Financial management Notes Anirudh

8/20/2019 Financial management Notes Anirudh

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Financial

management

Notes


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FINANCIAL MANAGEMENT

Financial management is an academic discipline which is concerned withdecision-making. This decision is concerned with the size and composition ofassets and the level and structure of financing. In order to make rightdecision, it is necessary to have a clear understanding of the objectives. uchan objective provides a framework for right kind of financial decision making.The objectives are concerned with designing a method of operating theInternal Investment and financing of a firm. There are two widely appliedapproaches, viz.

!a" profit ma#imization and

!b" wealth ma#imization.

The term $objective' is used in the sense of an object, a goal or decision

criterion. The three decisions - Investment decision, financing decision anddividend policy decision are guided by the objective. Therefore, what isrelevant - is not the over-all objective but an operationally useful criterion% Itshould also be noted that the term objective provides a normative framework.Therefore, a firm should try to achieve and on policies which should befollowed so that certain goals are to be achieved. It should be noted that thefirms do not necessarily follow them.

Profit Maximization as a Decision Criterion

&rofit ma#imization is considered as the goal of financial management. In thisapproach, actions that Increase profits should be undertaken and the actionsthat decrease the profits are avoided. Thus, the Investment, financing anddividend also be noted that the term objective provides a normativeframework decisions should be oriented to the ma#imization of profits. Theterm $profit$ is used in two senses. In one sense it is used as an owner-oriented.

In this concept it refers to the amount and share of national Income that ispaid to the owners of business. The second way is an operational concept i.e.profitability. This concept signifies economic efficiency. It means profitability

refers to a situation where output e#ceeds Input. It means, the value createdby the use of resources is greater that the Input resources. Thus in all thedecisions, one test is used I.e. select asset, projects and decisions that areprofitable and reject those which are not profitable.

The profit ma#imization criterion is criticized on several grounds. Firstly, thereasons for the opposition that are based on misapprehensions about theworkability and fairness of the private enterprise itself. econdly, profitma#imization suffers from the difficulty of applying this criterion in the actual

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real-world situations. The term $objective$ refers to an e#plicit operationalguide for the internal investment and financing of a firm and not the overallbusiness operations. 'e shall now discuss the limitations of profitma#imization objective of financial management.

!" Ambi#$it%&

The term $profit ma#imization$ as a criterion for financial decision is vague andambiguous concept. It lacks precise connotation. The term $profit$ is amenableto different interpretations by different people. For e#ample, profit may belong-term or short-term. It may be total profit or rate of profit. It may be netprofit before ta# or net profit after ta#. It may be return on total capitalemployed or total assets or shareholders e(uity and so on.

" Timin# of enefits&

)nother technical objection to the profit ma#imization criterion is that ItIgnores the differences in the time pattern of the benefits received from

Investment proposals or courses of action. 'hen the profitability is workedout t(e bi##er t(e better )rinci)*e is adopted as the decision is based onthe total benefits received over the working life of the asset, Irrespective ofwhen they were received. The following table can be considered to e#plain thislimitation.

+" ,$a*it% of enefits

)nother Important technical limitation of profit ma#imization criterion is thatit ignores the (uality aspects of benefits which are associated with thefinancial course of action. The term $(uality$ means the degree of certaintyassociated with which benefits can be e#pected. Therefore, the more certainthe e#pected return, the higher the (uality of benefits. )s against this, themore uncertain or fluctuating the e#pected benefits, the lower the (uality ofbenefits.

The profit ma#imization criterion is not appropriate and suitable as anoperational objective. It is unsuitable and inappropriate as an operationalobjective of Investment financing and dividend decisions of a firm. It is vagueand ambiguous. It ignores important dimensions of financial analysis viz. riskand time value of money.

)n appropriate operational decision criterion for financial management should

possess the following (uality.a" It should be precise and e#act.

b" It should be based on bigger the better principle.

c" It should consider both (uantity and (uality dimensions of benefits.

d" It should recognize time value of money.

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ea*t( Maximization Decision Criterion

'ealth ma#imization decision criterion is also known as *alue +a#imization oret &resent-'orth ma#imization. In the current academic literature valuema#imization is widely accepted as an appropriate operational decisioncriterion for financial management decision. It removes the technicallimitations of the profit ma#imization criterion. It posses the threere(uirements of a suitable operational objective of financial courses of action.These three features are e#actness, (uality of benefits and the time value ofmoney.

i" Exactness% The value of an asset should be determined In terms of returnsit can produce. Thus, the worth of a course of action should be valued Interms of the returns less the cost of undertaking the particular course ofaction. Important element in computing the value of a financial course ofaction is the e#actness in computing the benefits associated with the course of

action. The wealth ma#imization criterion is based on cash flows generatedand not on accounting profit. The computation of cash inflows and cashoutflows is precise. )s against this the computation of accounting is not e#act.

ii" ,$a*it% an. ,$antit% an. enefit an. Time /a*$e of Mone%&

T(e second feature of wealth ma#imization criterion is that. It considers boththe (uality and (uantity dimensions of benefits. +oreover, it also incorporatesthe time value of money. )s stated earlier the (uality of benefits refers tocertainty with which benefits are received In future.

The more certain the e#pected cash in flows the better the (uality of benefitsand higher the value. n the contrary the less certain the flows the lower the(uality and hence, value of benefits. It should also be noted that money hastime value. It should also be noted that benefits received in earlier yearsshould be valued highly than benefits received later.

The operational implication of the uncertainty and timing dimensions of thebenefits associated with a financial decision is that adjustments need to bemade in the cash flow pattern. It should be made to incorporate risk and tomake an allowance for differences in the timing of benefits. et present value

ma#imization is superior to the profit ma#imization as an operationalobjective.

It involves a comparison of value of cost. The action that has a discountedvalue reflecting both time and risk that e#ceeds cost is said to create value.uch actions are to be undertaken. ontrary to this actions with less valuethan cost, reduce wealth should be rejected. It is for these reasons that theet &resent *alue +a#imization is superior to the profit ma#imization as anoperational objective.

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P12FIT MA3IMI4ATI2N /5 EALT6 MA3IMI4ATI2N

&/FIT +)0I+I)TI - It is one of the basic objectives of financialmanagement. &rofit ma#imization aims at improving profitability,maintaining the stability and reducing losses and inefficiencies.

&rofit in this conte#t can be seen in 1 senses.

2. &rofit ma#imization for the owner.

1. &rofit ma#imization is for others.

ormally profit is linked with efficiency and so it is the test of efficiency.3owever this concept has certain limitations like ambiguity i.e. the term is notclear as it is nowhere defined, it changes from person to person.1. 4uality of profit - normally profit is counted in terms of rupees. ormallyamt earned is called as profit but it ignores certain basic ideas like wastage,efficiency, employee skill, employee5s turnover, product mi#, manufacturingprocess, administrative setup.6. Timing of benefit 7 time value of profit - in inflationary conditions the valueof profit will decrease and hence the profits may not be comparable over alonger period span.8. ome economists argue that profit ma#imization is sometimes leads tounhealthy trends and is harmful to the society and may result intoe#ploitation, unhealthy competition and taking undue advantage of theposition.

EALT6 MA3IMI5ATI2N - 2ne of t(e tra.itiona*

approaches of financial management , by wealth ma#imization we mean theaccumulation and creation of wealth , property and assets over a period oftime thus if profit ma#imization is aimed after taking care , of its limitations itwill lead to wealth ma#imization in real sense, it is a long term concept basedon the cash flows rather than profits an hence there can be a situationwhere a business makes losses every year but there are cash profits becauseof heavy depreciation which indirectly suggests heavy investment in fi#edassets and that is the real wealth and it takes into account the time value ofmoney and so is universally accepted.

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IMP21TANT F8NCTI2N5 2F T6E FINANCIAL MANAGE1&

The important function of the financial manager in a modern business consists

of the following%

1. &rovision of capital% To establish and e#ecute programmes for the

provision of capital re(uired by the business.2. Investor relations% to establish and maintain an ade(uate market for the

company securities and to maintain ade(uate liaison with investmentbankers, financial analysis and share holders.

