MBA II FINANCIAL MANAGEMENT UNIT I

Financial Management: Definition, Nature and Objectives | Financial Management

Some prominent definitions of financial management are cited below:

(1) “Financial management is an area of financial decision-making harmonizing individual motives and
enterprise goals.” —Weston and Brigham

(2) “Financial management is concerned with managerial decisions that result in acquisition and
financing of long-term and short-term credits for the firm. As such, it deals with situations that require
selection of specific assets and liabilities as well as problems of size and growth of an enterprise.
Analysis of these decisions is based on expected inflows and outflow of funds and their effects on
managerial objectives.” —Philppatus

Analysis of the above Definitions:

(i) Financial management is a specialized branch of general management.

(ii) The basic operational aim of financial management is to provide financial services to the whole
enterprise.

(iii) One most important financial service by financial management to the enterprise is to make
available requisite (i.e. required) finances at the needed time. If requisite funds are not made available
at the needed time; significance of finance is lost.

(iv) Another equally important financial service by financial management to the enterprise is to ensure
the most effective utilisation of finances; but for which finance would become a liability rather than
being an asset.

(v) Through providing financial services to the enterprise, financial management helps in the most
effective and efficient attainment of the common objectives of the enterprise.

There are three major areas of decision making, in financial management, viz:
(i) Investment decisions i.e. the channels into which finances will be invested-based on ‘risk
and return’ analysis, of investment alternatives.

(ii) Financing decisions i.e. the sources from which finances will be raised-based on ‘cost-
benefit analyses’ of different sources of finance.

(iii) Dividend decisions i.e. how much of corporate profits will be distributed, by way of
dividends; and how much of these will be retained in the company-requiring an intelligent
solution to the controversy ‘Retention vs. Distribution’.

Nature of Financial Management:

Nature of financial management could be spotlighted with reference to the following aspects of
this discipline:

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(i) Financial management is a specialized branch of general management, in the present-

day-times. Long back, in traditional times, the finance function was coupled, either with
production or with marketing; without being assigned a separate status.

(ii) Financial management is growing as a profession. Young educated persons, aspiring for
a career in management, undergo specialized courses in Financial Management, offered
by universities, management institutes etc.; and take up the profession of financial
management.

(iii) Despite a separate status financial management, is intermingled with other aspects of
management. To some extent, financial management is the responsibility of every
functional manager. For example, the production manager proposing the installation of
a new plant to be operated with modern technology; is also involved in a financial
decision.

(iv) Likewise, the Advertising Manager thinking, in terms of launching an aggressive

advertising programme, is too, considering a financial decision; and so on for other
functional managers. This intermingling nature of financial management calls for efforts
in producing a coordinated financial system for the whole enterprise.

(v) Financial management is multi-disciplinary in approach. It depends on other

disciplines, like Economics, Accounting etc., for a better procurement and utilisation of
finances.

(vi) For example, macro-economic guides financial management as to banking and financial
institutions, capital market, monetary and fiscal policies to enable the finance manager
decide about the best sources of finances, under the economic conditions, the economy
is passing through.

(vii) Micro-economics points out to the finance manager techniques for profit maximisation,
with the limited finances at the disposal of the enterprise. Accounting, again, provides
data to the finance manager for better and improved financial decision making in future.

(viii) The finance manager is often called the Controller; and the financial management
function is given name of controllership function; in as much as the basic guideline for
the formulation and implementation of plans-throughout the enterprise-come from this
quarter.

(ix) The finance manager, very often, is a highly responsible member of the Top Management
Team. He performs a trinity of roles-that of a line officer over the Finance Department; a
functional expert commanding subordinates throughout the enterprise in matters
requiring financial discipline and a staff adviser, suggesting the best financial plans,
policies and procedures to the Top Management.

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In any case, however, the scope of authority of the finance manager is defined by the Top
Management; in view of the role desired of him- depending on his financial expertise and the system
of organizational functioning.

Despite a hue and cry about decentralisation of authority; finance is a matter to be found
still centralised, even in enterprises which are so called highly decentralised. The reason
for authority being centralised, in financial matters is simple; as every Tom,Dick and
Harry manager cannot be allowed to play with finances, the way he/she likes. Finance is
both-a crucial and limited asset-of any enterprise.

Financial management is not simply a basic business function along with production and marketing; it
is more significantly, the backbone of commerce and industry. It turns the sand of dreams into the gold
of reality.

No production, purchases or marketing are possible without being duly supported by requisite finances.
Hence, Financial Management commands a higher status vis-a-vis all other functional areas of general
management.

Objectives of Financial Management:

Objectives of financial management may be multiple; as this branch of general management
encompasses the entire organizational functioning.

(1) Basic Objectives:

(i) Profit-Maximisation:
Since time immemorial, the primary objective of financial management has been held to be profit-
maximisation. That is to say, that financial management ought to take financial decisions and implement
them in a way so as to lead the enterprise along lines of profit maximasation. The support for these
objectives could be derived from the philosophy, that ‘profit is a test of economic efficiency’.

Though, there could be little controversy over profit maximisation, as the basic objective of
financial management – yet, in the modern times, several authorities on financial management
criticise this objectives, on the following grounds:
(i) Profit is a vague concept, in that; it is not clear whether profit means – short-run or long-run profits.
Or

– Profit before tax or profits after tax or

Rate of profits or the amount of profits.

(ii) The profit maximisation objective ignores, what financial experts call the time value of money’. To
illustrate, this concept, let us assume that two financial courses of action provide equal benefits (i.e.
profits) over a certain period of time. However, one alternative gives more profits in earlier years; while
the other one gives more profits in later years.

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Based on profit maximization criterion, both alternatives are equally well. However, the first alternative
i.e. the one which gives more profits in earlier years is better; as some part of the profits received earlier
could be reinvested also.

Modern financial experts call this philosophy, ‘the earlier the better principle’. The second alternative
which gives more profits only in later years is inferior; as the time-value of profits is more in the case
of the first alternative.

(iii) The profit maximization objective ignores the quality of benefits (i.e. profits). The factor implicit
here, is the risk element associated with profits. Quality of benefits (profits) is the most when risk
associated with their occurrence is the least. According to modern financial experts, less profit with less
risk are superior to more profits with more risk.

(iv) Profit-maximisation objective is lop-sided. This objective considers or rather over-

emphasizes only on the interests of owners. Interests of other parties like, workers,
consumers, the Government and the society as a whole are ignored, under this concept of
profit-maximisation.

(ii) Wealth-Maximisation:
Discarding the profit-maximisation objective; the real basic objective of financial
management, now-a-days, is considered to be wealth maximisation. Wealth maximisation
is also known as value-maximisation or the net present worth maximisation.

Since wealth of owners is reflected in the market-value of shares; wealth maximisation

means the maximisation of the market price of shares. Accordingly, wealth maximisation is
measured, by the market value of shares.

According to wealth maximisation objective, financial management must select those

decisions, which create most wealth for the owners. If two or more financial courses of action
are mutually exclusive (i.e. only one can be undertaken at a time); then that decision-which
creates most wealth, must be selected.

The wealth maximisation objective is held to be superior to the profit maximisation objective,
because of the following reasons:
(i) It is based on the concept of cash flows; which is more definite than the concept of profits. Moreover,
management is more interested in immediate cash flows than the profits a large part of which might be
hidden in credit sales- still to be realized.

(ii) Through discounting the cash flows arising from a financial course of action over a period of time
at an appropriate discount rate; the wealth maximisation approach considers both- the time value of
money and the quality of benefits.

(iii) Wealth maximisation objective is consistent with the long term profitability of the company.

(2) Operational Objectives:

(i) Timely Availability of Requisite Finances:

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A very important operational objective of financial management is to ensure that requisite funds are
made available to all the departments, sections or units of the enterprise at the needed time; so that the
operational life of the enterprise goes smoothly.

(ii) Most Effective Utilization of Finances:

Throughout the enterprise, the finances must be utilized most effectively. This is yet, another important
operational objective of the financial, management.

To ensure the attainment of this objective, the financial management must:

– Formulate plans for the most effective utilisation of funds, among channels of investment, which
create most wealth for the company.

– Exercise and enforce ‘financial discipline’ to prevent wasteful expenditure, by any department, or
branch or section of the enterprise.
(iii) Safety of Investment:
The financial management must primarily look to the safety of investment i.e. the channels of investment
might bring in less returns; but investment must be safe. Loss of investment, in any one line, might lead
to capital depletion; and ultimately tell upon the financial health of the enterprise.

