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Notes sendby thakur sir 08-03-11
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Notes sendby thakur sir 08-03-11

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  • 1. Financial Management Made EasyFinancial AnalysisA banker advances to many clients including individuals, traders, firms and corporate. Before aloan is granted the banker needs to do an evaluation of the firm’s/company’s financial positionby applying different parameters. On e important parameter is to do a financial analysis.The advantages of financial analysis are:  To understand the financial position of the firm/company (prospective/existing)  To assess the repayment capacity of the firms (the loan amount + interest + other fees)  To evaluate the managerial skills of the management team, with special reference to the financial management.The Tools used in financial Analysis: Financials Balance Sheet Profit & Loss Accounts Flow Statements Cash Flow Funds FlowBalance Sheet (BS)- A BS is statement indicates the financial position as on a particular date (ex: as on 31stMarch,2010)  A BS has two sides – Assets & Liabilities  Assets- What the firm Owns and its Receivable  Liabilities – What the firm Owes and its Payables
  • 2.  Shows Sources of Funds and Uses of fundsTo have a fair idea/view about the financial position of a firm/company, the interestedpersons /Institutions (investors,analysts,bankers,credit rating agencies) need to analyse thefinancials for a period of three to five years. The study/analysis helps to understand the trendabout the various aspects. The analysis need to cover the entire period of 12 months. Thestudy should be based on different set of figures to arrive at a meaningful decision.Ratio Analysis: (RA) is used by the analysts to compare and understand the financial position ofa firm/company. Ratios are used as tools for this type of analysis. Ratio analysis is a process ofestablishing a significant relationship between the items of financial statements to provide ameaningful understanding of the performance and financial position of a firm. Classification of ratios I-(Expression/Degree of Importance Types of Ratios Degree of Mode of expression Importance Simple/Pure Primary Percentage Rate Secondary tertiary
  • 3. Classification of ratios II-Users Auditors Short tem creditors-Banks Management Users Credit Analysts- Long term Credit Rating creditors-Banks/ Cos Fin Institutions Investors/Share holders
  • 4. Classification of ratios III – Important Parameters Liquidity Ratio Solvency ratio Activity ratio Profitability Ratio
  • 5. Classification of ratios IV – Financial Statements: Balance Sheet Funds P&L Flow Account Cash FlowBriefly we try to understand the following:Traditional Classification: On the basis of financials. They are classified asP&L a/c ratios: i.e., ratios calculated on the basis of p/l a/c onlyBalance sheet ratio: ratios on the basis of figures of balance sheet only
  • 6. Composite or inter statement ratios: on the basis of the figures of P&L as well as Balance sheetratios can be classified into: • Financial or Solvency Ratio • Turnover or Activity Ratio • Profitability or Income RatioFinancial Ratios may be classified intoShort term solvency ratios: This discloses the financial position or solvency of the firm in theshort term. This is also called as ‘Liquidity Ratio”Long term solvency ratios : This discloses the financial position or solvency of the firm in thelong term. This is also called as ‘Solvency Ratios”Advantages of Ratios as a tool for financial analysis: It simplifies the reading of the financial statements Helps in Inter firm comparison Highlights the factors associated with successful/unsuccessful firms. Reveals different positions of the firm/s such as strong/weak/overvalued and undervalued Helps in Planning and forecastingRecap: Ratios can assist the user (lender, management) in the basic functions of forecasting, planning, coordination, control and communication.Limitations of Ratios:+ Comparative study required+ Non financial changes, an important factor is not covered+ Different accounting policies in the same industry may distort the results+ Ratios alone are not adequate: Ratios are only indicators. Other things are also needed fortaking decision.