3. hort term financing% To maintain ade(uate sources for company5scurrent borrowing from commercial banks and other lending institutions.

4. 9anking and ustody% To maintain banking arrangement, to receive, hascustody of accounts.

:. redit and collections% to direct the granting of credit and the collection

of accounts due to the company including the supervision of re(uiredarrangements for financing sales such as time payment and leasingplans.

;. Investments% to achieve the company5s funds as re(uired and toestablish and co-ordinate policies for investment in pension and othersimilar trusts.

7. Insurance% to provide insurance coverage as re(uired.

valuating and consulting% To consult with all the segments ofmanagement responsible for policy or action concerning any phase ofthe operation of the business as it relates to the attainment ofobjectives and the effectiveness of policies, organization structure andprocedures.

22. Ta# administration% to establish and administer ta# policies andprocedures.

21. ?overnment reporting% To supervise or co-ordinate the preparation ofreports to government agencies.

26. &rotection of assets% To ensure protection of assets for the businessthrough internal control, internal auditing and proper insurancecoverage.

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DEENT81E5

The issue of debentures by public limited companies is regulated byompanies )ct 2@:;. Aebenture is a document, which either creates a debt oracknowledges it. Aebentures are issued through a prospectus. ) debenture is

issued by a company and is usually in the form of a certificate, which is anacknowledgement of indebtedness. They are issued under the company$s seal.Aebentures are one of a series issued to a number of lenders.

The date of repayment is invariably specified in the debenture. ?enerallydebentures are issued against a charge on the assets of the company.Aebentures may, however, be issued without any such charge. Aebentureholders have no right to vote in the meetings of the company.

:in.s of Debent$res

1. 9earer Aebentures% They are registered and are payable to its bearer.They are negotiable instruments and are transferable by delivery.

2. /egistered Aebentures% They are payable to the registered holder whosename appears both on debenture and in the register of debentureholders maintained by the company. /egistered debentures can betransferred but have to be registered again. /egistered debentures arenot negotiable instruments. &I registered debenture contains acommitment to pay the principal sum and interest. It also has adescription of the charge and a statement that it is issued subject to the

conditions endorsed therein.

3. ecured Aebentures% Aebentures which create a charge on the assets ofthe company, which may be fi#ed or floating, are known as secureddebentures

4. Bnsecured or aked Aebentures% Aebentures, which are issued withoutany charge on assets, are unsecured or naked debentures, The holdersare like unsecured creditors and may sue the company for recovery ofdebt.

5. /edeemable Aebentures% ormally debentures are issued on thecondition that they shall be redeemed after a certain period. They can,however, be reissued after redemption under ection 212 of ompanies)ct 2@:;.

6. &erpetual Aebentures% 'hen debentures are irredeemable they arecalled &erpetual.

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7. onvertible Aebentures% If an option is given to convert debentures intoe(uity shares at stated rate of e#change after a specified period theyare called convertible debentures. In our country the convertibledebentures are very popular. n conversion, the holders cease to belenders and become owners. Aebentures are usually issued in a serieswith a pari passu !at the same rate" clause which entitles them to bedischarged rate ably though issued at different times. ew series ofdebentures cannot rank pari passu with old series unless the old seriesprovides so.

8. ew debt instruments issued by public limited companies areparticipating debentures, convertible debentures with options, thirdparty convertible debentures, and convertible debentures redeemable atpremium, debt e(uity swaps and zero coupon convertible notes.

9. &articipating Aebentures% They are unsecured corporate debt securities,

which participate in the profits of the company. They might findinvestors if issued by e#isting dividend paying companies.

10. onvertible Aebentures with ptions% They are a derivative ofconvertible debentures with an embedded option, providing fle#ibility tothe issuer as well as the investor to e#it from the terms of the issue.The coupon rate is specified at the time of issue.

11. Third &arty convertible Aebentures% They are debt with a warrant

allowing the investor to subscribe to the e(uity of a third firm at apreferential vis-C-vis the market price. Interest rate on third partyconvertible debentures is lower than pure debt on account of theconversion option.

12. onvertible Aebentures /edeemable at a premium% onvertibledebentures are issued at face value with an option entitling investors tolater sell the bond to the issuer at a premium. They are basically similarto convertible debentures but embody less risk.

ALANCE 56EET

The balance sheet is a significant financial statement of the firm. In fact, it iscalled the fundamental accounting report. ther terms to describe thisfinancial statement are the statement of financial position or the positionstatement. )s the name suggests, the balance sheet provides informationabout the financial standing 7 position of a firm at a particular point of time,say as on +arch 62. It can be visualized as a snap shot of the financial statusof a company. The position of the firm on the preceding or the following day isbound to be different.

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The financial position of a firm as disclosed by the balance sheet refers to itsresources and obligations, and the interest of its owners in the business. Inoperational terms, the balance sheet contains information regarding theassets, liabilities and shareholder5s e(uity. The balance sheet can be presentin either of the two forms% /eport form or )ccount form.

ontents of the balance sheets%

2" )ssets1"6" Diabilities

Assets&

)ssets may be described as valuable resources owned by a business whichhave been ac(uired at a measurable money cost. )s an economics resource,

they satisfy three re(uirements. In the first place, the resource must bevaluable. ) resource is valuable if it is in cash or convertible into cash or it canprovide future benefits to the operations of the firm. econdly, the resourcesmust be owned in the legal sense of the term.

Finally, the resource must be ac(uired at a measurable money cost. In casewhere an asset is not ac(uired with cash or promise to pay cash, the criterionis, what the asset would have cost, had cash been paid for it.

The assets in the balance sheet are listed either in the order of li(uidity-promptness with which they are e#pected to be converted into cash- or inreverse order, that is, fi#ity or listing of the least li(uid asset first, followed byothers. )ll assets are grouped into categories, that is, assets with similarcharacteristics are put into one category. The assets included in one categoryare different from those in other categories. The standard classification ofassets divides them into%

2" Fi#ed assets7 long term assets

1" urrent assets

6" Investments

8" ther assets

Liabi*ities&

The second major content of the balance sheet is liabilities of the firm.Diabilities may be defined as the claims of outsiders against the firm.)lternatively, they represent the amount that the firm owes to outsiders thatis, other than owners. The assets have to be financed by different sources.

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ne source of funds is borrowing- long term as well as short term. The firmscan borrow on a long term basis from financial institutions7 banks or throughbonds7 mortgages7 debentures.

The short term borrowing may be in the form of purchase of goods andservices on credit. These outside sources from which a firm can borrow aretermed as liabilities. ince they finance the assets, they are, in a sense,claims against the assets. The amount shown against the liability items is onthe basis of the amount owed, not the amount payable.Aepending upon the periodicity of the funds, liabilities can be classified into

2" Dong-term liabilities

urrent liabilities

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ALANCE 56EET A5 2N

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1ATI2 ANAL@5I5

/atio analysis is the method or process by which the relationship of items orgroups of items in the financial statements are computed, determined andpresented. /atio analysis is an attempt to derive (uantitative measures orguides concerning the financial health and profitability of the businessenterprise. /atio analysis can be used both in trend and static analysis. There

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are several ratios at the disposal of the analyst but the group of ratios hewould prefer depends on the purpose and the objectives of the analysis.

)ccounting ratios are effective tools of analysis. They are indicators ofmanagerial and overall operational efficiency. /atios, when properly used arecapable of providing useful information. /atio analysis is defined as thesystematic use of ratios to interpret the financial statements so that thestrengths and weaknesses of a firm as well as its historical performance andcurrent financial condition can be determined the term ratio refers to thenumerical or (uantitative relationship between items7 variables. Thisrelationship can be e#pressed as%

2" Fraction

1" &ercentages

6" &roportion of numbers

These alternative methods of e#pressing items which are related to each otherare, for purposes of financial analysis, referred to as ratio analysis. It shouldbe noted that computing the ratio does not add any information in the figuresof profit or sales. 'hat the ratios do is that they reveal the relationship in amore meaningful way so as to enable us to draw conclusions from them.

