Financial Management

Introduction:

Finance is defined as
the art & science of
managing money. The
major areas of finance
are;

Financial Services.

Financial Management.

Objectives:
1.Profit Maximisation
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment
profit maximization is
regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

2.Maximising EPS

Ignores timing and risk

of the expected benefit
Market value is not a
function of EPS. Hence
maximizing EPS will not
result in highest price
for company's shares
Maximizing EPS
implies that the firm
should make no
dividend payment so
long as funds can be
invested at positive rate
of returnsuch a policy

3.Share holders wealth maximisation

Maximizes the net present

value of a course of action
to shareholders.
Accounts for the timing
and risk of the expected
benefits.
Benefits are measured in
terms of cash flows.
Fundamental objective
maximize the market
value of the firms shares.

Finance Functions:
1.Investment Decision / Long term assets mix
2. Financing Decision / Capital mix
3. Dividend Decision / Profit allocation mix
4. Liquidity Decision / Short term assets mix

Famous Quote of Ezra Solomon

The function of financial management is to
review and control decisions to commit or recommit
funds to new or ongoing uses. Thus , in addition to
raising funds , financial management is directly
concerned with production , marketing and other
functions, within an enterprise whenever decisions
are made about the acquisition or distribution of
assets.

Structure of Finance Department:

1.Regular

Structure
2.Multi divisional Structure
3. Structure with Treasurer & Controller

Emerging Role of Finance Manager in

India:
1. Industrial licensing framework- relaxed
2. Many acts has been abolished as well as liberalised.
3. Freedom given to company.
4. Cash credit replaced by working capital loans.
5. Stable & Administrated interest rate.
6. FDI has expanded.
7. Derivatives Introduced.
8. Merger, acquisition and restructuring.

Techniques of Financial Statement

Analysis

Introduction:

Analysis of financial statement is a

process of evaluating the relationship between
components parts of financial statement to obtain better
understanding of the firm's position & performance.
In brief, financial analysis is a
process of selection, relation and evaluation.

1.Comparative Financial Statement.

Compare financial data

with one or more
previous years.
Compare amount with
previous years.

Merits:

Demerits:

2. Trend Analysis

Here, ratios indicates

the direction of change.
Two factors considered
1. Rate of fixed
expansion in growth of
business.
2. Price level
Calculate Trend
percentage.

Common Size Statement:

Financial statement is
expressed as a %.
Convert absolute rupee
amount into %.
It can useful for interfirm comparison.

1. Limitations

Ratio Analysis:
Introduction:

1. Liquidity Ratio.

Current Ratio:
Current ratio=

Current Assets
Current Liabilities

Quick Asset Ratio:

Quick Asset ratio= Quick Assets
Quick/current liabilities

Cash / Absolute liquidity Ratio:

Cash ratio= cash+ marketable securities
Liquid Liabilities

2. Activity Ratio:

Inventory Turnover Ratio:

Inventory turnover ratio= cost of goods sold
Average inventory
* Cost of goods sold = net sales gross profit /
= Op. Stock + Purchases+
direct exp. - Cl. Stock.
* Average inventory = Op. Stock + Cl. Stock
2

Debtor's Turnover Ratio:

Debtor's turnover ratio = Net annual credit sales
Average debtors

Creditor's Turnover Ratio:

Creditor's turnover ratio= Net annual credit purchase
Average Trade creditors

Working Capital Turnover Ratio:

Working capital turnover ratio= Net sales/ cost of

goods sold
Working Cap.

Fixed Assets Turnover Ratio:

Fixed assets turnover ratio= Net sales /
Cost of goods sold
Net fixed assets

Total Assets Turnover Ratio:

Total assets turnover ratio = Net sales

Total assets.

3. Leverage Ratio:

Operating Leverage:
Operating leverage = Contribution
EBIT
* Contribution = sales variable cost

Financial Leverage:
Financial leverage =

EBIT
EBT

* EBT= EBIT Intt. & Preference dividend

Combined Leverage:
Combined ratio = contribution
EBT

Debt Equity Ratio:

Debt equity ratio = Debt
Equity

Debt Assets Ratio:

Debt assets ratio = Debt
Assets

4. Profitability Ratio:

General Profitability
ratio

1.Gross Profit Ratio

Overall Profitability ratio

1.Return on equity capital

2.Operating Ratio

2.Return on capital
employed

3. Expenses Ratio

3.Earning per share

4. Net Profit Ratio

4.Dividend pay out ratio

5.Price earning ratio
6.Return on total assets.

General Profitability ratio:

1.Gross Profit Ratio
Gross profit ratio = Gross Profit

* 100

Net Sales
2.Operating Ratio
Operating ratio = Operating cost *100
Net Sales
* Operating Cost = Cost of goods sold + Office /
Administrative exp.+ Selling
distribution exp. + Finance
Expenses

`+

.3. Expenses Ratio

a. Administrative Expenses ratio
= Admn. Expenses

* 100

Net Sales
b. Selling and Distribution Expenses ratio
= S & D Expenses *100
Net Sales
c. Non operating expenses ratio
= Non operating ratio *100
Net Sales

4. Net Profit Ratio

Net Profit Ratio = Net Profit *100
Sales
Overall Profitability ratio
1.Return on equity capital
Return on equity capital =
Net Profit after tax Pref. dividend *

100

Paid up equity share capital

2.Return on capital employed
= Net Profit before intt. & tax
Total capital employed (except debt and loans)

3.Earning per share

= Net profit available for equity shareholders
No. of equity shares
4.Dividend pay out ratio
= Dividend Per Share
EPS
5.Price earning ratio
= Market Price Per Share
EPS
6.Return on total assets.
= Net Profit
Total Assets

* 100

Inter Firm Analysis:

Utility of Ratio Ananlysis:

1. Performance Analysis.
2. Credit Analysis.
3. Security Analysis.
4. Competative
Analysis.

Sources of Finance &

Financing Decisions

Sources of Short term &

long term finance
1. Trade Credit :

Credit extended by
supplier of goods &
services.

