Professional Documents
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By:
D. Aruna Kumar
Assistant Professor (Finance & Accounting Area)
Lokamanya Tilak P G College of Management
Ibrahimpatnam, Hyderabad-501 506
E-mail: dakumars@yahoo.com
The American Heritage® Dictionary of the English Language, Fourth Edition defines
the term as under-
1:"To provide or raise the funds or capital for": financed a new car
2: "To supply funds to": financing a daughter through law school.
3: "To furnish credit to".
The same dictionary also defines the term as a function in similar words as under-
1: "obtain or provide money for;" " Can we finance the addition to our home?"
2:"sell or provide on credit "
All definitions listed above refer to finance as a source of funding an activity. In this
respect providing or securing finance by itself is a distinct activity or function, which
results in Financial Management, Financial Services and Financial Institutions.
Finance therefore represents the resources by way funds needed for a particular
activity. We thus speak of 'finance' only in relation to a proposed activity. Finance
goes with commerce, business, banking etc. Finance is also referred to as "Funds" or
"Capital", when referring to the financial needs of a corporate body. When we study
finance as a subject for generalising its profile and attributes, we distinguish between
'personal finance" and "corporate finance" i.e. resources needed personally by an
individual for his family and individual needs and resources needed by a business
organization to carry on its functions intended for the achievement of its corporate
goals.
There are areas or people with surplus funds and there are those with a deficit. A
financial system or financial sector functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of deficit. A Financial System is
a composition of various institutions, markets, regulations and laws, practices,
money manager, analysts, transactions and claims and liabilities.
Financial System;
The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy. The financial system is concerned about
money, credit and finance-the three terms are intimately related yet are somewhat
different from each other. Indian financial system consists of financial market,
financial instruments and financial intermediation. These are briefly discussed below;
FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial assets are created
or transferred. As against a real transaction that involves exchange of money for real
goods or services, a financial transaction involves creation or transfer of a financial
asset. Financial Assets or Financial Instruments represents a claim to the payment of
a sum of money sometime in the future and /or periodic payment in the form of
interest or dividend.
Money Market- The money market ifs a wholesale debt market for low-risk, highly-
liquid, short-term instrument. Funds are available in this market for periods ranging
from a single day up to a year. This market is dominated mostly by government,
banks and financial institutions.
Forex Market - The Forex market deals with the multicurrency requirements, which
are met by the exchange of currencies. Depending on the exchange rate that is
applicable, the transfer of funds takes place in this market. This is one of the most
developed and integrated market across the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short,
medium and long-term loans to corporate and individuals.
FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When the
borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the security
should be passed on to take place. There should be a proper channel within the
financial system to ensure such transfer. To serve this purpose, Financial
intermediaries came into existence. Financial intermediation in the organized
sector is conducted by a widerange of institutions functioning under the overall
surveillance of the Reserve Bank of India. In the initial stages, the role of the
intermediary was mostly related to ensure transfer of funds from the lender to the
borrower. This service was offered by banks, FIs, brokers, and dealers. However, as
the financial system widened along with the developments taking place in the
financial markets, the scope of its operations also widened. Some of the important
intermediaries operating ink the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories, custodians, portfolio
managers, mutual funds, financial advertisers financial consultants, primary dealers,
satellite dealers, self regulatory organizations, etc. Though the markets are different,
there may be a few intermediaries offering their services in move than one market
e.g. underwriter. However, the services offered by them vary from one market to
another.
FINANCIAL INSTRUMENTS
The money market can be defined as a market for short-term money and financial
assets that are near substitutes for money. The term short-term means generally a
period upto one year and near substitutes to money is used to denote any financial
asset which can be quickly converted into money with minimum transaction cost.
Some of the important money market instruments are briefly discussed below;
1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificate of Deposit
5. Commercial Papers
Call/Notice money is the money borrowed or lent on demand for a very short period.
When money is borrowed or lent for a day, it is known as Call (Overnight) Money.
Intervening holidays and/or Sunday are excluded for this purpose. Thus money,
borrowed on a day and repaid on the next working day, (irrespective of the number
of intervening holidays) is "Call Money". When money is borrowed or lent for more
than a day and up to 14 days, it is "Notice Money". No collateral security is required
to cover these transactions.
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term
money market. The entry restrictions are the same as those for Call/Notice Money
except that, as per existing regulations, the specified entities are not allowed to lend
beyond 14 days.
3. Treasury Bills.
Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is an IOU of the Government. It is a promise by the Government to
pay a stated sum after expiry of the stated period from the date of issue
(14/91/182/364 days i.e. less than one year). They are issued at a discount to the
face value, and on maturity the face value is paid to the holder. The rate of discount
and the corresponding issue price are determined at each auction.