  • 7. Example: (i) a high current ratio does not necessarily mean that the concern has a goodliquidity position ( in case the current assets consists of outdated stocks) (ii) debtors beyond areasonable period if not excluded from the current assets would not reveal the correct positionRatios tells the analyst/user to ‘stop, look and decide’Window dressing:} Window dressing is manipulation of accounts, i.e., concealment of facts and figures} Does not reveal the factual position, but reflects a better position that what actually is,Example : A high stock turnover ratio is generally considered as an indication to operationalefficiency. This may be achieved by unwarranted price reduction or failure to maintain properstock of goods This might result in a favorable ratio/s.Changes in Price levels: Two firms depreciate the machinery based on their date of purchasethen the deprecation would be lower for the older company than the new company. Hencemere comparative study does not convey purposeful meaning.A) Profitability Ratios:1) Overall Profitability Ratio:Known as ‘Return on Investment’ It indicates the % of return on the total capital employed inthe business. Formula : Operating Profit/Capital employed x 100Capital employed: (i) Sum Total of all assets (fixed+current) (ii)Sum total of fixed assets(iii) Sum total of long term funds employed in business., Share Capital + Reserves and surplus + Long Term loans – (Non-business assets + fictitiousassets)Operating Profit is the profit before interest and tax. Interest means Interest on long termborrowings. Interest on short term borrowings is deducted for computing operating profit.Non trading income such as interest on GOI Sec or non trading losses or expenses such as losson a/c of fire will be excluded2) Return on Investment(ROI): The ROI is a concept which is also stated as YOC (Yield onCapital). ROI indicates the efficiencies/deficiencies of the firm’s performance. The profit beingthe net result of all operations, the return on Capital is an important indicator to measure theperformance of a firm.
  • 8. Suppose a firm borrow funds @ 8% and the ROI is 7 %, it is better not to borrow (unlessabsolutely necessary). Further, it shows that the firm has not been employing the fundsefficiently3) Earning per Share (EPS): This indicates the overall profitability of a firm. ROI comparisonwould be effective only when two firms are of the same age, same size. To avoid thismismatch, evaluation based on EPS is a better option.EPS tells the earning per equity share. EPS= Net Profit after tax and pre dividend/Number ofequity share.EPS helps in determining the market price of the equity share of the company. Acomparison of EPs of two firms shows, whether the equity share capital is being effectivelyused or not.4) Price Earning (P/E) Ratio:The number of times the EPS is covered by the market price. P/E ratio=Market Price per equityshare/EPS. P/E ratio helps investor/s to decide to buy or not to buy the shares of a company5)Gross Profit Ratio: Gross Profit/Net Sales x100. This ratio indicate the degree to which theselling price of goods per unit may decline without resulting in losses from operations.6) Net Profit Ratio: This indicates the net margin earned on a sale of Rs.100.Net OperatingProfit/Net Sales x100This shows the efficiency of the firm. An increase in the ratio over the previous period showsimprovement in the operational efficiency of the business provided the gross profit ratio isconstant. An effective measure to check profitability of businessB) Solvency Ratios:A firm is said to be solvent or financially sound, if it is in a position to carry on its businesssmoothly and meet all its obligations, both long and short term without strain/any issue.1) Long term Solvency Ratios:(a) Fixed assets Ratio: Fixed assets/long term funds. This ratio should not be more than 1.{Fixed assets include net fixed assets (original cost –depreciation to date) and tradeinvestments including shares in subsidiaries. Long term funds include share capital reserves,and long term loans}If it is less than 1, it shows that a part of the working capital has beenfinanced through the long term funds. This is possible to some extent because, a part of theworking capital termed as core working capital is more or less of a fixed nature. The ideal ratio=0.67
  • 9. (b) Debt Equity Ratio: This is calculated to find out the soundness of the long term financialpolicies of the firm/company. It is also known as ‘External-Internal ‘equity ratio. Debt equityratio- External equities/Internal equitiesExternal equities : Total outside liabilities and Internal equities : Share holder funds or thetangible net worth. If the ratio is 1 :ie., outsiders’ funds are equal to share holders’ funds it isconsidered quite satisfactoryDebt equity ratio can also be calculated as: (i) Debt equity ratio- Total long term debt/Total longterm funds(ii) Debt equity ratio- Total long term debt/Shareholders’ funds, method, which more popular(ii) includes the proportion of the long term debt to the share holders’ funds(i.e., tangible networth) the ideal ratio is 1.This ratio indicates the proportion of owners’ stake in the business. The ratio indicates theextent to which the firm depends upon outsiders for its existence. The ratio tells its owners theextent to which they can borrow to increase the profits with limited investment.2) Short term Solvency Ratios:(i) Current Ratio: The firm’s commitment to meet its short term liabilities. Currentassets/Current liabilities. It includes cash and other assets convertible or meant to be convertedinto cash during the operating cycle of business (which is not more than a year) Currentliabilities mean liabilities payable within a years’ time either out of existing current assets or bycreation of new current assets. Book debts outstanding for more than 6 months and loose toolsshould not be included in the current assets. Prepaid expenses should be included in thecurrent assets.An ideal ratio is 2:1. A very high current ratio is also not desirable, since it means less efficientuse of funds. Current ratio is an index of a firm’s financial stability. A higher current ratioindicates inadequate employment of funds, while a poor current ratio indicates that thebusiness is trading beyond its resources (capacity).(ii) Liquidity Ratio: Known as ‘quick ratio or ‘Acid Test Ratio’. This ratio is worked out bycomparing the liquid assets (ie., assets which are immediately convertible into cash). Prepaidexpenses and stocks are not taken as liquid assets. Liquid assets/Current liabilities and the idealratio is 1. This is also an indicator of short term Solvency of the firm.A comparison of current ratio to quick ratio indicate the inventory management.
