INTRODUCTION

What is Finance: Finance is the accommodation & utilization of resources in order to achieve the goal of the organization. Finance can be defined as the art of science of managing money Finance is concerned with the Process, Institutions, Markets and Instruments involved in the transfer of money among Individuals, Businesses and Govt. Major areas & opportunities in Finance: 1. Financial Market & Institution: It includes banks, insurance , companies , savings & loan association , credit union are integral part of the general financial services marketplace. 2. Investments: This area of finance focuses on the decisions made by businesses and individuals as they choose securities for their investment portfolio. (1) Determining the values, risks, and returns associated with such financial assets as stocks & bonds and (2) determining the optimal mix of securities that should be held in portfolio of investments. 3. Financial Services: The area of Finance concerned with design and delivery of advice and financial products to individual , business and government. 4. Managerial Finance: Concerns the duties of the financial manger in the business firm. Importance of Finance in non-finance areas: Management: Strategic planning is one of the most important activities of management. It includes decision of setting salaries, hiring new staffs , paying bonuses must be co-ordinate with financial decision to ensure that needed funds are available. For these reason manager must have at least a general understanding of financial management. Marketing: The 4Ps of marketing product, price, place & promotion determine the success of products that are manufactured and sold by companies. The price that should be charged for a product and the amount of advertising a firm can afford for the product must be determine in consultation with financial manager. Coordination of financial & marketing function is critical to the success of a company. Accounting: Account managers must understand how financial manager use accounting in planning & decision making and vise verse. Similarly accountant must understand how accounting data are viewed by investors , auditors and other entities who are interested in the firm. Economy: Many tools used to make financial decisions evolved from theories or models developed by economists. It is important financial manager understand economics & economist understand finance. Economic activity and policy impact financial decisions & vice versa. What is Managerial Finance?

Managerial Finance Concerns the acquisition, financing, and management of assets with some overall goal in mind. Financial Manager: One who actively manages the financial affairs of any type of business whether financial or non-financial, private or public, large or small, profit seeking or nonprofit seeking. Three decisions of Managerial Finance: Investment Decisions Most important of the three decisions. What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or eliminated? Financing Decisions Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet). What is the best type of financing? What is the best financing mix? What is the best dividend policy? How will the funds be physically acquired? Asset Management Decision How do we manage existing assets efficiently? Financial Manager has varying degrees of operating responsibility over assets. Greater emphasis on current asset management than fixed asset management. Overall goal of the firm: The appropriate goal for management decisions, considering the risk & timing associated with expected cash flows to maximize the price of the firms common stock. Maximize the shareholders wealth. Value creation occurs when we maximize the share price for current shareholders. Strengths of shareholder wealth maximization: Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors. Thus, share price serves as a barometer for business performance. Shortcomings of Profit Maximization: Maximizing a firms earnings after taxes. Problems Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.). Ignores risk. Shortcomings of EPS Maximization:

Maximizing earnings after taxes divided by shares outstanding. Problems Does not specify timing or duration of expected returns. Ignores risk. Calls for a zero payout dividend policy. Managerial action to maximize shareholder wealth: Capital Structure Decision: Decisions about how much and what types of debt and equity should be used to finance the firm. Capital Budgeting Decision: Decisions as to what types of assets should be purchased to help generate future cash flows. Dividend Policy Decision: Decisions concerning how much of current earnings to pay out as dividends rather than retain for reinvestment in the firm. The Modern Corporation

Modern Corporation
Shareholders Management

There exists a SEPARATION between owners and managers.

Role of Management Management acts as an agent for the owners (shareholders) of the firm. An agent is an individual authorized by another person, called the principal, to act in the latters behalf. Agency Theory Jensen and Meckling developed a theory of the firm based on agency theory. Agency Theory is a branch of economics relating to the behavior of principals and their agents. Conflict of Goals: Agency Problem An agency problem is the conflict of goals between a firms shareholders and its managers. For example, decision to decision to establish a subsidiary in a particular area or to expand the business may be from the desire of managers to receive more responsibility and compensation.

