FINANCIAL MANAGEMENT

T.Y B.COM 

SEMESTER - V

FINANCIAL MANAGEMENT

UNIT - I

CHAPTER - 2

FINANCIAL STATEMENT ANALYSIS

Meaning of Financial Statements:

Every business concern wants to know the various financial aspects for effective decision making. The preparation of financial statement is required in order to achieve the objectives of the firm as a whole. The term financial statement refers to an organized collection of data on the basis of accounting principles and conventions to disclose its financial information. The financial statements are as follows :

1. Income Statements

2. Balance Sheet

3. Cash Flow Statement

4. Funds Flow Statement

1. The income statement :

The term ‘income statements’ is also known as Trading and Profit & Loss Account. This is first stage of preparation of final accounts in accounting cycle. The purpose of preparing these accounts is to ascertain the Net Profit or Net Loss of a business concern during the accounting period. 

2. Balance Sheet : 

 

Balance sheet may be defined as “a statement of financial position of any economic unit disclosing as at a given moment of time its assets at cost or depreciated cost or other indicated value, its liabilities and its ownership equities”. In other words it is a statement which indicates the financial position or soundness of a business concern at a specific period of time. Balance sheet may also be described as a statement of source and application of funds because it represents the source where the funds for the business were obtained and how the funds were utilized in the business. 

3. Cash Flow Statement :

 

It is prepared as per AS-3. It indicates the flows of cash or liquidity position of the company.. This statement shows changes in cash position from one period to another. It can be computed by taking into account sources and uses of cash. 

4. Funds Flow Statement:

In order to know the movement of the funds, the balance sheet of two different periods i.e. at the beginning and at the end of the accounting period are compared and a statement of movement of the funds is prepared. It is called funds flow statement. In short, Funds Flow Statements shows how funds have been raised and how they have been used. In helps to analyze the changes in Net 

Working Capital between two dates. 

 Techniques to analyze Financial Statements:

A. Comparative Financial Statement Analysis Technique:

In this method the Income Statement and Balance Sheet statements figures for two or more periods are placed side by side and any increase or decrease in the item is found out. In order to get still more clear idea, the percentage of increase or decrease during the current year over the 

previous year is also calculated.

B. Common Size Financial Statements Analysis Technique:

In this technique, figures of profit and loss account and balance sheet are converted into percentages to some common base.

In Income Statement, the Sales figure is assumed to be 100 and all figures of the income statement are converted as a percentage of this total.

In Balance Sheet Total Assets or Total Liabilities figures is assumed to be 100 and all figures of 

assets and liabilities are converted as a percentage of this total.

C. Trend Analysis Technique :

In this method a series of percentage of different items of different years is compared on the basis of base year. In this method, any year is taken as base year. Each item of base year is taken 

as 100 and on that basis, the percentage for each of the items for each of years are calculated. These percentages can also be taken as Index Numbers showing relative changes in the financial data resulting with the passage of time. 

D. Ratio Analysis :

This is an important technique for financial analysis. Ratio is simple arithmetic expression expressed by means of dividing one figure by another. Accounting ratio is the relationship between two inter-related accounting figures expressed by means of dividing one figure by another. The figures should be inter-related because the purpose would not be served if the figures are not related with each other. Accounting Ratios are expressed as under :

Type of Ratios :

1. Simple Ratio : It is expressed as a Proportion i.e. 2.00 :1.00

2. Rate or Time : It is expressed as a Rate over a period of time i.e. 2 times a year etc. 

3. Percentage : it is expressed as a Percentage i.e. 200% or 300% etc. 

Classification of Ratios:

      There are ratios for different purposes, for different types of users and for different types of analysis. The ratios can be classified as follows :

 

1. Profitability Ratios:

Profitability reflects the final result of the business operations. These ratios are calculated to measure the operating efficiency of the company. There are two types of profitability ratios: Profit margin ratios and Rate of return ratios. These ratios are calculated to know the profitability position on the basis of Sales and Investment of funds. Profit margin ratios show the relationship between 

Profit and Sales and the Rate of Return ratios reflect the relationship between Profit and Investment.

2. Leverage Ratios :

Leverage refers to the use of debt fund. Debt fund is a cheaper source of finance than equity fund. Therefore, debt funds are used by the firm to increase the Return on Investment (ROI). Even though debt funds are cheaper than equity, it is a riskier source of finance. Leverage ratio helps in assessing the risk arising from the use of debt fund. 

