CHAPTER – 2

CONCEPTUAL FRAMEWORK OF
FINANCIAL MANAGEMENT
2.1 INTRODUCTION:
Finance may be defined as the art and science of managing money. The major
areas of finance are financial services and managerial finance / corporate
finance/ financial management. While financial services is concerned with the
design and delivery of advice and financial products to individuals, businesses
and governments within the areas of banking and related institutions, personal
financial planning, investments, real estate, insurance and so on, financial
management is concerned with the duties of the financial managers in the
business firm. Financial managers actively manage the financial affairs of any
type of business, namely, financial and non – financial, private and public, large
and small, profit – seeking and not – for – profit. They perform such varied tasks
as budgeting, financial forecasting, cash management, credit administration,
investment analysis, funds management and so on. In recent years, the changing
regulatory and economic environments coupled with the globalization of
business activities have increased in the complexity as well as the importance of
the financial managers’ duties. As a result, the financial management function has
become more demanding and complex. This Chapter provides an overview of
financial management function, management control system and financial
performance analysis.

[2] AN OVERVIEW OF FINANCIAL MANAGEMENT:

2.2 INTRODUCTION:
Organization is a group of employees working together consciously towards
organization’s goal. The goal of traditional organizations is to maximize profit.
But the goal of modern organisations, which are raising funds by issue of equity
shares, is to maximize shareholders’ wealth. In other words, the objective is to
maximize ne present worth by taking right decisions which help increase share

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price. Maximizations of shareholders’ wealth is possible only when organisation
is able to maximize net profits. The employees work in organization under
different departments viz., HR, finance, production, marketing and R & D and
now-a-days, IT. All the employees who are in the decision making level have to
take decisions that helps to maximize shareholders’ wealth.

7 Ms of Management Men, Money, Machines, Materials,

Methods, Minutes and Management

Men, Money, Machines, Materials, Methods, Minutes and Management, are

7 M’s of management,

Money-is one of the important vitamins required for running any

organization, it is just like blood, without which there is no human being
similarly without finance there is no organization. Here, there is need to know
the difference between money and finance. Money is any Country’s currency,
which is in the hand of a person or an organization, where as finance is also a
country’s currency, which is owned by a person or organization, that is given to
others as loan to buy an asset or to invest in investment opportunities. Put it
simple a currency as long as you have with you it is money only and when you
lend it to others to buy or invest in investment avenues it becomes finance. For
example, Bank, which has raised money from public through various types of
deposits, when it grants the same money to others it, becomes finance. If it is
granted to buy a car, it is known as car finance, if it is granted to buy a house it is
called as housing finance. Organizations raise funds from public to buy assets or
invest in business, efficient management of finance helps in maximizing the
shareholders wealth. On other words, financial management plays key role in
maximization of owners’ wealth.

2.3 MEANING AND DEFINITION OF FINANCIAL MANAGEMENT:

Many authors use business finance and corporate finance as synonym, but
business finance is broader than corporate finance, since it covers sole
proprietorship, partnership and company business. Corporate finance is
restricted to the company finance only and not the other forms of business
organizations.

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According to the Encyclopedia of Social Sciences, Corporate finance deals with
the financial problems of corporate enterprises. Problems include 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 adjustment required for the bolstering upon
rehabilitation of a corporation which has come into financial difficulties.
Management of all these is financial management. Financial management mainly
involves rising of funds and their effective utilization with the objective of
maximizing shareholders’ wealth. To quote, Joseph 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”.

According to Van Horne and Wachowicz, “Financial Management is

concerned with the acquisition, financing and management of assets with some
overall goal in mind. “(1) Financial manager has to forecast expected events in
business and note their financial implications.

Financial Management is concerned with three activities: (i) anticipating

financial needs, which means estimation of funds required for investment in
fixed and current assets or long-term and short-term assets. (ii) acquiring
financial resources-once the required amount of capital is anticipated the next
task is acquiring financial resources i.e., where and how to obtain the funds to
finance the anticipated financial needs and (iii) allocating funds in business –
means allocation of available funds among best plans of asses, which are able to
maximize shareholders’ wealth. Thus the decisions of financial management can
be divided into three viz., investment, financing and dividend decision.

2.4 EVOLUTION OF FINANCIAL MANAGEMENT:

Financial management has emerged as a distinct field of study only in the early
part of this century as a result of consolidation movement and formation of large
enterprises. Its evolution may be divided into three phases – viz.,

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 1. The Traditional phase,
2. The Transitional phase and
3. Modern phase.

1. The Traditional Phase: This phase has lasted for about four decades. Its
finest expression was shown in the scholarly work of Arthur S. Dewing, in
his book tilted “the Financial Policy of Corporation in 19520s.” In this
phase the focus of financial management was on four selected aspects.

a. It treats the entire subject of finance from the outsider’s point

of view (investment banks, lenders, other) rather than the
financial decision maker view point in the firm.
b. It place much importance on corporation finance and too little
on the financing problems of non-corporate enterprises.
c. The sequence of treatment was on certain episodic events like
formation, issuance of capital, major expansion, merger,
reorganization and liquidation during the life cycle of an
enterprise.
d. It placed heavy emphasis on long –term financing, institutions,
instruments, procedures used in capital markets and legal
aspects of financial events. That is it lacks emphasis on the
problems of working capital management.

It was criticized throughout the period of its dominance, but the criticism
is based on matters treatment and emphasis. Traditional phase was only
outsiders looking approach, due to its over emphasis on episodic events
and lack of importance to day-to-day problems.

2. The Transition Phase: It has began around the early 1940’s and
continued though the early 1950’s. The nature of financial management in
this phase is almost similar to that of earlier phase but more emphasis
was given to the day-to-day (working capital) problems faced by the
finance managers. Capital budgeting techniques were developed in this

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 phase only. Much more details of this phase is given in the book titled
“Essay on Business Finance.”

3. The Modern Phase: It has begun in the mid 1950’s. It has shown
commendable development with combination of ideas from economic and
statistics that led the financial management more analytical and
quantitative. The main issue of this phase is rational matching of funds to
their uses, which leads to the maximization of shareholders’ wealth. This
phase witnessed significant development. The areas of advancement are :
capital structure. The study says the cost of capital and capital structure
are independent in nature, Dividend policy, suggest that there is the effect
of dividend policy on the value of the firm. This phase has also seen one of
the first applications of linear programming. For estimation of
opportunity cost of funds, multiple rates of return0gives way to calculate
multiple rates of a project. Investment decision under conditions of
uncertainty gives formulas for determination of expected cash inflows and
variance of net present value of project and gives how probabilistic
information helps the firm to optimize investment decisions involving
risk. Portfolio analysis gives the idea for allocation a fixed sum of money
among the available investment securities. Capital Asset Pricing Model
(CAPM), suggests that some of the risks in investments can be neutralized
by holding diversified portfolio of securities. Arbitrage Pricing Model
(APM), argued that the expected return must be related to risk in such a
way that no single investor could create unlimited wealth through
arbitrage. CAPM is still widely used in the real world, but APM is slowly
gaining momentum. Agency theory emphasizes the role of financial
contracts in creating and controlling agency problems. Option Pricing
Theory (OPT), applied Martingale pricing principle to the pricing of real
estates. Cash management of models (working capital management) by
Baumol Model, Miller and Orglers. Bauol models helps to determine
optimum cash conversion size; Miller model reorder point and upper
control points and Orglers model helps to determine optimal cash
management strategy by adoption of linear programming application.

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 Further new means of raising finance with the introduction of new capital
market instruments, such as Pads, Fads, PSBs and Capps, etc.. Financial
engineering that involves the design, development and implementation of
innovative financial instruments and formulation of creative optional
solutions to problems in finance. With the above developed areas of
finance is remarkable, but understanding the international dimension of
corporate finance was little, which is not sufficient in the globalization
era.

2.5 SCOPE OF FINANCIAL MANAGEMENT:

From the above discussion it is evident that financial management as an
academic discipline has undergone notable changes over years as its scope and
areas of coverage. At the same time the financial manager’s role also undergone
fundamental changes over the years. Study of the changes that have taken place
over the years is known as “scope of financial management.” In order to have
easy understanding and better exposition to the changes, it is necessary to divide
the scope into two approaches:
(1) The Traditional Approach and
(2) The Modern Approach.

(1) Traditional Approach:

Financial management emerged as a separate field of study in the early 1900’s.
The role of financial management is limited to fund raising and administering
needed by the corporate enterprises to meet their financial needs. Enterprise
requires funds for certain episodic events like merger, formation of new firms,
reorganization, liquidation and so on. Put is simple the scope of financial
management in traditional approach was in the narrow sense. The field financial
management was interrelated with aspects viz.,
(a) Raising of funds from financial institutions,
(b) Rising of funds through financial instruments-shares and bonds
from the capital markets.
(c) The legal and accounting relationship between an enterprise and
its sources of funds (creditors).

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Thus, the traditional approach of financial management is only rising of funds
needed by the corporation, externally that also limited the role of financial
manager. A part from the raising funds externally, the expected functions are :
preparation and preservation of financial (statement) reports on the enterprises
financial status and manage cash level that is needed to pay day-to-day maturing
obligations.

Traditional approach to the scope of financial management evolved during 1920

and continued to dominate academic thinking during the forties and through the
early fifties. But criticism was stated on this approach in the later fifties due to
the following:

 Ignored day-to-day problems: The traditional approach gives much

importance to funds rising for episodic events that are stated n the above
discussion. Put it simple the approach is confined to the financial
problems arising in the course of episodic events.

 Outsider-looking-in approach: This approach equated the function with

the issues involved in raising and administering funds. Thus, the subject
of finance moved around the suppliers of funds (investors, financial
institutions (banks), etc) who are outsider. It indicates that the approach
was outsider-looking-in approach and ignored insider-looking-out
approach, since it completely ignored internal decision-making.

 Ignored Working Capital Financing: The approach was given over

emphasis on long-term financing problems. It implies that it ignored
working capital finance, which is in the purview of the finance functions.

 Ignored Allocation of Capital: The main function of this approach is

procurement of funds from outside. It did not consider the function of
allocation of capital, which is the important one.

The capital issues of financial management were outside the purview of

traditional phase, which was rightly described by Solomon.
(i) Should an enterprise commit capital funds to certain purposes?

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 (ii) Do the expected returns meet financial standards of performance?
(iii) How should these standards be et and what is the cost of capital
funds to the enterprise?
(iv) How does the cost vary with the mixture of financing methods
used?

Traditional approach failed to provide answers to the above questions due to

narrow scope, but modern approach explained below provide answers to the
question, or it overcomes the shortcomings of traditional approach.

(2) Modern Approach:

Modern approach was starting during 1950s. Its scope is wider since it covers
conceptual and analytical framework for financial decision-making. In other
words, it covers both procurement of funds as well as their allocation. Allocation
if no just haphazard allocation, it is efficient allocation among various
investments, which will help to maximize shareholders wealth. The main
contents of the new approach are:
(a) What is the total volume of funds an enterprise should commit ?
(b) What specific assets should an enterprise acquire ?
(c) How should the funds required be financed ?
The above three questions are related to the three decisions of financial
management:
(i) Financial decision
(ii) Investment decision and
(iii) Dividend decision.