 An agency problem exist mostly in big corporations where management is separated from ownership. Insole proprietorship it does not exist Agency problem is more visible in MNCs than domestic companies. Corporate Control to reduce Agency Problem Principals must provide incentives so that management acts in the principals best interests and then monitor results. 1. Managerial Compensation: To partially compensate the management and board members by offering stock to them so that they take decisions that maximizes the value of the firm a. Performance Shares: A type of incentive plan in which managers are awarded share of stock on the basis of the firms performance over given intervals with respect to earnings per share or other measures. b. Stock Options: Allows managers to purchase stock at some future time at a given price . 2. The Threat of Firing: It is an effective measure today because ownership now a days not widely distributed as in the past. Management control over voting mechanism is also not so strong as in the past Today it is easier for dissident shareholders to gain enough votes to overthrow the managers. Recent examples of ousting the managers are Coca Cola, Xerox, United Airlines etc. 3. Hostile Takeover threat: The fear of taking over the firm by the by some other big firms against the desire of the managers, if the firm is inefficiently managed. This threat may encourage the management to run the firm as per the desire of the shareholders. Social Responsibility Wealth maximization does not preclude the firm from being socially responsible. Assume we view the firm as producing both private and social goods. Then shareholder wealth maximization remains the appropriate goal in governing the firm. Multinational Corporations A multi national corporation is a firm that operate in two or more nations. International operations are important to both Individual and National Economy Reasons for Companies going for multinational To seek new markets To seek raw materials To seek new technology To seek production efficiency To avoid Political and regulatory hurdles

Distinguishing characteristics of Multinational Managerial Finance over Domestic Managerial Finance Different Currency Denomination Economic and Legal Ramifications Difference of languages Difference of culture Role of Government Political Risk Management art or science Science teaches us to know while art teaches us to do. In that sense Management is both science and art. Management is the art of arts as it teaches us the best accomplishment of a job that needs skill in performance. Management is science as the managers can improve their skill of management by studying the scientific approaches to their practice of management.

FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis: The art of transforming data from financial statement into information that is useful for informed decision making. Balance Sheet: A summary of a firms financial position on a given date that shows total assets equals total liabilities & owners equity. Income Statement: A summary of a firms revenues & expenses over a specified period, ending with net income or loss for the period. Shareholders equity: The book value of a companies common stock (at par) plus additional paid in capital and retained earnings. Examples of External Uses of Statement Analysis - Trade Creditors -- Focus on the liquidity of the firm. - Bondholders -- Focus on the long-term cash flow of the firm. - Shareholders -- Focus on the profitability and long-term health of the firm. - Government - Auditor Examples of Internal Uses of Statement Analysis - Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities. - Control -- Focus on return on investment for various assets and asset efficiency. - Understand -- Focus on understanding how suppliers of funds analyze the firm. Framework for Financial Analysis 1. Analysis of the funds needs of the firm. Trend / Seasonal Component: How much funding will be required in the future? Is there a seasonal component? Analytical Tools Used - Sources and Uses Statement/ Funds flow statement: If uses of funds are bigger than sources, then there will be deficit. - Statement of Cash Flows: Statement of cash inflow & cash outflow. - Cash Budgets: A complete cash flow statement is cash budget. When youre bothering for previous years balance.

2. Analysis of the financial condition and profitability of the firm. Health of a Firm Financial Ratios: 1. Individually: Assets with liability only for year 2008. 2. Over time: Like year 2008, 2009, 2010 years ratio & compare. 3. In combination: When youre comparing an intem from Income Statement & other from balance sheet. 4. In comparison: Compare with another firm or from one year to other. 3. Analysis of the business risk of the firm. Business risk relates to the risk inherent in the operations of the firm. If you finance from equity then there is no risk but if you finance from debt then you have financial risk. Machine breakdown or accident of the vehicle or increase in the price of the raw material is business risk. Examples: - Volatility in sales - Volatility in costs - Proximity to break-even point

1. Analysis of the funds needs of the firm. 2. Analysis of the financial condition and profitability of the firm. 3. Analysis of the business risk of the firm.

Determining the financing needs of the firm.

A A Financial Financial Manager Manager must must Negotiations consider consider with all three all three suppliers of jointly capital. jointly when when determinin determinin g the g the financing financing needs of needs of the firm. the firm.

Financial Ratio: A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.

Liquidity Ratios Shows a firms ability to cover its current liabilities with its current assets. Current Ratio Current Assets Current Liabilities Lower the current ratio better for company. Ideal 2:1 Acid-Test (Quick) Current Assets - Inv Current Liabilities Financial Leverage Ratios Show the extent to which the firm is financed by debt. Debt-to-Equity Total Debt Shareholders Equity Debt-to-Total-Assets Show the percentage of the firms assets that are supported by debt financing. Total Debt Total Assets Total Capitalization (i.e., LT-Debt + Equity) Show the relative importance of long-term debt to the long-term financing of the firm. Total Debt Total Capitalization Coverage Ratios Interest Coverage Indicates a firms ability to cover interest charges. EBIT Interest Charges

Activity Ratios Receivable Turnover (Assume all sales are credit sales.)

