FINANCIAL MANAGEMENT
UNIT I FOUNDATIONS OF FINANCE: 9
Financial management – An overview- Time value of money- Introduction to the concept of risk
And return of a single asset and of a portfolio- Valuation of bonds and shares-Option valuation
Table of Contents
1. FINANCIAL MANAGEMENT INTRODUCTION .................................................................. 3
1.1. MEANING OF FINANCE ...................................................................................................... 3
1.2. DEFINITION OF FINANCE .................................................................................................. 3
1.3.TYPES OF FINANCE .............................................................................................................. 4
2. SCOPE OF FINANCIAL MANAGEMENT ............................................................................. 5
1. Financial Management and Economics ...................................................................................... 6
2.Financial Management and Accounting ...................................................................................... 6
3.Financial Management or Mathematics ....................................................................................... 6
5.Financial Management and Marketing ........................................................................................ 6
6.Financial Management and Human Resource ............................................................................. 6
2.1. OBJECTIVES OF FINANCIAL MANAGEMENT ............................................................... 7
.1.Profit Maximization .................................................................................................................... 7
2. Favourable Arguments for Profit Maximization......................................................................... 7
3. Unfavorable Arguments for Profit Maximization....................................................................... 7
2.2. Wealth Maximization............................................................................................................... 8
Favourable Arguments for Wealth Maximization .......................................................................... 8
Unfavorable Arguments for Wealth Maximization ........................................................................ 8
3. APPROACHES TO FINANCIAL MANAGEMENT ................................................................ 9
3.1. Traditional Approach ............................................................................................................... 9
3.2. Modern Approach .................................................................................................................. 10
4. FUNCTIONS OF FINANCE MANAGER .............................................................................. 11
Financial controller and treasurer ................................................................................................. 11
Table 1 .......................................................................................................................................... 11
Table 2 .......................................................................................................................................... 11
4.1. Forecasting Financial Requirements ...................................................................................... 12
4.2. Acquiring Necessary Capital ................................................................................................. 12
4.3. Investment Decision............................................................................................................... 12
4.4. Cash Management .................................................................................................................. 12
5. IMPORTANCE OF FINANCIAL MANAGEMENT .............................................................. 12
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5.1. Financial Planning ................................................................................................................. 12
5.2. Acquisition of Funds .............................................................................................................. 13
5.3. Proper Use of Funds............................................................................................................... 13
5.4. Financial Decision ................................................................................................................. 13
5.5. Improve Profitability.............................................................................................................. 13
5.6. Increase the Value of the Firm ............................................................................................... 13
5.7. Promoting Savings ................................................................................................................. 13
6. Risk and return of single assets and that of a portfolio ............................................................. 13
6.1. Direct Relationship between Risk and Return ....................................................................... 14
6.2. Risk of Individual Assets Vs. The Risk Of Portfolios ........................................................... 15
6.3. TYPES OF RISK ................................................................................................................... 16
1. SYSTEMATIC RISK ............................................................................................................... 16
2. UNSYSTEMATIC RISK.......................................................................................................... 16
7. The Time Value of Money........................................................................................................ 17
CONCEPTS ................................................................................................................................. 17
7.1Future Value............................................................................................................................. 17
7.2. PRESENT VALUE ................................................................................................................ 19
Present Value ................................................................................................................................ 20
7.3. Annuities ................................................................................................................................ 21
7.4. Present Value of an Annuity .................................................................................................. 22
8. STOCK VALUATION ............................................................................................................. 22
8.1. Constant Growth Stock Valuation ......................................................................................... 23
8.2.Non Constant Growth stock valuation .................................................................................... 24
8.3. PREFERRED STOCK VALUATION .................................................................................. 26
8.4. BOND VALUATION ............................................................................................................ 27
9. FINANCIAL STATEMENT ANALYSIS INTRODUCTION ................................................ 28
9.1. MEANING AND DEFINITION ........................................................................................... 29
9.2. TYPES OF FINANCIAL STATEMENT ANALYSIS ......................................................... 30
10. TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS ............................................. 31
10.1. Comparative Statement Analysis ......................................................................................... 32
10.2. Trend Analysis ..................................................................................................................... 32
10.3. Funds Flow statement .......................................................................................................... 32
10.4. Cash Flow statement ............................................................................................................ 33
10.6. Ratio Analysis ...................................................................................................................... 33
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1. FINANCIAL MANAGEMENT INTRODUCTION
Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfill their business
activities.
In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related with making profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labour, interest given to capital and profit given
to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.
1.1. MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. Finance also is referred as the provision of money at the time when it
is needed. Finance function is the procurement of funds and their effective utilization in business
concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part of
the business concern.
1.2. DEFINITION OF FINANCE
According to Khan and Jain, “Finance is the art and science of managing money”.
According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’.
Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the
management of funds’ and the management of fund as the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE
According to the Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall objectives of
a business enterprise”.
According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in the
business”.
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In the words of Parhter and Wert, “Business finance deals primarily with raising, administering
and disbursing funds by privately owned business units operating in non- financial fields of
industry”.
Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business concern and the
business concern needs to adopt modern technology and application suitable to the global
environment.
According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial
problems of corporate enterprises. These problems include the financial aspects of the promotion
of new enterprises and their administration during early development, the accounting problems
connected with the distinction between capital and income, the administrative questions created
by growth and expansion, and finally, the financial adjustments required for the bolstering up or
rehabilitation of a corporation which has come into financial difficulties”.
 Financial Management is concerned with three activities
Anticipating financial needs, which mean estimating requirements of the firm in terms of longterm and short-term needs or investment in fixed and current assets. Acquiring financial
resources from different sources to meet the financial needs. Allocating funds to maximize
shareholders’ wealth. The term financial management has been defined differently by various
authors. Some of the authoritative definitions are given below:
1. “Financial Management is concerned with the efficient use of an important
Economic resource, namely, Capital Funds.”Solomon
2. “Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short-term and long-term credits for the firm.”– Phillioppatus
3. “Financial Management is concerned with the acquisition, financing and
Management of assets with some overall goal in mind.”– James C. Van Horne
4. “Financial Management deals with procurement of funds and their effective
Utilization in the business.”– S.C. Kuchhal
 TYPES OF FINANCE
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names.
