Financial Planning & Ratio Analysis

ashok vasant edurkar

Consultant Stork ...

The business of business is earning profits. However, profit would accrue only if the business becomes a success. The business would become a success only if the area activity selected by an entrepreneur is the right one and effective financial and marketing planning is undertaken beforehand.

The financial plan would provide the entrepreneur with a complete picture / overview of how much and when funds are coming in the business, where funds are going, how much cash would be available, and the projected financial position. The financial plan provides the short-term basis for budgeting control and helps prevent / avoid one of the most common problems for entrepreneurial ventures – the liquidity crunch or lack of hard cash in hand, when it is most required. The financial plan helps explain how the entrepreneur plans to meet all financial obligations and maintain its liquidity in order to be able to pay-off debt/loans or provide a good return on investment, not only to the entrepreneur, but also to the potential investors / financiers.

It is desirable, indeed imperative, that the financial plan gives a forecast for the next 3 to 5 years, preferably on a monthly / quarterly basis.

The financial planning should encompass:

l Capital Budgeting

l Operating Budgets

l Income statement

l Proforma, Balance sheet

l Break Even Analysis

l Proforma / Cash flow / Fund flow

l Proforma uses / Sources of funds

Among these, Cash Flows, Income Statement and the Balance Sheet are the key financial areas which need careful management and control.

Interprietation of Ratios

The ratios calculated on the basis of grouping and regrouping of the figures appearing on either profitability statement or Balance Sheet or both, may not all by themselves mean anything, unless they can be compared with some yardstick. The yardstick with which the ratios can be compared may be in the following three forms:

1) The ratios of one organisation may be compared with the ratios of the same organisation for the various years, either the previous years or the future years. This may be in the form of “intra-firm comparison.”

2) The ratios of one organisation may be compared with the ratios of other organisations in the same industry and such comparison will be meaningful as the various organisations in the same industry may be facing similar kinds of financial problems. This may be in the form of “inter-firm comparison.”

3) The ratios of an organisation may be compared with some standards which may be thumb rules for the evaluation of the performance. For example, if comparison of current assets and current liabilities of an organisation is to be made, the result of 2:1 i.e., two rupees of current assets for one rupee of current liabilities is supposed to be ideal. The position as reflected by the actual current assets and actual current liabilities may be compared with this standard to evaluate the performance of the organisation.

Role of Ratio Analysis

It is true that the technique of Ratio Analysis is not a creative technique in the sense that it uses the same figures and information which are already appearing in the financial statements. At the same time, it is also true that what can be achieved by the technique of Ratio Analysis cannot be achieved by the mere preparation of financial statements.

Ratio Analysis helps to appraise the firms in terms of their profitability and efficiency of performance, either individually or in relation to those of other firms in the same industry. The process of this appraisal is not complete until the ratios so computed can be compared with something, as the ratios by themselves do not mean anything. This comparison may be an intra-firm comparison, inter-firm comparison or comparison with standard ratios. Thus, proper comparison of ratios may reveal where a firm is placed as compared with earlier periods or in comparison with other firms in the same industry.

Ratio Analysis is one of the best possible techniques available to the management to impart the basic functions like planning and control. As the future is closely related to the immediate past, ratios calculated on the basis of historical financial statements may be of good assistance to predict the future. For example, on the basis of inventory turnover ratio or debtors turnover ratio in the past, the level of inventory and debtors can easily be ascertained for any given amount of sales. Similarly, the ratio analysis may be able to locate and point out the various areas which need the management’s attention in order to improve the situation. For example, current ratio which shows a constant declining trend may indicate the need for further introduction of long term finance in order to improve the liquidity position. It should be remembered that a few specific ratios indicate certain specific aspects of the conduct of business. As such, the importance of various ratios may vary for different category of persons as well. For example, the commercial bankers, trade creditors and lenders of short term credit are basically interested in the liquidity position of the organisation and as such the ratios like current ratio, acid test ratio, inventory turnover ratio and average collection period are more important. On the other hand, the financial institutions and lenders of long-term finance are basically interested in the solvency and profitabilty position of the organisation and as such the ratios like debt equity ratio, debt service coverage ratio, interest coverage ratio and return on investment are more important.

As the ratio analysis is concerned with all the aspects of a firm’s financial analysis (liquidity, solvency, activity, profitability and overall performance), it enables the interested persons to know the financial and operational characteristics of an organisation and take the suitable decisions.

Classifications of Ratios :

The ratios may be classified under various ways which may use various criteria to do the same. However, for convenience purposes we will classify the ratios under the following groups:

(a) Liquidity Group. (d) Profitability Group.

(b) Turnover Group. (e) Overall Profitability Group.

(c) Solvency Group. (f) Miscellaneous Group.