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The basis for Comparison

between Financial Risk vs Business Risk Financial Risk


Business Risk

Business risk is the risk of not being able to Financial risk is the risk of not being
1. Meaning make the operations profitable so that the able to pay off the debt that the company
company can meet its expenses easily. has taken to get the financial leverage.

Financial risk is related to the payment of


2. What it’s all about? Business risk is purely operational.
debt.

Yes. If the firm doesn’t take debt, there


3. Avoidable? No.
would be no financial risk.

Business risk will be there as long as the Financial risk would be there until the
4. Duration
company operates. equity financing is increased drastically.

Every business wants to perpetuate and To generate better returns and to tap into the
5. Why? expand; and with continuation comes the risk lure of financial leverage, company gets
of not being able to do it. into debt and takes the financial risk.
By systemizing the process of production and
By reducing debt financing and
6. How to handle it? operation and by minimizing cost of
by increasing equity financing.
production/operation.

We can look at the debt-asset ratio, and


7. Measurement When there’s variability in EBIT.
financial leverage multiplier.

Connected with Economic environment Use of debt capital


Financial Intermediaries
These are the people who act as middlemen between the issuers and investors. They make the financial transactions
smooth and safe.

TYPES OF FINANCIAL INTERMEDIARIES

These are institutions which mediate/link between the savers and investors:

Examples of financial intermediaries

1. Commercial Banks.

They act as intermediary between savers and users (investment) of funds.


2. Savings and Credit Associations

These are firms that take the funds of many savers and then give the money as a loan in form of mortgage and to
other types of borrowers. They provide credit analysis services.
3. Credit Unions
These are cooperative associations whose members have a common bond e.g employees of the same company. The
savings of the member are loaned only to the members at a very low interest rate e.g. SACCOS charge p.m interest
on outstanding balance of loan.
4. Pension Funds

These are retirement schemes or plans funded by firms or government agencies for their workers. They are
administered mainly by the trust department of commercial banks or life insurance companies. Examples of
pension funds are NSSF, NHIF and other registered pension funds of individual firms.
5. Life Insurance Companies

These are firms that take savings in form of annual premium from individuals and them invest, these funds in
securities such as shares, bonds or in real assets. Savers will receive annuities in future.
6. Brokers

These are people who facilitate the exchange of securities by linking the buyer and the seller. They act on behalf of
members of public who are buying and selling shares of quoted companies.
7. Investment Bankers

These are institutions that buy new issue of securities for resale to other investors.
They perform the following functions:
1. Giving advice to the investors
2. Giving advice to firms which wants to
3. Valuation of firms which need to merge
4. Giving defensive tactics incase of forced takeover
5. Underwriting of securities.
Functions of SEBI

The various functions of SEBI are:

 To protect the interests of investors in securities market


 To promote the development of securities market
 To regulate the business in stock exchanges and any other securities markets
 To register and regulate the working of stock brokers, sub-brokers, share transfer
agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who
may be associated with securities markets in any manne
 To register and regulate the working of the depositories, participants, custodians
of securities, foreign institutional investors, credit rating agencies
 To register and regulate the working of venture capital funds and collective investment schemes
including mutual funds
 To promote and regulate self-regulatory organizations
 To prohibit fraudulent and unfair trade practices relating to securities markets
 To promote investors‘ education and training of intermediaries of securities markets
 To prohibit insider trading in securities
 To regulate substantial acquisition of shares and take over of companies
 To conducting research for efficient working and development of securities market
Purpose and Role of SEBI

SEBI acts as a watchdog for all the capital market participants and its main purpose is to provide such an
environment for the financial market enthusiasts that facilitate efficient and smooth working of the securities market.

To make this happen, it ensures that the three main participants of the financial market are taken care of, i.e. issuers
of securities, investor, and financial intermediaries.

Issuers of securities

These are entities in the corporate field that raise funds from various sources in the market. SEBI makes sure that
they get a healthy and transparent environment for their needs.

Investor

Investors are the ones who keep the markets active. SEBI is responsible for maintaining an environment that is free
from malpractices to restore the confidence of general public who invest their hard earned money in the markets.

What is a stable dividend policy?

a.) Stable dividend policy. This is also called Regular policy in this company pays dividend at fixed rate, and
maintains it for long time even the profit fluctuates. It pays minimum amount of dividend every year regularly. A
firm paying this can satisfy the shareholders and can enhance the credit in market.
Advantages of Stable Dividend Policy:

A stable dividend policy is advantageous to both the investors and the company on account of the following:
(a) It is sign of continued normal operations of the company.

