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CA. Seema Chiney

FINANCE FUNCTION : Finance is the management of monetary affairs of a company. It includes determining what has to be paid for & when; raising the money on the best terms available & devoting the available funds to the best uses. Finance functions : 1. Routine financial matters : these matters are looked after by the Treasurer. 2. Special financial functions : these functions are looked after by the Controller of finance.

Finance committee Chief Finance Officer [ CFO] Treasurer Cash & bank a/c Investments work to Tax & Insurances be Credit & collection performed Reconciliations Investor relations Controller of finance Accounting Budgeting Internal Audit Finance planning Profit planning Economies

Nature of financial function :

Finance functions
Technique of acquiring & utilizing the funds Integral part of over all management Deals with financial forecasting Financial planning & control Co-related with production, marketing & accounting Deals with budgeting, reporting & accounting Contributes to the decision making

SCOPE of financial management :


costing Decision making miscellaneous


CoCo-ordination & control

1. Forecasting :
1. 2. 3. 4. 5.

Analyzing economic trends Anticipating industrial trends Estimating financial requirements Profit planning Estimating ROI

2. financing:
1. 2. 3. 4.

Ensuring the availability of the funds Allocating funds Investing funds Raising funds

3. Co-ordination & control :

Financial adjustments 2. Accounting 3. Budgeting 4. Reporting

4. Costing :
Measuring & Controlling cost of capital 2. Measuring & Controlling company costs

5. Decision making :
1. 2. 3. 4. 5.

Financial decisions Investment decisions Mgt of income & div function Meeting special or contingent problems Working capital decisions

6. Miscellaneous :
1. 2. 3. 4. 5. 6.

Tax mgt Fixed assets & investment mgt Computer operations Insurance Credit & collections Pensions & welfare


1. 2. 3.


5. 6.

Responsible for dept of finance In charge of planning, developing strategies & guiding the mgt for financial decisions Responsible for maintaining good repo with baker, & other financial institutions timely submission of documents, stock statements, pymt of intt & principle sum, cash flow & fund flow statements, etc. Guiding the BOD in certain key decision making like allocation & utilization of funds, anticipation of financial need Contributes to overall progress of the business by putting his/her professional knowledge, experience. It is the primary objective to maximize the value of the firm to its stock holders.


7. Helping the business houses in over coming from their business problems 8. Helping the business houses in wealth maximization 9. To minimize the cost without affecting the financial flexibility. 10. To guide in episodic problems like merger, take over, consolidation, liquidation 11. Plays a significant role in optimal utilization of financial resources not only for survival but also for development



The financial decisions of a firm are significantly influenced by the legal form of an organization, the regulatory framework & tax laws applicable to it. Forms : 1. Sole Proprietorship 2. Partnership 3. Private company 4. Public company


Financial statement analysis is a study of relationship among the various financial factors in a business as disclosed by a single set of statements & study of trends of these factors as shown in series of statements. Techniques of analysis : 1. Ratio analysis 2. Common size statement 3. Du Pont analysis 4. Multiple discriminant analysis 5. Fund flow analysis

Ratio analysis
This one of the popular tools of FSA. It mean, the indicated quotient of two mathematical expressions & the relationship between 2 or more things. Interpretation of ratios is another most important task. It is based on certain factors like :
1. 2. 3. 4. 5.

General economic condition Opportunities Risk acceptance Accounting system Comparison with peers

Objectives of Ratio analysis

1. 2. 3. 4. 5. 6. 7. 8. 9.

Inter firm as well as intra firm comparison Inter period comparison To help in decision making To analyze the performance of the firm To check the liquidity, solvency, operational efficiency, overall profitability, capital gearing, etc. Provide effective control For forecasting, budgeting, planning, co-ordination To check the personnel efficiency To point out the financial condition of the business like very strong, good, questionable or poor & by that way enables the mgt to take proper steps

Advantages of Ratio Analysis :

1. 2. 3. 4. 5. 6. 7.

