research of financial management
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UNIVERSITY OF SAN JOSE RECOLETOS
Financial Managent
DBA
By
Mojgan Mashayekhi
June 2011
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I. Introduction:
Companies do not work in a vacuum, isolated from everything else. It interacts
and transacts with the other entities present in the economic environment. These
entities include Government, Suppliers, Lenders, Banks, Customers,
Shareholders, etc. who deal with the organisation in several ways. Most of these
dealings result in either money flowing in or flowing out from the company. This
flow of money (or funds) has to be managed so as to result in maximum gains to
the company. Managing this flow of funds efficiently is the purview of finance. So
we can define finance as the study of the methods which help us plan, raise and
use funds in an efficient manner to achieve corporate objectives. Finance grew
out of economics as a special discipline to deal with a special set of common
problems.
The corporate financial objectives could be to:
1. Provide the link between the business and the other entities in the
environment; and
2. Investment and financial decision making.
Let us first look at what we mean by investment and financial decision making.
1. Investment Decision: The investment decision, also referred to as the
capital budgeting decision, simply means the decisions to acquire assets
or to invest in a project. Assets are defined as economic resources that
are expected to generate future benefits.
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2. Financing Decision: The second financial decision is the financing
decision, which basically addresses two questions:
a. How much capital should be raised to fund the firm's operations
(both existing & proposed)
b. What is the best mix of financing these assets?
Financing could be through two ways: debt (loans from various sources like
banks, financial institutions, public, etc.) and equity (capital put in by the investors
who are also known as owners/ shareholders). Shareholders are owners
because the shares represent the ownership in the company.
II. COST OF CAPITAL
The cost ofcapital is a term used in the field of financial investment to refer to
the cost of a company's funds (both debt and equity), or, from an investor's point
of view "the shareholder's required return on a portfolio of all the company's
existing securities. It is used to evaluate new projects of a company as it is the
minimum return that investors expect for providing capital to the company, thus
setting a benchmark that a new project has to meet.
The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
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Adjusting for risk
Why is the cost of retained earnings cheaper than the cost of issuing new
common stock?
When a company issues new common stock they also have to pay
flotation costs to the underwriter.
Issuing new common stock may send a negative signal to the capital
markets, which may depress the stock price.
III. 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 do this, a sound procedure to evaluate, compare, and select
projects is needed. This procedure is called capital budgeting.
CAPITAL IS A LIMITED RESOURCE
In the form of either debt or equity, capital is a very limited resource. There is a
limit to the volume of credit that the banking system can create in the economy.
Commercial banks and other lending institutions have limited deposits from
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which they can lend money to individuals, corporations, and governments. In
addition, the Federal Reserve System requires each bank to maintain part of its
deposits as reserves. Having limited resources to lend, lending institutions are
selective in extending loans to their customers. But even if a bank were to
extend unlimited loans to a company, the management of that company would
need to consider the impact that increasing loans would have on the overall cost
of financing.
In reality, any firm has limited borrowing resources that should be allocated
among the best investment alternatives. One might argue that a company can
issue an almost unlimited amount of common stock to raise capital. Increasing
the number of shares of company stock, however, will serve only to distribute the
same amount of equity among a greater number of shareholders. In other
words, as the number of shares of a company increases, the company ownership
of the individual stockholder may proportionally decrease.
The argument that capital is a limited resource is true of any form of capital,
whether debt or equity (short-term or long-term, common stock) or retained
earnings, accounts payable or notes payable, and so on. Even the best-known
firm in an industry or a community can increase its borrowing up to a certain limit.
Once this point has been reached, the firm will either be denied more credit or be
charged a higher interest rate, making borrowing a less desirable way to raise
capital.
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Faced with limited sources of capital, management should carefully decide
whether a particular project is economically acceptable. In the case of more than
one project, management must identify the projects that will contribute most to
profits and, consequently, to the value (or wealth) of the firm. This, in essence, is
the basis of capital budgeting.
