Module – 1: Finance:
Meaning, Goals and functions of Finance, sources of Finance.
Financial Management: Nature, scope, objectives and
functions of Financial Management.
Financial Analysis :Nature and types of Ratio
Analysis, Utility and cautions in using Ratio
Analysis.
Module
– 1:
Finance: Meaning: Financial
Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the
enterprise.
Goals and functions of Finance:
Objectives of Financial Management
The financial management is generally concerned with procurement,
allocation and control of financial resources of a concern. The objectives can
be-
- To ensure regular and adequate
supply of funds to the concern.
- To ensure adequate returns to
the shareholders which will depend upon the earning capacity, market price
of the share, expectations of the shareholders.
- To ensure optimum funds
utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
- To ensure safety on investment,
i.e., funds should be invested in safe ventures so that adequate rate of
return can be achieved.
- To plan a sound capital
structure-There should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.
Functions of Financial Management
- Estimation of capital
requirements: Estimation has to make with
regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a
concern. Estimations have to be made in an adequate manner which increases
earning capacity of enterprise.
- Determination of capital
composition: Once the estimation have
been made, the capital structure have to be decided. This involves short-
term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
- Choice of sources of funds: For
additional funds to be procured, a company has many choices like-
- Issue of shares and debentures
- Loans to be taken from banks
and financial institutions
- Public deposits to be drawn
like in form of bonds.
Choice of factor will
depend on relative merits and demerits of each source and period of financing.
- Investment of funds: The
finance manager has to decide to allocate funds into profitable ventures
so that there is safety on investment and regular returns is possible.
- Disposal of surplus: The
net profits decision have to be made by the finance manager. This can be
done in two ways:
- Dividend declaration - It
includes identifying the rate of dividends and other benefits like bonus.
- Retained profits - The volume
has to be decided which will depend upon expansional, innovational,
diversification plans of the company.
- Management of cash: Finance
manager has to make decisions with regards to cash management. Cash is required
for many purposes like payment of wages and salaries, payment of
electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
- Financial controls: The
finance manager has not only to plan, procure and utilize the funds but he
also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit
control, etc.
sources of Finance.
Sources of Finance in Business: There are two major sources of finance for meeting the financial requirements of any business enterprises, which are as under:-
- Owners Fund
- Borrow Fund
- Owners Fund: Owners fund is
also called as Owners Capital or owned capital. It consists of the funds
contributed by the owners of business as well as profits reinvested in
business. A company cans raise owner’s funds in the following ways:-
- Issue of equity
shares
- Ploughed back
profits
- Borrow Fund: The second
source of funding to a business is the borrowed fund. Borrowed fund
consists of the amount raised by way of loans or credit. It is also known
as borrowed capital. The borrowed fund is procured from the following
sources;-
- Debentures
- Bank Loans
- Loans from
specialized financial institutions
- Other long term
financial institutions
Types of
Business Finance
All
businesses require an adequate finance. They need money for investment in fixed
asset such as land, building, machinery etc. Once business is in operation,
money is needed for Working Capital, such as purchase of raw material, payment
of wages, utility bills etc. A going concern also requires extra capital to
cover a temporary cash flow crisis, or purchase new improved machinery or
simply to expand the business. The financial requirements of a business, on the
basis of time duration, are usually classified under three heads which are as
follow:-- Short Term
Finance
- Medium Term
Finance
- Long Term
Finance
Short Term Finance:
- Short term
Sources of finance is defined as money raises for investment in
business for a period of less than one year, it is also named as working
capital or circulating capital or revolving capital.
- The purpose and
amount of obtaining short term capital varies with the nature and size of
the business. Generally the short term capital is required for meeting the
day to day expenses of business such as payment of utility bills, wages to
the workers, unforeseen expenses, seasonal upswings in business,
increasing inventories raw material, work in progress and finished goods
etc.
- Trade creditor
open book account
- Advance from
customers
- Instalment
credit
- Bank Overdraft
- Cash credit
- Discounting
bills
- Against bill of
lading
- Medium Term
Finance
- Commercial Banks
- Debentures
- Loans from
Specialized Credit Institutions
- Long Term
Finance
- Equity shares
- Issue of right
shares
- Debentures
- Loans from
industrial and financial institutions
- Leasing
- Ploughing back
of profits
Financial Management: Nature,
scope, objectives and functions of Financial Management.
