2. Financial management:

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1 2. Financial management: Meaning, scope and role, a brief study of functional areas of financial management. Introduction to various FM tools: ratio analysis, fund flow statement, cash flow statement. Financial management - Meaning Financial Management means the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. Financial management can be defined as the management of the finances of an organisation in order to achieve the financial objectives of the organisation. It includes how to rise the capital, how to allocate it i.e. capital budgeting. Not only about long term budgeting but also how to allocate the short term resources like current assets. It also deals with the dividend policies of the shareholders. Objectives of the organisation from financial point of view includes profit maximisation, wealth maximisation, sustenance of activity in recession and sustained growth. Financial management aims at maximum returns to the owners at the first instance and balancing this objective with optimum returns to all stake holders. This includes safeguarding the funds of the lenders, giving quality products to the consumers, giving appropriate compensation (salaries) to employees, paying all taxes to government, making financial provisions for environment conversation and so on. Money is a medium of transactions. Therefore one may equate money management (funds management), both for short term and for long term, as financial management. Financial management scope As is apparent from the above discussion about the meaning of financial management the scope of financial management is very wide. The scope extends over the following three dimensions. 1. Profitability for the organisation to minimise cost and to maximise return 2. Liquidity the ability to meet its operating activities 3. Safety or security to overcome undue risk 4. Decision making scope of decisions extends to the following areas.

2 a. Investment decision which include Short-term: working capital management and Long-term: capital budgeting. b. Financing decision includes decision about fixing Financing mix and determining capital structure. c. Dividend decisions are about Dividend policy: zero, residual, constant, stable dividend policies. Financial management primarily deals with Maximisation of return to the shareholder and peripherally deals with Secondary objectives like customer satisfaction, increase in market shares, Growth, Survival and innovation. To satisfy various stakeholders like Shareholders, Environment, Employees, Government, Management, Supplier, Community, and Customers is also within the scope of financial management. Role of finance manager- A description of the relationship between management and shareholders expressing the idea that managers act as agent for the shareholders, using delegated power to run the company in the shareholders best interest. providing and interpreting financial information; monitoring and interpreting cash flows and predicting future trends; analysing change and advising accordingly; formulating strategic and long-term business plans; researching and reporting on factors influencing business performance; analysing competitors and market trends; developing financial management mechanisms that minimise financial risk; conducting reviews and evaluations for cost-reduction opportunities; managing a company's financial accounting, monitoring and reporting systems; liaising with auditors to ensure annual monitoring is carried out; developing external relationships with appropriate contacts, e.g. auditors, solicitors, bankers and statutory organisations such as the Inland Revenue; producing accurate financial reports to specific deadlines;

3 managing budgets; arranging new sources of finance for a company's debt facilities; supervising staff; keeping abreast of changes in financial regulations and legislation. ACCOUNTING RATIOS An absolute figure often does not convey much meaning. Generally, it is only in the light of other information that significance of a figure is realised. A weighs 70 kg. Is he fat? One cannot answer this question unless one knows A s age and height. Similarly, a company s profitability cannot be known unless together with the amount of profit and the amount of capital employed. The relationship between the two figures expressed arithmetically is called a ratio. The ratio between 4 and 10 is 0.4 or 40% or 2:5. 0.4", 40%" and 2:5" are ratios. Accounting ratios are relationships, expressed in arithmetical terms, between figures which have a cause and effect relationship or which are connected with each other in some other manner. Accounting ratios are a very useful tool for grasping the true message of the financial statements and understanding them. Ratios naturally should be worked out between figures that are significantly related to one another. Obviously no purpose will be served by working out ratios between two entirely unrelated figures, such as discount on debentures and sales. Ratios may be worked out on the basis of figures contained in the financial statements. Ratios provide clues and symptoms of underlying conditions. They act as indicators of financial soundness, strength, position and status of an enterprise. Interpretation of ratios form the core part of ratio analysis. The computation of ratio is simply a clerical work but the interpretation is a taste requiring art and skill. The usefulness of ratios dependent on the judicious interpretations. USES OF RATIOS A comparative study of the relationship, between various items of financial statements, expressed as ratios, reveals the profitability,

