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)