MODULE B STUDY OF FINANCIAL STATEMENTS C.S.BALAKRISHNAN FACULTY MEMBER SPBT COLLEGE

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MODULE BSTUDY OF FINANCIAL STATEMENTSC.S.BALAKRI
SHNANFACULTY MEMBERSPBT COLLEGE
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Scope,Functions and objective

• Scope is
• Designing 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 for short-term
  and long-term assets keeping in view the profit
  generation of the business through which
  repayment obligation can be met.

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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 the
  principle of maximisation of shareholder wealth
  provides a rational guide for running a business
  and for efficient allocation of resources 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
  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 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 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.

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• Dividend decision-It is basically a financing
  decision.This is because profit is a source of
  fund.By not paying dividend,the retained
  earningsor reservecan 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,if the liquidity of the
  business is interrupted because of holding too
  much fund in current assets.

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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.When funds go the
  such companies the economys resources are
  directed to more efficient use.This basic
  objective of maximisingthe price of the companys
  shares is called 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 new
• products,new technologies and better
• employment.
• -External factors like pollution,product
  safety and
• job safety have acieved added dimensions
  in
• relation to value maximisation.

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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.

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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 of time.
• These statements are prepared every week.
• Funds Flow statement gives the liquidity position
  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
• Phases of capital budgeting
• -Capital budgeting is a complex process which
  
• may be divided into five broad phases.
• Planning Implementation
• Analysis Review.
• Selection

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• Levels of Decision Making
• -Operating decisions
• -Administrative decisions
• -Strategic decisions
• 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
  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.
• Internal rate of return method-A selection method
  using the compounding rate of return on the 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 and the investment
  outlay.The method evaluates the differential cash
  flow between proposals.
• 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.

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• 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 costsbenefits
• ii)Difficulty in measurement of
  costsbenefits
• 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)represen
  t 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,tax
  authorities.
• Different types of concerns of stakeholders
• Profitability and earning capacity,liquidity
  and repaying 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 term
• forecasts,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 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.

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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 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.

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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 is
  willing 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 with
• current 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 _at_8 and floats
  a debenture for Rs.60,000 _at_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 _at_10 and has a tax
  rate 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)23.33c)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 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.

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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 finance
• iv)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.