Financial Management

Introduction

Managerial level techniques to managing the financial activities inside or outside of

the organization.

Financial Management can be defined as:

The management of the finances of a business / organization in order to achieve

financial objectives taking a commercial business as the most common organizational
structure, the key objectives of financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the business is
taking and the resources invested

Nature of Financial Management

Financial Management is an important field of Management Sciences. It is a

combination of Managerial Finance and Corporate Finance. Managerial Finance concerns
with the managerial use of financial techniques. Whereas on the other hand, Corporate
finance deals with corporate financial decisions.

In both the cases, it is extremely important for Managers in an organization. Financial

Management is used to determine the best way to use the money available to an organization
in order to improve the future opportunities to earn money. Thus the financial managers use
techniques such as Valuation, Portfolio management, Hedging and capital structure etc for
better decisions about the future of an organization.

On the other hand, it is also used to interpret financial results in a given year or time period
using financial analysis techniques. This helps in judging the actual performance of an
organization in that time period. Financial management helps in proper allocation of costs,
anticipate future expense, and budgeting for the future

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Scope of Financial Management

Scope of financial management is vast and important to business. It is involve in all

level of management and all fields of human activities. We can prove that without good
financial management, no organization can be alive. Organization (duplicate name of selfish
group of people) is helpful for people and wants welfare of public. But, it need fund, money
and cash and for getting it, it uses techniques of financial management. So financial
management makes his place everywhere. Never understand it as the name of book but it is
practical science to support business to live respectful life in society.

We can divide financial management scope into three major parts:-

1.Financial Management in New Companies

A new company spends large amount on production and marketing but it should
ignore proper use of its fund. Financial management’s gateway is new company and if new
company ignores financial management study, it means it is ignoring cash, inventory, debtors
and fixed assets management. Past study reveals that big organization or companies did not
trade even one year and before one year they took their baggage and became liquidated.
Why? Because, given debt was demanded from these companies by creditors. By answering
no, court had liquidated them. So, if you are starting new company, become regular readers
of financial management.

2. Financial Management in Old Companies

Old company can survive in long run, if it is capable to pay debt timely, to pay salary
on time and to pay other daily expenses. Because old company has good reputation in
financial market, so financial management’s some part like working capital management is
very significant. Old company should try to increase growth rate by using new techniques of
financial management.

3. Financial Management in NGO

In this material age, every work is becoming business. Only NGO are working not for
profit aim. Its aim is not to earn money but here is also question of its existence. Like survive

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of company, NGO can live only and only after proper management of its cost and
management of cost can be taught only in financial management. So, NGO are also under the
scope of financial management. Every NGO wants to provide free services long time.
Without, use the techniques of financial management, NGO starts misuse the scarce sources
of public. After revealing this fact, public may reduce to donate to NGO, so NGO should be
aware about financial management.

Functions of Financial Management

1. Estimation of capital requirements:

A finance manager has to make estimation with regards to capital

requirements of the company. This will depend upon expected costs and profits and
future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition:

Once the estimation have been made, the capital structure have to be decided.
This involves short- term and long- term debt equity analysis. This will depend upon
the proportion of equity capital a company is possessing and additional funds which
have to be raised from outside parties.

3. Choice of sources of funds:

For additional funds to be procured, a company has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds:

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The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.

5. Disposal of surplus:

The net profits decision have to be made by the finance manager. This can be
done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash:

Finance manager has to make decisions with regards to cash management.

Cash is required for many purposes like payment of wages and salaries, payment of
electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.

7. Financial controls:

The finance manager has not only to plan, procure and utilize the funds but he
also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Financial Decisions Areas

There are two major decisions that the financial manager must make.

A). The Investment Decisions

A firm needs to invest in real assets in order to produce goods or services. Therefore,
decisions must be made on what assets to own and what mix of fixed assets (plant,
equipment, and land) and what mix of current assets (cash, accounts receivable, and

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inventories) will best facilitate the firm’s production of goods and services. In other words,
how much should the firm invest, and in which specific assets should it invest? Answers of
these questions involve the firm’s investment decisions.

B). The Financing Decisions

The company needs to finance it assets by acquiring cash from the financial markets.
Decisions must therefore be made about what securities to issue and what mix of short-term
credit, long-term debt, and equity best facilitates the effort to meet the firm’s objectives.
These questions are answered by the firm’s financing decision.

c). Dividend Decisions

It is the decision to pay out earnings versus retaining and reinvesting them in to
company. This is that amount pay to their shareholder. Financial managers decide what the
amount of dividend will pay to stockholder. It is decided in Dividend Decisions.

Frame work of Financial Management

A Financial Management Framework (FMF) must set out the Senior Executive’s and
Senior Financial Officer’s (SFO) standards and expectations for sound financial management
and control across the organization, consistent with the Financial Administration Act (FAA),
Treasury Board Secretariat (TBS) policies, and the Management Accountability Framework
(MAF). The objective of the FMF is to ensure that a robust financial management governance
framework exists that clearly articulates Legislation & Policies, Values & Principles,
Authorities & Accountabilities, Roles & Responsibilities, Processes, and Enablers that will,
when adhered to, lead to a number of positive financial and business Results.

