Chapter 3 Financial Management PDF

CHAPTER 3 FINANCIAL MANAGEMENT ENGR. MARK ANDREW M. ALINGOG Finance is the word used to describe the money resources available to governments, firms, or individuals, and the management of these resources. Financial management is the acquisition, management, and financing of resources b...

CHAPTER 3 FINANCIAL MANAGEMENT ENGR. MARK ANDREW M. ALINGOG Finance is the word used to describe the money resources available to governments, firms, or individuals, and the management of these resources. Financial management is the acquisition, management, and financing of resources by means of money, with due regard for prices in external markets. Resources are generally physical, such as cash, inventory, accounts receivable, equipment and machinery, or manufacturing and distribution facilities. The main feature of financial management is the formulation of the firm’s strategy towards determining the efficient use of funds currently at the disposal of the firm, and selecting the most favorable sources of additional funds that the firm will need in the foreseeable future. Accounting and Finance functions Accounting. It is a system for collecting, summarizing, analyzing and reporting, in monetary terms, financial information about an organization. It provides information to parties inside and outside such as shareholders, bankers, creditors, management, etc. The primary function of finance is the procurement of funds and their optimum utilization. The important assignments of a financial executive are (a) Assessment of capital requirements beforehand, (b) Obtaining funds at the lowest capital cost, and (c) Optimal use of the funds. Functions of Financial Controller (a) Designing and operating the accounting system; (b) Preparing financial statements and reports; (c) Establishing and maintaining systems and procedures; (d) Supervising internal auditing and arranging for external audit; (e) Supervising computer applications; ( f ) Overseeing cost control; (g) Preparing budgets; (h) Making forecasts and analytical reports; (i) Reporting financial information to top management; and ( j) Handling tax matters. Treasurer He is the custodian and manager of all the firm’s cash and near-cash resources. The treasurer handles credit reviews and sets the policy for collecting receivables. He also handles the relationship with banks and other lending/financial institutions. Functions of Financial Management Executive Function The investment in and management of long-term assets through the capital budgeting process. Evaluating, securing and servicing long-term financing from within the firm or from capital market instruments such as common or preferred stock, debt, leases, warrants or convertibles. Management of the marginal (or divisional) cost of capital through attention to the firm’s target capital structure and the various sources of funds available to the firm. Distribution of funds to the firm’s shareholders through a cash dividend policy. Securing, managing, and investing in current assets such as cash, accounts receivable, and inventory. Obtaining short-term financing from creditors or from the money markets. Planning for the ongoing activities of the firm and ensuring that the firm responds to the changing financial and economic environment. Assessing the viability of growth through merging, and ensuring the economic viability of the firm. Functions of Financial Management Routine Functions (low level) Record keeping and reporting. Preparation of various financial statements. Cash planning and its supervision. Credit management. Custody of, and safeguarding, different financial securities, etc. Providing top management with information on current and prospective financial conditions of the business as a basis for policy decisions on purchases, marketing, and pricing. Objectives of Financial Management Profit maximization. It is rational to accept profit as a standard for measuring the success or efficiency of a business enterprise; It is difficult to survive without profit maximization; Maximization of return. Maximization of return provides a basic guideline according to which financial decisions can be evaluated, but returns are mainly based on the profits earned by a firm. Maximization of wealth. According to Prof. Ezra Solomon of Stanford University, “The ultimate goal of financial management should be maximizing the owner’s wealth.” According to him, the maximization of profit is half and an unreal motive. Role and Scope of Financial Management Estimating the requirement of funds. A careful estimate of short-term and long-term requirements of funds must be made. The investments in fixed assets and current assets have to be estimated through the techniques of budgetary control and long-range planning. Capital structure decisions. After an estimate of the requirements of funds, a decision has to be taken regarding various sources from which these funds could be raised. Each source of fund involves different considerations with regard to cost, risk and control. Keeping these factors in