caiib_fmmodbacs_nov08 module finance.ppt

CAIIB-Financial Management- MODULE B
STUDY OF FINANCIAL STATEMENTS
M Syed Kunmir
email – kunmir@yahoo.co.uk

“Financial management involves the
application of general management
principles to particular financial
operation”.
- Howard and Upton

Attending to investment decisions
- as to when and
- how to acquire and allocate funds
- for short-term and long-term assets
keeping
- in view the profit generation of the
business
- through which repayment obligation
can be met.

Objectives and basic consideration of
Financial management.
 Though profit maximisation is the objective of
financial management
 The long-term goal of the business entity is to
achieve maximising the shareholder value of
the firm
 Because the “principle of maximisation of
shareholder wealth provides a rational guide
for running a business and for efficient
allocation of resources in society”.

The key objective of Financial
Management is to maximise the
value of the company.
This could be possible by
good investment decisions
prudent financing decisions and
well thought-out financial planning
and control.

Maximisation of the value of the
company is also known as
maximisation of the wealth of
the owners.

To achieve maximisation of value of the
company, finance manager has to take
careful decisions in respect of
-Financing
-Investment
-Dividend
-Current asset management.

• Financing decision-
• Has to decide on sources of funds for
business.
• It is to be decided whether entire capital
should be raised from equity capital or a part
is to be raised from loan.
• Hence Debt/Equity ratio or Leverage are
important since each source has in them
associated risk factors involved.

• Investment decision
• It relates to acquisition of assets.
• Assets are classified into
• real assets such as
- land
- building
- plant
- equipment etc.
and
- the financial assets are
- shares and
- debentures etc.
• It indicates available mix of financing to fund company’s
activities.
• Such decisions on investment in projects come within the
field of capital budgeting which is derived from net present
value of assets.

 Dividend decision-
- It is basically a financing decision.
- This is because profit is a source of
fund.
- By not paying dividend, the “retained
earnings”or ‘reserve’ can be increased
which could be otherwise available for
investment.
 This ultimately lead to maximisation of
wealth of the organisation provided
decisions on investments are correct.

 Current Asset Management-
 This is necessary to maintain balance
between current assets and current
liability,
 The liquidity of the business is
interrupted because of holding too
much fund in current assets.

Wealth maximisation &value maximisation
• The goal of financial management is to maximise
the value of companies.
• This is generally expressed in terms of maximising
the value of the ownership shares of the
company
• In short,maximising share price.
• Thus,better performing companies can raise
additional funds under more favourable terms.
• This basic objective of maximising the price of the
company’s shares is called ‘value maximisation’.

• Social responsibility is also an important goal of
a company which requires
-Maximising share-price by efficient,well-
managed operations related to consumer
demand parameters.
-Efficiency & innovation leads to value
maximisation which leads to new
products,new technologies and better
employment.
-External factors like pollution,product safety and
job safety have achieved added dimensions in
relation to value maximisation.

Profit maximisation vs.Wealth
maximisation
• Long run vs.Short run Profits.
• Convert total corporate profits to earning per
share(EPS).
• EPS is total profits divided by number of shares
outstanding.
• Assume the firm earns Rs.10 mn.and has 1mn.shares
outstanding.The EPS will work out to Rs.10.
• Profit maximisation is a short-term concept,
• while wealth maximisation emphasises the long-term
view point.

State whether true or false
• The income statement depicts the financial
position of the firm at a given point of time
• The balance sheet gives the financial
performance of the firm over a given period of
time.
• These statements are prepared every week.
• Funds Flow statement gives the liquidity
position of the firm.

Cash Flow statement tells from where the
money comes and where it is used.
The prime objective of financial management
is wealth maximisation,and not profit
maximisation.
What is earnings per share?
a)Net Profit
b)Profit before interest and tax
c)Total earnings divided by investment
d)Net profit divided by equity

What is the difference between long term
funds and short term funds?
-Difference in interest rates
-Difference in time of repayment
-Difference in the size of loan
-No difference

CAPITAL EXPENDITURE DECISIONS AND
PROFITABILITY STUDY
It represents the important decisions taken by
the firm.
Importance due to the following issues
-Long-term effects
-Irreversibility
-Substantial outlays

Difficulties
-Measurement problems
-Uncertainty
-Temporal spread

Phases of capital budgeting
-Capital budgeting is a complex process which
may be divided into five broad phases.
1) Planning
2) Analysis
3) Selection
4) Implementation
5) Review.

