MEANING OF FINANCIAL MANAGEMENT

Financial Management may be defined as Planning, Organizing, Directing and Controlling of

financial activities in a business enterprise. More specifically it is concerned with optimal
procurement and effective utilization of funds in a manner that the risk, cost and control
considerations are properly balanced in a given situation. Financial management is concerned
with efficient acquisition and allocation of funds. In operational terms, it is concerned with
management of flow of funds and involves decisions relating to procurement of funds,
investment of funds in long term and short term assets and distribution of earnings to owners.
In other words, focus of financial management is to address three major financial decision areas
namely, investment; financing; and dividend decisions.
Definition: “The activity which is concerned with acquisition and utilization of all money/ Funds
to be used in a corporate (Business) Enterprise.” - Wheeler
More specifically, Financial Management is concerned with making the following four decisions:
1. Investment decision i.e., where and how much to invest in long-term assets and working
capital?

2. Financing decision i.e., from where to raise funds?

3. Dividend decision i.e., how much earnings to be retained and how much to be distributed?

4. Liquidity decision i.e., how much cash in hand is to be maintained with the firm.

OBJECTIVE OF FINANCIAL MANAGEMENT

The objective of financial management is to maximize the current price of equity shares of the
company .However, the current price of equity shares should not be maximized by
manipulating the share prices. Rather it should be maximized by making efficient decisions
which are desirable for the growth of a company and are valued positively by the investors at
large. A decision is considered efficient if it increases the price of share but is considered as
inefficient if it results in decline in the share price. In other words, the objective of financial
management is to maximize the wealth of the owners of the company that is the shareholders.
Here wealth maximization means the maximization of the market price of the equity shares of
the company in the long run by making efficient decisions and not by manipulating the share
prices. The financial manager must identify those avenues of investment; modes of financing,
ways of handling various components of working capital which ultimately will lead to an
increase in the price of equity share. If share holders are gaining, it implies that all other
claimants are also gaining because the equity share holders get paid only after the claims of all
other claimants (such as creditors, employees, lenders) have been duly paid.
Objectives of financial management
Primary objectives Secondary objectives

1. Profit maximization. 1. To ensure availability if sufficient amount of

funds at reasonable costs.
2. Wealth maximization. 2. To ensure optimum utilization of funds.
3.To ensure safety of funds through creation of
reserves.

Nature and Scope of Financial Management:

1.Management of flow of money.

2. Concept with application of skills in manipulation

Use of Control of Money

Determining financial needs and Raising of funds

Utilization of funds.

1.Details :
Management of flow money : It refer to Inflow and outflow of money. Inflow of money means
Entering of money in business from external source and outflow of money refers to
consumption of money. Which gives us the Best output of financial Manager need to
concentrate over the inflows as well as out flow of money so that there cannot be shortage and
excursiveness of financial resources.

2 Concerns with application of skills in manipulation, we and control of money:

In an effective financial Management, there is always a process of applying. Manager skills in
Manipulate, utilization and control of money. In Financial Management, Controlling of firms
financial resources play a vital role that is why a financial manager uses his skills in order to
control such activities.

3 Determining the Financial needs and Raising of Funds:

In financial management, a financial manager, firstly determining the financial needs of an
enterprise and then finding out the best suitable sources for raising them. The sources should
be commensurate with needs of business. If the funds needed or longer period then long term
sources of like share capital, debentures, etc can be raise for short term, period, and the short
term sources like. Trade Bill, Commercial paper can be.
4. Proper utilization of funds:
Though raising funds is important but their effective utilization is also more important. The
funds should be used in such that maximum benefit is derived from them. The retires from
their use should be more than their cost. It should be ensured that funds do not remain idle at
my point of time. The funds committed to various operations should be effectively utilized.
Those projects would be preferred which are beneficial to the business.

Scope of financial Management:

1. Estimating Financial Requirement

2. Deciding Capital Structure
3. Selecting a source of finance
4. Selecting a Pattern of investment.
5. Proper Cash Management
6. Implementing Financial controls
7. Proper uses of surpluses.

1 Estimating Financial Requirements :

The first task of a financial manager is to estimate short-term and long-term financial
requirements of his business. For this purpose, he will prepare a financial plan for present as
well as for future. The amount required for purchasing fixed assets as well as needs of funds for
working capital will have to be ascertained.

2. Deciding Capital Structure.

The capital structure refers to the kind and proportion of different. Securities for raising funds.
After deciding about the quantum of funds required it should be decided which type of
securities should be raised. Long-term funds should be employed to finance working capital
also, if not wholly then partially. A decision about various sources for funds should be linked to
the cost of raising funds. If cost of raising funds is very high then such sources may not be useful
for long.

3. Selecting a Source of Finance:

After preparing a capital structure, an appropriate source of finances selected. Various from
which finance may be raised, include: share capital, debentures, financial institutions,
commercial banks, public deposits, etc. If finances are needed for short periods then banks,
public deposits and financial institutions may be appropriate, on the other hand, if long-term
finances are required then share capital ad debentures may be useful.
4. Selecting a Pattern of Investment:
When funds have been procured then a decision about Investment pattern is to be taken. The
selection of an investment pattern is related to the use of funds. A decision will have to be
taken as to which assets are to be purchased? The funds will have to be spent on fixed assets
and then an appropriate portion will be retained for working capital.