Components of the Financial Management Framework

Legislation & Policies are the foundations of sound financial management, including
legislation and regulations, andpolicies.

Values & Principles set out the ethical value statements and foundations of sound financial
management, which guide Managers in fulfilling their financial management duties.
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Authorities & Accountabilities reflect delegated authorities and financial management

accountabilities.

Roles & Responsibilities reflect the expected financial management responsibilities of

Business Managers, Senior Management, and Financial Officers. The Roles and
Responsibilities reflect the concept that financial management is everyone’s
Responsibility.

Dividend policy

Dividend policy refers to the policy chalked out by companies regarding the amount it
would pay to their shareholders as dividend. The policies are decided according to the current
and future financial positions of the company. The preference and orientation of the investors
are also taken into account. With profit making comes the question of utilizing the profit
gainfully.

The companies have two options with them:

(A) They can retain these profits within the company.

(B) They can pay these profits in the form of dividends to their shareholders.

The following are the types of dividend policies:

(1) Cash Dividend

(2) Stock Dividend

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The dividend policy acts as a signal for investors for gauging the future earning
possibilities as expected by the management of the company. The dividend policies are
directed towards attracting investors to their company. This is termed as the clientele effect.
The firms that hold back free cash flows are lesser in value than those firms, which allow free
cash flows and pay dividends from them.

There are quite a few impediments to companies paying dividends to their

shareholders. Some of these constraints are as follows:

(1) Consideration of taxes

(2) Consideration of returns

(3) Contractual constraints

(4) Cash flow constraints

(5) Legal constraints

The dividend policy of a company has a relation with its common stock value. The
Dividend Irrelevance Theory propounds that the dividend policy of a firm has no direct
bearing on the cost of its capital or its value. The Dividend Relevance Theory, on the other
hand, expostulates that the value of the firm is affected by its dividend policy. The Optimal
Dividend Policy helps in increasing the value of the firm to the maximum.

Major Dividend Policies

(1) Dividends are irrelevant: Investors don’t care about payout.

(2) Bird in the hand: Investors prefer a high payout.

(3) Tax preference: Investors prefer a low payout, hence growth

Tax Preference Theory

(1) Retained earnings lead to long-term capital gains, which are taxed at lower rates than
dividends: 20% vs. up to 39.6%. Capital gains taxes are also deferred.
(2) This could cause investors to prefer firms with low payouts, i.e., a high payout results
in a low P0.
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Bird-in-the-Hand Theory

(1) Investors think dividends are less risky than potential future capital gains, hence they
like dividends.
(2) If so, investors would value high payout firms more highly, i.e., a high payout would
result in a high P0.

Dividend Irrelevance Theory

(1) Investors are indifferent between dividends and retention-generated capital gains. If
they want cash, they can sell stock. If they don’t want cash, they can use dividends to
buy stock.
(2) Modigliani-Miller support irrelevance.
(3) Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may
not be true. Need empirical test.

Which theory is most correct?

(1) Empirical testing has not been able to determine which theory, if any, is correct.
(2) Thus, managers use judgment when setting policy.
(3) Analysis is used, but it must be applied with judgment.

Capital budgeting and Capital Rationing

Capital Budgeting

Capital budgeting is a required managerial tool. One duty of a financial

manager is to choose investments with satisfactory cash flows and rates of return.
Therefore, a financial manager must be able to decide whether an investment is worth
undertaking and be able to choose intelligently between two or more alternatives. To

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do this, a sound procedure to evaluate, compare, and select projects is needed. This
procedure is called capital budgeting.

Longer-term investment in fixed assets involve cash outlays that are

expected to result in benefits to the firm over several years. Such expenditures, which
are expected to generate future cash benefits lasting longer than one year, are
classified as capital expenditure.

The capital budgeting decision is a complex process that involves several

activites: searching for new profitable investment, marketing and production analyses
to determine economic attractiveness, careful cash flow estimation, prepration of cash
budgets, evaluation of proposals, and the control and monitoring of past projects.
Several types of capoital expenditures lend themselves to capital budgeting analysis.

Capital Rationing

The financial situation in which a firm has only a fixed number of Amount
available for capital expenditure and numerous projects compete for those Amount.

The act or practice of limiting a company's investment. That is, capital

rationing occurs when a company's management places a maximum amount on new
investments it can make over a given period of time. The two methods of capital
rationing are forbidding investments over a certain amount or increasing the cost of
capital for such investments. Capital rationing is most common when a company's
previous investments have not performed well.

Techniques of Capital Budgeting

(1) Payback Period

(2) Accounting Rate of Return

(3) Net Present Value

(4) Internal Rate of Return

(5) Profitability Index

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Payback Period

Since it does not use the time value of money principle, the Payback Period is the
weakest of the capital budgeting methods discussed here. By definition, the payback period
is the length of time that it takes to recover your investment.

For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years.
Companies that use this method will set some arbitrary payback period for all capital
budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less
will be accepted. (At a payback period of 3 years in the example above, that project would be
rejected.)