Indicates quality of receivables and how successful the firm is in its collections. Higher the receivable turnover better the quality of receivables. How your business activity will smoothly run., if there is higher receivables , then money will be blocked. Annual Net Credit Sales Receivables Avg Collection Period Average number of days that receivables are outstanding. (or RT in days) Days in the Year Receivable Turnover Try to reduce the average collection period. Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Indicates the promptness of payment to suppliers by the firm. How long we can hold the money. Annual Credit Purchases Accounts Payable Lower the PT, better for the company. PT in Days Average number of days that payables are outstanding. How many days I can take the advantage of credit purchase. Days in the Year Payable Turnover Higher the days , better for the company. Inventory Turnover Indicates the effectiveness of the inventory management practices of the firm. If inventory is high , blocking the capital. Cost of fund will be higher for higher inventory. Cost of Goods Sold Inventory Higher the inventory turnover, better for the company. Inventory Turnover in Days Average number of days the inventory is held before it is turned into accounts receivable through sales. 365 IT Total Asset Turnover Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. If with lower asset we can get higher sale, the company is said to be more efficient . Net Sales Total Assets Higher the asset turnover better the performance of the company.

Profitability Ratios Gross Profit Margin Indicates the efficiency of operations and firm pricing policies. Gross Profit = Net Sale Cost of Goods Sold If you need to increase gross profit then you need to increase your sale & continue your operation. Gross Profit Net Sales Net Profit Margin Indicates the firms profitability after taking account of all expenses and income taxes. Net Sale= Sale Sales Return Net Profit after Taxes Net Sales Return on Investment Indicates the profitability on the assets of the firm (after all expenses and taxes). Net Profit after Taxes Total Assets Return on Equity Indicates the profitability to the shareholders of the firm (after all expenses and taxes). Net Profit after Taxes Shareholders Equity Common-size Analysis An analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues. Index Analyses An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.

Working Capital Management

Working Capital Concepts Net Working Capital: Current Assets - Current Liabilities. Gross Working Capital: The firms investment in current assets. Working Capital Management: The administration of the firms current assets and the financing needed to support current assets. Significance of Working Capital Management - In a typical manufacturing firm, current assets exceed one-half of total assets. Usually manufacturing firm current assets is more than 50%. - Excessive levels of working capital can result in a substandard Return on Investment (ROI). - Current liabilities are the principal source of external financing for small firms. - Requires continuous, day-to-day managerial supervision. - Working capital management affects the companys risk, return, and share price. Working Capital Issues Optimal Amount (Level) of Current Assets In determining the appropriate amount or level of current assets, management must consider the trade off between profitability & risk. Assumptions: - 50,000 maximum units of production - Continuous production - Three different policies for current asset levels are possible Policy A

Policy B
ASSET LEVEL ($)

Policy C

Current Assets

25,000 OUTPUT (units)

50,000
Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity all other factors held constant.

Policy A is the most conservative of all three alternatives. At all levels of output policy A provides for more current assets than any other policy. Policy C is least liquid and can be labeled aggressive. This lean & mean policy calls for low levels of cash and marketable securities, receivables and inventories. Policy B uses moderate levels of current assets. Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise.

Though policy A clearly provide the highest liquidity, to rank the three alternatives from profitability we need to look into ROI equation: Net Profit ROI = Total Assets Net Profit ROI = (Cash + Receivables + Inventory) + Fixed Assets From the above equation we can see that decreasing the amount of current assets will increase the potential profitability. Policy C, then, provide the highest profitability potential as measured by ROI.

Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced.

Decreasing cash reduces the firms ability to meet its financial obligations. More risk! - Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! - Lower inventory levels increase stock outs and lost sales. More risk! Therefore more aggressive working capital policies lead to increased risk. Clearly Policy C is the most risky working capital policy. SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High 1. Profitability varies inversely with liquidity: Increased liquidity generally comes at the expense of reduced profitability. 2. Profitability moves together with risk: In search of higher profitability, must take greater risk. Classifications of Working Capital Components: Cash, marketable securities, receivables, and inventory Time: Permanent & Temporary Permanent Working Capital: The amount of current assets required to meet a firms longterm minimum needs. This is called bare bones working capital. Permanent working capital is similar to the firms fixed asset in two important respect: i) the dollar invested is long term despite the fact that the assets being financed are called current. ii) For a

growing firm , the level of permanent working capital needed will increase over time in the same way that a firms fixed assets will need to increase over time. Permanent working capital is different from fixed assets in one very important respect- it is constantly changing. Permanent working capital does not consists of particular current assets staying permanently in place, but is a permanent level of investment in current assets, whose individual items are constantly turning over.
DO LL AR AM OU NT TIME