4 liquidity, solvency as well as the overall financial position of the enterprises. Ratio analysis helps to analyse and understand the financial health and trend of a business, its past performance makes it possible to have forecast about future state of affairs of the business. Inter firm comparison and intra firm comparison becomes easier through the analysis. Past performance and future projections could be reviewed through the ratio analysis easily. Management uses the ratio analysis in exercising control in various areas viz. budgetary control, inventory control, financial control etc. and fixing the accountability and responsibility of different departmental heads for accelerated and planned performance. It is useful for all the constituents of the company as discussed under: 1. Management: Management is interested in ratios because they help in the formulation of policies, decision-making and evaluating the performances and trends of the business and its various segments. 2. Shareholders: With the application of ratio analysis to financial statements, shareholders can understand not only the working and operational efficiency of their company, but also the likely effect of such efficiency on the net worth and consequently the price of their shares in the Stock Exchange. With the help of such analysis, they can form opinion regarding the effectiveness or otherwise of the management functions. 3. Investors: Investors are interested in the operational efficiency, earning capacities and financial health of the business. Ratios regarding profitability, debt-equity, fixed assets to net worth, assets turnover, etc., are some measures useful for the investors in making decisions regarding the type of security and industry in which they should invest. 4. Creditors: Creditors can reasonably assure themselves about the solvency and liquidity position of the business by using ratio-analysis. Such analysis helps to throw light on the repayment policy and capability of an enterprise. 5. Government: The Government is interested in the financial health of the business. Carefully worked ratios will reflect the policy of the management and its consistency or otherwise with the overall regional and national economic policies. Such ratios help in better understanding

5 of cost-structures and may justify price controls by the Government to save the consumers. 6. Analysts: Ratio analysis is the most important technique available to the financial analysis to study the financial statements to compare the progress and position of various firms with each other and vis-a-vis the industry.

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21 Limitations of Financial Ratios There are some important limitations of financial ratios that analysts should be conscious of: Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low. Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.). It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations. A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company. In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.

22 Cash Flow Statement & Funds Flow Statement There are 3 basic financial statements that exist in the area of Financial Management. 1. Balance Sheet. 2. Income Statement. 3. Cash Flow Statement. The first two statements measure one aspect of performance of the business over a period of time. Cash flow statements signify the changes in the cash and cash equivalents of the business due to the business operations in one time period. Funds flow statements report changes in a business's working capital from its operations in a single time period, but have largely been superseded by cash flow statements. A Cash Flow statement is a statement showing changes in cash position of the firm from one period to another. It explains the inflows (receipts) and outflows (disbursements) of cash over a period of time. The inflows of cash may occur from sale of goods, sale of assets, receipts from debtors, interest, dividend, rent, issue of new shares and debentures, raising of loans, short-term borrowing, etc. The cash outflows may occur on account of purchase of goods, purchase of assets, payment of loans loss on operations, payment of tax and dividend, etc. A cash flow statement is different from a cash budget. A cash flow statement shows the cash inflows and outflows which have already taken place during a past time period. On the other hand a cash budget shows cash inflows and outflows which are expected to take place during a future time period. In other words, a cash budget is a projected cash flow statement. Funds Flow statements states the changes in the working capital of the business in relation to the operations in one time period. For example, if the inventory of the business increased from Rs 1, 40,000 to Rs 1, 60,000, then this increase of Rs 20,000 is the increase in the working capital for the corresponding period and will be mentioned on the funds flow statement. Net working capital is the total change in the business's working capital, calculated as total change in current assets minus total change in current liabilities.

23 Cash flow statements have largely superseded funds flow statements as measurements of a business's liquidity because cash and cash equivalents are more liquid than all other current assets included in working capital's calculation. What is Included in a Cash Flow Statement? The statement of cash flows uses information from the other two statements (Income Statement and Balance Sheet) to indicate cash inflows and outflows. A Cash Flow Statement comprises information on following 3 activities: 1. Operating Activities 2. Investing Activities 3. Financing Activities 1. Operating Activities Operating activities include cash flows from all standard business operations. Cash receipts from selling goods and services represent the inflows. The revenues from interest and dividends are also included here. The operational expenditures are considered as outflows for this section. Although interest expenses fall under this section but the dividends are not included.dividends are considered as a part of financing activity in financial accounting terms. 2. Investing Activities Investing activities include transactions with assets, marketable securities and credit instruments. The sale of property, plant and equipment or marketable securities is a cash inflow. Purchasing property, plant and equipment or marketable securities are considered as cash outflows. Loans made to borrowers for long-term use is another cash outflow. Collections from these loans, however, are cash inflows. 3. Financing Activities Financing activities on the statement of cash flows are much more defined in nature. The receipts come from borrowing money or issuing stock. The outflows occur when a company repays loans, purchases treasury stock or pays dividends to stockholders. As the case with other

