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Module 1: Scope of Financial Management

Topic No.1: Functions of Financial Management

• Financing Activities

• Investing Activities

• Asset Management (Working Capital Management)

• Financial Analysis

The first discussion of this course of Financial Management is scope of financial

management.
If we have a look at the title of this course that is financial management we see that
it is a combination of two words or two terms the “finance” and “management”
where finance means money, funds, dollars, rupees and management is a process
through which these funds or these rupees and dollars are managed by an
organization.

The scope is actually something that defines the boundaries of the scores meaning
that what is included in this course.
We will talk about financial management we are referring to certain topics that we
need to study that we need to learn because nothing is limitless, nothing is beyond
the boundaries and what financial management includes is a discussion in this
module 1.

Functions of financial management include four activities or you can say there
are four functions:

These four activities are to be performed by the finance manager or we can say that
this is the scope of Finance Department. The people working in a finance
department of an organization and obviously when we teach this course this is
what we teach to our students this is what the need to learn so that once they get
into an organization of business organization, Finance Department then they
should be in a position to take care of these activities.
The first one is what we called financing activities. In later lectures we will go into
the depth of these activities one by one and we will explore them.
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So, if I say that these four activities is basically the Crux of this Poll of this course
it won't be incorrect.
So I will talk about the first one that is:
Financing activity:
It simply means that every business organization whether it is an organization
which is already operational or I am talking about a new business to be started by
some people what is required if financing fund money without which it is not
possible to start a new business or even a continue business to be taken forward.
So when we talk about financing activity there are certain things which are
included in these activities and as a finance manager, we have to see that what are
these activities which are collectively termed as Financing activities as I see that it
is arranging finance, arranging finance is means that we need to get financing from
some sources.
When we talk about a business organization, one thing is for sure we cannot run
this business if we do not have enough financial resources. So how do we get it?
The first thing that comes to our mind is that we have our own money that we have
somehow generated from various sources. So we call it “equity”.
The equity of the people who are the owners of that business. Certainly yes, equity
is the First Source and the main source of Financing of any business, once the
equity is generated when the second source of Financing is Rooted that means
borrowing taking a loan, taking money and friends from people who are not the
owners of the organization, meaning that we have to get money from banks and
other financial institutions.

Investing activity:

We need to put these funds in the most efficient and effective manner so that we
get the maximum return out of it.

The second part of the activities of Financial Management is investment and these
investments are long term as well as short.

The third discussion of Financial Management is a function of the financial

management or the activity is:

Asset Management/Managing the current asset:

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We call it managing the working capital or we just call it Asset Management and
when will go into the details we see that how this working capital in the elements
are managed.

Financial Analysis:

Finally we get into what is called “financial analysis” that means whatever we
have done as a business organization before ultimately we need to analyze whether
we were good, we were very good, excellent, or we were bad or we did the lack or
where we need to improve. So, this basically is what we call the scope of financial
management and in later discussions will be all around these four activities.

Module 1: Scope of Financial Management

Topic No.2: Financing Activities-I

• Sources of Financing

• External Financing

• Internal Financing

• Types of Financing

• Equity Financing

• Debt Financing

• Time Period of Financing

• Long Term Financing

• Equity

• Cost of Financing
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Financing activities are about arranging finances for a business organization and
when we talk about arranging finances we need to look at the sources of finances.
Source means from where we get money and when we look at those sources we
say that we can classify those resources as: external sources/financing and
internal sources/financing.
But mainly, however a business is to be initiated or when a business is to be started
there are no internal sources because at the beginning we have got only external
sources.

External financing is the one on which a business has to rely mainly. Now what is
included in external financing and what do we mean by external financing that is
external to what?

There is a concept in accounting which is called the concept of separate business

entity and we need to know very well that every business organization is different
from its owners that are if I own a company I am not the company myself.

The company is a different entity and the business is a different entity. So anything
which is not a company is external to the company meaning that the people who
are the owners of the company are also external to that company or Money, funds
provided by them is the external sources.

In other words, the business owner and the business are two separate entities. Their
accounting should be kept separately. Transactions performed by the business are
separate from those performed by the business owners. For example, if an owner
purchased an asset for their personal use, the asset may not be considered the
property of the business.

Types of Financing:

So in this external source of Financing, we have got two major sources;

The first one is the sources and the funds which are provided by the owners of the
business and when it is a small business obviously it is the person who is doing the
business when it is even a little bigger business or doing in the form of partnership
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as they are providing money so they are the ones who are contributing in this
which is called Equity Financing.

As Equity financing means someone is putting money or assets into the business in
exchange for some percentage of ownership.

But when we talk about the corporation as our course will be mainly focused to.

SO here the equity providers are the shareholders, the people who purchase small
components of equity and other than equity we have get. That is a loan, that is the
amount that we are taking from some sources, or sources who are not the owners
of our business but who are the lenders to the business which is called Debt
Financing.

As Debt financing means you’re borrowing money from an outside source and
promising to pay it back with interest by a set date in the future.

Here our relation with them is of borrower and lender as they give us
money/financing and we will return them with interest.

In financing, next thing is to consider time period of financing. It means that

financing can be short term or long term or mix of both of them.

If the financing is for a year or less than a year then it is called short term
financing. And if it is more than a year then it is called long term financing. The
needs of the business are different. So accordingly, finance manager has to see
whether the requirement suits a short term financing or long term financing.

There is a difference between short term and long term financing.

Short term financing is generally cheaper. It means that the cost of financing is
lesser. The cost of financing means the return that we have to pay to the people
who are providing us this financing. If a person who is giving us financing as
equity funds (I.e., as a shareholder) then the return we are giving to the person is
called the profit that is distributed.