Finance can be classified into two major part
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finance
public finance
privatefinance

DEFINITION OF FINANCIAL MANAGEMENT
Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm.
The term financial management has been defined by Solomon, “It is concerned with the efficient
use of an important economic resource namely, capital funds”.
The most popular and acceptable definition of financial management as given by S.C. Kuchal is
that “Financial Management deals with procurement of funds and their effective utilization in the
business”.
Howard and Upton : Financial management “as an application of general managerial principles
to the area of financial decision-making.
Weston and Brigham : Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
Joshep and Massie : Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
2. SCOPE OF FINANCIAL MANAGEMENT
Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
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management covers wide area with multidimensional approaches. The following are the
important scope of financial management.
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc. Financial
economics is one of the emerging area, which provides immense opportunities to finance, and
economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.
3. Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance
required for each process of production activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements.
The
financial
manager or finance department is responsible to allocate the adequate
finance to the
marketing department. Hence, marketing and financial management are
interrelated and depends on each other.
6. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission, bonus, pension and other
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monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.
2.1. OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
1. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways
to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
 Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i)Main aim is earning profit.
(ii)Profit is the parameter of the business operation.
(iii)Profit reduces risk of the business concern.
(iv)Profit is the main source of finance.
(v)Profitability meets the social needs also.
 Unfavorable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i)Profit maximization leads to exploiting workers and consumers.
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(ii)Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.
(iii)Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.
Profit maximization objective consists of certain drawback also:
(i)It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
(ii)It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.
(iii)It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.
2. Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth maximization.
This objective is an universally accepted concept in the field of business.
2.1Favourable Arguments for Wealth Maximization
(i)Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
(ii)Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business operation. It
provides extract value of the business concern.
(iii)Wealth maximization considers both time and risk of the business concern.
(iv)Wealth maximization provides efficient allocation of resources.
(v)It ensures the economic interest of the society.
2.2. Unfavorable Arguments for Wealth Maximization
(i)Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
(ii)Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.
(iii)Wealth maximization creates ownership-management controversy.
(iv)Management alone enjoys certain benefits.
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(v)The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi)Wealth maximization can be activated only with the help of the profitable position of the
business concern.
3. APPROACHES TO FINANCIAL MANAGEMENT
Financial management approach measures the scope of the financial management in various
fields, which include the essential part of the finance. Financial management is not a
revolutionary concept but an evolutionary. The definition and scope of financial management has
been changed from one period to another period and applied various innovations. Theoretical
points of view, financial management approach may be broadly divided into two major parts.
3.1. Traditional Approach
Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and the
traditionally accepted methods. Main part of the traditional approach is rising of funds for the
business concern. Traditional approach consists of the following important area.
Arrangement of funds from lending body.
Arrangement of funds through various financial instruments.
Finding out the various sources of funds
The scope of finance function was treated in the narrow sense as procurement or arrangement of
funds. A finance manager was treated as just provider of funds, when organization felt its need.
The utilization or administering resources was considered outside the purview of the finance
function. It was felt that the finance manager had no role to play in the decision-making for its
utilization. Others used to take decisions regarding its application in the organization, without the
involvement of finance personnel. Finance manager had been treated, in fact, as an outsider with
a very specific and limited function, supplier of funds, to perform when the need of funds was
felt by the Organization. As per this approach, the following aspects only were included in the
scope of financial management:
(i) Estimation of requirements of finance.
(ii) Arrangement of funds from financial institutions.
(iii)Arrangement of funds through diverse financial instruments such as shares, debentures,
bonds and loans.
(iv)Looking after the accounting and legal work connected with the raising of funds, and
(v) Preparation of financial statements and managing cash levels needed to payday-to-day
maturing obligations. The traditional approach was evolved during the 1920s and 1930s period
and continued till 1950. The approach had been discarded due to the following limitations:
(I)No Involvement in Application of Funds:
The finance manager had not been involved in decision-making of the allocation of funds. He
had been ignored in internal decision-making process and treated as an outsider.
(ii)No Involvement in Day-to-day Management: The focus was on providing long-term funds
from a combination of sources. This process was more of one time happening. The finance
manager was not involved in day-to-day administration of working capital management. Smooth
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functioning of the firm depends on working capital management, where the finance manager was
not involved and allowed to play any role.
(iii)Not Associated in Decision-making–Allocation of Funds: The issue of allocation of funds
was kept outside his functioning. He had not been involved in decision-Making for its judicious
utilization.
(iv) Outsider-looking-in Approach: The subject of finance has moved around the approach has
been outsider-looking-in approach, since finance manager has never been involved in internal
decision-making process. Raising finance was an infrequent event. Its natural implication was
that the issues involved in working capital management were not in the purview of the finance
function. In nutshell, during the traditional phase, the finance manager was called upon, in
particular, when his specialty was required to locate new sources of funds, as and when the
requirement of funds was felt. The following issues, as pointed by Solomon, were ignored in the
scope of financial management, under this approach:
(A) Should an enterprise commit capital funds to a certain purpose?
(B) Do the expected returns meet financial standards of performance?
(C) How should these standards be set and what is the cost of capital funds to the
Enterprise?
(D) How does the cost vary with the mixture of financing methods used?
The traditional approach has failed to provide answers to the above questions due to
Narrow scope. Traditional approach has outlived its utility in the changed business
Situation. The scope of finance function has undergone a sea change, with the emergence
Of different capital instruments.
