Financial Management

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FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION

Meaning of Financial Analysis

Financial analysis is a process which involves reclassification and summarization of information through the
establishment of ratios and trends. Analysis of financial statement refers to the examination of the statements
for the purpose of acquiring additional information regarding the activities of the business. The users of the
financial information often find analysis desirable for the interpretation of the firm’s activities.
Financial statement analysis can be referred as a process of understanding the risk and profitability of a company
by analyzing reported financial info, especially annual and quarterly reports. Putting another way, financial
statement analysis is a study about accounting ratios among various items included in the balance sheet. These
ratios include asset utilization ratios, profitability ratios, leverage ratios, liquidity ratios, and valuation ratios.
Moreover, financial statement analysis is a quantifying method for determining the past, current, and prospective
performance of a company.
Financial analysis is certain procedures and methods applied to determine the past, present and also the future
status and performance of business with the aim to compare how the business performed in the past, how it
performs now and use such data for forecasting purposes, making decisions about the business performance,
manage it and control.

The overall objective of financial statement analysis is the examination of a firm’s financial position and returns in
relation to risk. This must be done with a view to forecasting the firm’s future prospective.

We know business is mainly concerned with the financial activities. In order to ascertain the financial status of
the business every enterprise prepares certain statements, known as financial statements. Financial statements
are mainly prepared for decision making purposes. But the information as is provided in the financial statements
is not adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis and interpretation of
financial statements is required.

Analysis means establishing a meaningful relationship between various items of the two financial statements
with each other in such a way that a conclusion is drawn. By financial statements we mean two statements:

(i) Profit and loss Account or Income Statement
(ii) Balance Sheet or Position Statement

These are prepared at the end of a given period of time. They are the indicators of profitability and financial
soundness of the business concern. The term financial analysis is also known as analysis and interpretation of
financial statements. It refers to the establishing meaningful relationship between various items of the two
financial statements i.e. Income statement and position statement. It determines financial strength and
weaknesses of the firm.

To summarize, financial statement analysis is concerned with analyzing the balance sheet and the income
statement of a business to interpret the business and financial ratios of a business for financial representations,
business evaluation, in addition to financial forecasting.

Objectives/Purposes of Financial Analysis

While learning how to perform a financial statement analysis, it is important to understand the purpose of
financial analysis.

The purpose of a financial analysis varies with the company conducting the analysis and the users of financial
analysis data. During a financial analysis, the relation between the various elements of financial statements is
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established and also compared with the other information obtained about the business. This is a very important
tool and is used by the investors, creditors and the management in determining the future prospects as well as
the plans regarding the company. This is also used to identify the areas that need improvement and also solve
any type of financial and operational problem. The prime aim of a financial analysis is to analyze the current
financial status and performance of the company, so that it will be possible to judge on the future performance of
the business.

The purpose of financial analysis usually differs depending on the users of this data. For example, creditors are
concerned with the solvency and liquidity because they are the ones who purchase bonds and debt securities of
the company. Therefore they want top know the company’s ability to pay off the debts and interest. The
investors (investing in the company’s stock) are mainly concerned with the profitability of the company. They
wish to know what returns they are going to earn in the form of dividends and a higher stock value.

Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise. Thus,
the analysis and interpretation of financial statements is very essential to measure the efficiency, profitability,
financial soundness and future prospects of the business units. Financial analysis serves the following purposes:

1. Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it. Financial analysis
helps in ascertaining whether adequate profits are being earned on the capital invested in the business or not. It
also helps in knowing the capacity to pay the interest and dividend.

2. Indicating the trend of Achievements
Financial statements of the previous years can be compared and the trend regarding various expenses,
purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be
compared and the future prospects of the business can be envisaged.

3. Assessing the growth potential of the business
The trend and other analysis of the business provide sufficient information indicating the growth potential of the
business.

4. Comparative position in relation to other firms
The purpose of financial statements analysis is to help the management to make a comparative study of the
profitability of various firms engaged in similar businesses. Such comparison also helps the management to study
the position of their firm in respect of sales, expenses, profitability and utilizing capital, etc.

5. Assess overall financial strength
The purpose of financial analysis is to assess the financial strength of the business. It also helps in taking
decisions, whether funds required for the purchase of new machines and equipments are provided from internal
sources of the business or not if yes, then how much and also to assess how much funds have been received
from external sources.

6. Assess solvency of the firm
The different tools of an analysis tell us whether the firm has sufficient funds to meet its short term and long
term liabilities or not.
Advantages of Financial Statements Analysis
The various advantages of financial statement analysis are:
1. Financial statements analysis helps the government agencies to analyze the taxation due to the
company.
2. Any company can analyze its own performance through financial statements analysis over any period of
time.
3. The investors get enough idea to decide about the investments of their funds in the specific company.
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4. The most important benefit if financial statement analysis is that it provides an idea to the investors
about deciding on investing their funds in a particular company.
5. Another advantage of financial statement analysis is that regulatory authorities like IASB (International
Accounting Standards Board) can ensure the company following the required accounting standards.
Disadvantages/Limitations of Financial Statements Analysis
Although analysis of financial statements is essential to obtain the relevant information for making several
decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from the
following limitations:
1. Mislead the user
The accuracy of financial information largely depends on how accurately financial statements are prepared. If
their preparation is wrong, the information obtained from their analysis will also be wrong which may mislead the
user in making decisions.
2. Not useful for planning
Since financial statements are prepared by using historical financial data, therefore, the information derived from
such statements may not be effective in corporate planning, if the previous situation does not prevail.
3. Qualitative aspects
Then financial statement analysis provides only quantitative information about the company's financial affairs.
However, it fails to provide qualitative information such as management labour relation, customer's satisfaction,
and management’s skills and so on which are also equally important for decision making.
4. Comparison not possible
The financial statements are based on historical data. Therefore comparative analysis of financial statements of
different years can not be done as inflation distorts the view presented by the statements of different years.
6. Wrong Judgment
The skills used in the analysis without adequate knowledge of the subject matter may lead to negative
direction. Similarly, biased attitude of the analyst may also lead to wrong judgement and conclusion.
6. No strong financial future
Strong financial statement analysis does not necessarily mean that the organization has a strong financial

future. Financial statement analysis might look good, but there may be other factors that can cause an
organization to collapse.
The limitations mentioned above about financial statement analysis make it clear that the analysis is a means to
an end and not an end to itself. The users and analysts must understand the limitations before analyzing the
financial statements of the company.
Tools/Techniques/Methods of Financial Analysis

A number of tools or methods or devices are used to study the relationship between financial statements.
However, the following are the important tools which are commonly used for analyzing and interpreting financial
statements:

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 Comparative Financial Statements/Horizontal Analysis
 Commonsize Statements/Vertical Analysis/CrossSectional Analysis
 Trend Analysis
 Ratio Analysis
 Funds Flow Analysis
 Cash Flow Analysis

1. Comparative Financial Statements/Horizontal Analysis:

In brief, comparative study of financial statements is the comparison of the financial statements of the business
with the previous year’s financial statements. It enables identification of weak points and applying corrective
measures. Practically, two financial statements are prepared in comparative form for analysis purposes. They are
as follows:

a) Comparative Balance Sheet
b) Comparative Income statement

a) Comparative Balance Sheet

The comparative balance sheet shows the different assets and liabilities of the firm on different dates to make
comparison of balances from one date to another. The comparative balance sheet has two columns for the data
of original balance sheets. A third column is used to show change (increase/decrease) in figures. The fourth
column may be added for giving percentages of increase or decrease. While interpreting comparative Balance
sheet, the interpreter is expected to study the following aspects:

(i) Current financial position and Liquidity position
(ii) Longterm financial position
(iii) Profitability of the concern

(i) For studying current financial position or liquidity position of a concern one should examine the working capital
in both the years. Working capital is the excess of current assets over current liabilities.

(ii) For studying the longterm financial position of the concern, one should examine the changes in fixed assets,
longterm liabilities and capital.

(iii) The next aspect to be studied in a comparative balance sheet is the profitability of the concern. The study of
increase or decrease in profit will help the interpreter to observe whether the profitability has improved or not.
After studying various assets and liabilities, an opinion should be formed about the financial position of the
concern.

b) Comparative Income Statement

The income statement provides the results of the operations of a business. This statement traditionally is known
as trading and profit and loss account. The important components of income statement are net sales, cost of
goods sold, selling expenses, office expenses etc. The figures of the above components are matched with their
corresponding figures of previous years individually and changes are noted. The comparative income statement
gives an idea of the progress of a business over a period of time. The changes in money value and percentage
can be determined to analyze the profitability of the business. Like comparative balance sheet, income statement
also has four columns. The first two columns are shown figures of various items for two years. Third and fourth
columns are used to show increase or decrease in figures in absolute amount and percentages respectively.

The analysis and interpretation of income statement will involve the following:

 The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold.
 To study the operating profits.
 The increase or decrease in net profit is calculated that will give an idea about the overall profitability of
the concern.

2. Commonsize Statements/Vertical Analysis/CrossSectional Analysis:

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The common size statements (Balance Sheet and Income Statement) are shown in analytical percentages. The
figures of these statements are shown as percentages of total assets, total liabilities and total sales. In the
balance sheet, the total assets are taken as 100 and different assets are expressed as a percentage of the total.
Similarly, various liabilities are taken as a part of total liabilities. Practically, two financial statements are prepared
in commonsize form for analysis purposes. They are as follows:

a) Commonsize Balance Sheet
b) Commonsize Income statement

a) Common size balance sheet

It is a statement in which the balance sheet items are expressed as a percentage of total assets and total
liabilities. The assets are expressed as a percentage of the total assets and the liabilities are expressed as a
percentage of total liabilities. It is prepared in the following ways:

i) The total assets or liabilities are taken as 100.
ii) The individual assets are expressed as a percentage of the total assets i.e.100. Similarly, different
liabilities are calculated as a percentage of total liabilities.

For example, if total assets are Rs10,00,000 and value of inventory is Rs1,00,000, and then inventory will be
10% of total assets.

b) Common size income statement

It is a statement in which the income statement items are expressed as a percentage of total sales. It shows the
relations of each item of income statement to sales. It is prepared in the following ways:

i) The total sales are taken as 100.
ii) The individual expenses and incomes are expressed as a percentage of the total sales i.e.100.

3. Trend Analysis/Trend Percentage Analysis (TPA)

The trend analysis is a technique of studying several financial statements over a series of years. In this analysis,
the trend percentages are calculated for each item over a series of years by taking the figure of that item for the
base year. The base year’s figure is taken as 100 and the trend percentages for other years are calculated in
relation to the base year. Generally, the first year is taken as the base year. After calculating the trend
percentages, the analyst becomes able to see the trend of figures, whether moving upward or downward.

Trend analysis is the type of analysis in which the information for a single company is compared over time. Over
the course of the business cycle, sales and profitability of a company may expand and contract. So the ratio
analysis for one year may not present an accurate picture of the firm. Therefore we look at trend analysis of
performance over a number of years. However, without industry comparisons even trend analysis may not
present a complete picture.