Basic Steps of Capital Budgeting
1. Estimate the cash flows
2. Assess the riskiness of the cash flows.
3. Determine the appropriate discount rate.
4. Find the PV of the expected cash flows.
5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or
payback < policy
Evaluation Techniques
A. Payback period
B. Net present value (NPV)
C. Internal rate of return (IRR)
D. Modified internal rate of return (MIRR)
E. Profitability index
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IV. OPERATING AND FINANCIAL LEVERAGE
One of the most important of the various financial decisions is how much
leverage a firm should employ. A fundamental decision made by any business is
the degree to which it incurs fixed costs. A fixed cost is one that remains the
same regardless of the level of operations. As sales increase, fixed costs don't
increase in the same proportion. Some fixed costs do not increase at all till a
particular point. As a result, profits can rise faster during good times. On the
other hand, during bad times fixed costs don't decline, so profits fall more rapidly
than sales do. The degree to which a firm locks itself into fixed costs is referred
to as its leverage position. The more highly leveraged a firm, the riskier it is
because of the obligations related to fixed costs that must be met whether the
firm is having a good year or not. At the same time, the more highly leveraged
the greater the profits during good times. This presents a classic problem of
making a decision where there is a trade-off between risk and return.
There are two major types of leverage - financial and operating. Financial
leverage is specifically the extent to which a firm gets its cash resources from
borrowing (debt) as opposed to issuance of additional shares of (equity). The
greater the debt compared to equity, the more highly leveraged the firm because
debt legally obligates the firm to interest payments. These interest payments
represent a fixed cost. Operating leverage is concerned with the extent to which
a firm commits itself to high levels of fixed costs other than interest payments. A
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firm that rents property using cancellable leases has less leverage than a firm
that commits itself to a long-term noncancellable lease does. A firm that has
substantial vertical integration has created a highly leveraged situation. Consider
what happens if a company vertically integrates by acquiring its raw materials'
supplier. Raw materials will now cost the company less, because it doesn't have
to buy them from an outside firm. But when times are bad, the firm will have to
bear the fixed costs associated with the supplier subsidiary. Had there still been
two separate companies, the big company could have simply slowed its
purchases of raw materials from supplier without having to bear its fixed costs.
In the cases of both financial and operating leverage, the crucial question is how
much everage is appropriate. We can't answer that question in absolute terms,
but we will help you understand the topic. This understanding should make it
simpler to make appropriate choices or to understand what went into making the
choices your firm has already made.
Operating Leverage
While decisions about financial leverage is strictly the domain of the firm's
highest levels of management, operating leverage is an issue that directly affects
the line managers of the firm. The level of operating leverage a firm selects
should not be made without input from the managers directly involved in the
production process. For example, one of the most significant operating leverage
issues is the choice of technology levels. Selection of the highest level of
technology available is not always in the best interests of the business. Suppose
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that we are opening a chain of copy centres. Each centre will provide a full
service operation. Customers can drop work off in the morning and pick it up later
in the day or the week. The employees will do the actual photocopying. We are
faced with the choice of renting a relatively slow copy machine, or the newest
technology machine, which is considerably faster. The faster machine is also
considerably more expensive to lease. It will generally be the case that newer
technology has a higher fixed cost and lower variable cost than the older
technology. Variable costs are those that vary directly with volume. If we double
the number of copies made, we double the amount of paper, printing ink toner,
and labour time needed for making the copies. One of the principle functions of
new technology is to reduce the variable costs of production. It may turn out that
a machine that can reduce the variable costs is more expensive to make, and
thus has a higher purchase or lease price than the older generation machine.
However, even if it doesn't cost more to make, its manufacturer will charge more
for the new machine than for the older machine. Intuitively, if the new machine is
in some respect better than the old machine (that is, it lowers the variable cost
without reducing quality), and doesn't cost more to buy, then no one will buy the
older machine. Thus, anytime we see two technologies being sold side by side,
such as slow and fast copy machines, we can expect the faster machine to have
a higher rental fee or purchase price, and therefore a higher fixed cost.
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V. RAISING CAPITAL
Raising capital for small business expenses is not the easiest step of starting a
small business but it is necessary. One major reason why small businesses fail is
because the owner lacked necessary funds. Money is needed for equipment,
property and more essentials for your small business. You may wonder how you
can raise the money needed to start your small business.
There are two major sources of funding you can seek for your business: Equity
VS Debt Financing. Below there are listed various methods of raising capital for a
small business including forms of equity and debt financing. Analyze each option
below and determine which method/ methods is better suited for your particular
small business.
