FINANCE FOR STRATEGIC MANAGERS

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1 FINANCE FOR STRATEGIC MANAGERS 1 P age

2 FINANCE FOR STRATEGIC MANAGERS S. No Description Page No I UNDERSTAND THE ROLE OF FINANCIAL INFORMATION IN BUSINESS STRATEGY 1. Need for Financial Information 1.1 Major Financial Activities of the Enterprise Mobilisation of Funds Required by the Enterprise Effective Use of Funds of the Enterprise 1.2 Strategic Managers Need Financial Information for Decision-Making 1.3 Assessing Finance Requirements 1.4 Obtaining Finance 1.5 Investment Decisions 1.6 Dividend Decisions 1.7 Setting and Meeting Targets 1.8 Appraising New Projects (Capital Budgeting) 1.9 Sources of Long-Term Finance 1.10 Managing Risks 1.11 Reporting to Shareholders and the Stock Exchange 2. Time Value of Money 2.1 Concept of Time Value of Money 2.2 Value of Money Received at Different Time 2.3 Compounding Technique 2.4 Technique of Discounting 3. Financial Information 3.1 Cash Flows 3.2 Profitability 3.3 Business Value 3.4 Financial Stability 3.5 Cost Projections 4. Business Risks 4.1 Concept of Risk 4.2 Systematic & Unsystematic Risks Systematic Risks Unsystematic Risks 4.3 Managing Risk: Trade-Off between Risk & Return 4.4 Risk-Modelling II. BE ABLE TO ANALYSE PUBLISHED FINANCIAL STATEMENTS FOR STRATEGIC DECISION MAKING PURPOSES 5. Published Accounts 5.1 Purpose of Published Accounts or Financial Statements 5.2 Users of Published Information 5.3 Annual Report of the Company 5.4 Internal Management Accounts versus Published Financial Accounts 5.5 Weakness of Published Accounts 2 P age

3 6. Structure of Financial Statements 6.1 Main Financial Statements 6.2 Balance Sheet Equity & Liabilities Assets 6.3 Statement of Profit and Loss Revenue Expenses 6.4 Cash Flow Statement 6.5 Notes to Accounts 7. Analysis & Interpretation of Financial Statements 7.1 Analysis of Financial Statements Comparative Statement Common-Size Statement Ratio Analysis Cash Flow Statement 7.2 Types of Financial Statements Analysis 7.3 Purpose of Financial Analysis 7.4 Comparison between Years Comparison between Years based on Comparative Balance Sheet Format of Comparative Statement of Profit & Loss Comparative Financial Statements Using Common Size Statement Common Size Statement for Profit & Loss Common Size Statement for Balance Sheet 7.5 Company/Industry Comparisons & Benchmarking 7.6 Difference between Capital and Revenue Expenditure 8. Accounting Ratios 8.1 Accounting Ratios 8.2 Reasons for using Ratios 8.3 Types of Accounting Ratios 8.4 Liquidity Ratio (Short-Term Solvency Ratios) 8.5 Capital Structure or Solvency Ratios (Long Term Solvency Ratios) 8.6 Activity / Efficiency Ratios 8.7 Profitability Ratios 8.8 Investor Ratios 8.9 Limitations of Ratio Analysis III. UNDERSTAND HOW BUSINESSES ASSESS AND FINANCE THE NON-CURRENT ASSETS, INVESTMENTS AND WORKING CAPITAL 9. Short and Long-Term Finance 9.1 Finance for Business 9.2 Meaning of Short Term and Long Term 9.3 Short-Term Finance 9.4 Long-Term Finance 9.5 Differences between Short & Long-Term Finance 9.6 Matching Finance-Issues with the Specific Business Requirement 3 P age

4 10. Sources of Finance 10.1 Range of Sources 10.2 Internal and External Sources Internal Source of Finance External Sources of Finance 10.3 Sources of Short-Term Finance Purpose of Short-term Finance Sources of Short-term Finance Merits and Demerits of Various Short-Term Finance Systems 10.4 Sources of Long -Term Finance Purpose of Long-term Finance Factors Determining Requirements of Long-term Finance Sources of Long-term Finance Merits / Demerits of Popular Sources of Long-Term Finance 10.5 Role of Markets and Government 11. Cash Flow Management 11.1 Objectives of Cash Management 11.2 Strategy for Cash Management 11.3 Cash Flow Forecast 11.4 Budgetary Control Process Budgetary Controls Cash Budget 11.5 Managing Inventory Necessity of Holding Inventory Managing the Inventory 11.6 Managing Trade Payables 11.7 Managing Trade Receivables 12. Investment Appraisal Techniques (Capital Budgeting) 12.1 Capital Budgeting 12.2 Capital Budgeting Decisions 12.3 Use of Cash-Flow Analysis in Capital Budgeting Process 12.4 Types of Cash-Flows Associated with Capital Budgeting 12.5 Payback Method for Analysing Investment Project 12.6 Accounting Rate of Return (ARR) Method 12.7 Discounted Value (Present Value) Method 12.8 Net Present Value (NPV) Method 12.9 Internal Rate of Return (IRR) Method Profitability Index (PI) or Benefits-Cost Ratio Method IV. UNDERSTAND DIFFERENT OWNERSHIP STRUCTURES AND HOW THEY INFLUENCE AND MEASURE FINANCIAL PERFPRMANCE 13. Ownership Structure 13.1 Sole Trader or Sole Proprietorship 13.2 Partnership 13.3 Types of Partnership 13.4 Private Corporation 13.5 Other Types of Corporations S Corporation 4 P age

