The process of determining financial strengths and weaknesses of a firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data. It is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm s position and performance firm' the extent of analysis should be determined. Then only the sphere of work can be decided. For e.g. if the aim is to find out the earning capacity of the firm, then analysis of income statement is made. On the other hand, if financial position is to be studied Balance Sheet analysis is made.
Task-1
a) The various sources of finance available to a business.
Many scholars have proposed a variety of ways to categorize forecasting methodologies. The following classification is a modification of the schema developed by Gordon over two decades ago:
Genius forecasting
This method is based on a combination of intuition, insight, and luck. Psychics and crystal ball readers are the most extreme case of genius forecasting. Their forecasts are based exclusively on intuition. Science fiction writers have sometimes described new technologies with uncanny accuracy.
There are many examples where men and women have been remarkable successful at predicting the future. There are also many examples of wrong forecasts. The weakness in genius forecasting is that it's impossible to recognize a good forecast until the forecast has come to pass.
Trend extrapolation
These methods examine trends and cycles in historical data, and then use mathematical techniques to extrapolate to the future. The assumption of all these techniques is that the forces responsible for creating the past will continue to operate in the future. This is often a valid assumption when forecasting short term horizons, but it falls short when creating medium and long term forecasts.
The common feature of these mathematical models is that historical data is the only criteria for producing a forecast. One might think then, that if two people use the same model on the same data that the forecasts will also be the same, but this is not necessarily the case. Mathematical models involve smoothing constants, coefficients and other parameters that must decided by the forecaster. To a large degree, the choice of these parameters determines the forecast.
b) Mentioned sources in terms of legal, financial and dilution of control.
Consensus methods
Forecasting complex systems often involves seeking expert opinions from more than one person. Each is an expert in his own discipline, and it is through the synthesis suasion skills. A better method is known as the Delphi technique. This method seeks to rectify the problems of face-to-face confrontation in the group, so the responses and respondents remain anonymous. The classical technique proceeds in well-defined sequence. In the first round, the participants are asked to write their predictions. Their responses are collated and a copy is given to each of the participants.
Simulation methods
Simulation methods involve using analogs to model complex systems. These analogs can take on several forms. A mechanical analog might be a wind tunnel for modeling aircraft performance. An equation to predict an economic measure would be a mathematical analog. A metaphorical analog could involve using the growth of a bacteria colony to describe human population growth
c) The Financial Manager of a company
They have been extremely successful in many company applications, especially in the physical sciences. In the social sciences however, their accuracy is somewhat diminished. The extraordinary complexity of social systems makes it difficult to include all the relevant factors in any model. Clarke reminds us of a potential danger in our reliance on mathematical models.
Another common mathematical analog involves the use of multivariate statistical techniques. These techniques are used to model complex systems involving relationships between two or more variables. Multiple regression analysis is the most common technique. Unlike trend extrapolation models, which only look at the history of the variable being forecast, multiple regression models look at the relationship between the variable being forecast and two or more other variables.
Cross-impact matrix method
Relationships often exist between events and developments that are not revealed by univariate company techniques. The cross-impact matrix method recognizes that the occurrence of an event can, in turn, affect the likelihoods of other events. Probabilities are assigned to reflect the likelihood of an event in the presence and absence of other events. The resultant inter-correlational structure can be used to examine the relationships of the components to each other, and within the overall system. The advantage of this technique is that it forces forecasters and policy-makers to look at the relationships between system components, rather than viewing any variable as working independently of the others.
Task-2
A) Access and compare the costs of different sources of finance.
External analysis
Internal analysis
External analysis
This analysis is done by outsiders who do not have access to the detailed internal accounting records of the business firm. (Investors, creditors, government agencies, credit agencies and general public.)
Internal analysis
This analysis is conducted by persons who have access to the internal accounting records of a business firm. (Executives and employees of the organization and government agencies which have statutory powers vested in them.