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(b) It stabilises the market value of shares.

(c) It creates confidence among the investors.

(d) It provides a source of livelihood to those investors who view dividends as a source of funds to meet day-to-day
expenses.

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(e) It meets the requirements of institutional investors who prefer companies with stable dividends.
(f) It improves the credit standing and makes financing easier.

(g) It results in a continuous flow to the national income stream and thus helps in the stabilisation of national
economy.

What is the role of the modern day finance manager?


Posted On October 27, 2014
Since most managerial decisions are measured in financial terms, the modern day finance manager plays a key role
within the company. The role is a strategic one and should not be confused with accounting and book keeping
functions. A finance manager role should primarily be focussed on just that, management.

Today, external factors have an increasing impact on the financial manager. Heightened corporate competition,
technological change, volatility in inflation and interest rates, worldwide economic uncertainty, fluctuating
exchange rates, tax law changes and ethical concerns must be dealt with on a daily basis. As a result, the finance
manager is required to play an ever more strategic role within the organisation. The finance manager has emerged
as a team player in the overall effort of a company to create value. The “old ways of doing things” simply are not
good enough in a world where old ways quickly become obsolete. Today’s financial manager must have the
flexibility to adapt to the changing external environment if his or her company is to survive.

Understanding the differences between financial management and the other accounting activities within the
organisation is key to understanding the role of the modern day finance manager.

The role of the finance manager


The first objective of the accounting activity is to deliver information necessary for the measurement of the
company’s performance. Using some generally accepted and regulated standards and principles, the accountants
prepare the financial statements that establish the profit based only on the registered sales and expenses. On the
other hand, the financial manager focuses on the actual entries and issues of cash flow that are related to such
income and expenses. He/she keeps the company solvent by analysing and planning the cash flows necessary for
paying the obligations and purchasing the assets needed by the company to reach its financial objectives. If the
individuals involved in the accounting activities focus on collecting information and presenting the financial
statements, the financial manager evaluates the situations elaborated by the accounting activity, creates additional
information and takes decisions based on subsequent analyses. The purpose of the financial activity is to provide
correct and easily interpretable information about the company’s past, present and future operations. The financial
manager uses this information, either in its basic form, or after certain processing and analyses, as important entries
in the decision making process.

Reporting
A good finance manager should produce financial reports that show the organisation’s financial position, operating
performance and cash flow over a period of time through the use of meaningful financial statements. He / She
should create management reports on a regular basis that are relevant to decision making processes, measuring
performance against measures and targets (output and outcomes) established during finance management planning,
against budget objectives, and/or against financial management performance standards used within an industry.

Need an experienced finance manager but your budget or scope of work is limited?
Many companies are in need of an experienced finance manager to help guide them but can’t afford to engage with
them on a full time basis or the scope of work simply does not justify employing a finance manager on a full time
basis. There are companies that offer solutions to both of these challenges by outsourcing exceptional finance
managers on a part time or interim basis.

Role of a Financial Manager


Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to
take care of these activities a financial manager performs all the requisite financial activities.

A financial manger is a person who takes care of all the important financial functions of an organization. The
person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient
manner. His actions directly affect the Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can
raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio
between debt and equity. It is important to maintain a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate the funds. The
funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best
possible manner the following point must be considered

 The size of the firm and its growth capability


 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence formation of a
good asset mix and proper allocation of funds is one of the most important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is important for
survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by
the firm.

Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of
demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an
increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to
maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of production which has gone thrown
wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities.
Hence a clear understanding of capital market is an important function of a financial manager. When
securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial
manger understands and calculates the risk involved in this trading of shares and debentures.
Its on the discretion of a financial manager as to how to distribute the profits. Many investors do not like the
firm to distribute the profits amongst share holders as dividend instead invest in the business itself to
enhance growth. The practices of a financial manager directly impact the operation in capital market.

1. Estimating the Requirements of Funds: A business requires funds for long term purposes i.e. investment
in fixed assets and so on. A careful estimate of such funds is required to be made. An assessment has to be
made regarding requirements of working capital involving, estimation of amount of funds blocked in current
assets and that likely to be generated for short periods through current liabilities. Forecasting the
requirements of funds is done by use of techniques of budgetary control and long range planning.

2. Determining Capital Structure:


Once the requirement of capital funds has been determined, a decision regarding the kind and
proportion of various sources of funds has to be taken. For this, financial manager has to
determine the proper mix of equity and debt and short-term and long-term debt ratio. This is
done to achieve minimum cost of capital and maximise shareholders wealth.