AD/ANTAGE5 2F 1ATI2 ANAL@5I5

• /atios simplify and summarize numerous accounting data in a

systematic manner so that the simplified data can be used effectively foranalytical studies.

• /atios avoid distortions that may result the study of absolute data or

figures

• /atios analyze the financial health, operating efficiency and future

prospects by inter-relating the various financial data found in thefinancial statement.

• /atios are invaluable guides to management. They assist themanagement to discharge their functions of planning, forecasting, etc.efficiently.

• /atios study the past and relate the findings to the present. Thus useful

inferences are drawn which are used to project the future.

• /atios are increasingly used in trend analysis.

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• /atios being measures of efficiency can be used to control efficiency and

profitability of a business entity.

• /atio analysis makes inter-firm comparisons possible. i.e. evaluation of

interdepartmental performances.

• /atios are yard stick increasingly used by bankers and financial

institutions in evaluating the credit standing of their borrowers andcustomers.

LIMITATI2N5 2F 1ATI2 ANAL@5I5&

)n investor should caution that ratio analysis has its own limitations. /atiosshould be used with e#treme care and judgment as they suffer from certainserious drawbacks. ome of them are listed below%

2. /ations can sometimes be misleading if an analyst does not know thereliability and soundness of the figures from which they are computed and thefinancial position of the business at other times of the year. ) businessenterprise for e#ample may have an acceptable current ratio of 6%2 but alarger part of accounts receivables comprising a great portion of the currentassets may be uncollectible and of no value. 'hen these are deducted theratio might be 1%2

1. It is difficult to decide on the proper basis for comparison. /atios ofcompanies have meaning only when they are compared with some standards.

ormally, it is suggested that ratios should be compared with industryaverages. In India, for e#ample, no systematic and comprehensive industryratios are complied.

6. The comparison is rendered difficult because of differences in situations of 1companies are never the same. imilarly the factors influencing theperformance of a company in one year may change in another year. Thus, thecomparison of the ratios of two companies becomes difficult and meaninglesswhen they are operation in different situations.

8. hanges in the price level make the interpretations of the ratios Invalid.The interpretation and comparison of ratios are also rendered invalid by thechanging value of money. The accounting figures presented in the financialstatements are e#pressed in monetary unit which is assumed to remainconstant. In fact, prices change over years and as a result. )ssets ac(uired atdifferent dates will be e#pressed at different values in the balance sheet. Thismakes comparison meaningless.

For e.g. two firms may be similar in every respect e#cept the age of the plant

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and machinery. If one firm purchased its plant and machinery at a time whenprices were very low and the other purchased when prices were high, thee(ual rates of return on investment of the two firms cannot be interpreted tomean that the firms are e(ually profitable. The return of the first firm isoverstated because its plant and machinery have a low book value.

:. The differences in the definitions of items, accounting, policies in thebalance sheet and the income statement make the interpretation of ratiosdifficult. In practice difference e#ists as to the meanings and accountingpolicies with reference to stock valuation, depreciation, operation profit,current assets etc. hould intangible assets be e#cluded to calculate the rateof return on investment If intangible assets have to be included, how willthey be valued imilarly, profit means different things to different people.

;. /atios are not reliable in some cases as they many be influenced by window 7 dressing in the balance sheet.

J. The ratios calculated at a point of time are less informative and defective asthey suffer from short-term changes. The trend analysis is static to an e#tent.The balance sheet prepared at different points of time is static in nature. Theydo not reveal the changes which have taken place between dates of twobalance sheets. The statements of changes in financial position reveal thisinformation, bur these statements are not available to outside analysts.


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resource basis, working capital basis and cash basis. The most commonlyaccepted form of fund flow is the one prepared on working capital basis.

CA56 FL2 /5 F8ND FL2

CASH FLOW - ) ash Flow tatement is a statement which shows inflowsand outflows of cash and cash e(uivalents of an enterprise during a particularperiod. It provides information about cash flows, associated with theperiod5s operations and also about the entity5s investing and financingactivities during the period.

FUND FLOW M Fund Flow tatement also referred to as the statement of Kource and )pplication of FundsL provides insight into the movement offunds and helps to understand the changes in the structure of assets,liabilities and e(uity capital.,

) fund flow statement is different from cash flow statement in the followingways Mi". Funds flow statement is based on the concept of working capital while cashflow statement is based on cash which is only one of the element of workingcapital. Thus cash flow statement provides the details of funds movements.

ii". Funds flow statement tallies the funds generated from various sources withvarious uses to which they are put. ash flow statement records inflows oroutflows of cash, the difference of total inflows and outflows is the net

increase or decrease in cash and cash e(uivalents.

iii". Funds Flow statement does not contain any opening and closing balancewhereas in cash flow statement opening as well as closing balances of cashand cash e(uivalents are given.

iv". Funds Flow statement is more relevant in estimating the firm5s ability tomeet its long-term liabilities, however, cash flow statement is more relevant inestimating the firms short-term phenomena affecting the li(uidity of thebusiness.v". The ash Flow statement considers only the actual movement of cash

whereas the funds flow statement considers the movement of funds onaccrual basis.

vi". In cash flow statement cash from the operations are calculated afteradjusting the increases and decreases in current assets and liabilities. Infunds flow statement such changes in current items are adjusted in thechanges of working capital.

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vii". ash flow statement is generally used as a tool of financial analysis whichis utilized by the management for short- term financial analysis and cashplanning purposes, whereas funds flow statement is useful in planning

intermediate and long-term financing. (at are t(e A.vanta#es of F$n. F*o 5tatementsB

)dvantages of fund flow are as follows%

management of various companies are able to review their cash budgetwith the aid of fund flow statements

3elps in the evaluation of alternative finance and investments plan

Investors are able to measure as to how the company has utilized thefunds supplied by them and its financial strengths with the aid of funds

statements.

It serves as an effective tool to the management of economic analysis

It e#plains the relationship between the changes in the working capitaland net profits.

3elp in the planning process of a company

It is an effective tool in the allocation of resources

3elps provide e#plicit answers to the (uestions regarding li(uid andsolvency position of the company, distribution of dividend and whetherthe working capital is effectively used or not.

3elps the management of companies to forecast in advance there(uirements of additional capital and plan its capital issue accordingly.

3elps in determining how the profits of a company have been invested%whether invested in fi#ed assets or in inventories or ploughed back.

6AT I5 EIG6TED A/E1AGE C25T 2F CAPITALB

The term cost of capital means the overall composite cost of capital defined as Kweighted average of the cost of each specific type of fund. The use ofweighted average and not the simple average is warranted by the fact thatproportions of various sources of funds in the capital structure of a firm aredifferent.

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Therefore the overall cost of capital should take into account the weightedaverage. The weighted cost of capital based on historical weights takes intoaccount a long-term view.

The term cost of capital, as the acceptance criterion or investment proposals,is used in the sense of the combined cot of all sources of financing. This ismainly because focus is on the valuation of the firm as a whole. It is related tothe firm5s objective of wealth ma#imization.

Thus, the weighted average cost of funds of a company is based on the mi# ofe(uity and loan capital and their respective costs. ) distinction is usuallydrawn between the average cost of all funds in an e#isting balance sheet andthe marginal cost of raising new funds.

6AT I5 2PE1ATING C@CLE F21 21:ING CAPITALB

The operating cycle is the length of time between the company5s outlay onraw materials, wages and other e#penditures and the inflow of cash from thesale of the goods. In a manufacturing business, operating cycle is the averagetime that raw materials remain in stock less the period of credit taken fromsuppliers, plus the time taken for producing the goods, plus the time goodsremain in finished inventory, plus the time taken by customers to pay for thegoods.

perating cycle concept is important for management of cash andmanagement of working capital because the longer the operating cycle themore financial resources the company needs. Therefore, the management hasto remain cautious that the operating cycle should not become too long.

