Importance of Financial Management
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Published: Fri, 24 Feb 2017
The modern thinking in financial management accords a far greater importances to the
management decisions and making policy. Today financial managers occupy key positions in top management areas and play dynamic role in solving complex management problems.
The main object ive of accounting is to provide the necessary information, which is useful for the person within the organization i.e.; owners, management, employees and also outside the organization i.e.; investors, creditors, government, consumers, etc.
Financial accounting is concerned with record keeping directed towards the preparation of income statement and financial position statement. It provides information regarding profit and loss of the enterprise and also its financial position as on that particular date. This information is helpful to management to control the major functions of the business i.e.; finance, administration, production and marketing, but details regarding operating efficiency to their lacking financial statements are mainly concerned with the management’s interest in future of the organization.
Thus the financial performance valuation involves the determination of the company’s ability
In mobilizing the funds required for the business and utilizing the funds in the business.
Therefore, the financial performance is concerned with the appraisal of the following:
- Capital formation
- Capital structure
- Profitability and profit allocation
- Working capital and liquidity management
Financial analysis is the process of determining the significant operating and financial characteristics of a firm from its accounting and its financial statements. The goal of such analysis is to determine the efficiency and performance of the firm’s management, reflected in the financial records and reports. This analysis will help us to measure firm’s liquidity, profitability and other indications that determine whether the business is conducted in a rational way or not.
METHODS OF FINANCIAL ANALYSIS:
There are 7 methods of financial analysis. Such are:
- Comparative statement
- Comparative income statement
- Comparative balance sheet
Financial statement plays a decisive role in setting the frame work of managerial decisions for the financial statements viz; income statement and balance statement are prepared to help the management in taking decisions. The Ratio analysis is the most power tool of financial analysis.
A ratio is simple arithmetical expression of the relationship of one member to another. Accounting ratios are relationships expressed in mathematical terms between figures which are connected with each other in some manner. Ratio analysis shows inter-relationship between the different items in the data.
- Current ratio:
Current ratio = Current assets / Current liabilities
The current ratio is calculated by dividing the current assets by the current liabilities.
Current assets include cash and those assets which can be converted into cash within year such as inventories, sundry debtors, marketable securities, loans and advances and prepaid expenses.
Current liabilities are obligations maturing within a year, including creditors, bills payable, accrued expenses, bank overdraft, income tax liability, loans and advances and provisions.
The company’s liquidity position was very low in the initial years where as it is very high in the later years.
- Quick (or) Acid test ratio:
Quick ratio = (Current assets – Inventory) / Current liabilities
The ratio is really at the rate of current ratio and is found out by dividing the total current liabilities.
From the analysis, it can be interpreted that the company’s liquidity position to pay for current liability is high. This result is higher interest cost on networking capital which affects the profitability of the firm.
- Debtors days:
Debtors days = (Debtors / sales) * 365
The liquidity position of the firm depends on the quality of the debtors to the great extent. This resulted in higher balance in debtors for which company had to pay more interest charges which affected profitability of the company. This can be improved 3 times better as observed in the ratios of well doing firms. This will result in big reduction in interest charges as well as increase in profits. This possible only through better debtors management and optimum credit policy of the firm.
- Creditor days:
Creditor days = (Creditor / Cost of goods sold ) * 365
This ratio is a variation of the credit ratio and gives similar indications. It measures the portion of the firm’s assets that are financed by creditors. A very high ratio indicates a greater risk to creditors as also to the share holders under adverse business conditions. On the other hand , a low ratio is for the creditors in extending credit.
- Net income ratio:
Net income ratio = (Net profit / sales) *100
This ratio measures the rate of the net profit earned on sales. It establishes a relationship between net profit and sales in overall measure of the firm’s ability to turn pound of sales into net profit, this ratio also indicate the firm’s capacity to withstand adverse economic conditions.
- Gross income ratio:
Gross income ratio = (Gross profit / Sales) *100
The gross profit has been arrived by adding the closing stock and subtracting the materials, excise duty, wages and other manufacturing expenses to sales.
This ratio reflects the efficiency with which management produces each unit of the product. When the gross margin in subtracted from 100% we get the ratio of cost of goods to sale.
- Return on equity:
Return on equity = Net income / Share holders equity
The amount of net incomereturnedas a percentageof shareholders equity.Return on equitymeasures a corporation’s profitabilityby revealing how muchprofit acompany generateswith the money shareholders have invested.
Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferredshares.
- Cost of sales to sales ratio:
Cost of sales to sales ratio = Cost of sales / Total sales
Through the manufacturing expenses percentage of company is less than the industry average the Cost of sales is slightly more than the industry. This can be, because of more depreciation charges or difference in excise duty. Therefore company has to produce goods by effective utilization of foxed assets to bring down the depreciation cost of sales.
- Stock turnover days:
Stock turnover days = sales / inventory
The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive. However, it will vary between industries and so it is important to compare within an industry.
- Return on net assets:
RONA = net income / (Fixed assets + Networking capital)
Here, Networking capital = Current assets – Current liabilities.
It is the useful measure the profitability of all financial resources invested in the firm’s assets. It evaluated the use of total funds without any regard to the sources of funds. Higher the ratio more effective is the firm is using the pool of funds.
- Sales to net assets employed:
Sales to net assets employed = sales / net assets
Here, Net assets = Fixed assets + Current assets – Current liabilities.
This ratio is also called the earning power of the firm and represents the return of the funds. It indicates how well management has used funds supplied by the creditors and owners.
Higher the ratio better is the position of the firm and more efficient of the management in utilizing funds, entrusted to it.
In the overall of a business is to earn a satisfactory return on funds invested in it, consistent with maintaining a sound financial position.
The position of the company according to ratio is satisfactory in the year 2008 – 2010. That means each year profit had been increased.
- Financial management – M Y Khan & P K Jain
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