Financial Management

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Financial Management

Understanding Financial Statements

Analysis of Financial Statements

Introduction to Financial Management

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Understanding Financial Statements

Objective of this section is;

To get an understanding about the Financial Statements

Income Statement (Earnings Statement) Balance Sheet Statement of Changes in Equity Statement of Cash Flows Accounting Policies & Notes

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Uses of financial statements?

allow user to assess: financial position of the company success of its operations policies and strategies of management insight into future performance

Financial statements are “history” BUT they can help project the future

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Accounting Period

Although the firm’s life is continuous (going concern), financial data is presented for arbitrary time periods - year, quarter, etc.

Leads to make adjustments and estimates Ex. Accruals, depreciations.

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Income Statement

For a given Period (Ex. Year, semi annual etc.)

Realization Principle Matching Concept Accrual Vs. Cash

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Revenue ***Cost of sales (**)Gross profit ***Other income **Distribution Cost (**)Admin. Expenses (**)Other (**)Operating Costs (**)Operating Profit ***Finance Cost (**)Profit before tax ***Tax

(**)PAT ***Extraordinary Items (**)NPAT ***

Income Statement cont…) Ex.

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Issues of the Income Statement

Accrual basis Estimates, Ex. depreciation

provision for bad debts) Cash flow Vs. Income statement. Opportunity cost is not

considered.

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Balance Sheet

A “statement of financial condition”On a particular date (a “snapshot”)

Assets = Liabilities + Equities

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Assets Note Rs.

Non Current AssetsProperty, Plant equipment (*) ***

Investments (*)***Intangible Assets (*) ***

Current AssetsInventories (*) ***Debtors (*) ***Cash & Bank (*)***

Total Assets ***

Capital & LiabilitiesShare Capital (*) ***Reserves (*) ***Accumulated Profits (*) ***

Non- current LiabilitiesDebentures (*) ***

Current LiabilitiesCreditors (*) ***Bank OD (*) ***

Capitol and Liabilities ***

Balance Sheet cont… Ex.

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Issues of the Balance Sheet

Historical costTangible (ex. Fixed assets)Intangible (ex. TM,

Goodwill) Estimates (ex. depreciation) Non-Comparability (ex. Assets

acquired at different time periods)

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Statement of Equity

Documents changes in balance sheet equity accounts from one accounting period to the next

Provides an important link between the balance sheet and the income statement

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Cash Flow Statement A positive net income on the income

statement is ultimately insignificant unless a company can translate its earnings into cash

Only source in financial statement to learn about the generation of cash from operations is the statement of cash flows”

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Components of Cash Flow Statement

OPERATING ACTIVITIES INVESTING ACTIVITIES FINANCING ACTIVITIES

Which do you think is most important in assessing the firm’s prospects? Why?

Defining these activities may help answer the question...

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The most important component of a cash flow

All sources and uses of cash represent important information

But, only cash flows from operating activities represent cash generated internally

In order to SURVIVE, a firm needs to generate positive cash flows internally, i.e. from “what it does for a living”...

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Notes Are an INTEGRAL part of the statements

Provide summary of accounting policies

Present detail about particular accounts (e.g. inventory, investments, etc.)

Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes, etc.)

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Profitable, yet in Trouble?

A firm is defined as “profitable if it has a positive net income

A positive net income results from accrual-based revenues exceeding accrual-based expenses

A firm may have a positive net income, but this does not guarantee that the firm has the CASH to meet its obligations!

However, the idea is that, financial statements will be much more of a map

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Analysis of Financial Statements

The objective is to understand;

How financial statement analysis helps to assess the firm’s health.

The basic tools of financial statement analysis (e.g. trend, cross-sectional, and ratio analysis)

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Basic Tools

Common size financial statements

Financial ratio analysis Trend analysis Cross-sectional analysis

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Common Size Statements

Common size income statement expresses each income statement

category as a percentage of net sales Common size balance sheet

expresses each item on balance sheet as a percentage of total assets

Both statements facilitate structural analysis of the firm

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Ratio AnalysisA ratio measures the relationship

between two or more variables.