  • 10. Ex:If two concerns have the same current ratio but a different liquidity ratio, it indicates overstocking by the concern having low liquidity ratio as compared to the concern which has ahigher liquidity ratioC) Turn Over Ratios:1) Stock Turnover Ratio: The ratio indicates whether the investments in inventories isefficiently used or not. This is arrived at by using the cost of goods sold and average inventoryCost of goods sold during the year/Average inventory .Average inventory is calculated by takingstock levels of raw materials, work in progress, finished goods at the end of each month addingthem up an dividing by 12.The inventory turn over ratio signifies the liquidity of inventory management. A high inventoryratio shows good sales. A low inventory turn over ratio results in the blocking of funds ininventory, which might result in losses due to inventory becoming obsolete or decreasing inqualityThis ratio is calculated as : inventory x 365/cost of goods sold2) Debtor’s Turnover Ratio: Debtors are important components of current assets, therefore thequality of debtors determines a firm’s good liquidity management. The Two important ratiosare (i) Debtor’s turnover ratio and (ii) Debt collection period ratio(i)Debtor’s turnover ratio = Credit sales/Average account receivables. The term AccountReceivable includes Trade Debtors and Bills Receivable. Credit Sales to Account ReceivableRatio indicates the firm’s efficiency in collection of receivables.. The higher the ratio , it isbetter, as it indicates that debts are being collected more promptly.(ii) Debt collection Period Ratio: This ratio indicates the extent to which the debts have beencollected in time. It gives an average debt collection period. The ratio is very helpful to thelenders because it explains to them whether their borrowers are collecting money within areasonable time. An increase in the period will result in greater blockage of funds in debtors.The ratio can be calculated by any of the following methods(a) Months (or days) in a year/Debtor’s turnover(b) {Average account receivables(months or days) in a year}/Credit sales for the year(c) Account receivables/Average monthly or daily credit sales
  • 11. For example, if sales during the year is Rs.365,000 or Rs.1,000 per day, and if the outstanding oramount receivable is Rs.100,000, the debt collection period is 100 days i.e., Rs 100,000/1000.Assuming if the firm has allowed a credit term of 60 days, this ratio indicates that the creditcollection needs to be geared up.Debtor’s collection period measures the quality of debtors. It measures the turnover time i.e.,quick or slow turnaround in respect of collection of money. A short collection period meansprompt payment by the debtors, and shows the efficiency of fund collection. Whereas, a longercollection period indicates an inefficient credit collection performance by the firm. Themanagement should have a flexible policy to have a better result. A restrictive policy may resultin slower sales and would result in low profits. A too liberal policy could result in delay incollection of dues and affect the liquidity management.Let us try to understand by some examples:A firm’s current ratio is 2. If so, identify in which of the following cases the current ratio willImprove/decline or will have no change.(i) purchase of fixed assets(ii) cash collected from Customers(iii) payment of a current liability(iv) Bill receivable dishonoredAnswers: If the current ratio is 2:1, then our assumption is current assets = Rs1,00,000 andcurrent liabilities = Rs.50,000(i) Purchase of fixed assets: On purchase of fixed assets in cash, current assets will decreasewithout any change in current liabilities. Hence he transaction will result in decline of currentratio from 2:1 (ii) Cash collected from customers: Collection of debtors (receivables) would result in theconversion of one current asset., viz., debtors into another current asset viz., debtors to cash.Hence amount of current assets and current liabilities remain unchanged the current ratio willtherefore remain 2:1(iii) Payment of a current liability: On payment of a current liability out of current assetsWorking capital will remain unchanged. However current ratio will improve. For example, if outof above current liabilities Rs20,000 is paid resultant current assets will be Rs.120,,000 andcurrent liabilities Rs30,000, this will give the current ratio 3:1
