Unit 1 Scope of Financial ManagementIn order to achieve the objectives of the financial management, the financial manager of the

e business concern, has to manage various aspects of finance function which lay down the scope of his duty. These aspects are discussed as under: 1.Estimatingthefinancialrequirement. 2.Determiningthestructureofcapitalization. 3. Investment decision 4.Managementofcashflow. 5.Managementofearnings. 6.Choiceofsourcesoffinance. 1. Estimating the financial requirement: on the basis of their forecast of the volume of business operations of the company, the finance executives have to estimate the amount of fixed capital and working capital required in a given period of time 2. Determining the structure of capitalization: after estimating the requirement of capital, the finance executives have to decide about the composition of capital. They have to determine the relative proportion of owners risk, capital and borrowed capital. These decisions have to be taken in the light of cost of raising form different resources, period for which funds are needed and several others factors. 3. Investment decision: the funds raised from different resources are to be intelligently invested in various assets so as to optimize their return of investment. While making investment decision, management should be guided by three important principles-safety, liquidity and profitability. 4. Management of cash flows: - Cash is needed to pay off creditors, for purchase of materials, pay labor and to meet everyday expenses. These should not be shortage of cash at any time as it will damage credit- worthiness of the company. These should not be access cash them required because money has time value. 5. Management

of earnings: - The finance executive has to decide

about the allocation of earnings among several competitive needs. A certain amount of total earnings may be kept as reserve or a portion of earnings may be distributed among and ordinary and preference share holders, yet another portion may be ploughed back or re-invested. The finance executives must consider the merits and de-merits of alternative schemes of utilizing the funds generating from the companies own earnings. 6. Choice of sources of finance: - The management can raise finance from various sources like share holders, banks and others financial distributors finance executives has to evaluate each source over method of finance and choose the best source. Financial management is the new branch of accounting that deals with the acquisition of financial resources & management of them.

Functions/ goals of Financial ManagementFinance functions are carried on to achieve the objective of the firm. There are mainly two approaches to express the "Financial Function". The first approach relates it to the collection of funds. The second approach relates finance functions to the procurements of funds and their effective utilization. The first ignores the uses of funds it was. It was major finance function at the early stage of the development of finance. The second is comprehensive and universally accepted; we are following the Second One.

Investment Decision It refers to acceptance/ rejection of long-term investment proposal. Proposal related to acquisition, modification and replacement of assets are long-term investment proposal. Longterm refers to the time horizon of more than one year. The long term assets like plants, machines, equipments, land, buildings etc 2. Financing Decision Is concerned with the collection of the fund. The financial manager needs to decide about the appropriate amount and sources of the fund. 3. Dividend Decision The net income after paying preference dividend belongs to the equity shareholders. However, there is no legal obligation to pay

dividend to the equity shareholders. The dividend decision is the allocation of net profit after tax and preference dividend to equity shareholders. . 4. Working Capital Decision Working capital decision refers to the commitment of funds to current such as inventory, bills receivable, cash balance, prepaid, etc. this decision is known as current assets management also.. 5. Routine Finance Decision It is also the incidental finance function, which is performed to execute the executive finance effectively. Routine finance function does not require specialized skills of finance. They are of clerical nature. So they are called clerical finance function too. These function cover procedures and system and involve a lot of paper work and time, some of them are below: 1. 2. 3. 4. 5. 6. 7. Supervision for cash receipts and disbursements Safeguarding of cash balances Custody and safeguarding of valuable documents like securities and insurance policies Taking care of mechanical details of financing Record keeping of the financial performance of the firm Reporting to the top management Superviion of fixed assets and current assets. Profit Maximization ObjectiveIn the conventional theory of the firm, the principle objective of a business fir is to maximize profits. Under the assumption of given tastes and technology, price and output of a given product under perfect competition are determined with the sole objective of maximization of profit.

