CHAPTER  I

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                                   INTRODUCTION  TO  FINANCIAL  MANAGEMENT

 

 

Definitions  :

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

c)      Survival

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.

 

                                                             CHAPTER   II

                                 WORKING  CAPITAL  MANAGEMENT

Definition :

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   

                 business

     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

i)        Inflation

j)       Technology—labour oriented/technology oriented

k)     Taxation Policies—High tax rates=more W Cap.

l)        Expanding business=more business

 

 

W. Cap.Management involves

-Cash  Mgt.

-Receivables  Mgt.

-Inventory Mgt.

-Creditors Mgt.

 

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.

 

 

 

Sales    
Less: Raw  Material    
          Wages    
          Variable  Overheads    
     
     
     
     

 

 

 

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 

                                                                                                        0.5/12mth

 

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

Ie.

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

                                                                Annual Purchases

                                     +

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

                                                          Credit  Sales

 

LESS  :

i)  Creditors  Payment  Period  =  Creditors                   X  365  days

                                                          Credit  Purchases

 

 

 

 

                                                   CHAPTER   III

 

                             RECEIVABLES   MANAGEMENT

 

 

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.

 

Receivables  Management—Definition

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

 

Collection  Methods

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

l) Factoring

 

 

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

 

Credit  Analysis

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  Cost

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

Example :

-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
Credit Period

2 mth.

2.5 mth.

3 mth

Sales

10,00,000

12,00,000

13,00,000

Less:Variable Cost

  3,50,000

4,20,000

4,55,000

Contribution(S-V)

  6,50,000

7,80,000

8,45,000

Less: Fixed Cost

  2,00,000

2,00,000

2,00,000

PROFIT(BENEFIT)

  4,50,000

5,80,000

6,45,000

 

 

 

 

TotalCost=FC+VC

5,50,000

6,20,000

6,55,000

Average Invt.in Debtors= Total Cost  X Creditsales   X    Total Sales 

Debtor Period mth

 12 mths

 

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
COST      
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%

= 7500

(13,00,000  X    3/12mth)   X 3%

= 9,750

TOTAL COST

33,800

55,900

77,470

NET  BENEFITS(Profit – Total Cost)

4,16,200

5,24,100

5,67,530

RATING

III

II

I

 

 

 

Formulae

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

 

 

 

 

                                                   CHAPTER   IV

 

                                   CASH   MANAGEMENT

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

I

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.

 

 

 

CASH  CYCLE

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
Opening Balance
RECEIPTS
1) Cash Sales 80000
2)Receipts from Debtors-after one mth.

-after 2 mths.

 

48000

 

 

72000

3)      Income  from4)      Invt.
4)
Total Receipts
 
PAYMENTS
1) Cash Purchases
2) Payment to Creditors
3) Payment of Wages
 
Total Payments
Closing Balance

 

 

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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


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