what is financial management?

Introduction

Financial Management can be defined as:

The management of the finances of a business / organisation in order to achieve financial

objectives

Taking a commercial business as the most common organisational structure, the key objectives
of financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the business is taking
and the resources invested

There are three key elements to the process of financial management:

(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs
of the business. In the short term, funding may be needed to invest in equipment and stocks, pay
employees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure that the business is
meeting its objectives. Financial control addresses questions such as:

• Are assets being used efficiently?

• Are the businesses assets secure?

• Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

• Investments must be financed in some way – however there are always financing alternatives
that can be considered. For example it is possible to raise finance from selling new shares,
borrowing from banks or taking credit from suppliers

• A key financing decision is whether profits earned by the business should be retained rather
than distributed to shareholders via dividends. If dividends are too high, the business may be
starved of funding to reinvest in growing revenues and profits further.

Financial Management
Financial management entails planning for the future of a person or a business

enterprise to ensure a positive cash flow. It includes the administration and

maintenance of financial assets. Besides, financial management covers the process
of identifying and managing risks.

The primary concern of financial management is the assessment rather than the techniques of
financial quantification. A financial manager looks at the available data to judge the performance
of enterprises. Managerial finance is an interdisciplinary approach that borrows from both
managerial accounting and corporate finance.

Some experts refer to financial management as the science of money management. The primary
usage of this term is in the world of financing business activities. However, financial
management is important at all levels of human existence because every entity needs to look
after its finances.

Financial Management: Levels

Broadly speaking, the process of financial management takes place at two levels. At the
individual level, financial management involves tailoring expenses according to the financial
resources of an individual. Individuals with surplus cash or access to funding invest their money
to make up for the impact of taxation and inflation. Else, they spend it on discretionary items.
They need to be able to take the financial decisions that are intended to benefit them in the long
run and help them achieve their financial goals.

From an organizational point of view, the process of financial management is

associated with financial planning

and financial control. Financial planning seeks to quantify various financial

resources available and plan the size and timing of expenditures. Financial control
refers to monitoring cash flow. Inflow is the amount of money coming into a
particular company, while outflow is a record of the expenditure being made by the
company. Managing this movement of funds in relation to the budget is essential for
a business.

At the corporate level, the main aim of the process of managing finances is to achieve the various
goals a company sets at a given point of time. Businesses also seek to generate substantial
amounts of profits, following a particular set of financial processes.

Financial managers aim to boost the levels of resources at their disposal. Besides, they control
the functioning on money put in by external investors. Providing investors with sufficient
amount of returns on their investments is one of the goals that every company tries to achieve.
Efficient financial management ensures that this becomes possible.

Strong financial management in the business arena requires managers to be able to:

• Interpret financial reports including income statements, Profits and Loss or

P&L, cash flow statements and balance sheet statements

• Improve the allocation of working capital within business operations

• Review and fine tune financial budgeting, and revenue and cost forecasting

• Look at the funding options for business expansion, including both long and
short term financing
• Review the financial health of the company or business unit using ratio
analyses, such as the gearing ratio,profit per employee and weighted cost of
capital
• Understand the various techniques using in project and asset valuations
• Apply critical financial decision making techniques to assess whether to
proceed with an investmtn
• Understand valuations frameworks for businesses, portfolios and intangible
assets

Finance > Financial Ratios

Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios
can be calculated from information provided by the financial statements. Financial ratios can be
used to analyze trends and to compare the firm's financials to those of other firms. In some cases,
ratio analysis can predict future bankruptcy.
Financial ratios can be classified according to the information they provide. The following types
of ratios frequently are used:

• Liquidity ratios
• Asset turnover ratios
• Financial leverage ratios
• Profitability ratios
• Dividend policy ratios

Liquidity Ratios

Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick
ratio.

