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Financial Management Made Easy

Financial Analysis A banker advances to many clients including individuals, traders, firms and corporate. Before a loan is granted the banker needs to do an evaluation of the firms/companys financial position by 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 Flow

Balance Sheet (BS)A BS is statement indicates the financial position as on a particular date (ex: as on 31st March,2010) A BS has two sides Assets & Liabilities Assets- What the firm Owns and its Receivable

Liabilities What the firm Owes and its Payables Shows Sources of Funds and Uses of funds To have a fair idea/view about the financial position of a firm/company, the interested persons /Institutions (investors,analysts,bankers,credit rating agencies) need to analyse the financials for a period of three to five years. The study/analysis helps to understand the trend about the various aspects. The analysis need to cover the entire period of 12 months. The study 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 of a firm/company. Ratios are used as tools for this type of analysis. Ratio analysis is a process of establishing a significant relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a firm. Classification of ratios I-(Expression/Degree of Importance
Types of Ratios Mode of expression Degree of Importance

Simple/Pure

Primary

Percentage

Rate

Secondary

tertiary

Classification of ratios II-Users

Auditors

Manageme nt

Short tem creditorsBanks

Users

Credit AnalystsCredit Rating Cos

Long term creditorsBanks/Fin Institutions

Investors/S hareholder s

Classification of ratios III Important Parameters

Liquidity Ratio Solvency ratio Activity ratio Profitabili ty Ratio

Classification of ratios IV Financial Statements:

Balanc e Sheet

Funds Flow

P&L Accou nt

Cash Flow

Briefly we try to understand the following: Traditional Classification: On the basis of financials. They are classified as

P&L a/c ratios: i.e., ratios calculated on the basis of p/l a/c only Balance sheet ratio: ratios on the basis of figures of balance sheet only Composite or inter statement ratios: on the basis of the figures of P&L as well as Balance sheet

ratios can be classified into:

Financial or Solvency Ratio Turnover or Activity Ratio Profitability or Income Ratio

Financial Ratios may be classified into Short term solvency ratios: This discloses the financial position or solvency of the firm in the short term. This is also called as Liquidity Ratio Long term solvency ratios : This discloses the financial position or solvency of the firm in the long 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 forecasting

Recap:
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 for taking decision. Example: (i) a high current ratio does not necessarily mean that the concern has a good liquidity position ( in case the current assets consists of outdated stocks) (ii) debtors beyond a reasonable period if not excluded from the current assets would not reveal the correct position Ratios 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 operational efficiency. This may be achieved by unwarranted price reduction or failure to maintain proper stock of goods This might result in a favorable ratio/s. Changes in Price levels: Two firms depreciate the machinery based on their date of purchase then the deprecation would be lower for the older company than the new company. Hence mere 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 in the business. Formula : Operating Profit/Capital employed x 100 Capital 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 + fictitious assets)

Operating Profit is the profit before interest and tax. Interest means Interest on long term borrowings. 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 loss on a/c of fire will be excluded 2) Return on Investment(ROI): The ROI is a concept which is also stated as YOC (Yield on Capital). ROI indicates the efficiencies/deficiencies of the firms performance. The profit being the net result of all operations, the return on Capital is an important indicator to measure the performance of a firm. Suppose a firm borrow funds @ 8% and the ROI is 7 %, it is better not to borrow (unless absolutely necessary). Further, it shows that the firm has not been employing the funds efficiently 3) Earning per Share (EPS): This indicates the overall profitability of a firm. ROI comparison would be effective only when two firms are of the same age, same size. To avoid this mismatch, evaluation based on EPS is a better option. EPS tells the earning per equity share. EPS= Net Profit after tax and pre dividend/Number of equity share.EPS helps in determining the market price of the equity share of the company. A comparison of EPs of two firms shows, whether the equity share capital is being effectively used 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 equity share/EPS. P/E ratio helps investor/s to decide to buy or not to buy the shares of a company 5)Gross Profit Ratio: Gross Profit/Net Sales x100. This ratio indicate the degree to which the selling 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 Operating Profit/Net Sales x100 This shows the efficiency of the firm. An increase in the ratio over the previous period shows improvement in the operational efficiency of the business provided the gross profit ratio is constant. An effective measure to check profitability of business

