FIBA201_Fundamental of Financial Management - PDF

Fundamentals of Financial Management 1 Module-1: Introduction to Financial Management & Notes To...

Fundamentals of Financial Management 1 Module-1: Introduction to Financial Management & Notes Tools for Financial Decision Making ity Structure: Unit-1.1 Introduction to Financial Management 1.1.1 Financial Management-Overview rs 1.1.2 Role of Finance Managers 1.1.3 Decision Areas in Financial Management & Objectives of the firm 1.1.4 Indian Financial System-Overview ve 1.1.5 Financial Statement Analysis-Analysis of fund flow & Cash Flow statement 1.1.6 Financial Statement Analysis-financial ratio analysis 1.1.7 Financial Statement Analysis-common size & Comparative statement 1.1.8 Financial Statement Analysis-trend analysis & time series analysis Unit-1.2 Time Value of Money 1.2.1 Concept of Time value of Money 1.2.2 Process of Compounding and Discounting ni U 1.2.3 Future Value of a Single amount 1.2.4 Future Value of an Annuity 1.2.5 Present Value of a Single Amount 1.2.6 Present Value of an Annuity ity 1.2.7 Time value of Money-Numerical -1 1.2.8 Time value of Money-Numerical -2 m )A (c Amity Directorate of Distance & Online Education  2 Fundamentals of Financial Management Unit-1.1: Introduction to Financial Management and Notes Tools for Financial Decision Making ity Learning Objectives After studying this chapter, you should be able to: Understand the meaning, nature, and importance of financial management. rs Understand the process of financial management of an organisation. Understand the Indian Financial System Understand the various aspects of financial statement analysis. Understand the various tools for financial decision making. ve Understand the concept and applications of time value for money. How compounding and discounting affects the financial management. Introduction ni Financial management refers to that part of management activity which is solely concerned with planning and controlling of the organisation’s financial resources. Financial management is applicable to all types of organisation’s irrespective of its size, kind of business, locations etc. Every management aims to utilize its financial U resources in the “best possible”, “least expensive” and “most profitable way”. Every business is operated in order to maximize wealth of the owners and to maximize the profit of the business firm. Financial management is the application of general management principles to an organization’s financial assets. Quality fuel and regular service are provided by proper ity financial management in order for an organization’s operations to run smoothly. If an organization’s finances aren’t handled correctly, it will face roadblocks that might stifle its growth and development. In any organisation, financial management is a critical activity. It is an ideal practise for managing an organization’s financial operations, such as fund procurement, fund m utilisation, accounting, payments, risk assessment, and everything else involving money. 1.1 Introduction to Financial Management Financial management refers to planning, designing, devising, directing, organising )A and controlling the financial activities, such as procurement and utilisation of the funds, of the organization. It is more towards application of general management principles towards financial resources of the organisation. Scope/Elements Investment decisions include investment in fixed assets—capital budgeting. (c Investment in current assets are also a part of investment decisions—working capital decisions. Financial decisions - They relate to the eliciting of finances from various Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 3 resources, which depends upon decision on type of source, period of financing, cost of financing and the returns, thereby. Notes ity Dividend decision - The finance manager takes decision in lieu of the net profit distribution. Net profits are generally divided into two: 1. Dividend for shareholders: Dividend and the rate of it requires to be decided. 2. Retained profits: Amount of retained profits has to be finalized, which rs depends upon expansion and diversification plans of the enterprise. Objectives of Financial Management The financial management is generally referred as procurement, allocation and ve control of financial resources of a concern. The objectives can be: To ensure regular, even, periodic and adequate supply of funds to the pertained. To ensure adequate returns to the stakeholders, which depends upon the earning capacity, market price of the share, expectations of the shareholders. ni To ensure optimum utilization of the finances. Once the funds are secured and received, they should be utilized in the maximum possible way, at the least cost. To ensure safety on investment funds or finances, i.e, finances need to be U invested in safe embarks so that the adequate and decent enough rate of return can be achieved. To plan a healthy and heavy capital structure: There should be a healthy, heavy and fair composition of capital so that an equilibrium is maintained between debt and equity capital. ity Functions of Financial Management Appraisal of capital demands: A finance manager makes an appraisal with regard to capital essentials of the firm. This depends upon anticipated costs and profits and future programmes and policies of a business. Estimations need to be made in a decent manner that increases earning capacity of the enterprise. m Determination of capital composition: Once the appraisal has been made, the capital structure needs to be decided. This involves short-term and long-term debt equity analysis. This depends on the proportion of equity capital a company is owning and additional funds that need be brought up from outside parties. )A Choice of sources of funds: For additional finances to be secured, an organisation has many options like- Issue of shares and debentures Loans to be taken from banks and financial institutions Public deposits to be drawn like in form of bonds. (c Choice of factor depends on relative merits and demerits of each source and period of financing. Amity Directorate of Distance & Online Education  4 Fundamentals of Financial Management Investment of funds: The finance manager decides to distribute funds into Notes profitable ventures so that there is safety on investment and regular, periodic returns ity are possible. Disposal of surplus: The net profits decision has to be made by the finance manager. This can be done in two ways: 1. Dividend declaration: It includes identification of the rate of dividends and other gains, like bonus. rs 2. Retained profits: The volume has to be decided, which depends upon expansion, path-breaking, variegation plans of the organisation. Management of cash: Finance manager has to make decisions with regards to cash management and direction. Cash is required for many purposes like payment ve of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance and sustenance of enough stock, purchase of raw materials, etc. Financial controls: The finance manager not only plans, procures, secures and utilizes the funds, but also exercises control over finances. This can be done through ni many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 1.1.1 Financial Management: Overview U Financial management is the whole process of the