Financial Management 1.What is a fund flow statement? Explain its uses.

There is a continuous change in the assets, liabilities, income and expenses during the course of business operations. A statement showing the increases or decreases in different related accounts for a specified period of time is called funds flow statement. Funds flow analysis touches upon an important problem of financial management, viz, how the business is procuring and using the funds. The flow of funds in a firm represent the net uses of funds and its liabilities and net work represent net sources. This is one type of statement of flow of funds widely used by financial analysts, credit granting institutions and financial managers. The Income statement and the Balance Sheet have limited role to perform as far as the question of analysis of financial position is concerned. The term 'funds' has a variety of meanings. It may be taken as 'cash', and in that case, there is no difference between a Funds Floe Statement and a Cash Flow Statement. The International Accounting Standard on 'Statement of Changes in Financial Position' recognizes the absence of single, generally accepted , definition of the term. As per IAS, the term 'fund' refers to cash and cash equivalents or to working capital. Here, with regard to working capital, it means net working capital. The term 'flow' means change and the term 'flow of funds' means 'change in funds' or 'change in Working Capital'. this means that any increase or decrease in working capital is 'Flow of Funds'. In business some transactions cause increase of funds while others decrease the funds, and some may not make any change in the position of funds. Where a transaction results in increase of 'application or use of funds'. For example, in case of issue of shares, the transaction increases the funds, and in case of purchase of plant and machinery, funds stands reduced. The first transaction cause funds to increase or it is the source of funds, and the later transaction causes funds to decrease and it is , therefore, an application or use of funds. The fund flow statement is a method by which we study the net funds flow between two points in time. These points conform to beginning and ending financial statement dates for whatever period of examination is relevant -a quarter or half-year or a year. The funds flow cycle for a typical manufacturing company is depicted below:

Shareholder equity
Dividend and Repurchase of shares Investments

Debt

Loan

CASH

Loan Repayment

Payment for purchases

Accounts Receivable

collections sales of assets cash sales

Accounts payable

Purchase of assets Selling & admin Expenses Payment of wages & expenses

wages & expenses o/s

Net fixed assets

Raw material

Labour expenses

Depreciation

Finished Goods inventory

Work in-progress

The summarized balance sheet of a company as at the close of an accounting period is given below: Non -current Liabilities 10% Pref Share Capital Equity capital Share premium P & L account Rs. 1,10,000 2,50,000 26,000 1,34,000 Non-current assets Machinery Building Land Long term investments Rs 2,10,000 1,26,000 18,000 70,000

Long Term Loans: 12% Debentures 64,000 Total Non-current Liabilities 5,84,000 Total non-current assets 4,24,000

Current Liabilities: Creditors Bills Payable Bills Payable Bank overdraft hOutstanding expenses Total Liabilities

46,000 4,000 12,000 8,000 70,000

Current Assets: Cash Debtors Bills Receivable Stock in hand Total current assets

32,000 38,000 62,000 98,000 2,30,000 6,54,000

6,54,000 Total assets

The net working capital of the company is Rs.1,60,000:(ie.,Current assets-Current Liabilities, ie.,Rs.2,30,000-Rs.70,000). There will be said to be a flow of funds in case the working capital position of the company changes on account of any transaction. Let us consider some transaction and their effect on the working capital position of the company. Issue of shares Rs.1,00,000 in cash This will increase the cash balance of the company to the same extent. The total cash balance becomes Rs.1,32,000. however, there is no change in the current liabilities position. Then, the new working capital will be Rs.2,60,000(Rs.3,30,000-Rs.70,000) evidencing increase in working capital. This means that issue of shares in cash increases the working capital. The firm sells one of its building for Rs.30,000. The book value of the same is Rs.25,000. This sale transaction increases the working capital , as the cash balance increases to the extent of Rs.30,000, and thus the current assets to Rs.3,60,000 while the total current liabilities remain the same. The new working capital will be Rs.2,90,000(ie., Rs.3,60,000-Rs.70,000). Here building is a non-current asset and cash is a current asset. Realization of debtors to the extent of Rs15,000