Definition of Financial Management:
Financial management could be defined as follows:
Financial management, is that
branch of general management, which has grown to provide specialized and
efficient financial services to the whole enterprise; involving, in particular,
the timely supplies of requisite finances and ensuring their most effective
utilization-contributing to the most effective and efficient attainment of the
common objectives of the enterprise.
Some prominent definitions of financial management are cited
below:
(1) “Financial management is an area of
financial decision-making harmonizing individual motives and enterprise goals.”
—Weston and Brigham
(2) “Financial management is
concerned with managerial decisions that result in acquisition and financing of
long-term and short-term credits for the firm. As such, it deals with
situations that require selection of specific assets and liabilities as well as
problems of size and growth of an enterprise. Analysis of these decisions is
based on expected inflows and outflow of funds and their effects on managerial
objectives.” —Philppatus
Analysis of the above Definitions:
The above definitions of financial management could be analyzed,
in terms of the following points:
(i) Financial management is a specialized branch
of general management.
(ii) The basic operational aim
of financial management is to provide financial services to the whole
enterprise.
(iii) One most important
financial service by financial management to the enterprise is to make
available requisite (i.e. required) finances at the needed time. If requisite
funds are not made available at the needed time; significance of finance is
lost.
(iv) Another equally important
financial service by financial management to the enterprise is to ensure the
most effective utilisation of finances; but for which finance would become a
liability rather than being an asset.
(v) Through providing financial services to the
enterprise, financial management helps in the most effective and efficient
attainment of the common objectives of the enterprise.
Points of Comment:
(i) In big business
enterprises, a separate cell, called the Finance Department is created to take
care of financial management, for the enterprise. This department is headed by
a specialist in Financial Management-called the Finance Manager.However, the
scope of authority of the finance manager, very much depends on the policies of
the top management; finance being a crucial management function.
(ii) In the present-day times,
at least, financial management represents a research area; in that the finance
manager is always expected to research into-new and better sources of finances
and into best schemes for the most efficient and profitable utilization of the
limited finances at the disposal of the enterprise.
(iii) There
are three major areas of decision making, in financial management, viz:
(1) Investment decisions i.e.
the channels into which finances will be invested-based on ‘risk and return’
analysis, of investment alternatives.(2) Financing decisions i.e. the sources
from which finances will be raised-based on ‘cost-benefit analyses’ of
different sources of finance.(3) Dividend decisions i.e. how much of corporate
profits will be distributed, by way of dividends; and how much of these will be
retained in the company-requiring an intelligent solution to the controversy
‘Retention vs. Distribution’.
Nature of Financial Management:
Nature of financial management could be spotlighted with reference
to the following aspects of this discipline:
(i) Financial management is a
specialized branch of general management, in the present-day-times. Long back,
in traditional times, the finance function was coupled, either with production
or with marketing; without being assigned a separate status.(ii) Financial
management is growing as a profession. Young educated persons, aspiring for a
career in management, undergo specialized courses in Financial Management,
offered by universities, management institutes etc.; and take up the profession
of financial management.(iii) Despite a separate status financial management,
is intermingled with other aspects of management. To some extent, financial
management is the responsibility of every functional manager. For example, the
production manager proposing the installation of a new plant to be operated
with modern technology; is also involved in a financial decision.Likewise, the
Advertising Manager thinking, in terms of launching an aggressive advertising
programme, is too, considering a financial decision; and so on for other
functional managers. This intermingling nature of financial management calls
for efforts in producing a coordinated financial system for the whole
enterprise.
(iv)Financial management is
multi-disciplinary in approach. It depends on other disciplines, like
Economics, Accounting etc., for a better procurement and utilisation of
finances.
For example, macro-economic
guides financial management as to banking and financial institutions, capital
market, monetary and fiscal policies to enable the finance manager decide about
the best sources of finances, under the economic conditions, the economy is
passing through.