  • 12. (iv) Bill receivable dishonored: When a bill receivable is dishonored, if the customer is solvent,then the amount of bills receivable will get deducted and the amount due from debtors willincrease, There will be no change in the amount of current liabilities Hence on this assumptionthe current ratio will remain 2:1Fund Flow AnalysisAnother method of financial analysis is fund flow analysis. The fund flow analysis indicates theinflow and outflow of cash. This statement is also known as “sources and application of funds”Sources of funds:(a) Cash inflow from operations (b) Income from investments (c) sale of investments (d) sale offixed assets (e) decrease in working capital (f) increase in liabilities (g) short and long term loansApplication of funds:(a) Operating expenses (b) Repayment of loans/debentures(c)Payment of dividend(d)acquisition of fixed assets (e) increase in working capital (f) Securities bought for investmentsA review of the balance sheet from the funds flow angle is an important factor in financialanalysis.Fund flow analysis – Advantages:: Cash inflow from operations is better a tool to measure whether cash is generated from thebusiness or otherwise.: Since funds flow statements are prepared based on estimates, these estimated figures help inplanning and can also be used to monitor the progress.: It helps in comparison of the pervious year’s budgeted estimates against the actual to find outwhether and to what extent the resources of the firm were used as per the plan.: From the point of view of the lending banker, the comparison of 3 to 5 years statementsindicate the diversion of funds from working capital to long term application viz., purchase offixed assets.Contingent Liabilities or Off Balance Sheet Items: These items appear outside the balancesheet as a foot note, hence called as off balance sheet items. While on the date of the balancesheet these figures may not have any impact, by default there are risks associated with theseitems. If,on the date of crystallization,(due date) these non fund based liabilities can be
  • 13. converted into the funds based items, there by can affect the current liabilities. In view of this,due importance and weight age needs to be given for these off balance sheet itemsSome examples are (a) Tax liability on account of cases pending with tribunals (b) Banker’sletter of credit issued (c) Banker’s guarantees issued (d) Derivatives of banksWorking Capital Finance:Features: (a) Short term finance (maximum for a period of one year) (b) Called as circulatingcapital.(c) Ganted against inventories and/or receivables (d) Working Capital Finance Inventory finance Receivables financeA bank which grants a working capital finance should ensure that the finance is granted to aborrower, should be, on a time bound basis based on the concept of operating cycle method..For a manufacturing company, the term working capital means, the requirement of funds forits day to day operations viz., ensure that sufficient cash is available to meet day to day cashflow needs.Cash is needed for(a) purchase of raw materials, spares (b) payment of wages to employees (c) payment ofadministrative expenses including expenses towards water, fuel energy consumption, paymentof statutory dues like taxes, transportation expenses etc.,(d)all other expenses on account ofproduction, sales, marketing, recoveries etc.,
  • 14. What is an operating cycle: A bank gives working capital finance in the form of fund basedfinance against inventories and or receivables. Depending upon the industry the finance can begranted for a period of 120 days to 180 days. This means, the finance availed by the clientneeds to be repaid at the end of the period. This can be shown in a diagram. This is also calledas the working capital cycle Bills Cash receivables Credit sales Raw materials Finished Semi finished goods goods  Each component of working capital has two dimensions TIME and MONEY.  As shown above the main feature of working capital is the cash getting converted into cash after different stages of the production of goods. Hence the entire process is reflected in the form of a cycle, which is called as operating cycle or working capital cycle.
