Financial Management (T.Y.B.Com.) PDF

31 T.Y.B.Com. BUSINESS MANAGEMENT PAPER - II FINANCIAL MANAGEMENT Revised Syllabis w.e.f. academic year 2007 - 2008 For IDE Students applicable from 2008- 2009  © UNIVERSITY OF MUMBAI Dr. Vijay Khole Dr....

31 T.Y.B.Com. BUSINESS MANAGEMENT PAPER - II FINANCIAL MANAGEMENT Revised Syllabis w.e.f. academic year 2007 - 2008 For IDE Students applicable from 2008- 2009  © UNIVERSITY OF MUMBAI Dr. Vijay Khole Dr. Dhaneswar Harichandan Vice Chancellor Professor -Cum- Director & Programme Coordinator Dr. Arun D. Sawant Pro-Vice Chancellor Programme Co-ordinator : Mrs. Nilam Panditrao Lecturer-cum Assistant, Director (Accounts IDE) Course Coordinator : Dr. Gopinadhan S. M.Com., MIB (IIFT), M.B.A. (HR), Ph.D Professor & Head of the Department of Commerce S.S. & L.S. Patkar college,.V.Road,, ` Goregaon (West) MUMBAI - 400 062 e-mail ID: [email protected] Course Writer : Dr. GOPINATHAN S. S.S. & L.S. Patkar College, S.V. Road, Goregaon (West),Mumbai. Mrs. Nilam Panditrao Lecturer-cum Assistant, Director (Accounts IDE) September - 08 - T.Y.B.Com. Business MS Group - Paper II Financial Management Published by : Professor cum Director Institute of Distance Education, University of Mumbai, Vidyanagari, Mumbai - 400 098. DTP Composed : Ashwini Arts Gurukripa Chawl, M.C. Chagla Marg, Bamanwada, Vile Parle (E), Mumbai - 400 099. Printed by :  CONTENTS Unit No. Title Page No. 1. Meaning, Definitions & Scope of Financial Management 01 2. Study of Financial Statements : 22 3. Study of Financial Statements (Comparative Statement, Common size Statement, Trend Analysis) 41 4. Ratio Analysis 78 5. Sources Of Finance 129 6. Capital Budgeting 171 7. Working Capital 182 8. Receivable Management 217 9. Cash and Marketable Securities Management 238 10. Basic Principles of Cost Accounting 281 Meaning and definitions 11. Marginal Costing 300   Revised Syllabus for T.Y.B.Com. Business Management Paper II – Financial Management Objectives : 1. To enable the students to understand basic concepts, functions and objectives of Financial Management 2. To introduce them to the various finance functions, principles and techniques. 3. To bring to their attention the various instruments of finance. 4. To acquaint the students with the recent changes in the field of financial management. 1) Nature of Financial Management : · Meaning and Definition · Scope of Financial Management · Functions of Finance · Objectives of Financial Management 2) Study of Financial Statements : Meaning Definitions, purposes & objectives of Financial Statements · Preparation of financial Statements – Balance Sheet and Revenue Statements · Statutory Requirements for constructing Financial Statements by Limited Companies · Limitations of Financial Statements · Relationship between items of Revenue statements and Balance Sheet 3) Study of Financial Statements (Comparative Statement, Common size Statement, Trend Analysis · Parties Interested in the Financial Statements · Objectives and Purposes of Financial Analysis and Interpretation · Relation between Analysis and Interpretation. · Steps involved in the Analysis of Financial Statements 4) Ratio Analysis · Ratio Analysis – Meaning and definition · Different modes of expressing an accounting ratio · Comparison by Ratios · Objectives of ratio Analysis · Classification of Ratios i) Traditional classification ii) Functional classification iii) Classification from the viewpoint of Users a) Compilation of Ratios : i. Balance Sheet Ratios § Current Ratio § Liquid Ratio § Proprietory Ratio § Stock Working Capital Ratio § Capital Gearing Ratio § Debt Equity ratio ii Revenue Statement ratios § Gross Profit Ratio § Operating Ratio § Expense Ratio § Stock Turnover Ratio iii Combined Ratios § Return on capital Employed § Return on Proprietors’ Funds § Return on Equity Share Capital § Debtors Turnover Ratio (Debtors’ Velocity) b) Uses of Accounting Ratios c) Limitations of Ratio Analysis 5) (a) Sources Finance of Sources Of Finance i) According to period ii) According to Ownership iii) According to Source of generation · Internal Financing · Loan finance · Choice of Securities (b) Statement of Sources and Application of Funds Nature and Meaning of Funds · Concept of Flow · Purposes of Funds Flow Statements · Difference between Funds Flow Statements and Income Statements · Preparation of Funds Flow Statements i) Calculation of Funds from Operations ii) Statement of changes in Working Capital iii) Format of funds Flow Statements · Uses of Funds Flow Statement · Limitations of funds Flow Statements 6) Capital Budgeting · Meaning and Importance; · Evaluation techniques – DCF, NFV, Profitability Index, Pay-Back Method, IRR )Practical problem to be asked only on NPV and Pay Back) 7) Working Capital Importance of Working Capital · Working Capital Cycle · Classification of Working Capital i) Gross and Net Working Capital ii) Permanent and Variable Working Capital iii) Positive and Negative Working Capital iv) Cash and Net current Assets concept of Working Capital · Factors determining working Capital requirements · Management of Working Capital · Statement showing the requirement of Working Capital 8) Receivable Management Meaning and Importance · Aspects of Receivable Management · Credit Policy · Credit Evaluation · Credit granting decision · Control of accounts receivables. 9) Cash and Marketable Securities Management Motives of Holding Cash · Aspects of Cash Management · Speeding up Collections · Optimal Cash Balances · Options for Investing Surplus Cash · Cash Management Models · Marketable Securities – Meaning and Selection Criteria · Money Market Instruments · Treasury Bills (T. Bills) · Repurchase Agreements (REPOS) · Certificate of Deposits (CDs) · Commercial Paper (CPs) · Corporate Debentures and Bonds · Bankers Acceptances · Inter Corporate Deposits · Bills Discounting 10) Basic Principles of Cost Accounting Meaning and definitions · Concept of Cost Centre and Cost Unit · Financial and Cost Accounting · Classification of Costs · Determination of Total Cost · Non-cost items · Cost Sheet 11) Marginal Costing · Meaning, Features, Advantages and Limitations of Marginal Costing · Concept of profit · Contribution · Absorptions vs. Marginal costing · Profit/Volume Ratio · Break even point · Margin of Safety · Break even chart · Angle of incidence · Cost Volume profit analysis · Key factor · Application of marginal costing PAPER PATTERN : There must be 8 questions out of which Five questions must be practical orientation. Total questions to be attempted Five out of which one question will be compulsory. Practical question be asked on Chapter Nos.3,4,5,7,10 & 11. Case Study question should be asked on 8 & 9. Books Suggested : 1) Financial Management – James C. Van Horne. 2) Financial Management – by I.M. Pandey 3) Financial Management – By Prasanna Chandra 4) Financial Management – By S.C. Kucchal 5) Principles of Management Finance – By Lawrence J. Gitman, Harper 6) Financial Management – By Ravi Kishore 7) Techniques of Financial Analysis – Ekrich A. Helfert, Donjone’s   1 Module-1 MEANING AND DEFINITIONS SCOPE OF FINANCIAL MANAGEMENT MEANING Financial management involves obtaining funds required by an organization in the most economic and prudent manner and employment of these funds in the most optimum manner to maximize the returns to the owners. Since success of the organisation depends on raising of funds and their best utilization, financial management as a functional area has occupied a place of price relevance. All business decisions have financial implications and hence financial management is related to each and every aspect of business operation. In simple words, financial management includes any decision made by a business that affects its finances. DEFINITIONS It can be defined as “the management of flow of funds in a firm and it deals with the financial decision making of firm”. According to Joshep and Massie. “Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations”. According to Dr. S.N. Maheshwari, “Financial Management is concerned with raising financial resources and their effective utilization towards achieving the organisational goals”. EVOLUTION OF FINANCIAL MANAGEMENT Financial management emerged as a distinct filed of study during the second half of the twentieth century. The evolution of financial management and the changes in its scope appeared mainly due to two factors i.e. the continuous growth and diversity in business and the gradual appearance of new financial analytical tools. financial man\1 2 The evolution of financial management can be divided into three broad phases – the traditional phase, the transitional phase and the modern phase. These are explained as under : 1. The traditional phase (upto 1940) Initially finance was considered a part of economics and no separate attention was paid to fiancé. More importance was given to operational activities. In the traditional phase, the finance manager’s functions included record keeping, preparing different reports and managing cash. The traditional phase can be summarized as under :  Financial management was not a part of overall management of the organization.  Organization were more concerned with procurement of funds rather than application of funds.  The focus of financial management was primarily on activities such as formation, mergers, expansions, reorganisations and so on.  More emphasis was on institutional financing and banking.  Finance function was viewed from the point of view of supplier of funds i.e. lenders. Therefore, the outsider’s point of view was dominant.  Long term financial planning was emphasized on. The concept of working capital and its management was virtually non-existent.  The treatment of different aspects of finance was descriptive rather than analytic, In fact, there were no analytical financial analysis as such. 2. The transitional phase (1940 – 1950) The transitional phase began around the early 1940s and continued through the early 1950s. this phase was an extension of the traditional phase. In this phase, greater emphasis was placed on day to day finance problems faced by an organization. However, these problems were discussed within limited analytical framework. Funds analysis and control on a regular basis started. 