Payback period is the time duration required to recoup the investment committed to a
project. Business enterprises following payback period use "stipulated payback period",
which acts as a standard for screening the project.

Computation Of Payback Period

When the cash inflows are uniform the formula for payback period is cash outflow
divided by annual cash inflow.

• When the cash inflows are uneven, the cumulative cash inflows are to be arrived at and then
the payback period has to be calculated through interpolation.

• Here payback period is the time when cumulative cash inflows are equal to the outflows.

Payback Reciprocal Rate

• The payback period is stated in terms of years. This can be stated in terms of percentage
also. This is the payback reciprocal rate.

• Reciprocal of payback period = [1/payback period] x 100

Decision Rules

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A. Capital Rationing Situation

• Select the projects which have payback periods lower than or equivalent to the stipulated
payback period.

• Arrange these selected projects in increasing order of their respective payback periods.

• Select those projects from the top of the list till the capital

Budget is exhausted.

B. Mutually Exclusive Projects

In the case of two mutually exclusive projects, the one with a lower payback period is
accepted, when the respective payback periods are less than or equivalent to the stipulated
payback period. Determination Of Stipulated Payback Period.

• It is easy to understand and apply. The concept of recovery is familiarto every decision-
maker.

Net Present Value (NPV)

Net present value of an investment/project is the difference between present value of

cash inflows and cash outflows. The present values of cash flows are obtained at a discount
rate equivalent to the cost of capital.

Computation Of Net Present Value (Npv)

• When the cash outflow is required for only one year i.e., in the

present year, then the Net present value is calculated as follows:

• "I" is the initial investment (cash outflow) required by the project.

Decision Rules

A. "Capital Rationing" situation

Select projects whose NPV is positive or equivalent to zero.

Arrange in the descending order of NPVs.

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Select Projects starting from the list till the capital budget allows.

B. "No capital Rationing" Situation

Select every project whose NPV >= 0

C. Mutually Exclusive Projects

Select the one with a higher NPV.

Computation of Internal Rate Of Return (IRR)

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to
earn on the investment. Technically, it is the discount rate that causes the present value of the
benefits to equal the present value of the costs. According to surveys of businesses, the IRR
method is actually the most commonly used method for evaluating capital budgeting
proposals. This is probably because the IRR is a very easy number to understand because it
can be compared easily to the expected return on other types of investments (savings
accounts, bonds, etc.).

The calculation of the IRR, however, cannot be determined using a formula; it must be
determined using a trial-and-error technique.

Decision Rules

A. "Capital Rationing" Situation

Select those projects whose IRR (r) = k, where k is the cost of capital.

Arrange all the projects in the descending order of their Internal Rate of Return.

Select projects from the top till the capital budget allows.

B. "No Capital Rationing" Situation

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Accept every project whose IRR (r) = k, where k is the cost of capital.

• If the cost of capital is less than or equal to 7% we will accept the investment of Rs.8200 in
the new machine since it offers a return of 7%. Marginal projects since the company on
accepting worse off nor better off. They will just pay for them Where the cash inflows are not
uniform series and/or where cash outflows occur at other periods be necessary to experiment
be found out through interpolation.

Profitability Index

The profitability index is a technique of capital budgeting. This holds the relationship
between the investment and a proposed project's payoff. Mathematically the profitability
index is given by the following formula:

Profitability Index = (Present Value of future cash flows) / (Present Value of Initial
investment)

The profitability index is also sometimes called as value investment ratio or profit
investment ratio. Profitability index is used to rank various projects.

Leasing and types of leasing

Introduction

A lease is a type of rental agreement that typically involves a series of fixed payments
that extend over several periods.

A lease represents a contract udder which one party is entitled to use an asset for a
specified period. In consideration of this use, the user is required to make periodic payments
to the owner of the asset. Stated differently, a lease is a contract between a lessor and a lessee
wherein the owner of an asset allows another party to use it for a leasing fee.

Lessor

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The lessor in a lease arrangement is the party that has the title to Owns the property
being leased.

Lessee

The lessee in a lease arrangement is the party that has the use of the asset being
leased.

Advantages
• For businesses, leasing property may have significant financial benefits:

• Leasing is less capital-intensive than purchasing, so if a business has constraints on its

capital, it can grow more rapidly by leasing property than it could by purchasing the
property outright.
• Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the
property market has shown steady growth over time, a business that depends on
leased property is sacrificing capital gains.
• Because of investments which are done with leasing, new businesses are formed.
Furthermore, unemployment in that country is decreased.
• Leasing may provide more flexibility to a business which expects to grow or move in
the relatively short term, because a lessee is not usually obliged to renew a lease at the
end of its term.
• In some cases a lease may be the only practical option; such as for a small business
that wishes to locate in a large office building within tight locational parameters.

Disadvantages
• For businesses, leasing property may have significant drawbacks:
• A net lease may shift some or all of the maintenance costs onto the tenant.
• If circumstances dictate that a business must change its operations significantly, it
may be expensive or otherwise difficult to terminate a lease before the end of the
term. In some cases, a business may be able to sublet property no longer required, but

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this may not recoup the costs of the original lease, and, in any event, usually requires
the consent of the original lessor.
• If the business is successful, lessor may demand higher rental payments when leases
come up for renewal. If the value of the business is tied to the use of that particular
property, the lessor has a significant advantage over the lessee in negotiations.

