FINANCIAL MANGEMENT

 FINANCIAL STATEMENT
Formal statement is prepared by a business firm to disclose its
financial information. These statements are prepared to present a
periodical review by the management for showing the states of
investment in business and the results achieved during the period
under review.

Financial Statement Analysis

It’s a process of analyzing a company’s financial statement for

decision making purpose and to understand the overall health of
an organization. Financial statement record financial data which
must be evaluated through financial statement analysis to
become more useful to investors, shareholders, managers and
other interested parties.

There are two methods for analyzing financial statements:-

1. Vertical Analysis (Common Size)

2. Horizontal Analysis (Compare Size)

 LONG TERM DEBT

Long term debt consists of loans and financial obligations lasting
over one year. Long term debt for a company would include any
financing or leasing obligations that are to come due after a 12
month period. Long term debt also applies to governments as
nations can also have long term debt.

Source of Long Term Debt:-

1. Bonds
2. Loans
 3. Agreements
4. Leasing obligation or contract.

Financial and leasing obligations are also called as long term

liabilities or fixed liabilities. Which would include company’s bond
issue or long term leases that have been capitalized a firm’s
balance sheet.

5. Individual Notes payable.

These are debt instruments issued to individual investors.

6. Convertible Bonds.
7. Pension.

 WORKING CAPITAL
Working capital is the capital required for the day to day working
of an enterprise. It is required for the purchase of raw materials
and for meeting daily expenditure on salaries, wages, rent,
advertising etc. working capital is also known as Circulated
Capital or Revolving capital or Floating Capital or Liquid
Capital.

Concepts of Working Capital:-

I. Balance Sheet Concept

a) Gross Working Capital
b) Net Working Capital
II. Operating Cycle or Circular Flow Concept

Gross Working Capital

According to gross concept, working capital refers to the amount

of funds invested in current assets. Thus working capital is equal
to the total current assets. The working capital as per gross
concept is called gross working capital. This concept is used by
the management to evaluate the current working capital position
and to ensure the optimum investment in individual current
assets.

Example: Cash in hand & Bank, Bills receivable, Sundry Debtors,

Short term loans, Inventories of stock.

Net Working Capital

According to net concept, working capital refers to excess of

current assets over current liabilities. Working capital is equal to
the total current assets minus total current liabilities. Thus
working capital refers to net current asset. The working capital as
per net concept is called net working capital. Net working capital
can be positive or negative. When current assets exceed current
liabilities it is called positive working capital. When current
liabilities are is excess of current assets it is called negative
working capital.

The gross concept is financial concept while net concept is an

accounting concept of working capital. The net concept is for sole
traders or partnership firms and the gross concept is for
companies.

Operating Cycle / Circular Flow Concept

The circular flow concept of working capital is based upon its

operating or working capital cycle of a firm. The cycle starts with
the purchase of raw materials and other resources and end with
realization of cash from the sale of finished goods.

Gross Operating Cycle(GOC) = Inventory Holding Period +

Receivables Collection Period

Or
Gross OC = Raw Material Holding Period + Work-In Process Period
+ Finished Goods Holding Period + Receivables Collection Period.

 ACCOUTING RATIO
Accounting ratios are a group of metrics used to measure the
efficiency and profitability of a company based on its financial
reports. They provide a way of exposing the relationship between
one accounting data points to another and are the basis of ratio
analysis. Analysis and interpretation of financial statements with
the help of ratio is called Ratio Analysis.

Examples: Gross Margin, Operating Margin, Debt to Equity ratio,

Quick Raito, Payout Ratio.

Gross Margin

The gross profit as a percentage of sales is referred to as gross

margin. It is calculated by dividing gross profit by sales.

Operating Margin

The operating profit as a percentage of sales is referred to as

operating profit margin. It is calculated by dividing operating
profit by sales.

Debt to Equity Ratio

It’s the Capital structure of the company. It is calculated by

dividing debt by equity.

Quick Ratio

It is also known as Acid-test ratio; it is an indicator of a company’s

short-term liquidity and measures a company’s ability to meet its
short term obligations with its most liquid assets.
Dividend Payout Ratio

The payout ratio is the percentage of net income paid out to

investors.

 CASH FLOW FROM OPERATING ACTIVITIES

(CFO)
An accounting item that indicates the amount of money a
company brings in from the ongoing regular business activities
such as manufacturing and selling goods or providing a service.