(iv) Growth of the Enterprise:

The financial management must plan for the long-term stability and growth of the enterprise. The limited
finances of the enterprise must be so utilized that not only short run benefits are available; but the
enterprise grows slow and steady, in the long run also.

(3) Social Objectives:

(i) Timely Payment of Interest:
The financial management must see to it that interest on bonds, debentures or other loans of the company
is paid in time. This will not only keep the creditors satisfied with the company adding to its goodwill;
but also prevent any untoward consequences of the non-payment of interest, in time.

(ii) Payment of Reasonable Dividends:

An important social objective of financial management is that shareholders i.e. the equity members of
the company must get at least some regular dividends.

This objective is important for two reasons: –

– It helps the company maintain its competitive image, in the market.
– The members on whose funds the company is running profitable operations must be duly
compensated, as a matter of natural justice.

(iii) Timely Payment of Wages:

The financial management must make a provision for a timely payment of wages to workers. This is
necessary to keep the labour force satisfied and motivated. Further, if wages are paid on time; the legal
consequences of non-payment of wages, under the ‘ Payment of Wages Act’, need not frighten
management.

(iv) Fair-Settlement with Suppliers:

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The financial management must make it a point to settle accounts with suppliers and fellow-
businessmen in time, in a fair way; otherwise the commercial reputation of the enterprise will get a
setback.

(v) Timely Payment of Taxes:

An important objective of financial management would be to make timely payment of taxes to the
Government – so as to avoid legal consequences; and also fulfill its social obligations towards the State.

(vi) Maintaining Relations with Financiers:

The financial management must develop and maintain friendly relations with financiers i.e. banks,
financial institutions and various segments of the money market and capital market. When good relations
are maintained with financiers; they might come to the rescue of the enterprise, in situations of financial
crisis.

(4) Research Objectives:

The successful attainment of various objectives by the financial management requires it to follow a
research approach. It must research into new and better sources of finances; and also into new and better
channels for the investment of finances.

This research objective of financial management requires it to:

– Collect financial data about the progress of its competitive counterparts.

– Make a study of money market and capital market operations, through a study of latest financial
magazines and other literature on financial management.

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Financing Decision

Short term sources of finance

The main sources of short-term financing are (1) trade credit, (2) commercial bank loans, (3) commercial
paper, a specific type of promissory note, and (4) secured loans

Trade credit

A firm customarily buys its supplies and materials on credit from other firms, recording the debt as
an account payable. This trade credit, as it is commonly called, is the largest single category of short-
term credit. Credit terms are usually expressed with a discount for prompt payment. Thus, the seller may
state that if payment is made within 10 days of the invoice date, a 2 percent cash discount will be allowed.
If the cash discount is not taken, payment is due 30 days after the date of invoice. Thecost of not taking
cash discounts is the price of the credit.

Commercial bank loans

Commercial bank lending appears on the balance sheet as notes payable and is second in importanceto
trade credit as a source of short-term financing. Banks occupy a pivotal position in the short-term and
intermediate-term money markets. As a firm’s financing needs grow, banks are called upon to provide
additional funds. A single loan obtained from a bank by a business firm is not different in principle from
a loan obtained by an individual. The firm signs a conventional promissory note.Repayment is made in
a lump sum at maturity or in installments throughout the life of the loan. A line of credit, as distinguished
from a single loan, is a formal or informal understanding between the bank and the borrower as to the
maximum loan balance the bank will allow at any one time.

Commercial paper

Commercial paper, a third source of short-term credit, consists of well-established firms’ promissory
notes sold primarily to other businesses, insurance companies, pension funds, and banks. Commercial
paper is issued for periods varying from two to six months. The rates on prime commercial paper vary,
but they are generally slightly below the rates paid on prime business loans.

A basic limitation of the commercial-paper market is that its resources are limited to the excess liquidity
that corporations, the main suppliers of funds, may have at any particular time. Another disadvantage is
the impersonality of the dealings; a bank is much more likely to help a good customer weather a storm
than is a commercial-paper dealer

Secured loans

Most short-term business loans are unsecured, which means that an established company’s credit rating
qualifies it for a loan. It is ordinarily better to borrow on an unsecured basis, but frequently a borrower’s
credit rating is not strong enough to justify an unsecured loan. The most common typesof collateral
used for short-term credit are accounts receivable and inventories.
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Long term sources of finance

Bonds

Long-term capital may be raised either through borrowing or by the issuance of stock. Long-term
borrowing is done by selling bonds, which are promissory notes that obligate the firm to pay interest at
specific times. Secured bondholders have prior claim on the firm’s assets. If the company goes out of
business, the bondholders are entitled to be paid the face value of their holdings plus interest.
Stockholders, on the other hand, have no more than a residual claim on the company; they are entitled
to a share of the profits, if there are any, but it is the prerogative of the board of directors to decide
whether a dividend will be paid and how large it will be.

Long-term financing involves the choice between debt (bonds) and equity (stocks). Each firm chooses
its own capital structure, seeking the combination of debt and equity that will minimize the costs of
raising capital. As conditions in the capital market vary (for instance, changes in interest rates, the
availability of funds, and the relative costs of alternative methods of financing), the firm’s desired capital
structure will change correspondingly

The larger the proportion of debt in the capital structure (leverage), the higher will be the returns to
equity. This is because bondholders do not share in the profits. The difficulty with this, of course, is that
a high proportion of debt increases a firm’s fixed costs and increases the degree of fluctuation in the
returns to equity for any given degree of fluctuation in the level of sales. If used successfully, leverage
increases the returns to owners, but it decreases the returns to owners when it is used unsuccessfully.
Indeed, if leverage is unsuccessful, the result may be the bankruptcy of the firm.

Long-term debt

There are various forms of long-term debt. A mortgage bond is one secured by a lien onfixed
assets such as plant and equipment. A debenture is a bond not secured by specific assets but accepted
by investors because the firm has a high credit standing or obligates itself to follow policies that ensure
a high rate of earnings. A still more junior lien is the subordinated debenture, which is secondary (in
terms of ability to reclaim capital in the event of a business liquidation) to all other debentures and
specifically to short-term bank loans.

Periods of relatively stable sales and earnings encourage the use of long-term debt. Other conditions that
favour the use of long-term debt include large profit margins (they make additional
leverage advantageous to the stockholders), an expected increase in profits or price levels, a low debt
ratio, a price–earnings ratio that is low in relation to interest rates, and bond indentures thatdo not
impose heavy restrictions on management.

Stock

Equity financing is done with common and preferred stock. While both forms of stock represent shares
of ownership in a company, preferred stock usually has priority over common stock with respect to
earnings and claims on assets in the event of liquidation. Preferred stock is usually cumulative—that

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is, the omission of dividends in one or more years creates an accumulated claim that must be paid to
holders of preferred shares. The dividends on preferred stock are usually fixed at a specific percentage
of face value. A company issuing preferred stock gains the advantages of limited dividends and no
maturity—that is, the advantages of selling bonds but without the restrictions of bonds. Companies sell
preferred stock when they seek more leverage but wish to avoid the fixed charges of debt. The
advantages of preferred stock will be reinforced if a company’s debt ratio is already high and if common
stock financing is relatively expensive.

If a bond or preferred stock issue was sold when interest rates were higher than at present, it may be
profitable to call the old issue and refund it with a new, lower-cost issue. This depends on how the
immediate costs and premiums that must be paid compare with the annual savings that can beobtained.

Earnings and dividend policies

The size and frequency of dividend payments are critical issues in company policy. Dividend policy
affects the financial structure, the flow of funds, corporate liquidity, stock prices, and the morale of
stockholders. Some stockholders prefer receiving maximum current returns on their investment, while
others prefer reinvestment of earnings so that the company’s capital will increase. If earnings are paid
out as dividends, however, they cannot be used for company expansion (which thereby diminishes the
company’s long-term prospects). Many companies have opted to pay no regular dividend to
shareholders, choosing instead to pursue strategies that increase the value of the stock.

Companies tend to reinvest their earnings more when there are chances for profitable expansion. Thus,
at times when profits are high, the amounts reinvested are greater and dividends are smaller. For similar
reasons, reinvestment is likely to decrease when profits decline, and dividends are likely to increase.

