Study of Financial Statements

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    MODULE B

    STUDY OF FINANCIAL STATEMENTS

    C.S.BALAKRISHNAN

    FACULTY MEMBER

    SPBT COLLEGE

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    Scope,Functions and objective

    Scope isDesigning and implementing certain plans.

    Ensuring effective funds utilisation by directing

    funds flow according to some plan.Serving as a necessary tool and technique for

    resources allocation to various projects of the

    business and providing the best guide for existing

    and prospective resource allocation.

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    According to Howard and Upton Financial

    management involves the application of

    general management principles to particular

    financial operation.

    Attending to investment decisions as to when

    and how to acquire and allocate funds forshort-term and long-term assets keeping in

    view the profit generation of the business

    through which repayment obligation can bemet.

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    Objectives and basic consideration of

    Financialmanagement.

    Although profit maximisation is the objective

    of financial management,the long-term goalof

    the business entity is to achieve maximising

    the shareholder value of the firm,since theprinciple of maximisation of shareholder

    wealth provides a rational guide for running a

    business and for efficient allocation ofresources in society.

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    The key objective of Financial Management is to

    maximise the value of the company.This is the result

    of good investment decisions,prudent financingdecisions and well thought-out financial planning

    and control.

    Maximisation of the value of the company is also

    known as maximisation of the wealth of the

    owners.To achieve this,finance manager has to take

    careful decisions in respect of

    -Financing -Dividend-Investment -Current asset management.

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    Financing decision-Has to decide on sources offunds for business.It is to be decided whether

    entire capital should be raised from equity capitalor a part is to be raised from loan.HenceDebt/Equity ratio or Leverage are important sinceeach source has in them associated risk factorsinvolved.

    Investment decision-It relates to acquisition ofassets.Assets are classified into real assets suchas land,building,plant,equipment etc.and thefinancial assets are shares and debentures etc.It

    indicates available mix of financing to fundcompanys activities.Such decisions oninvestment in projects come within the field ofcapital budgeting which is derived from netpresent value of assets.

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    Dividend decision-It is basically a financingdecision.This is because profit is a source of

    fund.By not paying dividend,the retainedearningsor reservecan be increased whichcould be otherwise available for investment.

    This ultimately lead to maximisation of wealth

    of the organisation provided decisions on

    investments are correct.

    Current Asset Management-This is necessary tomaintain balance between current assets andcurrent liability,if the liquidity of the business isinterrupted because of holding too much fund incurrent assets.

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    Wealth maximisation &value maximisation

    The goal of financial management is to maximisethe value of companies.This is generallyexpressed in terms of maximising the value of theownership shares of the company,in

    short,maximising share price.Thus,betterperforming companies can raise additional fundsunder more favourable terms.When funds go thesuch companies the economys resources are

    directed to more efficient use.This basic objectiveof maximisingthe price of the companys shares iscalled value maximisation.

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    Social responsibility is also an important goal of

    a company which requires

    -Maximising share-price by efficient,well-managed operations related to consumer

    demand parameters.

    -Efficiency & innovation leads to value

    maximisation which leads to newproducts,new technologies and better

    employment.

    -External factors like pollution,product safety and

    job safety have acieved added dimensions inrelation to value maximisation.

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    Profit maximisation vs.Wealth

    maximisation

    Long run vs.Short run Profits.

    Convert total corporate profits to earning pershare(EPS).

    EPS is total profits divided by number of sharesoutstanding.

    Assume the firm earns Rs.10 mn.and has1mn.shares outstanding.The EPS will work out to

    Rs.10. Profit maximisation is a short-term concept,while

    wealth maximisation emphasises the long-termview point.

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    State whether true or false

    The income statement depicts the financial

    position of the firm at a given point of time

    The balance sheet gives the financial

    performance of the firm over a given period oftime.

    These statements are prepared every week.

    Funds Flow statement gives the liquidityposition of the firm.

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    Cash Flow statement tells from where the

    money comes and where it is used.

    The prime objective of financial management

    is wealth maximisation,and not profit

    maximisation.

    What is earnings per share?

    a)Net Profit

    b)Profit before interest and tax

    c)Total earnings divided by investment

    d)Net profit divided by equity

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    What is the difference between long term

    funds and short term funds?