3.2. Modern Approach
Modern approach has started during mid 1950s. The approach and utility of financial
Management has started changing in a revolutionary manner. Modern approach provides
Answers to those questions which traditional approach has failed to provide. Financial
management is considered as vital and an integral part of overall management. Its scope is wider,
as it covers both procurement of funds and its efficient allocation. Allocation is not a just
haphazard process. Its effective utilization and allocation among various investments helps to
maximize shareholders’ wealth. The emphasis of Financial Management has been shifted from
raising funds to the effective and judicious utilization of funds. The modern approach is
Analytical way of looking into the financial problems of the firm. Financial Management and
Management Accounting The main contents of this new approach are:
(A) What is the total volume of funds an enterprise should commit?
(B) What specific assets an enterprise should acquire?
(C) How should the funds required be financed?
Advice of finance manager is required at every moment, whenever any decision with
involvement of funds is taken. There is hardly any activity that does not involve funds. In the
words of Solomon, “The central issue of financial policy is the use of funds. It is helpful in
achieving the broad financial goals which an enterprise sets for itself”. Now-a-days, the finance
manager is required to look into the financial implications of every decision to be taken by the
firm. He is involved before taking any decision, during its review and, finally, when the final
outcome is judged. In other words, his association has been continuous in every decision-making
process from inception till it sends.
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4. FUNCTIONS OF FINANCE MANAGER
Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function. He must
have entire knowledge in the area of accounting, finance, economics and management. His
position is highly critical and analytical to solve various problems related to finance. A person
who deals finance related activities may be called finance manager.
Financial controller and treasurer
The following table shows the different functions of financial control and treasury.
Table 1
Financial controller





Preparation of external annual
accounts
Preparation
of
internal
monthly
management
accounts
Preparation of capital and
revenue budgets
Tracking of budget variances
Key relationship: auditors
Treasurer






Raising short-term and long-term external funds
Management of liquidity
Minimization of cost of external funds
Management of cash within the organization
Management of exposure to financial risks –
interest-rate and foreign exchange
Key relationships: existing and potential providers
of funds, stock market analysts and the financial
press
To analyses the activity of the finance division using the terms financial control and treasury is
perhaps natural in view of the division of responsibilities between the two key sub-divisional
heads. But a more useful analysis might divide the activities into internal and external functions.
Table 2
Internal




Management of liquidity
Management of cash within the
firm
Preparation of internal monthly
management accounts
Preparation of capital and
External





Raising short-term and long-term external funds
Preparation of external annual accounts
Minimization of cost of external funds
Management of exposure to financial risks –
interest-rate and foreign exchange
Key relationships: existing and potential sources
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
revenue budgets
Tracking of budget variances
of funds, stock market analysts, financial press,
auditors.
Finance manager performs the following major functions:
4.1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.
After deciding the financial requirement
4.2. Acquiring Necessary Capital
The finance manager should concentrate how the finance is mobilized and where it will be
available. It is also highly critical in nature.
4.3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital
4.4. Cash Management
Present days cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern. Interrelation with Other Departments.
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
5. IMPORTANCE OF FINANCIAL MANAGEMENT
Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their
smooth running of the business concern and also maintain the business carefully to achieve the
goal of the business concern. The business goal can be achieved only with the help of effective
management of finance. We can’t neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial management is as follows:
5.1. Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
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5.2. Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost
5.3. Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
5.4. Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct
relationship with various department functions such as marketing, production personnel, etc.
5.5. Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.
5.6. Increase the Value of the Firm
important in the field of increasing the wealth of the investors and the business concern. Ultimate
aim of any business concern will achieve the maximum profit and higher profitability leads to
maximize the wealth of the investors as well as the nation.
5.7. Promoting Savings
Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings.
Nowadays financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of
the financial management.
6. Risk and return of single assets and that of a portfolio
Risk is the possibility of loss by unforeseen happenings. it may be categorized as monetary and
non- monetary. in financial parlance risk is the possibility of loss in your investments made
(either the capital u had invested, returns or both).
Return is the expected value from an investment which has a risk associated with it. For ex:
investing in stock market has a equity risk involved with it. Generally returns are based on risk
levels.
Higher the risk higher the return and the vice versa
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6.1. Direct Relationship between Risk and Return
(A) High Risk - High Return
According to this type of relationship, if investor will take more risk, he will get more reward.
So, he invested million, it means his risk of loss is million dollars. Suppose, he is earning 10%
return. It means, his return is Lakh but he invests more million, it means his risk of loss of money
is million. Now, he will get Lakh return.
(B) Low Risk - Low Return
It is also direct relationship between risk and return. If investor decreases investment. It means,
he is decreasing his risk of loss, at that time, his return will also decrease.
(A) High Risk Low Return
Sometime, investor increases investment amount for getting high return but with increasing
return, he faces low return because it is nature of that project. There is no benefit to increase
investment in such project. Suppose, there are 1, 00,000 lotteries in which you will earn the prize
of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize wills same but
at increasing of risk, your return will decrease.
(B) Low Risk High Return
There are some projects, if you invest low amount, you can earn high return. For example,
Govt. of India needs money. Because, govt. needs this money in emergency and Govt. is giving
high return on small investment. If you get this opportunity and invest your money, you will get
high return on your small risk of loss of money.
The average return level is usually described by the expected value of the return and the
risk is usually described by the variance of the return. The role of the expected return is clear: it
gives us an idea of how high; the return is likely to be, on average. But how does variance
measure risk?
Since the variance measures the spread of the distribution, we can learn something about the
extent of uncertainty that exists regarding the return on the investment by looking at the variance.
So variance measures risk in the sense of uncertainty.