3. Modern phase (After 1950) The modern phase began in mid 1950s and is still ongoing. The finance function widened further. Now it is concerned with not only procurement of funds, but also with its effective application. The features of the modern phase include : financial man\1 3  Financial panning focuses on the shareholders. Efforts are made to maximize their wealth.  Funds required for business are tapped not only from local or national markets but also from global markets.  Financial planning involves not only acquiring funds from the most economical sources but also deploying them in order to make best possible use of funds.  New ways of acquiring funds are evolving day by day such as securitization global depository receipts and so on which has made financial planning complex.  New bodies like SEBI have come into existence to monitor the financial performance of the organization and various legislations are being enacted to make the oranisations more accountable to the shareholders in particular and the society in general. Organisation, therefore have to be very discreet in their acquiring and utilizing of funds.  Various developments in the fields of capital budgeting, valuation models, working capital management etc. have made the approach of financial management more analytical and quantitative. OBJECTIVES OF FINANCIAL MANAGEMENT The objectives of financial management include : 1. Identifying total funds required Funds are required by an organization for various purposes. These are required for promoting the organization, acquiring fixed assets for day-to-day business operations, growth oriented activities and so on. Identify in the total funds requi4edis one of the most important objectives of financial management. However, identifying the total funds required is very difficult as it would depend upon various factors like the level of technology to be adopted, number5 of employees to be recruited, area of operations legal requirements etc. 2. Effective utilization of funds Funds collected from various sources should be put to productive use. It is an important objective of financial management to make optimum utilization of the funds available. Funds could be utilized properly by :  Minimising wastages  Avoiding unviable projects  Having shorter credit period financial man\1 4  Avoiding unnecessary blockage of funds in inventory and so on. 3. Reducing cost of capital Cost of capital is the cost incurred for procurement of funds. Each fund involves different costs. It is the responsibility of the finance manager to plan the capital structure in such a manner that the cost of capital is minimised. 4. Planning capital structure Capital structure refers to the composition of capital. Funds can be collected from various sources such as by issue of shares, debentures, fixed deposits, obtaining loans from banks and financial institutions and so on. It is necessary to have a right blend of various funds, which will ensure liquidity. Flexibility, economy and stability. Financial management aims at bringing about a proper balance between the various sources of funds. 5. Reducing operating risks For smooth functioning of business operations, it is necessary to reduce operating risks. This can be done by selecting a right blend of various risk management tools like futures and forward contracts, insurance avoiding high risks projects and so on. Thus selecting the combination of right tolls and thereby reducing operating risks is one of the objectives of financial management. 7. Maximising shareholders wealth. The ultimate objective of any organization is to maximise the w3ealth of the shareholders value of shares is generally, directly correlated to the performance of the company. Better the performance higher is the market value of shares and vice versa. So the financial manager should strive to maximize shareholders value. 8. Creating reserves The entire profit earned by an organization is not distributed to the shareholders in the form of dividends. A part of it has to be retained for various purposes such as for growth oriented activities, facing contingencies in future and so on. Hence, an important objective of financial management is build unnecessary reserves for facing unforeseen contingencies. financial man\1 5 Concept of Cost of Capital The cost of capital is an important concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposals etc. In particular, the concept of cost of capital has two applications, i.e. i) In capital budgeting, it is used to discount the future cash flows to obtain their present values. ii) It is used in optimization of the capital structure of the company. The concept of cost of capital is a widely used in capital budgeting. Here,. It means “the discount rate or minimum required rate of return a project must earn in order to cover, the cost of raising funds being used by the firm in financing the proposals. Every organization needs funds for financing various proposals. These funds can be collected from different sources like shares, debentures, bonds, loans etc. All finance providers have to be compensated for th3 funds provided by them. For example dividend to shareholders, interest to debenture holders, bankers etc. these investors while providing finance to the organization, have an expectation of receiving a minimum return from the organization. The minimum return expected depend son the risk element. It is generally directly proportionate to the risk involved i.e. higher the risk greater would be the return and vice versa. This minimum return which an organisation has to pay to its investors is called the cost of capital. It can be defined as “the rate at which an organization must pay to the suppliers of capital for the use of their funds”. The finance executive must devise the capital structure of an organization is such a manner that the cost of capital is minimum. Importance and Significance The cost of capital serves the following purposes : 1. It enables an organization to achieve its most important objective of maximization of the wealth of the shareholders. The wealth maximization goal is said to be achieved when the organisation’s actual rate of return exceeds its cost of capital. This excess return can be put to several uses such as : i) For distribution of higher dividends to shareholders; financial man\1 6 ii) Reinvesting the funds of expansion and diversification programs. 2. It enables an organization to decide its capital structure i.e. to have a balanced capital structure where the resources would be utilized in an optimum manner. 3. It is widely used in capital budgeting. It enables the organization to estimate the future discounted cash flows arising due to operation of the project. The project is feasible only if the discounted cash inflow exceed the discounted cash outflows. Factors affecting the cost of capital of an organization : 1. Risk in business operations There is a direct correlation between the risks involved in business and the cost of capital. Higher the risk, higher would be the cost of capital and vice versa. The lender of funds demands higher returns if the proposal is risky. 2. Risk free securities The securities issued by the government of India are relatively risk free in respect of payment of periodic interest as well as the repayment of principal amount on maturity. Hence, people invest in such securities even if they get a low rate of return. Thus the cost of raising funds for the government securities is usually low. 3. Liquidity or marketability of securities There is an inverse correlation between the liquidity of securities and the cost of capital i.e. more is the liquidity, lesser is the cost of capital and vice versa e.g. short term loans are more liquid than long term loans. So the cost of acquiring short tem loans is comparatively less. 4. Inflation Inflation is the general rise in the price level in the economy. The lender of funds estimates the price level that would prevail at the time of redemption of the principal amount by the borrower. If the price level is rising, he would expect a higher interest rate. In such a case, the cost of capital would be high. financial man\1 7 5. New Business In case of a new business organization, promoters have to pay higher returns in order to attract the investors. Hence the cost of capital is high. On the other hand, well established business organizations are in a position to raise capital at lower rates. 6. Hypothecation If the borrowings are secured, the interest rates are lower as compared to unsecured borrowings. This would automatically reduce the cost of capital. Concept of Risk and Return Financial decisions cover two aspects i.e. the risk and the return. Every financial decision involves risk. However, the degree of risk differs from one decision to another. Every financial decision fetches return too. Higher the risk involved, higher would be the return expected. In financial management, the risk is defined as “the variability of expected returns from an investment”. For example, when an investor invests in a fixed deposit carrying 8% interest with a schedule bank, there is virtually no risk attached with this investment since the returns are fixed. On the other hand, if the same amount is invested in equity shares of a company, then the return in the form of dividends may vary from one year to another. In other words, the returns are variable this makes investment in equity shares more risky. Return associated with a decision means the total gain or loss expected over a given period of time by the decision maker. While making financial decisions, both the aspects of risk and return have to be taken into account. Usually, when the return from an investment increases, so also its risk. Therefore, the finance executive must bring out a balance between the risk and the return so as to maximize the wealth of the shareholders. Types of Risks The different types of risk involved in financial decisions are : 1. Capital risk Capital risk is the risk of incurring a capital loss due to fall in the market price of a security. For example, investment in most of the equity shares carry this type of risk. financial man\1 8 2. Income risk This arises due to variations in return available from the security. For example, dividend paid on equity shares by a company may vary from one year to another. On the other hand, since fixed interest is paid on debentures and bonds, income risk does not arise in such securities. 