Motivation for use of ratios 1. Gives a summary statistic2. Helps to identify benchmarks3. Standardizes financial

statements4. Easy to measure

relationships5. Easy to make comparisons

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Ratio Analysis cont…

Profitability ratios Liquidity ratios Debt ratios Asset activity ratios Market value ratios

Five Categories of RatiosFive Categories of Ratios

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Ratio Analysis cont…

Profitability Ratios

Profit Vs. Profitability

Profitability ratios measure the overall effectiveness of the firm’s management.

There are two profitability ratios

Profit on Sales

Profit on Investment

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Gross Profit Margin Gross ProfitSales

Measures a firm's ability to control its expenses relative to its sales.

Operating profit margin

Operating IncomeSales

How effective is the firm in keeping costs of production low

Net Profit Margin Net IncomeSales

How much net profit is being generated from sales

Return On Assets Net IncomeTotal Assets

How effectively is the firm generating net income from its assets

Return On Equity Net Income Common Equity

How well is the firm generating return to its equity providers

Profitability Ratios

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Profit margin ratio measures a firm's ability to control its expenses relative to its sales.

Profitability Ratios cont…

Gross Profit Margin =Gross Profit Margin = Gross ProfitSales

How effective is the firm in generating revenue in excess of its cost of goods sold?

Profit Margin

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Cash Rs.175 Accounts PayableRs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 BondsRs.600Plant & EquipmentRs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800

Total Owners’ Equity

Rs.1,700Total Liabilities and Owners Equity

Rs.2,530

SalesRs.1,450Cost of Goods Sold 875Gross ProfitRs.575Operating Expenses 45Depreciation 200Net Operating IncomeRs.330Interest Expense 60 Income Before TaxesRs.270Taxes (40%) 108Net IncomeRs.162Dividends Paid 100Addition to Retained EarningsRs.62

Balance SheetBeta Company Ltd.

Income StatementBeta Company Ltd.

575 1,450

Gross Profit Margin = = 39.7%

GrossProfit =Margin

Gross ProfitSales

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Operating Profit Margin =Operating Profit Margin =Operating Income

Sales

How effective is the firm in keeping costs of production low?

Operating profit margin


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Balance SheetBeta Company Ltd.

Cash Rs.175 Accounts PayableRs.115Accounts Receivable430 S-T Notes Payable Rs.115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 Long-term DebtRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Cap.l in Excess of ParRs.600 Total Assets Rs.2,530 Retained EarningsRs.800



Rs.2,530

SalesRs.1,450Cost of Goods Sold 875Gross ProfitRs.575Operating Expenses 45Depreciation 200Operating IncomeRs.330Interest Expense 60Income Before TaxesRs.270Taxes (40%) 108Net IncomeRs.162Dividends Paid 100Addition to Retained EarningsRs.62

Income StatementBeta Company Ltd.

330 1,450

Oper. Profit Margin = = 22.8%

OperatingProfit =Margin

Operating IncomeSales

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Net Profit Margin =Net Profit Margin =Net Income

Sales

How much net profit is being generated from sales?

Net Profit Margin


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Income StatementBeta Company Ltd

162 1,450

Net Profit Margin = = 11.2%

NetProfit =Margin

Net IncomeSales

Balance SheetBeta Company Ltd

Cash Rs.175 Accounts PayableRs.115Accounts Receivable430 S-T Notes Payable Rs.115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 Long-term DebtRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Cap.l in Excess of ParRs.600 Total Assets Rs.2,530 Retained EarningsRs.800



Rs.2,530

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Return on Assets = Return on Assets = Net IncomeTotal Assets

• How effectively is the firm generating net How effectively is the firm generating net income from its assets ?income from its assets ?

ROA dROA does not consider leverage

Return On Assets


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Sales Rs.1,450Cost of Goods Sold Rs.875Gross Profit Rs.575Operating Expenses Rs. 45Depreciation Rs. 200Operating Income Rs.330Interest Expense Rs. 60Income Before Taxes Rs.270Taxes (40) Rs.108Net Income Rs.162Dividends Paid Rs.100Addition to Retained EarningsRs.62


162 2,530

ROA = = 6.4%

Return onAssets

Net IncomeTotal Assets=


Cash Rs.175 Accounts PayableRs.115Accounts Receivable430 S-T Notes Payable Rs.115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 Long-term DebtRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Cap.l in Excess of ParRs.600

Retained EarningsRs.800



Rs.2,530

Total Assets Rs.2,530

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Return on Equity =Return on Equity = Net Income Common Equity

How well is the firm generating return to its equity providers?