Micro-economics points out to
the finance manager techniques for profit maximisation, with the limited
finances at the disposal of the enterprise. Accounting, again, provides data to
the finance manager for better and improved financial decision making in
future.
(v) The finance manager is
often called the Controller; and the financial management function is given
name of controllership function; in as much as the basic guideline for the
formulation and implementation of plans-throughout the enterprise-come from
this quarter.
The finance manager, very
often, is a highly responsible member of the Top Management Team. He performs a
trinity of roles-that of a line officer over the Finance Department; a
functional expert commanding subordinates throughout the enterprise in matters
requiring financial discipline and a staff adviser, suggesting the best
financial plans, policies and procedures to the Top Management.
In any case, however, the scope
of authority of the finance manager is defined by the Top Management; in view
of the role desired of him- depending on his financial expertise and the system
of organizational functioning.
(vi) Despite a hue and cry
about decentralisation of authority; finance is a matter to be found still
centralised, even in enterprises which are so called highly decentralised. The
reason for authority being centralised, in financial matters is simple; as
every Tom, Dick and Harry manager cannot be allowed to play with finances, the
way he/she likes. Finance is both-a crucial and limited asset-of any
enterprise.
(vii) Financial management is
not simply a basic business function along with production and marketing; it is
more significantly, the backbone of commerce and industry. It turns the sand of
dreams into the gold of reality.
No production, purchases or
marketing are possible without being duly supported by requisite finances.
Hence, Financial Management commands a higher status vis-a-vis all other
functional areas of general management.
Objectives of Financial Management:
Objectives of financial management
may be multiple; as this branch of general management encompasses the entire
organizational functioning.
For sake of analysis and better comprehension, the objectives of
financial management might be classified into certain categories-as depicted in
form of the following chart:
Following is a brief account of each one of the above objectives
of financial management:
(1) Basic Objectives:
(i) Profit-Maximisation:
Since time immemorial, the
primary objective of financial management has been held to be
profit-maximisation. That is to say, that financial management ought to take
financial decisions and implement them in a way so as to lead the enterprise
along lines of profit maximasation. The support for these objectives could be
derived from the philosophy, that ‘profit is a test of economic efficiency’.
Though, there could be little controversy over profit
maximisation, as the basic objective of financial management – yet, in the
modern times, several authorities on financial management criticise this
objectives, on the following grounds:
(i) Profit is a vague concept,
in that; it is not clear whether profit means – short-run or long-run profits.
Or
– Profit before tax or profits
after tax or
– Rate of profits or the amount
of profits.
(ii) The profit maximisation
objective ignores, what financial experts call the time value of money’. To
illustrate, this concept, let us assume that two financial courses of action
provide equal benefits (i.e. profits) over a certain period of time. However,
one alternative gives more profits in earlier years; while the other one gives
more profits in later years.
Based on profit maximization
criterion, both alternatives are equally well. However, the first alternative
i.e. the one which gives more profits in earlier years is better; as some part
of the profits received earlier could be reinvested also.
Modern financial experts call
this philosophy, ‘the earlier the better principle’. The second alternative
which gives more profits only in later years is inferior; as the time-value of
profits is more in the case of the first alternative.
(iii) The profit maximization
objective ignores the quality of benefits (i.e. profits). The factor implicit
here, is the risk element associated with profits. Quality of benefits (profits)
is the most when risk associated with their occurrence is the least. According
to modern financial experts, less profit with less risk are superior to more
profits with more risk.
(iv) Profit-maximisation
objective is lop-sided. This objective considers or rather over-emphasizes only
on the interests of owners. Interests of other parties like, workers,
consumers, the Government and the society as a whole are ignored, under this
concept of profit-maximisation.
(ii) Wealth-Maximisation:
Discarding the profit-maximisation
objective; the real basic objective of financial management, now-a-days, is
considered to be wealth maximisation. Wealth maximisation is also known as
value-maximisation or the net present worth maximisation.
Since wealth of owners is reflected
in the market-value of shares; wealth maximisation means the maximisation of
the market price of shares. Accordingly, wealth maximisation is measured, by
the market value of shares.