    -Difference in interest rates

    -Difference in time of repayment

    -Difference in the size of loan-No difference

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    CAPITAL EXPENDITURE DECISIONS AND

    PROFITABILITY STUDY

    It represents the important decisions taken by

    the firm.Importance due to the following issues

    -Long-term effects

    -Irreversibility-Substantial outlays

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    Difficulties

    -Measurement problems

    -Uncertainty

    -Temporal spread

    o

    Phases of capital budgeting-Capital budgeting is a complex process which

    may be divided into five broad phases.

    Planning ImplementationAnalysis Review.

    Selection

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    Levels of Decision Making

    -Operating decisions

    -Administrative decisions-Strategic decisions

    o Profitability Study important facets are

    -Market analysis-Technical analysis

    -Financial analysis

    -Economic analysis-Ecological analysis

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    The basic characteristic of a capital project is thatit typically involves a current outlay(or current

    and future outlays)of funds in expectation of astream of benefits extending far into future.

    Accounting rate of return method-A selectioncriterion using average net income and

    investment outlay to compute a rate of return fora project.This method ignores the time value ofmoney & cash flows.

    Internal rate of return method-A selection

    method using the compounding rate of return onthe cash flow of the project.

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    Net Present Value method-A selection method

    using the difference between the present

    value of the cash inflows of the project andthe investment outlay.The method evaluates

    the differential cash flow between proposals.

    Payback method-A selection method in whicha firm sets a maximum payback period during

    which cash inflow must be sufficient to

    recover the initial outlay.This method ignores

    the time value of money and cash flow

    beyond the pay back period.

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    What are the three important factors which arise

    from capital expenditure decisions?

    a)Long-term effects e)Debtb)Profitability f)Substantial outlays

    c)Irreversibility g)Short-term effects.

    d)Risk

    Why are capital expenditure decisions difficult?

    i)Uncertainity in predicting costs&benefits

    ii)Difficulty in measurement of costs&benefits

    iii)Risk involved

    iv)Problems in estimating discount rates

    v)All the above

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    If the IRR of the project is 7% and the cost of

    capital is (11.4% should we reject or accept

    the project). Yes/No.

    The firm should always make an ecological

    analysis to know the likely damage that may

    be caused by the project to the environment.

    a)Must do b)No need.

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    Sources of finance and

    cost of capital

    For what purposes a firm needs a finance?

    Since the cash receipts lag behind cash

    payments necessitating loans,bonds,overdrafts

    etc.the firm needs finance for short term and long

    term requirements-fixed assets and working

    capital.

    Permanent sources of finance

    Share capital and retained profits.

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    Depreciation is not a real expenditure.It is a

    non-cash expenditure(T/F)

    Depreciation amount increases the liquidity of

    the firm(T/F)

    Cost of goods sold and Cost of production refer

    to the same amount(T/F)

    Net profit is calculated before tax(T/F)

    Balance sheet and Income statement can be

    prepared every quarter for internal use(T/F)

    A loss is shown as asset in the balance

    sheet(T/F).

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    Provisions for taxes and accrued expenses to

    be paid within a year are current assets(T/F)

    Debtors(also known as accounts

    receivable)represent the amount of money to

    be paid by the firm to the suppliers(T/F)

    Fund Flow statements can be prepared

    without the basis of balance sheets(T/F).

    Fund flow statements represent only bank

    borrowing and trade credit(T/F)

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    State whether following are sources or uses

    -Buying materials

    -Payment of dividend to shareholders

    -Advance received from buyer of goods

    -Investment in machinery

    -Issue of debentures

    -Retained earnings

    -Increase in Inventories-Sale of old machinery

    -Depreciation amount

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    Study of financial statements

    Who are the party interested in firms financial

    condition?

    Shareholders,creditors/suppliers,managers,taxauthorities.

    Different types of concerns of stakeholders

    Profitability and earning capacity,liquidity andrepaying loan instalments and interest.

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    Long term sources

    Preferenceshares,bonds,debentures and long

    term loans from financial institutions.

    Various sources of short term finance-

    Cash credit,overdraft,billsdiscounting,commercial

    papers and trade credit.

    Short term & long term cash forecasts-

    Time periods involved-Yearly for long termforecasts,monthly for short term forecasts.

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    Factors considered in equity financing

    Issue costs,servicing costs such as paying out

    dividends, and when there is retained earnings

    there will be capital appreciation of sharevalues.