9 Ways of Raising Capital
1. Saving up your own money- When starting a small business you may not
have all the money needed for start up costs; however you should have some
money saved up for the purpose of starting your business. Bank lenders in
particular are more suspicious of entrepreneurs who dont invest in their own
business. As a result they can decline a loan because of your lack of investment.
2. Borrow from Friends and Family- I know raising capital for small business
expenses by asking friends and family for money isnt fun, but hopefully you can
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win them over with your great business idea. To avoid complications in the future
make sure to have a written agreement stating terms and details of the loan. You
wouldnt want to fight with loved ones over money. Be sure to present your
proposition in a professional manner. Show them your business plan, explain to
them why they should invest in you, and answer all their questions. If someone is
giving you money for your business as a gift, be sure you obtain a letter from
them stating the amount of money and that it was a gift. This is precaution to
avoid future complications and misunderstandings.
3. Getting a small business loan- When raising capital for small business
expenses many entrepreneurs go this route. However before attaining a loan you
should be aware that there are many factors associated with business loans such
as interest rates, late charges and collateral. Local community banks are often a
great place to obtain a business loan. Click here for SME Loans and otherFund
sources here.
4. Find a business partner and use their funds- Another way of raising capital
for small business expenses is to develop a business partnership with someone
who can invest in your business. Make sure to present them with a persuasive
explanation for why they should join forces with you.
5. Incorporating your small business- Many entrepreneurs decide to
incorporate their businesses for the purpose of raising capital for small business
expenses. When you incorporate your small business, you will be able to sell
shares of stocks. However when you sell shares of stocks you will also be selling
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a percentage of the ownership over the business. So if you sell 50% of your
corporations shares of stocks you are selling 50% of the business ownership.
6. Finding a venture capitalist- Venture Capitalists are professionals who invest
in businesses that show a high growth potential. Not only do venture capitalists
provide funding for their clients by investing in their business but they also
provide valuable business advice and strategies. If a venture capitalist decides to
invest in your business it demonstrates to others that they viewed your chances
of success to be favorable. However once a venture capitalist decides to invest in
your business they often have a say on how it should be run. Since venture
capitalists invest in businesses that demonstrate very high and fast growth rates,
many small businesses do not meet the criteria.
7. Small Business Investment Companies- Small Business investment
companies are venture capitalists targeted for small businesses. They are
partnered with the government and provide small businesses with funding in
exchange for a percentage of ownership in the business.
8. Angel investors- Finding an angel investor is another way of raising capital
for small business expenses. Angel investors are simply private investors who
invest money in your business with the belief and hope that in a couple of years
they will see a higher return on their investment. After a 5 year period an angel
investor may expect a return of at least double their initial investment. Of course
starting a small business is risky business so the angel investor may not see any
return if your small business fails. Naturally an angel investor will want
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guaranteed exit provisions in the case that your small business fails. You can find
an angel investor by networking with other business owners and small business
professionals. You can also subscribe to angel network firms that can match you
with an angel investor.
9. Credit Cards Many small businesses have turned to credit cards in order to
pay their small business expenses. Credit Cards may seem like a quick fix but
make sure the terms and interest rates are reasonable.
Wait Before you go
Before raising capital for small business expenses it is important that you first
determine how much capital you need for your small business. Create a business
budget. Take in consideration that entrepreneurs often underestimate how much
money is needed to run a small business and fail to expect the unexpected. For
example what if your equipment gets damaged and you need replacementsdo
you have a back up plan? That is why it is a good idea to always have extra
money put aside just in case.
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VI. CREDIT AND INVENTORY MANAGEMENT
Inventory management is primarily about specifying the size and placement of
stocked goods. Inventory management is required at different locations within a
facility or within multiple locations of a supply network to protect the regular and
planned course of production against the random disturbance of running out of
materials or goods. The scope of inventory management also concerns the fine
lines between replenishment lead time, carrying costs of inventory, asset
management, inventory forecasting, inventory valuation, inventory visibility, future
inventory price forecasting, physical inventory, available physical space for
inventory, quality management, replenishment, returns and defective goods and
demand forecasting
Other definitions of inventory management from across the web:
Involves a retailer seeking to acquire and maintain a proper merchandise
assortment while ordering, shipping, handling, and related costs are kept
in check.
