INTRODUCTION TO FINANCIAL MANAGEMENT
F.W.Paish –“In a modern money using economy finance may defined as the provision of money at the time it is wanted .”—- Procurement View .
John J Hampton—“The term finance can be defined as the management of the flows of money through an organization, whether it will be a corporation , school, bank or a govt. agency.”—Custodian Function.
Howard and Upton —“Finance may be defined as that administrative area or set of administrative functions in an organization which relate with the arrangement of cash and credit so that the organization may have the means to carry out its objectives as satisfactorily as possible.”
Functions of Finance — three major decisions
1) Investment Decision—Capital Budgeting.
2) Financing Decision—Procuring Owned & Borrowed Capital
3) Dividend Decision— Profits-> Dividends and Retained Earnings
Scope of FM
1) Estimating requirements of funds
2) Decision regarding capital structure
3) Investment Decision
4) Dividend Decision
5) Cash Mgt.
6) Evaluation of Financial Performance
7) Negotiation for additional funds
Objectives/Goals of FM
Fundamental objective is WEALTH MAXIMISATION.
Objectives which lead to Wealth Maximisation
a) Proper Utilisation of Funds
b) Maximisation of ROI
d) Achieving BEP
e) Managing Cash Flows
f) Minimum Profits—Peter Drucker—“Profit is a condition of survival.”
g) Coordination amongst different depts.-Prodcn., Sales, Finanace etc
h) Good Image of Orgn. in market & Public
Two Approaches for attaining Objectives/Goals of FM
A) Profit Maximisation Approach
B) Wealth Maximisation Approach
Changing Role of Finance Managers
Traditional role of Finance Managers was concerned only with raising funds for the organization. In the Modern times role of FM includes
a) Determining the requirement of funds for the orgn.
b) Determining Capital Structure –Owned Funds and Borrowed funds
c) Raising Funds at minimum cost and restrictive conditions.
d) Optimum utilization of funds
e) Financial solvency to be ensured at all cost.
f) Allocating the funds to different departments
g) Allocating funds between Fixed assets and Working Capital
Types of Risks (FM has to deal with)
1) Credit /Default risk- possibility that debtor will default
2) Interest Rate risk- change in bank deposit/loan rates
3) Business risk- failure of business due to controllable/uncontrollable factors
4) Inflation risk- Decrase in purchasing of money
5) Industry risk- failure of the related industry
6) Liquidity risk- inability to convert investment into cash
7) Systematic/undiversifiable risk- arising from external uncontrollable factors like political,economic etc.
8) Unsystematic/diversifiable risk- arising from internal controllable factors like plant breakdown/labour strike etc.
WORKING CAPITAL MANAGEMENT
Gerestenberg—“ Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another,as from cash to inventories, inventories to receivables and receivables to cash.”
Components of Working Capital
Current Assets = Stock of raw material , Work in process , Finished goods , spares and consumable stores , sundry debtors , bills receivable , cash balance , bank balance ,prepaid expenses , accrued income , advance payments , short term investments , marketable investments .
Current Liabilities = Sundry creditors , Bank Overdraft , bills payable , outstanding expenses , proposed dividend , provision for tax , income received in advance .
Types of Working Capital
A) a)Gross Working Capital = Total Current Assets
b)Net Working Capital = Total Current Assets – Total Current Liabilities
B) a)Positive Working Capital — when CA > CL
b)Negative Working Capital — when CA < CL
c)Zero Working Capital — when CA = CL
C) a)Permanent Working Capital— stays continuously /permanently in business
Types 1)Initial Working Capital – inception/beginning of business
2) Regular Working Capital – Minimum W Cap for normal
b)Variable Working Capital— varying WCap
Types 1) Seasonal Working Capital – according to season,
2) Special Working Capital – unforeseen events like strike, large contracts &
3) Peak Working Capital – Highest WCap required during operations.
D) Balance Sheet Working Capital – asper Balance Sheet at the year end.
E) Cash Working Capital—operational inflows & outflows of cash
Factors determining Working Capital
a) Nature of business
b) Size of business
c) Production period
d) Stocking requirements for raw material & Finished goods
e) Credit available from suppliers of goods and services
f) Credit to be given to customers
g) Production policies
h) Inventories Turnover
j) Technology—labour oriented/technology oriented
k) Taxation Policies—High tax rates=more W Cap.
l) Expanding business=more business
W. Cap.Management involves
Aim of W. Cap.Management=Reducing investment in W.Cap. + Reducing Operating Cycle Duration
Maximum Permissible Bank Finance (MPBF)
RBI appointed Tandon Committee and Chore Committee recommended that business enterprises should improve their liquidity position and strive to achieve Current Ratio of 2:1.
