Ratio Analysis

Ratio Analysis is a form of Financial Statement Analysis that is

used to obtain a quick indication of a firm's financial
performance in several key areas. The ratios are categorized
as Short-term Solvency Ratios, Debt Management Ratios,
Asset Management Ratios, Profitability Ratios, and Market
Value Ratios.

Ratio Analysis as a tool possesses several important features.

The data, which are provided by financial statements, are
readily available. The computation of ratios facilitates the
comparison of firms which differ in size. Ratios can be used
to compare a firm's financial performance with industry
averages. In addition, ratios can be used in a form of trend
analysis to identify areas where performance has improved
or deteriorated over time.

Types of Ratios
1. Profitability ratios measure the firm’s use of its assets and
control of its expenses to generate an acceptable rate of
return.
2. Liquidity ratios measure the availability of cash to pay
debt.
3. Activity ratios, also called efficiency ratios, measure the
effectiveness of a firm’s use of resources, or assets.
4. Debt, or leverage, ratios measure the firm’s ability to repay
long-term debt.
5. Market ratios are concerned with shareholder audiences.
They measure the cost of issuing stock and the relationship
 between return and the value of an investment in
company’s shares.

Meaning of Financial Management

Financial Management means planning, organizing, directing
and controlling the financial activities such as procurement
and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the
enterprise.
Scope/Elements
1. Investment decisions includes investment in fixed assets
(called as capital budgeting). Investment in current assets
are also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance
from various resources which will depend upon decision
on type of source, period of financing, cost of financing
and the returns thereby.
3. Dividend decision - The finance manager has to take
decision with regards to the net profit distribution. Net
profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has
to be decided.
b. Retained profits- Amount of retained profits has to be
finalized which will depend upon expansion and
diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with
procurement, allocation and control of financial resources of
a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the

concern.
2. To ensure adequate returns to the shareholders which will
depend upon the earning capacity, market price of the
share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are
procured, they should be utilized in maximum possible
way at least cost.
4. To ensure safety on investment, i.e, funds should be
invested in safe ventures so that adequate rate of return
can be achieved.
5. To plan a sound capital structure-There should be sound
and fair composition of capital so that a balance is
maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager
has to make estimation with regards to capital
requirements of the company. This will depend upon
expected costs and profits and future programmes and
policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of
enterprise.
2. Determination of capital composition: Once the
estimation have been made, the capital structure have to
be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of
 equity capital a company is possessing and additional
funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be
procured, a company has many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and

demerits of each source and period of financing.

4. Investment of funds: The finance manager has to decide

to allocate funds into profitable ventures so that there is
safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be
made by the finance manager. This can be done in two
ways:
a. Dividend declaration - It includes identifying the rate of
dividends and other benefits like bonus.
b. Retained profits - The volume has to be decided which will
depend upon expansional, innovational, diversification
plans of the company.
6. Management of cash: Finance manager has to make
decisions with regards to cash management. Cash is
required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to
creditors, meeting current liabilities, maintainance of
enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to
plan, procure and utilize the funds but he also has to
exercise control over finances. This can be done through
 many techniques like ratio analysis, financial forecasting,
cost and profit control, etc.

What is EOQ?

EOQ is the acronym for economic order quantity. The

economic order quantity is the optimum quantity of goods to
be purchased at one time in order to minimize the annual
total costs of ordering and carrying or holding items in
inventory.
EOQ is also referred to as the optimum lot size.

What is a Dividend Policy?

A company’s dividend policy dictates the amount of
dividends paid out by the company to its shareholders and
the frequency with which the dividends are paid out. When a
company makes a profit, they need to make a decision on
what to do with it. They can either retain the profits in the
company (retained earnings on the balance sheet), or they
can distribute the money to shareholders in the form of
dividends.

What is Leverage?
In finance, leverage is a strategy that companies use to
increase assets, cash flows, and returns, though it can also
magnify losses.
Operating Leverage:
Operating leverage refers to the use of fixed operating costs
such as depreciation, insurance of assets, repairs and
maintenance, property taxes etc. in the operations of a firm.
But it does not include interest on debt capital. Higher the
proportion of fixed operating cost as compared to variable
cost, higher is the operating leverage, and vice versa.

Financial Leverage:
Financial leverage is primarily concerned with the financial
activities which involve raising of funds from the sources for
which a firm has to bear fixed charges such as interest
expenses, loan fees etc. These sources include long-term
debt (i.e., debentures, bonds etc.) and preference share
capital.

Capital Structure Theory

NET INCOME APPROACH

This approach was suggested by Durand and he was in favor
of financial leverage decision. According to him, a change in
financial leverage would lead to a change in the cost of
capital. In short, if the ratio of debt in the capital structure
increases, the weighted average cost of capital decreases and
hence the value of the firm increases.

NET OPERATING INCOME APPROACH

This approach is also provided by Durand. It is opposite of the
Net Income Approach if there are no taxes. This approach
says that the weighted average cost of capital remains
constant. It believes in the fact that the market analyses a
firm as a whole and discounts at a particular rate which has
no relation to debt-equity ratio. If tax information is given, it
 recommends that with an increase in debt financing WACC
reduces and value of the firm will start increasing.

TRADITIONAL APPROACH
This approach does not define hard and fast facts. It says that
the cost of capital is a function of the capital structure. The
special thing about this approach is that it believes an
optimal capital structure. Optimal capital structure implies
that at a particular ratio of debt and equity, the cost of
capital is minimum and value the of the firm is maximum.

MODIGLIANI AND MILLER APPROACH (MM APPROACH)

It is a capital structure theory named after Franco Modigliani
and Merton Miller. MM theory proposed two propositions.

 Proposition I: It says that the capital structure is irrelevant to

the value of a firm. The value of two identical firms would
remain the same and value would not affect by the choice of
finance adopted to finance the assets. The value of a firm is
dependent on the expected future earnings. It is when there
are no taxes.
 Proposition II: It says that the financial leverage boosts the
value of a firm and reduces WACC. It is when tax information
is available.