The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio
= Current Liabilities

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may
prefer a lower current ratio so that more of the firm's assets are working to grow the business.
Typical values for the current ratio vary by firm and industry. For example, firms in cyclical
industries may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to
liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative
measure of liquidity that does not include inventory in the current assets. The quick ratio is
defined as follows:

Current Assets - Inventory

Quick Ratio
= Current Liabilities

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick ratio often is referred to as
the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets
except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:

Cash + Marketable Securities

Cash Ratio
= Current Liabilities
The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some
reason immediate payment were demanded.

Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are
referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two
commonly used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts receivables
and is defined as follows:

Annual Credit Sales

Receivables Turnover
= Accounts Receivable

The receivables turnover often is reported in terms of the number of days that credit sales remain
in accounts receivable before they are collected. This number is known as the collection period.
It is the accounts receivable balance divided by the average daily credit sales, calculated as
follows:

Accounts Receivable
Average Collection Period
= Annual Credit Sales / 365

The collection period also can be written as:

365
Average Collection Period
= Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time
period divided by the average inventory level during that period:

Cost of Goods Sold

Inventory Turnover
= Average Inventory

The inventory turnover often is reported as the inventory period, which is the number of days
worth of inventory on hand, calculated by dividing the inventory by the average daily cost of
goods sold:

Average Inventory
Inventory Period
= Annual Cost of Goods Sold / 365

The inventory period also can be written as:

 365
Inventory Period
= Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Financial Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets:

Total Debt
Debt Ratio
= Total Assets

The debt-to-equity ratio is total debt divided by total equity:

Total Debt
Debt-to-Equity Ratio
= Total Equity

Debt ratios depend on the classification of long-term leases and on the classification of some
items as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover the interest
payments on its debt. This ratio also is known as the interest coverage and is calculated as
follows:

EBIT
Interest Coverage
= Interest Charges

where EBIT = Earnings Before Interest and Taxes

Profitability Ratios

Profitability ratios offer several different measures of the success of the firm at generating
profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:

Sales - Cost of Goods Sold

Gross Profit Margin
= Sales
Return on assets is a measure of how effectively the firm's assets are being used to generate
profits. It is defined as:

Net Income
Return on Assets
= Total Assets

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for
each dollar invested in the firm's stock. Return on equity is defined as follows:

Net Income
Return on Equity
= Shareholder Equity

Dividend Policy Ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for
future growth. Two commonly used ratios are the dividend yield and payout ratio.

The dividend yield is defined as follows:

Dividends Per Share

Dividend Yield
= Share Price

A high dividend yield does not necessarily translate into a high future rate of return. It is
important to consider the prospects for continuing and increasing the dividend in the future. The
dividend payout ratio is helpful in this regard, and is defined as follows:

Dividends Per Share

Payout Ratio
= Earnings Per Share

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

• A reference point is needed. To to be meaningful, most ratios must be compared to

historical values of the same firm, the firm's forecasts, or ratios of similar firms.
• Most ratios by themselves are not highly meaningful. They should be viewed as
indicators, with several of them combined to paint a picture of the firm's situation.
• Year-end values may not be representative. Certain account balances that are used to
calculate ratios may increase or decrease at the end of the accounting period because of
seasonal factors. Such changes may distort the value of the ratio. Average values should
be used when they are available.
• Ratios are subject to the limitations of accounting methods. Different accounting choices
may result in significantly different ratio values.
Finance > Financial Ratios

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CAPITAL BUDGETING
The total capital (long-term and short term ) of a company is employed in fixed and current
assets of the firm. Fixed assets include those assets which are not meant for sale such as land,
building, machinery etc. it is a challenging task before the management to take judicious
regarding capital expenditures, i.e., investments in fixed assets to that the amount should not
unnecessarily be locked up in capital goods which may have fa-reaching effects on the success or
failure of an enterprise. A capital asset, once acquired, cannot be disposed of without any
substantial loss and if it is acquired on long term credit basis, a continuing liability is incurred
over a long period of time, and will affect the financial obligations of the company adversely. It,
therefore, requires a long-range planning while taking decision regarding investments in fixed
assets. Such process of taking decisions regarding capital expenditure is generally known as
capital budgeting. In capital budgeting process, due consideration should b given to the
following problems-

(1) Problem of ranking project, i.e., choice of one project over other project.

