CH 2
CH 2
CH 2
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.
2.1. Financial Analysis
Financial analysis is the assessment of firm's past, present, and anticipated future financial condition. It is
the base for intelligent decision making and starting point for planning the future courses of events for the
firm. Its objectives are to determine the firm's financial strength and to identify its weaknesses. The focus of
financial analysis is on key figures in the financial statements and the significant relationships that exist
between them.
The goal of financial analysis is to analyze whether an entity is stable, solvent, liquid, or profitable enough
to warrant a monetary investment. It is used to evaluate economic trends, set financial policy, build long-
term plans for business activity, and identify projects or companies for investment.
2.1.1. The need for financial analysis
Financial statement analysis is used to identify the trends and relationships between financial statement
items. Both internal management and external users (such as analysts, creditors, and investors) of the
financial statements need to evaluate a company's profitability, liquidity, and solvency.
2.1.2. Source of financial data
The three main sources of data for financial analysis are a company's balance sheet, income statement,
and cash flow statement.
A. Income statement
Is also called as profit and loss account, which reflects the operational position of the firm during a
particular period. Normally it consists of one accounting year. It determines the entire operational
performance of the concern like total revenue generated and expenses incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is
determined by preparation of trading or manufacturing and net profit is determined by preparation of
profit and loss account.
B. The balance sheet
Is also called Position Statement which reflects the financial position of the firm at the end of the
financial year. Position statement helps to ascertain and understand the total assets, liabilities and capital
of the firm. One can understand the strength and weakness of the concern with the help of the position
statement. It is a summary of what the business owns (its assets) and what it owes (its liabilities) and the
difference between the two (net worth, also called owner’s equity).
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C. The cash flow statement
Is a log of cash inflows (cash coming in to the business as income) and cash outflows (cash going out of
the business as cash expenses).
2.1.3. Approaches to financial analysis and interpretation
The three most commonly practiced methods of financial analysis are horizontal analysis, vertical
analysis, and ratio analysis. For this course, we are mainly focused on Ratio analysis.
2.1.3.1. Ratio Analysis
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, and profitability by studying its financial statements such as the balance sheet and income
statement.
Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding
profitability, liquidity, operational efficiency, and solvency. It can mark how a company is performing
over time, while comparing a company to another within the same industry or sector. it may also be
required by external parties that set benchmarks often tied to risk.
From the point of view of financial management it is classified as:
A. Liquidity Ratio D. Profitability Ratio
B. Activity Ratio E. Market value ratios.
C. Solvency Ratio
A. Liquidity Ratio
Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and as they fall
due. It provides the basis for answering the questions: Does the firm have sufficient cash and near cash
assets to pay its bills on time?
It is also called as 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 liability of the business concern during a particular period.
The firm's ability to repay these obligations when due depends largely on whether it has sufficient cash
together with other assets that can be converted into cash before the current liabilities mature. The firm's
current assets are the primary source of funds needed to repay current and maturing financial obligations.
Thus, the current ratio is the logical measure of liquidity. Lack of liquidity implies inability to meet its
current obligations leading to lack of credibility among suppliers and creditors.
The following are the major liquidity ratio:
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1. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term creditors by
using only current assets. That is, it measures a firm’s short-term solvency or liquidity. The current
ratio is calculated by dividing current assets to current liabilities.
─ A very high current ratio than the Standard may indicate: excessive cash due to poor cash
management, excessive accounts receivable due to poor credit management, excessive
inventories due to poor inventory management, or a firm is not making full use of its current
borrowing capacity.
─ A very Low current ratio than the Standard may indicate: difficulty in paying its short term
obligations, under stocking that may cause customer dissatisfaction.
2. Quick (Acid-test) Ratio: This ratio measures the short term liquidity by removing the least liquid
assets such as:
i. Inventories: are excluded because they are not easily and readily convertible into cash and
moreover, losses are most likely to occur in the event of selling inventories. Because inventories
are generally the least liquid of the firm's assets, it may be desirable to remove them from the
numerator of the current ratio, thus obtaining a more refined liquidity measure.
ii. Prepaid Expenses such as; prepaid rent, prepaid insurance, and prepaid advertising, pre-paid
supplies are excluded because they are not available to pay off current debts.
