Chapter-2

AN OVERVIEW OF FINANCIAL
ANALYSIS

Business concern needs finance to meet their requirements in the

economic world. Any kind of business activity depends on the finance. Hence, it is called
as lifeblood of business organization. Whether the business concerns are big or small,
they need finance to fulfil their business activities. In the modern world, all the activities
are concerned with the economic activities and very particular to earning profit through
any venture or activities. The entire business activities are directly related with making
profit. A business concern needs finance to meet all the requirements. Hence finance may
be called as capital, investment, fund etc., but each term is having different meanings and
unique characters.

2.2 FINANCIAL MANAGEMENT

Financial management refers to that part of the management activity,

which is concerned with the planning, & controlling of firms financial resources. It deals
with finding out various sources for raising funds for the firm. Financial management is
practiced by many corporate firms and can be called Corporation finance or Business
Finance. Financial Management is the application of the general management principles
in the area of financial decision-making, namely in the areas of investment of funds,
financing various activities, and disposal of profits. Financial management is the art of
planning; organizing, directing and controlling of the procurement and utilization of the
funds and safe disposal of profits to the end that individual, organizational and social
objectives are accomplished. 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.

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2.2.1 DEFINITION OF FINANCIAL MANAGEMENT
Howard and Upton: Financial management as an
application of general managerial principles to the area of financial decision-making.
The most popular and acceptable definition of financial
management as given by S.C. Kuchal is that Financial Management deals with
procurement of funds and their effective utilization in the business.

2.2.2 FUNCTIONS OF FINANCIAL MANAGEMENT

A financial manager has to concentrate on the following areas of the finance
function.
1. Estimating Financial Requirements: The first task of the financial manager
is to estimate short term and long-term financial requirement of his business.
For this purpose, he will prepare a financial plan for present as well as future.
2. Deciding Capital Structure: The capital structure refers to the kind and
proportion of the different securities for raising funds. After deciding about the
quantum of funds required it should be decided which type of security should
be raised. It may be wise to finance fixed securities through long term debts.
Long-term funds should be employed to finance working capital also.
3. Selecting a Source of Finance: After preparing a capital structure, an
appropriate source of finance is selected. Various sources from which finance
may be raised, includes share capital, debentures, financial deposits etc. If
finance is needed for short periods then banks, publics deposits, financial
institutions may be appropriate. If long-term finance is required the share
capital, debentures may be useful.
4. Selecting a Pattern of Investment: When fund have been procured then a
decision about investment pattern is to be taken. The selection of investment
pattern is related to the use of the funds. A decision has to be taken as to which
assets are to be purchased? The fund will have to be spent first. Fixed asset
and the appropriate portion will be retained for the working capital.
5. Proper Cash Management: Cash management is an important task of
financial manager. He has to assess the various cash needs at different times
and then make arrangements for arranging cash. Cash may be required to
make payments to creditors, purchasing raw material, meet wage bills, and
meet day to day expenses. The sources of cash may be Cash sales, Collection
of debts, Short-term arrangement with the banks. The cash management

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 should be such that neither there is shortage of it and nor it is idle. Any
shortage of cash will damage the creditworthiness of the enterprise. The idle
cash with the business mean that it is not properly used. Through Cash Flow
Statement one is able to find out various sources and applications of cash.
6. Implementing Financial Controls: An efficient system of financial
management necessitates the use of various control devices.
7. Proper use of Surpluses: The utilization of profits or surpluses as also an
important factor in financial management. A judicious use of surpluses is
essential for the expansion and diversification plans and also protecting the
interest of the shareholders. The ploughing back of profit is the best policy of
further financing. A balance should be struck in using the funds for paying
dividends and retaining earnings for financing expansion plans.

2.2.3 OBJECTIVES OF FINANCIAL MANAGEMENT

The main objective of a business is to maximize the owners economic

welfare. This objective can be achieved by;
1. Profit Maximization 2.Wealth Maximization
Profit Maximization: -
Profit maximization means maximizing the rupee income of a firm. Profit earning
is the main aim of every economic activity. No business can survive without
earning profit. Profit is a measure of efficiency of a business enterprise. Profit
also serve as a protection against risk which enables a business to face risk like
fall in prices, competition from other units, adverse govt. polices etc. So the profit
maximization is considered as the main objective of business.