However, some people intuitively associate risk with undesirable outcomes alone. If we think
of the mean return as a "neutral" outcome, returns less than the mean would be "bad" outcomes
and returns more than the mean would be "good" outcomes. If the return distribution is
symmetric, this also means that good outcomes are as likely as bad outcomes. Since the variance
measures the spread of the distribution around the mean, in this case, it would also give us a
measure of how "bad" a bad outcome is likely to be, on average. However, if the distribution is
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not symmetric, then this is not true, and we need other measures such as skewness (the extent to
which the distribution is skewed or tilted in one direction, instead of being symmetric) to give us
this information. For symmetric distributions, like the normal distribution, the variance is a good
measure of risk in this sense as well.
In what follows, we will interpret the concept of risk to mean uncertainty. However, the
notion of variance as a measure of risk works only for portfolios containing the entire wealth of
an individual --it does not work for the individual assets that make up the portfolio.
6.2. Risk of Individual Assets Vs. The Risk Of Portfolios
The variance of returns can be used as a measure of risk if we are evaluating the entire
portfolio of investments that an investor has. However, if the investment under consideration is
meant to be an addition to an existing portfolio, then the variance of the asset return is not
appropriate as a measure of risk of this investment. This is because we are interested primarily
in the risk of our entire portfolio, and as far as this new asset is concerned, we would be
interested in the incremental risk of the investment. The appropriate measure of the incremental
risk of an investment differs from the variance, which is a measure of the total risk of the
investment.
Consequently, we need to investigate how the variance of a portfolio is affected by the
addition of a single asset. First, we need to define a portfolio in a more formal manner, and see
how its variance is related to the variances of the assets that make up the portfolio.
RETURN – The Return from holding a Financial Asset over a specified period can be defined as
the total gain earned in the form of cash payments received due to ownership and any change in
market price of the Asset divided by the beginning price.
RISK – The Risk is the variability of Returns from those that are expected. The difference
between actual and expected return is the source of Risk. It is the chance of financial loss. Assets
having greater chances of loss are viewed as more risky than those with lesser chances of losses.
RISK PREFERENCES – Managers and Firms have different risk preferences: Risk Indifferent
Managers – Required or expected return does not change as risk changes. Risk adverse Managers
– Required or expected return increases as risk increases. Risk seeking Managers – Required or
expected return decreases as risk increases.
COMPUTATION OF EXPECTED RATE OF RETURN - The expected rate of return E(R) is the
weighted average of all possible returns multiplied by their respective probabilities.
COMPUTATION OF RISK - Risk is computed for any financial assets as (i) asset being the
standalone asset and/or (ii) asset being the part of a portfolio. The risk can be assessed in
following manner:
SENSITIVITY ANALYSIS
It uses several possible-return estimates to obtain a sense of the variability among outcomes. One
common method involves making pessimistic (worst), most likely (expected), and optimistic
(best) estimates of the returns associated with a given asset. In this case, the asset’s risk can be
measured by the range of returns. The range is found by subtracting the pessimistic outcome
15
from the optimistic outcome. The greater the range, the more variability, or risk, the asset is said
to have.
PROBABILITY DISTRIBUTION – An event’s probability is defined as the chance that the
event will occur. A probability distribution is a model that relates probabilities to the associated
outcomes. Bar Chart is the simplest type of probability distribution but it shows only a limited no
of outcomes. For all the possible large no of outcomes, continuous probability distribution is
used.
RISK MEASUREMENT FOR SINGLE ASSET STANDARD DEVIATION – It measures
the dispersion around the expected return. The expected return is the most likely return on an
asset. Investment with higher returns has higher standard deviation because higher standard
deviation is associated with greater risk. The relationship reflects risk aversion by market
participants, who require higher returns as compensation for greater risk. COEFFICIENT OF
VARIANCE (Variation) – Coefficient of variance (Variation) is the standard deviation divided
by the expected return.
6.3. TYPES OF RISK
1. SYSTEMATIC RISK – A systematic risk is one that influences a large number of assets,
each to a greater or lesser extent. Because systematic risk has market wide effects, they are
sometimes called market risks.
2. UNSYSTEMATIC RISK – An unsystematic risk is one that affects a single asset or a small
group of assets. Because these risks are unique to individual companies or assets ,they are
sometimes called unique or asset-specific risk. These can be minimized with diversification.
Examples of Systematic Risk - Change in Interest rate policy, Tax rates. Govt goes for a
massive deficit financing. Inflation rate increases. Relaxes foreign exchange control. Examples
of unsystematic Risk - Company workers declare strikes. R&D Expert leaves the company.
Formidable Competitor enters the market. Inadequate/Irregular supply of raw material.
The Portfolio Return is the weighted average of return on individual assets.
E(R p ) = wE(R 1 ) + (1-w) E (R 2 )
The portfolio Variance/Standard Deviation is not weighted average of the Individual
assets’ standard deviation/Variance. The Portfolio Variance/Standard Deviation depends
on the co-movement (measured by co-variance) of returns on assets. An Investor has to
suffer systematic risk as it can’t be diversified away. The difference between variance and
co-variance is the diversifiable risk. Unsystematic risk can be eliminated as more
securities are added into portfolio. Research show that in USA 15 securities in a Portfolio
can eliminate the unsystematic risk while in India this number is 40. Required rate of
return on a security is equal to risk free rate plus risk premium for a risky security. Risk
premium equals the market risk premium, i.e., the difference between expected market
return and risk free return. Since market risk premium is same for all securities, the total
risk premium varies directly with systematic risk measured by β (Beta).
To know the contribution of an individual security to the risk of a well diversified
portfolio, the market risk of the security is measured. The market risk of the security is
measured by measuring its sensitivity to market movements. This is called as β (Beta). By
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Definition, β for market portfolio is 1.Any company having β value more than 1 will
fluctuate more widely than the market and any company having β value less than 1 will
fluctuate less widely than the market . Computation of β Market risk premium is the
difference between the return on the market ( r m ) and the risk free return ( r f) . Market
risk premium = r m – r f Treasury Bills return is considered as risk free return which is
currently 6%-7%.T bills as guaranteed by government have zero risk and hence have zero
β .On the other hand market portfolio with a β of 1 will have risk premium as r m – r f.
