MODULE B

STUDY OF FINANCIAL STATEMENTS

C.S.BALAKRISHNAN
FACULTY MEMBER
SPBT COLLEGE
 Scope,Functions and objective
Scope is
 Designing and implementing certain plans.
 Ensuring effective funds utilisation by directing
funds flow according to some plan.
 Serving as a necessary tool and technique for
resources allocation to various projects of the
business and providing the best guide for existing
and prospective resource allocation.
 According to Howard and Upton “Financial
management involves the application of
general management principles to particular
financial operation”.
 Attending to investment decisions as to when
and how to acquire and allocate funds for
short-term and long-term assets keeping in
view the profit generation of the business
through which repayment obligation can be
met.
Objectives and basic consideration of
Financialmanagement.
 Although profit maximisation is the objective
of financial management,the long-term goalof
the business entity is to achieve maximising
the shareholder value of the firm,since the
“principle of maximisation of shareholder
wealth provides a rational guide for running a
business and for efficient allocation of
resources in society”.
 The key objective of Financial Management is to
maximise the value of the company.This is the result
of good investment decisions,prudent financing
decisions and well thought-out financial planning
and control.
 Maximisation of the value of the company is also
known as maximisation of the wealth of the
owners.To achieve this,finance manager has to take
careful decisions in respect of
-Financing -Dividend
-Investment -Current asset management.
• Financing decision-Has to decide on sources of
funds for business.It is to be decided whether
entire capital should be raised from equity capital
or a part is to be raised from loan.Hence
Debt/Equity ratio or Leverage are important since
each source has in them associated risk factors
involved.
• Investment decision-It relates to acquisition of
assets.Assets are classified into real assets such
as land,building,plant,equipment etc.and the
financial assets are shares and debentures etc.It
indicates available mix of financing to fund
company’s activities.Such decisions on
investment in projects come within the field of
capital budgeting which is derived from net
present value of assets.
 Dividend decision-It is basically a financing
decision.This is because profit is a source of
fund.By not paying dividend,the “retained
earnings”or ‘reserve’can be increased which
could be otherwise available for investment.
This ultimately lead to maximisation of wealth
of the organisation provided decisions on
investments are correct.
 Current Asset Management-This is necessary to
maintain balance between current assets and
current liability,if the liquidity of the business is
interrupted because of holding too much fund in
current assets.
 Wealth maximisation &value maximisation
• The goal of financial management is to maximise
the value of companies.This is generally
expressed in terms of maximising the value of the
ownership shares of the company,in
short,maximising share price.Thus,better
performing companies can raise additional funds
under more favourable terms.When funds go the
such companies the economy’s resources are
directed to more efficient use.This basic objective
of maximisingthe price of the company’s shares is
called ‘value maximisation’.
• Social responsibility is also an important goal of
a company which requires
-Maximising share-price by efficient,well-
managed operations related to consumer
demand parameters.
-Efficiency & innovation leads to value
maximisation which leads to new
products,new technologies and better
employment.
-External factors like pollution,product safety and
job safety have acieved added dimensions in
relation to value maximisation.
 Profit maximisation vs.Wealth
maximisation
• Long run vs.Short run Profits.
• Convert total corporate profits to earning per
share(EPS).
• EPS is total profits divided by number of shares
outstanding.
• Assume the firm earns Rs.10 mn.and has
1mn.shares outstanding.The EPS will work out to
Rs.10.
• Profit maximisation is a short-term concept,while
wealth maximisation emphasises the long-term
view point.
 State whether true or false
• The income statement depicts the financial
position of the firm at a given point of time
• The balance sheet gives the financial
performance of the firm over a given period of
time.
• These statements are prepared every week.
• Funds Flow statement gives the liquidity
position of the firm.
 Cash Flow statement tells from where the
money comes and where it is used.
 The prime objective of financial management
is wealth maximisation,and not profit
maximisation.
 What is earnings per share?
a)Net Profit
b)Profit before interest and tax
c)Total earnings divided by investment
d)Net profit divided by equity
 What is the difference between long term
funds and short term funds?
-Difference in interest rates
-Difference in time of repayment
-Difference in the size of loan
-No difference
CAPITAL EXPENDITURE DECISIONS AND
PROFITABILITY STUDY