Wealth Maximization: -
It is assumed that the goal of the firm should be to maximize the wealth of its
current shareholders. Wealth maximization is the appropriate objective of an
enterprise. Financial theory asserts that wealth maximization is the single
substitute for a stockholders utility. When the firm maximizes the stockholders
wealth, the individual stockholder can use this wealth to maximize his individual
utility

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2.3 FINANCIAL STATEMENT

A financial statement is an official document of the firm, which explores the

entire financial information of the firm. The main aim of the financial statement is to
provide information and understand the financial aspects of the firm. Hence, preparation
of the financial statement is important as much as the financial decisions . Financial
statements are the end products of financial accounting. These include
mainly Income statement or Profit and loss account, Position statement or
Balance sheet, Cash flow statement, Fund flow statement, statement of
retained earnings, Schedules etc.
The financial statements usually include the following:
1. Profit and loss Account (Income statement)
Income statement is prepared to determine the operational position of the
concern. It is a statement of revenues earned and expenses incurred for earning
that revenue. The difference is either profit or loss. The income statement is
prepared for a particular period.
2. Balance Sheet (Position statement)
A balance sheet is a financial statement that depicts the
financial position or soundness of a business concern as on any particular date. It
shows all the assets owned by the concern and all liabilities and claims it owes to
owners and outsiders.
3. Cash flow statement
The cash flow statement summarizes the causes of changes in cash
position of a business enterprise between two balancesheet dates. It focuses on
cash changes only. It describes the sources of cash and its uses.
4. Funds flow statement
The fund flow statement is designed to analyse the changes in the
financial condition of a business enterprise between two periods. This statement
will show the sources from which the funds are received and the uses to which
these have been put.
5. Statement of retained earnings
It is also known as Profit and loss appropriation account. It shows the
appropriation of earnings like dividend paid, transfer to reserve, etc. The balance
in this account will show the amount of profit retained and carried forward.

2.3.1 MEANING AND DEFINITION

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 Financial statement means the summarized statements and reports
prepared by business concerns to disclose their accounting information and
communicating them to the interested parties.
According to John N. Nyer defines, Financial statements provide a summary of the
accounting of a business enterprise, the balance-sheet reflecting the assets, liabilities and
capital as on a certain data and the income statement showing the results of operations
during a certain period.

2.4 FINANCIAL STATEMENT ANALYSIS

Financial statement analysis (or financial analysis) is the process of

reviewing and analyzing a company's financial statements to make better economic
decisions. Financial statement analysis is a method or process involving specific
techniques for evaluating risks, performance, financial health, and future prospects of an
organization.

2.4.1 MEANING AND DEFINITION

Financial statement analysis is the process of ascertaining the
profitability and financial position of a firm by analyzing its financial characteristics. It
helps the executives to evaluate past performance, present position, profitability of the
firm and to make forecast for the future earnings. The term financial analysis includes
both analysis and interpretation.

According to Metcalf and Titard: Analysis of financial statement is a process of

evaluating the relationship between component parts of a financial statement to obtain a
better understanding of a firms position and performance.

2.4.2 OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

1. Knowing the Profitability of the business:

Financial statements are required to ascertain
whether the enterprise is earning adequate profit and to know whether
the profits have increased or decreased as compared to the previous
years, so that corrective steps can be taken well in advance.

