Financial Management. Sandeep Gokhale. References. Financial Management Authors : Khan & Jain Prasanna Chandra Myers Van Horne. Syllabus. Ratio Analysis Fund & Cash flow analysis Cost of Capital Working Capital Mgmt. Means of Financing Capital Budgeting Dividend Structuring
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Financial Management Sandeep Gokhale
References Financial Management Authors : • Khan & Jain • Prasanna Chandra • Myers • Van Horne
Syllabus • Ratio Analysis • Fund & Cash flow analysis • Cost of Capital • Working Capital Mgmt. • Means of Financing • Capital Budgeting • Dividend Structuring • Bonus Shares • Share Holder Value Measurement
FINANCIAL MANAGEMENT Objective: Create share holder value Methodology: Capturing of value at all Levels. Business Process restructuring Enterprise resource management. Vertically integrated operations. Customer relationship Management Sustained up scaling of operations Effectiveness: Proximity of gross profit to net profit Maximisation of EVA EV / EBIDTA multiple
Financial Management – an Overview Business environment Planning Policies&Decisions (Management Accounting) Restructuring Resource Mobilisation Treasury Financial Markets Investor Wish List Control&Information ( Audit & Taxation) Valuation Technique
Environmental scan Economy: Convertibility of Local Currency GDP / Industrial growth rate Scalability of Operations FDI – Incoming / outgoing Inflation rate / Fiscal deficit Trade surplus/deficits Balance of payment status WTO Implications Emerging markets scenario Gross national income distribution
Government Policy: Industrial policy Government programmes and projects Tax regime Subsidies, incentives and concessions Exim policies / VAT Government Expenditure Lending considerations of financial institutions and commercial banks Infrastructure Development Rating of Govt paper Agricultural policies
Technology: Emergence of new technologies. Access to technical Up gradation Level of obsolescence. Socio Demographic: Population trends Age shifts in population Educational profile. Attitudes toward consumption and investment
Competition: Number of players in the industry and their market share. Duty barrier and status of international cost and volume positioning. Degree of homogeneity and differentiation among products. Entry barriers for new capacities. Comparison with substitute products. Unorganised sector operations. Marketing polices and practices.
ORGANISATIONAL INTERFACE OF FINANCE Areas Interface Corp planning: Long term financial goals in terms of assets, sales,profits,dividends etc. Expansion, new projects diversifications takeovers , mergers,disinvestments. Internal generation, tax planning. Operations: Integrating functional plans. Working capital management
Areas Interface Control:Budgetary control of all divisions Variance analysis Marketing: Credit norms Cost analysis of decisions like discounts , premium pricing,product promotion etc. Manufacturing: Budgeting for manufacturing operations. Product mix decisions. Personnel: Budgeting for personnel & administrative function.
FINANCIAL FUNCTION Money Mgmt Accounting Control Advisory Role Financial Accounting Project Financing Resource Mobilisation Budgets Working Capital Mgmt Cost Accounting Variance Analysis Pricing Investment Mgmt Mgmt Accounting Profit Center Div. Policy Cost Center Valuation of Assets
Financial Decision Areas • Investment analysis • Working capital management • Sources and cost of funds • Determination of capital structure • Dividend policy • Analysis of risks & returns • Treasury - interest / exchange rate swaps • Restructuring of operations / term debt profile • Equity buyback / Bonus / Capitalisation • To result in shareholder wealth maximisation
PROFIT AND LOSS ACCOUNT For the Period 1st April to March 31st Income: Gross sales from Goods & Services Less: Excise Duty Net Sales Other Income Non operating Income Total Income
Expenditure: Raw materials consumed Manufacturing expenses Administrative expenses Selling expenses WIP +FG adjustment PBIDT (Gross Profit) Less: Interest Less Depreciation PBT (Operating Profit) Less: Tax PAT (net profit) Gross cash accruals : PAT + Depn Net cash accruals : GCA - Dividend
THE BALANCE SHEET For the year ended March 31st 200... Liabilities: Equity share capital Reserves & Surplus Term loan Debentures Fixed deposits Other unsecured loans Commercial bank borrowings Creditors Other current liabilities
Assets: Gross fixed assets Less: Acc. Depn Net Block Investments Currents Assets: RM Stock WIP F.G.Stock Debtors Cash in bank Loans & Advances Misc.. expenditure Deferred expenditure
RATIO ANALYSIS Principal tool for analysis Inter firm comparison Intra firm comparison Industry analysis Responsibility accounting
TYPES OF FINANCIAL RATIOS Liquidity Leverage Turnover Profitability / Valuation
LIQUIDITY RATIOS Current Ratio: Current assets Current liabilities Acid test ratio: C.A- Inventories Current liabilities Cash position ratio: Cash in bank + hand Current liabilities Inventory to G.W.C: Inventory Current assets
LEVERAGE RATIOS Debt / Equity ratio: Long term debt Net worth Borrowing / Assets: 1 - Net worth Total Assets Fixed asset / Networth: Fixed Assets Net worth
Capital gearing ratio: Capital entitled to fixed return Capital not entitled to fixed return Debt. Service coverage ratio: PBDIT - Tax Interest + Annual installment Interest coverage ratio: PBDIT - Tax Interest F. Asset coverage ratio: Gross fixed asset - Acc. Depn LT Secured liabilities
ACTIVITY RATIOS Total asset turnover: Net sales Total assets Fixed asset turnover: Net sales Fixed assets Inventory turnover: Net sales Inventory
Debtors turnover: Credit sales Avg. debtor Collection period: Avg. debtor * 365 CR. Sales Creditors Turnover: Credit purchase Avg.. Creditors Payment period: Avg. Creditor * 365 Net Purchases
PROFITABILITY / VALUATION RATIOS Gross profit ratio: PBDIT / Sales EBITDA / Sales RONW : PAT / Networth ROSE: PAT - Pref. Div Net worth Return on CAP. Employed: PBIT Total Lia - Creditors – Provisions Return on Investment : PBIT / Investments
Book value per share: Net Worth NO of Equity Shares EV / EBITDA: Enterprise value / Gross profit Earning per share: PAT - Pref Div No. of Equity shares Price Earning ratio: Market price Earnings per share Pay out ratio: Dividend paid Profit after Tax
USERS OF FINANCIAL RATIOS Lenders of funds for appraising credit worthiness for long term / short term lending decisions. Valuations in investment / disinvestment decisions. Financial analyst / Mutual Funds / Investment Bankers. Management for operational short / longterm planning. Credit Rating Agencies Tax authorities
LIMITATIONS OF RATIO ANALYSIS • A ratio in absolute terms has no meaning. It has to be compared. • Inter firm comparison. • Companies resort to window dressing of Balance sheets. • Operating and accounting practices differ from company to company. • Consolidation of group / subsidiary companies figures. • E.G. Changes in Depreciation methods • Inventory Valuation • Treatment of contingent liabilities. • Valuation of investments. • Conversion or transaction of foreign exchange items.
FUND FLOW ANALYSIS It is a statement indicating the methods by which a company has been financed and the uses to which it has applied its funds over a period of time. It provide an insight into the movement of funds and helps in understanding the changes in the structure of asset & liabilities. Provides information as to how funds are raised and utilised. Determines need for funds and helps in deciding finance mix Determines financial consequences of business decisions. Free cash flow generation ability and Utilisation of the same.
FUND MANAGEMENT Requirement Mobilisation Quantum Source Cost Equity Buy back Normal Capital expenditure IncrementalWorkingcapital New Investments
FUND FLOW OCCASIONS Sources Uses Funds from operations Loss from operations Sale of fixed assets Increase in fixed assets Increase in liabilities Redemption of liabilities Sale of securities Purchase of securities Decrease in W.C Increase In W.C Cash Dividends, Equitybuy back
FUND FLOW Assets Uses of funds Liabilities Uses of funds Assets Source of funds Liabilities Source of funds Comparison of balance sheets of consecutive years.
TYPES OF FUND FLOW STATEMENTS OVERALL FUND FLOW OPERATIONAL FUND FLOW WORKING CAPITAL BASED FUND FLOW (ONLY STS/STU STATEMENT)
COST OF CAPITAL Aggregate of the liabilities raised by a company is the total capital employed in business. Different sources have different cost and tax implications. Cost of capital It is a single rate (weighted average ) for a finance mix. It is computed on a post - tax basis since cost of different sources have different tax implications E.g.. Interest on debt capital enjoys tax shield while dividend paid on equity has no tax shield. COC is used as a discounting rate in DCF analysis.
RELEVANCE OF COC • Used as a hurdle rate in DCF analysis. • Wt. Average cost of capital • Marginal cost of capital • K0 = Ki + Ke • K0 = WT. Average cost of capital • Ki = Cost of debt capital • Ke = Cost of equity capital
COST OF CAPITAL • Consists of three components: • Risk less cost of a particular type of finance (rj) • Business risk premium(b) • Finance risk premium(f) • K0 = rj + b + f
RELATIONSHIP BETWEEN WEIGHTED AVERAGE COST AND MARGINAL COST OF CAPITAL • Degree of leverage • Cost of instruments • Tax Rate / Treatment • WACOC : K0 = Ki1 + Ke1 • MCOC : K0 = Ki2 + Ke1
METHODS OF COMPUTATION OF COST OF EQUITY ROI approach Ke = PAT - pref. div + non tax shield portion of depn Equity block (E + R +S + acc depn) Market capitalisation approach Ke = D/P + G D = Dividend per share G = Growth rate = b*r P = Market price per share b= % Retained earnings = PAT - Dividends / PAT r = % Return on “b” = PAT - Pref div / Net worth
Capital Asset Pricing model Ke = Rf +beta ( Rf – Rm) Rf = risk free rate of return Beta = stock relationship with a index Rm = Market expectations of return ( Bloomberg base )
If ROI approach is used to determine Ke then book value to be considered as weights.If market capitalization approach is used then market value to be considered as weights. • All cost to be considered on a post tax basis. • The market capitalization approach is superior to the ROI approach since the parameters are market determined and futuristic as compared to the ROI approach. • The CAPM approach is a further refinement which also includes premium for risk • In loss making companies minimum cash flow approach is used. • Cost of equity could be benchmarked with return on guilts,market risk and portfolio risk ( Asset Beta )
WORKING CAPITAL MANAGEMENT Objective: Optimise current asset deployment. Advantages: Lower interest cost. Inventory holding cost reduced. Disadvantages: Interruption in production. Stock out to customers.
ASSET STRUCTURE FOR VARIOUS INDUSTRIAL SEGMENTS FA CA Power Generation 80% 20% Chemical process plants 50% 50% Engineering 40% 60% Service 20% 80% Trading 10% 90%
WORKING CAPITAL Current assets comprise of stocks of raw materials, work in progress, finished goods, and receivables. Gross working capital = total current assets. Net working capital = CA - CL Objective is to optimse asset requirement and funding the same at minimal cost. Working capital requirement Permanent component Variable component)
CONSTITUENTS OF CURRENT ASSETS Raw material stock Work in progress Finished goods stock Cash in hand / bank Debtors / Receivables
OPERATING CYCLE TIME Time required for rolling or rotation of current assets. Date of receipt RM issued to Throughput time of RM production Dept Collection of Despatched to consumers Converted to FG Receivables
FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS • Nature of business • Manufacturing process • Competitive forces in raw material & finished goods segment. • Infrastructural support. • Through put time • Seasonality in demand • Shelf life of RM / Finished product • Customer relationship management
CREDIT MANAGEMENT • Terms of payment Cash against delivery • Consignee basis • Proforma invoice • Letter of credit • Advances • Suppliers / Buyers LOC • Credit policy variablesCredit standards • Credit period • Cash Discounts
Credit evaluation Character • Capacity • Capital • Collateral • Macro conditions • Control of accounts Days sales outstanding • receivables Ageing schedule (in days) • Collection matrix • Average collection period
RECEIVABLES MANAGEMENT • Credit standards Collection cost • Average collection period • Bad debts • Level of incremental sale • Credit terms • Collection policies • Factoring
CASH MANAGEMENT Cash budgets : Quarterly / monthly / weekly Operating cash inflow/ outflow items: Cash inflowCash outflow Cash sales Accounts payable Collection of receivables R.M purchase Salary factory expense Administration/selling exp. Taxes / Duties