3. Choice of Sources of Funds:


Before the actual procurement of funds, the finance manager has to decide the sources from
which the funds are to be raised. The management can raise finance from various sources like
equity shareholders, preference shareholders, debenture- holders, banks and other financial
institutions, public deposits, etc.
4. Procurement of Funds:
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The financial manager takes steps to procure the funds required for the business. It might require
negotiation with creditors and financial institutions, issue of prospectus, etc. The procurement of
funds is dependent not only upon cost of raising funds but also on other factors like general
market conditions, choice of investors, government policy, etc.

5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in various assets so as
to maximise the return on investment: While taking investment decisions, management should be
guided by three important principles, viz., safety, profitability, and liquidity.

6. Disposal of Profits or Surplus:


The financial manager has to decide how much to retain for ploughing back and how much to
distribute as dividend to shareholders out of the profits of the company. The factors which
influence these decisions include the trend of earnings of the company, the trend of the market
price of its shares, the requirements of funds for self- financing the future programmes and so on.

7. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It
involves forecasting the cash inflows and outflows to ensure that there is neither shortage nor
surplus of cash with the firm. Sufficient funds must be available for purchase of materials,
payment of wages and meeting day-to-day expenses.

8. Financial Control:
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Evaluation of financial performance is also an important function of financial manager. The


overall measure of evaluation is Return on Investment (ROI). The other techniques of financial
control and evaluation include budgetary control, cost control, internal audit, break-even analysis
and ratio analysis. The financial manager must lay emphasis on financial planning as well.

8. Keeping in Touch with Stock Exchange Quotations and Behavior of Share Prices: It involves analysis of
major trends in the stock market and judging their impact on share prices of the company's shares.

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Financial management
Financial management is defined as dealing with and analyzing money and investments for a person or a business
to help make business decisions. An example of financial management is the work done by an accounting
department for a company.
Financing Decision
Decisions, decisions. Running an organization must involve taking thousands of decisions a day as you can imagine.
The decisions that have to be taken with respect to the capital structure are known as Financing Decision. Let us learn
a bit more about the types of financing decisions.

Financing Decisions

If carefully reviewed what constitutes a business, we will come to the conclusion that there are two things that matter,
money and decision Without money, a company won’t survive and without decisions, money can’t survive. An
administration has to take countless decisions in the lifetime of the company. Thus, the most important ones are
related to money. The decisions related to money are called ‘Financing Decisions.’

There are three decisions that financial managers have to take:

 Investment Decision

 Financing Decision and

 Dividend Decision
Investment Decision

These are also known as Capital Budgeting Decisions. A company’s assets and resources are rare and must be
put to their utmost utilization. A firm should pick where to invest in order to gain the highest conceivable
returns.This decision relates to the careful selection of assets in which funds will be invested by the firms. The
firm puts its funds in procuring fixed assets and current assets. When choice with respect to a fixed asset is
taken it is known as capital budgeting decision.

Factors Affecting Investment Decision

 Cash flow of the venture: When an organization starts a venture it invests a huge capital at the start. Even so, the
organization expects at least some form of income to meet everyday day-to-day expenses. Therefore, there must
be some regular cash flow within the venture to help it sustain.

 Profits: The basic criteria for starting any venture is to generate income but moreover profits. The most critical
criteria in choosing the venture are the rate of return it will bring for the organization in the nature of profit for,
e.g., if venture A is getting 10% return and venture В is getting 15% return then one must prefer project B.

 Investment Criteria: Different Capital Budgeting procedures are accessible to a business that can be utilized to
assess different investment propositions. Above all, these are based on calculations with regards to the amount
of investment, interest rates, cash flows and rate of returns associated with propositions. These procedures are
applied to the investment proposals to choose the best proposal.

Financing Decision
Financial decision is important to make wise decisions about when, where and how should a business acquire
fund. Because a firm tends to profit most when the market estimation of an organization’s share expands and
this is not only a sign of development for the firm but also it boosts investor’s wealth. Consequently, this relates
to the composition of various securities in the capital structure of the company.

Factors affecting Financing Decisions


 Cost: Financing decisions are all about allocation of funds and cost-cutting. The cost of raising funds from
various sources differ a lot. The most cost-efficient source should be selected.

 Risk: The dangers of starting a venture with the funds from various sources differ. Larger risk is linked with the
funds which are borrowed, than the equity funds. This risk assessment is one of the main aspects of financing
decisions.

 Cash flow position: Cash flow is the regular day-to-day earnings of the company. Good or bad cash flow
position gives confidence or discourages the investors to invest funds in the company.