3. Default risk It refers to chances of default in payment of interest or repayment of principal amount by the Company. It also includes the risk of losing the principal amount of shares and debentures in case the company is wound up. 4. Other business risks Faced by an organization are depicted in the following chart : Types of Risk l---------------------------------------------------------------------------------------------- l l l l l Business Financial Legal and Internal Social, political Portfolio rates statutory process and economic Risks risks risks risks risks 1. Business portfolio risks This risk arises on account of the different products of the organization in the market. If the organization is a diversified one then the risk is less as compared to single product company, whereon performance of that product may lead to closure of the company. The organization an reduce this risk by restricting the revenue from a particular product to around 25% of total revenue, not depending on a particular client for morethan10% to 15% of revenue for a particular product, identifying new areas for selling existing or new products and so on. 2. Financial risks Financial risk can arise due to defective capital structure borrowing debts at high rate of interest and so on. Even though it is difficult to predict future cash flows, efforts should be made to ensure that cash inflows are always more than ash outflows. This will prevent the firm from facing any payment crisis. Financial risk can be minimized by organizing stock – debtors – cash circle properly i.e. the time required to collect amount from debtors so that adequate liquid balance is maintained financial man\1 9 It is advisable for accompany to have around 25% revenues in liquid assets. 3. Legal and statutory risks These risks arise due to different legislations in different countries. Most of the economies have started reducing trade barriers and the companies throughout the world are now contemplating of going global. While this has widened the scope of business. It has also increased the risk arising due to different legislations existing in different countries. For example liquor cannot be advertised on doordarshan in India, In short the organization should be aware of the various laws prevailing in different countries to reduce the risks arising due to legal violations. In order to overcome these risks, the organization can have a legal department to oversee and review various contract agreements If necessary insurance can be undertaken to cover all possible liabilities arising out of non performance of contractual obligations. Avoiding contracts having open ended legal obligations can also reduce these risks. 4. Internal process risks These risks arise in the production process. For example, if the quality of the product is unsatisfactory it would increase the risk as product may not survive in the market or if the work environments unfavourable and the workers compensation plan is not adequate talented people may leave the organization. This jay adversely affect the productivity. The organization can overcome this risk by undertaking various measure like ISO Certification for their products or providing adequate compensation plan for employees, by allocating sufficient amount for research and development and so on. 5. Social political and economic risks Social environment includes various groups like the shareholders, creditors etc. their expectations are different sometimes they may even be contradictory. Moreover the lifestyles culture, preferences etc. of people keep on changing. The policies programs products etc. of the organisation have to modified accordingly. For example since most Indians don’t eat beef, McDonalds the food chain restaurant has Indianised around 85% of its products to be sold in India. Its advertising campaign in financial man\1 10 India in fact emphasized around that its products do not contain beef. Political risk arises when the continuance of government is uncertain Proper policy decisions may not betaken and if taken may be reverted by the new government. This leads to uncertainty on the political front. Thus long term organization planning becomes difficult. What is more, uncertain political environment leads to unwise economic decisions. For example there is always a school of thought that agriculture income should be taxed in India but it may not happen, as it is politically unwise. Corporate Risk Management Corporate Risk Management involves identifying the various risks and taking necessary steps to reduce the impact of these risks. With the growth of equity culture since 70’s amongst the masses in India, the financial prices have become very volatile. Financial prices includes prices of equity shares, exchange rates especially vis-à-vis dollar, interest rates of banks and so on. It is very difficult to exactly foretell as to the direction in which these share prices would change. The financial market responded by developing a range of risk management tools like forwards, options and so on. It is observed that organizations with high fluctuations in the prices of shares re likely to face more financial difficulties. For example IT Companies whose share prices fluctuated tremendously within last few months were always at risk Investors were hesitant to subscribe to their new issue making their expansion plans difficult. An organization should effectively manage its risk, or else it may lead to distressed financial condition. The following may be the outcome : 1. The organization may select highly risky investment to over come the financial difficulties faced by it. However, if this initiative is infective then it may have to close its operations. 2. The organization would reduce the amount spent on research and development which may lead to a loss of finding promising business opportunities. financial man\1 11 3. In order to become profitable again in the short run, the organization may take certain imprudent decisions like reducing the quality of the product delaying mandatory payments reducing the payment to workers etc. this may adversely affect its image. 4. Creditors, distributors etc. may start disassociating themselves from such loss making units. 5. If then loss making trend continues for a longer period the organization may go into liquidation. 6. Future borrowing would become more costly. Lenders may be ready to lend but on their terms and conditions which may further affect the organisation’s liquidity. 7. Talented skilled workers may hesitates to join the organization making its retrieval difficult.   financial man\1 12 Module-2 : FUNCTIONS OF FINANCE As long as finance function is confined to the process of raising funds, it cannot and does not provide answers to question like : Should a business commit capital funds to a certain purpose ? Are the expected returns adequate to compensate the cost and risk attached to additional capital ? How does the cost of capital vary with the mixture of financing methods used ? These questions lie at the very heart of sound financial management. Hence there is need to define the scope of finance function which covers decisions not only for the acquisition of funds but also for their effective use. In the light of this broader scope, the finance function includes Judgments about whether a company should hold, reduce or increase investment in various assets. These, in turn, require defensible basis to answer three questions : 1. What specific assets should a company acquire ? 2. What total volume of funds should a company commit ? 3. How should the funds required be raised ? It may be noted that these questions are closely inter related. Another way of stating the content of these three related questions is as under : 1. How large and how fast a company should grow ? 2. In what specific forms should it have its assets ? 3. What should be the compositions of its liabilities? One is likely to get the impression from the preceding survey of the scope of finance function that it is concerned with almost all aspects of business operations. But that is not so. Although it is difficult to set limits to the finance function, a fairly large group of business decisions do not involve changes in the volume of funds to be used. These lie outside the orbit of finance function though they may affect the profitability of the business. These decisions may bethought of as “technical” or non financial decisions. Some examples of such decisions are : 1. Decision about labour’s participation in management 2. Decision about changes in employment practices. 3. Decision on administrative practices. 4. Change in marketing and advertising technique that do not involve a change in the annual advertising budget. Many of these decisions affect the size and timing of future flow of funds, but they do not involve a current change in the volume o0f funds committed. financial man\1 13 Classification and description of Finance Function Finance function may be classified into two groups : executive finance function and incidental finance function. The executive finance function is so termed because it requires administrative skill in planning and execution, and the incidental function is so called because, for the most part, it covers routine work, chiefly clerical that is necessary to carry into effect financial decisions at the executive level. Some of the basic executive finance functions are given below. 