Return On Equity


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Assets Liabilities



162 1,700

ROE = = 9.53%

Return on Equity = Net Income Common Equity


Cash Rs.175 Accounts Payable Rs.115Accounts Receivable430 S-T Notes Payable Rs.115Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300 Cap.l in Excess of Par Rs.600

Retained Earnings Rs.800

Total Liabilities and Owners Equity

Rs.2,530

Total Assets Rs.2,530Total Owners’ Equity Rs.1,700

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Current Ratio Current Assets Current Liabilities

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety

Quick/Acid-test ratio

Current Assets - InventoryCurrent Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted

Liquidity RatiosLiquidity Ratios

Measure the ability of the firm to meet its short-term financial obligations.

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Liquidity Ratios

Current Ratio =Current Ratio = Current Assets Current Liabilities

Measure the ability of the firm to meet its short-term financial obligations.

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

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Assets Liabilities

1,230230

Current Ratio = = 5.35

Current Ratio = Current Assets

Current Liabilities

Cash Rs.175 Accounts Payable Rs.115Accounts Receivable430 S-T Notes Payable 115Inventories 625 Current Liabilities Rs. 230 Current Assets Rs.1,230 Long-term DebtRs. 600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr (1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800

Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530

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Quick/Acid-test ratioQuick/Acid-test ratio

Acid-Test Ratio =Acid-Test Ratio = Current Assets - InventoryCurrent Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

Liquidity Ratios cont…

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Assets Liabilities

1,230 -625230

Acid-Test Ratio= = 2.63

Acid-Test Ratio = Current Assets - Inventory Current Liabilities

Cash Rs.175 Accounts Payable Rs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities Rs. 230 Current Assets Rs.1,230 Long-term Debt Rs. 600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr.(1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800

Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530

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Debt Ratio Total Debt Total Assets

What proportion of firm’s assets are financed with debt

Debt To Equity Ratio Total Debt Common Equity

What is the proportion of debt relative to equity financing for the firm

Times Interest Earned ratio

Operating IncomeInterest Expense

What is the firm’s ability to repay interest payments from their income

Debt RatiosDebt Ratios

Measure the relative size of the firm’s debt and the firm’s ability to pay off the debt.

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Debt RatiosDebt Ratios

Measure the relative size of the firm’s debt and the firm’s ability to pay off the debt.

Debt Ratio =Debt Ratio = Total Debt Total Assets

– What proportion of firm’s assets are financed with debt?

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Cash Rs.175Accounts Payable Rs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 8 00

Total Owners’ EquityRs.1,700


Rs.2,530


Assets Liabilities



230 + 600 2,530

Debt Ratio = = 33%

Debt Ratio = Total Debt Total Assets

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Debt to Debt to Equity Ratio Equity Ratio

Total Debt Common Equity

What is the proportion of debt relative to equity financing for the firm?

Debt Ratios cont…

Debt To Equity RatioDebt To Equity Ratio

==

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Cash Rs.175 Accounts Payable Rs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800

Total Owners’ Equity Rs.1,700Total Liabilities and Owners Equity Rs.2,530


Assets Liabilities



230 + 600 1,700

D/E = = 48.8%

Debt to Equity Ratio

Total Debt Common Equity=

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Times Interest Earned Ratio =Times Interest Earned Ratio = Operating IncomeInterest Expense

• What is the firm’s ability to repay interest payments from their income?

Debt Ratios cont…

Times Interest Earned ratioTimes Interest Earned ratio

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Cash Rs.175Accounts PayableRs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 Long-term DebtRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par

600 Total Assets Rs.2,530Retained Earnings 800

Total Owners’ EquityRs.1,700


Rs.2,530



Assets Liabilities


330 60TIE Ratio

=

= 5.5

TimesInterest =Earned Ratio

Operating IncomeInterest Expense

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Average Collection Period

Accounts Receivable Avg. Daily Credit Sales

How long does it take for the firm to collect its credit sales from customers

Inventory Turnover ratio

Sales Inventory

How many times the inventory is translated into sales

Fixed Asset Turnover Ratio

Sales Net Fixed Assets

How effective is the firm in using its fixed assets in generating sales

Total Asset Turnover Ratio

Sales Total Assets

How effective is the firm in using total assets to generate sales

Asset Activity RatiosAsset Activity Ratios

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Asset Activity Ratios

Help to assess how effectively the firm is using assets to generate sales.