(2) Problem of capital rationing, i.e., limited budget resources.

(3) Limitations imposed by top management decision on the total volume of investments to be
made.

Now-a-days, however, some new analytical techniques are developed for evaluating capital
expenditure projects an are under study.

More Notes on CAPITAL BUDGETING

CAPITAL STRUCTURE

Capital structure of a company refers to the make up of its capitalisation. A company procures
funds by issuing various types of securities, i.e., ordinary shares, preference shares, bonds and
debentures. Before issuing any of these securities, a company should decide about the kinds of
securities to be issued. In what proportion will the various kinds of securities be issued, should
also be considered. However, in broader sense, capital structure includes all the long term capital
resources including loans, bonds, share issued, reserves, etc. and the components of the total
capital. A company engaged in devising a financial plan will be faced with problem regarding
the proportion of funds to be raised bu issue of its shares and the amount to be raised though
borrowings. There is an important difference between these two methods. Funds raised from
shareholders require the payments of dividend only out of profits of the company and the amount
will be paid only out of profits, if there is any, a company should maintain a fair balance between
these two types of securities-(a) fixed cost bearing securities. (debentures and preference shares),
and (b) Variable cost bearing securities (ordinary shares). This security mix affects the financial
stability of the company. If a company fails in its efforts in maintaining the security mix, its
capital structure will be imbalanced which may affect its profitability.
More Notes on CAPITAL STRUCTURE
CAPITALISATION

The term capitalization has been defined in a number of ways. As a result, one finds almost as
many definitions of the term as there are writers on the subject. On careful analysis, however,
one finds two schools of thought on this concept. One of them assigns a broad interpretation to
the term, while the outer interprets it in a narrow sense. In the following pages an attempt is mad
to examine and discuss the views of both these schools.
More Notes on CAPITALISATION
COST OF CAPITAL

The cost of capital is a very important factor in formulating a firm's capital structure It is one of
the corner-stones of the theory of financial management, yet it is very controversial topic in
finance. In deciding the capital structure of a company, it is very necessary to consider the cost
of each source of capital and compare them so as to decide which source of capital is in the
interest of owners as well as of the contributors, i.e., creditors etc. Now-a-days, cost of capital is
the major deciding factor of the capital structure. Prior to tis development, cost of capital was
either ignored or by passed. In modern times, cost of capital is used as the very basis of capital
budgeting decisions or long term capital investment decisions and to evaluate the alternative
sources of capital. Different costs ae used in different times and for different purposes.

More Notes on COST OF CAPITAL

DEPRECIATION POLICIES

In every day usage, the term depreciation denotes the decrease in the value of tangible assets due
to wear and tear, deterioration an decay of assets with the passage of time, and damage or
destruction. It is treated as an expense and is charged against profits of the concern. According to
statutory provisions, charging of depreciation to profit and loss account is a must in order to
ascertain the net profits available for the distribution of dividend to shareholders. The provision
of depreciation is also necessary to have a true and fair view of the fixed assets of the company.

There are so many methods of providing depreciation on fixed asset and the company is free to
adopt any of these methods which suits to6the needs of the business. But the method once
adopted should be followed throughout the life of the asset unless there is some exceptional
circumstances. The firm should establish a sound depreciation policy taking in view the general
principles of providing depreciation and the statutory provisions relating to depreciation because
it affects considerably the profits, profitability and the production capacity of to be concern. So,
it is the responsibility of the Finical executives to see whether the provision of adequate an
reasonable depreciation is being made or not.
More Notes on DEPRECIATION POLICIES
DIVIDEND POLICIES

