UNIT – V
Analysis of Financial Statement and Capital
Budgeting: Ratio Analysis – Liquidity ratios,
Profitability ratios and solvency. Capital and Capital
Budgeting: Meaning of capital budgeting, Need for
capital budgeting – Capital budgeting decisions -
Methods of Capital Budgeting: Payback Method,
Accounting Rate of Return (ARR), IRR and Net
Present Value Method (simple problems)
What is Capital & Capital Budgeting?
Capital is the money or wealth needed to produce
goods and services. In the most basic terms, it is
money. All businesses must have capital in order to
purchase assets and maintain their operations.
Capital budgeting is the process that a business
uses to determine which proposed fixed asset
purchases it should accept, and which should be
declined. This process is used to create a
quantitative view of each proposed fixed asset
investment, thereby giving a rational basis for
making a judgment.
Need & importance Capital Budgeting:
(1) Large Investments:
Capital budgeting decisions, generally, involve large investment of funds. But the
funds available with the firm are always limited and the demand for funds far exceeds
the resources. Hence, it is very important for a firm to plan and control its capital
expenditure.
(2) Long-term Commitment of Funds:
Capital expenditure involves not only large amount of funds but also funds for long-
term or more or less on permanent basis. The long-term commitment of funds
increases the financial risk involved in the investment decision. Greater the risk
involved, greater is the need for careful planning of capital expenditure, i.e. Capital
budgeting.
(3) Irreversible Nature:
The capital expenditure decisions are of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very
difficult to dispose of these assets without incurring heavy losses.
(4) Long-Term Effect on Profitability:
Capital budgeting decisions have a long-term and significant effect on the
profitability of a concern. Not only the present earnings of the firm are
affected by the investments in capital assets but also the future growth
and profitability of the firm depends upon the investment decision taken
today. An unwise decision may prove disastrous and fatal to the very
existence of the concern. Capital budgeting is of utmost importance to
(5) Difficulties of Investment Decisions:
The long term investment decisions are difficult to be taken because:
(i) Decision extends to a series of years beyond the current accounting
period, (ii) Uncertainties of future and (iii) Higher degree of risk.
(6) National Importance:
Investment decision though taken by individual concern is of national
importance because it determines employment, economic activities and
economic growth. Thus, we may say that without using capital budgeting
techniques a firm may involve itself in a losing project. Proper timing of
purchase, replacement, expansion and alternation of assets is essential.
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore, while
performing a capital budgeting analysis an organization must keep the
following objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due
to capital restrictions, an organization needs to select the right mix of
profitable projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital
budgeting. However, controlling capital costs is also an important objective.
Forecasting capital expenditure requirements and budgeting for it, and
ensuring no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is
another important objective of capital budgeting. Finding the balance
between the cost of borrowing and returns on investment is an important
goal of Capital Budgeting.
Capital Budgeting Process
Capital budgeting methods
Pay back period
• The payback period refers to the amount of
time it takes to recover the cost of an
investment.
• Simply put, the payback period is the length
of time an investment reaches a break-even
point.
• Least payback period is preferred for
investment
Calculate the Pay back period of Project A
& Project B and suggest best project for
investment by using Payback period
Particulars Project Project
A B
Investment Rs. 10,00,000 Rs. 12,00,000
Cash inflows Rs. Rs.
1 year 3,00,000 3,00,000
2year 3,00,000 2,75,000
3 year 3,00,000 3,40,000
4 year 3,00,000 3,80,000
5 year 3,00,000 2,60,000
Investment
Pay back Period A= ------------
returns per year
Particulars Project
A
Investment Rs. 10,00,000
Cash inflows Rs. Investment =10L
1 year 3,00,000 Average Cash inflows= TCIf/No. of
Years
2year 3,00,000 [Link]= 18L/5
3 year 3,00,000 Average cash inflows= 3,00,000
4 year 3,00,000
PBP = Investment / avg. cash inflows
5 year 3,00,000 =10L / 3L
18,00,0000 Pbp = 3.33Years
PBP = L1+(A/B)
L1= Lower year
A = required cash inflows
Particulars Project
B= CashB inflows during the L2 year
Investment Rs.
12,00,000
Cash Rs. C c inflows
inflows PBP = L1+A/B
1 year 3,00,000 3000000 =3+285000/380000
2year 2,75,000 5750000 =3+0.75
3 year (L1) 3,40,000 9150000 3.75years
4 year (L2) 3,80,000 1295000
5 year 2,60,000 1555000 Project = 3.1 Year
project = 3.75 year
Bharat Company Ltd has to choose one of the
following two actually exclusive machines. Both
the machines have to be depreciated. Which
machine would you recommend based on PBP,
ARR, Net Present Value, PI method?
Year Machine ‘P’ Machine
‘Q’
0 -20,000 -20,000
1 5,500 6,200
2 6,200 8,800
3 7,800 4,300
4 4,500 3,700
5 3,000 2,000
PBP = L1+(A/B)
L1= Lower year
A = required cash inflows
B= Cash inflows during the L2 year
Year Machine Cumulati
‘P’ ve cash
inflows
0 -20,000 - PBP= L1 + A/B
1 5,500 5500
= 3 + 500/4500
2 6,200 11700
= 3+0.1
3 L1 7,800 19500
4 L2 4,500 24000 3.1 Year
5 3,000 27000
PBP = L1+(A/B)
L1= Lower year
A = required cash inflows
B= Cash inflows during the L2 year
Year Machine Cum.