planning, direction, monitoring, organising, and control of the financial and monetary resources of the Unit-as individual, family or organisation. It is the process towards programming, planning, budgeting and execution for managing the financial and monetary assets. It is mainly done to determine the priorities and use the financial resources accordingly. The purpose of this management planning is to own a plan, program and budget to function financially as a ity unit. It deals with the ways in which a Unit-can raise funds in the most productive and efficient way, to exercise control over those funds, and to distributer the returns of the funds to various shareholders/stakeholders. Financial management ensures that the organisation meets its primary objective of maximising the stakeholder’s wealth, downsizing the financial toll, and other m nonfinancial activities, such as the government, employees and the suppliers. Scope of Financial Management Financial management comprises of the following key areas: )A 1. Financial functions: This is mainly in lieu of dealing with decisions on ways to raising funds for financing or sponsoring the activities of the organisation. The short- term sources of funds for the financial management include bank overdrafts, factoring, commercial papers, account payable delays, sale and leaseback, and account receivables collections. Whereas, the long- term sources of funds for the financial management include ordinary share capital, preference share capital, long (c term loans (debt capital) and leases. Before choosing the source of funds factors such as cost, tax effects, dilution of ownership and control, financial risks, collateral securities, access to capital markets, Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 5 nature of project to be financed and other conditions and restrictive covenants must be considered by a financial manager. Notes ity 2. Investment function: This function involves decisions regarding the allotment of funds to various projects. These projects need to be verified and evaluated by financial manager to embark into considering both their level of returns and risks. These decisions are difficult to make as they involve difficult to predict assessment of future with precision and as most of them are irreversible. rs 3. Liquidity function: These decisions are regarding the management of working capital to avoid problems regarding liquidity. Thus, it generally involves investments related to current assets (easily convertible to cash within a year) and current liabilities (mature for payment within a financial year). ve 4. Dividend function: This involves decisions on the amount of total earnings of organisations to be paid as dividends to the shareholders and the amount that needs to be retained by the organisations for re-investment. The dividend decision corresponds to the dividend policy of the organisation, contained in the article of association. It should be ensuring by the finance manager that the organisation has the optimal dividend pay-out ratio. Goals or Objective of a Firm ni The main goal for an organisation is to maximise the wellbeing of its owners and shareholders/stakeholders. This is indicated by sustaining the following parameters. U Profit maximisation: This is in regard to maximising the income of a firm by either increased sales value or increased price in return to the maximised profit leading to increase in dividends paid to stakeholders. Capital gain and wealth maximisation: It is represented by the market value of shares where wealth is maximised when the value of those market shares increases. ity Therefore, wealth gain is with respect to the increase in the value of market shares. The secondary objectives of the firms are the responsibilities in pursuit of the main objectives. For example, responsibilities owed to the employees are providing them with reasonable accommodation, medical, transport, pension and training facilities. Responsibilities owed to customers are providing them with high-quality goods within m reasonable price range. Responsibilities owed to the society are participating in charitable organisations ensuring that those activities are environment favourable. Role of financial managers )A Accounting and bookkeeping. A financial manager prepares or supervises the preparation of the various financial statements, activity reports, and forecasts, ensuring that there is an effective accounting system in the organization. Estimating the amount of capital required in lieu of purchase of assets, growth, and expansion of the business and meeting working capital requirements Ensuring that debt and equity ratios are maintained and balanced while funds being (c raised from various sources. Analyzing the market trends for identifying readily available opportunities for both investment and expansion of the business. Amity Directorate of Distance & Online Education  6 Fundamentals of Financial Management Financial control. Exercising financial control through the use of techniques like an Notes internal audit. ity Forecasting cash flow into the business and out of the business, to ensure that there is no shortage of funds or even surplus cash within the firm. Funds must be made available requiring to meet the day-to-day expenses of the organisation, such as wages to employees. Importance of financial management to organizations rs 1. Financial management ensures enabling organisation to meet its day-to-day expenses, such as wages to workers, maintaining enough product to meet customer demands and enough funds for investment and expansion of the business. ve 2. Budgeting (tool of financial management) ensures that a business makes prominent and spectacular decisions with the use ofavailable information and resources 3. Bookkeeping. This helps tracking the daily fiscal activities of the organization, such as sales. 4. Through financial management, a firm is able to allocate funds appropriately. Proper ni use of allocated funds to assets enhances the operational proficiency for the business concern. 5. Growth and stability: Financial management ensures business plans for its resources regarding both investment and growth needs. U 1.1.2 Role of Finance Managers Financial activities of a firm are considered to be one of the most important and complex activities of a firm. Therefore, a financial manager performs all the requisite financial activities to take care of these activities. ity A financial manager is an individual taking care of all the important financial functions and needs of an organization. The person-in-charge should assert far sightedness and be able to foresee, in order to ensure that the funds are used in the most efficient manner. The person’s actions directly affect the profitableness, lucrativeness, growth and goodwill of the firm. m Following are the main functions of a Financial Manager: 1. Raising of Funds To fulfill the function of meeting the obligation of the business, it is important to have )A enough cash and liquidity—readiness and availability of money. A firm can deduce funds by the way of equity and debt. The financial manager is responsible for the decision of the ratio between debt and equity. A good balance between equity and debt is equally and extremely important. 