view, an optimum financing mix of various sources has to be worked out. Role and Scope of Financial Management Investment decisions. The investment of funds into various fixed and current assets also requires careful scrutiny. Long-term funds should be invested in various projects only after an in-depth study through capital budgeting techniques and uncertainty analysis is made. Asset management policies should be laid down which relate to management of inventories, book debts, cash, trade creditors, etc. Dividend decision. The decision to declare a dividend involves a number of considerations such as trend of earnings, trend of share market prices, requirement of funds for future growth, cash flow situation, restrictions under the Companies Act, tax position of shareholders, etc. The controller has to strike a balance between the current needs of the firm for cash and the needs of the shareholders for adequate returns. Role and Scope of Financial Management Investment decisions. The investment of funds into various fixed and current assets also requires careful scrutiny. Long-term funds should be invested in various projects only after an in-depth study through capital budgeting techniques and uncertainty analysis is made. Asset management policies should be laid down which relate to management of inventories, book debts, cash, trade creditors, etc. Dividend decision. The decision to declare a dividend involves a number of considerations such as trend of earnings, trend of share market prices, requirement of funds for future growth, cash flow situation, restrictions under the Companies Act, tax position of shareholders, etc. The controller has to strike a balance between the current needs of the firm for cash and the needs of the shareholders for adequate returns. Role and Scope of Financial Management Investment decisions. The investment of funds into various fixed and current assets also requires careful scrutiny. Long-term funds should be invested in various projects only after an in-depth study through capital budgeting techniques and uncertainty analysis is made. Asset management policies should be laid down which relate to management of inventories, book debts, cash, trade creditors, etc. Dividend decision. The decision to declare a dividend involves a number of considerations such as trend of earnings, trend of share market prices, requirement of funds for future growth, cash flow situation, restrictions under the Companies Act, tax position of shareholders, etc. The controller has to strike a balance between the current needs of the firm for cash and the needs of the shareholders for adequate returns. Internal Reporting of Financial Statements Internal reporting of financial statements to the management helps in the following areas: Decision on the policy matters. Exercise control. Appraise the performance at various levels of organization. Motivate to achieve better performance. Ensure better coordination. Planning for the future. External Reporting of Financial Statements External reporting of balance sheet and profit and loss account includes: Shareholders. Financial institutions/banks. Taxation authorities. Government and semi-government authorities. Income and Expenditure Statement Income and expenditure statement, popularly known as profit and loss account, shows the summary of income and expenses during a specified period. It includes the following segments: (a) Sale of products/services, (b) Income from other than sales, (c) Manufacturing/factory cost, (d) Office and administrative cost, (e) Selling and distribution cost, ( f ) Finance cost, and (g) Non-operating cost. Balance Sheet The balance sheet is a statement, which reveals its assets and liabilities on a particular date. It is not an account, as a convention the liabilities are recorded on the left side while the assets on the right. Total of both sides of the balance sheet must tally with each other. The liabilities are total funds of the business, which include the owner’s funds (equity) and borrowed funds. These funds are invested in various assets of an enterprise to earn profit. Therefore, total of the assets must tally with the total of funds invested in them. In other words, the liabilities as resources are equal to the total assets on which the resources are deployed. This phenomenon may be expressed in the following equations: (a) Total of liabilities = Total of assets (b) Owner’s fund + Borrowed fund = Total assets (c) Equity + Debt = Total assets. Assets are the valuable resources owned by the business entity and are used as the main criteria to earn profit. Since the assets are acquired at cost, they have monetary value. For inclusion in the balance sheet, assets are divided into four main categories: Current assets: It consists of cash, bank balances, short-term investments, sundry debtors of accounts receivables, bills receivables, inventories or stock of all kinds, prepaid expenses, accrued income, advances recoverable in cash or in kind for value to be received, short-term loans made, deposits kept with various authorities, advance payment of income-tax, current accounts, etc. Fixed assets: It consists of land, building, plant and machinery, furniture and fittings, electric installations, equipment, vehicles, etc. (to be shown at written down value, i.e., at original cost less accumulated depreciation). Miscellaneous assets: It consists of deferred revenue expenditure underwriting commission, preliminary expenses, development expenditures, R&D costs, and accumulated losses (to the extent not adjusted against free reserves). Intangible assets: It consists of goodwill, technical know-how, patent, trademarks, copyrights, etc. Contrary to the assets, liabilities are claims on the business and against all assets by the owners and outside creditors. At the same time, they are the sources of funds. For inclusion in the balance sheet, liabilities are classified into four main categories: Current liabilities: It consists of trade creditors, accounts payable, bills payable, short-term loans from banks and others, short-term fixed deposit, short-term portion of long-term loans, outstanding advances from customers, provisions for taxation, proposed dividend, unpaid dividend, etc. Long-term liabilities: It consists of debentures, long-term loans from banks and financial institutions, deferred payment credits, long- term fixed deposits, loans from other convertible bonds, etc. Reserves: It consists of capital reserves, committed reserves, general reserve, dividend equalization reserve, other free reserves, development rebate reserve, investment allowance reserve and residue surplus, share premium, etc. Share capital: It consists of paid-up portion of share capital— preference and equity share. Every company shall keep, at its registered office, proper books of accounts with respect to (a) all sums of money received and spent by the company and the matters in respect of which the receipt and expenditure take place, (b) the assets and liabilities of the company, and (c) all sales and purchases of company goods. Cash Books All cash and/or cheque transactions are entered in the cash book, viz., receipts and payments. Transactions are recorded in appropriate columns with necessary details. This book is balanced regularly so that the cash or bank account balance can be ascertained. Depending on the magnitude of cash transactions, more than one cash book may be maintained. Receipts and vouchers are the source documents for making entries in the cash book. Sales Book All sales transactions are recorded in sales books. Entries in the sales book are made on the basis of invoices/bills, which are prepared and addressed to customers after the goods are despatched. More than one sales book must be prepared for different groups of products, territories, branches, etc. Purchase Book All transactions of purchase are recorded in the purchase book. Entries in the purchase book are made on the basis of bills/invoices, which are received from suppliers whenever goods are purchased. Debit Note/Credit Note Book For goods purchased and sold, certain adjustments are required to be made, viz., cancellations, reductions for equality rebate/discount, reduction for short quantity despatched, reduction for damaged goods, etc. To incorporate such adjustments in the accounts, either a debit note or credit note is issued against or in favor of the supplier/customer. These debit and credit notes are recorded in the debit/credit note registers. Journal All transactions which cannot be recorded in any other book are entered in the journal. These include, inter alia, rectification entries, transfer entries, closing entries, adjustments, provisions, etc. Ledger Once the transaction is recorded in the appropriate book/register, it has to be posted in the ledger to the appropriate account. Since each and every transaction is recorded with respect to the dual aspect, it is posted to the debit and credit of the appropriate account. Each account in the ledger represents a summarized record of all transactions concerning that particular account. 1. Record the transaction in the appropriate book of primary entry. For this purpose, cash books, sales books, purchase books, debit notes/credit notebook, and journals are regarded as the books of prime entry, where the transaction is first recorded. 2. Post the transaction from the book of prime entry to the appropriate account in the ledger. This is popularly known as ledger posting. 3. Balance each ledger account at definite periodic intervals which cannot be more than one year. 4. Prepare a statement of ledger balance as on a particular day, which is known as trial balance. In this statement, the total of debits and credits must agree with each other, which is the test of arithmetical accuracy. 5. Make necessary adjustments and provisions to ensure that the accounting is done in conformity with the accepted principle, viz., accrual or cash or mixed as the case may be, which is to be followed consistently. 6. Prepare financial statements, viz., income statement for the period ended and balance sheet as on the last day of the period.