• Levels of Decision Making
-Operating decisions
-Administrative decisions
-Strategic decisions
o Profitability Study important facets are
-Market analysis
-Technical analysis
-Financial analysis
-Economic analysis
-Ecological analysis

The basic characteristic of a capital
project is that it typically involves
- A current outlay(or current and
future outlays)of funds
- In expectation of a stream of
benefits
- Extending far into future.

Accounting rate of return method
- A selection criterion using
average net income and
investment outlay to compute
a rate of return for a project.
- This method ignores the time
value of money & cash flows.

Net Present Value method
- A selection method using the
difference between the
present value of the cash
inflows of the project and the
investment outlay.
- The method evaluates the
differential cash flow
between proposals.

Internal rate of return method
A selection method using the
compounding rate of return on
the cash flow of the project.

Payback method
- A selection method in which a firm
sets a maximum payback period
during which cash inflow must be
sufficient to recover the initial outlay.
- This method ignores the time value
of money and cash flow beyond the
pay back period.

 What are the three important factors which arise
from capital expenditure decisions?
a)Long-term effects e)Debt
b)Profitability f)Substantial outlays
c)Irreversibility g)Short-term effects.
d)Risk
 Why are capital expenditure decisions difficult?
i)Uncertainity in predicting costs&benefits
ii)Difficulty in measurement of costs&benefits
iii)Risk involved
iv)Problems in estimating discount rates
v)All the above

• If the IRR of the project is 7% and the cost of
capital is (11.4% should we reject or accept
the project). Yes/No.
• The firm should always make an ecological
analysis to know the likely damage that may
be caused by the project to the environment.
a)Must do b)No need.

Sources of finance and
cost of capital
For what purposes a firm needs a finance?
- Since the cash receipts lag behind cash
payments necessitating
- loans,bonds,overdrafts etc.
- the firm needs finance for short term and
long term requirements-
- fixed assets and working capital.
Permanent sources of finance Share capital and
retained profits.

Study of financial statements
• Who are the party interested in firm’s financial
condition?
- Shareholders
- Creditors/suppliers
- Financiers
- Employees
- Tax authorities.

Long term sources
- Preference shares
- Bonds
- Debentures
and
- Long term loans from
financial institutions..

Various sources of short term finance-
- Cash credit
- Overdraft
- Billsdiscounting
- Commercial papers and
- Trade credit.

Short term & long term cash forecasts
Time periods involved -
- Yearly for long term forecasts
- Monthly for short term forecasts.

Factors considered in equity financing
- Issue costs
- servicing costs such as paying out
dividends
- when there is retained earnings
there will be capital appreciation of
sharevalues.

Preference Shares
- These shareholders get a fixed return
and their risk is less than the equity
Shareholders.
- They have a right to the first slice
of dividend.
- Obligation to redeem the preference
shares after its time period.
- They do not have a right to vote.

Debentures or loan financing
- the firm will have to pay fixed
interest every year.
- There is an obligation to
redeem it at the end of the
period.
- There is also an advantage of
tax deductibility of interest
paid which makes it cheaper.

Bills rediscounting
- The buyer can repay in a long
period of time
- while seller gets his money back
by discounting the bills.
- For the seller, this helps him to go
ahead with production and
increase the turnover.

Working capital term loan
A part of working capital has to be with the
manufacturer since there is a time lag between
ordering and procuring.
This particular portion (say25%)can be financed
by long term funds.
When firm is not able to infuse its own funds
for this purpose,it gets a long term loan from
the bank.
This carries fixed interest and for a fixed period.

Overdraft and bank loan-
- Overdraft is a running account
- whereas bank loan instalment
are fixed.

Trade credit
- When materials are bought from
suppliers,the trade credit is
extended for few days or a couple of
months.
- The supplier is willing to wait to
collect money.
- This also depends on the suppliers’
financial position and
- The buyers credit worthiness.

Commercial paper
- These are short term promissory
notes with fixed maturity period.
- They are issued by very large
companies
- Who are reputed and
- Have high credit worthiness.
- Credit rating agencies certify
their credit rating.