Average Collection Period =Average Collection Period = Accounts Receivable Avg. Daily Credit Sales

How long does it take for the firm to collect its credit sales from customers?

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Cash Rs.175 Accounts PayableRs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230BondsRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par

600 Total Assets Rs.2,530 Retained Earnings800



Rs.2,530



Assets Liabilities


AverageCollection = Period

Accounts ReceivableAvg. Daily Credit Sales

430 1,450/365

ACP =

= 108.24 days

Days in a year

Days in a year

Additional Info:We assume all sales are creditsales.

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Inventory Turnover Ratio =Inventory Turnover Ratio = Sales Inventory

How many times the inventory is translated into sales?

Asset Activity Ratios cont…

Inventory Turnover ratioInventory Turnover ratio

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Cash Rs.175 Accounts PayableRs.115

Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current LiabilitiesRs.230 Current Assets Rs.1,230 Long-term DebtRs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common StockRs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par

600 Total Assets Rs.2,530 Retained Earnings

800Total Owners’ Equity


Rs.2,530


Assets Liabilities



1450625

Inventory Turnover = = 2.3

InventoryTurnover =Ratio

Sales Inventory

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Fixed Asset Turnover Ratio =Fixed Asset Turnover Ratio = Sales Net Fixed Assets

How effective is the firm in using its fixed assets in generating sales?


Fixed Asset Turnover RatioFixed Asset Turnover Ratio

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Rs.2,530


Assets Liabilities


1,4501,300

Fixed Asset Turnover = = 1.12

Fixed AssetTurnover = Ratio

Sales Net Fixed Assets

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Total Asset Turnover Ratio =Total Asset Turnover Ratio = Sales Total Assets

How effective is the firm in using total assets to generate sales?


Total Asset Turnover RatioTotal Asset Turnover Ratio

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Assets Liabilities






Rs.2,530




1,450 2,530

Total Asset Turnover = = 0.57

Total AssetTurnover = Ratio

Sales Total Assets

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Price to Earnings Ratio

Market Price per ShareEarnings per Share

How much are investors willing to pay per rupee of earnings of the firm/(Indicator of investor’s attitudes toward future prospects of the firm.)

Market to Book Ratio

Market Price per ShareBook Value per Share

How much are investors willing to pay per rupee of book value

Market Value RatiosMarket Value Ratios

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Price to Earnings Ratio =Price to Earnings Ratio = Market Price per ShareEarnings per Share

How much are investors willing to pay per rupee of earnings of the firm?

(Indicator of investor’s attitudes toward future prospects of the firm.)

Market Value Ratios

Measure the relationships between financial Measure the relationships between financial statement figures and market value of sharesstatement figures and market value of shares

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Rs.2,530

SalesRs.1,450Cost of Goods Sold 875Gross ProfitRs.575Operating Expenses 45Depreciation 200Operating IncomeRs.330Interest Expense 60 Income Before TaxesRs.270Taxes (40%) 108Net IncomeRs.162Dividends Paid 100Addition to Retained EarningsRs.62

Assets Liabilities



P/E Ratio

Market Price/ShareEPS

Additional Info:100 sharesRs.20.00 per share

20 162/100

P/E ratio = = 12.35

=

=

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Market to Book Ratio =Market to Book Ratio = Market Price per ShareBook Value per Share

How much are investors willing to pay per rupee of book value?

Market Value Ratios cont…

Market to Book RatioMarket to Book Ratio

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Assets Liabilities



20 1,700/100

M/B = = 1.18

Market to = Book

Price/Share Common Equity/ # shares


Additional Info:100 shares

Rs.20.00 per share

Cash Rs.175 Accounts Payable Rs.115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800

Total Owners’ Equity Rs.1,700Total Liabilities and Owners Equity Rs.2,530

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RatioRatio Industry Industry Beta Ltd. Beta Ltd.ProfitabilityProfitabilityGross Profit Margin 38% 39.7%Operating Profit Margin 20% 22.8%Net Profit Margin 12% 11.2%Return on Assets 9.0% 6.4%Return on Equity 13.4% 9.5%

Beta Ltd –

• May be Good at keeping operating costs down

• May not be good at controlling total costs

• ROA and ROE are low could be due to productivity problems.

