UNIT 1

INVESTMENT SETTING

INVESTMENT

The money a person earns is partly spent and the rest saved for meeting future
expenses. Instead of keeping the savings idle he may like to use savings in order to get
return on it in the future. This is called Investment.

The term investment refers to exchange of money wealth into some tangible
wealth. The money wealth here refers to the money (savings) which an investor has and
the term tangible wealth refers to the assets the investor acquires by sacrificing the money
wealth. By investing, an investor commits the present funds to one or more assets to be
held for some time in expectation of some future return in terms of interest or dividend and
capital gain.

Definition:

“Investment may be defined as an activity that commits funds in any

financial/marketable or physical form in the present with an expectation of receiving
additional return in the future.”

For example, a Bank deposit is a financial asset, the purchase of gold is a physical asset
and the purchase of bonds and shares is marketable asset.

“Investment is the commitment of current funds in anticipation of receiving larger

inflow of funds in future, the difference being the income”. An investor hopes to be
compensated for (i) forgoing present consumption, (ii) for the effects of inflation, and (iii)
for taking a risk.

Features:

There are three basic features common to all types of investment:

1. There is a commitment of present funds.

2. There is an expectation of some return or benefits from such commitment in future,

and
3. There is always some risk involved in respect of return and the principal amount
invested.
 OBJECTIVES OF INVESTMENT:

1. RETURN:
Investors expect a good rate of return from their investments. Return from
investment may be in terms of revenue return or income (interest or dividend) and/or in
terms of capital return (capital gain i.e. difference between the selling price and the
purchasing price). The net return is the sum of revenue return and capital return.

For example, an investor purchases a share (Face Value FV Rs.10) for Rs.130. After one
year, he receives a dividend of Rs.3 (i.e. 30% on FV of Rs.10) from the company and sells
it for Rs.138. His total return is Rs.11, i.e., Rs.3 + Rs.8. The normal rate of return is Rs.11
divided by Rs.130 i.e., 8.46%.

In the same case, if he is able to sell the share only for Rs.128, then his net return is Re.1 (i.e., Rs.3
– Rs.2) only. The annual rate of return in this case is 0.77% (i.e., 1/130)

a) Expected Return:
The expected return refers to the anticipated return for some future period. The
expected return is estimated on the basis of actual returns in the past periods.

b) Realised Returns:
The realized return is the net actual return earned by the investor over the holding period.
It refers to the actual return over some past period.

2. RISK:
Variation in return i.e., the chance that the actual return from an investment would
differ from its expected return is referred to as the risk. Measuring risk is important
because minimizing risk and maximizing return are interrelated objectives.

3. LIQUIDITY:
Liquidity, with reference to investments, means that the investment is saleable or
convertible into cash without loss of money and without loss of time. Different types of
investments offer different type of liquidity.
 Most of financial assets provide a high degree of liquidity. Shares and mutual fund
units can be easily sold at the prevailing prices. An investor has to build a portfolio
containing a good proportion of investments which have relatively high degree of
liquidity.Cash and money market instruments are more liquid than the capital market
instruments which in turn are more liquid than the real estate investments. For ex, money
deposited in savings a/c and fixed deposit a/c in a bank is more liquid than the investment
made in shares or debentures of a company.

4. SAFETY:

An investor should take care that the amount of investment is safe. The safety of an
investment depends upon several factors such as the economic conditions, organization
where investment is made, earnings stability of that organization, etc. Guarantee or
collateral available against the investment should also be taken care of. For ex,

 Bonds issued by RBI are completely safe investments as compared with the bonds of a
private sector company.
 Like wise it is more safer to invest in debenture than of preference shares of a company
 Accordingly, it is more safer to invest in preference shares than of equity shares of a
company, the reason being that in case of company liquidation, order of payment is
debenture holders, preference share holds and then equity share holders.

5. TAX BENEFITS:
Investments differ with respect to tax treatment of initial investment, return from
investment and redemption proceeds. For example, investment in Public Provident Fund
(PPF) has tax benefits in respect of all the three characteristics. Equity Shares entails
exemption from taxability of dividend income but the transactions of sale and purchase are
subject to Securities Transaction Tax or Tax on Capital gains. Sometimes, the tax
treatment depends upon the type of the investor.