Firms’cost of capital-A firm’s is the average cost of
capital is the weighted average arithmetic mean
of the cost of resources from various sources.
Questions:
a)Long term sources are banks and financial
institutions (T/F)
b)Current liabilities should be repaid within a
financial year(T/F)
c)Fixed assets are generally financed with
current liabilities(T/F)

 Equity Shareholders bear the greatest risk(T/F)
 Bills discounting scheme has been introduced to ease
flow of funds in the economy(T/F)
 Trade creditors are suppliers of goods and services to
whom the firm is yet to pay.(T/F)
 Accounts Receivables should be less than trade
creditors(T/F).
 Bills of Exchange is same as cash credit(T/F).
 Equity and Preference shares are one and the
same(T/F)
 A part of working capital can be financed by long
term sources(T/F)

• A firm borrows Rs.20,000 from bank @8% and
floats a debenture for Rs.60,000 @6%,for a
special project,what is the cost of capital of the
project?
a)5.5% b)6.5% c)7.5% d)8.5%
• If a firm borrows Rs.2 lac @10% and has a tax
rate of 40%.What is the cost of capital?
a)5% b)6% c)7% d)8%

Data for analyzing the situations
of the firm
Balance Sheet
Income Statement
Fund flow statement

Basic concepts while preparing balance sheet
- Entity concept
- Money measurement concept
- Going concern concept
- Cost concept
- Consevatism concept
- Dual aspect concept
- Accounting period concept
- Accrual concept
- Realisation concept
- Matching concept

What is revenue reserve & capital reserve?
 Revenue reserves are accumulated
earnings from profits and normal business
operations.
 Capital reserves arise due to capital gains
from revaluation of assets or due to premium
on issue of shares.

Elements of financial statements
Main financial statements:
 Balance Sheet
 Income statement
 Statement of Sources of funds and Uses of
funds

Balance Sheet
Typical Limited
Balance Sheet
as at 30 June 2002 2002 2001
Rm Rm
ASSETS
Non-Current Assets
Property, plant & equipment 1,227 1,137
Current Assets
Inventories 65 60
Receivables 122 108
Cash assets 21 15
Total Current Assets 208 183
Total Assets 1,435 1,320
EQUITY AND LIABILITIES
Equity
Share Capital (500m shares of R1 each) 500 500
Retained earnings 415 340
Total Equity 915 840
Non-current Liabilities
Long-term borrowings 400 380
Total non-current liabilities 400 380
Current Liabilities
Trade and other payables 98 88
Short-term borrowings 22 12
Total current liabilities 120 100
Total Equity and Liabilities 1,435 1,320

Income Statement
Typical Limited
Income Statement
For the year ended 30 June 2002 2002 2001
Rm Rm
Sales revenue 3,573 2,320
Cost of Sales 2,036 1,206
Gross Profit 1,537 1,114
Distribution, selling and marketing expenses 679 394
Administration and general expenses 322 186
Other expenses 254 116
Profit (earnings) before interest and tax expense 282 418
Finance costs 100 80
Profit before tax 182 338
Income tax expense 54 101
Profit for the period 128 237
Earnings per share 0.256 0.474
Statement of changes in equity
for the year ended 30 June 2002
Balance at 30 June 2001 340 202
Profit for the period 128 237
468 439
Dividends -53 -99
Balance at 30 June 2002 415 340

Sources and Uses of Funds
7-7
Sources and
Uses Statement
Sources and
Sources and
Uses Statement
Uses Statement
The letters labeling
the boxes stand for
Uses, Sources,
Assets, and
Liabilities (broadly
defined). The pluses
(minuses) indicate
increases
(decreases) in
assets or liabilities.
The letters labeling
the boxes stand for
U
Uses
ses, S
Sources
ources,
A
Assets
ssets, and
L
Liabilities
iabilities (broadly
defined). The pluses
(minuses) indicate
increases
(decreases) in
assets or liabilities.
A
A L
L
- +
+ -
S
S
U
U

Debtors 1600 2000 400
Stock 770 1090 320
Bills Receivable200 300 100
Cash 150 100 -- 50
Bank 100 80 20
Liabilities
Creditors 550 830 280
B/P 200 160 40
Net Increase in
working capital 510
860 860

• Accounts payable-These are current liabilities
payable within one year from date of balance
sheet.
• Fund Flow Statement-It shows the sources
and uses of funds during a given accounting
period.
• Horizontal analysis and Vertical analysis-
Horizontal analysis is comparing the
operations over a time period ie.comparing
past performance with current position for
predicting the future performance.