5. Proper Cash Management:

Cash management is also an important task of finance manager. He has to access various cash
needs at different times and then make arrangements for arranging cash. Cash may be required
to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills, (d) meet day
to day expenses. The usual sources of cash may be a: (a) cash sales, (b) collection of debts, (c)
short term arrangements with bank etc. The cash management should be such that neither
there is a shortage of it and nor it is idle. Any shortage of cash will damage the creditworthiness
of the enterprise.

6. Implementing Financial Controls:

An efficient system of financial Management necessitates the use of various control devices.
Financial control devices generally used are : (a) Return on investment, (b)Budgetary Control,
(c), Break Even Analysis, (d) Cost Control, (e) Ratio Analysis (f ) Cost of Internal Audit return on
investment is the best control device to evaluate the performance of various financial policies
the higher this percentage, better may be the financial performance.

7. Proper Use of Surpluses.

The utilization of profits or surpluses is also an important factor in
Financial management. A effective use of surplus is essential for expansion and diversification
plans and also in protecting the interests of shareholders.

3. Finance Function:
Finance function is the most important of all business function. It remains a focus of all the
activities it is possible to substitute or eliminate this function because the business will close
down in the absence of finance.

Approaches to finance functions -

1. Traditional approaches – According to this approach the finance function was conformed
only Procurement of funds needed by business on most suitable firms. The utilization of funds
was considered beyond the purview of finance function here, it was felt that decision regarding
application of funds are taken same where.
Limitations :
a. If completely ignore the decision making to the proper utilization of funds.
b. If ignores the important issue of working capital finance and management.
c. If ignore issue of allocation of funds.
d. If ignore day to day financial problem of organization.

2. Modern Approach: It used in broader firms. It includes both raising and utilization of funds.
The finance function does not stop only by finding out sources of raising enough funds, their
proper utilization .According to this approach, it cover financial planning, rising of funds.
Allocation of funds and financial control etc .

Aims of Finance Function

1. Acquiring sufficient funds.
2. Proper utilization of funds.
3. Increasing profitability
4. Maximizes firm’s value.

1. Acquiring Sufficient Funds: The main aim of finance function is to assess the financial needs
of an enterprise and then finding out suitable sources for raising them. If funds are needed for
longer periods then long-term sources like share capital, debentures, term loans may be
explored.

2. Proper Utilization of Funds: Though raising of funds is important but their effective
utilization is more important. The funds should be used in such a way that maximum benefit is
derived from them. The returns from their use should be more than their cost. It should be
ensured that funds do not remain idle at any point of time.

3. Increasing Profitability: The planning and control of finance function aims at increasing
profitability of the concern. It is true that money generates money. To increase profitability,
sufficient funds will have ton or wastes more funds than required.

4. Maximizing Firm’s Value: Finance function also aims at maximizing the value of the firm. It is
Generally said that a concern’s value is linked with its profitability. Besides profit, the type of
sources used for raising funds, the cost of funds, the condition of money market, the demand for
products are some other considerations which also influence a firm’s value.

Sources of Financial information:

1. Banks
2. Financial institution
3. Government agencies
4. Investors
5. Brokers
6. Media
7. Supplier.

Functional Areas Financial Management:

1. Determining financial needs.
2. Selecting the sources of funds.
3. Financial analysis and interpretation
4. Cost volume and profit analysis.
5. Capital Budgeting.
6. Working Capital management
7. Profit Planning and Control.
8. Dividend Policy.

1. Determining financial needs: A finance manager is supposed to meet financial needs of the
Enterprise. For this purpose, he should determine financial needs of the concern. Funds are needed
to meet promotional expenses, fixed and working capital needs.

2. Selecting the Source of Funds: A number of sources may be available for raising funds a
concern may resort to issue of share capital and debentures. Financial institutions may be
requested to provide long term funds. A finance manager has to be very careful and cautious in
approaching different sources. The terms and conditions of banks may not be favorable to the
concern.

3. Financial Analysis and Interpretation: The analysis and interpretation of financial statements
is an important task of a fiancé manager. He is expected to know about the profitability, liquidity
position, short term and long-term financial position of the concern. For this purpose, a number of
ratios have to be calculated. The interpretation of various ratios is also essential to reach certain
conclusions. Financial analysis and interpretation has become an important area of financial
management.

4. Cost –Volume –Profit Analysis: Cost-volume-profit analysis is an important tool of profit

planning. The costs may be subdivided as: fixed costs, variable costs and semi-variable costs. Fixed
costs remain constant irrespective of changes in production. An increase or decrease in volume of
production will not influence fixed costs. Variable costs, on the other hand, vary in direct
proportion to change in production. Semi-variable remain constant for a period and then become
variable for a short period.