  • 15.  The shorter the period of operating cycle, the larger will be the turnover of the funds invested in various purposes.The working capital management needs to address the following aspects, before taking adecision:(i) How much inventory is to be held (ii) How much cash and bank balance is to be maintained(iii) How much the company should provide credit to its clients, also what should be the creditterms? (iv) Similarly to what extent the company can enjoy or avail of the credit facilities andthe credit terms thereof (v) What should be the composition of current assets and liabilities.What is working capital?A working capital is the excess of current assets over current liabilities. Cash which is one of theimportant component of the current assets, plays a significant role in working capitalmanagement. As far as possible the company should maintain adequate working capital asmuch as requited by the company. It should neither be excessive nor inadequate.Working Capital - Definition1.According to Guttmann & Dougall -“Excess of current assets over current liabilities”.2. According to Park & Gladson -“The excess of current assets of a business over current items owned to employees andothers”.Types of Working Capital:One of the important role of a finance manager is to ensure proper flow of funds. In thisconnection arrangement of cash flow through proper working capital management is veryimportant. Depending upon the business models the working capital can be classified intodifferent types, as shown in the diagram: PERMANENT, FIXED OR REGULAR WORKING CAPITAL : The requirement of minimumcash/funds required to run the firm, company. This is also called as hard core Working Capital.If this quantity of Working capital is not maintained, it would affect the business.FLEXIBLE OR TEMPORARY WORKING CAPITAL: During the course of production activities a firmmay need more funds on a temporary basis to meet the short term requirements. The fund
  • 16. requirement may be over and above the overall fixed working capital limits. The lender(banker) should based on the merits of the case, may grant the temporary working capital.SEASONAL WORKING CAPITAL OR SPECIAL WORKING CAPITAL : The need for the funds varyfrom a company to another and/or from industry to industry. Sometimes, there may besituations where the firms may need additional working capital on certain special seasons. Asalready indicated any additional or temporary requirements for funds needs to decided basedon the merit of the case/s. Permanent, Fixed or Regular Flexible / Temporary/ Negative Types of Variable Working Capital Balance Sheet SeasonalNEGATIVE WORKING CAPITAL : Negative Working Capital is when current liabilities exceedcurrent assets
  • 17. BALANCE SHEET WORKING CAPITAL: It is that Working Capital which is calculated from theitems appearing in the balance sheet of a firm.Working Capital – Classification based on concepts: Net Working Gross Working CapitalWorking Capital means the funds available for day to day operation of an enterprise. There aretwo concepts of Working Capital viz., (a) Gross Working Capital and (b) Net Working Capital
  • 18. (a) Gross Working Capital:Gross concept of Working Capital is quantitative in nature. It represents the total of all currentassets. It is also known as circulating capital or current capital. The word current assets means,those assets which can be converted into cash within an accounting period or operating cyclelike;§ Inventory § Trade debtors § Bills receivables§ Loans and advances § Investments§ Cash and Bank Balance § Marketable securitiesThe gross concept of Working Capital is a going concern concept, because current assets arenecessary for the proper utilization of fixed assets.(b) Net Working Capital: Net Working Capital represents the excess of current assets overcurrent liabilities or the portion of current assets which is financed by long term funds..It isknown as net working capital.Current liabilities are those usually repaid within an accounting year like;§ Account Payable / sundry creditors § Bills Payable§ Trade Advances § Outstanding Expenses§ Short Term Bonus § Bank OverdraftThe net concept of Working Capital shows the financial soundness and liquidity of a firm. Thisconcept creates the confidence to the creditors about the security of their funds.Net Working Capital = Current Assets – Current LiabilitiesHow to calculate the working capital requirements:ESTIMATING WORKING CAPITAL REQUIREMENTFor this purpose the length of cash to cash cycle is measured:The duration of the working capital cycle can be mentioned as follows:O = R+W+F+D-CO = Duration of operating cycle
  • 19. R = Raw materials storage periodW= Work in progress periodF = Finished goods storage periodD= Debtors collection periodC=Creditors collection periodGross operating cycle = inventory Conversion period + Debtors conversion PeriodDeterminants of Working CapitalWC is determined on the basis of certain factors, like :(i) Nature of Industry (ii) Size of Business (iii) Manufacturing Cycle (iv) Firm’s Production Policy(v) Terms of purchase & Sales (vi) Volume of Sales (vii) Capital base of the firm (viii) BusinessCycle (ix)Management of Inventory an d receivables (x) changes in economy – inflation (xi)Government policies (xii) Profit marginImportance or Advantages of Adequate Working Capital (WC):Adequate WC helps to (a) maintain solvency of business (b) create & maintaining goodwill (c) arrange loans frombanks & others on easy and favorable terms (d) avail cash discount/s and hence reduction incost of production (e) get regular supply of raw materials (f) adhere to payment schedules forsalary & wages and other dues – taxes (g) negotiate the terms more comfortably (i) managethe liquidityPosition of excess WC:Excessive WC - disadvantagesDisadvantages of redundant or excessive WC;(i) Excessive WC means idle funds which earn no income for the business (ii) Since funds are notinvested business cannot earn a proper rate of return (iii)Improper inventory managementleads to a situation of redundant WC and increases the cost of inventory management (iv)Similarly excessive debtors & defective receivable management policy may create higherlevels of bad-debts.
