LEVERAGES

Leverage arises from the presence of fixed costs in a firm's cost structure. It is useful to classify leverage as operating and financial leverage.

Operating Leverage

Operating leverage stems from the presence of fixed costs. When a firm has fixed operating costs, a change in 1 percent in sales results in a change of more than 1 percent in PBIT.

Financial leverage

Financial leverage arises from the use of fixed cost financing. When a firm has fixed cost financing a change in 1 percent in PBIT  results in a change of more than 1 percent in earnings per share.

Total leverage

Total leverage refers to the combination of operating leverage and financial leverage. Thanks to the presence of fixed operating costs and fixed financing costs, a given change in sales is translated into a larger relative change in earnings pet share through  a two step magnification process.

BREAK EVEN ANALYSIS

Like ratio analysis, break even analysis also called cost volume profit analysis, is a tool for financial analysis. It is primarily concerned with the following issues.
1. How profit varies with changes in output?
2. How profit varies with changes in costs prices?

Basic Assumptions

A simple tool for profit planning and analysis,break even analysis is based on several assumptions

Cost classification

The break even model assumes that the costs of the firm can be divided into two components.

A. Fixed costs

B. Variable costs.

Fixed costs remain constant irrespective of the changes in output. They include items such as managerial and supervisory salaries, depreciation charges, property tax, rent, interest on term loans, insurance and so on. Variable costs vary proportionately with output. They include items like material cost, power cost, and selling commission.

Constancy of unit selling price

This implies that the total revenue of the firm is a linear functions of the output. For firms which have a strong market for their products, this Assumptions is quote valid. For other firms, however it may not be so. Price reduction might assumption and not unrealistic enough to impair the validity of the cost volume profit model, particularly in the relevant range of output.

Stability of product mix

In the case of a multi product firm, the cost volume profit model assumes that the product mix of the firm remains stable. Without this premise, it is not possible to define the average variable profit ratio when different products have different variable profit ratios. While it is necessary to make this assumption, it must be borne in mind that the actual mix of products may differ from the planned one. Where this discrepancy is likely to be significant, cost volume profit model has limited applicability.

No change in inventory

A final assumption underlying the conventional cost volume profit model is that the volume of sales is equal ti the volume of production during an accounting period. Put differently inventory changes are assumed to be nil. This is required because in cost volume profit analysis, we match total costs and total revenues for a particular period

CLASSIFIED CASH FLOW STATEMENT

The statement presented above lumped together all sources of cash and uses of cash. To understand better how cash flows have been influenced by various decision, it is helpful to classify cash flows into three classes.

Operating activities

Operating activities involve producing and selling goods and services. Cash inflows from operating activities include monies received from customers for sales of goods and services. Cash outflows from operating activities include payments to suppliers for materials to employees for services, and to the government for taxes.

Investing activities

Investing activities involve acquiring and disposing fixed assets,buying and selling financial securities and disbursing and collecting loans. Cash inflows from investing activities include receipts from the sale of assets recovery of loans and collection of dividend and interest. Cash outflows from investing activities include payments for the purchase of assets and disbursement of loans.

Financing activities

Financing activities involve raising money from lenders and shareholders, paying interest and dividend, and redeeming loans and share capital. Cash inflows from financing activities include receipts from issue of securities and from loans and deposits. Cash outflows from financing activities include payment of interest on various forms of borrowings, payment of dividend, retirement of borrowings and redemption of capital.

GUIDELINES FOR FINANCIAL STATEMENT ANALYSIS

From the foregoing discussion, it is clear financial statement analysis can not be treated as a simple, structured exercise. When you analyse financial statement bear in mind the following guidelines.

1. Use ratios to get clues to ask the right questions.

By themselves ratios rarely provide answers, but they definitely help you to raise the right questions.

2. Be selective in the choice of ratios

You can compute scores of different ratios and easily drown yourself into confusion, for most purpose a small set of ratios three to seven would suffice. Few ratios aptly chosen, would capture most of the information that you can derive from financial statements.

3. Employ proper benchmarks

It is a common practice to compare the ratios against some benchmarks. These benchmarks may be the average ratios of the industry or the ratios of the industry leaders or the historic ratios of the firm itself.

4. Know the tricks used by accountants

Since firms tend to manipulate the reported income, you should learn about the devices employed by them.

5. Read the footnotes.

Footnotes sometimes contain valuable information. They may reveal things that management may try to hide. The more difficult it is to read a footnote, the more information laden it may be.

6. Remember that financial statement analysis is an odd mixture of art and science

Financial statement analysis can not be regarded as a simple, structured exercise. It is a process requiring care, thought,common sense, and business judgement a process for which there are no mechanical substitutes.

FINANCIAL MARKETS AND FUNCTIONS

A financial market is a market for creation and exchange of financial assets. If you buy or sell financial assets, you will participate in financial markets in some way or the others

Functions of Financial Markets

Financial markets play a pivotal role in allocating resources in an economy by performing three important functions.

1. Financial markets facilitate price discovery

The continual interaction among numerous buyers and sellers who throng financial markets helps in establishing the prices of financial assets. Well organised financial markets seem to be remarkably efficient in price discovery. That is why financial economists say. If you want to know what is value of financial assets simply look at its price in the financial market.

2. Financial markets provide liquidity to financial assets.

Investors can readily sell their financial assets through the mechanism of financial markets. In the absence of financial markets which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished. Thanks to negotiability and transferability of securities through the financial markets, it is possible for companies to raise long term funds from investors with short term and medium term horizons. While one investor is substituted by another when a security is transacted, the company is assured of long term availability of funds.

3. Financial markets considerably reduce the cost of transacting

The two major costs associated with transacting are search costs and information cost. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the effort and time one has to put in to locate a customer. Information costs refer to costs incurred in evaluating the investment merits of financial assets.

FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system performs the following interrelated functions that are essential to a modern economy.
A. It provides a payment system for the exchange of goods and services.
B. It enables the pooling of funds for undertaking large scale enterprises.
C. It provides a mechanism for spatial and temporal transfer of resources.
D. It provides mechanisms for managing uncertainty and controlling risk.
E. It generates information that helps in coordinating decentralised decision making.
F. It helps in dealing with the incentive problem when one party has an informational advantage.

FINANCIAL DECISIONS IN A FIRM

There are three broad areas of financial decision making viz. Capital budgeting, capital structure, and working capital management.

Capital Budgeting

The first and perhaps the most important decision that any firm has to make is to define the business or businesses that it want to be this decision has a significant bearing on how capital is allocated in the firm.

Once the managers of a firm choose the business or businesses they want to be in, they have to develop a plan to invest in building, machineries, equipments, research and brands, and other long lived assets. This is the capital budgeting process.

Capital structure

Once a firm has decided on the investment projects it wants to undertake, it has to figure out way and means of financing them.

The key issues in capital structure decision are.

A. What is the optimal debit-equity ratio for the firm?

B. Which specific instruments of equity and debit finance should the firm employ?

C. Which capital markets should the firm access?

D. When should the firm raise finance?

E. At what price should the firm offer it's securities?

Capital structure and dividends decisions should be guided by considerations of cost and flexibility, in the main. The objective should be to minimise the cost of financing without impairing the ability of the firm to raise finance required for value creating investment projects.

Working capital management

Working capital management also referred to as short term financial management refers to the day to day financial activities that deal with current assets and current liabilities.