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Pillai Institute of Management Studies and Research (PIMSR),

New Panvel

Master of Management Studies (MMS)

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MMS – Semester-2Subject : Financial Management

Basic Concepts of Financial Management

byProf. K.G.S. MANI

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(1) Basic concepts of Accounting :

(a) Basics Accounting Principles :(i) Debit the Receiver and Credit the Giver,(ii) Debit what comes in, and credit what goes out,(iii) Debit all expenses and losses, and Credit all gains and

profits.

(b) Financial statements : (i) Trial Balance, (ii) Trading and Profit & Loss Account (Income and Expenses Account), and (iii) Balance Sheet.

(c) Remember : All items appearing in Trading, Profit & Loss Account and Balance Sheet have already undergone double entry booking effect. All items given below the balance sheet as adjustments have not undergone double entry booking. As such, respective accounts have to be prepared for such items.

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(1) Current Assets : All items of assets which are receivable or realisable within an accounting period of one year are known as ‘current assets’. The following items are current assets :

(1) Cash in hand(2) Cash at bank(3) Sundry Debtors (4) Bills Receivables(5) Inventories (raw-material, semi-finished goods, finished

goods and consumable stores)(6) Short term loans, deposits and advances(7) Marketable investments and short term securities, etc.(8) Temporary investments(9) Prepaid expenses,(10)Accrued income (Income accrued but not received)(11)Other assets (to be received within one year)

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(2)Current Liabilities : All items of liabilities which are payable within an accounting period of one year are known as ‘current liabilities. These include the following items :

(1) Sundry Creditors(2) Bills Payables (amount payable to suppliers of raw materials

etc (3) Bank Loans and Overdraft (repayable within one year)(4) Instalment on loan secured/unsecured payable within one year(5) Outstanding expenses(6) Proposed Dividends (dividends payable during current year)(7) Unclaimed dividends(8) Advances received from customers(9) Provision for taxation(10)Income received in advance(11)Interest accrued but not due on secured and unsecured loans(12)Other liabilities (if any payable within one year)

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(3)Long Term Liabilities : This is also known as non-current liabilities. These are liabilities payable after/beyond one year

(1) Equity share capital (permanent liabilities)(owners’ capital)(2) Share Premium account(3) Shares forfeited account(4) Reserves and Surplus(all reserves including capital reserve)(5) Sinking Fund, Compensation Fund, etc(6) Preference share capital (redeemable preference shares)(7) Debentures and Bonds (borrowed capital) (creditorship

securities)(8) Long term loans (Bank loans, Mortgage Loans repayable

beyond one year)(9) Other Long term loans (borrowed from Associate concern,

etc)(10) Provision for depreciation on fixed assets(11) Other Liabilities (payable after one year)

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(4)Non-current Assets : These are fixed assets and other assets which are maturing or receivable after/beyond one year.

Fixed Assets : (1) Land & Buildings(2) Plant & Machinery, (3) Furnitures and Fixtures,Intangible Assets : (4) Goodwill (5) Trade Marks and Patent Rights(6) Investments : Long Term Investments (more than one year)(7) Loans and Advances extended to Associate Concerns

(maturing after one year)Miscellaneous expenses :(8) Preliminary expenses (portion not written-off)(9) Discount on issue of shares and debentures(10) Deferred expenses (advertisement suspense account, etc)(11) Profit & Loss Debit balance (Loss) (to be adjusted against

capital funds)

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Long Term Borrowings : These are long term liabilities repayable beyond/after one year and include the following items :

(i) Debentures,(ii) Bonds,(iii) Term Loans from Banks (repayable after/beyond one

year)(iv) Term Loans from Financial Institutions (-do-)(v) Deferred payment liabilities(vi) Fixed Deposits (repayable after/beyond one year)(vii) Loans and Advances from related parties (Customers,

Associate companies, Friends & Relatives),(viii)Long Term maturities of ‘finance-lease’ obligations,(ix) Other long term loans (specifying nature), if any.