1. Establishing asset-management policies. All finance functions are concerned with the control of the cash flows. In order to estimate and arrange for cash requirements of an enterprise, the financial managers must know, among other things, how much cash will be “tied up” in the various kinds of non-cash assets. The determination of asset-management policies includes decisions regarding kinds and coverage of insurance that a company will carry. The formation of sound and consistent asset-management policies is an indispensable pre-requisite to successful financial management. However, the role of Financial Managers in formulating asset management policies is not an exclusive one. Marketing Executive participate in making decisions involving the carrying of inventors of finished goods, customer credit policy, etc. Production managers, likewise, participation making decisions concerned with the carrying of inventories of raw materials and factory supplies, the purchase or renting of building, machinery and equipment. 2. Determining the allocation of net profits. The typical corporation may be said to have three choices regarding the allocation of et profits after payment of taxes : (a) Pay dividends to the shareholders as a return upon their investments; (b) Make distributions to people other than the shareholders as to employees in profit sharing plans and(c) Retain earnings for the expansion of business. As the second alternative is ordinarily made on a large contractual basis or as a mater of fixed policy, the company’s continuing free choices in the matter of the use of net profits involve only the other two alternatives i.e. payment of dividends and the retention of earnings to acquire additional assets. 3. Estimating and controlling cash flows and requirements. A prime responsibility of financial management is to see that an adequate supply of cash is on hand at the proper time for smooth flow of operations of the company. Since flow of cash originates in sales and cash requirements are closely related to the volume of sales, the fulfillment of the responsibility of providing cash in the proper amount at the proper time requires forecasting. financial man\1 14 The function creates an increasing dilemma. Ideally the financial manager would like to match the inflow of cash to the outflow of cash so that after providing enough cash to meet current obligations, there would be no idle cash balance earning nothing for the company. But the trouble is that cash inflows are not precisely predictable and seldom offset one another. So the financial Manager must keep a cash balance on hand to pay his bills on time. At this point the dilemma sets in. the more he protects his company against risks associated with inability to pay bills on time, the more he loses returns that might have been gained from investment of the idle cash. It is, in essence, the dilemma of liquidity Vs Profitability. 4. Deciding upon needs and sources of new outside financing. The Financial Managers, on the basis of their forecasts of the volume of operations, may have to plan upon borrowing to supplement cash flowing from these 0operations. All kinds of borrowing, including borrowing from commercial banks and other financial institutions, and the floatation of debentures is one of the two principal means of outside financing. Another principal method of outside financing is the sale of additional shares. On the basis of the forecasts of the inflow and outflow of cash in the ordinary course of operations, the financial manager should be able to judge rather closely the time when additional funds from outside sources will be needed, how long they will be needed, how best they can be raised, and from what sources they will be repaid. 5. Carrying on negotiations for new outside financing. Finance function does not stop with the decisions to undertake outside financing, it extends towards carrying on the negotiations to arrange for it. Short-term financing requirements are often arranged for on a continuing basis, may be through an establishment of credit with commercial banks. Even a continuing arrangements of this kind, however involves negotiations. Normally lines of credit are “held-open” for not more than a year; hence it is necessary to reopen negotiations annually to continue this arrangement. The factor of advance planning assumes greater importance in the matter of long term financing because negotiations and the completion of arrangements for long term financing always require much more time than does the working out of arrangements for short terms financing. 6. Checking upon financial performance. The checking of financial performance in a business deserves much attention in carrying out finance function. It requires retrospective analysis of operating period for the purpose of evaluating the wisdom and efficiency of financial planning. Analysis of what has happened should be of great value in improving the standards techniques and financial man\1 15 procedures of financial control involved in carrying out finance function. The executive finance functions are interrelated. Therefore, a change in decision with respect to one of the functions is likely to require a change in decision concerning some or al others. The incidental finance functions are : (a) Supervision of cash receipts and disbursements and the safeguarding of cash balances (b) Custody and safeguarding of securities, insurance policies and other valuable papers (c) Taking care of the mechanical details of financing (d) Record keeping and reporting. The incidental finance functions are self-explanatory. Orientation of the finance subject matter In many writings on the finance subject, the stand point of the owners of a finance firm has been given an exclusive position. It has been considered that the large corporate enterprise is operated on behalf of the share holders, even though ownership is diffused. Recently, there have been more cases of separation of ownership and control. There have also been trends requiring a broader point of view. The business firm represents an institution in the sociological sense. It has a role to lay, involving a balancing of the various groups of interests. The rising in strength of the interest of the consumers workers and government represent forces against which share holder interests must be balance. There is another view which holds that relationships with consumers employees suppliers and general public have long been recognized by business managers. Only recently the corporate management has considered the need for communicating with shareholders. In business schools, the professional view point trends to be the demanding one in the study of business finance. On the other hand, courses in business finance presented in an economics department may have a general economic or social point of view. The behaviour and performances of business firms are the keys to understanding the modern e4conomic society. Hence the subject of business finance is to be studied from the standpoint of its impact on the operation of the economy. The problems of corporate concentration, the separation of ownership and control, the role of government regulations and the emergence of national and international fiscal and financial policies are of crucial importance requiring the major attention from the corporate financial executives. The national fiscal and monetary policies have a great impact on financial decisions. It is, therefore, essential that financial mangers get themselves concerned with national fiscal and monetary policies. In addition, international financial man\1 16 trading and financial policies increasingly have an impact on domestic policies. The scope of the finance function and the finance subject matter is thus broadened to incorporate the entire fid of economics and management. In the traditional course on corporation finance, undue emphasis was laid on matters like promotion, merger, consolidation, recapitalization and reorganization which were infrequent influences during the life cycle of a company. It resulted in leaving a limited room for the problems of a normal going company and the treatment of subject was too closely around certain specific happenings. This dissatisfaction with emphasis on the episodic outsider point of view gave rise to a news stream of thinking in business finance. Prof Hunt (Harvard Business school) coined the phrase on the outside looking in” and contrasted it to the point of view of the financial manager concerned with the internal operation of the business firm i.e. the insider looking out. A survey was conducted by Prof. Weston (University of California) on the activities of financial managers and he found that most of the time of financial executives was spent on various aspects of working capital management, reflecting their day to day responsibilities However the financial executives assigned greatest importance to the episodic decisions such as long term contracts for financing mergers and capital budgets. In recent years anew approach has emerged which combines both views. In long range panning control functions and financial analysis of alternative product market decisions, the finance function covered both the indiv9dual episodes and provides a framework for the day-to-day decisions involved in w0rking capital management. Thus, working capital management vs individual financial episodes are two sides of the same coin,. The insider versus the outsider view:. Should the study of finance take the insider’s or the outsider’s point of view? Phrased in another way, should a finance book emphasis the managerial point of view, or should it be aimed at the person who is interested in business finance as a customer,lender, a stockholder, or a voter ? These two points of view are not incompatible. The financial manager, whose preoccupation is with the internal administration of the firm, must still take into account the reaction of outsiders to his operations. Small firm versus large firm financing. Similarly, the issue of the large firm versus the small firm as the appropriate focus of att3ention in finance courses is a false one. Principles of business finance are just as applicable to the small firm as to the large.  