2. Allocation of Funds Once the funds are raised through different channels and transports, allocation of (c the funds is the next of importance in line. The funds should be allocated in such a manner that they are optimally and fully utilized to its best of capacity. The following points need to be considered for allocating funds in the best possible manner: Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 7 The size of the firm and its growth capacity Status of assets as to whether long-term or short-term Notes ity Mode of fund raising These financial decisions directly and indirectly influence other managerial activities. Hence, formation of a good asset mix and proper allocation of funds is of utmost importance. 3. Profit Planning rs Profit making is one of the prime functions and goals of a business organization. Profit earning is important for survival and sustenance of organization. Profit planning refers to proper usage of the profit generated by the firm. Profit is achieved due to many factors, such as pricing, industry contention, economic ve state, demand and supply mechanism, cost and output. A healthy mix of variable and fixed factors of production leads to an increase in the profitability of the firm. Fixed costs are obtained with the use of fixed factors of production, such as land and machinery. For maintenance of a tandem—one behind other, it is important to continuously value the depreciation cost of fixed cost of production. An opportunity 4. profit. Understanding Capital Markets ni cost must be calculated to replace those factors of production that have undergone wear and tear. If this is not noted, then such fixed costs can cause vast variations in U Shares of a company are traded on stock exchange, and there is a continuous sale and purchase of securities. Hence, clarity of capital market is an important function of a financial manager. When securities are traded on stock market, a huge risk is involved. Therefore, a financial manger fully understands and calculates the ity risks involved in such trading of shares and debentures, and how it can affect the organisation. It is on the prudence of a financial manager on the way to distribute the profits. Many investors do not like the firm to distribute the profits amongst shareholders as dividend, instead want to invest in the business itself to enhance growth. The practices of a financial manager directly impact the operations in capital market. m 1.1.3 Decision Areas in the Financial Market and Objectives of the Firm The company must have a Finance Manager having the power, ability and training to deal key financial management decisions. The main prospects of the financial )A decision-making process relate to investments, financing, dividends and asset management. Financial management refers to the acquisition, financing and management in terms of focus of assets. This decision-making process is very sensitive and raw, and must be under the control of a Financial Manager to analyze external and internal variables affecting the normal development of company activities. (c The decision-making process can be divided into the below given areas: The Investment decision. It is one of the most important decisions taken by the finance manager as here they decide in which project (the one which Amity Directorate of Distance & Online Education  8 Fundamentals of Financial Management is most profitable) will they invest the firm’s money, which will yield them a Notes greater share of amount in the near future. The investment decision relates to ity the selection of assets in which funds will be invested by the firm. The assets which can be acquired by the the firm falls into two broad categories: I. Long term assets which yield a return over a period of time in future. II. Short term or current assets, defined as those assets which in the normal course of business are convertible into cash without dimunition in value rs usually within a year. The first of these involving the first category of assets is popularly known as capital budgeting and the aspect of financial decision made with reference to current assets or short- term assets is referred to as working capital management. ve Capital budgeting: Is basically financing of long- term assets which yield a return over a period of time of the project and these decisions are irrevocable in nature once taken /implemented cannot be changed as massive amount of money is invested in these projects and are related to potentially large anticipated benefits. Working capital management: is concerned with the management of current ni assets. it is an important and integral part of financial management as short term survival is a pre-requisite for long term success. In the investments area, the Financial Manager is responsible for defining and etching out the optimal sizeable organisation. In this regard, it is of utmost importance U to have a market study in situ and a clarity on the goals that the company necessitates to meet. It is important to comprehensively be aware and in a depth knowledge of the requirement, technology and equipment, financing methods and human resources available. Secondly, the director must analyse whether the resources that are in demand for the company adapt to the optimal size. If they do not, in order to achieve ity efficient, impeccable management, it is necessary to cut the types of assets that the company must gain, or otherwise sell or get rid of Financing: The second major decision involved in financial management is the financial decisions. The financing decision of the firm related to the choice of the proportion of these sources (debt or equity) to finance the investment requirements. Business firm prefers choosing finance from the “cheapest and optimal source of m capital” under which a proper combination of debt and equity is maintained. Defining a financing strategy: It is essential to the continuity of the business concern over the long term. Access to financing is closely concerned with asserting and conserving a constant inflow of assets, since the savings margin does not allow )A operations to sustain longer without the support of additional liquidity or fluidity. The Financial Manager must delineate various aspects of the financing strategy. For example, study the sources willing to extend credit to the organization and define the best financing options for operations. The Financial Manager also designs a mixed financing strategy for efficient financial management: this is called the company’s “financing mix”. Sometimes the company benefits from a combination of short- and (c long-term financing to meet various investment funds and financial scheme objectives.    