The Capital Asset pricing Model suggests the expected risk premium for a security when β
is neither zero nor 1. Expected risk premium (r – r f ) = β (r m – r f ) OR , r = β (r m – r f )
+ r f Where r = required rate of return on security
7. The Time Value of Money
A rupee on hand today is worth more than a rupee to be received in the future because the rupee
on hand today can be invested to earn interest to yield more than a rupee in the future. The Time
Value of Money mathematics quantifies the value of a dollar through time. This, of course,
depends upon the rate of return or interest rate which can be earned on the investment.
The Time Value of Money has applications in many areas of Corporate Finance including
Capital Budgeting, Bond Valuation, and Stock Valuation. For example, a bond typically pays
interest periodically until maturity at which time the face value of the bond is also repaid. The
value of the bond today, thus, depends upon what these future cash flows are worth in today's
dollars.
The Time Value of Money concepts will be grouped into two areas: Future Value and Present
Value. Future Value describes the process of finding what an investment today will grow to in
the future. Present Value describes the process of determining what a cash flow to be received in
the future is worth in today's dollars.
CONCEPTS
7.1Future Value
The Future Value of a cash flow represents the amount, at some time in the future, that an
investment made today will grow to if it is invested to earn a specific interest rate. For example,
if you were to deposit $100 today in a bank account to earn an interest rate of 10% compounded
annually, this investment will grow to $110 in one year. This can be shown as follows:
Year 1
Rs 100(1 + 0.10) = Rs110
At the end of two years, the initial investment will have grown to Rs 121. Notice that the
investment earned $11 in interest during the second year, whereas, it only earned Rs 10 in
interest during the first year. Thus, in the second year, interest was earned not only on the initial
17
investment of Rs 100 but also on the $10 in interest that was paid at the end of the first year. This
occurs because the interest rate in the example is a compound interest rate.
Compound Interest
Under compound interest, interest is earned not only on the initial principal but also on the
accumulated interest. Interest begins to be earned on the accumulated interest as soon as it is
paid, which occurs at the end of each compounding period. This is in contrast to simple interest,
under which interest is only earned on the initial principal.
Valuations should generally be based on compound interest because, after the interest has been
paid, the full amount, i.e., the initial principal plus interest, could be withdrawn and reinvested
elsewhere. Thus, interest on the new investment would be earned on the full amount
The interest rate in the example is 10% compounded annually. This implies that interest is paid
annually. Thus the balance in the account was Rs 110 at the end of the first year. Thus, in the
second year the account pays 10% on the initial principal of $100 and the Rs 10 of interest
earned in the first year. Thus, the Rs121 balance in the account after two years can be computed
as followingYear 2
Rs 110(1+0.10) = Rs 121 or
Rs 100(1+0.10)(1+0.10) = Rs 121 or
Rs 100(1+0.10)2 = Rs 121
If the money was left in the account for one more year, interest would be earned on $121, i.e., the
initial principal of $100, the $10 in interest paid at the end of year 1, and the $11 in interest paid
at the end of year 2. Thus the balance in the account at the end of year three is $133.10. This can
be computed as follows:
Year 3
Rs 121(1+0.10) = Rs 133.10 or
Rs 100(1+0.10) (1+0.10) (1+0.10) = Rs 133.10 or
Rs 100 (1+0.10)3 = Rs 133.10
A pattern should be becoming apparent. The Future Value of an initial investment at a given
interest rate compounded annually at any point in the future can be found using the following
equation:
18
where




FVt = the Future Value at the end of year t,
CF0 = the initial investment,
r = the annually compounded interest rate, and
t = the number of years.
Future Value Example
Find the Future Value at the end of 4 years of Rs 100 invested today at an interest rate 10%.
Solution
7.2. PRESENT VALUE
Present Value describes the process of determining what a cash flow to be received in the future
is worth in today's dollars. Therefore, the Present Value of a future cash flow represents the
amount of money today which, if invested at a particular interest rate, will grow to the amount of
the future cash flow at that time in the future. The process of finding present values is called
Discounting and the interest rate used to calculate present values is called the discount rate. For
example, the Present Value of $100 to be received one year from now is $90.91 if the discount
rate is 10% compounded annually. This can be demonstrated as follows
One Year
$90.91(1 + 0.10) = $100 or
$90.91 = $100/(1 + 0.10)
Notice that the Future Value Equation is used to describe the relationship between the present
value and the future value. Thus, the Present Value of $100 to be received in two years can be
shown to be $82.64 if the discount rate is 10%.
Two Years
$82.64(1 + 0.10)2 = $100 or
$82.64 = $100/(1 + 0.10)2
Valuations should generally be based on compound interest because, after the interest has been
paid, the full amount, i.e., the initial principal plus interest, could be withdrawn and reinvested
elsewhere. Thus, interest on the new investment would be earned on the full amount
19
A pattern should be becoming apparent. The following equation can be used to calculate the
Present Value of a future cash flow given the discount rate and number of years in the future that
the cash flow occurs. (This equation can be obtained algebraically from the Future Value
Equation.)
where




PV = Present Value
CFt = Future Cash Flow which occurs t years from now
r = the interest or discount rate
t = the number of years
Present Value Example
Find the Present Value of $100 to be received 3 years from today if the interest rate is 10%.
Solution:
Present Value
The Present Value of a Cash Flow Stream is equal to the sum of the Present Values of the
individual cash flows. To see this, consider an investment which promises to pay $100 one year
from now and $200 two years from now. If an investor were given a choice of this investment or
two alternative investments, one promising to pay $100 one year from now and the other
promising to pay $200 two years from now, clearly, he would be indifferent between the two
choices. (Assuming that the investments were all of equal risk, i.e., the discount rate is the same.)
