Using Financial Statements For Business Decision Making
The financial statements are very useful in many ways in business. they are the basis of decision making for its users that is management, investors, creditors, etc. the ability of a firm to meet short term and long term liabilities, the proportion of long term borrowing in total capital is reasonable, adequacy of profits for dividend payments, and such matters can be clearly understood by management with the help of financial analysis. Unfavorable conditions can be diagnosed and corrective measures taken. Investors and shareholders are concerned about the financial stability, earning capacity and future growth of the firm. The investors can take decision about investment in the business from changes reflected in the statements about the earnings and financial position over tune.
The ratios analysis is the best method to analyses the company performance. There are different types of ratios. The different type of ratios helps to analysis the performance of company in every stage of that enterprise.
Current ratio shows the relationship between the total current assets and total current liabilities.
Total current assets
Total current liabilities
Quick ratio is concerned with the relationship between liquid assets and liquid liabilities
Quick ratio = Liquid assets
This ratio establishes the relationship between the proprietor’s funds and total assets. It shows the relation between equity and creditors.
Proprietary ratio = capital employed or proprietors fund
Total liability total assets
Capital gearing ratio
This ratio is used to describe the capital relationship between equity share capital and fixed interst bearing securities of a company.
Capital gearing ratio = Equity capital
Fixed interest/ dividend bearing securities
Debts equity ratio
It establishes the share holders funds and the outsiders funds.
Equity ratio= Equity/Total debt
Debt ratio= Debt/ Total assets
Debt to equity ratio = Equity/Total debt
Debt/ Total assets
Gross profit ratio
This ratio measures the profitability of the business.
Gross profit ratio= gross profit/ Net sales
Operating profit ratio
Operating profit ratio= operating profit/ net sales
Net profit ratio
Net profit ratio= net profit/ Net sales
Return on equity shareholders ratio
This ratio shows the relationship between net profit and equity capital
Net profit after tax and interest/Equity shareholders fund* 100
This shows the divend paid per share to the market price per share.
Dividend paid by share/ Market price per share
These are the important ratios.
Trend analysis is the continuous analysis of a particular financial data and making repots on that particular data. Trend analysis is commonly used to analyses share value. Trend analysis is the tool when the data are comparing with ratio analysis. The trend analysis is helpful to investors to take correct investment decisions. When the share price in boom then the investors can buy or existing shareholders can sell their shares. The trend analysis is also calculate the sales volume and to forecast to meet the production target. The trend analysis is the analysis of a continuous series or trend like stock and predit the future movement of stock and stock value. This very helpful to the investors who like to invest their money into a particular company or enterprise.
Cash flow statement
Cash flow statement considers all movements of cash. The term cash here means cash and bank balance. While preparing the a cash flow statement two types of cash flow, namely actual cash flows and notional cash flow are identified. Actual cash flow refers to the actual movements of cash flow to the actual movements of cash into or out of business. Purchase of fixed assets, redemption of debentures, etc are actual cash flows. Notional cash flow arises from indirect cash movements into or out of the business. Increase or decrease in current assets and current liabilities are examples of notional cash flow. In the cash flow statement the sources of cash and application of cash are separately shown. The sources of cash are
Issue of shares and debentures for cash
Sale of fixed assets and investments for cash.
Borrowing from banks and other financial institutions.
Cash from operations.
The application of cash includes;
Redemption of shares and debentures by cash.
Purchase of fixed assets and investments by cash.
Payment of loan.
Payment of tax.
Payment of dividend.
Cash lost in operation or trading losses.
Cash from operation or cash loss in operation are calculated by adding the amount of fund from operation to decrease in current assets and increase in current liability and increase in current assets and decrease in current liability to the funds from operation.
Fund from operation xxxx
Decrease in current aseets xxxx
Increase in current liabilities xxxx
Increase in current assets xxxx
Decrease in current liabilities xxxx
Cash from operations xxxx
When all transactions are cash transaction, the net profit or net loss showing in profit and loss account may be taken as cash from operation or loss.
Funds flow statement
Funds flow statement shows the inflow of funds and out flow of funds clearly. the funds flow statement reports on financial operations changes, flows or movements, during specified period of time. It covers all movements of funds. In modern technique of funds flow statement, two statements are prepared
Schedule of changes in working capital
Funds flow statement.
The working capital is used for the capital required for day to day working in business concerns. Purchasing of raw materials, wages, rents, advertising like this expenditure are meeting through working capital.
Working capital = Current assets – Current liabilities
The funds flow statement have two parts applications of funds and sources of funds.
The applications of funds are
funds loss from operations
purchase of fixed assets
repayment of loans
payment of dividend
Increase in working capital.
Source of funds are
funds from operations
issue of shares
long term loans
Sales of fixed assets.
decrease in working capital
Fund from operation is that fund which the firm has earned from its operations. To find out fund from operation non operating expenses are to be added and non operating incomes are to be deducted from net profit.
The fundamental analysis
Mr. Ahamed Hussain is a 75 years pensioner, he won 20000 pound on a lottery. He has two alternative enterprises to invest the money into business. The first alternative is a mining company and it’s have subsidiary companies in 70 different countries. The second alternative is J phones Ltd, which have started operation from 2 years. To find out the correct financial investment decisions here conducting the technical analysis of financial data of two companies, that is ABC Corporation and J phones Ltd.