Companies having relatively stable earnings over a period of years tend to pay high dividends.Well-
established large firms are likely to pay higher-than-average dividends because they have better access
to capital markets and are not as likely to depend on internal financing. A firm with a strong cash or
liquidity position is also likely to pay higher dividends. A firm with heavy indebtedness, however, has
implicitly committed itself to paying relatively low dividends; earnings must be retained to service the
debt. There can be advantages to this approach. If, for example, the directors of a company are
concerned with maintaining control of it, they may retain earnings so that they can finance
expansion without having to issue stock to outside investors. Some companies favour a stable dividend
policy rather than allowing dividends to fluctuate with earnings; the dividend rate will then be lower
when profits are high and higher when profits are temporarily in decline. Companies whose stock is
closely held by a few high-income stockholders are likely to pay lower dividends in order to lower the
stockholders’ individual income taxes.

Convertible bonds and stock warrants

Companies sometimes issue bonds or preferred stock that give holders the option of converting them
into common stock or of purchasing stock at favourable prices. Convertible bonds carry the option of
conversion into common stock at a specified price during a particular period. Stock purchase warrants

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are given with bonds or preferred stock as an inducement to the investor, because they permit the
purchase of the company’s common stock at a stated price at any time. Such option privileges make it
easier for small companies to sell bonds or preferred stock. They help large companies to float new
issues on more favourable terms than they could otherwise obtain. When bondholders exercise
conversion rights, the company’s debt ratio is reduced because bonds are replaced by stock. The exercise
of stock warrants, on the other hand, brings additional funds into the company but leaves the existing
debt or preferred stock on the books. Option privileges also permit a company to sell new stock at more
favourable prices than those prevailing at the time of issue, since the prices stated on the options are
higher. Stock purchase warrants are most popular, therefore, at times when stock prices are expected to
have an upward trend.

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MBA II FINANCIAL MANAGEMENT UNIT III

Financial statement analysis(Introduction)

Financial statement analysis reviews financial information found on financial statements to make
informed decisions about the business. The income statement, statement of retained earnings, balance
sheet, and statement of cash flows, among other financial information, can be analyzed. The information
obtained from this analysis can benefit decision-making for internal and external stakeholders and can
give a company valuable information on overall performance and specific areas for improvement. The
analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future
capital investments opportunities.

When considering the outcomes from analysis, it is important for a company to understand that data
produced needs to be compared to others within industry and close competitors. The company should
also consider their past experience and how it corresponds to current and future performance
expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical
analysis, and financial ratios.

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial
statement line items. A company will look at one period (usually a year) and compare it to another
period. For example, a company may compare sales from their current year to sales from the prior
year. The trending of items on these financial statements can give a company valuable information on
overall performance and specific areas for improvement. It is most valuable to do horizontal analysis
for information over multiple periods to see how change is occurring for each line item. If multiple
periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes
is called the base year (usually the prior period). The year of comparison for horizontal analysis is
analyzed for change and percent changes against the base year.

Vertical Analysis

Vertical analysis shows a comparison of a line item within a statement to another line item within that
same statement. For example, a company may compare cash to total assets in the current year. This
allows a company to see what percentage of cash (the comparison line item) makes up total assets (the
other line item) during the period. This is different from horizontal analysis, which compares across
years. Vertical analysis compares line items within a statement in the current year. This can help a
business to know how much of one item is contributing to overall operations. For example, a company
may want to know how much inventory contributes to total assets. They can then use this information
to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital
investments.

The company will need to determine which line item they are comparing all items to within that
statement and then calculate the percentage makeup. These percentages are considered
common-size because they make businesses within industry comparable by taking outfluctuations for
size. It is typical for an income statement to use net sales (or sales) as the comparison line item. This
means net sales will be set at 100% and all other line items within the income statementwill represent a
percentage of net sales.

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On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities
and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of
total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within
liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The
line item set at 100% is considered the base amount and the comparison line item is considered the
comparison amount

Overview of Financial Ratios

Financial ratios help both internal and external users of information make informed decisions about a
company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal
operations, among other things, based in part on the outcomes of ratio analysis. The information
resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for
success, set budget expectations, and compare industry competitors. There are four main categories of
ratios: liquidity, solvency, efficiency, and profitability.

Meaning of Analysis of Financial Statements

The process of critical evaluation of the financial information contained in the financial statements in
order to understand and make decisions regarding the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of relationship among various financial facts and figures as
given in a set of financial statements, and the interpretation thereof to gain an insight into theprofitability
and operational efficiency of the firm to assess its financial health and future prospects. The term
‘financial analysis’ includes both ‘analysis and interpretation’. The term analysis means simplification
of financial data by methodical classification given in the financial statements. Interpretation means
explaining the meaning and significance of the data. These two are complimentary to each other.
Analysis is uselesswithout interpretation, and interpretation without analysis is difficult or even
impossible.

Financial statement analysis is a judgemental process which aims to estimate current and past financial
positions and the results of the operation of an enterprise, with primary objective of determining the best
possible estimates and predictions about the future conditions. It essentially involves regrouping and
analysis of information provided by financial statements to establish relationships and throw light on
the points of strengths and weaknesses of a business enterprise, which can be useful in decision-making
involving comparison with other firms (cross sectional analysis) and with firms’ own performance, over
a time period (time series analysis).

Significance of Analysis of Financial Statements

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Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by
properly establishing relationships between the various items of the balance sheet and the statement of
profit and loss. Financial analysis can be undertaken by management of the firm, or by parties outside
the firm, viz., owners, trade creditors, lenders, investors, labour unions, analysts and others. The nature
of analysis will differ depending on the purpose of the analyst. A technique frequently used by an analyst
need not necessarily serve the purpose of other analysts because of the difference in the interests of the
analysts. Financial analysis is useful and significant to different users in the following ways:

(a) Finance manager: Financial analysis focusses on the facts and relationships related to managerial
performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the
company. A finance manager must be well-equipped with the different tools of analysis to make rational
decisions for the firm. The tools for analysis help in studying accounting data so as to determine the
continuity of the operating policies, investment value of the business, credit ratings and testing the
efficiency of operations. The techniques are equally important in the area of financial control, enabling
the finance manager to make constant reviews of the actual financial operations ofthe firm to analyse
the causes of major deviations, which may help in corrective action wherever indicated.

(b) Top management: The importance of financial analysis is not limited to the finance manager alone.
It has a broad scope which includes top management in general and other functional managers.
Management of the firm would be interested in every aspect of the financial analysis. It is their overall
responsibility to see that the resources of the firm are 2022-23 Analysis of Financial Statements 173
used most efficiently and that the firm’s financial condition is sound. Financial analysis helps the
management in measuring the success of the company’s operations, appraising the individual’s
performance and evaluating the system of internal control

. (c) Trade payables: Trade payables, through an analysis of financial statements, appraises not only
the ability of the company to meet its short-term obligations, but also judges the probability of its
continued ability to meet all its financial obligations in future. Trade payables are particularly interested
in the firm’s ability to meet their claims over a very short period of time. Their analysis will, therefore,
evaluate the firm’s liquidity position.

(d) Lenders: Suppliers of long-term debt are concerned with the firm’s longterm solvency andsurvival.
They analyse the firm’s profitability over a period of time, its ability to generate cash, to be able to pay
interest and repay the principal and the relationship between various sources of funds (capital structure
relationships). Long-term lenders analyse the historical financial statements to assess its future solvency
and profitability

. (e) Investors: Investors, who have invested their money in the firm’s shares, are interested about the
firm’s earnings. As such, they concentrate on the analysis of the firm’s present and future profitability.
They are also interested in the firm’s capital structure to ascertain its influences on firm’s earning and
risk. They also evaluate the efficiency of the management and determine whether a change is needed
or not. However, in some large companies, the shareholders’ interest is limited to decide whether to buy,
sell or hold the shares.

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(f) Labour unions: Labour unions analyse the financial statements to assess whether it can presently
afford a wage increase and whether it can absorb a wage increase through increased productivity or by
raising the prices.

(g) Others: The economists, researchers, etc., analyse the financial statements to study the present
business and economic conditions. The government agencies need it for price regulations, taxation and
other similar purposes.