The shareholders’ value maximization focus continuous as we begin the 21st

century. However two other are gaining momentum, viz., (a) Increased use of
information technology and (b) Globalization of business. Both these trends
provide companies with new opportunities to reduce risks and thereby increase
profitability. But these trends are also leading to increased competition and new
tasks.

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2.6 INTERFACE OF FINANCIAL MANAGEMENT WITH OTHER DISCIPLINES:
As all of us know that organization of group of people (employees) working
together consciously towards organizations goal. The employees are divided
based on their specialization and put them under different departments.
Generally, there are departments – Human Resource, Finance, Production,
Marketing, R&D and MIS. All these departments are integrated. There is no single
department that works independently.

Financial management has relationship with almost all functional departments.

But it has close relationship with economics and accounting.

Relationship to Economics
The relationship between Finance and economics can be studied under two
prime areas of economics. They are macroeconomics, and microeconomics.
Macroeconomics is the environment in which an industry operates, which is not
controllable. The macroeconomic factors include, economy growth rate,
domestic savings rate, structure and growth of financial system fiscal policies,
monetary policies, and so on. It is important for financial managers to
understand changes in macroeconomics and their impact on the firm’s operating
performance. External environment analysis help in identifying opportunities
and threats.

Microeconomics is firm’s specific environment, and also controllable on. It is

concerned with the determination of optimum operational strategies. In other
words financial managers use economic theories as guidelines for efficient
business operations. Supply and demand relationship profit maximization;
pricing strategies; risk and return determination; marginal analysis are the few
examples of relevant economic theories used in financial management. Marginal
analysis is the prime principle used in financial decision making. That is all
financial decisions of a firm are made on the basis of marginal cost, and marginal
revenue. Therefore it is necessary to understand the relationship between
finance and economics.

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Relationship to Accounting
If you observe the Figure 1.3, you can find the relationship between finance and
accounting. Finance (treasure) and accounting (controller) are the two prime
dominos of Chief Finance Manager (Vice President Finance). Finance and
accounting are not separable and generally considered overlapping activities of
Chief Finance Officer (CEO).

 Objective: Financial accounting is concerned with developing and

reporting data for measuring performance of the firm. Whereas the
finance is concerned with maximization of value of the firm, by selecting
and executing feasible projects.

 Method: Finance accounting prepares records on the accrual basis.

Whereas the financial manager takes decision on the basis of cash flows
(inflows and outflows).

 Data: Financial accounting deals with past data (certainty) whereas

finance deals with future data (uncertainty).

Relationship to HR:
HR activities include recruitment, training, development, fixing compensation,
incentives, promotion, and providing other benefits. All these activities need
finance. Therefore before going to take any of these decision after studying the
impact of HR activity on organization. Therefore there is relation to HR function.

Relationship to Production:
Production department is another functional area that involves huge investment
on fixed assets (machines and tools). For example production of new product
requires new machinery, which involves capital investment. Before going to
select machinery, he/she need to evaluate the machine or equipment and select
some cases changing manufacturing process. Improper evaluation involves huge
consequences on the firm. Their production manager and finance manager need
to work closely for effective investment (optimum investment) on plant and
machinery.

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Relationship to Marketing:
Marketing functions involves selection of distribution channel and promotion
policies. These two are the primary activities of marketing department and
involves huge cash outflows. Therefore finance and marketing managers need to
work with coordination for maximize value of the firm.

Relationship to R & D:
Innovation of products and process is the only way to survive in the competitive
market. Innovation need to invest funds on R&D. But R&D department does not
give guarantee of development. Therefore it does not mean that financial
manager should not provide funds, or cut funds heavily to R&D. It should be
given importance and try to make balance.

2.7 FINANCIAL DECISIONS:

As we have read in the above that financial management is concerned with the
acquisition, financing and management of assets with some over all goals in
mind. As mentioned in the contents of modern approach the discussions of
financial management can be broken down into three major decision viz., (1)
Investment decision. (2) Financing decision, and (3) Dividend decision. A firm
takes these decisions simultaneously and continuously in the normal course of
business. Firm may not take these decisions in a sequence, but decisions have to
be taken with the objective of maximizing shareholders’ wealth.

Financial
Decisions

Investment Financing Dividend

Decisions Decisions Decisions

1. Investment Decisions:
It is important than the other two decisions. It begins with a determination of the
amount of assets needed to be held by the firm. In other words, investment

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decision relates to the selection of assets, on which a firm will invest funds. The
required assets fall into two groups:

i. Long-term Assets (fixed assets: plant & machinery, land and building etc.)
, which involve huge investment and yield return over a period of time in
future. Investment in long-term assets is popularity known as “capital
budgeting”. It may be defined as the firm’s decision to invest its current
funds most efficiently in fixed assets with an expected flow of benefits
over a series of years.

ii. Short-term Assets (current assets: raw materials, working in process,

finished goods, debtors, cash, etc.) that can be converted into cash within
a financial year without diminution in value. Investment in current assets
if popularly termed as “working capital management”. It relates to the
management of current assets. It is important decision of a firm, as short
survival is the prerequisite for long-term success. Firm should not
maintain more or less assets. More assets reduce return and there will be
no risk, but having less assets is more risk and more profitable. Hence, the
main aspects of working capital management are the tradeoff between
risk and return. Management of working capital involves two aspects. One
determination of amount required for running of business and secondly
financing these assets.

2. Financing Decisions:
After estimation of the amount required and the selection of assets required to
be purchased then the next financing decision comes into the picture. Here the
financial manager is concerned with makeup of the right hand side of balance
sheet. It is related to the financing mix or capital structure or leverage. Here the
financial manager has to determine the proportion of debt and equity in capital
structure. It should be optimum finance mix, which maximizes shareholders’
wealth. A proper balance will have to be struck between risk and return. Debt
involves fixed cost (interest), which may help in increasing the return on equity
but also increases risk. Rising of funds by issue of equity shares is one permanent
source, but the shareholders will expect higher rates of earnings. The two

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aspects of capital structure are: One capital structure theories and second
determination of optimum capital structure.

3. Dividend Decisions:
This is the third financial decision, which relates to dividend policy. Dividend is a
part of profits which are available for distribution to equity shareholders.
Payment of dividends should be analyzed in relation to the financial decision of a
firm. There are two options available in dealing with net profits of a firm, viz.,
distribution of profits as dividends to the ordinary shareholders’ where there is
no need of retention of earnings or they can be retained in the firm itself if they
require for financing of any business activity. But distribution of dividends or
retaining should be determined in terms of its impact on the shareholders’
wealth. Financial manager should determine optimum dividend policy, which
maximizes market value of the shares there by market value of the firm.
Considering the factors to be considered while determining dividends is another
aspect of divided policy.

2.8 INTER-RELATION AMONG FINANCIAL DECISIONS:

The above-discussed three financial decisions are different kinds of financial
management decisions, but these decisions are inter-related due to the
underlying objectives of all the three decisions is (same) maximization of
shareholders’ wealth. The financial decisions are not independent; they are inter-
related to each other. Below figure shows the Interrelationship among financial
decisions.

Investment
Decision

Financing Dividend
Decision Decision

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1. Inter-relation between “Investment and Financing Decisions”:
Under the investment decision financial manager will decide what type of asset
or project should be selected. The selection of a particular asset of project will
help to determine the amount of funds required to finance the project or asset.
For example, investment on fixed assets if Rs. 10 crore and investment on
current assets is Rs. 4 crore so the total funds required to finance the total assets
are Rs. 14 crore.

Once the anticipation of funds required is completed then the next decision is
financing decision. Financing decision means raising the required funds by
various instruments of finance. There is and interrelation between investment
decision and financing decision, without knowing the amount of funds required
and types of funds (short-term and long-term) it is not possible to raise funds.
Put it simple investment decision and financing decisions cannot be independent
on each other.

2. Inter-relation between “Financing Decision and Dividend Decision”:

Financing decision influences and is influenced by divided decision, since
retention of proofs for financing selected assets or projects reduces the profits
available to ordinary shareholders, thereby reducing dividend payout ratio. For
example, in the above we have decided the amount required to finance a project
is Rs. 14 crore. If financial manager plans to raise only Rs. 7 crore form outside
and the remaining by way of retained earnings. If the dividend decision is 100
per cent payout ratio then financial manager has to depend completely on
outside sources to raise the required funds. So, dividing decision influences the
financing decision. Hence, there is and interrelation between financing decision
and dividend decision.

3. Inter-relation between “Dividend Decision and Investment Decision”:

Dividend decision and investment decision are interrelated because retention of
profits for financing the selected asset depends on the rate of return on proposed
investment and the opportunity cost of retained profits. Profits are retained
when return on investment is higher than the opportunity cost of retained

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profits and vice-versa. Hence, there is interrelation between investment decision
and dividend decision.

The above decision says that there is neither relationship among financial
decisions. Financial manager has to take optimal joint decision by evaluating of
the decisions that will affect wealth of shareholders, if there any negative affect
on wealth it should be rejected and vice versa.

2.9 AIMS OF FINANCE FUNCTION:

As we have seen the financial management is concerned with acquisition,
financing and management of assets with some overall goal in mind. And we
have seen that there are three financial decisions. While taking these decisions,
an organisation tries to balance cash inflows and cash outflows, which is called is
liquidity decision. The following points discuss the aims of finance function.
 Anticipation of Funds Needed: In the series of financial decisions,
investment decision takes first place, but before going to identify the
investment assets or projects, there is a need to evaluate available
investment projects. Selection of assets or projects takes place only after
proper evaluation, which is helpful to anticipate the funds required for
financing the selected assets of projects. Hence, anticipation of funds
required to finance assets is one aim of financial function.
 Acquire the Anticipated Funds: The main aim of finance function is to
assess the required needs of a firm and then arrange the funds needed by
raising from suitable sources of finance. The total required funds can be
raised by different sources, viz., long-term sources and short-term
sources. If the funds are needed for long-period then the funds need to be
raised only from long-term sources of finance, like share capital, bonds,
debentures, capital and long-term loans from financial institutions. If the
organisation if old company, which is running with profit track record it,
can use profit by retaining them in business. Short-term (capital) finance
needs can be raised mainly from bank by way of short-term loans.
Acquiring funds needed should be at least possible cost and it should not
affect owner’s interest.