B. Activity Ratio
It is also called as turnover ratio. This ratio is helpful to understand the performance of the business
concern.
Turnover ratios measure the degree to which assets are efficiently employed in the firm. These ratios
indicate how well the firm manages its assets. They provide the basis for assessing how the firm is
efficiently or intensively using its assets to generate sales. These ratios are called turnover ratios because
they show the speed with which assets are being converted into sales.
Some of the activity ratios are given below:
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1. Inventory Turnover Ratio/stock turnover ratio
The inventory turnover ratio measures the effectiveness or efficiency with which a firm is managing its
investments in inventories is reflected in the number of times that its inventories are turned over (replaced)
during the year. It is a rough measure of how many times per year the inventory level is replaced or turned
over.
Inventory Turnover = Cost of Goods Sold
Average Inventories
In general, a high inventory turnover ratio is better than a low ratio. An inventory turnover
significantly higher than the industry average indicates: Superior selling practice, improved
profitability as less money is tied-up in inventory.
2. Average Age of Inventory
The number of days inventory is kept before it is sold to customers. It is calculated by dividing the number
of days in the year to the inventory turnover.
No days in year /365 days
Average Age of Inventory = Inventory Turnover
The longer period indicates that, the company is keeping much inventory in its custody and, the company
is expected to reassess its marketing mechanisms that can boost its sales because, the lengthening of the
holding periods shows a greater risk of obsolescence and high holding costs.
3. Accounts Receivable Turnover Ratio:
Measures the liquidity of firm’s accounts receivable. That is, it indicates how many times or how rapidly
accounts receivable is converted into cash during a year. The accounts receivable turnover is a comparison
of the size of the company’s sales and its uncollected bills from customers. This ratio tells how successful
the firm is in its collection. If the company is having difficulty in collecting its money, it has large
receivable balance and low ratio.
Receivable Turnover = Net Sales
Average Account Receivables
Reasonably high accounts receivable turnover is preferable.
A ratio substantially lower than the industry average may suggest that a Company has: More liberal
credit policy (i.e. longer time credit period), poor credit selection, and inadequate collection effort or
policy.
A ratio substantially higher than the industry average may suggest that a firm has; More restrictive
credit policy (i.e. short term credit period), more liberal cash discount offers (i.e. larger discount and
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sale increase), more restrictive credit selection.
4. Average Collection Period
Shows how long it takes for account receivables to be cleared (collected). The average collection period
represents the number of days for which credit sales are locked in with debtors (accounts receivables).
365 days
Average Collection period = Re ceivable Turnover
The higher average collection period is an indication of reluctant collection policy where much of the
firm’s cash is tied up in the form of accounts receivables, whereas, the lower the average collection period
than the standard is also an indication of very aggressive collection policy which could result in the
reduction of sales revenue.
5. Average Payment Period
The average Payment Period/ Average Age of accounts Payable shows, the time it takes to pay to its
suppliers.
The Average Payment Period = Accounts Payable
Average purchase per day
The longer these days, the more the credit financing the firm obtains from its suppliers.
6. Fixed Asset Turnover
Measures the efficiency with which the firm has been using its fixed assets to generate revenue.
Fixed assert turnover = Net sales
Net Fixed Asset
Other things being equal, a ratio substantially below the industry average shows; underutilization of
available fixed assets (i.e. presence of idle capacity) relative to the industry, possibility to expand activity
level without requiring additional capital investment, over investment in fixed assets, low sales or both.
Helps the financial manager to reject funds requested by production managers for new capital investments.
Other things being equal, a ratio higher than the industry average requires the firm to make additional
capital investment to operate a higher level of activity. It also shows firm's efficiency in managing and
utilizing fixed assets.
7. Total Asset Turnover
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the company is not generating a sufficient volume of sales for the size of its investment in assets.