 It represents the important decisions taken by

the firm.
 Importance due to the following issues
-Long-term effects
-Irreversibility
-Substantial outlays
• Difficulties
-Measurement problems
-Uncertainty
-Temporal spread
o Phases of capital budgeting
-Capital budgeting is a complex process which
may be divided into five broad phases.
Planning Implementation
Analysis Review.
Selection
• Levels of Decision Making
-Operating decisions
-Administrative decisions
-Strategic decisions
o Profitability Study important facets are
-Market analysis
-Technical analysis
-Financial analysis
-Economic analysis
-Ecological analysis
 The basic characteristic of a capital project is that
it typically involves a current outlay(or current
and future outlays)of funds in expectation of a
stream of benefits extending far into future.
 Accounting rate of return method-A selection
criterion using average net income and
investment outlay to compute a rate of return for
a project.This method ignores the time value of
money & cash flows.
 Internal rate of return method-A selection
method using the compounding rate of return on
the cash flow of the project.
 Net Present Value method-A selection
method using the difference between the
present value of the cash inflows of the
project and the investment outlay.The
method evaluates the differential cash flow
between proposals.
 Payback method-A selection method in which
a firm sets a maximum payback period during
which cash inflow must be sufficient to
recover the initial outlay.This method ignores
the time value of money and cash flow
beyond the pay back period.
 What are the three important factors which arise
from capital expenditure decisions?
a)Long-term effects e)Debt
b)Profitability f)Substantial outlays
c)Irreversibility g)Short-term effects.
d)Risk
 Why are capital expenditure decisions difficult?
i)Uncertainity in predicting costs&benefits
ii)Difficulty in measurement of costs&benefits
iii)Risk involved
iv)Problems in estimating discount rates
v)All the above
• If the IRR of the project is 7% and the cost of
capital is (11.4% should we reject or accept
the project). Yes/No.
• The firm should always make an ecological
analysis to know the likely damage that may
be caused by the project to the environment.
a)Must do b)No need.
 Sources of finance and
cost of capital

For what purposes a firm needs a finance?