It is not advisable to invest in debentures of ABC Mining Corporation because it matures after 10 years (2012).
It is not advisable to invest in debentures of J Phones Ltd. because it matures after 16 years (2018).
Investing in Preference shares Yield only 10 % in both the companies. It is low risk security but low rate of income offers. If there is no other option to invest in fixed income investments, the client can select the preference shares of J Phones Ltd. which shows good growth rate (PEG) and Retention ratio which will helpful to fixed income securities.
Overall analysis shows the company ABC is under better position- Fixed EPS and Growth rate, Dividend payout and yield is constant.
J Phones ltd. Is not good for long term investment because- even if it has high DPS it is not helpful to growing companies. But for our client, since his age is 75 years he can accept this security for short term investment.
The client is 75 years old. Hence it is advisable to him that, it is better to invest in low risk securities like Govt. securities, Bank deposits or other investment schemes which give fixed monthly return.
The methods to analysing performance of company
The important methods which help to analyses the financial performance of a company are cash flow statement, balance sheet and income statement. This financial statements help to make critical financial decisions of a company. Financial statements are the statements which show the financial position of a company. This statement helps to identify the strength and weakness of company.
Ratio analysis is the most powerful technique to analyses the performance of a company. Financial analysis refers to the process of examining the strengths and weakness of an enterprise with the help of information provided by the balance sheet and profit and Loss account. It involves a systematic attempt to look into the significance of data with respect to particular items or groups of items presented in the financial statements. The main objective of financial analysis is to gain an insight into the profitability of business operations and financial position so as to judge whether the progress is adequate or the financial position has improved.
Methods of financial analysis
For undertaking analysis of financial statements it is necessary that the items of income, expenditure, assets and liabilities should be properly classified and arranged. The items and figures should be arranged in such a manner that changes in figures and the comparison of amounts against the items as well as their interrelationship may be easily brought out.
A ratio is the measure of relationship between two numbers or values. The relationship may be expressed as the quotient of one number divided by another. The ratio then conveys the value of one item permit of the value of another or the value of one item being so many times or fraction of the other value.
Ratios are different types.
Balance sheet ratios
Profit and Loss ratio
Balance sheet ratio
Balance sheet ratios deal with the relationship between two items or group of items contained in balance sheet and they generally indicate short or long term financial positions. Liquidity and solvency ratios are the balance sheet ratios.
Profit and loss ratio
Profit and loss account ratios deal with the relationship between two items or group of items contained in the profit and loss account. Gross profit ratio, net profit ratio, operating profit ratio, stock turnover ratio are the profit and loss ratios.
Composite ratio or combined ratio deal with the relationship between items or groups items contained in both and loss account and balance sheet. They generally indicate the operational efficiency of the business.
Ratios are classified on the basis of functions. They are
Liquidity ratio: Liquidity ratios bring out the ability of the firm to honors the short term obligations as and when they fall due.
Solvency ratio: Solvency ratios indicate the firm’s ability to meet long term liabilities.
Turnover ratio: turn over ratio indicate the efficiency with which funds have been employed in business operations.
Profitability ratios: Profitability ratios indicate the profit earnings capacity of the business.
Useful of ratios
The importance of ratio analysis is widely recognized on account of its usefulness in different ways as outlined below.
Ratios convey the inter relationship between different items of balance sheet and profit and loss account. They reelect the financial state of affairs and efficiency of operations more clearly than the absolute accounting figures.
Efficiency of performance of management and the overall financial position are reveled by means of financial ratios which may not be other wise apparent from a set of accounting figures. The index of efficiency reflected in the ratios can be used as the basis of management control.
The credit worthiness of a firm, its earning power, ability to pay interest and debt, prospects of growth and similar information are reveled by ration analysis. These are required by creditors, financiers, investors, as well as share holders.
The ratios are using for inter firm comparison, comparing the performance of a particulars firm, say A with that of similar firm say B. the performance of A may also be compared with its close rivals or with the performance of the leader in the industry. Sometimes, the average ratios of the industry as a whole may be calculated and the present performance of a particular firm may be compared with the industry average.
Cash flow statement
Cash plays an important role in economic life of business. Cash flow statement is a statement showing the change in cash position from one period to another or two balance sheet dates. Cash flow statement summaries the reason for increase or decrease the amount of cash between two periods. The cash flow statement considers all movements of cash.
Use of cash flow statement
Cash flow statement shows the cause of changes in cash balance between two balance sheet date and this help to identify the financial position of concern.
This indicates the factors contributing to relation of cash balance in spite of increase in sales and profit and vice versa.
Fund flow statement
The funds flow statement is a report on financial operations changes, flows or movements, during specified period of time. It shows the sources and uses of funds have been used during a particular period of time. This funds flow statement is prepared with the help of non current assets and non current liabilities.
Helpfulness of funds flow statements
Analysis of financial position: This brings into light the most important changes that have place during a specific period.
It helps to access the working capital position of the firm.
Evaluation of the firms financing, it revels how the firm financed its developmental projects.
An instrument for allocation of reserves, it puts forth an order of priorities for various projects and helps in arranging finances for them.
A control device: the analysis can be comparable with that they may be in the modern technique of funds flow statement.
Tool of communication to outsiders: it communicates to the outsider world valuable information regarding firm’s financial positions.
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