 Control: In the situation where existing investors need to hold control of the business then finance can be raised
through borrowing money, however, when they are prepared for diluting control of the business, equity can be
utilized for raising funds. How much control to give up is one of the main financing decisions.

 Condition of the market: The condition of the market matter a lot for the financing decisions. During boom
period issue of equity is in majority but during a depression, a firm will have to use debt. These decisions are an
important part of financing decisions.
Dividend Decision

Dividends decisions relate to the distribution of profits earned by the organization. The major alternatives are
whether to retain the earnings profit or to distribute to the shareholders.
Equity Shares vs Preference Shares Comparison Table
Let’s look at the top Comparison between Equity Shares vs Preference Shares

Source of Division Equity Shares Preference Shares

Brief/Gist Equity share is the main source for Preference shares are the shares which
raising funds, and they signify guarantee shareholders fix the rate of
ownership in the company. dividend, and they are a lender of
capital and not an owner.

Equity shareholders received a Preference shareholders received


dividend at a Fluctuating rate and paid dividend payments at a fixed rate and
Dividend Rate
after all liabilities payment. before Equity Shareholders.

Capital Payment/Liquidation In the case of company insolvency In the case of company insolvency
Equity shareholders payment settled or Preference shareholders payment is
repaid at the end. repaid before the equity shareholders.

Equity shareholders have the right to Generally, Preference shareholders do


vote on all matters of the company. not carry the voting rights but in some
Voting Authority
cases, they get the voting rights.
Convertibility Equity shares cannot be converted. Some types of preference share can be
converted to Equity shares.

There is no provision to accumulate Preference shareholders get the


the previous year dividend; due to this previous year’s pending dividend
Equity shareholders will not get payment in certain cases (Depend on
Amount Overdue previous year overdue payment of which Type of preference share they
dividends. hold).

A risk associated with Equity shares is A risk associated with preference


higher. share is less than compared to Equity
Risk
share.

Investors who are ready to take risk of Investors who want a stable return on
invest in Equity shares. investment invest in Preference
Investors
shares.

Decision of Rate The dividend rate on Equity share is The dividend rate is fixed at the time
decided by the board of the company. of the issue of preference shares.
Components of a Capital Budget

The capital budgeting process is an activity that helps a company create a budget for acquiring assets. Asset
acquisitions often are an expensive process, leading to the need for a budget. Several components are necessary
to complete this process, and, in some cases, a capital budget does not follow a traditional budget process.

Cash Inflows

Cash inflows represent all receipts a company will receive from the asset acquisition. In most cases, the inf lows
represent extra money earned through increased operating activity. Cash flows usually are specified for each year
in a specific time period. For example, a company may have a five-year plan for repaying the costs associated
with the asset acquisition. The cash inflows for these five years are part of the capital budget.

Cash Outflows

In the capital budget, cash outflows are any cost a company must pay for the asset acquisition. For example, the
purchase price, freight and handling and similar costs are part of the cash outflows. Training and costs for
changing current facilities also fall under this category. Another term for cash outflows may be cash payments,
which clarifies what falls under this category.

Budgeting Model

Businesses can choose from among several capital budget models. These include the payback period, rate of
return and net present value. Companies often select one model for this process. The payback period determines
the number of months or years it takes to recoup cash outflows. The rate of return presents the average return for
the asset's entire life. Net present value discounts future dollars earned into today's dollar value for comparison.

Considerations

Each capital budget model usually presents a different figure. A company can prepare a capital budget using each
model, although this is not necessary. The best method for this process is to review multiple alternatives using
the same method, such as payback period. This allows for a comparison process that provides similar numbers
for all assets involved in the budget process. Companies can select whichever method they believe provides the
best representation for the given scenario.

5 Strategies for Effective Accounts Receivable Management


Accounting
Posting by Geoffrey Brown, CPA

One of the biggest barriers to proper cash flow and a source of anxiety for many business owners is overdue
accounts receivable (AR). Getting a customer is a big win for you and your marketing/sales team; getting that
customer to pay in a timely manner is essential for your company’s financial health.