‘Q’ cash
0 -20,000 -
1 6,200 6200 PBP= L1 + A/B
2 8,800 15000 = 3 + 700/3700
3 4,300 19300 =3+ 0.18
4 3,700 23000
3.18 year
5 2,000 25000
P= 3.1 year
Q= 3.18 year
Average Rate of Return
• The average rate of return is
the average annual amount of cash flow
generated over the life of an investment.
This rate is calculated by aggregating all
expected cash flows and dividing by the
number of years that the investment is
expected to last.
• Highest ARR is preferred for investment
Calculate the Average rate of return of
Project A & Project B and suggest best
project for investment by using ARR
Particulars Project Project
A B
Investment Rs. 10,00,000 Rs. 12,00,000
Cash inflows Rs. Rs.
1 year 3,00,000 3,00,000
2year 3,00,000 2,75,000
3 year 3,00,000 3,40,000
4 year 3,00,000 3,80,000
5 year 3,00,000 2,60,000
ARR = (average returns / avg. investment ) *100
average returns = total returns / Number of Years
average investment = total investment /2
Particulars Project
A
Investment Rs. 10,00,000
average returns = total returns / Number of Years
Cash inflows Rs. = 1800000/5= 300000
Avg. Investment = total investment /2
1 year 3,00,000 =10L / 2
= 5,00,000
2year 3,00,000
ARR = (avg. returns/ avg. investment)*100
3 year 3,00,000 = (300000/500000)*100
4 year 3,00,000 = 60 %
5 year 3,00,000
1800000
Net Present Value (NPV)
It is calculated by taking the difference between
the present value of cash inflows and present
value of cash outflows over a period of time. As
the name suggests, net present value is nothing
but net off of the present value of cash inflows
and outflows by discounting the flows at a
specified rate.
• Rules for NPV is
– Accept the project if NPV is Positive
– Reject the project if NPV is Negative
– May or May not accept the project if NPV is ‘0’
Formula for time value of money
• FV = 1/(1+r)n
RATIO ANALYSIS
Ratio analysis is a quantitative procedure of
obtaining a look into a firm’s functional efficiency,
liquidity, revenues, and profitability by analyzing its
financial records and statements. Ratio analysis is a
very important factor that will help in doing an
analysis of the fundamentals of equity.
Ratio analysis is a useful management tool that will
improve your understanding of financial results and
trends over time, and provide key indicators of
organizational performance. Managers will use ratio
analysis to pinpoint strengths and weaknesses from
which strategies and initiatives can be formed.
• Objectives of Ratio Analysis are:
• Simplify accounting information.
• Determine liquidity or Short-term solvency and Long-
term solvency. Short-term solvency is the ability of the
enterprise to meet its short-term financial obligations.
Whereas, Long-term solvency is the ability of the
enterprise to pay its long-term liabilities of the business.
• Assess the operating efficiency of the business.
• Analyze the profitability of the business.
• Help in comparative analysis, i.e. inter-firm and intra-
firm comparisons.
1. Current Ratio: The current ratio is the ratio
between the current assets and current liabilities
of a company. The current ratio is used to indicate
the liquidity of an organization in being able to
meet its debt obligations in the upcoming twelve
months. A higher current ratio will indicate that
the organization is highly capable of repaying its
short-term debt obligations.
Current Ratio = Current Assets / Current Liabilities
2. Quick Ratio: The quick ratio is used to ascertain
information pertaining to the capability of a
company in paying off its current liabilities on an
immediate basis.
Quick Ratio = (Cash and Cash Equivalents +
Marketable Securities + Accounts Receivables) /
Current Liabilities.
Gross Profit Ratios: Gross profit ratios are
calculated in order to represent the operating
profits of an organization after making necessary
adjustments pertaining to the COGS or cost of
goods sold.
The formula used for the calculation of gross profit
ratio is-
Gross Profit Ratio = (Gross Profit / Net Sales) * 100
Net Profit Ratio: Net profit ratios are calculated in
order to determine the overall profitability of an
organization after reducing both cash and non-cash
expenditures.
The formula used for the calculation of net profit
ratio is-
Net Profit Ratio = (Net Profit / Net Sales) * 100
4. Return on Capital Employed (ROCE): Return on
capital employed is used to determine the
profitability of an organization with respect to the
capital that is invested in the business.
The formula used for the calculation of ROCE is:
ROCE = Earnings Before Interest and Taxes / Capital
Employed
1. Debt Equity Ratio: The debt-equity ratio can be
defined as a ratio between total debt and
shareholders fund. The debt-equity ratio is used to
calculate the leverage of an organization. An ideal
debt-equity ratio for an organization is 2:1.
The formula for debt-equity ratio is-
Debt Equity Ratio = Total Debts / Shareholders
Fund
• Advantages Of Ratio Analysis
• Ratio analysis plays an important role in analyzing a
company’s financial performance. Therefore, the
advantages of ratio analysis are:
• Useful tools for analysis for Financial Statements
• Simplifies accounting data
• Helpful in assessing the operating efficiency of
business
• Useful for forecasting
• Useful in locating the weak areas
• Useful in inter-firm and intra-firm comparison
• Limitations Of Ratio Analysis
• Ratio analysis is a powerful tool for assessing the
strengths and weaknesses of an enterprise. But, it
has certain limitations which are:
• False result
• Ignores Qualitative factors
• Lack of standard ratio
• May not be comparable
• Price level changes are not considered
• Window dressing
