Subject: Financial Management

Q.1 What are the significant factors of Financial Statements? Discuss the
various tools of financial Analysis?

Answer –

Financial Statements :
1. Introduction:

A) A financial statement is an organized collection of data according to

logical and consistent accounting procedures. Its purpose is to convey an
understanding of some financial aspects of a business firm.
The following are the basic financial statement:
 The income statement
 The balance sheet
 Statement of retained earnings and

Statement of changes in financial position.

1.The income statement:

It measures profitability. The income statement, having been termed

as profit and loss

account is the most useful financial statement to enlighten what has

happened to the business

between the specified time intervals while showing, revenues, expenses gains
and losses.

2.The balance sheet:

It shows assests and the financing of those assets. The statement of

changes in financial

position, especially the cash flow indicates the change in cash position of
the firm. Balance

sheet is a statement which shows the financial position of a business at

certain point of time.

3.Statement of retained earnings:

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 It is a connecting link between the balance sheet and the income
statement. It is also termed as profit and loss appropriation account.

4.Statement of changes in financial position:

This statement shows the movement of working capital or cash in

and out of the business.

Financial Analysis is defined as being the process of identifying financial

strength and weakness of a business by establishing relationship between
the elements of balance sheet and income statement. The information
pertaining to the financial statements is of great importance through which
interpretation and analysis is made. It is through the process of financial
analysis that the key performance indicators, such as,liquidity solvency,
profitability as well as the efficiencyof operations of a business entity may be
ascertained, while short term and long term prospects of a business may be
evaluated. Thus, identifying the weakness, the intent is to arrive at
recommendations as well as forecasts for the future of a business entity.
Financial analysis focuses on the financial statements, as they are a
disclosure of a financial performance of a business entity. “A Financial
Statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey an
understanding of some financial aspects of a business firm. It may
show assets position at a moment of time as in the case of balance
sheet, or may reveal a series of activities over a given period of times,
as in the case of an income statement.”
The various tools of financial analysis are:
 Comparative financial statements
 Trend percentages
 Fund flow analysis
 Ratio analysis

1.Comparative financial statements:

It is an important method of analysis which is used to make

comparison between two financial statements. Being a technique of

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horizontal analysis and applicable to both financial statements, income
statement and balance sheet, it provides meaningful information when
compared to the similar data of prior periods. The comparative statement of
income statements enables to review the operational performance and to
draw conclusions, whereas the balance sheets, presenting a change in the
financial position during the period, show the effects of operations on the
assets and liabilities. Thus, the absolute change from one period to another
may be determined.

2.Trend percentages:

1.Trend percentages are calculated for making a comparative study

of the financial statements for several years. Usually the earliest year is
taken as the base year and a relationship is established with percentages of
each item of each of the years.

3.Fund flow analysis:

2. It is an important analytical tool of financial analysts, credit

granting institutions and financial managers. It reveals the sources from
which the working capital was obtained and the purposes for which it was
used.

4.Ratio analysis:

A ratio shows the relationship in mathematical terms between two

interrelated accounting figures. The financial analyst may calculate
different ratios for different purposes. The most popular way to analyze the
financial statements is computing ratios. It is an important and widely
used tool of analysis of financial statements. While developing a
meaningful relationship between the individual items or group of items of
balance sheets and income statements, it highlights the key performance
indicators, such as, liquidity, solvency and profitability of a business
entity. The tool of ratio analysis performs in a way that it makes the
process of comprehension of financial statements simpler, at the same
time, it reveals a lot about the changes in the financial condition of a
business entity.
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Q2: What is a fund flow statement? Discuss the uses and the
preparation of fund Flow statement.

Answer –

Fund Flow Statements :

1. Introduction:

A) The term “funds” has a variety of meanings. It may be taken as ‘cash’,

and in that case, there is no difference between a funds flow statement
and cash flow statement.
“The International Accounting Standard”, The term ‘fund’ refers to
cash and cash equivalents or to working capital. Here, with regard
to working capital, it means net working capital.

Fund flow statement is a statement which shows the inflow and out flow of
funds between two dates of balance sheet. So, it is known as the statement
of changes in financial position. We all know that balance sheet shows our
financial position and inflow and outflow of fund affects it. So, in company
level business, it is very necessary to prepare fund flow statement to know
what the sources are and what are applications of fund between two dates of
balance sheet. Generally, it is prepare after getting two year balance sheet.