It guides mgt in formulating financial planning & policies It throws light on the efficiency of the business organisation Comparison with similar firms, segment & industry is possible Ensures effective cost control It provides greater clarity, perspective & meaning to the data It measures profitability & solvency of the concern It helps in investment decisions

Common size statement :

In this method each statement is reduced to the total of 100 & each individual item contained therein is expressed as a % to the total 100. Income statement & Balance Sheet is presented in the form of common size statements. In case of Income Statement, Sales has been taken as a base & each item Of this account is represented in % to sales out of 100. In case of Balance Sheet every item is represented in % to the total Assets & Total Liabilities.

Common size income statement :

ABC Company Ltd. For the period ending 31st March, 2010 Particulars Sales Cost of production Cost of sales Gross margin Operating exps Net operating profit Profit after interest Amounts 560,000 400,000 400,000 160,000 24,600 135,400 131,400 % to sales 100 71.4 71.4 28.3 4.4 24.2 23.4

Common size Balance Sheet :

ABC Company Ltd As on 31/03/2010 Assets Land & building Plant & machinery Furniture & fixtures Investments Current assets Total Assets Amounts 500,000 900,000 100,000 200,000 616,000 2316,000 % to total assets 21.6 38.8 4.4 8.6 26.6 100%

Common size Balance Sheet :

Liabilities Share capital General reserve Investment fund Welfare fund Debentures Loans Creditors Total Liabilities Amounts 800,000 120,000 16,000 12,000 400,000 800,000 168,000 2316,000 % to total assets 34.5 5.2 0.7 0.5 17.3 34.5 7.3 100%

Fund flow analysis

Balance sheet is a static statement which shows the financial position of the entity as on that particular date. The change in the financial position for the two years can be compared with help of Fund Flow statement. The Fund Flow statements reveals the sources from which the funds are made available and how they are utilized or applied. In other words funds flow statement explains in brief the changes occurred in the same items in two Balance Sheet. Fund flow includes cash as well as non cash funds like depreciation. It is nothing but movement of funds.

Format of Fund Flow statement :

Sources of funds Funds from operations Issue of new share capital Issue of debentures Long term borrowings Sale of investments Sale of fixed assets Application of funds Loss from operations Payment of dividend Purchase of assets, invt Payment of taxes Redemption of shares & debentures Repymt of loans Increase in WC [if sources amount is more than application]

Decrease in WC [if application amount if more than sources ]

Steps in preparation of Fund flow

Preparation of Adjusted Profit & Loss Account to find out inflow / out flow of funds from business operations 2. Preparation of statement of changes in WC 3. Determination of sources & application of funds

Adjusted Profit & Loss Account

Profit / Loss as per the Income statement Add : -Depreciation -Preliminary exps -Discount on issue of shares/debentures w/off -Intangible assets w/off -Loss on sale of machinery, investment or any other fixed assets -Interim div paid -Proposed div -Provision for tax -Transfer to reserves

Adjusted Profit & Loss Account

Less : -Profit on sale of machine, investment or any other fixed assets -Dividend received -Tax refund

Statement of changes in WC :
Particulars Current assets Inventories Debtors Cash Bank Prepaid exps,etc Total : A : Current liabilities Creditors Outstanding exps Bills payable Bank o/d Total :B: Net WC [A-B] Increase / decrease in WC previous yr current yr increase decrease

Capital budgeting refers to planning the deployment of available capital for the purpose of maximizing long term profitability of a firm. This includes to take various decisions like, investing in long term objectives, acquiring fixed assets, implementation of projects, set aside the funds. It involves : 1. Idea generation 2. Evaluation / analysis 3. Selection 4. Financing the selected projects 5. Implementation 6. Review of the project

Significance & nature of capital budgeting :

1. 2. 3. 4.

5. 6. 7.

It involves investment of current funds for future benefits These decisions have long term implications for a firm It is one of the main tool of financial mgt. It gives sufficient scope to the financial manager to evaluate different proposals & only viable projects must be taken up for investments. It has gained importance as it offers effective control on cost of capital expenditure on the projects. Helps the mgt to avoid over / under involvement of funds It guides the mgt for essential & objective oriented investments are to be made

Significance & nature of capital budgeting :

8. Capital budgeting decisions are exposed to risk & uncertainty 9. CB decisions are irreversible in nature ie once made cant be taken back or changed. It affects the liquidity & marketability; so to be made carefully.