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Share-holders’ Funds (or) Proprietor’s funds :

(i) Shareholders’ funds = Equity share capital (+) Preference share capital (+) Undistributed profit (+) Reserves & Surplus (-)Accumulated Losses

(ii) Capital Employed = Equity share capital (+) Preference share capital (+) Undistributed profits (+) Reserves & Surplus (+) Long Term Borrowings (-) Fictitious Assets

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Intangible Assets : These are not generally not visible assets but have value in the books of account of the company :

(i) Goodwill,(ii) Trade Marks and Brands,(iii) Patent Rights and Copy Rights,(iv) Computer Software,(v) Publishing Titles,(vi) Mining Rights,(vii)Intellectual property rights and operating rights,(viii)Formulae (Coca Cola), Recipes (Maggie Ketchup),

Models, Designs, Proto-types,(ix) Licences and Franchise,(x) Others (specifying nature), if any.

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Contingent Liabilities : These items always appear outside the Balance Sheet since they are not liabilities as on the date of Balance Sheet (example : 31st March 2014). The following items are included under ‘Contingent Liabilities’ :

(i) Claims against the Company not acknowledged as debt,(ii) Guarantees (given by the Company on behalf of Associate

companies, Sister concerns, etc to banks and others),(iii) Other monies for which the Company is contingently liable,(iv) Uncalled liability on shares (subscribed by the company)

and other investments partly paid,(v) Estimated amount of contracts remaining to be executed on

capital account and not provided for (in the accounts during the year),

(vi) Other commitments (specifying nature), if any.

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Basic Concepts of Financial Management : Cost of goods sold (COGS) : (also known as Cost of Sales (COS)

Opening stock of finished goods + Raw-material consumed + all manufacturing expenses - closing stocks of finished goods

• Raw material consumed = opening stock of RM + Purchase of RM – closing stock of RM;

• Manufacturing expenses means all direct expenses (other than administration, sales and financial expenses)

Short term provisions made by the Company : This includes the following items :(i) Provision for taxation, (ii) Provision for dividend,(iii) Provision for employee benefits (for workmens’

compensation fund), (iv) Provision for warranty.

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Working Capital : (a) Gross Working Capital : This is the total of all items of

Current Assets(b) Net Working Capital : This is the excess of current assets

over current liabilities (example : CA – CL). This is also known as ‘Working Capital’ (WC). Net Working Capital (NWC) is defined as excess of current assets over current liabilities. If CA are more, then it is called NWC is positive(+) and if CL are more, it is known as NWC is negative (-).

Example : CA = 100, CL=60, see the changes in WC below :NWC or Working Capital (WC) = 100 – 60 = 40 Important points :(a) If CA increases, WC increases = 140 – 60 = 80 (increased),(b) If CA decreases, WC decreases = 80 – 60 = 20 (decreased),(c) If CL increases, WC decreases = 100 – 50 = 50 (decreased),(d) If CL decreases, WC increases = 100 – 30 = 70 (increased).

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(c ) Working Capital Gap : Current Assets (minus) current liabilities (excluding short term bank borrowings). That is, Current Assets (-) [(Current Liabilities minus Short Term Bank Borrowings)]

Example : CA = 100, CL = 60, Short Term Bank Borrowings or Loans = 10

Net Working Capital Gap = 100 (-) [(60-10)] = 50

(d) Source of Funds means ‘inflow of funds’ or ‘inflow of cash’(e) Application of funds means ‘outflow of funds’ or ‘outflow of

cash’(f) Remember : Increase in CA and decrease in CL both

increases working capital (see concept and example in previous slide). This is known as ‘application of funds’. Decrease in CA and increase in CL both increases Working Capital. This is known as ‘source of funds’.

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(d)Basic Concepts : (i) Financial Leverage : A firm/company which finances

completely with shareholders equity is called an ‘unlevered’ firm/company. A levered company is one which has financed its long-term capital with debt. Financial leverage is used by the company to improve the returns to equity shareholders by way of dividends. Financial Leverage can bring in higher returns to equity shareholders only when return on assets is higher than the cost of debt. Hence, the cost of debt should be kept minimum. In other words, debt component in capital structure should less. Higher debt will retail more payment of interest from the profit and less amount would be available for equity shareholders by ways of dividends. This is also known as ‘capital gearing’. The standard capital mix by debt and equity is 2 : 1 (example : for Re 1 of equity (owned capital) ideal debt (borrowed capital) should not be more than Rs 2 as a measure of standard ratio)

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(ii) Capital Gearing : (a) Capital gearing refers to the relationship between

capital (borrowed capital or debt) entitled to fixed rate of return (interest) and owners’ capital (equity) which has varying rate of return (dividend).

(b) It refers to the relationship between equity (owned capital) and debt (borrowed capital).

(c) A company is said to be highly geared when its fixed interest bearing securities (debts) are more than equity share holders. This means equity is less and debt is more in the capital structure of the company. (example : equity is 1 or 1/3 and debt is 2 or 2/3).

(d) A company is said to be low-geared when equity shareholders’ funds are greater than fixed interest bearing securities (debts). In other words, equity is more than debt. (example : equity is 2 or 2/3 and debt is 1 or 1/3).

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(e) High gearing is also known s “trading on equity”. If the company operates with less equity and more debts, it is ‘trading on equity’ (owners may get more dividend due to less equity shares and payment of fixed interest amounts for debts, if assets are more efficient and generate more income).

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(viii)Overtrading : Overtrading the stage where the company is doing more business than its normal capacity. Overtrading is the result of excessive sales. The decision of accepting excessive orders compels the management to make more credit purchases and engage more workers or make over-time payment to workers engaged longer than usual hours in order to fulfil the commitments. Overtrading can be indicated from the following tests : (a) Increasing tendency of total trade creditors,(b) Piling of stock,(c ) Reduction in turnover,(d) comparison of credit period obtained with normal credit period allowed in that trade. If the credit period taken is more than normally allowed, it is definitely an index of poor cash position and consequently over-trading.

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(ix)Undertrading : It is the reverse of ‘overtrading’. Undertrading generally hints at inadequate volume of business. This is due to under-employment of assets of the business, leading to fall in sales and results in financial crisis. This makes the business unable to meet the commitments and ultimately leads to forced liquidation.

(x) Over-capitalisation : A company is said to be over-capitalised if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is also said to be over-capitalised when the total of owned-capital and borrowed capital exceeds its fixed and current assets, i.e. when it shows accumulated losses on the assets side of Balance Sheet. Over capitalisation can be removed by reducing capital so as to obtain a satisfactory relationship between proprietor’s funds and net profits. In case over-capitalisation is the result of over-valuation of assets then it can be remedied by bringing down the value of assets to their proper value.

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(xi) Under-capitalisation : If the owned-capital of business is much less than total borrowed capital, then it is a sign of under-capitalisation. This means that the owned capital of business is disproportionate to scale of its operation and hence the business is dependent upon borrowed money and trade creditors. Under-capitalisation may be result of over-trading. It must be distinguished from ‘high gearing’. In the case of ‘high gearing’ there is a comparison between equity capital and fixed interest bearing capital (which includes preference share capital also and excludes trade creditors) whereas in the case of under-capitalisation, the comparison is between total owned capital (both equity and preference share capital) and total borrowed capital (which includes trade creditors also).

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e) Concepts of various ratios :(i) Current Ratio : Current Ratio is a measure of liquidity

calculated dividing the current assets by current liabilities.(ii) Liquidity Ratio : Liquidity Ratio is the ability of a

business/firm to satisfy its short-term obligations as they become due.

(iii) Acid Test Ratio (or) quick Ratio : It is a measure of liquidity calculated divided current assets minus inventory and prepaid expenses by current liabilities.

(iii) Net Working Capital : It is a measure of liquidity calculated by subtracting current liabilities from current assets. It is the excess of current assets over current liabilities.

(iv) Debt-Equity Ratio : This ratio measures the ratio of long-term debts or total debts to shareholders equity. (a) D/E ratio = Total debt divided by Shareholders’ equity.(b) D/E ratio = Long term debt divided by Shareholders’ equity.

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(v) Proprietary Ratio : This indicates the extent to which assets re financed by owners’ funds.

(vi) Interest Coverage Ratio : This ratio measures the firm’s ability to meet all interest payments obligations.

(vii)Debt Service Coverage Ratio (DSCR) : DSCR is the ability of a firm to make the contractual payments (instalments and interest) required on a scheduled basis over the life of the debt or loan.

(viii) Gross Profit Ratio : This ratio measures the percentage of each sales rupee remaining after the firm has paid for its goods.

(ix) Net Profit Ratio : It measures the percentage of each sles rupee rupee remaining after all costs and expenses including interest and taxes have been deducted.

(x) Return on Investments (ROI) : This ratio measures the overall effectiveness of management in generating profits with its available assets.

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(xi) Return on Shareholders Equity : This measures the return on the owners’ (both preference and equity shareholders) investment in the business/firm.

(xii)Return on Ordinary Shareholders’ Equity : This measures the return on the total equity funds of ordinary shareholders.Shareholders’ Ratio :

(xiii)Earnings Per Share (EPS) : Earning per share is calculated to find out overall profitability of the organisation. Higher ratio signifies higher overall profitability. The growth Company is identified as one, where EPS increases year after year.

(xiv)Price-Earning Ratio (P/E ) : This ratio is a multiple obtained by dividing the market price of the share with the earnings per share. This multiple changes as a result of changes in the market price. Higher the ratio, better the investors’ confidence in the Company. Low PE ratio indicates that investors’ perception about the company for investment in its shares is very low and risky.

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(xv)Dividend Pay-out Ratio : The purpose of this ratio is to find out the proportion of earning used for payment of dividend and the proportion of earnings retained in the business. The ratio is a relationship between earning per equity share and dividend per equity share. Higher ratio signifies that the company has utilised larger portion of its earning for payment of dividend to equity shareholders. Lower ratio indicates that smaller portion of earning has been utilised for payment of dividend.

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Turnover Ratios :(xvi) Stock Turnover Ratio (or) Inventory Turnover Ratio :

This ratio is computed by dividing the cost of goods sold by the average stocks (inventory). (Average stock refers to simple average of opening and closing stocks). The ratio indicates how fast stocks are sold. A high ratio is good form the view-point of liquidity. A low ratio would signify that stocks do not sell fast and stay on in the shelf or in the warehouse of the company for a long time.

(xvii)Debtors Turnover Ratio : It is determined by dividing the net credit sales by average debtors (including bills receivable) outstanding during the year. A high ratio indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not beingcollected rapidly.

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(xviii) Creditors Turnover Ratio : It is a ratio between net credit purchases and the average amount of creditors (including bills payable) outstanding during the year. A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as the company can reduce its requirement of current assets by relying on supplier’s credit.

(xix)Fixed Assets Turnover Ratio : This ratio is a relationship between Net Sales and Fixed Assets. It is calculated by dividing Net Sales by Fixed Assets. Higher ratio is favourable. It shows that the Company is able to generate more sales in relation to the size of assets invested. It indicates efficiency of the management in utilisation of fixed assets.

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(xx) Working Capital Turnover Ratio : This ratio is

calculated by dividing Net Sales by working capital. The ratio shows the extent of working capital required turned over for achieving the sales. Higher ratio is favourable. It shows that working capital has been utilised effectively for achieving of sales.

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Funds Flow Statement (Statement of Sources and Applications) :

(1) Steps in the preparation of Funds Flow Statement :(i) Preparation of profit and loss account (to know funds

from operations or funds lost in operations);(ii) Preparation of accounts for non-current items (to

ascertain the hidden information);(iii) Preparation of statement of changes in Working Capital

(taking current assets and current liabilities only);(iv) Preparation of Funds Flow Statement.

(2) Format (specimen/proforma) for Funds Flow Statement :Funds Flow statement should be prepared in ‘T’ shape

format or vertical format. But ‘T’ shape format is preferred. (Refer to slides for problems and solutions in Funds Flow Statement for details)

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(i) General Rules for flow of funds :(1) There will be flow of funds if a transaction involves :

(i) current assets and fixed assets i.e. purchase of building for cash;(ii) current assets and capital i.e. issue of shares for cash;(iii) current assets and fixed liabilities i.e. redemption of debentures in cash;(iv) current liabilities and fixed liabilities i.e. creditors paid-off in debentures;(v) current liabilities and capital e.g. creditors paid-off in shares(vi) current liabilities and fixed assets e.g. Building transferred to creditors in satisfaction of their claims.

(Fixed Liabilities : share capital, reserves and surplus, debentures , long term loans)

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(2) There will not be any flow of funds, if transaction involves : (i) current assets and current liabilities e.g. payment made to creditors;(ii) fixed assets and fixed liabilities e.g. building purchased and payment made in debentures;(iii) fixed assets and capital e.g. building purchased and payment made in shares.

(j)Rules for preparing Schedule of Changes in Working Capital(WC): (Note : WC is excess of current assets over current liabilities)(i) Increase in current asset, results in increase (+) in ‘working capital’(ii) Decrease in current asset, results in decrease(-) in “wc”(iii) Increase in current liability, results in decrease (-) in “wc”(iv) Decrease in current liability, results in increase (+) in “wc”

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Concepts on Cash Flow Statement : (to be discussed later)

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