C. Solvency Ratio
It is also called as leverage ratio, which measures the long-term obligation of the business concern.
This ratio helps to understand, how the long-term funds are used in the business concern. Solvency is
a firm’s ability to pay long term debt as they come due. Leverage shows the degree of ineptness of
firm.
There are two types of debt measurement tools. These are:
1. Financial Leverage Ratio: These ratios examine balance sheet ratios and determine the extent to which
borrowed funds have been used to finance the firm. It is the relationship of borrowed funds and owner
capital.
a. Debt Ratio: The debt ratio compares total liabilities (total debt) to total assets. It shows the
percentage of total funds obtained from creditors. Creditors would rather see a low debt ratio
because there is a greater cushion for creditor losses if the firm goes bankrupt/insolvent. Higher ratio
shows more of a firm’s assets are provided by creditors relative to owners indicating that, the firm
may face some difficulty in raising additional debt as creditors may require a higher rate of return
(interest rate) for taking high-risk. Creditors prefer moderate or low debt ratio, because low debt
ratio provides creditors more protection in case a firm experiences financial problems.
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a. Times Interest Earned (Interest Coverage) Ratio. The times interest earned ratio reflects the
number of times before-tax earnings cover interest expense. It is a safety margin indicator in the
sense that it shows how much of a decline in earnings a company can absorb/engage.
Profitability is the ability of a business to earn profit over a period of time. Profitability ratios are used to
measure management effectiveness. Besides management of the company, creditors and owners are also
interested in the profitability of the company. Creditors want to get interest and repayment of principal
regularly. Owners want to get a required rate of return on their investment. These ratios include:
Gross Profit Margin Return on Investment
Operating Profit Margin Return on Equity
Net Profit Margin Earnings Per Share
1. Gross Profit Margin: This ratio computes the margin earned by the firm after incurring
manufacturing or purchasing costs. It indicates management effectiveness in pricing policy,
generating sales and controlling production costs. It is calculated as:
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2. Operating Profit Margin: This ratio is calculated by dividing the net operating profits by net sales.
The net operating profit is obtained by deducting depreciation from the gross operating profit. The
operating profit is calculated as:
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6. Earnings per Share (EPS): EPS is another measure of profitability of a firm from the point of view
of the ordinary shareholders. It reveals the profit available to each ordinary share. It is calculated by
dividing the profits available to ordinary shareholders (i.e. profit after tax minus preference
dividend) by the number of outstanding equity shares.
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with the financial activities of an organization. It essentially concerned with the economical procurement
and profitable use of funds.
In the first unit, we discussed that financial management involves planning for raising and utilizing funds.
Financial managers should be able to plan before hand in making investment and financing decisions. So,
financial forecasting helps financial managers to predict events before they occur. This, particularly, is
true when they plan to raise funds externally.
Financial forecasting also forces financial managers to develop financial statements beforehand. These
financial statements are called Pro forma financial statements. They include forecasted sales and
forecasted expenses, forecasted assets, forecasted liabilities, and forecasted stockholders’ equity. Based on
these forecasted items, the financial manager is able to determine the amount of finance to be obtained
from external sources.
Uses of Pro forma financial statements.
Managers make pro forma, or projected, financial statements and then use them in four ways:-
─ By looking at projected statements, they can assess whether the firm’s anticipated performance is
in line with the firm’s own general targets and with investors’ expectations. For example, if the
projected financial statements indicate that the forecasted return on equity is well below the
industry average, managers should investigate the cause and then seek a remedy.
─ Pro forma statements can be used to estimate the effect of proposed operating changes. Therefore,
financial managers spend a lot of time doing “what if” analyses.
─ Managers use pro forma statements to anticipate the firm’s future financing needs.
─ Projected financial statements are used to estimate future free cash flows, which determine the
company’s overall value. Thus, managers forecast free cash flows under different operating plans,
forecast their capital requirements, and then choose the plan that maximizes shareholder value.
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Financial planning involves the following steps.
