1.

Scope of Financial Management & Financial Manager

Financial management is broadly concerned with the acquisition and use of funds by a business firm. In other words, FM is planning, directing, monitoring, organizing, and controlling of the monetary resources of an organization. FM scope may be defined in terms of the following questions: 1. How large should the firm be and how fast should it grow? 2. What should be the composition of the firms assets? 3. What should be the mix of the firms financing? 4. How should the firm analyze, plan, and control its financial affairs? In order to achieve the objectives of the financial management, the financial manager of the 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. Estimating the financial requirement. 2. Determining the structure of capitalization. 3. Selecting a source of finance. 4. Selecting a pattern of investment. 5. Implementing financial control. a. Management of cash flow. b. Management of earnings. 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. In the middle and long term funds are required to make additions to the productive capacity of the business 2. Determining the structure of capitalization: after estimating the requirement of capital, it has to be decided about the composition of capital. They have to determine the relative proportion of owners risk i.e. capital and borrowed capital. These decisions have to be taken in the light of cost of raising from different resources, period for which funds are needed and several others factors. 3. 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. 4. 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. 5. Implementing Financial Control: Financial control helps the business to ensure that it is meeting its goals. Through financial control the firm decides how much to invest in short term assets and how to raise the required funds. (a). 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. There should not be excess cash than required because money has time value. (b). 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 ordinary and preference share holders, and yet another portion may be ploughed back or reinvested. The finance executives must consider the merits and de-merits of alternative schemes of utilizing the funds generating from the companies own earnings.

2. Financial Statement Analysis

Financial statement information is used by both external and internal users, including investors, creditors, managers, and executives. These users must analyze the information in order to make business decisions. So understanding financial statements is of great importance. The process of determining financial strengths and weaknesses of a firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data, between component parts of a financial statement to obtain a better understanding of a firms position and performance. Purpose: To diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm. 1. Profitability - its ability to earn income and sustain growth in both the short- and 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 the income statement and the balance sheet, as well as other financial and non-financial indicators. etc. The Balance Sheet In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year. A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities. Another way to look at the same equation is that assets equal liabilities plus owner's equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner's money (owner's equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections "balancing." A balance sheet summarizes an organization or individual's assets, equity and liabilities at a specific point in time. We have two forms of balance sheet. They are the report form and the account form. Individuals and small businesses tend to have simple balance sheets. Larger businesses tend to have more complex balance sheets, and these are presented in the organization's annual report. Large businesses also may prepare balance sheets for segments of their businesses. A balance sheet is often presented alongside one for a different point in time (typically the previous year) for comparison. Income Statement or Trading and Profit & Loss Account: Income statement also referred to as profit and loss statement (P&L), statement of financial performance or statement of operations is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net

income (the result after all revenues and expenses have been accounted for, also known as Net Profit). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time. The income statement can be prepared in one of two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement (as the name implies) takes several steps to find the Net Profit, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured. COMMON SIZE STATEMENT:

3. Ratio Analysis
Profitability Ratios These ratios tell us whether a business is making profits - and if so whether at an acceptable rate. The key ratios are:
Ratio Gross Profit Margin Calculation [Gross Profit / Revenue] x 100 (expressed as a percentage Comments This ratio tells us something about the business's ability consistently to control its production costs or to manage the margins its makes on products its buys and sells. Whilst sales value and volumes may move up and down significantly, the gross profit margin is usually quite stable (in percentage terms). However, a small increase (or decrease) in profit margin, however caused can produce a substantial change in overall profits. Assuming a constant gross profit margin, the operating profit margin tells us something about a company's ability to control its other operating costs or overheads.

Operating Profit Margin

[Operating Profit / Revenue] x 100 (expressed as a percentage) Net profit before tax, interest and dividends ("EBIT") / total assets (or total assets less current liabilities

Return on capital employed ("ROCE")

ROCE is sometimes referred to as the "primary ratio"; it tells us what returns management has made on the resources made available to them before making any distribution of those returns.

Efficiency ratios (Turnover Ratios) These ratios give us an insight into how efficiently the business is employing those resources invested in fixed assets and working capital.
Ratio Sales /Capital Employed Calculation Sales / Capital employed Comments A measure of total asset utilisation. Helps to answer the question - what sales are being generated by each pound's worth of assets invested in the business. Note, when combined with the return on sales (see above) it generates the primary ratio - ROCE.

