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Financial Management.ppt

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Sole Proprietorship One owner Unlimited liability The firm has no separate status from a legal and tax point of view Partnership Two or more owners Unlimited liability The firm has a separate status TYPES OF BUSINESS ORGANISATIONS
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  • Sole Proprietorship One ownerUnlimited liabilityThe firm has no separate status from a legal and tax point of view

    Partnership Two or more owners Unlimited liability The firm has a separate status

    TYPES OF BUSINESS ORGANISATIONS

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • TYPES OF BUSINESS ORGANISATIONS

    Private Limited Company Upto 50 owners Limited liability A distinct legal person

    Public Limited Company Many owners Limited liability Distinct legal person Free transferability of shares

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PUBLIC LIMITED COMPANYS ATTRACTION

    Potential for growth is immense because of access to substantial fundsInvestors enjoy liquidity because of free transferability of securities.

    Requirement of Funds Working Capital Capital Expenditure Expansion/ Modernisation/Acquisition

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • FINANCIAL DECISIONS IN A FIRMCapital BudgetingHow to take decision when alternative investment plans

    Capital StructureWhat would be the sources / composition of financeCompany should relay upon more equity finance or long-term loans and debt issue?What should be the ideal Debt-Equity Ratio ?

    Working Capital ManagementHow to finance everyday expenditure of the company ? Should the company go for more short-term bank loan or issue commercial papers?What would be the ideal portion of short-term loan and long-term loans ?

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • MANAGERS FUNCTIONFunding Decision: Sources of financeEquity capital or Promoters moneyBank finance or Capital Market financeAssessment and Provision of Working capitalAllocation of Funds/ Resources: Distribution between short-term and Long-term requirements For different competing projectsDistribution of Profit: Decision on DividendDecision to transfer to Networth

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • IMPORTANT QUESTIONSManagers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm:What is the financial position of the firm at a given point of time?How has the firm performed financially over a given period of time?What have been the sources and uses of cash over a period of time?Answer: Balance Sheet and Profit & Loss A/c

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • QUESTIONS ASKED BY OWNERS/MANAGERSWas it a good year or bad year?What was the volume of operations?What was the margin available on sales realization?The answer*Profit and Loss Account

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFIT AND LOSS ACCOUNTA Profit & Loss Account shows a company's earnings and expenses over a given period of time

    It exclusively summarizes revenue and expenses of the period and shows the net difference i.e., profit or loss of the period*While a Balance SheetReports value of assets, liabilities and owners equity at a particular point in timeAnd Reflects net change in owner(s) equity brought about by operations

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • FIXED ASSETS AND DEPRECIATIONThe cost of a fixed asset, written off or matched as expense against the revenues of different periods during which the asset is used It is the expired cost of an asset during an accounting period*Illustration A crushing machine purchased for Rs 50,000 having a five-year life and no salvage value is used in a business. During the life of the asset, it will be able to earn revenue of Rs 100,000

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • METHODS OF DEPRECIATION*Depreciation MethodsAccelerated ApproachUniform ApproachLarger amounts are expired during the initial years of life of the assets Expires the cost uniformly over the useful life of the assetsPrinciple of ConservatismPopular as it is an easy method to follow

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DEPRECIATION: SOME CONCEPTSOriginal cost Cost incurred in making the asset available for use at the first instance. This amount is specific and known on the acquisition of the assetSalvage valueRecovery (or sales value) of the asset at the end of its useful life. Value needs to be estimated (mostly).Useful lifeExpected time period for which the asset is to provide economic service or productive life. Estimated based on experience/technical factors *

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DEPRECIATION: SOME CONCEPTSDepreciable costOriginal Cost of asset Salvage ValueBook valueOriginal Cost Accumulated Depreciation*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • STRAIGHT LINE METHODDepreciable cost of the asset is proportionately allocated as expense against the revenues during each year of useful life of the asset*IllustrationA company acquires a machine at the beginning of operations at Rs 10,000. It is expected that machine will last 10 years and will have no salvage value at the end of its useful life

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DEPRECIATION @ 10% PER ANNUM: STRAIGHT-LINE METHOD*

    YearCostAnnual DepreciationAccumulated DepreciationRemaining Book Value010000---11000010001000900021000010002000800031000010003000700041000010004000600051000010005000500061000010006000400071000010007000300081000010008000200091000010009000100010100001000100000

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • WRITTEN DOWN VALUE METHODDepreciation is taken as a certain rate applied to the written down value of the asset as at the beginning of each year

    The amount of expiration of the cost of the asset is higher during the initial years

    *

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • WRITTEN DOWN VALUE METHOD: @20% PER ANNUM*Since there is no salvage value for the asset at the end of its useful life, the terminal year depreciation will be taken as Rs. 1,342 i.e., Rs. 268 (the depreciation for the period) plus Rs 1074 (the terminal value of the asset).