Dividend is that portion of profits of a company which is distributed among its shareholder
according to the decision taken and resolution passed in the meeting of Board of Directors. This
may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount
per share. It means only profits after meeting all the expenses and providing for taxation and for
depreciation and transferring a reasonal amount to reserve funds should be distributed to
shareholders as dividend. There is always a problem before the top management or Board of
Director to decide how much profits should be transferred to Reserve funds to meet any
unforeseen contingencies and how much should be distributed to shareholder,. Payment of
dividend is desirable because it affects the goodwill of the concern in the market on the one
hand, and on the other, shareholders invest their funds in the company in a hope of getting a
reasonable return. Retained earnings are the sources of internal finance for the financing of
corporate future projects but payment of dividend constitute an outflow of ca to shareholders.
Although both-expansion and payment of dividend-are desirable, these two are in conflicts. It is,
therefore, one of the important functions of the financial management to constitute a dividend
policy which can balance these two contradictory view paints and allocate the reasonable amount
of profits after tax between retained earnings and dividend.
More Notes on DIVIDEND POLICIES
FUNDS FLOW AND CASH FLOW STATEMENTS

Every company prepares it balance sheet at the end of its accounting year. It reveals the financial
position of the company at a certain point of time. It does not present any analysis. It is simply a
statement of assets and liabilities of the concern. Its usefulness is, therefore, limited for analysis
and planning purposes. The statement of sources and application of funds serves the purpose,
which is popularly known as 'Funds Flow Statement'.

Funds-Flow-Statement is a widely used tool in the hands of financial executives for analyzing
the financial performance of a concern. Good concerns always prepare such statement along with
the balance sheet at the end of year. This statement shows how the activities of a business have
been financed or how the available financial resource have been used during a particular period.
But it is quite different from income statement which is primarily a presentation of revenue and
expenses items and computation of net income for the period while the funds flow statement is a
report of financial operations of a business undertaking. It generally reports changes in current
assets and current liabilities and is much useful for financial executives, financial institutions and
creditor for the analysis of financial position of the company.
More Notes on FUNDS FLOW AND CASH FLOW STATEMENTS
INSTITUTIONAL FINANCING OF INDUSTRY

Capital market comprises the sources of long-term finance for industry and Government. It is the
market that attracts savings from various sources and makes them available to the sectors of the
economy requiring funds for productive uses the savings and to he funds are converted into
investments through the issue of new securities by the Government, public bodies and industrial
and commercial companies. The major constituents of the capital market are the savers and the
bodies which mobilizes savings and chanalise them into investment channels. Savers of funds
may be individuals or institutions and the mobilizers of savings includes savings banks,
investment trusts, specialised finance corporations and stock exchanges. Prominent among he
savings institutions investing in industry is the Life Insurance Corporations and other insurance
companies, banks and finance corporations. The capital market needs to be distinguished from
the money market which is concerned with the supply of short-term money to trade and industry
an from the discount market which consists in dealings in bills of different kinds and supply of
money to discount houses for discounting of bills. The money market comprises the commercial
banks, exchange banks, co-operative banks, etc., and the central bank (i.e., the Reserve Bank of
India in India). The discount maker consists of brokers, banks discounting bills, discount houses,
etc.

In this lesson, we concern ourselves with those important constituents of the capital market
which serve to channelize funds into industry by investing in the shares and debentures issued by
companies and otherwise.
These are:-

1. Investment Trusts
II. Unit Trust of India
III. LIC. and Insurance Companies
IV. Industrial Finance Corporation
V. State Finance Corporations
VI. The Industrial Credit and Investment Corporation
More Notes on INSTITUTIONAL FINANCING OF INDUSTRY
INTRODUCTION

Finance is the life-blood of modern business economy. We cannot imagine a business without
finance in the modern world. It is the basis of all economic activities, no matter, the business is
big or small. The problem of finance and that of financial management is to be dealt within every
organisation. The problem of finance is equally important to government, semi-governments and
private bodies, and to profit and non-profit organisations. It is therefore, essential to clearly
understand the meaning of financial management, its scope and goals.
More Notes on INTRODUCTION
MANAGEMENT OF INVENTORY