2. Knowing the Solvency of the Business:

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 Financial statements help to analyse the position of the business as
regards to the capacity of the entity to repay its short as well as long
term liabilities.
3. Judging the Growth of the Business:
Through comparison of data of two or more
years of business entity, we can draw a meaningful conclusion as
regard to growth of the business. For example, increase in sales with
simultaneous increase in the profits of the business, indicates a healthy
sign for the growth of the business.
4. Judging the financial strength of the Business:
Financial statements help the entity in
determining solvency of the business and help to answer various
aspects viz., whether it is capable to purchase assets from its own
resources and/or whether the entity can repay its outside liabilities as
and when they become due.
5. Making comparison and Selection of appropriate policy:
To make a comparative study of the profitability of the
entity with other entities engaged in the same trade, financial
statements help the management to adopt sound business policy by
making intra firm comparison.
6. Forecasting and preparing Budgets:
Financial statement provides information
regarding the weak-spots of the business so that the management can
take corrective measures to remove these short comings. Financial
statements help the management to make forecast and prepare budgets.

2.4.3 TYPES OF FINANCIAL ANALYSIS

Analysis of financial statement may be broadly classified into three important
types on the basis of materials used, methods of operations, and objectives of
analysis.
1. Based on materials used: Based on the material used, financial
statement analysis may be classified into two major types
such as External analysis and internal analysis.

A. External Analysis

External analysis of financial statement is made by those

who do not have access to the detailed accounting records
of the concern such as bankers, creditors, investors, and
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 general public. These people depend almost entirely on
published financial statements. The main objective of such
analysis varies from party to party.
B. Internal Analysis:
Internal analysis is a type of analysis made by the
accounting department to assess the possibility of different
activities of the organization.
2. Based on Methods of operation: Based on the methods of
operation, financial statement analysis may be classified into
two major types such as horizontal analysis and vertical
analysis.
A. Horizontal Analysis:
Under the horizontal analysis, financial
statements are compared with several years and
based on that, a firm may take decisions. Normally,
the current years figures are compared with the
base year (base year is consider as 100) and how
the financial information are changed from one year
to another. This analysis is also called as dynamic
analysis.
B. Vertical Analysis:
Under the vertical analysis, financial
statements measure the quantities relationship of
the various items in the financial statement on a
particular period. It is also called as static analysis,
because, this analysis helps to determine the
relationship with various items appeared in the
financial statement.
3. Based on Objectives of analysis: Based on the objectives of analysis,
financial statement analysis may be classified into two major types such
as Long term analysis and Short term analysis.

A. Long term Analysis:

Long term analysis is done to ascertain the
stability and earning potentiality of the concern by
analyzing the fixed assets, long term debt structure and the
ownership interest.
B. Short term Analysis:

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 It is also known as working capital analysis. In
short term analysis, the current assets and current liabilities
are analyzed and cash position of the concern is determined.
For short term analysis the ratio analysis is very useful.

2.4.4 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is interpreted mainly to determine the financial and

operational performance of the business concern. A number of methods or techniques are
used to analyse the financial statement of the business concern. The following are the
common methods or techniques, which are widely used by the business concern.

1. Comparative Statement
Comparative statement analysis is an analysis of financial statement at different
period of time. This statement helps to understand the comparative position of financial
and operational performance at different period of time. When financial statements
figures for two or more years are placed side-by-side to facilitate comparison, these are
called 'Comparative Financial Statements.' Such statements not only show the absolute
figures of various years but also provide for columns to indicate the increase or decrease
in these figures from one year to another. 'In addition, these statements may also show the
change from one year to another in percentage form. Because of the utmost usefulness of
the comparative statements, the Companies Act, 1956 has provided that the Profit & Loss
Account and Balance Sheet of a Company must show the figures of the previous year also
with the figures of the current year.

Comparative financial statements again classified into two major parts such as
comparative balance sheet analysis and comparative profit and loss account analysis.

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 A. Comparative Balance sheet:
Comparative balance sheet is a statement prepared to compare the
balance sheet items of one year with that of another year or years of the same
business enterprise.
The comparative balance sheet analysis is the study of the trend of the same
items or group of items of two or more balancesheet of the same business
enterprise on different dates. The changes in periodic balance sheet items
reflect the conduct of the business. The changes can be observed by
comparison of the items of the balance sheet at the beginning and at the end
of the period and the analysis of these changes help us in forming an opinion
about the progress of an enterprise.