According to wealth
maximisation objective, financial management must select those decisions, which
create most wealth for the owners. If two or more financial courses of action
are mutually exclusive (i.e. only one can be undertaken at a time); then that
decision-which creates most wealth, must be selected.
The wealth arising from a financial course of action could be
stated as follows:
Wealth = Gross present worth of
a financial course of action minus amount of capital invested which is required
to achieve the benefits i.e. cash flows.
Explanation:
The gross present worth of a
financial course of action is equal to the capitalized value of the flow of
expected future benefits (i.e. cash flows); which are discounted at a rate –
reflecting both- time value of money and their quality (i.e. the risk
associated with benefits).
Mathematically, the wealth arising from a financial course of
action could be calculated as follows:
Where,
W = Wealth, arising from a
financial course of action.
A1, A2,
An =
Stream of cash flows expected to come from the financial course of action,
K = Appropriate discount rate,
reflecting time value of money and quality of benefits, associated with the
financial course of action.
and C = initial capital outlay
to pursue that financial course of action.
The wealth maximisation objective is held to be superior to the
profit maximisation objective, because of the following reasons:
(i) It is based on the concept
of cash flows; which is more definite than the concept of profits. Moreover,
management is more interested in immediate cash flows than the profits a large
part of which might be hidden in credit sales- still to be realized.
(ii) Through discounting the
cash flows arising from a financial course of action over a period of time at
an appropriate discount rate; the wealth maximisation approach considers both-
the time value of money and the quality of benefits.
(iii) Wealth maximisation
objective is consistent with the long term profitability of the company.
(2) Operational Objectives:
(i) Timely
Availability of Requisite Finances:
A very important operational
objective of financial management is to ensure that requisite funds are made
available to all the departments, sections or units of the enterprise at the
needed time; so that the operational life of the enterprise goes smoothly.
(ii) Most
Effective Utilization of Finances:
Throughout the enterprise, the
finances must be utilized most effectively. This is yet, another important
operational objective of the financial, management.
To ensure the attainment of this objective, the financial
management must:
– Formulate plans for the most
effective utilisation of funds, among channels of investment, which create most
wealth for the company.
– Exercise and enforce ‘financial discipline’ to prevent
wasteful expenditure, by any department, or branch or section of the
enterprise.
(iii) Safety
of Investment:
The financial management must
primarily look to the safety of investment i.e. the channels of investment
might bring in less returns; but investment must be safe. Loss of investment,
in any one line, might lead to capital depletion; and ultimately tell upon the
financial health of the enterprise.
(iv) Growth
of the Enterprise:
The financial management must
plan for the long-term stability and growth of the enterprise. The limited
finances of the enterprise must be so utilized that not only short run benefits
are available; but the enterprise grows slow and steady, in the long run also.
(3) Social Objectives:
(i) Timely
Payment of Interest:
The financial management must
see to it that interest on bonds, debentures or other loans of the company is
paid in time. This will not only keep the creditors satisfied with the company
adding to its goodwill; but also prevent any untoward consequences of the
non-payment of interest, in time.
(ii) Payment
of Reasonable Dividends:
An important social objective
of financial management is that shareholders i.e. the equity members of the
company must get at least some regular dividends.
This objective is important for two reasons: –
– It
helps the company maintain its competitive image, in the market.
– The members on whose funds
the company is running profitable operations must be duly compensated, as a
matter of natural justice.
(iii) Timely
Payment of Wages:
The financial management must
make a provision for a timely payment of wages to workers. This is necessary to
keep the labor force satisfied and motivated. Further, if wages are paid on
time; the legal consequences of non-payment of wages, under the ‘ Payment of
Wages Act’, need not frighten management.
(iv) Fair-Settlement
with Suppliers:
The financial management must
make it a point to settle accounts with suppliers and fellow- businessmen in
time, in a fair way; otherwise the commercial reputation of the enterprise will
get a setback.
(v) Timely
Payment of Taxes:
An important objective of
financial management would be to make timely payment of taxes to the Government
– so as to avoid legal consequences; and also fulfill its social obligations
towards the State.
(vi) Maintaining
Relations with Financiers:
The financial management must
develop and maintain friendly relations with financiers i.e. banks, financial
institutions and various segments of the money market and capital market. When
good relations are maintained with financiers; they might come to the rescue of
the enterprise, in situations of financial crisis.