    Preference Shares-These shareholders get a

    fixed return and their risk is less than the equity

    Shareholders.They have a right to the first slice

    of dividend.Obligation to redeem the preference

    shares after its time period.They do not have a

    right to vote.

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    Debentures or loan financing-the firm will have

    to pay fixed interest very year.There is an

    obligation to redeem it at the end of theperiod.There is also an advantage of tax

    deductibility of interest paid which makes it

    cheaper.Bills rediscounting The buyer can repay in a

    long period of time,while seller gets his money

    back by discounting the bills.For the seller,this

    helps him to go ahead with production and

    increase the turnover.

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    Working capital term loan-A part of working

    capital has to be with the manufacturer,since

    there is a time lag between ordering and

    procuring.This particular portion (say25%)can

    be financed by long term funds.When firm is

    not able to infuse its own funds for thispurpose,it gets a long term loan from the

    bank.This carries fixed interest and for a fixed

    period.

    Overdraft and bank loan-Overdraft is a running

    account whereas bank loan instalment are

    fixed.

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    Trade credit-When materials are bought from

    suppliers,the trade credit is extended for few

    days or a couple of months.The supplier iswilling to wait to collect money.This also

    depends on the suppliersfinancial position

    and the buyers credit worthiness.Commercial paper-These are short term

    promissory notes with fixed maturity

    period.They are issued by very large

    companies who are reputed and have high

    credit worthiness.Credit rating agencies certify

    their credit rating.

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    Firmscost of capital-A firms is the average cost of

    capital is the weighted average arithmetic mean

    of the cost of resources from various sources.Questions:

    a)Long term sources are banks and financial

    institutions (T/F)b)Current liabilities should be repaid within a

    financial year(T/F)

    c)Fixed assets are generally financed withcurrent liabilities(T/F)

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    Equity Shareholders bear the greatest risk(T/F)

    Bills discounting scheme has been introduced to ease

    flow of funds in the economy(T/F)

    Trade creditors are suppliers of goods and services to

    whom the firm is yet to pay.(T/F)

    Accounts Receivables should be less than trade

    creditors(T/F).

    Bills of Exchange is same as cash credit(T/F).

    Equity and Preference shares are one and the

    same(T/F)A part of working capital can be financed by long

    term sources(T/F)

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    A firm borrows Rs.20,000 from bank @8% and

    floats a debenture for Rs.60,000 @6%,for a

    special project,what is the cost of capital of theproject?

    a)5.5% b)6.5% c)7.5% d)8.5%

    If a firm borrows Rs.2 lac @10% and has a taxrate of 40%.What is the cost of capital?

    a)5% b)6% c)7% d)8%

    A company has issued preference share of Rs.100

    face value carrying 14% dividend repayable at

    par after 12 years.Cost of capital after tax of

    40%?a)21.22% b)23.33%c)24.23%

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    Data for analyzing the situations of the firm

    Balance Sheet,Income Statement,fund flow

    statement.

    Basic concepts while preparing balance sheet

    -Entity concept

    -Money measurement concept

    -Going concern concept

    -Cost concept

    -Consevatism concept

    -Dual aspect concept

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    Accounting period concept

    Accrual concept

    Realisation concept

    Matching concept

    Materiality concept.

    What is revenue reserve & capital reserve?

    Revenue reserves are accumulated earnings

    from profits and normal business

    operations.Capital reserves arise due to

    capital gains from revaluation of assets or due

    to premium on issue of shares.

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    Accounts payable-These are current liabilities

    payable within one year from date of balancesheet.

    Fund Flow Statement-It shows the sources and

    uses of funds during a given accounting

    period.

    Horizontal analysis and Vertical analysis-

    Horizontal analysis is comparing the

    operations over a time period ie.comparing

    past performance with current position for

    predicting the future performance.

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    In vertical analysis we use percentages to show

    the relationship between various items in the

    balance sheet.

    a)X contributes Rs.10,000 to his properietory

    concern and the amount is deposited in the

    bank.What is the nature of liability?i)Owners equity

    ii)Loan

    iii)Short term financeiv)Fixed Asset.

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    b)ABC co.paid Rs.30,000 as deposit to the

    suppliers for a period of 3 months.

    i)Liability

    ii)Current Asset

    iii)Trade Credit

    iv)Debenture

    c)Materials costing Rs.2000 destroyed by fire

    i)Asset

    ii)Liability

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    Moving over to other questions.