Illustration:

From the following data relating to ABC Hotel for the year 2004 to 2007, calculate trend percentages (taking
2004 as base year):

Particulars 2004 2005 2006 2007

Net sales 200,000 190,000 249,000 260,000
Less : Cost of goods sold 120,000 117,800 139,200 145,600
Gross profit 80,000 72,000 100,800 114,400
Less : Expenses 20,000 19,400 22,000 24,000
Net profit 60,000 52,800 78,800 90,400

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Solution:

Particulars 2004 2005 2006 2007

Net sales 100 95.0 124.5 130.0
Less : Cost of goods sold 100 98.2 116.0 121.3
Gross profit 100 90.3 126.0 143.0
Less : Expenses 100 97.0 110.0 120.0
Net profit 100 88.0 131.3 150.6

Interpretation:

 On the whole, 2005 was a bad year but the recovery was made during 2006. In this year there is
increase in sales as well as profit.
 The figure of 2005, when compared with 2004, reveal that the sales have come down by 5%. However,
the cost of goods sold and the expenses have decreased only by 1.8% and 3% respectively. This has
resulted in decrease in Net profit by 12%.
 The position was recovered in 2006 with a positive growth in both 2006 and 2007. Moreover, the
increase in profit by 31.3% (2006) and 50.6% (2007) is much more than the increased in sales by 20%
and 30% respectively. This shows major portion of cost of goods sold and expenses is of fixed nature.

4. Ratio Analysis:

Ratio analysis is essentially concerned with the calculation of relationships which after proper identification and
interpretation may provide information about the operations and state of affairs of a business enterprise. The
analysis is used to provide indicators of past performance in terms of critical success factors of a business. This
assistance in decisionmaking reduces reliance on guesswork and intuition and establishes a basis for sound
judgment.The significance of a ratio can be appreciated only when:

 It is compared with other ratios in the same set of financial statements.
 It is compared with the same ratio in previous financial statements (trend analysis).
 It is compared with a standard of performance (industry average).Such a standard may be either the
ratio which represents the typical performance of the trade or industry, or the ratio which represents the
target set by management as desirable for the business.

5. Funds Flow Analysis:

Flow of funds refers to change in fund. Increase of funds of any transaction is a source and decrease of funds in
any transaction is application or uses of funds. Fund being working capital, funds flow refers to the flow of
working capital between two points of time. It involves information relating to the various transformations
undergone by working capital (i.e. the changes that have taken place in working capital) during the period
involved between the two points of time.

Every change in working capital is associated with (or is on account of) a flow either an inflow or an outflow.
Thus, funds flow involves information relating to the inflows and outflows that resulted in a change in working
capital between the two points of time.

Funds flow statement is a statement which depicts the sources from which funds were obtained and the uses to
which they have been put. It speaks about the changes in financial items of balance sheets prepared at two
different dates. Therefore, the funds flow analysis studies the movement of funds (inflows and outflows of funds)
during a given period, generally a year. Thus it exhibits the movements of funds in both the directions – inside
and outside the business. In other words, the term ‘flow’ in the context of funds flow analysis indicates the
transfer of cash or cash equivalent from asset to equity or from one equity to equity or from one asset to
another asset.

6. Cash Flow Analysis:

Cash flow is essentially the movement of cash into and out of a business firm. It is the cycle of cash inflows and
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cash outflows that determine the firm’s solvency. Cash flow analysis is the study of the changes in the financial
position of a business enterprise during a given period on the basis of cash. In other words, it studies the changes
in the cash position of a business enterprise between two balancesheet dates. For this purpose, a statement is
prepared which is called the funds flow statement. Its main aim is to maintain an adequate cash flow for the
business, and to provide the basis for cash flow management.

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of a company. The
primary goal of cash flow analysis is to identify, in a timely manner, cash flow problems as well as cash flow
opportunities. The primary document used in cash flow analysis is the cash flow statement.

The cash flow statement is useful to managers, lenders, and investors because it translates the earnings
reported on the income statement—which are subject to reporting regulations and accounting decisions—into a
simple summary of how much cash the company has generated during the period in question.

A typical cash flow statement is divided into three parts: cash from operations (from daily business activities like
collecting payments from customers or making payments to suppliers and employees); cash from investment
activities (the purchase or sale of assets); and cash from financing activities (the issuing of stock or borrowing of
funds). The final total shows the net increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning the profitability,
financial condition, and financial management of a company. While historical cash flow statements facilitate the
systematic evaluation of past cash flows, projected (or pro forma) cash flow statements provide insights
regarding future cash flows. Projected cash flow statements are typically developed using historical cash flow data
modified for anticipated changes in price, volume, interest rates, and so on.

FINANCIAL STATEMENTS
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Meaning:
A financial statement can be well defined as a formal record of any business’, individual, or entity’s financial
activities. All the important information of a business enterprise is presented in the financial statements as these
are easy to understand because of their structured presentation. These statements might, however, get complex
for large corporations and might also include a wideranging set of notes to financial statements explaining about
the financial policies, management discussion, and analysis.
The main objective of financial statements is to provide information about the financial position, performance and
changes in financial position of a business enterprise that is useful to a wide range of users in making economic
decisions. The financial statements of any business entity should be relevant, understandable, reliable, and
comparable. An understandable financial statement helps business entity’s stakeholders to get reasonable
knowledge about the business and its economic activities. As far as financial statements are easy to understand,
this helps investors to make investment decisions in the company.
Importance of Financial Statements:
Financial statements show the financial performance of a company. They are used for both internal and external
purposes. When they are used internally, the management and sometimes the employees use it for their own
information. Managers use it to plan ahead and set goals for upcoming periods. When they use the financial
statements that were published, the management can compare them with their internally used financial
statements. They can also use their own and other enterprises’ financial statements for comparison with macro
economical data and forecasts, as well as to the market and industry in which they operate in.
Externally, current and potential investors and lenders always require financial statements for their lending or
investment decisions. In important board and stockholder meetings, copies of these are always given out to
participants. Analysts, brokers, rating agencies and money managers dig into these before making
recommendations. Major customers and suppliers of businesses ask for these in order to stay informed.
Corporate raiders, competitors and potential competitors attempt to get these before plunging into a business.
Objectives of Preparing Financial Statements:
The main objectives of preparing the financial statements are listed below:
 The financial statements are required by the owners and managers for making imperative business
decisions.
 The financial statements are used by prospective investors for assessing the feasibility of investing in a
company.
 Financial statements of a business are used by banks and other financial institutions to make decisions
about granting loan or extending debt securities, and similar more.
 Financial statements help vendors understand the financial position and creditworthiness of a company
to pay off its short term debts.
 Financial statements of a business are also helpful for government to ascertain the accuracy of taxes and
similar duties stated and paid by a company.
Different Types of Financial Statements:
The following are the various financial statements that are prepared in modern business enterprises:
1. Income Statement/Profit and Loss Account
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2. Balance Sheet/Financial Position Statement
3. Statement of Retained Earnings/Profit and Loss Appropriation Account
4. Funds Flow Statement
5. Cash Flow Statement
1. Income Statement/ Profit and Loss Account:
It is a financial statement that shows the operating results (net profit or net loss) of a business enterprise for a
given period. It has two sides viz. debit side and credit side. The left hand side represents the debit side, whereas
the right hand side represents the credit side. The debit side of the statement records all expenses, while the
credit side records all incomes. The difference between the totals of the two sides of the income statement
represents either net profit or net loss. The format of an income statement is as follows:

XYZ Co. Ltd.
Income Statement
For the year ended
Dr. Cr.
Particulars Amount ( ) Particulars Amount ( )

2. Balance Sheet/Financial Position Statement

It is a financial statement that shows the financial position of a business enterprise as on a particular date and
point of time. It has two sides viz. liabilities side and assets side. The left hand side represents the liabilities side,
whereas the right hand side represents the assets side. The liabilities side records all outside liabilities and capital,
whereas the assets side records all assets of the business. The totals of the two sides of the balancesheet always
become equal. The format of a balance sheet is as follows:

XYZ Co. Ltd.
Balance Sheet
As on

Liabilities Amount ( ) Assets Amount ( )

3. Statement of Retained Earnings/Profit & Loss Appropriation Account

It is a financial statement that shows the various appropriations made out of the profits earned during the year
like transfer to general reserve, transfer to any other reserve or fund, interim dividend, proposed dividend,
provision for taxation etc. It has two sides viz. debit side and credit side. The left hand side represents the debit
side, whereas the right hand side represents the credit side. The debit side of the statement records all
appropriations made out of the profits, while its credit side records the previous year’s profits, if any and current
year’s profits. The difference between the totals of the two sides of the income statement represents the profit
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surplus left which is called retained earnings. These retained earnings mean the profit that is retained in the
business for reinvestment purposes and are carried to the balance sheet under the heading ‘Reserves & Surplus’.
The format of a statement of retained earnings is as follows:

XYZ Co. Ltd.
Statement of Retained Earnings
For the year ended
Dr. Cr.
Particulars Amount ( ) Particulars Amount ( )
To Transfer to general reserve By Balance b/d
To Transfer to any other By Net profit for the year
reserve or fund
To Interim dividend
To Proposed dividend
To Provision for taxation
To Retained earnings
(Balancing Figure)

4. Funds Flow statement

different dates. It studies the movement of funds (inflows and outflows of funds) during a given period, generally
a year. Thus, funds flow statement provides information relating to the changes in working capital of a firm
between the two points of time.

In other words, a funds flow statement is a statement which is prepared to show the various causes of changes
in the working capital position of an enterprise during a given period. It studies the causes of changes in the
financial position of a business enterprise between two balance sheet dates on the basis of working capital. The
format of a funds flow statement is as follows:

XYZ Co. Ltd.
Funds Flow Statement
For the year

Sources of Funds Amount ( ) Applications of Funds Amount ( )

5. Cash Flow statement

A cash flow statement is a statement which is prepared to show the various causes of changes in the cash
position of an enterprise during a given period. It studies the causes of changes in the financial position of a
business enterprise between two balance sheet dates on the basis of cash.

In other words, a cash flow statement is a statement which shows the various inflows and outflows of cash made
in a business enterprise during a period. The format of a cash flow statement is as follows:

XYZ Co. Ltd.
Cash Flow Statement
For the year

Cash inflows Amount ( ) Cash outflows Amount ( )
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Limitations of Financial Statements:
1. Historic Nature: Financial statements provide financial statistics of past events; but they are not forward
looking i.e. financial statements represent the past performance of a company and it carries no guarantee of
future results.
2. Ignores Nonfinancial Information: They don’t provide key nonfinancial information like quality of
revenues, types of customers and risk factors.
3. Ignores Qualitative Aspects: Certain qualitative elements are not considered in the financial statements
terms like the quality and reputation of the management team and employees because they cannot be
measured in monetary terms. Financial statements ignore the productivity and the skills of the employee in an
organization. That means looking at through the financial statement, there is no reflection of how well or bad our
staffs or employees perform the work and it is unable to evaluate the skills which a company has through
financial statement.
4. Not Attributable to Future: The figures provided in financial statements can’t be attributed to future since
future earnings depend on many more factors like local and global market conditions, inflation etc.
5. Do not Directly Show the Changes in the Structure of the Company: It's absolutely crucial to know
about structural elements of a company that change over a time period. For instance, a company could have
added a new plant, launched a new product, be preparing for an acquisition etc. But financial statements don't
directly show the changes in the structure of the company.
Limitations of Financial Statements:

Financial statements are based on historical costs and as such the impact of price level changes is completely
ignored. They are interim reports. The basic nature of financial statements is historic. These statements are
neither complete nor exact. They reflect only monetary transactions of a business. The following limitations may
be noted as below:

1. The financial position of a business concern is affected by several factorseconomic, social and financial, but
financial factors are being recorded in these financial statements. Economic and social factors are left out. Thus
the financial position disclosed by these statements is not correct and accurate.