Besides hounding your late-paying customers (which may not be the best approach for customer satisfaction), here
are 5 steps you can take to effectively manage your accounts receivable and get that much-needed cash in the door:

1. Sign a Contract and Check Credit. Managing accounts receivable begins before the first invoice goes out
the door. With the guidance of legal counsel, develop a binding contract or engagement letter that sets forth
your payment terms. Run a credit check on prospective clients to see if they have a history of late payments
or bankruptcies and other financial troubles.
2. Track Accounts Receivable. A key part of this process is to effectively track accounts receivable. You
should always know which accounts are outstanding and for how long. Run reports to highlight payment
trends and which customers are frequently behind. You can also set up alerts that will tell you when a
customer is overdue or soon to be overdue in their payments to allow for more effective follow-up.
3. Make Payment Easy. Give your customers the options they need to pay you quickly. Look into accepting
credit cards or allow direct transfers of payments. Depending on your business, Paypal or another mobile
payment solution could also be a good fit. Yes, many of these methods require a cut of the transaction total,
but if overdue payments are haunting your business, it is likely worth the cost.
4. Do Your Part. A delayed invoice will obviously lead to delayed payment. Make sure you tie up loose ends
on your side of the equation and ensure that invoices are sent out in a timely fashion.
5. Re-Think Your Billing Approach. If billing after you finish the work is causing some problems, reassess
your payment terms. Ask clients to pay you in installments throughout the engagement, and/or require a
deposit before work begins. If you’re not ready for a step this big, start with simply shortening your payment
terms.
explain investment decision in firm

The common categories are as follows:


(i) Inventory Investment:
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Holding of stocks of materials is unavoidable for smooth running of a business. The expenditure
on stocks comes in the category of investments.

(ii) Strategic Investment Expenditure:


In this case, the firm makes investment decisions in order to strengthen its market power. The
return on such investment will not be immediate.

(iii) Modernisation Investment Expenditure:


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In this case, the firm decides to adopt a new and better technology in place of the old one for the
sake of cost reduction. It is also known as capital deepening process.

(iv) Expansion Investment on a New Business:


In this case, the firm decides to start a new business or diversify into new lines of production for
which a new set of machines are to be purchased.

(v) Replacement Investment:


In this category, the firm takes decisions about the replacement of worn out and obsolete assets
by new ones.

(vi) Expansion Investment:


In this case, the firm decides to expand the productive capacity for existing products and thus
grows further in a uni-direction. This type of investment is also called capital widening.

Diversification:

Diversification is a technique that reduces risk by allocating investments among


various financial instruments, industries, and other categories. It aims to maximize returns
by investing in different areas that would each react differently to the same event.

12 Main Factors Affecting Working Capital


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Main factors affecting the working capital are as follows:

(1) Nature of Business:


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The requirement of working capital depends on the nature of business. The nature of business is
usually of two types: Manufacturing Business and Trading Business. In the case of manufacturing
business it takes a lot of time in converting raw material into finished goods. Therefore, capital
remains invested for a long time in raw material, semi-finished goods and the stocking of the
finished goods.

Consequently, more working capital is required. On the contrary, in case of trading business the
goods are sold immediately after purchasing or sometimes the sale is affected even before the
purchase itself. Therefore, very little working capital is required. Moreover, in case of service
businesses, the working capital is almost nil since there is nothing in stock.

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(2) Scale of Operations:


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There is a direct link between the working capital and the scale of operations. In other words,
more working capital is required in case of big organisations while less working capital is needed
in case of small organisations.

(3) Business Cycle:


The need for the working capital is affected by various stages of the business cycle. During the
boom period, the demand of a product increases and sales also increase. Therefore, more working
capital is needed. On the contrary, during the period of depression, the demand declines and it
affects both the production and sales of goods. Therefore, in such a situation less working capital
is required.

(4) Seasonal Factors:


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Some goods are demanded throughout the year while others have seasonal demand. Goods which
have uniform demand the whole year their production and sale are continuous. Consequently,
such enterprises need little working capital.

On the other hand, some goods have seasonal demand but the same are produced almost the
whole year so that their supply is available readily when demanded.

Such enterprises have to maintain large stocks of raw material and finished products and so they
need large amount of working capital for this purpose. Woolen mills are a good example of it.

(5) Production Cycle:


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Production cycle means the time involved in converting raw material into finished product. The
longer this period, the more will be the time for which the capital remains blocked in raw material
and semi-manufactured products.

Thus, more working capital will be needed. On the contrary, where period of production cycle is
little, less working capital will be needed.

(6) Credit Allowed:


Those enterprises which sell goods on cash payment basis need little working capital but those
who provide credit facilities to the customers need more working capital.
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(7) Credit Availed:
If raw material and other inputs are easily available on credit, less working capital is needed. On
the contrary, if these things are not available on credit then to make cash payment quickly large
amount of working capital will be needed.

(8) Operating Efficiency:


Operating efficiency means efficiently completing the various business operations. Operating
efficiency of every organisation happens to be different.