B) Solvency Ratios: A firm is said to be solvent or financially sound, if it is in a position to carry on its business smoothly 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 trade investments 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 been financed through the long term funds. This is possible to some extent because, a part of the working capital termed as core working capital is more or less of a fixed nature. The ideal ratio =0.67 (b) Debt Equity Ratio: This is calculated to find out the soundness of the long term financial policies of the firm/company. It is also known as External-Internal equity ratio. Debt equity ratio- External equities/Internal equities External equities : Total outside liabilities and Internal equities : Share holder funds or the tangible net worth. If the ratio is 1 :ie., outsiders funds are equal to share holders funds it is considered quite satisfactory Debt equity ratio can also be calculated as: (i) Debt equity ratio- Total long term debt/Total long term 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 net worth) the ideal ratio is 1. This ratio indicates the proportion of owners stake in the business. The ratio indicates the extent to which the firm depends upon outsiders for its existence. The ratio tells its owners the extent to which they can borrow to increase the profits with limited investment. 2) Short term Solvency Ratios: (i) Current Ratio: The firms commitment to meet its short term liabilities. Current assets/Current liabilities. It includes cash and other assets

convertible or meant to be converted into cash during the operating cycle of business (which is not more than a year) Current liabilities mean liabilities payable within a years time either out of existing current assets or by creation of new current assets. Book debts outstanding for more than 6 months and loose tools should not be included in the current assets. Prepaid expenses should be included in the current assets. An ideal ratio is 2:1. A very high current ratio is also not desirable, since it means less efficient use of funds. Current ratio is an index of a firms financial stability. A higher current ratio indicates inadequate employment of funds, while a poor current ratio indicates that the business is trading beyond its resources (capacity). (ii) Liquidity Ratio: Known as quick ratio or Acid Test Ratio. This ratio is worked out by comparing the liquid assets (ie., assets which are immediately convertible into cash). Prepaid expenses and stocks are not taken as liquid assets. Liquid assets/Current liabilities and the ideal ratio 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. Ex:If two concerns have the same current ratio but a different liquidity ratio, it indicates over stocking by the concern having low liquidity ratio as compared to the concern which has a higher liquidity ratio C) Turn Over Ratios: 1) Stock Turnover Ratio: The ratio indicates whether the investments in inventories is efficiently used or not. This is arrived at by using the cost of goods sold and average inventory Cost of goods sold during the year/Average inventory .Average inventory is calculated by taking stock levels of raw materials, work in progress, finished goods at the end of each month adding them up an dividing by 12. The inventory turn over ratio signifies the liquidity of inventory management. A high inventory ratio shows good sales. A low inventory turn over ratio results in the blocking of funds in inventory, which might result in losses due to inventory becoming obsolete or decreasing in quality This ratio is calculated as : inventory x 365/cost of goods sold

2) Debtors Turnover Ratio: Debtors are important components of current assets, therefore the quality of debtors determines a firms good liquidity management. The Two important ratios are (i) Debtors turnover ratio and (ii) Debt collection period ratio (i)Debtors turnover ratio = Credit sales/Average account receivables. The term Account Receivable includes Trade Debtors and Bills Receivable. Credit Sales to Account Receivable Ratio indicates the firms efficiency in collection of receivables.. The higher the ratio , it is better, 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 been collected in time. It gives an average debt collection period. The ratio is very helpful to the lenders because it explains to them whether their borrowers are collecting money within a reasonable 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/Debtors 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

For example, if sales during the year is Rs.365,000 or Rs.1,000 per day, and if the outstanding or amount 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 credit collection needs to be geared up. Debtors 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 means prompt payment by the debtors, and shows the efficiency of fund collection. Whereas, a longer collection period indicates an inefficient credit collection performance by the firm. The management should have a flexible policy to have a better result. A restrictive policy may result in slower sales and would result in low profits. A too liberal policy could result in delay in collection of dues and affect the liquidity management.