This transaction reduces the debtors to Rs.23,000(ie., Rs.38,000-Rs.15,000)and cash balances increases by Rs.15,000. However ,both debtors and cash balances are current assets.ie., both these accounts fall on the same side of the balance sheet. The effect is that one component of current asset is reduced and another component of current asset increased,with the result,the current asset remains unaltered. There is no change in the working capital position of them. Creditors are paid cash Rs.5000 This transaction reduce the cash balance by Rs.5000. The new cash balances will be Rs.27,000 and thus the reduced current asset will be Rs.2,25,000. As the creditors are paid Rs.5000,creditors balance get reduced to Rs.41,000 and this reduces the total current liabilities to Rs.65,000. Then the new working capital will be Rs.1,60,000. Thus the transaction has not resulted in any change in the working capital position. This is because the two accounts involved in the transactions. Purchase of machinery worth Rs.15,000 by raising long term loan. Machinery is non-current asset and long term loan is non-current liability. Therefore, the above transaction will not have any effect on the working capital Position. Generalizing the above and other similar transactions, we have the following set of rules with regard to the working capital position. There will be a flow of funds if a transaction involves: Current Assets and Fixed Assets . Current Assets and Capital Current Assets and Fixed Liabilities Current Liabilities and Fixed Liabilities. Current Liabilities and Capital Current Liabilities and fixed assets. There will be no flow of funds if a transaction involves: Current Asset and Current Liabilities. Fixed Assets and Fixed Liabilities. Fixed Assets and Capital.

The funds flow statement can be best comprehended from the given diagram:

FIXED LIABILITIES Share Capital Reserves and surplus Debentures Long -term Loans

FIXED ASSETS Land and Building Plant and Machinery Goodwill Furniture & Fixtures Long Term Investments

CURRENT LIABILITIES Creditors Bank Overdraft Outstanding Expenses Accounts payable

CURRENT ASSETS Cash & Bank balances Marketable Investments Account receivables Stocks Prepaid Expenses

USES OF FUNDS FLOW STATEMENT Funds flow statement is a tool for analysis and understanding changes in the distribution of resources between two balances sheet dates. The uses of funds flow statement are as follows: It explains the financial consequences of business operations. It gives reasonable answers for intricate queries such as regarding the overall credit worthiness of the business , the sources of repayment of the term loans, funds generated through normal business operations, utilization of funds etc. It acts as an instrument for allocation of resources. It serves as a test of effectiveness or otherwise use of working capital.

5.Explain financial statement analysis and tools of financial analysis Financial Statement: The balance sheet, which summarizes what a firm owns and owes at a point in time. The income statement, which reports on how much a firm earned in the period of analysis. The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis. Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports. Putting another way, financial statement analysis is a study about accounting ratios among various items included in the balance sheet. These ratios include asset utilization ratios, profitability ratios, leverage ratios, liquidity ratios, and valuation ratios. Moreover, financial statement analysis is a quantifying method for determining the past, current, and prospective performance of a company. Financial statement analysis is part of a large information processing system on which informed decisions can be based. Advantages of financial statement analysis The different advantages of financial statement analysis are listed below: The most important benefit if financial statement analysis is that it provides an idea to the investors about deciding on investing their funds in a particular company. Another advantage of financial statement analysis is that regulatory authorities like IASB can ensure the company following the required accounting standards. Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm. Above all, the company is able to analyze its own performance over a specific time period.

Limitations of financial statement analysis In spite of financial statement analysis being a highly useful tool, it also features some limitations, including comparability of financial data and the need to look beyond ratios. Although comparisons between two companies can provide valuable clues about a companys financial health, alas, the differences between companies accounting methods make it. Sometimes, it is difficult to compare the data of the two. Besides, many a times, sufficient data are on hand in the form of foot notes to the financial statements so as to restate data to a comparable basis. Or else, the analyst should remember the lack of data comparability before reaching any clear-cut conclusion. However, even with this limitation, comparisons between the key ratios of two companies along with industry averages often propose avenues for further investigation. The analysis of the financial statements is done through: Methodical classification of the data given in the financial statements. Comparison of the various inter-connected figures with each other by different " Tools of Financial Analysis"