Some such examples are: (i) converting raw material into finished goods at the earliest, (ii) selling
the finished goods quickly, and (iii) quickly getting payments from the debtors. A company which
has a better operating efficiency has to invest less in stock and the debtors.

Therefore, it requires less working capital, while the case is different in respect of companies with
less operating efficiency.

(9) Availability of Raw Material:


Availability of raw material also influences the amount of working capital. If the enterprise makes
use of such raw material which is available easily throughout the year, then less working capital
will be required, because there will be no need to stock it in large quantity.

On the contrary, if the enterprise makes use of such raw material which is available only in some
particular months of the year whereas for continuous production it is needed all the year round,
then large quantity of it will be stocked. Under the circumstances, more working capital will be
required.
(10) Growth Prospects:
Growth means the development of the scale of business operations (production, sales, etc.). The
organisations which have sufficient possibilities of growth require more working capital, while the
case is different in respect of companies with less growth prospects.

(11) Level of Competition:


High level of competition increases the need for more working capital. In order to face
competition, more stock is required for quick delivery and credit facility for a long period has to
be made available.

(12) Inflation:
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Inflation means rise in prices. In such a situation more capital is required than before in order to
maintain the previous scale of production and sales. Therefore, with the increasing rate of
inflation, there is a corresponding increase in the working capital.

Conflict Between NPV and IRR


CFA EXAM LEVEL 1

When you are analyzing a single conventional project, both NPV and IRR will provide you the same indicator about whether to accept
the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one
project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the
two projects.
The following example illustrates this point.

Project A Project B

Year 0 -5000 -5000

Year 1 2000 0

Year 2 2000 0

Year 3 2000 0

Year 4 2000 0

Year 5 2000 15000


NPV $2,581.57 $4,313.82

IRR 29% 25%

The above example assumes a discount rate of 10%. As you can see, Project A has higher IRR, while Project B has higher NPV.

If these two projects were independent, it wouldn’t matter much because the firm can accept both the projects. However, in case of
mutually exclusive projects, the firm needs to decide one of the two projects to invest in.

When facing such a situation, the project with a higher NPV should be chosen because there is an inherent reinvestment assumption.
In our calculation, there is an assumption that the cash flows will be reinvested at the same discount rate at which they are discounted.
In the NPV calculation, the implicit assumption for reinvestment rate is 10%. In IRR, the implicit reinvestment rate assumption is of
29% or 25%. The reinvestment rate of 29% or 25% in IRR is quite unrealistic compared to NPV. This makes the NPV results superior
to the IRR results. In this example, project B should be chosen.

The above example illustrated the conflicting results of NPV and IRR due to differing cash flow patterns. The conflicting results can
also occur because of the size and investment of the projects. A small project may have low NPV but higher IRR.
Project A Project B

Year 0 -5000 -20000

Year 1 2000 7000

Year 2 2000 7000

Year 3 2000 7000

Year 4 2000 7000

Year 5 2000 7000


NPV $2,581.57 $6,535.51

IRR 29% 22%

In this case, Project A has lower NPV compared to Project B but has higher IRR. Again, if these were mutually exclusive projects, we
should choose the one with higher NPV, that is, project B.
Operating Leverage Vs Financial Leverage

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

BASIS FOR OPERATING FINANCIAL


COMPARISON LEVERAGE LEVERAGE

Meaning Use of such assets in the Use of debt in a company's


company's operations for capital structure for which
which it has to pay fixed it has to pay interest
costs is known as Operating expenses is known as
Leverage. Financial Leverage.

Measures Effect of Fixed operating Effect of Interest expenses


costs.

Relates Sales and EBIT EBIT and EPS


BASIS FOR OPERATING FINANCIAL
COMPARISON LEVERAGE LEVERAGE

Ascertained by Company's Cost Structure Company's Capital


Structure

Preferable Low High, only when ROCE is


higher

Formula DOL = Contribution / EBIT DFL = EBIT / EBT

Risk It give rise to business risk. It give rise to financial risk.


The agency costs definition is the internal costs incurred from asymmetric information or conflicts of interest
between principals and agents in an organization.
Types of Agency Costs
When the principals attempt to monitor or restrict the actions of agents, they incur. Learn about the types of agency
costs below:

Monitoring Costs
For example, the board of directors at a company acts on behalf of shareholders to monitor and restrict the
activities of management. This is to ensure that behavior maximizes shareholder value. The cost of having
a board of directors is therefore, at least to some extent, considered an agency monitoring cost. Costs associated
with issuing financial statements and employee stock options are also monitoring costs.
Bonding Costs
Furthermore, an agent may commit to contractual obligations that limit or restrict the agent’s activity. For example,
a manager may agree to stay with a company even if the company is acquired. The manager must forego other
potential employment opportunities. Consider that implicit cost an agency bonding cost.
Residual Losses
Residual losses are the costs incurred from divergent principal and agent interests despite the use of monitoring
and bonding.
Advantages of Preference Shares
1. Absence of voting rights:
The preference shareholders do not possess the voting rights in the personal matters of the company. There is thus no
interference in general by the preference shareholders, even though they gain more profits and advantages over the
common shareholders.