There are different methods to find out the C.F.O:-

1. Funds from operations + Change in Working Capital.

Funds from operation = Net Income + Depreciation, Depletion &

Amortization + Deferred Tax & Investment Tax Credit + Other
Funds.

2. Net Income + Non-cash Expenses + Change in working

Capital

(Net income+ Depreciation + Adjustment to Net Income +

Change in a/c receivable + Change in Liabilities + Change in
Inventories + Change in other operating activities)

 FUND FLOW STATEMENT v/s PROFIT & LOSS

STATEMENT or INCOME STATEMENT
MEANING

Fund flow statement deals with financial resources of the

company.

Income statement deals with the operating results of the

company.

CONTENTS
Fund flow statement shows the sources of funds and applications
of funds of the company.

Income statement shows the extent of profit earned or loss

suffered by the company.

FINANCIAL POSITION OF COMPANY

Fund flow statement shows the changes in the financial position

of the company.

Income statement does not show the changes in the financial

position of the company.

PREPARATION

The fund flow statement does not help in the preparation of P/L
a/c.

The P/L a/c helps the preparation of funds flow statement.

MATCHING OF FUNDS

Fund flow statement matches the funds raised and funds applied
for a specific period.

Income statement matches the revenue income and revenue

expenses of the company for a specific period.

FORMAT

There is no prescribed format for preparing fund flow statement.

Income statement is prepared in a prescribed format.

PUBLISHING

Fund flow statement is not published.

Income statement is published.

WHO PREPARES
Fund flow statement is prepared by the management accountant.

Income statement is prepared by the C.A.

 RATIO ANALYSIS
It is an analysis and interpretation of financial statements with the
help of ratio.

Objectives of Ratio Analysis:-

1. Measure of Profitability.
2. Evaluation of Operating Efficiency.
3. Ensure suitable liquidity.
4. Overall financial strength.
5. Comparison

Advantages of Ratio Analysis

1. Forecasting & Planning:-

The trend in costs, sales, profit and other factors can be known
by computing ratios of relevant accounting figures of last few
years.

2. Budgeting:-

Budget is an estimate of future activates on the basis of past

experience.

3. Measurement of Operating Efficiency:-

Ratio analysis indicates the degree of efficiency in the

management and utilization of its assets.
 4. Communications:-

Ratios are effective means of communication and play a vital

role in forming the position of and progress made by the
business concern to the owners or other parties.

5. Control of Performance & Cost:-

Ratios may be used for control of performances of the different

divisions or departments of an undertaking as well as control of
costs.

6. Aid to Decision Making:-

Ratio analysis helps to take decisions like whether to supply

goods on credit to a firm.

7. Inter firm comparison.

8. Indication of liquidity position.
9. Indicates of long term solvency position.
10. Indication of overall profitability.

Limitations of Ratio Analysis:-

1. Limitation of Financial statements:-

Ratios are calculated from the information recorded in the

financial statements. But financial statements suffer from a
number of limitations.

2. Historical information:-

Financial statements provide historical information.

3. Different Accounting Policies:-

Different accounting policies regarding valuation of inventories,

charging depreciation etc. make the accounting data and
accounting ratios of two firms non-comparable.

4. Lack of Standard Comparison:-

No fixed standards can be laid down for ideal ratios.

5. Quantities Analysis:-

Ratios are tools of quantities analysis only and qualitative

factors are ignored while computing the ratios.

6. Change in Price Value:-

Fixed assets show the position statement at cost only. It does

not reflect the changes in price level.

7. Window Dressing.
8. Ratios account for one variable.
9. Seasonal factors affecting financial data.
 CAPITAL STRUCTURE
The capital structure implies the proportion of debt and equity
in the total capital of a firm. It represents different sources of
long term funds; short term funds and retained earnings.

Capital Structure V/s Financial Structure.

Capital structure is the proportion of different sources of long

term capitals.

Finance Structure refers to the way the company’s assets are

financed.

Thus capital structure is only a part of financial structure.

Importance of Capital Structure:-

1. Affects the financial risk assumed by the company.

2. Affects the firms cost of capital.
3. Affects the value of the firm.
4. Represents the management attitude towards risk and
return.

Capital Structure Planning

 The capital structure should be planned and designed in such a
way as to lead to the maximization of the shareholders wealth.

Factors Determining Capital Structure

1. Internal Factors:-

These are the characteristics of the company.