Types of leases

Several types of leases are utilized in financial markets. In general, they may be
classified as:

1. Operating Leases

Operating lease are characterized by the fact that the maintenance and service

of the leased equipment are provided by the lessor; the cost of the maintenance and service
are incorporated into the lease agreement or stated in a separate service contract. Typically,
operating lease are for terms shorter than the usable life of the equipment. Since the lease
payments do not ordinarily amortize the lessor’s cost for the equipment, the returns to the
lessor in addition to the lease payments are in the form of subsequent lease renewals or
proceeds from the disposal of the equipment upon expiration of the lease.

Another common feature of operating leases is a cancellation clause that gives the
lessee the right to cancel the lease agreement before expiration of the primary term. This has
the effect of shifting the risk associated with technological obsolescence from the lessee to te
lessor.

2. Financial Leases

A financial or capital lease differs from an operating lease in that it is a non

cancellable, longer-term lease that fully amortizes the lessor’s cost for equipment. Under this
form of lease, service and maintenance are usually provided by the lessee. Further, the lessee
may have to provide insurance and pay property taxes. Automobile leases are an example of
such financial leases.
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Some financial leases provide for certain renewal or purchase option at the end of the
lease term, although these options are subject to certain IRS restrictions.

3. Sale-Lease back

A special type of financial lease often utilized by firms is the sale-leaseback

arrangement. Under these arrangements, assets that are already owned by a firm are
purchased by lessor back to firm. The firm, as lessee, executes a lease agreement with the
lessor, which ordinarily is a financial institution such as a commercial bank, insurance
company, or leasing company.

The structure of this arrangement is analogous to a mortgage on the asset taken out by
the lessee. Rather than making a series of payments to amortize a loan, however, the lessee
makes a series of payments that to amortize a acquisition costs and provide the lessor with a
required return.

4. Leveraged leases

A leveraged lease is a special lease arrangement under which the lessor borrows a
substantial portion of the acquisition cost of the leased asset from a third party. The leverage
refers to the financial leverage used b the lessor in structuring the lease, and the risk
associated with default by the lessee is partially borne by the third-party lender. Typically,
leveraged leases involve only large assets due to complexity and expense of structuring the
lease arrangement. The third party financing the asset is usually an institution such as an
insurance company or pension fund. Often this lender takes assignment of the lessor’s interest
in the lease and requires direct receipt of lease payments.

5. Domestic and International Lease:

All the parties of the lease agreement reside in the same country, it is called domestic
lease.

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International lease are of two types – Import Lease and Cross Border Lease. When
lessor and lessee reside in same country and equipment supplier stays in different country, the
lease arrangement is called import lease. When the lessor and lessee are residing in two
different countries and no matter where the equipment supplier stays, the lease is called cross
border lease.

6. Franchising

Franchising is a method of expanding business on less capital than would otherwise

be needed. For suitable businesses, it is an alternative to raising extra capital for growth.
Franchisors include Budget Rent-a-Car.

Under a franchising arrangement, a franchisee pays a franchisor for the right to

operate a local business, under the franchisor's trade name. The franchisor must bear certain
costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the
cost of other support services) and will charge the franchisee an initial franchise fee to cover
set-up costs, relying on the subsequent regular payments by the franchisee for an operating
profit. These regular payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of
a franchisee's outlet, the franchisee will be expected to contribute a share of the investment
himself. The franchisor may well help the franchisee to obtain loan capital to provide his-
share of the investment cost.

The advantages of franchises to the franchisor are as follows:

• The capital outlay needed to expand the business is reduced substantially.

• The image of the business is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.

Cash Management

Cash management is a broad term that refers to the collection, concentration, and
disbursement of cash. It encompasses a company's level of liquidity, its management of cash
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balance, and its short-term investment strategies. In some ways, managing cash flow is the
most important job of business managers. If at any time a company fails to pay an obligation
when it is due because of the lack of cash, the company is insolvent. Insolvency is the
primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should
compel companies to manage their cash with care. Moreover, efficient cash management
means more than just preventing bankruptcy. It improves the profitability and reduces the risk
to which the firm is exposed.

Luckily, the first step to improved cash management isn't exactly brain surgery: just
start maximizing cash flow. "There are often ways for companies to improve their cash
position simply by making certain that their billing, collections, and payables systems are
operating as efficiently as possible," King observes. Aim to bring cash into the company as
quickly as possible: bill promptly, aggressively follow up on overdue invoices, and, if
possible, require up-front deposits when making sales. (See "Cash Management Tools,"
below, for additional ideas.) Then hold onto your cash as long as possible by managing your
payables. That means, quite simply, take as long as you're allowed--without incurring late
fees or interest charges--to pay your company's bills.

The corporate process of collecting, managing and (short-term) investing cash. A key
component of ensuring a company's financial stability and solvency. Frequently corporate
treasurers or a business manager is responsible for overall cash management.