Comparing the Beta Ltd with Industry Average

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RatioRatio Industry Industry Beta Ltd. Beta Ltd.

LiquidityLiquidityCurrent Ratio 5.00x 5.35xAcid-Test Ratio 3.00x 2.63x

Beta Ltd –

•Current Ratio – more liquid than the industry

• Acid Test Ratio -

•Not as liquid as the industry

•Could be due to high inventory levels

Comparing the Beta Ltd with Industry Average Cont..

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RatioRatio Industry Industry Beta Ltd. Beta Ltd.

DebtDebtDebt Ratio 35% 33%Times Interest Earned 7.00 5.5Debt to Equity 49% 48%

Beta Ltd –

•Interest cover is poor than the industry.

•Since the debt ratios are almost similar, this could be due to higher interest rates.

•Debt ratio & Debt to equity ratio are almost equal to the industry.

Comparing the Beta Ltd with Industry Average Cont..

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RatioRatio Industry Industry Beta Ltd. Beta Ltd. Asset ActivityAsset Activity Avg. Collection Period 90 days 108 daysInventory Turnover 3.00 2.32Fixed Asset Turnover 1.00 1.12Total Asset Turnover 0.75 .57

Beta Ltd –

• Collection policies need examining

• Inventory turnover is low may be due to high inventory levels

• Efficient at converting Fixed Assets in to Sales

• It may be due to lower book value of fixed assets

Comparing the Beta Ltd with Industry average Cont..

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RatioRatio Industry Industry Beta Ltd. Beta Ltd.Market ValueMarket Value Price Earnings 18.0 12.35 Market to Book 2.5 1.18

Beta Ltd –• Investors are not willing to pay as

much per rupee of earnings or per rupee of book value for shares of Beta

• This signals that they consider the firm’s prospects to be lower than the average.

Comparing the Beta Ltd with Industry average Cont..

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Relationships Among Ratios:The Du Pont Analysis

• Ratio Analysis generally involves an examination of related ratios.

Ex. Du pont Analysis.

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3.62% Growth

ROE 9.47%ERR

(1-0.62)

ROTA 6.37%Assets/Equity

1.48

Asset Turnover0.57

ROS 11.18%(Net margin)

Sales 1450

Investment 2530

NI 162

Sales 1450

Ex. The Du Pont Analysis

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Limitations of Ratio Analysis

1. Ratios based on financial data share the same limitations of financial data (ex. Accrual basis).

2. Changes in many ratios relate with other ratios so a direct interpretation of a change in a ratio is not always apparent.

3. Comparing ratios over time is complicated due to the fact that economic conditions may change.

4. Comparing ratios between two firms is complicated due to different –

Economic environments Technologies even though they produce the same

product Industries Strategies

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0

20

40

60

80

100

120

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Trend / Time series analysis Compare present with past. Forecast the future.

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Trend / Time series analysis

Trend Analysis

0

5

10

15

20

25

2000 2002 2004 2006 2008

Year

RO

I/RO

E

ROI ROE

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Cross-Sectional Analysis Compare with similar firms Compare with industry benchmarks.

Ratio Alfa Competitor Industry

ROS 20 22 20

ROI 16 18 16

ROE 15 19 15.5

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Time Series Cross-Sectional Analysis

Time Series Cross Sectional Analysis

0

5

10

15

20

2000 2002 2004 2006 2008

Year

ROE

Alfa Competitor

ROE Analysis

Year AlfaCompetito

r

2001 15 16

2002 14 15.5

2003 15.5 15

2004 14.5 15

2005 16 18

2006 15.5 18

2007 10 16

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Introduction to Financial Management

Financial management is concerned with the financial aspect of the firm.

It is part of the decisions and control sub-systems of the firm.

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Managers need to answer Will particular investment be profitable? Where will the funds come from to

finance the investment? Does the firm have adequate cash? Which customer should be offered credit? How much inventories should be held? Is merger or acquisition advisable How should profits be used or

distributed? What is the optimal dividend policy How risk and return are balanced?