Inventories are the stocks of the product of a company and components thereof that make up the
product. The different forms in which inventories exist are- raw materials, work in process (or
semi finished goods) and finished goods. Raw materials are those inputs that are converted into
finished product. Work in progress inventories are semi-finished products. That requires more
work before they are ready for sale. Finished goods inventories are those which are completely
manufactured products and are ready for sale. Raw materials and semi finished goods inventories
facilitate production while finished goods inventories are required for smooth marketing
operations. Thus inventories serve as a line between the production and the consumption of
goods.

Inventories constitute, in every business concern, the most significant part of working capital or
current assets. Inventories in Indian industries constitute more than 60% of the current assets.
Inventories are significant elements in cost process. It is, therefore essential to control the
inventories. Inventories control is usually used in two ways-unit or physical control and value
control. Purchase and production department officials use this wok in terms of unit control
because they are concerned only with the physical control of the inventories. Where as in
accounting department official use it in terms of value control because
More Notes on MANAGEMENT OF INVENTORY
MARKETING AND UNDERWRITING OF SECURITIES

One of the important functions of Financial Management is the marketing of securities of a

company i.e., shares and debentures. Marketing is a process which a company resorts to
approach the investing public for collecting funds for the company. For this purpose, various
methods and techniques are used. The problem of marketing of securities arises for the first time
when the company comes into existence and collects funds by the issue of shares and again at the
time of subsequent issues of shares an debentures. Trading in outstanding or old securities-shares
and debentures-are negotiable and the Stock Exchanges provide the continuous market for the
sale and purchase of securities in the process of mobilizing savings of individuals, and
institutions. For this purpose, a company has to utilise the services of certain intermediaries
which help the company in selling, transferring, underwriting and sometimes in direct
subscribing the securities of the company. By marketing of securities, here we mean, the primary
distribution of securities by the company at the time of its formation or at any time after its first
issue either direct or trough an underwriting agreement.
More Notes on MARKETING AND UNDERWRITING OF SECURITIES
PROBLEMS OF CASH MANAGEMENT

Cash management has very serious problems attached to it. We can examine these problems
under the following four heads:-

1. Controlling of level of cash,

2. Controlling inflow of cash,

3. Controlling outflow of cash

4. Optimal investment of surplus cash.

More Notes on PROBLEMS OF CASH MANAGEMENT
PROBLEMS OF NEW ISSUE

A company requires funds from time to time to meet its financial requirements for expansion
projects. For this purpose, company issues securities-ordinary shares, preference shares or
debentures. While fissuring securities company faces so many problems as to:-

(i) How to market such securities-direct or through some intermediaries or whether to underwrite
the issue or hot.

(ii) What is the time of issuing securities, that should naturally be the proper time to issue a
particular security taking in view the stock market conditions.

(iii) What price should be fixed or at what price at security should be issued i.e., at par, at
premium or at discount, i.e., problem of pricing is there.

(iv) The problems attached to the rights issues.

The first problem i.e., the problem is of marketing and under writing. The other three problems
are the timing of issue, the pricing of issue and the right issue.

The success of a new capital issue depends largely on as to how these problems have been
tackled: if the hurdles i these problems have been overcome, the company will face no difficulty
in raising the funds to meet its needs properly otherwise they will imperil even the existence of
the company. Therefore, careful considerations are needed
More Notes on PROBLEMS OF NEW ISSUE
financial ratio analysis
 Financial ratio analysis is the calculation and comparison of ratios which
are derived from the information in a company's financial statements.
The level and historical trends of these ratios can be used to make
inferences about a company's financial condition, its operations and
attractiveness as an investment.

Financial ratios are calculated from one or more pieces of information from a company's financial statements. For example,
the "gross margin" is the gross profit from operations divided by the total sales or revenues of a company, expressed in
percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can
give a financial analyst an excellent picture of a company's situation and the trends that are developing.

