1 finance december 7 th 2012. what is financial management? art & science of managing money 2
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FINANCE
December 7th 2012
What is Financial Management?
Art & Science of managing money
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Primary Activities
• Financing Decision Raising of funds; amount, sources
• Investment DecisionBuy assets; fixed assets/projects Current Assets/Working CapitalCorrelate with risk and uncertainty
• Dividend DecisionRetain profits (reinvest)/give dividends
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Controlling and Monitoring
• Stakeholders in a business (Owners, Managers, Regulators, Creditors)
are interested in knowing– current status of the business
– results of business carried out during a specific period
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Basic Accounting Concepts
• Business Entity• Money Measurement• Cost; Acquisition cost• Going Concern• Conservative nature• Accounting Period• Matching; revenues and expenses• Materiality• Consistency
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Tools for Controlling / Monitoring
Annual Reports - Financial Statements • Balance Sheet – Summary of Financial position at a given point of time.– Like a snapshot; list of assets and liabilities
• Profit & Loss Statement– Summary of operating results during a period.
• Cash Flow Statement– Summary of firms operating, investment and financing
cash flows during a period
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Working Capital• Investment in various forms of Current Assets • Necessary for smooth and uninterrupted functions of
business operations of the firm• Current Assets include: Inventory (Raw Material, Work
in Process & Finished Goods), Debtors (Receivables), Advances, Cash
• Tradeoff between profitability and liquidity• Gross Working Capital = ∑ (Current Assets)• Net Working Capital
= ∑ Sum (Current Assets) - ∑ Sum (Current Liabilities)
Receivables
Inventory
Cash
Operating Cycle
It is sum of 1. Inventory Conversion Period (ICP)
Total Time required for producing and selling the product; includes
1. Raw Material Storage Period (RMSP)2. Work in Process Conversion Period (WIPCP)3. Finished Goods Storage Period (FGSP)
2. Debtors Conversion Period (DCP)Time required to collect outstanding amount from customers
Operating Cycle Constituents
Gross Operating Cycle (GOC) = ICP + DCP
• Actually purchase of Raw Materials on Credit • leads to temporarily postponing payments, source of finance.
Payment Deferral Period (PDP)
• Time firm is able to delay payments on purchase of various resources Net Operating Cycle(NOC) = GOC – PDP
NOC is also called as Cash Cycle
Operating Cycle Calculation
Analysis of Financial Statements
Ratio Analysis - widely used toolMakes related information comparablee.g. Net Profit in relation to what?
Standards of Comparison• Cross sectional Analysis; competitors ratio or industry ratio• Time series Analysis evaluation of performance over time
Classification of Ratios• Liquidity• Activity• Leverage • Profitability
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Liquidity Ratios
Indicate ability to meet current obligationsCurrent Ratio
Current Assets / Current Liabilities
It is a test of quantity not quality
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Liquidity Ratios
Quick (Acid Test) Ratio
(Current Assets – Inventories - Loans & Advances) Current Liabilities
• Select only Current Assets that can be converted to cash without loss of value
• Measure of liquidity when inventory cannot be easily converted to cash
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Activity Ratios
• Measure firm’s operating efficiency; • Indicates speed with which assets are converted
into salesFixed Assets Turnover Ratio
Sales
Average Net Fixed Assets
• High is better, means better utilization of assets
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Inventory Turnover RatioSales
Average Inventory
Average Collection Period
365 days
Inventory Turnover Ratio
Inventory Turnover Ratio
Debtors Turnover Ratio Credit Sales / Average Debtors
Average Collection Period
365 days / Debtors Turnover Ratio
• Measures speed with which debtors are converted to cash• High means better management of credit, quality of debtors
good
Debtors Turnover Ratio
• Indicates financial risk and firms ability to use debt to shareholders advantage
• Ability to service debts or degree of indebtedness• Indicates mix of funds provided by owners and lenders
• The process of magnifying shareholder return through use of debt is called “Financial Leverage”, “Financial Gearing” or “Trading on Equity”
Leverage Ratios
Debt Equity RatioTotal DebtNet Worth
• High means Risky Investment
Interest Coverage Ratio
EBIT
Interest Charges • Measures ability to meet contractual payments
Leverage Ratios
• Profitability in relation to Sales and in relation to InvestmentOperating Profit Margin
Operating Profit (EBIT)Sales
• Measure for operating efficiency of the company
Net Profit MarginProfit after Tax(PAT)
Sales
Profitability Ratios
Return on Capital (ROC)
Profit before Interest & Taxes (PBIT)Capital
Capital= Debt +Equity
Return on Equity (ROE)Profit After Tax
Net Worth
Profitability Ratios
Earnings Per Share (EPS)Profit after Tax/Number of shares
• Profit earned by firm on a per share basisPrice/Earnings Ratio(P/E)
Market Price of Equity Share/EPS
• Measures the amount investors are ready to pay for every rupee of current day earnings
• Higher P/E – indicates higher investor confidence
Some other Measures
• Capital Budgeting –investment in Long Term Assets (Fixed Assets) in anticipation of future benefits over a series of years
• e.g.. Expansion, Diversification, Modernization, Cost Reduction Proposal
• Investment in Short Term Assets (Current Assets) - Working Capital Management
Capital Budgeting
• Related to long term survival of the business• e.g.. investment in technology
• Large amount of funds
• Assessment of future events and cash flows
makes it difficult
• Typically Irreversible
Importance
Types of Projects-Independent or Mutually Exclusive
Steps in Project Evaluation and Management
• Project/Proposal Generation• Project Evaluation – Congruence with objectives of firm
• Project Selection• Project Execution• Monitoring
Project Management Process
Some ignore Time Value of Money Some consider Time Value of Money
Payback Period Time taken for the Cash benefits to recover the original cost of an investment • Very basic measure of feasibility, has its limitations• Better metric is Discounted Payback Period
Project Evaluation Techniques
Present Values of Cash Inflows and Outflows are calculated using cost of capital
NPV = ∑ PV (Cash Flows)in - ∑ PV (Cash Flows)out
NPV>0 May acceptNPV<0 Reject
Net Present Value (NPV)
• It is the rate of return that the project gives independent of any external rate
• Depends solely on cash inflows and cash outflowsIt is the rate at which, ∑ PV (Cash Flows)in = ∑ PV (Cash Flows)out
or NPV = 0
IRR>Cost of Capital (k) may acceptIRR<Cost of Capital (k) reject
Internal Rate of Return (IRR)