I. Size of the Business: - Small, Medium and Big.

II. Nature of Business: - Manufacturing Companies & Trading
Firms; Fixed Asset and Current Assets.
III. Regularity & Certainty Income: - Debentures should be
issued when the company expects a high and regular
income.
IV. Period & Purpose of Financing: - Equity share for a long term,
Debentures and Preference shares for Medium term.
V. Trading on Equity:- The use of debentures, loan and
preference share capital along with equity share capital.
VI. Desire to Retain Control:- Company will issue more
preference shares or raise debt.
VII. Asset Structure: - Total fixed & Current Asset of the
company.

2. External factors:-

These factors are connected with future developments likely to

take place in the economy and the industry to which the company
belongs. The management has no control upon such external
factors.

1. Condition in the Capital Market: - Determine the type of

securities to be issued. Capital structure is also influenced
by the condition of capital market.
2. Attitude of Investors: - High Risk, Medium Risk and No Risk.
3. Cost of Financing: - Employ cheapest source of finance to
maximize return.
 4. Legal Requirements: - Government Rule, Financial
Institutions, SEBI & Stock Exchange etc.
5. Taxation Policy: - High taxation rate directly influence the
capital structure decisions.
6. Attitude of Management: - Aggressive and Conservative.

Meaning of Optimum Capital Structure

The basic purpose of capital structure decision is to maximize

the value of the firm or shareholders wealth. The capital
structure which maximizes the value of the firm is called
Optimum Capital Structure, Best / Most Economical
Capital Structure.

The cost of the capital should be the lowest and the value of
the firm should be highest.

Essentials of Optimal Capital Structure: -

1. Clarity of Objective: - Clear Cut.

2. Balance: - Ownership & Creditorship.
3. Economy: - Minimum Risk.
4. Liquidity & Solvency: - Importance to Liquidity.
5. Flexibility: - Raise funds and Repay them.
6. Simplicity: - Easy to understand and simple to operate.
7. Safety: - Ensure safety of investment.
8. Maximum Return: - Maximum return to equity shareholders.
9. Maximum Control: - Company’s management and existing
shareholders.
10. Balanced Leverage: - Issue all classes of Securities.

THEROIES OF CAPITAL STRUCTURE

1. Traditional Theory: - It was developed by Soloman Ezra. It

is based on Net Income & Net Operating income approach. It
is an intermediate approach. A firm can reduce the overall
cost of capital (Ko) or increase the total value of the firm (V)
by increasing the proportion of debt in the capital structure to
 a certain limit. Beyond this limit the additional doses of debit
may result in a decrease in the total value of the
firm(v) ,mixing the debt and equity it is possible to minimize
the overall cost of capital (Ko) and maximize the total value of
the firm (v). V increases then Ko decreases.

FIRST STAGE

The use of debt in capital structure increases the value of the firm
(V) and decreases the overall cost of capital (Ko).

SECOND STAGE

The increase in debt beyond a particular limit has no effect on

the value of the firm (V) and overall cost of capital (Ko).

THIRD STAGE

The further increase in debt in the capital structure will increase

overall cost of the capital (Ko) and decrease the value of the firm
(V).

MERIT

1. Market Imperfections are considered.

2. Tax deductibility of interest charges: - Helps in designing an
ideal Capital Structure.

DEMERIT

1. Assuming that the cost of equity capital remains unaffected

by leverage up to some reasonable limit.
2. Value of the firm depends upon its net operating income and
the risk attached to it.

2. MODIGLIANI-MILLER THEORY [M.M THEORY]

This theory was developed in 1958. It is identical with net
operating income theory in the absence of corporate tax. When
corporate tax exists their theory is similar to net income theory.

 In the absence of Corporate Taxes (Irrelevance Theory): -

A firm’s total vale (V) and its overall cost of capital will be
same at all degrees of financial leverages. Capital structure
is irrelevant and there is no optimal capital structure.

The following are the assumptions of MM approach: -

1. There is a perfect capital market.

2. The business risks of all the firms are same.
3. There are no taxes.
4. Investors are rational.
5. There is no transaction cost.
6. All the earnings are distributed to shareholders in the form of
dividend.
7. Investors are free to buy and sell securities.

 When Corporate Taxes are assumed to exist (Theory of

Relevance):- This theory was developed in 1963. The
theory states that the value of the firm will increase or
decrease and cost of capital will increase or decrease with
the use of debt capital in capital structure. Due to the
existence of tax the overall cost of capital of the levered firm
will be lower than unlevered firm.

The market value of unlevered firm: -

Vu = EBIT [1-T]
Ko
Vu = Value of the firm.
 T = Tax rate
EBIT = Earnings before interest and taxes

The market Value of Levered firm: -

Vl = Vu + tD

t = Rate of tax.