Horizontal analysis
Vertical analysis
Horizontal analysis:-
Comparison of financial data of a company for several years. The figures for this type of analysis are presented horizontally over a number of columns. The figures of the various years are compared with standard or base year.
Vertical analysis:-
The study of relationship of the various items in the financial statements of one accounting period. Figures from financial statements of a year are compared with a base selected from the same year s statement.
Selection
Selection of information necessary for analysis of financial statements.
Classification
The methodical classification of the data.
Interpretation
Drawing of conclusions.
Explaining the meaning and significance of the data.
B) The importance of financial planning in relation.
The extent of analysis should be determined. Then only the sphere of work can be decided. For e.g. if the aim is to find out the earning capacity of the firm, then analysis of income statement is made. On the other hand, if financial position is to be studied Balance Sheet analysis is made relationship is established among financial statements with the help of tools and techniques of analysis. For e.g. Ratios, trends, comparative statements, common size statements, fund flow statements and cash flow statements. :-
Comparative statement may show the following:
Absolutefigures.
Changes in absolute figures
Increase or decrease in terms of percentages.
Comparative Balance Sheet
Interpretation of Comparative Balance Sheet:
Current Financial Position
Short term Financial Position.
Working Capital = Current Assets.
Current Liabilities
The increase in working capital means improvement in the current financial position of the business. An increase in current assets accompanied by an increase in current liabilities of the same amount will not show any improvement in the short term financial position.
C).The information needs of different decision makers.
Quality position of the Concern Liquidity Concern Increase in liquid assets like cash in hand, cash at bank, bills receivables, debtors, etc will improve the liquidity position of the concern. An increase in inventory may increase working capital of the business but will not be good for the business.
Interpretation of Comparative Balance Sheet:
Long term Financial Position
Changes in Fixed Assets, Long Changes Long-term
Liabilities and -Capital.
An increase in fixed assets should be compared to the increase in long term loans and capital. If the increase in fixed assets is more than the increase in long term securities then part of fixed assets has been financed from the working capital. A wise policy will be to finance fixed assets by raising long term funds.
D) The impact of finance on financial statements and the interaction of assets and liabilities in the balance sheet?
Interpretation of Comparative Balance Sheet:
Long term Financial Position.
Nature of Assets/Liabilities which have increased or decreased An increase in Plant & Machinery will increase production capacity of the concern. An increase in loaned funds will mean an increase in interest liability whereas an increase in share capital will not increase any liability for paying interest. Interpretation of Comparative Balance Sheet: Profitability of the Concern Increase or decrease in retained earnings, various resources and surpluses, etc.
An increase in the balance of Profit and Loss Account and other resources created from profits will mean an increase in profitability to the concern.
The term FLOW means movement and includes both inflow and outflow "inflow" " Flow of funds is said to have taken place when any transaction makes changes in the amount of funds available before happening of the transaction. According to the working capital concept of funds, the term flow of funds refers to the movement of funds in the working c outflow"
Source or Inflow of Funds
Transaction results in the increase in Working Capital
Application or outflow of Funds
Transaction results in the decrease of Working Capital
The flow of funds occurs when a transaction changes on the one hand a non current account and on the other a current account and vice versa.When a change in a non current eg fixed asset, long term liabilities, etc. is followed by a change in another non current account, it does not amount to flow of funds neither working capital increase nor decreases. Similarly a change in two current accounts does not affect funds.
The basic purpose of fund flow statement is to reveal the changes in the working capital on the two balance sheet dates. It also describes the sources from which additional working capital has been financed and the uses to which working capital has been applied.
FUNDS FLOW STATEMENT - How to prepare?
The funds flow statement is prepared by comparingtwo balance sheets and with the help of suchother information derived from the accounts. The preparation of a funds flow statement consists of two parts: Statement or Schedule of Changes in Working Capital. Statement of Sources and application of funds.