Systems and processes that identify inventory requirements, set targets,
provide replenishment techniques and report actual and projected
inventory status.
Handles all functions related to the tracking and management of material.
This would include the monitoring of material moved into and out of
stockroom locations and the reconciling of the inventory balances. Also
may include ABC analysis, lot tracking, cycle counting support etc.
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Management of the inventories, with the primary objective of
determining.controlling stock levels within the physical distribution function
to balance the need for product availability against the need for minimizing
stock holding and handling costs.
In business management, inventory consists of a list of goods and
materials held available in stock.
An inventory can also be a self examination, a moral inventory.
Credit Management: Key Issues
Granting credit increases sales
Costs of granting credit
Chance that customers wont pay
Financing receivables
Credit management examines the trade-off between increased sales and
the costs of granting credit.
Components of Credit Policy
Terms of sale
= Credit period
= Cash discount and discount period
= Type of credit instrument
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Credit analysis distinguishing between good customers that will pay
and bad customers that will default
Collection policy effort expended on collecting receivables
Credit Policy Effects
Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales
Cost Effects
Cost of the sale is still incurred even though the cash from the sale has
not been received
Cost of debt must finance receivables
Probability of nonpayment some percentage of customers will not pay
for products purchased
Cash discount some customers will pay early and pay less than the full
sales price
Five Cs of Credit
Character willingness to meet financial obligations
Capacity ability to meet financial obligations out of operating cash flows
Capital financial reserves
Collateral assets pledged as security
Conditions general economic conditions related to customers business
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Types of Inventory
Manufacturing firm
Raw material starting point in production process
Work-in-progress
Finished goods products ready to ship or sell
Remember that one firms raw material may be another firms finished
good
Different types of inventory can vary dramatically in terms of liquidity
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VII. FORMS OF CORPORATE RESTRUCTURING
Corporate restructuring changes the way a company approaches finances,
technology or its business focus.Corporate restructuring is a general term used
to describe major changes within a company. These changes usually affect basic
business practices, redetermining who makes the major decisions in a company
or how certain parts of its business plan are approached. The type of
restructuring depends on the elements of the business being affected and the
reasons that the restructuring is occurring.
Internal Restructuring
Corporate restructuring occurs based on the needs of the company. Internal
restructuring typically occurs as a result of business analysis that shows a need
for greater efficiency in the way business departments communicate and
complete tasks. Sometimes a particular segment of the business will start to fail,
and the company will need to reallocate resources in order to support it.
Sometimes a business may have expanded to much, and needs to refocus on its
core abilities. At other times a business may need to restructure its financial
position in order to continue making profits. Often, restructuring plans are
necessary simply to meet the constantly change demands of technology that
competitors are embracing. Not all reasons for restructuring are negative, and
many benefit employees as well as executives in the company.
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Financial Restructuring
Financial restructuring deals with all changes the businesses makes to its debts
and equity, including mergers, acquisitions, joint ventures and other deals.
Generally these occur when a company joins or is bought by another company.
Ownerships of the company, or at least some interest in the company, is
transferred to another organization or group of investors. Actual business
practices may remain unchanged.
Technological Restructuring
Technological restructuring occurs when a new technology has been developed
that changes the way an industry operates. This type of restructuring usually
affects employees, and tends to lead to new training initiatives, along with some
layoffs as the company improves efficiency. This type of restructuring also
involves alliances with third parties that have technical knowledge or resources.
Restructuring Methods
Restructuring methods are typically divided into expansion, refocusing, corporate
control, and ownership structure. The last two, corporate control and ownership
structure, apply mostly to financial changes and affect ownership. Corporate
control, for instance, is a method where the company buys back enough shares
to be able to make its own decisions again. Expansion occurs with acquisition,
mergers, or joint ventures. Refocusing can take many forms, including business
splits, sell offs of certain ventures, and general consolidation practices.
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VIII. COMPARATIVE ANALYSIS
Comparative financial statements are ones, which have been prepared in a
systematic manner and provides statistical information about a particular event
(financial transaction) or aspect, taking place on different dates or during different
periods.
The comparative financial statements are chalked out in a columnar form (in
majority of the cases). One is also able to view comparative accounts of different
companies.