ADVERTISEMENTS:

2. Fixed return:
The dividends to be paid to the preference shareholders are fixed as compared to the equity shareholders. The company
can thus maximize the profits that are available on the part of preference shareholders.

3. Absence of charge on assets:


Because preference shares have no payment of dividends, no charges are levied on the assets of the company unlike in
the case of debentures.

ADVERTISEMENTS:

4. Capital structure flexibility:


By means of issuing redeemable preference shares, flexibility in the company’s capital structure can be maintained
because redeemable preference shares can be redeemed under the terms of issue.

5. Widening of the capital market:


The scope of a company’s capital market is widened as a result of the issuance of preference shares because of the
reason that preference shares provide not only a fixed rate of return but also safety to the investors.

ADVERTISEMENTS:

6. Absence of financial burden:


As a result of the issuance of preference shares, because dividends are paid only in the presence or profits; absence of
profits means absence of dividends.

main functions of a Financial Manager:

1. Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can
raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio
between debt and equity. It is important to maintain a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate the funds. The
funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best
possible manner the following point must be considered

 The size of the firm and its growth capability


 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence formation of a
good asset mix and proper allocation of funds is one of the most important activity

2 marks

1. Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can
increase operating income by increasing revenue.
2. IRR:
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular
project equal to zero.
Present Value and future value
Present value is defined as the current worth of the future cash flow whereas Future value is the value of the future cash
flow after a certain time period in the future.
CAPM:
the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to
make decisions about adding assets to a well-diversified portfolio.
RISK RATE OF RETURN:
Definition: Higher risk is associated with greater probability of higher return and lower risk with a greater probability of
smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called
the risk return trade off.

why does money have time value


The time value of money (TVM) is the concept that money available at the present time is worth more than the identical sum in
the future due to its potential earning capacity.
factors affecting weighted average cost of capital:
Weighted cost of capital is affected by factors like increase in the corporate tax rate and debt ratio of the firm. Some other factors
that affect WACC are payment of dividends, investor risk aversion techniques and lowering of interest rates by central banks.
discuss the rationale for share buybacks
Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the
issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously
distributed among public and private investors.

accruals are a free source of finance

They represent spontaneous, interest free sources of financing. The most important components of accruals are wages and
salaries, taxes and interest. Accrued taxes and interest also constitute another source of financing.
financial decision making
They are:
(i) the investment decision,
(ii) the financing decision and
(iii) the dividend policy decision.
 Investment Decisions. The investment decision relates to the selection of assets in which funds will be invested by a
firm. ...
 Finance Decisions. ...
 Dividend Policy Decisions.

 There are three types of financial management decisions: Capital budgeting, Capital structure, and Working
capital management.

what are financial assets


A financial asset is a liquid asset that gets its value from a contractual right or ownership claim. Cash, stocks, bonds, mutual
funds, and bank deposits are all are examples of financial assets.

what is meant by value creation in the firm


Value creation is the primary aim of any business entity. Creating value for customers helps sell products and services,
while creating value for shareholders, in the form of increases in stock price, insures the future availability of investment capital to
fund operations.
difference between market value and intrinsic value

Intrinsic value is an estimate of the actual true value of a company, regardless of market value. Market value is the
current value of a company as reflected by the company's stock price.

describe the concept of oppourtunity cost of capital


The opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an
internal project, rather than investing cash in a marketable security. ... The opportunity cost of capital is the difference between the
returns on the two projects
Agency Cost:
Agency costs usually refers to the conflicts between shareholders and their company's managers. A shareholder
wants the manager to make decisions which will increase the share value. Managers, instead, would prefer to
expand the business and increase their salaries, which may not necesarrily increase share value.
describe the accounting rate of return
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio
does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the
proposed capital investment. The ARR is a percentage return.
what is operational efficiency
Operational efficiency is the capability of an enterprise to deliver products or services to its customers in the most cost-effective
manner possible while still ensuring the high quality of its products, service and support.
The working capital measures both a company's efficiencies and its short term financial health. It also gives investors an idea of
the companies underlying operational efficiency. ... Working capital is important to the operations of a firm but the maintenance
of a working capital is more crucial.
describe hedging approach of finance
Maturity matching or hedging approach is a strategy of working capital financing wherein short term requirements are met with
short-term debts and long-term requirements with long-term debts. The underlying principal is that each asset should be
compensated with a debt instrument having almost the same maturity.