The term we use for it is the dividend. Or if any group or any bank or organization
is giving us financing as a lender then they return that we pay to this
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person/institution is what we call interest or markup or sometimes profit

sharing.

But if it is long term financing, this return is higher than short term financing, this
return is lower in percentage.

So if an organization is having more long term financing then they need or bear
more cost which is obviously not the desired objective of the organization.

By the way, we will talk about again and again that the prime objective of every
business organization is to make profit or is to enhance returns or increase the
wealth of organization. And keeping this objective in mind all these activities are
to be performed and all these decisions are to be made.

In next, we will see that working capital in itself is short term requirement.

The last term in financing activities in part 1 is “Cost of financing” as I have

already touched upon it. Cost of financing means that it is the return that we have
to pay to the fund provider

Module 1: Scope of Financial Management

Topic 3: Financing Activities-II

• Equity Financing

• Common Shares

• Features and Rights

• Preferred Shares?

• Types and Features

• Dividend

• Nature, needs and types

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• Profit (Internal Financing)

In this lecture, we are discussing the scope of financial management and we have
talked about the financing activity and in this module we will continue with our
discussion on financing activity.

Equity Financing:

As we discussed that the internal sources of Financing are equity and debt.

The ownership rights and the lending rights, (Equity financing) the people who
give us their money as owners, we give them share, (Debt financing) the people
who give us money in the form of loan or they lend this money either they become
our lenders or they become bond holders.

And we will discuss bonds later on.

Equity is basically generated through the issuance of what we call common share.

Common shares:

Common shares is a term which is used for the ownership rights which are given
to those people who actually become the risk taker in an organization and owner is
the person who gets the profit and owner is a person who has to face the loss.

The Common shareholders are actually the people who are the ones who will take
all that risk.

The term share simply means a piece of capital, a share of capital that is if I divide
the total amount of capital in a business, suppose it is a million rupees then in how
many pieces I am dividing this capital.

Let’s say, if 1 million rupees capital is divided into one hundred thousand pieces
then one piece will have a value of 10 rupee. This is one share and with some
attributes it is called common share.

Common share is the share which gives a person, the right of ownership of that
business. In addition to this, common shareholders have some other rights which
we will discuss in the later parts of our discussion but very quickly we have just
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touched upon them it is that is further shares are to be issued by the company then
the common shareholders have the first right on them.

Preferred shares:

Similarly if the decisions are to be made at the level where all shareholders have to
contribute then they also give their opinion about various decisions that are to be
made. But common shareholders are in line just behind another type of share
which is called preferred shares.

Common shareholders are the fund providers so as the preferred shareholders.

Preferred shareholders are not the owners of that organization.

In that true sense, as the common shareholders are, and preference shareholders
have gotten certain preferences and that is why these are called preference or
preferred shareholder.

What are these preferences?

First one preference for preferred shareholder is that Preference shareholders are
given profit that is dividend before the common shareholders.

That is, if a company has some profit and wants to give dividend, then the
preference shareholders are first in line to get that ever and the common
shareholders will get the dividend after that.

And suppose if no profit is left afterwards and certainly common shareholders will
not get anything. So, this is one preference that preferred shareholder get.

And second preference they get is what is called during the process of liquidation.
When a business goes into liquidation, when a businesses are to be shut down or
companies are to be liquidated then profit shareholders are the first right on the
funds of the company.

So they are better or they are safer but in spite of this, preferred shareholders get
dividend or profit at as given rate which is generally less than what the common
shareholders get.

So the preferred shareholders get a fixed rate of dividend or profit.

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If a company is earning more or if a company has a lot of profit then preferred

shareholders will have that fixed rate of return whereas the common shareholders
will have a lot more than that.

Both get profit in the form of dividend or we can call it as the distribution of profit
in the form of dividend.

And we will have a detailed discussion on dividend policy in our course of

financial management detail later on. But here what I want to mention is that
dividend is the distribution of profit. It is annual and at times, it is also interim
dividend.

Interim means somewhere in between the year.

An interim dividend is the distribution of earnings to shareholders before the end

of the fiscal year. Such dividends are typically paid out monthly or quarterly and in
smaller amounts than an annual dividend.

There are many types of preferred shares that we will learn later on.

And profit which is earned by the company is the last thing that is the internal
source of financing and we will highlight and discuss it later.

Module 1: Scope of Financial Management

Topic 4: Financing Activities-III

• Debt Financing

• Types of Debts

• Public Issue

• Private Loans and Financing

• Types of Interest and its Base

• Fixed verses Floating Rate

• KIBOR or Prime Rate

• Financial Leverage
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We have discussed that finances are essential for any business organization. And
financial management includes arranging these finances from different sources
i.e., external & internal and then from equity & debt. We talk about equity
financing where we discussed common shareholders & preferred shareholders who
provide financing to a business organization.

And now the second part is related to what is called debt financing. Again debt
financing is divided into two portions or we can say that we can classify debt
financing into two;

One is that type of debt which is taken from one organization (i.e., bank, financial
institution, leasing company or any other similar financial institution) and the other
type of debt financing which is generated from the general public meaning that a
small amount or small contribution is taken from individuals and collectively it
makes the total amount of debt that we require.

If I give a simple example, suppose again if in our business’ entity, we need one
million rupees so one way to get this 1 million is to go to a bank and ask it in term
of loan and get 1 million rupees.

And the second is that we ask the general public to purchase a security at debt
security which is called bond which is a generic term used for it. And every person
will purchase a bond of Rs.100 will contribute towards a debt. And once we issue
10,000 bonds, each of Rs.100 we will be able to generate 1 million rupees. This is
what is called a public debt.

Now what is difference between a loan and public debt?

A bank is basically what is called a financial intermediary that is the money is,
the financing is actually with the people who have got this saving and the
requirement is with the business organization but directly the people cannot
approach this business organization so they deposit their money in banks and
banks have funds which they ultimately distribute as loans to various business
organizations. So they act as intermediary.