5 Limited Liability Company (LLC) Private Limited Company Public Limited Company Non-Profit Corporations Cooperatives Limited by Guarantee Companies 13.6 Public Sector Organisation 13.7 Accounting Standards 13.8 Tax Laws 13.9 Commercial Laws 14. Accountability and Roles 14.1 Accountability Concept 14.2 Accountability towards Stakeholder Interests Control Issues 14.3 Shareholder versus Sole Trader 14.4 Manager and Owner 14.5 Decision-Making Interests 14.6 Organisation Strategy 14.7 Corporate Social Responsibility (CSR) 5 P age

6 I. UNDERSTAND THE ROLE OF FINANCIAL INFORMATION IN BUSINESS STRATEGY 6 P age

7 UNIT 1. NEED FOR FINANCIAL INFORMATION 1.1 Major Financial Activities of the Enterprise 1.2 Strategic Managers Need Financial Information for Decision-Making 1.3 Assessing Finance Requirements 1.4 Obtaining Finance 1.5 Investment Decisions 1.6 Dividend Decisions 1.7 Setting and Meeting Targets 1.8 Appraising New Projects (Capital Budgeting) 1.9 Sources of Long-Term Finance 1.10 Managing Risks 1.11 Reporting to Shareholders and the Stock Exchange 1.1 Major Financial Activities of the Enterprise All business activities have certain financial implications. The objectives of a business organisation is mostly expressed in finance-related terms like business share or market leadership, cost leadership, profitability, wealth maximisation etc. Financial management at corporate level is concerned with taking decisions regarding planning, organising, and controlling of financial activities of the organisation. There are two major areas of financial management relating to: (i) arranging the required funds for the organisation; and (ii) effective-utilisation of these funds for achieving the objectives of the organisation Mobilisation of Funds Required by the Enterprise Funds for a business enterprise can be obtained from different sources which have different degree of cost, risk and control factors for the organisation. Finance managers have an important responsibility to ensure that funds are procured at minimum cost, at relatively low risk and control factors. Different sources of funds namely equity shares, bank-loans, other credits, debts, foreign direct investments (FDI) etc carry different level of annual pay-backs, and pose different levels of financial risks. Therefore, senior managers of the enterprise need appropriate financial information for taking various strategic decisions, such as: Options for raising funds from various sources; Determining the optimal finance-mix (financial packages from various sources) for the organisation; Action-plan for raising the funds at minimum possible cost(s); and Allocation of profits into (i) dividends for shareholders and (ii) retention within the organisation Effective Use of Funds of the Enterprise An important responsibility of a Senior Financial Manager is ensuring optimum allocation and utilisation of funds to various activities. He has dual responsibility: funds should not be kept idle; and funds must be used optimally to get best possible returns to the organisation. A fundamental requirement is that the funds must generate more income for the enterprise than the cost of the (procurement of) the funds. The Finance Managers require proper financial information and 7 P age

8 knowledge regarding capital-budgeting techniques and also for working capital management techniques. 1.2 Strategic Managers Need Financial Information for Decision-Making Various types of decisions taken by strategic managers of an enterprise require extensive information, knowledge and skills of financial nature so that they may carry out proper quantitative analysis of all related issues to arrive at optimal decisions. As discussed above, managers need variety of financial information for: assessing the finance-requirements of the enterprise; and procuring finance at minimum possible cost and manageable risks. Many financial decisions are inter-related; and such issues are considered simultaneously to arrive at proper decisions in the short-term and long-term interests of the enterprise. Various important corporate decisions needing detailed and accurate financial information include: Assessing the requirements of funds for the enterprise; Understanding short-term & long-term requirement of funds; Deciding proper capital structure for meeting the fund-requirement; Working-capital management; Cash management; Financial negotiations; Investment decisions; and Dividend decisions etc. Some of these important examples of financial information required by the corporate decisionmakers are described briefly in subsequent sections of this Unit. These are also the important roles of Senior Finance Manager in a business enterprise. 1.3 Assessing Finance Requirements A business company needs finance for its short-term and long term needs. As a practice, these are carefully forecasted or assessed. For this, the business managers need extensive information regarding various activities needing allocation of funds. Major activities needing fund allocations include the following: Investments for fixed long-term assets; Working capital requirements; Estimation of funds blocked in current assets; and Other liabilities needing payments in the period under consideration. Techniques namely budgetary-control and long-range planning are used for forecasting the requirement for finance. Based on such forecasting regarding all business activities, a proper estimate is prepared for fund-requirements. 1.4 Obtaining Finance Adequate financial information is required for understanding of fundamental issues & activities for which funds are required to be raised. These activities include: Identifying the possible sources of finance; Analysing the cost of finance from each possible source; 8 P age