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Organization of the Financial Management Function Organization of the Financial Management Function

Board of Directors

President/Chairman(Chief Executive Officer)

VP/DGMOperations

VP/DGMMarketing

VP/DGM

Finance

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TreasurerInvestors RelationCorporate Finance

Pension ManagementCash managementCredit Management

Organization of the Financial Management…Organization of the Financial Management…

DGM/VP of Finance

ControllerTax

Budget & AnalysisInternal Audit

Cost AccountingFinancial Reporting

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Objective of the Firm

Profit Maximization OR

Wealth Maximization

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ObjectiveObjectiveofof

ShareholderShareholder

Wealth Maximization Wealth Maximization (SWM)(SWM)

Profit maximizationProfit maximizationEPS maximizationEPS maximization

ObjectiveObjectiveofof

Financial ManagementFinancial Management( FM )( FM )

?Social Responsibility

• Ethical issues will constantly confront with financial managers as they try to achieve the goal of the firm ( SWM ).

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Maximization of wealth? Wealth? How can it be determined?

Market Value? Book Value? Liquidation value? Example;

You have purchased 1,000 of a listed company from the open market. To purchase the shares you have paid Rs. 23.50. The other information about the share as follows.

par value Rs. 10.00each Book value is 17.50 each Current market price 22.75.

Your wealth?

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Stockholderselect a boardof directors

Board of directors then hire

management( officers )

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Agency Consideration in Agency Consideration in Financial ManagementFinancial Management

Agents; A persons who performs activities for another person , called principle. Managers are the agents of the form

Principal; A individual who establishes a compensation scheme to motivate an agent to choose activities to the principal. Shareholders are the principals of the firm

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Agency Consideration in Financial Agency Consideration in Financial Management…Management…

Principal - Agent problem; The possibility that an agent will

act in her or his own self interest to the determent of the principal for whom she or he is acting

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Financial Environment The Role of Financial System

provides the mechanism by which funds can be transferred from those with surplus funds to those who wish to borrow.

acts as an intermediary between surplus and deficits

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Financial Intermediaries

Financial Markets

Lenders (Savers)1. Households2. Business Firms3. Government4. Foreigners

Borrowers (Spenders)

1. Households2. Business Firms3. Government4. Foreigners

The Flow of Funds

Funds Funds

Funds Funds

Indirect Finance

Direct Finance

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Financial Intermediaries (FI)

Individuals or institutions which bring borrowers and lenders of funds together to trade.

The FI aid in arranging financial transactions between surplus units and deficit units; banks as the main financial intermediary

involve in most of financing activities, (from the underwriting of shares to the issuing of bonds).

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Types of Financial Intermediaries

1. Commercial Banks. Major suppliers of short-term and medium-term loans to

businesses for various purposes. Accept time deposits and demand deposits. Provides these funds as loans to individuals, businesses and

governments.

2. Investment companies Include mutual funds and real estate investment trusts. Pool funds from many savers and invest them in various

types of assets.

3. Investment Bankers

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Types of Financial Intermediaries Cont……

4. Pension funds. Pool pension contributions from employers and their

employees and invest them in a variety of financial assets.5. Insurance companies

The premiums collected on insurance policies are invested in variety of assets.

The proceeds from these assets are used to pay claims against insured events/losses such as death, disability, accident, fire, etc.

6. Finance companies. Raise funds by issuing their own debt or by borrowing

from commercial banks. These funds are lended out to individuals and businesses.

7. Brokers

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Types of Markets Cont….

Market:

Any organized system which facilitates for meeting buyers and sellers.

Markets may exist in a specific physical location or not

Money/Capital Money Market:

Market for the short term securities having maturities less than one year.

Capital Market:

market for the Long-term securities having maturities greater than one year.

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Types of Markets Cont…

Primary/SecondaryPrimary markets: Primary markets are

markets that involve new issues of securities and hence, provide a direct flow of cash to the issuing entity.

Initial Public Offering (IPO); issuing equity to the public for the first time by a company.

Seasoned Offering (SEO); is simply selling more stocks by a firm is already publicly traded

Secondary Market: A market for the securities issued already. Secondary market exists for the trading of

common and preferred stock, warrants, bonds, and put and call options.