2. The profit revealed by the Profit and Loss Account and the financial position disclosed by the Balance Sheet
cannot be exact. They are essentially interim reports.
3. Facts which have not been recorded in the financial books are not depicted in the financial statement. Only
quantitative factors are taken into account. But qualitative factors such as reputation and prestige of the
business with the public, the efficiency and loyalty of its employees, integrity of management etc. do not appear
in the financial statement.
4. The rupee of 1995, as for example, does not mean the same as the rupee of 2010. The existing historical
accounting is based on the assumption that the value of monetary unit, say rupee, remains constant and
accordingly assets are recorded by the business at the price at which they are required and the liabilities are
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recorded at the amounts at which they are contracted for. But monetary unit is never stable under inflationary
condition. This instability has resulted in a number of distortions in the financial statements and is the most
serious limitation of historical accounting.
5. Many items are left to the personal judgment of the accountant. For example; provision of depreciation, stock
valuation, bad debts provision etc. depend on the personal judgment of accountant.
6. On account of convention of conservation the income statement may not disclose true income of the business
since probable losses are considered while probable incomes are ignored.
7. The fixed assets are shown at cost less depreciation on the basis of "going concern concept" (one of the
accounting concept). But the value placed on the fixed assets may not be the same which may be realized on
their sale.
8. The data contained in the financial statements are dumb; they do not speak themselves.
The human judgment is always involved in the interpretation of statement. It is the analyst or user who provides
tongue to those data and makes them to speak.

Funds Flow Analysis

Meaning:

Flow of funds refers to change in fund. Increase of funds of any transaction is a source and decrease of funds in
any transaction is application or uses of funds. Fund being working capital, funds flow refers to the flow of
working capital between two points of time. It involves information relating to the various transformations
undergone by working capital (i.e. the changes that have taken place in working capital) during the period
involved between the two points of time.

Every change in working capital is associated with (or is on account of) a flow either an inflow or an outflow.
Thus, funds flow involves information relating to the inflows and outflows that resulted in a change in working
capital between the two points of time.

different dates. Therefore, the funds flow analysis studies the movement of funds (inflows and outflows of funds)
during a given period, generally a year. Thus it exhibits the movements of funds in both the directions – inside
and outside the business. In other words, the term ‘flow’ in the context of funds flow analysis indicates the
transfer of cash or cash equivalent from asset to equity or from one equity to equity or from one asset to
another asset.

Significance of funds flow:

 Helps shareholders, creditors and others to evaluate the uses of funds by the enterprise.
 Assists in analysis of past t rends and thus aid future expansion decisions.
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 Helps finance managers in identification of problems, enabling detailed analysis and immediate action.

Uses of Funds Flow Statement:

 Guides the management in deciding about the dividend and retention policies.
 Enables planning for longterm purposes.
 Facilitates proper allocation of resources and funds.
 Indicates the sources from which the company has obtained its funds.
 Helps in ascertaining the factors resulting in change in working capital.
Advantages of Funds Flow Statement:
Funds flow statement is prepared to show changes in the assets, liabilities and equity between two balance sheet
dates, it is also called statement of sources and uses of funds. The advantages of preparing funds flow statement
are:
 Funds flow statement reveals the net result of operations done by the company during the year.
 In addition to the balance sheet, it serves as an additional reference for many interested parties like

creditors, suppliers, government etc. to look into financial position of the company.
 It shows how the funds were raised from various sources and also how those funds were put to use in
the business, therefore it is a great tool for management when it wants to know about where and from
funds were raised and also how those funds got utilized into the business.
 It reveals the causes for the changes in liabilities and assets between the two balance sheet dates
therefore providing a detailed analysis of the balance sheet of the company.
 Funds flow statement helps the management in deciding its future course of plans and also it acts as a
control tool for the management.
Funds flow statement should not be looked alone rather it should be used along with balance sheet in order
judge the financial position of the company in a better way.
Limitations of Funds Flow Statement:
Though funds flow statement has many advantages, it has also some disadvantages or limitations. The major

limitations of funds flow statement are:
 Funds flow statement has to be used along with balance sheet and profit and loss account, it cannot be
used alone.
 It does not reveal the cash position of the company, and that is why company has to prepare cash flow
statement in addition to funds flow statement.
 Funds flow statement merely rearranges the data which is there in the books of account and therefore it
lacks originality. In simple words it presents the data in the financial statements in systematic way and
therefore many companies tend to avoid preparing funds flow statements.
 Funds flow statement is basically historic in nature, that is it indicates what happened in the past and it
does not communicate anything about the future, only estimates can be made based on the past data
and therefore it cannot be used the management for taking decision related to future.

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Cash Flow Analysis

Meaning:






Purpose/Objectives of Cash Flow Statement:

The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the
income statement summarizes a firm's financial transactions over an interval of time. These two financial
statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated
with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash
equivalents; it excludes transactions that do not directly affect cash receipts and payments. These noncash
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transactions include depreciation or writeoffs on bad debts or credit losses to name a few. The cash flow
statement is a cash basis report on three types of financial activities: operating activities, investing activities, and
financing activities. Noncash activities are usually reported in footnotes.
The different objectives of cash flow statement are:
1. to provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
2. to provide additional information for evaluating changes in assets, liabilities and equity
3. to improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
4. to indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations,
which might be derived from different accounting methods, such as various timeframes for depreciating fixed
assets.
Cash flow activities:
The cash flow statement is partitioned into three segments. They are:
1. Cash flow resulting from operating activities
2. Cash flow resulting from investing activities
3. Cash flow resulting from financing activities.
The money coming into the business is called cash inflow, and money going out from the business is called cash
outflow.
i. Operating activities
Operating activities include the production, sales and delivery of the company's product as well as collecting
payment from its customers. This could include purchasing raw materials, building inventory, advertising, and
shipping the product.
Measuring the cash inflows and outflows caused by core business operations, the operations component of cash
flow reflects how much cash is generated from a company's products or services. Generally, changes made in
cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in
revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting
from transactions that occur from one period to the next. These adjustments are made because noncash items
are calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because
not all transactions involve actual cash items, many items have to be reevaluated when calculating cash flow
from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of
an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash
flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be
reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company
from customers paying off their credit accounts the amount by which AR has decreased is then added to net
sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must
be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to purchase more
raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net
sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in
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accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other
would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid
off, then the difference in the value owed from one year to the next has to be subtracted from net income. If
there is an amount that is still owed, then any differences will have to be added to net earnings.
Operating cash flows include:
 Receipts from the sale of goods or services
 Receipts for the sale of loans, debt or equity instruments in a trading portfolio
 Interest received on loans
 Dividends received on equity securities
 Payments to suppliers for goods and services
 Payments to employees or on behalf of employees
 Interest payments (alternatively, this can be reported under financing activities)
 buying Merchandise
Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the
Income Statement) to arrive at cash flows from operations generally include:
 Depreciation (loss of tangible asset value over time)
 Deferred tax
 Amortization (loss of intangible asset value over time)
 Any gains or losses associated with the sale of a noncurrent asset, because associated cash flows do
not belong in the operating section.(unrealized gains/losses are also added back from the income
statement)
ii. Investing activities
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing
are a "cash out" item, because cash is used to buy new equipment, buildings or shortterm assets such as
marketable securities. However, when a company divests of an asset, the transaction is considered "cash in" for
calculating cash from investing. Investing activities include:
 Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
 Loans made to suppliers or received from customers
 Payments related to mergers and acquisitions
iii. Financing activities
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the
outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the
longterm liabilities and equity of the company are also listed in the financing activities section of the cash flow
statement.
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are
"cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a
bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the
company is reducing its cash.
Financing activities include:
 Proceeds from issuing shortterm or longterm debt
 Payments of dividends
 Payments for repurchase of company shares
 Repayment of debt principal, including capital leases
 For nonprofit organizations, receipts of donorrestricted cash that is limited to longterm purposes
Items under the financing activities section include:
 Dividends paid
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 Sale or repurchase of the company's stock
 Net borrowings
 Payment of dividend tax
Uses/Significance/Advantages of Cash Flow Statement:
 It is especially useful in preparing cash budgets.
 It helps the newly formed companies to know their inflow and outflow of cash.
 It helps the investors to judge whether the company is financially sound or not.
 It helps the company to know whether it will be able to cover the payroll and other expenses.
 It helps the lenders to know the company’s ability to repay.
 A cash flow statement is provided on monthly basis or quarterly basis or six monthly basis or yearly
basis.
 These statements help to have an accurate analysis of the firm’s ability to meet its current liabilities.
 A cash flow statement is helpful for planning and managing future financial commitments.
 A cash flow statement summarizes the company’s cash receipts and cash payments over a period of
time.
 It is useful for determining the short term ability of the concern to meet its liabilities i.e. helps the
management in taking shortterm financial decisions.
 A cash flow statement gives vital information not only about the company’s performance but also about
its major activities during the year.
 Cash Flow statement is also a control device for the management.
 Since it gives a clear picture of cash inflow from operations (and not income flow of operation), it is,
therefore, very useful to internal financial management such as in considering the possibility of retiring
longterm debts, in planning replacement of plant facilities or in formulating dividend policies.
 It enables the management to account for situation when business has earned huge profits yet run
without money or when it has suffered a loss and still has plenty of money at the bank.
Disadvantages/Limitations of Cash Flow Statement:
 By itself, it cannot provide a complete analysis of the financial position of the firm.
 It can be interpreted only when it is in confirmation with other financial statements and other analytical
tools like ratio analysis.
 It may not give accurate details about the money coming into and going out of the business. Costs may
change and this could cause the business to loose money.
 Since it shows only cash position, it is not possible to arrive at actual profit and loss of the company by
just looking at this statement alone.
 In isolation this is of no use and it requires other financial statements like balance sheet, profit and loss
etc…, and therefore limiting its use
 It is difficult to precisely define the term ‘cash’.
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 Working capital is a wider concept of funds. Therefore a funds flow statement gives a clearer picture than
a cash flow statement.
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Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise. It is concerned with the acquisition
and use of funds in a business enterprise to achieve its predetermined objectives effectively.

Scope/Elements of Financial Management OR Major Financial decisions

1. Investment decision: It includes decisions regarding investment in fixed assets (called as capital
budgeting) as well as investment in current assets (called as working capital decisions).