Establishing objectives: the 1st step in financial planning is the formulation of financial objectives in
tune with business objectives. Even though the extent to which capital is employed varies from firm to
firm, the objectives are similar in all firms. The financial planner should formulate both short term and
long term objectives in order to successful in changing economic conditions. In other words, Project
financial statements and use these projections to analyze the effects of the operating plan on projected
profits and various financial ratios. The projections can also be used to monitor operations after the
plan has been finalized and put into effect. Rapid awareness of deviations from the plan is essential in
a good control system, which, in turn, is essential to corporate success in a changing world.
Determine the funds needed to support the five-year plan/estimate the amount of capital required.
This includes funds for plant and equipment as well as for inventories and receivables, for R&D
programs, and for major advertising campaigns. So the financial planners should estimate the amount
of both fixed and working capital required for various needs of the business.
Forecast funds availability over the next five years. This involves estimating the funds to be
generated internally as well as those to be obtained from external sources. Any constraints on
operating plans imposed by financial restrictions must be incorporated into the plan; constraints
include restrictions on the debt ratio, the current ratio, and the coverage ratios.
Establish and maintain a system of controls to govern the allocation and use of funds within the
firm. In essence, this involves making sure that the basic plan is carried out properly.
Develop procedures for adjusting the basic plan/formulating financial polices if the economic
forecasts upon which the plan was based do not materialize. For example, if the economy turns out to
be stronger than was forecasted, then these new conditions must be recognized and reflected in higher
production schedules, larger marketing quotas, and the like, and as rapidly as possible. Thus, Step 5 is
really a “feedback loop” that triggers modifications to the financial plan. Financial polices of business
firm may be brought in to the following:-
- Policies governing the amount of capital required.
- Policies which determine the control by the parties who furnish the capital.
- Policies which act as a guide in the use of debt or equity capital.
- Policies which guide management in the selection of sources of funds.
- Policies which govern credit and collection activities. Etc.
- Establish a performance-based management compensation system. It is critically important that
such a system rewards managers for doing what stockholders want them to do—maximize share
prices.
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Factors considered for estimating financial requirements
- Cost of financing:- it should be minimum
- Advertising expenses፡- Brokerage on securities, Commission on underwriting. Etc. are expenses
incurred for raising funds.
- Repayment date: - the time for which finance is required should be taken in to account while
estimating financial requirement of a concern.
- Liquidity: - liquidity means ability to produce cash on demand. Due regard should be given to it as a
poor liquidity may lead to insolvency.
- Interest payment:- interest payment should be the minimum as heavy interest charges are
embarrassing.
- Claim on assets: - the borrowings of concern may result in a charge on its assets.
- Control:- the capital structure of concern should be as to ensure that control does not pass in to the
hands of outsiders.
- Risk: the financial manager is more concentrated about the financial risk which is created by a high
debt –equity ratio than about other risk. It is better to ignore launching risky projects when equity
finance is not available to the desired extent.
- Seasonality: - financial requirements of a concern are highly influenced by seasonality which cannot
be easily predicted. The events like strikes, product failures, changes in the supply price, and
changes in technology or consumers tastes significantly affect financial requirements.
- Cost of promotion: - expense incurred before the incorporation of a company is called promotion
expenses. These include expense on preliminary investigations, accounting, marketing and legal
advice, etc.
- Cost of fixed assets: - the need for fixed capital should be on estimates supplied by the production and
engineering department.
- Cost of current asset:- it should be assessed on the basis of estimated sales and production schedules
or projections.
- Cost of establishing the business:
2.4. The importance of sales forecasting
An accurate financial forecast is very important to any firm in several aspects:
- It helps a firm to predict appropriate demand for its products.
- It helps a firm to project its sales and accordingly to predict its assets properly.
- It contributes significantly to the firm’s profitability.
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- It plays a crucial role in the value maximization goal of a firm.
- It helps to explain the proper requirement of funds and their optimum utilization.
- It assists the firm for the successful financial planning by providing significant information.
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