CAIIB-Financial ManagementMODULE B

STUDY OF FINANCIAL
STATEMENTS
C.S.BALAKRISHNAN
FACULTY MEMBER
SPBT COLLEGE

Scope,Functions and
objective

Scope is
Designing and implementing certain
plans.
Ensuring effective funds utilisation by
directing funds flow according to some
plan.
Serving as a necessary tool and
technique for resources allocation to
various projects of the business and
providing the best guide for existing and
prospective resource allocation.

 According to Howard and Upton

Financial management involves the
application of general management
principles to particular financial
operation.
Attending to investment decisions as
to when and how to acquire and
allocate funds for short-term and
long-term assets keeping in view the
profit generation of the business
through which repayment obligation
can be met.

Objectives and basic consideration of

Financialmanagement.
Although profit maximisation is the
objective of financial management,the
long-term goalof the business entity is
to achieve maximising the shareholder
value of the firm,since the principle of
maximisation of shareholder wealth
provides a rational guide for running a
business and for efficient allocation of
resources in society.

 The key objective of Financial Management is

to maximise the value of the company.This is
the result of good investment
decisions,prudent financing decisions and
well thought-out financial planning and
control.
Maximisation of the value of the company is
also known as maximisation of the wealth of
the owners.To achieve this,finance manager
has to take careful decisions in respect of
-Financing
-Dividend
-Investment
-Current asset
management.

 Financing decision-Has to decide on sources

of funds for business.It is to be decided
whether entire capital should be raised from
equity capital or a part is to be raised from
loan.Hence Debt/Equity ratio or Leverage
are important since each source has in them
associated risk factors involved.
Investment decision-It relates to acquisition
of assets.Assets are classified into real
assets such as
land,building,plant,equipment etc.and the
financial assets are shares and debentures
etc.It indicates available mix of financing to
fund companys activities.Such decisions on
investment in projects come within the field
of capital budgeting which is derived from
net present value of assets.

 Dividend decision-It is basically a financing

decision.This is because profit is a source of
fund.By not paying dividend,the retained
earningsor reservecan be increased which
could be otherwise available for investment.
This ultimately lead to maximisation of
wealth
of the organisation provided decisions on
investments are correct.
Current Asset Management-This is
necessary to maintain balance between
current assets and current liability,if the
liquidity of the business is interrupted
because of holding too much fund in current
assets.

Wealth maximisation &value

maximisation
The goal of financial management is to
maximise the value of companies.This is
generally expressed in terms of maximising
the value of the ownership shares of the
company,in short,maximising share
price.Thus,better performing companies
can raise additional funds under more
favourable terms.When funds go the such
companies the economys resources are
directed to more efficient use.This basic
objective of maximisingthe price of the
companys shares is called value
maximisation.

Social responsibility is also an important goal

of
a company which requires
-Maximising share-price by efficient,wellmanaged operations related to consumer
demand parameters.
-Efficiency & innovation leads to value
maximisation which leads to new
products,new technologies and better
employment.
-External factors like pollution,product safety
and
job safety have acieved added dimensions in
relation to value maximisation.

Profit maximisation vs.Wealth

maximisation
Long run vs.Short run Profits.
Convert total corporate profits to
earning per share(EPS).
EPS is total profits divided by number of
shares outstanding.
Assume the firm earns Rs.10 mn.and
has 1mn.shares outstanding.The EPS will
work out to Rs.10.
Profit maximisation is a short-term
concept,while wealth maximisation
emphasises the long-term view point.

State whether true or false

The income statement depicts the
financial position of the firm at a given
point of time
The balance sheet gives the financial
performance of the firm over a given
period of time.
These statements are prepared every
week.
Funds Flow statement gives the liquidity
position of the firm.