5. Capital Budgeting: Capital budgeting is the process of making investment decisions in capital
 Expenditures. It is an expenditure the benefits of which are expected to be received over a period of
time exceeding one year. Capital budgeting decisions are vital to any organization. An unsound
investment decision may prove to be fatal for the very existence of the concern.

6. Working Capital Management: Working capital is the life blood and nerve center of business.
Justas circulation of blood is essential in the human body for maintaining life, Working capital is
essential to maintain the smooth running of business. No business can run successfully without an
adequate amount of working capital. Working capital refers to that part of the firm’s capital which
is required for financing short term or current assets such as cash, receivables and inventories. It is
essential to maintain a proper level of these assets.

7. Profit Planning and Control: Profit planning and control is an important responsibility of the
financial manager. Profit maximization is, generally, considered to be an important objective of a
business. Profit is also used as a tool for evaluating the performance of management. Profit is
determined by the volume of revenue and expenditure.

8. Dividend Policy: Dividend is the reward of the shareholders for investments made by them in
the share of the company. Their investors are interested in earning the maximum return on their
investment where as management wants to retain profits for further financing. The company
should distribute are asonable amount as dividends to its members and retain the rest for its
growth and survival.

Sources of Finance

Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and
control, and their source of generation.

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20
years or maybe more depending on other factors. Capital expenditures in fixed assets like plant
and machinery, land and building etc of a business are funded using long-term sources of
finance. Part of working capital which permanently stays with the business is also financed with
long-term sources of funds. Long-term financing sources can be in form of any of them:

 Share Capital or Equity Shares

 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
.
Medium Term Sources of Finance
Medium term financing means financing for a period of 3 to 5 years and is used generally for
two reasons. One, when long-term capital is not available for the time being and second when
deferred revenue expenditures like advertisements are made which are to be written off over a
period of 3 to 5 years. Medium term financing sources can in the form of one of them:

 Preference Capital or Preference Shares

 Debenture / Bonds
 Medium Term Loans from
o Financial Institutes
o Government, and
o Commercial Banks
 Lease Finance
 Hire Purchase Finance
Short Term Sources of Finance
Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing. Short term finances are available in the form of:

Sources of Finance

Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and
control, and their source of generation. It is ideal to evaluate each source of capital before
opting for it.

Sources of capital are the most explorable area especially for the entrepreneurs who are about
to start a new business. It is perhaps the toughest part of all the efforts. There are various
capital sources, we can classify on the basis of different parameters.

Having known that there are many alternatives to finance or capital, a company can choose
from. Choosing the right source and the right mix of finance is a key challenge for every finance
manager. The process of selecting the right source of finance involves in-depth analysis of each
and every source of fund. For analyzing and comparing the sources, it needs the understanding
of all the characteristics of the financing sources. There are many characteristics on the basis of
which sources of finance are classified.
On the basis of a time period, sources are classified as long-term, medium term, and short
term. Ownership and control classify sources of finance into owned capital and borrowed
capital. Internal sources and external sources are the two sources of generation of capital. All
the sources of capital have different characteristics to suit different types of requirements. Let’s
understand them in a little depth.

According to Time Period

Sources of financing a business are classified based on the time period for which the money is
required. The time period is commonly classified into following three:

LONG TERM MEDIUM TERM SHORT TERM

SOURCES OF SOURCES OF SOURCES OF
FINANCE / FUNDS FINANCE / FUNDS FINANCE / FUNDS

Share Capital or Equity Preference Capital or

Shares Preference Shares Trade Credit

Preference Capital or
Preference Shares Debenture / Bonds Factoring Services

Retained Earnings or
Internal Accruals Lease Finance Bill Discounting etc.

Advances received
Debenture / Bonds Hire Purchase Finance from customers

Medium Term Loans Short Term Loans like

Term Loans from Financial from Financial Institutes, Working Capital Loans
Institutes, Government, Government, and from Commercial
and Commercial Banks Commercial Banks Banks

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20
years or maybe more depending on other factors. Capital expenditures in fixed assets like plant
and machinery, land and building etc of a business are funded using long-term sources of
finance. Part of working capital which permanently stays with the business is also financed with
long-term sources of funds. Long-term financing sources can be in form of any of them:
 Share Capital or Equity Shares
 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
 International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR etc.

Medium Term Sources of Finance

Medium term financing means financing for a period of 3 to 5 years and is used generally for
two reasons. One, when long-term capital is not available for the time being and second when
deferred revenue expenditures like advertisements are made which are to be written off over a
period of 3 to 5 years. Medium term financing sources can in the form of one of them:

 Preference Capital or Preference Shares

 Debenture / Bonds
 Medium Term Loans from
 Financial Institutes
 Government, and
 Commercial Banks
 Lease Finance
 Hire Purchase Finance

Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing. Short term finances are available in the form of:

 Trade Credit
 Short Term Loans like Working Capital Loans from Commercial Banks
 Fixed Deposits for a period of 1 year or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.
Meaning of Ratio Analysis

Once the financial statements of an organization are prepared they then need to be analyzed.
One such tool to analyze and asses the financial situation of a firm is Ratio Analysis. It allows the
stakeholder to make better sense of the accounts and better understand the current fiscal
scenario of an entity. They are a comparison of two numbers with respect to each other. Similarly,
in finance, ratios are a correlation between two numbers, or rather two accounts. So two numbers
derived from the financial statement are compared to give us a more clear understanding of
them.