The stages of operating cycle could be depicted through the figure given%)3 !Bltimate tage".

undry Aebtors /aw materials!&eriod of credit !&eriod of Turnover

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taken by customers" of raw material stock"

Finished goods 'ork-in-progress!&eriod of turnover !&eriod in production"of finished goods"

The above figure would reveal that operating cycle is the time that elapsesbetween the cash outlay and the cash realization by the sale of finished goodsand realization of sundry debtors. Thus cash used in productive activity, oftensome times comes back from the operating cycle of the activity. The length ofoperating cycle of an enterprise is the sum of these four individual stages i.e.components of time.

6AT I5 P1EFE1ENCE 56A1E CAPITALB

&reference capital represents a hybrid form of financing M it takes somecharacteristics of e(uity and some attributes of debentures.

It resembles e(uity in the following ways%

!i" &reference dividend is payable only out of distributed profits

!ii" &reference dividend is not an obligatory payment !the payment of

preference dividend is entirely within the discretion of the directors"

&reference capital is similar to debentures in several ways%

!i" The dividend rate of preference capital is usually fi#ed

!ii" The claim of preference shareholders is prior to the claim of e(uity

shareholders

!iii" &reference shareholders do not normally enjoy the right to vote

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AD/ANTAGE AND DI5AD/ANTAGE 2F P1EFE1ENCE CAPITAL

Preference Capital has the following Advantages:

2" There is no legal obligation to pay preference dividend. ) company doesnot face bankruptcy or legal action if it skips preference dividend.

1" There is no redemption liability in the case of perpetual preferenceshares. >ven in the case of redeemable preference shares, financialdistress may not be much because%

!i" &eriodic sinking fund payments are not re(uired!ii" /edemption can be delayed without significant penalties

3) &reference capital is generally regarded as part of net worth. 3ence, itenhances the creditworthiness of the firm.

4) &reference shares do not, under normal circumstances, carry votingright. 3ence, there is no dilution of control.

Preference Capital, however suffers from some serious shortcomings:

1) ompared to debt capital, it is an e#pensive source of financing becausethe dividend paid to preference shareholders is not, unlike debt interest,a ta#-deductible e#pense.

2) Though there is no legal obligation to pay preference dividends, skippingthem can adversely affect the image of the firm in the capital market.

3) ompared to e(uity shareholders, preference shareholders have a priorclaim on the assets and earnings of the firm.

6AT I5 T1END ANAL@5I5B

Trend analysis is employed when it is re(uired to analyze the trend of datashown in a series of financial statements of several successive years. Thetrend obtained by such an analysis is e#pressed as percentages. Trendpercentage analysis moves in one direction either upward or downwardprogression or regression. This method involves the calculation of percentagerelationship that each statement bears to the same item in the base year. The

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base year may be any one of the periods involved in the analysis but theearliest period is mostly taken as the base year. The trend percentagestatement is an Kanalytical device for condensing the absolute rupee dataL bycomparative statements.

Merits of Tren. Ana*%sis&

• Trend percentages indicate the increase or decrease in an accounteditem along with the magnitude of change in percentage, which is moreeffective than the absolute data.

• The trend percentages facilitate an efficient comparative study of the

financial performance of a business enterprise over a period of time.

Demerits of Tren. Ana*%sis&

• )ny one trend by itself is not very analytical and informative.

• If interpretation has to be done on percentages and ratios in isolation

and not along with the absolute data from which the percentages havebeen derived, the inferences tend to be absurd and baseless.

• omparability of trend percentages is unfavorably affected when the

accounts have not been drawn on a consistent basis year after year andwhen the price level is not constant.

• Auring inflationary periods the data over a period of time becomes

incomparable unless the absolute rupeee data is adjusted.

• There is always the danger of selecting the base year which may not be

representative, normal and typical.

• Though the trend percentages provide significant information, undue

importance and emphasis should not be laid down on the percentageswhen there is a small number in the base year. In such cases even aslight variation will be magnified by the percentage change.

8ses

• It indicates the increase or decrease in an accounted item along with the

magnitude of change in percentage, which is more effective thanabsolute data.

• The trend percentage facilitates an effective comparative study of the

financial performance of a business enterprise over a period of time

6AT I5 C2MME1CIAL PAPE1B

) company can use commercial papers to raise funds. It is a promissory notecarrying the undertaking to repay the amount on or after a particular date.ormally it is an unsecured means of borrowing and the companies are

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allowed to issue commercial papers as per the regulations issued by >9I andompany5s )ct. ome of them are%

a" +inimum size 1: Dacs

b) +a#imum limit is 2==N of working capital limit.

c" &eriod is from 2: days to 2 year, and every renewal is treated as a freshcommercial paper.

d) 'hile using ommercial &aper, company should ensure that its net worth isat least 8 crores or more and it has been noted by at least 1 ratingagencies like /IID, I/), )/>.

e) ommercial papers on maturity are to be honoured at face value and theregistrars or the issue agencies lay down all the formalities of funding

through commercial papers.

CA56 8DGETING

2. ash 9udget shows the policy and programme of cash inflows andoutflows to be followed in a future period under planned condition.

2. ash 9udget usually of 1 parts gives detailed estimate of cash receiptsand cash distribution. >stimate of cash receipts budget on cashincoming. >stimate of cash distribution based on cash outgoing.

3. ash 9udget is a tool of control since it represents actions which can beshaped to will so that it can be suited in the conditioning which may ormay not happen.

8. ash 9udget begins when ash Forecasting ends. ash Forecasting isconvince in ash 9udget.

:. ash 9udget has a limited scope.

;. ash 9udget denotes a definite target.

CA56 F21ECA5TING&

2. ash Forecast is a main estimate of cash balance likely to happen underanticipated conditions using a specified period of time.

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1. ash Forecasting is an estimate showing amt of cash which would beavailable in future period.

3. ash forecast being statement of future event does not connote anysense of control.

8. ash Forecasting is a preliminary step for ash 9udgeting. It ends withthe forecast of likely cash balances.

:. ash Forecast is a wider scope.

;. ash Forecasting denotes some degree of fle#ibility.

LE/E1AGE5

The employment of an asset or source of funds for which the firm has to pay afi#ed cost or fi#ed return maybe termed as leverage.

2PE1ATING LE/E1AGE M perating Deverage may be defined as the firm5sability to use fi#ed operating costs to magnify the effects of changes in saleson its earnings before interest and ta#es.

FINANCIAL LE/E1AGE M Financial Deverage can be defined as the ability ofa firm to use fi#ed financial charges to magnify the effects of changes in >9ITon the earnings per share.

i". perating Deverage results from the e#istence of fi#ed operating e#pensesin the firm5s income stream whereas Financial Deverage results from thepresence of fi#ed financial charges in the firm5s income stream.

ii". perating Deverage is determined by the relationship between a firm5ssales revenues and its earnings before interest and ta#es. !>9IT"FinancialDeverage is determined by the relationship between a firm5s earnings beforeinterest and ta# and after subtracting the interest component.

iii". perating Deverage O ontribution>9IT

Financial Deverage O >9IT >9T

iv". perational Deverage relates to the )ssets side of the 9alance heet,whereas Financial Deverage relates to the Diability side of the 9alance heet.

v". perational Deverage affects profit before interest and ta#, whereasFinancial Deverage affects profit after interest and ta#.

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vi". perational Deverage involves operating risk of being unable to coverfi#ed operating cost, whereas Financial Deverage involves financial risk ofbeing unable to cover fi#ed financial cost.

vii". perational Deverage is concerned with investment decisions, whereasFinancial Deverage is concerned with financing decisions.

viii". perating Deverage is described as a first stage leverage, whereasFinancial Deverage is described as a second stage leverage.

T22L5 85ED F21 FINANCIAL ANAL@5I5

The various tools used for financial analysis are%

Fund flow tatement

/atio )nalysis

ommon ize tatements

omparative Financial tatements

Trend )nalysis

ash 9udget

'orking apital

Deverages

F$n. F*o 5tatement

Fund flow statement also referred to as statement of Ksource and applicationof fundsL provides insight into the movement of funds and helps tounderstand the changes in the structure of assets, liabilities and e(uitycapital. The information re(uired for the preparation of funds flow statementis drawn from the basic financial statements such as the 9alance heet and&rofit and loss account. KFunds Flow tatementL can be prepared on total

resource basis, working capital basis and cash basis. The most commonlyaccepted form of fund flow is the one prepared on working capital basis.