According to Prof. Anthony, “The funds flow statement describes the

sources from which additional funds were derived and the use of which
these funds were put.”
Fund flow statements are known with different names, Statement of source
and uses of funds or summary of financial operations, Movement of working
capital statement or Fund received and distributed statement or Fund
generated and expended statement.

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Steps for preparation of Fund flow statement

First Step:

1.Making of statement of Changes of Working Capital :

For making of fund flow statement. It is very necessary to make statement of

changes of working capital. Because net increase in working capital is use of
fund and net decrease in working capital is source of fund. So, it is duty of
accountant to make statement of changes of working capital. Making of
statement of changes working capital is very easy and simple.

We take two balance sheets, one is current year balance sheet and other
is previous year balance sheet. Then we separate current assets and current
liabilities.

If current assets are more than previous year current assets, it means
increase in working capital. If current assets are less than previous
year current assets, it means decrease in working capital. Because,
relationship between current assets and working capital is positive and if
any changes in current assets, working capital will change in same
direction.

If current liabilities are more than previous year current liabilities, it

means decrease in working capital. If current liabilities are less than
previous year current liabilities, it means increase in working capital.
Relationship between working capital and current liabilities are inverse.

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1. Statement or schedule of changes in working capital

---------------------------------------------------------------------------------------
-
Particular--------------- ↓ previous year ↓ Current year ↓ Effect on
working capital
---------------------------------------------------------------------------------------
--
-----------------------------------------------------------↓ Increase ↓ Decrease
---------------------------------------------------------------------------------------
-
Current Assets

1. Cash in hand
2. Bills receivable
3. Sundry debtors
4. Temporary investments
5.Stocks / inventories
6.Prepaid expenses
7. Accrued incomes
---------------------------------------------------------------------------------------
-----
Total current assets----------- ↓xxxx ↓ xxxxx↓
----------------------------------------------------------------------- ---------------
--

Current liabilities

1. Bills payables
2.Sundry creditors
3. Bank overdraft
4. Short term advances
5.Dividends payables

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 6.Provision for taxation

I. ---------------------------------------------------------------------------------------
Total current Liabilities ----------↓xxxx ↓xxxx ↓
------------------------------------------------------------------ -------------------
Working capital
CA- CL
---------------------------------------------------------------------------

Net increase or decrease in working capital =

Increase in working capital – Decrease in working capital

2nd Step

Statement showing the fund from operation

Because is the source of fund and will show in fund flow statement’s
source side. So before making fund flow statement, we must make
statement showing the fund from operation.

Operation means business activity and fund from operation means

profit from business activity. So, you will easy understand that profit
from business activity between two accounting period must be the
source of fund.

Statement of fund from operations

---------------------------------------------------------------------------------------
---
------------------------------------------------------------------------>↓ Amount
↓
---------------------------------------------------------------------------------------
----
Closing balance of profit and loss account or retained earnings asgiven

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 in the Balance sheet
Add non –fund and non-operating items which have been
alreadydebited to profit and loss account

1.Depreciation:
2. Amortization of fictitious and intangible assets:
 goodwill
 Patents
 trade marks
 preliminary expenses
 discount on issue of shares

3. Appropriation of retained earning such as:

 Transfer to general reserve
 Dividend equalization fund
 Transfer tosinking fund
 Contingency reserve etc.

4. Loss on sale of any non-current or fixed assets such as:

 Loss on sale of land and building
 Loss on sale of machinery
 Loss on sale of furniture
 Loss on sale of long term investments

5. Dividends including
 Interim dividend
 Proposed dividend

(If it is an appropriation of profit and not taken as current liability)

6. Provision for taxation (if it is not taken as current liability)
7. Any other non-fund / non-operating items which have been
debited to P/L account

-----------------------------------------------------------------------------------
Total ( A)-------------------------------------------------------> ↓ XXXXX ↓
-------------------------------------------------------------------------------------

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LessNon–Fund or non-operating items which have already been credited
to profit and loss account

1. Profit or gain from the sale of non-current / fixed assets such as:
 Profit on sale of land and building
 Profit on sale of plant and machinery
 Profit on sale of long term investment etc.

2. Appreciation in the value of fixed assets such as increase in the value of

land if it has been credited to profit and loss account
3. Dividends received
4. Excess provision retransferred to profit and loss account or written back.
5. Any other non-operating item which has been credited to profit and loss
account
6. opening balance of profit and loss account or retained earnings as given in
the balance sheet
-------------------------------------------------------------------------------------
Total ( B)--------------------------------------------------------------> ↓ XXXXX ↓
----------------------------------------------------------------------------------------
Funds received from operation or business activities = total ( A) – Total ( B)
You can make also above statement in t shape adjusted profit and loss
account form .
3rdStep
Fundflowstatement

--------------------------------------------------------------------------------------
-------------------------------------------------------------------> ↓ Amount
---------------------------------------------------------------------------------

Source of funds
1. fund from operation ( balance of second step )
2. issue of shares capital
3. issue of debentures

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 4. raising of long termloans
5. receipts from partly paid shares , called up
6. amount received from sales of non-current or fixed assets
7. non trading receipts such as dividend received
8. sale of investments ( Long term )
9. Decrease in working capital as per schedule of changes in working
capital
----------------------------------------------------------------------------------
total-------------------------------------------------------------> ↓ XXXXX ↓
---------------------------------------------------------------------------------

Applications or uses of funds

1. Funds lost in operations (Balance negative in second step)
2. Redemption of preference share capital
3. Redemption of debentures
4. Repayment of long term loans
5. Purchase of long term loans
6. Purchase of long term investments
7. Non trading payments
8. Payment of tax
9. Payment of dividends
10. Increase in working capital (As per positive balance of 1st step)
-------------------------------------------------------------------------------------
total --------------------------------------------------------> ↓ XXXXX ↓
--------------------------------------------------------------------------------------

The uses of fund flow statement:

Fund flow statement is a tool for analysis and understanding changes in the
distribution of resources between two balance sheet dates. The uses of fund
flow statement are as follows:
 It explains the financialconsequences of business operations.

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  It gives reasonable answers for intricate queries such as regarding
the overall creditworthiness of the business, the sources of
repayment of the term loans, fund generated through normal
business operations, utilization of funds etc.
 It acts as an instrument for allocation of resources.
 It serves as a test of effectivenessor otherwise use of working capital

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Q3. What is financial forecasting? Explain.

Answer –

Financial Forecasting :

1. Introduction:

A) Financial forecasting is a planning process through which the

management of the company position the firm’s future activities keeping in
view the various influencing factors such as economic, technical social and
competitive environment. Financial forecasting is essential to the strategic
growth of the firm. A financial forecast is a financial plan or budget for a
business. A financial forecast is derived by trying to estimate two things.
These are the in come that the business is expected to receive and the
expenses that it is expected to have to pay. Of course, it is impossible to
know for sure how much income a business will get or how much its
expenses will be. However, it is possible to make educated guesses on these
issues. These guesses make up a financial forecast.
While financial forecasts are not likely to be perfect, they are important.
There are two main reasons why it is important for a business to engage in
financial forecasting. First, financial forecasting allows a business to plan
ahead. Imagine, for example, that you work for an airline. One of the major
expenses that an airline incurs is the price of fuel. If you foresee that fuel
costs will rise dramatically two years from now, you will want to take steps to
raise revenues to offset the cost increases that you are predicting. Second,
financial forecasting can be important if you think that your business is

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going to need loans or other inputs of capital from outsiders. For example,
imagine that you are going to open a small business and that you need a
loan to do so. You will need to have plausible financial forecasts that show
when you believe that you will start to make a profit. Any bank will want to
see such forecasts (and to analyze them) before they will be willing to risk
lending you any money.
In these ways, financial forecasts are a vital ingredient in the planning
process for any business, whether it be a start-up or an established firm.
Business plans evidence strategies and action for achieving the desired
short-term, medium-term and long-term results. The process of financial
forecasting allows the financial manager to anticipate events before they
occur, particularly the need for raising funds externally.
The most comprehensive means of financial forecasting is to go through the
process of developing a series of pro forma or projected financial statements.
Financial forecasting for the future is not easy. It has become much more
difficult because the economy is much more volatile. However, the basics of
financial forecasting remain the same. Small business owners must develop
the talent to plan ahead. It is one of their essential talents if they want their
business to succeed.
In order to do a good job of financial forecasting for the small business firm,
the owner should develop a comprehensive set of projected financial
statements. These projected financial statements, called pro forma financial
statements, help forecast future levels of balance sheet accounts as well as
profits and anticipated borrowing. These pro forma financial statements are
the small business owner's financial plan.