Comparative financial statements, like all other financial statements have the
following types of financial statements:
Income statements
Cash flow statements
Balance Sheet
Income statements:
Also known as profit and loss financial statement, these types of comparative
financial statements suggest profit amount earned by a company as well as
amount of money lost by a company. Loss or profit may not always mean, loss or
profit of money, it may also include any asset or stock, which has an economic
value. Income statements also include expenditure incurred for conducting
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activities, related to operations. This type of a financial statements is referred to
as an operating financial statement.
An income statement can be of two types:
Single step income statements
Multi step income statements
It is suggested that, in the preparation of a financial statement, the income
statement, is first worked on. This is generally followed by the statements of cash
flow and balance sheet. In the preparation of a balance sheet, information from
the cash flow statement as well as income statement is often required.
Balance sheet:
Information pertaining to expenses and profit earned by a company are recorded
in the balance sheet.
Statement of cash flow:
Records information about movement of cash within and outside the company.
Usefulness of comparative financial statements: The comparative financial
statements are very helpful in carrying out company analysis. This type of
financial statement is also helpful in observing trends. The auditor traces the
various trends pertaining to a particular financial activity of a company. The
auditor may suggest measures to improve the financial health of the company.
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IX. FINANCIAL RATIOS
Financial ratios are useful indicators of a firm's performance and financial
situation. Most ratios can be calculated from information provided by the financial
statements. Financial ratios can be used to analyze trends and to compare the
firm's financials to those of other firms. In some cases, ratio analysis can predict
future bankruptcy.
Financial ratios can be classified according to the information they provide. The
following types of ratios frequently are used:
Liquidity ratios
Asset turnover ratios
Financial leverage ratios
Profitability ratios
Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term
financial obligations. They are of particular interest to those extending short-term
credit to the firm. Two frequently-used liquidity ratios are the current ratio (or
working capital ratio) and the quick ratio.
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The current ratio is the ratio of current assets to current liabilities:
Current Ratio =Current Assets
Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk.
Shareholders may prefer a lower current ratio so that more of the firm's assets
are working to grow the business. Typical values for the current ratio vary by firm
and industry. For example, firms in cyclical industries may maintain a higher
current ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items thatare difficult to liquidate quickly and that have uncertain liquidation values. Thequick ratio is an alternative measure of liquidity that does not include inventory inthe current assets. The quick ratio is defined as follows:
Quick Ratio =Current Assets - Inventory
Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and
notes receivable. These assets essentially are current assets less inventory. The
quick ratio often is referred to as the acid test.
Finally, the cash ratio is the most conservative liquidity ratio. It excludes allcurrent assets except the most liquid: cash and cash equivalents. The cash ratiois defined as follows:
Cash Ratio =Cash + Marketable Securities
Current Liabilities
The cash ratio is an indication of the firm's ability to pay off its current liabilities if
for some reason immediate payment were demanded.
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Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They
sometimes are referred to as efficiency ratios, asset utilization ratios, or asset
management ratios. Two commonly used asset turnover ratios are receivables
turnoverand inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accountsreceivables and is defined as follows:
Receivables Turnover =Annual Credit Sales
Accounts Receivable
The receivables turnover often is reported in terms of the number of days thatcredit sales remain in accounts receivable before they are collected. This numberis known as the collection period. It is the accounts receivable balance divided bythe average daily credit sales, calculated as follows:
Average Collection Period =Accounts Receivable
Annual Credit Sales / 365
The collection period also can be written as:
Average Collection Period =365
Receivables Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goodssold in a time period divided by the average inventory level during that period:
Inventory Turnover =Cost of Goods Sold
Average Inventory
The inventory turnover often is reported as the inventory period, which is thenumber of days worth of inventory on hand, calculated by dividing the inventoryby the average daily cost of goods sold:
Inventory Period =Average Inventory
Annual Cost of Goods Sold / 365
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The inventory period also can be written as:
Inventory Period =365
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-term solvency of the
firm. Unlike liquidity ratios that are concerned with short-term assets and
liabilities, financial leverage ratios measure the extent to which the firm is using
long term debt.
The debt ratio is defined as total debt divided by total assets:
Debt Ratio =Total Debt
Total Assets
The debt-to-equityratio is total debt divided by total equity:
Debt-to-Equity Ratio =Total Debt
Total Equity
Debt ratios depend on the classification of long-term leases and on the
classification of some items as long-term debt or equity.