B. Comparative Income statement:

The comparative income statement is a statement prepared to get an
idea of the progress of a business over a period of time. The changes in
absolute data in money values and percentages help to analyze the
profitability of a business.
2. Common Size Income Statement

A common size income statement is a statement in which each item of expense is

shown as a percentage of net sales. A significant relationship can be established between
items of income statement and volume of sales. Increase in sales will certainly the selling
expense and not the administration and financial expenses which are mostly fixed in
nature. In case the volume of sales increases to a considerable extent, administration and
financial expenses may also go up by a narrow margin.

1. Trend Analysis

Trend ratios or trend percentages are the ratios of certain accounting variables of
the current year over the base year variables. Trend Analysis is the review and appraisal
of tendency in accounting variables. Trend ratios is also an important tool of horizontal
financial analysis. Under this technique of financial analysis, the ratios of different items
for various period are calculated and then a comparison is made. An analysis of the ratios
over the past few years may well suggest the trend or direction in which the concern is
moving. Trend analysis is helpful in forecasting and budgeting.

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 current year amount
100
Trend percentage = Base year amount

2. Average Analysis
It is an improvement over trend analysis method. When trend ratios
have been determined for concern, these figures are compared with average trend of the
industry. Both these trends can be presented on the graph paper also in the shape of
curves. This presentation of facts in shape of pictures makes the analysis and comparison
more comprehensive and impressive.

3. Statement of changes in working capital

To discuss the increase or decrease in working capital over a period of
time, the preparation of a statement of changes in working capital is also very useful.
4. Cash Flow Statement and Fund Flow Statement
Cash flow statement is a statement which shows the sources of cash inflow
and uses of cash out-flow of the business concern during a particular period of time. It is
the statement, which involves only short-term financial position of the business concern.
Cash flow statement provides a summary of operating, investment and financing cash
flows and reconciles them with changes in its cash and cash equivalents such as
marketable securities. A cash flow statement reveals the sources of cash and its
application.
Funds flow statement is one of the important tools, which is used in many
ways. It helps to understand the changes in the financial position of a business enterprise
between the beginning and ending financial statement dates. It is also called as statement
of sources and uses of funds. The term Funds has been described in many ways.
Many interpret funds as cash only and fund flow statement prepared of this ratio is called
a cash flow statement. In this type of statement only inflow and outflow of cash flow
obtain into account. This narrow concept of cash flow often leads to omission of such
items which do not directly affect cash or working capital. Thus the term funds flow
refers to change in working capitals.
5. Ratio Analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio
is a mathematical relationship between one numbers to another number. Ratio is used as
an index for evaluating the financial performance of the business concern. It is essentially
to attempt to develop meaningful relationship between individual items and group of
items in the balancesheet or profit and loss account. An accounting ratio shows the

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mathematical relationship between two figures, which have meaningful relation with each
other.
Ratio analysis may be defined as the process of computing, determining and presenting
the relationship of items and groups of items of financial statements with the help of
ratios and interpreting the results there from. Ratios can be classified into various types.
Classification from the point of view of financial management is as follows:

A. Liquidity Ratio
Liquidity ratio is also called short term ratio. This ratio helps to understand the
liquidity in a business which is the potential ability to meet current obligations. This ratio
expresses the relationship between current assets and current assets of the business
concern during a particular period. The following are the major liquidity ratios,
1. Current Ratio:
Current ratio is the most common ratio for measuring liquidity. It represents the
ratio of current assets to current liabilities. It is also called working capital ratio. It
is calculated by dividing current assets by current liabilities.
Current assets
Current Ratio=
Current liabilities
2. Quick Ratio
This ratio sometimes known as Acid Test Ratio or Liquidity Ratio. It is the
relation between quick assets to current liabilities.
Quick or Liquid assets
Quick Ratio=
Current Liabilities
3. Absolute Liquidity Ratio
This ratio is obtained be dividing cash and Marketable securities by current
liabilities. It is also known as cash position ratio.