D = Quantum of debt.

3. NET INCOME APPROACH

It was developed by David Durrant. According to this theory the

capital structure decision is relevant to the valuation of a firm.

Assumptions of Net Income Approach: -

1. The cost of debt is less than cost of equity.

2. There are no taxes.
3. The risk per capital of investors is not changed by use of debt.
4. Cost of debt and cost of equity are constant; Kb & Ke.

Ko = EBIT

V = Value of the firm;

Ko = Overall cost of capital.

4. NET OPERATING INCOME APPROACH

This theory was developed by David Durrent. This approach

states that the capital structure of a company does not affect the
market value of the firm and the overall cost of capital remains
constant.
Assumptions of Net Income Approach: -

1. Business risk remains constant at every level of debt equity

mix.
2. The cost of debt capital is constant.
3. There are no taxes.
4. Cost of debt is lower than cost of equity.
5. Increased use of debt increases the financial risk of the
equity shareholders and thus the cost of equity capital
increases.

 WORKING CAPITAL MANAGEMENT

Capital required for the day to day working of an enterprise.

Components of working capital: - Current assets and current

liabilities.

TYPES OF WORKING CAPITAL: -

1. Permanent Working Capital / Fixed Working Capital:

Minimum amount of working capital that is needed to
function an enterprise: -
a. Initial Working Capital.
b. Regular Working Capital.
c. Reserve Working Capital.

2. Variable Working Capital / Temporary Working Capital: Any

amount over and above the permanent working capital: -
a. Seasonal Working Capital.
b. Special Working Capital.

FACTORS DETERMING WORKING CAPITAL REQUIRMENTS: -

1. Nature of Business.
2. Production Cycle.
 3. Size of the Business.
4. Turnover.
5. Terms of Trade.
6. Nature & Value of the Product.
7. Seasonal Fluctuations.
8. Use of Manual Labor or Machines.
9. Growth & Expansion of Business.
10. Company Policies.

PRINCIPLES OF WORKING CAPITAL: -

1. Principle of Risk Variations:

There is an inverse relationship between the degree of risk
and profitability.
2. Principle of Cost of Capital:
Higher the risk, lower is the cost and lower the risk, higher is
the cost.
3. Principle of Equity Position:
The amount of working capital invested in each component
should contribute to the net worth of the firm.
4. Principle of Maturity of Payment:
A firm should make every effort to relate maturities of
payment to its flow of internally generated funds.

SOUCRES OF WORKING CAPITAL: -

1. Long Term Sources.

2. Short Term Sources.
3. Transitionary Sources.

LONG TERM SOURCES: -

1. Shares
2. Debentures
3. Loans from Financial Institutions
4. Retained Earnings.

SHORT TERM SOURCES: -

 1. Commercial Bank
2. Public Deposits
3. Money Lenders
4. Factoring

TRANSACTIONARY SOURCES: -

1. Trade Creditors
2. Depreciation
3. Tax Liabilities.

 COMPARATIVE STATEMENT
SALES – SALES RETURN = NET SALES.

Sales returns occur when customers return defective,

damaged, or otherwise undesirable products to the seller. Sales
allowances occur when customers agree to keep such
merchandise in return for a reduction in the selling price.

OPENING STOCK + PURCHASE RETURN – CLOSING STOCK =

COST OF GOODS SOLD.

A purchase return occurs when a buyer returns merchandise that

it had purchased from a supplier.

NET SALES – COSTS OF GOOD SOLD = GROSS PROFIT.

Gross profit is the profit a company makes after deducting the

costs associated with making and selling its products, or the costs
associated with providing its services.

GROSS PROFIT – OPERATING EXPENSES = OPERATING

PROFIT.

An operating expense is an expense a business incurs through its

normal business operations. OPEX, include rent, equipment,
inventory costs, marketing, payroll, insurance, step costs, and
funds allocated for research and development.
Operating profit is the profitability of the business, before taking
into account interest and taxes.