Let us try to understand by some examples: A firms current ratio is 2. If so, identify in which of the following cases the current ratio will Improve/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 dishonored Answers: If the current ratio is 2:1, then our assumption is current assets = Rs1,00,000 and current liabilities = Rs.50,000 (i) Purchase of fixed assets: On purchase of fixed assets in cash, current assets will decrease without any change in current liabilities. Hence he transaction will result in decline of current ratio from 2:1 (ii) Cash collected from customers: Collection of debtors (receivables) would result in the conversion 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 will therefore remain 2:1 (iii) Payment of a current liability: On payment of a current liability out of current assets Working capital will remain unchanged. However current ratio will improve. For example, if out of above current liabilities Rs20,000 is paid resultant current assets will be Rs.120,,000 and current liabilities Rs30,000, this will give the current ratio 3:1 (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 will increase, There will be no change in the amount of current liabilities Hence on this assumption the current ratio will remain 2:1

Fund Flow Analysis Another method of financial analysis is fund flow analysis. The fund flow analysis indicates the inflow 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 of fixed assets (e) decrease in working capital (f) increase in liabilities (g) short and long term loans Application 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 investments A review of the balance sheet from the funds flow angle is an important factor in financial analysis. Fund flow analysis Advantages: : Cash inflow from operations is better a tool to measure whether cash is generated from the business or otherwise. : Since funds flow statements are prepared based on estimates, these estimated figures help in planning and can also be used to monitor the progress. : It helps in comparison of the pervious years budgeted estimates against the actual to find out whether 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 statements indicate the diversion of funds from working capital to long term application viz., purchase of fixed assets. Contingent Liabilities or Off Balance Sheet Items: These items appear outside the balance sheet as a foot note, hence called as off balance sheet items. While on the date of the balance sheet these figures may not have any impact, by default there are risks associated with these items. If,on the date of crystallization,(due date) these non fund based liabilities can be 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 items Some examples are (a) Tax liability on account of cases pending with tribunals (b) Bankers letter of credit issued (c) Bankers guarantees issued (d) Derivatives of banks

Working Capital Finance: Features: (a) Short term finance (maximum for a period of one year) (b) Called as circulating capital.(c) Ganted against inventories and/or receivables (d)

Working Capital Finance

Inventory finance

Receivables finance

A bank which grants a working capital finance should ensure that the finance is granted to a borrower, 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 for its day to day operations viz., ensure that sufficient cash is available to meet day to day cash flow needs. Cash is needed for (a) purchase of raw materials, spares (b) payment of wages to employees (c) payment of administrative expenses including expenses towards water, fuel energy consumption, payment of statutory dues like taxes, transportation expenses etc.,(d)all other expenses on account of production, sales, marketing, recoveries etc.,

What is an operating cycle: A bank gives working capital finance in the form of fund based finance against inventories and or receivables. Depending upon the industry the finance can be granted for a period of 120 days to 180

days. This means, the finance availed by the client needs to be repaid at the end of the period. This can be shown in a diagram. This is also called as the working capital cycle

Bills receivable s

Cash

Credit sales

Raw materials

Finished goods

Semi finished 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.

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 a decision: (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 credit terms? (iv) Similarly to what extent the company can enjoy or avail of the credit facilities and the 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 the important component of the current assets, plays a significant role in working capital management. As far as possible the company should maintain adequate working capital as much as requited by the company. It should neither be excessive nor inadequate. Working Capital - Definition 1.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 and others. Types of Working Capital: One of the important role of a finance manager is to ensure proper flow of funds. In this connection arrangement of cash flow through proper working capital management is very important. Depending upon the business models the working capital can be classified into different types, as shown in the diagram: PERMANENT, FIXED OR REGULAR WORKING CAPITAL : The requirement of minimum cash/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 firm may need more funds on a temporary basis to meet the short term requirements. The fund 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 vary from a company to another and/or from industry to industry. Sometimes, there may be situations where the firms may need additional working capital on certain special seasons. As already indicated any additional or temporary requirements for funds needs to decided based on the merit of the case/s.