Asset management: Asset management is one of the principal aspects for a company to adequately meet its duties and, in turn, to position itself for meeting the Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 9 objectives or growth targets that have been laid out. In other words, the Financial Manager must specify and affirm that the existing assets are managed in the most Notes ity efficient way possible. Generally, manager prioritizes current asset management before fixed asset management. Current assets are those that become effective in the near future, such as accounts receivable or inventories. By contrast, fixed assets lack fluidity, since they are needed for permanent, fixed operations. This includes offices, warehouses, machinery, vehicles, etc. rs Dividend Policy: One of the most significant financial decisions that a Financial Manager must make relates to the company’s dividend policy. It concerns with regard to the amount of the company’s earnings paid out to stakeholders. Specifically, it is necessary to determine whether generated earnings will be reinvested in the company for improvisations of operations or its distribution among shareholders. It is also ve possible to choose a mixed policy in this regard—distributing a part among various stakeholders and investing the rest in the organisation. However, if the dividends that are to be distributed are too high, the company may come across limitations for expansion or improvisation of the management of its operations. It is important to consider that short-term reinvestments are essential for growth perspectives over the long term. 1.1.4 Indian Financial System—Overview ni The Indian Financial System is one of the most important aspects of the economic U development of our country. By definition, this system manages the flow of funds between the people (household savings) of the country and the ones who may invest it wisely (investors/businessmen) for the benefit of both the parties. Given below are the features of the Indian Financial system: ity It plays an important role in the economic development of the country by encouraging both savings and investment It helps in mobilizing and allocating one’s savings It facilitates the expansion of financial institutions and markets It plays a key role in capital formation It helps form a link between the investor and the one saving it m It is also concerned with the Provision of funds Components of the Indian Financial System )A There are four main components of the Indian financial system. 1. Financial Institutions: They act as an intermediary between investor and borrower. The savings of the investor are mobilized either directly or indirectly through the financial markets. The main functions of the financial institutions are as follows: (c Conversion of a short-term liability into a long-term investment. Conversion of a risky investment into a risk-free investment. Amity Directorate of Distance & Online Education  10 Fundamentals of Financial Management Acting as a medium of a convenience denomination—matching a small Notes deposit with large loans and a large deposit with small loans ity The best example of a financial institution is a bank. The bank acts as an intermediary body between the two—people with surplus amount of money and people in dire need of money. People with surplus amount of money make savings in their accounts, whereas, people in dire need of money take loans. Financial institutions are further divided into two types: rs 1. Banking Institutions or Depository Institutions: This category includes banks and other credit unions collecting money from the public against interest provided on the deposits made and contribute that money to the ones in need. ve 2. Non-banking Institutions or Non-Depository Institutions: This category consists of Insurance, mutual funds and brokerage companies. They cannot ask for monetary deposits but rather sell financial products to their customers. Further, financial institutions can be categorized into three categories: 1. Regulatory: Institutes regulating financial markets like RBI, IRDA, SEBI, etc. 2. 3. ni Intermediates: Commercial banks providing loans and other financial assistance, such as SBI, BOB, PNB, etc. Non-intermediates: Institutions providing financial aid to corporate customers or institutions. For example, NABARD, SIDBI. U 2. Financial Assets: The products that are traded in the financial market are called financial assets. The securities in the market also differ from each other based on the various requirements and needs of the credit seeker. Some important financial assets are as follow: ity Call Money: When a loan is granted for one day and is repaid on the second day, it is called call money. No collateral securities are required for such transaction. Notice Money: When a loan is granted for more than a day and for less than 14 days, it is called notice money. No collateral securities are required for m such transaction. Term Money: When the maturity period of a deposit is beyond 14 days, it is called term money. Treasury Bills: Also known as T-Bills, these are Government bonds or debt )A securities with maturity of less than a year. Buying a T-Bill means lending money to the Government. Certificate of Deposits: It is a dematerialized form (electronically generated) for finances deposited in the bank for a particular period of time. Commercial Paper: It is an unsecured, unguaranteed, short-term debt instrument issued by corporations. (c 3. Financial services: These are the services provided by the asset management and liability management companies. Such companies help to get required funds and also make sure that they are efficiently handled and invested. Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 11 The financial services in India include: Notes ity Banking Services: Any small or big service provided by banks like granting loan, depositing money, issuing debit/credit cards, opening accounts, etc. Insurance Services: Services like issuing of insurance, selling policies, insurance undertakings and brokerages, etc., are all a part of the Insurance services rs Investment Services: It mostly includes asset management. Foreign Exchange Services: Exchange of currency, foreign exchange, etc., are a part of the Foreign exchange services. The main aim of the financial services is to assist a person with selling, borrowing or purchasing securities, allowing payments and settlements and lending and investing. ve 4. Financial markets: The marketplace where buyers and sellers interact with each other and participate in trading of money, bonds, shares and other assets is called a financial market. The financial market can be further divided into four types: 1. Capital Market: Designed to finance the long-term investment, the Capital ni market deals with transactions that take place in the market for over a year. The capital market can further be divided into three types: (a)Corporate Securities Market (b)Government Securities Market (c)Long Term Loan Market 2. Money Market: As it is mostly dominated by Government, Banks and other Large U Institutions, this type of market is authorized for small-term investments only. It is a wholesale debt market working on low-risk and highly liquid instruments. The money market can further be divided into two types: (a) Organized Money Market (b) Unorganised Money Market 3. Foreign exchange Market: One of the most developed markets across the ity world, the Foreign exchange market, deals with the requirements related to multicurrency. The transfer of funds in this market takes place on the basis of foreign currency rate. 4. Credit Market: A market where short-term and long-term loans are granted to individuals or organisations by various banks and Financial & Non-Financial Institutions is called Credit Market. m 1.1.5 Financial Statement Analysis—Analysis of Fund Flow or Cash Flow Cash Flow vs. Fund Flow—An Overview )A In accounting, there are generally four different types of financial statements: the balance sheet, the income statement, the cash flow