MODULE 1

INTRODUCTION TO THE WORLD OF FINANCE

Important Business Activities

2

Production

Marketing
Finance

Why Finance Matters?

3

All

business activities involve acquisition and use of funds. Finance function makes money available to meet the costs of production and marketing operations.

Various Financial Market & Instruments

Money

market Capital market

Primary market Secondary market

Long term funds -Equity and Borrowed

Shares

represent ownership rights of their holders. Shareholders are owners of the company. Shares can of two types:

Equity Shares Preference Shares

Loans,

Bonds or Debts: represent liability of the firm towards outsiders. Lenders are not owners of the company. These provide interest tax shield.

Equity and Preference Shares

6

Equity

Shares are also known as ordinary shares.

Do not have fixed rate of dividend. There is no legal obligation to pay dividends to equity shareholders.

Preference

Shares have preference for dividend payment over ordinary shareholders.

They get fixed rate of dividends. They also have preference of repayment at the time of liquidation.

Finance Functions
7

Finance functions or decisions can be divided as follows

Long-term financial decisions

Long-term asset-mix or investment decision or capital budgeting decisions. Capital-mix or financing decision or capital structure and leverage decisions. Profit allocation or dividend decision Short-term asset-mix or liquidity decision or working capital management.

Short-term financial decisions

Finance Managers Role

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Raising

of Funds Allocation of Funds Profit Planning Understanding Capital Markets

Financial Goals
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Profit maximization

(profit after tax) Maximizing earnings per share Wealth maximization

Financial Statement Analysis

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Financial Statements
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Financial

statements provide information about the financial activities and position of a firm. are:

Important financial statements Balance sheet Profit & Loss statement Cash flow statement

Balance Sheet
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Balance

sheet indicates the financial condition of a firm at a specific point of time. It contains information about the firms: assets, liabilities and equity. Assets are always equal to equity and liabilities: Assets = Equity + Liabilities

Assets
13

Assets

are economic resources or properties owned by the firm. There are two types of assets:

Fixed assets Current assets

Current Assets
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Current

assets (liquid assets) are those which can be converted into cash within a year i.e. accounting period or operating cycle of the business (time taken to convert raw material into finished goods, sell them and convert debtors into cash). Current assets include:

Cash Tradable (marketable) securities Debtors (account receivables) Stock of raw material Work-in-process Finished goods

Fixed Assets
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Fixed

assets are long-term assets. Normally recorded at cost price.

Tangible fixed assets are physical assets like land, machinery, building, equipment. Their cost is allocated over their useful lives by depreciation. Intangible fixed assets are the firms rights and claims, such as patents, copyrights, goodwill etc. Their cost is allocated over their useful lives by amorization. Gross block represent all tangible assets at acquisition costs. Net block is gross block net of depreciation.

Liabilities
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Liability

is a firms obligation to pay cash or provide goods or services in the future. types of liabilities are:

Two

Current liabilities Long-term liabilities

Current Liabilities
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Current

liabilities are payable within a year in the normal course of business. They include:

Accounts payable (creditors) Outstanding expenses Advances from customers Provision for tax Provision for dividend

Long-term Liabilities
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Long-term

liabilities are the obligations or debts payable in a period of time greater than the accounting period. They include - Debentures, bonds, and secured long-term loans from financial institutions.

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Shareholders Funds or Equity

capital is owners contribution. As liabilities are the claims of outside parties, equity represents owners claims against the business entity. Shareholders equity has two parts:
Share

(i) paid-up share capital, and (ii) reserves and surplus (retained representing undistributed profits.

earnings)

Paid-up

share capital and reserve and surplus together are called net worth.

20

Gujarat Narmada Valley Fertilizers Company Balance Sheet as on 31 March

Sources of Funds
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It is the sum of net worth or equity (E) and borrowing/debt (D), both long and short term. This is also called as Capital Employed. It do not include current liabilities.
CE = Net Worth + Borrowing = E + D

Net

current assets (NCA) is the difference between current assets (CA) and current liabilities (CL):
NCA = CA CL

Application of Funds
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It

includes Net fixed assets, net current assets, investment and other assets. Net current assets (NCA) is the difference between current assets (CA) and current liabilities (CL):
NCA = CA CL

Balance Sheet Relationship

23

Sources

of Funds are equal to application of funds. It means capital employed finances its net assets.
Capital Employed = Net Assets

Note:

Contingent liabilities are written as a note to the balance sheet as they are not the actual liabilities.

Profit & Loss Statement

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Profit &

Loss statement provides information about a firms:

revenues, expenses, and Profitability

It

is a flow statement It is a measure of firms profitability, solvency and liquidity.

Nature of Revenues
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Revenue

is the amount received or receivable within the accounting period from the sale of the firms goods or services. Operating revenue is the one that arises from main operations of the firm i.e. sale of finished goods, and the revenue arising from other activities is called non-operating revenue i.e. sale of old equipment.

Nature of Expenses
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Expense

is the amount paid or payable within the accounting period for generating revenue.
Examples: raw material consumed, salary and wages, power and fuel, repairs and maintenance, rent, selling and marketing expenses, administrative expenses.

Expenses

are expired costs and capital expenditures represent un-expired costs and appear as assets in balance sheet.

Concepts of Profit
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Gross profit = sales cost of goods sold (CGS) CGS = raw material consumed + manufacturing expenses of goods that have been sold PBDIT = Profit before dep., interest and tax = sales expenses, except dep., interest and tax Operating profit (OP), OP = GP OEXP DEP. It is also known as PBIT. It measures firms operative performance without regard to firms sources of financing. PBIT= Profit before interest and tax= PBDIT DEP PBT= Profit before tax = PBIT Interest PAT = Profit after tax = PBT Tax Net operating profit after tax (NOPAT)=PBIT (1 Tax rate)

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Gujarat Narmada Valley Fertilizers Company Ltd Profit & Loss Account for the year ended on 31 March

Financial Statement Analysis

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LEARNING OBJECTIVES
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We

will see how financial ratios helps in getting useful information from the financial statements Recognize the diagnostic role of financial ratios Highlight the utility of financial ratios in credit analysis and competitive analysis as well as in determining the financial capability of the firm Understand the limitations of financial ratios

Financial Analysis
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Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by property establishing relationships between the item of the balance sheet and the profit and loss account.

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USERS OF FINANCIAL ANALYSIS

creditors firms liquidity position Suppliers of long-term debt- firms profitability over time so as to be able to pay their interest and principal Investors- firms earningsits present and future profitability Managementoverall growth of the company
Trade

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NATURE OF RATIO ANALYSIS

Ratio

analysis is a powerful tool used for financial analysis A financial ratio is a relationship between two accounting numbers. Ratios help to make a qualitative judgement about the firms financial performance.

Standards of Comparison
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Time

series analysis Inter-firm analysis Industry analysis Proforma financial statement analysis

Types of Financial Ratios

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Liquidity

ratios Leverage ratios Activity ratios Profitability ratios

LIQUIDITY RATIOS
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Liquidity

ratios measure a firms ability to meet its current obligations.

Current assets Current liabilities Current assets Inventories Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities Current ratio =

Cont
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LEVERAGE RATIOS
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To

judge the long-term financial position of the firm, financial leverage, or capital structure ratios are calculated. These ratios indicate mix of funds provided by owners and lenders.

Cont
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ACTIVITY RATIOS
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Activity

ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. These ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales. ratios, thus, involve a relationship between sales and assets.

Activity

Inventory Turnover and Debtors Turnover

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Assets Turnover Ratios

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PROFITABILITY RATIOS
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The

profitability ratios are calculated to measure the operating efficiency of the company. two major types of profitability ratios are calculated:
1. 2.

Generally,

profitability in relation to sales profitability in relation to investment.

Cont
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Cont
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Cont
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Cont
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Cont
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COMPARATIVE STATEMENTS ANALYSIS

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simple method of tracing periodic changes in the financial performance of a company is to prepare comparative statements. Comparative financial statements will contain items at least for two periods. Changesincreases and decreasesin income statement and balance sheet over a period can be shown in two ways:

(1) aggregate changes and (2) proportional changes.

TREND ANALYSIS
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In

financial analysis the direction of changes over a period of years is of crucial importance. Time series or trend analysis of ratios indicates the direction of change. This kind of analysis is particularly applicable to the items of profit and loss account.

Cont
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For

trend analysis, the use of index numbers is generally advocated. The procedure followed is to assign the number 100 to items of the base year and to calculate percentage changes in each items of other years in relation to the base year. This procedure may be called as trend-percentage method.

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Example: Hindustan Manufacturing Company

INTER-FIRM ANALYSIS
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The

analysis of the financial performance of all firms in an industry and their comparison at a given point of time is referred to the cross-section analysis or the inter-firm analysis. To ascertain the relative financial standing of a firm, its financial ratios are compared either with its immediate competitors or with the industry average.

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Example: Construction industry: Inter-firm Comparison Market Share

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UTILITY AND LIMITATIONS OF RATIO ANALYSIS

UTILITY OF RATIO ANALYSIS

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the

ability of the firm to meet its current obligations; the extent to which the firm capital structure has been financed by borrowed funds; the efficiency with which the firm is utilizing its assets in generating sales revenue the overall operating efficiency and performance of the firm.

Diagnostic Role of Ratios

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Profitability analysis

Assets

utilization Liquidity analysis Strategic Analysis

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CAUTIONS IN USING RATIO ANALYSIS

Standards for

comparison Company differences Different definitions of variables Changing situations Historical data

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Present & Future value basics

Time Preference for Money

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preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at some future time. Three reasons may be attributed to the individuals time preference for money:
Time

risk...uncertainty abt future cash receipts preference for present consumption over future...becoz of risk of not enjoying future consumption that may be caused by death or illness or inflation investment opportunities...they can put present cash to earn additional cash

Required Rate of Return

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The

time preference for money is generally expressed by an interest rate. An individual will require a rate of return which compensates him for time and is called as risk-free rate. He would also demand compensation for assuming risk, which is called risk premium. The investors required rate of return is: Risk-free rate + Risk premium.

Required Rate of Return

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Would an investor want Rs. 100 today or after one year? Cash flows occurring in different time periods are not comparable. It is necessary to adjust cash flows for their differences in timing and risk. Example : If preference rate =10 percent

An investor can invest if Rs. 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10% interest rate. Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest rate.

If the investor gets less than Rs. 110 then he will not invest. Anything above Rs. 110 is favourable.

Time Value Adjustment

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Two

most common methods of adjusting cash flows for time value of money:
Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows.

Future Value
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Compounding

is the process of finding the future values of cash flows by applying the concept of compound interest. Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods. Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place.

Future Value
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Future Value: Example

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Future Value of an Annuity

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Future Value of an Annuity: Example

Sinking Fund
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Example

Present Value
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Present

value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker. Discounting is the process of determining present value of a series of future cash flows. The interest rate used for discounting cash flows is also called the discount rate.

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Present Value of a Single Cash Flow

Example
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Present Value of an Annuity

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Capital Recovery and Loan Amortisation

Example
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Loan Amortisation Schedule

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End of Year 0 1 2 3

Payment

Interest Principal Outstanding Repayment Balance 900 625 326 3,051 3,326 3,625* 10,000 6,949 3,623 0

3,951 3,951 3,951

Present Value of Perpetuity

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Present Value of a Perpetuity: Example

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Present Value of an Uneven Periodic Sum

In

most instances the firm receives a stream of uneven cash flows. Thus the present value factors for an annuity cannot be used. The procedure is to calculate the present value of each cash flow and aggregate all present values.

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PV of Uneven Cash Flows: Example

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Present Value of Growing Annuities

Example
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Example
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Value of an Annuity Due

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Future Value of An Annuity: Example

Example
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The

present value of Re 1 paid at the beginning of each year for 4 years is 1 3.170 1.10 = Rs 3.487

Multi-Period Compounding
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Effective Interest Rate: Example