Functions/Objectives of financial management

Estimation of capital requirements: A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits and future programmes
and policies of a concern. Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.

Determination of capital composition: Once the estimation have been made, the capital structure have
to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds which have to be raised from
outside parties.

Choice of sources of funds: For additional funds to be procured, a company has many choices like-

Issue of shares and debentures

Loans to be taken from banks and financial institutions

Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.

Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done
in two ways:

Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.

Retained profits - The volume has to be decided which will depend upon expansional, innovational,
diversification plans of the company.

Management of cash: Finance manager has to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw
materials, etc.

Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also
has to exercise control over finances. This can be done through many techniques like ratio analysis,
financial forecasting, cost and profit control, etc.

Ratio: the quantitative relation between two amounts showing the number of times one value
contains or is contained within the other.
Current Ratio: The current ratio is a liquidity ratio that measures a company's ability to pay short-term
and long-term obligations. To gauge this ability, the current ratio considers the current total assets of
a company (both liquid and illiquid) relative to that company's current total liabilities.

Quick ratio: The quick ratio is a measure of how well a company can meet its short-term financial
liabilities. Also known as the acid-test ratio.

Inventory turnover ratio: Inventory turnover is a ratio showing how many times a company's
inventory is sold and replaced over a period of time.

Debtors turnover ratio: The receivables turnover ratio is an activity ratio measuring how efficiently a
firm uses its assets.

Gross profit: Gross profit is the profit a company makes after deducting the costs associated with
making and selling its products, or the costs associated with providing its services.

Net profit: the actual profit after working expenses not included in the calculation of gross profit have
been paid.

Operating ratio: In finance, the operating ratio is a company's operating expenses as a percentage of
revenue. This financial ratio is most commonly used for industries which require a large percentage of
revenues to maintain operations, such as railroads.

Earning per share: The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures
its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes
known as the price multiple or the earnings multiple.

Return on equity: In corporate finance, the return on equity (ROE) is a measure of the profitability of a
business in relation to the book value of shareholder equity, also known as net assets or assets minus
liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

Working capital: the capital of a business which is used in its day-to-day trading operations, calculated
as the current assets minus the current liabilities.

RONW/ROE: Return on equity (ROE) is a measure of profitability that calculates how many dollars of
profit a company generates with each dollar of shareholders' equity.

ROCE: Return on capital employed (ROCE) is a financial ratio that measures a company's profitability
and the efficiency with which its capital is employed.

Why funds flow?

A fund flow statement is a statement in summary form that indicates changes in terms of financial
position between two different balance sheet dates showing clearly the different sources from which
funds are obtained and uses to which funds are put.

It summarizes the financing and investing activities of the enterprise during an accounting period.
Importance of Fund Flow Statement:

The importance of fund flow statement may be summarised:

1. Analyses Financial Statements:

Balance Sheet and Profit and Loss Account do not reveal the changes in the financial position of an
enterprise. Fund flow analysis shows the changes in the financial position between two balance sheet
dates. It provides details of inflow and outflow of funds i.e., sources and application of funds during a
particular period.

Hence it is a significant tool in the hands of the management for analysing the past, and for planning
the future. They can infer the reasons for imbalances in the uses of funds in the past and take
corrective measures for the future.

2. Answers Various Financial Questions:

Fund flow statement helps us to answers various financial questions such as:

(a) How much fund flowed into the business?

(b) How much of these funds were provided by the operations?

(c) What are the other sources of funds?

(d) How were these funds used?

(e) Why was there less/more amount of net working capital at the end of the period than at the
beginning?

(f) Why were the dividends not larger?

(g) How was the purchase of fixed assets financed?

(h) Where have the net profits gone?

(i) How were the loans repaid?

3. Rational Dividend Policy:

Sometimes it may happen that a firm, instead of having sufficient profit, cannot pay dividend due to
inadequate working capital. In such circumstances, fund flow statement shows the working capital
position of a firm and helps the management to take policy decisions on dividend etc.

4. Proper Allocation of Resources:

Financial resources are always limited. So it is the duty of the management to make its proper use. A
projected fund flow statement enables the management to take proper decision regarding allocation
of limited financial resources among different projects on priority basis.

5. Guide to Future Course of Action:

The future needs of the fund for various purposes can be known well in advance from the projected
fund flow statement. Accordingly, timely action may be taken to explore various avenues of fund.

6. Proper Managing of Working Capital:

It helps the management to know whether working capital has been effectively used to the maximum
extent in business operations or not. It depicts the surplus or deficit in working capital than required.
This helps the management to use the surplus working capital profitably or to locate the resources of
additional working capital in case of scarcity.

7. Guide to Investors:

It helps the investors to know whether the funds have been used properly by the company. The
lenders can make an idea regarding the creditworthiness of the company and decide whether to lend
money to the company or not.

8. Evaluation of Performance:

Fund flow statement helps the management in judging the financial and operating performance of the
company.

What is 'Cost Of Capital'

The cost of funds used for financing a business. Cost of capital depends on the mode of financing used
– it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if
it is financed solely through debt. Many companies use a combination of debt and equity to finance
their businesses, and for such companies, their overall cost of capital is derived from a weighted
average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the
cost of capital represents a hurdle rate that a company must overcome before it can generate value, it
is extensively used in the capital budgeting process to determine whether the company should
proceed with a project.

What is 'Weighted Average Cost Of Capital - WACC'

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are
included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity
increase, as an increase in WACC denotes a decrease in valuation and an increase in risk.
To calculate WACC, multiply the cost of each capital component by its proportional weight and take the
sum of the results. The method for calculating WACC can be expressed in the following formula:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D = total market value of the firm’s financing (equity and debt)

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

What is 'Net Present Value - NPV'

Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected
investment or project.

A positive net present value indicates that the projected earnings generated by a project or investment
(in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with
a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. This concept
is the basis for the Net Present Value Rule, which dictates that the only investments that should be
made are those with positive NPV values.

Sources of long term and short term finance

Short Term Financing

Banks can be an invaluable source of short term working capital finance.

1. Overdraft Agreement:

By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to
a certain limit without the need for further discussion. The bank might ask for security in the form of
collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if
the business is confident of making the repayments quickly, then an overdraft agreement is a valuable
source of financing, and one that many companies resort to.

2. Accounts Receivable Financing:

Many banks and non-banking financial institutions provide invoice discounting facilities. The company
takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due
date the bank collects the money from the customer. This is another popular method of financing
especially among small traders. Businesses that offer large terms of credit can carry on their operations
without having to wait for the customers to settle their bills.

3. Customer Advances:

There are many companies that insist on the customer making an advance payment before selling them
goods or providing a service. This is especially true while dealing with large orders that take a long time
to fulfill. This method also ensures that the company has some funds to channelize into its operations
for fulfilling those orders.

4. Selling Goods on Installment:

Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles and so on,
allow customers to make their payments in installments. Since many of these items have become
modern day essentials, their customers might not come from well-to-do backgrounds or the cost of the
product might be too prohibitive for immediate payment. In such a case, instead of waiting for a large
payment at the end, they allow the customers to make regular monthly payments. This ensures that
there is a constant flow of funds coming into the business that does not choke up the accounts
receivable numbers.

Long-Term Financing

Relying purely on short-term funds to meet working capital needs is not always prudent, especially for
industries where the manufacture of the product itself takes a long time: automobiles, aircraft,
refrigerators, and computers. Such companies need their working capital to last for a long time, and
hence they have to think about long term financing.

1. Long-Term Loan from a Bank:

Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their
working capital needs for two, three or more years.

2. Retain Profits:

Rather than making dividend payments to shareholders or investing in new ventures, many businesses
retain a portion of their profits so that they may use it for working capital. This way they do not have to
take loans, pay interest, incur losses on discounted bills, and they can be self-sufficient in their financing.

3. Issue Equities and Debentures:

In extreme cases when the business is really short of funds, or when the company is investing in a large-
scale venture, they might decide to issue debentures or bonds to the general public or in some cases
even equity stock. Of course, this will be done only by conglomerates and only in cases when there is a
need for a huge quantum of funds.

Companies cannot rely only on limited sources for their working capital needs. They need to tap
multiple avenues. They also need to constantly evaluate what their needs are, through analysis of
financial statements and financial ratios, and choose their working capital channels judiciously. This is an
ongoing process, and different routes are appropriate at different points in time. The trick is to choose
the right alternative as per the situation.

Why working capital management

Proper management of working capital is essential to a company’s fundamental financial health and
operational success as a business. A hallmark of good business management is the ability to utilize
working capital management to maintain a solid balance between growth, profitability and liquidity.

A business uses working capital in its daily operations; working capital is the difference between a
business' current assets and current liabilities or debts. Working capital serves as a metric for how
efficiently a company is operating and how financially stable it is in the short-term. The working capital
ratio, which divides current assets by current liabilities, indicates whether a company has adequate cash
flow to cover short-term debts and expenses.

What is a 'Dividend Policy'

A dividend policy is the policy a company uses to decide how much it will pay out to shareholders in the
form of dividends. Some research and economic logic suggests that dividend policy may be irrelevant (in
theory), but many investors rely on dividends as a vital source of income.