(4) Research Objectives:
The successful attainment of
various objectives by the financial management requires it to follow a research
approach. It must research into new and better sources of finances; and also
into new and better channels for the investment of finances.
This research objective of financial management requires it to:
– Collect financial data about
the progress of its competitive counterparts.
– Make a study of money market
and capital market operations, through a study of latest financial magazines
and other literature on financial management.
Meaning of Financial Management
Financial Management means planning, organizing,
directing and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
Scope/Elements
- Investment decisions includes
investment in fixed assets (called as capital budgeting). Investment in
current assets are also a part of investment decisions called as working
capital decisions.
- Financial decisions - They
relate to the raising of finance from various resources which will depend
upon decision on type of source, period of financing, cost of financing
and the returns thereby.
- Dividend decision - The finance
manager has to take decision with regards to the net profit distribution.
Net profits are generally divided into two:
- Dividend for shareholders-
Dividend and the rate of it has to be decided.
- Retained profits- Amount of
retained profits has to be finalized which will depend upon expansion and
diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned
with procurement, allocation and control of financial resources of a concern.
The objectives can be-
- To ensure regular and adequate
supply of funds to the concern.
- To ensure adequate returns to
the shareholders which will depend upon the earning capacity, market price
of the share, expectations of the shareholders.
- To ensure optimum funds
utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
- To ensure safety on investment,
i.e, funds should be invested in safe ventures so that adequate rate of
return can be achieved.
- To plan a sound capital
structure-There should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.
Functions of Financial Management
- Estimation of capital
requirements: A finance manager has to
make estimation with regards to capital requirements of the company. This
will depend upon expected costs and profits and future programmes and
policies of a concern. Estimations have to be made in an adequate manner
which increases earning capacity of enterprise.
- Determination of capital
composition: Once the estimation have
been made, the capital structure have to be decided. This involves short-
term and long- term debt equity analysis. This will depend upon the proportion
of equity capital a company is possessing and additional funds which have
to be raised from outside parties.
- Choice of sources of funds: For additional funds to be procured, a company
has many choices like-
- Issue of shares and debentures
- Loans to be taken from banks
and financial institutions
- Public deposits to be drawn
like in form of bonds.
Choice of factor will depend on relative merits and demerits of
each source and period of financing.
- Investment of funds: The finance manager has to decide to allocate
funds into profitable ventures so that there is safety on investment and
regular returns is possible.
- Disposal of surplus: The net profits decision have to be made by the
finance manager. This can be done in two ways:
- Dividend declaration - It includes
identifying the rate of dividends and other benefits like bonus.
- Retained profits - The volume
has to be decided which will depend upon expansion, innovational,
diversification plans of the company.
- Management of cash: Finance manager has to make decisions with
regards to cash management. Cash is required for many purposes like
payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough
stock, purchase of raw materials, etc.
- Financial controls: The finance manager has not only to plan, procure
and utilize the funds but he also has to exercise control over finances.
This can be done through many techniques like ratio analysis, financial
forecasting, cost and profit control, etc.
Financial Analysis :Nature and
types of Ratio Analysis, Utility and cautions in using Ratio
Analysis.
Ratio
Analysis: Nature, Uses and Limitations | Financial Analysis
Let
us make in-depth study of the nature, uses and limitations of ratio analysis.
Nature of Ratio Analysis:
Ratio analysis is a technique of analysis and interpretation of
financial statements. It is the process of establishing and interpreting
various ratios for helping in making certain decisions. However, ratio analysis
is not an end in itself. It is only a means of better understanding of
financial strengths and weaknesses of a firm.
Calculation of mere ratios does not serve any purpose, unless
several appropriate ratios are analyzed and interpreted. There are a number of
ratios which can be calculated from the information given in the financial
statements, but the analyst has to select the appropriate data and calculate
only a few appropriate ratios from the same keeping in mind the objective of
analysis. The ratios may be used as a symptom like blood pressure, the pulse
rate or the body temperature and their interpretation depends upon the calibre
and competence of the analyst.