The performance of any investment decision should be measured by its after tax rate of
return. For example, between 8.5% PPF and 8.5% Debentures, PPF should be preferred as
it is exempt from tax while debenture is subject to tax in the hands of the investors.
6. REGULARITY OF INCOME:

The prime objective of making every investment is to earn a stable return. If returns
are not stable, then the investment is termed as risky. For example, return (i.e. interest)
from Savings a/c, Fixed deposit a/c, Bonds & Debentures are stable but the expected
dividends from equity share are not stable. The rate of dividend on equity shares may
fluctuate depending upon the earnings of the company.
RISK

Investors invest for anticipated future returns, but these returns can be rarely
predicted. The difference between the expected return and the realized return and latter
may deviate from the former. This deviation is defined as risk.

All investors generally prefer investment with higher returns, he has to pay the
price in terms of accepting higher risk too. Investors usually prefer less risky
investments than riskier investments. The government bonds are known as risk-free
investments, while other investments are risky investments.

RISK

Systematic Unsystematic

Or Or

Uncontrollable controllable

1. Market risk 1. Business risk

2. Interest rate risk 2. Financial risk

3. Purchasing power risk

SYSTEMATIC RISK
It affects the entire market. It indicates that the entire market is moving in
 particular direction. It affects the economic, political, sociological changes. This risk is
further subdivided into:

1. Market risk

2. Interest rate risk

3. Purchasing power risk

1. Market risk:

Jack Clark Francis defined market risk as “portion of total variability in return
caused by the alternating forces of bull and bear markets. When the security index
moves upward for a significant period of time, it is bull market and if the index
declines from the peak to market low point is called troughs i.e. bearish for significant
period of time.

The forces that affect the stock market are tangible and intangible events. The
tangible events such as earthquake, war, political uncertainty and fall in the value of
currency. Intangible events are related to market psychology.

For example – In 1996, the political turmoil and recession in the economy
resulted in the fall of share prices and the small investors lost faith in market. There
was a rush to sell the shares and stocks that were floated in primary market were not
received well.

2. Interest rate risk:

It is the variation in single period rates of return caused by the fluctuations in

the market interest rate. Mostly it affects the price of the bonds, debentures and stocks.
The fluctuations in the interest rates are caused by the changes in the government
monetary policy and changes in treasury bills and the government bonds.
Interest rates not only affect the security traders but also the corporate bodies who carry
their business with borrowed funds. The cost of borrowing would increase and a heavy
outflow of profit would take place in the form of interest to the capital borrowed. This
would lead to reduction in earnings per share and consequent fall in price of shares.

EXAMPLE –In April 1996, most of the initial public offerings of many
companies remained under subscribed, but IDBI & IFC bonds were over subscribed.
The assured rate of return attracted the investors from the stock market to the bond
market.

3. Purchasing power risk:

Variations in returns are due to loss of purchasing power of currency. Inflation is the reason
 behind the loss of purchasing power. The inflation may be, “demand-pull or cost-push “.

 Demand pull inflation, the demand for goods and services are in excess of their
supply. The supply cannot be increased unless there is an expansion of labour force or
machinery for production. The equilibrium between demand and supply is attained at a
higher price level.
 Cost-push inflation, the rise in price is caused by the increase in the cost. The increase
in cost of raw material, labour, etc makes the cost of production high and ends in high
price level. The working force tries to make the corporate to share the increase in the
cost of living by demanding higher wages. Hence, Cost-push inflation has a spiraling
effect on price level.

UNSYSTEMATIC RISK

Unsystematic risk stems from managerial inefficiency, technological change in

production process, availability of raw materials, change in consumer preference and
labour problems. They have to be analysed by each and every firm separately. All these
factors form Unsystematic risk. They are

1. Business risk
2. Financial risk

1. BUISNESS RISK:
It is caused by the operating environment of the business. It arises from the
inability of a firm to maintain its competitive edge and the growth or stability of the
earnings. The variation in the expected operating income indicates the business risk. It
is concerned with difference between revenue and earnings before interest and tax. It
can be further divided into:

 Internal business risk

 External business risk

Internal business risk - it is associated with the operational efficiency of the firm. The
efficiency of operation is reflected on the company’s achievement of its goals and their
promises to its investors. The internal business risks are:

 Fluctuation in sales
 Research and development
 Personal management
 Fixed cost
 Single product

External business risk –It is the result of operating conditions imposed on

the firm by circumstances beyond its control. The external business risk are,
 Social and regulatory factors
 Political risk
 Business cycle.
2. FINANCIAL RISK:

It is the variability of the income to the equity capital due to the debt capital.
Financial risk is associated with the capital structure of the firm. Capital structure of
firm consists of equity bonds and borrowed funds. The interest payment affects the
payments that are due to the equity investors. The use of debt with the owned funds to
increase the return to the shareholders is known as financial leverage.