4. Certificate of Deposits
5. Commercial Paper
The capital market generally consists of the following long term period i.e., more
than one year period, financial instruments; In the equity segment Equity shares,
preference shares, convertible preference shares, non-convertible preference shares
etc and in the debt segment debentures, zero coupon bonds, deep discount bonds
etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of
instruments is called as hybrid instruments. Examples are convertible debentures,
warrants etc.
Conclusion
References
By
D. Aruna Kumar
Assistant Professor (Finance & Accounting Area)
Lokamanya Tilak PG College of Management
Ibrahimpatnam, Hyderabad-501 506
The focus of this paper is on Ratio Analysis as the most widely used technique of
financial statement analysis. It briefly discusses about the standards of comparison
and various types of Ratios, which are widely used by the corporates, with brief
interpretations and conclusions.
Introduction:
Financial analysis is the process of identifying the financial strengths and weaknesses
of the firm by properly establishing relationships between the items of the balance
sheet and the profit and loss account. Financial analysis can be undertaken by
management of the firm or by parties outside the firm like owners, creditors,
investors and others.
STANDARDS OF COMPARISION:
The ratio analysis involves comparison for a useful interpretation of the financial
statements. A single ratio is itself does not indicate favourable or unfavourable
condition. It should be compared with some standard. It consists of:
• PAST RATIOS: Rations calculated from past financial statements of the same
firm.
• COMPETITORS RATIOS: Ratios of some selected firms, especially most
progressive and successful competitor, at the same point of time.
• INDUSTRY RATIOS: Ratios of industry to which the firm belongs.
• PROJECTED RATIOS: Ratios developed using the projected or proforma,
financial statements of the same firm.
CLASSIFICATION OF RATIOS:
The parties interested in financial analysis are short and long term creditors, owners
and management. Short term creditors main interest is I the liquidity position or
short term solvency of the firm. Long term creditors on the other hand are more
interested in the long term solvency and profitability of the firm. Similarly, owners
concentrate on the firm's profitability and financial condition. Management is
interested in evaluating every aspect of the firm's performance. They are classified
into 4 categories:
• Liquidity ratios
• Liverage ratios
• Activity ratios
• Profitability ratios
LIQUIDITY RATIOS:
Liquidity ratios measure the firms ability to meet current obligations. It is extremely
essential for a firm to be able to meet its obligations as they become due liquidity
ratio's measure. The ability of the firm to meet its current obligations. In fact
analysis is of liquidity needs in the preparation of cash budgets and cash and funds
flow statements, but liquidity ratios by establishing a relationship between cash and
other current assets to current obligations provide a quick measure of liquidity.
A firm should ensure that it does not suffer from lack of liquidity and also that it
does not have excess liquidity. The failure of the company to meet its obligations
due to the lack of sufficient liquidity will result in a poor credit worthiness, loss of
creditors confidence or even in legal tangles resulting in the closure of company. A
very high degree of liquidity is also bad, idle assets earn nothing. The firm's funds
will be unnecessarily tied up to current assets. Therefore, it is necessary to strike a
proper balance between high liquidity and lack of liquidity.
• Current ratio
• Quick ratio
• Interval measure
• Net working capital ratio
CURRENT RATIO:
Quick ratio establishes a relationship between quick or liquid, assets and current
liabilities. Cash is the most liquid asset, other assets which are considered to be
relatively liquid and included in quick assets are debtors and bills receivables and
marketable securities. Inventories are considered to be less liquid.
INTERVAL MEASURE:
The ratio which assesses a firm's ability to meet its regular cash expenses is the
interval measure. Interval measure relates the liquid assets to average daily
operating cash outflows. The daily operating expenses will be equal to cost of goods
sold plus selling, administrative and general expenses less depreciation divided by
number of days in the year.
The difference between current assets and current liabilities excluding short term
bank borrowing is called net working capital or net current assets. Net working
capital is some times used as measure of firm's liquidity.
LIVERAGE RATIOS:
The short term creditors, like bankers and suppliers of raw material are more
concerned with the firms current debt paying ability. On the other hand, long term
creditors like debenture holders, financial institutions etc. are more concerned with
firms long term financial strength. In fact a firm should have short as well as long
term financial position. To judge the long term financial position of the firm, financial
leverage or capital structure, ratios are calculated. These ratios indicate mix of
funds provided by owners and lenders. As a general rule, there should be an
appropriate mix of debt and owners equity in financing the firm's assets.
• Debt Ratio
• Debt Equity Ratio
• Capital employed to net worth ratio
• Other Debt Ratios
DEBT RATIO:
Several debt ratios may be used to analyse the long term solvency of the firm. It
may therefore compute debt ratio by dividing total debt by capital employed or net
assets.
