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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. One 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:

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

Financials

Balance SheetProfit & Loss

AccountsFlow Statements

Cash Flow Funds Flow

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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 ratingagencies) 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 afirm.

Classification of ratios I-(Expression/Degree of

Importance

Types of

Ratios

Mode of

expression

Degree of

Importance

Simple/Pure

Percentage Rate

Primary

tertiary

Secondary

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Classification of ratios II-Users

Manageme

nt

Credit

Analysts-

Credit

Rating Cos

Investors/S

hareholder

s

Long term

creditors-

Banks/Fin

Institutions

Short tem

creditors-

Banks

Auditors

Users

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Classification of ratios III Important Parameters

Profitabili

ty

Ratio

Activityratio

Solvency

ratio

Liquidity

Ratio

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Classification of ratios IV Financial Statements:

Briefly we try to understand the following:

Traditional Classification: On the basis of financials. They are classified as

Balanc

e

Sheet

P&L

Accou

nt

Cash

Flow

Funds

Flow

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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

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+ 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 concernhas 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)

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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

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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 longterm 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

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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 nottaken 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

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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. Theratio 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 periodindicates 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.

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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 ratiowill 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

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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 currentliabilities. 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

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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)

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 sufficientcash 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

Working Capital Finance

Inventory finance Receivables finance

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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

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.

Cash

Credit

sales

Bills

receivable

s

Raw

materials

Finished

goods

Semi

finished

goods

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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.

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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.

Negative

BalanceSheet

Seasonal

Flexible /

Temporar

y/

Variable

Permanen

t, Fixed

or Regular

Types ofWorking

Capital

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NEGATIVE WORKING CAPITAL : Negative Working Capital is when current

liabilities exceed current assets

BALANCE SHEET WORKING CAPITAL: It is that Working Capital which iscalculated from the items appearing in the balance sheet of a firm.

Working Capital Classification based on concepts:

Net

Working

Capital

Gross Working Capital

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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 Trade debtors Bills

receivables

Loans and advances Investments

Cash and Bank Balance Marketable securities

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 ofcurrent 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 Bills Payable

Trade Advances Outstanding Expenses

Short Term Bonus 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:

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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:

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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

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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

Borrowin

gs

Retained

Earnings

Hybrid

Financin

g

Debentur

es

Equity

Shares

Long

Term

Funds

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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.

Working Capital Ratios;

Working Capital Ratios;

Short Term

Financing

Working Capital

FinancePublic Deposits Other Credits

Overdraft

Cash Credit

Six Months

Three Years Commercial

Paper

Trade CreditsSecurity

Deposits

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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

Ratios

Liquidity

Ratios

Efficienc

y Ratios

Other

Ratios

Current

Ratio

Turnover

Ratio

Debtors

Turnover

Ratio

Quick Ratio

Inventory

Turnover

Ratio

Debtor

collection

period

period

CreditorsPayment

Period

Current

Assets

Turnover

Ratio

Bad debts

to sales

ratio

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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.