OPERATING PROFIT – NON-OPERATING EXPENSES = NET

PROFIT +,-

A non-operating expense is an expense incurred from activities

unrelated to core operations. Examples of non-operating
expenses include interest payments or costs from currency
exchanges.
PARTICULAR (A) (B) +/- Percentage
BASE YEAR $ (B-A) (B-A/A*100)
$
Net Sales Xxx Xxx +,-xxx %
Less(Costs of Xxx xxx +,-xxx %
Goods Sold)
Gross Profit Xxx Xxx +,-xxx %
Less(Operating xxx xxx +,-xxx %
expenses
Operating Profit Xxx Xxx +,-xxx %
Less (Non-
operating Xxx Xxx +,-xxx %
expenses)
Net Profit Xxx xxx =,-xxx %
+,-
Particulars 31st 31st Increase or Percentage
December December Decrease in
2014 2015 2015 over
$ $ 2015
Amount
Net Sales 1000000 1200000 +200000 +20%
Less: Cost of goods 550000 605000 +55000 +10%
Sold

Gross Profit 450000 595000 +145000 +32.22%

Less: Operating
expenses +20000
80000 100000 +20000
Adm Exp 60000 80000 +40000
140000 18000 +28.5%
Selling Exp

Total

Operating Profit 310000 415000 +105000 +33.8%

 Less: Non-operating
Expense
40000 50000 +10000
Interest 50000 80000 +30000
90000 130000 +40000 +44.44%
Income tax

Total

Net Profit 220000 285000 +65000 +29.54%

Particulars 2010 2011 Increase or Percentage

Decrease
in 2011
over 2010
Amount
ASSETS
CURRENT ASSETS
 Inventory 40000 60000 +20000 +50%
 Debtors 40000 80000 +40000 +100%
 Cash 20000 8000 -12000 -60%
Total Current Asset 100000 148000 +48000 +48%
FIXED ASSETS
 L&B
 P&M
 Furniture 80000 74000 -6000 -7.5%
Total Fixed Asset 60000 54000 -6000 -10%
TOTAL ASSET 20000 28000 +8000 +40%
160000 156000 -4000 -2.5%
260000 304000 +44000 +16.9%

LIABILITIES
CURRENT
LIABILITIES
 Creditors 50000 70000 +20000 +40%
 Bills payable 10000 15000 +5000 +50%
Total Current
Liability 6000 85000 +25000 +41%
LONG LIABILITY
 Debentures
TOTAL LIABILITY
80000 90000 +10000 +12%
140000 175000 +35000 +2%
CAPITAL &
RESERVE 80000 80000 0 0%
 Equity Shares
 Retained 40000 49000 +9000 +20%
Earnings
TOTAL 120000 129000 +9000 +7.5%
TOTAL 260000 304000 +44000 +16.9%
L+C&R

 COMMON SIZE INCOME STATEMENT

Sales amount is considered as base amount
Particular X year Y year
Amount Percentage Amount Percentage
Sales Xxx 100% Xxx 100%
Less: Cost of xxx % %
goods sold
Gross Profit Xxx % Xxx %
Less: Operating
Expenses
Xxx % Xxx %
Operating Profit Xxx % Xxx %
Less: Non-
Operating Xxx % XXX %
Expenses
Net Profit Xxx % Xxx %

Particular 2010 2011

Amount Percentag Amount Percentag
e e
Sales 200000 100% 500000 100%
Less: Cost
of goods 100000 50% 220000 44%
sold
Gross Profit 100000 50% 280000 56%
Less:
Operative
Expense 20000 10% 30000 6%

Operating 80000 40% 250000 50%

Profit
Less: Non-
Operating
Expenses 3000 15% 35000 7%
Net Profit 50000 25% 215000 43%
Here total is taken as Base

Particulars 2011 2012

Amount Percentage Amount Percentage
ASSETS
CURRENT ASSETS
 Stocks 200000 13.33% 300000 15%
 Debtors 200000 13.33% 250000 12.5%
 Cash 100000 6.66% 50000 2.5%
TOTAL C.A 500000 33.33% 600000 30%
FIXED ASSET
 Building
 Machinery 400000 26.66% 400000 20%
TOTAL F.A 600000 40% 1000000 50%
1000000 66.66% 1400000 70%
TOATL ASSET
150000 100% 200000 100%
0 0
LIABILITY
CURRENT
LIABILITY
 Creditors 300000 20% 500000 25%
 Bills Payable 100000 6.66% 80000 4%
 Tax Payable
TOTAL C.L
LONG LIABILITY 100000 6.66% 120000 6%
 Debtors 500000 33.33% 700000 35%

TOTAL 200000 13.33% 300000 15%

LIABILITY
700000 46.66% 1000000 50%

CAPITAL &
RESERVES
 Share capital
 Reserve 200000 13.33% 300000 15%
600000 40% 700000 35%
TOTAL C&R
800000 53.33% 100000 50%
TOTAL 150000 100% 200000 100%
L+C&R 0 0