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FIRST SESSION

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What is Finance?

• As a term ‘Finance’ is defined in various ways, However a more comprehensive definition of finance could be:– Finance is the set of administrative functions in

an organization which manage the flow of cash within an organization so that the organization will have the means to carry out its objectives as easily as possible and in the meantime also meet the obligations as they become due.

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Main subdivisions of Finance

• Finance is traditionally sub-divided into 3 interrelated segments:

Finance

Financial Management Investments

Financial Markets and Institutions

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1. Financial Management

• Specialty area of finance.• Financial management is known by

different names.• Interrelated decision making process.• Three main types of financial

management decisions. • Important for financial managers to

evaluate these decision on an interrelated basis.

Financial Management

Financial Decision Making

Investment Decision Making

Managerial Decision Making

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i. Investment Decisions

• Long term in nature.• ‘Capital budgeting’ decisions.• Example: Sale of a division or business, change in method of

advertising, expansion, acquisition, modernization and replacement of long term assets all have potential to impact firm’s expenditures and benefits in the long run and are known as capital budgeting decisions.

• Involves determining the type and amount of assets the firm wants to buy and hold.– Example: Spinning machine for a textile unit, setting up an

electric power generating facility for a sugar mill.

Assets are any item owned by an individual or company which has value (i.e. they could be sold).

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i. Investment Decisions

• Involve finding a right balance between long-term and short-term goals.

• Explained through example.

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i. Investment Decisions

• Asset side of balance sheet (left-hand side) is related to investment decisions.

Assets5

Machinery 100105

Total Current AssetsTotal Long Term Assets

Total Assets

Investment decision

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i. Investment Decisions

• Common investment decisions to be undertaken by the financial manager:– In what lines of business should the firm engage?– Should the firm acquire other companies?– Should the firm modernize or sell an old

production facility?

• Note.

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ii. Financing Decisions

• The second question that a financial manager faces.

• Concerned with the ways and sources through which firm obtains and manages long term financing it needs to support long term investments.

• A firm’s capital structure refers to the specific mixture of debt and equity the firm uses to finance its investments.

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ii. Financing Decisions• An important part of manager’s financing decisions is to answer

the question, ‘How to raise cash for meeting firm’s capital expenditures?

• The answer to this questions involves the right side of the balance sheet, the firm’s capital structure.

Liabilities xOwner's Equity 105

105

Liabilities and Equity

Total Liabilities and Equity

Financing decision

Stockholders’ equity representing owner investment into assets of the company.

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ii. Financing Decisions

• Types of Financing:– Equity financing– Debt Financing

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ii. Financing Decisions

• Common Financing decisions to be undertaken by the financial manager:– How to finance?– Short-term or long-term?– People or banks?– Wait or to invest now?

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iii. Managerial Decisions

• Concerned with day-to-day decision making– Making investing and financing decisions that

improve the firms value for its owners.– What should be the growth rate of the firm?– Does a firm need external (debt) financing? If Yes,

then work to improve credibility so that financial institutions would grant loans.

Functions of Financial Manager1. Financial analysis– Discovering full meaning contained within F.S.– Unlock activity pattern.

2. Financial planning– Deciding how much and where to invest

3. Financial forecasting– Primary function, estimate financial requirement

4. Financial control– Tracking performance and evaluating org. progress towards

achieving organizational goals

5. Interrelation with other departments– Very important to regularly interact and maintain relationship

Goals of Financial Manager

• F.M. makes decisions for stockholders of firm• From stockholders P.O.V what would be a

good F.M. decision?

• The goal of maximizing stock value avoids a number of problems. – Stockholders are residual owners of a firm.

The goal of financial manager of a corporation is to increase the value per share of the corporation’s stock.

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Agency Relationships• Goal of a financial manager is to act in best interest of

stockholders.• However, in large corporations extreme diversity of

ownership.• Dispersion in ownership Greater managerial control• Agency relationship

• Two main players

The relationship between stockholder and manager is called

agency relationship.

Within the financial management context the primary agency relationships are of 2

types:

1. Between shareholders and management

2. Between shareholders and creditors

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1. Stockholders versus managers

• Stockholders delegate decision making authority to managers to run the business.