1atio Ana*%sis

/atio analysis is the method or process by which the relationship of items orgroups of items in the financial statements are computed, determined andpresented. /atio analysis is an attempt to derive (uantitative measures or

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guides concerning the financial health and profitability of the businessenterprise. /atio analysis can be used both in trend and static analysis. Thereare several ratios at the disposal of the analyst but the group of ratios hewould prefer depends on the purpose and the objectives of the analysis.

)ccounting ratios are effective tools of analysis. They are indicators ofmanagerial and overall operational efficiency. /atios, when properly used arecapable of providing useful information. /atio analysis is defined as thesystematic use of ratios to interpret the financial statements so that thestrengths and weaknesses of a firm as well as its historical performance andcurrent financial condition can be determined the term ratio refers to thenumerical or (uantitative relationship between items7 variables. Thisrelationship can be e#pressed as%

2. Fraction1. &ercentages

6. &roportion of numbers

These alternative methods of e#pressing items which are related to each otherare, for purposes of financial analysis, referred to as ratio analysis. It shouldbe noted that computing the ratio does not add any information in the figuresof profit or sales. 'hat the ratios do is that they reveal the relationship in amore meaningful way so as to enable us to draw conclusions from them.

Common 5ize 5tatements

It facilitates the comparison of two or more business entities with a commonbase. In case of balance sheet, Total assets or liabilities or capital can betaken as a common base. These statements are called Kommon+easurementL or Komponent &ercentageL or K2== percentL statements. inceeach statement is reduced to the total of 2== and each individual componentof the statement is represented as a N of the total of 2== which invariablyserves as the base.

Thus the statement prepared to bring out the ratio of each asset of liability tothe total of the balance sheet and the ratio of each item of e#pense orrevenues to net sales known as the ommon ize statements.

Com)arative Financia* 5tatements

omparative financial statements is statement of the financial position of abusiness so designed as to facilitate comparison of different accountingvariables for drawing useful inferences.

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Financial statements of two or more business enterprises may be comparedover period of years. This is known as Kinter-firm comparisonL Financial statements of particular business enterprise maybe compared overtwo periods of years. This is known as Kinter-period comparisonL.

Tren. Ana*%sis

Trend analysis is employed when it is re(uired to analyze the trend of datashown in a series of financial statements of several successive years. Thetrend obtained by such an analysis is e#pressed as percentages. Trendpercentage analysis moves in one direction either upwards or downwards,progression or regression. This method involves the calculation of percentagesrelationship that each statement bears to the same item in the base year.

The base year maybe any one of the periods involved in the analysis but the

earliest period id mostly taken as the base year. The trend percentagestatement is an Kanalytical device for condensing the absolutely rupee dataLby comparative statements.

Cas( $.#et

ash budget is a forecast or e#pected cash receipts and payments for a futureperiod. It consists of estimates of cash receipts, estimate of cashdisbursements and cash balance over various time intervals. easonal factorsmust be taken into account while preparing cash budget. It is generallyprepared for 2 year and then divided into monthly cash budgets.

orin# Ca)ita*

'orking capital is the amount of funds held in the business or incurring day today e#penses. It is also termed as short term funds held in the business. It isascertained by finding out the differences between total current assets andtotal current liabilities. 'orking capital is a must for every organization. It islike a life blood in the body. It must be of sufficient amount and should bekept circulated in the different forms of current assets and current liabilities.The success of organization depends upon how successfully the circulation of

short term fund is maintained smoothly and speedily. 'orking capital is alsocompared with the water flowing in the river as the water is always flowing itis pure water similarly working capital should be kept circulated in differentshort term assets.

Levera#es

The employment of an asset or source of funds for which the first firm has topay a fi#ed cost or fi#ed return may be termed as leverage.

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Operating leverages: is determined by the relationship between firms, salesrevenue and its earnings before interest and ta#es !>9IT" which are generallycalled as perating profits. perating leverage results from the e#istence offi#ed operating e#penses in the firm5s income stream. the operating leveragemay be defined as the firm5s ability to use fi#ed operating cost to magnify theaffects of charges In sales on its earnings before interest and ta#es.

Financial leverages: it relates to the financing activities of a firm. Financialleverage results from the presence of fi#ed financial charges in the firm5sincome stream. Financial leverages concerned with the effects or changes inthe >9IT in the earnings available to e(uity shareholders. It is defined as theability of a firm to use fi#ed financial charges to magnify the effects orchanges in >9IT on the earnings per share.

5281CE5 2F FINANCE

5o$rces of 5(ort term an. *on# term finance

The business re(uires two types of finance namely%

2. hort term finance1. Dong term finance

hort term finance is concerned with decisions relating to current assets andcurrent liabilities and is also called as working capital finance.hort term financial decisions typically involve cash flows within a year orwithin the operating cycle of the firm. ormally short term finance is for aperiod up to 6 years.

The main sources of short term finance are%

2. ash credit1. hort term loans from financial institutions6. 9ill Aiscounting8. Detter of credit:. Inter-corporate deposits

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1. hort term loans from financial institutions% 9ank overdraft

6. 9ill Aiscounting%9ill Aiscounting is a short term source of finance, whereby 9ills /eceivablereceived from debtors is in cashed from the bank at a discounted rate.

8. Detter of creditDetter of credit is an indirect form of working capital financing and banksassume only the risk, the credit being provided by the supplier himself.) letter of credit is issued by a bank on behalf of its customer to the seller. )sper this document, the bank agrees to honor drafts drawn on it for thesupplies made to the customer. I f the seller fulfills the condition laid down inthe letter of credit.

:.Inter- corporate Aeposits

) deposit made by one company with another, normally for a period of si#months is referred to as an IA ie. hort-term deposits with other companiesare a fairly attractive form of investment of short term funds in terms of rateof return. These deposits are usually of three types%

a. all deposits% ) call deposit is withdraw able by the lender on a givendays notice.

b. Three-months Aeposits% These deposits are taken by the borrowers totied over a short term cash inade(uacy

c. i#-month Aeposits% ormally lending companies do not e#tend depositsbeyond this time frame. uch deposits are usually made with first-classborrowers.

;. ommercial papers) company can use commercial papers to raise funds. It is a promissory notecarrying the undertaking to repay the amount or7 on after a particular date.

J. Factoring) factor is a financial institution which offers services relating to managementand financing of debts arising form credit sales. Factoring provides resourcesto finance receivables as well as facilitates the collection of receivables.

There are 1 banks, sponsored organizations which provide such services%

a. 9I factors and commercial services DTA

b. anbank factors DTA, started operations since the beginning of 2@@J.


30/68

ince the above sources do not permit the use of funds, for a longer period oftime, the business has to seek further sources, if the need is for a longerperiod of time, i.e. This e#tends up to 6 years and above.

'hen a firm wants to invest in long term assets, it must find the needs tofinance them. The firm can rely to some e#tent on funds generated internally.3owever, in most cases internal resources are not enough to supportinvestment plans. 'hen that happens the firm may have to curtail investmentplan or seek e#ternal funding. +ost firms choose to take e#ternal funding.They supplement internal funding with e#ternal funding raise from a variety ofsources.The main sources of long term finance can broadly divided into%

Interna* so$rces inc*$.e&

a. hare capital !>(uity shares and preference shares"

b. /eserves and urplusc. &ersonal loans and advances from owners called as P4uasi apital5

Externa* so$rces inc*$.e&

a. Term loan from banks, financial institutions and international bodies

like International +onetary Funds, 'orld 9ank, )sian Aevelopment

9ank.

b. Aebentures

c. Doans and advances from friends and relativesd. Inter- orporate Aeposits

e. )sian Aepository /eceipts 7 ?lobal Aepository /eceipts

f. ommercial &apers.

