Financial Management - Lecture notes 1 PDF

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National Institute of Business Management Master of Business Administration (MBA) Financial Management

CONTENTS Chapter

Title

Page No.

I

BUSINESS FINANCE

5

II

SOURCES OF FINANCE

16

III

MANAGEMENT OF WORKING CAPITAL

33

IV

MANAGEMENT OF CASH

45

V

MANAGEMENT OF RECEIVABLES

54

VI

MANAGEMENT OF INVENTORY

59

VII

FINANCIAL ANALYSIS AND PLANNING

68

VIII

FUNDS FLOW ANALYSIS

73

IX

CASH FLOW STATEMENT

81

X

RATIO ANALYSIS

86

XI

CAPITAL BUDGETING

93

XII

FINANCIAL FORECASTING

105

XIII

CAPITAL STRUCTURE

116

XIV

COST OF CAPITAL

120

XV

BUDGETARY CONTROL

131

CHAPTER - I

BUSINESS FINANCE OBJECTIVES To make the reader understand the finer points of business finance which is one of the major factors in all kinds of economic activity. This chapter is to familiarise the reader the objectives of financial management, interphase between finance and other functions and also Indian financial system. IMPORTANCE OF FINANCE Finance is regarded as the life blood of a business enterprise. Finance is one of the basic foundations of all kinds of economic activities, particularly in the present modern money-oriented economy. The manufacturing and merchandising activities are supported by this key factor. Business needs money to make more money. The success and health of any business enterprise is buttressed on efficient management of its finances. THE FIELD OF FINANCE The field of finance is closely related to accounting and economics. Accounting is referred to as the language of finance because it provides financial data through income statements, balance sheets and the statement of cash flows. The financial manager must know how to interpret and use the financial statements in allocating the firm’s financial resources to generate the best return possible in the long run. Economics provides a structure for decision making in such areas as risk analysis, pricing theory through demand and supply relationships and many other important areas. Economics provides the broad framework of the economic environment in which business enterprises must continually make decisions. A finance manager must understand the institutional structure of the Central Banking System, the Commercial Banking System and the interrelationship between the various sectors of the economy. He must be well versed in economic variables, such as gross national product, industrial production, disposable income, unemployment, inflation, interest rates, taxes etc. MEANING OF BUSINESS FINANCE Finance is defined as the provision of money at the time it is wanted. As a management function, finance may be defined as the procurement of funds and their effective utilisation. 5

Business finance may be defined as the process of raising, providing and managing of all the money to be used in connection with business activities. “Financing consists of raising, providing, managing of all the money, capital or funds of any kind to be used in connection with the business”- J.H.Bonnevilla and Llyod Ellis Dewey. While taking the financial decisions, Finance Manager has to consider the external and internal factors. The external factors are: †

State of Economy

†

Structure of capital and money markets

†

Govt. Policy and regulations

†

Taxation Policy

†

Requirements of investors

†

The Central Bank’s credit policy

†

Lending policy of financial institutions. The internal factors include:

Nature of business †

Size of business

†

Age of the firm and stability of the organisation

†

Nature of product (Demand and Supply in the market)

†

Expected return, cost and risk

†

Fixed assets and working capital structure of the firm

†

Capital structure

†

Trends of earnings

†

Restriction in loan agreements and

†

Management attitude.

MEANING OF FINANCIAL MANAGEMENT According to Ezra Soloman & John. J.Pringle, “Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds”. Financial management is mainly concerned with the proper management of funds. The finance manager must see that the funds are procured in such a manner that the risk, cost and control considerations are properly balanced in a given situation and there is optimum utilisation of funds. 6

OBJECTIVES OF FINANCIAL MANAGEMENT What is the purpose or objective sought to be achieved by the Finance Manager? Traditionally the basic objectives of financial management are the maintenance of liquid assets and maximisation of profitability of the firm. MAINTENANCE OF LIQUID ASSETS: Maintenance of liquid assets is to ensure that the firm has adequate cash in hand to meet its obligations at all times. Profit Maximisation Suppose the Finance Manager manages to make available the required funds at an acceptable cost and that the funds are suitably invested and that everything goes according to plan because of the effective control measures used. A business firm is a profit-seeking organisation. Hence, profit maximisation is also well considered to be an important objective of financial management. The results of good performance are reflected as profits of the firm. However, profit maximisation cannot be the sole objective of a firm as there is a direct relationship between risk and profit. If profit maximisation is the only goal, then risk factor is ignored. Sometimes, higher the risk, higher is the possibility of profits. Maximisation of wealth: Profit maximisation is not considered to be an ideal criterion for making investment and financing decisions. Prof. Ezra Soloman has suggested the adoption of wealth maximisation as the best criterion for the financial decision-making. The objective of a firm or company must be to create value for its shareholders. Value is represented by the market price of the company’s common stock, which, in turn is a function of the firm’s investment, financing and dividend decisions. The idea is to acquire assets and invest in new products and services where expected return exceeds their cost, to finance with those instruments where there is particular advantage, tax or otherwise, and to undertake a meaningful dividend policy for stockholders. Thus, wealth maximisation or value creation is considered to be the main objective of modern financial management. 7