3. Liquidity Ratios :

Liquidity means the ability of a firm to pay its short term debt as and when they become due. Current Liabilities are met out of realization of Current Assets. Therefore, the Current Assets should be liquid enough to pay the Current Liabilities of a firm. Current Assets should be easily convertible into cash. Liquidity is the pre-requisite for the survival of a firm. A firm having no liquidity may soon meet with its downfall and ultimately die. The short term creditors and bankers are interested in liquidity position of the firm.

4. Turnover Ratios :

This ratio is also called efficiency ratios or activity ratios or current assets movement ratios or velocity ratios. These ratios show the efficiency with which the capital invested in the assets is rotated in the business. The efficiency with which assets are managed, directly affect the volume of sales. Better the management of assets, higher the volume of sales and profit. These ratios are also called TR because they show the speed with which assets are turned or converted into sales. The overall profitability of the firm depends on the speed with which capital employed in assets rotates in the business. Higher the turnover higher the profit and lower the turnover lower the profit.

---> STANDARDS OF COMPARISON

A single ratio in itself does not indicate favorable or unfavorable financial condition. It should be compared with some standard. Standards of comparison may consist of:

1. Past Ratios

Past ratios are the ratios calculated from the past financial statements of the same firm. By comparing current years ratios with past ratio the improvement or deterioration in firm's performance over the period can be studied.

2. Competitor's Ratios

Competitor’s Ratios are ratios of some selected firms, especially the most progressive competitor, at the same point in time. By comparing firm’s ratios with competitor's ratios the firm’s financial position in respect to competitors can be known.

3. Industry Ratios

Industry Ratios are the ratios of industry to which the firm belongs. By comparing firms ratios with industry average ratios the firm's position vis a vis other firms in the industry can be understood.

4. Projected Ratios

Projected Ratios are the ratios developed by using the projected financial statements of the firm. The comparison of current or past ratios with future ratios indicates the firm's relative strength and weaknesses in the past and in the future.

 USERS OF FINANCIAL ANALYSIS :

Financial analysis can be undertaken by two groups of persons: one Internal i.e. Management and second External i.e. Outsiders 

(A) INTERNAL USERS :

 Management :

Management of the firm would be interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently and that the firm’s financial condition is sound. The financial analysis greatly helps the management in knowing what has happened and what should be done to improve the profitability and financial position of the business in the period to come. The analysis also helps the management in planning the future expansion, modernization and development, in obtaining loans at reasonable rate of interest, in raising funds from the capital market and in increasing profitability of the company without creating additional financial burden. 

(B) EXTERNAL USERS:

1. Creditors :

Financial analysis is also useful to the Short Term and Long Term Creditors both in ascertaining whether the business will be in a position to meet their commitments i.e. interest and principal amount on due maturity date. Those creditors who have lent money for short term are interested in the liquidity position of the company in order to get back their principal amount of debt on maturity. On the other hand, those creditors who have lent money for the long term are interested in the long-term financial position of the company to determine the ability of the company in order to repay the debt in time and the current interest obligations when it becomes due for payment. According to them, if a company earns less than what is paid in the form of interest, it is not safe to lend money to that company.

2. Prospective Investors :

The investors particularly, Debenture holders and Shareholders are interested in the company’s profitability and financial position for the safety of their money in the company. A study of the financial statements will help them in taking right decision for investment in the business. The debenture holders analyze the long-term financial position of a company to determine the degree of safety of their principal amount as well as interest. A relatively large amount of equity capital in the capital structure of the company provides an adequate margin of safety to debenture holders for their investment in the company. The shareholders, on the other hand, are interested in the overall 

financial and profitability position of the company in order to determine the safety and the return on their capital employed. 

3. Employees :

Employees are interested in the financial position of the company for the demand for increase in the wages. The employees’ wages to a great extent depend upon the success of the company. Thus, the past operating performance and the current financial position of the company are often studied to measure the ability of the company to meet the wage commitments. They are also interested in the financial position on account of various profit sharing and bonus schemes. Their interest may further increase in case they purchase shares of the companies in which they are employed. 

4. Bankers :

Bankers are primarily concerned with the company’s ability to pay its current debts. They wish not only repayment of loans and advances but also their repayment at right time. For this purpose, they analyze different sources of long term as well as short term funds raised by the company before granting loans and advances. A sound financial position provides safety to the bankers of their amount invested in the company.

5. Government :

The government is interested in the financial statements of business on account of control costs, prices and profits for taxation, labor, and corporate laws.

6. Students and Researchers :

The financial statements enables the research scholars and financial analyst to study the financial policies pursued by the management and on the basis of their studies, they can offer constructive suggestions to overcome any financial malady disclosed

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