The times interest earnedratio indicates how well the firm's earnings can coverthe interest payments on its debt. This ratio also is known as the interest
coverage and is calculated as follows:
Interest Coverage =EBIT
Interest Charges
where EBIT = Earnings Before Interest and Taxes
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Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at
generating profits.
The gross profit margin is a measure of the gross profit earned on sales. Thegross profit margin considers the firm's cost of goods sold, but does not includeother costs. It is defined as follows:
Gross Profit Margin =Sales - Cost of Goods Sold
Sales
Return on assets is a measure of how effectively the firm's assets are being used
to generate profits. It is defined as:
Return on Assets =Net Income
Total Assets
Return on equityis the bottom line measure for the shareholders, measuring the
profits earned for each dollar invested in the firm's stock. Return on equity is
defined as follows:
Return on Equity =Net Income
Shareholder Equity
Dividend Policy Ratios
Dividend policy ratios provide insight into the dividend policy of the firm and the
prospects for future growth. Two commonly used ratios are the dividend yield
and payout ratio.
The dividend yield is defined as follows:
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Dividend Yield =Dividends Per Share
Share Price
A high dividend yield does not necessarily translate into a high future rate ofreturn. It is important to consider the prospects for continuing and increasing the
dividend in the future. The dividendpayout ratio is helpful in this regard, and isdefined as follows:
Payout Ratio =Dividends Per Share
Earnings Per Share
Use and Limitations of Financial Ratios
Attention should be given to the following issues when using financial ratios:
A reference point is needed. To to be meaningful, most ratios must be
compared to historical values of the same firm, the firm's forecasts, or
ratios of similar firms.
Most ratios by themselves are not highly meaningful. They should be
viewed as indicators, with several of them combined to paint a picture of
the firm's situation.
Year-end values may not be representative. Certain account balances that
are used to calculate ratios may increase or decrease at the end of the
accounting period because of seasonal factors. Such changes may distort
the value of the ratio. Average values should be used when they are
available.
Ratios are subject to the limitations of accounting methods. Different
accounting choices may result in significantly different ratio values.
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X. FINANCIAL RISK MANAGEMENT
Financial risk management is a process to deal with the uncertainties resulting
from financial markets. It involves assessing the financial risks facing an
organization and developing management strategies consistent with internal
priorities and policies. Addressing financial risks proactively may provide an
organization with a competitive advantage. It also ensures that management,
operational staff, stakeholders, and the board of directors are in agreement on
key issues of risk. Managing financial risk necessitates making organizational
decisions about risks that are acceptable versus those that are not. The passive
strategy of taking no action is the acceptance of all risks by default. rganizations
manage financial risk using a variety of strategies and products. It is important to
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understand how these products and strategies work to reduce risk within the
context of the organizations risk tolerance and objectives.Strategies for risk
management often involve derivatives. Derivatives are traded widely among
financial institutions and on organized exchanges. The value of derivatives
ontracts, such as futures, forwards, options, and swaps, is derived from the price
f the underlying asset. Derivatives trade on interest rates, exchange rates,
commodities, equity and fixed income securities, credit, and even weather. The
products and strategies used by market participants to manage financial risk are
the same ones used by speculators to increase leverage and risk. Although it can
be argued that widespread use of derivatives increases risk, the existence of
derivatives enables those who wish to reduce risk to pass it along to those who
seek risk and its associated opportunities. The ability to estimate the likelihood of
a financial loss is highly desirable. However, standard theories of probability
often fail in the analysis of financial markets. Risks usually do not exist in
isolation, and the interactions of several exposures may have to be considered in
developing an understanding of how financial risk arises. Sometimes, these
interactions are difficult to forecast, since they ultimately depend on human
behavior. The process of financial risk management is an ongoing one.Strategies
need to be implemented and refined as the market and requirements change.
Refinements may reflect changing expectations about market rates, changes to
the business environment, or changing international political conditions, for
example. In general, the process can be summarized as follows:
Identify and prioritize key financial risks.
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Determine an appropriate level of risk tolerance.
Implement risk management strategy in accordance with policy.
Measure, report, monitor, and refine as needed.