TOOLS OF FINANCIAL ANALYSIS The various tools or methods of Financial Analysis are as follows: a) Comparative Financial Statements: In these statements, figures for two or more periods are placed side by side to facilitate comparison. Both the income statement and Balance sheet can be prepared in the form of Comparative Financial Statements. The American Institute of Certified Public Accountants has explained the utility of preparing the Comparative Financial Statements as follows: " The presentation of comparative financial statements in annual and other reports enhance the usefulness of such reports and brings out clearly the nature and trend of current changes affecting the enterprise. Such presentation emphasizes the fact that the statements for a series of periods are far more significant than those of a single period and that the accounts of one period. In any one year , it is ordinarily desired that the balance sheet, Income statement and the surplus statement be given for one or more preceding years as well as for the current year". In India, the companies Act 1956, provides that the companies should give figures for different items for the previous period, together with current period figures in their Profit and Loss Account and Balance Sheet. b) Trend Percentages: Trend percentages are calculated for making a comparative study of the financial statements for several years. Usually the earliest year is taken as the base year and a relationship is established with percentages of each item of each of the years. However, the defect of this tool is that trend percentages are not calculated for all the items in the financial statements, instead, they are usually calculated only for major items since the purpose is to highlight important changes. c) Funds Flow Analysis: Funds flow analysis is an important tool of financial analyst, credit granting institutions and financial managers. Funds Flow analysis reveals the changes is working capital position. It reveals the sources from which the working capital was obtained and the purpose for which it was used. Funds flow analysis touches upon an important problem of financial management, viz, how the business is procuring and using the funds. The flow of funds in a firm represent the net uses of funds and its liabilities and net work represent net sources. This is one type of statement of flow of funds widely used by financial analysts, credit granting institutions and financial managers. The Income statement and the Balance Sheet have limited role to perform as far as the question of analysis of financial position is concerned. d) Ratio Analysis: A ratio shows relationship in mathematical terms between the two interrelated accounting figures. The financial analyst may calculate different ratios for different purposes. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.

Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further. 3.What is financial Forecasting? Explain. Financial Forecasting is a planning process through which the management of the company positions the firm's future activities keeping in view the various influencing factors such as the economic, technical, social and competitive environment . Financial forecasting is essential to the strategic growth of the firm. Business plans evidence strategic and actions for achieving the desired short term, medium term and long term results. The process of financial forecasting allows the financial manager to anticipate events before they occur , particularly the need for raising funds externally. The most comprehensive means of financial forecasting is to go through the process of developing a series of pro forma or projected financial statements. There are three main techniques of financial projections as follows: Pro forma financial statements Cash Budgets Operating Budgets

Based on the projected statements, the firm is able to judge its future level of receivables, inventory, payables and other corporate accounts as well as its anticipated profits and borrowing requirements. The finance officer can then carefully track actual events against the plan and make necessary adjustments. Also, the statements are often required by bankers and other lenders as a guide for the future. Pro forma statements are projected financial statements embodying a set of assumptions about the future performance of a company and the funding requirements. A systematic approach is necessary for the development of pro forma statements. The various steps involved in the construction of a pro forma statements as follows: Preparation of a pro forma statement based on sales projections and production plan. Translation of these into a cash budget, and then finally. Assimilation of all previously developed material into a pro forma balance sheet.

this process can be depicted as under:

Prior Balance sheet

Sales Projection

Production Plan

Pro forma Income statement

Pro forma Balance sheet

Cash Budget

Other supportive Budgets

Pro Forma Income Statement: Pro forma Income statement is developed by the following four important steps: Establishment of a sales projection Preparation of production schedule and the associated use of new material, direct labour and overhead, to arrive at gross profit. Computation of other expenses. Determination of profit by completing the actual pro forma statement.