CONSTRAIN OF PAYING DIVIDENT


CASH CONVERSION CYCLE:

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its
investments in inventory and other resources into cash flows from sales. ... CCC is one of several quantitative measures that helps
evaluate the efficiency of a company's operations and management.
OPERATING CYCLE:
The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the
goods, and receive cash from customers in exchange for the goods. ... Longer payment terms shorten the operating cycle, since
the company can delay paying out cash.
Definition and meaning. Market equilibrium, also known as the market clearing price, refers to a perfect balance in the market of
supply and demand, i.e. when supply is equal to demand. ... When the quantity of goods supplied is equal to the quantity of goods
demanded, the equilibrium price is reached.

EQUILLIBRIUM IN FINANCIAL MANAGEMENT:


Equilibrium is the state in which market supply and demand balance each other, and as a result, prices become stable.

Generally, an over-supply for goods or services causes prices to go down, which results in higher demand. The balancing
effect of supply and demand results in a state of equilibrium

MARKET VALUE VS BOOK VALUE:

Book Value vs Market Value Differences. ... The market value of a company is calculated by multiplying the market

price per share of thecompany with the number of outstanding shares.Market value can vary and at any point in time, it
can be more or less than book value.

INVESTMENT GRADE BOND:

A bond is considered investment grade or IG if its credit rating is BBB- or higher by Standard & Poor's or Baa3 or higher
by Moody's. Generally they are bonds that are judged by the rating agency as likely enough to meet payment obligations
that banks are allowed to invest in them.

JUNK BOND:

A junk bond is a fixed-income instrument that refers to a high-yield or noninvestment-grade bond. Junk bonds carry a

credit rating of BB or lower by Standard & Poor's (S&P), or Ba or below by Moody's Investors Service. Junk bonds are so
called because of their higher default risk in relation to investment-grade bonds
Market risk vs unique risk

Market risk cannot be mitigated through portfolio diversification. However, an investor can hedge against systematic risk.

A hedge is an offsetting investment used to reduce the risk in an asset. ... Specific risk, or diversifiable risk, is the riskof
losing an investment due to company or industry-specific hazard.

Annuity:
An annuity is a long-term investment that is issued by an insurance company designed to help protect you from the risk of outliving
your income.
Ordinary annuity refers to the sequence of steady cash flow, whose payment is to be made or received at the end of each
period. Annuity due implies the stream of payments or receipts which fall due at the beginning of each period. ... As the payment
made on annuity due, have a higher present value than the regular annuity.
ARR:
ARR is the value of the contracted recurring revenue components of your term subscriptions normalized to a one-year period.
Definition: The accounting rate of return (ARR), also called the simple or average rate of return, is an
investment formula used to measure the annual earnings or profit an investment is expected to make. In
other words, it calculates how much money or return you as an investor will make on your investment.
Gross networking capital
Gross working capital is the sum of all of a company's current assets (assets that are convertible to cash within a year or less).
... Gross working capital less current liabilities is equal to net working capital, or simply "working capital," a more useful measure
for balance sheet analysis.
Share split
A stock split is a decision by a company's board of directors to increase the number of shares that are outstanding by issuing
more shares to current shareholders.
Reasons for Stock Splits
 Identification. A stock split divides one share of stock into two or more shares. ...
 Influence Market Price. As the market price per share of stock increases, the price may become too hig
 h for the average investor to purchase. ...
 Increase Stockholder Base. ...
 Perception of Future Growth. ...
 Reverse Stock Split.

(BOOT) is a form of project financing, wherein a private entity receives a concession from the private or public sector to finance,
design, construct, own, and operate a facility stated in the concession contract.
BOO (build, own, operate) is a public-private partnership (PPP) project model in which a private organization builds, owns and
operates some facility or structure with some degree of encouragement from the government

Definition of Build, Lease, Transfer (blt)


Financing arrangement in which a developer (1) designs and builds a complete project or facility (such as an airport,
power plant, seaport), (2) sells it to the government or a joint venture partner, (3) simultaneously leases it back (usually
for 10 to 30 years) to operate it as a business and, after the expiry of the lease, (4) transfers it to the government or
partner at a previously agreed upon or market price. See also build, own, operate, transfer.