But that is a business of a bank.

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How these banks earn money? They give returns to their depositors at fewer
rates whereas they give loan to business organizations at high rates. And they earn
profit from this difference of rates. This is what we call spread of a bank.

When a business directly goes to people for financing or debt financing in the form
of bond then it generates money directly by eliminating that intermediary. We will
talk about it in detail in the later parts of a course.

The interest that we have to pay as return on the debt is sometimes fixed at the time
of deal, at the time of taking loan or at the time it is returned at the fixed
percentage.

Many times this rate of return that we call interest is usually linked to some other
rate. For example, many a times it is linked with what is called KIBOR.

KIBOR stands for Karachi Interbank Offered Rate which is every day, the rate
has been announced and banks would relate a certain plus percentage to KIBOR
and so the final interest rate is determined.

Similarly, banks would always also relate to what is called Prime rate of return.
The prime rate is the best rate or the minimum rate of interest that a bank would
offer to somebody that is called the prime rate.

So an organization want to get financing from a bank, they will have to pay
something plus that prime rate. So the floating rate of interest is one that keeps on
changing because of the KIBOR, because of the underlined percentage rate.

If KIBOR is changing then your interest to be paid will also be changed because
bank is charging let’s say 3% above KIBOR, and if the KIBOR is 7% then we have
to pay 10% and if the KIBOR is 6% then we have to pay 9%. SO in this way, the
rate of interest to be determined is called floating rate of interest.

The next important discussion that we will discuss in detail that is what is called
financial leverage.

The debt or loan, when a business organization takes loan or debt or borrows then
there is a general question that it is good or bad. Then some people would say, no it
is bad, it is not good to take a loan. But it is not true; it is good to take a loan
because it creates what is called financial leverage.
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And again we will have more detailed discussion on financial leverage but at this
point let me explain the basic concept of financial leverage.

Financial leverage is simply difference between what we have to pay to the fund
provider. The rate of interest that we pay to bank on given loan and invest this loan
in our business and the profit that we earn on it and when if this profit is more than
that interest rate then financial leverage created.

That is, if you are borrowing at 10% per annum and we are earning 15% on that
amount of loan then this additional 5% that we have earned would be added to the
profit of shareholders/equity holders and their rate of return will be enhanced
because of this loan that they have taken from a bank or a financial institution.

So it is good to have financial leverage but there are some questions marks.

There are some conditions that we need to see that while we are creating a leverage
in a firm and that condition is that how much is the rate of interest that we are
paying and how much is the capacity of an organization to earn because a positive
difference creates a financial leverage but a negative difference would create this
opposite leverage and hence would make effect the return of the equity holders.

Module 1: Scope of Financial Management

Topic 5: Investing Activities-I

• Term of Investments

• Long Term Investments

• Short Term Investments

• Rate of Return

• How much should we earn?

• Investing outside the Business

• Stock Markets

• Other Markets
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• Lending and other options

In this course of financial management, we discussed that financial management is

about arranging finances and then investing these funds. When we collect money
from different sources we talked about that an equity financing. The next step is to
invest this financing effectively.

And we say the effective investment means that it has to be invested in a way that
it gives us the required rate of return.

The required rate of return again is a benchmark, it is you can say that it is a
minimum level of the return that we want to have because on the other hand we
have a certain cost of financing.

We talked about cost of financing, when we are arranging funds then during such
finances/funds arrangement, we have to pay some return on this financing as a
business organization. It is cost of financing for us either it is equity cost or it is
cost of debt.

Now we have to earn enough profit on these money/funds such that we can meet
such cost of financing. And for that we have to invest our funds in the most
effective manner that we are able to earn enough on that.

Now, the investment that we make is the distribution of those funds in

different assets.

Suppose when we start any manufacturing business then it is obvious that we will
have to buy land, will do some construction of building, then we will have some
plant and machinery and equipment and vehicles. So the funds will be invested in
these assets.

But once the plant and machinery get ready, we will need to do further investment
or funds to earn money or run this plant. And that investment is in short term
form that is current asset i.e., electricity bill to run machinery which is a short term
investment, we have to buy raw material which is a short term investment, we have
to give money to labor that is a short term investment.

So our investment either it goes into long term which are called capital assets. The
technical term that we use for them is property, plant and equipment. It is not just
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three assets but it is a combine term means used for those fixed assets that are used
in the operations of business.

Here those fixed assets which are not using in the operations of business which are
called non-operating fixed assets. And these are not included in property, plant
and equipment but we have to do investment in them also.

Suppose capital work in progress means such building which is under

construction or such plant or machinery is under construction and is not in our use.
That is non-operating fixed asset in which we have to invest.

Now what return we expect from our investment?

As I said that the return has to be matched with the cost of financing or cost of
funds. If our cost of financing is less then we can survive on less rate of return.

The required rate of return is that rate of return which we want to earn from the
operations of our business.

Other than our business, which money we have, the prime objective is firstly that
money should be invested in the core activity of our business. Suppose we are
doing business of textile, then this money should be invested in the textile
production that we have arranged.

But if I got surplus funds which are short term funds so many times we do lend
this money, means this lending is investment for us. This lending is not those that
we have taken from people but this is one that we give it to someone and getting
return on it.

Similarly, we can invest our money from capital market to other markets. As
stock exchanges that is such a market where people buy or sell debt or equity
securities.

So if a business organization has funds, surplus funds then can invest those funds
in stock exchanges or in other markets like commodity markets (A commodity
market involves buying, selling, or trading a raw product, such as oil, gold, or
coffee.) or bullion markets (A bullion market is a market through which buyers
and sellers trade gold and silver.) but this decision is to be made by the finance
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team, the finance manager or the department that when and how much funds are to
be invested in which type of investment.