Successful cash management involves not only avoiding insolvency (and therefore
bankruptcy), but also reducing days in account receivables (AR), increasing collection rates,
selecting appropriate short-term investment vehicles, and increasing days cash on hand all in
order to improve a company's overall financial profitability.

Successfully managing cash is an essential skill for small business developers because
they typically have less access to affordable credit and have a significant amount of upfront
costs they need to manage while waiting for receivables. Wisely managing cash enables a
company to meet unexpected expenses in addition to handling regularly-occurring events like
payroll.

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Holding cash
Nearly every investor holds a certain amount of cash. That's because cash can play a
vital role in meeting a short-term savings goal or play a larger part in a long-term asset
portfolio. So whether it's to meet a short-term or longer-term need, there is always a good
reason for holding cash.

Reasons for Holding Cash

Perhaps the best explanation for holding cash in a portfolio was summarized by John
Maynard Keynes - after which Keynesian economics or Keynesian Theory is named.
Keynesian economic theory states that both the state (government) and private sectors play an
important role in the health of an economy. In particular, Keynes also spoke about the
importance of cash.

Cash is King

Perhaps the most advantageous time to hold cash is when a recession hits and the
economy starts to slow down. When that happens you'll be glad you had some money on
hand if you lose your job. And if the stock market takes a dive you'll be glad you had some
spare cash to buy stocks at bargain prices.

Cash-management Strategies

When the economy is strong, companies can lapse into sloppy cash-management practices.
Don't let that happen to you. Try exploring these options:

1. Sweep accounts.

These bank accounts are the easiest way to generate some income from your
company's spare funds; however, they make sense only if the money you'll earn will
be greater than the fees your bank will charge. Business owners have two types of
sweep accounts to choose between:

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• Controlled-investment accounts.

Think of these as checking accounts with the ultimate in zero balances. Every
day, your bank will leave only enough in your checking account to cover those checks
that were presented the night before for payment that day. The rest gets swept, quite
early, into overnight investments. "These are the most profitable form of sweep
account, but they won't work for your company if you have any electronic payments
or wire transfers, since those may be submitted for payment later in the day and your
account won't have enough cash in it to cover them," warns Stephen King.

• End-of-day sweep accounts.

A safer bet for most small-business owners, these accounts wait until a late-
hour cutoff to determine how much to sweep into your overnight investments.
Typically their investment yields are 10 to 20 basis points (.1% to .2% of the
investment) lower than those offered with controlled investments.

2. Lock-box accounts.

A lock box is a cash-management system that helps you collect your funds
quickly. Generally set up with the assistance of a big money center or regional bank,
lock boxes provide your company with a special zip code and, usually, quicker
deliveries from regional post offices. They are especially important if you have
clusters of customers in out-of-state locations and don't want to lose days waiting for
their checks to arrive by long-distance mail.

3. Account Reconcilement Services:

Balancing a checkbook can be a difficult process for a very large business,

since it issues so many checks it can take a lot of human monitoring to understand
which checks have not cleared and therefore what the company's true balance is. To
address this, banks have developed a system which allows companies to upload a list
of all the checks that they issue on a daily basis, so that at the end of the month the
bank statement will show not only which checks have cleared, but also which have

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not. More recently, banks have used this system to prevent checks from being
fraudulently cashed if they are not on the list, a process known as positive pay.

4. Automated Clearing House:

Services are usually offered by the cash management division of a bank. The
Automated Clearing House is an electronic system used to transfer funds between
banks. Companies use this to pay others, especially employees (this is how direct
deposit works). Certain companies also use it to collect funds from customers (this is
generally how automatic payment plans work). This system is criticized by some
consumer advocacy groups, because under this system banks assume that the
company initiating the debit is correct until proven otherwise

Financial Ratios

Definition

“Financial ratio analysis is the systematic use of ratios to interpret financial statements
so that the existing strength and weaknesses of a firm, as well as its historical performance
and current financial condition, can be determined.”

This is achieved by reducing the information from financial statements to a small set
of indices or percentage values that then form the basis for measuring different aspect of a
firm’s activities.

Uses of Ratio Analysis

Ratios are useful in intrafirm analysis, where the performance of the firm is evaluated
over time, or in interfirm analysis where the performance of a firm is compared to that of
other firms in the industry.

Purpose Of Ratios
Financial ratios quantify many aspects of a business and are an integral part of the
financial statement analysis. Financial ratios are categorized according to the financial aspect
of the business which the ratio measures. Liquidity ratios measure the availability of cash to
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pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets.
Debt ratios measure the firm's ability to repay long-term debt. Profitability ratios measure
the firm's use of its assets and control of its expenses to generate an acceptable rate of return.
Market ratios measure investor response to owning a company's stock and also the cost of
issuing stock.
Financial ratios allow for comparisons

• between companies
• between industries
• between different time periods for one company
• between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else,
like past performance or another company. Thus, the ratios of firms in different industries,
which face different risks, capital requirements, and competition are usually hard to compare.