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 Allocation or Utilisation of Funds: Acquisition of funds need by a firm is
prime objective of traditional finance function, but efficient allocation or
utilisation of funds is the objective of modern finance function. Efficient
allocation among investment avenues means investing funds on profitable
projects. Profitable projects means a project or asset that provides return,
which is higher than the cost of funds, rose to finance. For example, there
are three projects, X,Y and Z, which are identified as profitable in terms of
ROI (%) with 10, 20 and 30 return on investment respectively. The cost of
raised funds is 20%. Here, the project ‘Z’ is only eligible to invest because
its (30) return on investment (ROI) is higher than cost of funds (20) i.e. it
is able to provide 10 (30 – 20) profit, but the project X’s ROI is less than
cost of funds, i.e., 10 loss (10 – 20). The project Y is considerable but not
preferable its ROI is equal to cost of funds, which means there is no profit.
So, project Y is not helpful to maximize shareholders wealth. Hence,
finance manager should allocate funds among profitable investment
assets and operations that help to maximize shareholders’ wealth.

 Increase Profitability: Planning and control are the main functions of

management that helps to increase profits by reducing costs of
minimizing waste or effective utilisation available resources. In the same
way proper planning and control of finance functions aims at increasing
profitability of the firm. Proper planning of anticipation of fund selection
of investment avenues, acquiring and allocation of funds helps to increase
profits, by way of arranging sufficient funds at least at right time,
investing on right asset. Control of operations like cash receipts and
payments also helps to increase profits. Hence, finance function need to
match the costs and return from the funds.

 Maximizing Firm’s Value: The prime objective of any function in any

organisation is to maximize firm’s value by taking right decisions so as to
finance function. But maximization of shareholders’ wealth is possible
only when the firm is able to increase profits. Hence, financial manager
whatever decision he/she takes it should be with the objective of
maximization of owner’s wealth.

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2.10 GOALS OF FINANCIAL MANAGEMENT:
Equity shareholders are the owners’ of a company. Any person becomes owner
of any company by purchasing (in primary market or secondary market) stocks
and he/she expects financial return in the form of dividends and increase in
stock price (capital gain). Shareholders elect directors, who then hire managers
to run the company on day-to-day basis. Financial manager requires the
existence of some objectives or goal without which judgment as to whether or
not a financial decision is efficient must be made in the light of some standard. In
other words, the goals provide a framework for optimum financial decision-
making. Although various goals or objectives are possible, we assume in this
book that the management’s prime goal is stockholders wealth maximizing the
price of the firm’s equity stock. Maximization of shareholders’ wealth is possible
only when the decisions of manager’s are helpful to increase profit. Therefore
there are two widely accepted goals, viz., (1) Profit maximization and (2) Wealth
maximization.

(1) Profit Maximization:

Profit is primary motivation force for any economic activity. Firm is essentially
being and economic organisation, it has to maximize the interest of its
stakeholders. To this end the firm has to earn the profit from its operations. In
fact are useful intermediate beacon towards which a firm’s capital should be
directed. McAlpine rightly remarked that profit cannot be ignored since it is both
the measure of the success of business and means of its survival and growth.
Profit is the positive and fruitful difference between revenues and expenses of a
business enterprise over a period of time. If an enterprise fails to make profit,
capital invested is eroded and if this situation prolongs, the enterprise ultimately
ceases to exit. The overall objective of business enterprise is to earn at least
satisfactory return on the funds invested, consistent with maintaining a sound
financial position.
Limitations: The goal of profit maximization has, however, been criticized in
recent times because of the following reasons:

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  Vague: The term “profit” is vague and it does not clarify what exactly does
it mean. It has different interpretations for different people. Does it mean
short-term or long-term; total profit or net profit; profit before tax(PBT)
or profit after tax (PAT); return on capital employed (ROCE). Profit
maximization is taken as objective, the question arises which of the about
concepts of profit should an enterprise try to maximize. Apparently the
vague expression like profit can form the standard of efficiency of
financial management.
 Ignores Time value of Money: Time value of money refers a rupee
receivable today is more valuable than a rupee, which is going to be
receivable in future period. The profit maximization goal does not help in
distinguishing between the returns receivable in different periods. It gives
equal importance to all earnings though the receivable in different
periods. Hence, it ignores time value of money.
 Ignores quality of benefits: Quality refers the degree of certainty with
which benefits can be expected. The more certain expected benefits, the
higher are the quality of the benefits and vice versa. Two firms may have
some expected earnings available to shareholders, but if the earnings of
one firm stream vacillate considerably when compared to other firm, it
will be more risky.

Profit maximization objective leads to exploiting employees and consumers. It

also leads to colossal inequalities and lowers human values that are an essential
part of ideal social system. it assumes perfect competition and in the existence of
imperfect competition, it cannot be legitimate objective of any firm. It is suitable
for self-financing, private property and single owner firms. A company is
financed by shareholders, creditors and financial institutions and is managed and
controlled by professional manager. From these people, there are some other
who are interested towards company they are: Employees, government,
customers and society. Hence, one has to take into consideration of all these
parties’ interests, which is not possible under the objective of profit
maximization. Wealth maximization objective is the alternative of profit
maximization.

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2. Shareholders wealth maximization: On account of the above-discussed
limitation of profit maximization shareholders wealth maximization is an
appropriate goal for financial decision making. Finance theory rests on the
proposition that the goal of a firm should be to maximize shareholders’ wealth. It
is operationally feasible since it satisfies all the three requirements of a suitable
operational objective of financial courses of action, namely exactness, quality of
benefits and the time value of money. It provides an unambiguous measure of
what financial management should seek to maximize in making investment and
financing decisions on behalf of owners. Firms do, of course, have other goals – in
particular the manager’s decisions are interested in their own personal
satisfaction, in their employees’ welfare and in the good of the community and
society at large. Still stock price maximization is the most important goal for
majority of companies.

Shareholders wealth maximization means maximizing net present value (or

wealth) of a course of action to shareholders. NPV can be derived more explicitly
by using the following formula:
CIF1 CIF2 CIF3 CIFn
W   ...........   ICo
(1  r)1 (1  r)2
(1  r)3
(1  r)n

Where, W = Net present worth

CIF1, CIF2, CIF3 .... CIFn represent the stream of cash inflows
(benefits) expected to occur from a course of action that is
adopted.
ICo = Initial cash out flow to buy the asset
r = Expected rate of return or appropriate rate of discount.

A financial decision that has a positive NPV creates wealth for ordinary
shareholders and therefore preferable and vice versa. The wealth will be
maximized if this criterion is followed in making financial decisions. From
shareholders’ point of view, the wealth created by a corporation thorough
financial decisions or any decision is reflected in the market value of the

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company shares. For example, take Infosys Co., whose share price is increasing
year by year, even by issue of bonus shares, and the company is trying to put its
shares at popular trading level. Therefore, the wealth maximization principle
implies that the fundamental objective of a firm is to maximize market value of
its share. In other words, the market value of the firm is represented by its
market price, which in turn is a reflection of a firm’s financial decisions. Hence,
market price acts as a firm’s performance indicator. A shareholders’ wealth at a
period of time can be computed by the following formula:
Swt = NS x MPt
Where, Swt = Shareholders wealth at ‘t’ period
NS = No. of equity shares (outstanding) owned
MP = Market price of share at ‘t’ period
3. Alternative Goals: A part from the above-discussed goals, there are several
alternative goals, which will again help to maximize value of the fir or market
price per share. They are:
- Maximization of return on equity (ROE)
- Maximization of earning per share (EPS)
- Management of reserves for growth and expansion.

[2] CONCEPTUAL FRAMEWORK OF MANAGEMENT CONTROL SYSTEM:

2.11 INTRODUCTION:
Control exists in nature, human body, machines and equipment we use. Without
control no work is possible. Desired result is very difficult to achieve without
adequate control over activities. In a small business, the owner himself exercises
the control. He pre-conceives a plan of action uses his resources in right
direction, checks actual with reference to the plan and obtains desired result. In a
big organization, the control is exercised through a large number of persons
working at different places dealing with multiple activities to attain their
ultimate goals.

An organization consist a group of people, who work together to achieve some

desired results called it goals. The leaders of the organization are collectively
named as ‘management’. The organization is divided into several units and

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subunits such as sales, production, finance, personnel, secretarial etc as units and
sales administration, sales accounting, market research, sales promotion and
after sales service as sub units. Each of these units and subunits perform their
respective activities for accomplishment of the responsibilities assigned to them.

Management control is a must in any organization that practices

decentralization. One view argues that management control systems must fit the
firm’s strategy. This implies that the strategy is first developed through a formal
and rational process, and this strategy then dictates the design of the firm’s
management systems. An alternative perspective is that strategies emerge
through experimentation, which is influenced by the firm’s management
systems. In this view, management control systems can affect the development of
strategies.

When firms operate in industry contexts where environmental changes are

predictable, they can use a formal and rational process to develop the strategy
first and then design management control systems to execute that strategy.
However, in a rapidly changing environment, it is difficult for a firm to formulate
the strategy first and then design management systems to execute the chosen
strategy. Perhaps, in such contexts, strategies emerge through experimentation
and ad hoc processes that are significantly influenced by the firm’s management
control systems.

The importance of the subject matter is captured in the widely accepted truism
that more than 90 percent of businesses including non organizations is founded
on the rocks of implementation; either the strategies never come into being or
get distorted, or the implementation is much more costly and time-consuming
than anticipated. However, laudable strategic intentions may be, if they do not
become reality, they usually are not worth the paper on which they are written.
Conversely, high-performing companies excel at execution.

The collapse of companies such as Enron, WorldCom, Global Crossing and Tyco.
Part of the reason for their demise was the lapse in controls. CEO and top

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management compensation in these companies was so heavily tied to stock
options that executives were motivated to manipulate financials to buoy the
short-term stock price.

Consider world-class companies such as Dell Computer, Walmart, Cisco Systems,

New York Times, Emerson Electric, Lincoln Electric, Worthington industries, 3M
Corporation, Nucor Corporation, Analog Devices and so on. Their long-term
success is not just because they have developed good strategies; more
importantly, they have designed systems and processes that energize their
employees to execute those strategies; more importantly, they have designed
systems and processes that energize their employees to execute those strategies
effectively.

The traditional perception of control systems is similar to that of the autocrat

through his policemen controlling an unruly mob. But in the twenty-first century
the unmistakable forward trend towards empowerment should not go
unnoticed. Systems, which are in perfect control without an autocrat and
policemen controlling them, would show the profound difference between the
concept of controlling persons and that of systems being under control and being
able to achieve their goals and objectives with ease. They deserve to be
emulated.

2.12 DEFINITION OF MANAGEMENT CONTROL SYSTEM:

A MCS is a set of interrelated communication structures that facilitates the
processing of information for the purpose of assisting managers in coordinating
the parts and attaining the purpose of an organization on a continuous basis.

A MCS is a logical integration of techniques, to gather and use information to

make planning and control decisions, to motivate employee behaviour, and to
evaluate performance.