Sales or Profit / Fixed Assets

Sales or profit / Fixed Assets

This ratio is about fixed asset capacity. A reducing sales or profit being generated from each pound invested in fixed assets may indicate overcapacity or poorer-performing equipment.

Stock Turnover

Cost of Sales / Average Stock Value

Stock turnover helps answer questions such as "have we got too much money tied up in inventory"?. An increasing stock turnover figure or one which is much larger than the "average" for an industry, may indicate poor stock management. The "debtor days" ratio indicates whether debtors are being allowed excessive credit. A high figure (more than the industry average) may suggest general problems with debt collection or the financial position of major customers. A similar calculation to that for debtors, giving an insight into whether a business is taking full advantage of trade credit available to it.

Credit Given / "Debtor Days"

(Trade debtors (average, if possible) / (Sales)) x 365 ((Trade creditors + accruals) / (cost of sales + other purchases)) x 365

Credit taken / "Creditor Days"

Liquidity Ratios Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:
Ratio Current Ratio Calculation Current Assets / Current Liabilities Comments A simple measure that estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time. Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors. The Quick Ratio therefore adjusts the Current Ratio to eliminate all assets that are not already in cash (or "near-cash") form. Once again, a ratio of less than one would start to send out danger signals.

Quick Ratio (or "Acid Test"

Cash and near cash (short-term investments + trade debtors)

Stability Ratios These ratios concentrate on the long-term health of a business - particularly the effect of the capital/finance structure on the business:
Ratio Gearing Calculation Borrowing (all long-term debts + normal overdraft) / Net Assets (or Shareholders' Funds) Comments Gearing (otherwise known as "leverage") measures the proportion of assets invested in a business that are financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows. This measures the ability of the business to "service" its debt. Are profits sufficient to be able to pay interest and other finance costs?

Interest coverage ratio

Operating profit before interest / Interest

Investor Ratios There are several ratios commonly used by investors to assess the performance of a business as an investment:
Ratio Earnings per share ("EPS") Calculation Earnings (profits) attributable to ordinary shareholders / Weighted average ordinary shares in issue during the year Market price of share / Earnings per Share Comments A requirement of the London Stock Exchange - an important ratio. EPS measures the overall profit generated for each share in existence over a particular period.

Price-Earnings Ratio ("P/E Ratio") Dividend Yield

At any time, the P/E ratio is an indication of how highly the market "rates" or "values" a business. A P/E ratio is best viewed in the context of a sector or market average to get a feel for relative value and stock market pricing. This is known as the "payout ratio". It provides a guide as to the ability of a business to maintain a dividend payment. It also measures the proportion of earnings that are being retained by the business rather than distributed as dividends.

(Latest dividend per ordinary share / current market price of share) x 100

4. Funds Flow Statement

The net of all cash inflows and outflows in and out of various financial assets. Fund flow is usually measured on a monthly or quarterly basis. The performance of an asset or fund is not taken into account, only share redemptions (outflows) and share purchases (inflows). A funds flow statement is a consolidated statement of all the cross transactions over the period for which the flow is being analysed. Cross Transactions i.e. transactions involving a current account and a non-current account bring about a change in the fund or working capital. Some bring about an increase in fund and others bring about a decrease in the available fund (working capital).

Statement of changes in working capital

The statement of changes in working capital (fund) is prepared by taking the current account balances from the balance sheet. It is prepared for the period for which funds flow is being analysed which generally is the accounting period. It provides us the information relating to change in the values of the various current account balances by comparing the balance as on the first day (opening balance) with the balance on the last day (closing balance) of that period. The aggregate value of the changes in the current accounts would give us the net change in working capital (fund) over the period. The cross transactions presented in the funds flow statement are classified/grouped into two as, Sources/Inflows of funds: Transactions which bring about an increase in the available fund (working capital) Applications/Outflows of funds: Transactions which bring about a decrease in the available fund (working capital)

Net inflows create excess cash for managers to invest, which theoretically creates demand for securities such as stocks and bonds.
Balance Sheet of M/s ___ As on 31st December Liabilities 2004 2005 Assets 2004 2005

Share Capital Profit and Loss

10,000 15,000 8,000 6,000 12,000 3,000

Cash Debtors Stock Land

5,000

8,000

Appropriation account 5,000 Long Term Loan Sundry Creditors Bills Payable *Current, *Non-Current 4,000 8,000 5,000

10,000 15,000 10,000 12,000 5,000 4,000 4,000

Machinery 3,000

32,000 44,000

32,000 44,000

Schedule/Statement of Changes in Working Capital for the period from __ to __ Particulars/Account

Balance as on 31st December

Working Capital Change Increase Decrease

2004

2005

a) CURRENT ASSETS 1) Cash 2) Sundry Debtors 3) Stock TOTAL b) CURRENT LIABILITIES 1) Sundry Creditors 2) Bills Payable TOTAL Working Capital [(a) - (b)] TOTAL Net Change in Working Capital

5,000 10,000 10,000 25,000 8,000 5,000 13,000 12,000

8,000 15,000 12,000 35,000 12,000 3,000 15,000 20,000 4,000 4,000

3,000 5,000 2,000 10,000

2,000 4,000 2,000 12,000 8,000

Funds Flow Statement for the period from __ to __ Particulars a) Sources (Inflow) of Funds 1) Share Capital 2) Funds from Operations [P/L appropriation account] b) Applications (Outflow) of Funds 1) General Reserve 2) Machinery Change in Working Capital [a - b] Amount Amount

5,000 3,000

8,000

2,000 2,000

4,000 + 4,000

Exercise: Options: (a). Inflow of funds;

(b). Outflow of funds; (c). No effect on funds.

To which of the above options does each of the following belong: (i). Depreciation on machinery. [ ] (ii). Payment of outstanding Dividend. [ ] (iii). Provision for General Reserve. [ ] (iv). Loan taken from Partner. [ ] (v). Accrued expenses. [ ]

4. Cash Flow Statement

In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. Accounting Standard 4 (AS 4) is the International Accounting Standard that deals with cash flow statements. People and groups interested in cash flow statements include: Purpose The cash flow statement was previously known as the flow of Cash statement. The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are usually reported in footnotes. The cash flow statement is intended to provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances provide additional information for evaluating changes in assets, liabilities and equity improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods indicate the amount, timing and probability of future cash flows Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses Potential lenders or creditors, who want a clear picture of a company's ability to repay Potential investors, who need to judge whether the company is financially sound Potential employees or contractors, who need to know whether the company will be able to afford compensation Shareholders of the business.

The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets. Cash - comprises of cash on hand and demand deposits with banks. Cash equivalents - short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of canges in value. Cash flows - the inflows and outflows of cash and cash equivalents.

Operating activities - the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. Investing activities - the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Financing activities - activities that result in changes in the size and composition of the owners' capital (including preference share capital) and borrwoings of the enterprise.
CASH FLOW STATEMENT FOR THE YEAR
Rs. (' 000) A. CASH FLOW FROM OPERATING ACTIVITIES: Profit before tax and extraordinary items Depreciation
# Operating Profit before Working Capital changes:

80608 23036
103644

Adjustments: Decrease in Trade & Other receivables Decrease in Inventories Increase in Trade Payable Increase in Current Assets (R.B.I. Bonds)
# Cash generated from Operations:

103979 1548 6628 -214140

1659

Interest paid Direct Taxes

# Cash flow before extra ordinary activities:

-44272 -22000
-64613

Extraordinary items
# Net cash from operating activities:

87693
23080 *

B. CASH FLOW FROM INVESTING ACTIVITIES: Purchase of Fixed Assets Sale of Fixed Assets Purchase of Investments
# Net cash used in investing activities:

-58972 10557 -1454

-49869 *

C. CASH FLOW FROM FINANCING ACTIVITIES: Proceeds from issue of Share Capital Proceeds from long term borrowings Repayment of Finance lease liabilities Dividend
# Net cash used in financing activities:

242 71961 -3036 -11727

57440 *

Cash and cash equivalent as Opening balance A # Net cash from operating activities: B # Net cash used in investing activities: C # Net cash used in financing activities: Cash and cash equivalent as Closing balance

50727 23080 -49869 57440 81378

Statement of Cash Flow - Simple Example for the period 01/01/2009 to 31/01/2009 Opening Balance of Cash/Bank Cash flow from operations Cash flow from investing Cash flow from financing Closing Balance of Cash/Bank Rs.50,000 Rs.4,00,000 (Rs.1,00,000) (Rs.2,00,000) Rs.1,50,000

Parentheses indicate negative values

Exercise: Options:

(a). Cash from Operating Activity;

(b). Cash from Investing Activity; (c). Cash from Financing Activity;

To which of the above options does each of the following belong: (i). Receipt of interest on Govt. Securities. [ ] (ii). Payment of hire-purchase installment on machine. [ ] (iii). Payment of outstanding tax. [ ] (iv). Net Profit before depreciation [ ] (v). Receipt from debtors. [ ] (vi). Redemption of debentures [ ] (vii). Issue of share capital [ ] (viii). Interest paid on Debentures [ ] (ix). Purchase of Equipment [ ] (x). Repairs to Machinery [ ]

5). Capital budgeting & Investment appraisal techniques

or investment appraisal is the planning process used to determine whether an organization's long term investments such as new or improved machinery, replacement of machinery, new plants, new products, research development projects and expansions are worth pursuing. It is budget for major capital, or investment, expenditures. Need for Capital Investment: 1. Replacement: maintenance of business. One category consists of expenditures to replace worn-out or damaged equipment used in the production of profitable products. Replacement projects are necessary if the firm is to continue in business. The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? The answers are usually yes, so maintenance decisions are normally made without going through an elaborate decision process. 2. Replacement for cost reduction. This category includes expenditures to replace serviceable but obsolete equipment. The purpose here is to lower the costs of labor, materials, and other inputs such as electricity. These decisions are discretionary, and a fairly detailed analysis is generally required. 3. Expansion of existing products or markets. Expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets now being served, are included here. These decisions are more complex because they require an explicit forecast of growth in demand. Mistakes are more likely, so a more detailed analysis is required. Also, the go/no-go decision is generally made at a higher level within the firm. 4. Expansion into new products or markets. These are investments to produce a new product or to expand into a geographic area not currently being served. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums of money with delayed paybacks. Invariably, a detailed analysis or research is required, and the final decision is generally made at the very top, by the board of directors as a part of the firms strategic plan. 5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this category. These expenditures are called mandatory investments, and they often involve non-revenue-producing projects. How they are handled depends on their size, with small ones being treated much like the Category 1 projects described above. 6. Other. This catch-all includes office buildings, parking lots, executive aircraft, and so on. How they are handled varies among companies. Need for Capital Budgeting: As large sum of money is involved it influences the profitability of the firm, this makes capital budgeting an important task. Long term investment once made cannot be reversed without significant loss to invested capital. The investment becomes sunk and mistaken, rather than being readily rectified, must often be borne until the firm can be withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the years to come. Investment decision are the base on which the profit will be earned and probably measured through the return on the capital. A proper mix of capital investment is quite important to ensure adequate rate of return on investment, calling for the need of capital budgeting. The implication of long term investment decisions are more extensive than those of short run decisions because of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decision.

Many formal methods are used in capital budgeting, including the techniques such as Payback period Accounting rate of return

Discounted Cash Flow: - Net present value - Internal rate of return

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period. PAYBACK PERIOD Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case the cash flow per period are even, the formula to calculate payback period is: Initial Investment Payback Period = Cash Inflow per Period When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: B Payback Period = A + C In the above formula, A = Last period with a negative cumulative cash flow; B = Absolute value of cumulative cash flow at the end of the period A; C = Actual Cash Flow during the period after A Advantages of payback period are: 1. 2. Payback period is quite simple to calculate. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

3.

Disadvantages of payback period are: 1. Payback period does not take into account the time value of money which is a serious drawback since it could lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method.

It does not take into account, the cash flows that occur after the payback period is reached. ACCOUNTING RATE OF RETURN Accounting rate of return: also known as the Average rate of return or ARR is a financial ratio used in capital budgeting. The accounting rate of return is used in capital budgeting to estimate whether you should proceed with an investment. In this the method the accounting profit for the project is estimated and expressed as a percentage of the initial investment. Normally if the proposal gives a yield above a predetermined required rate of return, then it is chosen. Example: A certain labour saving devise is purchased say at Rs.10000 and it is assumed to reduce the expenses related to labour and raw material to the tune of Rs.3000 per annum. If the devise has an expected life of five years and if it's scrap value at the end of the fifth year is Rs.3000; then depreciation on straight line method would be Rs.1400 p.a.,

Calculation of depreciation: Asset Value for calculation of Depreciation= Cost of the devise-Residual Value = Rs.10000-3000= Rs.7000; Depreciation = Asset value for calculation of Depreciation / Useful life of asset =Rs.7000 /5years=Rs.1400 Hence the net saving after depreciation (i.e. Accounting Profit) would be Rs.1600 per annum. Therefore the Accounting Rate of Return is 16% p.a. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. In case of mutually exclusive proposals, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

Where

Advantages 1. 2. Like payback period, this method of investment appraisal is easy to calculate. It recognizes the profitability factor of investment.

Disadvantages 1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher. It can be calculated in different ways. Thus there is problem of consistency. It uses accounting income rather than cash flow information. Thus it is not suitable for projects which having high maintenance costs because their viability also depends upon timely cash inflows.

2. 3.

DISCOUNTED CASH FLOW (DCF) METHODS: As the flaws in the payback were recognized, people began to search for ways to improve the effectiveness of project evaluations. It is a method of assessing and comparing alternative capital projects. Comparison is made of the present value of the flows of cash that can be expected from each capital project during the course of it's existence. There are two popular methods using this technique - Net Present Value method (NPV); Internal Rate of Return method (IRR). a). NET PRESENT VALUE (NPV) To implement this approach, we proceed as follows: 1. Find the present value of each cash flow, including both infl ows and outflows, discounted at the projects cost of capital. 2. Sum these discounted cash flows; this sum is defined as the projects NPV. 3. If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. The equation for the NPV is as follows: Here CFt is the expected net cash flow at Period t, k is the projects cost of capital, and n is its life. Cash o utflows (expenditures such as the cost of buying equipment or building factories) are treated as negative cash flows.

b). INTERNAL RATE OF RETURN (IRR) The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)." You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

6. Working Capital Management

A very important part of the business finance. Also called as Circulating Capital. The source of this is Long-term Liabilities. This is used in the day-to-day running of the business. Without this the business would, in no time come to a halt. Working Capital = Current Assets - Current Liabilities. CURRENT ASSETS: These are the assets that fluctuate throughout. These assets can be converted into cash at short notice, I.e. within a year. These in relation to Current Liabilities show the financial liquidity of a business. Examples: Cash in hand, Cash at bank, Sundry Debtors, Bills Receivable, Outstanding or Accrued Income, Prepaid Expenditure, Stock, Preliminary Expenses. CURRENT LIABILITIES: These also fluctuate throught the period of operation. These are the amounts payable at short notice. The business' good-will depends on it's ability to meet these short-term commitments. Examples: Bank Overdraft, Sundry Creditors, Bills Payable, Outstanding or Accrued Expenses, Advances Received Cash flow can be described as a cycle: The business uses cash to acquire resources (assets such as stocks) The resources are put to work and goods and services produced. These are then sold to customers Some customers pay in cash, but others ask for time to pay. Eventually they pay and these funds are used to settle any liabilities of the business (e.g. pay suppliers) And so the cycle repeats Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not necessarily, and if management dont carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble. The cash needed to make the cycle above work effectively is known as working capital. Working capital is the cash needed to pay for the day to day operations of the business. In other words, working capital is needed by the business to: Pay suppliers and other creditors Pay employees Pay for stocks Allow for customers who are allowed to buy now, but pay later (so-called trade debtors) What is crucially important, therefore, is that a business actively manages working capital. It is the timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business. There are many advantages to a business that actively manages its cash flow: It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact It can plan ahead with more confidence. Management are in better control of the business and can make informed decisions for future development and expansion It can reduce its dependence on the bank and save interest charges It can identify surpluses which can be invested to earn interest

The following, easily calculated, ratios are important indicators of working capital utilization. Ratio Formulae Result Interpretation On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management. Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.

Stock Turnover (in days)

Average Stock * 365/ = x days Cost of Goods Sold

Receivables Ratio (in days)

It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ? Debtors * 365/ = x days One or more large or slow debts can drag out the average days. Sales Effective debtor management will minimize the days.

Creditors * Payables Ratio 365/ = x days (in days) Cost of Sales (or Purchases)

On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.

Current Ratio

Total Current Assets/ Total Current Liabilities

=x times

Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.

Quick Ratio

(Total Current Assets Inventory)/ Total Current Liabilities

=x times

Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.

Working Capital Ratio

(Inventory + Receivables Payables)/ Sales

As % Sales

A high percentage means that working capital needs are high relative to your sales.

The normal sources available for different Working Capital requirements are: 1. Trade Credit: The credit that is allowed by the suppliers / creditors to the business.

Normally an interest-free credit given by the suppliers. They allow the amount payable on purchases a certain time between one month to few months, depending on credibility and commitment. Sometimes they also charge a certain percentage on the amount if paid after the credit period. 2. Accrued Expenses and Deferred Income: The liability towards the services already received, like accrued wages, salaries, electricity & telephone charges, etc. These allow a spontaneous, interest-free credit for a limited period of upto a month. Deferred income represents funds received by the firm for goods and services which it has agreed to provide in future. Advance payments made by customers constitute the major part. 3. Bank Finance: A credit finance from banks at a certain rate of interest. The bank fixes the limits based on the sales and production plans and also on the levels of certain current assets. -i). Overdraft; ii). Cash Credit; iii). Bills purchasing and discounting; iv). LOC (letter of credit); v). Working capital loan etc. Working capital requirements of a concern or pressure on working capital depend on the following: 1. General nature of the business; 2. Length of the period of manufacturing process; 3. The amount of capital required for financing production during such periods; 4. Rate of turnover; 5. Seasonal variations in demand; 6. Total manufacturing expenditure; 7. Minimum stocks of raw materials and finished goods that the business shall be required to maintain; 8. Terms of purchase and sale-period of credit obtained and granted; 9. Facilities of converting assets into cash. OVER TRADING: A firm is said to be overtrading when it has inadequate working capital funds to meet the requirements of its present level of business. It also is a negative working capital phenomenon. Very risky to the business, short term liabilities can not be discharged. UNDER TRADING: A firm is said to be undertrading when it's Current Ratio is much more than the normal ratio for that type of business. Generally for most of the businesses the suggested ratio is 2:1 (Current Assets : Current Liabilities). The cost of holding such excess Working Capital will be detrimental to the profitability. This could be due to incompetent Debtor Collection mechanism, where debtor's have not been paying promptly,

7. CAPITAL STRUCTURE
To shape a new business dream or when a company is growing rapidly, for example when contemplating investment in capital equipment or an acquisition, financial resources are required. Few growing companies are able to finance their expansion plans from cash flow alone. They will therefore need to consider raising finance from other external sources. In 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. 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 main differences between borrowed money (debt) and equity are that bankers request interest payments and capital repayments, and the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline. In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake. However in most circumstances venture capitalists will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake. The overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an optimal level. EQUITY SHARES: The individual portion of a joint stock company's capital owned by a shareholder is called a share. For a start-up, the main source of outside (external) investor in the share capital of a company is friends and family of the entrepreneur. Opinions differ on whether friends and family should be encouraged to invest in a start-up company. They may be prepared to invest substantial amounts for a longer period of time; they may not want to get too involved in the day-to-day operation of the business. Both of these are positives for the entrepreneur. However, there are pitfalls. Almost inevitably, tensions develop with family and friends as fellow shareholders. PREFERENCE SHARES: These shares rank for payment immediately after debentures (if issued), a fixed rate of dividend being payable on them before any sum is allotted to the ordinary shares of a company. Special types of preference share include Redeemable Preference Shares (repayable after a stipulated period), Cumulative Preference Shares (if, in a previous year the interest on these shares has not been paid the holders are entitled to receive it in a later year before any dividend is paid on the ordinary shares if profit is available). Preference Shares are not entitled to vote at ordinary meetings of the company. DEBENTURES: A debenture is a document that either creates a debt or acknowledges it, and it is a debt with or without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure.

BANK LOAN: A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and amount of repayments. The bank will usually require that the start-up provide some security for the loan, although this security normally comes in the form of personal guarantees provided by the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a bank overdraft. However, they dont provide much flexibility. A bank overdraft is a more short-term kind of finance which is also widely used by start-ups and small businesses. An overdraft is really a loan facility the bank lets the business owe it money when the bank balance goes below zero, in return for charging a high rate of interest. As a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed. Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time).

RETAINED EARNINGS: It is the undistributed part of the Net Profit. Normally at the end of the year, the Net Profit made during the year is distributed as dividend among the Share Holders. Either a part of the Net Profit or complete, which has not been declared as dividend is carried forward to the next year. This amount is used for any contingency, or expansion or updation of assets, also termed as Ploughing Back of Profit. This is displayed in the Balance Sheet as a Liability. This belongs to the owners, i.e. the Equity Share Holders of the firm. The Retained Earning is added to the Capital alongwith Reserves and Surpluses to compute the Net Worth of a business. Borrowing from friends and family This is also common. Friends and family who are supportive of the business idea provide money either directly to the entrepreneur or into the business. This can be quicker and cheaper to arrange (certainly compared with a standard bank loan) and the interest and repayment terms may be more flexible than a bank loan. However, borrowing in this way can add to the stress faced by an entrepreneur, particularly if the business gets into difficulties. OVER CAPITALIZATION: An undertaking can be said to be over-capitalised when the value of it's real assets is less than it's issued capital. This may be the result of failure to make a sufficient allowance for depreciation or of a rise in the value of money in a deflationary period or of having paid an excessive price on acquiring some of the assets. Is a situation when a firm raises more capital than is justified by the scale of operations. It reduces the rate of dividend. Very un-healthy, as the capital is not efficiently used. TRADING ON EQUITY: The use of long-term fixed interest bearing debt and preference share capital along the equity share capital is called financial leverage or trading on equity. It is owner's equity (equity share capital and reserves) which is used as a basis to raise loans and that is why it is called trading on equity. The long-term fixed interest bearing debt is employed by a firm to earn more from the use of these sources than their cost so as to increase the return on owner's equity. Example: A company has an Equity Capital of 1000 shares of Rs.100 each fully paid and earns an average profit of Rs.30000. Now the company wants to make expansion and needs another Rs.100000. The options with the company are either to issue new shares o raise loans @ 10% p.a. Assuming that the company would earn the same rate of profits. It is advisable to raise loans as by doing so earnings per share will magnify. The company shall pay only Rs.10000 as interest and the profit expected shall be Rs.60000 before payment of interest. After payment of interest, the profit left for equity share holders shall be Rs.50000 i.e. 50% on their equity against 30% otherwise. However, this can also be adverse if the interest paid on the loan is higher than the return generated by the expansion.

Financial leverage = Earnings before interest & tax (EBIT) /( Earnings Before Interest & Tax - Interest & preference dividend)

Exercise: Calculate from the following information:

a. The Tax Liability___________________________ b. Earnings per share__________________________ c. Interest Coverage Ratio ________________________
Equity Capital 3,20,000 shares of Rs.10 each. 12% Debentures of Rs.28,00,000. Tax rate on NPBT is 45%. With the above investment the AGRI-PRODUCTS Ltd. had a NPBIT of Rs.7, 20,000 during the year 2010

9. FINANCIAL PLANNING
It is the task of determining how a business will afford to achieve its strategic goals and objectives. Usually, a company creates a Financial Plan immediately after the vision and objectives have been set. The Financial Plan describes each of the activities, resources, equipment and materials that are needed to achieve these objectives, as well as the timeframes involved. The Financial Planning activity involves the following tasks; Assess the business environment Confirm the business vision and objectives Identify the types of resources needed to achieve these objectives Quantify the amount of resource (labor, equipment, materials) Calculate the total cost of each type of resource Summarize the costs to create a budget Identify any risks and issues with the budget set

Performing Financial Planning is critical to the success of any organization. It provides the Business Plan with rigor, by confirming that the objectives set are achievable from a financial point of view. It also helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within the budget set. The role of financial planning includes three categories: 1. Strategic role of financial management: 2. Objectives of financial management: 3. The planning cycle:

FINANCIAL PLAN In general usage, a financial plan can be a budget, a plan for spending and saving future income. This plan allocates future income to various types of expenses, such as rent or utilities, and also reserves some income for short-term and long-term savings. A financial plan can also be an investment plan, which allocates savings to various assets or projects expected to produce future income, such as a new business or product line, shares in an existing business, or real estate. In business, a financial plan can refer to the three primary financial statements (balance sheet, income statement, and cash flow statement) created within a business plan. Financial forecast or financial plan can also refer to an annual projection of income and expenses for a company, division or department. A financial plan can also be an estimation of cash needs and a decision on how to raise the cash, such as through borrowing or issuing additional shares in a company. While a financial plan refers to estimating future income, expenses and assets, a financing plan or finance plan usually refers to the means by which cash will be acquired to cover future expenses, for instance through earning, borrowing or using saved cash.