Types and Implications of Ratios

Short-term solvency Ratios

Short-term solvency or liquidity ratios measure a firm’s ability to meet its short-term
obligations. They focus on the extent to which a firm has enough cash or assets readily
convertible into cash to pay its current liabilities. If a firm has adequate cash, it should have
no problem paying its bills on time (i.e.it is solvent). If it has insufficient cash, a short-term
crisis called insolvency occurs. Insolvency can be disastrous for a firm: Banks become
reluctant to loan money, suppliers balk at selling goods on credit, and an overall drop in
creditworthiness occurs.

Two ratios are calculated to measure liquidity: The current ratio and the quick ratio

Current Ration

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The
current ratio
is one of the most famous of all financial ratios. It serves as a test of a company's financial
strength and relative efficiency [i.e., does a company have too much cash on hand or not
enough.

Formula: Current Assets / Current Liabilities

Quick (Acid Test) Ratio

The current ratio assumes that all current assets are equally liquid. Inventories,
however are often quite illiquid compared to marktable securities or accounts receivable. The
quick ratio considers only assets that can be readily converted to cash and is therefore a
stricter test for liquidity.

Formula

Long-term solvency Ratios

Long-term solvency ratios emphasize the longer-term commitments to creditors.

Claims by creditors on a firm’s income arise from a contractual agreement that must be
honored before any income becomes available to stockholders. Further, the greater the
amount of these claims, the greater the chances are that a firm will fail to satisfy them.
Failure to meet these claims may result in legal action to force their fulfillment. This may
fore the company to liquidate (sell) part or all of its assets to satisfy these obligations. These
ratios are two types Debt utilization ratios and coverage ratios.

Debt Utilization Ratios

The debt to equity financial ratio is a measure of the total debt a company owes
compared to the equity of the shareholders. It tells you just how much of the capitalization is
the owners vs. the creditors.
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Coverage Ratios

The interest coverage ratio has huge implications for bond and preferred stock
investors in particular. This financial ratio tells the investor the number of times the earnings
before interest and taxes can pay, or "cover", the interest payment the company makes on its
debt.

Assets Utilization Ratios

Asset utilization or turnover ratios indicate how efficiently management utilizes its
assets in generating revenus by relating or comparing sales to different types of asset. The
intent is to obtain an idea of the speed with which assets generate sales. The more rapidly
assets are “turned over,” the more efficient is their uses.

An implicit assumption of any turnover ratio is that there is some optimal mix
between sales and different asset investments. By analyzing these ratios, one can determine
whether too many or too few resources are invested in a particular asset. It is possible, for
example, that too much is invested in accounts receivable. This discovery may suggest that
the firm’s credit policy is too lax and that the inflated receivables hide an excessive amount
of delinquent debts. All three of the most widely used asset utilization ratios relate sales to
accounts receivable, inventories, and fixed assets.

Account Receivable

The average collection period is a measure of the efficiency of a firm’s credit policy.
It estimates the number of days it takes for a dollar in sales to be collected by the firm.

Formula

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Inventory Turn Ratio

This financial ratio tells an investor how many times a business turns its inventory
over a period of time. It allows you to see if a company has too many of its assets tied up in
inventory and is heading for financial trouble.

Inventory turnover = cost of goods sold / inventories

Fixed Assets

The fixed-asset turnover ratio indicates how well the investment in longterm (fixed)
assets is being managed. Normaly, the higher the turnover ratio, the more efficiently assets
are being used to generate sale.

Fixed-asset turnover ratio = net sale / net fixed assets

A total asset turnover ratio (sales divided by total assets) may also be examined. This
ratio signifies how efficiently total resources are being used.

Profitability Ratios

Profitability ratios measure the overall record of management in producing profits. If

a firm does not earn ad adequate profit, its long-term survival will be threatened. If profits are
too low, for example, investors will be reluctant to provide new capital, which, in turn, will
stifle or even halt its growth.

How do we determine when profits are low or high? The level of profits alone does
not answer this question. Profits must be converted into a measure of profitability, which then
reveals how successful past decisions and policies have been in earning a return for its

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investors. Four profitability ratios will be examined. As with all ratios, it is important to note
that profitability ratios can measure only past performance. Too, often, it is assumed that
these figures will persist into the future.

Operating Profit Margin

The operating profit margin determines the percentage of each sales dollar that is
represented by operating profit. The operating profit margin is a financial ratio that measures
the efficiency of management.

Formula

The Net Profit Margin

The net profit margin tells you how much money a company makes for every $1 in
revenue.

Formula

Return On Equity - ROE

The return on equity is my favorite financial ratio. It reveals how much profit a
company earned in comparison to the total amount of shareholder equity on the balance
sheet. For those of you interested in long-term investing with rich rewards, companies that
have high return on equity ratios can provide the biggest payoff.

Formula

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Return On Assets - ROA

Return on asset is a guide to the overall proifitability of a firm and measures the after-
tax returns without regard to te manner in which the assets were financed.

Formula

And 2nd method is

ROA= net operating income (1-T) / Total Assets

Cash Conversion Cycle

Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period

Financial Markets

Introduction

A financial market is a mechanism that allows people to buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural
goods).