Permanen t, Fixed or Regular

Negative

Types of Working Capital

Flexible / Temporar y/ Variable

Balance Sheet

Seasonal

NEGATIVE WORKING CAPITAL : Negative Working Capital is when current liabilities exceed current assets BALANCE SHEET WORKING CAPITAL: It is that Working Capital which is calculated from the items appearing in the balance sheet of a firm. Working Capital Classification based on concepts:

Net Working Capital

Gross Working Capital

Working Capital means the funds available for day to day operation of an enterprise. There are two concepts of Working Capital viz., (a) Gross Working Capital and (b) Net Working Capital

(a) Gross Working Capital: Gross concept of Working Capital is quantitative in nature. It represents the total of all current assets. 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 cycle like; Inventory receivables Loans and advances Cash and Bank Balance Trade debtors Investments Marketable securities Bills

The gross concept of Working Capital is a going concern concept, because current assets are necessary for the proper utilization of fixed assets. (b) Net Working Capital: Net Working Capital represents the excess of current assets over current liabilities or the portion of current assets which is financed by long term funds..It is known as net working capital. Current liabilities are those usually repaid within an accounting year like; Account Payable / sundry creditors Trade Advances Short Term Bonus Bills Payable

Outstanding Expenses Bank Overdraft

The net concept of Working Capital shows the financial soundness and liquidity of a firm. This concept creates the confidence to the creditors about the security of their funds. Net Working Capital = Current Assets Current Liabilities How to calculate the working capital requirements:

ESTIMATING WORKING CAPITAL REQUIREMENT For 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-C O = Duration of operating cycle R = Raw materials storage period W= Work in progress period F = Finished goods storage period D= Debtors collection period C=Creditors collection period Gross operating cycle = inventory Conversion period + Debtors conversion Period

Determinants of Working Capital WC is determined on the basis of certain factors, like : (i) Nature of Industry (ii) Size of Business (iii) Manufacturing Cycle (iv) Firms Production Policy (v) Terms of purchase & Sales (vi) Volume of Sales (vii) Capital base of the firm (viii) Business Cycle (ix)Management of Inventory an d receivables (x) changes in economy inflation (xi) Government policies (xii) Profit margin Importance or Advantages of Adequate Working Capital (WC): Adequate WC helps to (a) maintain solvency of business (b) create & maintaining goodwill (c) arrange loans from banks & others on easy and favorable terms (d) avail cash discount/s and hence reduction in cost of production (e) get regular supply of raw materials (f) adhere to payment schedules for salary & wages and other dues taxes (g) negotiate the terms more comfortably (i) manage the liquidity Position of excess WC:

Excessive WC - disadvantages Disadvantages of redundant or excessive WC; (i) Excessive WC means idle funds which earn no income for the business (ii) Since funds are not invested business cannot earn a proper rate of return (iii)Improper inventory management leads to a situation of redundant WC and increases the cost of inventory management (iv) Similarly excessive debtors & defective receivable management policy may create higher levels of bad-debts. Thus the factors can reflect the inefficiency of the firm and it does not speak well of the role of the financial manager Sources of Working Capital:

Sources of Funds

Long Term Funds

Short Term Funds

Equity Shares

Long Term Borrowin gs

Long Term Funds

Debentur es

Retained Earnings

Hybrid Financin g

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 capital finance, also consist of other sources.
Short Term Financing

Working Capital Finance

Public Deposits

Other Credits

Cash Credit

Six Months Three Years

Commercial Paper

Overdraft

Trade Credits

Security Deposits

Working Capital Ratios; Working Capital Ratios;

Working Capital Ratios Liquidity Ratios Efficienc y Ratios


Inventory Turnover Ratio Current Assets Turnover Ratio

Other Ratios
Debtors Turnover Ratio
Debtor

Current Ratio

Turnover Ratio

Bad debts to sales ratio

Quick Ratio

collection

period period
Creditors Payment Period

Working Capital Ratios; Liquidity Ratios: Current Ratio = Current Assets/ Current Liability Quick Ratio = Current Assets Inventory/ Current Liability Bank Overdraft Efficiency Ratios: Working Capital to sales ratios= Sales/Working Capital Inventory Turnover ratio = Sales/Inventory Current assets turnover ratio: Sales/Current Assets Other Ratios: Debtors Turnover Ratio = Credit Sales/Debtors Bad debts to sales ratio = Bad Debts/Sales Debtor Collection period = Debtors x 365/credit sales Creditor Payment Period= Creditorsx365/credit purchase

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 the working 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 ratio is usually expressed as x number of times. Working Capital Turnover Ratio = Net Sales/ Working Capital Interpretation: It indicates the firms ability to generate sales per rupee of working capital. In general, higher the ratio, the more efficient the management and utilization of working capital and vice versa.