The financial risk considers the difference between EBIT and EBT. The
business risk causes the variation between revenue and EBIT. The financial risk is
an avoidable risk because it is the management which has to decide how much has
to be funded with equity capital and borrowed capital.

INVESTMENT & SPECULATION:

In speculation, there is an investment of funds with an expectation of some
return in the form of capital profit resulting from the price change and sale of
investment. Speculation is relatively a short term investment. The degree of
uncertainty of future return is definitely higher in case of speculation than in
investment.

In case of investment, the investor has an intention of keeping the

investment for some period whereas in speculation, the investor looks for an
opportunity of making a profit and “exit- out” by selling the investment.

DIFFERENCES IN INVESTMENT & SPECULATION:

FACTOR INVESTEMENT SPECULATION

1. Degree of risk Relatively lesser Relatively higher
2.Basis of return Income and capital Change in market
gain price
3. Basis for Analysis of Rumors, tips, etc
decision fundamentals
4.Position of Ownership Party of an
investor agreement
5.Investment Long term Short term
period
INVESTMENT ALTERNATIVES

Physical assets like real estate, gold/jewelry, commodities etc. and/or

Financial assets /Non-Marketable financial assets such as fixed deposits with banks,
small saving instruments with post offices, insurance/provident/pension fund etc.
Marketable financial assets - securities market related instruments like shares, bonds,
debentures, derivatives, mutual fund etc.

REAL ASSETS FINANCIAL ASSETS

1. Real Estate 1. Equity Claims

• Residential Apartments • Equity Shares
• Office Buildings • Mutual Funds
• Land • Convertible Debentures
2. Gems and Metals • Convertible Preference Shares
• Diamonds 2. Redeemable Preference Shares
• Gold 3. Creditors Claims
• Silver • Debt Securities
3. Antiques • Commercial Paper
• Art Pieces • Loans and Deposits
• Stamps • Savings Account
• Coins etc

Intangible Alternative Investments :

Hedge funds
Private equity
Venture capital
Derivatives
Cryptocurrency
 Return

Return can be defined as the actual income from a project as well as appreciation in
the value of capital. Thus there are two components in return—the basic component
or the periodic cash flows from the investment, either in the form of interest or
dividends; and the change in the price of the asset, com-monly called as the capital
gain or loss.

The term yield is often used in connection to return, which refers to the income
component in relation to some price for the asset. The total return of an asset for the
holding period relates to all the cash flows received by an investor during any
designated time period to the amount of money invested in the asset.

Computation of Return

1. Grow More Ltd. Is evaluating the rate of return on two of its

Assets, I and II. The Asset I was purchased a year ago for Rs.4,00,000
and since then it has generated cash inflows of Rs. 16,000. Presently, it
can be sold for a price of Rs.4,30, 000.Asset II was purchased a few
years ago and its market price in the beginning and at the end of the
current year was Rs.2,40,000 and Rs.2,36,000 respectively. The Asset
II has generated cash inflows of Rs.34,000 during the year. Find out the
rate of return on these assets.

Solution: The rate of return on these assets can be ascertained with the
help of the above equation:

For Asset I R= 16000+(430000-400000) = 11.5%

 400000

11.5%

For Asset II R= 34000+(236000-240000) =12.5%

240000

2. A had purchased a bond at a price of Rs.800 with a coupon payment of

Rs.150 and sold it Rs.1000.i)What is his holding period return and ii)If the bond is
sold is sold for Rs.750 after receiving Rs.150 as coupon payment then what is his
holding period return?

i) R= 150+(1000-800) X 100 = 43.75%

800

ii) R= 150+(750-800) X 100 = 12.5%

800

Expected rate of Return

The expected return is the profit or loss that an investor anticipates on an investment
that has known historical rates of return (RoR). It is calculated by multiplying
potential outcomes by the chances of them occurring and then totaling these results.
Expected returns cannot be guaranteed. The expected return for a portfolio
containing multiple investments is the weighted average of the expected return of
each of the investments.
Expected return calculations are a key piece of both business operations and
financial theory, including in the well-known models of the modern portfolio theory
(MPT)

For example, if an investment has a 50% chance of gaining 20% and a 50% chance
of losing 10%, the expected return would be 5% = (50% x 20% + 50% x -10% =
5%).