In the accounting literature there are various interpretations of the concept of

control. See, for example, Anthony & Herzlinger, 1986; Marciariello, 1984;

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Hopper & Berry, 1983; Jensen & Meckling, 1976; Hofstede, 1968; Arrow, 1964;
and Cyert & March, 1963. This diversity of interpretations of control implies that
the control literature does not claim a single dominant paradigm representing
coherent and consistent laws, theories, applications and methodologies
(Macintosh, 1995). The traditional definitions of control as given in accounting
books published in the US mainly apply to large organizations with many
divisions. Here control is exercised to monitor the performance of division
managers. Robert Anthony, for example, defines management control as ‘the
process by which managers ensure that resources are obtained and used effectively
and efficiently in the accomplishment of the organization’s objectives’ (1967: cited
in Otley et al., 1995, p.S32). However, this particular definition of control solely
focuses on controlling the behaviour of division managers (Puxty, 1989: cited in
Otley, 1994). According to the definition of Anthony, the organizational strategy
is the starting point, on the basis of which MCS serves as a tool to support its
adoption. Traditional MCS definitions also start from the assumption that
employees are not allowed to participate and that control is exercised in favour
of the owners (Wickramasinghe, 1996). Control systems of this kind may result
in tight control, disciplinary actions and unfair wages. Moreover, they may create
a climate in which employees are not being motivated to improve their
productivity. In this way, firm performance is not stimulated and the
development of a nation is undermined (ibid).

Both internal and external environmental changes have determined the nature of
businesses today. This process of change started in the 1990s (Otley, 1994).
Otley stresses that the management of today’s businesses requires flexibility, a
wider focus, a larger degree of adaptation and a willingness to learn. The
traditional control systems, however, are not based on these concepts. Otley
therefore argues that Anthony’s definition is no longer up-to-date and that it is
obstructive to the development of the field of management accounting. The more
recent MCS literature particularly aims at worker-oriented control systems (e.g.
Macintosh, 1995). Here the focus is on a clear participation of the workers in the
decision-making process. The notion is that if workers are being trained in this
direction, they will become more motivated in their work, and as a result the

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labour productivity will increase. In such circumstances, the firm will be inclined
to pay its workforce more, encouraging investors to make additional investments
(Wickramasinghe, 1996).

2.13 PURPOSE AND IMPORTANCE OF MANAGEMENT CONTROL SYSTEM:

In business organizations management control systems play a pivotal role, as
they serve as an instrument to survive in an uncertain environment. Otley argues
that in a climate of continuous change management is forced to adapt itself
constantly, which requires the active involvement of a larger number of
organizational participants. This means that there is a need for the
empowerment of the lower levels of the organization. In this context, MCS can be
used as a control tool by work groups on all levels. Empowerment means giving
the lower levels in the organization both authority and responsibility, so lower-
level managers are encouraged to take whatever action is necessary to achieve
the organizational goals.

Imagine that you have the tendency to put on weight. It is in your genes and if
you are not careful you might go the same way as several people in your family
went earlier. So what do you do? You cut down on your food intake. It might help
or may not. You start exercising, but you are alarmed to discover that you are
building up a lot of needless muscle. Maybe the exercises you are doing are not
suited to your constitution.

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Then you change your method of exercising and you find that it works. You start
shedding weight. This is weight control. It gives us control over our body and its
functioning. If such control is not exercised, we may not be able to do whatever
we set out to do so. In a similar way, organizations need to be in control of them.
An organization lacking in controls is bad for its employees and hence, bad for
itself in the long run.

The purpose of all management and control systems is to achieve the goals and
objectives of an organization with ease and at least cost. The ultimate purpose of
any system is that it should be ‘in control’ instead of controlling people. It also
aims at assisting management in the coordination of the parts of an organization
and the steering of those parts toward the achievement of its overall purposes,
goals and objectives.

The purposes of a management control system are:

 To clearly communicate the organization’s goals;
 To ensure that managers and employees understand the specific actions
required of them to achieve organizational goals;
 To communicate results of actions across the organisation; and
 To ensure that managers can adjust to changes in the environment.

A control system is designed to bring unity out of the diverse activities of an

organization as it seeks to fulfill its overall purpose. In the above following
diagram shows the components of a management control system.

2.14 BASIC CONCEPTS:

1. Control
Press the accelerator, and your car goes faster. Rotate the steering wheel, and it
changes direction. Press the brake pedal, and the car slows or stops. With these
devices, you control speed and direction; if any of them is inoperative, the car
does not do what you want it to. In other words, it is out of control. An
organization must also be controlled, i.e., devices must be in place to ensure that

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its strategic intentions are achieved. But controlling an organization is much
more complicated than controlling a car.

Elements of a Control System

Every control system has at least four elements:

1. A detector or sensor – a device that measures what is actually happening in

the process being controlled.
2. An assessor – a device that determines the significance of what is actually
happening by comparing it with some standard or expectation of what
should happen.
3. An effector – a device (often called ‘feedback’) that alters behaviour if the
assessor indicates the need to do so.
4. A communications network – devices that transmit information between the
detector and the assessor and between the assessor and the effector.

These four basic elements of any control system are given in the following
diagram.

The functioning of these four basic elements is described in three examples of

increasing complexity; the thermostat, which regulates room temperature; the
biological process that regulates body temperature; and the driver of an
automobile, who regulates the direction and speed of the vehicle.

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Thermostat The components of the thermostat are (i) a thermometer (the
detector), which measures the current temperature of a room; (ii) an assessor,
which compares the current temperature with the accepted standard for what
the temperature should be; (iii) an effector, which prompts a furnace to emit
heat (if the actual temperature is lower than the standard) or activates an air
conditioner (if the actual temperature is higher than the standard) and which
also shuts off these appliances when the temperature reaches the standard level;
and (iv) a communications network, which transmits information from the
thermometer to the assessor and from the assessor to the heating or cooling
element.

Body Temperature Most mammals are born with a built-in standard of desirable
body temperature; in humans that standard is 98.6°F. The elements of the
control mechanism by which the body strives to maintain that standard are (i)
the sensory nerves (detectors) scattered throughout the body; (ii) the
hypothalamus centre in the brain (assessor), which compares information
received from detectors with the 98.6°F standard; (iii) the muscles and organs
(effectors) that reduce the temperature when it exceeds the standard (via
panting and sweating, and opening the skin pores) and raise the temperature
when it falls below the standard (via shivering and closing the skin pores); and
(iv) the overall communications systems of nerves.

This biological control system is homeostatic – that is, self-regulating. If the

system is functioning properly, it automatically corrects for deviations from the
standard without requiring conscious effort.

The body temperature control system is more complex than the thermostat, with
body sensors scattered throughout the body and hypothalamus directing actions
that involve a variety of muscles and organs. It is also more mysterious;
scientists know what the hypothalamus does but not how it does it.

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Automobile driver Assume you are driving on a highway where the legal (i.e.,
standard) speed is 65 mph. your control system acts as follows: (i) Your eyes
(sensors) measure actual speed by observing the speedometer; (ii) your brain
(assessor) compares actual speed with desired speed, and, upon detecting a
deviation from the standard, (iii) directs your foot (effector) to ease up or press
down on the accelerator; and as in body temperature regulation, your nerves
form the communication system that transmits information from eyes to brain
and brain to foot.

But just as body temperature regulation is more complicated than the

thermostat, so the regulation of a car is more complicated than the regulation of
body temperature. This is because there can be no certainty as to what action the
brain will direct after receiving and evaluating information from the detector.

For example, once they determine that the car’s actual speed exceeds 65 mph,
some drivers, wanting to stay within the legal limit, will ease up on the
accelerator, while others, for any number of reasons, will not. In this system,
control is not automatic; one would have to know something about the
personality and circumstances of the driver to predict what the actual speed of
the automobile would be at the end point of the process.

2. Management
Management in business and human organization activity is simply the act of
getting people together to accomplish desired goals. Management comprises
planning, organizing, staffing, leading or directing, and controlling an
organization (a group of one or more people or entities) or effort for the purpose
of accomplishing a goal. Resourcing encompasses the deployment and
manipulation of human resources, financial resources, technological resources,
and natural resources.

Management can also refer to the person or people who perform the act(s) of
management. An organization consists of a group of people who work together
to achieve certain common goals (in a business organization a major goal is to

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earn a satisfactory profit). Organizations are led by a hierarchy of managers, with
the chief executive officer (CEO) at the top, and the managers of business units,
departments, functions and other subunits ranked below him or her in the
organizational chart. The complexity of the organization determines the number
of layers in the hierarchy. All managers other than the CEO are both superiors
and subordinates; they supervise the people in their own units, and they are
supervised by the managers to whom they report.

The CEO or a team of senior managers decides on the overall strategies that will
enable the organization to meet its goals. Subject to the approval of the CEO, the
various business unit managers formulate additional strategies that will enable
their respective units to further these goals. The management control process is
the process by which managers at all levels ensure that the people they supervise
implement their intended strategies.

Management Control Systems versus Simpler Control Processes

 Unlike in the thermostat or body temperature systems, the standard is
not preset. Rather, it is a result of a conscious planning process. In this
process, management decides what the organization should be doing and
part of the control process is a comparison of actual accomplishments
with these plans. Thus, the control process in an organization involves
planning. Management control, however, involves both planning and
control.
 Like controlling an automobile, management control is not automatic.
Some detectors in an organization may be mechanical, but the manager
often detects important information with her own eyes, ears and other
senses. Although she may have routine ways of comparing certain reports
of what is happening with standards of what should be happening, the
manager must personally perform the assessor function, deciding for
herself whether the difference between actual and standard performance
is significant enough to warrant action, and if so, what action to take.
 Unlike controlling an automobile, a function performed by a single
individual, management control requires coordination among

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 individuals. An organization consists of many separate parts, and
management control must ensure that each part works in harmony with
the others, a need that exists only minimally in the case of the various
organs that control body temperature and not all in the case of the
thermostat.
 The connection for perceiving the need for action to determine the action
required to obtain the desired result may not be clear.
 Much management control is self control; i.e., control is maintained not
by an external regulating device like the thermostat, but by managers who
are using their own judgment rather than following instructions from a
superior.

Systems
System is a set of interacting or interdependent entities, real or abstract,
forming an integrated whole.
The concept of an “integrated whole” can also be stated in terms of a system
embodying a set of relationships which are differentiated from relationships of
the set to other elements, and from relationships between an element of the set
and elements not a part of the relational regime.

The scientific research field which is engaged in the study of the general
properties of systems includes systems theory, systems science and systemic.
They investigate the abstract properties of the matter and organization,
searching concepts and principles which are independent of the specific domain,
substance, type, or temporal scales of existence.

The term system may also refer to a set of rules that governs behavior or
structure.

A system is a prescribed and usually repetitious way of carrying out an

activity or a set of activities. Systems are characterized by a more or less
rhythmic, coordinated, and recurring series of steps intended to accomplish a
specified purpose. The thermostat and the body temperature control processes

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are examples of systems. Management control systems are far more complex and
judgmental.

Most systems share the same common characteristics. These common

characteristics include the following:
 Systems are abstractions of reality.
 Systems have structure which is defined by its parts and their composition.
 Systems have behaviour, which involves inputs, processing and outputs of
material, information or energy.
 The various parts of a system have functional as well as structural
relationships between each other.