statement, and the fund flow statement. Here, we will delve into the final two. In financial accounting, the statement of cash flows refers to the change in a company’s cash and equivalents from one period to the next. The fund flow, however, (c has two different meanings—One for accounting purposes, whereas, the other one serves investment purposes. Amity Directorate of Distance & Online Education  12 Fundamentals of Financial Management Key aspects: Notes ity A company’s cash flow or input and fund flow statements reflect two different variables during a specific/particular period of time. The cash flow will record a company’s inflow and outflow of actual cash (cash and cash equivalents). The fund flow records the movement of cash in and out of the company. Both help provide investors and the market a snapshot of the way company is rs doing on a periodic basis. The cash flow statement is the best suited to estimate a company’s liquidity profile, whereas, the fund flow statement is the best pitched towards long-term financial planning. ve Cash Flow Cash flow is registered on a company’s cash flow statement. This statement—one of the main statements for a company—shows the influx and outflow of actual cash (or cash-like assets) from its operational activities. It is a required report under Generally Accepted Accounting Principles (GAAP). ni This is much different from the income statement, which records data or transactions that may not have been fully realized, such as uncollected revenue or unpaid income. The cash flow statement, on the other hand, already has this information entered and gives a more accurate portrait of how much cash a company is U generating. Cash flow sources can be divided into three different classes for a cash flow statement: Cash flows from operating activities: Cash generated from the general or ity core operation of the business. Cash flows from investing activities: This section covers cash flow spent on investments like new equipment. Cash flows from financing activities: Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow m of cash to shareholders as dividends as the company generates income. Companies receive inflows of cash revenue from selling goods, providing services, selling assets, earning interest on investments, rent, taking out loans, or issuing new shares. Cash outflows can result from making purchases, paying back loans, expanding )A operations, paying salaries, or distributing dividends. Since, investors and lenders rely on the statement of cash flow to evaluate a company’s liquidity and cash flow management, as the Securities and Exchange Commission (SEC) requires all listed companies to use accrual accounting, which largely ignores the actual balance of cash in hand. It is a much more reliable tool than the metrics companies use to fancy up their earnings, such as earnings before interest, (c taxes, depreciation, and amortization (EBITDA). Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 13 Illustration: Notes ity From the following Cash Account, prepare a cash flow statement of ABC Ltd. for the year ended March 31, 2020. Cash Account Particulars Amount Particulars Amount To Bal b/d 19,600 By suppliers 73,800 rs To customers 2,00,800 By operating expenses 20,000 To borrowings 60,000 By interest expense 2,400 By taxes 27,200 By Property, Plant, and Equipment 1,35,500 ve By dividend 7,200 By bal c/d 14,300 2,80,400 2,80,400 ni Solution: Abc Inc. The Cash Flow Statement For The Year Ended March 31, 2020 Amount (Rs.) U CASH FLOW FROM OPERATING ACTIVITIES Cash Received from Customers 200,800 Cash Paid to Suppliers (73,800) ity Cash Payments for Operating Expenses (20,000) Cash Payments for Interest (2,400) Cash Payments for Taxes (27,200) NET CASH FLOW FROM OPERATING ACTIVITIES 77,400 m CASH FLOW FROM INVESTING ACTIVITIES Purchase of Property, Plant and Equipment (135,500) )A NET CASH FLOW FROM INVESTING ACTIVITIES (135,500) CASH FLOW FROM FINANCING ACTIVITIES Proceeds from Borrowings 60,000 Payment of Dividends (7,200) (c NET CASH FLOW FROM FINANCING ACTIVITIES 52,800 NET INCREASE (DECREASE) IN CASH FOR THE PERIOD (5,300) Amity Directorate of Distance & Online Education  14 Fundamentals of Financial Management Notes Abc Inc. ity The Cash Flow Statement For The Year Ended March 31, 2020 Amount (Rs.) Cash at the beginning of the period 19,600 CASH AT THE END OF THE PERIOD 14,800 rs The cash inflow from operating activities is Rs. 77400 and from financing activities is Rs. 52800. The cash outflow from investing activities is Rs. 135,500. Therefore, the net cash outflow of the business for the year is Rs. 5,300. Fund Flow ve The fund flow statement was required by GAAP between 1971 and 1987— accounting side. The statement of fund flow was primarily used by accountants to report any change in a company’s net working capital when it was required, or the difference between assets and liabilities, during a fixed time period. Much of this information is now captured in the statement of cash flow. ni The fund flow does not give the cash position of a company in lieu of investment; if a company wants the same, it prepares its cash flow statement. The fund flow highlights the movement of cash only—it reflects the net movement after examining inflows and outflows of monetary funds. It also keys out any activity that U might be out of persona for the company, such as an atypical expense. The use of the fund flow statement in investing is more useful today. Investor sentiment can be gauged as it relates to different asset classes. For example, if the flow of funds for equities is positive, it suggests that investors have a generally optimistic ity view of the economy—or, at least, the short-term profitability of listed companies. Key Differences The fund flow statement is the earlier version of the cash flow statement. The cash flow statement is much more comprehensive and, rather than just focusing on working capital, details the various cash flows of a company. m The cash flow statement is the best used to comprehend the liquidity position of a business firm, whereas, the fund flow statement is the best suited for long-term financial planning, which is why it is an important tool for investors. The fund flow statement is able to identify the sources of cash and their uses, and the cash flow statement starts )A with looking at the current level of cash and the way it leads to the closing balance of cash. 1.1.6 Financial Statement Analysis—Financial Ratio Analysis Financial ratio analysis is the quantitative ability to gain perceptiveness into company’s liquidity, operational efficacy, and profitability by studying its financial (c statements, such as balance sheet and pay slip. It is the base of the equity analysis. Financial ratios are formulated using numerical values taken from financial statements for gaining meaningful information about a company. The numbers found Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 15 on a company’s financial statements—balance sheet, income statement, and cash flow statement—are used to perform quantitative analysis and assess a company’s liquidity, Notes ity leverage, growth, margins, profitability, rates of return, valuation, and more. Financial ratios are grouped into the following categories: Liquidity ratios Leverage ratios rs Efficiency ratios Profitability ratios Market value ratios Uses and Users of Financial Ratio Analysis ve Analysis of financial ratios serves two main purposes: 1. Track company performance Determining individual financial ratios per period and tracking the change in their values over time is performed to identify trends and tendencies that may be developing ni in a company. For example, an increasing debt-to-asset ratio may suggest that a company is weighed down with debt and may eventually be facing default risk. 2. Make comparative judgments regarding company performance U Comparison of financial ratios with that of major competitors is done to discover whether a company is performing better or worse than the average of industry performance. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets. ity Users of financial ratios include parties external and internal to the company: External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers Internal users: Management team, employees, and owners m Liquidity Ratios Liquidity ratios are financial ratios measuring a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following: )A The current ratio measures a company’s ability to pay off short-term liabilities with current assets: Current ratio = Current assets/Current liabilities The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets: (c Acid-test ratio = Current assets – Inventories/Current liabilities Amity Directorate of Distance & Online Education  16 Fundamentals of Financial Management The cash ratio measures a company’s ability to pay off short-term liabilities with Notes cash and cash equivalents: ity Cash ratio = Cash and Cash equivalents/Current Liabilities The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period: Operating cash flow ratio = Operating cash flow/Current liabilities rs Leverage Financial Ratios Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common ve leverage ratios include the following: The debt ratio measures the relative amount of a company’s assets that are provided from debt: Debt ratio = Total liabilities/Total assets ni The debt-to-equity ratio calculates the weight of total debt and financial liabilities against shareholders’/stakeholders’ equity: Debt-to-equity ratio = Total liabilities/Shareholder’s equity U The interest coverage ratio shows how easily a company can pay its interest expenses: Interest coverage ratio = Operating income/Interest expenses The debt service coverage ratio reveals how easily a company can pay its debt ity obligations: Debt service coverage ratio = Operating income/Total debt service Efficiency Ratios Efficiency ratios, also known as activity financial ratios, are used to measure how m well a company is utilizing its assets and resources. Common efficiency ratios include: The asset turnover ratio measures a company’s ability to generate sales from assets: )A Asset turnover ratio = Net sales/Average total assets The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period: Inventory turnover ratio = Cost of goods sold/Average inventory The accounts receivable turnover ratio measures how many times a company can (c turn receivables into cash over a given period: Receivables turnover ratio = Net credit sales/Average accounts receivable Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 17 The days’ sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers: Notes ity Days sales in inventory ratio = 365 days/Inventory turnover ratio Profitability Ratios Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability rs financial ratios include the following: The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold: ve Gross margin ratio = Gross profit/Net sales The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency: Operating margin ratio = Operating income/Net sales to generate profit: Return on assets ratio = Net income/Total assets ni The return on assets ratio measures how efficiently a company is using its assets U The return on equity ratio measures how efficiently a company is using its equity to generate profit: Return on equity ratio = Net income/Shareholder’s equity ity Market Value Ratios Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following: The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders: m Book value per share ratio = (Shareholder’s equity – Preferred equity)/Total common shares outstanding The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share: )A Dividend yield ratio = Dividend per share/Share price The earnings per share ratio measures the amount of net income earned for each share outstanding: Earnings per share ratio = Net earnings/Total shares outstanding (c The price-earnings ratio compares a company’s share price to its earnings per share: Amity Directorate of Distance & Online Education  18 Fundamentals of Financial Management Price-earnings ratio = Share price/Earnings per share Notes ity Illustration: Following information is given by a company from its books of accounts as on March 31, 2019: Inventory 50,000 Total Current Assets 80,000 rs Shareholders’ funds 2,00,000 13% Debentures 1,50,000 Current liabilities 50,000 ve Net Profit Before Tax 1,75,500 Cost of revenue from operations 2,50,000 Calculate: i) Current Ratio ii) Liquid Ratio iii) Debt-Equity Ratio iv) Interest Coverage Ratio v) Inventory Turnover Ratio Solution: i) ni Current Ratio = Current Assets/Current Liabilities = Rs. 80,000/Rs. 50,000 = 1.6 : 1 U ii) Liquid Assets = Current assets – Inventory = Rs. 80,000 – Rs. 50,000 = Rs. 30,000 Liquid Ratio = Liquid Assets/Current Liabilities = Rs. 30,000/Rs. 50,000 = 0.6 : 1 iii) Debt-Equity Ratio = Long-term Debts/Shareholders’ Funds = Rs. 1,50,000/Rs. 2,00,000 = 0.75 : 1 ity iv) Net Profit before Interest = Net Profit before Tax + Interest on Long & Tax term Debts = Rs. 1,75,500 + (13% of Rs. 1,50,000) = Rs. 1,95,000 Interest Coverage Ratio = Net Profit before Interest & Tax/Interest on Long Term Debts = Rs. 1,95,000/Rs. 19,500 = 10 times v) Inventory Turnover Ratio = Cost of Revenue from Operations/Average Inventory = Rs. 2,50,000/Rs. 50,000 = 5 times m 1.1.7 Financial Statement Analysis—Common Size and Comparative Statement Common size analysis, also referred as vertical analysis, is a tool that financial )A managers use to analyze financial statements. It evaluates financial statements by showing each line item as a percentage of the base amount for that period. The technique can be used to analyze the three primary financial statements— balance sheet, income statement, and cash flow statement. In the balance sheet, the common base item to which other line items are expressed is total assets, while, in the income statement, it is total revenues. (c Formula for Common Size Analysis Common size financial statement analysis is computed using the following formula: Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 19 Percentage of Base = Amount of Individual item/Amount of Base Item ×100 Notes ity Types of Common Size Analysis Common size analysis can be conducted in two ways—vertical analysis and horizontal analysis. Vertical analysis refers to the analysis of particular line items in relation to a base item within the same financial period. For example, in the balance sheet, we can assess the proportion of inventory by dividing the inventory line using total assets as the base item. rs On the other hand, horizontal analysis refers to the analysis of particular line