The term "market" is sometimes used for what are more strictly exchanges,
organizations that facilitate the trade in financial securities, e.g., a stock exchange or
commodity exchange. This may be a physical location (like the NYSE).

Major Financial Markets

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The financial markets can be divided into different parts.

1. Capital markets:- which consist of:

Stock markets

Which provide financing through the issuance of shares or common stock, and enable
the subsequent trading thereof.

Bond markets

Which provide financing through the issuance of bonds, and enable the subsequent
trading thereof.

2. Commodity Markets

Which facilitate the trading of commodities.

3. Money Markets

Which provide short term debt financing and investment.

4. Derivatives Markets

Which provide instruments for the management of financial risk.

5. Futures Markets

Which provide standardized forward contracts for trading products at

some future date.

6. Insurance Markets

Which facilitate the redistribution of various risks.

7. Foreign Exchange Markets

Which facilitate the trading of foreign exchange.

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The capital markets consist of primary markets and secondary markets. Newly formed
(issued) securities are bought or sold in primary markets. Secondary markets allow investors
to sell securities that they hold or buy existing securities.

Concept of Time-value of money and Its kinds

Time value of money

One of the most fundamental principles of financial decision making is the time value
of money. In simple terms, this concept states that when faced with a choice between two
identical cash flow amounts, an individual should prefer the cash flow that occurs earlier in
time because the time value of money makes this alternative more valuable.

For example A dollar today is said to be worth more than a dollar tomorrow. This is
because a dollar invested today will earn interest and be worth more than a dollar by the end
of the year. Similarly, $5,000 to be received in two year is worth more than $5,000 to be
received in three year. This is because, even though the magnitude of the cash flows is the
same (both are $5,00), they occur at different points in time and the potential to earn interest
on the earlier cash flow gives to time a value-commonly referred to as the time value of
money.

Kinds Of Annuities

Back to our example: by receiving $10,000 today, you are poised to increase the
future value of your money by investing and gaining interest over a period of time. For
Option B, you don't have time on your side, and the payment received in three years would be
your future value. To illustrate, we have provided a timeline:

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If you are choosing Option A, your future value will be $10,000 plus any interest
acquired over the three years. The future value for Option B, on the other hand, would only
be $10,000. So how can you calculate exactly how much more Option A is worth, compared
to option B? Let's take a look.
Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the
future value of your investment at the end of the first year is $10,450, which of course is
calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and
then adding the interest gained to the principal amount:

Future value of investment at end of

first year:
= ($10,000 x 0.045) + $10,000
= $10,450

You can also calculate the total amount of a one-year investment with a
simple manipulation of the above equation:

• Original equation: ($10,000 x 0.045) + $10,000 = $10,450

• Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
• Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the
principal amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left
untouched and you invested it at 4.5% for another year, how much would you have? To
calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the
end of two years, you would have $10,920:

Future value of investment at end of second

year:
= $10,450 x (1+0.045)

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= $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x

(1+0.045)

Think back to math class and the rule of exponents, which states that the
multiplication of like terms is equivalent to adding their exponents. In the above equation, the
two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation
can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is
earning interest in an investment. So, the equation for calculating the three-year future value
of the investment would look like this:

This calculation shows us that we don't need to calculate the future

value after the first year, then the second year, then the third year, and so
on. If you know how many years you would like to hold a present amount
of money in an investment, the future value of that amount is calculated by
the following equation:

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Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because
present value is what your investment gives you now if you were to spend it today. If $10,000
were to be received in a year, the present value of the amount would not be $10,000 because
you do not have it in your hand now, in the present. To find the present value of the $10,000
you will receive in the future, you need to pretend that the $10,000 is the total future value of
an amount that you invested today. In other words, to find the present value of the future
$10,000, we need to find out how much we would have to invest today in order to receive
that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must
subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can
discount the future payment amount ($10,000) by the interest rate for the period. In essence,
all you are doing is rearranging the future value equation above so that you may solve for P.
The above future value equation can be rewritten by replacing the P variable with present
value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to
be received in three years is really the same as the future value of an investment. If today we
were at the two-year mark, we would discount the payment back one year. At the two-year
mark, the present value of the $10,000 to be received in one year is represented as the
following:

Present value of future payment of $10,000 at end of year

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two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered
the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of
$10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a
$10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value
of the investment every year counting back from the $10,000 investment at the third year. We
could put the equation more concisely and use the $10,000 as FV. So, here is how you can
calculate today's present value of the $10,000 expected from a three-year investment earning
4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if

interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97
now and then investing it for three years. The equations above illustrate that Option A is
better not only because it offers you money right now but because it offers you $1,237.03
($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive
from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000)
greater than the future value of Option B.

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Present Value of a Future Payment

Let's add a little spice to our investment knowledge. What if the payment in three years
is more than the amount you'd receive today? Say you could receive either $15,000 today or
$18,000 in four years. Which would you choose? The decision is now more difficult. If you
choose to receive $15,000 today and invest the entire amount, you may actually end up with
an amount of cash in four years that is less than $18,000. You could find the future value of
$15,000, but since we are always living in the present, let's find the present value of $18,000
if interest rates are currently 4%. Remember that the equation for present value is the
following:

In the equation above, all we are doing is discounting the future value of an investment.
Using the numbers above, the present value of an $18,000 payment in four years would be
calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or
$15,386.48 today. Of course we should choose to postpone payment for four years!
These calculations demonstrate that time literally is money - the value of the money you have
now is not the same as it will be in the future and vice versa. So, it is important to know how
to calculate the time value of money so that you can distinguish between the worth of
investments that offer you returns at different times.