9 Carrying out cost-benefits analysis for raising funds from different sources; and Taking decisions regarding the fund/source-mix or the capital structure. After deciding on requirement of finance, a decision is taken regarding the sources from where funds are to be raised and also a proper source-mix has to be decided as various sources of funds have different risks and control issues. The management has to decide on the proper capital structure by evolving balance between long-term funds and short-term funds. Due care has to be taken to ensure that sufficient funds are available for use as the working-capital. Both profitability and liquidity issues have to be considered simultaneously by the Financial Managers. The main objective in arranging for corporate finance is to procure funds at minimum cost. 1.5 Investment Decisions The funds raised have to be properly utilised for generation of revenue and profits. This activity is aiming at effective use of funds raised for the organisation. The Finance Managers have to: analyse the investment proposals received from various groups of the organisation; analyse various investment-proposals using the established techniques; rank the investment-proposals on the basis of the evaluation criterion; and decide on most-attractive investment proposal for the organisation. Taking investment decisions about the long-term assets involves use of a financial technique called Capital Budgeting. Deciding on short-term assets involves use of technique called Working Capital Management. The investment proposals are analysed to calculate cost of funds and also the benefits and financial-returns from the investment. The timing and magnitude of the cash-flows likely to be generated are also assessed and analysed. Working capital management is also called short-term financial management. It takes care of cash requirements for day-to-day dealings involving current assets. It is important as meeting the shortterms requirements is crucial for ensuring success of the business in the long-term. Sufficient availability of cash with various units of the organisation is essential for ensuring liquidity for the organisation. But on the other side, keeping large amount of cash money in the organisation means that such money is not being used for revenue generation; and it has adverse affect on the profitability of the organisation. Therefore, a judicious balance has to be achieved between liquidity and revenue generation for profitability. 1.6 Dividend Decisions Senior managers have important responsibility in taking dividend related decisions for the enterprise. The company earns certain net profit after providing for depreciation and making payment of taxes as applicable. This net profit can be partly distributed as dividend among the shareholders of the company, and the balance called retained profit remains with the company as the reserve over the existing equity capital. Retained profit can be used as internal finance for business investment. It thus helps in further generation of revenue and helps the organisation in earning further profit for the shareholders. Though the above mentioned dividend related decision-making looks very simple, it can affect the market price of company s shares and also the sentiments of the shareholders. It can have an important impact on shareholders interest in investing for further equity capital, if such an offer is made by the company. However, the accumulated retained profit can also be used as the basis of a right-issue offer for new equity capital for the existing shareholders. Such right issues are generally 9 P age

10 made at a price lesser than the net worth value of existing share (to make the offer attractive for the shareholders). 1.7 Setting and Meeting Targets The senior managers set goals and targets for achievement of progress for the company for meeting its objectives. Such targets may be in terms of sales-targets, production-quality targets, employee productivity targets, accident-free days targets, cost-reduction target, market-share targets, or customer satisfaction target. These business-related targets have certain financial implications. For example, sales targets are related to production quality, product pricing, and more importantly providing customers satisfaction. Each of these issues has cost implications which need to be resolved through a balanced approach. The production may be organised to produce better quality products; which have higher customer-value, result in higher level of satisfaction for the customers at relatively lesser price. Such a combination provides a winning strategy for the company leading to higher sales, cost-reduction for the product, and higher profitability for the company. 1.8 Appraising New Projects (Capital Budgeting) Any new project has three common characteristics: It needs funds for investment (which may be for long-term); It has potential for providing good financial returns for the organisation in terms of revenue generation and good profitability, and Every investment proposal has inherent financial-risks which require careful analysis before taking any final decision. The new projects need large capital outlays and have to undergo careful appraisal from technical and financial aspects. The financial appraisal of new long-term project proposals is carried out using the Capital Budgeting technique. Some commonly used methods/techniques to arrive at capital budgeting decisions (for project appraisal) are mentioned below: Traditional Capital Budgeting Techniques; Average Rate of Return; Pay Back Method; Discounted Cash Flow (DCF)/Time-Adjusted Techniques; Cash Flow Analysis Method; Net Present Value Method; Profitability Index Method; and Internal Rate of Return. These are described in a subsequent unit on long-term financing. Various capital budgeting techniques are used to either (i) to assess the profitability of an investment proposal, or (ii) to rank various proposals on the basis of financial returns or payback. 1.9 Sources of Long-Term Finance A business enterprise needs funds to purchase (and to build) fixed assets namely land, buildings, office furniture, equipment, plant and machinery. Such funds are called fixed capital. A part of working capital is also of permanent nature. Long-term finance is required for following purposes: To finance fixed assets of the enterprise; 10 P age