Module 1: Scope of Financial Management

Topic 6: Investing Activities-II

• Long Term Investments

• Capital Budgeting

• Discounted Cashflow Methods

• Marketable Investments

• Capital Markets www.psx.com.pk

• Money Markets

• Indirect Investment

• Mutual Funds www.mufap.com.pk

As we have started our discussion on Investing Activities and we have seen that it
is extremely important for any business organization to effectively invest the funds
that are generated from different sources. Otherwise, the businesses will not be
profitable and we will not be able to meet the cost of financing or cost of funds.

We have also discussed that investments can either be short term or long term.

When investments are to be done in long term business then it involves more
risk. Here Risk is an uncertainty because it is something which is related to
future i.e., in future what will be our return either it will be equal to our expected
return or it will be less or more than it.
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So if there is probability, if there is a chance that we may earn more or less than
what we expect, we can say that there is an element of risk in it. So when we are
making our investments for long term so we are committing many for a long
period that is many years and if it is not profitable then the results will be seen after
a few years and there will be no time for us to recover.

And that is why, in financial management we have to planned our long term
investments and what we do is we do is capital budgeting. Capital budgeting is a
technique which is used in making long term investments wherever it lies every
long term investment in terms of cash flows. The term of cash flow, simply means
that the cash inflow and the cash outflow. If our organization is giving
money/funds to someone or money is going from us then it is called cash outflow.
And if we are taking money from someone for our organization then it is called
cash inflow.

Why would we pay when we are purchasing something or we are incurring

expenses?

When we do long term investments then there is a cash outflow. And this cash
outflow has to be returned in the future with additional return. So in capital
budgeting, we use some methods through which we do analysis of our long term
investments. And these are called discounted Cash flow methods.

The term discounted means that these methods used to calculate the present values
of those cash flows which will be generated in the future and then we make our
analysis on the basis of results of these methods.

The four common methods that we will discuss in the detail in later part of our
course are: IRR (Internal Rate of Return), NPV (Net Present Value), PI
(Profitability Index) and Payback Period Method.

When an organization is making investment outside its core business activities then
this investment can be done in stock exchanges or stock market. In Pakistan, we
had three stock exchanges that now we have talk one stock exchanges which is
called Pakistan Stock Exchange.
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This is the website of Pakistan Stock Exchange: www.psx.com.pk where you can
find all the details which are related to stock markets’ operations, rates, changing
rates, value etc. that we will discuss in future.

The second investment which is called a short term investment that is in the
Money Market.

Money market is not as the term operating same as the market of currency but it is
a term which is used for making short term investments. If we want to invest for
short period (i.e., for one week or one day or one month or 4 months or for few
months etc.) then we invest in Money Market.

And other way of making our investment is through what is called Mutual Fund.
A Mutual Fund is an organization where many people pool/collect their money
and then they invest this collected amount in export & stock markets and in real
estate markets, investments trusts, in commodity markets, in bullion markets and
try to earn profit from these investments. So Mutual Fund is a more secure way
of making your investments as these is an element of risk is lesser than
individual investments.

There is another organization that is called Mutual Funds Association of

Pakistan (MUFAP) whose website is given as: www.mufap.com.pk where you
can go and can see how these mutual funds actually works and the different mutual
funds which are operating in Pakistan and what are the benefits of making
investments through Mutual Funds.

But there is a variety of Mutual Funds and basic classification which is there is in
the Mutual Fund is what is called Closed-end and Open-end Mutual Funds.

Those mutual funds whose share capital is once fixed are called Closed-end
mutual funds and one can buy the shares of such mutual funds and make
investments. And others are Open-end mutual funds where we can continue to
make as much investments as we want.

Module 1: Scope of Financial Management

Topic 7: Asset Management (Working Capital Management)-I

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• Why Working Capital is Required?

• Major Components of Working Capital

• Inventories/Stocks

• Receivables

• Cash

• Gross and Net Working Capital

• Working Capital Ratios

• Current Ratio/Acid Test Ratio

• Cash Cycle/Credit Cycle

Working Capital is actually that part of our investment which is made in current
assets.

Why do we need Working Capital?

Whenever we make an investment in a business, a major chunk of our investment

goes into Capital assets (i.e., property, plant & equipment) but when to utilize
those property, plant & equipment fixed assets to make profit, we have to put
money in what we call Working Capital.

Working Capital has got two basic terms: one is the Gross Working Capital
and other one is the Net Working Capital.

Gross Working Capital is simply own the current assets(I.e., cash, accounts
receivable/customers’ unpaid bills, inventory of raw material, finished goods etc.);
the value of all current assets is what is called the gross working capital. And if we
subtract the value of current liabilities (I.e., accounts payable, income tax, rental
fees, utilities, debts etc.) out of current assets what we get is Net Working Capital
(NWC).
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Net Working Capital = Current assets (minus cash) – Current liabilities (minus
debt)

What is the importance of this Working Capital?

It is said that Working Capital is like the blood in the body of business
organization. As if there is no blood movement in the body then this body is dead
and similarly there is no circulation of working capital then that business
organization will also become dead. So without working capital, there is no way
that a business can be operated.

Now this amount that we generated from different sources will go into the full
components of working capital and there are three major components which are
Inventory/Stock, Receivable and Cash or cash equivalence.

Inventories means that the stocks which are kept in the business for the purpose of
re-sale. If a business is into what is called manufacturing or trading business then it
purchases or manufactures some things and then sale it (they are some products).
They are the inventories in that organization; they will be stocks (i.e., raw material
stocks, stocks of work in process/incomplete, stocks of finished goods).

Other than them, some inventories are those that are internally consumed (I.e.,
stores, & spare and used tools) on which we also spend working capital.