What is Expected Return?

The expected return on an investment is the expected value of the probability
distribution of possible returns it can provide to investors. The return on the
investment is an unknown variable that has different values associated with different
probabilities. Expected return is calculated by multiplying potential outcomes
(returns) by the chances of each outcome occurring, and then calculating the sum of
those results (as shown below).

Computation of Expected Return.

1. Compute expected return on security X from the particulars given:

Ret Prob
urn abilit
y
20 .15
%
21 .20
%
22 .50
%
23 .10
%
24 .05
%

Ret Prob PX
urn( abilit
X) y(P)
20 .15 3.00
%
21 .20 2.10
%
22 .50 13.20
%
23 .10 2.30
%
24 .05 1.20
%
21.8

Expected return R = 21.8%

RISK
Risk is defined in financial terms as the chance that an outcome or investment's
actual gains will differ from an expected outcome or return. Risk includes the
possibility of losing some or all of an original investment.

Investing money into the markets has a high degree of risk and you should be
compensated if you're going to take that risk. If somebody you marginally trust asks
for a Rs.500 loan and offers to pay you Rs.600 in two weeks, it might not be worth
the risk, but what if they offered to pay you Rs.1000? The risk of losing Rs.500 for
the chance to make Rs.1000 might be appealing.

Calculation of Risk

The market price of an equity share is Rs.100.Following information is available

respect of dividends.market price and expected market condition after one year

Market Probabilit Market Dividend

Condition y Price
Good 25 Rs.115 9

Normal 50 107 5

Bad 25 97 3

Find out the expected return and variability of return of the equity share.
 UNIT 2
FUNDAMENTAL ANALYSIS
 FUNDAMENTAL ANALYSIS:

Fundamental analysis is the study of economic factors, industrial environment and

the factors related to the company. The earnings of the company, the growth rate and
the risk exposure of the company have a direct bearing on the price of the share.
These factors in turn rely on the host of other factors like economic development in
which they function, the industry belongs to, and finally companies’ own
performance. The fundamental school of thought appraised the intrinsic value of
shares through
 Economic Analysis
 Industry Analysis
 Company Analysis

ECONOMIC ANALYSIS:

The state of the economy determines the growth of gross domestic product and
investment opportunities. An economy with favorable savings, investments, stable
prices, balance of payments, and infrastructure facilities provides a best environment
for common stock investment. If the company grows rapidly, the industry can also
be expected to show rapidly growth and vice versa. When the level of economic
activity is low, stock prices are low, and when the level of economic activity is high,
stock prices are high reflecting the prosperous outlook for sales and profits of the
firms. The analysis of macro economic environment is essential to understand the
behaviour of the stock prices.
The commonly analyzed macro economic factors are as follows:

 Gross domestic product (GDP):

GDP represents the aggregate value of goods and services produced in the economy.
It consists of personal consumption expenditure, gross private domestic investment
and government expenditure on goods & services and net export of goods &
services. It indicates rate of growth of economy. The estimate on GDP available on
annual basis.

 Business Cycle:
Business cycles refer to cyclical movement in the economic activity in a country as a
whole. An economy marching towards prosperity passes through different phases,
each known as a component of a business cycle. These phases are:
a. Depression: Demand level in the economy is very low. Interest rates and Inflation
rates are high. These affect profitability and dividend pay out and reinvestment
activities.
b. Recovery: Demand level starts picking up. Fresh investment by corporate firms
shows increasing trend.
c. Boom: After a consistent recovery for a number of years, the economy starts
showing signs of boom which is characterized by high level of economic activities
such as demand, production and profits.
d. Recession: The boom period is generally not able to sustain for a long period. It
slows down and results in the recession.