The short term or long term finance is a function of financial management.The good and efficient management is that which can raise the fundswhenever re(uired and at the most competitive terms and conditions. /aisingof funds either internally or e#ternally re(uires a professional approach andalso complying with so many legal, technical and statutory re(uirements

prescribed by the ompanies )ct, ecurities >#change 9oard f India, tock>#changes )uthorities and also allied laws like Income Ta#, Foreign >#change+anagement )ct, 9anking /egulations )ct, etc.

C2NTENT5 2F T6E CAPITAL 5T18CT81E

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The capital structure includes Funds received from the owners of the businessi.e. the hareholders and therefore called as%

• hare holders fund

• &roprietor fund

• wners fund

The share holders fund are further classified into

hare apital% >(uity and &reference

/eserves and urplus% ?eneral reserve, etc

Fictitious assets% &reliminary e#penses etc

The capital structure also includes 9orrowed Funds which are further dividedinto%

ecured Doans !9ank loans, debentures, etc"

Bnsecured loans ! loans from friends and relatives"

The /esult of which is% The apital employed i.e. the total long term fundssupplied by the creditors and owners of the firm. It can be computed in 1ways. First as mentioned above M the non-current liabilities plus owner5se(uity. )lternatively its is e(ual to net working capital plus fi#ed assets.

Gd! before ta#" O /

Gd ! )fter ta#" O / ! 2-t"

Ge O Aividend Q 2== et proceeds

Tra.in# on E$it%

T(e format of t(e ca)ita* str$ct$re i**

f$rt(er i**$strate t(e meanin#

1efer to c(o$.(ari an. c(o).e boofor t(e format"

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Trading on >(uity refers to the practice of using borrowed funds, carrying afi#ed charge, to obtain a higher return to the >(uity hareholders. 'ith a larger proportion of the debt in the financial structure, the earnings,available to the owners would increase more than the proportionately with anincrease in the operating profits of the firm. This is because the debt carries a fi#ed rate of return and if the firm is able toearn, on the borrowed funds, a rate higher than the fi#ed charges on loans,the benefit will go the shareholders. This is referred to as KTrading on >(uityL

The concept of trading on e(uity is the financial process of using debt toproduce gain for the residual owners or the e(uity shareholders. The termowes its name also to the fact that the e(uity supplied by the owners, whenthe amount of borrowing is relatively large in relation to capital stock, acompany is said to be trading on e(uity, but where borrowing is comparativelysmall in relation to capital stock, the company is said to be trading on thick

e(uity. apital gearing ration can be used to judge as to whether the companyis trading on thin or thick e(uity.

I**$stration

&)/TIBD)/ ) 9 ) 9 >4BIT 1== 1== 1== 9TR2:N TR2:N 21= 21= 21= 6= ;= 21=

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The objective of receivables management is to promote sales and profits untilthat point is reached where the returns that the firm gels from funding ofreceivables is less than the cost that the firm has to incur in order to fundthese receivables. This, the purpose of receivables is directly connected withthe firms objective of making credit sales.

The following aspects of receivables management are important%

A" Cre.it Po*ic%& redit policy means the decisions with regard to the creditstandards, i.e. who gets credit and up to what amount and on what specificterms. The firms credit policy influences the sales level, the investment .level,in cash, inventories, accounts receivables and physical e(uipments, bad debtlosses and collection costs. The various factors associated with credit policyare%

!i" redit tandards

!ii" redit &eriod

!iii" ash Aiscount

!iv" ollection &rogramme.

Cre.it 5tan.ar. means classification of customers to whom credit can notbe e#pended or can be e#tended. ) firm can take the help of credit ratingagencies for this purpose.

Cre.it Perio. means the length of time customers are allowed to pay fortheir purchases. It may vary from 2: days to ;= days.

Cas( Disco$nt is generally offered to induce prompt payment by thecustomers, credit terms provide the percentage of discount and the periodduring which it may be available, for e#ample, credit terms of 172= net 6=means that a discount of 1 percent is offered if the payment is made by the2=th day otherwise the full payment is due by the 6=th day.

T(e Co**ection Pro#ramme means the collection effort of a firm as decidedby the credit policy. The objective of the collection policy is to collect thereceivables in time. The collection programme consists of the followingdetails%

!2" +onitoring the state of receivables,

!1" Aispatch the letters to customers, whose due date is approaching,

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!6" communicate the customers by telephone at about the due date,

!8" Threat of legal action to overdue accounts,

!:" )ctual legal action against overdue accounts.

" Cre.it Eva*$ation& redit evaluation means a review of a prospectivecustomer by obtaining the information to judge the customers willingness andability to pay his debt. In judging the credit worthiness of an applicant thethree basic factors which should be considered are, character, capacity andcollateral. The character refers to the willingness of the customer to honourhis obligations. The capacity $ refers to the ability of a customers to pay ontime and the collateral represents the security offered by him in the form ofmortgages. ) firm can use different ways to judge the creditworthiness of anapplicant. ome of the ways are as follows%

- )nalysis of financial statements- obtaining of bank certificate

- )nalysis of past e#perience

- umerical credit scoring.

C" Cre.it Grantin# Decision& redit evaluation helps to judge the creditworthiness of a prospective customer. redit granting decision is a procedure

of final decision whether to grant credit to the prospective customer or not.The decision to grant credit or not depends upon the !cost benefit analysis.The manager can form a subjective opinion based on credit evaluation aboutthe chance of getting payment and the chance of not getting payment. Therelative chances of getting the payment or not getting the payment are at theback of his mind while taking such a decision.

C2NCEPT8AL5 ,8E5TI2N5&

Net ort(& et worth means total e(uity including reserves and surplus lessintangible assets like goodwill.

!F)H)" M !D E 9orrowed funds".

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Ca)ita* em)*o%e.& apital employed is total shareholders fund and borrowedfund. In other words, it means total sources. The formula for capital employedis% apital employedOhare capital H reserves E surplus H &ED a7c !cr" Hloans !borrowed funds".

1et$rn on ca)ita* em)*o%e.% /eturn on capital employed is the return ontotal resources or profitability on the overall investment viz total resourcesutilized by the business. Total resources employed or total capital employedmeans the total funds at the disposal of the business.

Common size statement& The determination of trends and comparisons ofamounts are facilitated by use of percentage of figures instead of rupeeamount. The amounts and accounts in financial statements are reduced to Nand these N are presented for comparison purpose. uch statements arecalled common size statements.

1atio ana*%sis& /atio analysis is the process of computing, determining andpresenting the relationships between items or group of items in the financialstatements through accounting ratios. )n analysis is normally undertaken forthe purpose of projecting financial position or profitability, knowledge oftrends is usually more significant than knowledge of present status only. )nanalysis of trends through ratio analysis helps in appraisal of financialconditions, efficiency and profitability of a business. /atio analysis helps torelate information in the financial data in a meaningful manner. It facilitatescomparison.

," T(e fo**oin# financia* res$*ts in.icate a mismatc( beteen sa*es

an. )rofit an increase in sa*es is fo**oe. b% .ecrease in )rofit or viceversa Disc$ss vario$s )ossib*e res$*ts

Ans" )n increase in sales is followed by a decrease in profit or vice versa. Itindicates that although sales might have increased, the cost of sales hasincreased much more that is why the profits have decreased. It could bepossible that the operating e#penses, administrative e#penses and othere#penses might have increased at a higher rate than the increase in sales so,the profit will definitely decrease. )nother reason could be an increase in thecost of production which decreases the profit. It can be also that the salesmight decrease and the profit increase. This may be decrease in operatingcost or decrease in the cost of raw materials.," 5tate an% + reasons for t(e c(an#es in&

!" Ex)ense ratio" C$rrent ratio

)" a" >#pense ratio is a profitability ratio, related to sales which can becomputed by dividing e#penses by sales.