A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of
25% is meaningless by itself. If we know that this company's competitors have profit margins of 10%, we know that it is
more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for
example has been increasing steadily for the last few years, this would also be a favourable sign that management is
implementing effective business policies and strategies.

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and
operations. An overview of some of the categories of ratios is given below.

• Leverage Ratios which show the extent that debt is used in a company's capital structure.
• Liquidity Ratios which give a picture of a company's short term financial situation or solvency.
• Operational Ratios which use turnover measures to show how efficient a company is in its
operations and use of assets.
• Profitability Ratios which use margin analysis and show the return on sales and capital employed.
• Solvency Ratios which give a picture of a company's ability to generate cashflow and pay it
financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio
is governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility
companies and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability ratios
over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using
historical data independent of fundamental changes in a company's situation or prospects would predict very little about
future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its
technology or market position would tell very little about the prospects for this company.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since they
gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to
ascertain a company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine the
future profits that will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often
develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in
their conclusions from the same ratio analysis.
 Archive for the ‘Ratio Analysis’ category

Limitations of Ratio Analysis

An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and

judgment as they suffer from certain serious drawbacks. Some of them are listed below:

Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from

which they are computed and the financial position of the business at other times of the year. A business enterprise

for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great

portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1

It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are

compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In

India, for example, no systematic and comprehensive industry ratios are complied.

The comparison is rendered difficult because of differences in situations of 2 companies are never the same.

Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the

comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different

situations.

Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios

are also rendered invalid by the changing value of money. The accounting figures presented in the financial

statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years

and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This

makes comparison meaningless.

For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased

its plant and machinery at a time when prices were very low and the other purchased when prices were high, the

equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally

profitable. The return of the first firm is overstated because its plant and machinery have a low book value.
The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make

the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with

reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded

to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued?

Similarly, profit means different things to different people.

Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet.

The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The

trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. They do

not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in

financial position reveal this information, bur these statements are not available to outside analysts.

The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to

calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.

Advantages of Ratio Analysis

Ratio analysis is the method or process by which the relationship of items or groups of items in the financial

statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or

guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in

trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer

depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency.

Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic

use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its

historical performance and current financial condition can be determined the term ratio refers to the numerical or

quantitative relationship between items/ variables. This relationship can be expressed as:

1) Fraction

2) Percentages

3) Proportion of numbers
These alternative methods of expressing items which are related to each other are, for purposes of financial analysis,

referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of

profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to

draw conclusions from them.

Advantages of Ratio Analysis

• Ratios simplify and summarize numerous accounting data in a systematic manner so that the

simplified data can be used effectively for analytical studies.

• Ratios avoid distortions that may result the study of absolute data or figures.

• Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the

various financial data found in the financial statement.

• Ratios are invaluable guides to management. They assist the management to discharge their

functions of planning, forecasting, etc. efficiently.

• Ratios study the past and relate the findings to the present. Thus useful inferences are drawn

which are used to project the future.

• Ratios are increasingly used in trend analysis.

• Ratios being measures of efficiency can be used to control efficiency and profitability of a business

entity.

• Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental

performances.

• Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit

standing of their borrowers and customers.

CLASSIFICATION OF RATIOS:

1. Traditional Classification: Balance sheet ratios, P&L a/c ratios and mixed ratios.

2. Functional classification: liquidity ratios, profitability ratios and earning ratios.

3. Importance ratios: primary & secondary ratios. Primary- ROCE, secondary- operating profit ratio.
 4. Basis of point of time: Structural & Trend analysis.

5. Basis of usage: for management, creditors and shareholders.

6. Basis of nature of ratios: leverage, liquidity and turnover ratios

Ratio Analysis- Its Use

Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the

financial statements so that the strength and weaknesses of a firm as well as its historical performance and current

financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two

variables.