 Cash Flow statement tells from where

the money comes and where it is used.
The prime objective of financial
management is wealth
maximisation,and not profit
maximisation.
What is earnings per share?
a)Net Profit
b)Profit before interest and tax
c)Total earnings divided by investment
d)Net profit divided by equity

 What is the difference between long

term funds and short term funds?
-Difference in interest rates
-Difference in time of repayment
-Difference in the size of loan
-No difference

CAPITAL EXPENDITURE
DECISIONS AND PROFITABILITY
STUDY
It represents the important decisions
taken by the firm.
Importance due to the following
issues
-Long-term effects
-Irreversibility
-Substantial outlays

 Difficulties
-Measurement problems
-Uncertainty
-Temporal spread
o Phases of capital budgeting
-Capital budgeting is a complex process
which
may be divided into five broad phases.
Planning
Implementation
Analysis
Review.
Selection

 Levels of Decision Making

-Operating decisions
-Administrative decisions
-Strategic decisions
o Profitability Study important facets are
-Market analysis
-Technical analysis
-Financial analysis
-Economic analysis
-Ecological analysis

 The basic characteristic of a capital

project is that it typically involves a
current outlay(or current and future
outlays)of funds in expectation of a
stream of benefits extending far into
future.
Accounting rate of return method-A
selection criterion using average net
income and investment outlay to
compute a rate of return for a
project.This method ignores the time
value of money & cash flows.
Internal rate of return method-A selection
method using the compounding rate of
return on the cash flow of the project.

 Net Present Value method-A selection

method using the difference between the
present value of the cash inflows of the
project and the investment outlay.The
method evaluates the differential cash
flow between proposals.
Payback method-A selection method in
which a firm sets a maximum payback
period during which cash inflow must be
sufficient to recover the initial outlay.This
method ignores the time value of money
and cash flow beyond the pay back
period.

 What are the three important factors which

arise from capital expenditure decisions?
a)Long-term effects
e)Debt
b)Profitability
f)Substantial outlays
c)Irreversibility
g)Short-term effects.
d)Risk
Why are capital expenditure decisions difficult?
i)Uncertainity in predicting costs&benefits
ii)Difficulty in measurement of costs&benefits
iii)Risk involved

iv)Problems in estimating discount rates

v)All the above

 If the IRR of the project is 7% and the

cost of capital is (11.4% should we
reject or accept the project). Yes/No.
The firm should always make an
ecological analysis to know the likely
damage that may be caused by the
project to the environment.
a)Must do
b)No need.

Sources of finance and

cost of capital
For what purposes a firm needs a finance?
Since the cash receipts lag behind cash
payments necessitating
loans,bonds,overdrafts
etc.the firm needs finance for short term
and long term requirements-fixed assets
and working capital.
Permanent sources of finance
Share capital and retained profits.

 Depreciation is not a real expenditure.It

is a non-cash expenditure(T/F)
Depreciation amount increases the
liquidity of the firm(T/F)
Cost of goods sold and Cost of production
refer to the same amount(T/F)
Net profit is calculated before tax(T/F)
Balance sheet and Income statement can
be prepared every quarter for internal
use(T/F)
A loss is shown as asset in the balance
sheet(T/F).

 Provisions for taxes and accrued

expenses to be paid within a year are
current assets(T/F)
Debtors(also known as accounts
receivable)represent the amount of
money to be paid by the firm to the
suppliers(T/F)
Fund Flow statements can be prepared
without the basis of balance sheets(T/F).
Fund flow statements represent only
bank borrowing and trade credit(T/F)

 State whether following are sources or

uses
-Buying materials
-Payment of dividend to shareholders
-Advance received from buyer of goods
-Investment in machinery
-Issue of debentures
-Retained earnings
-Increase in Inventories
-Sale of old machinery
-Depreciation amount

Study of financial
statements
Who are the party interested in firms
financial condition?
Shareholders,creditors/suppliers,manager
s,tax authorities.
Different types of concerns of
stakeholders
Profitability and earning
capacity,liquidity and repaying loan
instalments and interest.

 Long term sources

Preferenceshares,bonds,debentures and
long
term loans from financial institutions.
Various sources of short term financeCash
credit,overdraft,billsdiscounting,commerci
al
papers and trade credit.
Short term & long term cash forecastsTime periods involved-Yearly for long term
forecasts,monthly for short term forecasts.

 Factors considered in equity financing

Issue costs,servicing costs such as paying out
dividends, and when there is retained earnings
there will be capital appreciation of sharevalues.
Preference Shares-These shareholders get a
fixed return and their risk is less than the equity
Shareholders.They have a right to the first slice
of dividend.Obligation to redeem the preference
shares after its time period.They do not have a
right to vote.