In vertical analysis we use percentages to show
the relationship between various items in the
balance sheet.
a)X contributes Rs.10,000 to his properietory
concern and the amount is deposited in the
bank.What is the nature of liability?
i)Owner’s equity
ii)Loan
iii)Short term finance
iv)Fixed Asset.

Cost of goods sold and Cost of production
refer to the same amount(T/F)
Net profit is calculated before tax(T/F)
Balance sheet and Income statement can
be prepared every quarter for internal
use(T/F)
A loss is shown as asset in the balance
sheet(T/F).

• Provisions for taxes and accrued expenses
to be paid within a year are current
assets(T/F)
• Debtors(also known as accounts
receivable)represent the amount of money
to be paid by the firm to the suppliers(T/F)
• Fund Flow statements can be prepared
without the basis of balance sheets(T/F).
• Fund flow statements represent only bank
borrowing and trade credit(T/F)

• State whether following are sources or uses
-Buying materials
-Payment of dividend to shareholders
-Advance received from buyer of goods
-Investment in machinery
-Issue of debentures
-Retained earnings
-Increase in Inventories
-Sale of old machinery

Horizontal Analysis
Time
Comparing a company’s financial condition
and performance across time
Tools of Analysis

Time
Now, let’s
look at some
ways to use
horizontal
analysis.
Horizontal Analysis
The term horizontal analysis arises from
left-to-right (or right-to-left) movement of
our eyes as we review comparative
financial statements across time.

CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
2004 2003
Dollar
Change
Percent
Change
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000
$ 164,700
$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000
$ 125,000
$
Total assets 315,000
$ 289,700
$

Comparative Statements
Calculate Change in Dollar Amount
Dollar
Change
Analysis Period
Amount
Base Period
Amount
= –
Since we are measuring the amount of
the change between 2003 and 2004, the
dollar amounts for 2003 become the
“base” period amounts.

Comparative Statements
Calculate Change as a Percent
Percent
Change
Dollar Change
Base Period Amount
100%
= ×

CLOVER CORPORATION
31-Dec
2004 2003
Dollar
Change
Percent
Change*
Assets
Current assets:
$ 23,500
$ (11,500)
$ (48.9)
Inventory 80,000 100,000
$ 164,700
$
Land 40,000 40,000
$ 125,000
$
$ 289,700
$
* Percent rounded to first decimal point.
($11,500 ÷ $23,500) × 100% = 48.9%
$12,000 – $23,500 = $(11,500)

CLOVER CORPORATION
31-Dec
2004 2003
Dollar
Change
Percent
Change*
Assets
Current assets:
$ 23,500
$ (11,500)
$ (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
$ 164,700
$ (9,700)
$ (5.9)
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
$ 125,000
$ 35,000
$ 28.0
$ 289,700
$ 25,300
$ 8.7

Now, let’s review the dollar
and percent changes for
the liabilities and
shareholders’ equity
accounts.

CLOVER CORPORATION
31-Dec
2004 2003
Dollar
Change
Percent
Change*
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable 67,000
$ 44,000
$ 23,000
$ 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000
$ 50,000
$ 20,000
$ 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000
$ 130,000
$ 15,000
$ 11.5
Shareholders' equity:
Preferred shares 20,000 20,000 - 0.0
Common shares 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000
$ 90,000
$ - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total shareholders' equity 170,000
$ 159,700
$ 10,300
$ 6.4
Total liabilities and shareholders' equity 315,000
$ 289,700
$ 25,300
$ 8.7

Now, let’s
look at trend
analysis!

Trend Analysis
Trend analysis is used to reveal patterns in data
covering successive periods.
Trend
Percent
Analysis Period Amount
Base Period Amount
100%
= ×
Also called trend
percent analysis
or index number
trend analysis.

Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues 400,000
$ 355,000
$ 320,000
$ 290,000
$ 275,000
$
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
2000 is the base period so its
amounts will equal 100%.