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3ere the term e#penses includes%-i" ost of goods soldii" )dministrative e#pensesiii) elling and distribution e#pensesiv" Financial e#penses

The e#penses ratio is closely profit margin, gross as well as net. It is veryimportant for analyzing the profitability of a firm. ) low e#penses ratio isfavourable whereas a high e#penses ratio is unfavourable. The implicationsof a high e#penses ratio is that only a relatively small percentage share ofsales is available for meeting financial liabilities like interest, ta# Edividends and so on.

Thus, an increase in a company5s e#penses ratio would leave the companyin a financial crunch.

)n analysis of the factors responsible for a low ratio may reveal changes inthe selling price on the operating e#penses. It is likely that individual itemsmay behave differently.

'hile some operating e#penses may show a rising trend, others mayrecord a fall. The specific e#penses ratio for each of the item of operatingmay be calculated. These ratios would identify the specific cause.

To, illustrate, an increase in selling e#penses may be due to a number ofreasons like%

i" ?eneral rise in selling e#penses.ii" Inefficiency of the +arketing department leading to

uncontrolled promotional and other e#penses.iii" ?rowing competition.iv" Ineffective advertising.v" Inefficient utilization of resources.

b" urrent ratio%

The current ratio is the ratio of total current assets to total currentliabilities. The calculation is done by using the formula%

urrent assets urrent ratioO

urrent liabilitiesThe current assets are those can be converted into cash within a short periodof time during the ordinary course of business of a firm, whereas the currentliabilities include liabilities which are short term obligations to be met within ayear. Thus any change in the composition of current assets E7or liabilities willlead to a change in the current ratio.

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The current ratio of a firm its short term solvency i.e. the ability to meet shortterm obligations. The higher the larger is the amount of rupees available perrupee of current liability, the more is the firm5s ability to meet currentobligations E assures greater safety of funds of short term creditors.

The flow of funds through current assets and liabilities account is (uiteinevitably uneven. urrent assets might shrink due to reasons like% - i" baddebts, ii" inventories becoming obsolete or unsaleable, iii" occurrence ofune#pected losses in marketable securities etc.

) firm should have a satisfactory and a reasonable current ratio S1%2 isconsidered to be satisfactory. ) satisfactory ratio depends upon thedevelopment of the capital market E the availability of long term funds tofinance current assets, the nature of industry and so on. Thus the currentratio varies with variations in such factors.

The nature of the industry is one of the major cases for difference in thecurrent ratio. For instance, public utility companies generally have a very littleneed for current assets. The wholesale dealers, on the other hand, purchasinggoods on a cash7credit basis for a very short period but selling to retailers oncredit basis, re(uire a higher current ratio.

," As a cre.itor or investor or finance mana#er s$##est an% + ratios

to be $se. for ana*%sis it( reasonsAns" /atio analysis is a tool of financial analysis used to interpret the financialstatements so that the strengths E weaknesses of a firm as well as itshistorical performance E current financial condition can be determined. /atiosare used for comparison with related facts. omparison involves i" trendsratio, comparison of ratios of a firm over time. ii" inter-firm comparison, iii"comparison of items within a single year5s financial statement of a firm E iv"comparison with standards or plans.

/atios e classified into 8 broad groups%-i" Di(uidity ratioii" apital structure7leverage ratioiii" &rofitability ratios E iv" )ctivity ratios.

The use of following ratios is suggested%-

Firstly, the li(uidity ratio as ade(uate li(uidity is (uite important since itindicates the firm5s ability to meet current7short term obligations. reditorsare interested in the short term solvency of a firm.

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urrent ratio is one important component7type or li(uidity ratio. It measuresfirm5s short term solvency i.e. its ability to meet short term obligations bycomparing the current assets and current liabilities. The higher the currentratio, the larger the amount of rupees available per rupee of current liability,the more is the firm5s ability to meet current obligations E assures greatersafety of funds of short term creditors.

econdly the leverage7capital structure ratio. These ratios throw light on thelong term solvency of a firm. It judges the soundness of a firm in terms of itsability to pay the interests regularly to long term creditors E repayment ofprincipal on maturity.

)mong the leverage ratios, the debt-e(uity is one of the important ones. Itshows the relationships between borrowed bunds and owner5s capital tomeasure the long term financial solvency of the firm. This ratio reflects therelative claims of the creditors E shareholders against the assets of the firm.

)lternatively, it includes the relative proportions of debt E e(uity in financingthe assets of the firm. It can be e#pressed as follows%

Aebt->(uity ratioO Dong term debt

hareholder5s e(uityr

Total debt

hareholder5s e(uity.

The A7> ratio is thus, the ratio of the amount invested by outsiders to theamount invested by the owners of the business.

It is an important tool of financial analysis to appraise the financial structureof a firm. It has important implications from the view point of creditors,owners E the firm itself.

) high ratio shows a large share of financing by the creditors of the firm whilea lower ratio implies smaller claim by creditors. It indicates the margin ofsafety to creditors.

For e#% If the A7> ratio is 1%2, it implies for every rupee of outside liability, thefirm has two rupees of the owner5s capital. 3ence there is a safety of marginof ;;.;JN available to the creditors of the firm. onversely if the A7> ratio is2%1, it implies low safety of margin for the creditors.

) high A7> ratio has e(ually serious implications from the firm5s point of view.It would affect the fle#ibility of operations of the firm, restrict the borrowingsetc. the shareholders would however gain in 1 ways%-

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i" with a limited stake they would be able to retain control of the firm.ii" The returns would be magnified.) low A7> ratio would have just the opposite implications.

Thirdly, the profitability ratios. The creditors !long term7short term", theowners E the management of the company. The management is eager tomeasure its operations efficiently. imilarly, owners invest their in thee#pectation of reasonable returns. 9oth these factors depend ultimately onthe profits earned by it which can be measured by its profitability ratios.

&rofitability ratios can be determined on the basis of either sales orinvestments.

2" /elated to sales%a" &rofit margin Sgross E net%- It measures the relationship between

profit E sales of a firm.

b" >#penses ratio% - It measures the relationship between e#penseslike administration, selling E distribution, financial etc E the salesof the firm.

1" /elated to investments%-a" /eturn on investments

i" /eturn on assets Scompare net profits E assets.ii" /eturn on capital employed Scompare profits E capitalemployedii" /eturn on shareholder5s e(uity Smeasure the returns on

owner5s funds

, (at is t(e effect of t(e fo**oin# on t(e f$n.s f*o statementB

Ans Transfer to reserve% Transfer of profits to general reserve the journalentry is

&rofit and loss appropriation a7c Ar To general reserve a7c

This transaction affectsi" profit and loss appropriation a7c

ii" general reserve a7c

9oth the accounts belong to the non current category and hence there is noflow of fund. Increase in any of the reserves on account of transfer from &EDa7c is to be added back to the profits to ascertain funds from operations. Ifincrease is on account of adjustment of profits on non current accounts itwould not affect the fund. imilarly if the decrease in reserves is on account ofadjustment of loss on non current assets, it would not affect the funds.

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a" Aepreciation% It means decrease in the value of asset due to wear andtear, lapse of time, obsolescence. Aepreciation is taken as an operatinge#pense. 'hile calculating funds from operations the accounting entriesare

i" Aepreciation a7c Ar. To fi#ed assets a7c

ii" &rofit and loss a7c Ar. To depreciation a7c

Thus effectively the &ED a7c is debited while the fi#ed asset a7c is creditedwith the amount of depreciation. ince both &ED a7c and the fi#ed asseta7c are non current accounts depreciation is a non fund item. It is neithera source nor an application of funds. It is added back to operating profit tofind out funds from operation. ince it has already been charged to profit

but it does not decrease funds from operations. Aepreciation should not,therefore be taken as a source of funds.

3owever depreciation can be taken as a source of funds in a limited sense.This is mainly because it helps to consumer funds by reducing the profitsavailable for dividends and also by reducing the ta# liability. Aepreciationcharge unlike other e#pense is paid by the company to itself. Thereforedepreciation is reduced as a non cash item and it does not affect the fundsfrom operations of an accounting period.

b" &roposed dividend% It may be taken as a current liability. In such a caseit will appear as one of the items decreasing working capital in theschedule of changes in working capital. It will not be shown as anapplication of funds when dividend is paid later on.