Sales Projection: Sales projection or Sales Forecast is the starting point of the financial forecasting exercise. The projection of other financial variables are based on sales projection, and therefore , the necessity for accuracy of sales projection need not to be over emphasized. Suppose the company ABC Ltd. has two primary products, Product A and Product B and the sales expected for the ensuring period is 4000 units and 6000 units at prices of Rs.25 and

Rs.15 respectively. Then, from the above, the anticipated sale for the said period is calculated as under: Quantity Selling Price per unit Sales Revenue Total Product A 4000 Rs.25 Rs.1,00,000 Product B 6000 Rs.15 Rs.90,000 Rs.1,90,000

There are different forecasting techniques and methods of sales forecasting , but all of them fall within the following three categories. Quantitative Techniques Time Series Projection methods Casual Models

Preparation of Production Schedule: Based on the anticipated sales the necessary production plan for the projected period is prepared. The number of units produced will depend on the beginning stock of inventory, the sales projection and the desired level of closing stock of inventory. Production Requirement = Projected sales + Desired closing stock- Opening stock Computation of value of opening stock: Let the cost per unit of the opening stock be Rs.16 and Rs.10 respectively for Product A and Product B. Then, the stock of beginning inventory is computed as follows: Quantity (units) Cost Total Value Product A 100 Rs.16 Rs.1,600 Product B 1700 Rs.10 Rs.17,000

The production requirements for the next budget period is computed as under:

Projected Sales(units) Desired closing stock of inventory (assumed) Opening Stock Units to be produced= (A)+ (B)-(C)

Product A (A)4000 (B)500 (c)100 4400

Product B 6000 1000 1700 5300

Preparation Of Cost of Production: We must now determine the cost to produce these units Let the unit cost be as under: Product A Product B Rs Rs Materials 10 7 Labour 7 4 Overhead 3 1 Total 20 12 Total Production costs can be computed as follow: Product A Units to be produced Cost per unit Total Cost 4400 Rs.20 Rs.88,000 Product B 5300 Rs.12 Rs.63,600

Cost of Goods Sold: The main consideration in constructing a Pro Forma statement is the costs specifically associated with units sold during the period under consideration. The anticipated sales of Product A is 4000 units, but considering the closing stock requirement and availability of opening stock, the production requirement has gone up to 4400 units ie., an increase of 400 units in inventory level. For profit measurement purposes, these extra 400 units are changed to current sales. Also, in determining the cost of 4000 units sold during the current time period, all the items sold or not considered as manufactured during the period. In the case of Product A, the sales expected is Rs.1,00,000(ie., 4000 units* Rs.25). Of the 4000 units , 100 units are from the opening stock and the balance of 3900 units are from the current production. The total cost of goods sold for product A is Rs.79,000, yielding a gross profit of Rs.20,400. Similar in the case of Product B.

Product A Quantity Selling Price per unit Sales Revenue Total Costs of goods sold: Old inventory: Product A Quantity (units) Cost Total Value 100 Rs.16 Rs.1,600 4000 Rs.25 Rs.1,00,000

Product B 6000 Rs.15 Rs.90,000 Rs.1,90,000

Product B 1700 Rs.10 Rs.17,000

New inventory: Product A Quantity (units) Cost Total Value 3900 Rs.20 Rs.78,000 Product B 4300 Rs.12 Rs.51,600

Inventory Old value New value Total Value

Product A in Rs 1,600 78,000 79,600 1,00,000

Product B in Rs 17,000 51,600 68,600 90,000 21,400

Gross profit

20,400

The value of closing stock can be computed as follow: Opening stock of inventory(Rs.1,600+ 17,000) Total production costs(88,000+ 63,600) Total inventory available for sales Less: Cost of goods sold(Rs.79,600+68,600) Closing stock of inventory Having computed total revenue, costs of goods sold and gross profits, the next step is to subtract other expenses items to arrive at the net profit before tax. These include general and administrative expenses as well as interest expenses. Income after tax is found out by deducting taxes, and the dividends are deducted to ascertain the contribution to retained earnings. Let us assume that the general and administrative expenses at Rs.11,300, interest expenseof Rs.3000 and Dividend Rs.2,500 Then the actual Pro Forma income Statement is presented as follows: PRO FORMA INCOME STATEMENT for the Year ended 31st March 2000 Rs Sales Revenue Cost of Goods sold Gross Profit General and administrative expenses Operating Profit (ie., Earning before Invest & Tax) Interest Expenses Earnings Before Tax(EBT) Taxes(50%) Earnings After Tax(EAT) Dividends Increase in retained earnings Cash Budget: The generation of sales and profit does not indicate the necessarily that there will be adequate cash on hand to meet financial obligations as they come due. A profitable sale may generate accounts receivables in the short run, but no immediate cash to meet the maturing obligations. Therefore, we must translate the pro forma income statement into cash flow. The long term Pro forma statement is divided in to smaller and more precise time frames in order to appreciate the seasonal and monthly patterns of cash inflow and outflows. Cash budget or cash flow estimates are very specific planning tools that are prepared every month or every week. Cash budgets show the cash needs or exercises. 1,90,000 1,48,2000 41,800 11,300 30,500 3,000 27,500 13,750 13,750 2,500 11,250