Permanent current assets

Temporary Working Capital: The amount of current assets that varies with seasonal requirements. Temporary current assets DO LL AR AM OU NT

Permanent current assets

TIME

Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firms day-to-day operations. - Based on policies regarding payment for purchases, labor, taxes, and other expenses. - We are concerned with managing non-spontaneous financing of assets.

Hedging (or Maturity Matching) Approach A method of financing where each asset would be offset with a financing instrument of the same approximate maturity. Financing Needs and the Hedging Approach - Fixed assets and the non-seasonal portion of current assets are financed with long-term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm). - Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost). The rationale for this is that if long term debt is used to finance short-term needs, the firm will be paying interest for the use of funds during times when these funds are not needed. Self-Liquidating Nature of Short-Term Loans - Seasonal orders require the purchase of inventory beyond current levels. - Increased inventory is used to meet the increased demand for the final product. - Sales become receivables. - Receivables are collected and become cash. - The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs. Risks vs. Costs Trade-Off Risks of short term financing:

Committing funds to a long term assets and borrowing short term carries the risk that the firm may not able to renew its borrowings. Suppose a company borrows on a short term basis in order to build a new plant. The cash flows from the plant would not be sufficient in the short run to pay off the loan. As a result the company bears the risk that the lender may not roll over (renew) the loan at maturity. There is also uncertainty associated with interest cost. When the firm finances with long term debt , it knows precisely its interest costs over the period of time for which it needs the funds. If it finances with short term debt it is uncertain of interest costs on refinancing. We know short term interest rate fluctuate far more than long term rates.

Risk of long term financing: - The longer the maturity schedule of a firms debt , the more costly the financing is likely to be. - The firm may well end up paying interest on debt over periods of time when the funds are not needed. The margin is the difference between the firms expected cash flow and the contractual payment on its debt. The margin of safety will depend on the risk preference of management, managements decision of composition of the firms debt will determine the portion of current assets financed by current liabilities and the potion financed on long term basis. On the basis of firms there are two types of policy: 1. Conservative Financing Policy 2. Aggressive Financing Policy Conservative Financing Policy: If the firm finances a portion of its expected seasonal funs requirement , less payables and accruals, on a long term basis, that is called conservative approach. Firm can reduce risks associated with short-term borrowing by using a larger proportion of long-term financing. The higher the long term financing line , the more conservative the financing policy and higher the cost. Benefits: - Less worry in refinancing short-term obligations - Less uncertainty regarding future interest costs Risks: - Borrowing more than what is necessary - Borrowing at a higher overall cost (usually) Result :Manager accepts less expected profits in exchange for taking less risk. Aggressive Financing Policy: When the firm finance part of its permanent current assets with short term debt , that is called aggressive approach. As a result, it must refinance its debt at maturity and this involves an elements of risk. Firm increases risks associated with short-term borrowing by

using a larger proportion of short-term financing. The greater the portion of permanent asset needs financed with short term debt, the more aggressive the financing is said to be. Benefits: - Financing long-term needs with a lower interest cost short-term debt - Borrowing only what is necessary Risks: - Refinancing short-term obligations in the future - Uncertain future interest costs Result: Manager accepts greater expected profits in exchange for taking greater risk.

Combining Liability Structure and Current Asset Decisions: Financing Maturity Asset Maturity SHORT-TERM LONG-TERM

SHORT-TERM (Temporary Temporary)

Moderate Risk-Profitability High Risk-Profitability

Low Risk-Profitability

LONG-TERM (Permanent Permanent)

Moderate Risk-Profitability

The firm can reduce the risk of cash insolvency either by increasing the maturity schedule of its debt or by carrying greater amounts of short lived assets.

Maintaining a policy of short term financing for short term or temporary aseets needs (Box 1) and long term financing for long term and permanent asset needs (box 3) would comprise a set of moderate risk profitability strategies that is the hedging approach to financing. Low risk profitability approach (box 2) that is the conservative approach using long term financing to support short term asset needs comes at the expense of curtailed profits. High risk profitability approach as the most aggressive approach which will provide high profit with high level of risks.