Sources of Finance

Short Term Financing

Commercial Paper
An unsecured, short-term debt instrument issued by a corporation, typically for the financing
of accounts receivable, inventories and meeting short-term liabilities. Maturities on
commercial paper rarely range any longer than 270 days. The debt is usually issued at a
discount, reflecting prevailing market interest rates.
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A major benefit of commercial paper is that it does not need to be registered with the
Securities and Exchange Commission (SEC) as long as it matures before nine months (270
days), making it a very cost-effective means of financing. The proceeds from this type of
financing can only be used on current assets (inventories) and are not allowed to be used on
fixed assets, such as a new plant, without SEC involvement.

Commercial Bank loans

Bank loans are very flexible. They can vary in the length of time that the loan has to
be repaid. Loans arranged with a bank that are less than one year are regarded as short term
finance. As with any other form of loan there are interest payments to be made and this can
be expensive and also can vary.

Most businesses have an account with a bank. The bank deals with all the deposits
(money put into the account) and withdrawals (money taken out). Most banks know that
businesses do not always receive money from sales straight away. If you run a sandwich bar
in a local trading estate then you might get money straight away when you sell your
sandwiches. If you are a business selling electrical equipment to an electrical retailer then you
may not get paid straight away when you deliver your goods.

When differences occur in the money a business receives from sales (its revenue or
turnover) and the money it has to pay out on labour, machinery, equipment, distribution and
so on (its costs) the firm can face difficulties.

For solve this situation company get loan from commercial bank and gives a specific
amount of interest on it for meeting his business needs.

P The purpose of the loan A loan request will be refused if the purpose of the loan is
not acceptable to the bank.
A The amount of the loan. The customer must state exactly how much he wants to

borrow. The banker must verify, as far as he is able to do so, that the amount
required to make the proposed investment has been estimated correctly.
R How will the loan be repaid? Will the customer be able to obtain sufficient income to

make the necessary repayments?

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T What would be the duration of the loan? Traditionally, banks have offered short-
term loans and overdrafts, although medium-term loans are now quite common.
S Does the loan require security? If so, is the proposed security adequate?

Trade Credit

This is a period of time given to a business to pay for goods that they have received. It
is often 28 days but some businesses might not pay for 6 months and on some occasions even
a year after they have received goods.

Almost all firms use trade credit as a method of financing. Although the extent of its
use varies by industry, trade credit accounts for approximately 40% of the total current
liabilities of Business Corporation. It is used extensively for several reasons.

First it is a continuous source of financing. That is, although the amount varies with
fluctuations in purchases, the firm always has some accounts payable: as some accounts are
paid, new purchases create new payables.

Another reason is that trade credit is more available than negotiated sources of short-
term credit. As purchases of goods and services increase in anticipation of increased
production and sales, accounts payable will increase automatically.

Collateral Supported Loans

A collateral loan is also called a secured loan. It is a loan obtained from a banking or
other financial institution, where in exchange, the creditor may sell that which is offered for
collateral if the loan is unpaid. A collateral loan is often offered at a lower interest rate than
an unsecured loan, because there is a guarantee of repayment should the borrower default on
the loan.

A collateral loan may use different things to secure the loan. Often people use stocks
or bonds to establish a collateral loan. They can use their ownership in property, where a
portion of perhaps a home, or a piece of land, is set up as collateral. If the borrower defaults,
he must sell the property to pay back the loan, and the lender has rights to sell the property
also, even if only a portion of the full value belongs to them. In these cases, a lender would
sell the home, and give the previous owner the monies not offered on collateral. A collateral
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loan may also be based on expected collateral, like the expected return on a harvested crop, or
on an investment. Occasionally, one can use property like high-valued jewelry as collateral,
or other high-valued goods. This is rare, as most collateral loans are based on paper assets, or
on real estate.

Intermediate financing

A situation in which a financial institution stands between counterparties in a

transaction. For example, in the sale of a house, a bank usually serves as a financial
intermediary by providing a mortgage to the buyer to pay the seller. In some non-traditional
transactions, a bank may buy a product (e.g. corn) and immediately re-sell it for a profit to a
third party. Most transactions requiring a loan to one of the parties include intermediation.
The normal flow of money into financial institutions in the form of deposits, which are then
loaned out to earn income. Contrast with disintermediation, which occurs when depositors
take their money out of financial institutions because they can earn more money, relatively
risk free, in other investments.

Intermediate-term financing Short-term loans are repaid in a period of weeks or

months, intermediate-term loans are scheduled for repayment in 1 to 15 years. Obligations
due in 15 or more years are thought of as long-term debt. The major forms of intermediate-
term financing include (1) term loans, (2) conditional sales contracts, and (3) lease financing

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