Objectives of Analysis of Financial Statements

Analysis of financial statements reveals important facts concerning managerial performance and the
efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the information
contained in financial statements with a view to know the weaknesses and strengths of the firm and to
make a forecast about the future prospects of the firm thereby, enabling the analysts to takedecisions
regarding the operation of, 2022-23 174 Accountancy : Company Accounts and Analysis of Financial
Statements and further investment in the firm. To be more specific, the analysis is undertaken to serve
the following purposes (objectives): • to assess the current profitability and operational efficiency of the
firm as a whole as well as its different departments so as to judge the financial health of the firm. • to
ascertain the relative importance of different components of the financial position of the firm. • to
identify the reasons for change in the profitability/financial position of the firm. • to judge the ability of
the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of the
firm. Through the analysis of financial statements of various firms, an economist can judge the extent
of concentration of economic power and pitfalls in the financial policies pursued. The analysis also
provides the basis for many governmental actions relatingto licensing, controls, fixing of prices, ceiling
on profits, dividend freeze, tax subsidy and other concessions to the corporate sector.

Tools of Analysis of Financial Statements

The most commonly used techniques of financial analysis are as follows:

1. Comparative Statements: These are the statements showing the profitability and financial position
of a firm for different periods of time in a comparative form to give an idea about the position of two
or more periods. It usually applies to the two important financial statements, namely, balance sheet and
statement of profit and loss prepared in a comparative form. The financial data will be comparative only
when same accounting principles are used in preparing these statements. If this is not the case, the
deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures
indicate the trend and direction of financial position and operating results. This analysis is also known
as ‘horizontal analysis’.

2. Common Size Statements: These are the statements which indicate the relationship of different items
of a financial statement with a common item by expressing each item as a percentage of that common
item. The percentage thus calculated can be easily compared with the results of corresponding
percentages of the previous year or of some other firms, as the numbers are brought to

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common base. Such statements also allow an analyst to compare the operating and financing
characteristics of two companies of different sizes in the same industry. Thus, common size statements
are useful, both, in intra-firm comparisons over different years and also in making inter-firm
comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis

3. Trend Analysis: It is a technique of studying the operational results and financial position over a
series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to
observe the percentage changes over time in the selected data. The trend percentage is the percentage
relationship, in which each item of different years bear to the same item in the base year. Trend analysis
is important because, with its long run view, it may point to basic changes in the nature of the business.
By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining
relatively constant. From this observation, a problem is detected or the sign of good or poor management
is detected.

4. Ratio Analysis: It describes the significant relationship which exists between various items of a
balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting
ratios measure the comparative significance of the individual items of the income and position
statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the
technique of ratio analysis.

5. Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an
organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the
flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between
the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner
in which the cash has been received and has been utilised during an accounting year as it shows the
sources of cash receipts and also the purposes for which payments are made. Thus, it summarises the
causes for the changes in cash position of a business enterprise between dates of two balance sheets.

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MBA II FINANCIAL MANAGEMENT UNIT IV

Cost of Capital
The minimum rate of return that a business must earn before generating value

What is Cost of Capital?

Cost of capital is the minimum rate of return that a business must earn before generating value. Before
a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it
uses to fund its operations. This consists of both the cost of debt and the cost of equity used for financing
a business. A company’s cost of capital depends, to a large extent, on the type of financing the company
chooses to rely on – its capital structure. The company may rely either solely on equity orsolely on debt
or use a combination of the two.
The choice of financing makes the cost of capital a crucial variable for every company, as it will
determine its capital structure. Companies look for the optimal mix of financing that provides adequate
funding and minimizes the cost of capital.
In addition, investors use the cost of capital as one of the financial metrics they consider in evaluating
companies as potential investments. The cost of capital figure is also important because it is used asthe
discount rate for the company’s free cash flows in the DCF analysis The most common approach to
calculating the cost of capital is to use the Weighted Average Cost of Capital (WACC). Under this
method, all sources of financing are included in the calculation, and each source is given a weight
relative to its proportion in the company’s capital structure.
WACC provides us a formula to calculate the cost of capital:
The cost of debt in WACC is the interest rate that a company pays on its existing debt. The cost of equity
is the expected rate of return for the company’s shareholders.
Cost of Capital and Capital Structure
Cost of capital is an important factor in determining the company’s capital structure. Determining a
company’s optimal capital structure can be a tricky endeavor because both debt financing and equity
financing carry respective advantages and disadvantages.
Debt is a cheaper source of financing, as compared to equity. Companies can benefit from their debt
instruments by expensing the interest payments made on existing debt and thereby reducing the
company’s taxable income. These reductions in tax liability are known as tax shields. Tax shields are
crucial to companies because they help to preserve the company’s cash flows and the total value of the
company.
However, at some point, the cost of issuing additional debt will exceed the cost of issuing new equity.
For a company with a lot of debt, adding new debt will increase its risk of default and the inability to
meet its financial obligations. A higher default risk will increase the cost of debt, as new lenders will
ask for a premium to be paid for the higher default risk.
In addition, a high default risk may also drive the cost of equity up because shareholders will likely
expect a premium over and above the rate of return for the company’s debt instruments for taking on
the additional risk associated with equity investing.

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Despite its higher cost (equity investors demand a higher risk premium than lenders), equity financing
is attractive because it does not create a default risk to the company. Also, equity financing may offer
an easier way to raise a large amount of capital, especially if the company does not have extensive credit
established with lenders. However, for some companies, equity financing may not be a good option, as
it will reduce the control of current shareholders over the business.

Cost of equity is approximated by the capital asset pricing model (CAPM):

In this formula:

● Rf= risk-free rate of return

● Rm= market rate of return
● Beta = risk estimate
3. Weighted average cost of capital
Cost of capital is based on the weighted average of the cost of debt and the cost of equity.

In this formula:

● E = the market value of the firm's equity

● D = the market value of the firm's debt
● V = the sum of E and D
● Re = the cost of equity
● Rd = the cost of debt
● Tc = the income tax rate

● Example of Cost of Capital calculations using WACC

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● Aero Ltd had the following cost capital structure employed for financing its projects and would like to
calculate the cost of capital.

Amount ( Rs.) After-tax

Cost %

Equity share capital 8,00,000 16%

Retained earnings 4,00,000 15%

Preference share capital 6,00,000 12%

Debentures 6,00,000 9%

Total 24,00,000

●
● Calculation of Cost of capital of Aero Ltd

Source Amount Weights After-tax Weighted

(Rs. ) (Specific Cost Cost
Capital/Total (Cost%/100)
cost)

(2)
(3)
(1) (4) = (2) *(3)

Equity share capital 8,00,000 0.34 0.16 0.053

Retained earnings 4,00,000 0.16 0.15 0.024

Preference share capital 6,00,000 0.25 0.12 0.03

Debentures 6,00,000 0.25 0.09 0.023

Total 24,00,000 0.13

●
● Weight Average Cost of Capital here is 13% (0.13*100). This implies that the overall cost of capital
employed by Aero Ltd is 13%. In other words, we can say that the company is paying a premium of 13%
to the lenders of capital as a return for their risk.

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The following points will highlight the top four theories of capital structure.

Capital Structure Theory # 1. Net Income (NI) Approach:

According to NI approach a firm may increase the total value of the firm by lowering its cost of capital.

When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital structure for
the firm and, at this point, the market price per share is maximised.

The same is possible continuously by lowering its cost of capital by the use of debt capital. In other words,
using more debt capital with a corresponding reduction in cost of capital, the value of the firm will increase.

The same is possible only when:

(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes

(iii) The use of debt does not change the risk perception of the investors since the degree of leverage is
increased to that extent.

Since the amount of debt in the capital structure increases, weighted average cost of capital decreases which leads
to increase the total value of the firm. So, the increased amount of debt with constant amount of cost of equity
and cost of debt will highlight the earnings of the shareholders

Capital Structure Theory # 2. Net Operating Income (NOI) Approach:

Now we want to highlight the Net Operating Income (NOI) Approach which was advocated by David Durand
based on certain assumptions.

They are:
(i) The overall capitalisation rate of the firm Kw is constant for all degree of leverages;
(ii) Net operating income is capitalised at an overall capitalisation rate in order to have the total market value of
the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital (Kw):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total market value in order to get the market value
of equity.

S–V–T

(iv) As the Cost of Debt is constant, the cost of equity will be

Capital Structure Theory # 3. Traditional Theory Approach:

It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the cost of capital.
So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at
its lowest point. Practically, this approach encompasses all the ground between the Net Income Approach and the
Net Operating Income Approach, i.e., it may be called Intermediate Approach.

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The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the
firm to rise and the cost of capital to decline. But after attaining the optimum level, any additional debt will cause
to decrease the market value and to increase the cost of capital.

In other words, after attaining the optimum level, any additional debt taken will offset the use of cheaper debt
capital since the average cost of capital will increase along with a corresponding increase in the average cost of
debt capital.