OBJECTIVES OF RATIO ANALYSIS

1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs
last year, how will you determine if that is a good or bad figure? Context is required to measure
profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio
etc provide a measure of profitability of a firm. The management can use such ratios to find out
problem areas and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and
other resources. It is important that assets and financial resources be allocated and used efficiently
to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any
mismanagement of assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So
the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm
maintain the required level of short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They help determine if
there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need
to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-
Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better
understanding of its financial health and fiscal position. The management can take corrective
action if the standards of the market are not met by the company. The ratios can also be
compared to the previous years’ ratio’s to see the progress of the company. This is known as trend
analysis.

Advantages of Ratio Analysis

 Ratio analysis will help validate or disprove the financing, investment and operating
decisions of the firm. They summarize the financial statement into comparative figures, thus
helping the management to compare and evaluate the financial position of the firm and the
results of their decisions.

 It simplifies complex accounting statements and financial data into simple ratios of operating
efficiency, financial efficiency, solvency, long-term positions etc.

 Ratio analysis help identify problem areas and bring the attention of the management to
such areas. Some of the information is lost in the complex accounting statements, and ratios
will help pinpoint such problems.

 Allows the company to conduct comparisons with other firms, industry standards, intra-firm
comparisons etc. This will help the organization better understand its fiscal position in the
economy.

Limitations of Ratio Analysis

 The firm can make some year-end changes to their financial statements, to improve their
ratios. Then the ratios end up being nothing but window dressing.

 Ratios ignore the price level changes due to inflation. Many ratios are calculated using
historical costs, and they overlook the changes in price level between the periods. This
does not reflect the correct financial situation.

 Accounting ratios completely ignore the qualitative aspects of the firm. They only take
into consideration the monetary aspects (quantitative)

 And finally, accounting ratios do not resolve any financial problems of the company. They
are a means to the end, not the actual solution.

MEANING OF WORKING CAPITAL

Working Capital refers to funds required to be invested in the business for a short period
usually upto one year. It is also known as short-term capital or circulating capital or working
capital. Working capital is sometimes known as circulating capital or revolving capital because
funds invested in current assets are continuously recovered through the realization of cash and
again reinvested in current assets. Thus, the amount keeps on circulating or revolving from cash
to current assets and back again to cash.

CONCEPTS / TYPES OF WORKING CAPITAL

On the basis of Concept :

a. Gross working capital: It refers to all the current assets taken together.
b. Net working capital : It is the surplus of current assets over and above current liabilities.
(i) A positive net working capital occurs when current assets exceed current liabilities;
(ii) A negative net working capital occurs when current liabilities exceed current assets. A
negative working capital implies -ve liquidity and the company is not likely to be able to payoff
even its current liabilities & hence may considerably damage its reputation. A weak liquidity
position is perceived as a threat to the solvency of the company.

II) On the basis oF Time :

a. Permanent capital:
i. Regular Working capital: It is the working capital required to ensure circulation of inventories.
ii. Reserve working capital: It is the excess amount over the requirement of regular working
capital which may be provided for contingencies.

b. Temporary working capital :

i. Seasonal working capital: It is required to meet seasonal demands.
ii. Special working capital: It is required to meet special occasion such as launching of extensive
marketing campaign.

Factors affecting working capital requirements

1.Nature of business: There are some business which require higher initial capital and lesser
working capital whereas some business require lower initial capital and larger amounts of
working capital.

2. Credit policy: Liberal credit policy will require higher and strict dividend policy will require low
working capital.
3. Production cycle: If length of production cycle is big it will require larger working capital and
vice versa.

4. Seasonal operations: Larger amounts of working capital is required for seasonal products
because they are produced once and sold throughout the year.

5. Inventory policy : If firm wishes to maintain higher stock levels then higher working capital is
required and if lesser amount of inventory levels are maintained, it will require lesser working
capital.

6. Business cycle fluctuations: During Boom, higher working capital is required and lesser
working capital is required during depression .

7. Working capital cycle : If the time gap between raw materials purchased and its conversion
into cash is big large working capital is required by the firm and vice versa.