24 activities on the statement of cash flows depend on activities rather than actual general ledger accounts. Difference between Funds Flow Statement and Cash Flow Statement Basis Difference 1. Basis of Analysis of Funds Flow Statement Funds flow statement is based on broader concept i.e. working capital. 2. Source Funds flow statement tells about the various sources from where the funds generated with various uses to which they are put. 3. Usage Funds flow statement is more useful in assessing the longrange financial strategy. 4. Schedule of Changes in Working Capital In funds flow statement changes in current assets and current liabilities are shown through the schedule of changes in working capital. 5. End Result Funds flow statement shows the causes of changes in net working capital. Cash Flow Statement Cash flow statement is based on narrow concept i.e. cash, which is only one of the elements of working capital. Cash flow statement stars with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses. Cash flow statement is useful in understanding the short-term phenomena affecting the liquidity of the business. In cash flow statement changes in current assets and current liabilities are shown in the cash flow statement itself. Cash flow statement shows the causes the changes in cash.

25 6. Principal of Accounting Funds flow statement is in alignment with the accrual basis of accounting. In cash flow statement data obtained on accrual basis are converted into cash basis. Advantages of Cash Flow Statement 1. It shows the actual cash position available with the company between the two balance sheet dates which funds flow and profit and loss account are unable to show. So it is important to make a cash flow report if one wants to know about the liquidity position of the company. 2. It helps the company in accurately projecting the future liquidity position of the company enabling it arrange for any shortfall in money by arranging finance in advance and if there is excess than it can help the company in earning extra return by deploying excess funds. 3. It acts like a filter and is used by many analyst and investors to judge whether company has prepared the financial statements properly or not because if there is any discrepancy in the cash position as shown by balance sheet and the cash flow statement, it means that statements are incorrect. Disadvantages of Cash Flow Statement 1. Since it shows only cash position, it is not possible to deduce actual profit and loss of the company by just looking at this statement. 2. In isolation this is of no use and it requires other financial statements like balance sheet, profit and loss etc, and therefore limiting its use. Advantages of Fund Flow Statements A Funds flow statement is prepared to show changes in the assets, liabilities and equity between two balance sheet dates, it is also called statement of sources and uses of funds. The advantages of such a financial statement are many fold. Some of these are:

26 1. Funds flow statement reveals the net result of Business operations done by the company during the year. 2. In addition to the balance sheet, it serves as an additional reference for many interested parties like analysts, creditors, suppliers, government to look into financial position of the company. 3. The Fund Flow Statement shows how the funds were raised from various sources and also how those funds were deployed by a company, therefore it is a great tool for management when it wants to know about where and from what sources funds were raised and also how those funds got utilized into the business. 4. It reveals the causes for the changes in liabilities and assets between the two balance sheet dates therefore providing a detailed analysis of the balance sheet of the company. 5. Funds flow statement helps the management in deciding its future course of plans and also it acts as a control tool for the management. 6. Funds flow statement should not be looked alone rather it should be used along with balance sheet in order judge the financial position of the company in a better way. Limitations of funds flow statement OF Disadvantages of Fund Flow Statements 1. Funds flow statement has many advantages; however it has some disadvantages or limitations also. Let s look at some of the limitations of funds flow statement. 2. Funds Flow statement has to be used along with balance sheet and profit and loss account for inference of financial strengths and weakness of a company it cannot be used alone. 3. Fund Flow Statement does not reveal the cash position of the company, and that is why company has to prepare cash flow statement in addition to funds flow statement. 4. Funds flow statement only rearranges the data which is there in the books of account and therefore it lacks originality. In simple words it

27 presents the data in the financial statements in systematic way and therefore many companies tend to avoid preparing funds flow statements. 5. Funds flow statement is basically historic in nature, that is it indicates what happened in the past and it does not communicate anything about the future, only estimates can be made based on the past data and therefore it cannot be used the management for taking decision related to future. We can conclude that shorter the planning period more relevant is the Cash Flow Statement and longer the planning period more relevant is the Fund Flow Statement