2. Financing decision: It relates to the raising of necessary finance from various sources. It
includes the decisions such as type of source, debtequity ratio, period of financing, and cost
of financing.

3. Dividend decision: The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into the following two:

 Dividend to shareholders Amount of profit to be declared as dividend to the
shareholders has to be decided.

 Retained profits Amount of profits to be retained in the business for reinvestment
purposes will depend upon the expansion and diversification plans of the enterprise.

Objectives of Financial Management

Financial Management as the name suggests is management of finance. It deals with planning and
mobilization of funds required by the firm. There is only one thing which matters for everyone right
from the owners to the promoters. That is money. Managing of finance is nothing is but managing
of money. Every activities of an organization are reflected in its financial statements. Financial
Management deals with activities which have financial implications. The very objective of Financial
Management is to maximize the wealth of the shareholders by maximizing the value of the firm.
This prime objective of Financial Management is reflected in the EPS (Earning per Share) and the
market price of its shares.

The earlier objective of profit maximization is now replaced by wealth maximization. Since profit
maximization cannot be the sole objective of a firm it is a limited one. The term profit is a vague
phenomenon and if given undue importance problems may arise where as wealth maximization on
the other hand overcomes the drawbacks of profit maximization.

Thus the objective of Financial Management is to trade off between risk and return. The objective
of Financial Management is to make efficient use of economic resources mainly capital. The
functions of Financial Management involves acquiring funds for meeting short term and long term
requirements of the firm, deployment of funds, control over the use of funds and to tradeoff
between risk and return.

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. Therefore, its objectives can be:

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To ensure regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders. It depends upon the earning capacity, market
price of the share, expectations of the shareholders.
To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
To ensure safety on investment, i.e. funds should be invested in safe ventures so that
adequate rate of return can be achieved.
To plan a sound capital structure. There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements:

A finance manager has to make estimation with regards to capital requirements of the
company. This will depend upon expected costs and profits and future programmes and
policies of a concern. Estimations have to be made in an adequate manner which increases
earning capacity of enterprise.

2. Determination of the capital structure:

Once the estimation of capital requirements has been made, the optimum capital structure of
the company is to be decided. This involves the decision regarding the debtequity mix or
composition of long term finance. This will depend upon the proportion of equity capital a
company is possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds:

For funds to be procured, a company has many choices like issue of shares, debentures or
bonds, loans from banks and financial institutions, public deposits etc. Choice of factor will
depend on relative merits and demerits of each source and period of financing.

4. Investment of funds:

The finance manager has to decide to allocate funds into profitable ventures so that there is
safety on investment and regular returns is possible.

5. Disposal of surplus:

The disposal of net profit decision has to be made by the finance manager. This can be done
in two ways:

 Dividend declaration It includes identifying the rate of dividends and other benefits
like bonus.
 Retained profits The volume has to be decided which will depend upon expansion and
diversification plans of the company.

6. Management of cash:

Finance manager has to make decisions with regards to cash management. Cash is required
for many purposes like payment of wages and salaries, payment of electricity and water
bills, payment to creditors, meeting current liabilities, maintenance of enough stock,
purchase of raw materials, etc.

7. Financial controls:

The finance manager has not only to plan, procure and utilize the funds but he also has to
exercise control over finances. This can be done through many techniques like ratio analysis,
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financial forecasting, cost and profit control, etc.
Relationships between Finance and Other Disciplines

Financial management is an integral part of the overall management of an enterprise and thus, it
has a relationship with other disciplines and fields of study like economics, accounting, production,
marketing, personnel and quantitative methods. The relationship of financial management with
other fields of study is explained as under:

Finance and Economics

Finance is a branch of economics. Economics deals with supply and demand, costs and profits,
production and consumption and so on. The relevance of economics to financial management can be
described in two broad areas of economics i.e., micro economics and macro economics. Micro
economics deals with the economic decisions of individuals and firms. It concerns itself with the
determination of optimal operating strategies of a business firm. These strategies include profit
maximization strategies, product pricing strategies, strategies for valuation of firm and assets
etc. The basic principle of micro economics that applies in financial management is marginal
analysis. Most of the financial decisions should be made taken into account the marginal revenue
and marginal cost. So, every financial manager must be familiar with the basic concepts of micro
economics. Macro economics deals with the aggregates of the economy in which the firm
operates. Macroeconomics is concerned with the institutional structure of the banking system,
money and capital markets, monetary, credit and fiscal policies etc. So, the financial manager must
be aware of the broad economic environment and their impact on the decision making areas of the
business firm.

Finance and Accounting

Accounting and finance are closely related. Accounting is an important input in financial decision
making process. Accounting is concerned with recording of business transactions. It generates
information relating to business transactions and reporting them to the concerned parties. The end
product of accounting is financial statements namely profit and loss account, balance sheet and the
statements of changes in financial position. The information contained in these statements assists
the financial managers in evaluating the past performance and future direction of the firm
(decisions) in meeting certain obligations like payment of taxes and so on. Thus, accounting and
finance are closely related.

Finance and Production

Finance and production are also functionally related. Any changes in production process may
necessitate additional funds which the financial managers must evaluate and finance. Thus, the
production processes, capacity of the firm are closely related to finance.

Finance and Marketing

Marketing and finance are functionally related. New product development, sales promotion plans,
new channels of distribution, advertising campaign etc. in the area of marketing will require
additional funds and have an impact on the expected cash flows of the business firm. Thus, the
financial manager must be familiar with the basic concept of ideas of marketing.

Finance and Quantitative Methods

Financial management and Quantitative methods are closely related such as linear programming,
probability, discounting techniques, present value techniques etc. are useful in analyzing complex
financial management problems. Thus, the financial manager should be familiar with the tools of
quantitative methods. In other way, the quantitative methods are indirectly related to the dayto
day decision making by financial managers.

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Objectives of Financial Management
(Profit Maximization vs. Wealth Maximization Objective)

Profit Maximization Objective (Traditional Approach):

The traditional approach of financial management was all about profit maximization. Earlier the
main objective of companies was only to make more and more profits. This approach of financial
management had many limitations:

Limitations of Profit Maximization Objective

 The term ‘profit’ is vague.
 The term ‘maximum’ is ambiguous.
 The time factor is ignored.
 It does not consider the time value of money.
 It ignores the risk factor.
 Business may have several other objectives other than profit maximization. Companies
may have goals like: a larger market share, high sales, greater stability and so on. The
traditional approach did not take into account these aspects.
 Social Responsibility is one of the most important objectives of many firms. Big companies
make an effort towards giving back something to the society. They use a certain amount of
the profits earned for social causes. It seems that the traditional approach did not
consider this point.

Wealth Maximization Objective (Modern Approach):

Modern Approach is about the idea of wealth maximization that removes all the limitations of the
profit maximization objective. Wealth maximization involves increasing the Earning per share of the
shareholders and to maximize the net present worth. Wealth means net present worth which is
the difference between gross present worth of some decision or course of action (capitalized value
of the expected cash benefits) and the investment required to achieve these benefits (original cost).

The Wealth Maximization approach is concerned with the amount of cash flow generated by a
course of action rather than the profits. Any course of action that has net present worth above zero
creates wealth should be selected. The goals of financial management may be such that they should
be beneficial to owners, management, employees and customers. These goals may be achieved
only by maximizing the value of the firm.

Elements of Wealth Maximization:

The elements involved in wealth maximization of a firm are as follows:

1. Increase in Profits

A firm should increase its revenues in order to maximize its value. For this purpose, the volume of
sales or any other activities should be stepped up. It is a normal practice for a firm to formulate
and implement all possible plans of expansion and take every opportunity to maximize its profits.
In theory, profits are maximized when a firm is in equilibrium. At this stage, the average cost is
minimum and the marginal cost and marginal revenue are equal. A word of caution, however,
should be sounded here. An increase in sales will not necessarily result in a rise in profits unless
there is a market for increased supply of goods and unless overhead costs are properly controlled.
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2. Reduction in Cost

Capital and equity funds are factor inputs in production. A firm has to make every effort to reduce
cost of capital and launch economy drive in all its operations.

3. Sources of Funds

A firm has to make a judicious choice of funds so that they maximize its value. The sources of
funds are not riskfree. A firm will have to assess risks involved in each source of funds. While
issuing equity stock, it will have to increase ownership funds into the corporation. While issuing
debentures and preferred stock, it will have to accept fixed and recurring obligations. The
advantages of leverage, too, will have to be weighed properly.

4. Minimum Risks

Different types of risks confront a firm. "No risk, no gain" is a common adage. However, in the
world of business uncertainties, a corporate manager will have to calculate business risks, financial
risks or any other risk that may work to the disadvantage of the firm before embarking on any
particular course of action. While keeping the goal of maximization of the value of the firm, the
management will have to consider the interest of pure or equity stockholders as the central focus of
financial policies.

5. Longrun Value

The goal of financial management should be to maximize long run value of the firm. It may be
worthwhile for a firm to maximize profits by pricing its products high, or by pushing an inferior
quality into the market, or by ignoring interests of employees, or, to be precise, by resorting to
cheap and "getrich quick" methods. Such tactics, however, are bound to affect the prospects of a
firm rather adversely over a period of time. For permanent progress and sound reputation, it will
have to adopt an approach which is consistent with the goals of financial management in the long
run.

Advantages of Wealth Maximization:

 Wealth maximization is a clear term. Here, the present value of cash flow is taken into
consideration. The net effect of investment and benefits can be measured clearly (i.e.
quantitatively).
 It considers the concept of time value of money. The present values of cash inflows and
outflows help the management to achieve the overall objectives of a company.
 The concept of wealth maximization is universally accepted, because, it takes care of
interests of financial institution, owners, employees and society at large.
 Wealth maximization guides the management in framing consistent strong dividend policy, to
earn maximum returns to the equity holders.
 The concept of wealth maximization considers the impact of risk factor, while calculating
the Net Present Value at a particular discount rate; adjustment is made to cover the risk that
is associated with the investments.

Criticisms of Wealth Maximization:

The concept of wealth maximization is being criticized on the following grounds:

 The objective of wealth maximization is not descriptive. The concept of increasing the wealth
of the stockholders differs from one business entity to another. It also leads to confusion in
and misinterpretation of financial policy because different yardsticks may be used by
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different interests in a company.

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Ratio Analysis

Meaning of Ratio Analysis:

Ratio analysis is an important technique of making financial analysis. Under this method, financial
statements are analyzed by

calculating various financial ratios by taking the relevant data contained in the financial
statements (income statement and balance sheet).
comparing the ratios calculated with the past ratios of the same firm or with the ratios of
other firms or with the ratios of the industry to which the firm belongs and
interpreting the ratios calculated.

Advantages/Uses and Limitations of Ratio Analysis:

Advantages/Uses

Ratio analysis is a useful tool for users of financial statements. It has following advantages:

It simplifies the financial statements.
It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over a period.
It highlights important information in a simpler form quickly. A user can judge a company’
financial position and profitability by just looking at few ratios instead of reading the whole
financial statements.