STATEMENT OF CHANGES IN WORKING CAPITAL
Working Capital = Current Assets Current Liabilities -
An increase in current assets increases working capital
A decrease in current assets decreases working capital
An increase in current liabilities decreases working capital
A decrease in current liabilities increases working capital
STATEMENT OF SOURCES AND APPLICATION OF FUNDS :-
This statement indicates various sources from which funds have been obtained during a particular period of time and the uses or application to which these funds have been put.
SOURCES OF FUNDS
Funds From Operations or Trading Profits.
issue of Share Capital.
Issue of Debentures and Raising of Loans, etc.
Sale of Fixed (non-current) Assets and Lon-term
Investments.
Non-Trading Receipts dividends.
Decrease in Working Capital
APPLICATION or USES OF FUNDS
Funds Lost in Operation.
Redemption of Preference Share Capital.
Repayment of Long-term Loans and Redemption
Of Debentures.
Purchase of Non-Current Assets.
Payment of Dividend and Tax.
Non-Trading Payments.
Increase in Working Capital
Task-3.
1 Profitability ratios
Return on capital employed (ROCE)
Capital employed is normally measured as fixed assets plus current assets less current liabilities and represents the long-term investment in the business, or owners' capital plus long-term liabilities. Return on capital employed is frequently regarded as the best measure of profitability.
ROCE = Profit before interest and taxation (PBIT) = Ã- 100%
Capital employed
Note that the profit before interest is used, because the loan capital rewarded by that interest is included in capital employed. A low return on capital employed (assets used) is caused by either a low profit margin or a low asset turnover or both. This can be seen by breaking down the primary ROCE ratio into its two components: profit margin and asset turnover.
ROCE = PBIT
Capital employed
PBIT Ã- Capital employed
Sales = Profit margin Ã- Asset turnover
Profit margin (on sales)
Margin = Profit before interest and taxation Ã- 100%
Sales
A low margin indicates low selling prices or high costs or both.
Asset turnover
This will show how fully a company is utilising its assets.
Asset turnover = Sales
Capital employed
A low turnover shows that a company is not generating a sufficient volume of business for the size of the asset base. This may be remedied by increasing sales or by disposing of some of the assets or both.
Gross profit margin = Gross profit Ã- 100
Sales
The gross profit margin focuses on the trading account. A low margin could Indicate selling prices too low or cost of sales too high.Return on owners' equity
Profit after interest and preference dividends but before tax Ã- 100%
Ordinary share capital and reserves
This looks at the return earned for ordinary shareholders. We use the profit after preference dividends and interest (i.e., the amounts that have to be paid before ordinary shareholders can be rewarded).
2 Liquidity ratios and asset utilisation Current ratio this indicates the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash.
Current ratio = Current liabilities
Current assets
Acid test ratio (quick ratio) This is calculated in the same way as the current ratio except that stocks are Excluded from current assets.
Acid test ratio = Current assets - S
Current liabilities
This ratio is a much better test of the immediate solvency. Debtor's ratio This is computed by dividing the debtors by the average daily sales to determine the number of days sales held in debtors.
Average collection period = Trade debtors Ã- 365 days
Credit sales
A long average collection period probably indicates poor credit control. Creditor's ratio
This is computed by dividing the creditors by the average daily credit purchases to determine the number of days purchases held in creditors.
Average payment period = Trade creditors Ã- 365 days
Credit purchases Stock turnover
This ratio indicates whether stock levels are justified in relation to sales. The higher the ratio, the healthier the cash flow position.
Stock turnover = Cost of sales Stocks
Stock turnover can also be calculated in days as:
Stockholding period = Stock Ã- 365 days
Cost of sales
3 Investor ratios
Earnings per share = Earnings available for ordinary shareholders Number of ordinary shares in issue
Earnings available for ordinary shareholders' mean profits after interest, taxation and preference dividends. Earnings per share are used by investors in calculating the price-earnings ratio or PE ratio. This is simply calculated as follows.