NON-FINANCIAL OBJECTIVES It is possible to have non-financial corporate objectives which may or may not conflict with the financial objective of shareholder wealth maximisation. Some of the non-financial corporate objectives are: a)

Total employment generation

b)

Employee welfare

c)

Rate of growth of business

d)

Increase in market share

e)

Technological leadership through substantial investment in research and development

f)

Customer satisfaction

g)

Community welfare. Achievement of the non-financial objectives may indirectly help the company in increasing

its value. A corporate advertising campaign highlighting the above achievements may boost the share prices in the market. FUNCTIONS OF FINANCE Funds requirement decision is the most important function performed or decision taken by the finance manager. A careful estimate has to be made about the total funds required by the enterprise taking into account both the fixed and working capital requirements. Financing Decision is the second major decision of the firm and the financial manager is concerned with determining the best financing mix or capital structure. A proper balance has to be kept between the fixed and non-fixed cost-bearing securities. Investment Decision is another major decision of the firm, when it comes to the creation of value. Capital investment is the allocation of capital to investment proposals whose benefits are to be realised in the future. In addition to selecting new investments, a firm must manage existing assets efficiently. The fourth important decision of the firm is its dividend policy, which includes the percentage of earnings paid to the stockholders in cash dividends and the repurchase of stock. The dividendpayout ratio determines the amount of earnings retained in the firm and must be evaluated in the light of the objective of maximising shareholder wealth. 8

Risk, Return and Trade off A proper balance is to be maintained between risk and return in order to maximise the market value of the share. Such a balance is called risk, return and trade off. Risk is to be minimised and return is to be increased. The interrelationship between market value, financial decisions and risk-return trade off is depicted in the following chart: Financial Management Maximisation of Share Value Financial Decision

Financing Decision

Funds Requirement Decision

Investment Decision

Maximum Return

Dividend Decision

Minimum Risk

Trade off Liquidity Vs Profitability Liquidity means that: (i)

the firm has adequate cash to pay for the expenses

(ii)

the firm has enough cash to make unexpected large purchases

(iii)

the firm has cash reserve to meet emergencies at all times. Profitability requires that the funds of the firm are used in the most efficient and effective

way so as to yield the highest return. When liquidity increases profitability decreases and when profitability increases liquidity decreases. Liquidity and profitability goals conflict in most of the decisions which the finance manager takes. 9

FINANCIAL TOOLS The important financial tools or methods used by financial manager in performing his job are: 1.

Cost of Capital : Cost of capital helps the financial manager in deciding about the sources from which funds are to be raised. There are different sources of finance, viz., shares, debentures, loans from banks and financial institutions, public deposits etc. The financial manager takes into account the cost of capital and opts for the source which is the cheapest. The optimum capital structure of the firm is also determined based on the cost of capital.

2.

Financial Leverage: This helps the financial manager in increasing the return to equity shareholders.

3.

Capital budgeting appraisal methods: Capital budgeting appraisal methods such as Payback Period, Average Rate of Return, Internal Rate of Return, Net Present Value, Profitability Index etc., help the financial manager in selecting the best among alternative capital investment proposals.

4.

Current Assets management tools like ABC analysis, Cash Management Models, Ageing Schedule of Inventories and Debtors Turnover Ratio.

5.

Ratio Analysis for evaluating different aspects of the firm. Different ratios serve different purposes.

6.

Cash Flow and Funds Flow analyses techniques help in determining whether the funds have been procured from the best available source and they have been utilised in the most efficient and effective way.

INTERFACE BETWEEN FINANCE AND OTHER FUNCTIONS The finance manager depends upon the inputs provided by other operating managers: †

the production manager or engineer, who is accountable for optimum use of equipment and facilities and of the funds invested therein;

†

the marketing manager, answerable for the forecast of demand for the product, customer satisfaction, credit policy etc;

†

the top management, which is interested in ensuring that the firm’s long-term goals are met.

FORMS OF ORGANISATION The finance function may be carried out within a number of different forms of organisations. Of primary interest are the sole proprietorship, partnership and the companies.