There are three main techniques of financial projections as follows:

 Pro forma financial statements

 Cash budgets and
 Operating budgets

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1.Pro forma financial statement:

Having this financial plan allows the owner to track actual events
against the financial plan and make adjustments as the year passes.This is
invaluable to the owner in order to keep the business out of financial trouble
in a changing economic environment. If the business firm needs a bank loan
or other financing, these pro forma financial statements are usually
required.Small businesses can develop their pro forma financial statements
for varying time periods. The most common time periods are either six
months or one year. Sets of pro forma financial statements for three or five
year time periods are often developed for banks or equity investors when
seeking financing. Both venture capitalists and angel investors require pro
forma financial statements.In order to prepare a comprehensive financial
plan, the best method is to first prepare a pro forma financial statement.
Then, you will need a cash budget and, finally, a pro forma budget sheet.
Here is an overview of each of these statements.

Pro forma income statement:

The pro forma income statement provides a projection of how much profit
the firm anticipates

earning over a given time period.

 Establish a sales projection

 Set up a production schedule
 Calculate your other expenses
 Determine your expected profit

Sales projection:

Sales projection or sales forecast is the starting point of the financial

forecasting exercise.

Projection of other financial variables are based on sales projection,

and therefore, the

necessity for accuracy of sales projection need not be overemphasized.

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Pro forma balance sheet:
After developing the pro forma income statement and the cash budget,
the small business owner now has all the information necessary to develop
the pro forma balance sheet. The pro forma balance sheet shows the
cumulative changes in the firm over time.

The owner also needs information from the prior year's balance sheet. The
amount of each line item on the balance sheet can be obtained from one of
these three documents. Some of the accounts on the balance, possibly long-
term debt and/or common stock, will remain unchanged.

If the firm's assets increase from the previous time period, then the firm's
owner has to look at the liability side of the balance sheet and find where the
increase is in liabilities to support the increase in assets. That is only one
possible scenario for the business owner.

2. Cash budget:

Small business owners can't assume that just because they show an
expected profit for their business that all is well. Profit is not the same as
cash in the till. Cash up front is necessary to operate day to day operations.
As a result, small business owners must also develop a projected cash
budget in order to assure that they will have adequate cash in the future to
operate their firm.

Cash budgets are done on a monthly basis. Cash receipts or inflows,

which are usually sales revenue, are based on the sales projections from the
expected income statement. Cash expenditures or outflows are calculated
similarly. The difference between them is the net cash flow. The business
owner has to take into consideration whether or not he allows customers to
pay on credit and account for that when calculating cash inflows upon
receipt.

Each month, the small business owner then calculates if there will
be enough cash to meet the minimum cash balance and the firm's cash
needs for the month. If not, the owner will have to borrow. If there is excess
cash, the owner can repay past loans. In this way, the business owner can
keep a good handle on the cash position of the firm.

3. Operating budgets:

Operating budgets are directed towards achieving short term

operational goals of the organization. The elements of operating budget vary
depending upon the size and nature of the business, however an operational
budget would include;

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 Sales Forecast: The sales forecast termed as future sales and would
be the starting point in the preparation of master budget. The sales
projections would be prepared on the basis of past sales figures and
business trend, plant capacity, overall economic conditions, financial aspects
and expected level of competition in the local/ international markets.

Production budget:

Product oriented companies prepare production budget as an

estimate of total volume of production. Once the level of sales had been
forecasted the next step would be the quantity/ number of units that must
be manufactured by the organization. The production budget is prepared
while taking into consideration factors like, inventory policy, standard
production capacity of the plant and process timings.

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Q6. Describe the various aspects of Zero Based Budgeting

with its merits and demerits.

A) A zero-base budget requires managers to justify all of their

budgeted expenditures, rather than the more common approach of only
requiring justification for incremental changes to the budget or the actual
results from the preceding year. Thus, a manager is theoretically assumed to
have an expenditure base line of zero (hence the name of the budgeting
method).Zero Based Budgeting: ZBB is defined as ‘a method of budgeting
which requires each cost element to be specifically justified, as though the
activities to which the budget relates were being undertaken for the first
time. Without approval, the budget allowance is zero’.

Zero – base budgeting is so called because it requires each

budget to be prepared and justified from zero, instead of simple using last
year’s budget as a base. Incremental level of expenditure on each activity are
evaluated according to the resulting incremental benefits. Available
resources are then allocated where they can be used most effectively. Zero
based budgeting is a decision oriented approach.

In Zero Based budgeting no reference is made to previous level

expenditure. Zero based budgeting is completely indifferent to whether total
budget is increasing or decreasing.

ZBB is "a technique which complements and links to existing

planning, budgeting and review processes. It identifies alternative and
efficient methods of utilizing limited resources. It is a flexible management
approach which provides a credible rationale for reallocating resources by

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focusing on a systematic review and justification of the funding and
performance levels of current programs.”