Limitations

Despite advantages, ratio analysis has some disadvantages. Some key demerits of financial ratio
analysis are:

Different companies operate in different industries each having different environmental
conditions such as regulation, market structure, etc. Such factors are so significant that a
comparison of two companies from different industries might be misleading.
Financial accounting information is affected by estimates and assumptions. Accounting
standards allow different accounting policies, which impairs comparability and hence ratio
analysis is less useful in such situations.
Ratio analysis explains relationships between past information while users are more
concerned about current and future information.
There may be window dressing of financial statements by the management of the company
which may lead to misleading information.
Many times comparison of ratios over time is meaningless because of inflation.

Importance/Uses/Advantages of Ratio Analysis

Ratio analysis is an important tool for analyzing a company's financial statements (Income
Statement and Balance Sheet). The following are the important advantages of the accounting ratios:
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1. Analyzing the Financial Statements:

Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful
for understanding the financial position of the company. Different users such as
investors, management, bankers and creditors use the ratio to analyze the financial situation of the
company for their decision making purpose.

2. Judging the efficiency of the company:

Accounting ratios are important for judging the company's efficiency in terms of its operations and
management. They help judge how well the company has been able to utilize its assets and earn
profits.

3. Locating the weakness of the company:

Accounting ratios can also be used in locating weakness of the company's operations even though
its overall performance may be quite good. Management can then pay attention to the weakness
and take remedial measures to overcome them.

4. Formulating Plans:

Although accounting ratios are used to analyze the company's past financial performance, they can
also be used to establish future trends of its financial performance. As a result, they help formulate
the company's future plans.

5. Comparing the performance of a company:

It is essential for a company to know how well it is performing over the years or as compared to
the other firms of the similar nature. Besides, it is also important to know how well its different
divisions are performing among themselves in different years. Ratio analysis facilitates such
comparison.

Limitations of Financial Ratios

There are some important limitations of financial ratios that analysts should be conscious of:
Many large firms operate different divisions in different industries. For these companies it is
difficult to find a meaningful set of industryaverage ratios.
Inflation may have badly distorted a company's balance sheet. In this case, profits will also
be affected. Thus a ratio analysis of one company over time or a comparative analysis of
companies of different ages must be interpreted with judgment.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a
business can reduce the chance of misinterpretation. For example, a retailer's inventory may
be high in the summer in preparation for the backtoschool season. As a result, the
company's accounts payable will be high and its ROA low.
Different accounting practices can distort comparisons even within the same company (leasing
versus buying equipment, LIFO versus FIFO, etc.).
It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sign, but could also be
seen as a sign that the company is no longer a growth company and should command lower
valuations.
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A company may have some good and some bad ratios, making it difficult to tell if it's a good
or weak company.
In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other
hand, if used intelligently, ratio analysis can provide insightful information.

LIMITATIONS OF RATIO ANALYSIS:
Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any
investor, who wants to be more efficient at their job, must devote more time towards
understanding ratios and ratio analysis. However, this does not mean that it is free of
limitations. Like all techniques, financial ratios have their limitations too. Understanding the
limitations will help investors understand the possible shortcomings with ratios and avoid them.
Here are the shortcomings:
1. Misleading Financial Statements
The first and foremost threat to ratio analysis is deliberate misleading statements issued by the
management. The management of most companies is aware that investors look at certain numbers
like sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not
get such attention. They therefore manipulate the numbers within the legal framework to make
important metrics look good. This is a common practice amongst publicly listed companies and is
called “Window Dressing”. Investors need to be aware of such window dressing and must be careful
in calculating and interpreting ratios based on these numbers.
2. Incomparability
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be
compared with other companies or over time. However, many times companies have accounting
policies that do not match with each other. This makes it impossible to have any meaningful ratio
analysis. Regulators all over the world are striving to make financial statements standardized.
However in many cases, companies can still choose accounting policies which will make their
statements incomparable.
3. Qualitative Factors
Comparison over time is another important technique used in ratio analysis. It is called horizontal
analysis. However, many times comparison over time is meaningless because of inflation. Two
companies may be using the same machine with the same efficiency but one will have a better ratio
because it bought the machine earlier at a low price. Also, since the machine was purchased
earlier, it may be closer to impairment. But the ratio does not reflect this.
4. Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a business should operate. However
some of these rules of thumb have become obsolete. Therefore when companies come with a new
kind of business model, ratios show that the company is not a good investment. In reality the
company is just “unconventional”. Many may even call these companies innovative. Ratio analysis
of such companies does not provide meaningful information. Investors must look further to make
their decisions.
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Capital Budgeting

Meaning of Capital Budgeting:

Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed
assets or capital assets such as land, building, machinery or furniture. Normally capital expenditure is one which
is intended to benefit in the future period of time i.e. more than one year.

Capital budgeting is the planning process used to determine whether an organization's long
term investments such as purchase of new machinery, replacement of old machinery, Purchase of new plants,
Introduction of new products, and research development projects are worth pursuing. It is a budget for
major capital expenditures.

The word ‘investment’ refers to the expenditure which is required to be made in connection with the acquisition
and the development of longterm or fixed assets. It refers to process by which management selects those
investment proposals which are worthwhile for investing available funds. For this purpose, management is to
decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm.

Capital budgeting is an extremely important aspect of a company's financial management. If a company makes a
mistake in its capital budgeting process, then it has to live with that mistake for a long period of time as it cannot
be reversed.

Nature of Capital Budgeting

Nature of capital budgeting can be explained in brief as under Capital expenditure plans involve a huge
investment in fixed assets. Capital expenditure once approved represents longterm investment that cannot be
reserved or withdrawn without sustaining a loss. Preparation of coital budget plans involve forecasting of several
years profits in advance in order to judge the profitability of projects. It may be asserted here that decision
regarding capital investment should be taken very carefully so that the future plans of the company are not
affected adversely.

Importance/Need of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision. So it needs special care on account
of the following reasons:

1) Longterm Implications:

A capital budgeting decision has its effect over a long time span and inevitably affects the company’s future cost
structure and growth. A wrong decision can prove disastrous for the longterm survival of firm. On the other
hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting
decisions determine the future destiny of the company.

2) Involvement of large amount of funds:

Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful,
wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from
earning profit from other investments which could not be undertaken.

3) Irreversible decisions:

Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such
assets. The only way out will be scrap the capital assets so acquired and incur heavy losses.
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4) Risk and uncertainty:

Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and
investment is future. The future is uncertain and full of risks. Longer the period of project, greater may be the
risk and uncertainty. The estimates about cost, revenues and profits may not come true.
5) Difficult to make:

Capital budgeting decision making is a difficult and complicated exercise for the management. These decisions
require an over all assessment of future events which are uncertain. It is really a marathon job to estimate the
future benefits and cost correctly in quantitative terms subject to the uncertainties caused by economicpolitical
social and technological factors.
Kinds of capital budgeting decisions:
Generally the business firms are confronted with three types of capital budgeting decisions.

(i) AcceptReject Decisions;
(ii) Mutually Exclusive Decisions; and
(iii) Capital Rationing Decisions.
i) AcceptReject Decisions: Business firm is confronted with alternative investment proposals. If the proposal is
accepted, the firm incur the investment and not otherwise. Broadly, all those investment proposals which yield a
rate of return greater than cost of capital are accepted and the others are rejected. Under this criterion, all the
independent proposals are accepted.
ii) Mutually Exclusive Decisions: It includes all those projects which compete with each other in a way that
acceptance of one precludes the acceptance of other or others. Thus, some technique has to be used for selecting
the best among all and eliminates other alternatives.
iii) Capital Rationing Decisions: Capital budgeting decision is a simple process in those firms where fund is not the
constraint, but in majority of the cases, firms have fixed capital budget. So, large amount of projects compete for
these limited budgets. So the firm rations them in a manner so as to maximize the long run returns. Thus,
capital rationing refers to the situations where the firm has more acceptable investment requiring greater
amount of finance than is available with the firm. It is concerned with the selection of a group of investment out
of many investment proposals ranked in the descending order of the rate or return.

Procedure of Capital Budgeting

Capital investment decision of the firm have a pervasive influence on the entire spectrum of entrepreneurial
activities so the careful consideration should be regarded to all aspects of financial management.

In capital budgeting process, main points to be borne in mind how much money will be needed of implementing
immediate plans, how much money is available for its completion and how are the available funds going to be
assigned tote various capital projects under consideration. The financial policy and risk policy of the management
should be clear in mind before proceeding to the capital budgeting process. The following procedure may be
adopted in preparing capital budget:

(1) Organisation of Investment Proposal

The first step in capital budgeting process is the conception of a profit making idea. The proposals may come from
rank and file worker of any department or from any line officer. The department head collects all the investment
proposals and reviews them in the light of financial and risk policies of the organisation in order to send them to
the capital expenditure planning committee for consideration.

(2) Screening the Proposals

In large organisations, a capital expenditure planning committee is established for the screening of various
proposals received by it from the heads of various departments and the line officers of the company. The
committee screens the various proposals within the longrange policyframe work of the organisation. It is to be
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ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do no
lead to department imbalances or they are profitable

(3) Evaluation of Projects

The next step in capital budgeting process is to evaluate the different proposals in term of the cost of capital, the
expected returns from alternative investment opportunities and the life of the assets with any of the following
evaluation techniques:

 PayBack Period Method
 Accounting Rate of return Method
 Net Present Value Method
 ProfitabilityIndex Method
 Internal Rate of Return Method

(4) Establishing Priorities

After proper screening of the proposals, uneconomic or unprofitable proposals are dropped. The profitable projects
or in other words accepted projects are then put in priority. It facilitates their acquisition or construction
according to the sources available and avoids unnecessary and costly delays and serious cotoverruns. Generally,
priority is fixed in the following order.

 Current and incomplete projects are given first priority.
 Safety projects ad projects necessary to carry on the legislative requirements.
 Projects of maintaining the present efficiency of the firm.
 Projects for supplementing the income.
 Projects for the expansion of new product.

(5) Final Approval

Proposals finally recommended by the committee are sent to the top management along with the detailed report,
both o the capital expenditure and of sources of funds to meet them. The management affirms its final seal to
proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects
are then sent to the budget committee for incorporating them in the capital budget

(6) Evaluation

Last but not the least important step in the capital budgeting process is an evaluation of the programme after it
has been fully implemented. Budget proposals and the net investment in the projects are compared periodically
and on the basis of such evaluation, the budget figures may be reviewer and presented in a more realistic way.

Significance of capital budgeting

The key function of the financial management is the selection of the most profitable assortment of capital
investment and it is the most important area of decisionmaking of the financial manger because any action
taken by the manger in this area affects the working and the profitability of the firm for many years to come.
The need of capital budgeting can be emphasized taking into consideration the very nature of the capital
expenditure such as heavy investment in capital projects, longterm implications for the firm, irreversible
decisions and complicates of the decision making. Its importance can be illustrated well on the following other
grounds:

(1) Indirect Forecast of Sales

The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased.
It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget.
Any failure to make the sales forecast accurately would result in over investment or under investment in fixed
assets and any erroneous forecast of asset needs may lead the firm to serious economic results

(2) Comparative Study of Alternative Projects

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Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are
wearing out or are in danger of becoming obsolete so as to make the best possible investment in the
replacement of assets. For this purpose, the profitability of each project is estimated.

(3) Timing of AssetsAcquisition

Proper capital budgeting leads to proper timing of assetsacquisition and improvement in quality of assets
purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not
arise until sales impinge on productive capacity and such situation occurs only intermittently. On the other hand,
supply of capital goods with their availability is one of the functions of capital budgeting.

(4) Cash Forecast

Capital investment requires substantial funds which can only be arranged by making determined efforts to
ensure their availability at the right time. Thus it facilitates cash forecast.

(5) WorthMaximization of Shareholders

The impact of longterm capital investment decisions is far reaching. It protects the interests of the shareholders
and of the enterprise because it avoids overinvestment and underinvestment in fixed assets. By selecting the
most profitable projects, the management facilitates the wealth maximization of equity shareholders.

(6) Other Factors

The following other factors can also be considered for its significance:

 It assists in formulating a sound depreciation and assets replacement policy.
 It may be useful n considering methods of coast reduction.
 A reduction campaign may necessitate the consideration of purchasing most upto—date and modern
equipment.
 The feasibility of replacing manual work by machinery may be seen from the capital forecast be
comparing the manual cost an the capital cost.
 The capital cost of improving working conditions or safety can be obtained through capital expenditure
forecasting.
 It facilitates the management in making of the longterm plans an assists in the formulation of general
policy.
 It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation,
insure and there fixed assets.

Limitations of Capital Budgeting

The limitations of capital budgeting are as follows:

1. It has long term implementations which can't be used in short term and it is used as operations of the
business. A wrong decision in the early stages can affect the longterm survival of the company. The
operating cost gets increased when the investment of fixed assets is more than required.
2. Inadequate investment makes it difficult for the company to increase it budget and the capital.
3. Capital budgeting involves large number of funds so the decision has to be taken carefully.
4. Decisions in capital budgeting are not modifiable as it is hard to locate the market for capital goods.
5. The estimation can be in respect of cash outflow and the revenues/saving and costs attached which are
with projects.
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Funds Flow Analysis

Meaning:

Funds flow refers to change in fund. Increase of funds of any transaction is a source and decrease of funds in any
transaction is application or uses of funds. Fund being working capital, funds flow refers to the flow of working
capital between two points of time. It involves information relating to the various changes undergone in working
capital during a given period of time i.e. between the two balance sheet dates.

Every change in working capital is associated with a flow of funds i.e. either an inflow or an outflow of funds.
Thus, funds flow involves information relating to the inflows and outflows of funds that resulted in a change in
working capital between the two points of time.

Funds flow statement is a statement which shows the sources from which funds were obtained and the uses to
which they have been put during a particular period. It speaks about the changes in financial items of balance
sheets prepared at two different dates. Therefore, the funds flow analysis studies the movement of funds (inflows
and outflows of funds) during a given period, generally a year. Thus it exhibits the movements of funds in both
the directions – inside and outside the business. In other words, the term ‘flow’ in the context of funds flow
analysis indicates the transfer of cash or cash equivalent from asset to equity or from one equity to equity or
from one asset to another asset.

Significance of funds flow:

 It helps shareholders, creditors and others to evaluate the uses of funds by the enterprise.
 It assists in analysis of past t rends and thus aid future expansion decisions.
 It helps finance managers in identification of problems, enabling detailed analysis and immediate action.

Uses of Funds Flow Statement:

 It guides the management in deciding about the dividend and retention policies.
 It enables planning for longterm purposes.
 It facilitates proper allocation of resources and funds.
 It indicates the sources from which the company has obtained its funds.
 It helps in ascertaining the factors resulting in changes in the working capital position of an enterprise.

Advantages of Funds Flow Statement:
Funds flow statement is prepared to show changes in the assets, liabilities and equity between two balance sheet
dates, it is also called statement of sources and uses of funds. The advantages of preparing funds flow statement
are:
 Funds flow statement reveals the net result of operations done by the company during the year.
 In addition to the balance sheet, it serves as an additional reference for many interested parties like

creditors, suppliers, government etc. to look into financial position of the company.
 It shows how the funds were raised from various sources and also how those funds were put to use in
the business, therefore it is a great tool for management when it wants to know about where and from
funds were raised and also how those funds got utilized into the business.
 It reveals the causes for the changes in liabilities and assets between the two balance sheet dates
therefore providing a detailed analysis of the balance sheet of the company.
 Funds flow statement helps the management in deciding its future course of plans and also it acts as a
control tool for the management.
Funds flow statement should not be looked alone rather it should be used along with balance sheet in order
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judge the financial position of the company in a better way.
Limitations of Funds Flow Statement:
Though funds flow statement has many advantages, it has also some disadvantages or limitations. The major
limitations of funds flow statement are:
 Funds flow statement has to be used along with balance sheet and profit and loss account, it cannot be
used alone.
 It does not reveal the cash position of the company, and that is why company has to prepare cash flow
statement in addition to funds flow statement.
 Funds flow statement merely rearranges the data which is there in the books of account and therefore it
lacks originality. In simple words it presents the data in the financial statements in systematic way and
therefore many companies tend to avoid preparing funds flow statements.
 Funds flow statement is basically historic in nature, that is it indicates what happened in the past and it
does not communicate anything about the future, only estimates can be made based on the past data
and therefore it cannot be used the management for taking decision related to future.

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Cash Flow Analysis

Meaning:






Purpose/Objectives of Cash Flow Statement:

The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the
income statement summarizes a firm's financial transactions over an interval of time. These two financial
statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated
with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash
equivalents; it excludes transactions that do not directly affect cash receipts and payments. These noncash
transactions include depreciation or writeoffs on bad debts or credit losses to name a few. The cash flow
statement is a cash basis report on three types of financial activities: operating activities, investing activities, and
financing activities. Noncash activities are usually reported in footnotes.
The different objectives of cash flow statement are:
1. to provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
2. to provide additional information for evaluating changes in assets, liabilities and equity
3. to improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
4. to indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations,
which might be derived from different accounting methods, such as various timeframes for depreciating fixed
assets.
Cash flow activities:
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The cash flow statement is partitioned into three segments. They are:
1. Cash flow resulting from operating activities
2. Cash flow resulting from investing activities
3. Cash flow resulting from financing activities.
The money coming into the business is called cash inflow, and money going out from the business is called cash
outflow.
i. Operating activities
Operating activities include the production, sales and delivery of the company's product as well as collecting
payment from its customers. This could include purchasing raw materials, building inventory, advertising, and
shipping the product.
Measuring the cash inflows and outflows caused by core business operations, the operations component of cash
flow reflects how much cash is generated from a company's products or services. Generally, changes made in
cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in
revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting
from transactions that occur from one period to the next. These adjustments are made because noncash items
are calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because
not all transactions involve actual cash items, many items have to be reevaluated when calculating cash flow
from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of
an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash
flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be
reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company
from customers paying off their credit accounts the amount by which AR has decreased is then added to net
sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must
be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to purchase more
raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net
sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in
accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other
would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid
off, then the difference in the value owed from one year to the next has to be subtracted from net income. If
there is an amount that is still owed, then any differences will have to be added to net earnings.
Operating cash flows include:
 Receipts from the sale of goods or services
 Receipts for the sale of loans, debt or equity instruments in a trading portfolio
 Interest received on loans
 Dividends received on equity securities
 Payments to suppliers for goods and services
 Payments to employees or on behalf of employees
 Interest payments (alternatively, this can be reported under financing activities)
 buying Merchandise
Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the
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Income Statement) to arrive at cash flows from operations generally include:
 Depreciation (loss of tangible asset value over time)
 Deferred tax
 Amortization (loss of intangible asset value over time)
 Any gains or losses associated with the sale of a noncurrent asset, because associated cash flows do
not belong in the operating section.(unrealized gains/losses are also added back from the income
statement)
ii. Investing activities
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing
are a "cash out" item, because cash is used to buy new equipment, buildings or shortterm assets such as
marketable securities. However, when a company divests of an asset, the transaction is considered "cash in" for
calculating cash from investing. Investing activities include:
 Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
 Loans made to suppliers or received from customers
 Payments related to mergers and acquisitions
iii. Financing activities
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the
outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the
longterm liabilities and equity of the company are also listed in the financing activities section of the cash flow
statement.
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are
"cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a
bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the
company is reducing its cash.
Financing activities include:
 Proceeds from issuing shortterm or longterm debt
 Payments of dividends
 Payments for repurchase of company shares
 Repayment of debt principal, including capital leases
 For nonprofit organizations, receipts of donorrestricted cash that is limited to longterm purposes
Items under the financing activities section include:
 Dividends paid
 Sale or repurchase of the company's stock
 Net borrowings
 Payment of dividend tax
Uses/Significance/Advantages of Cash Flow Statement:
 It is especially useful in preparing cash budgets.
 It helps the newly formed companies to know their inflow and outflow of cash.
 It helps the investors to judge whether the company is financially sound or not.
 It helps the company to know whether it will be able to cover the payroll and other expenses.
 It helps the lenders to know the company’s ability to repay.
 A cash flow statement is provided on monthly basis or quarterly basis or six monthly basis or yearly
basis.
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 These statements help to have an accurate analysis of the firm’s ability to meet its current liabilities.
 A cash flow statement is helpful for planning and managing future financial commitments.
 A cash flow statement summarizes the company’s cash receipts and cash payments over a period of
time.
 It is useful for determining the short term ability of the concern to meet its liabilities i.e. helps the
management in taking shortterm financial decisions.
 A cash flow statement gives vital information not only about the company’s performance but also about
its major activities during the year.
 Cash Flow statement is also a control device for the management.
 Since it gives a clear picture of cash inflow from operations (and not income flow of operation), it is,
therefore, very useful to internal financial management such as in considering the possibility of retiring
longterm debts, in planning replacement of plant facilities or in formulating dividend policies.
 It enables the management to account for situation when business has earned huge profits yet run
without money or when it has suffered a loss and still has plenty of money at the bank.
Disadvantages/Limitations of Cash Flow Statement:
 By itself, it cannot provide a complete analysis of the financial position of the firm.
 It can be interpreted only when it is in confirmation with other financial statements and other analytical
tools like ratio analysis.
 It may not give accurate details about the money coming into and going out of the business. Costs may
change and this could cause the business to loose money.
 Since it shows only cash position, it is not possible to arrive at actual profit and loss of the company by
just looking at this statement alone.
 In isolation this is of no use and it requires other financial statements like balance sheet, profit and loss
etc…, and therefore limiting its use
 It is difficult to precisely define the term ‘cash’.
 Working capital is a wider concept of funds. Therefore a funds flow statement gives a clearer picture than
a cash flow statement.

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Working Capital Management

Meaning of Working Capital

Working capital is that part of the total capital of an enterprise which is required to be invested in
the short term or current assets. This capital is needed in an enterprise to meet its day to day
expenses.