PE ratio = Market price of share
Earnings per share
A high PE ratio means that the shares are seen as an attractive investment. For example, if the PE ratio is 20, it means that investors are prepared to pay 20 times the annual level of earnings in order to acquire the shares.
Dividend cover = Profit available to ordinary shareholders This gives an indication of the security of future dividends. A high dividend cover ratio means that available profits comfortably cover the amount being paid out in dividends.
4. Risk
Gearing measures the extent to which a business is dependent on borrowed Funds, as opposed to equity funding. Gearing gives an indication of long-term liquidity and the risk inherent within the business. Highly geared companies have to meet interest commitments before paying dividends and may have problems raising further finance if expansion is necessary.
Gearing = Long - term debt and preference share capital Ã- 100%
Shareholder funds and long - term debt and preference share capital Interest cover
Interest cover = Profit before interest
Interest paid
Interest on debt has to be paid before shareholders can receive dividends. Therefore a good easure of risk is to compare available profit with the amount of interest to be paid. Examples Now alculate all of the above ratios on the following profit and loss account and balance sheet for a company called JG Ltd.
TASK-4
SUMMARISED BALANCE SHEET AT 31 DECEMBER 20X8
£000 £000
Fixed assets 2,600
Current assets
Stocks 600
Debtors 900
Balance at bank 100
_____
1,600
Trade creditors 800
_____
800
_____
3,400
Debenture stock 1,400
_____
2,000
_____
Capital and reserves
Ordinary share capital (£1
Shares) 1,000
Preference share capital 200
Profit and loss account 800
_____
2,000
_____
SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 20X8
£000
Sales 6,000
Cost of sales (including purchases £4,300) 4,500
_____
Gross profit 1,500
Administrative and distribution costs 1,160
_____
Trading profit 340
Debenture interest 74
_____
Profit before tax 266
Taxation 106
_____
Profit after tax 160
Preference dividend 10
_____
Profit available for ordinary shareholders 150
Ordinary dividend 10 _____
Retained profit 140
_____
Solution
ROCE = 10% 340/3,400 Ã- 100%
Profit margin = 5.7% 340/6,000 Ã- 100%
Asset turnover = 1.8 times 6,000/3,400
Gross profit margin = 25% 1,500/6,000 Ã- 100%
Return on owners' equity = 14.2 (266 - 10)/ (1,000 + 800) Ã- 100%
Current ratio = 2 times 1,600/800
Acid test ratio = 1.25 times (900 + 100)/800
Debtors ratio = 55 days 900/6,000 Ã- 365 days
Creditors ratio = 68 days 800/4,300 Ã- 365 days
Stock turnover = 7.5 times 4,500/600
Earnings per share = 15p 150/1,000
Dividend cover = 15 times 150/10
Gearing = 47% (1,400 + 200)/3,400 Ã- 100%
Interest cover = 4.6 times 340/74
Conclusion:-
The first stage of answering questions on interpretation is to calculate the ratios; the second is to draw conclusions about the company based on those ratios. A study of the trend of ratios for several years is desirable before drawing firm conclusions about many aspects of a company's position. Let us consider what conclusions we may draw from the Illustrative accounts of J G Ltd above.
Profitability
Return on capital employed - The company shows a return on total capital employed of 10%: not dramatically good, but satisfactory. Note that it exceeds the rate of interest being paid on the debentures (5.3%).
Net profit as percentage of sales - This is fairly low at 5.7%. The net profit as a percentage of sales varies greatly from industry to industry: more information is needed about the performance of other companies to draw useful conclusions about the level of this ratio.
Asset turnover ratio - The overall efficiency may be judged by asset turnover. This is 1.8 times for J G Ltd.
Gross profit margin - This is a more respectable 25% but again comparison to theindustry average would indicate whether it is acceptable.
Return on owners' equity - The level of acceptability of 14.2% will depend on three things.
The investors' anticipated return.
The industry average or that of competitors.
The return available in other forms of investment, eg building society.