Zero-based budgeting is a method of budgeting in which all

expenses must be justified for each new period. Zero-based budgeting starts
from a "zero base" and every function within an organization is analyzed for
its needs and costs. Budgets are then built around what is needed for the
upcoming period regardless of whether the budget is higher or lower than
the previous one.

ZBB allows top-level strategic goals to be implemented into

the budgeting process by tying them to specific functional areas of the
organization. Costs can be first grouped, then measured against previous
results and current expectations

The basic process flow under zero-base budgeting is:

1. Identify business objectives

2. Create and evaluate alternative methods for accomplishing each
objective
3. Evaluate alternative funding levels, depending on planned
performance levels
4. Set priorities
The concept of paring back expenses in layers can also be used in reverse,
where you delineate the specific costs and capital investment that will be
incurred if you add an additional service or function. Thus, management can
make discrete determinations of the exact combination of incremental cost
and service for their business. This process will typically result in at least a
minimum service level, which establishes a cost baseline below which it is
impossible for a business to go, along with various gradations of service
above the minimum.

 Alternatives analysis. Zero-base budgeting requires that managers

identify alternative ways to perform each activity (such as keeping it
in-house or outsourcing it), as well as the effects of different levels of
spending. By forcing the development of these alternatives, the process
makes managers consider other ways to run the business.
 Budget inflation. Since managers must tie expenditures to activities,
it becomes less likely that they can artificially inflate their budgets –
the change is too easy to spot.

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  Communication. The zero-base budget should spark a significant
debate among the management team about the corporate mission and
how it is to be achieved.
 Eliminate non-key activities. A zero-base budget review forces
managers to decide which activities are most critical to the company.
By doing so, they can target non-key activities for elimination or
outsourcing.
 Mission focus. Since the zero-base budgeting concept requires
managers to link expenditures to activities, they are forced to define
the various missions of their departments – which might otherwise be
poorly defined.
 Redundancy identification. The review may reveal that the same
activities are being conducted by multiple departments, leading to the
elimination of the activity outside of the area where management
wants it to be centered.
 Required review. Using zero-base budgeting on a regular basis makes
it more likely that all aspects of a company will be examined
periodically.
 Resource allocation. If the process is conducted with the overall
corporate mission and objectives in mind, an organization should end
up with strong targeting of funds in those areas where they are most
needed.

The main downside of zero-base budgeting is the exceptionally high level of

effort required to investigate and document department activities; this is a
difficult task even once a year, which causes some entities to only use the
procedure once every few years, or when there are significant changes within
the organization. Another alternative is to require the use of zero-base
budgeting on a rolling basis through different parts of a company over
several years, so that management can deal with fewer such reviews per
year. Other drawbacks are:-

 Bureaucracy. Creating a zero-base budget from the ground up on a

continuing basis calls for an enormous amount of analysis, meetings,
and reports, all of which requires additional staff to manage the
process.

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  Gamesmanship. Some managers may attempt to skew their budget
reports to concentrate expenditures under the most vital activities,
thereby ensuring that their budgets will not be reduced.
 Intangible justifications. It can be difficult to determine or justify
expenditure levels for areas of a business that do not produce
“concrete,” tangible results. For example, what is the correct amount
of marketing expense, and how much should be invested in research
and development activities?
 Managerial time. The operational review mandated by zero-base
budgeting requires a significant amount of management time.
 Training. Managers require significant training in the zero-base
budgeting process, which further increases the time required each
year.
 Update speed. The extra effort required to create a zero-base budget
makes it even less likely that the management team will revise the
budget on a continuous basis to make it more relevant to the
competitive situation.

MERITS OF ZBB

 Prioritisation among activities and efficient and effective re-allocation

of resources.
 Goals will be more sharply established and alternative means are
explicitly considered.
 It helps in identifying areas of wasteful expenditure and if desired, it
can also be used for suggesting alternative courses of action.
 It enables the management to approve departmental budgets on the
basis of cost benefit analysis.
 The technique can also be used for the introduction and
implementation of the system of ‘management by objective.’ Thus, it
cannot only be used for fulfillment of the objectives of traditional
budgeting but it can also be used for a variety of other purposes.

DEMERITS OF ZBB

 Determination of performance is difficult.

 Time and cost of preparing the budget will be higher.
 Top managers fail to follow through the use of the ZBB information in
making choices.

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 The work involves in the creation of decision-making and their
subsequent ranking has to be made on the basis of new data. This
process is very tedious to management.
 The activity selected for the purpose of ZBB are on the basis of the
traditional functional departments. So the consideration scheme may
not be implemented properly.

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