CAIIB-Financial Management-

MODULE B
STUDY OF FINANCIAL
STATEMENTS

M Syed Kunmir
email kunmir@yahoo.co.uk
Financial management involves
the application of general
management principles to
particular financial operation.

- Howard and Upton

 Attending to investment decisions
- as to when and
- how to acquire and allocate
funds
- for short-term and long-term
assets keeping
- in view the profit generation of
the business
- through which repayment
obligation can be met.
Objectives and basic consideration of
Financial management.
Though profit maximisation is the
objective of financial management
The long-term goal of the business
entity is to achieve maximising the
shareholder value of the firm
Because the principle of maximisation
of shareholder wealth provides a
rational guide for running a business
and for efficient allocation of resources
in society.
The key objective of Financial
Management is to maximise
the value of the company.
This could be possible by
good investment decisions
prudent financing decisions 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 maximisation of
value of the company, finance
manager has to take careful
decisions in respect of
-Financing
-Investment
-Dividend
-Current asset management.
 Financing decision-
Has to decide on sources of funds for
business.
It is to be decided whether entire
capital should be raised from equity
capital or a part is to be raised from
loan.
Hence Debt/Equity ratio or Leverage
are important since each source has in
them associated risk factors involved.
 Investment decision
It relates to acquisition of assets.
Assets are classified into
real assets such as
- land
- building
- plant
- equipment etc.
and
- the financial assets are
- shares and
- debentures etc.
It indicates available mix of financing to fund
companys activities.
Such decisions on investment in projects come
within the field of capital budgeting which is
derived from net present value of assets.
 Dividend decision-
- It is basically a financing decision.
- This is because profit is a source of
fund.
- By not paying dividend, the
retained earningsor reserve can be
increased which could 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 to maintain balance
between current assets and current
liability,
The liquidity of the business is
interrupted because of holding too
much fund in current assets.
 Wealth maximisation &value
maximisation
The goal of financial management is to
maximise the value of companies.
This is generally expressed in terms of
maximising the value of the ownership
shares of the company
In short,maximising share price.
Thus,better performing companies can
raise additional funds under more
favourable terms.
This basic objective of maximising the
price of the companys shares is called
value maximisation.
 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 new
products,new technologies and better
employment.
-External factors like pollution,product safety
and
job safety have achieved added dimensions
in
relation to value maximisation.
 Profit maximisation vs.Wealth
maximisation
Long run vs.Short run Profits.
Convert total corporate profits to earning per
share(EPS).
EPS is total profits divided by number of
shares outstanding.
Assume the firm earns Rs.10 mn.and has
1mn.shares outstanding.The EPS will work
out to Rs.10.
Profit maximisation is a short-term concept,
while wealth maximisation emphasises the
long-term view point.
 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 of time.
These statements are prepared every
week.
Funds Flow statement gives the liquidity
position of the firm.
 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
 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
 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
 Difficulties

-Measurement
problems
-Uncertainty
-Temporal spread
Phases of capital budgeting

-Capital budgeting is a complex process

which
may be divided into five broad phases.

1) Planning
2) Analysis
3) Selection
4) Implementation
5) Review.
 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
The basic characteristic of a
capital project is that it
typically involves

- A current outlay(or current

and future outlays)of
funds
- In expectation of a stream
of benefits
- Extending far into future.
Accounting rate of return
method

- A selection criterion using

average net income and
investment outlay to compute
a rate of return for a project.
- This method ignores the
time value of money & cash
flows.
Net Present Value method
- A selection method using
the difference between
the present value of the
cash inflows of the project
and the investment outlay.
- The method evaluates
the differential cash flow
between proposals.
Internal rate of return
method

A selection method using

the compounding rate of
return on the cash flow of
the project.
Payback method
- A selection method in which a
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.
 What are the three important factors which
arise from capital expenditure decisions?
a)Long-term effects e)Debt
b)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
 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.
 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.
 Study of financial
statements
Who are the party interested in firms
financial condition?
- Shareholders
- Creditors/suppliers
- Financiers
- Employees
- Tax authorities.
Long term sources
- Preference shares
- 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 term forecasts

- Monthly for short term forecasts.

Factors considered in equity
financing
- Issue costs
- servicing costs such as paying
out
dividends
- 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.
Debentures or loan financing
- the firm will have to pay fixed
interest every year.
- There is an obligation to
redeem it at the end of the
period.
- 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.
 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 this purpose,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.
Trade credit
- When materials are bought from
suppliers,the trade credit is
extended for few days or a
couple of months.
- The supplier is willing to wait to
collect money.
- This also depends on the
suppliers financial 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.
 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 with
current liabilities(T/F)
 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)
 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 the
project?
a)5.5% b)6.5% c)7.5%
d)8.5%

If a firm borrows Rs.2 lac @10% and

has a tax rate of 40%.What is the cost
of capital?
a)5% b)6% c)7% d)8%
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
- Accounting period concept
- Accrual concept
- Realisation concept
- Matching 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.
 Elements
Elements of
of financial
financial statements
statements

Main financial statements:

Balance Sheet
Income statement
Statement of Sources of funds and
Uses of funds
 Balance Sheet
Typical Limited
Balance Sheet
as at 30 June 2002 2002 2001
Rm Rm
ASSETS
Non-Current Assets
Property, plant & equipment 1,227 1,137
Current Assets
Inventories 65 60
Receivables 122 108
Cash assets 21 15
Total Current Assets 208 183