items and comparing them to a similar line item in the previous or subsequent financial period. Although, common size analysis is not as detailed as trend analysis using ratios, it does provide a simple way for financial managers to examine financial statements. ve Balance Sheet Common Size Analysis The balance sheet common size analysis mostly uses the total assets value as the base value. On the balance sheet, the total assets value equals the value of total liabilities and shareholders’ equity. A financial manager or investor uses the common ni size analysis to see how a firm’s capital structure compares to rivals. They can make important observations by examining particular line items in relation to the total assets. For example, if the value of long-term debts in relation to the total assets value is too high, the company’s debt levels are shown too high. Similarly, looking at the U retained earnings in relation to the total assets as the base value can reveal amount of the annual profits retained on the balance sheet. Illustration: From the following Balance Sheet of XYZ Ltd., prepare a common-size balance ity sheet for the year ended 31st march 2020:- Particulars Note no. 31.3.20 I. Equity and Liability 1. Shareholders’ Funds (a) Share Capital 300000 m (b) Reserves and Surplus 40000 2. Non-Current Liabilities (a) Long term borrowings 100000 3. Current Liabilities )A 60000 (a) Trade Payables 500000 Total II. Assets 1. Non-current Assets 300000 (a) Fixed Assets (i) Tangible Assets (c (ii) Intangible Assets 60000 2. Current Assets (a) Inventories 100000 Amity Directorate of Distance & Online Education  20 Fundamentals of Financial Management (b) Cash and Cash Receivables 40000 Notes ity Total 500000 Solution: Common-size Balance Sheet For the year ended 31st march 2020 rs Absolute Percentage of Particulars Note Amount Balance Sheet no. (Rs) Total (%) III. Equity and Liability ve 4. Shareholders’ Funds (c) Share Capital 300000 66.7 (d) Reserves and 40000 10 Surplus 5. Non-Current Liabilities 100000 20 ni (a) Long term borrowings 60000 3.3 6. Current Liabilities 500000 100 (b) Trade Payables Total U IV. Assets 300000 66.7 2. Non-current Assets 60000 3.3 (b) Fixed Assets 100000 20 (iii) T a n g i b l e 40000 10 Assets 500000 100 ity (iv) I n t a n g i b l e Assets 3. Current Assets (a) Inventories (b) Cash and Cash Receivables m Total Income Statement Common Size Analysis The base item in the income statement is usually the total sales or total revenues. )A Common size analysis is used to calculate net profit margin, as well as gross and operating margins. The ratios tell investors and finance managers about the way the company is doing in terms of revenues, and they can make forecasting’s of future revenues. Companies can also use this tool for analysing competitors to know the proportion of revenues that goes to advertising, research and development, and other essential expenses. (c Illustration: From the following Statement of Profit and Loss of XYZ Ltd. for the year ended 31st March 2020, prepare a Common-size Statement of Profit and Loss:- Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 21 Particulars Note no. 31.3.2020 (Rs.) Notes ity Revenue from Operations 200000 Employee Benefit Expense 100000 Other Expenses 10000 Solution: rs Common-size Statement of Profit and Loss for the year ended 31st March 2020 Percentage Absolute Note of Revenue Particulars Amount no. from (Rs) ve Operations I. Revenue from Operations 200000 100 100000 50 II. Employee Benefit Expense Other Expenses 10000 5 III. Total expenses 110000 55 IV. Profit before Tax (I – III) Importance of Common Size Analysis ni 90000 One of the benefits of using common size analysis is that it allows investors to 45 U identify drastic changes in a company’s financial statement. This primarily applies when the financials are compared over a period of two or three years. Any significant movements in the financials across several years can help investors decide whether to invest in the company. For example, large drops in the company’s profits in two or more consecutive years may indicate that the company is going through financial distress. ity Similarly, considerable increases in the value of assets may indicate that the company is implementing an expansion or acquisition strategy, making the company an attraction to investors. Common size analysis is also an excellent tool to compare companies of different sizes but in the same industry. Looking at their financial data can reveal their strategy and their largest expenses that give them a competitive edge over other comparable m companies. For example, some companies may sacrifice margins to gain a large market share, which increases revenues at the expense of profit margins. Such a strategy allows the company to grow faster than comparable companies, because they are more preferred by investors. )A 1.1.8 Financial Statement Analysis—Trend Analysis and Time Series Analysis Time series data analysis is the analysis of datasets that change over a period of time. Time series datasets record observations of the same variable over various points of time. Financial analysts use time series data, such as stock price movements or a company’s sales over time, to analyze a company’s performance. (c Correlation Unlike cross-sectional data analysis, time series data analysis cannot make use of the random sampling framework. This makes time series data analysis much more Amity Directorate of Distance & Online Education  22 Fundamentals of Financial Management complex and computationally demanding than cross-sectional data analysis. Random Notes sampling cannot be used, because the past values of a variable are almost always ity highly correlated with the present value of that variable. For example, the GDP of the US in the fourth quarter of 2017 is highly correlated with the GDP in the third quarter of 2017. The degree of correlation is much higher than the correlation across economic entities at the same point in time. The correlation coefficient between the US GDP in the current quarter and the rs US GDP in the previous quarter for the period 2008–2018 is 0.998. The correlation coefficient between the US GDP in the current year and the US GDP in the previous year for the period 2008–2018 is 0.992. Check your Understanding ve 1. The __________ measures how efficiently a company is using its equity to generate profit 2. _____________also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include: 3. 4. ni ____________ensures that the organisation meets its primary objective of maximising the stakeholder’s wealth, downsizing the financial toll, and other nonfinancial activities, such as the government, employees and the suppliers. ______________: This category consists of Insurance, mutual funds and brokerage U companies. They cannot ask for monetary deposits but instead sell financial products to their customers 5. One of the benefits of using __________is that it allows investors to identify drastic changes in a company’s financial statement ity Summary Making a business plan and then ensuring that all departments stay on track is known as financial management. Solid financial management allows the CFO or VP of finance to provide data that aids in the development of a long-term strategy, informs investment decisions, and provides insights into how to fund those investments, liquidity, profitability, cash runway, and more. m Thus in a nutshell, Financial management is the process of managing a company’s finances in such a manner that it is both profitable and compliant with the law. This necessitates both a high-level strategy and on-the-ground execution. )A Activity 1. Find out the balance sheet of any company of your choice and implement the various types of ratios analysis on them. Questions and Exercises 1. What is the importance of Financial Management? (c 2. What is your understanding towards the role of a finance manager? 