financial man\1 17 Module - 3 OBJECTIVES OF FINANCIAL MANAGEMENT The objective of a company is to maximize its value to its shareholders. Value is represented by market price of the ordinary share of the company over the long run, which is a reflection of the company’s investment and financing decisions. The long run means a period long enough so that a normalized market price can be worked out Management can make decisions on the basis of day to day fluctuations in the market price in order to make decisions that will raise the market price of the shares over the short run at the expense of the long run. For instance, a company may cut its research and development expense significantly in order to increase current earnings. This action may result in an increase in market price per share temporarily but future profits of the company are likely to suffer without sufficient research and develo0ment and the result will be a drop in market price in the long run. Often maximization of profits is regarded as the objective of a business enterprise. But it does not specify the timing of expected returns. Few shareholders may think favorably of a project that promises its first return after 30 years, no mater how large this return. In other words, we have to take into account the time pattern of returns secondly, the objective of maximizing profits does not consider the risk or uncertainty of prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective steam of earnings would be more uncertain if these projects were undertaken. Further, this objective of profit maximization does not allow for the effect of dividend policy on the market price of the share. If the objective wr4 only to maximize earnings per share the firm would never pay a dividend. To the extent that the payment of dividends can affect the value of the share, the maximization of earnings per share will not be a satisfactory objective by itself. For these reasons an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of the corporate share represents the maintenance centre. It takes into account present and prospective earnings per share, the timing and risk of these earnings, the dividend policy of the company and any other factor that may be having a bearing upon the market price of the share. Thus the market price serves as a performance index of the company’s progress. It indicates how well management is doing. Management is under a continuous appraisal. financial man\1 18 Profit maximization vs wealth maximization. There is an interesting controversy regarding the goals of financial decision makingi.;e; should the goal of financial decision making be profit maximization or wealth maximization ? Certain objections have been raised against profit maximisation as the goal of the business enterprise. First, it relates to the problem of uncertainty as future cannot be known well enough to express the probability of possible return. (It is not possible to maximize what cannot be known. Secondly, most decisions involve a balancing between expected return and risk. Opportunities promising the possibility of higher expected yields are associated with greater risk to recognize such a balancing nd wealth maximisation is brought into the analysis. If greater expected returns are associated with highest risks, a higher capitalisation rate should be applied to opporttnities that involve greater risk. The combination of expected returns with risk variations and related capitalization rate cannot be considered in the concept of profit maximisation. Thirdly, the decision maker may not have enough confidence in estimates of future returns so that he does not attempt further to maximize. It is argued that the firm’s goals cannot be to maximize profits but to attain a certain level or rate of profit holding a certain share of the market or a certain level of sales. Firms try to satisfice rather than to maximize. The satisficing goal is appropriate for behavioural theory of the firm and is perfectly manageable. Satisficing is primarily a sort rum search strategy and relates to the cost of search If information and search costs are low, additional efforts will be made to maximize. Where information and search costs are high additional effort to seek to maximize promises little additional net gains. So the decisions maker may be said to satisfice. Thus, when information and search costs are taken into account, the differences between satisficing and maximising may be insignificant or non existent. Lastly, the objective to profit maximization indicat4s that it is too narrowly centred. Such maximisation criteria fail to take into consideration the interests of government workers and other persons in the enterprise. Prof. Solomon (Stanford University) has handled this issue logically. He argues that its is useful to distinguish between profits and profitability. Maximisation of profit in the sense of maxmising the wealth accruing to shareholders is clearly an unreal motive. On the other hand, profitability maximisation in the sense of using resources o yield economic values higher than the joint values of inputs required is a useful goal. The goal of the profitability achieved in terms of greater outputs than input values involves a different set of considerations. ‘thus the proper goal of financial management is wealth maximisation. Even if management has other motives such as maximizing sales or size, growth or market share, or their own survival or peace of mind, these operating goals do not necessarily conflict with operating goal of wealth financial man\1 19 maximization. Prof. Solomon has made a good case for the thesis that wealth maximisation also maximizes the achievement of these other objectives. He concludes that maximization of wealth provides a useful and meaningful objective as basic guideline by which financial decisions should be evaluated. Recent developments in economics and finance have placed the financial manager in a central position in the business firm. The developments of financial management over the past two decades have prepared the financial executive better than any other officer to provide the chief corporate executive with the planning and control tools he needs. Since most business activities involve the use of funds, financial management must have recognized involvement in all the other activities which take place. Prof. Solomon elaborate on the nature of the business function as follows. “Financial management is properly viewed as an integral part of over all management rather than as a staff speciality concerned with fund raising operations. “In this broader view, the central issue of financial policy is the wise use of funds and the central process involved is a rational matching of the advantage of potential uses against the cost of alternative potential sources so as to achieve the broad financial goals which an enterprise sets for itself In addition to raising funds financial management is directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or distribution of assets. Finance must consider a broad range of business decisions for their cash flow implications. In addition, financial managers are involved in evaluation of resource allocation choice. Finance is, therefore, concerned with the following wide range of areas; size of the firm, rate of growth, asset mix, product mix, project evaluation, financial analysis, financing mix, fixed versus variable costs, make or buy decisions and the like. We feel that the field of finance is a subset of behavioural sciences and derives its analytical foundations from the economic theory of the firm. The field of finance is enriched by the behavioural characteristics of all market participants – management, shareholders, lenders and consumers. Similarly, it is constrained by the institutional and legal environmental factors of government market and so on. We are interested in the efforts of all participants to optimize their own welfare through the pursuance of specific goals, within the accepted modes of behaviour. Decision Making Figure 1.1 depicts the analytical and conceptual framework developed I this book for financial management decision making. It sho0ws the components of the finance function and the financial man\1 20 interrelationship among them. The financial management decisions an be classified into three basic kinds : investment decisions, financing decisions and dividend decisions. These three components of the finance interact among themselves through the medium of the cost of capital in order to attain the objective of financial management, namely, wealth maximization. Investment Decisions Risk versus Return 1. Establishing asset. Risk versus return External financing 3. Estimating and contro- Internal Financing Debtor/ Equity ratios lling cash flows and Payout Ratios Requirements etc. Financing Decisions Diviend Decisions 4. Deciding upon needs and 2. Determination of the allocation sources of new outside of net profits financing. 