Total Assets 1,435 1,320

EQUITY AND LIABILITIES

Equity
Share Capital (500m shares of R1 each) 500 500
Retained earnings 415 340
Total Equity 915 840
Non-current Liabilities
Long-term borrowings 400 380
Total non-current liabilities 400 380
Current Liabilities
Trade and other payables 98 88
Short-term borrowings 22 12
Total current liabilities 120 100

Total Equity and Liabilities 1,435 1,320

 Income Statement
Typical Limited
Income Statement
For the year ended 30 June 2002 2002 2001
Rm Rm
Sales revenue 3,573 2,320
Cost of Sales 2,036 1,206
Gross Profit 1,537 1,114
Distribution, selling and marketing expenses 679 394
Administration and general expenses 322 186
Other expenses 254 116
Profit (earnings) before interest and tax expense 282 418
Finance costs 100 80
Profit before tax 182 338
Income tax expense 54 101
Profit for the period 128 237
Earnings per share 0.256 0.474

Statement of changes in equity

for the year ended 30 June 2002
Balance at 30 June 2001 340 202
Profit for the period 128 237
468 439
Dividends -53 -99
Balance at 30 June 2002 415 340
Sources and Uses of Funds

Sources and
Uses Statement
The letters labeling
the boxes stand for
Uses,
U ses,
ses SSources,
ources,
ources A L
Assets,
A ssets,
ssets and
Liabilities
L iabilities (broadly
defined). The pluses
(minuses) indicate
S - +
increases
(decreases) in
assets or liabilities.
U + -
7-7
 Accounts payable-These are current
liabilities payable within one year from
date of balance sheet.
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.
 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 finance
iv)Fixed Asset.
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).
 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)
 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
 Tools of Analysis

Horizontal
Horizontal Analysis
Analysis
Comparing a companys financial condition
and performance across time

Time
Horizontal Analysis
Now, lets
look at
some ways
to use
horizontal
analysis.
Time
The term horizontal analysis arises from
left-to-right (or right-to-left) movement of
our eyes as we review comparative
financial statements across time.
Comparative Statements
Calculate Change in Dollar Amount

Dollar Analysis Period Base Period

Change = Amount Amount

Since we are measuring the amount of

the change between 2003 and 2004, the
dollar amounts for 2003 become the
base period amounts.
 Comparative Statements
Calculate Change as a Percent

Percent Dollar Change

Change
=
Base Period Amount 100%
 $12,000 $23,500 = $(11,500)

($11,500 $23,500) 100% = 48.9%

Now, lets review the dollar
and percent changes for
the liabilities and
shareholders equity
accounts.
 Now, lets
look at trend
analysis!
 Trend Analysis
Also called trend
percent analysis
or index number
trend analysis.

Trend
Trend analysis
analysis is
is used
used to
to reveal
reveal patterns
patterns in
in data
data
covering
covering successive
successive periods.
periods.

Trend Analysis Period Amount

Percent = Base Period Amount
100%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

2000 is the base period so its

amounts will equal 100%.
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2004 2003 2002 2001 2000
Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100%

(290,000 275,000) 100% = 105%

(198,000 190,000) 100% = 104%
(92,000 85,000) 100% = 108%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December

Item 2004 2003 2002 2001 2000

Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2003 2002 2001 2000

Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

How would this trend analysis

look on a line graph?
 Trend Analysis
We can use the trend percentages to construct
a graph so we can see the trend over time.
 Vertical Analysis VV
ee
rr
Vertical Analysis is also called as tt
ii
common-size analysis cc
aa
ll
AA
nn
aa
ll
The term vertical analysis arises from the up- yy
down (down-up) movement of our eyes as we ss
review common-size financial statements. ii
ss
 Common-Size Statements
Calculate Common-size Percent

Common-size Analysis Amount

Percent
= Base Amount 100%

Financial
FinancialStatement
Statement Base
BaseAmount
Amount
Balance
BalanceSheet
Sheet Total
TotalAssets
Assets
Income
IncomeStatement
Statement Revenues
Revenues
($12,000 $315,000) 100% = 3.8%

($23,500 $289,700) 100% = 8.1%

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

Materials costing Rs.2000 destroyed by

fire
i) Reduction in Asset
ii)Reduction in liability
Profit maximization is a

a) Short term concept

b) long term concept
c) both
d) none of the above
Wealth maximization is a

a) Short term concept

b) long term concept
c) either a or b
d) both a& b.
Criterion for payback period

a) Accept PBP>target period

b) Accept PBP<target period
c) Accept PBP=target period
d) d) none of the above
Criterion for accounting rate of return

a) Accept ARR>target rate

b) Accept ARR< target rate
c) Accept ARR=target rate.
d) none of the above
Criterion for Net Present Value

a)Accept NPV>0
b) Accept NPV<0
c) Accept NPV=0
d) none of the above
Criterion for IRR(Internal Rate of
Return)

a) Accept IRR>Cost of capital

b) Accept IRR <Cost of capital
c) Accept IRR= Cost of capital
d) none of the above
Criterion for benefit cost ratio

a) Accept BCR >1

b) Accept BCR<1
c) Accept BCR=1
d) none of the above
Common size statements are

a) Financial Statements that depict

financial data in the form of verticle
percentages
b) Financial Statements that depict
financial data in the form of
horizontal percentages
c) Both a & b
d) none of the above.
Horizontal Analysis is

a)Changes in financial statements

b) percentage analysis of increase &
decrease in corresponding items in
comparative financial statements.
c) Financial statements which depict
financial data.
d)none of the above.
Fund Flow is

a) Sources & Uses statement

b) Sources Statement
c) Uses Statement
d) none of the above.
Economic Income is defined as

a) Change in wealth
b) Change in income
c) Change in profit
d) none of the above
 THANK YOU

Email kunmir@yahoo.co.uk