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Financial Analysis & Financial Tools What is Financial Analysis? The roots of major management decisions revolve around financial information. A careful scrutiny of alternative choices on the basis of projected information depicting the comparative results of each is needed to arrive at the selection of most favourable decision for eventual implementation. This brings us to the question what constitute financial information? What information enables the finance manager to evaluate and plan the firm's earning ability? The basic source covering financial information about a firm's affairs is its annual final accounts i.e. Profit & Loss Statement for the last operating period (quarter/halfyear/year etc,) and the Balance Sheet as at the end of that period. Profit and Loss accounts reveal the operating results of the business activities of the firm. The Balance Sheet is a statement of resources at the disposal of the firm and how they are put to use. In other words the acquired assets at the disposal of the firm and liabilities that the firm has incurred and remains indebted to others. These sources, however, reveal only part of the necessary and required information and leaves a considerable gap. It is therefore necessary to further examine and break-down the information in these statements with a much greater elaboration and detail to decipher the comparative strengths and weaknesses of the firm. The finance manager, for this purpose, employs certain analytical tools and perceptive statements based on the source data from the balance sheet and profit & loss account statements. Before we enter into the methodology and procedure for financial analysis, it is desirable to identify to whom such information is useful and how? Financial analysis serves the following purposes to the concerned authorities/bodies.
Finanancial data is to be analysed with reference to the particular objectives of the person concerned either external or internal as regards the firm. Before commencing analysis the type of analysis and the type of information needed are to be ascertained, as well as identification of the source-data, and the analytical tools to be employed. Analysis may be done with reference to a particular financial year in respect of different firms of a particular group or industry to assess their comparative status and performance or it may be restricted to a particular firm for a stretched period of 5 to 10 years to decipher its strengths and weakness and to analyse how it is progressing indifferent directions over this period. Basically a financial analysis consist of a three-step process as under-
Time Value of Money A promoter pools a fixed amount of investment in a business at the current year. When the project is completed and starts yielding positive results he reaps a series cash flow over a period of years. The pattern consists of a current investment of one lump sum, and getting a recurring return in the future, say (assume) for a period of ten years. Can he sum of the aggregate return yielded in the period of ten years and compare the amount with the initial investment made by him. This is wrong, since we know time increments money, i.e. Rs.100/- today becomes Rs.110/- next year assuming the prevailing interest rate at 10%. If we borrow an overdraft of Rs.1000/- in our bank account and offer to repay the same after a lapse of three months, the bank manager demands something more than Rs.1000/- which we originally borrowed, representing the interest or hire charges for the use of the money for the period it was held by us. This feature of money-value linked to the time factor is conceptualised by the standard called "time value of money". The time value of money means that a rupee received today is different from the worth of a rupee to be received in future. A rupee receivable in future is less valuable than the rupee held today. On this yardstick the future value of a rupee held today is arrived at by the formulae of applying a compounding factor. Similarly the present value of a future cash flow can be ascertained by applying the discounting factor. The concept of time value of money is used to determine the comparative value of different rupee amounts at different points of time into equivalent value of a particular point of time (present or future). This is calculated either by compounding the present value money to a future date and arriving at the value of the present money at those dates in future, or by discounting the future money to present date and arrive at the present value of the cash flow accruing at a future span of time. We will see how this method is applied in analysis tool called "Discounted Cash Flow" in evaluating Capital Investment Projects. One of the multiple roles of the finance manager is to strive in achieving a right balance between risk and return. Risk and return go hand in hand. One cannot hope for returns without facing/overcoming inherent risks in each kind of venture. Investment decision therefore involve a trade-off between risk and return. Risk in business is defined as the chance that the actual outcome on the investment will differ from the expected outcome. Leverage analysis is the technique used by business firms to quantify risk-return relationship of different alternative capital structures. Leverage in financial analysis represents the influence of financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, EBIT (earnings before interest & tax), EPS (Earning per share) etc. There are three commonly used measures of leverage in financial analysis. These are-
Operating leverage is defined as the "firm's ability to use fixed operating costs to magnify effect of changes in sales on its earnings before interest and taxes." Operating leverage occurs- when a firm has fixed costs, which must be met regardless of volume of sales. When the firm has fixed costs, the %-age change in profits due to change in sales level is greater than the %-age change in sales. With positive (i.e. greater than zero) fixed operating costs, a change of 1% change in sales produces a more than 1% change in EBIT. A measure of this effect is referred to as the Degree of Operating Leverage (DOL), which measures the level of operating income (EBIT)to change in the level of output and gives management an indication of the response in profits it can expect if the level of sales is altered. Specifically DOL is defined as the percentage of change in operating income (EBIT) divided by the percentage of change in the level of output (Q) Where Q=Quantity Produced and sold Financial Leverage Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm capital structure contains obligation of fixed financial charges e.g. interest on debentures, dividend on preference shares etc. along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with operating profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT. The ordinary shareholders of the firm are entitled to residual income i.e. earnings after fixed financial charges. The measure for financial leverage is called DFL (Degree of financial leverage) Thus the effect of changes in operating of profit or EBIT on the level of earnings per share (EPS) is measured by financial leverage. It is calculated as: (%-age change in EPS / %-age change in EBIT) or
(Increase in EPS / EPS divided by The financial leverage is favourable when the firm earns more on the investments/assets financed by the sources having fixed charges. It is obvious that the shareholders gain in a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds. Financial Leverage in such cases is therefore also called "Trading on Equity" Combined Leverage By combining operating and financial leverages into a combined leverage a firm can bring balance between operating as well as financial risks. Such a combined leverage measures the effect of a %-age change in sales on %-age change in EPS. i.e. Combined Leverage = Operating Leverage x Financial Leverage For evaluating investment decision involving capital outlay, a finance manager uses the following tools of analysis for arriving at risk-minimised capital budgeting.
Profitability can also be improved by efficient management of the current assets (Working Capital Management) in respect of Inventory, Receivables and Cash. | |
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