. It may be expressed in the form of co-efficient,

percentage, proportion, or rate.

Ratio Analysis is one of the techniques of financial analysis ratio are used as a

yardstick for evaluating the financial condition and performance of a firm.

1.18 RATIO CAN BE EXPRESSED IN THREE WAYS

1.18.1 Times

When one value is divided by another the unit used to express the quotient is termed

as “times”.

1.18.2 Percentage

If the quotient obtained is multiplied by 100, the unit of expression is termed as

“percentage”.

1.18.3 Proportion

If one number divided by another and express relationship between first and second

number is known as proportion. i.e., 2:1

Accounting ratio is therefore, mathematical relationship expressed between inter-

connected accounting figures.

1.19 ADVANTAGES OF RATIO ANALYSIS

Ratio analysis is an important and age-old technique of financial analysis. The

following are some of the advantages / benefits of ratio analysis:

1.19.1 It simplifies financial statements

It simplifies the comprehension of financial statements. Ratios tell the whole story of

changes in the financial condition of the business

1.19.2 Facilitates inter-firm comparison

It provides data for inter-firm comparison. Ratios highlight the factors associated with

successful and unsuccessful firm. They also reveal strong firms and weak firms,

overvalued and undervalued firms.

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1.19.3 Helps in planning

It helps in planning and forecasting. Ratios can assist management, in its basic

functions of forecasting, planning, co-ordination, control and communications.

1.19.4 Makes inter-firm comparison possible

Ratios analysis also makes possible comparison of the performance of different

divisions of the firm. The ratios are helpful in deciding about their efficiency or

otherwise in the past and likely performance in the future.

1.19.5 Help in investment decisions

It helps in investment decisions in the case of investors and lending decisions in the

case of bankers etc.

1.20 LIMITATIONS OF RATIOS ANALYSIS

The ratios analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer from serious

limitations.

1.20.1 Limitations of financial statements

Ratios are based only on the information which has been recorded in the financial

statements. Financial statements themselves are subject to several limitations. Thus

ratios derived, there from, are also subject to those limitations. For example, non-

financial changes though important for the business are not relevant by the financial

statements. Financial statements are affected to a very great extent by accounting

conventions and concepts. Personal judgment plays a great part in determining the

figures for financial statements.

1.20.2 Comparative study required

Ratios are useful in judging the efficiency of the business only when they are

compared with past results of the business. However, such a comparison only provide

glimpse of the past performance and forecasts for future may not prove correct since

several other factors like market conditions, management policies, etc. may affect the

future operations.

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Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final

regarding good or bad financial position of the business. Other things have also to be

seen.

1.20.3 Problems of price level changes

A change in price level can affect the validity of ratios calculated for different time

periods. In such a case the ratio analysis may not clearly indicate the trend in solvency

and profitability of the company. The financial statements, therefore, be adjusted

keeping in view the price level changes if a meaningful comparison is to be made

through accounting ratios.

1.20.4 Lack of adequate standard

No fixed standard can be laid down for ideal ratios. There are no well accepted

standards or rule of thumb for all ratios which can be accepted as norm. It renders

interpretation of the ratios difficult.

1.20.5 Limited use of single ratios

A single ratio, usually, does not convey much of a sense. To make a better

interpretation, a number of ratios have to be calculated which is likely to confuse the

analyst than help him in making any good decision.

1.20.6 Personal bias

Ratios are only means of financial analysis and not an end in itself. Ratios have to

interpret and different people may interpret the same ratio in different way.

1.20.7 Incomparable

Not only industries differ in their nature, but also the firms of the similar business

widely differ in their size and accounting procedures etc. It makes comparison of

ratios difficult and misleading.

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