  • 20. Thus the factors can reflect the inefficiency of the firm and it does not speak well of the role ofthe financial managerSources of Working Capital: Sources of Funds Long Term Funds Short Term Funds Equity Shares Long Term Debentures Borrowings Long Term Funds Retained Earnings Hybrid Financing
  • 21. ♦ Issue of Shares: This is popularly known as “Equity Financing”. The main source of long term funds is raised through the issuance of different types of equity shares. The share holders are part owners of the companies depending upon the type of shares. ♦ Debentures: This is called as “Debt Financing”. The investors in the debentures are creditors of the company. They are entitled for the dividend as return and also charge over the assets of the company. ♦ Hybrid Financing: The combination of equity and debt is called hybrid financing. The Finance manager needs to decide the proportion of the equity and debt funds. ♦ Retained Earning: One of the important component of the long term funds is the profits retained in business. It creates no charge on the future of the firm ♦ Long Term Borrowings: Acceptance of public deposits, debts from financial institutions and banks, etc., Other sources are security deposits accepted from the customers (depending on the business models)Short Term Financing: The short term financing mainly arranged through the working capitalfinance, also consist of other sources. Short Term Financing Working Capital Public Deposits Other Credits Finance Six Months – Three Cash Credit Years Commercial Paper Overdraft Trade Credits Security DepositsWorking Capital Ratios;Working Capital Ratios;
  • 22. Working Capital Ratios Liquidity Efficiency Other Ratios Ratios Ratios Current Inventory Current Assets Debtors Bad debts to Turnover Ratio Ratio Turnover Ratio Turnover Ratio Turnover Ratio sales ratio Debtor Quick Ratio collection period Creditors Payment PeriodWorking Capital Ratios;Liquidity Ratios:Current Ratio = Current Assets/ Current LiabilityQuick Ratio = Current Assets – Inventory/ Current Liability – Bank OverdraftEfficiency Ratios:Working Capital to sales ratios= Sales/Working CapitalInventory Turnover ratio = Sales/InventoryCurrent assets turnover ratio: Sales/Current AssetsOther Ratios:Debtors Turnover Ratio = Credit Sales/DebtorsBad debts to sales ratio = Bad Debts/SalesDebtor Collection period = Debtors x 365/credit salesCreditor Payment Period= Creditorsx365/credit purchase
  • 23. Working Capital Turnover Ratio:Meaning: This ratio establishes a relationship between net sales and working capital.Objective: The objective of computing this ratio is to determine the efficiency with which theworking capital is utilized.Components: There are two components of this ratio which are as under:  Net Sales which mean gross sales minus sales returns  Working Capital which means current assets minus current liabilities.Computation: This ratio is computed by dividing the net sales by the working capital. This ratiois usually expressed as ‘x’ number of times. Working Capital Turnover Ratio = Net Sales/Working CapitalInterpretation: It indicates the firm’s ability to generate sales per rupee of working capital. Ingeneral, higher the ratio, the more efficient the management and utilization of working capitaland vice versa.