Since the cash receipts lag behind cash
payments necessitating loans,bonds,overdrafts
etc.the firm needs finance for short term and long
term requirements-fixed assets and working
capital.
Permanent sources of finance
Share capital and retained profits.
 Depreciation is not a real expenditure.It is a
non-cash expenditure(T/F)
 Depreciation amount increases the liquidity of
the firm(T/F)
 Cost of goods sold and Cost of production
refer to the same amount(T/F)
 Net profit is calculated before tax(T/F)
 Balance sheet and Income statement can be
prepared every quarter for internal use(T/F)
 A loss is shown as asset in the balance
sheet(T/F).
• Provisions for taxes and accrued expenses to
be paid within a year are current assets(T/F)
• Debtors(also known as accounts
receivable)represent the amount of money to
be paid by the firm to the suppliers(T/F)
• Fund Flow statements can be prepared
without the basis of balance sheets(T/F).
• Fund flow statements represent only bank
borrowing and trade credit(T/F)
• State whether following are sources or uses
-Buying materials
-Payment of dividend to shareholders
-Advance received from buyer of goods
-Investment in machinery
-Issue of debentures
-Retained earnings
-Increase in Inventories
-Sale of old machinery
-Depreciation amount
 Study of financial statements
• Who are the party interested in firm’s financial
condition?
Shareholders,creditors/suppliers,managers,tax
authorities.
• Different types of concerns of stakeholders
Profitability and earning capacity,liquidity and
repaying loan instalments and interest.
 Long term sources
Preferenceshares,bonds,debentures and long
term loans from financial institutions.
 Various sources of short term finance-
Cash credit,overdraft,billsdiscounting,commercial
papers and trade credit.
 Short term & long term cash forecasts-
Time periods involved-Yearly for long term
forecasts,monthly for short term forecasts.
 Factors considered in equity financing
Issue costs,servicing costs such as paying out
dividends, and when there is retained earnings
there will be capital appreciation of sharevalues.
 Preference Shares-These shareholders get a
fixed return and their risk is less than the equity
Shareholders.They have a right to the first slice
of dividend.Obligation to redeem the preference
shares after its time period.They do not have a
right to vote.
 Debentures or loan financing-the firm will have
to pay fixed interest very year.There is an
obligation to redeem it at the end of the
period.There is also an advantage of tax
deductibility of interest paid which makes it
cheaper.
 Bills rediscounting –The buyer can repay in a
long period of time,while seller gets his money
back by discounting the bills.For the seller,this
helps him to go ahead with production and
increase the turnover.
 Working capital term loan-A part of working
capital has to be with the manufacturer,since
there is a time lag between ordering and
procuring.This particular portion (say25%)can
be financed by long term funds.When firm is
not able to infuse its own funds for this
purpose,it gets a long term loan from the
bank.This carries fixed interest and for a fixed
period.
 Overdraft and bank loan-Overdraft is a running
account whereas bank loan instalment are
fixed.
 Trade credit-When materials are bought from
suppliers,the trade credit is extended for few
days or a couple of months.The supplier is
willing to wait to collect money.This also
depends on the suppliers’financial position
and the buyers credit worthiness.
 Commercial paper-These are short term
promissory notes with fixed maturity
period.They are issued by very large
companies who are reputed and have high
credit worthiness.Credit rating agencies certify
their credit rating.
 Firms’cost of capital-A firm’s is the average cost
of capital is the weighted average arithmetic
mean of the cost of resources from various
sources.
Questions:
a)Long term sources are banks and financial
institutions (T/F)
b)Current liabilities should be repaid within a
financial year(T/F)
c)Fixed assets are generally financed with
current liabilities(T/F)
 Equity Shareholders bear the greatest risk(T/F)
 Bills discounting scheme has been introduced to ease
flow of funds in the economy(T/F)
 Trade creditors are suppliers of goods and services to
whom the firm is yet to pay.(T/F)
 Accounts Receivables should be less than trade
creditors(T/F).
 Bills of Exchange is same as cash credit(T/F).
 Equity and Preference shares are one and the
same(T/F)
 A part of working capital can be financed by long
term sources(T/F)
• A firm borrows Rs.20,000 from bank @8% and
floats a debenture for Rs.60,000 @6%,for a special
project,what is the cost of capital of the project?
a)5.5% b)6.5% c)7.5% d)8.5%
• If a firm borrows Rs.2 lac @10% and has a tax rate
of 40%.What is the cost of capital?
a)5% b)6% c)7% d)8%
• A company has issued preference share of Rs.100
face value carrying 14% dividend repayable at par
after 12 years.Cost of capital after tax of 40%?
a)21.22% b)23.33%c)24.23%
 Data for analyzing the situations of the firm
Balance Sheet,Income Statement,fund flow
statement.
 Basic concepts while preparing balance sheet
-Entity concept
-Money measurement concept
-Going concern concept
-Cost concept
-Consevatism concept
-Dual aspect concept
 Accounting period concept
 Accrual concept
 Realisation concept
 Matching concept
 Materiality concept.
What is revenue reserve & capital reserve?
Revenue reserves are accumulated earnings
from profits and normal business
operations.Capital reserves arise due to
capital gains from revaluation of assets or due
to premium on issue of shares.
• Accounts payable-These are current liabilities
payable within one year from date of balance
sheet.
• Fund Flow Statement-It shows the sources
and uses of funds during a given accounting
period.
• Horizontal analysis and Vertical analysis-
Horizontal analysis is comparing the
operations over a time period ie.comparing
past performance with current position for
predicting the future performance.
 In vertical analysis we use percentages to show
the relationship between various items in the
balance sheet.
a)X contributes Rs.10,000 to his properietory
concern and the amount is deposited in the
bank.What is the nature of liability?
i)Owner’s equity
ii)Loan
iii)Short term finance
iv)Fixed Asset.
b)ABC co.paid Rs.30,000 as deposit to the
suppliers for a period of 3 months.
i)Liability
ii)Current Asset
iii)Trade Credit
iv)Debenture
c)Materials costing Rs.2000 destroyed by fire
i)Asset
ii)Liability
• Moving over to other questions.