Project Evaluation Techniques

methods Traditional Methods

methods Modern methods


Pay back period is defined as that period required to recover the original cash out flow invested in the project. It is the minimum required number of years to recover the original cash outflow. Formula : Pay back period =

original investments constant annual cash flow after tax

Decision rule : acceptance or rejection of the project is decided on the comparison of calculated PBP with standard PBP.


Accept : calculated PBP < standard PBP Reject : calculated PBP > standard PBP Advantages of PBP 1. Very simple to calculate & easy to understand Limitations / disadvantages : 1. It ignores the cash flow after PBP 2. It doesnt consider all cash inflows yielded by the investments 3. It doesnt take into consideration the time value of money


Calculation of cash flow after taxes [CFAT] Particulars
Sales revenue Less : variable costs Contribution Less : fixed costs Earnings Before Dep & taxes [EBDT] Less : taxes Earnings after taxes [EAT] Add : depreciation Cash flow After Taxes [CFAT]


Average Rate of Return [ARR]

It also known as Accounting Rate of Return & Return on Investments [ROI]. Average annual earnings after depreciation & taxes [PAT] are used to calculate ARR. It is measured in %. ARR = PAT * 100 original investments Original investments :original invt+ additional NWC+ installation & transportation charges Advantages : Simple & easy to calculate 2. Information can easily be drawn from accounting period

3. It takes into account all profits of the projects life period. Limitations : 1. It ignores the time value of money 2. It does not allow the fact that profit can be reinvested 3. It doesnt take in to consideration any benefits, which can be accrued to the firm by selling the equipments which are replaced by the new investments 4. It never take in to account the size of the investments required for different types of projects

Decision rule : Accept : calculated ARR > predetermined ARR Reject : calculated ARR < predetermined ARR

Modern techniques : NPV:

Net Present Value can be defined as present value of benefits minus present value of costs. It is the process of calculating the present values of inflow using the cost of capital as rate of discount & subtract the present value of cash outflow from the present value of cash inflow & find out the present value which may be +ve or ve. Decision rule : Accept : NPV > Zero Reject : NPV < Zero

Advantages : 1. It takes into account the time value of money 2. It uses all cash inflows occurring over the entire life period of the project, including scrape value of the old project Limitations : 1. It is difficult to under when compared with PBP & ARR 2. Difficult calculations

This is defined as that discounting factor at which the present value of cash inflow equals to the present value of cash outflows. IRR = LDF% + [PVLDF Cash outflow] [PVLDF PVHDF ] LDF = lower discount factor HDF = higher discount factor PVLDF = present value of cash inflow at lower disc factor PVHDF = present value of cash inflow at high disc factor Decision Rule : Accept : IRR> cost of capital Reject : IRR < cost of capital

Profitability Index [PI]

It is similar to NPV. PI = present value of cash inflow present value of cash outflow

Decision rule : Accept : PI > 1 Reject : PI < 1


Nature of WC : there are two types of WC 1. Gross WC which represents the total current assets 2. Net WC : excess of current assets over current liabilities. Net WC refers to that portion of firms current assets which financed with long term funds Both of the terms are equally important & useful at various levels of decision making by the mgt.


Current assets includes cash, bank balance, marketable securities, accounts receivables, inventory, prepaid expenses, advance payment of taxes, debtors, one year FDs with bank, etc Current liabilities : creditors, loans & advances, bank o/d, short term borrowings, taxes & proposed dividend. Need for WC Maximization of shareholders wealth of a firm is possible only when there is sufficient return from the operations. Successful sales activity is necessary for earning profits but sales do not convert into cash immediately, there is


An invisible time lag between the sale of goods & receipt of cash. So that there is need for working capital. Operating cycle : The operating cycle concept penetrates to the heart of WC mgt in a more dynamic form. The time lapses to convert the raw material into cash is known as Operating Cycle.

Operating cycle in manufacturing firm :




Raw materials

Finished goods


Operating cycle in non manufacturing firm :



Stock of finished goods

Operating cycle
OC can be computed with the following formula : Inventory conversion period + Accounts receivable period Inventory conversion period = avg. inventory cost of goods sold/365 days Accounts receivable period = avg. accounts receivable sales /365 days

Estimation of WC requirement : WC means current assets less current liabilities. Hence, following steps to be done : 1. Estimation of current assets 2. Estimation of current liabilities 3. Calculation estimated WC 4. Add certain % as contingency to estimated WC Factors influencing WC : 1. Nature of business 2. Size of business 3. Production cycle process 4. Production policy 5. Terms of purchase & sale 6. Business cycle

Estimation of WC requirement : 7. Growth & expansion 8. Availability of raw materials 9. Profit level 10. Taxes 11. Operating efficiency 12. Availability of credit 13. Price level changes

Financing of WC requirement :

Short term financing : for a period of less than 1 year from a. loan from banks, b. short term deposits from public, c. commercial papers d. factoring of receivables e. bills discounting f. retention of profits 2. Long term financing :for a period above 5 years from a. ordinary share capital b. preference share capital c. loan from banks

Financing of WC requirement :

Spontaneous financing : this refers to the automatic sources of short term funds arising in the normal course of a business. It includes trade credits [ suppliers] & out standing exps. All these spontaneous sources of finance are available at free of costs.

Commercial Papers [CP]

Commercial Paper is short term, unsecured promissory note issued by large companies. It is a money market instrument. Money market instrument refers to the market for short term securities. It was introduced in 1990 with a view to enable the highly rated corporate borrowers to diversify the sources of their short term borrowings, as also provide an additional instrument to the investors, to park their surplus funds for a short term period. There are certain guideline given by the RBI for issue of CP.

Commercial Papers [CP]

Features of CP : 1. CPs can be either directly issued or thru dealers. 2. It should not be underwritten or co-accepted. 3. The minimum maturity period is not less than 15 days to a maximum period of 1 year. Eligibility criteria for issuing CPs 1. Tangible net worth of issuing co should be more than Rs. 4 crores as per the latest BS 2. The co should have been sanctioned a WC limit by the Bank & classified as Std Asset by the Bank 3. Co can issue CPs amounting to 75% of the permitted bank WC limit

Commercial Papers [CP]

4. Minimum credit rating of P-2 of CRISIL or any other equivalent credit rating agency approved by RBI 5. They are issued in the denomination of Rs. 5 lakhs or multiples thereof. 6. The size of single issue should not be less than Rs. 1 Crore. The main attraction is the interest rate which is higher than that offered by the treasury bills or certificate of deposits.

Factoring :
From 1994, banks are allowed to enter in factoring services. Banks provide WC finance through financing receivables, which is known as factoring. a factor is a financial institution, which renders services relating to the mgt & financing of sundry debtors that arises from credit sales. There are only 4 PSBs which are permitted to offer factoring related services in India. SBI, Canara Bank, Allahabad Bank, & PNB.

How factor works??

1. 2. 3. 4. 5. 6. 7. 8.

Buyer approaches to the seller to provide goods on credit The seller that has factoring option approaches the factor for credit limit, factor fixes credit limit Once the factor sets limit for credit, then seller sends goods & invoice to the buyer After receiving invoice from the buyer, seller sends the same to the factor. Factor pays up to 80% of invoice Factor sends monthly statements to seller Factor allow for collection of credit so the buyer pays the amounts to the factor. Factor settles after paying balance 20% & deducting commission to the seller.

Capitalization means total amount of long term funds available to the company. It includes shares, debentures, long term loans, reserves & surplus. The assessment of the funds needed by the co should be done in such a way that the total amount of funds available should be neither too large nor less. Over capitalization : It means existence of excess capital as compared to the level of activity & requirements. It doesnt mean that there is excess funds. It may mean that the co is having more funds & still the earning capacity is low.

Causes of Over capitalization : Eg. If the earning of a co is Rs.50k & the rate of return is 10%; then the expected capital of the co is 50k/10% = Rs. 5 lakh. If the actual capital is more than this expected capital then there is the situation of over capitalization. Some of the reasons of over capitalization are : 1. Assets might have been purchased in the inflationary situation. 2. Adequate provision of depreciation is not made so that the picture of earnings is not real & affects the capitalization position. 3. The requirement of the funds might not have been properly planned by the co, as a result, the co may realise shortage of funds & borrow from the market

Over capitalization : At higher interest rate; resulting in reduction of earnings of the co. 4. Retained earnings of the co is not sufficient to cope up with the requirement of funds. Effects of over capitalization :