5. Carrying on negotiations 6. Checking upon financial for new 0utside financing performance etc. etc. Debt/Equity/Ratios Payout Ratios Cost of Capital (a) Financing Decisions (b) Investment Decisions (c) Dividend Decisions Fig.1.1 Componen5s of finance function and their interrelation The investment decisions allocate and ration the resources among the competing investment alternatives. The effort is to find out the projects which are acceptable through the discounted cash flow (DSF) technique using the cost of capital as the cut off criterion and also to choose the projects with higher Net Present Values (NPV) or Internal Rates of Return (IRR) if the resources are limited, and, therefore, have to be rationed. These analytical techniques are required because of the facts that the timings of the cash flows are different and that cash has a time value. Further, future cash flows are subject to uncertainty. Therefore, the investment decisions have also to be subjected to risk versus return analysis. financial man\1 21 The financing decisions are helpful in planning for a balanced capital structure. Risk, return and control are the crucial factors relevant in formulating the financing decisions. The debt/equity and the pay-out ratios act as constraints on the quantum and timing of external and internal financing. Analytical tools such as EPS/EBIT computations, leverage calculations and interest and dividend coverage estimates are used in the process of making the financing decisions. The dividend decisions are concerned with the determination of the quantum and the timing of dividend payment, the payout ratio being the controlling factor. The internal profitability versus the external profitability (Walter’s Approach) analysis helps in developing the payout ratio, that part of the profits not paid out as dividends constitutes the source for internal financing. The cost of capital acts as the nucleus in the frame work for financial management decision making. It has a two-way effect on the investment, financing and dividend decisions. It influences and is in turn influenced by them. The cost of capital leads to the acceptance or rejection of projects as it is the cut off criterion in investment decisions. In turn, the profitability of the projects raises or lowers the cost of capital. The financing decisions affect the cost of capital as it is the weighted average of the cost of different sources of capital. The need to raiser or lower the cost of capital, in turn influences the financing decisions. The dividend decisions try to meet the expectations of the investors reflected through the cost of capital In turn, the expectations of the investors raise or lower the cost of capital.    2 STUDY OF FINANCIAL STATEMENTS Module-1: OBJECTIVES OF FINANCIAL STATEMENTS The objective of financial statements is to provide information about the financial position, performance and changes and financial position of an enterprise that is useful to wide range of users in making economic decisions. Financial statements are prepared for this purpose to meet the common needs of most users. However, financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non financial information. Financial statements also show the results of the stewardship of management or the accountability of management for the resources entrusted to it. Those users who wish to assess the stewardship or accountability of management do so in order that they may make economic decision, these decisions may include, for example, whether to hold or sell their investment in the enterprise or whether to reappoint or replace the management. Financial reporting includes not only financial statements like balance sheet, profit and loss account etc. but also other means of communicating information that relates, directly or indirectly to the information provided by the accounting system. Management may also provide information to those outside an enterprise by means of financial reporting which may not necessarily be in the form of formal financial statements. Such financial information may be required to be provide under various corporate legislations. Information communicated by means of financial reporting other than financial statements may take various forms and relate to various mattes. Annual reports, quarterly and half yearly reports as per the requirements of stock exchange listing agreements to be given as per the requirements of SEBI etc. The financial statements also contain notes and supplementary schedules and other information. It may contain additional information that is relevant to the needs of users about the items in the balance sheet and income statement,. They may include disclosure about the risks and uncertainties affecting the enterprise and any resources and obligations not recognized in the balance sheet. Information about geographical and industry segments and the effect on the enterprise of changing prides also be provided in the form of financil-m/2 23 supplementary information. The impor5tanty objectives of financial statements are given below : Providing information for Economic decisions making - The economic decisions that are taken by users of financial statements require an evaluation of the ability of an enterprise to generate cash and cash equivalents and of the timing and certainty of their generation. This ability ultimately determines the capacity of an enterprise to pay its employees and suppliers meet interest payments, repay loans and make distributions to its owners. Providing information about financial position – The financial position of an enterprise is effected by the economic resources it controls, its financial structures its liquidity and solvency and its capacity to adapt to changes in the environment in which it operates.  Information about the economic resources controlled by the enterprise and its capacity in the past to modify these resources is useful in predicting the ability of the enterprise to generate cash and cash equivalents in the future.  Information about financial structure is useful in predicting future borrowing needs and how future profits and cash flows will be distributed among those with an interest in the enterprise.  Information is useful in predicting how successful the enterprise is likely to be in raising further finance.  Information about liquidity and solvency is useful to predicting the ability of the enterprise to met the financial commitments as fall due. Liquidity refers to the availability of cash in the near future after taking account of financial commitments over this period. Solvency refers to the availability of cash over the longer term to meet financial commitments as they fall due. Providing information about performance(working results) of an enterprise – Another important objective of the financial statements is that it provides information about the performance and in particular its profitability, which is require in order to assess potential changes in the economic resources that are likely to control in future. Information about variability of performance is important in this respect. Information about performance is useful in predicting the capacity of the enterprise to generate cash flows from its existing resource base. It is also useful in forming judgment about the effectiveness with which the enterprises might employ additional resources. financil-m/2 24 Providing Information about changes in financial position – The financial statements provide information concerning changes in the financial position of an enterprise, which is useful in order to assess its investing financing and operating activities during the reporting periods. This information is useful in providing the user with a basis to assess the ability of the enterprise to generate cash and cash equipments and the needs of the enterprise to utilize those cash flows. UNDERLYING ASSUMPTIONS OF FINANCIAL STATEMENTS It is fundamental to the understanding and interpretation of financial accounts that, those who use them should be aware of the main assumptions on which they are based. The users of financial statements need to be familiar with these fundamental assumptions in order to understand both how to prepare accounts and how to interpret them. The users of the financial information may assume that the assumptions have been applied in the preparation of a set of financial statements unless warning is given to the contrary. Going concern It is assumed that accounts are drawn up on the basis that enterprise will continue in operational existence for the foreseeable future. The values of assets are, therefore, generally taken to be based on what they cost with adjustment in the form of depreciation for fixed assets which have been declining in value over a period of time. This is an important assumption as fart as the valuation of assets is concerned. Since the value to a firm of very specific assets such as plant and equipment will be much higher on the going concern basis than it would be if the organizations were to go in to liquidation. Accrual Basis Profit has been defined as a change in value, expressed in the profit and loss account as revenue less expenses. Profit is usually measured and profit and loss accounts prepared at regular interval. The process of matching is an attempt to ensure that revenues recorded in a period are matched with the expenses incurred in earning them. Revenues and costs are not calculated on the basis of cash received or paid. Revenues are recognized when they are earned usually at the date of a transaction with a third party. Against such revenues are charged, not the financil-m/2 25 expenditures of a particular period, but the costs of earning the revenue which has been recognized. The matching principle leads to the association of an expense with the revenue that it generated, irrespective of the timing of the cash payment connected with that expenses. Thus costs of running the business should not be treated as a flow of cash. QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS Qualitative characteristics are the attributes that make the information provided in the financial statements useful to users. The important qualitative characteristics are given below: Understanda- An essential quality of information provided ability in financial statements is that it is readily understandable by users. For this purpose, users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. Relevance To be useful information must be relevant to the decision making needs of users. Information has the quality of relevance when it influences the ec0omic decisions of users by helping them to evaluate past, present or future events or confirming or correcting their past evaluations. Materiality The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or mis-statement. Reliability To be useful information must also be reliable. Information has the quality of reliability when it is free from material error and bias and the users can be depend upon it for reliable financil-m/2 26 information. To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonable be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets liabilities and equity of the enterprise at the reporting date which meet the recognition criteria. Substance If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Neutrality To be reliable, the information contained in financial statements must be neutral that is, free from bias. Financial statements are not neutral, if, by the selection or presentation of information, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome. Prudence Where an accountant could deal with an item in more than one way, his choice between the alternatives should give precedence to that which provides the most conservative result. For example, in the valuation of stock, if the current price is lower than the cost of acquisition, the stock should be recorded as its current price. However, if the stock has gained in value this gain should not be recorded until the assert is sold. In general, in order not to overstate profit, any possible gain or extra profits should be excluded from accounting calculations but any possible losses should be allowed for. Completeness To be reliable the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance. Comparability Users must be able to compare the financial statements of an enterprise through time in financil-m/2 27 order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and changes in financial position. Hence, the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an enterprise and in a consistent way for different enterprises. CONSTRAINTS ON RELEVANT AND RELIABLE INFORMATION Timeliness – If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. To provide information on a timely basis it may often be necessary to report before all aspects of a transaction or other event are known, thus impairing reliability. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little use to users who have had to make decisions in the interim. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the economic decision making needs of users. Balance Between Benefit and Cost – The balance between benefit and cost is a pervasive constraint rather than a qualitative characteristic. The benefits derived from information should exceed the cost of providing it. The evaluation of benefits and costs is, howsoever substantially a judgmental process. Balance Between Qualitative Characteristics – In practice balancing or trade off between qualitative characteristics is often necessary. Generally the aim is to achieve an appropriate balance among the characteristics in order to meet the objective of financial statements. The relative importance of the characteristics in different cases is a matter of professional judgment. True and Fair View/Fair Presentation – Financial statements are fre3quently described as showing a true and fair view of the financial position, performance and changes in financial position of an enterprise. Although this framework does not deal directly with such concepts, the applications of the principal qualitative characteristics and of appropriate accounting standards, normally results in financial statements that convey what is generally understood as a true and fair view of such information. financil-m/2 28 Forms of Consistency While preparation of financial statements the following forms of consistency are taken into consideration : Vertical Consistency It is achieved when the same accounting policies, methods and practices are adopted while preparing interrelated financial statements of the same date. Horizontal consistency It is achieved when the same entity adopts the same accounting policies methods and practices from year to year. Third dimensional It is the consistency in accounting policies, Consistency methods and practices followed by different units in the same industry.  financil-m/2 29 Module-2 : DIFFERENT TYPES OF FINANCIAL STATEMENTS Income Statement : The income statement or profit and loss account is considered as a very useful statement of all financial statements, It depicts the expenses incurred on production sales and distribution and sales revenue and the net profit or loss for a particular period. It shows whether the operations of the firm resulted in profit or loss at the end of a particular period. Balance Sheet Balance sheet is a statement which shows the financial position of a business as on a particular date. It represents the asserts owned by the business and the claims of the owners and creditors against the assets in the form of liabilities as on the date of the statement. Statement of retained earnings – The statement of retained earnings is also called the profit and loss appropriation account. It is a link between the income statement and the balance sheet. Retained earnings are the accumulated excess of earnings over losses and dividends. The balance shown by the income statement is transferred to the balance sheet through this statement after making the necessary appropriations. Funds Flow Statement - According to Anthony, “The funds flow statement described the sources from which additional funds were derived and the use to which these funds were put”. Funds flow statement helps the financial analyst in having a more detailed analysis and understanding the changes in the distribution of resources between two balance sheet periods. The statement reveals the sources of funds and their application for different purposes. Cashflow Statement – A cash flow statement depicts the changes in cash position from one period to another. It shows the inflow and outflow of cash and helps the management in making plans for immediate future. An estimated cash flow statement enables the management to ascertain the availability of cash to meet business obligations. This statement is useful for short term planning by the management. Schedules - These are the statements which explain the items given in income statement and balance sheet. Schedules are a part of financial statements which give detailed information about the financial position of a business organization. financil-m/2 30 FORMATS OF FINANCIAL STATEMENTS The two maintenance financial statements, viz. the income statement and the balance sheet, fan either be presented in the horizontal form or the vertical form. Where statutory provisions are applicable the statement has to be prepared in accordance with such provisions. Income Statement There is no legal format for the profit and loss account. Therefore, it can be presented in the traditional T Form or vertically in statement form. An example of the two formats is given as under : (i) Horizonatal Form Manufacturing Trading and Profit and Loss Account of………….for the year ending …………… Dr. Cr. Particulars (Rs) Particulars (Rs) To Opening stock By cost of finished goods c/d xxx Raw materials xxx By Closing stock Work in progress xxx xxx Raw materials xxx To purchase of raw Work in progress xxx xxx Materials xxx To manufacturing wages xxx To Carriages inwards xxx To other factory expenses xxx ------ xxx To opening stock of finished Goods xxx By Sales xxx To Cost of finished By Closing stock of Goods b/d xxx finished goods xxx To Gross profit c/d xxx By Gross loss c/d xxx ----- --------- xxx xxx ----- ------- To Gross loss b/d xxx By Gross profit b/d xxx To Office and adm. Expenses xxx By Net Loss c/d xxx To Interest and financial Expenses xxx To Provision for Income tax xxx To Net profit c/d xxx financil-m/2 31 ----- xxx ----- To Net loss b/d xxx By Balance b/d (from Previous year) xxx To General reserve xxx By Net Profit b/d xxx To Dividend xxx To Balance c/f xxx ---------------- ----------- xxx xxx (ii) Vertical Form Income Statement of …….. for the year ending ………. Particulars (Rs.) (Rs) Sales xxx Less : Sales returns xxx Sales tax/Excise duty xxx ----- xxx Net Sales (1) xxx ---- Cost of goods sold Materials consumed xxx Direct labour xxx Manufacturing expenses xxx Add/Less: Adjustment for change in stock xxx ---- (2) xxx ---- Gross profit (1) - (2) xxx Less: Operating expenses xxx Office and administration expenses xxx Selling and distribution expenses xxx xxx ---- Operating profit xxx Add : Non operating income xxx ---- xxx Less: Non operating expenses (including interest) xxx ---- Profit before interest and tax xxx Less Interest xxx ---- Profit before tax xxx Less Tax xxx ---- Profit after tax xxx ---- Appropriations : Transfer to reserves xxx Dividends declared/paid xxx Surplus carried to Balance sheet xxx ---- xx financil-m/2 32 Balance Sheet The companies Act, 1956 stipulates that the balance sheet of a joint stock company should be prepared as per Part I of Schedule VI of the Act. However, the statement form has been emphasised upon by accountants for the purpose of analysis and interpretation. (i) Horizontal Form Balance Sheet of …………as on …………….. Liabilities (Rs) Assets (Rs) Share Capital Fixed Assets (with all particulars of 1. Goodwill xxx authorized issued 2. Land & buildings xxx subscribed capital) 3. Leasehold property xxx Called-up capital xxx 4. Plant and machinery xxx Less: Calls in arrears xxx 5. Furniture & fittings xxx Add: For4feited shares xxx 6. Patents and trade marks xxx 7. Vehicles xxx Reserves and Surplus Investments 1. Capital reserve xxx Current Assets,Loans and 2. Capital redemption advances reserve xxx (a) Current Assets 3. Share premium xxx 4. Other reserves xxx 1. Interest accrued on Less: investments xxx Debit balance of profit & 2. Loose tools xxx Loss A/c. (if any) xxx 3. Stock in trade xxx 5. Profit & Loss 4. Sundry debtors xxx appropriation A/c xxx Less: Provisions for 6. Sinking fund xxx doubtful debts xxx 5. Cash in hand xxx Secured Loans 6. Cash at bank xxx Debentures xxx (b) Loans and Advances financil-m/2 33 Add: Outstanding int. xxx 7. Advances to subsidiaries xxx Loans from Bank xxx 8. Bills receivable xxx 9. Prepaid expenses xxx Unsecured Loans Miscellaneous expenditure Fixed deposits xxx 1. Preliminary expenses xxx Short term loans and 2. Discount on issue of Advances xxx shares and debentures xxx Current Liabilities 3. Unmderwriting And Provisions Commission xxx (a) Current Liabilities Profit and loss account (loss) if any xxx 1. Bills payable xxx 2. Sundry creditors xxx 3. Income received in advance xxx 4. Unclaimed dividends xxx 5. Other liabilities xxx (b) Provisions 6. Provisions for taxation xxx 7. Proposed dividends xxx 8. Provident fund & pension fund contingent liabilities not provided for xxx ---- ---- xxx xxx --- ---- financil-m/2 34 (ii) Vertical Form Balance Sheet of …………..As on ………………… Particulars Schedule Current Previous No year year I. Source of funds 1. Shareholders’ Funds (a) Capital xxx xxx (b) Reserves and surplus xxx xxx 2. Loan funds (a) Secured loans xxx xxx (b) Unsecured loans xxx xxx ----- ---- Total xxx xxx ---- ---- II. Application of Funds 1. Fixed assets (a) Gross block xxx xxx (b) Less Depre3ciation xxx xxx ---- ---- © Net block xxx xxx (d) Capital work in progress xxx xxx 2. Investments xxx xxx 3. current assts loans and Advances (a) Inventories xxx xxx (b) Sundry debtors xxx xxx © Cash and bank balances xxx xxx (d) Other current assets xxx xxx (e) Loans and advances xxx xxx ---- ---- xxx xxx Less : Current Liabilities and Provisions (a) current liabilities xxx xxx (b) Provisions xxx xxx ---- ---- Net Current Assets xxx xxx 4.