10

Sole Proprietorship The sole proprietorship form of organisation represents single-person ownership. The proprietor enjoys all the powers of taking and assuming risks for his/her concern. The profits/losses and incurring of all the liabilities of the business are to the proprietor. The advantages of a sole proprietorship are: ƒ

easy and inexpensive setup

ƒ

simplicity of decision making

ƒ

low organisational and operational costs

ƒ

few governmental regulations

ƒ

no firm tax The disadvantages are:

ƒ

there is unlimited liability to the owner

ƒ

in settlement of the firm’s debt, the owner can lose not only the capital that has been invested in the business, but also personal assets

ƒ

Life of the firm is limited to the life of the owner

ƒ

Tax on the income is very high

ƒ

Fund raising is possible only with attached personal liability commitment.

Partnership The second form of organisation is the partnership, which is similar to a sole proprietorship except that there are two or more owners. They are partners in business and they bear the risks and reap the rewards of the business. Most partnerships are formed through an agreement between the participants known as the articles of partnership, which specify the ownership interest, the methods of distributing profits and the means for withdrawing from the partnership. The partnerships are governed by Indian Partnerships Act, 1932. The advantages of partnership form of business are: —

Multiple ownership makes it possible to raise more capital and to share ownership responsibilities.

—

It can be set up easily and inexpensively.

—

It is relatively free from governmental regulations.

—

The firm can make use of the experience and expertise of the partners. 11

The disadvantages are: —

Like the sole proprietorship, the partnership arrangement carries unlimited liability for the owners.

—

Possible conflict between the partners may hamper the existence of the firm.

—

Withdrawal of a partner from partnership or death of a partner results in dissolution of the firm.

Companies A group of persons working together towards a common objective is called a company. A company is owned by shareholders who enjoy the privilege of limited liability, i.e., their liability exposure is generally no greater than their initial investment. A company has a continual life and is not dependent on any one shareholder for maintaining its legal existence. The ownership interest in a company is divisible through the issuance of shares of stock. The shareholders’ interests are managed by the company’s board of directors. The directors, who may include key management personnel of the firm as well as outside directors not permanently employed by it, serve in a stewardship capacity and may be liable for the mismanagement of the firm or for the misappropriation of funds. As the company is a separate legal entity, it pays taxes on its own income. A company can be a private company or a public company. A private company (means private limited company) is a corporate body that can be formed by just two persons subscribing to its share capital. The minimum number of persons required to form a private company is 2 and the number of its shareholders cannot exceed 50. It must have at least 2 directors. Public cannot be invited to subscribe to its capital. The members’ right to transfer shares is restricted. The advantages of a private company form of organisation are: (i)

the liability of shareholders is limited

(ii)

under the Companies Act, the regulation and control of private companies are not very extensive

(iii)

the promoters, by being selective in choosing the members, can hope to enjoy unchallenged control over the firm. The disadvantages of the private company form of organisation are :

(i)

the burden of taxation is high 12

(ii)

the shares of a private company are not freely negotiable

(iii)

the ability of the firm to raise capital is limited.

A Public Company (means a public limited company) is a corporate body that has a minimum of seven members or shareholders. A public company unlike a private company does not limit the number of its members. It can invite the public to subscribe to its capital. It permits free transfer of shares. The advantages of public company form of organisation are: i)

the company has an unlimited life

ii)

the ownership of the company is easily transferable through transfer of ownership of shares.

iii)

liability of shareholders is limited to the extent of the capital subscribed by them.

iv)

it can raise substantial funds. The disadvantages of public company form of organisation are:

i)

there is elaborate procedure for setting up of a public company.

ii)

the affairs of the company are subject to the regulations under the Companies Act.

REGULATORY FRAMEWORK Investments in business and financing decisions are influenced by various regulations with the aim of a)

identifying the avenues of investment available for particular form of business organisations.

b)

identifying specific industries, locations etc., which are preferred for investment as state policy, in order to promote uniform regional growth and fiscal incentives for such investment

c)

restricting the sources and uses of funds by entrepreneurs, in order to protect the interest of investors. The following Acts/Regulations provide the regulatory framework in India:

(a)

The Companies Act, 1956

(b)

Monopolies and Restrictive Trade Practices Act (MRTP)

(c)

Industrial Policy

(d)

Foreign Exchange Management Act (FEMA)

(e)

Industries (Development & Regulation) Act, 1951

(f)

Guidelines issued by the Securities and Exchange Board of India (SEBI)

(g)

Provisions of the Income Tax Act, 1961, Central and State notifications regarding the various concessions, restrictive conditions etc.

13

The New Industrial Policy of 1991 attempted to correct the distortions or weaknesses that may have crept in and unshackle the Indian Industry from the multiplicity of administrative and legal controls and enhance international competitiveness. Most of the restrictions and requirements of prior approvals have been removed. Simultaneously, the office of Controller of Capital Issues was abolished and capital issues and free pricing of shares were permitted subject to their conforming to the disclosure and investor-protection guidelines issued by the SEBI. INDIAN FINANCIAL SYSTEM The financial system facilitates the transform...