This is because the cash flows that the investor would receive at each point in time in the future
are the same under either alternative. Thus, if the discount rate is 10%, the Present Value of the
investment can be found as follows:
Present Value of the Investment
PV = $100/(1 + 0.10) + $200/(1 + 0.10)2
PV = $90.91 + $165.29 = $256.20
The following equation can be used to find the Present Value of a Cash Flow Stream.
20
Where





PV = the Present Value of the Cash Flow Stream,
CFt = the cash flow which occurs at the end of year t,
r = the discount rate,
t = the year, which ranges from zero to n, and
n = the last year in which a cash flow occurs.
Present Value Example
Find the Present Value of the following cash flow stream given that the interest rate is 10%.
Solution:
7.3. Annuities
An Annuity is a cash flow stream which adheres to a specific pattern. Namely, an Annuity is a
cash flow stream in which the cash flows are level (i.e., all of the cash flows are equal) and the
cash flows occur at a regular interval. The annuity cash flows are called annuity payments or
simply payments. Thus, the following cash flow stream is an annuity.
Figure 1
While, the following cash flow stream is not an annuity because the payments do not occur at a
regular interval.
Figure 2
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When a cash flow stream is of the form given in Figure 1, i.e., an annuity, the process of finding
the Present Value or Future Value of the cash flow stream is greatly simplified.
7.4. Present Value of an Annuity
The Present Value of an Annuity is equal to the sum of the present values of the annuity
payments. This can be found in one step through the use of the following equation:
Where




PVA = The Present Value of the Annuity
PMT = The Annuity Payment
r = The Interest or Discount Rate
t = The Number of Years (also the Number of Annuity Payments)
Consider the annuity of $100 per year for five years given in Figure 1. If the discount rate is
equal to 10%, then the Present Value of the Annuity can be found as follows:
Present Value of the Annuity
8. STOCK VALUATION
Firms obtain their long-term sources of equity financing by issuing common and preferred stock.
The payments of the firm to the holders of these securities are in the form of dividends. Unlike
interest payments on debt which are tax deductible, dividends must be paid out of after-tax
income.
The common stockholders are the owners of the firm. They have the right to vote on important
matters to the firm such as the election of the Board of Directors. Preferred stock, on the other
hand, is a hybrid form of financing, sharing some features with debt and some with common
22
equity. For example, preferred dividends like interest payments on debt are generally fixed. In
addition, the claims against the assets of the firm of the preferred stockholders, like those of the
debt holders, are also fixed.
The common stockholders have a residual claim against the assets and cash flows of the firm.
That is, the common stockholders have a claim against whatever assets remain after the debt
holders and preferred stockholders have been paid. Moreover, the cash flow that remains after
interest and preferred dividends have been paid belongs to the common stockholders.
The priority of the claims against the assets of the firm belonging to debt holders, preferred
stockholders, and common stockholders differ. The owners of the firm's debt securities have the
first claim against the assets of the firm. This means that the debt holders must receive their
scheduled interest and principal payments before any dividends can be paid to the equity holders.
If these claims are not paid, the debt holders can force the firm into bankruptcy. The preferred
stockholders have the next claim. They must be paid the full amount of their scheduled dividends
before any dividends may be distributed to the common stockholders.
The value of these securities, as with other assets, is based upon the discounted value of their
expected future cash flows. In this section, Time Value of Money principles are applied to value
common and preferred stock. Two approaches are presented for the valuation of common stock.
The first approach illustrates the valuation of a constant growth stock, i.e., a stock whose
dividends are growing at a rate which mirrors the long-term growth rate of the economy. The
second approach is a more general approach which can be applied to value stocks whose growth
is not constant in the near term.
8.1. Constant Growth Stock Valuation
Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite
maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques
used for stock valuation must make some assumptions regarding the structure of the dividends.
A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the
foreseeable future. This condition fits many established firms, which tend to grow over the long
run at the same rate as the economy, fairly well. The value of a constant growth stock can be
determined using the following equation:
where





P0 = the stock price at time 0,
D0 = the current dividend,
D1 = the next dividend (i.e., at time 1),
g = the growth rate in dividends, and
r = the required return on the stock, and
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
g < r.
Constant Growth Stock Valuation Example
Find the stock price given that the current dividend is Rs2 per share, dividends are expected to
grow at a rate of 6% in the foreseeable future, and the required return is 12%.
Solution:
Please see the Constant Growth Stock Exercise for additional example problems which illustrate
the calculation of the other variables, i.e., the growth rate, required return, and dividend.
Dividend yield and capital gains yield
The constant growth stock equation can be rearranged to obtain an expression for the expected
return on the stock as follows:
When expressed in this manner, it is apparent that the expected return on the stock equals the
expected dividend yield plus the expected capital gains yield where the dividend yield and
capital gains yield are defined as follows
A more general form of the Constant Growth Stock Valuation formula which can be used to find
the price of the stock at any period t in the future is given by the following:
8.2.Non Constant Growth stock valuation
Many firms enjoy periods of rapid growth. These periods may result from the introduction of a
new product, a new technology, or an innovative marketing strategy. However, the period of
rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and
catch up with the firm.
24
These firms cannot be valued properly using the Constant Growth Stock Valuation approach.
This section presents a more general approach which allows for the dividends/growth rates
during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from
that point on at a constant rate which reflects the long-term growth rate in the economy.
Stocks which are experiencing the above pattern of growth are called non constant, supernormal,
or erratic growth stocks.
The value of a non constant growth stock can be determined using the following equation:
where






P0 = the stock price at time 0,
Dt = the expected dividend at time t,
T = the number of years of non constant growth,
gc = the long-term constant growth rate in dividends, and
r = the required return on the stock, and
gc < r.
Non constant Growth Stock Valuation Example
The current dividend on a stock is $2 per share and investors require a rate of return of 12%.
Dividends are expected to grow at a rate of 20% per year over the next three years and then at a
rate of 5% per year from that point on. Find the price of the stock.