Cash + Marketable securities

Absolute Liquidity Ratio =
Current Liabilities

B. Leverage Ratios
Financial leverage refers to the use of debt finance. While debt capital is a cheaper
source of finance, it is also a riskier source of finance. Leverage ratios help in assessing
the risk arising from the use of debt capital. The following are the important leverage
ratios:

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1. Debt Equity Ratio
The relationship between borrowed funds and owners capital is a popular
measure of the long term financial solvency of a firm. The relationship is shown
by the debt equity ratio. This ratio is computed by dividing the total debt of the
firm by its net worth.
Debt
Debt equity ratio =
Equity
2. Proprietary Ratio
Proprietary ratio relates to the shareholders fund to total assets. This ratio
shows the long term solvency of the business. It is calculated by dividing
shareholders fund by the total assets.
Shareholders fund
P roprietary ratio=
Total Assets
3. Solvency Ratio
Solvency ratio indicates the relationship between total outside liabilities to total
assets does not include fictitious assets.
Total liabilities to outsiders
Solvency Ratio = Total Assets

4. Fixed Assets Ratio

Fixed assets ratio is the ratio of fixed assets after depreciation to long-term
funds. Here long term fund means shareholders fund including preference share
capital and long term borrowings.
asset ( after depreciation)
asset ratio=
Total Long term funds
5. Debt Service Ratio
Earning before interest and Tax
Debt Service Ratio=
Fixed Interest Charges
6. Ratios of long term debt to shareholders fund
Long term debt
Ratios of long term debt to shareholders fund = Shareholders fund

7. Fixed assets to net worth

Fixed Assets
Fixed assets to net worth = Net worth or shareholders fund

8. Capital Gearing Ratio

This ratio mainly used to analyse the capital structure of a company.
Fixed interest bearing funds
Capital Gearing Ratio = Equity share capital + Reserve & surplus

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C. Profitability Ratio
Profitability ratio helps to measure the profitability position of the
business concern. The important profitability ratios are the following.
1. Gross Profit Ratio
This ratio express the relationship between gross profit and sales.
Gross Profit 100
Gross Profit Ratio = Net Sales

2. Net Profit Ratio

Net Profit100
Net profit ratio = Sales

3. Operating Ratio
Operating cos t
Operating ratio = Net sales 100

4. Operating Profit Ratio

Operating Profit Ratio = 100 Operating ratio
Or
Operating profi t
Operating Ratio = Net sales 100

5. Expenses Ratio
Expense ratio indicates the relationship of each item of expense to net sales.
Particular Expense
Particular expense ratio = Net sales 100

6. Earning Per Share (E.P.S)

Earning per Share measures the profit available to the equity shareholders per
share.
Net profit available to equity shareholders
E.P.S = Number of equity shares issued

D. Turn over Ratios

Turnover ratios, also referred to as activity ratios or asset management ratios,
measure how efficiently the assets are employed by a firm. These ratios are based on the
relationship between the level of activity, represented by sales or cost of goods sold, and
levels of various assets. The important turn over ratios are the following;
1. Inventory Turnover ratio
The inventory turnover, or stock turnover, measures how fast the
inventory is moving through the firm and generating sales.
Cost of goods sol d
Inventory Turnover ratio = Average stock

2. Fixed assets turnover ratio

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 This ratio measures sales per rupee of investment in fixed assets.
Net sales
Fixed assets turnover ratio = Fixed assets

3. Working capital turnover ratio

The ratio reflects the turnover of the firms networking capital in the course
of the year.
Net sales
Working capital turnover ratio = Networking capital

4. Debtors turnover ratio

The purpose of this ratio is to discuss the credit collection power and
policy of the firm.
Net credit sales
Debtors turnover ratio = Average accounts receivables

5. Average debt collection period

The average collection period represents the number of days worth of credit
sales that is locked in sundry debtors.
Average debt collection period (in days) =

Average accounts receivable 365

Net credit sales

Average debt collection period (in month) =

Average account receivable 12

Net credit sales or sales

6. Creditors turnover ratio

Creditors turnover ratio indicates the number of times the accounts
payable rotate in a year.
Net Credit Purchase
Creditors turnover ratio = Average accounts payable

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