Our working capital is also used in accounts Receivables. When we sell our
products or services and this sell is not on cash but on credit (means today we will
provide our product or service but its cash of return will be paid in future). This
amount is kept as Receivable till we get that cash/return.

Receivable are actually our investment that we have given to somebody for certain
period of time. It is an asset or it is an amount which will be recovered in the
future.

Need: And if we want to do business then we have to sell products or services on

credit and when we will sell on credit then accounts Receivable arises and our
money will be invested in this component of working capital.

Similarly, we also need Cash, we always need cash as it is the power of the
business organization because we have to pay our expenses, salaries, installments
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or loan or other things so cash is extremely important for any business

organization.

But how much cash should be kept in the business? Because more cash means
that it is un-invested. The more cash we will hold which means that we have that
cash without investment which results that it does not earn further profit for our
business.

So, how to manage cash or what amount should be invested in business? It is

our part of discussion of working capital management.

When we see working capital management in relative analysis, then there are some
ratios through which we do analysis of working capital. Most common ratios are:
Current Ratio/Acid Test Ratio and Cash Cycle/Credit Cycle.

The third component or third function of finance manager is to manage

Working Capital. That is to manage inventories and receivables and cash. We
will see that what are the instruments and tools which are used to manage all these
three major components of working capital.

Although, we have some other components of working capital and If we see the
report of any business organization then we can see some other things in working
capital or current assets but these will not be more significant.

Module 1: Scope of Financial Management

Topic 8: Asset Management (Working Capital Management)-II

• Inventory Management

• Types of Inventories

• Stock in Trade

• Stores and Spares

• Types of Stock in Trade

• Raw Material
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• Work in Process

• Finished Goods

• Cost of Inventories

• Carrying Cost

• Ordering Cost

We have talked about Working Capital Management as the management of three

major components of working capital which are inventories, receivables and
cash.

The finance department or finance manager has to manage all these components.
When we say this then by management we mean that it should be the most
profitable way of handling these three components. It means that our investments
should be enough in our inventories that will be more profitable for us which
means that neither less nor more.

Why we keep inventories?

Inventories are used in trading business and manufacturing businesses. In trading

business we purchase something and sell it as it is. And in manufacturing business
we actually purchase raw material means that such things which we convert by
investing in the form of labor and overheads into a finished product.

For example if we purchase cotton in raw form and convert it into the form of
thread so this is a manufacturing process. And if we purchase cotton and sell it in
the form of cotton then it is a trading business.

In trading businesses we have inventories, in manufacturing businesses we have

inventory.

The inventories when we hold them or purchase them then we do investment of

our money in them. So we need to see that what is the most appropriate
quantity of an inventory that we are taking?

If there is no inventory then there are many disadvantages.

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Our production will be hindered and the labor will be sitting idle and the machine
will be running but there will be no output, no production out of that. And that will
result in huge loses.

So meaning that there is a situation where we know that we need inventory but we
also know that keeping large inventories, inventories which are more than our use
will be a waste of our funds.

So, managing working capital means managing these inventories. As I mentioned

earlier that these inventories or these stocks are:

Stock in trade is the stock or the inventory which is kept for the purpose of sale.

Stores and Spares is the term used for the Stock which is kept for the purpose of
internal consumption i.e., spares parts, dyes, tools which are used in our business.
Our working capital is also invested in them and we have to manage them.

What is Raw material?

Raw material is actually the finished good or raw material from the reference of
any business manufacturing concern. Suppose a textile sector, its starts lets say
from cotton production, the produced cotton then goes to the ginning factory
where the seed has been separated from the flower of the cotton.

So for a ginning factory, the raw material is cotton which is in which the seed is
the product of the raw. And finished good is that where the seed has been
separated from the flower of the cotton and it has been stocked in the form of
bundles.

Now the next process is that the cotton goes into a manufacturing of yarn so the
cotton which is ginned cotton goes into a process where it is called the spinning
process where the cotton is converted into yarn. So for spinning business or
spinning company, ginned cotton is raw material, yarn is the finished product but
the story doesn’t end here.

Because such yarn or thread is then used to produce cloth and this cloth is in its
very raw form that we call Greige cloth (also known as grey fabric).
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That means for a business, which actually uses yarn as a raw material then the
finished product is grey cloth. Similarly when the grey cloth is finished and so on
then we can say that one product may be a raw material for a business and it is a
finished product for another business.

So when this raw material while in the process of conversion then it is called the
Work in Process. When inventories are incomplete goods we call them work in
process and the goods which we have in completed form before selling them that
we call them finished goods.

The inventories of all these three (raw material, work in process and finished
goods) will be in manufacturing concern and we have to manage them in working
capital.

There has been cost for keeping inventories which is called the Carrying Cost of
inventory. There is a cost for ordering an inventory which is called an Ordering
Cost of inventory.

For example, we or store keepers have to see in store, check bins, check inventory
cards, made purchase recognition, need to approve, send purchase orders after that
we have to do delivery; there is delivery time also etc. to order something. And the
cost incurred on during all this process.

If a company will order to purchase inventories again and again then its ordering
cost will become increased. But due to more orders, carrying cost (its holding an
inventory at one time) becomes reduced.

But on the other side if a company or business is ordering less then it needs to hold
an inventory for long term. Due to which ordering cost will be reduced but
carrying cost will become increased. So this is tradeoff between ordering cost and
carrying cost.

A finance manager has to see that what its best suitable combination is where sum
of our ordering cost and carrying cost becomes minimum.

So, in inventory management, we have to manage every type of inventory and also
see that its which quantity we need to hold every time.
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Module 1: Scope of Financial Management

Topic 9: Asset Management (Working Capital Management)-III

• Receivables Management

• Credit Policy

• Credit Period

• Cash Discount

• Discount Period

• Bad Debts

• Collection Cost

• Factoring Receivables

• Matching Receivables and Payables

Working Capital management is about the management of three major

components of working capital of current assets that is inventories, receivables and
cash.

We have discussed a bit about inventory management and now we are moving
towards the management of Accounts Receivables. This is actually the amount that
is receivable in the future.

How this amount is generated?

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Whenever a business organization makes credit sales then these credit sales
actually results into accounts receivables.

Or

When we sell our products or services and this sell is not on cash but on credit
(means today we will provide our product or service but its cash of return will be
paid in future). This amount is kept as Receivable till we get that cash/return.

Importance: Receivables are integral part of our business because if you are
operating in a market with various competitors they are all giving a certain credit
to the customer then we have to provide that credit to our customers too to compete
with them.

But if this credit period becomes longer then we are actually investing more than
what we need to invest in our receivables. That means there is a requirement of
managing these receivables.

Receivables management is actually about the management of credit. If we

summarize it then we can say that it is the discussion of Credit Policy.

Credit Policy is about determining the credit period, the credit time, cash discount,
bad debts etc. so collectively that is, what is called is credit policy.

So when we talk about Receivables management in working capital management

then actually we are talking about discussion of credit policy.

Credit period means that when you are selling your product then you are giving
this credit to your customers for how many days i.e., if credit period is for 30 days,
then customers will purchase today from you and after 30days they have to pay it
to you. And this is simply the credit period.

Credit Period is considered as an incentive for the buyer that is if your customer is
given a credit they will be happy to buy it from you. It means that if you increase
this credit period then customer will also become happier and buy more which
means that extending the credit period generally results into an increase into your
sales.
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Cash Discount means that when you ask your receivables to pay before the end of
the credit period and you give them an incentive in terms of discount that is called
Cash Discount.

For example if a customer has given me 10,000 after one month then if I say to
him that you give me this 10,000 within 10 days then I will give you 2% discount
or left 2%. Then this discount is called Cash Discount. Its attraction for customer
but there are some advantage and disadvantages of it that we see in credit policy.

Discount Period means that if credit period is 30 days and you are asking the
person to pay it within 10 days to get a discount then this 10 day period will be
called Discount period.

Whenever there is credit sale, there is always a possibility of not getting your
money from the customer. When you are selling something then you don’t know
about which customer will not give you your money. But from your experience,
you know that out of the total receivables, a certain percentage always goes as bad
debts. Lets say out of every Rs.100, Rs.2 are always never recovered and become
bad debts.

Then another thing which is associated to the management of accounts receivables

is Collection Cost. That is if you have to collect lets say 10 million rupees from
100 different people, then how would you do that. You would have a team or have
a department for the collection of this money and the people who will be working
in that department be paid some salary and there will be the cost of keeping that
department.

And they have to incur cost for transportation or any other cost to collect this
money or the funds receivables for you.

So whenever there is some credit given, there is always some collection of cost. To
avoid this collection cost, there is a process which is called the process of
Factoring Receivables.

It is also the part of working capital that the management or finance manager has to
see whether it is good to collect the receivables by the department of the
organization or outsource. The process in which someone collects our receivables
for us is called the process of factoring. And that organization or institution or
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person which does collection for us of our receivables is called factor. But there is
a cost involves in factoring.

But again it is a tradeoff between keeping your own collection department or

outsourcing it and as a finance manager we have to decide that which one of the
two is the most profitable. That is the collecting the receivables ourselves or
factoring the receivables that means selling the receivables to a factor.

Another very important part of our receivables management is

comparing/matching our receivables with our payables.

On one side of business, when we buy from somebody then we get some credit or
someone give us credit and when we sell something then we are giving credit to
someone.

So on one side of the business, we are payables from those we have purchased
things and we have to pay them, and on the other side of the business, we are
receivables, as those who are purchasing from us and those who have to return
money to us.

So on one side, business is generating some receivables and one the other side, the
business is generating some payables. And one side there is an amount to be
recovered and received in the future and on the other side, there is an amount
which is to be paid in the future.

Now suppose these two amounts (payable and receivables) become equal means
that money/fund that we have to pay is equal to the amount that we have to receive
from the people which means that no money of business has involved in these
receivables.

But this kind of management is almost impossible that we have exactly the same
amount of payables as the same amount of receivables. Because from such market
we purchase things, its terms of trade are different from and such market where we
sell our things, its terms of trade are different.

Suppose from where we are purchasing, the credit period is 15 days and where we
are selling, may be its credit period is 1 month.
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Another term which is used very commonly in this management regarding the
payables only called Stretching the Payables. It means that how much we can
increase the credit period of our payables. Due this increase we need to take care of
something which we will discuss in upcoming lectures.

Module 1: Scope of Financial Management

Topic 10: Asset Management (Working Capital Management)-IV

• Cash Management

• Cash Budget

• Cash Inflows and Outflows

• Surplus and Deficit

• Financing and Lending

• Technical Insolvency

• Cash Flow Statement

• Cash Ratios

We have discussed about Working Capital Management till now in which we have
discussed its two major components’ management that is inventory management
and receivables management.

Now we are going to discuss about third major component of working capital
management that is Cash Management. It is a significant component whose
management is more important as it acts as key element in any business
organization. As if cash is not managed well then even a good profitable business
organization may also face problems or crisis.

So, the third component of working capital of the current asset is Cash. And the
management related to Cash is actually about anticipating the need of cash in the
future and the availability of the cash.
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How much cash we need in upcoming days, weeks or months and how much
money/funds we will get/receive from different sources.

If we have cash generated from business, is sufficient or more than what we need
then we are very comfortable. That means when we have surplus cash then we will
invest somewhere.

But if we have low cash that means if our cash inflows will be less than our cash
outflows then we will be in trouble. That means we will have to fill that cash which
means cash deficit.

Cash deficit means that our cash inflows are lesser than our cash outflows.

And Cash Surplus means that our cash inflows are more than our cash outflows.

Now if there is deficit then the management of cash requires borrowing and this
borrowing is to be done in the most efficient manner. So that we need to borrow
cash which should be for days/weeks/months at the minimum rate and should be
on more appropriate terms.

So cash management is basically done through what is called Cash Budgeting.

The instrument that we use for cash management we call it Cash Budget. In Cash
Budget, we simply say that we talk about the balances of the cash at the beginning
of a year, beginning of a month.

Suppose if we are making a monthly cash budget then at the beginning of the
month how much the balance is. And then what are the anticipated inflows in
that month.

And anticipated inflows comes from where that we sell?

Some of them will come from cash sale and then we have done some credit sales,
when their credit period will be completed then we get some cash/inflows from
these receivables. If we have other sources of investments then we also get inflows
in form of return or profit from there. And if we have given loan from somewhere
then getting installments from there. All these are our inflows.
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Similarly we have our outflows that we budget or plan them. Outflows are that we
meet expenses i.e., utility expenses, salaries, repair & maintenance, traveling and
convenience etc.

In such way, we have to pay our loans or installments that we have borrowed or
loan from somewhere. There is a time for them if they are not paid at time then
there are penalties on them. Similarly on utilities, means if I pay electricity bill late
then I have to pay an extra penalty which is a cost for the business that is never
desirable for any business.

So, likewise I have to see that what the outflows are. And now a Cash Budget is
actually a plan for the sources of funds or cash means that from where inflows
come and how much within every month and what will the payments that we will
have to make that are the outflows. Then after that, we see by adding cash inflows
in opening balance that how much money we will have in this month and how
much will be our outflows then how much amount with we left.

So in advance we are in a position to know that what will be our cash surplus or
shortage in upcoming months. And if there will be cash/inflow shortage then we
will plan it today that from where we can arrange it.

In Cash Management, another very interesting term used is called Technical

Insolvency. This term means that an organization which is profitable, otherwise
which is profitable but because of shortage of cash has gone into crisis and the
crisis could be wastes that ultimately the business has to be shut down and
liquidated because the cash is not available.

So, this technical insolvency is different from insolvency or bankruptcy where

there are no profits but no cash. The cash management is enough important that
any company may go cash in technical insolvency because of poor management of
cash.

There is also a statement; financial statement which is prepared by considering the

cash inflows and outflows which is called the Cash Flow Statement. It has three
components; one is Cash Flows related to operating activities and then related to
investing activities and then related financing activities. In these three activities we
see cash inflows and outflows but they are made on actual basis.
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Similarly, as we have discussed about the ratios related to current assets. So there
are some ratios related to cash. These ratios are used to link cash with our current
assets i.e., cash to our current assets, cash to our liquid assets, cash to our current
liability etc. so make the benchmarks of these ratios that how much of these ratios
need to be, by doing so we can do our cash management in a more better way.

So this third component (Cash) of working capital management actually requires a

lot of continuous management by the finance department in order to always have
enough cash neither more than what is desired nor less than what is desired.

If there is shortage then we will go towards financing to arrange it before time of

any problem or crisis. And if there is surplus then we will see that how we can
invest it on right time in order to earn more profit on it.

Module 1: Scope of Financial Management

Topic 11: Financial Analysis-I

• Why Financial Analysis?

• When it is done?

• Types of Financial Analysis

• Absolute verses Relative Analysis

• Comparative Analysis

• Index Analysis

• Cost, Volume and Profit Analysis

• Risk Analysis
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Financial Analysis is the fourth function or fourth activity of financial

management. We have discussed arranging finances, investing finances and then
working capital management. And then the fourth activity which is in the scope of
financial management is Financial Analysis.

Financial Analysis is simply looking at the finances, the receivables, the payables,
revenues, expenses, costs, investments from different angles. And then comparing
and contrasting them and then deciding about the performance of the organization.
This may be the performance in terms of the operations or this may be the
performance in terms of the investments that the company has made. So obviously
we want to know whether we did or did not. That is why we need to conduct
financial analysis.

Somebody would say that we calculate profit and we can see that we got profit so
our performance will be good. Yes that is correct but if we want go into the depth
of this analysis, then we need to have a more detailed financial analysis and we
have to look at each and every component of our financial statements to see
whether our performance was up to our mark or not.

Financial analysis is not merely related to the analysis of our performance that is
the operating performance but it is also related to some other things. For example,
if a particular company, corporations when to purchase another business or another
company then financial analysis would lead you to the right decision whether it
should be purchased or not or what is the most suitable price to offer that company
for getting into deal of acquisition of an organization.

Similarly, we talk about Mergers where businesses and corporations actually

merge with each other in order to be cost effective and to capture the market, to be
technologically advancement ultimately to be more profitable.

But once you are getting into the mergers, financial analysis would help you to
decide whether a particular merger will be beneficial for you or not or at what cost
and what price you get into that deal. So this means that financial analysis is not
required just at the end of the year to see whether business did good or not. Yes
this is one component but its uses are many others.

When do we do it(Financial Analysis)?

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It is as I have mentioned a matter of requirement, it may be done at the end of the

month or it may be done at the end of every year. When we have to meet certain
requirements of some of the organizations who have given finances to us then we
have to see whether we are meeting those requirements or not in that is we do in
financial analysis.

For example, a bank states that our current ratio should never go below 1.5. So, it
is financial analysis which will tell us that in which months we were equal to or
above 1.5 current ratio or on which months we were actually below 1.5. So, when
you were up to the mark or when we were not. So this is what we will be able to
know when we are performing financial analysis.

In financial analysis, at times we do analysis in absolute terms. Absolute means

that we are comparing sales or amount of sales or amount of profit with others. A
relative way in which we compare two things i.e., profit is 1 million this is
absolute amount and profit with reference to sales is actually 10%, so it is relative.

Financial analysis is also Comparative in which we do comparison among

different months and years or we can do analysis in such way that we see our sales;
our different components are less or more than those sales.

Similarly we do Index Analysis and other analysis also in financial analysis in

which we convert big amounts or big values in Index base and then that Index
value which is relatively simple for using and understanding then on its bases we
make our statements and do comparison.

Similarly we do Cost, Volume and Profit Analysis in which we see that where we
will see economies of scale, where our cost will be minimum, which volumes of
production where we will be more beneficial in term of our production in cost and
enhancement of profits. So this is another part of our financial analysis that we
perform.

Another very interesting and important of the financial analysis is related to Risk.
We need to see that whenever we are investing how much is the level of risk and
what is the expected return on that level of risk. Whenever business organization
gets into risky investment then the expectation of return are always higher.
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So financial analysis would help you to make this decisions that if you are getting
into risky investment then how much return you would expect to get from that.
And this is something that we would now by performing in financial analysis.

Module 1: Scope of Financial Management

Topic 12: Financial Analysis-II

• Ratio Analysis: Why Ratios?

• Liquidity Analysis

• Turnover or Activity Analysis

• Leverage or Gearing Analysis

• Coverage Analysis

• Profitability Analysis

• Market Analysis

We are reaching to end of our basic discussion related to the scope of financial
management. Starting from financing activities and investing and asset
management and we are discussing now Financial Analysis. We talked about
Financial Analysis being the analysis related to the various aspects of finances
and for various purposes.

A very common way of making analysis is Relative Analysis. This relative

analysis is done by comparing some amounts, some values with some other
amounts and developing some ratios and indices. These ratios and indices actually
help us to make better decisions and understand the scenario in a better way.

This ratio analysis has been enough developed till now that we had identified some
ratios in different aspects of business and we see these ratios, we have determined
some standards for their values, their levels and then we make decisions by
comparing them that one business is financially good or bad.
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Before I talk about these different areas and these different ratios, I would like to
tell you that a Ratio is a tool which is when applied, is to be compared. It means
that when we find the value of a ratio by dividing one value by the other.

Suppose its answer become 1.6 then this 1.6 will be meaningful when we know
about this 1.6 that this value is good if it is more or bad if it is less or if this value is
1.6 then in the industry where this company is working, its average value is more
than 1.6 or less than it. Or this company’s previous given value was more than 1.6
or less than it.

Whenever we are calculating some ratios which is merely a number, the analysis
would actually be complete when we are able to see and analyze the ratio by
further comparing it with some standards and benchmarks. And then we are in a
position to say whether the company is better or not.

Have a look at these ratios as:

First one is Liquidity Ratio. The analysis of a company related to liquidity where
liquidity means that a company has how many such assets which we can quickly
convert into cash. There are some ratios which tell us about liquidity i.e., current
ratio and quick ratio (also known as acid test ratio) and cash ratios etc.

We also have some ratios which are part of our Turnover or Activity Analysis. It
means that how many activities in our business i.e., activities related to making
sales, generating receivables, collecting money from them, buying assets, selling
assets etc. So if these activities or this cycle will be more enough then we will get
more enough profit from them.

Suppose there is a product that I buy for Rs.100 and sell it for Rs.110, if I have
done this work one time in a year then this turnover occurs once or this activity
occurs once. So I have earned Rs.10 in a whole year. And if I circulate it two times
and sell it for Rs.110 two times in a year then I have earned Rs.20 from this Rs.100
and similarly if I sell it 3 times in a year then I have earned Rs.30 from this Rs.100.

So higher is our rate of the activity or turnover of our sales in receivables, more
will be the profit. So similarly we see our turnover through ratios in which we
view/check receivables turnover, payable turnover or asset turnover.
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Then there are ratios that are related to Leverage or Gearing Analysis in which
we compare debt and equity because the mix of debt and equity makes the capital
structure. Sometimes, more debt is good and sometimes more debt is not good.
Sometimes our organization needs to keep debt at specific level to meet certain
requirements. So analysis of ratios related to leverage in which the common ratios
are; debt and equity ratio or total debt to long term fixed asset ratios and likewise.

In Coverage analysis, we talk about the profits which are available for the
payment of certain expenses. The most common is Interest Coverage Ratio and
Debt Service Coverage Ratio.

Then there is a ratio related to Profitability. Profit is an absolute amount which is

in rupees and profitability is that how much this profit is as a percentage of our
sales or our investments or our equity, so we say that we calculate ratios like profit
margins, ratios like return on equity, return on investments. So these ratios tell us
that our profit is how much in comparison of equity or investment and that is part
of our financial analysis.

Similarly we determine some Market Ratios in financial analysis. Market Ratio

means that what is our price earnings ratio or price of our share in market how it
relates to our earning per share. And what is our dividend payout ratio (dividend
per share divided by earning per share). Similarly, the ratios which we determine
such as dividend or our current market price or earning related ratios, and these
ratios becomes part of our Market financial analysis.

Similarly, financial analysis’s component which we name relative or ratio

analysis, we do analysis of each and every field or part of business/organization
through ratios and then determine through comparison whether our organization in
different areas is upto the mark or not. It may be that one business will be good in
profitability but its liquidity position will not be good.

Similarly, one business whose profitability will be high but its leverage becomes
higher. So one complete set of analysis of a business organization actually puts us
in a position where we know whether what are the strong areas and what are the
weak areas of the organization and this is how we perform our Financial Analysis.