It’s a tool which enables the banker or lender to arrive at the following factors :

Liquidity position

The liquidity position is the difference between the sum of liquid assets and incoming cash flows on one side and

outgoing cash flows resulting from commitments on the other side, measured over a defined period, being the

measure of the liquidity risk. Related position codes are: 1. Liquidity position -spot. 2. Liquidity position – forward.

The related report is the Liquidity Risk Analysis report. Two position codes are defined, one for the spot time bracket

and one for the forward time brackets. See also Position, position administration tables, standard position codes,

combined position code, risk management, foreign exchange risk, forex, open currency position, mismatch, interest

risk, liquidity risk, forward revaluation, interest revaluation, break even.

Profitability

Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm’s

cost of goods sold, but does not include other costs. It is defined as follows:

Gross Profit Margin = Sales – Cost of Goods

Sold / Sales

Return on assets is a measure of how effectively the firm’s assets are being used to generate profits. It is defined as:
Return on Assets = Net Income / Total
Assets

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar

invested in the firm’s stock. Return on equity is defined as follows:

Return on Equity = Net Income / Shareholder

Equity

Solvency

Solvency is the ability of a business to have enough assets to cover its liabilities. Solvency is often confused with

liquidity, but it is not the same thing. Solvency is often measured as a ratio, the “current ratio,” which is the total

current assets divided by the total current liabilities. In order to be solvent and cover liabilities, a business should

have a current ratio of 2/1, meaning that it has twice as many current assets as current liabilities. This ratio

recognizes the fact that selling assets to obtain cash may result in losses, so more assets are needed.

Financial Stability

The firm’s ability to remain in business in the long run, without having to sustain significant losses in the conduct of its

business. Assessing a company’s stability requires the use of both the income statement and the balance sheet, as

well as other financial and non-financial

Importance of Ratio Analysis

It helps in evaluating the firms performance:

With the help of ratio analysis conclusion can be drawn regarding several aspects such as financial health,

profitability and operational efficiency of the undertaking. Ratio points out the operating efficiency of the firm i.e.

whether the management has utilized the firm’s assets correctly, to increase the investor’s wealth. It ensures a fair

return to its owners and secures optimum utilization of firms assets

It helps in inter-firm comparison:

Ratio analysis helps in inter-firm comparison by providing necessary data. An interfirm comparison indicates relative

position.It provides the relevant data for the comparison of the performance of different departments. If comparison

shows a variance, the possible reasons of variations may be identified and if results are negative, the action may be

intiated immediately to bring them in line.

It simplifies financial statement:

The information given in the basic financial statements serves no useful Purpose unless it s interrupted and analyzed

in some comparable terms. The ratio analysis is one of the tools in the hands of those who want to know something

more from the financial statements in the simplified manner.

It helps in determining the financial position of the concern:

Ratio analysis facilitates the management to know whether the firms financial position is improving or deteriorating or

is constant over the years by setting a trend with the help of ratios The analysis with the help of ratio analysis can

know the direction of the trend of strategic ratio may help the management in the task of planning, forecasting and

controlling.

It is helpful in budgeting and forecasting:

Accounting ratios provide a reliable data, which can be compared, studied And analyzed.These ratios provide sound

footing for future prospectus. The ratios can also serve as a basis for preparing budgeting future line of action.

Liquidity position:

With help of ratio analysis conclusions can be drawn regarding the Liquidity position of a firm. The liquidity positon of

a firm would be satisfactory if it is able to meet its current obligation when they become due. The ability to met short

term liabilities is reflected in the liquidity ratio of a firm.

Long term solvency:

Ratio analysis is equally for assessing the long term financial ability of the Firm. The long term solvency s measured

by the leverage or capital structure and profitability ratio which shows the earning power and operating efficiency,

Solvency ratio shows relationship between total liability and total assets.

Operating efficieny:
Yet another dimension of usefulness or ratio analysis, relevant from the View point of management is that it throws

light on the degree efficiency in the various activity ratios measures this kind of operational efficiency.

Help in investment decisions

It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc.