Financial Management

MBA ZG 521/ BA ZG521/ POM ZG513/FIN ZG521

Contact Hour 2 & 3, 13 Jan 18, 4 – 6 pm

BITS Pilani Dr. Saurabh Chadha

Assistant Professor, Management - Finance
Pilani Campus
Email: saurabh.chadha@pilani.bits-pilani.ac.in
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Financial Management Module 1

Forms of Business Organizations:

Sole Proprietorship
• A sole proprietorship firm is a business owned by a single person.
• Legal and tax point of view, a sole proprietorship firm has no
separate status apart from its owners.
– The owner realizes all profits and bears all the losses.
– The owner has unlimited liability for the debts of the business.
– There is no distinction between personal and business income.
All business income is taxed as personal income.
– Equity capital of a firm is limited to the personal wealth of the
owner.
– The transfer of ownership requires the sale of entire business to
the buyer.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Forms of Business Organizations (Cont’d):

Partnership
• A partnership firm is a business owned by two or more persons.
• It may be viewed as an extension of sole proprietorship. The
partners bears the risks and reap the rewards of the business.
(Unlimited liability).
• However as per Indian partnership act 1932, a partnership firm is a
separate legal entity. It can pay interest and remuneration to its
partners and claim the same as business expense.
• The tax rate applicable to the net profit of partnership firm is 30%.
• Recently, Limited Liability Partnership (LLP) was introduced in India.
• The distinctive feature of LLP is the limited liability of its partners
other things remains the same.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Forms of Business Organizations (Cont’d):

Cooperative Society
• A cooperative society may be defined as a society which has its
objective to promote the economic interest of its members in
accordance with cooperative principles.
• Minimum members: 10 and Maximum: No limit.
• The members are its owners.
• The management is appointed by managing committee. One
member one vote.
• The liability of the members is limited.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Forms of Business Organizations (Cont’d):

Company
• A company is collectively owned by the shareholders who entrust
the task of management to their elected representatives called the
directors.
• The company is a separate legal entity. It can own assets, incur
liabilities, enter into contracts, sue and be sued in its name.
• The liability of the shareholders is limited to the share capital
subscribed by them.
• A company pay corporate taxes (25% less than 50 crore turnover –
30% more than 50 crores) and then pay dividends to its
shareholders from net profits. The shareholders are required to pay
taxes on dividends received by them. So in effect, there is double
taxation.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Forms of Business Organizations (Cont’d):

Company
• Setting up and managing a company is very complicated than
setting other forms of business organizations.
• Companies are governed by Indian companies act 1956 and 2013.
• A company can be private or public limited.
• Shareholders, Private company (Min: 2 and Max 200) and Public
company (Min: 7 and Max: No limit)
• A public company can go for public issue of its shares whereas
private company cannot do so.
• Free transfer of shares in public company whereas there are
restrictions on such transfer in private company.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financing decisions

Financing
decisions

Internal corporate External sources

financing of funds

Direct financing Indirect financing

Retained
(financial markets (financial
earnings
Instruments) Intermediaries)

Stocks Loans

Debt instruments
(bonds, CPs etc.)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financial markets

• The main goal of financial markets is to

take the savings from those who do not
wish to consume (savings surplus units
or suppliers of funds) and to channel
them to those who wish to invest more
than what they presently have (saving
deficit units or demanders of funds)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financial markets and
financial system

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Functions of the financial system

• Provides payment system for the exchange of goods and services.

Example Banks and Credit card companies.

• Enables the pooling of funds for undertaking large scale enterprises

or operations.

• Provides a mechanism for transfer of resources. Inflow and outflow

of capital.

• Helps in risk management. Examples insurance or forward contract.

• Enables decentralized decision making. Example: Interest rates are

used by households in making their consumption-savings decisions.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financial markets

Financial markets

Organized
Primary markets Money market exchanges
Secondary markets Capital market Over-the-counter

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Primary and secondary
markets
• Primary market – primary issues of
securities are sold, allows governments,
banks, corporations to raise money by
directly selling financial instruments to the
public. Such issues are referred as IPO’s

• Secondary market – allows investors to

trade financial securities among
themselves. Examples: BSE, NSE, etc.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Money and capital markets

Money market instruments – short-term assets

(typically maturity less than 1 year):
• Certificates of deposits (CDs)
• Commercial papers (CPs)
• Treasury bills

Capital markets – long-term assets (maturity longer

than 1 year) are traded:
• Stocks
• Corporate bonds
• Long-term government bonds

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Organized exchanges and
over-the-counter
• Organized exchanges – most stocks, bonds and
derivatives are traded on organized exchanges. It has a
trading floor where floor traders execute transactions in
the secondary market for their clients.

• Stocks not listed on the organized exchanges are traded

in the over-the-counter (OTC) market. OTC market
facilitates secondary market transactions and unlike an
organized exchange, the OTC market doesn’t have a
trading floor. The buy and sell orders are typically
completed through a telecommunications/ computer
network.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Recent Developments

• Digital Disruption! (Affecting the existing system

through technologies)

• Peer to Peer Lending (P2P) – Online platform that

eliminates the middle man or financial institution.

• Instead of the bank acting as a intermediary, the

platform brings lenders and borrowers together so
that both can benefit.
• Example in India: i2ifunding.com

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Indian Financial System

•Banking - RBI, Commercial banks, Co-operative banks, Post

office savings banks

•Non-banking - LIC, GIC, UTI, Housing development finance

companies-HDFC, HUDCO

•Developmental financial institutions - ICICI, IDBI, IFCI,

NABARD, SIDBI, Tourism finance corporation SFCs

•Regulatory Institutions - SEBI, RBI, IRDA- Insurance Regulatory

and Development Authority, etc.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Understanding the Financial
Statements

1. Balance Sheet
2. Income Statement
3. Statement of Retained Earnings
4. Cash flow Statement

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Purpose of Financial Statements

Financial Statements helps investors/ stakeholders to understand the

performance of the company in the most recent period and answers basic
questions such as:

• What is the company’s current financial status?

•What was the company’s operating results for the period?

• How did the company obtain and use cash during the period?

Key points:

• Only public source of financial data (regulatory and voluntary)

• Main external communication tool (to all stake holders)
• Subject to verification by external experts – auditors, etc.
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Balance Sheet

The Balance Sheet provides a summary of the financial position of a company as of a

particular date.

It lists the following details:

Assets: cash, accounts receivable, inventory, land, buildings, equipment and intangible
items

Liabilities: accounts payable, notes payable and mortgages payable

Owners’ Equity: net assets after all obligations have been satisfied

It helps answer the following questions:

What are the resources of the company?
What are the company’s existing obligations?
What are the company’s net assets?

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Basic Accounting Entity

Assets = Liabilities + Owners’ Equity

Resources Sources of Funding

Resources Creditors’ Owners’

used to claims claims
generate = against + against
revenues resources resources

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Sample Balance Sheet
Assets Liabilities
Cash $ 50 Accounts payable $ 100
Accounts receivable 100 Notes payable 200
Land 300 $ 300
Owners’ Equity
Total assets $450
Capital stock $ 100
Must Retained earnings 50
Equal $ 150
Total liabilities
and owners’ equity $ 450
This form of presentation is also
referred to as Horizontal BS

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Classified and Comparative
Balance Sheets
Classified Balance Sheet:

A classified balance sheet arranges the balance sheet into a format that is useful for
investors and stakeholders.

•A typical arrangement distinguishes between:

•Current and long-term assets
•Current and long-term liabilities

•They are listed in decreasing order of liquidity

Comparative Balance Sheet:

• A comparative balance sheet presents side by side information about a firm’s assets,
liabilities and equity across multiple points of time.

•Such a statement helps stakeholders to identify significant changes over time.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Classified and Comparative
Balance Sheets

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Limitations of Balance Sheet

• Assets recorded at historical value

• Assets depreciated using accounting rules

• Above two features leads to BV not reflecting MV

• Additionally, estimations are required for valuing certain assets and liabilities (example:
net realizable value of accounts receivable, cost of warranty, etc.)

• Only recognizes assets that can be expressed in monetary terms

• In some organizations (consulting, etc.) Human Resources may be the most critical
assets but may not be reflected on the BS!

• Does not include off balance sheet liabilities

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Income Statement

The Income Statement shows the results of a company’s operations over a period of
time, and answers questions such as:

• What goods were sold or services performed that provided revenue for the
company?

• What costs were incurred in normal operations to generate these revenues?

• What are the earnings or company profit?

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Balance Sheet Vs. Income Statement

Snapshot
Balance sheet Balance sheet Balance sheet Balance sheet
31/12/2011 31/12/2012 31/12/2013 31/12/2014

Income Income Income

statement 2012 statement 2013 statement 2014

“Flow” data

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Income Statement - Components

Revenues
Assets (cash or AR) created through business operations

Expenses
Assets (cash or AP) consumed through business operations

Net Income or (Net Loss)

Revenues - Expenses

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Sample Income Statement

2014 2013
Revenue:
Sales $150 $ 125
Other revenue 50 25
Total revenues $200 $150
Expenses:
Cost of goods sold $ 100 $ 90
Operating & admin. 40 30
Income tax 20 15
Total expenses $ 160 $ 135
Net Income $ 40 $ 15

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Typical Income Statement

Income statement for period 2014

$ ’000
Sales 5,356
Cost of sales (2,601)
2,755
1
Distribution costs 382
Administrative expenses 874 (1256)
Profit before interest and tax 1,499
Interest (362)
2 Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753

Note: 1) Operating result 2) Return to other stakeholders (other than owners)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Typical Income Statement

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Statement of Retained
Earnings
• This financial statement outlines the changes in retained earnings from one
accounting period to the next

Beginning retained earnings

+ Net income
– Dividends paid

= Ending retained earnings

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Cash Flow Statement

The cash flow statement reports the amount of cash collected

and paid out by a company during a particular period of time
and is usually classified into three buckets, namely: operating,
investing and financing activities.

It helps answer two important questions:

• How did the company receive cash?

• How did the company use its cash?

• The cash flow statement complements the income statement

and gives an indication of the ability of a company to continue
in business and generate income in the future.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Cash flow Statement

Cash inflows:

• Sell goods or services

• Sell other assets or by borrowing
• Receive cash from investments by owners

Cash outflows:

• Pay operating expenses

• Expand operations, repay loans
• Pay owners a return on investment

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Classification of Cash Flows

Operating activities – Transactions and events that factor into

the determination of net income.
Investing activities – Transactions and events that involve the
purchase and sale of securities, property, plant, equipment,
and other assets not generally held for resale, and cash
advances and collections on loans made to other entities.
Financing activities – Transactions and events where resources
are obtained from (or repaid to) owners and creditors.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Operating Activities

Cash Inflow Cash Outflow

• Sale of goods or • Inventory payments
services • Interest payments
• Sale of investments • Wages
in trading securities • Utilities, rent
• Interest revenue • Taxes
• Dividend revenue

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Investing Activities
Cash Inflow
• Sale of plant assets
• Sale of securities, other
than trading securities
• Collection of principal
on loans (made to other
entities)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Cash Outflow
• Purchase of plant assets
• Purchase of securities,
other than trading
securities
• Making of loans to other
entities
Financing Activities

Cash Inflow Cash Outflow

• Issuance of own stock • Dividend payments
• Borrowing • Repayment of debt (i.e.
principal borrowed)
• Equity repurchases
(Treasury stock)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Cash Flow Statement

Operating Investing Financing

Activities Activities Activities
CASH
INFLOWS Inv
Ops
CASH ON
Fin HAND

CASH
OUTFLOWS
Operating Investing Financing
Activities Activities Activities
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Sample Cash Flow Statement

Best Consultants Ltd.

Statement of Cash Flow
December 31, 2014

Cash Flows From Operating Activities:

Receipts 50
Payments (45) 5

Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:

Receipts 12
Payments (6) 6

Net Cash Flow 7

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Sample Cash Flow Statement

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Cash Flow - Interpretation

Operating Investing Financing Interpretation

Building up a pile of cash; possibly looking to
1 + + + make an acquisition

Operating cash flow being used to buy fixed

2 + ─ ─ assets and pay down debt

3 Operating cash flow and sale of fixed assets

being used to pay down debt
+ + ─

Operating cash flow and borrowed

4 + ─ + money being used to expand the business

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Cash Flow - Interpretation

Operating Investing Financing Interpretation

Operating cash flow problems covered by
5 ─ + + sale of fixed assets, borrowing and owner
contributions.

Rapid growth, short falls in operating cash

6 ─ ─ + flow; purchase of fixed assets.

7 Sale of fixed assets is financing operating

cash flow shortages.
─ + ─

Company is using reserves to finance cash

8 ─ ─ ─ flow short falls.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Notes to Financial Statements
• Notes are used to convey information required by GAAP or to provide
more detailed explanations

• The notes help investors to better understand and interpret the

numbers presented in the main financial statements

Four general types of notes:

• Summary of significant accounting policies such as key assumptions and

estimates

• Additional information about the summary totals

• Disclosure of important information that is not recognized in the financial

statements

• Supplementary information required by accounting rules or investment or other

regulations

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Manipulations of the bottom line or financial
statements
• Corporate managers have some influence in measurement and reporting of

these statements. Examples:

– Inflate the sales for the current year by advancing the sales from the following

year.

– Other income includes sale of assets and investments.

• Companies do manipulations or manage bottom line to project company

more profitable or less risky or better long term prospects of the firm or to

attract potential investors or management incentives.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Thank You

46
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956