Working capital shows the strength of a business in a short period of time. If a company has some
amount of working capital, it means that the company has certain amount of liquid assets out of
which it can meet its day to day expenses.

Working capital is also known as short term capital or operating capital or circulating capital.

Concept of Working Capital
There are two concepts of working capital working capital. They are as follows:

1. Gross Working Capital
2. Net Working Capital

1. Gross Working Capital

Gross working capital is the total current assets of an enterprise. In this concept, we do not deduct
current liabilities from current assets, but we use current liabilities as a source of fund. When we
buy goods on credit, it means we save our cash to the extent of the value of goods purchased on
credit and we can use this as working capital for paying other expenses. The mathematical formula
for calculating the gross working capital is as follows:

Gross Working Capital = Total Current Assets

Current assets are those assets which can be converted into cash within one accounting year. For
example, cash, bank, debtors, bill receivables, closing stock, prepaid expenses, accrued incomes,
marketable securities etc.
2. Net Working Capital

Net working capital is difference between the total current assets and total current liabilities of an
enterprise. The excess of current assets over current liabilities is also called net current assets. In
this concept, a business enterprise has to maintain the minimum level of working capital for smooth
operation of the business activities. This concept of working capital is used for the preparation of
balance sheet. In the vertical form of balance sheet, we show excess of current assets over current
liabilities. The mathematical formula for calculating the net working capital is as follows:
Net Working Capital = Current Assets Current Liabilities
Current Liabilities are those liabilities which can be paid within one accounting year. For example,
creditors, outstanding expenses, bank overdraft, bills payable, short term loans, income tax
payable, incomes received in advance, dividend payable etc.

Importance of / Need for Working Capital
A business enterprise needs working capital for various reasons. When creditors demand their
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money from a company, its high working capital saves the company from this situation. Selling of

current assets is easy in small period of time but a company can not sell their fixed assets within
small period of time. So, if a company has sufficient working capital, it can easily pay off its
creditors and create his reputation in market. But if a company has zero working capital, then it can
not pay its creditors in time. In this situation, the company may either become bankrupt or take a
loan at higher rate of interest. In both the conditions, it is very dangerous. Therefore, the
company’s finance manager tries to keep some amount of working capital for creating goodwill in
market.
Positive working capital enables the company to pay its day to day expenses like payment of
wages, salaries, raw materials or goods and other operating expenses. Adequate working capital
not only enables the company to pay its matured liabilities but also to pay its outstanding liabilities
without any delay.

Determinants of Working Capital Requirements/Factors Influencing Working
Capital Requirements

The following are the various factors that determine the working capital requirements of a
company:

1. Size of Business
The amount of working capital required in a business firm is largely affected by its size or scale
of business operations. The business of a form may be small or large. In small business, the
company needs smaller amount of working capital, but in large business, it requires larger
amount of working capital.

2. Nature of Business
The amount of working capital required in a business firm is largely affected by the nature of its
business. Manufacturing concerns require larger amount of working capital, whereas trading
concerns require smaller amount of working capital.
3. Nature of Demand
Nature of demand also absolutely affects the working capital need. Some product can be easily
sold by businessman, in that business; you need small amount of working capital because your
earned money from sale can easy fulfill the shortage of working capital. But, if demand is very
less, it is required that you have to invest large amount of working capital because your all
fixed expenses must be paid by you.

4. Production Policy
Production policy is also main determinant of working capital requirement. Different company
may different production policy. Some companies stop or decrease the production level in off
seasons, in that time, company may also reduce the number of employees or decrease the
purchasing of new raw material, so, it will certainly decrease the amount of working capital but
on the side, some company may continue their productions in off season, in that case, they need
definitely large amount of working capital.

5. Credit Policy
Credit policy is relating to purchasing and selling of goods on credit basis. If company
purchases all goods on credit and sells on cash basis or advance basis, then it is certainly
company need very low amount of working capital. But if in company, goods are purchased on
cash basis, and sold on credit basis, it means, our earned money will receive after sometime
and we require large amount of working capital for continuing our business.
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6. Dividend Policy
Dividend policy also effect working capital requirement. Company can distribute major part of
net profit. But, if there is no reserve, we have to invest large amount in working capital
because, lacking of reserve will affect on adversely on fulfill our liabilities. In that case, we
have to yield working capital by taking short term loan for paying uncertain liability.
7. Working Capital Cycle
Working capital cycle shows all steps which starts from cash purchasing of raw material and
then this converted into finished product, after this it is converted into sale, if it is credit sale,
debtors will also the part of working capital cycle and when we gets money from our debtors, it
is the final part of working capital cycle. If we receive fastly from our debtors, we need small
amount working capital. Otherwise, for purchasing new raw material, we need more amount of
working capital.
8. Manufacturing Cycle
Manufacturing cycle means the process of converting raw material into finished product. Long
manufacturing cycle will create the situation in which we require large amount of working
capital. Suppose, we have to construct the building, for constructing colony of buildings, it
may consume the time more than 5 years, so according to this we need working capital.
9. Business Cycle
There are two main part of business cycle, one is boom and other is recession. In boom, we
need high money or working capital for development of business but in recession, we need only
low amount of working capital.
10. Price Level Changes
If there is increasing trend of products prices, we need to store high amount of working capital,
because next time, it is precisely that we have to pay more for purchasing raw material or other
service expenses. Inflation and deflation are two major factors which decide the next level of
working capital in business.
11. Effect of External Business Environmental Factors
There are many external business environmental factors which affect the need of working
capital like fiscal policy, monetary policy and bank policies and facilities.

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OverTrading and UnderTrading
Overtrading and undertrading are the facets of overPcapitalization and undercapitalization.
Overtrading
Over trading means a situation where a company does more business than what its finances allow. The result of
overtrading is disastrous as it gives rise to increase in size, diminishing margin of safety and feeling a sense of
stress and strain. Thus it is advisable for every company to carry on its business in terms of the financial
resources that it has and not to do more business or trading than its finances permit. Overtrading is an aspect
of undercapitalization.

A company which is undercapitalized will try to do too much with the limited amount of capital which it has. For
example it may not maintain proper stock of stock. Also it may not extend much credit to customers and may
insist only on cash basis sales. It may also not pay the creditors on time. One can detect cases of overtrading by
computing the current ratio and the various turnover ratios. The current ratio is likely to be very low and turn
over ratios are likely to be very higher than normally in the industry concerned.
Overtrading can be defined as “Transacting more business than the firm's working capital can normally sustain,
thus placing serious strain on its cash flow and risking collapse or insolvency.”
Overtrading is a term in financial statement analysis. Overtrading often occurs when companies expand its own
operations too quickly (aggressively). Overtraded companies enter a negative cycle, where increase in interest
expenses negatively impact net profit leads to lesser working capital leads to increase borrowings leads to more
interest expense and the cycles continues. Overtraded companies eventually face liquidity problems and/or
running out of working capital.
Conditions/Symptoms of Overtrading:
 Rapid growth in business development and sales.
 Lesser net profit.
 The business running a business with limited knowledge.
 Cash flow problem or short of working capital.
 Bad cash budget or unrealistic.
 Having large amount of unpaid vendors.
 High amount of financial interest expenditure.
 High gearing ratio.
 Keen market competition.
 Overstock or slow movement of inventory
Under Trading

Undertrading is the reverse of overtrading where the funds of a company are not utilized fully because of
insufficient management. This is due to the under employment of assets of the business, leading to the fall
of sales and results in financial crises. This makes the business unable to meet its commitments and ultimately
leads to forced liquidation. The symptoms in this case would be a very high current ratio and very low turnover
ratio. Undertrading is an aspect of overcapitalization and leads to low profits, low rate of return on investment,
decline in the share prices in the market, loss of goodwill etc.

Capitalization
Capitalization comprises of share capital, debentures, loans, free reserves, etc. Capitalization
represents permanent investment in companies excluding longterm loans. Capitalization can be
distinguished from capital structure. Capital structure is a broader term and it deals with qualitative
aspect of finance, while capitalization is a narrower term and it deals with the quantitative aspect.
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Capitalization is generally of the following two types:
Over Capitalization
Under Capitalization
Overcapitalization
Meaning of Overcapitalization:
Overcapitalization is a situation in which actual profits of a company are not sufficient enough to
pay dividends at a proper rate on shares over a period of time. This situation arises when the
company raises more capital than what is actually required. In such a situation, a part of the total
capital of the company always remains idle and it results in lower earnings.
Causes of Overcapitalization:
The main causes of overcapitalization are:
1. High promotion cost When a company goes for high promotional expenditure, i.e., making
contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual
returns are not adequate in proportion to high expenses, the company is overcapitalized in
such cases.
2. Purchase of assets at higher prices When a company purchases assets at an inflated rate, the
result is that the book value of assets is more than the actual returns. This situation gives rise
to overcapitalization of company.
3. A company’s floatation n boom period At times company has to secure it’s solvency and
thereby float in boom periods. That is the time when rate of returns are less as compared to
capital employed. This results in actual earnings lowering down and earnings per share
declining.
4. Inadequate provision for depreciation If the finance manager is unable to provide an
adequate rate of depreciation, the result is that inadequate funds are available when the
assets have to be replaced or when they become obsolete. New assets have to be purchased
at high prices which prove to be expensive.
5. Liberal dividend policy When the directors of a company liberally divide the dividends into
the shareholders, the result is inadequate retained profits which are very essential for high
earnings of the company. The result is deficiency in company. To fill up the deficiency, fresh
capital is raised which proves to be a costlier affair and leaves the company to be over
capitalized.
6. Overestimation of earnings When the promoters of the company overestimate the earnings
due to inadequate financial planning, the result is that company goes for borrowings which
cannot be easily met and capital is not profitably invested. This results in consequent
decrease in earnings per share.
Effects of Overcapitalization
On Shareholders
Over capitalization has the following effect on shareholders:
a. Since the profitability decreases, the rate of earning of shareholders also decreases.
b. The market price of shares goes down because of low profitability.
c. The profitability going down has an effect on the shareholders. Their earnings become
uncertain.
d. With the decline in goodwill of the company, share prices decline. As a result shares
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cannot be marketed in capital market.
On Company
Over capitalization has the following effect on the company:
e. Because of low profitability, reputation of company is lowered.
f. The company’s shares cannot be easily marketed.
g. With the decline of earnings of company, goodwill of the company declines and the
result is fresh borrowings are difficult to be made because of loss of credibility.
h. In order to retain the company’s image, the company indulges in malpractices like
manipulation of accounts to show high earnings.
i. The company cuts down its expenditure on maintenance, replacement of assets,
adequate depreciation, etc.
On Public
Overcapitalization has the following adverse effects on the public:
j. In order to cover up their earning capacity, the management indulges in tactics like
increase in prices or decrease in quality.
k. Return on capital employed is low. This gives an impression to the public that their
financial resources are not utilized properly.
l. Low earnings of the company affects the credibility of the company as the company is
not able to pay it’s creditors on time.
m. It also has an effect on working conditions and payment of wages and salaries also
lessen.
Remedies for Overcapitalization:
Restructuring of the firm is to be executed to avoid the overcapitalization situation of the company.
It involves:

Reduction of debt burden/ Reduction of funded debts.
Negotiation with term lending institutions for reduction in interest obligation/ Reduction of
interest on debentures and loans.
Redemption of preference share through a scheme of capital reduction.
Reduction of the face value and paidup value of equity shares.
Reduction in the number of equity shares.
Ploughing back of profits.
Initiating merger with well managed profit making companies interested in talking over ailing
company.
Undercapitalization
An undercapitalized company is one which earns exceptionally high profits as compared to industry.
An undercapitalized company situation arises when the estimated earnings are very low as
compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, and
high earnings and thus the return on capital shows an increasing trend.
Causes of Undercapitalization
The main causes of undercapitalization are:
 Low promotion costs
 Purchase of assets at deflated rates
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 Conservative dividend policy
 Floatation of company in depression stage
 High efficiency of directors
 Adequate provision of depreciation
 Large secret reserves are maintained.
Effects of Under Capitalization
1. On Shareholders
a. Company’s profitability increases. As a result, rate of earnings go up.
b. Market value of share rises.
c. Financial reputation also increases.
d. Shareholders can expect a high dividend.
2. On company
a. With greater earnings, reputation becomes strong.
b. Higher rate of earnings attract competition in market.
c. Demand of workers may rise because of high profits.
d. The high profitability situation affects consumer interest as they think that the company
is overcharging on products.
3. On Society
a. With high earnings, high profitability, high market price of shares, there can be
unhealthy speculation in stock market.
b. ‘Restlessness in general public is developed as they link high profits with high prices of
product.
c. Secret reserves are maintained by the company which can result in paying lower taxes
to government.
The general public inculcates high expectations of these companies as these companies can import
innovations, high technology and thereby best quality of product.

Remedies for Undercapitalization:
The possible corrections for undercapitalisation may be outlined as under:
Splitting up of the shares: The effect of this measure will be more apparent than real
because the overall rate of earnings in this case will remain the same though the dividend per
share will now be a smaller amount. Thus, split up of the company’s shares will reduce the
dividend per share.
Issue of bonus shares: This will reduce both the dividend per share and earning per share
of the company. The most widely used and effective remedy for under capitalisation is the
conversion of reserves and accumulated profits into shares. This will affect both dividend per
share and the overall rate of earnings.
 Increase in par value of shares: The values of assets, under this scheme, may be
revised upwards and the existing shareholders may be given new shares carrying higher par
(face) value. In this way, the rate of earnings will decline though the amount of dividend per
share may not be affected. As a further step, the com pay may offer the shareholders a
share splitup and an increase in parvalue.

In short, the remedies of undercapitalisation are:
Splitting up of shares.
Increasing the number of shares.
Increase in the par value of shares.
Issue of Bonus shares.
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Fresh issue of shares.
Both overcapitalization and undercapitalization are detrimental to the interests of the society.

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Financial Planning

Meaning of Financial Planning:

Financial planning means deciding in advance the course of action to be undertaken in
future with respect to the financial management of a business enterprise. This function is
mainly concerned with the economical procurement and profitable use of funds. It involves
the determination of objectives, policies and procedures relating to the finance function.

A financial plan is a statement estimating the amount of capital and determining its
composition.

Objectives of Financial Planning:

 To ensure the availability of sufficient funds.
 To make a perfect balance of costs and risks.
 To ensure flexibility so as to adjust as per the requirements.
 To provide sufficient liquidity throughout the year.
 To ensure the optimum use of funds.
 To minimize the cost of capital.
 To improve the profitability of the enterprise.
 To make adequate provision for funds for meeting the contingencies likely to arise in
future.
 To ensure growth and expansion of the business.
 To maximize the value of the firm.

Need/Importance of Financial Planning:

 It ensures the availability of sufficient funds.
 It makes a perfect balance of costs and risks.
 It ensures flexibility so as to adjust as per the requirements.
 It provides sufficient liquidity throughout the year.
 It ensures the optimum use of funds.
 It keeps the cost of capital minimum.
 It improves the profitability of the enterprise.
 It makes adequate provision for funds for meeting the contingencies likely to arise in
future.
 It ensures growth and expansion of the business.
 It maximizes the value of the firm.

Steps Involved in Financial Planning:

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1. Estimating the total capital requirements (longterm as well as shortterm) of the
enterprise.
2. Determining the forms and the proportion of various securities to be issued to
raise the necessary capital.
3. Setting financial objectives.
4. Formulating financial policies.
5. Laying down the financial procedures.
6. Making financial forecasting.

Characteristics/Essentials/Requisites of a good financial plan:
OR
Principles Governing a Sound Financial Plan:

 The financial plan should be so simple that it may easily be understood by everyone.
 It should have longterm view.
 It should be a flexible one so that it can be adjusted as per the requirements.
 It must be visualized with much foresight.
 It must ensure the optimum use of funds.
 It should make adequate provision for funds for meeting the contingencies likely to
arise in future.
 It should provide sufficient liquidity throughout the year.
 It should keep the cost of capital minimum.
 It should keep in mind the temperament of the investors.

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Capital Structure

Meaning of Capital Structure:
Capital structure of a company is the composition of its longterm finance. It is the mix or
proportion of a firm's debt and equity. It is related to the longterm financial requirements of the
business enterprise. It is determined by the longterm debts and equity capital used by the business
enterprise. As a matter of fact, the capital structure of a business enterprise should be ideal i.e.
according to the requirements of the business enterprise.
Determinants of Capital Structure/Factors Influencing Capital structure:
The capital structure of a company depends upon a large number of factors. The factors influencing
the capital structure of a company are as follows:
1. Financial Leverage or Trading on Equity: The use of long term fixed interest bearing debts
and preference share capital along with equity share capital is called financial leverage or
trading on equity. Effects of leverage on the shareholders return or earnings per share have
already been discussed in this chapter. The use of long term debt increases, magnifies the
earnings per share if the firm yields a return higher than the cost of debt. The earnings per
share also increase with the use of preference share capital but to the act fact that interest
is allowed to be deducted while computing tax, the leverage impact of debt is much more.

2. Growth and Stability of Sales: The capital structure of a firm is highly influenced by the
growth and stability of its sales. If the sales of a firm are expected to remain fairly stable, it
can raise a higher level of debt. Stability of sales ensures that the firm will not face any
difficulty in meeting its fixed commitments of interest payment and repayments of debt.
Similarly, the rate f growth in sales also affects the capital structure decision.

3. Cost of Capital: Every rupee invested in a firm has a cost. Cost of capital refers to the
minimum return expected by its suppliers. The capital structure should provide for the
minimum cost f capital. The main sources of finance for a firm are equity, preference share
capital and debt capital. The return expected by the supplier of capital depends upon the risk
they have to undertake. Usually, debt is a cheaper source of finance compared to preference
and equity capital due to (i) fixed rate of interest on debt. (ii) legal obligation to pay
interest.

4. Cash Flow: A firm which shall be able to generate larger and stable cash inflows can employ
more debt in its capital structure as compared to the one which has unstable and lesser
ability to generate cash inflow. Debt financial implies burden of fixed charge due to the fixed
payment of interest and the principal. Whenever a firm wants to raise additional funds, it
should estimate, project its future cash inflows to ensure the coverage of fixed charges.
5. Retaining Control: Whenever additional funds are required by a firm, the management of the
firm wants to raise the funds without any loss of control over the firm. In case the funds are
raised though the issue of equity shares, the control of the existing shareholder is diluted.
Hence they might raise the additional funds by way of fixed interest bearing debts and
preference share capital in order to retain control over the company. Preference
shareholders and debenture holders do not have the voting right. Hence, from the point of
view of control, debt financing is recommended.

6. Flexibility: Capital structure of a firm should be flexible, i.e. it should be such as to be
capable of being adjusted according to the needs of the changing conditions. It should be
possible to raise additional funds as and when to be required without much difficulty and
delay.

7. Size of the Business Enterprise: The capital structure of a business enterprise is also
influenced by the size of business enterprise. It may be small, medium or large. A large
sized business enterprise requires much more capital as compared to a smallsized business1/2
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sized business enterprise requires much more capital as compared to a smallsized business
enterprise.
8. Nature of the Business Organisation: The capital structure of a business enterprise is also
influenced by nature of business organisation. It may be manufacturing, financing, trading or
public utility type.

9. Period of Finance: The Period of finance, i.e., short, medium or long term is also another
factor which determines the capital structure of a business enterprise. For example, short
term finances are raised through borrowings as compared to longterm finance which is
raised through issue of shares.

10. Purpose of Financing: The purpose of financing should also be kept in mind in determining
the capital structure of a business enterprise. The funds may be required either for
betterment expenditure or for some productive purposes. The betterment expenditure, being
nonproductive, may be incurred out of funds raised by issue of shares or from retained
profits. On the contrary, funds for productive purposes may be raised through borrowings.

11. Requirements of the Potential Investors: The capital structure of a business enterprise is
also affected by the requirement of the potential investors. Different classes of investors go
for different types of securities. It is necessary to meet the requirements of both
institutional as well as private investor. Investors who are interested in the stability and
safety and regularity of income prefer debentures and preference shares. On the contrary,
investors who want to take more risk so as to have higher income and to take part in the
day to day management of the company prefer equity shares.

12. Legal Considerations: At the time of determining the capital structure of a company, the
financial manager should also take into account the legal and regulatory framework. For
example, in case of the redemption period of debenture is more than 18 months, then credit
rating is required as per SEBI guidelines. Moreover, approval from SEBI is required for
raising funds from capital market. But no such approval is required if the firm avails loans
from financial institutions. Similarly, in India, banking companies are not allowed by the
Banking Companies Act to issue any type of securities except shares.

13. Capital Market Conditions: Capital market conditions also influence the capital structure of a
business enterprise. Capital Market Conditions do not remain the same for ever. Sometimes
there may be depression while at other times there may be boom in the market. In case of
boom period, it is advisable to issue shares which can fetch higher premium due to large
profits. On the contrary, during the depression period, it is advisable to issue debentures or
raise longterm debts as investors would prefer safety.

14. Inflation: Another factor to consider in the financing decision is inflation. By using debt
financing during periods of high inflation, we will repay the debt with dollars that are worth
less. As expectations of inflation increase, the rate of borrowing will increase since creditors
must be compensated for a loss in value. Since inflation is a major driving force behind
interest rates, the financing decision should be cognizant of inflationary trends.

15. Risk: There are two types of risk that are to be considered while planning the capital
structure of a firm viz (i) business risk and (ii) financial risk. Business risk refers to the
variability to earnings before interest and taxes. Business risk can be internal as well as
external. Internal risk is caused due to improper products mix non availability of raw
materials, incompetence to face competition, absence of strategic management etc. internal
risk is associated with efficiency with which a firm conducts it operations within the broader
environment thrust upon it. External business risk arises due to change in operating
conditions caused by conditions thrust upon the firm which are beyond its control e.g.
business cycle.

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