Leverage
In generic sense leverage means influence of power i.e. utilizing the existing resources to attain
something else.
In finance it means the influence of independent financial variable on dependent financial
variable. It explains how the dependent variable responds to a particular change in the
independent variable. If X is an independent financial variable and Y is dependent financial
variable, then the leverage which y has with X can be assessed by the percentage change in Y to
a percentage change in X.
Percentage Change in Y/Percentage Change in X

Measures of Leverage
- Operating leverage
- Financial Leverage
- Combined/Total Leverage

I). Operating Leverage

Operating leverage examines the effect of the change in the quantity produced on EBIT of the
company and is measured by calculating Degree of Operating Leverage (DOL)
DOL = % change in EBIT/% change in SALES
DOL = CONTRIBUTION / EBIT
Inference: If DOL of a company is 3 it means, a 10% increase or decrease in the level of output
will increase or decrease the operating income by 30%.
Operating BEP (Q): F/(S-V) or
Fixed cost/Contribution

II). Financial Leverage

Financial leverage measures the effect of change in EBIT on the EPS of the company. Financial
leverage also refers to the mix of debt and equity in the capital structure of the company.
Financial leverage specifies

DFL = % change in EPS / % change in EBIT

DFL = EBIT / EBT
Financial Break Even DFL (EBIT amount)= EBIT

III). Combined / Composite Leverage

Combination of operating and financial leverages is the total combined leverage. Thus the
degree of total leverage (DCL) is the measure of the output and the EPS of the company. DTL is
the product of DOL and DFL.

DCL = % change in EPS / % change in output

DCL = DOL*DFL
=Contribution / EBT
Overall BEP (Q) = F + I + Dp /[(1-t)/ (S-V)]

ANALYSIS & INTERPRETATION OF FINANCIAL STATEMENT

What is a financial statement?

The term financial statement refers to statement of Changes in financial position, Statement of
Retained Earnings, Balance Sheet, Profit and Loss Account, etc. But, generally, the financial
statements include only two statements, they are profit and Loss Account and Balance Sheet.
The importance of these statements lies in their analysis and interpretation. In the beginning,
analysis was done only for extending credit, but now it is being used as most important function
of Management Accountant for providing various useful information to many persons

Meaning of Analysis
Analysis means the process of splitting or broken up of the contents of financial statements into
many parts for getting meaningful information at the maximum.
Meaning of Interpretation
Interpretation means explaining the meaning and significance of the rearranged and/or
modified data of the financial statements.

Procedure for Analysis and Interpretation

To make an effective analysis and interpretation of financial statements, the following
groundwork are required to be completed.

 The objectives of financial statement analysis are the basis for the selection of
techniques of analysis. Hence, the organization should decide the purpose of financial
statement analysis.

 The extent of interpretation is also decided to select right type of techniques of financial
statement analysis.

 The financial statements are prepared on certain assumptions, principles and practices
which are ascertained to understand their significance.

 The collected data should be presented in a logical sequence by rearrangement of data.

 Data should be analyzed for preparing comparative statement, common size statement,
trend percentage, calculation of ratios and the like.

Objectives of Analysis and Interpretation

 To measure the managerial efficiency under various business situations.

 To estimate the performance evaluation of different departments over a period of

time.

 To measure short term and long term solvency position of the business organization
with the help of Balance Sheet.

 To examine the source of finance and way of utilizing the available finance.

 To determine earning capacity and future prospects of the business concern.

 To identify the way of utilizing fixed assets and the role of fixed assets on maintaining
the earning capacity of the business concern.
Importance of Analysis and Interpretation

 Wrong and defective decisions are taken by the top management in the absence of
analysis and interpretation.

 Sometimes, hasty and intuitive decisions are also taken by the various responsible
executives.

 Analysis and interpretation are necessary to verify and examine the correctness and
accuracy of the decisions already taken on the basis of intuition.

Meaning of Funds Flow Statement:

Funds flow statement is a statement which discloses the analytical information about the
different sources of a fund and the application of the same in an accounting cycle. It deals with
the transactions which change either the amount of current assets and current liabilities (in the
form of decrease or increase in working capital) or fixed assets, long-term loans including
ownership fund.

This statement supplies an efficient method for the financial manager in order to assess the:
(a) Growth of the firm,

(b) Its resulting financial needs, and

(c) To determine the best way to finance those needs.

Objective of Preparing a Fund Flow Statement:

The main purpose of preparing a Funds Flow Statement is that it reveals clearly the important
items relating to sources and applications of funds of fixed assets, long-term loans including
capital. It also informs how far the assets derived from normal activities of business are being
utilized properly with adequate consideration.

Secondly, it also reveals how much out of the total funds is being collected by disposing of fixed
assets, how much from issuing shares or debentures, how much from long-term or short-term
loans, and how much from normal operational activities of the business.

Thirdly, it also provides the information about the specific utilization of such funds, i.e. how
much has been applied for acquiring fixed assets, how much for repayment of long-term or
short-term loans as well as for payment of tax and dividend etc.
 Significance and Importance of Funds Flow Statement:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit the
result of the operation and financial position of a firm. Balance Sheet presents a static view
about the resources and how the said resources have been utilized at a particular date with
recording the changes in financial activities. But Funds Flow Statement can do so, i.e., it
explains the causes of changes so made and effect of such change in the firm accordingly.

(b) Realistic Dividend Policy:

Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay dividend
due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow Statement helps the
firm to take decision about a sound dividend policy which is very helpful to the management.

(c) Proper Allocation of Resources:

Resources are always limited. So, it is the duty of the management to make its proper use. A
projected Funds Flow Statement helps the management to take proper decision about the
proper allocation of business resources in a best possible manner since it highlights the future.

(d) As a Future Guide:

A projected Funds Flow Statement acts as a business guide. It helps the management to make
provision for the future for the necessary funds to be required on the basis of the problem
faced. In other words, the future needs of the fund for various purposes can be known well in
advance which is a very helpful guide to the management. In short, a firm may arrange funds on
the basis of this statement in order to avoid the financial problem that may arise in future.

How to Prepare Fund Flow Statement ?

Steps in the preparation of Fund Flow Statement:
 First and fore most method is to prepare the statement of changes in working capital i.e., to
identify the flow of fund / movement of fund through the detection of changes in the volume
of working capital.
 Second step is the preparation of Non- Current A/c items-Changes in the volume of Non
current a/cs have to be prepared only in order to quantify the flow fund i-e either sources or
application of fund.
 Third step is the preparation Adjusted Profit& Loss A/c, which already elaborately discussed
in the early part of the section.
 Last step is the preparation of fund flow statement.
Cash Flow Statement
Share

What is a Cash Flow Statement?

A cash flow statement is the financial statement that measures the cash generated or used by a
company in a given period.

How does a Cash Flow Statement work?

A cash flow statement typically breaks out a company's cash sources and uses for the period
into three categories: --
 cash flow from operating activities,
 cash flow from investing activities, and
 cash flow from financing activities.
It is important to note that cash flow is not the same as net income, which includes transactions
that did not involve actual transfers of money(depreciation is common example of a noncash
expense that is included in net income calculations but not in cash flow calculations).

Cash flow from operating activities are generally calculated according to the following formula:

Cash Flows from Operations = Net income + Noncash Expenses + Changes in Working Capital

Because working capital is a component of cash flow from operations, investors should be
aware that companies can influence cash flow by lengthening the time they take to pay the bills
(thus preserving their cash), shortening the time it takes to collect what’s owed to them (thus
accelerating the receipt of cash), and putting off buying inventory .

How to Prepare a Statement of Cash Flows?

The operating section of the statement of cash flows can be shown through either the direct
method or the indirect method. For either method, the investing and financing sections are
identical; the only difference is in the operating section. The direct method is a method that
shows the major classes of gross cash receipts and gross cash payments. The indirect method,
on the other hand, starts with the net income and adjusts the profit/loss by the effects of the
transactions. In the end, cash flows from the operating section will give the same result
whether under the direct or indirect approach, however, the presentation will differ.

Cash Flow Classifications

1. Operating Cash Flow - Operating activities are the principal revenue-producing activities of
the entity. Cash Flow from Operations typically includes the cash flows associated with sales,
purchases, and other expenses.
The company’s chief finance officer (CFO) chooses between the direct and indirect presentation
of operating cash flow:

 Direct Presentation: Operating cash flows are presented as a list of cash flows; cash in
from sales, cash out for capital expenditures, etc. Simple but rarely used method, as the
indirect presentation is more common.
 Indirect Presentation: Operating cash flows are presented as a reconciliation from profit
to cash flow:

Profit P
Depreciation D
Amortization A
Impairment expense I
2. Investing Cash Flow
Cash Flow from Investing Activities includes the acquisition and disposal of non-current assets
and other investments not included in cash equivalents. Investing cash flows typically include
the cash flows associated with buying or selling property, plant, and equipment (PP&E), other
non-current assets, and other financial assets.

Cash spent on purchasing PP&E is called capital expenditures (or CapEx for short).

3. Financing Cash Flow

Cash Flow from Financing Activities are activities that result in changes in the size and
composition of the equity capital or borrowings of the entity. Financing cash flows typically
include cash flows associated with borrowing and repaying bank loans, and issuing and buying
back shares. The payment of a dividend is also treated as a financing cash flow.

What is Cost Volume Profit Analysis (CVP Analysis)?

Cost Volume Profit Analysis (CVP Analysis) is an accounting technique which helps in identifying
the effect of sales volume and product cost on the operating profit of a business. Cost Volume
Profit analysis is also known as “Break Even Analysis”.

 Cost Volume Profit Analysis includes the analysis of sales price, fixed costs, variable
costs, the number of goods sold and how it affects the profit of the business.
  The aim of a company is to earn profit and profit depends upon a large number of
factors, most notable among them are the cost of manufacturing and the volume of
sales. These factors are largely interdependent.

 The volume of sales is dependent upon production volume which in turn is related to
costs which are affected by Volume of production, product mix, internal efficiency of the
business, production method used etc.

 CVP analysis helps management in finding out the relationship between cost and
revenue to generate profit.

 CVP Analysis helps them to determine the break-even point for different sales volume
and cost structures.

 With CVP Analysis information, the management can better understand the overall
performance and determine what units it should sell to break even or to reach a certain
level of profit.

Importance of Cost Volume Profit Analysis

CVP analysis helps in determining the level at which all relevant cost is recovered and there is
no profit or loss which is also called the breakeven point. It is that point at which volume of
sales equal total expenses (both fixed and variable). Thus CVP analysis helps decision makers
understand the effect of a change in sales volume, price and variable cost on the profit of an
entity while taking fixed cost as unchangeable. CVP Analysis helps in understanding the
relationship between profits and costs on the one hand and volume on the other. CVP Analysis
useful for setting up flexible budgets which indicate costs at various levels of activity. CVP
Analysis also helpful when a business is trying to determine the level of sales to reach a
targeted income.

Benefits of Cost-Volume Analysis (CVP)

1. CVP analysis provides a clear and simple understanding of the level of sales which are
required for a business to break even (No profit No loss), level of sales required to
achieve targeted Profit.

2. CVP analysis helps management to understand the different cost at different levels of
production/sales volume. CVP analysis helps decision makers in forecasting cost and
profit on account of change in volume.
 3. CVP Analysis helps business analyze during recessionary times the comparative effects
of shutting down a business or continuing business at a loss; as it clearly bifurcates
the Direct and Indirect cost.

4. Effects of changes in fixed and variable cost help management decide the optimum level
of production

Limitations of Cost-Volume Analysis (CVP)

1. CVP analysis assumes fixed cost is constant which is not the case always; beyond certain
level fixed cost also changes.

2. Variable cost is assumed to vary proportionately which doesn’t happen in reality.

3. Cost volume profit analysis assumes costs are either fixed or variable; however, in
reality, some costs are semi-fixed in nature. For example, Telephone expenses which
comprise a fixed monthly charge and a variable charge based on the number of calls
made.

BUDGETING & BUDGETARY CONTROL

MEANING - Budgeting is used by businesses as a method of financial planning for the future.
Budgets are prepared for main areas of the business – purchases, sales (revenue), production,
labour, trade receivables, trade payables, cash – and provide detailed plans of the business for the
next three, six or twelve months. The focus of this chapter is the cash budget. In this chapter we
shall be examining:

• the benefits of budgets and budgetary control

• the limitations of budgets and budgetary control

• the preparation and use of cash budgets.

BENEFITS OF BUDGETS AND BUDGETARY CONTROL

Budgets provide benefits both for the business, and also for its managers and other staff:
i). The budget assists planning - By formalizing objectives through a budget, a business can
ensure that its plans are achievable. It will be able to decide what is needed to produce the
output of goods and services, and to make sure that everything will be available at the right
time.
ii).The budget communicates and co-ordinates Because a budget is agreed by the business,
all the relevant managers and staff will be working towards the same end. When the budget
is being set, any anticipated problems should be resolved and any areas of potential
confusion clarified. All departments should be in a position to play their part in achieving
the overall goals.

iii).The budget helps with decision-making By planning ahead through budgets, a business
can make decisions on how much output – in the form of goods or services – can be
achieved. At the same time, the cost of the output can be planned and changes can be
made where appropriate.

iv).The budget can be used to monitor and control An important reason for producing a
budget is that management is able to use budgetary control to monitor and compare the
actual results (see diagram below). This is so that action can be taken to modify the
operation of the business as time passes, or possibly to change the budget if it becomes
unachievable.

v).The budget can be used to motivate A budget can be part of the techniques for
motivating managers and other staff to achieve the objectives of the business. The extent to
which this happens will depend on how the budget is agreed and set, and whether it is
thought to be fair and achievable. The budget may also be linked to rewards (for example,
bonuses) where targets are met or exceeded

LIMITATIONS OF BUDGETS AND BUDGETARY CONTROL

There are a number of limitations of budgets to be aware of:

i). The benefit of the budget must exceed the cost - Budgeting is a fairly complex process
and some businesses – particularly small ones – may find that the task is too much of a
burden in terms of time and other resources, with only limited benefits. Nevertheless, many
lenders – such as banks – often require the production of budgets as part of the business
plan. As a general rule, the benefit of producing the budget must exceed its cost.

ii).Budget information may not be accurate - It is essential that the information going into
budgets should be as accurate as possible. Anybody can produce a budget, but the more
inaccurate it is, the less use it is to the business as a planning and control mechanism. Great
care needs to be taken with estimates of sales – often the starting point of the budgeting
 process – and costs. Budgetary control is used to compare the budget against what actually
happened – the budget may need to be changed if it becomes unachievable.

iii). The budget may demotivate - Employees who have had no part in agreeing and setting a
budget which is imposed upon them, will feel that they do not own it. As a consequence,
the staff may be demotivated. Another limitation is that employees may see budgets as
either a ‘carrot’ or a ‘stick’, ie as a form of encouragement to achieve the targets set, or as a
form of punishment if targets are missed.

iv). Budgets may lead to dysfunctional management - A limitation that can occur is that
employees in one department of the business may over-achieve against their budget and
create problems elsewhere. For example, a production department might achieve extra
output that the sales department finds difficult to sell. To avoid such dysfunctional
management, budgets need to be set at realistic levels and linked and co-ordinate across all
departments within the business.

V). Budgets may be set at too low a level - Where the budget is too easy to achieve it will be
of no benefit to the business and may, in fact, lead to lower levels of output and higher
costs than before the budget was established. Budgets should be set at realistic levels,
which make the best use of the resources available.

Capital Structure
Meaning and Concept of Capital Structure:
The term ‘structure’ means the arrangement of the various parts. So capital structure means
the arrangement of capital from different sources so that the long-term funds needed for the
business are raised.
Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-term
sources of funds in the total amount of capital which a firm should raise to run its business.
Definition “Capital structure is the combination of debt and equity securities that comprise a
firm’s financing of its assets.”—John J. Hampton.

Importance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.
 2. Utilization of available funds:

A good capital structure enables a business enterprise to utilize the available funds fully. A
properly designed capital structure ensures the determination of the financial requirements of
the firm and raises the funds in such proportions from various sources for their best possible
utilization. A sound capital structure protects the business enterprise from over-capitalization
and under-capitalization.

3.Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much rising of debt
capital because, at the time of poor earning, the solvency is disturbed for compulsory payment
of interest to .the debt-supplier.

4. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that,
according to changing conditions, adjustment of capital can be made.

5. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business to be
diluted.

COST OF CAPITAL
Definition: As it is evident from the name, cost of capital refers to the weighted average cost of
various capital components, i.e. sources of finance, employed by the firm such as equity,
preference or debt. In finer terms, it is the rate of return, that must be received by the firm on
its investment projects, to attract investors for investing capital in the firm and to maintain its
market value.

The factors which determine the cost of capital are:

 Source of finance
 Corresponding payment for using finance.
On raising funds from the market, from various sources, the firm has to pay some additional
amount, apart from the principal itself. The additional amount is nothing but the cost of using
the capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals.
 Importance of Cost of Capital

 It helps in evaluating the investment options, by converting the future cash flows of the
investment avenues into present value by discounting it.
 It is helpful in capital budgeting decisions regarding the sources of finance used by the
company.
 It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is
maximum, and the cost of capital is minimum.
 It can also be used to appraise the performance of specific projects by comparing the
performance against the cost of capital.

Classification of Cost of Capital

1. Explicit cost of capital: It is the cost of capital in which firm’s cash outflow is oriented towards
utilization of capital which is evident, such as payment of dividend to the shareholders, interest
to the debenture holders, etc.
2. Implicit cost of capital: It does not involve any cash outflow, but it denotes the opportunity
foregone while opting for another alternative opportunity.

CAPITAL BUDGETING
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain
the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization would like to invest
in all profitable projects but due to the limitation on the availability of capital an organization
has to choose between different projects/investments.

Objectives of Capital budgeting

1. Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital
restrictions, an organization needs to select the right mix of profitable projects that will
increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However,
controlling capital costs is also an important objective. Forecasting capital expenditure
requirements and budgeting for it, and ensuring no investment opportunities are lost is the
crux of budgeting.

3. Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is another important
objective of capital budgeting. Finding the balance between the cost of borrowing and returns
on investment is an important goal of Capital Budgeting.

Capital Budgeting Process

The process of capital budgeting is as follows:

1. Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment opportunity
can be anything from a new business line to product expansion to purchasing a new asset. For
example, a company finds two new products that they can add to their product line.

2. Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its
options for investment. That is to say, once it is decided that new product/products should be
added to the product line, the next step would be deciding on how to acquire these products.
There might be multiple ways of acquiring them. Some of these products could be:

 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchased from the market

3. Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an
organization needs to decide the most profitable investment and select it. While selecting a
particular project an organization may have to use the technique of capital rationing to rank the
projects as per returns and select the best option available.
In our example, the company here has to decide what is more profitable for them.
Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring
both.
4. Capital Budgeting and Apportionment
After the project is selected an organization needs to fund this project. To fund the project it
needs to identify the sources of funds and allocate it accordingly.
The sources of these funds could be reserves, investments, loans or any other available
channel.

5. Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially, the
organization had selected a particular investment for a predicted return. So now, they will
compare the investments expected performance to the actual performance.
In our example, when the screening for the most profitable investment happened, an expected
return would have been worked out. Once the investment is made, the products are released in
the market, the profits earned from its sales should be compared to the set expected returns.
This will help in the performance review.

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various techniques
available based on the comparison of cash inflows and outflows.
These techniques are:

1. Payback period method

In this technique, the entity calculates the time period required to earn the initial investment of
the project or investment. The project or investment with the shortest duration is opted for.

2. Net Present value

The net present value is calculated by taking the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. The investment with a
positive NPV will be considered. In case there are multiple projects, the project with a higher
NPV is more likely to be selected.

3. Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average
investment to derive at the most profitable investment.

4. Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero.
The project with higher IRR is usually selected.

5. Profitability Index
Profitability Index is the ratio of the present value of future cash flows of the project to the
initial investment required for the project.
Each technique comes with inherent advantages and disadvantages. An organization needs to
use the best-suited technique to assist it in budgeting. It can also select different techniques
and compare the results to derive at the best profitable projects.