Many management actions are unsystematic. Managers regularly encounter

situations for which the rules are not well defined and thus must use their best
judgment in deciding what actions to take. The effectiveness of their actions is
determined by their skill in dealing with people, not by a rule specific to the
system.

If all systems ensure the correct action for all situations, there would be no need for
human managers.

Boundaries of Management Control:

Management control is distinguished from two other systems or activities that
also require both planning and control: strategy formulation and task control.
Management control fits between strategy formulation and task control in
several respects. Strategy formulation is the least systematic of the three, task
control is the most systematic, and management control lies in between. Strategy
formulation focuses on the long run, task control focuses on short run activities,
and management control is in between. Strategy formulation uses rough
approximations of the future, task control uses current accurate data, and
management control is in between.

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Each activity involves both planning and control, but the emphasis varies with
the type of activity. The planning process is much more important in strategy
formulation, the control process is much more important in task control, and
planning and control are of approximately equal importance in management
control.

1. Management Control
Management control is the process by which managers influence other members
of the organization to implement the organization’s strategies.

i. Management Control Activities

Management control involves a variety of activities including
 Planning what the organization should do
 Coordinating the activities of several parts of the organization
 Communicating information

 Evaluating information
 Deciding what, if any, action should be taken
 Influencing people to change their behaviour

ii. Conforming to a budget is not necessarily good, and departure from a

budget is not necessarily bad.
Budgets or plans are based on circumstances believed to exist at the time they
were formulated. If these circumstances have changed at the time of
implementation, the actions dictated by the plan may no longer be appropriate. If
a manager discovers a better approach – one more likely than the predetermined
plan to achieve the organization’s goals – the management control systems
should not obstruct its implementation.

iii. Goal Congruence

Organizational goals explain how an organization intends to go about achieving
its mission. For example, a car manufacturer might identify its mission as
increasing market share and making a profit. Establishing goals of introducing a

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new model of car each year and providing the highest-quality spare parts to
customers will enable it to achieve that mission.
Goal congruence means the goals of an organization’s individual members
should be consistent with the goals of the organization itself. The management
control system should be designed and operated keeping in mind the principle of
goal congruence.

iv. Tool for Implementing Strategy

Management control systems help managers move an organization toward its
strategic objectives. Therefore, management control focuses primarily on
strategy execution.
Apart from management controls, strategies are also implemented through the
organization’s structure, its management of human resources, and its particular
culture. This is indicated in the following diagram.
Organizational structure: An organizational structure is a mostly hierarchical
concept of subordination of entities that collaborate and contribute to serve one
common aim.

Organizational structure allows the expressed allocation of responsibilities for

different functions and processes to different entities. Ordinary description of such
entities is as branch, site, department, work groups and single people. Contracting of
individuals in an organizational structure normally is under timely limited work
contracts or work orders or under timely unlimited employment contracts or

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program orders. It specifies the roles, reporting relationships, and division of
responsibilities that shape decision-making within an organization.

Human Resource Management (HRM): Human Resource Management is the

strategic and coherent approach to the management of an organization’s most
valued assets - the people working there who individually and collectively
contribute to the achievement of the objectives of the business. In simple sense,
Human Resource Management means employing people, developing their resources,
utilizing, maintaining and compensating their services in tune with the job and
organizational requirement.

HRM is the selection, training, evaluation, promotion, and termination of employees

so as to develop the knowledge and skills required to execute organizational
strategy.

Organizational Culture
Every organization has an unwritten culture that defines standards of acceptable
and unacceptable behavior for employees. After a few months, most employees
understand their organization’s culture. They know things like how to dress for
work, whether rules are rigidly enforced, what kinds of questionable behaviors are
sure to get them into trouble and which are likely to be overlooked, the importance
of honesty, integrity and the like. While many organizations have sub cultures –
often created around the work groups – with an additional and modified set of
standards, they still have dominant culture that conveys to all employees those
values the organization holds dearest. Members of work groups have to accept the
standards implied in the organization’s dominant culture if they are to remain in
good standing.

Organizational climate
Perhaps one of the most important and significant characteristics of a great
workplace is its organizational climate. Organizational climate, while defined
differently by many researchers and scholars, generally refers to the degree to
which an organization focuses on and emphasizes:
 Innovation

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  Flexibility
 Appreciation and recognition
 Concern for employee well-being
 Learning and development
 Citizenship and ethics
 Quality performance
 Involvement and empowerment
 Leadership

Organizational climate, manifested in a variety of human resource practices, is an

important predictor of organizational success. Numerous studies have found
positive relationships between positive organizational climates and various
measures of organizational success, most notably for metrics such as sales, staff
retention, productivity, customer satisfaction, and profitability

v. Financial and Non-financial Emphasis

Management control systems encompass both financial and nonfinancial
performance measures. The financial measures are focused on the monetary
“bottom line” – net income, return on equity, etc. But all organizations have
nonfinancial objectives – product quality, market share, customer satisfaction, on-
time delivery, and employee morale.

vi. Aid in Developing New Strategies

In industries that are subject to rapid environmental changes, management control
systems can also provide the basis for considering new strategies. This function,
referred to as interactive control, draws management’s attention to both positive
and negative developments – that indicate the need for new strategic initiatives.
Interactive controls are an integral part of the management control system. This is
illustrated below in diagram:

Today’s controls Tomorrow’sstrategy

InteractiveControls

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2. Strategy Planning & Formulation
Strategic planning is an organization’s process of defining its strategy, or
direction, and making decisions on allocating its resources to pursue this
strategy, including its capital and people. Various business analysis techniques
can be used in strategic planning, including SWOT analysis (Strengths,
Weaknesses, Opportunities, and Threats ) and PEST analysis (Political, Economic,
Social, and Technological analysis) or STEER analysis involving Socio-cultural,
Technological, Economic, Ecological, and Regulatory factors and EPISTEL
(Environment, Political, Informatic, Social, Technological, Economic and Legal)
Strategic planning is the formal consideration of an organization’s future course.
All strategic planning deals with at least one of three key questions:
1. “What do we do?”
2. “For whom do we do it?”
3. “How do we excel?”

In many organizations, this is viewed as a process for determining where an

organization is going over the next year or more -typically 3 to 5 years, although
some extend their vision to 20 years.
In order to determine where it is going, the organization needs to know exactly
where it stands, then determine where it wants to go and how it will get there.
The resulting document is called the “strategic plan”.
It is also true that strategic planning may be a tool for effectively plotting the
direction of a company; however, strategic planning itself cannot foretell exactly
how the market will evolve and what issues will surface in the coming days in
order to plan your organizational strategy. Therefore, strategic innovation and
tinkering with the ‘strategic plan’ have to be a cornerstone strategy for an
organization to survive the turbulent business climate.
Strategy formulation is the process of deciding on the goals of the organization
and the strategies for attaining these goals. Goals describe the broad overall aims
of an organization and objectives describe specific steps to accomplish the goals
within a given time frame.

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Goals are timeless; they exist until they are changed, and they are changed only
rarely. For many businesses, earning a satisfactory return on investment is an
important goal; for others, attaining a large market share is equally important.
Non-profit also have goals to provide maximum services possible with available
funding. In the strategy formulation process, the goals of the organization are
usually taken as given, although on occasion strategic thinking can focus on the
goals themselves. Strategies are big plans, important plans. They state in a
general way the direction in which senior management wants the organization to
move. A decision by a automobile manufacturer to produce and sell an electric
automobile would be a strategic decision.

3. Task Control
Task control is the process of ensuring that specified tasks are carried out
effectively and efficiently. It is transaction-oriented i.e., it involves the
performance of individual tasks according to rules established in the
management control process. Task control often consists of seeing that these
rules are followed, a function that in some cases does not even require the
presence of human beings.
Numerically controlled machine tools, process control computers, and robots are
mechanical task control devices. Their function involves humans only when the
latter proves less expensive or more reliable; this is likely to happen only if
unusual events occur so frequently that programming a computer with rules for
dealing with these events is not worthwhile.
Many task control activities are scientific; i.e., the optimal decision or the
appropriate action for bringing an out-of-control condition back to the desired
state is predictable within acceptable limits.

For instance, the rules for economic order quantity determine the amount and
timing of purchase orders. Task control is the focus of many management science
and operations research techniques.

Most of the information in an organization is task control information: the

number of items ordered by customers, the pounds of material and units of
components used in the manufacture of products, the number of hours worked

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by employees, and the amount of cash disbursed. Many of an organization’s
central activities – including procurement, scheduling, order entry, logistics,
quality control, and cash management – are task control systems.

2.15 MANAGEMENT CONTROL PROCESS:

Control process consists in verifying whether everything occurs in conformity
with the plans adopted, the instructions issued and principles established. Its
main objective is to point out weaknesses and mistakes and give suggestions for
corrective measures and thus their reoccurrence. Thus the control process
involves a comparison of actual with the expected and locates the deviations, if
any.
Management control process aims to bring to light that everything is taking place
in accordance with the plan and thus it compel events to confirm to plan. One can
say control is forward looking since it aims to locate any deviation from the plan
with a view to incorporate corrective action.

Features of Control Process:

1. A Management Function: this control is performed by managers in order
to confirm that everything is taking place inconformity with the plan
2. Dynamic Process: Whenever plans are implemented, the control process
becomes imperative to check if there is any deviation.
3. Continuous Activity: It is a continuous process. Management
continuously reviews its actions so as to confirm their performance is in
the right track. This helps to avoid wastage of resources.
4. Control is forward looking: control is futuristic. It is future oriented. One
cannot control which relates to past or what had already happened. It
keeps check on the performance that is currently carried out or going to
be carried out in near future.
5. Control closely related to planning: It is rightly said that “There can be a
planning without controlling but there cannot be a controlling without
planning”. This so because, it is the plan or the budget against which the
actual performance can be compared to arrive at deviations if any.

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Steps in Management Control Process:
The management control process contains the following basic steps. The
manager first of all establishes performance standards which can be used as a
yard stick to measure and compare the actual with the standards. The end result
of comparison is the spotting out deviations. Then corrective actions are
designed to correct errors and also avoid their reoccurrence. Generally, the steps
involved in the management control process are listed below:
1. Establish Standards
2. Measuring Actual Performance
3. Comparison of Actual with the Standard
4. Taking Corrective Actions.

1. Establish Standards: The standards are the yard sticks using which the
actual can be verified. The standards are the expected out comes. The set
standards should be simple and easily understood by the workers so that
they have a clear idea of what is expected from them in terms
performance. The standards set should be precise, attainable, accurate,
flexible and realistic.

2. Measuring Actual Performance: In this stage the actual performance is

measured and compared with that of the set standards. This process of
measuring is easy if the standards are set in quantitative terms. However
in certain cases setting quantitative standards is not possible, hence
manager sets standards in qualitative terms.

3. Comparison of Actual with the Standard: under this step the actual
performance is compared with the standards. This is said to be the heart
of control process. Because this step brings to light whether the
performance is taking place in accordance to the plan or not. For example
the supervisor in the production department compares the actual output
with that of the scheduled one, then he is said to carry out the control
process for his production department.