 Savings & investment:

The growth requires investment which in turn requires substantial amount of
domestic savings. Stock market is a channel through which the savings of investors
are made available to the corporate bodies. Savings are distributed over various
assets like equity shares, deposits, mutual fund unit, real estate and bullion. The
saving and investment pattern of the public effect the stock to great extent.
 Inflation:
The inflation is raise in price, where its rate increases, than the real rate of growth
 would be very little. The demand is the consumer product industry is significantly
affected. The industry which comes under the government price control policy may
lose the market. If the mild level of inflation, it is good to the stock market but high
rate of inflation is harmful to the stock market.
 Interest rates:
The interest rate affects the cost of financing to the firms. Higher interest rates
increase the cost of funds and lower interest rates reduce the cost of funds resulting
in higher profit. There are several reasons for change in interest rates such as
monetary policy, fiscal policy, inflation rate, etc,
 Monetary Policy, Money supply and Liquidity:
The liquidity in the economy depends upon the money supply which is regulated by
the monetary policy of the government. RBI regulate the money supply and liquidity
in the economy. Business firms require funds for expansion projects. The capacity to
raise funds from the market is affected by the liquidity position in the economy. The
monetary policy is designed with an objective to maintain a balance in liquidity
position. Neither the excess liquidity nor the shortage are desirable. The shortage of
liquidity will tend to increase the interest rates while the excess will result in
inflation.
 Budget:
The budget draft provides an elaborate account of the government revenues and
expenditures. A deficit budget may lead to high rate of inflation and adversely affect
the cost of production. Surplus budget may result in deflation. Hence, balanced
budget is highly favourable to the stock market.
 Tax structure:
Every year in March, the business community eagerly awaits the government’s
announcement regarding the tax policy. Concessions and incentives given to the
certain industry encourage investment in particular industry. Tax relief given to
savings encourages savings. The minimum alternative tax (MAT) levied by finance
minister in 1996 adversely affected the stock market. Ten years of tax holiday for all
industries to be set up in the northeast is provided in the 1999 budget. The type of tax
exemption has impact on the profitability of the industries.
 Monsoon and agriculture:
Agriculture is directly and indirectly linked with the industries. For example, sugar,
cotton, textile and food processing industries depend upon agriculture for raw
material. Fertilizer and insectide industries are supplying inputs to agriculture. A
good monsoon leads to higher demand for input and results in bumper crop. This
would lead to buoyancy in the stock market. When the monsoon is bad, agricultural
and hydro power production would suffer. They cast a shadow on a share market.
 Infrastructure facilities:
Infrastructure facilities are essential for the growth of industrial and agricultural
sector. A wide network of communication system is a must for the growth of the
economy. Good infrastructure facilities affect the stock market favourably. The
government are liberalized its policy regarding the communication, transport and
power sector.
 Demographic factors:
The Demographic data provides details about the population by age, occupation,
literacy and geographic location. This is needed to forecast the demand of customer
goods. The population by age indicates the availability of able work force.
 Economic forecasting:
To estimate the stock price changes, an analyst the macro economic environment and
the factor peculiar to industry concerned to it. The economic activities affect the
corporate profits, Investors, attitude and share prices.
 Economic indicators:
The economic indicators are factors that indicate the present status, progress or slow
down of the economy. They are capital investment, business profits, money supply,
GNP, interest rate, unemployment rate, etc. The economic indicators are grouped
 into leading, coincidental and lagging indicators. The indicators are selected on the
following criteria
Economic
significance,
Statistical adequacy,
Timing, conformity.
 Diffusion index:
Diffusion index is a composite index or consensus index. The diffusion index consist
of leading, coincidental and lagging indicators. This type of index has been
constructed by the National Bureau of Economic Research in USA. But it is complex
in nature to calculate and the irregular movements that occur in individual indicators
cannot be completely eliminated.
 Econometric model building:
For model building several economic variables are taken into consideration. The
assumptions underlying the analysis are specified. The relationship between the
independent and dependent variables is given mathematically. While using the
model, the analyst has to think clearly all inter-relationship between the variables.
This model use simultaneous equations.