Maximization of profit simply refers to the maximization of rupees income of the firm. Under profit maximization objective, business firm attempt to adopt those investments projects, which yield profits, and drop all other unprofitable activities. In maximizing profit, input-output relationship is crucial, either input is minimized to achieve a given amount of output or the output is maximized with a given amount of input. Thus, this objective of the firm enhances productivity and improves the efficiency of the firm. Wealth Maximization Objective Wealth refers to the market price of stock. Wealth maximization (shareholders wealth maximization) is almost universally accepted goal/ objective of a firm. According to this goal, the manager should take decision that maximizes the shareholders wealth. In other words, it is to make the shareholders as richer as possible. Shareholders wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore only those projects which have positive net present value should be accepted. Wealth maximization: A superior Decision Criterion a. b. c. d. Efficient allocation of resources Separation between ownership and management Residual owners Emphasis on cash flow

e.

Recognizes time value of money

Division of Financial Markets 1. Primary Market: - When securities are issued for the first time, they are traded in the primary market. All proceeds from the issue in this market go to issuing corporation. It is the market for first issue of securities by corporation, in which the corporation raise new capital. However in issuing the securities, the issuing corporation could take the service of investment bankers and securities dealers, which could cover wide geographical area for distribution of securities by forming underwriting syndicat. 2. Secondary Market: - Secondary market is the market for existing securities. It deals with trading of outstanding securities. Once the securities are issued in primary markets, they become a part of secondary market. A secondary market is the market for already existing securities, where trading between investors to investors take place. The original issuer has no role in secondary markets, and the proceeds from securities transaction do not go to them. 3. Money Market: - money market deals with trading of securities with less than one year of life spam, it is the market for borrowing and lending for relatively short period of time, usually less than one year. Government, corporations and individuals requiring short-term loan are major participants of money market. Government issues Treasury bills to meet its need of short-term funds. Corporation could issue commercial papers or take loan on short-term basis from banks to satisfy their short-term needs of funds. Other money market instruments include bankers'

acceptance, certificate of deposits, promissory notes, bills of exchange and any other with less than one year life. 4. Capital Market:-Capital market involves the trading of financial assets having a life spam greater than one year .all long terms securities issued by corporation and government such as common stock, corporate bonds, government bonds are the instruments of capital market. These capital market instruments are also traded in both primary as well as secondary market. Capital market instruments are not as liquid as money market instruments because of longer maturity. However the existence of secondary market adds to the liquidity of these instruments to a greater extent. When there is a change in market interest rates, value of these instruments fluctuate widely tan money market instruments because of longer maturity. Financial Institutions Organizations that issue financial claims against themselves for cash and use the proceeds from this assurance to purchase primarily the financial assets of others. They help in generating the saving from people, business and government which is supplied to the users of funds. They are specialized firms that facilitate the transfer of funds from savers to borrowers. They offer accounts to the savers and in turn the money deposited are used to buy the financial assets issued by other. Commercial Banks Finance Companies Insurance Companies Mutual Funds Pension Funds

1. 2. 3. 4. 5.

6. a. b. c.

Other Financial Institutions Credit Unions Saving and Loan Associations Mutual Saving Banks

Goal of Financial ManagementIf we were to consider possible financial goals, we might come up with some ideas like the following:

Survive. Avoid financial distress and bankruptcy. Beat the competition. Maximize sales or market share. Minimize costs. Maximize profits. Maintain steady earnings growth.

1. Profitability - its ability to earn income and sustain growth in both the shortand long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results of operations; 2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term; 3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations; Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time. 4. Stability - the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators. etc.

THE OBJECTIVE OF THE FIRMProfitMaximizationvs.WealthMaximization Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealth. For one thing, total profits are not as important as earnings per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment project that will produce $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years? An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years. We must take into account the time pattern of returns in our analysis. Managementvs.Stockholders In certain situations the objectives of management may differ from those of the firms stockholders. In a large corporation whose stock is widely held, stockholders exert very little control or influence over the operations of the company. When the control of a company is separate from its ownership, management may not always act in the best interests of the stockholders [Agency Theory]. [Managers] sometimes are said to be "satisficers" rather than "maximizers"; they may be content to "play it safe" and seek an acceptable level of growth, being more concerned with perpetuating their own existence than with maximizing the value of the firm to its shareholders. The most important goal to a management [team]of this sort may be its own survival. As a result, it may be unwilling to take reasonable risks for fear of making a mistake, thereby becoming conspicuous to the outside

suppliers of capital. In turn, these suppliers may pose a threat to managements survival. ANormativeGoal Because the principal of maximization of shareholder wealth provides a rational guide for running a business and for the efficient allocation of resources in society, we use it as our assumed objective in considering how financial decisionsshould be made. The purpose of capital markets is to efficiently allocate savings in an economy from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be channeled to the most promising investment opportunities, a rational economic criteria must exist that governs their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. The market value of a firms stock embodies both of these factors. It therefore reflects the markets tradeoff between risk and return. If decisions are made in keeping with the likely effect upon the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy.

InventoryIn a business accounting context, the word inventory is commonly used in American English to describe the goods and materials that a business holds for the ultimate purpose of resale. In the rest of the English speaking world stock is more commonly used, although the word inventory is recognised as a synonym. In British English, the word inventory is more commonly thought of as a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished.[1] In American English, the word stock is commonly used to describe the capital invested in a business, while in British English, the word share is more widely used in the same context. In both British and American English, stock is the collective noun for one hundred shares as shares were usually traded in stocks on Stock Exchanges. For this reason the word stock is used by both American and British English in the term Stock Exchange.

DefinitionInventory management is primarily about specifying the size and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods. The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods and demand forecasting.

Inventory management-

Inventory management is a science primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials. The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods, and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment. Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.

The reasons for keeping stockThere are four basic reasons for keeping an inventory: 1. Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this lead time. However, in practice, inventory is to be maintained for consumption during 'variations in lead time'. Lead time itself can be addressed by ordering that many days in advance. 2. Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. 3. Economies of scale - Ideal condition of "one unit at a time at a place where a user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory. 4. Appreciation in Value - In some situations, some stock gains the required value when it is kept for some time to allow it reach the desired standard

for consumption, or for production. For example; beer in the brewing industry

PurposeInventory proportionality is the goal of demand-driven inventory management. The primary optimal outcome is to have the same number of days' (or hours', etc.) worth of inventory on hand across all products so that the time of runout of all products would be simultaneous. In such a case, there is no "excess inventory," that is, inventory that would be left over of another product when the first product runs out. Excess inventory is sub-optimal because the money spent to obtain it could have been utilized better elsewhere, i.e. to the product that just ran out. The secondary goal of inventory proportionality is inventory minimization. By integrating accurate demand forecasting with inventory management, rather than to past averages, a much more accurate and optimal outcome. Integrating demand forecasting into inventory management in this way also allows for the prediction of the "can fit" point when inventory storage is limited on a per-product basis.

Role of inventory accountingBy helping the organization to make better decisions, the accountants can help the public sector to change in a very positive way that delivers increased value for the taxpayers investment. It can also help to incentivise progress and to ensure that reforms are sustainable and effective in the long term, by ensuring that success is appropriately recognized in both the formal and informal reward systems of the organization. To say that they have a key role to play is an understatement. Finance is connected to most, if not all, of the key business processes within the organization. It should be steering the stewardship and accountability systems that ensure that the organization is conducting its business in an appropriate, ethical manner. It is critical that these foundations are firmly laid. So often they are the litmus test by which public confidence in the institution is either won or lost. Finance should also be providing the information, analysis and advice to enable the organizations service managers to operate effectively. This goes beyond the traditional preoccupation with budgets how much have we spent so far, how much do we have left to spend? It is about helping the organization to better understand its own performance. That means making the connections and understanding the relationships between given inputs the resources brought to

bear and the outputs and outcomes that they achieve. It is also about understanding and actively managing risks within the organization and its activities.

Cash managementCash management refers to a broad area of finance involving the collection, handling, and usage of cash. It involves assessing market liquidity, cash flow, and investments.[1][2] In banking in the United States, cash management, or treasury management, is a marketing term for certain services related to cash flow offered primarily to larger business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it is more often used to describe specific services such as cash concentration, zero balance accounting, andautomated clearing house facilities. Sometimes, private banking customers are given cash management services. Financial instruments involved in cash management include money market funds, treasury bills, and certificates of deposit.[ Cash management is a broad term that covers a number of functions that help individuals and businesses process receipts and payments in an organized and efficient manner. Administering cash assets today often makes use of a number of automated support services offered by banks and other financial institutions. Services range from simple checkbookbalancing to investing and using software that allows easy, automated cash collection. Propermanagement of company funds requires those in the finance department to be extremely literate regarding the different strategies and tools available. Technology is drastically changing how businesses manage their funds, streamlining processes.

DefinitionCash management is a set of strategies or techniques a company uses to collect, track and invest money. Although cash by definition refers only to paper or coin money, in cashmanagement, companies usually also work with cash equivalents such as checks. This is becoming increasingly common as the money system becomes more abstract, using electronic methods.

Purpose-

In general, small businesses do not always have the ability to obtain the credit they might need. They have to rely more on their own money to meet expenses. Even in a large business, costs might come up that are not expected. Being unable to handle these situations puts a company at risk for loss of revenue or, in the worst case scenario, going out of business.

Accounts receivableAccounts receivable is money owed to a business by its clients (customers or debtors) and shown on its balance sheet as an asset. [1] It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. These may be distinguished from notes receivable, which are debts created through formal legal instruments called promissory notes. Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms. The accounts receivable departments use the sales ledger, because a sales ledger normally records:[3] The sales a business has made. The amount of money received for goods or services. - The amount of money owed at the end of each month varies (debtors). The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the accounts receivable department. While the collections department seeks the debtor, the cashiering team applies the monies received.

Payment termsAn example of a common payment term is Net 30 days, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date; businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60 and 30 days end of month. The creditor may be able to charge late fees or interest if the amount is not paid by the due date. Booking a receivable is accomplished by a simple accounting transaction; however, the process of maintaining and collecting payments on the accounts receivable subsidiary account balances can be a full-time proposition. Depending

on the industry in practice, accounts receivable payments can be received up to 10 15 days after the due date has been reached. These types of payment practices are sometimes developed by industry standards, corporate policy, or because of the financial condition of the client. Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts[4] which appears on the balance sheet as a contra account that offsets total accounts receivable. When accounts receivable are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action. Outstanding advances are part of accounts receivable if a company gets an order from its customers with payment terms agreed upon in advance. Since billing is done to claim the advances several times, this area of collectible is not reflected in accounts receivables. Ideally, since advance payment occurs within a mutually agreed-upon term, it is the responsibility of the accounts department to periodically take out the statement showing advance collectible and should be provided to sales & marketing for collection of advances. The payment of accounts receivable can be protected either by a letter of credit or byTrade Credit Insurance

BookkeepingOn a company's balance sheet, accounts receivable is the money owed to that company by entities outside of the company. The receivables owed by the company's customers are called trade receivables. Account receivables are classified as current assets assuming that they are due within one calendar year or fiscal year. To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. The ending balance on the trial balance sheet for accounts receivable is usually a debit. Business organizations which have become too large to perform such tasks by hand (or small ones that could but prefer not to do them by hand) will generally use accounting software on a computer to perform this task. Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account.

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts , or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision); or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement. The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger. The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad (for example, if the debtor has gone intoliquidation.)

Capital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage.[citation needed] In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc. The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.

Capital structure in a perfect market-

Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions are not affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt. Trade-off theoryTrade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry. Pecking order theoryPecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984)[1] when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of

this over-valuation. As a result, investors will place a lower value to the new equity issuance. Agency CostsThere are three types of agency costs which can help explain the relevance of capital structure.

Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem (or Debt overhang problem) : If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

short term sources of funds?There are a variety of short term sources of funds available to a company, which require varying levels of collateral, personal guarantees, and interest rate expense. Here is a listing of potential sources of short term funds: Accounts payable delays. You can delay paying suppliers, but they may eventually retaliate with higher prices or a lower order priority. This is essentially an interest-free loan, but can only be used with care. Accounts receivable collections. You can add staff and use a variety of procedures to accelerate the payment of accounts receivable by customers. Commercial paper. Quite inexpensive, but only available to large firms with a high rating from a credit rating agency. Credit cards. Very expensive interest rates, and funds are generally only available in modest amounts. Customer advances. It may be possible to successfully alter customer payment terms to require customers to pay all or a portion of their ordered amounts in advance. However, this approach can also send customers toward competitors who offer looser credit terms. Early payment discounts . You can offer an early payment discount to customers, though the interest rate tends to be quite high.

Factoring. Funding based on accounts receivable. Decidedly expensive, but it can dramatically accelerate cash flows. Field warehouse financing. Funding based on inventory levels. Requires detailed inventory tracking, and is more expensive than the prime borrowing rate. Floor planning. Funding based on inventory held by a retailer. Requires detailed inventory tracking, and is more expensive than the prime borrowing rate. Inventory reduction. One of the best forms of short term financing is to tie up fewer funds in inventory, which requires considerable attention to the management of inventory. Lease. Specific funding that is tied to an asset, which is the collateral for the lease. Term can cover multiple years, and the interest rate can vary from near the prime rate to excessively high. Line of credit. Short term general funding that may require assets for collateral. Cost can be near the prime rate, but is closely monitored by the lender. Receivables securitization. Inexpensive, but only available to large firms with a broad base of quality receivables. Sale and lease back. Can result in immediate large cash receipt in exchange for a long-term lease commitment.

Of the short term sources of funds noted above, the best are generated internally through the close management of accounts receivable and inventory. Keeping these assets at a minimal level reduces your need for working capital, and hence your need for funds.

Sources of Short-term FinanceThere are a number of sources of short-term finance which are listed below: 1. Trade credit 2. Bank credit Loans and advances Cash credit Overdraft Discounting of bills 3. Customers advances 4. Instalment credit 5. Loans from co-operatives 1. Trade Credit Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually

business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance. 2. Bank Credit Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in instalments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. (i) Loans When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. (ii) Cash Credit It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. (iii) Overdraft When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit. (iv) Discounting of Bill Banks also advance money by discounting bills of exchange, promissory notes and hundies. When these documents are presented

before the bank for discounting, banks credit the amount to cutomers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. This part has been discussed in detail later on in this chapter. 3. Customers Advances Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers advances. 4. Instalment credit Instalment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of instalments. The supplier charges interest for extending credit. The amount of interest is included while deciding on the amount of instalment. Another comparable system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last instalment. Sometimes commercial banks also grant instalment credit if they have suitable arrangements with the suppliers. 5. Loans from Co-operative Banks Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks.

Purpose of Short-term FinanceAfter establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges

have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closureof business.

Short-term finance serves following purposes1. It facilitates the smooth running of business operations by meeting day to day financial requirements. 2. It enables firms to hold stock of raw materials and finished product. 3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business. 4. Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice. 5. Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realisation of sales.

Merits of short-term finance

a) Economical : Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance. b) Flexibility : Loans to meet short-term financial need can be raised as and when required. These can be paid back if not required. This provides flexibility. c) No interference in management : The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retain their freedom in decision making. d) May also serve long-term purposes : Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended upto 3 years with annual review.

After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes.

Demerits of short-term finance

Short-term finance suffers from a few demerits which are listed below: a) Fixed Burden : Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organisation. That is why business firms use short-term finance only for temporary purposes. b) Charge on assets : Generally short-term finance is raised on the basis of security of moveable assets. In such a case the borrowing concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid). c) Difficulty of raising finance : When business firms suffer intermittent losses of huge amount or market demand is declining or industry is in recession, it loses its creditworthiness. In such circumstances they find it difficult to borrow from banks or other sources of short-term finance. d) Uncertainty : In cases of crisis business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance. e) Legal formalities : Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be
deposited as security, then transfer deed must be prepared. Such formalities take lot of time and create lot of complications.

Long Term Sources of FinanceLong term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance. Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

Shares

A share is a part ownership of a company. Shares relate to companies set up as private limited companies or public limited companies (plcs). There are many small firms who decide to set themselves up as private limited companies; there are advantages and disadvantages of doing so. It is possible, therefore, that a small business might start up and have just two shareholders in the business. If the business wants to expand, they can issue more shares but there are limitations on who they can sell shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different. They sell shares to the general public. This means that anyone could buy the shares in the business.
Venture Capital

Venture capital is becoming an increasingly important source of finance for growing companies. Venture capitalists are groups of (generally very wealthy) individuals or companies specifically set up to invest in developing companies. Venture capitalists are on the look out for companies with potential. They are prepared to offer capital (money) to help the business grow. In return the venture capitalist gets some say in the running of the company as well as a share in the profits made. Venture capitalists are often prepared to take on projects that might be seen as high risk which some banks might not want to get involved in. The advantages of this might be outweighed by the possibility of the business losing some of its independence in decision making. Examples of venture capitalists (who are also called private equity firms) are Advantage Capital Limited, Braveheart Ventures, Permira and Hermes Private Equity.

Government Grant

Some firms might be eligible to get funds from the government. This could be the local authority, the national government or the European Union. These grants are often linked to incentives to firms to set up in areas that are in need of economic development. In Cornwall, for example, there have been a number of initiatives to encourage new businesses to locate there.

Cornwall has the lowest gross domestic product (GDP) per head of the population in the UK. The average wage in Cornwall is 28% below the UK average. As a result, the area attracts funding from the EU and the government. Firms looking to set up in Cornwall might be able to apply for some help in starting or moving a business to the area. One of the disadvantages of this type of funding is that it involves large amounts of paperwork and administration. This can add to costs and in some cases might not make the project worthwhile.
Bank Loans

As with short term finance, banks are an important source of longer term finance. Banks may lend sums over long periods of time - possibly up to 25 years or even more in some cases. The loans have a rate of interest attached to them. This can vary according to the way in which the Bank of England sets interest rates. For businesses, using bank loans might be relatively easy but the cost of servicing the loan (paying the money and interest back) can be high. If interest rates rise then it can add to a businesses costs and this has to be taken into account in the planning stage before the loan is taken out.
Mortgage
A mortgage is a loan specifically for the purchase of property. Some businesses might buy property through

a mortgage. In many cases, mortgages are used as a security for a loan. This tends to occur with smaller businesses. A sole trader, for example, running a florists shop might want to move to larger premises. They find a new shop with a price of 200,000. To raise this sort of money, the bank will want some sort of security - a guarantee that if the borrower cannot pay the money back the bank will be able to get their money back somehow. The borrower can use their own property as security for the loan - it is often called taking out a second mortgage. If the business does not work out and the borrower could not pay the bank the loan then the bank has the right to take the home of the borrower and sell it to recover their money. Using a mortgage in this way is a very popular way of raising finance for small businesses but as you can see carries with it a big risk.
Owner's Capital

Some people are in a fortunate position of having some money which they can use to help set up their business. The money may be the result of savings, money left to them by a relative in a will or money received as the result of a redundancy payment. This has the advantage that it does not carry with it any interest. It might not, however, be a large enough sum to finance the business fully but will be one of the contributions to the overall finance of the business.

Retained Profit This is a source of finance that would only be available to a business that was already in existence. Profits from a business can be used by the owners for their own personal use (shareholders in plcs receive a share of the company profits in the form of a dividend - usually expressed as Xp per share) or can be used to put back into the business. This is often called 'ploughing back the profits'. The owners of a business will have to decide what the best option for their particular business is. In the early stages of business growth, it may be necessary to put back a lot of the profits into the business. This finance can be used to buy new equipment and machinery as well as more stock or raw materials and hopefully make the business more efficient and profitable in the future.
Selling Assets

As firms grow they build up assets. These assets could be in the form of property, machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business to sell off some of these assets to finance other projects.
Lottery Funding

In the UK the National Lottery might be a possible source of funds for some types of business. These businesses will mostly be charities or charitable trusts. The Eden Project, referred to earlier, received some funding from the Lottery. The company that run the Eden Project are a not for profit business so any surplus they make is put back into the business to help develop and improve it.

Modified internal rate of returnThe Modified Internal Rate of Return (MIRR) is a financial measure of an investment's attractiveness.[1][2] It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

Problems with the IRR

While there are several problems with the IRR, MIRR resolves two of them. Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them. [3] This is usually an

unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study. Generally for comparing projects more fairly, the weighted average cost of capital should be used for reinvesting the interim cash flows. Secondly, more than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion and ambiguity. MIRR finds only one value.

Limitations of payback method(1) It completely ignores the annual cash inflows after the pay-back period. (2) The method considers only the period of a pay back. It does not consider the pattern of cash inflows, i.e., the magnitude and timing of cash inflows. For example, if two projects involve equal cash outlay and yield equal cash inflows over equal time periods, it means both proposals are equally good. But the proposal with larger cash inflows in earlier years shall be preferred over the proposal which generated larger cash inflows in later years. (3) It overlooks the cost of capital; i.e., interest factor which is a important consideration in making sound investment decisions. (4) The methods is delicate and rigid. A slight change in operation cost will affect the cash inflows and as such pay-back period shall also be affected. (5) It over-emphasizes the importance of liquidity as a goal of capital expenditure decisions. The profitability of t project is completely ignored. Undermining the importune of profitability can in no way be justified.

Credit policy consideration

There are several considerations to bear in mind when developing your payment and credit policy and well cover these on the following pages. They include: Types of payments - The types of payments you accept and when

Credit limits - How much credit you're prepared to extend, to whom, for how long and how it helps your business Early payment scheme - Whether you offer an early payment scheme Legal requirements - Checking requirements into your credit policy that you incorporate statutory

Clients credit worthiness - How to reduce the risk of bad debts by assessing a client's credit worthiness.

Difference Between Operating Leverage And Financial Leverage -

Following are the main differences between operating leverage and financial leverage: 1.Relation Operating leverage shows the relationship between sales and operating profit. Financial leverage show the relationship between operating profit and earning per share. 2.Cause Operating leverage arises due to the use of fixed operating cost. Financial leverage arises due to the use of debt or cost of financing.

3.Measurement Of Risk Operating leverage measures the business risk. Financial leverage measures the financial risk.

CAPITAL BUDGETINGCapital budgeting:

The process of planning significant investments in projects that have long lives and affect more than one future period, such as the purchase of new equipment.

Cash Flows:
Actual cash inflows received and actual cash outflows made for out-ofpocket costs such as salaries, advertising, repairs and similar costs. Net cash flows are cash inflows less cash outflows. Net cash flows are not the same as operating income: o Cash flow depreciation expense = operating income o Operating income + depreciation expense = cash flow.

Time Value of Money or Present Value: A dollar received today is worth more than a dollar received sometime in the future. Since the dollar cannot be invested until it is received, the sooner it is received, the sooner it can be invested and earning a return and the more it will be worth at any time in the future. Compound interest and present value are mirror images of each other: o Compound interest assumes that the current investment (present value) and interest rate are known and the future value is to be calculated. The future value is calculated as follows: FV = PV (1+i)n where i is the interest rate and n is the number of periods. o Present value assumes that the future value(s) and discount rate are known and the present value is to be calculated. The present value is calculated as follows: PV = FV / (1+i) n where i is the interest rate and n is the number of periods.

o In other words, multiply to solve for future value because future value will be larger and divide to solve for present value because present value will be smaller.

Discounted Cash FlowAlways considers the time value of money which makes this model superior to other methods of evaluating capital projects. Two separate approaches to capital investment analysis: Net Present Value method and Internal rate of Return method. Net Present Value method computes the difference between the present value of an investment projects future net cash flows and net initial cash outflows using a known discount rate. Internal Rate of Return solves for the discount rate which makes the net present value of an investment projects future net cash flows equal to net initial cash outflows, i.e., the internal rate of return sets the net present value = 0. The discounted cash flow model always uses cash flows, not operating income. Choosing an appropriate discount rate is crucial and may significantly impact the final decision. Typically, the discount rate is based on the cost of capital, the average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds.

Net Present Value MethodNet Present Value method computes the difference between the present value of an investment projects future net cash flows and net initial cash outflows using a known discount rate. The net present value method always uses cash flows, not operating income. When project require investments of significantly different amounts, the project profitability index is computed and used to compare various investment alternatives.

Project profitability index is the ratio of the net present value of a projects cash flows to the investment required.

Payback MethodIgnores the time value of money. Calculates the time period to recover the initial net investment through future cash flows. The method for determining the payback period differs whether the future cash flows are even (the same each period) or uneven (differ in one or more future periods.)