Solution:
There are 3 years of non constant growth, thus, T = 3. Before substituting into the formula given
above it is necessary to calculate the expected dividends for years 1 through 4 using the provided
growth rates.
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8.3. PREFERRED STOCK VALUATION
Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt.
Preferred stock is similar to common stock in that it entitles its owners to receive dividends
which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source
of financing does not increase the probability of bankruptcy for the firm.
However, like the coupon payments on debt, the dividends on preferred stock are generally
fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as are
the claims of the debt holders.
Preferred stock has the following features:
Par Value
The par value represents the claim of the preferred stockholder against the value of the
firm.
Preferred Dividend / Preferred Dividend Rate
The preferred dividend rate is expressed as a percentage of the par value of the preferred
stock. The annual preferred dividend is determined by multiplying the preferred dividend
rate times the par value of the preferred stock.
Since the preferred dividends are generally fixed, preferred stock can be valued as a constant
growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred
stock can be determined using the following equation:
where



Pp = the preferred stock price,
Dp = the preferred dividend, and
r = the required return on the stock.
Preferred Stock Valuation Example
Find the price of a share of preferred stock given that the par value is $100 per share, the
preferred dividend rate is 8%, and the required return is 10%.
26
Solution:
8.4. BOND VALUATION
Bonds are long-term debt securities that are issued by corporations and government entities.
Purchasers of bonds receive periodic interest payments, called coupon payments, until maturity
at which time they receive the face value of the bond and the last coupon payment. Most bonds
pay interest semiannually. The Bond Indenture or Loan Contract specifies the features of the
bond issue. The following terms are used to describe bonds.
Par or Face Value
The par or face value of a bond is the amount of money that is paid to the bondholders at
maturity. For most bonds the amount is $1000. It also generally represents the amount of money
borrowed by the bond issuer.
Coupon Rate
The coupon rate, which is generally fixed, determines the periodic coupon or interest payments.
It is expressed as a percentage of the bond's face value. It also represents the interest cost of the
bond issue to the issuer.
Coupon Payments
The coupon payments represent the periodic interest payments from the bond issuer to the
bondholder. The annual coupon payment is calculated be multiplying the coupon rate by the
bond's face value. Since most bonds pay interest semiannually, generally one half of the annual
coupon is paid to the bondholders every six months.
Maturity Date
The maturity date represents the date on which the bond matures, i.e., the date on which the face
value is repaid. The last coupon payment is also paid on the maturity date.
Original Maturity
The time remaining until the maturity date when the bond was issued.
Remaining Maturity
The time currently remaining until the maturity date.
Call Date
For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to maturity,
the call date represents the date at which the bond can be called.
27
Call Price
The amount of money the issuer has to pay to call a callable bond. When a bond first becomes
callable, i.e., on the call date, the call price is often set to equal the face value plus one year's
interest.
Required Return
The rate of return that investors currently require on a bond.
Yield to Maturity
The rate of return that an investor would earn if he bought the bond at its current market price
and held it until maturity. Alternatively, it represents the discount rate which equates the
discounted value of a bond's future cash flows to its current market price.
Yield to Call
The rate of return that an investor would earn if he bought a callable bond at its current market
price and held it until the call date given that the bond was called on the call date.
The box below illustrates the cash flows for a semiannual coupon bond with a face value of
$1000, a 10% coupon rate, and 15 years remaining until maturity. (Note that the annual coupon
is $100 which is calculated by multiplying the 10% coupon rate times the $1000 face value.
Thus, the periodic coupon payments equal $50 every six months.)
Bond Cash Flows
Because most bonds pay interest semi annually, the discussion of Bond Valuation presented here
focuses on semiannual coupon bonds. However, the corresponding equations for annual coupon
bonds are provided on the Bond Equations par value
9. FINANCIAL STATEMENT ANALYSIS INTRODUCTION
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. Hence, preparation of the financial statement is
important as much as the financial decisions.
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9.1. MEANING AND DEFINITION
According to Hamptors John, the financial statement is an organized collection of data according
to logical and consistent accounting procedures. Its purpose is to convey an understanding of
financial aspects of a business firm. It may show a position at a moment of time as in the case of
a balance-sheet or may reveal a service of activities over a given period of time, as in the case of
an income statement.
Financial statements are the summary of the accounting process, which provides useful
information to both internal and external parties. John N. Nyer also defines it “Financial
statements provide a summary of the accounting of a business enterprise, the balance-sheet
reflecting the assets, liabilities and capital as on a certain data and the income statement showing
the results of operations during a certain period”.
Financial statements generally consist of two important statements:
(i) The income statement or profit and loss account.
(ii) Balance sheet or the position statement.
A part from that, the business concern also prepares some of the other parts of statements, which
are very useful to the internal purpose such as:
(i) Statement of changes in owner’s equity.
(ii) Statement of changes in financial position.
Financial Statement
Income Statement
Statement of changes in Owner's Equity
Position Statement
Statement of changes in Financial Position
Income Statement
Income statement is also called as profit and loss account, which reflects the operational position
of the firm during a particular period. Normally it consists of one accounting year. It determines
the entire operational performance of the concern like total revenue generated and expenses
incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is
determined by preparation of trading or manufacturing a/c and net profit is determined by
preparation of profit and loss account.
Position Statement
Position statement is also called as balance sheet, which reflects the financial position of the firm
at the end of the financial year.
29
Position statement helps to ascertain and understand the total assets, liabilities and capital of the
firm. One can understand the strength and weakness of the concern with the help of the position
statement.
Statement of Changes in Owner’s Equity
It is also called as statement of retained earnings. This statement provides information about the
changes or position of owner’s equity in the company. How the retained earnings are employed
in the business concern. Nowadays, preparation of this statement is not popular and nobody is
going to prepare the separate statement of changes in owner’s equity.