4. Taking Corrective Actions: The last step in the control process is taking
corrective action, in case any deviation is identified. Deviation means

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 difference between the standard and the actual. If the deviation is found
to be insignificant then immediate correction may not be required only its
reoccurrence can be checked. On the other hand if the deviation id
significant its and serious the management must take corrective action
immediately and gives suggestions for controlling its reoccurrence.

It is the responsibility of the management to see whether all the suggested

recommendations are properly implemented and followed. In some organization
the control process has become ineffective because of failure on the part of
management to check the follow up actions.

Essentials of a Good Management Control Process:

The management control process to be effective should posses the following
characteristic features:

1. Suitability: The control system followed by the management should be

suitable for the type of activity to which it is applied.
2. Comprehendible: The control system followed must be easily
understandable by all in the organization. Especially by those, who are
going to use it.
3. Economical: The control system should be cost effective. It must not a
costly system which is beyond the means of the organization. With less
expenditure the control system must bring more benefit to the
organization.
4. Flexibility: The control system followed by the management should be
flexible enough to give room for changes.
5. Less time consuming: The control process must commune less time and
produce results expeditiously. Because the aim of the control system is to
check deviation in near future.
6. Forward looking: The control system should be futuristic. Because one
cannot control what had happened already in the past.
7. Objectivity: The standards set are objective in nature rather than being
subjective. This helps to avoid bias in appraisal of performance.

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 8. Conformity to organizational structure: To avoid confusion the
responsibility of people in the organization in carrying out the control
process should be clearly demarcated for this purpose control should
confirm to organizational pattern of the concern.
9. Indicate critical points: An efficient control system must not only high
light the deviations but also pin point the critical areas of management.
10. Suggest corrective actions: A good control system not only focus on
deviations but also give suggestions about the corrective actions needed
to be taken.

2.16 MANAGEMENT CONTROL AND MANAGEMENT ACCOUNTING

Traditionally, management accounting and management control are closely
related. Yet, they are not identical. This will become clear by looking at some of
the definitions of management accounting. The National Association of
Accountants (1990, p.4) for example, defines management accounting in SMA 1A
as `the process of identification, measurement, accumulation, analysis, preparation,
interpretation, and communication of financial information used by management
to plan, evaluate, and control within an organization and to assure appropriate use
of and accountability for its resources'. Similarly, Horngren, Foster and Datar
(1994, p.4) describe management accounting as follows: `Management
accounting, focusing on internal customers, measures and reports financial and
other information4 that assists managers in fulfilling goals of the organization.'
From these definitions we can conclude, that, while management control focuses
on attaining the organization's goals and strategies, through planning, evaluating,
and controlling activities, management accounting is focused on preparing,
measuring, and reporting the financial information that is needed to practice
these functions efficiently and effectively. Thus, management accounting
provides tools for management control. This explains why many accounting
textbooks contain a section on management control. In such sections, attention is
usually given to topics like responsibility accounting, budgeting, standard
costing, decentralization and transfer pricing (see for example Horngren &
Sundem, 1993; Kaplan & Atkinson, 1989; Horngren, Foster & Datar, 1994;
Hansen & Mowen, 1994).

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That management accounting and management control are closely related does
not become clear solely by looking at the definition of both concepts, but also by
examining how management control has been described by Anthony (1988), and,
subsequently, in many accounting textbooks. In describing the traditional view
on management control, a distinction can be made between the management
control structure and the management control process; the structure is what the
system is, the process is what it does (Young, 1994).

Traditionally, the main characteristic of management control structure is

responsibility accounting: the organization is organized in different sub-units,
which are responsible for costs, revenues, profit, or profit/investment.
Depending on their responsibilities, the sub-units are respectively referred to as
cost center, revenue center, profit center, or investment center. Other parts of
the management control structure are rules and procedures, and organizational
culture (Anthony, 1988).

2.17 INTERNAL FACTORS THAT INFLUENCE MCS CHANGE

Innes and Mitchell (1990) state that MCS change involves the interaction of
several variables, for example the availability of an adequate accounting staff,
computing resources, and the degree of authority that a firm ascribes to the
accounting function. These variables relate to conditions favourable to MCS
change. Other variables are associated with factors that in fact influence MCS
change. These are competitiveness of the market, production technology, and the
product cost structure. Finally, there are conditions that are directly connected
with MCS change. The variables associated with these conditions are, for
example, the loss of market share, a new accounting staff member or a decrease
in the firm’s profitability. According to the contingency theory, organizational
design and MCS practices are affected by contingency factors (Sharma & Nandan,
2000; Fisher, 1995; Otley, 1980). An effective design, which matches internal
organizational elements with contingency factors (Burrell & Morgan, 1979), is
believed to lead to an effective business performance (Langfield-Smith, 1997;
Otley, 1980). In this study we will use the following contingency factors as
relevant predictors of MCS change: competition, size, the capacity to change

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(Libby & Waterhouse, 1996), the introduction of new technology, and change of
strategy (Haldma & Lääts, 2002). In addition, we include the institutional factor
‘capacity to undertake action’. We selected the internal factors on the basis of
their relevance as confirmed by the results obtained in our pilot study and
fieldwork. We believe that the above-mentioned factors play an important role in
MCS change and that they may enable us to analyse and explain the phenomenon
more thoroughly.

[3] CONCEPTUAL FRAMEWORK OF FINANCIAL PERFORMANCE

ANALYSIS:
2.18 INTRODUCTION AND CONCEPT OF PERFORMANCE:
According to Robart Albanese “Performance is used to mean the efforts extended
to achieve the targets efficiently and effectively. The achievement of targets
involves the integrated use of human, financial and natural resources.”
According to Erich L. Kohlar "It is a general term applied to a part or to all of the
conduct of activities of an organization over a period of time; often with
reference to past or projected cost efficiency, management responsibility or
accountability or the like.

The above definitions describe that the word ‘Performance refers to presentation
with quality and result achieved by the management of company. It considers the
accomplishment of objectives as well as goals setting for the company comparing
the present progress with the past, although in context of the present. It also
covers financial cost and social aspects. Overall activities conclusion is
represented by the term ‘Performance’

2.19 FINANCIAL PERFORMANCE:

Financial performance is a close and a critical study of various measures
observed in the operation of business organization. The concept of human body
is similar to the concept and case of a business organization. Human body
requires medical checkup and examination for maintaining fitness of body;
similarly, the financial performance of a business organization has got to be
assessed periodically. Erich A. Helfert stated, “The person analyzing business

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performance has clearly in mind which tests should be applied and for what
specific reasons. One must define the view point to be taken, the objectives of the
analysis and possible standard comparison”.

According to Flippo, a prominent personality in the field of Human resources,

"performance appraisal is the systematic, periodic and an impartial rating of an
employee’s excellence in the matters pertaining to his present job and his
potential for a better job." Performance appraisal is a systematic way of
reviewing and assessing the performance of an employee during a given period
of time and planning for his future. The Process of “financial Performance”
involves an evaluation of actual against desired performance. It also helps in
reviewing various factors which influence performance. Managers should plan
performance.

2.20 FINANCIAL EFFICIENCY:

Financial Efficiency is a measure of the organization’s ability to translate its
financial resources into mission related activities. Financial Efficiency is
desirable in all organizations regardless of individual mission or structure. It
measures the intensity with which a business uses its assets to generate gross
revenues and the effectiveness of producing, purchasing, pricing, financing and
marketing decisions. At the micro level, Financial Efficiency refers to the
efficiency with which resources are correctly allocated among competing uses at
a point of time. Financial Efficiency is a measure of how well an organization has
managed certain tradeoffs in the use of its financial resources. Financial
Efficiency is regarded efficiency and is a management guide to greater efficiency
the extent of profitability, productivity, liquidity and capital strength can be
taken as a final proof of financial efficiency.

It is interesting to note that sometimes, even sufficient profits can mask

inefficiency and conversely, a good degree financial efficiency could be dressed
with the absence & profit.

2.21 EFFICIENCY AND PERFORMANCE:

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The word efficiency as defined by the Oxford dictionary states that: "Efficiency is
the accomplishment of or the ability to accomplish a job with minimum
expenditure of time and effort". It refers to the internal process that leads to
output. It focuses on the means to achieve the desired end.

Fatless and speedy compliance to the process or system procedure is a measure

of efficiency. Providing a specified volume and quality of service with the lowest
level of resources capable of meeting that specification, performance measures
and or indicators are required. These include measures of productivity, unit o
volume of service etc. These measures help in minimizing of the resources in
achieving the organizational objectives.

Performance is the execution or accomplishment of work feats etc. or a

particular, action, deed or proceeding is refers as performance. However, the
manner in which or the efficiency with which something reacts or fulfills its
intended purpose is defined as performance. Performance may thus, mean
different things to different businesses.

Success or failure in the economic sense is judged in relation to expectations,

return on invested capital and the objective of the business concern. In
understanding the term performance, a clear distinction needs to be drawn
between Performance Measures and Performance Indicators. Performance
measures need to be based on cat evaluation of the causes and effects of policy
intervention whereas a performance indicator is less precise and usually
provides only intermediate measure of achievement.

2.22 OBJECTIVES OF FINANCIAL PERFORMANCE:

 To help the management in exercising organizational control.
 To diagnose the strengths and weaknesses of the business
 To prove reliable financial information about economic resources and
obligations of a business enterprise.
 To provide reliable information about in net resources of an enterprise
that results from its activities.

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  To prove financial information that assist in estimating the earning
potentials of a business.
 To provide other needed information about changes in economic
resources of obligation.
 To disclose, to the extent possible, other information related to the
financial statements that is relevant to the needs of the users of these
statements.

2.23 AREAS OF FINANCIAL PERFORMANCE ANALYSIS:

Financial analysts often assess firm's production and productivity performance,
profitability performance, liquidity performance, working capital performance,
fixed assets performance, fund flow performance and social performance.
However in the present study financial health of GSRTC is measured from the
following perspectives:
1. Working capital Analysis
2. Financial structure Analysis
3. Activity Analysis
4. Profitability Analysis.
5. Liquidity Analysis

2.24 INTRODUCTION OF FINANCIAL STATEMENT ANALYSIS

Business cannot exist without profit and economy cannot exist without sound
business. Profit is the main motto behind the establishment of a business. It is
the engine that drives the business enterprise. Basically profit is the primary
motivating force for all economic activities and the report card of the past.
Service motive is the secondary function of an enterprise. Thus, Profit is the soul
of the business without which a business becomes dull and lifeless. “ In fact profit
is useful intermediate beacon towards which a firms capital should be directed”.
No company can exist/survive longer without profit. If the firm is to survive in
competitive and expanding environment it has to go on expanding the scale of its
operations on a regular and continuing bases. “ profits are the record card of the
past the inventive lode star for the future. If and enterprise fails to make profit.
Capital invested is eroded and if this situation prolongs the enterprise ultimately

96
ceases to exit”. Thus, profit is the soul of the business concern without which it
becomes weak and lifeless. Explaining the importance of profit to different
parties Weston and brigham pointed out that “ to the financial management
profit is the test of efficiency and a measure of control , to the owners ; a measure
of the worth of their investment to the creditors, the margin of safety, to the
government a measure of taxable capacity and basis of legislative action ? and to
the country profit is an index of economic progress, national income generated
and rise in the standard of living” On the other hand profit is a single for the
allocation of resources and a yardstick for judging the managerial efficiency

2.25 SCOPE OF FINANCIAL STATEMENT ANALYSIS:

In order to develop a basic understanding of financial analysis, we first need to
understand the difference between the roles of financial reporting and financial
statement analysis. The role of financial reporting is to provide information
about a company’s performance (Income Statement), financial position (Balance
Sheet) and changes in financial position (Statement of Changes in Equity).
The role of financial statement analysis is to use these financial reports prepared
by companies, combined with other information, to evaluate the past, current
and potential future performance and financial position of a company for the
purpose of making investment, credit, and other economic decisions. Examples
of such decisions include:
 Should an equity investment be included in a portfolio?
 Should credit be extended to a particular customer?
 What is the future net income and cash flow for a particular company?