Net assets consist of net fixed assets and net current assets:
It is computed by dividing long term borrowed capital or total debt by Share holders
fund or net worth.
To assess the proportion of total funds – Short and Long term provided by outsiders
to finance total assets, the following ratio may be calculated
ACTIVITY RATIOS:
Funds of creditors and owners are invested in various assets to generate sales and
profits. The better the management of assets, the larger is an amount of sales.
Activity ratios are employed to evaluate the efficiency with which the firm manages
and utilizes its assets these ratios are also called turnover ratios because they
indicate the speed with which assets are being converted or turned over into sales.
Activity ratios, thus, involve a relationship between sales and assets. A proper
balance between sales and assets generally reflects that assets are managed well.
Inventory turnover ratio indicates the efficiency of the firm in producing and selling
its product. It is calculated by dividing cost of goods sold by average inventory.
Average inventory consists of opening stock plus closing stock divided by 2.
Debtors turnover ratio is found out by dividing credit sales by average debtors.
Debtors turnover indicates the number of times debtors turnover each year.
Generally the higher the value of debtors turnover, the more efficient is the
management of credit
COLLECTION PERIOD:
The average number of days for which debtors remain outstanding is called the
average collection period.
A firm should manage its assets efficiently to maximise sales. The relationship
between sales and assets is called net assets turnover ratio. Net assets include net
fixed assets and net current assets
A firm may also like to relate net current assets to sales. It may thus compute net
working capital turnover by dividing sales by net working capital
PROFITABILITY RATIOS:
A company should earn profits to survive and grow over a long period of time.
Profits are essential but it would be wrong to assume that every action initiated by
management of a company should be aimed at maximizing profits, irrespective of
social consequences.
Profit is the difference between revenues and expenses over a period of time. Profit
is the ultimate output of a company and it will have no future if it fails to make
sufficient profits. Therefore, the financial manager should continuously evaluate the
efficiency of the company in terms of profits. The profitability ratios are calculated to
measure the operating efficiency of the company.
It is calculated by dividing gross profit by sales. The gross profit margin reflects the
efficiency with which management produces each unit of product. This ratio
indicates the average spread between the cost of goods sold and the sales revenue.
Net profit is obtained when operating expenses, interest and taxes are subtracted
from the gross profit. The net profit margin is measured by dividing profit after tax
or net profit by sales.
Operating expense ratio explains the changes in the profit margin ratio. This ratio is
computed by dividing operating expenses like cost of goods sold plus selling
expenses, general expenses and administrative expenses by sales.
OPERATING EXPENSE RATIO= OPERATING EXPENSES
SALES
The higher operating expenses ratio is unfavorable since it will leave operating
income to meet interest dividends etc.
RETURN ON INVESTMENT:
The term investment may refer to total assets or net assets. The conventional
approach of calculating return on investment is to divide profit after tax by
investment. Investment represents pool of funds supplied by shareholders and
lenders. While PAT represent residue income of shareholders
RETURN ON EQUITY:
`Ordinary share holders are entitled to the residual profits. A return on shareholders
equity is calculated to see the profitability of owners investment. Return on equity
indicates how well the firm has used the resources of owners. The earning of a
satisfactory return is the most desirable objective of business.
The measure is to calculate the earning per share. The earning per share is
calculated by dividing profit after tax by total number of outstanding. EPS simply
shows the profitability of the firm on a per share basis, it does not reflect how much
is paid as dividend and how much is retained in business.
The net profits after taxes belong to shareholders. But the income which they really
receive is the amount of earnings distributed as cash dividends. Therefore, a larger
number of present and potential investors may be interested in DPS rather than
EPS. DPS is the earnings distributed to ordinary shareholders divided by the number
of ordinary shares outstanding.
The dividend pay out ratio is simply the dividend per share divided by Earnings Per
Share.
DIVIDEND PAY OUT RATIO= DIVIDEND PER SHARE
EARNINGS PER SHARE
The reciprocal of the earnings yield is called price earning ratio. The price earning
ratio is widely used by security analysts to value the firm's performance as expected
by investors. Price earning ratio reflects investors expectations about the growth of
firm's earnings. Industries differ in their growth prospects. Accordingly, the P/E
ratios for industries very widely.
Conclusions
Ratio analysis plays an important role in the corporate world. It is a widely used tool
of financial analysis. Ratio Analysis is relevant in assessing the performance of a firm
in respect of liquidity position, long-term solvency, operating efficiency, overall
profitability, inter-firm comparison and trend analysis. Hence, understanding the
Ration Analysis is of immense helpful for the non-finance executives in today's
competitive world.
References: