CAIIB-Financial Management- MODULE BSTUDY OF FINANCIAL STATEMENTSM Syed Kunmiremail – firstname.lastname@example.org
“Financial management involves the application of general management principles to particular financial operation”. - Howard and Upton
Attending to investment decisions - as to when and - how to acquire and allocate funds - for short-term and long-term assets keeping - in view the profit generation of the business - through which repayment obligation can be met.
Objectives and basic consideration of Financial management. • Though profit maximisation is the objective of financial management • The long-term goal of the business entity is to achieve maximising the shareholder value of the firm • Because the “principle of maximisation of shareholder wealth provides a rational guide for running a business and for efficient allocation of resources in society”.
The key objective of Financial Management is to maximise the value of the company. • This could be possible by • good investment decisions • prudent financing decisions and • well thought-out financial planning and control.
Maximisation of the value of the company is also known as maximisation of the wealth of the owners.
To achieve maximisation of value of the company, finance manager has to take careful decisions in respect of -Financing -Investment -Dividend -Current asset management.
Financing decision- • Has to decide on sources of funds for business. • It is to be decided whether entire capital should be raised from equity capital or a part is to be raised from loan. • Hence Debt/Equity ratio or Leverage are important since each source has in them associated risk factors involved.
Investment decision • It relates to acquisition of assets. • Assets are classified into • real assets such as - land - building - plant - equipment etc. and - the financial assets are - shares and - debentures etc. • It indicates available mix of financing to fund company’s activities. • Such decisions on investment in projects come within the field of capital budgeting which is derived from net present value of assets.
Dividend decision- - It is basically a financing decision. - This is because profit is a source of fund. - By not paying dividend, the “retained earnings”or ‘reserve’ can be increased which could be otherwise available for investment. • This ultimately lead to maximisation of wealth of the organisation provided decisions on investments are correct.
Current Asset Management- • This is necessary to maintain balance between current assets and current liability, • The liquidity of the business is interrupted because of holding too much fund in current assets.
Wealth maximisation &value maximisation • The goal of financial management is to maximise the value of companies. • This is generally expressed in terms of maximising the value of the ownership shares of the company • In short,maximising share price. • Thus,better performing companies can raise additional funds under more favourable terms. • This basic objective of maximising the price of the company’s shares is called ‘value maximisation’.
Social responsibility is also an important goal of a company which requires -Maximising share-price by efficient,well- managed operations related to consumer demand parameters. -Efficiency & innovation leads to value maximisation which leads to new products,new technologies and better employment. -External factors like pollution,product safety and job safety have achieved added dimensions in relation to value maximisation.
Profit maximisation vs.Wealth maximisation • Long run vs.Short run Profits. • Convert total corporate profits to earning per share(EPS). • EPS is total profits divided by number of shares outstanding. • Assume the firm earns Rs.10 mn.and has 1mn.shares outstanding.The EPS will work out to Rs.10. • Profit maximisation is a short-term concept, • while wealth maximisation emphasises the long-term view point.
State whether true or false • The income statement depicts the financial position of the firm at a given point of time • The balance sheet gives the financial performance of the firm over a given period of time. • These statements are prepared every week. • Funds Flow statement gives the liquidity position of the firm.
Cash Flow statement tells from where the money comes and where it is used. • The prime objective of financial management is wealth maximisation,and not profit maximisation. • What is earnings per share? a)Net Profit b)Profit before interest and tax c)Total earnings divided by investment d)Net profit divided by equity
What is the difference between long term funds and short term funds? -Difference in interest rates -Difference in time of repayment -Difference in the size of loan -No difference
CAPITAL EXPENDITURE DECISIONS AND PROFITABILITY STUDY • It represents the important decisions taken by the firm. • Importance due to the following issues -Long-term effects -Irreversibility -Substantial outlays
Difficulties -Measurement problems -Uncertainty -Temporal spread
Phases of capital budgeting -Capital budgeting is a complex process which may be divided into five broad phases. 1) Planning 2) Analysis 3) Selection 4) Implementation 5) Review.
Levels of Decision Making -Operating decisions -Administrative decisions -Strategic decisions • Profitability Study important facets are -Market analysis -Technical analysis -Financial analysis -Economic analysis -Ecological analysis
The basic characteristic of a capital project is that it typically involves - A current outlay(or current and future outlays)of funds - In expectation of a stream of benefits - Extending far into future.
Accounting rate of return method - A selection criterion using average net income and investment outlay to compute a rate of return for a project. - This method ignores the time value of money & cash flows.
Net Present Value method - A selection method using the difference between the present value of the cash inflows of the project and the investment outlay. - The method evaluates the differential cash flow between proposals.
Internal rate of return method A selection method using the compounding rate of return on the cash flow of the project.
Payback method - A selection method in which a firm sets a maximum payback period during which cash inflow must be sufficient to recover the initial outlay. - This method ignores the time value of money and cash flow beyond the pay back period.
What are the three important factors which arise from capital expenditure decisions? a)Long-term effects e)Debt b)Profitability f)Substantial outlays c)Irreversibility g)Short-term effects. d)Risk • Why are capital expenditure decisions difficult? i)Uncertainity in predicting costs&benefits ii)Difficulty in measurement of costs&benefits iii)Risk involved iv)Problems in estimating discount rates v)All the above
If the IRR of the project is 7% and the cost of capital is (11.4% should we reject or accept the project). Yes/No. • The firm should always make an ecological analysis to know the likely damage that may be caused by the project to the environment. a)Must do b)No need.
Sources of finance and cost of capital For what purposes a firm needs a finance? - Since the cash receipts lag behind cash payments necessitating - loans,bonds,overdrafts etc. - the firm needs finance for short term and long term requirements- - fixed assets and working capital. Permanent sources of finance Share capital and retained profits.
Study of financial statements • Who are the party interested in firm’s financial condition? - Shareholders - Creditors/suppliers - Financiers - Employees - Tax authorities.
Long term sources - Preference shares - Bonds - Debentures and - Long term loans from financial institutions..
Various sources of short term finance- - Cash credit - Overdraft - Billsdiscounting - Commercial papers and - Trade credit.
Short term & long term cash forecasts Time periods involved - - Yearly for long term forecasts - Monthly for short term forecasts.
Factors considered in equity financing - Issue costs - servicing costs such as paying out dividends - when there is retained earnings there will be capital appreciation of sharevalues.
Preference Shares - These shareholders get a fixed return and their risk is less than the equity Shareholders. - They have a right to the first slice of dividend. - Obligation to redeem the preference shares after its time period. - They do not have a right to vote.
Debentures or loan financing - the firm will have to pay fixed interest every year. - There is an obligation to redeem it at the end of the period. - There is also an advantage of tax deductibility of interest paid which makes it cheaper.
Bills rediscounting - The buyer can repay in a long period of time - while seller gets his money back by discounting the bills. - For the seller, this helps him to go ahead with production and increase the turnover.
Working capital term loan • A part of working capital has to be with the manufacturer since there is a time lag between ordering and procuring. • This particular portion (say25%)can be financed by long term funds. • When firm is not able to infuse its own funds for this purpose,it gets a long term loan from the bank. • This carries fixed interest and for a fixed period.
Overdraft and bank loan- - Overdraft is a running account - whereas bank loan instalment are fixed.
Trade credit - When materials are bought from suppliers,the trade credit is extended for few days or a couple of months. - The supplier is willing to wait to collect money. - This also depends on the suppliers’ financial position and - The buyers credit worthiness.
Commercial paper - These are short term promissory notes with fixed maturity period. - They are issued by very large companies - Who are reputed and - Have high credit worthiness. - Credit rating agencies certify their credit rating.
Firms’cost of capital-A firm’s is the average cost of capital is the weighted average arithmetic mean of the cost of resources from various sources. Questions: a)Long term sources are banks and financial institutions (T/F) b)Current liabilities should be repaid within a financial year(T/F) c)Fixed assets are generally financed with current liabilities(T/F)
Equity Shareholders bear the greatest risk(T/F) • Bills discounting scheme has been introduced to ease flow of funds in the economy(T/F) • Trade creditors are suppliers of goods and services to whom the firm is yet to pay.(T/F) • Accounts Receivables should be less than trade creditors(T/F). • Bills of Exchange is same as cash credit(T/F). • Equity and Preference shares are one and the same(T/F) • A part of working capital can be financed by long term sources(T/F)
A firm borrows Rs.20,000 from bank @8% and floats a debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project? a)5.5% b)6.5% c)7.5% d)8.5% • If a firm borrows Rs.2 lac @10% and has a tax rate of 40%.What is the cost of capital? a)5% b)6% c)7% d)8%
Data for analyzing the situations of the firm Balance Sheet Income Statement Fund flow statement
Basic concepts while preparing balance sheet - Entity concept - Money measurement concept - Going concern concept - Cost concept - Consevatism concept - Dual aspect concept - Accounting period concept - Accrual concept - Realisation concept - Matching concept
What is revenue reserve & capital reserve? • Revenue reserves are accumulated earnings from profits and normal business operations. • Capital reserves arise due to capital gains from revaluation of assets or due to premium on issue of shares.
Elements of financial statements Main financial statements: • Balance Sheet • Income statement • Statement of Sources of funds and Uses of funds
Typical Limited Balance Sheet as at 30 June 2002 2002 2001 Rm Rm ASSETS Non-Current Assets Property, plant & equipment 1,227 1,137 Current Assets Inventories 65 60 Receivables 122 108 Cash assets 21 15 Total Current Assets 208 183 Total Assets 1,435 1,320 EQUITY AND LIABILITIES Equity Share Capital (500m shares of R1 each) 500 500 Retained earnings 415 340 Total Equity 915 840 Non-current Liabilities Long-term borrowings 400 380 Total non-current liabilities 400 380 Current Liabilities Trade and other payables 98 88 Short-term borrowings 22 12 Total current liabilities 120 100 Total Equity and Liabilities 1,435 1,320 Balance Sheet
Typical Limited Income Statement For the year ended 30 June 2002 2002 2001 Rm Rm Sales revenue 3,573 2,320 Cost of Sales 2,036 1,206 Gross Profit 1,537 1,114 Distribution, selling and marketing expenses 679 394 Administration and general expenses 322 186 Other expenses 254 116 Profit (earnings) before interest and tax expense 282 418 Finance costs 100 80 Profit before tax 182 338 Income tax expense 54 101 Profit for the period 128 237 Earnings per share 0.256 0.474 Statement of changes in equity for the year ended 30 June 2002 Balance at 30 June 2001 340 202 Profit for the period 128 237 468 439 Dividends -53 -99 Balance at 30 June 2002 415 340 Income Statement