    YearOriginal CostAnnualDepreciationAccumulated DepreciationRemaining Book Value010000--100001100002000200080002100001600360064003100001280488051204100001024590440965100008196723327761000065573792621710000524790320978100004198322167891000033686581342101000026889261074

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFIT & LOSS A/C HORIZONTAL FORMAT

    Tools India Ltd.Profit & Loss Account For the year ended December 31, 2000ScheduleAmountSales net1255Other income25 Total Revenue260Cost of goods sold3130Gross profit130Operating expenses:Personnel449Depreciation511Other expenses628Operating profit42Interest712Profit before taxes30Income tax provision12Net profit after tax18

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • BALANCE SHEET

    Sources of Funds(1) Shareholders funds:(a) Capital(b) Reserves and Surplus(2) Loan funds:(a) Secured loans(b) Unsecured loansApplication of funds(1) Fixed assets(2) Investments(3) Current assets, loans and advancesLess: Current liabilities and provisions:Net current assets(4) Miscellaneous expenditures and losses

  • PROFIT & LOSS A/C ITEMSGross ProfitReflects the direct input costs To a great extent variable with the volume of operationsOperating ExpensesAll those costs of making the inventory available for saleAre directly or indirectly traceable to the inventory to be soldUsually segregated under two groups selling expenses & administrative expenses*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFIT & LOSS A/C ITEMSOperating ProfitMeasure of operational efficiencyObtained by deducting personnel, depreciation and other expenses from gross profitUsually referred to as OPBIT or EBITInterest ExpenseArises out of managements decision to finance part of the assets from borrowingsThe level of interest expense presents the amount of risk the company is carrying in terms of fixed commitments*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFIT & LOSS A/C ITEMSNet Profit before TaxThe surplus after meeting all expenses including interestThe profit available as a result of both operating and financing performanceIncome TaxesDetermined by profit before taxTax payable is determined by tax lawsNet profit or Profit after TaxIt is the net amount of surplus earned by the companyThe amount ultimately available for appropriationCan be either distributed as dividends or retained*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • EXPLANATIONS TO ITEMS Gross Sales (or Gross Turnover): The aggregate amount for which product sales are effected (or services rendered) by an enterprise (inclusive of taxes paid)

    Net Sales (or Net Turnover): The sales after deduction of sales returns & allowances, sales discounts, etc.

    Operating Income: The net income arising from the normal operations and activities of an enterprise without taking into account extraneous transactions and expenses of a purely financial nature*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • EXPLANATIONS TO ITEMSGross Profit (or Gross Margin or Gross Loss): The excess of the proceeds of goods sold and services, rendered during a period over their cost, before taking into account administration, selling, distribution and financing expenses

    Net Income (or Net Profit or Net Loss): The excess of revenue during a particular accounting period*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DIVIDENDS & RETAINED EARNINGSDividendsAn appropriation of profits among owners not an expenseTechnically the withdrawals by owners of the businessIn Joint Stock Companies, it is subject to Company Law

    Retained EarningsAfter subtracting dividends declared from the net profit, any surplus remaining is added to (accumulated) retained earnings. Also referred to as reserves and surplusSometimes designated to signify retention of earnings for different future purposes such as redemption of debt (redemption reserve), replacement of assets etc.*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • USING FINANCIAL RATIOSCompany performance is usually analyzed on two parametersProfitabilityLiquidity*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFITABILITY RATIOS*

    Marginon salesGross Profit Margin Operating Profit MarginEarnings Before Interest & TaxProfit before taxNet Profit Margin (i.e., Profit after tax)Return onInvestmentOperating Profit to Operating AssetsNet Income to Total AssetsReturn on EquityEfficiencyTotal Asset TurnoverOperating Asset TurnoverWorking Capital TurnoverShareholder Equity TurnoverReturnper shareEarnings per shareEarnings to priceDividends per share