(a) Misccellaneous expenditure to the extent not written off or adjusted xxx xxx financil-m/2 35 (b) Profit and loss account (debit) xxx xxx ---- ---- Total xxx xxx (iii) Vertical Form for Analysis Balance Sheet of………..as on ……. Particulars Rs. Assets (1) Current Assets Cash and bank balances xxx Debtors xxx Stock xxx Other current assets xxx ---- xxx (2) Fixed Assets xxx less : Depreciation xxx ----- xxx (3) Investments xxx ---- Total assets (1))+ (2) + (3) xxx ----- Liabilities (a) Current Liabilities Bills payable xxx Creditors xxx Other current liabilities xxx ---- xxx ---- (b) Long term Debt Debentures xxx Other long term debts xxx ---- xxx ----- financil-m/2 36 (c) Capital and Reserves Share capital xxx Reserves and surplus xxx ---- xxx ----- Total liabilities (a) +(b) + (c) xxx Statement of Retained Earnings The preparation of Statement of retained Earnings is a common feature in corporate accounting practice, to show how the balance in Profit and Loss accounts is appropriated for various purposes like provision for dividend, transfer to reserves etc. Profit and Loss Appropriation Account Particulars (Rs) Particulars (Rs) To Transfers to reserves xxx By Last year’s balance xxx To Dividends paid xxx By current year’s net profit (interim or final) (Transferred from Profit and loss A/c) xxx To Dividends proposed xxx By Excess provisions (which are no longer required) xxx To Surplus carried to Balance sheet xxx By Reserves withdraws (if any) xxx ---- ---- xxx xxx Limitations of Financial Statements The financial statements are subject to the following limitations :  In Profit and Loss accounts are subject to the following limitations : financil-m/2 37  Profit arrived at by the profit and loss account is of interim nature. Actual profit can be ascertained only after the firm achieves its maximum capacity  The net income disclosed by the profit and loss account is not absolute but only relative.  The profit and loss account does not disclose factors like quality of product, efficiency of the management etc.  The net income is the result of personal judgment and bias of accountants cannot be removed in the matters of depreciation, stock valuation, etc.  There are certain assets and liabilities which are not disclosed by the balance sheet. For example, the most tangible asset of a company is its management force and a dissatisfied labour force is its liability which re not disclosed by the balance sheet.  The book value of assets is shown as original cost less depreciation. But in practice, the value of the assets may d8fferdepending upon the technological and economic changes.  The assets are valued in a balance sheet on a going concern basis. Some of the assets may not realize their value on winding up.  The accounting year may be fixed to show a favourable picture of the business. In case of sugar industry the balance sheet prepared in off season depicts a better liquidity position than in the crushing season.  An investor likes to analyse the present and future prospects of the business while the balance sheets shows past position. V as such the use of balance sheet is only limited.  Due to flexibility of accounting principles, certain liabilities like provision for gratuity etc. are not shown in the balance sheet giving the outsiders a misleading picture.  The financial statements are generally prepared from the point of view of shareholders and their use is limited to decision making by the management, investors and creditors. financil-m/2 38  Even the audited financial statements does not provide complete accuracy.  Financial statements do not disclose the changes in management loss of markets, etc. which have a vital impact on the profitability of the concern.  The financial statements are based on accounting policies which may vary from company to company and as such cannot be formed as a reliable basis of Judgment. Other Limitations of Financial Statements Financial statements are the result of the accounting process which begins with recording of transactions. Accounting process involves recording, classifying and summarizing business transactions. Financial statements are the result of the third process viz. summarizing. But the profit or loss figures and financial position as disclosed should not be taken to be an exact representation of the position. The financial statements are based on certain accounting concepts and conventions which cannot be said to be foolproof. The following are the important limitations of financial statements : 1. The information is historical in nature. It does not reflect the future. 2. It is the outcome of accounting concepts and conventions combined with personal judgment. 3. The statements portray the position in monetary terms. The profit or loss position and the financial position exclude from their purview things which cannot be expressed or recorded in monetary terms. 4. While studying financial statements of different units, the size of the units and the difference in the accounting procedures adopted by them have to be kept in mind. They may be reflected in the financial statements by one has to enquire into them before analysing the statements. Parties Interested in Financial Statements In recent years, the ownership of capital of many public companies has become truly broad based due to dispersal of shareholding. Therefore, one may say that the public in general has become interested in financial statements. However, in addition to the share holders, there are other persons and bodies who are also interested in the financial results disclosed by the annual reports of companies. Such persons and bodies include : financil-m/2 39 1. Creditors, potential suppliers or others doing business with the company; 2. Debenture-holders; 3. Credit institutions like banks;’ 4. Potential Investors; 5. Employees and trade unions; 6. Important customers who wish to make a long standing contract with the company; 7. Economists and investment analysis; 8. Members of Parliament, the Public Accounts Committee and the Estimates Committee in respect of Government Companies; 9. Taxation authorities; 10. Other departments dealing with the industry in which the company is engaged; and 11. The Company Law Board Financial Statement analysis, therefore, has become of general interest; it should be obviously intelligible even to laymen. Though this will be kept in mind in the discussion that follows, the treatment has been from the view point of management.   3 STUDY OF FINANCIAL STATEMENTS (Comparative Statements, Common size statements, Trend analysis) Module – 1 Meaning of Analysis Financial statements viz. the income statement or the profit or loss account and the position statement or the balance sheet, are indicators of two significant factors : (i) profitability and (ii) financial soundness. Analysis of statements means such a treatment of the information contained in the two statements as to afford a full diagnosis of the profitability and financial position of the firm concerned. To have a clear understanding of the profitability and financial position, the data provided in the financial statements should be methodically classified and compared with figures of previous periods or other similar firms. Thereafter, the significance of the figures is established. Such a comparative study would lead us to further questioning, the answers for which have to be brought out by further and deeper analysis. We may work out the figure of income of two firms A and B for a period but to analyze systematically one should (i) arrange the cost and revenue, (ii) relate the income to the capital employed and (iii) compare the result. On this basis we may come to know that A is more profitable than B (vice versa). The next question is why is A more profitable than B ? This question will require further analysis and study of the underlying situation. We may define financial statement analysis as the process of methodical classification, comparison and raising pertinent questions and then seeking answers for them. Objects of Analysis Analysis of financial statements should always be tuned to the objective. People use financial statements for satisfying their particular curiosity. A prospective shareholder would like to know whether the business is profitable and is progressing on sound lines. A financier would like to be satisfied with the safety and reliability of return on his investment. The suppliers and others who would like to transact business with the concern may be interested in the company’s ability to hour is short term commitments. Over and above all these, the management is interested in knowing the operational efficiency and financial position of the concern as a financial-man\3 41 whole and of its various parts or department. The different parties look at the company from their respective points of vi3ew, but the objects generally looked for are : (i) profitability and (i