The performance of a company can include an assessment of a company’s

profitability, ability to generate positive cash flows, liquidity and solvency.
Liquidity refers to the ability of a company to meet short-term obligations.
Solvency refers to the ability of a company to meet long-term obligations.

2.26 THE NEED FOR FINANCIAL STATEMENT ANALYSIS:

The important point to recognize is that just having the financial statement
numbers is not enough to answer the questions that financial statement users

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want answered. Without further analysis, the raw numbers themselves don’t tell
much of a story. Financial statement analysis involves the examination of both
the relationships among financial statement numbers and the trends in those
numbers over time. One purpose of financial statement analysis is to use the past
performance of a company to predict how it will do in the future. Another
purpose is to evaluate the performance of a company with an eye toward
identifying problem areas. In sum, financial statement analysis is both
diagnosis— identifying where a firm has problems—and prognosis—predicting
how a firm will perform in the future.

Relationships between financial statement amounts are called financial ratios.

Net income divided by sales, for example, is a financial ratio called return on
sales, which tells you how many pennies of profit a company makes on each
dollar of sales. For external users of financial statements, such as investors and
creditors, financial statement analysis plays the same role in the decision-making
process. Whereas management uses the analysis to help in making operating,
investing, and financing decisions, investors and creditors analyze financial
statements to decide whether to invest in, or loan money to, a company.

2.27 IMPORTANCE OF FINANCIAL PERFORMANCE ANALYSIS:

The significance and requirement of performance appraisal ascend from the
viewpoint of all live participants who are interested in the routine of the unit.
These are as under.

 Management Point of View: Performance appraisal plays a vital role in

providing such information to the management, which is required for
planning, decision-making and control e.g. operational analysis provides
gross margin, operating expense analysis and profit margin. Asset
management outlines asset turnover, working capital under inventory
turnover, accounts receivable and payable. Profitability position shows
return on assets, Earning Before Interest and Tax (EBIT) and return on
assets. Gresternberg stated that, “Management can measure the
effectiveness of its own policies and decisions, determine the advisability

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 of adopting new policies and procedures and documents to owners as a
result of their managerial efforts.” Thus, management should examine a
great deal of information in the context of various resources placed at the
disposal of an undertaking.

 Potential Investors Point of View: According to Erich A. Helfert,

“Importance of Performance lies for owners / potential investors should
know easily. The financial position of a company by return on net worth,
return on common equity, earnings per share, cash flow per share,
dividends per share, dividend yield, dividend coverage, price earnings
ratio, market to book value, pay out / retention.” The potential investors
of the business organization in turn are interested in the current features.

 Creditors Point of View: Creditors doing business with company simply

appraise its performance by current ratio, acid test ratio, debt to assets
ratio, equity and capitalization, interest coverage and principal coverage
before lending the finance. Performance appraisal describes real features
of business organization to the creditors.

 Government Point of View: Government has significance of performance

appraisal of an individual organization or industry as a whole by the
means of various taxes, revenues, financial assistance, sanctioning
subsidy to a unit or industry as well as price fixing policies frame outlines.
The key role of performance appraisal for the government lies in
planning, decision-making and control process.

 Employees and Trade Unions Point of View: Employees are resources

of the company and are interested to know the financial position and
profits of the company. Generally, they are analyzed by making the
comparison between past and present performance, profit margin and
cash flow of the company. Trade unions are interested to know the data of
financial performance pertaining to their demands for increase in wages,
salaries, facilities and social welfare.

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  Society and Others Point of View: Society and Others are included in
external environment of the company and every business organization
has a greater responsibility towards society. In this context, performance
appraisal should be appraised through various types of elements such as
customers, investors, media, credit institutions, labor bureaus, taxation
authorities; economists are interested for the appraisal of a business
organization. The society as a whole also looks forward to know about the
social performance i.e. environmental obligations, social welfare, etc.

2.28 ESSENTIAL FEATURES OF FINANCIAL STATEMENT:

 The Financial Statement should be relevant for the purpose for which
they are prepared. Unnecessary and confusing disclosures should be
avoided and all those that are relevant and material should be reported to
the public.
 They should convey full and accurate information about the performance
position progress and prospects of an enterprise, it is also important that
those who prepare and present the finical statement should not allow
their personal prejudices to distort the facts.
 They should be easily comparable with pervious statement or with those
of similar concerns or industry. Comparability increases the utility of
financial statement.
 They should be prepared in a classified form so that better and
meaningful analyses could be made.
 The financial statement should be prepared and presented at the right
time. Undue delay in their preparation would reduce the significance and
utility of these statements.
 The financial statement must have general acceptability and
understanding. This personal judgment and procedural choices exercise
by the accountant.
 The financial statement should not be affected by inconsistencies arising
out of personal judgment and procedural choices exercised by the
accountant.

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  Financial statement should comply with the legal requirements if any, as
regards from, contents and disclosures and methods. In India, companies
are required to present their financial statements according to the
companies Act, 1956.

2.29 TECHNIQUES OF MEASURING FINANCIAL PERFORMANCE:

A study of liquidity, productivity and financial efficiency through profitability is
made by using the following tools and techniques Analysis of financial statement
reveals the underlying significance of item composed in them. Analysis breaks
down the complex set of facts of figures into simple elements. Interpretation is
the next step. It consists in explaining the real significance of this statement. The
analysis consist of the study of inter relationship between various item
comprised in financial statement to determine whether the earning and the
financial position of the company are satisfactory. A number of devices are used
in the analysis of financial statement, some of which are as follow :

(A) RATIO ANALYSIS:

Ratio analysis is the principal technique used to measure the profitability of a
business enterprise. The growth, development and the present position of a
business in terms of profit can be analyzed through the calculation of various
ratios. Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “
The indicated quotient of two mathematical expressions” and as “The
relationship between two or more things”.

In financial analysis, a ratio is used as an index or yardstick for evaluating the

financial position and performance of a firm. The technique involves four steps
Viz. determining the accounting ratio to be used, computation of the ratio
comparison of ratio with the standard set and interpretation. The interpretation
of ratios requires careful study and sound judgment on the part of the analyst as
they do not give clear picture but tend to give indications. Ratios by themselves
are not conclusion the analyst must draw interest from them before arriving at
final conclusion.

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The primary function of accounting is to accumulate accounting data in order to
calculate the profit and loss made by the business firm during and also to
understand the financial position of the business on a given date. A business can
ascertain this by preparing the Final Accounts (financial statements). Financial
statements show the financial performance of a company. They are used for both
internal and external purposes. When they are used internally, the management
and sometimes the employees use it for their own information. Managers use it
to plan ahead and set goals for upcoming periods. When they use the financial
statements that were published, the management can compare them with their
internally used financial statements. They can also use their own and other
enterprises’ financial statements for comparison with macro economical data
and forecasts, as well as to the market and industry in which they operate in.
Preparation of final accounts from a trial balance is the final phase of the
accounting process. Final accounts include the preparation of Trading and Profit
and Loss Account and the Balance Sheet, although the Balance Sheet is not an
account but only a statement. Trading and Profit and Loss Account is simply one
account which is usually divided into two sections. The first section is called the
Trading Account and the second section the Profit and Loss Account. In case of
manufacturing concerns, Final Accounts also include the Manufacturing Account.

The analysis of the financial statements and interpretations of financial results of

a particular period of operations with the help of 'ratio' is termed as "ratio
analysis." Ratio analysis used to determine the financial soundness of a business
concern. Alexander Wall designed a system of ratio analysis and presented it in
useful form in the year 1909.

MEANING AND DEFINITION

The term 'ratio' refers to the mathematical relationship between any two inter-
related variables. In other words, it establishes relationship between two items
expressed in quantitative form.
According J. Batty, Ratio can be defined as "the term accounting ratio is used to
describe significant relationships which exist between figures shown in a balance

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sheet and profit and loss account in a budgetary control system or any other part
of the accounting management."
Ratio can be used in the form of
(1) Percentage (20%)
(2) Quotient (say 10) and
(3) Rates.

In other words, it can be expressed as a to b; a: b (a is to b) or as a simple

fraction, integer and decimal. A ratio is calculated by dividing one item or figure
by another item or figure.

ANALYSIS OR INTERPRETATIONS OF RATIOS

The analysis or interpretations in question may be of various types. The
following approaches are usually found to exist:
(a) Interpretation or Analysis of an Individual (or) Single ratio.
(b) Interpretation or Analysis by referring to a group of ratios.
(c) Interpretation or Analysis of ratios by trend.
(d) Interpretations or Analysis by inter-firm comparison.

PRINCIPLES OF RATIO SELECTION

The following principles should be considered before selecting the ratio:
(1) Ratio should be logically inter-related.
(2) Pseudo ratios should be avoided.
(3) Ratio must measure a material factor of business.
(4) Cost of obtaining information should be borne in mind.
(5) Ratio should be in minimum numbers.
(6) Ratio should be facilities comparable.

ADVANTAGES OF RATIO ANALYSIS:

Ratio analysis is necessary to establish the relationship between two accounting
figures to highlight the significant information to the management or users who
can analyze the business situation and to monitor their performance in a
meaningful way. The following are the advantages of ratio analysis:

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  It facilitates the accounting information to be summarized and simplified
in a required form.
 It highlights the inter-relationship between the facts and figures of
various segments of business.
 Ratio analysis helps to remove all type of wastages and inefficiencies.
 It provides necessary information to the management to take prompt
decision relating to business.
 It helps to the management for effectively discharge its functions such as
planning, organizing, controlling, directing and forecasting.
 Ratio analysis reveals profitable and unprofitable activities. Thus, the
management is able to concentrate on unprofitable activities and consider
improving the efficiency.
 Ratio analysis is used as a measuring rod for effective control of
performance of business activities.
 Ratios are an effective means of communication and informing about
financial soundness made by the business concern to the proprietors,
investors, creditors and other parties.
 Ratio analysis is an effective tool which is used for measuring the
operating results of the enterprises.
 It facilitates control over the operation as well as resources of the
business.
 Effective co-operation can be achieved through ratio analysis.
 Ratio analysis provides all assistance to the management to fix
responsibilities.
 Ratio analysis helps to determine the performance of liquidity,
profitability and solvency position of the business concern.