 Debentures or loan financing-the firm

will have to pay fixed interest very
year.There is an obligation to redeem it
at the end of the period.There is also
an advantage of tax deductibility of
interest paid which makes it cheaper.
Bills rediscounting The buyer can
repay in a long period of time,while
seller gets his money back by
discounting the bills.For the seller,this
helps him to go ahead with production
and increase the turnover.

 Working capital term loan-A part of

working capital has to be with the
manufacturer,since there is a time lag
between ordering and procuring.This
particular portion (say25%)can be
financed by long term funds.When firm is
not able to infuse its own funds for this
purpose,it gets a long term loan from the
bank.This carries fixed interest and for a
fixed period.
Overdraft and bank loan-Overdraft is a
running account whereas bank loan
instalment are fixed.

 Trade credit-When materials are bought

from suppliers,the trade credit is
extended for few days or a couple of
months.The supplier is willing to wait to
collect money.This also depends on the
suppliersfinancial position and the
buyers credit worthiness.
Commercial paper-These are short term
promissory notes with fixed maturity
period.They are issued by very large
companies who are reputed and have
high credit worthiness.Credit rating
agencies certify their credit rating.

 Firmscost of capital-A firms is the average

cost of capital is the weighted average
arithmetic mean of the cost of resources
from various sources.
Questions:
a)Long term sources are banks and
financial
institutions (T/F)
b)Current liabilities should be repaid
within a
financial year(T/F)
c)Fixed assets are generally financed with
current liabilities(T/F)

 Equity Shareholders bear the greatest

risk(T/F)
Bills discounting scheme has been introduced
to ease flow of funds in the economy(T/F)
Trade creditors are suppliers of goods and
services to whom the firm is yet to pay.(T/F)
Accounts Receivables should be less than
trade creditors(T/F).
Bills of Exchange is same as cash credit(T/F).
Equity and Preference shares are one and the
same(T/F)
A part of working capital can be financed by
long term sources(T/F)

 A firm borrows Rs.20,000 from bank @8%

and floats a debenture for Rs.60,000
@6%,for a special project,what is the cost of
capital of the project?
a)5.5%
b)6.5%
c)7.5%
d)8.5%
If a firm borrows Rs.2 lac @10% and has a
tax rate of 40%.What is the cost of capital?
a)5%
b)6%
c)7%
d)8%
A company has issued preference share of
Rs.100 face value carrying 14% dividend
repayable at par after 12 years.Cost of
capital after tax of 40%?a)21.22%
b)23.33%c)24.23%

 Data for analyzing the situations of the

firm
Balance Sheet,Income Statement,fund
flow statement.
Basic concepts while preparing balance
sheet
-Entity concept
-Money measurement concept
-Going concern concept
-Cost concept
-Consevatism concept
-Dual aspect concept

 Accounting period concept

Accrual concept
Realisation concept
Matching concept
Materiality concept.
What is revenue reserve & capital
reserve?
Revenue reserves are accumulated
earnings from profits and normal
business operations.Capital reserves
arise due to capital gains from
revaluation of assets or due to premium
on issue of shares.

 Accounts payable-These are current

liabilities payable within one year from
date of balance sheet.
Fund Flow Statement-It shows the
sources and uses of funds during a
given accounting period.
Horizontal analysis and Vertical analysisHorizontal analysis is comparing the
operations over a time period
ie.comparing past performance with
current position for predicting the future
performance.

In vertical analysis we use percentages to

show
the relationship between various items in
the
balance sheet.
a)X contributes Rs.10,000 to his
properietory concern and the amount is
deposited in the bank.What is the nature
of liability?
i)Owners equity
ii)Loan
iii)Short term finance
iv)Fixed Asset.

b)ABC co.paid Rs.30,000 as deposit to

the suppliers for a period of 3 months.
i)Liability
ii)Current Asset
iii)Trade Credit
iv)Debenture
c)Materials costing Rs.2000 destroyed
by fire
i)Asset
ii)Liability

 Moving over to other questions.