&roposed dividend may simply be taken as an appropriation of profit. Insuch a case proposed dividend for the current year will be added it tocurrent year5s profit in order to find out the funds from operation if suchamount of dividend has already been charged to profits. &roposed dividendwill be shown as an application of funds.

c" Interim dividend% &ayment of dividend is an application of funds. In thecase of interim dividend the following entry is passed

Interim dividend a7c Ar To bank a7c

Interim dividend is transferred to &ED a7c by the following entry

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&ED a7c ArTo interim dividend a7c

The composite entry is&ED a7c ArTo bank a7c

)s the transaction affects the &ED a7c !a non current item". &ayment ofinterim dividend results in application of funds.

d" &rovision of ta#% It is an application of funds and as such it appears inthe funds flow statement. &rovision for ta# may be treated as a currentliability. 'hen ta# provision is treated as a current liability, it forms apart of the working capital calculations. In that case ta# paid will not betreated as an application of funds.

The second alternative is to treat provision for ta# as a non currentliability. In that case the following entries are passed &ED a7c ArTo provision for ta# a7c

'hen the assessment is completed and ta# is paid the amount of ta#paid is debited to provision for ta# and is treated as an application andthe following entry is passed&rovision for ta# a7c Ar.To bank a7c

, (at are t(e )reca$tions to be taen .$rin# tren. ana*%sisB

)ns. Auring the calculation of trend analysis the following precautionsshould be taken%

i" There should be consistency in the principles and practices followedby the organizations through out the period for which analysis ismade.

ii" The base year should be normal i.e. representative of the itemsshown in the statement.

iii" It should be calculated only for the items which are having logicalrelationship with each other.

iv" It should be studied after considering the absolute figures on whichthey are based.

v" Figures of the current year should be adjusted in the light of pricelevel changes as compared to the base year before calculating trendanalysis.

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vi" The changes in financial data can understood clearly when the N ofchange interpreted concurrently with the absolute change.

vii" The changes in incomes should always be studied in the light ofchanges in e#pect items.

viii" hanges should be interpreted with some reservations.i#" The interpretation of the statements should be done in the light of all

possible factors which might have brought about such changes.

Thus the above precautions have to be taken during the calculations of trendanalysis.

, Give an% t(ree objectives of financia* ana*%sisB

)ns. Financial management analysis is an integral part of interpretations ofresults disclosed

by financial statements. It supplies to decision makers crucial financialinformation and points out the problem areas which can be investigatedfinancial statement analysis involves regrouping of the data suitably byarithmetic operations. Financial statements may be analyzed with a view toachieve the following purposes%

2" &rofitability analysis% Bsers of financial statements may analyze financialstatements to decide past and present profitability of the business.&rospective investors may do profitability analysis before taking adecision to invest in the shares of the company.

1" Di(uidity analysis% uppliers of goods moneylenders and financialinstitutions may do li(uidity analysis to find out ability of the companyto meet its obligations. Di(uid assets are compared with thecommitments in order to test li(uidity position of a company.

6" olvency analysis% It refers to analysis of long term financial position ofa company. This analysis helps to the ability of a company to repay itsdebts. For this purpose, financial structure, interest coverage isanalyzed.

, Differentiate beteen static an. .%namic ana*%sis

)ns. /. Aynamic analysis tatic analysis

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2. It re(uires financialstatements of 1 or moreyears.

It re(uires financial statementsof one year.

1. It gives information inabsolute as well as

percentage form.

It gives information inpercentage form only.

6. It deals with same item ofdifferent years.

Ti deals with different items ofthe same year.

8. It is used for times seriesanalysis.

It is used for cross sectionanalysis.

, 5tate an% + $ses of common size statement com)arative

statement tren. ana*%sis an. ratio ana*%sisB

)ns.Bse of common size statement%2. ommon size analysis reveals the sources of capital and all other

sources of funds and the distribution or use or application of thetotal funds in the assets of a business enterprise.

1. omparison of common size statements over a number of yearswill clearly indicate the changing proportions of the variouscomponents of assets, liabilities, costs, net sales and profits.

6. omparison of common size statements of 1 or more enterprisesin the same industry or that of an enterprise with the industry asa whole will assist corporate evaluation and ranking.

Bses of comparative statement%2. These statements are very useful to the financial analysts because they

indicate the direction of the movement of the financial position andperformance over the years.

1. These statements can also be used to compare the position of the firmevery month or every (uarter. They can be prepared to facilitatecomparison with the financial position of other firms in the sameindustry or with the average performance of the entire industry. uch

comparisons facilitate identification of Ptrouble spots5 in a company5sworking and taking corrective measures.

6. omparative statements present a review of the past activities and theircumulative effect on the financial position of the concern.

Bses of trend analysis%

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2. Trend analysis indicate the increase or decrease in an accounted itemalong with the magnitude of change in percentage which is moreeffective than absolute data.

1. The trend analysis facilitates an efficient comparative study of thefinancial performance of a business enterprise over a period of time.

Bses of ratio analysis%2. The relation between 1 or more financial data brought out by an

accounting ratio is not an end in itself. They are means to get to knowthe financial position of an organization.

1. Industrial ratios may provide valuable information only when they arestudied and compared with several other related ratios.

6. /atio analysis will tend to be more meaningful when certain standards

and norms are laid down so that what the ratios indicate can becompared with the said standards.

, Difference beteen f$n. f*o an. cas( f*o statement

T1EA581@ ILL5&

ash flow statement Fund flow statement

2. It shows net change in the positionof cash and cash e(uivalents.

It shows change in the position of workingcapital.

1. ash flow statement is based onnarrower concept of funds i.e. cashand cash e(uivalent.

Fund flow statement is based on broaderconcept of funds i.e. working capital.

6. It is now mandatory for all thelisted companies and is morewidely used in India or abroad.

It is not mandatory and it is not being used

by the companies.

8. ash flow statement classifies andhighlights the cash flows into 6categories Poperating activities5,

Pinvesting activities5, and Pfinancingactivities5.

'hereas such a meaningful classificationis not used in fund flow statement.

:. In cash flow statement of changesin working capital is not preparedas the changes in working capitalare adjusted for ascertaining cash

generated from operations.

In fund flow statement of changes inworking capital is prepared.

;. In cash flow statement decrease incurrent liability or increase incurrent asset results in decrease incash and vice-versa.

In fund flow statement decrease in currentliability or increase in current asset bringsincrease in working capital and vice-versa.

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Treasury bills are obligations of the government. They are sold on a discountbasis for that reason. The investor does not receive an actual interestpayment. The return is the difference between the purchase price and the face!par" value of the bill.

The treasury bills are issued only in bearer form. They are purchased,

therefore, without the investor5s name upon them. This attribute makes themeasily transferable from one investor to the ne#t. ) very active secondarymarket e#ists for these bills. The secondary market for bills not only makesthem highly li(uid but also allows purchase of bills with very short maturities.)s the bills have the full financial backing of the government, they are, for fullpractical purposes, risk free. This negligible financial risk and the high degreeof li(uidity make their yield lower than on marketable securities. Aue theirvirtually risk-free nature and because of active secondary market for them,treasury bills are one of the most popular marketable securities even thoughthe yield on them is lower.

(at are inter- cor)orate .e)ositsB

) deposit made by one company to another normally for a period up to ;months is referred to as an inter-corporate deposit. uch deposits are usuallyof three types%

1. Ca**e. .e)osits& In theory a called deposit is withdraw able by thelender on a day5s notice. In practice, however the lender has to wait forat least three days. The interest rate on such deposits may be around2;N p.a.

2. + mont(s .e)osits& +ore popular in practice, these deposits are takenby borrower to tide over a short term cash inade(uately that may becaused by one or more of the following factors, disruption in production,e#cessive imports of raw materials, ta# payments, delay in collection,dividend payable and planned capital e#penditure. The interest rate onsuch deposit is around


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It may be interest to note the following characteristics of the inter-corpo

Financial management Notes Anirudh

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