3. How does the Indian Finance System functions? Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 23 4. What are the various liquidity ratios? Notes ity Glossary Management of cash: Finance manager has to make decisions with regards to cash management and direction. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance and sustenance of enough stock, purchase of raw materials, etc. rs Dividend Policy: One of the most significant financial decisions that a Financial Manager must make is related to the company’s dividend policy. It concerns as to the amount of the company’s earnings paid out to stakeholders. Specifically, it is necessary to determine whether generated earnings will be reinvested in the company for ve improvisations of operations or its distribution among shareholders Financial ratio analysis: is the quantitative ability to gain perceptiveness into company’s liquidity, operational efficacy, and profitability by studying its financial statements, such as balance sheet and pay slip. It is the base of the equity analysis. Financial ratios are formulated using numerical values taken from financial ni statements for gaining meaningful information about a company. The numbers found on a company’s financial statements—balance sheet, income statement, and cash flow statement—are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more. U Financial ratios are grouped into the following categories: Liquidity ratios Leverage ratios Efficiency ratios ity Profitability ratios Market value ratios Uses and Users of Financial Ratio Analysis Further Readings and References 1. Strategic Corporate Finance: Applications in Valuation & Capital Structure by m Jitendra Kushwaha and Pallavi k. Kindle Edition. 2. Financial Management: Text, Problems and Cases by M. Y. Khan, P. K. Jain, 8th Edition, McGraw Hill Education. 2018. )A 3. Pandey, I. M. Ninth Edition, Financial Management, Vikas Publishing House Pvt. Ltd. 4. Brearly R.A. and Myers, S.C. Eighth Edition Principles of Corporate Finance, Tata Mc-Graw Hill 5. Chandra, P. Fundamentals of Financial Management, Sixth Edition, Tata McGraw Hill. (c 6. Horne. V. Tenth Edition, Financial Management and Policy, Prentice Hall of India Amity Directorate of Distance & Online Education  24 Fundamentals of Financial Management Check your Understanding – Answers Notes ity 1. return on equity ratio 2. Efficiency ratios, 3. Financial management 4. Non-banking Institutions or Non-depository Institutions 5. common size analysis rs ve ni U ity m )A (c Amity Directorate of Distance & Online Education  Fundamentals of Financial Management 25 Unit-1.2: Time Value of Money Notes ity Learning Objectives After studying this chapter, you will be able to understand: Concept of Time value of Money Process of Compounding and Discounting rs Future Value of a Single amount Future Value of an Annuity Present Value of a Single Amount ve Present Value of an Annuity Time value of Money-Numerical -1 Time value of Money-Numerical -2 Introduction ni Time value of money corresponds to a concept that money present now is worth more than identical sum in the future due to its potential earning capacity. This is the core principle of finance states that the provide money can earn interest, any amount of money is worth more the sooner it is obtained. U Thus, it is also referred as present discounted value. 1.2.1 Concept of Time Value of Money ity It is the concept that, all else being equal, money is more valuable when it is received closer to the present. The key to conceptualising the time value of money is the concept of opportunity cost. To illustrate, consider the fact that, if an investor receives money today, they can invest that money and earn a positive return. If, on the other hand, they receive that money one year in the future, they effectively lose the positive return they could have otherwise earned. m The time value of money absorbs from the concept that rational investors prefer to receive money today rather than the same amount of money in the future, because of money’s potential to grow in a value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is, therefore, said to )A be compounding/intensifying in value. It is of utmost importance because it can help guide financial investment decisions. For instance, suppose an investor can choose between two projects: Project A and Project B. Both projects have identical descriptions except that Project A promises a $5 million cash disburse in year 1, whereas Project B offers a $5 million cash disburse in year 5. If the investor did not understand the time value of money, they might believe that these two projects are equally attractive. In fact, however, time of money dictates (c that Project A is more attractive than Project B, because its $5 million disburse or cash payout has a higher present or current value. Amity Directorate of Distance & Online Education  26 Fundamentals of Financial Management Main Points Notes ity Time value of money is based on the concept that people would rather have money today than in the future. Given that money can earn compound interest, it is more valuable in the present rather than the future. The formula for computing time value of money considers the current payment, the future value, the interest rate, and the time frame. rs The number of compounding periods during each time frame is an important determinant in the time value of money formula as well. Time Value of Money Formula ve Depending on the exact situation in question, the time value of money formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But, in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate ni n = number of compounding periods per year U t = number of years Based on these variables, the formula for TVM is: FV = PV x [ 1 + (i / n) ] (n x t) ity Effect of Compounding Periods on Future Value The number of compounding periods can have a drastic or forceful effect on the TVM calculations. Thus, TVM not only depends on interest rate and time horizon, but also on the number of times the compounding calculations are computed annually. m Time Value of Money The factors that determine time value money are: )A i. Investment: For instances “A” and “B” are given an option of either taking Rs 1000 today or after a week. “A” choose to take the money today while “B” chooses to take it after a week. “A” invest the money gaining a return of 10% within a week. After a week “A” will have 1100 Rs. While “B” will have only 1000 Rs. So, from the above example we can state that money multiples itself and a rupee of today is more worth than a money of tomorrow ii. Inflation: Suppose the price of rice is 50 rs per kg the person having 100 rs can buy (c 2kgs of rice today. after 5 years the price of rice rises from 50 to