The
following are the four steps involved in the ratio analysis:
(i) Selection of relevant data from the financial statements
depending upon the objective of the analysis.(ii) Calculation of appropriate
ratios from the above data.(iii) Comparison of the calculated ratios with the
ratios of the same firm in the past, or the ratios developed from projected
financial statements or the ratios of some other firms or the comparison with
ratios of the industry to which the firm belongs.(iv) Interpretation of the
ratios.
Uses of Ratio Analysis:
The ratio analysis is one of the most powerful tools of
financial analysis. It is used as a device to analyze and interpret the
financial health of enterprise. Just like a doctor examines his patient by
recording his body temperature, blood pressure, etc. before making his
conclusion regarding the illness and before giving his treatment, a financial
analyst analyses the financial statements with various tools of analysis before
commenting upon the financial health or weaknesses of an enterprise.
‘A ratio is known as a symptom like blood pressure, the pulse
rate or the temperature of an individual.’ It is with help of ratios that the
financial statements can be analyzed more clearly and decisions made from such
analysis. The use of ratios is not confined to financial managers only. There
are different parties interested in the ratio analysis for knowing the
financial position of a firm for different purposes.
The supplier of goods on credit, banks, financial institutions,
investors, shareholders and management all make use of ratio analysis as a tool
in evaluating the financial position and performance of a firm for granting
credit, providing loans or making investments in the firm. With the use of
ratio analysis one can measure the financial condition of a firm and can point
out whether the condition is strong, good, questionable or poor. The
conclusions can also be drawn as to whether the performance of the firm is
improving or deteriorating.
Thus,
ratios have wide applications and are of immense use today:
(a) Managerial Uses of Ratio Analysis:
1.
Helps in decision-making:
Financial statements are prepared primarily for decision-making.
But the information provided in financial statements is not an end in itself
and no meaningful conclusion can be drawn from these statements alone. Ratio
analysis helps in making decisions from the information provided in these
financial statements.
2.
Helps in financial forecasting and planning:
Ratio Analysis is of much help in financial forecasting and
planning. Planning is looking ahead and the ratios calculated for a number of
years work as a guide for the future. Meaningful conclusions can be drawn for
future from these ratios. Thus, ratio analysis helps in forecasting and
planning.
3.
Helps in communicating:
The financial strength and weakness of a firm are communicated
in a more easy and understandable manner by the use of ratios. The information
contained in the financial statements is conveyed in a meaningful manner to the
one for whom it is meant. Thus, ratios help in communication and enhance the
value of the financial statements.
4.
Helps in co-ordination:
Ratios even help in co-ordination which is of utmost importance
in effective business management. Better communication of efficiency and
weakness of an enterprise results in better coordination in the enterprise.
5.
Helps in Control:
Ratio analysis even helps in making effective control of the
business. Standard ratios can be based upon proforma financial statements and
variances or deviations, if any, can be found by comparing the actual with the
standards so as to take a corrective action at the right time. The weaknesses
or otherwise, if any, come to the knowledge of the management which helps in
effective control of the business.
6.
Other Uses:
These are so many other uses of the ratio analysis. It is an essential
part of the budgetary control and standard costing. Ratios are of immense
importance in the analysis and interpretation of financial statements as they
bring the strength or weakness of a firm.
(b) Utility to Shareholders/Investors:
An investor in the company will like to assess the financial
position of the concern where he is going to invest. His first interest will be
the security of his investment and then a return in the form of dividend or
interest. For the first purpose he will try to asses the value of fixed assets
and the loans raised against them. The investor will feel satisfied only if the
concern has sufficient amount of assets.
Long-term solvency ratios will help him in assessing financial
position of the concern. Profitability ratios, on the other hand, will be
useful to determine profitability position. Ratio analysis will be useful to
the investor in making up his mind whether present financial position of the
concern warrants further investment or not.
(c) Utility to Creditors:
The creditors or suppliers extend short-term credit to the
concern. They are interested to know whether financial position of the concern
warrants their payments at a specified time or not. The concern pays short-
term creditor, out of its current assets. If the current assets are quite
sufficient to meet current liabilities then the creditor will not hesitate in
extending credit facilities. Current and acid-test ratios will give an idea
about the current financial position of the concern.