• This relationship between stockholder and manager is called agency relationship.

• Several problems may exist with this agency relationship:i. Managerial abuse of benefits putting cost on firm

and its stockholdersii. Managers acting in their own self interest (behavior

towards risk)

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1. Stockholders versus managers

• Firms incur cost to reduce the conflict.

Agency cost

Direct agency costCorp. exp. at the expense of shareholders,

Monitoring cost

Indirect agency costResult from managers’ failure to

make a profitable investment because of its aversion to risk

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1. Stockholders versus managers

Different mechanisms to reduce conflict between shareholders and managers

• How to make managers work in stockholder’s best interest?

• By using a mixture of reward and punishment strategies:i. Managerial Compensationii. Direct intervention by stockholdersiii. Threat of firingiv. Threat of takeover

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i. Managerial Compensation• Managerial compensation package must meet

two objectives:– Attract and retain able managers– Offer executives incentives to motivate them to take actions

that will enhance shareholder wealth(stock price maximization)

• Bonus• Performance shares• Executive stock option

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iii. Threat of takeover• Occurs when:

– A firm's stock is undervalued relative to its potential because of inadequate management

• Acts as a check on manager performance because:– In a hostile takeover, the senior managers of the acquired firm are

typically dismissed.

iv. Threat of dismissalii. Direct intervention by stockholders

– Today institutional investors hold a large portion of company’s stock and can intervene to nominate members to BOD who’d represent their interest.

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2. Stockholders (through managers) versus creditors

• Conflict of interest may also exist between stockholders and creditors.

• Stockholders through managers may take steps that tend to maximize shareholder value but works against the cause of creditors– Invest in risky projects – if successful all benefits go to stockholders if

unsuccessful creditors bear the risk.

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Practical Illustration >

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2. Stockholders versus creditors

Different mechanisms to reduce conflict between shareholders and creditors

• Creditors may charge higher rate upfront• Writing detailed debt agreements/covenants

SECOND SESSION

What are Financial Statements?

• Financial statements are records that outline the financial activities of a business.

• Presentation of financial information in a clear manner.

• Aiding creditors and investors in making effective credit and investment decisions.

Basic Financial Statements used in Financial Analysis

• Two basic financial statements that are used in financial analysis:– Balance sheet (statement of financial position)– Income statement (profit and loss statement)

Balance Sheet

• Financial snapshot of a company at a particular point in time.

• Components:– Assets– Liabilities and owner’s equity

Income Statement

• Income statement reports the primary performance measure of a company i.e. revenue less expenses during an accounting period.

Significance/need for the analysis of Financial Statements

• It is important to analyze financial statements as this analysis aids in getting information about a company’s:1. Liquidity position2. Growth rate3. Profitability4. Capacity to borrow5. Credit worthiness6. Assessing market risk7. Financial strengths and weaknesses

1. Liquidity position

• “The ease or convenience with which we can convert a current asset into cash”– Speed– Convenience – Fair price

2. Growth rate• Financial analysis involving growth rate

focuses on whether a company is growing in sales, stock price, profitability etc.

3. Profitability• Taking help from profitability ratios to

make important financial decisions

4. Capacity to borrow• Using debt ratios to determine portion of

firms total assets financed with creditor’s funds

• Long term creditors most interested in firm’s debt ratio

• High debt ratio sends warning signal to firms’ creditors

6. Credit worthiness• Capacity to meet debt obligations in full and on

time• Credit ratings help determine CW.

5. Assessing market risk• Analyzing past financial statements to determine

trends w.r.t. elements that control market risk

7. Strengths and weaknesses

Users of Financial Statements

Users of Financial Statements

Internal users- Management

- Investing public-Creditors

External users- Government

- Auditors- Potential investors

Ratio Analysis

• “Ratio is the mathematical relationship of one number to another number”.

• Financial ration analysis is a valuable tool helping small business owners and managers measure their progress against:– A competing firm/s– Industry average– Previously defined internal goal

5 main categories of Financial Statement

ratios

Liquidity ratiosAsset

Management Ratio

Debt utilization

ratio

Profitability ratio

Market value ratio