Risk Management Process
The process of financial risk management comprises strategies that enable an
organization to manage the risks associated with financial markets. Riskmanagement is a dynamic process that should evolve with an organization and
its business. It involves and impacts many parts of an organization including
treasury, sales, marketing, legal, tax, commodity, and corporate finance. The risk
management process involves both internal and external analysis. The first part
of the process involves identifying and prioritizing the financial risks facing an
organization and understanding their relevance. It may be necessary to examine
the organization and its products, management, customers, suppliers,
competitors, pricing, industry trends, balance sheet structure, and position in the
industry. It is also necessary to consider stakeholders and their objectives and
tolerance for risk. Once a clear understanding of the risks emerges, appropriate
strategies can be implemented in conjunction with risk management policy. For
example, it might be possible to change where and how business is done,
thereby reducing the organizations exposure and risk. Alternatively, existing
exposures may be managed with derivatives. Another strategy for managing risk
is to accept all risks and the possibility of losses. There are three broad
alternatives for managing risk:
1. Do nothing and actively, or passively by default, accept all risks.
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2. Hedge a portion of exposures by determining which exposures can and should
be hedged.
3. Hedge all exposures possible.
Measurement and reporting of risks provides decision makers with information to
execute decisions and monitor outcomes, both before and after strategies are
taken to mitigate them. Since the risk management process is ongoing, reporting
and feedback can be used to refine the system by modifying or improving
strategies. An active decision-making process is an important component of risk
management. Decisions about potential loss and risk reduction provide a forum
for discussion of important issues and the varying perspectives of stakeholders.
XI. TYPES OF SHORT TERM BARROWINGS
A loan can be a big financial commitment. By taking one out, you will be required
to give up a portion of your salary every month until the loan is paid off, and
ailing to do so could result in serious consequences. There are two main types of
loan: secured and unsecured. Each have their advantages and disadvantages,
depending on a) your financial health and b) how much you want to borrow.
Secured loan
If a loan is secured, it means it is secured against something you own (an
asset) and failing to repay the loan could result in the lender taking possession
of that asset, and selling it to cover their losses.
The asset in a secured loan will normally be your home, but it can also be your
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car or another item of a high value.
Advantages of a secured loan
Its usually possible to borrow more than with an unsecured loan. Its also
possible to spread payments over a longer period of time. Since the lender
knows they have your asset as backup, there is much less uncertainty
about whether they are going to get all their money back.
For the same reason, interest rates are often lower.
Even if you have a bad credit history, you may be able to get a secured
loan. Your secured asset will reassure lenders that they are able to get all
their money back. However, if you currently have other debt problems,
taking out further loans of any type could be a bad idea.
Unsecured loan
An unsecured loan does not require you to secure anything against the loan
the lender relies on your contractual obligation to pay it back.
Because there is no security and the risk they are taking is therefore greater, the
amount you can borrow tends to be less, and the repayment period is usually
shorter.
The lending criteria also tend to be tighter: lenders generally charge a higher
interest rate which is determined mainly by your credit history and level of
income.
Advantages of an unsecured loan
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Preserves the equity in your property and avoid the risk of losing your
home or assets. Lenders are not entitled to repossess your belongings if
you struggle to make your payments although they can attempt to
pursue this in court if necessary.
You dont need a property or any other expensive assets to take out an
unsecured loan.
Its cheaper than credit/store cards for smaller purchases. Credit and store
cards usually have very high interest rates, so if youre planning on
repaying over a few months, you can save a lot of money by taking out an
unsecured loan to fund your purchase.
XII. WORKING CAPITAL MANAGEMENT
Working capital management is the device of finance. It is related to manage of
current assets and current liabilities. After learning working capital management,
commerce students can use this tool for fund flow analysis. Working capital is
very significant for paying day to day expenses and long term liabilities.
Meaning and Concept of Working Capital and its management
Working capital is that part ofcompanys capital which is used for purchasing raw
material and involve in sundry debtors. We all know that current assets are very
important for proper working of fixed assets. Suppose, if you have invested your
money to purchase machines of company and if you have not any more money
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to buy raw material, then your machinery will no use for any production without
raw material. From this example, you can understand that working capital is very
useful for operating any business organization. We can also take one more liquid
item of current assets that is cash. If you have not cash in hand, then you can not
pay for different expenses of company, and at that time, your many business
works may delay for not paying certain expenses. If we define working capital in
very simple form, then we can say that working capital is the excess of current
assets over current liabilities.