It is easily available as well

as it is flexible.

the

Cost of credit depends on

terms of sales & size of
operations.
Cash discount implies on
transactions.

2. Accruals:
In internal accruals of a firm consist of
depreciation charges & retained earnings.

Depreciation

Retained earnings.
3. Commercial Paper:
Unsecured, short-term, negotiable promissory note sold
in money market.
Two parts : 1. The dealer market
2. The direct placement market.

4. Bank Credit:
Bank credit a formal legal commitment to
extend credit up to some max. amount over stated
period of time.
Single payment loan.
Letter of credit.
5. Factoring :
Factoring the selling of receivables to a
finance institution, the factor, usually without
resources.
6. Public Deposit , Private institution:
Commercial Loans

Cost of Capital:
Cost of capital is the
rate of return that a firm
must earn on its project
investment to maintain
its market value and
attract funds.
Surplus =
Return from business
cost of capital

Cost of different sources finance

1.Cost of Debt :
It is return that potential inventors require of the
firms debt securities. It has two basic components: 1.
Annual interest 2. Premium paid or received when debt
is initially issued.
Equation =
2. Cost of Preference Share :
Cost of preference share is represented by firms
dividend payment.
Equation =

3. Cost of Retained Earnings :

The cost of retained earnings is closely related
to the cost of equity shares. If earnings are not retained
they will paid out to the equity shareholders as
dividend.
Equation =
4. Cost of Equity :
Cost of equity can be generally stated as the
rate at which investors discount the expected dividend
of the firm in order to determine the market price of the
firm.
Equation =

Weighted Average Cost of Capital

Weighted average cost of capital is the
expected average future cost of funds over the long
run found by weighting the cost of each specific type
of capital by its proportion in the firms capital
structure.
The computation of the overall cost of
capital involves the following steps:
1. Assigning weights to specific costs.
2. Multiplying the cost of each of the sources by the
appropriate weights.
3. Dividing the total weighted cost by the total weights.

Optimal Capital Structure

Capital Structure is the proportion of debt and
preference and equity shares on firms balance sheet.
Optimum Capital Structure is the capital structure at
which the weighted average cost of capital is minimum
and there by maximum value of the firm.
Features of Optimum capital structure:
1.Profitability
2.Flexibility
3.Solvancy
4.Control
5.Conservation

Working Capital
Management
This chapter deals :
Current Assets Management

2 concept of working capital

1. Gross Working Capital
2.Net Working capital

Need Of Working Capital:

Finished Goods

Work in Process

Account
Receivables
Wages, Salaries
&factory
overheads

Raw Material

Supplier

Determinants of Working Capital

Nature of Business
Production Cycle
Business Cycle
Production Policy
Credit Policy
Market and Demand Conditions
Price level Changes
Conditions of supply
Growth & Expansion

Financing Working Capital

Long-term Sources of financing of working capital
1.Equity Share Capital
2. Preference Share Capital
3.Retained Earnings.
4.Debebtures and bonds
5Long term loans.
Short-term Sources of financing Working capital
1.Shortterm bank credit
2.Cash Credit
3.Letter of credit

4.Bills finance
5.Overdraft
6.Working Capital Demand Loan
7.Public Deposits
8.Factoring
9. Commercial Paper
Spontaneous Financing of Working Capital
1.Trade Credit
2.Outstanding Expenses
3.Provision of depreciation
4.Provision of taxation

Capital Budgeting
Nature of Capital Budgeting:
Allocation of funds to different long term assets.
Returns are expected over a long period.
Capital budgeting process of evaluation and selecting
long term investments that are consistent with the
goal of shareholders wealth maximisation.
The role of finance manager in the capital budgeting
basically critical analysis and evaluation of various
alternative proposals.

Significance of capital budgeting

Long term effects
Substantial commitment
Irreversible Decisions
Affect the capacity and strength to compete

Problems & Difficulties in Capital Budgeting

Future Uncertainty
Time Element
Measurement Problem

Techniques of Capital Budgeting

1.Pay Back Period:
no. of years required for the proposals
cumulative cash inflows to be equal to its cash
outflow.
Estimation of the Payback Period
When annual inflows
are equal

When the annual cash

inflows are unequal

Decision Rule:
1.Pay back period Target period ( Rejected)
2. Pay back period Target period (Accepted )

2.Accounting Rate Of Return Or Average Rate Of Return:

ARR is based on the accounting concept of return on
investment or rate of return.
It is annual returns of a project are expressed as a
percentage of the net investment in the project.
Average Annual Profit ( after tax)
ARR =
Average Investment in the Project
Decision Rule:
1. Highest ARR = Accept the Project
2. Lowest ARR = Reject the Project

3. Net Present Value (NPV) & Profitability Index:

The NPV of any proposal, that involves cash inflows
and outflows over a period of time, is equal to the net
present value of all the cash flow.
Decision Rule:
1. Positive NPV = Accept the proposal
2. Negative NPV = Reject the proposal
The PI is defined as the benefits per rupee invested
in the proposal. It is also known as Benefit cost ratio /
Present Value Index.
Total Present Value of Cash Inflow
PI =
Total Present Value of Cash Outflow

Decision Rule:
1. Greater than 1 or equal to 1 = Accept the Project
2. Less than 1 = Reject the Project
4. Internal Rate Of Return (IRR)
IRR is also based on the discounting
technique. Rate of discount so calculated which
equates the present value of future cash inflows with
the present value of outflow, is known IRR
Highest IRR Accept the project.