Advanced Financial Management Class Notes PDF

FIN411 - ADVANCED FINANCIAL MANAGEMENT CLASS NOTES 1: INTRODUCTION; The term financial management simply means effectively managing your utility’s financial functions. The financial functions of your utility include accounting, your policies and procedures, record-keeping and reporting systems, plan...

FIN411 - ADVANCED FINANCIAL MANAGEMENT CLASS NOTES 1: INTRODUCTION; The term financial management simply means effectively managing your utility’s financial functions. The financial functions of your utility include accounting, your policies and procedures, record-keeping and reporting systems, planning and forecasting practices, budgeting procedures, and financial-oversight responsibilities. The goal of good financial management is to ensure that your utility is operated as a financially sustainable enterprise. Financial Management Simply means planning, organizing, directing, Monitoring, Decision making and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. a. Definition of Financial Planning Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Objectives of Financial Planning Financial Planning has got many objectives to look forward to: a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements. b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term. c. Framing financial policies with regards to cash control, lending, borrowings, etc. d. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment. Importance of Financial Planning Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as- 1. Adequate funds have to be ensured. 2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. 1  3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning. 4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company. 5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. 6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern. b). Forecasting practices Financial forecasting refers to a process businesses use to predict future revenues, expenses and cash flow. Executives use financial forecasting to help them make confident, profitable financial decisions and be able to determine where the company is headed. Forecasting methods typically fall into one of two categories: qualitative and quantitative forecasting. 1.Quantitative financial forecasting - Takes a straightforward approach to generating forecasts based on hard data. Here are some of the top quantitative models used by businesses for forecasting, i. Straight line - A straight-line forecasting method is one of the easiest to implement, requiring only basic math and providing reasonable estimates for what businesses can anticipate in future financial scenarios. Straight-line forecasting is commonly used when a business is assuming revenue growth in the future. ii. Moving average - A moving average is the average performance of a specific metric over a specific period of time. Typically, a moving average is used to evaluate on monthly time frames, rather than yearly time frames. It’s often used to evaluate revenues, profits, sales growth, stock prices, and other common financial metrics. iii. Time series - Time series is an umbrella term representing a few different approaches to financial forecasting. The strategy behind this forecasting method is to identify patterns in historical data that will repeat in the future, enabling data-driven forecasting across a range of financial metrics. iv. Linear regression – Linear regression is a graphical representation of the relationship between two or more data points. It uses the relationship between x and y variables to chart a trend line illustrating the relationship between the two. Sales and profits serve as an easy example. If sales increase, profits are likely to increase, creating a linear regression that shows a positive correlation between the two. But if sales increase and profits decrease, it can indicate other problems, such as rising expenses that are cutting into profits’ The equation has the form Y= a + bX, where Y is the dependent variable (that's the variable that goes on the Y axis), X is the independent variable (i.e. it is plotted on the X axis), b is the slope of the line and a is the y-intercept. 2  2.Qualitative forecasting methods - It is an inexact science. It uses soft data, such as estimates from experts that cannot be corroborated by historical data. An example of qualitative data is when an executive predicts the costs a company will incur due to a new regulatory law. The expert could be correct in their prediction, given their vast experience and insight, but there is limited data available to support any prediction when such circumstances have never been faced before. Here’s a look at the two leading models for qualitative forecasting: i. Market research - Market research is widely used in the business world to evaluate potential scenarios a company hasn’t faced before. One well-known example of this is when a business is choosing where to open a new location, or when it’s testing the marketing and packaging for an upcoming product. Market research does generate data to inform financial forecasts, but there are many variables and unreliable circumstances that make it hard to rely too heavily on the accuracy of this data ii. Delphi method - Similar to market research, the Delphi method of financial forecasting sources its data from experts who can speak knowledgeably on the subjects being evaluated. Your company will seek outside sources, as well as in-house expert insight, to compile data through questionnaires that can be used to identify consensus opinions about various financial matters. c). Organizing Organizing is the function of management which follows planning. It is a function in which the synchronization and combination of human, physical and financial resources takes place. Organizing is the function of management that involves developing an organizational structure and allocating human resources to ensure the accomplishment of objectives. The structure of the organization is the framework within which effort is coordinated. SCOPE/ELEMENTS AND NATURE OF FINANCE 1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions. 2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. 3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise. 3 Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be- 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved. 5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. The objectives or goals of financial management can also be classified as; 1. Maximization of the profits of the firm; Profit is considered as the yardstick for economic efficiency of any company. Interest of other parties such as lenders, creditors, society etc. cannot be ignored since they affect profits. Financial management has to face tough task of reconciling the interest of all the parties. There are various problems with the profit max. asan objective such as , i It ignores the risk associated with profits such as financing risk. ii. It ignores timing of costs and returns by ignoring the time value of money 2. Maximization of shareholders wealth; Shareholders wealth is represented by the value of all future cash flows in form of dividends or other benefits expected from the firm. The economic value of the shareholders wealth is the market price of the shares. 