Prior Balance Sheet (unchanged items) Market securities Long term Debt Capital Stock

Pro Forma Income statement analysis Inventory retained earnings

Pro Forma Balance Sheet

Cash Budget Analysis Cash Accounts Receivable Plant and equipment accounts payable Notes Payable

Pro Forma Balance Sheet: Preparation of balance sheet involves of pro forma statement and cash budget. This is relatively a simple job. as the balance sheet represents cumulative changes in the business over time, the prior period's balance sheet is first examined and then these items are translated through time to represent the latest balance sheet. 2.Explain the factors determining Capital Structure. Under the capital structure, decision the proportion of long-term sources of capital is determined. Most favourable proportion determines the optimum capital structure. That happens to be the need of the company because EPS happens to be the maximum on it. Some of the chief factors affecting the choice of the capital structure are the following:

(1) Cash Flow Position: While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital. (2) Interest Coverage Ratio-ICR: With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio. It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position. (3) Debt Service Coverage Ratio-DSCR: This ratio removes the weakness of ICR. This shows the cash flow position of the company. This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure. (4) Return on Investment-ROI: The greater return on investment of a company increases its capacity to utilise more debt capital. (5) Cost of Debt: The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa. (6) Tax Rate: The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes. For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid). (7) Cost of Equity Capital: Cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilised more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.

Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it. (8) Floatation Costs: Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital. This attracts the company towards debt capital. (9) Risk Consideration: There are two types of risks in business: (i) Operating Risk or Business Risk: This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc), (ii) Financial Risk: This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company. The total risk of business depends on both these types of risks. If the operating risk in business is less, the financial risk can be faced which means that more debt capital can be utilised. On the contrary, if the operating risk is high, the financial risk likely occurring after the greater use of debt capital should be avoided. (10) Flexibility: According to this principle, capital structure should be fairly flexible. Flexibility means that, if need be, amount of capital in the business could be increased or decreased easily. Reducing the amount of capital in business is possible only in case of debt capital or preference share capital. If at any given time company has more capital than as necessary then both the abovementioned capitals can be repaid. On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility to issue debt capital and preference share capital is the best. (11) Control: According to this factor, at the time of preparing capital structure, it should be ensured that the control of the existing shareholders (owners) over the affairs of the company is not adversely affected. If funds are raised by issuing equity shares, then the number of companys shareholders will increase and it directly affects the control of existing shareholders. In other words, now the number of owners (shareholders) controlling the company increases. This situation will not be acceptable to the existing shareholders. On the contrary, when funds are raised through debt capital, there is no effect on the control of the company because the

debenture holders have no control over the affairs of the company. Thus, for those who support this principle debt capital is the best. (12) Regulatory Framework: Capital structure is also influenced by government regulations. For instance, banking companies can raise funds by issuing share capital alone, not any other kind of security. Similarly, it is compulsory for other companies to maintain a given debt-equity ratio while raising funds. Different ideal debt-equity ratios such as 2:1; 4:1; 6:1 have been determined for different industries. The public issue of shares and debentures has to be made under SEBI guidelines. (13) Stock Market Conditions: Stock market conditions refer to upward or downward trends in capital market. Both these conditions have their influence on the selection of sources of finance. When the market is dull, investors are mostly afraid of investing in the share capital due to high risk. On the contrary, when conditions in the capital market are cheerful, they treat investment in the share capital as the best choice to reap profits. Companies should, therefore, make selection of capital sources keeping in view the conditions prevailing in the capital market. (14) Capital Structure of Other Companies: Capital structure is influenced by the industry to which a company is related. All companies related to a given industry produce almost similar products, their costs of production are similar, they depend on identical technology, they have similar profitability, and hence the pattern of their capital structure is almost similar.