Thus, the basic proposition of this approach are:

(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain level and
thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level remains unchanged more or less and
thereafter rises after attaining a certain level.
Capital Structure Theory # 4. Modigliani-Miller (M-M) Approach:
Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital structure and the
valuation of the firm should be explained by NOI (Net Operating Income Approach) by making an attack on the
Traditional Approach.

The Net Operating Income Approach, supplies proper justification for the irrelevance of the capital structure. In
Income Approach, supplies proper justification for the irrelevance of the capital structure.

In this context, MM support the NOI approach on the principle that the cost of capital is not dependent on the
degree of leverage irrespective of the debt-equity mix. In the words, according to their thesis, the total market
value of the firm and the cost of capital are independent of the capital structure.

They advocated that the weighted average cost of capital does not make any change with a proportionate change
in debt-equity mix in the total capital structure of the firm.

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Capital budgeting decision may be defined as the firm's decision to invest its funds in the long
term assets in anticipation of an expected flow of benefits over a number of years. It involves a
current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits.

The time value of money (TVM) is the concept that a sum of money is worth more now than the
same sum will be at a future date due to its earnings potential in the interim. This is a core
principle of finance. A sum of money in the hand has greater value than the same sum to be paid in
the future.

How the Time Value of Money Works

A simple example can be used to show the time value of money. Assume that someone
offers to pay you one of two ways for some work you are doing for them: They will either
pay you $1,000 now or $1,100 one year from now.
Which pay option should you take? It depends on what kind of investment return you can
earn on the money at the present time. Since $1,100 is 110% of $1,000, then if you believe
you can make more than a 10% return on the money by investing it over the next year, you
should opt to take the $1,000 now.
On the other hand, if you don’t think you could earn more than 9% in the next year by
investing the money, then you should take the future payment of $1,100 – as long as you
trust the person to pay you then.

Time Value and Purchasing Power

The time value of money is also related to the concepts of inflation and purchasing power.
Both factors need to be taken into consideration along with whatever rate of return may be
realized by investing the money.
Why is this important? Because inflation constantly erodes the value, and therefore the
purchasing power, of money. It is best exemplified by the prices of commodities such as
gas or food. If, for example, you were given a certificate for $100 of free gasoline in 1990,
you could have bought a lot more gallons of gas than you could have if you were given
$100 of free gas a decade later.
Inflation and purchasing power must be factored in when you invest money because to
calculate your real return on an investment, you must subtract the rate of inflation from
whatever percentage return you earn on your money.
If the rate of inflation is actually higher than the rate of your investment return, then even
though your investment shows a nominal positive return, you are actually losing money in
terms of purchasing power. For example, if you earn 10% on investments, but the rate of
inflation is 15%, you’re actually losing 5% in purchasing power each year (10% – 15% =
-5%).

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Time Value of Money Formula

The time value of money is an important concept not just for individuals, but also for
making business decisions. Companies consider the time value of money in making
decisions about investing in new product development, acquiring new business equipment
or facilities, and establishing credit terms for the sale of their products or services.
A specific formula can be used for calculating the future value of money so that it can be
compared to the present value:
Where:
FV = the future value of money
PV = the present value
i = the interest rate or other return that can be earned on the money
t = the number of years to take into consideration
n = the number of compounding periods of interest per year

Using the formula above, let’s look at an example where you have $5,000 and can expect
to earn 5% interest on that sum each year for the next two years. Assuming the interest is
only compounded annually, the future value of your $5,000 today can be calculated as
follows:
FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50

Present Value of Future Money Formula

The formula can also be used to calculate the present value of money to be received in the
future. You simply divide the future value rather than multiplying the present value. This
can be helpful in considering two varying present and future amounts.
In our original example, we considered the options of someone paying your $1,000 today
versus $1,100 a year from now. If you could earn 5% on investing the money now, and
wanted to know what present value would equal the future value of $1,100 – or how much
money you would need in hand now in order to have $1,100 a year from now – the formula
would be as follows:
PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

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The calculation above shows you that, with an available return of 5% annually, you would
need to receive $1,047 in the present to equal the future value of $1,100 to be received a
year from now.
To make things easy for you, there are a number of online calculators to figure the future
value or present value of money.
Capital Budgeting Techniques:

Book Profit VS Cash Flow:

Book Profit: It is also known as accounting profit.

Cash Flow: It is focused on cash inflow and outflow and ignores all non-cash activities

Proforma Book Profit and Cash Flow After Tax

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Particulars INR

Sales XXX

Less: Variable Cost (Always Cash) (XXX)

Contribution XXX

Less: Cash Fixed Cost (XXX)

Less: Depreciation (Non-Cash Item) (XXX)

Profit Before Tax (Accounting or Book Profit) XXX

Less: Tax @ 50% (XXX)

Profit After Tax (Accounting or Book Profit) XXX

Add: Depreciation (Non-Cash Item) (XXX)

Cash Flow After Tax (CFAT)/Cash Receipts After Tax XXX

. Cash Flow & Discounted Cash Flow (DCF):

Cash Flow: Cash flow without considering time value of money.

Discounted Cash Flow: Cash flow after considering time value of money.

Discounted Cash Flow (Formulae):

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Sum of Discounted Cash Flow (In Case of Equal Inflow Formula):

Σ Discounted Cash Flow = Uniform Cash Flow × PVIFA or Sum of DF

Note:

● ARR Technique is based on Accounting/Book Profit

● Payback Period is based on Cash Flow (Non-Discounted)
● Discounted Payback, NPV, PI and IRR Techniques are based on Discounted Cash Flow
● MIRR technique if based on Future/Compounded Cash Flow
● Discounted Cash Flow is also known as Present Value of Cash Flow

7. Accounting/Average Rate of Return (ARR): ARR is the rate of return in terms of average book profit
on investment. It can be calculated by using one of the following three methods:

Formula 1: ARR (Total Investment Basis) = × 100

Formula 2: ARR (Average Investment Basis) = × 100

Formula 3: ARR (Annual Basis):

Step 1: Calculate Annual Rate of Return =

Step 2: Calculate Average Rate of Return of Annual ARR in Step 1

Note:

Average Investment = ½ × (Initial Investment + Salvage) + Additional Working Capital (If Any)

Or

Average Investment = (½ × Depreciable Investment) + Salvage + Additional Working Capital

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8. Payback Period (Traditional) It is refers to the period within which entire amount of investment is
expected to be recovered in form of Cash.

Situation 1: Uniform Cash Receipts:

Situation 2: Unequal Cash Receipts:

Step 1: Calculate Cumulative Cash Inflow

Step 2: Calculate Payback Period

9. Discounted Payback Period: It is refers to the period within which entire amount of investment is
expected to be recovered in form of Discounted Cash.

Step 1: Calculate Cumulative Discounted Cash Inflow

Step 2: Calculate Discounted Payback Period

10. Net Present Value (NPV): The net present value of a project is the amount, in current value of
amount, the investment earns after paying cost of capital in each period.

NPV = PV of Inflow – PV of Outflow/Initial Investment Or

NPV = (PI – 1) × PV of Outflow/Initial Investment

11. Profitability Index (PI)/Desirability Factor (DF)/Present Value Index Method:

PI = PV of Inflow ÷ PV of Outflow/Initial investment Or

Note: PI technique is useful:

●
● In case of Capital Rationing with indivisible projects
● In case of equal NPV under mutually exclusive projects

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12. Internal Rate of Return (IRR): Internal rate of return refers to the actual rate of return generated by
the project. Internal rate of return for an investment proposal is the discount rate that equates the
present value of the expected cash inflows with the initial cash outflow.

Situation 1: One Point Inflow & Outflow:

Situation 2: Multiple Point Inflow (Unequal Cash) & Outflow:

Step 1: Calculate one positive and one negative NPV by using random discount rate

Where,

L = Lower Discount Rate

H = Higher Discount Rate

NPVL = NPV at Lower Discount Rate

NPVH = NPV at Higher Discount Rate

Situation 3: `Multiple Point Inflow (Equal Cash) & Outflow:

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Step 1: `Calculate PVIFA at IRR: PVIFAIRR =

Step 2: `Calculate IRR on the basis of PVIFA table:

(a) If matched in table : Matched PVIFA rate is IRR

(b) If not matched then have to use interpolation: IRR

13. Modified Internal Rate of Return (MIRR) The MIRR is obtained by assuming a single outflow in the
zero year and the terminal cash inflow.