3. Social Responsibility; A firm will decide whether to operate strictly in there shareholders best interest or be responsible to others also such as the Employees, Customers, Community / public etc. 4. Business Ethics; These are issues related to social responsibility. These are Standards of conduct or moral behavior. The co. Attitude towards stakeholders i.e. Employees, creditors, customers, suppliers etc. A firm is expected to treat each of these groups in a fair and honest manner. 5. Growth; This can be a major objective for small firms. They may invest in projects with negative NPV to increase their size. Increase Size to enjoy economies of scale. 4 Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. Choice of sources of funds: For additional funds to be procured, a company has many choices like- a. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company. 6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc. 7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 5 Finance Functions The following explanation will help in understanding each finance function in detail Investment Decision One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decision a. Evaluation of new investment in terms of profitability b. Comparison of cut off rate against new investment and prevailing investment. Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in calculating the expected return of the prospective investment. Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved. Investment decision not only involves allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those assets which become less profitable and less productive. It wise decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR) Financial Decision Financial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure. A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds. A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital structure. 6 Dividend Decision Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of profitability Another way is to issue bonus shares to existing shareholders. Liquidity Decision It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets. Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency. Role of finance manager: The functions of Financial Manager can broadly be divided into two i.e. 1. The Routine functions and 2. The Executive/Managerial Functions. 7 1.The Executive functions of financial management (FM) are, 1. Estimating capital requirements The company must estimate its capital requirements (needs) very carefully. This must be done at the promotion stage. The company must estimate its fixed capital needs and working capital need. If not, the company will become over 2. Determining capital structure Capital structure is the ratio between owned capital and borrowed capital. There must be a balance between owned capital and borrowed capital. If the company has too much owned capital, then the the shareholders will get fewer dividends. Whereas, if the company has too much of borrowed capital, it has to pay a lot of interest. It also has to repay the borrowed capital after some time. So the finance managers must prepare a balanced capital structure. 3. Estimating cash flow : Cash flow refers to the cash which comes in and the cash which goes out of the business. The cash comes in mostly from sales. The cash goes out for business expenses. Therefore, the finance manager must estimate the future sales of the business. This is called Sales forecasting. He also has to estimate the future business expenses. 4. Investment Decisions : The business gets cash, mainly from sales. It also gets cash from other sources. It gets long-term cash from equity shares, debentures, term loans from financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer deposits, etc. The finance manager must invest the cash properly. Long-term cash must be used for purchasing fixed assets. Short-term cash must be used as a working capital. 5. Allocation of surplus : Surplus means profits earned by the company. When the company has a surplus, it has three options, viz., 1. It can pay dividend to shareholders. 2. It can save the surplus. That is, it can have retained earnings. 3. It can give bonus to the employees. 6. Deciding additional finance : Sometimes, a company needs additional finance for modernization, expansion, diversification, etc. The finance manager has to decide on following questions. 1. When the additional finance will be needed? 2. For how long will this finance be needed? 8  3. From which sources to collect this finance? 4. How to repay this finance? Additional finance can be collected from shares, debentures, loans from financial institutions, fixed deposits from public, etc 7. Negotiating for additional finance : The finance manager has to negotiate for additional finance. That is, he has to speak to many bank managers. He has to persuade and convince them to give loans to his company. There are two types of loans, i.e. short-term loans and long-term loans. It is easy to get short-term loans from banks. However, it is very difficult to get long-term loans. 8. Checking the financial performance : The finance manager has to check the financial performance of the company. This is a very important finance function. It must be done regularly. This will improve the financial performance of the company. Investors will invest their money in the company only if the financial performance is good. The finance manager must compare the financial performance of the company with the established standards. He must find ways for improving the financial performance of the company. 2.The routine functions are also called as Incidental Functions. Routine functions are clerical functions. They help to perform the Executive functions of financial management. The six routine functions of financial management are listed below. 1. Supervision of cash receipts and payments. 2. Safeguarding of cash balances. 3. Safeguarding of securities, insurance policies and other valuable papers. 4. Taking proper care of mechanical details of financing. 5. Record keeping and reporting. 6. Credit Management. The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm. He must however, supervise the activities of these junior staff. 9