Calculation of MPBF
a) Low Risk Category of Borrowers— MPBF = 0.75 (CA-CL)
b) Medium Risk Category of Borrowers—MPBF = 0.75CA – CL
c) High Risk Category of Borrowers— MPBF = 0.75(CA-CCA) – CL
CCA= Core Current Assets
Core Current Assets mean minimum permanent level of current assets to be maintained by an enterprise so long as it is a going concern . Such core current assets assure uninterrupted production. Core current Assets should be financed from long term funds / owned funds.
|Less: Raw Material|
WORKING CAPITAL CALCULATION
A) Current Assets
1) Stock of Raw Material (1mth) = Annual Raw mat X 2/12mth
2) Stock of WIP (1.5 mth)
R Mat–Annual Raw mat X 1.5/12mth
+Labour — Annual Labour X 1.5/12mth X 1/2
+Expenses — Annual Expenses X 1.5/12mth X 1/2
3) Stock of Finished goods (2.5 mth) = Total Annual Cost of Prodn. X 2.5/12mth
4) Bills Receivable (3mth) = Credit Sales X 3/12 mth
5) Debtors ( 2mth) = Credit Sales X 2/12 mth
6) Advance for Raw Material(Adv. To creditors) (0.5mth)= Annual Raw mat X
7) Advance Fixed Overheads (1.2mth) = Annual Fixed Overheads X 1.2/12mth
8) Prepaid Expenses(1mth) = Annual Expenses X 1/12 mth
9) Cash & Bank Balance
Total Current Assets (CA)
Less: Current Liabilities
1) Creditors for Materials (1mth) = Annual Raw mat X 1/12mth
2)Outstanding Wages (1mth) = = Annual Labour charges X 1/12mth
3) Bills Payable(2mth) = Credit Purchases X 2/12mth
Total Current Liabilities (CL)
Working Capital ( CA – CL )
Eg.—1)Cash balance is 30% of monthly Profit—then prepare cost structure. Find Annual profit (profit per unit X units produced) .Find 30% of Annual profit.
2) If inland & export Sales given calculate Debtors for inland & export Sales separately.
4) Cost W. Cap–àCalculate Debtors and Bill Receivables on Total cost instead of Credit sales.
5) Cash Cost W.Cap.-> Calculate stock of WIP & Finished goods and Debtors and Bill Receivables at Cash Cost ( Total Cost other than Depreciation)
Working Capital Cycle/Operating Cycle
A continuous process starting from payment of cash for purchasing raw material ,
production , stocking , selling until obtaining money from debtors.
It is a cycle involving—- conversion of cash into raw material > conversion of raw material into WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors and > conversion of debtors into cash.
OC = R+W+F+D-C
Duration of Operating Cycle = Raw mat. period+WIP period +Finished goods period +Debtors collection period –Creditors payment period
CALCULATION OF W. CAP . CYCLE
i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days
ii) WIP duration = WIP stock X 365 days
Cost of Prodn.
iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days
Cost of Goods Sold
iv) Debtors Collection Period = Debtors X 365 days
i) Creditors Payment Period = Creditors X 365 days
Receivables include Debtors and Bills Receivables. Increase in Receivables ( more credit period) will lead to increase in sales and profits but it will also lead to increase in risk of bad debts.
Management of debtors and bills receivables involves determining the appropriate credit period extended to debtors in such a manner that sales are maximized and yet minimum funds are blocked in debtors and bad debts are minimized.
Importance of Receivables Management
Right receivables management leads to following benefits :
a) Increase in sales
b) Minimum funds blocked in receivables/Capital Cost
c) Tight recovery system/ controlled delinquency cost
d) Minimum bad debts/default cost
e) Minimum Collection Cost
Costs associated with A/cs. Receivables
1) Collection Costs—exp. of admn., collecting credit info.
2) Capital Cost—Cost of Funds blocked in Receivables
3) Delinquency Cost—Legal charges addnl. Collection costs
4) Default Cost—Bad Debts
Steps in Credit Appraisal
1) Customer Evaluation—Character+Capacity+Capital+Collateral Security+Conditions (economic)
2) Financial Stmts. of Customers
3) Bank references
4) Trade References
5) Credit Bureaus
6) Bank & Third Party Guarantees
7) Field Visits
a) Centralised Collection System
b) Decentralised Collection System
c) Post dated cheques
d) Pay order/bank draft
e) Bills of exchange
f) Lock Box System
g) Drop –box System
h) Collection Staff
i) Debt Collector
j) Del Credere Agent— collection of debts + assumes risk of bad debts
gets additional commission.
k) Concentration Banking
Control of Receivables
1) Days Sales Outstanding (DSO)
DSO= Debtors + Bills Receivable days
Average Daily Sales:
2) Ageing Schedule
Debtors are classified into different age brackets.
3) ABC Analysis
Classification of Debtors into A Category, B Category and C Category
A Category—Small no. of debtors but of large values—Highest Control
B Category— Moderate no. of debtors and of moderate values—
– Moderate Control
C Category— Large no. of debtors but of small values
– Less Control
Involves evaluating capacity of customers requiring credit period. Criteria of measuring creditworthiness of prospective customers :
2) Character of customer
3) Capacity to repay
4) Capital / financial position of customer
5) Collateral Security provided by customer
6) Conditions (Economic, Social , competition etc.)