LIMITATIONS OF RATIO ANALYSIS:

Ratio analysis is one of the important techniques of determining the
performance of financial strength and weakness of a firm. Though ratio analysis
is relevant and useful technique for the business concern, the analysis is based
on the information available in the financial statements. There are some

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situations, where ratios are misused; it may lead the management to wrong
direction. The ratio analysis suffers from the following limitations:

 Ratio analysis is used on the basis of financial statements. Number of

limitations of financial statements may affect the accuracy or quality of
ratio analysis.
 Ratio analysis heavily depends on quantitative facts and figures and it
ignores qualitative data. Therefore this may limit accuracy.
 Ratio analysis is a poor measure of a firm's performance due to lack of
adequate standards laid for ideal ratios.
 It is not a substitute for analysis of financial statements. It is merely used
as a tool for measuring the performance of business activities.
 Ratio analysis clearly has some latitude for window dressing.
 It makes comparison of ratios between companies which is questionable
due to differences in methods of accounting operation and financing.
 Ratio analysis does not consider the change in price level, as such, these
ratio will not help in drawing meaningful inferences.

CLASSIFICATION OF RATIOS
Accounting Ratios are classified on the basis of the different parties interested in
making use of the ratios. A very large number of accounting ratios are used for
the purpose of determining the financial position of a concern for different
purposes. Ratios may be broadly classified in to:
1. Classification of Ratios on the basis of Balance Sheet.
2. Classification of Ratios on the basis of Profit and Loss Account.
3. Classification of Ratios on the basis of Mixed Statement (or) Balance Sheet
and Profit and Loss Account.
This classification further grouped in to:
a. Liquidity Ratios
b. Profitability Ratios
c. Turnover Ratios
d. Solvency Ratios
e. Overall Profitability Ratios

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(B) COMPARATIVE STATEMENT ANALYSIS:
When financial statements of a few years are presented columnar form, it
indicated the trend of changes taking place in business. The methods presenting
both financial statements in columnar form and judging the trend of profitability
and financial condition of business is known as comparative financial statement
analysis. The methods of comparative statement are used to indicate the changes
the current year’s figures as compare to past year figures. It may also be
presented in manner that will show the percentages of various figures with some
significant item. The various item of Profit and loss account and Balance sheet
may be presented side by side which will show the trend of increasing or
decreasing expensed of income and increasing or decreasing assets or liabilities.
Statement prepared in a form reflecting financial data for two or more periods
are known as comparative statements.

The data must first be properly set before comparison in the preparation of
comparative financial statement uniformity is essential otherwise comparison
will be vitiated. Comparative financial statement is very useful to the analyst
because they contain not only the data appearing in a single statement but also
information necessary for the study of financial and operating trends over a
period of a year. They indicate the direction of the movement in respect of
financial position and operating results. Comparison of absolute figures has no
significance if the scale of operations of one company is much different from that
of others:
A) Comparative Balance-Sheet: Increase and decrease in various assets and
liabilities as well as in proprietor’s equity or capital brought about by the
conduct of a business can be observed by a comparison of balance sheets at the
beginning and end of the period. Such observation often yield considerable
information, which is of value informing an opinion regarding the progress of the
enterprise and in order to facilitate comparison a simple device known as the
“comparative balance Sheet” may be used.

B) Comparative Income Statement: As income statement shows the net profit

or net loss resulting from the operations of a business for designated period of

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time. A comparative income statement shows the operating result for a number
of accounting periods so that changes in absolute data from one period to
another may be started in terms of money and percentage. The comparative
income statement contains the same columns as the comparative balance sheet
and provides the same type of information. As the income statement presents the
review of the operating activities of the business and the comparative balance
sheet shows the effect of operation of its assets and liabilities. The latter contains
a connecting link between the balance sheet and income statement. Income
statement and balance sheet are contemporary documents and they highlight
certain important facts.

(C) TREND ANALYSIS:

The trend statement analysis of various item of financial statement, figures of a
single year are not enough. Comparative figures of some more years are
significant. Such comparative figures may be wither absolute figures of may be
presented in percentage form. If the item of one year, which may be called base
year, are compared with similar item of other year in the form of percentages,
the methods is known as trend percentages method or trend ratio method

The Common sized Statement so far discussed do not provided any common
base with which all item in each stamen can be compared. For this purpose
common size statement are presented in which all item are compared with one
common item. It is also analysis of balance sheet and Profit and Loss Accounts. In
Balance sheet, total assets and liabilities is taken as 100 and all item are
presented as percentage of total assets and liabilities. And In Profit and Loss
Account , sales is base taken as 100 and all individual item of expense and
incomes are shown as percentage of sales.

The different approaches of trend analysis are (I) Common Size Vertical Analysis
and (II) Common Size Horizontal Analysis Trend analysis helps the analyst and
management to evaluate the performance, efficiency and financial condition of
an enterprise as follows:

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A) Common Size Vertical Analysis: All the statement may be subject to
common size vertical analysis a figure from the same year’s statement is
compared with the basic figure selected from the statement should be converted
in to percentage to some common base. The common size vertical income
statement and balance sheets of Aluminum group of companies covered by this
study are given in the study.

B) Common Size Horizontal Analysis: When asking horizontal analysis, a

figure from the account is expressed in terms of same account figures from
selected base year. It is calculation of percentage relation that each statement
then bears to the same item in the base year. Horizontal analysis can help the
analysis to determine how an enterprise has arrived at its current position.

The technique of common size statement is very useful when we wish to

compare the performance of one company with that of another for presentation
of the data in percentage form since it eliminates problems relating to
differences in organization size.

(D) STATEMENT OF CHANGES IN WORKING CAPITAL:

As we have seen earlier the excess of current assets over current liabilities is
known as working capital. The amount of working capital is of prime important
of the management, since most of transaction affects working capital. The
practice has therefore developed to prepare statement shown changes in the
working capital. There are various methods used to show such changes. One of
the methods generally used to prepare a statement with four columns to show
such changes. In the first column the values of current assets and liabilities of the
current year are shown, while in the second column the current assets and
liabilities of the previous year are written. The third and fourth columns are
meant for indicating either increase or decrease in the working capital due to
changes in assets and liabilities. The net effect of changes of all current assets
and current liabilities is shown at the end of the statement, which would disclose
where the working capital has increased or decreased.

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(E) CASH FLOW ANALYSIS:
The fund flow statement indicates changes in working capital which have taken
place during the year. But the management is more interested in the changes in
cash inflow and outflow in the short run. It is historical statement which
indicated the cash inflows during the last year and would guide the management
in framing policy regarding cash management. The cash budget shows the
projected in flow and outflow of cash for the future budget period, while the cash
flow statement is prepared on the basis of historical financial statement.

(F) FUND FLOW ANALYSIS:

In a statement which shows the inflow and outflow of funds during the year, the
meaning of the world fund is working capital. The objective of preparing such a
statement is to show to the management and other interested parties, what
funds have come to the business and how they have been applied. A Balance
sheet is a static statement showing the condition of assets and liabilities on a
particular date only. While the fund flow statement is a dynamic statement
showing changes that have taken place during the year.

(G) VALUE ADDED STATEMENT:

In manufacturing business, the company purchase raw material from outside
and through manufacturing process, convert them into finished products and
thus add to the value. It is the values of services rendered by various parties
connected with business. This added values is distribution among various parties
who have contributed to its. Workers and other employees are paid wages and
other benefits of their services, the providers of capital get dividend and interest,
the supplier of convenient social infrastructure. Thus, there is a system of
evaluating business performance by means of value added also so some of the
companies give value added statement in their annual report along with other
financial Statement.

(H) OTHER TECHNIQUES OF ANALYSIS:

In addition to comparative statements, common-size statements, and ratio
analysis, analysts have many specialized tools and techniques which they can

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apply to special purpose studies. Such studies could include factors such as
insurance coverage, the seasonal nature of the business, segment data, foreign
operations, concentration of sales within a small number of customers, unusual
events affecting the company, and the effect of inventory method (LIFO, FIFO)
and depreciation methods on financial statements. Additional procedures that
are available for use in special situations include:
1. Gross margin analysis: Gross margin analysis provides special insights
into the operating performance of a company. It helps in evaluating
overall gross margin by product mix.
2. Breakeven, cost-volume-profit, and contribution analysis: This tool
discloses relationships between revenue and patterns of cost behavior for
fixed and variable expenses. Different managers within a company use
breakeven analysis because it is important when beginning a new activity,
such as starting a new line of business, expanding an existing business, or
introducing a new product or service. This topic is reserved for courses
such as Analyzing Cost Data for Management or Cost Management.
3. Return on investment analysis: Return-on-investment analysis
provides a comprehensive measure of financial performance. Especially,
the ROI breakdown, known as the Du Pont formula, analysis gives an
insight into how a company improves its performance. Special analytical
procedures are available to isolate the different types of fluctuations as
they relate to historical data and forecasts. When there is an established
relationship between series, it is possible to use these relationships to
make estimates and forecasts.
4. Time-series analysis is used where data classified on the basis of
interval of time represent vital information in the control and operation of
a business. The changes that can be isolated in time-series analysis
represent the following major types of economic change: secular trend,
seasonal variations, cyclical fluctuations, and random or erratic
fluctuations.
5. Regression analysis is another tool of financial statement analysis.
Regression analysis seeks to determine the relationship between financial
statement variables.

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 6. Correlation analysis measures the degree of relationship between two or
more variables. Time series, regression, and correlation analyses are
more sophisticated techniques and are beyond the scope of this course.

So, several other techniques like cash flow analysis and break-even analysis are
also some time useful for analysis. The use of various statistical techniques is
also used frequently for financial analysis, providing a more scientific analysis.
The tools generally applied are moving average, index number, range, Standard
deviation, correlation, regression and analysis of time series Diagrammatic and
graph orientations are often used in financial analysis. Graphs provide a
simplified way of presenting the data and often give much more vivid
understandable of trends and relationships. Pie graphs bar diagrams and other
simple graphs are often used for financial analysis.

2.30 CONCLUSION:
Performance is refers to presentation with quality and result achieved by the
management of company and Financial Efficiency is a measure of the
organization’s ability to translate its financial resources into mission related
activities. So, the financial performance analysis identifies the financial strengths
and weaknesses of the firm by properly establishing relationships between the
items of the balance sheet and profit and loss account. Company also calculated
different type of profit and last Measurement of profitability is the overall
measure of performance profits known, as bottom lines are also important for
financial institutions. Analyzing and interpreting various types of profitability
ratios can obtain creditor performance of portability.

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