Step 1: Calculate cumulative compounded value of intermediate cash inflow by using cost of capital
as rate of compounding.

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Short term investment decision

Working capital management is a business strategy designed to ensure that a company operates efficiently by
monitoring and using its current assets and liabilities to their most effective use. The efficiency of working capital
management can be quantified using ratio analysis.

Working Capital Management

Activities performed by a company to make sure it got enough resources for day-to-day operating expenses

What is Working Capital Management?

Working capital management refers to the set of activities performed by a company to make sure it got enough
resources for day-to-day operating expenses while keeping resources invested in a productive way Understanding
Working Capital

Working capital is the difference between a company’s current assets and its current liabilities.

Current assets include cash, accounts receivable, and inventories.

Current liabilities include accounts payable, short-term borrowings, and accrued liabilities.

Some approaches may subtract cash from current assets and financial debt from current liabilities.

Why Working Capital Management is Important

Ensuring that the company possesses appropriate resources for its daily activities means protecting the company’s
existence and ensuring it can keep operating as a going concern. Scarce availability of cash, uncontrolled
commercial credit policies, or limited access to short-term financing can lead to the need for restructuring, asset
sales, and even liquidation of the company.

Factors That Affect Working Capital Needs

Working capital needs are not the same for every company. The factors that can affect working capital needs can
be endogenous or exogenous.

Endogenous factors include a company’s size, structure, and strategy.

Exogenous factors include the access and availability of banking services, level of interest rates, type of industry
and products or services sold, macroeconomic conditions, and the size, number, and strategy of the company’s
competitors.

Managing Liquidity
Properly managing liquidity ensures that the company possesses enough cash resources for its ordinary business
needs and unexpected needs of a reasonable amount. It’s also important because it affects a company’s
creditworthiness, which can contribute to determining a business’s success or failure.

The lower a company’s liquidity, the more likely it is going to face financial distress, other conditions being
equal.

However, too much cash parked in low- or non-earning assets may reflect a poor allocation of resources.

Proper liquidity management is manifested at an appropriate level of cash and/or in the ability of an
organization to quickly and efficiently generate cash resources to finance its business needs.

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Managing Accounts Receivables

A company should grant its customers the proper flexibility or level of commercial credit while making sure
that the right amounts of cash flow in via operations.

A company will determine the credit terms to offer based on the financial strength of the customer, the industry’s
policies, and the competitors’ actual policies.

Credit terms can be ordinary, which means the customer generally is given a set number of days to pay the invoice
(generally between 30 and 90). The company’s policies and manager’s discretion can determine whether different
terms are necessary, such as cash before delivery, cash on delivery, bill-to-bill, or periodic billing.

Managing Inventory
Inventory management aims to make sure that the company keeps an adequate level of inventory to deal with
ordinary operations and fluctuations in demand without investing too much capital in the asset.

An excessive level of inventory means that an excessive amount of capital is tied to it. It also increases the risk
of unsold inventory and potential obsolescence eroding the value of inventory.

A shortage of inventory should also be avoided, as it would determine lost sales for the company.

Managing Short-Term Debt

Like liquidity management, managing short-term financing should also focus on making sure that the company
possesses enough liquidity to finance short-term operations without taking on excessive risk.

The proper management of short-term financing involves the selection of the right financing instruments and the
sizing of the funds accessed via each instrument. Popular sources of financing include regular credit lines,
uncommitted lines, revolving credit agreements, collateralized loans, discounted receivables, and factoring.

A company should ensure there will be enough access to liquidity to deal with peak cash needs. For example, a
company can set up a revolving credit agreement well above ordinary needs to deal with unexpected cash needs.

Managing Accounts Payable

Accounts payable arises from trade credit granted by a company’s suppliers, mostly as part of the normal
operations. The right balance between early payments and commercial debt should be achieved.

Early payments may unnecessarily reduce the liquidity available, which can be put to use in more productive
ways.

Late payments may erode the company’s reputation and commercial relationships, while a high level of
commercial debt could reduce its creditworthiness.

Summary

● Working capital management involves balancing movements related to five main items – cash, trade
receivables, trade payables, short-term financing, and inventory – to make sure a business possesses
adequate resources to operate efficiently.
● The levels of cash should be enough to deal with ordinary or small unexpected needs, but not so high to
determine an inefficient allocation of capital.
● Commercial credit should be used properly to balance the need to maintain sales and healthy business
relationships with the need to limit exposure to customers with low creditworthiness.
● Managing short-term debt and accounts payable should allow the company to achieve enough liquidity
for ordinary operations and unexpected needs, without an excessive increase in financial risk.

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● Inventory management should make sure there are enough products to sell and materials for its
production processes while avoiding excessive accumulation and obsolescence.

How to Calculate Working Capital

Working capital is calculated as current assets minus current liabilities, as detailed on the balance sheet.

Formula for Working Capital

Working capital = current assets – current liabilities

Positive vs Negative Working Capital

A company has positive working capital if it has enough cash, accounts receivable and other liquid assets to cover
its short-term obligations, such as accounts payable and short-term debt.

In contrast, a company has negative working capital if it doesn’t have enough current assets to cover its short-
term financial obligations. A company with negative working capital may have trouble paying suppliers and
creditors and difficulty raising funds to drive business growth. If the situation continues, it may eventually be
forced to shut down.

Elements Included in Working Capital

The current assets and liabilities used to calculate working capital typically include the following items:

Current assets

include cash and other liquid assets that can be converted into cash within one year of the balance sheet date,
including:

▪ Cash, including money in bank accounts Marketable securities, such as U.S. Treasury bills and money market
funds.
▪ Short-term investments a company intends to sell within one year.
▪ Accounts receivable, minus any allowances for accounts that are unlikely to be paid.
▪ Notes receivable — such as short-term loans to customers or suppliers — maturing within one year.

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▪ Other receivables, such as income tax refunds, cash advances to employees and insurance claims.
▪ Inventory including raw materials, work in process and finished goods.
▪ Prepaid expenses, such as insurance premiums.
▪ Advance payments on future purchases.

Current liabilities

all liabilities due within a year of the balance sheet date, including:

▪ Accounts payable.
▪ Notes payable due within one year.
▪ Wages payable.
▪ Taxes payable.
▪ Interest payable on loans.
▪ Any loan principal that must be paid within a year.
▪ Other accrued expenses payable.
▪ Deferred revenue, such as advance payments from customers for goods or services not yet delivered.

Cash Management
Cash management is the process of managing cash inflows and outflows. There are many cash management
considerations and solutions available in the financial marketplace for both individuals and businesses. For
businesses, the cash flow statement is a central component of cash flow management.

Cash Management
The process of collecting and managing cash flows from the operating, investing, and financing activities of a
company

What is Cash Management?

Cash management, also known as treasury management, is the process that involves collecting and managing
cash flows from the operating, investing, and financing activities of a company. In business, it is a key aspect of
an organization’s financial stability.

Cash management is important for both companies and individuals, as it is a key component of financial stability.

Financial instruments involved in cash management contain money market funds, Treasury bills, and certificates
of deposit.

Companies and individuals offer a wide range of services available across the financial marketplace to help with
all types of cash management. Banks are typically a primary financial service provider. There are also many

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different cash management solutions for both companies and individuals seeking to get the best return on cash
assets or the most efficient use of cash.

Summary

● Cash management, also known as treasury management, is a process that involves collecting and
managing cash flows.
● Chief financial officers, business managers, and corporate treasurers are usually the main individuals
responsible for overall cash management strategies, stability analysis, and cash related responsibilities.
● Many businesses fail at cash management and the reasons vary. Typically, a poor understanding of the
cash flow cycle, profit versus cash, lack of cash management skills, and bad capital investments are the
reasons for failing at cash management.

The Importance of Cash

Cash is the primary asset individuals and companies use regularly to settle their debt obligations and operating
expenses, e.g., taxes, employee salaries, inventory purchases, advertising costs, and rents, etc.

Cash is used as investment capital to be allocated to long-term assets, such as property, plant, and equipment
(PP&E) and other non-current assets. Excess cash after accounting for expenses often goes towards dividend
distributions.

Companies with a multitude of cash inflows and outflows must be properly managed to maintain adequate
business stability. For individuals, maintaining cash balances is also a major concern.

Understanding Cash Management

In an organization, chief financial officers, business managers, and corporate treasurers are usually the main
individuals responsible for overall cash management strategies, stability analysis, and other cash-related
responsibilities. However, many organizations may outsource part or all of their cash management responsibilities
to some service providers.