Trend Analysis
Berry Products
Income Information
Item 2004 2003 2002 2001 2000
Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100%
(290,000 ¸ 275,000) ´ 100% = 105%
(198,000 ¸ 190,000) ´ 100% = 104%
(92,000 ¸ 85,000) ´ 100% = 108%
Item 2004 2003 2002 2001 2000
Revenues 400,000
$ 355,000
$ 320,000
$ 290,000
$ 275,000
$
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Trend Analysis
Berry Products
Income Information
Item 2004 2003 2002 2001 2000
Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%
How would this trend analysis
look on a line graph?
Item 2004 2003 2002 2001 2000
Revenues 400,000
$ 355,000
$ 320,000
$ 290,000
$ 275,000
$
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Trend Analysis
We can use the trend percentages to construct
a graph so we can see the trend over time.
100
110
120
130
140
150
160
2000 2001 2002 2003 2004
Year
Percentage
Revenues
Cost of Sales
Gross Profit

Vertical Analysis is also called as
common-size analysis
Vertical Analysis V
e
r
t
i
c
a
l
A
n
a
l
y
s
i
s
The term vertical analysis arises from the up-
down (down-up) movement of our eyes as we
review common-size financial statements.

Common-Size Statements
Calculate Common-size Percent
Common-size
Percent
Analysis Amount
Base Amount
100%
= ×
Financial Statement Base Amount
Balance Sheet Total Assets
Income Statement Revenues

CLOVER CORPORATION
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
$ 23,500
$ 3.8% 8.1%
Inventory 80,000 100,000
$ 164,700
$
Land 40,000 40,000
$ 125,000
$
$ 289,700
$ 100.0% 100.0%
($12,000 ÷ $315,000) × 100% = 3.8%
($23,500 ÷ $289,700) × 100% = 8.1%

CLOVER CORPORATION
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
$ 23,500
$ 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
$ 164,700
$ 49.2% 56.9%
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
$ 125,000
$ 50.8% 43.1%
$ 289,700
$ 100.0% 100.0%

CLOVER CORPORATION
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable 67,000
$ 44,000
$ 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities 70,000
$ 50,000
$ 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities 145,000
$ 130,000
$ 46.0% 44.9%
Shareholders' equity:
Preferred shares 20,000 20,000 6.3% 6.9%
Common shares 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital 90,000
$ 90,000
$ 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity 170,000
$ 159,700
$ 54.0% 55.1%
Total liabilities and shareholders' equity 315,000
$ 289,700
$ 100.0% 100.0%

CLOVER CORPORATION
Comparative Income Statements
Common-size
Percents*
2004 2003 2004 2003
Revenues 520,000
$ 480,000
$ 100.0% 100.0%
Less: Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes 25,000
$ 32,000
$ 4.8% 6.7%
Less: Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income 17,500
$ 22,400
$ 3.4% 4.7%
Net income per share 0.79
$ 1.01
$
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.

ABC co.paid Rs.30,000 as deposit to the
suppliers for a period of 3 months.
i)Liability
ii)Current Asset
iii)Trade Credit
iv)Debenture
Materials costing Rs.2000 destroyed by fire
i) Reduction in Asset
ii)Reduction in liability

Profit maximization is a
a) Short term concept
b) long term concept
c) both
d) none of the above

Wealth maximization is a
a) Short term concept
b) long term concept
c) either a or b
d) both a& b.

Criterion for payback period
a) Accept PBP>target period
b) Accept PBP<target period
c) Accept PBP=target period
d) d) none of the above

Criterion for accounting rate of return
a) Accept ARR>target rate
b) Accept ARR< target rate
c) Accept ARR=target rate.

Criterion for Net Present Value
a)Accept NPV>0
b) Accept NPV<0
c) Accept NPV=0

Criterion for IRR(Internal Rate of Return)
a) Accept IRR>Cost of capital
b) Accept IRR <Cost of capital
c) Accept IRR= Cost of capital

Criterion for benefit cost ratio
a) Accept BCR >1
b) Accept BCR<1
c) Accept BCR=1

Common size statements are
a) Financial Statements that depict financial
data in the form of verticle percentages
b) Financial Statements that depict financial
data in the form of horizontal percentages
c) Both a & b
d) none of the above.

Horizontal Analysis is
a)Changes in financial statements
b) percentage analysis of increase & decrease in
corresponding items in comparative financial
statements.
c) Financial statements which depict financial
data.
d)none of the above.

Fund Flow is
a) Sources & Uses statement
b) Sources Statement
c) Uses Statement
d) none of the above.

Economic Income is defined as
a) Change in wealth
b) Change in income
c) Change in profit

THANK YOU
Email – kunmir@yahoo.co.uk

caiib_fmmodbacs_nov08 module finance.ppt

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