Types of Working Capital
1. Gross working capital
Total or gross working capital is that working capital which is used for all the
current assets. Total value of current assets will equal to gross working capital.
2. Net Working Capital
Net working capital is the excess of current assets over current liabilities.
Net Working Capital = Total Current Assets Total Current Liabilities
This amount shows that if we deduct total current liabilities from total current
assets, then balance amount can be used for repayment of long term debts at
any time.
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3. Permanent Working Capital
Permanent working capital is that amount of capital which must be in cash or
current assets for continuing the activities of business.
4. Temporary Working Capital
Sometime, it may possible that we have to pay fixed liabilities, at that time we
need working capital which is more than permanent working capital, then this
excess amount will be temporary working capital. In normal working of business,
we dont need such capital.
In working capital management, we analyze following three points
Ist Point
What is the need for working capital?
After study the nature of production, we can estimate the need for working
capital. If company produces products at large scale and continues producing
goods, then company needs high amount of working capital.
2nd Point
What is optimum level of Working capital in business?
Have you achieved the optimum level of working capital which has invested in
current assets? Because high amount of working capital will decrease the return
on investment and low amount of working capital will increase the risk of
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business. So, it is very important decision to get optimum level of working capital
where both profitability and risk will be balanced. For achieving optimum level of
working capital, finance manager should also study the factors which affects the
requirement of working capital and different elements of current assets. If he will
manage cash, debtor and inventory, then working capital will automatically
optimize.
3rd Point
What are main Working capital policies of businesses?
Policies are the guidelines which are helpful to direct business. Finance manager
can also make working capital policies.
1st Working capital policy
Liquidity policy
Under this policy, finance manager will increase the amount of liquidity for
reducing the risk of business. If business has high volume of cash and bank
balance, then business can easily pays his dues at maturity. But finance manger
should not forget that the excess cash will not produce and earning and return on
investment will decrease. So liquidity policy should be optimized.
2nd Working Capital Policy
Profitability policy
Under this policy, finance manger will keep low amount of cash in business and
try to invest maximum amount of cash and bank balance. It will sure that profit of
business will increase due to increasing of investment in proper way but risk of
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business will also increase because liquidity of business will decrease and it can
create bankruptcy position of business. So, profitability policy should make after
seeing liquidity policy and after this both policies will helpful for proper
management of working capital.
XIII. TYPES OF FINANCIAL STATEMENTS
Financial statements can be referred to as representation of the financial status
of a company in a systematically documented form.
There are different types of financial statements. Financial statements, are
required to be audited by authentic, efficient audit firms to avoid manipulation of
numbers. Statements are usually audited by the accounting firms after a
thorough study of the company records. The accounting and the audit firms make
sure that the company is obeying and operating as per norms laid down by the
Generally Accepted Accounting Principles or GAAP.
Basically, there are four different types of financial statements. The different
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types of financial statements indicate the different activities occurring in a
particular business house.
Balance Sheet
Income statement
Statement of retained earnings
Statement of cash flow or Cash flow statement
Balance sheet:
The balance sheet provides an insight into the financial status of a company at a
particular time. The balance sheet, type of financial statement is different in
comparison to the other types of financial statements. Other financial statements
are prepared by taking into account the financial health of the company over a
considerable span of time.
Income statements:
Also known as the P&L statement or the Profit And Loss Statement. This
statement, ascertains the profit and loss of any business. This can be again of
two types:
Single Step Income Statement
Multi Step Income Statement
Statements Of Retained earnings:
This financial statement denotes alterations in the title rights of equities, in any
business.
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Cash flow statement:
This statement highlights flow of cash over a period of time. The cash flow may
be from investment activities, operations or financing activities.
XIV. CONCLUSION
The Financial Management SMF describes the principal processes in managing
the financial aspect of the IT organization, addresses financial risk as part of
these processes, and discusses the means to measure the value realized from IT
solutions.
The major financial management processes described by the Financial
Management SMF are:
Establish service requirements and plan budget.
Manage finances.
Perform IT accounting and reporting.
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