Statement of Changes in Financial Position
Income statement and position statement shows only about the position of the finance, hence it
can’t measure the actual position of the financial statement. Statement of changes in financial
position helps to understand the changes in financial position from one period to another period.
Statement of changes in financial position involves two important areas such as fund flow
statement which involves the changes in working capital position and cash flow statement which
involves the changes in cash position.
9.2. TYPES OF FINANCIAL STATEMENT ANALYSIS
Analysis of Financial Statement is also necessary to understand the financial positions during a
particular period. According to Myres, “Financial statement analysis is largely a study of the
relationship among the various financial factors in a business as disclosed by a single set of
statements and a study of the trend of these factors as shown in a series of statements”.
Analysis of financial statement may be broadly classified into two important types on the basis
of material used and methods of operations.
Types of Financial Analysis
On the basis of
On the basis of
Materials Used
Methods of Operations
External Internal
Analysis
Analysis
Horizontal Vertical
Analysis
Analysis
1. Based on Material Used
Based on the material used, financial statement analysis may be classified into two major types
such as External analysis and internal analysis.
A. External Analysis
Outsiders of the business concern do normally external analyses but they are indirectly involved
in the business concern such as investors, creditors, government organizations and other credit
30
agencies. External analysis is very much useful to understand the financial and operational
position of the business concern. External analysis mainly depends on the published financial
statement of the concern. This analysis provides only limited information about the business
concern.
B.Internal Analysis
The company itself does disclose some of the valuable information’s to the business concern in
this type of analysis. This analysis is used to understand
the operational performances of each and every department and unit of the business concern.
Internal analysis helps to take decisions regarding achieving the goals of the business concern.
2. Based on Method of Operation
Based on the methods of operation, financial statement analysis may be classified into two major
types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several years and based on
that, a firm may take decisions. Normally, the current year’s figures are compared with the base
year (base year is consider as 100) and how the financial information are changed from one year
to another. This analysis is also called as dynamic analysis.
B. Vertical Analysis
Under the vertical analysis, financial statements measure the quantities relationship of the
various items in the financial statement on a particular period. It is also called as static analysis,
because, this analysis helps to determine the relationship with various items appeared in the
financial statement. For example, a sale is assumed as 100 and other items are converted into
sales figures.
10. TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to analyse the
financial statement of the business concern. The following are the common methods or
techniques, which are widely used by the business concern.
Techniques of Financial Statement Analysis
1. Comparative Statement Analysis
A. Comparative Income Statement Analysis
B. Comparative Position Statement Analysis
31
2. Trend Analysis
3. Common Size Analysis
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
10.1. Comparative Statement Analysis
Comparative statement analysis is an analysis of financial statement at different period of time.
This statement helps to understand the comparative position of financial and operational
performance at different period of time.
Comparative financial statements again classified into two major parts such as comparative
balance sheet analysis and comparative profit and loss account analysis.
Comparative Balance Sheet Analysis
Comparative balance sheet analysis concentrates only the balance sheet of the concern at
different period of time. Under this analysis the balance sheets are compared with previous
year’s figures or one-year balance sheet figures are compared with other years. Comparative
balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to
understand the real financial position of the concern as well as how the assets, liabilities and
capitals are placed during a particular period.
10.2. Trend Analysis
The financial statements may be analyzed by computing trends of series of information. It may
be upward or downward directions which involve the percentage relationship of each and every
item of the statement with the common value of 100%. Trend analysis helps to understand the
trend relationship with various items, which appear in the financial statements. These
percentages may also be taken as index number showing relative changes in the financial
information resulting with the various period of time. In this analysis, only major items are
considered for calculating the trend percentage.
10.3. Funds Flow statement
Funds flow statement is one of the important tools, which is used in many ways. It helps to
understand the changes in the financial position of a business enterprise between the beginning
and ending financial statement dates. It is also called as statement of sources and uses of funds.
Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement
prospective or retrospective, setting out the sources and application of the funds of an enterprise.
The purpose of the statement is to indicate clearly the requirement of funds and how they are
proposed to be raised and the efficient utilization and application of the same”.
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10.4. Cash Flow statement
Cash flow statement is a statement which shows the sources of cash inflow and uses of cash outflow of the business concern during a particular period of time. It is the statement, which
involves only short-term financial position of the business concern. Cash flow statement
provides a summary of operating, investment and financing cash flows and reconciles them with
changes in its cash and cash equivalents such as marketable securities. Institute of Chartered
Accountants of India issued the Accounting Standard (AS-3) related to the preparation of cash
flow statement in 1998.
Difference between Funds Flow and Cash Flow Statement
Funds Flow Statement
1.Funds flow statement is the report on the
Cash Flow Statement
1.Cash flow statement is the report showing
movement of funds or working capital
sources and uses of cash.
2.Funds flow statement explains how working 2.Cash flow statement explains the inflow and
capital is raised and used during the particular out flow of cash during the particular period.
3.The main objective of fund flow statement is 3.The main objective of the cash flow statement
to show the how the resources have been
is to show the causes of changes in cash
Balanced mobilized and used.
Between two balance sheet dates.
4.Funds flow statement indicates the results of 4.Cash flow statement indicates the factors
Current financial management.
contributing to the reduction of cash balance
in spite of increase in profit and vice-versa.
5.In a funds flow statement increase or decrease5.In a cash flow statement only cash receipt and
in working capital is recorded.
6.In funds flow statement there is no opening
payments are recorded.
6.Cash flow statement starts with opening cash
and closing balances.
balance and ends with closing cash balance.
10.6. Ratio Analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a mathematical
relationship between one numbers to another number. Ratio is used as an index for evaluating the
financial performance of the business concern. An accounting ratio shows
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The mathematical relationship between two figures, which have meaningful relation with each
other. Ratio can be classified into various types. Classification from the point of view of
financial management is as follows:
●Liquidity Ratio
●Activity Ratio
●Solvency Ratio
●Profitability Ratio
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