11 To finance permanent part of the working capital ; and To finance growth and expansion of business. Numbers of sources are available to meet the requirements of long-term finance. Broadly these sources are of two types: (i) share capital, and (ii) debt financing. Various sources of long-term finance are as under: Ordinary Equity Capital; Preference Share Capital; Debentures and Bonds; Loans from Banks & Other Financial Institutions; Retained Earnings; and Bridge Finance Managing Risks All financial actions namely investments, loans, or any other activity have uncertainty regarding future outcome; and therefore have inherent financial risk. Such a risk arises as the financial outcome cannot be estimated or forecasted with accuracy. It is not practically possible to accurately forecast the possibility of occurrence of an event. In real-life situation, there may be three possibilities: Certainty: The risk associated is NIL. Risk: The outcome is not known, and the uncertainty poses a finite amount of risk. Uncertainty: The likely event, or the outcome is not known. Thus, there is total risk; as no idea is possible regarding the future state. In business activities, there can be various types of risks: Market Risk: Its examples may include sudden change in equity price, or change in foreign currency rates, or sudden fluctuations in commodity prices. Interest Rate Risk: There may be change in the interest-bearing assets namely loan, bond due to change in the interest rates. Purchasing Power Risk: There may be impact of inflation or deflation on an investment. Prices of goods or services may change due to changes in demand-supply conditions. In any business, changes in the business-risk conditions influence the financial returns. Generally a high-risk investment may lead to higher financial returns, though not always true. It is said that the risk and return go together. Therefore, business managers attempt to make some kind of tradeoff between the risk and the returns Reporting to Shareholders and the Stock Exchange The Board of Directors of a company have a legalistic responsibility to make a summary reporting about the company s performance and the financial results to the shareholders during their Annual General Meeting (AGM). An Annual Report is an essential requirement as per company laws of the country, and comprises of following documents authenticated by the Board of Directors: A Report prepared by the Board of Directors, presenting: Ø Report in terms of the Companies Act; Ø Directors Statement regarding their responsibilities; Ø Corporate Governance Report; Board s analysis of the prevailing business environment and the business-progress made by the company. 11 P age

12 Report of the Company s Auditors prepared as per the laid down Accounting Standards; Financial Statements prepared as per the Accounting Standards, giving summary of financial activities and achievements of the Company for the year under consideration, presenting: Ø Balance Sheet as on the end of last financial year; Ø Profit & Loss Statement for the last financial year; Ø Cash-Flow Statement. Ø Notes to the Accounts of the last Year. A copy of the Annual Report is required to be provided to the respective Stock Exchange where company s equity shares (and other financial instruments) are listed for the purpose of trading. The Annual Report can thus be accessed by anybody in the general public through the Stock Exchange. Thus, the annual report and its constituent financial statements meet the external need(s) for the financial information about the company. External investors, lenders, suppliers, general public and even the competitors use this information for assessing the financial state of the company. Other companies interesting to form joint ventures also need such financial information. Further, decisions regarding acquisitions and mergers are also taken by external agencies/companies on the basis of such financial information provided by the company in the open public-domain. 12 P age

13 UNIT 2. TIME VALUE OF MONEY 2.1 Concept of Time-Value of Money 2.2 Value of Money Received at Different Time 2.3 Compounding Technique 2.4 Technique of Discounting 2.1 Concept of Time-Value of Money In business environment, money is not kept idle as it does not earn further money when idling. The basic concept in business operations is that rather than keeping the money idle, it should be invested to generate more revenue. Therefore, if $ 1000 is earned and is available in a business organisation, it is to be invested further and is not kept idle. If the interest rate is 4%, than in one year, it can earn interest of $ 40, and thus then the total amount becomes $ In financial terms, we may state that at interest rate of 4%, the present value of money available is $1000, but its future value after 12 months is $ Stated in other way, if $ 1040 is likely to be received after 12 months, then its present value in $ In yet another manner, we may say that the discounted value today (at interest rate pf 4%) of $ 1040 receivable after 12 months, is $ It may be noted that interest rate is the yardstick for computation of value of money at different time. 2.2 Value of Money Received at Different Time Money received in future is less valuable than the money received today. The time value of money helps in converting the different money amounts arising at different points of time into equivalent values of a particular point of time. These equivalent values can be expressed as future values or as present values. By compounding techniques, the present value can be converted into a future value and by discounting method, a future value can be converted into present value. For this purpose, we use rate of interest as the discounting factor. Time Value of Money is an important concept in financial management. It is one of the important tools used in project appraisal to compare various investment alternatives. Time Value of Money is based on the concept that money invested today is worth more than the same amount expected to be received in future. For example, $ 1000 on hand now is more valuable than $ 1000 receivable after a year. A key concept behind Time Value of Money is that a single sum of money or a series of equal, evenly spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, there may be some cash flows of a single sum or a series of payments at some future times, then these future payments may be converted into their present money-values. The former is called the Future Value of Cash Flows. And the later is called the Present Value of (future) Cash Flows. Present Value is an amount that is equivalent to a future payment or a series of payments, that has been discounted by an appropriate interest rate. 13 P age