(d) Utility to Employees:
The employees are also interested in the financial position of
the concern especially profitability. Their wage increases and amount of fringe
benefits are related to the volume of profits earned by the concern. The
employees make use of information available in financial statements. Various
profitability ratios relating to gross profit, operating profit, net profit,
etc. enable employees to put forward their viewpoint for the increase of wages
and other benefits.
(e) Utility to Government:
Government is interested to know the overall strength of the
industry. Various financial statements published by industrial units are used
to calculate ratios for determining short-term, long-term and overall financial
position of the concerns. Profitability indexes can also be prepared with the
help of ratios. Government may base its future policies on the basis of
industrial information available from various units. The ratios may be used as
indicators of overall financial strength of public as well as private sector,
in the absence of the reliable economic information, governmental plans and
policies may not prove successful.
(f) Tax Audit Requirements:
Section 44 AB was inserted in the Income Tax Act by the Finance
Act, 1984. Under this section every assesse engaged in any business and having
turnover or gross receipts exceeding Rs. 40 lakh is required to get the
accounts audited by a chartered accountant and submit the tax audit report
before the due date for filing the return of income under Section 139 (1). In case
of a professional, a similar report is required if the gross receipts exceed Rs
10 lakh.
Clause
32 of the Income Tax Act requires that the following accounting ratios should
be given:
(i) Gross Profit/Turnover
(ii) Net Profit/Turnover
(iii) Stock-in-trade/Turnover
(iv) Material Consumed/Finished Goods Produced.
Further, it is advisable to compare the accounting ratios for
the year under consideration with the accounting ratios for the earlier two
years so that the auditor can make necessary enquiries, if there is any major
variation in the accounting ratios.
Limitations of Ratio Analysis:
The ratio analysis is one of the most powerful tools of
financial management.
Though
ratios are simple to calculate and easy to understand, they suffer from some
serious limitations:
1. Limited Use of a Single Ratio:
A single ratio, usually, does not convey much of a sense. To
make a better interpretation a number of ratios have to be calculated which is
likely to confuse the analyst than help him in making any meaningful conclusion.
2. Lack of Adequate Standards:
There are no well accepted standards or rules of thumb for all
ratios which can be accepted as norms. It renders interpretation of the ratios
difficult.
3. Inherent Limitations of Accounting:
Like financial statements, ratios also suffer from the inherent
weakness of accounting records such as their historical nature. Ratios of the
past are not necessarily true indicators of the future.
4. Change of Accounting Procedure:
Change in accounting procedure by a firm often makes ratio
analysis misleading, e.g., a change in the valuation of methods of inventories,
from FIFO to LIFO increases the cost of sales and reduces considerably the
value of closing stocks which makes stock turnover ratio to be lucrative and an
unfavorable gross profit ratio.
5. Window Dressing:
Financial statements can easily be window dressed to present a
better picture of its financial and profitability position to outsiders. Hence,
one has to be very careful in making a decision from ratios calculated from
such financial statements. But it may be very difficult for an outsider to know
about the window dressing made by a firm.
6. Personal Bias:
Ratios are only means of financial analysis and not an end in
itself. Ratios have to be interpreted and different people may interpret the
same ratio in different ways.
7. Un-comparable:
Not only industries differ in their nature but also the firms of
the similar business widely differ in their size and accounting procedures,
etc. It makes comparison of ratios difficult and misleading. Moreover,
comparisons are made difficult due to differences in definitions of various
financial terms used in the ratio analysis.
8. Absolute Figures Distortive:
Ratios devoid of absolute figures may prove distortive as ratio
analysis is primarily a quantitative analysis and not a qualitative analysis.
9. Price Level Changes:
While making ratio analysis, no consideration is made to the
changes in price levels and this makes the interpretation of ratios invalid.
10. Ratios no Substitutes:
Ratio analysis is merely a tool of financial statements. Hence,
ratios become useless if separated from the statements from which they are
computed.
11. Clues not Conclusions:
Ratios provide only clues to
analysts and not final conclusions. These ratios have to be interpreted by
these experts and there are no standard rules for interpretation.
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