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Types of MarketsTypes of Markets Cont…..

Secondary Market for Equity Shares

Common stocks, preferred stocks, and warrants are traded.

Auction markets are involving an auction process in a specific

physical location. Negotiated markets

are involving a network of dealers who make a market by standing ready to buy and sell securities at specific prices. Negotiated market involves the over-the-counter market.

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Financial Instruments

A financial instrument can be

defined as a claim to the payment of a sum of money at some future dates.

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Characteristics of Financial Instruments

Risk: The future outcome of the instruments is

not known with certainty. Ex. uncertainty of the price, default risk of the capital or income stream.

Liquidity: It refers to the ease and speed at which a

financial instrument can be turned into cash without any loss.

Real Value certainty: Effect of changes of the general price level

(Inflation or deflation)

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Characteristics of Financial Instruments Cont…

Terms of maturity: FI vary widely according to their maturity. Sight

deposits at bank have zero term to maturity, as they can be withdrawn on demand.

Currency denomination: the return on non-domestic instruments are

affected on the appreciation or depreciation of the relevant exchange rates.

Divisibility: the degree to which the instruments can be

subdivided into small units for transaction purposes.

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Corporate Securities

Security: "A legal contract representing the right to receive future benefits under a stated set of conditions."

The piece of paper defining the property rights is the security.

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Financial Instruments Available in Sri Lanka

MONEY MARKET Treasury Bills Repurchase (Repo) Reverse-repurchase

agreement Commercial paper Banker Acceptances Eurodollar

CAPITAL MARKET Common stock Preferred stocks Corporate Bonds Treasury Bonds Sri Lanka Development

Bonds Rupee Loans Mutual funds – unit trust Deposits Whole-life insurance

policy Nation Building Bonds

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The Securities and Exchange Commission of Sri Lanka

regulates the disclosure of information in new security offerings and sets disclosure requirements for nearly all firms trading publicly.

The SEC also regulates "insider" trading, which includes trading done by directors, officers, and major shareholders of a corporation.

All trading by insiders must be reported to the SEC. the SEC attempts to prevent insiders from secretly

trading securities on the basis of private information that outside shareholders do not possess.

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Colombo Stock Exchange The Colombo Stock Exchange (CSE)

CSE is a company limited by guarantee, and established under the Companies Act No. 17 of 1982.

The policy making body (Board of Directors)

There are 9 Directors (the members elect five Directors and the Minister of Finance appoints four Directors).

CDS is used in the CSE for dealing shares.

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The Central Depository System

The CDS provides depository facilities and clearing services for securities traded on the CSE.

The CDS is a 100% owned subsidiary of the CSE. A Board of Directors constitutes the CDS's

policy-making body. The Board consists of nine Directors. Five

directors are elected to office by the members of the CSE and four directors are nominated by the Ministry of Finance.

Colombo Stock Exchange cont…

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Colombo Stock Exchange Cont…

The Colombo Stock Exchange (CSE) currently has 235 listed companies representing 20 business sectors. The market capitalization as at 03rd September 2009 was 842.3 billion rupees.

21 Member firms As at 03rd Sep. 2009 and 9th Dec.

2011 ASPI – 2,630.8, 6027.1 MPI – 2, 983.6, 5248.9 TRI for all shares – 3,110.1 TRI for Milanka shares – 3, 546.28

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Market Indices

The four Indices are: All Share Price Index (ASPI), which

comprises all listed companies on the market.

Milanka Price Index (MPI), which is based on 25 selected companies.

Total Return Index (TRI) Sector price indices

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Market Indices Cont…

All Share Price Index

ASPI = Market Capitalization of All Listed Companies x 100

Base Market Capitalization

BMC = Number of shares at Base year (1985) x Base Market Price

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Market Indices Cont…

Milanka Price IndexMPI= Market Capitalization of 25 Selected Companies x100 Base Market Capitalization of those 25 Companies as at 31st December

1998

The MPI is revised annually and the

Total Return Index

y

tyt PI

XDJPITRITRI

Financial Management

Documents

cash bank

income statement cont

generation of cash

financial management

financial data

financial position

positive cash flows

financial statements