14 Discounting of future value is the process of determining the present value of future cash flows. It is an important concept, which is used in project appraisals. The opportunity cost rate is the rate available on the next best alternative with same equal risk as the current investment. Future Value is the amount of money that an investment with a fixed, compound interest rate will grow to, at a future date. 2.3 Compounding Technique The process of putting the money and any accumulated interest on an investment for more than a year s period, thereby reinvesting the interest is called compounding. Future Value of a Single Cash Flow:- Suppose that an infant-baby wins a Baby-Show, and wins $ 5000 gift receivable when the child attains the age of 18 years. This money can be invested at 10% per annum until the baby-child attains age of 18 years. Future-value concept helps in determining how much the child will receive will be in the account 18 years from now. The Future Value of a single sum is given by the formula: FV = PV (1+r) n Here, r = Rate of Interest, And n = Nos of years for which compounding is done. In this case, we have FV = $ 5000 (1.10) 18 = $ 27, Technique of Discounting Discounting the future value is the process of figuring out what that the future value is in terms of present day money. By compounding technique, the present value can be converted into a future value and by discounting method future value can be converted into present value. Present Value of a Single Future Amount:- Present value = Future Amount X ( 1/(1+r) n ) here r = Interest rate; n = number of periods, and X is the sign of multiplication. Present Value of an Ordinary Annuity:- Present value = Annuity Amount X (1/r) X [ 1 1/(1+r) n ] Here, r = interest rate, and n = number of periods. 14 P age

15 UNIT 3. FINANCIAL INFORMATION USEFUL IN DECISION MAKING 3.1 Cash Flow 3.2 Profitability 3.3 Business Valuation 3.4 Financial Stability 3.5 Cost Projections 3.1 Cash Flow The movement of cash in a business enterprise is seen as the flow of cash in and out of the enterprise. Such a movement of cash is referred as the cash-flow in the business organisation. The cash flow related information regarding a business enterprise forms the basis for preparing financial statements for the enterprise. It thus provides a basis to assess: (i) the ability of the enterprise to generate cash and cash equivalents and (ii) the needs of the enterprise to utilise these cash flows. The term cash broadly covers both, the currency and other generally accepted equivalents of cash, such as cheques, drafts, and demand deposits in banks. The broad term of cash also includes nearcash assets such as marketable securities and time deposits in banks. These are included in the term cash as these can be converted into cash. Thus, these support the liquidity of the organisation by providing cash in short time, when needed. Thus, the excess cash available can be kept as a shortterm investment instrument which may be encashed when need arises. There are four primary motives of maintain cash balances: transaction motive; precautionary motive, speculative motive, and compensating motive. There are inflows and outflows of cash and cash equivalents. When cash is paid out to receive/procure some asset, it is called outflow of cash. On the other hand, when cash is received on selling some asset or on maturity of other asset, or on sale of goods & services, it is called inflow of cash. A cash flow information when used with financial statements, provides information that helps in evaluating the changes in net assets of an enterprise. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents; and enables users to develop models for assessing and comparing the present value of the future cash-flows of different enterprise. In financial term, cost and benefits are measured through cash-flows. The costs are denoted as cash outflows and benefits are denoted as cash inflows. Thus, all estimates of receipts and payments are also based in terms of likely/expected cash flows in financial analysis. Cash inflows are shown with positive sign and cash outflows are shown with negative sign for the purpose of quantitative analysis. At the end of the operating cycle (generally the year-end) the annual report submitted to shareholders is accompanied by the Cash Flow Statement (CFS). Here the cash flows from different types of activities are reported under four major-heads as under: 15 P age

16 Cash Flow from Operating Activities; Cash Flow from Investing Activities; Cash Flows from Financing Activities; and Net Increase in Cash and Cash-equivalents 3.2 Profitability All types of capital raised for the business have certain cost (like the interest payable) which may be called as the pay-out. The funds available with the company are invested for generating revenue (income) for the enterprise. The difference between such revenue earned and the cost paid on the capital is called profit, and this process is called as the profitability process. Basic aim of business is profit generation through positive difference between income and expenditure. The business process is based on the principle of revenue generation through sales generated by meeting customers requirements and providing satisfaction to the customers. Thus, production and marketing are the basic workhorses for profit generation. External business environmental factors have strong influence of profitability of the firm. Therefore, different types of business strategies are adopted to ensure optimum degree of profitability for the enterprise. In trade and business: Profit = Price {Costs of production (and all allied expenditures)} (Depreciation) (Taxes as payable) Therefore, cost reduction and competitive advantage are the two very important strategies for enhancing profitability for the enterprise. Profitability is closely linked with effective utilisation of funds, particularly the cash funds of the enterprise. Thus cash management has an influence on profitability. Companies generally face the risk of running out of cash when the need arises to make payment through cash money. All companies want to ensure liquidity and avoid risk of becoming technical bankruptcy. Therefore, all business enterprise try to keep certain additional cash then what is necessary. But, keeping excess cash money means idle money which is not earning revenue. This has adverse effect of profitability of the company. Therefore there is a need for trade-off between liquidity and profitability. 3.3 Business Valuation The term valuation implies estimation of value of the asset, security-instrument, or a business. The purchasing decision regarding an asset is based on such a valuation. But there is no specific method of valuation of any asset; it is only based on estimation. Two different buyers may have different understanding regarding the worth/value of an asset. Business valuation is required to be done both for tangible as well as for intangible assets. Similarly the business liabilities may be both recorded liabilities and also unrecorded liabilities. Thus, the valuation process is affected by subjective considerations. Book Value: The assets are shown in the Balance Sheet and certain value is mentioned there. This value is called the book value of the asset. Generally, this amount is the initial acquisition cost of 16 P age

17 the asset less the accumulated depreciation. This method of valuation is as per the principles of accounting. This book value of an asset may differ with its sale value. The sum of book values of all assets of a business firm less the total of its external liabilities including preference shares gives the book value or net worth of a business entity. Market Value: The value at which the asset can be sold in the market, is called its market value. This valuation can be applied only to the tangible assets of a business entity. The intangible assets cannot be sold or purchased in the market. Therefore, they do not have market value. Market value of a company, listed in stock exchange, refers to the total price of all shares of the company as per the quotation in a stock exchange. Intrinsic Value: The intrinsic value of an asset is given by the discounted values of future cashinflows likely to occur due to the particular asset. When an asset is acquired and put to use, it is likely to earn certain cash flows in coming time. These cash-inflows are discounted at the appropriate rate of return to get the intrinsic or economic value of the asset. It is also an indication of maximum price a buyer may be willing to pay. This method of valuation using discounted values of future cash flow is similar to the methodology used for Capital Budgeting Decision-Making. (For present value and discounted value, see the previous Unit on Time-Value of Money.) Value of Goodwill: It has been noticed that business entities enjoying market goodwill, earn higher rate of return (ROR) on invested funds than by a similar firms without goodwill. As per this concept of goodwill, the value of goodwill is equivalent to the discounted present value of such additional profits due to goodwill, likely to accrue in future. Fair Value: The fair value of an asset or a business is in fact the hybrid of the book value, intrinsic value, and market value. It is most often is the average of these three values. 3.4 Financial Stability A firm acquires its assets using two types of funds: its equity funds or the borrowed capital (liabilities). The liability includes the borrowed capital and also value of goods provided by the creditors as per the general business practice. Owners equity (paid by owners/promoters and general public) is the internal or owner's fund. If the liabilities are greater than the owner's equity, than the firm can face a financial problem; as the creditors can demand their money, which the firm may not be able to pay at that particular time. This is a risk, which the business must avoid. In such a circumstance, if the creditors demand payment, owner may not be able to meet that obligation and the firm may fail. Therefore, the business should be able to demonstrate that: It can pay the creditors when payment is due. The profitability of the business is increasing. It has enough profits to cover the interests on liabilities. Its net cash flow is positive. 3.5 Cost Projections Before starting any venture or project, a proper estimate is needed for the total cost involved in different kinds of expenditures. At a preliminary stage, when exact cost figures are not available, a broad projection of costs involved is made to prepare the first estimate of the total cost involved. 17 P age

18 Compilation of cost projections for proposed task/investment/project involves following steps: Identification of broad heads of expenditures; Further, identification of minor heads of expenditure involved for each broad majorheads of expenditure for the proposed tasks/activities; Making best possible financial estimates of costs for each expenditure-head so identified; Summing up the estimated expenditures for all work-packages identified under above steps; Adding any further cost due to any other activities required to be undertaken to complete the procedural requirements or other necessities. Thus cost projection is carried out during the project planning stage for a project needing financial investments. Cost-projection statement and its analysis are the essential steps for estimating the future investments. The cost projections for a business project cover the cost of procurement of all assets, lease-based procurement costs, and also the amounts for all payable taxes. Further, there is a need for adding the capital required for purchasing the hardware-equipment required for business and the associated software; and also cost of training of employees. 18 P age

19 UNIT 4. BUSINESS RISKS 4.1 Concept of Risk 4.2 Systematic & Unsystematic Risks 4.3 Managing Risk: Trade-Off between Risk & Return 4.4 Risk-Modelling 4.1 Concept of Risk Exact guess regarding the future returns on investment can be made only in case of investments carrying a fixed rate of return. For other type of investments, it is not possible to guess the future rate of return. The situation where rate of return can be guessed, poses financial risk. Risk is defined as the variability that is likely to occur in future cash flows from an investment. Larger the variability of likely return, higher is the financial risks. Uncertain outcomes mean financial risks. A state of certainty means zero level of risk. Risk is a situation between certainty and uncertainty. Higher the degree of uncertainty, higher is the degree of risk. 4.2 Systematic & Unsystematic Risks Systematic Risks Systematic risks refer to situations, where the cause of risk can be understood and explained. Such factors affect all business in a similar way. Its systematic nature makes it explainable. For example, market related risk factors affect all business organisations operating in the market. Such market-related factors include changes in interest rates, and taxation policies etc. These types of risks are not manageable by individual investor or business entity. Systematic risks can be divided into following categories: market risks, interest rate risk, and purchasing power risk. (a) Market Risk: This risk refers to the situation when changes in market related factors reduce the profitability of business. This may be due to change in cost of finance or relating to cost of commodities required for business. Four factors may contribute to such risks: Ø Equity Risk arising out of changes (generally big fall) in equity share prices making it difficult to raise market finance; Ø Loan-Interest Rate Risk arising from variation (increase) in Loan-Interest rate etc, Ø Currency Risk arising from variation in foreign exchange rate, and Ø Commodity Risk arising due to change (increase) in commodity prices due to changes in demand-supply conditions and or due to inflation. (b) Interest Rate Risk: Change in the interest-rate affects the net cost of assets which are acquired using such loans. This may increase the cost of future investment, and introduce uncertainties in the likely income from such assets. (c) Purchasing Power Risk: Changes in inflation or deflation bring a change in the prices of goods and services, needed for running the business operations. Further, there may be changes in market demand-supply position. 19 P age

20 4.2.2 Unsystematic Risks Unsystematic risks refer to the factors which do not affect all business units in the same manner, but differently. For example, such factors may relate to changes in import/export policies, price rise in certain raw materials, and labour unrest etc. These are specific to certain types of businesses, and not the market as a whole. Unsystematic risks may have variety of reasons. One example is increase in cost of raw material and other inputs for some types of business. Such risks are specific only to few types of businesses for some period of time. These risks are commonly called Business Risks. Financial Risks refer to the situations where the revenue generated from the business are insufficient to cover the fixed charges like interest payments on debt payable. Management Risk refers to the situation when the managers of a business firm lack the required managerial knowledge and expertise manage the business operations and the competition, thereby not able to ensure profitably of business in a particular situation arising due to external business environment. 4.3 Managing Risk: Trade-Off between Risk & Return It is generally said that risks are inevitable and have to be faced. Business practices show that greater the risk, greater the gain. As stated earlier, return is defined as the variability of expected returns from an investment. Return is the gain or loss expected over a period of time. Business managers attempt to maximise/optimise the returns from their investments by adopting a tradeoff between risk and return. In business operations, returns and risks go together. Business decisions are based on finding optimal risk-return trade-off. If risk can be assessed properly, a comparison of return and risk is meaningful; and trade-off can be attempted. Risk arises when expected return is not known precisely. As the risk arises due to variability in the expectations, risk can be assessed through measurement of variability using statistical techniques, namely (i) standard deviation, (ii) variance, (iii) co-efficient of variation, (iv) skewness, and (v) probability distribution. 4.4 Risk-Modelling Capital Asset Pricing Model (CAPM): The standard deviation of the returns on the portfolio is used as an indicator of increase or decrease of risk. Thus, if adding a stock to a particular portfolio increases its standard deviation, then it means that the new stock adds to the risk of the portfolio. A variable Beta is used to assess the systematic risks. Beta is defined as under. Beta = Risk of the Market Portfolio when New Asset is added it Risk of the Market Portfolio Thus, Beta is a measure of the systematic risk of an asset relative to that of the market portfolio. Beta value of 1, indicates an asset of average risk. Beta value > 1, indicates that the selected investment is riskier than the average level of market-risk. Beta value < 1, indicates that new investment is less riskier than the market level. 20 P age

21 II. BE ABLE TO ANALYSE PUBLISHED FINANCIAL STATEMENTS FOR STRATEGIC DECISION MAKING PURPOSES 21 P age

22 UNIT 5. PUBLISHED ACCOUNTS 5.1 Purpose of Published Accounts or Financial Statements 5.2 Users of Published Information 5.3 Annual Report of the Company 5.4 Internal Management Accounts versus Published Financial Accounts 5.5 Weakness of Published Accounts 5.1 Purpose of Published Accounts or Financial Statements As per companies Act, business companies are required to disclose and publish their financial accounts or financial statements every year. The Financial Statements are summarised statements of accounting data prepared at the end of an accounting year. As required by the law, these serve as a medium of disclosing accounting information for use by the internal and external users. Following documents form part of the Yearly Financial Statements of a company: Balance Sheet: It is a statement of assets and liabilities, and their constituents, of the company at a particular date, generally the end of the accounting year. Statement of Profit and Loss: It is a statement showing the result of business operations in terms of the income and expenditure made during the accounting year. Notes to Accounts: It provides the details of items mentioned in the Balance Sheet and the Statement of Profits and Loss. Cash Flow Statement: it shows the flow of cash into the company (called Cash In-Flows or the Receipts) and the cash flowing out of the company (called Cash Out-Flows or the Payments). The objectives of financial statements are to disclose: Financial data on assets and the liabilities of the company at the end of the accounting year. Implications of financial profits on the financial-performance of the company. Summarised financial information about the company for use by various interested parties. Fair and correct picture of the financial position of the company as required under the Laws. It also serves as the basis of further reporting on the business operations of the company. 5.2 Users of Published Information (a) Internal Users The internal users of financial statements of a company may be classified in three categories as under: Shareholders: They have invested in the equity of the company and have a right to know the true picture regarding the financial position of the company, particularly its profitability, assets, liability, and cash position. Company s Management: They are responsible to manage the operations and profitability of the company. For this purpose, they need summarised financial position for taking appropriate decisions. 22 P age