The cash flow statement is the main component of a company’s cash flow management. The cash flow statement
comprehensively records all of the organization’s cash inflows and outflows. It includes cash from operating
activities, cash paid for investing activities, and cash from financing activities. The bottom line of the cash flow
statement shows how much cash is readily available for an organization.

The cash flow statement is divided into three parts: investing, financing, and operating activities. The operating
part of cash activities is based heavily on the net working capital, which is presented on the cash flow statement
as a company’s current assets minus current liabilities. Businesses strive to make the current assets balance exceed
the current liabilities balance.

The other two parts of the cash flow statement are somewhat more straightforward with cash inflows and outflows
connected to investing and financing, such as investments into real estate, buying new equipment and machinery,
and originating stock repurchases, or paying out dividends as part of the financing activities.

There are many internal controls utilized to manage and achieve efficient business cash flows. Some of a
business’s major cash flow considerations comprise the average length of account receivables, write-offs for
uncollected receivables, collection processes, rates of return on cash equivalent investments, liquidity, and credit
line management.

Causes of Problems with Cash Management

Unfortunately, many businesses engage in poor cash management, and there are several reasons for the problem.
Let us look at some of them:

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1. Poor understanding of the cash flow cycle

Business management should clearly understand the timing of cash inflows and outflows from the entity, such
as when to pay for accounts payable and purchase inventory. During rapid growth, a company can end up running
out of money because of over-purchasing inventory, yet not receiving payment for it.

2. Lack of understanding of profit versus cash

A company can generate profits on its income statement and be burning cash on the cash flow statement.

When a company generates revenue, it does not necessarily mean it already received cash payment for that
revenue. So, a very fast-growing business that requires a lot of inventory may be generating lots of revenue but
not receiving positive cash flows on it.

3. Lack of cash management skills

It is crucial for managers to acquire the necessary skills despite the understanding of the abovementioned issues.
The skills involve the ability to optimize and manage the working capital. It can include discipline and putting
the proper frameworks in place to ensure the receivables are collected on time and that payables are not paid more
quickly than is needed.

4. Bad capital investments

A company may allocate capital to projects that ultimately do not generate sufficient return on investment or
sufficient cash flows to justify the investments. If such is the case, the investments will be a net drain on the cash
flow statement, and eventually, on the company’s cash balance.

Inventory Management

Inventory management helps companies identify which and how much stock to order at what time. It tracks
inventory from purchase to the sale of goods. The practice identifies and responds to trends to ensure there’s
always enough stock to fulfill customer orders and proper warning of a shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although reported as an asset on the balance
sheet) ties up cash. Therefore, too much stock costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An accounting measurement, inventory
turnover reflects how often stock is sold in a period. A business does not want more stock than sales. Poor
inventory turnover can lead to dead stock, or unsold stock.

Why Is Inventory Management Important?

Inventory management is vital to a company’s health because it helps make sure there is rarely too much or too
little stock on hand, limiting the risk of stockouts and inaccurate records.

Public companies must track inventory as a requirement for compliance with Securities and Exchange
Commission (SEC) rules and the Sarbanes-Oxley (SOX) Act. Companies must document their management
processes to prove compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re able to fulfill incoming or open orders
and raises profits. Inventory management also:

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▪ SavesMoney:
Understanding stock trends means you see how much of and where you have something in stock so you’re better
able to use the stock you have. This also allows you to keep less stock at each location (store, warehouse), as
you’re able to pull from anywhere to fulfill orders — all of this decreases costs tied up in inventory and decreases
the amount of stock that goes unsold before it’s obsolete.

▪ ImprovesCashFlow:
With proper inventory management, you spend money on inventory that sells, so cash is always moving through
the business.

▪ SatisfiesCustomers:
One element of developing loyal customers is ensuring they receive the items they want without waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much inventory and not being able to sell it, not
having enough inventory to fulfill orders, and not understanding what items you have in inventory and where
they’re located. Other obstacles include:

▪ GettingAccurateStockDetails:
If you don’t have accurate stock details,there’s no way to know when to refill stock or which stock moves well.

▪ PoorProcesses:
Outdated or manual processes can make work error-prone and slow down operations.

▪ ChangingCustomerDemand:
Customer tastes and needs change constantly. If your system can’t track trends, how will you know when their
preferences change and why?

▪ UsingWarehouseSpaceWell:
Staff wastes time if like products are hard to locate. Mastering inventory management can help eliminate this
challenge.

Receivable management

Receivable management is a process of managing the account receivables within a business

organisation. Account receivables simply mean credit extended by the company to its customers and are
treated as liquid assets. It involves taking decisions regarding the investment to be made in trade debtors
by organisation. Deciding the proper amount be lent by the company to its customers in the form of
credit sales is quite important. It affects the overall cash availability for undertaking various operations

Receivable management business ensures that a sufficient amount of cash is always maintained within
the business so that operations can continue uninterrupted. It helps in deciding the optimum proportion
of credit sales. The overall process of receivable management involves properly recording all credit

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sales invoices, sending notices on due date to collection department, recording all collections,
calculation of outstanding interest on late payments etc.

Receivable management aims at raising the sales volumes and profit of the business by managing and
providing credit facilities to customers. A proper receivable management process aims at monitoring
and avoidance of occurrence of any overdue payment and non-payment. It is an effective way of
improving the financial and liquidity position of the company. Credit facilities are important for
attracting and retaining customers and this makes management of credit facilities by business crucial.

Objectives of receivable management are as follows:

Regulate Cash Flow

Receivable management regulates all cash flows in an organization. It controls all inflow and outflow
of funds and ensure that an efficient amount of cash is always available. Proper management of
receivables enables organizations in efficient functioning at all the times.

Credit Analysis
It perform proper analysis of customer credentials for determining their credit ratings. Monitoring and
scanning of customers before provide them any credit facility helps in minimizing the credit risk.

Decide Credit Policy

Receivable management decides the credit policy and standards as per which credit facility should be
extended to customers. A company may have a lenient credit policy where customer credit-worthiness
is not at all considered or a stringent policy where credit-worthiness is considered for providing credit.

Credit Collection
Receivable management focuses on efficient and timely collection of business payments from its
customers. It works towards reducing the time gap in between the moments when bills are raised and
payment is collected.

Maintain Up-To-Date Records

Receivable management maintains a systematic record of all business transactions on a regular basis.
All transactions are maintained fairly in the form of proper billing and invoices which helps in avoiding
any confusion or settling of disputes arising later.

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Dividend Decisions
What are Dividend Decisions?
Dividend decisions, as the very name suggests, refer to the decision-making mechanism of the
management to declare dividends. It is crucial for the top management to determine the portion of
earnings available for the distribution as the dividend at the end of every reporting period. A company’s
ultimate objective is the maximization of shareholders’ wealth. It must, therefore, be very vigilant about
its profit-sharing policies to retain the faith of the shareholders. Dividend payout policies derive
enormous importance by virtue of being a bridge between the company and shareholders for profit-
sharing. Without an organized dividend policy, it would be difficult for the investors to judge the
intentions of the management.
Impact of Dividend Decisions on Price
The dividend policies of an organization have a significant bearing on the market value of stocks.
Companies must distribute dividends in line with the industry standards and previously distributed
dividends by the company. The shareholders will otherwise perceive this variability negatively. It casts
suspicion on the financial health and motives of the management (signaling effect). In aggregate, an
inefficient dividend decision mechanism would adversely impact the valuation of the company.
Evaluation of Price Sensitivity
Companies chosen by investors for their regularity of dividends must have a more stringent dividend
policy than others. It becomes essential for such companies to take effective dividend decisions for
maintaining stock prices.
Stage of Growth
Dividend decisions must be in line with the stage of the company- infancy, growth, maturity & decline.
Each stage undergoes different conditions and therefore calls for different dividend decisions.
Good Dividend Policy
What Constitutes a Good Dividend Policy?
There does not exist a single dividend decision process that works for every organization. A decision
suitable for one company may prove fatal for another company. For example, businesses with a
consistent order book such as telecom and banking are expected to pay regular dividends. It may impact
the stock prices if they do not pay dividends regularly. On the contrary, sectors of pharmaceutical and
technology are highly research-oriented. These require huge cash expenses to further their operations.
Therefore they cannot afford to pay a regular dividend. Investors of such stocks earn income mainly
through capital appreciation. In essence, there are a lot of factors affecting dividend policy or decisions.
We can refer to the following renowned theories on Dividend Policy:

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Modigliani- Miller Theory on Dividend Policy

Gordon’s Theory on Dividend Policy
Walter’s Theory on Dividend Policy
A good financial manager must, therefore, answer the following questions before taking crucialdividend
decisions
Importance of Dividend Decisions
While deciding the distribution of dividends, management has to answer various questions such as:
Q. How much Dividend should a Company Distribute to its Shareholders?
The ideal dividend decision should be commensurate with the profitable investment opportunity
available to the company. If it can invest a dollar and reap two, it is insensible to lose out on that dollar
by paying dividends.
Industry standards are another input to be factored in. A company paying fewer dividends than its peers
can face problems while raising capital.
It also depends on the kind of investors which the company wants to attract. For example, companies
such as American Express and Coke can be relied upon for their stable dividend policies. They attract
investors with a longer horizon and larger disposable funds since they are compensated by steady cash
flows.
Q. What will be the Impact of Dividend Decisions on the Share Prices of the Company?
To answer this question, it is important to know the dividend history of the company. If the company is
known for regularly paying dividends, pressure for maintaining the payout hovers over it. A one-off
year, where it may not want to pay dividends and divert the funds for reinvestment plan or retention may
be hazardous. Conversely, an interesting phenomenon occurs in cases of companies depicting no
stability in dividend policies. When it does declare a dividend, the share prices see a huge spike before
the ex-dividend date. More and more people seek to make a quick buck by buying its shares on dividend
declaration. These shares are then sold as soon as the dividends are declared. This is followed by a fall
in the share prices (dividend stripping). Thus the shares of a sparsely dividend-paying company undergo
great volatility between the date of dividend declaration and payment
Q. What is the Consequential Impact of Inability to Maintain Dividend Year after Year?
Only a company with sustainable profitability and cash flows can expect to reasonably pay dividends
year after year. If any other company claims the same, it is a hoax. If the stock of the company in question
is a growth stock such as Qualcomm (NYSE), the shareholders may pardon a stingy dividend policy.
Such shareholders expect to earn via a fat capital appreciation and hardly through the dividend.

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On the other hand, if the shareholders are sensitive to the dividend decisions of the company, it is not a
good idea to have an irregular policy. For example, Avista Corp and CMS Energy Corporation
(NYSE) have been consistently paying dividends for a while. Investors which buy into these companies
are conditioned to expect the same. Having established the expectation of regular dividends, the
companies must ensure regular payouts. The failure of same could drive down the prices.
Types of Dividend Decision
There are various types of dividends and dividend decisions.

Stable Dividends
● The same amounts of dividends are paid out every year irrespective of the profitability.
● Shareholders remain immune to fluctuations and volatility faced by the company.
● Only long-standing and well-established companies with steady cash flows can afford to
follow this policy
● Investors that buy into stock dividend investing companies have a low-risk appetite. They also
do not get to participate in the profits of the company
Constant Dividends
● Dividends are paid at a fixed percentage of the profits.
● The brunt of recession is as much borne by them as much they reap benefits of the boom.
● This policy is suitable for companies in their infancy stage as well as those prone to volatility.
● Investors of these companies are risk-taking. They prefer to swing with the company in its
earnings
Alternate Dividend Decisions
A company may not always issue dividends in cash. A stock dividend is a significant option with the
management for recourse to non-cash options. It is a handy tool to which management may resort when
it wants to balance both, shortage of cash and shareholder expectations. Such decisions are only helpful
in exceptional circumstances.

WALTER`S MODEL

Walter's model is one of the most important theories of dividend in financial management. Proposed by
Professor James E. Walter, the model states that the dividend policy is a precursor of the value of a
company. As companies pay dividends depending on the earnings, the payout of dividends can show
how much the company was valued.
Walter's model is based on the relationship between a company's Internal Rate of Return (IRR) and
the Cost of Capital (CoC). These two factors are used to find the dividend theory that will reflect the
want of the company to maximize the shareholder's wealth. As increasing the shareholder wealth is an
objective of most corporate firms, it is a key policy that shows how dividend payout influences the
valuation of a firm.

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Formula for Walter's Model

The formula that is used to determine the market price per share with Walter's model is,
P=D+rk(E−D)kP=D+rk(E−D)k
Where,
● P = Market Price of share
● D = Dividend per share
● E = Earnings per share
● r = Internal rate of return
● k = cost of capital

Criticism of Walter's Dividend Model

Walter's theory is based on some principles like most other theories, and among all other dividend
policy theories, it is the best. However, the theory is not free from criticism.
● As the theory considers the entire amount of dividend to be retained or distributed, it is a theory
that is not quite practical in nature.
● Walter's theory also requires the Cost of Capital and the Internal Rate of Return to be constant
which is impractical in nature.
● Walter's model also considers that starting earnings and dividends never change. However,
Earnings Per Share (EPS) and Dividend Per Share may change.
● To be considered under Walter's model, a company must have an infinite life, which is quite
impractical to assume.
As mentioned above, Walter's Model uses the Internal Rate of Return and Cost of Capital to determine
the dividend policy of a firm. It is an excellent way to calculate the valuation of a firm. Theoretically,
Walter's model has no flaws because it considers all aspects related to the dividend policy of a firm.
However, in terms of regular and practical use cases, it is rigid and cannot be used to determine the true
dividend policy.

Conclusion
In brief, Walter's dividend policy model is a great theoretical model to determine the value of a firm
using IRR and the Cost of Capital. However, it is not applicable in many practical situations.Therefore,
one must understand the difference between theoretical and practical use cases before using Walter’s
model
Gordon’s Model
Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends
are relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to study the
effects of dividend policy on a stock price of the firm.

P = [E (1-b)] / Ke-br

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Where, P = price of a share

E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate

Assumptions of Gordon’s Model

1. The firm is an all-equity firm; only the retained earnings are used to finance the investments, no
external source of financing is used.
2. The rate of return (r) and cost of capital (K) are constant.
3. The life of a firm is indefinite.
4. Retention ratio once decided remains constant.
5. Growth rate is constant (g = br)
6. Cost of Capital is greater than br
Criticism of Gordon’s Model

1. It is assumed that firm’s investment opportunities are financed only through the retained earnings and
no external financing viz. Debt or equity is raised. Thus, the investment policy or the dividend policy or
both can be sub-optimal.
2. The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is
constant, but, however, it decreases with more and more investments.
3. It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the real life
situations, as it ignores the business risk, which has a direct impact on the firm’s value.

Miller and Modigliani theory on Dividend Policy

Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no
effect on the price of the shares of the firm and believes that it is the investment policy that increases
the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns are more than
the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the earnings,
dividends or cash flows are converted into equity or value of the firm. If the returns are less than “Ke”
then, the shareholders would like to receive the earnings in the form of dividends.

Miller and Modigliani have given the proof of their argument, that dividends have no effect on the firm’s
share price, in the form of a set of equations, which are explained in the content below:

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Proof of Miller and Modigliani Hypothesis

Assumptions of Miller and Modigliani Hypothesis

1. There is a perfect capital market, i.e. investors are rational and have access to all the information free
of cost. There are no floatation or transaction costs, no investor is large enough to influence the market
price, and the securities are infinitely divisible.
2. There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
3. It is assumed that a company follows a constant investment policy. This implies that there is no change
in the business risk position and the rate of return on the investments in new projects.
4. There is no uncertainty about the future profits, all the investors are certain about the future
investments, dividends and the profits of the firm, as there is no risk involved.
Criticism of Miller and Modigliani Hypothesis

1. It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and the transaction
costs are there, but, however, these are untenable in the real life situations.
2. The Floatation cost is incurred when the capital is raised from the market and thus cannot be ignored
since the underwriting commission, brokerage and other costs have to be paid.
3. The transaction cost is incurred when the investors sell their securities. It is believed that in case no
dividends are paid; the investors can sell their securities to realize cash. But however, there is a cost
involved in making the sale of securities, i.e. the investors in the desire of current income has to sell a
higher number of shares.
4. There are taxes imposed on the dividend and the capital gains. However, the tax paid on the dividend
is high as compared to the tax paid on capital gains. The tax on capital gains is a deferred tax, paid
only when the shares are sold.
5. The assumption of certain future profits is uncertain. The future is full of uncertainties, and the dividend
policy does get affected by the economic conditions.
Thus, the MM Approach posits that the shareholders are indifferent between the dividends and the
capital gains, i.e., the increased value of capital assets.

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