Other factors:
a. Industrial growth rate
b. Fiscal policy of the Government
c. Foreign exchange reserves
d. Growth of infrastructural facilities
e. Global economic scenario and confidence
f. Economic and political stability.
 INDUSTRY ANALYSIS

An industry is a group of firms that have similar technological structure of

production and produce similar products. E.g.: food products, textiles, beverages and
tobacco products, etc. These industries can be classified on the business cycle i.e.
classified according to their relations to the different phases of the business cycle.
They are classified into
 Growth industry
 Cyclical industry
 Defensive industry
 Cyclical Growth industry

 Growth industry:
The growth industry has special features of high rate of earnings and growth in
expansion, independent of the business cycle. The expansion of the expansion of the
industry mainly depends upon the technological change.
 Cyclical industry:
The growth and the profitability of industry move along with the business cycle.
During the boom period they enjoy the growth and during depression they suffer set
back.
 Defensive industry:
Defensive industry defies the movement of business cycle. The stock of defensive
industries can be held by the investor for income earning purpose. They expand and earn
income in the depression period too, under the government’s of production and are
counter-cyclical in nature.
 Cyclical Growth industry
This is a new type of industry that is cyclical and at the same time growing. The changes
in technology and introduction of new models help the automobile industry to resume
their growth path.

INDUSTRY LIFE CYCLE

The life cycle of the industry is separated into four well defined stages such as
o Pioneering stage
o Rapid growth stage
o Maturity and stabilization stage
o Declining stage

Fig.5
 Pioneering stage:

The prospective demand for the product is promising in this stage and the technology of
the product is low. The demand for the product attracts many producers to produce the
particular product. There would be severe competition and only fittest companies this
stage. The producers try to develop brand name, differentiate the product and create a
product image. This would lead to non- price competition too. The severe competition
often leads to the change of position of the firms in terms of market shares and profit. In
this situation, it is difficult to select companies for investment because the survival rate
is unknown.
Rapid growth stage:
This stage starts with the appearance of surviving firms from the pioneering stage. The
companies that have withstood the competition grow strongly in market share and
financial performance. The technology of the production would have improved resulting
in low cost of productions and good quality products. The companies have stable growth
rate in this stage and they declare dividend to the share-holders. It is advisable to invest
in the shares of these companies.
Maturity and stabilization stage:
In the stabilization stage, the growth rate tends to moderate and the rate of growth
would be more or less equal to the industrial growth rate or the gross domestic
product growth rate.
Symptoms of obsolescence may appear in the technology. To keep going,
technological innovations in the production process and products should be
introduced. The investors have to closely monitor the events that take place in the
maturity stage of the industry.
Declining stage:
In this stage, Demand for the particular product and the earnings of the companies in the
industry decline. The specific feature of the declining stage is that even in the boom
period; the growth of the industry would be low and decline at a higher rate during the
recession. It is better to avoid investing in the shares of the low growth industry even in
the boom period. Investment in the shares of these types of companies leads to erosion
of capital.

KEY FACTORS IN INDUSTRY ANALYSIS:

1. The past performance of the industry.
2. The performance of the product and technology of the industry.
3. Role of government in the industry.
4. Labour conditions relating to the industry.
5. Competitive conditions in the market
6. Inter-linkages with other industries

DETERMINING THE SENSITIVITY OF THE INDUSTRY:

1. Sensitivity to sales.
2. Operating leverage
3. Financial leverage.

SWOT ANALYSIS FOR THE INDUSTRY

Strength: Strength of the industry refers to its capacity and comparative advantage in
the economy. For example, the existing research and development facilities and greater
dependence on allopathic drugs are two elements of strength to the pharmaceutical
industry in India.
Weakness: Weakness refers to the restrictions and inherent limitations in the industry,
which keep the industry away from meeting its target. For example, Lack of
infrastructure facility, rail-road links, etc., are weakness of the tourism industry in India.
Opportunities: Opportunities refers to the expectation of favourable situation for an
industry. For example, with increase in purchasing power with the people, demand for
pharmaceutical industry will increase and likewise, changing preference from gold to
diamond jewellary has brought a lot of opportunities for the diamond industry.
Threats: Threat refers to an unfavourable situation that has a potential to endanger the
existence of an industry. For example, after liberalization of import policy in India,
import of Chinese goods has threatened many industries in India, such as toys, novelties,
etc.
III. COMPANY ANALYSIS
Effect of a business cycle on an individual company may be different from one
industry to another. Here, the main point is the relationship between revenues and
expenses of the firm and the economic and industry changes. The basic objective of
company analysis is to identify better performing companies in an industry .These
companies would be identified for investment.
The processes that may be taken up to attain the objective are as follows:
a. Analysis of management of the company to evaluate its trust-worthiness, capacity
and efficiency.
b. Analyse the financial performance of the company to forecast its future expected earnings.
c. Evaluation of long-term vision and strategies of company in terms of
organizational strength and resources of company.
d. Analysis of key success factor for particular industry.
SOURCES OF INFORMATION:
Information and data required for analysis of earnings of a firm are primarily available in the
annual financial statements of the firm. It include,
 Balance sheet or Position statement
 Income statement or Profit & Loss account.
 Financial statement analysis (Ratio analysis)
 Cash flow statement, the statement of sources and uses of cash and also
 Top level management people in the company.
I. BALANCE SHEET (BS):
It is the most significant and basic financial statement of any firm. It is prepared by a
firm to present a summary of financial position at a given point of time, usually at the
end of financial year. It shows the state of affairs of the firm at a point of time. In fact,
the total assets must be equal to the total claim against the firm and this can be stated as,
Total assets =Total claim (Debt +Share holders)
=Liabilities +Share holders equity
The different items contained in BS can be grouped into,
1. Assets
 2. Liabilities
3. Shareholder’s funds.
a. ASSETS: An asset of the firm represents the investments made by the firm in
order to generate earnings. It can be classified into (a).Fixed Asset (b).Current assets.
i. FIXED ASSET – Those which are intended to be for a longer period .These are
permanent in nature, relatively less liquid and are not easily converted into cash in short
run. Fixed asset include, plant & machinery, furniture & fixtures, buildings, etc. The
value of fixed asset is known as book value, which may be different from market value
or replacement cost of the assets. The amount of depreciation is anon-cash expense and
does not involve cash out flow. It is taken as an expense item and is included in the cost
of goods sold or indirect expense.
ii. CURENT ASSET - It is the liquid asset of the firm and is convertible into cash
within a period of one year. It includes cash and bank balance, receivables, inventory
(raw material, finished goods, etc), prepaid expenses, loan, etc.
b. LIABILITIES: It is also called as debts. It is claimed by the outsiders against the
assets of the firm. The liabilities refer to the amount payable by the firm to the claim
holders. The liabilities are classified into long term and short term liabilities.
i. LONG TERM LIABILITIES: It is the debt incurred by the firm, which is not
payable during the period of next one year. It represents the long term borrowings of the
firm.
ii. CURRENT LIABILITITES: It is the debt which the firm expects to pay within a
period of one year. It is related to the current assets of the firm in the sense that current
liabilities are paid out of the realization of current assets.
3. SHAREHOLDERS EQUITY (SE): It represents the ownership interest in the firm
and reflects the obligations of the firm towards its owners. It the direct contribution of
the shareholders to the
firm.The retained earnings on the other hand reflects the accumulated effect of the firms
earnings. SE is also called as net worth. The liabilities and the SE must be equal to the
total assets of the firm.
II.INCOME STATEMENT OR PROFIT & LOSS ACCOUNT (IS):
It shows the result of the operations of the firm during a period. It gives detail sources of
income and expenses; Income statement is a flow report against the balance sheet which
is a stock report or status report. It helps in understanding the performance of the firm
during the period under consideration. It can be grouped into three classes. (i) Revenues
(ii) Expenses & (iii) Net profit or loss
REVENUES- It is the inflow of resources\cash that arise because of operation of the firm.
The revenue arises from the sale of goods and services to the customer and other non-
operating incomes. The firm may also get revenue from the use of its economic resources
elsewhere. E.g. – some of the funds might have been invested in some other firm. The
income by way of interest or dividend is also a revenue.
EXPENSES- The cost incurred in the earning the revenues is called the expenses.
Expenses like, salaries, general expenses, repairs, etc. It occurs when there is a decrease
in assets or increase in liabilities
III. CASH FLOW STATEMENT AND FUND FLOW STATEMENT:
The balance sheet and the income statement are the two common financial
statements and are also known as traditional financial statements. It is essential to
know the movement of cash during the period. It is a historical record of where the
cash came from and how was it used.
IV. FINANCIAL STATEMENT ANALYSIS:
Financial statement analyses are ratio like:
a. Profitability ratios
b. Liquidity ratios
c. Solvency ratios