23 Company s Employees: The employees have interest in the growth and profitability of the company, as their bonus is liked with the profits and the reserves of the company. (b) External Users The external users of financial statements of a company may be categorised as under: Investors: They need authenticated statement of financial position of the company so as to decide about continuing with their investments. Creditors: As per business practice, materials and semi-finished goods are supplied to the company on credit basis. The terms and conditions of credit vary with the financial position of a company. Therefore, the suppliers (as creditors) need to know authentic statements of financial position of a company. Banks and Other Lenders: As providers of loans, they are interested to know the true financial positions of the company so as to safeguard their loans and to ensure timely recovery of their loans. Cash Flow Statements provide useful information to assess the cash position of the company. Industry Bodies and Government Agencies: Government agencies make assessment of business related factors and to make assessment about various industry segments so as to make appropriate policies for industrial development and growth. 5.3 Annual Report of the Company A company is required, as per the law, to publish its Annual Report and provide prescribed information to help the users in making appropriate financial judgements and decisions about the company. The information is required to be disclosed in the Financial Statements, Board Report, and by a separate statement being part of the annual report. The Annual Report of a company comprises of following documents: A Report submitted by the Board of Directors having: Ø A report prepared according to the Company s Act and summarising the business environment, company s performance, and the results in brief; Ø Director s Responsibility Statement ; Ø Report on Corporate Governance ; and Ø Discussion/Comments by the Management. Auditor s Report, as per the provisions of the Company s Act. Financial Statements including: Ø Balance Sheet as on the last day of the accounting year; Ø Statement of Profits & Loss for the year ended; and Ø Cash Flow Statement. Ø Notes to the Accounts, providing: o o Accounting Policy followed by the Company; Notes to the Accounts giving details of the Items mentioned in the Balance Sheet and the Statement of Profit & Loss ; and Other additional information required to be disclosed in terms of the Company s Act. As per the company s Act, a company is required to hold a meeting of all shareholders once a year, called the Annual General Meeting (AGM). This meeting is convened to adopt, consider and approve the Board s Report, Balance Sheet, Statement of Profit and Loss, and the Cash Flow Statement. The meeting also considers the report of the Auditors appointed for the company in the last AGM. 23 P age

24 The Auditors are required to examine the Books of Accounts of the company, make a considered professional opinion on the financial figures provided in the Balance Sheet and the Statement of Profit and Loss. The Auditors record their expert-views, which are included in the Auditor s Report. The Annual Report is submitted to the shareholders for consideration in the Annual General Meeting. 5.4 Internal Management Accounts versus Published Financial Accounts Financial accounting is prepared to meet the requirements of the Companies Act for providing information regarding financial performance in the last accounting year to the shareholders, bankers, creditors, and others who are outside the organisation. Management Accounting is defined as the process of identification, measurement, analysis, interpretation, and communication of information for use by the management in planning, evaluating, and controlling the business operations within the organisation. Management accounting refers to (i) analysing the financial performance of a company and (ii) generating financial inputs for the management of the organisation, for use in financial planning (for the future) and for appropriate decision-making (for the present). Management accounting is prepared to meet the specific requirement(s) of the business-managers. Managerial accounting generates financial data for running the business activities of the organisation. Financial accounting provides the summarised authenticated financial results useful for evaluating the company s past performance. Major differences between financial accounting and managerial accounting are as under:- Financial accounting covers business results of the entire organisation, but management accounting may be prepared for a part of the organisation. Financial accounting discloses the financial results of the business for its stakeholders as per the requirement stipulated in the Company s Act. But management accounting information is prepared to provide to generate certain information required by the management of the organisation for planning and goal-setting. Financial accounting provides reports on the past performance whereas the management accounting aims at supporting the activities of the future. Financial accounting reports are prepared as per a specified format, but management accounting reports may be prepared in any format. 5.5 Weakness of Published Accounts The financial statements provide summarised financial information about a company, for a particular accounting period. While making a summary, specific details are not mentioned and are lost in the process. Their limitations are described as under: Use of different accounting practices may present all together different picture. Presents only the historic summarised statements, but not full year s picture. These are based on accounting practices. Financial statements present company s position in monetary terms. Only quantitative picture is presented, and qualitative explaination is not provided. Only a summarised picture is presented; details of various transactions of business activities are not presented. 24 P age