FM THEORY

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital

budgeting). Investment in current assets is also a part of investment decisions
called as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the
net profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and

control of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders, this will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation

with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
 equity analysis. This will depend upon the proportion of equity capital a company
is possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and
period of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decisions have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and
other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done
through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.

Cash Flow vs. Fund Flow: An Overview

There are generally four different kinds of financial statements in accounting: the balance
sheet, the income statement, the cash flow statement, and the fund flow statement. Here,
we delve into the final two.

In financial accounting, the statement of cash flows refers to the change in a company's
cash and equivalents from one period to the next. The fund flow, however, has two
different meanings. One is for accounting purposes, while the other serves investment
purposes.

Cash Flow
Cash flow is recorded on a company's cash flow statement. This statement—one of the
main statements for a company—shows the inflow and outflow of actual cash (or cash-
like assets) from its operational activities. It is a required report under generally accepted
accounting principles (GAAP).
This is different from the income statement, which records data or transactions that may
not have been fully realized, such as uncollected revenue or unpaid income. The cash
flow statement, on the other hand, will already have this information entered and will
give a more accurate portrait of how much cash a company is generating.

Cash flow sources can be divided into three different categories on a cash flow statement:

 Cash flows from operating activities: Cash generated from the general or core
operation of the business would be listed in this category.
 Cash flows from investing activities: This section would cover any cash flow
spent on investments like new equipment.
 Cash flows from financing activities: This category includes any transactions
involving debtors, such as proceeds from new debts or dividends paid to
investors.1

Companies receive inflows of cash revenue from selling goods, providing services,
selling assets, earning interest on investments, rent, taking out loans, or issuing new
shares. Cash outflows can result from making purchases, paying back loans, expanding
operations, paying salaries, or distributing dividends.

Since the Securities and Exchange Commission (SEC) requires all listed companies to
use accrual accounting, which largely ignores the actual balance of cash on hand,
investors and lenders rely on the statement of cash flow to evaluate a company's liquidity
and cash flow management. It is a more reliable tool than the metrics companies use to
dress up their earnings, such as earnings before interest, taxes, depreciation, and
amortization (EBITDA).2

Fund Flow
On the accounting side, the fund flow statement was required by GAAP between 1971
and 1987.3 When it was required, the statement of fund flow was primarily used by
accountants to report any change in a company's net working capital, or the difference
between assets and liabilities, during a set period of time. Much of this information is
now captured in the statement of cash flow.

For investment purposes, the fund flow does not give the cash position of a company; if a
company wanted to do that, it would prepare its cash flow statement.

The fund flow highlights the movement of cash only—that is, it reflects the net
movement after examining inflows and outflows of monetary funds. It will also identify
any activity that might be out of character for the company, such as an irregular expense.

The use of the fund flow statement in investing is more useful today. Investor sentiment
can be gauged as it relates to different asset classes. For example, if the flow of funds for
equities is positive, it suggests investors have a generally optimistic view of the
economy—or at least the short-term profitability of listed companies.

Key Differences
The fund flow statement is the earlier version of the cash flow statement. The cash flow
statement is more comprehensive and details the multiple cash flows of a company, rather
than just focusing on working capital.

The cash flow statement is best used to understand the liquidity position of a firm
whereas the fund flow statement is best suited for long-term financial planning, which is
why it is an important tool for investors. The fund flow statement is able to identify the
sources of cash and their uses, and the cash flow statement starts with looking at the
current level of cash and how it leads to the closing balance of cash.

What Is Goodwill?
Goodwill is an intangible asset that is associated with the purchase of one company by
another. Specifically, goodwill is the portion of the purchase price that is higher than the
sum of the net fair value of all of the assets purchased in the acquisition and the liabilities
assumed in the process. The value of a company’s brand name, solid customer base, good
customer relations, good employee relations, and proprietary technology represent some
reasons why goodwill exists.

Preliminary expenses:

Preliminary expenses are expenses which the promoters of a company incur at the
time of incorporating the company. Generally, preliminary expenses are disallowable
on the ground that they are of a capital nature or incurred prior to the setting up of a
business.

These include expenses such as legal or professional fees, logo designing cost, printing,
registration fees, stamp duty, etc.

Bad Debts:
Bad debt is an expense that a business incurs once the repayment of credit previously
extended to a customer is estimated to be uncollectible.

What Is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible or physical asset
over its useful life or life expectancy. Depreciation represents how much of an asset's
value has been used up. Depreciating assets helps companies earn revenue from an asset
while expensing a portion of its cost each year the asset is in use. If not taken into
account, it can greatly affect profits.
Businesses can depreciate long-term assets for both tax and accounting purposes. For
example, companies can take a tax deduction for the cost of the asset, meaning it reduces
taxable income. However, the Internal Revenue Service (IRS) states that when
depreciating assets, companies must spread the cost out over time. The IRS also has rules
for when companies can take a deduction.

What Is Amortization?
Amortization is an accounting technique used to periodically lower the book value of
a loan or intangible asset over a set period of time. In relation to a loan, amortization
focuses on spreading out loan payments over time. When applied to an asset,
amortization is similar to depreciation.

KEY TAKEAWAYS

 Amortization typically refers to the process of writing down the value of either a
loan or an intangible asset.
 Amortization schedules are used by lenders, such as financial institutions, to
present a loan repayment schedule based on a specific maturity date.
 Intangibles amortized (expensed) over time help tie the cost of the asset to the
revenues generated by the asset in accordance with the matching principle of
generally accepted accounting principles (GAAP).

What Is Share Capital?

Share capital is the money a company raises by issuing common or preferred stock. The
amount of share capital or equity financing a company has can change over time with
additional public offerings.

The term share capital can mean slightly different things depending on the context.
Accountants have a much narrower definition and their definition rules on the balance
sheets of public companies. It means the total amount raised by the company in sales of
shares.

KEY TAKEAWAYS

 A company's share capital is the money it raises from selling common or

preferred stock.
 Authorized share capital is the maximum amount a company has been approved
to raise in a public offering.
 A company may opt for a new offer of stock in order to increase the share capital
on its balance sheet.
What Is a Profit and Loss Statement (P&L)?
The profit and loss (P&L) statement is a financial statement that summarizes the
revenues, costs, and expenses incurred during a specified period, usually a fiscal quarter
or year. The P&L statement is synonymous with the income statement.

These records provide information about a company's ability or inability to generate

profit by increasing revenue, reducing costs, or both. Some refer to the P&L statement as
a statement of profit and loss, income statement, statement of operations, statement of
financial results or income, earnings statement, or expense statement.

For non-profit organizations, revenues and expenses are generally tracked in a financial
report called the statement of activities (sometimes called statement of financial activities
or statement of support).

P&L management refers to how a company handles its P&L statement through revenue
and cost management.

KEY TAKEAWAYS

 The P&L statement is a financial statement that summarizes the revenues, costs,
and expenses incurred during a specified period.
 The P&L statement is one of three financial statements every public company
issues quarterly and annually, along with the balance sheet and the cash flow
statement.
 It is important to compare P&L statements from different accounting periods, as
the changes in revenues, operating costs, R&D spending, and net earnings over
time are more meaningful than the numbers themselves.
 Together with the balance sheet and cash flow statement, the P&L statement
provides an in-depth look at a company's financial performance.

What Are Financial Statements?

Financial statements are written records that convey the business activities and the
financial performance of a company. Financial statements are often audited by
government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing,
or investing purposes. Financial statements include:

 Balance sheet
 Income statement
 Cash flow statement.

KEY TAKEAWAYS

 Financial statements are written records that convey the business activities and the
financial performance of a company.
  The balance sheet provides an overview of assets, liabilities, and stockholders'
equity as a snapshot in time.
 The income statement primarily focuses on a company’s revenues and expenses
during a particular period. Once expenses are subtracted from revenues, the
statement produces a company's profit figure called net income.
 The cash flow statement (CFS) measures how well a company generates cash to
pay its debt obligations, fund its operating expenses, and fund investments.

What Is a Creditor?
A creditor is an entity (person or institution) that extends credit by giving another entity
permission to borrow money intended to be repaid in the future. A business that provides
supplies or services to a company or individual and does not demand payment
immediately is also considered a creditor, based on the fact that the client owes the
business money for services already rendered.

Creditors can be classified as either personal or real. People who loan money to friends or
family are personal creditors. Real creditors such as banks or finance companies have
legal contracts with the borrower, sometimes granting the lender the right to claim any of
the debtor's real assets (e.g., real estate or cars) if they fail to pay back the loan.

KEY TAKEAWAYS

 A creditor is an entity that extends credit, giving another entity permission to

borrow money to be repaid in the future.
 A business that provides supplies or services and does not demand immediate
payment is also a creditor, as the client owes the business money for services
already rendered.
 Personal creditors who cannot recoup a debt may be able to claim it as a short-
term capital gains loss on their income tax return.
 Creditors such as banks can repossess collateral like homes and cars on secured
loans, and they can take debtors to court over unsecured debts.

What Are Current Assets?

Current assets represent all the assets of a company that are expected to be conveniently
sold, consumed, used, or exhausted through standard business operations with one year.
Current assets appear on a company's balance sheet, one of the required financial
statements that must be completed each year.

Current assets would include cash, cash equivalents, accounts receivable, stock inventory,
marketable securities, pre-paid liabilities, and other liquid assets. Current assets may also
be called current accounts.

KEY TAKEAWAYS:
  Current assets are all the assets of a company that are expected to be sold or used
as a result of standard business operations over the next year.
 Current assets include cash, cash equivalents, accounts receivable, stock
inventory, marketable securities, pre-paid liabilities, and other liquid assets.
 Current assets are important to businesses because they can be used to fund day-
to-day business operations and to pay for the ongoing operating expenses.
What Are Current Liabilities?
Current liabilities are a company's short-term financial obligations that are due within one
year or within a normal operating cycle. An operating cycle, also referred to as the cash
conversion cycle, is the time it takes a company to purchase inventory and convert it to
cash from sales. An example of a current liability is money owed to suppliers in the form
of accounts payable.

KEY TAKEAWAYS

 Current liabilities are a company's short-term financial obligations that are due
within one year or within a normal operating cycle.
 Current liabilities are typically settled using current assets, which are assets that
are used up within one year.
 Examples of current liabilities include accounts payable, short-term debt,
dividends, and notes payable as well as income taxes owed.

What Is Ratio Analysis?

Ratio analysis is a quantitative method of gaining insight into a company's liquidity,
operational efficiency, and profitability by studying its financial statements such as the
balance sheet and income statement. Ratio analysis is a cornerstone of fundamental
equity analysis.

KEY TAKEAWAYS

 Ratio analysis compares line-item data from a company's financial statements to

reveal insights regarding profitability, liquidity, operational efficiency, and
solvency.
 Ratio analysis can mark how a company is performing over time, while
comparing a company to another within the same industry or sector.
 While ratios offer useful insight into a company, they should be paired with other
metrics, to obtain a broader picture of a company's financial health.ume 75%

Ratio Analysis
What Does Ratio Analysis Tell You?
Investors and analysts employ ratio analysis to evaluate the financial health of companies
by scrutinizing past and current financial statements. Comparative data can demonstrate
how a company is performing over time and can be used to estimate likely future
performance. This data can also compare a company's financial standing with industry
averages while measuring how a company stacks up against others within the same
sector.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is
found on a company's financial statements.

Ratios are comparison points for companies. They evaluate stocks within an industry.
Likewise, they measure a company today against its historical numbers. In most cases, it
is also important to understand the variables driving ratios as management has the
flexibility to, at times, alter its strategy to make its stock and company ratios more
attractive. Generally, ratios are typically not used in isolation but rather in combination
with other ratios. Having a good idea of the ratios in each of the four previously
mentioned categories will give you a comprehensive view of the company from different
angles and help you spot potential red flags.

Examples of Ratio Analysis Categories

The various kinds of financial ratios available may be broadly grouped into the following
six silos, based on the sets of data they provide:

1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they
become due, using the company's current or quick assets. Liquidity ratios include the
current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels
with its assets, equity, and earnings, to evaluate the likelihood of a company staying
afloat over the long haul, by paying off its long-term debt as well as the interest on its
debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and
interest coverage ratios.

3. Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Profit
margin, return on assets, return on equity, return on capital employed, and gross margin
ratios are all examples of profitability ratios.

4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its
assets and liabilities to generate sales and maximize profits. Key efficiency ratios include:
turnover ratio, inventory turnover, and days' sales in inventory.

5. Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other
obligations associated with its debts. Examples include the times interest earned ratio and
the debt-service coverage ratio.
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend
yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these
metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and
the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven
would be considered undervalued. In contrast, one with a P/E ratio of 50 would be
considered overvalued. The former may trend upwards in the future, while the latter may
trend downwards until each aligns with its intrinsic value.

Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance—for better or worse.
Successful companies generally boast solid ratios in all areas, where any sudden hint of
weakness in one area may spark a significant stock sell-off. Let's look at a few simple
examples

Net profit margin, often referred to simply as profit margin or the bottom line, is a ratio
that investors use to compare the profitability of companies within the same sector. It's
calculated by dividing a company's net income by its revenues. Instead of dissecting
financial statements to compare how profitable companies are, an investor can use this
ratio instead. For example, suppose company ABC and company DEF are in the same
sector with profit margins of 50% and 10%, respectively. An investor can easily compare
the two companies and conclude that ABC converted 50% of its revenues into profits,
while DEF only converted 10%.

Using the companies from the above example, suppose ABC has a P/E ratio of 100, while
DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay
$100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

Ratios are typically only comparable across companies within the same sector. For
example, a debt-equity ratio that might be normal for a utility company might be deemed
unsustainably high for a technology play.

For classification:

https://courses.lumenlearning.com/boundless-finance/chapter/overview-of-ratio-
analysis/