Opportunity/profit foregone(givenup) as a result of blocking the money in Debtors instead of investing it in other manner.
Credit Policy Variables
Determining Credit Policy involves determining the following variables:
a) Credit evaluation and Credit Rating of customers
b) Costs associated with accounts receivables- Collection cost , Capital cost , Delinquency cost and Default cost .
c) Collection methods of receivables
d) Control of Receivables through – Days Sales Outstanding ,Ageing Schedule and ABC Analysis
Evaluation of credit Policies
-Current Sales 10 lakh, shall increase by 200000 in option 1 , by 300000 in option 2 . —Variable cost are 35% of Sales. Fixed cost are Rs 200000 .
-Existing credit period is 2 mth, option 1 is 2.5 mth. and option 2 is 3 mth.
-Credit Sales are 80% of total Sales.
-Required rate of return is 12%.
-Existing Bad debt loss is 2% , option 1 is 3% and option 2 is 4%.
-Collection cost is 3% of debtors .
|Particulars||Present Policy||Option 1||Option 2|
|Less: Fixed Cost||
|Average Invt.in Debtors= Total Cost X Creditsales X Total Sales
Debtor Period mth
|5,50,000 X 80% X 2/12mth =73333||6,20,000 X 80% X 2.5/12mth =103333||6,55,000 X 80% X 3/12 mth. = 131000|
|a) Opportunity cost of capital= eg. 12% x Avg.Invt.in Debtor||73333 X 12% = 8800||103333 X 12% = 12400||131000 X 12% = 15720|
|b) Bad debt cost= eg.Bad debt % x Sales||10,00,000 X 2% =20,000||12,00,000 X 3% = 36,000||13,00,000 X 4% = 52,000|
|c) Collection Cost = 3% x Debtors||(10,00,000 X 2/12mth) X 3% = 5000||(12,00,000 X2.5 /12 mth)X 3%
|(13,00,000 X 3/12mth) X 3%
|NET BENEFITS(Profit – Total Cost)||
a) If P/V Ratio is given find — Contribution = Sales X P/V ratio.
b) If Debtors Turnover ratio is given — Debtors = Credit sales
Debtors Turnover ratio
c) Debtors Velocity = 12 mths.
Debtors Turnover ratio
Cash in a broader sense includes coins, currency notes, cheques , bank drafts and also marketable securities and time deposits with banks.
Objectives of Cash Management
a) To meet payment needs of trading & business activities.
b) To minimize idle funds
c) To avoid cash crunch
d) To maintain liquidity
e) To make payments to creditors and suppliers on time.
MOTIVES for holding Cash
1) Transaction Motive — for routine business/ operating payments
2) Precautionary Motive — to provide for unexpected/ unpredictable events like strike, flood, increase in raw material cost etc.
3) Speculative Motive — to take advantage of unexpected opportunities like favourable/ reduced prices of material , discount for bulk purchases etc.
4) Compensating Motive — Minimum balance is required to be maintained with the banks for various services provided by them.
CASH MANAGEMENT MODELS
1) Baumol’s Model —Baumol (1952) Cash can be managed in the same manner as inventory using Economic Order Quantity Model (EOQ model) .
C = √2FT
C = Optimal Transaction size
F = Fixed Cost per transaction
T = Expected cash payments during the period
I = Interest rate on Marketable Securities
2) Miller – Orr Model (1966) ( Stochastic Model )
Specifies two control limits
Upper Control Limit- When cash touches UCL marketable securities are purchased.
Lower Control Limit- When cash touches LCL marketable securities are sold.
Involves Two Cycles—Disbursement Cycle and Receipt Cycle
a) Disbursement Cycle—Total time between obligation to pay supplier arises and upto when payment clears the bank. To be maximized.
Three Floats should be maximized to postpone payment
Mail Float- Time spent in mail
Clearance Float- Time spent for clearing payment through bank
Processing Float – Time required for processing payment transaction.
b) Receipt Cycle—- Total time between products or services are provided and upto when payment from customer clears the bank.
Cash Budget Definition
A Statement showing expected receipts and payments (of both trading and capital nature) over a period of time , prepared with the intention of planning and controlling the use of cash.
Preparation of Cash Budget
|Particulars||Jan. 2010||Feb. 2010||Mar. 2010|
|1) Cash Sales||80000|
|2)Receipts from Debtors-after one mth.
-after 2 mths.
|3) Income from4) Invt.|
|1) Cash Purchases|
|2) Payment to Creditors|
|3) Payment of Wages|
Eg. 1) Total Sales of Jan 2010 are 400000. 20% Cash Sales. 40% of credit sales are paid in next month and balance in second month.
-à It means 80000 are cash sales received in Jan.2010 & 120000 credit sales. Of 120000, 40% ie. 48000 shall be received in Feb.2010 and balance 72000 in March 2010
2) If specifically given closing cash balance is to be maintained every month.
à Take it as closing cash balance and balancing figure should be taken as
payment to debtor in that month.