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • SOLVENCY RATIOS*

    Short-termNet Working CapitalCurrent RatioQuick RatioAccounts Receivable TurnoverCollection PeriodInventory TurnoverConversion Period

    Long-termTotal Debt to Total CapitalLong Term Debt to Total CapitalLong Term Debt to Fixed AssetsInterest CoverTimes Fixed Charges CoveredGearingEquity Multiplier

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PBT, PAT, AND RETAINED EARNINGSProfit Before TaxIt is the surplus amount obtained after meeting interest expenseInfluenced to a great extent by the financing decisionsProfit After Tax (a.k.a. Net Income)Overall surplus available out of sales to shareholdersThis is influenced by three major factors namely, operating efficiency, financing efficiency and taxationAs a percentage of sales it is known as Net Profit Margin and is used to compare margins of players in the same industryRetained Earnings (a.k.a Retained Profit)Amount of profit remaining after the distribution of dividends*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • RETURN ON INVESTMENTProfitability has to be judged on the basis of the amount of resource used in obtaining the profitThe management has to be evaluated on the basis on to how far they had been successful in profitably utilizing the assets The assets used is to be related to the profit earnedReturn on Operating Assets (ROA)Operating profit to operating assets is obtained by dividing the operating profit by average value of operating assets used during the yearOperating assets refer to total current assets and fixed assets used*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • ROTA AND ROE Return on Total Assets (ROTA)The rate of profit the company is able to earn after meeting the cost of financing of a portion of the total assetsIt is the amount available to the shareholders in relation to the total amount of resources used in the businessHere again the average total assets is used (Why?)Return on Equity (ROE)Net income is the amount available to owners for compensating their investment and the risk being carried by themROE measures the net income as a percentage of shareholders investment*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • Performance Measurement Financial Ratios Comparative Analysis

  • FINANCIAL RATIOS Liquidity Ratios Leverage Ratios Turnover Ratios Profitability Ratios Valuation Ratios

  • HORIZON LIMITED: PROFIT & LOSS ACCOUNT FOR THE YEAR ENDING 31ST MARCH 20X1(Rs.in crore)20X1 20X0Net sales 70.1 62.3Cost of goods sold 55.2 47.5 Stocks 42.1 37.0 Wages and salaries 6.8 5.5 Other manufacturing expenses 6.3 5.0Gross profit 14.9 14.8Operating expenses 6.0 4.9 Depreciation 3.0 2.6 General administration 1.2 1.1 Selling 1.8 1.2Operating profit 8.9 9.9Non-operating surplus/deficit 0.6Profit before interest and tax 8.9 10.5Interest 2.1 2.2Profit before tax 6.8 8.3Tax 3.4 4.1Profit after tax 3.4 4.2Dividends 2.8 2.7Retained earnings 0.6 1.5Per share data (in rupees) Earnings per share 2.27 2.80 Dividends per share 1.87 1.80 Market price per share 21.00 20.00 Book value per share 17.47 17.07

  • HORIZON LIMITED : BALANCE SHEET AS ON 31ST MARCH 20X1 (Rs.in million)20X1 20X0 Sources of Funds(1) Shareholders funds26.20 25.60(a) Share capital 15.00 15.00(b) Reserves and surplus 11.20 10.60 (2) Loan funds21.20 15.60(a) Secured loans 14.30 13.10 (b) Unsecured loans 6.90 2.50 Total47.40 41.20Application of Funds (1) Fixed assets 33.00 32.20(2) Investments 1.00 1.00(3) Current assets, loans and advances23.40 15.60(a) Cash & bank 1.00 0.60(b) Debtors11.40 6.80(c) Inventories10.50 7.20(d) Prepaid expenses 0.50 1.00Less: Current liabilities and provisions10.50 8.10Net current assets12.90 7.50(4) Miscellaneous expenditures and losses 0.50 0.50 Total47.40 41.20

  • LIQUIDITY RATIOS Current Ratio Current assets 23.4 = = 2.23Current liabilities 10.5

    Acid-Test Ratio Quick assets 12.9 = = 1.23 liabilities 10.5

  • LEVERAGE RATIOS Debt-equity Ratio (or Gearing Ratio) Debt 21.2 = = 0.809Equity 26.2

    Interest Coverage Ratio PBIT 8.9 = = 4.23Interest 2.1

  • TURNOVER RATIOS Inventory TurnoverNet sales 70.1 = = 6.68Inventory 10.5 Debtors TurnoverNet credit sales 70.1= = 6.15 Debtors 11.4 Average Collection Period 365 365 = = 53.3 days Debtors turnover 6.15 Fixed Assets Turnover Net sales 70.1 = = 2.12Net fixed assets 33.0 Total Assets Turnover Net sales70.1 = = 1.48Total assets 47.4

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • PROFITABILITY RATIOS Gross Profit Margin RatioGross profit 14.9 = = 0.21 or 21 percent Net sales 70.1

    Net Profit Margin RatioNet profit 3.4 = = 0.049 or 4.9 percent Net sales 70.1

  • RETURN PER SHAREInterest of a shareholder lies in the amount of dividend that can be earned on the investment in shares and the increase in the price of shares that can be had by holding the same

    Earnings per share (EPS) is computed by dividing net income to ordinary shareholders by the number of ordinary shares outstanding*

    Earnings per Share (EPS)20X420X3Profit After Taxes (PAT) (Rs Million)2724Number of ordinary shares (Million)3.73.7Earnings per Share (EPS) (Rs)7.306.49

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • EARNINGS-PRICE RATIO (E/P)The earnings per share related to the current market price of the share provides a measure of the rate of yield

    Earnings Price Ratio= EPS / MP per share

    This yield measure could be used by the shareholder in making decisions about this investment in comparison to other alternate investments *

    Earnings-Price Ratios (E/P)20X420X3Earnings per Share (EPS) (Rs)7.306.49Market price per share (Rs)3028Earnings/Price Ratio (%)24.323.18Price Earnings Ratio4.14.31

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DIVIDEND PER SHAREIt is a common practice to express the E/P ratio by reversing the relationship to measure the price-earnings (P/E) relationshipHere, this relationship expresses market price as a certain multiple of the earnings per shareDividend per share is another per share calculation, which shows the cash income available to the shareholder of a share *

    Dividend per Share (DPS) (Rs)20X420X3Dividend (Rs Million)2 2 Number of ordinary shares (Million)3.73.7 Dividend per Share (Rs)0.540.54

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • SOLVENCYAbility to meet all the short-term commitments and ability to keep sufficient assets to cover all the liabilities in the long run Companies can be liquid (solvent) but not profitable. For example, imagine a cash rich construction company with no ordersCompanies can be profitable but not liquid. For example, a construction company with lot of orders but no cash to execute themHence, we need both profitability and solvencySolvency can be of two types Short Term and Long Term*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • EVALUATING SHORT-TERM SOLVENCYLiquidity is of major concern to short-term creditors and management

    Sale of merchandise (inventory turnover) and collection of receivable generates liquidity (receivable turnover)

    Assessing excess of current assets over current liabilities Working Capital

    Net working capital is financed by long-term sources of funds and as such provides a cushion for liquidity

    This is obvious since it is financed by long-term sources it is not required to be repaid in the short-term*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • EQUITY MULTIPLIEREquity Multiplier = Total Assets / Owners Equity

    The equity multiplier will show the extent of enhancement of return to equity holder due to leverage or borrowing*

    Tools & Tools Ltd.20X420X3Total Debt (Rs Million)195160Shareholders Equity (Rs Million)135110Total Assets330270Equity multiplier (Total Assets/Owners Equity)2.442.45Return on Total Assets (%)8.188.89Return on Equity ( ROTA * Equity Multiplier)(%)2021.8

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"

  • DU PONT ANALYSISA combination of margin on sales ratio, efficiency ratio, and long-term solvency ratio is popularly known as the DuPont analysis

    Return on Equity (ROE) = Net Profit Margin (defined as Net Profit/Sales) x Asset Utilization Ratio (defined as Sales/Total Asset) x Equity Multiplier Ratio (Total Assets/Owners Equity)

    The DuPont analysis approach helps in identifying and pinpointing the reasons behind high or low profitability of a firm vis--vis its competitors*

    Financial Accounting for Management by Ramachandran & KakaniCopyright with Tata McGraw-Hill Publishing Co Ltd, 2005"


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