Basics on Finance

A webinar by PR Cell, IIM Rohtak for Preparation for WAT-PI process, Admissions - 2016

Discussion Topics

FINANCIAL ACCOUNTING: Accounting Principles and Accounting Concepts Accounting Policies Financial Statements Financial RatiosFINANCIAL MANAGEMENT: Procurement and Utilization of Funds Cost of Capital Role of CFO Profit Maximization vs Value Maximization Risk and Return

Financial Accounting “Accounting is the art of recording, classifying,

and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof.” - American Institute of Certified Public Accountants (AICPA)

Accounting is also understood as the systematic and comprehensive recording of financial transactions pertaining to a business.

Accounting is one of the key functions for almost any business; it may be handled by a bookkeeper and accountant at small firms or by sizable finance departments with dozens of employees at larger companies.

Accounting Concepts

There are few basic rules for recording any accounting transactions

a) Dual Aspect Concept - It must have two sides

b) Money Measurement Concept - It has to be in terms of money

c) Periodicity Concept - It falls between a specified period

d) Entity Concept – It is specific to a particular entity

e) Conservatism Concept - Future losses to be recorded but not future gains

Accounting Concepts

f) Matching Concept - Expenses related to Incomes only can be recorded

g) Historical Cost Concept - Assets to be recorded at purchase price

h) Realisation Concept - Profits to be recorded only when sale has taken place

i) Materiality Concept - It needs to be material for decision making

j) Capitalisaiton Concept - Costs related to capital assets before put to use

Accounting Standards and AssumptionsAccounting Standards issued by ICAI

31 Active Accounting Standards

Also converging to IFRS (International Financial Reporting Standards) – IND AS

Important Accounting Assumptions:

a) Going Concern

b) Consistency

c) Accrual

Process of Records

Consists of a) Profit & Loss Statementb) Balance Sheetc) Cash flow Statement

Final Accounts

Helps in ensuring that the entries in a company’s book keeping system are accurate in figures

Trial Balance

A general ledger is a complete record of financial transactions over the life of a company

LedgerFirst recording of financial transactions as they occur in time, so that they can then be used for future reconciling

JournalAny monetary transaction for exchangeExample: Money exchanged for a pen

Transaction

Financial Statements – Profit and Loss Account It reports a company's revenues, expenses, and

most of the gains and losses which occurred during the period of time specified

Generally prepared for one year period

The bottom line of this financial statement appears as net income, which is the net amount of the revenues, expenses, gains, and losses being reported

Financial Statements – Balance Sheet It represents a company's financial position at the end

of a specified dateAssets: Businesses need to use assets in order to generate

wealth. Assets are the things that a business owns or sums that are owed to the business at any one moment in time

The business obtains the finance for these assets from two main source: Internally (inside the business) from capital raised

from the business owners (the shareholders in the case of a company)

Externally - for example, in the form of loans, and other forms of finance which needs to be repaid

Financial Statements – Balance SheetLiabilities: When you set up a business, the business becomes

a legal body in its own right Internal finance (shareholders' funds) is owed

to shareholders External finance is owed to people outside the

business - liabilities The Balance Sheet will therefore balance since in

simple terms this shows that the value of a businesses assets is financed by the two groups – Internal (owner's capital), External (liabilities).

A balance sheet typically appears in a vertical format

Financial Statements – Cash Flow Statement A financial statement that shows how changes in

balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities

Management decisions for the next years can be based on the cash inflows or cash outflows from each individual activities

Also it portrays the usage or generation of cash from which of the following operating, investing or financing activities

Financial Statements – Ratios Liquidity Ratio

Profitability Ratio

Activity Ratio

Solvency Ratio

Leveraging Ratio

Financial Management

The theory of Financial Management is the theory of financial decision making by business firms

It can be described as the study of decisions that every firm has to make related to financial matters

It is the managerial activity which is concerned with the planning and controlling of the firm’s financial resources

It can be viewed as proper management of flows of funds in a firm

“Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long-term credits for the firm”

Financial Management – Procurement of Funds

Sources of

Funds

Equity

Debt

Hire Purchase

Angel Financing

Venture Capital

Commercial Banks

Financial Management – Types of Capital

Equity Share CapitalReserves and Surplus

Preference Share Capital

Long Term Loan Funds

Term LoansDebentures

Short Term Loan Funds

Bank OverdraftCredit Limit

Types of Capital

Financial Management – Cost of Capital Cost of Capital is the cost of using funds of the owners

or the creditors (can also be termed as expectation from the owners)

Cost of Equity (Ke):

Dividend Discount Method

Ke = (D1/P0 )+g

Capital Asset Pricing Method

Ke = Rf+ ß *(Equity Risk Premium)

Factor Model

Financial Management – Cost of Capital

Cost of Preference Shares

KPS = (Dividend+(M.V.-N.P.))/(0.5*(M.V.+N.P.))

(M.V.=Maturity Value, N.P.=Net Proceeds)

Cost of Debt

Kd = r(1-t)

Yield to maturity approach and Debt

Weighted Average Cost of Capital

= (We*Ke + Wd*Kd + WPS*KPS)

Financial Management – Utilization of Funds

Utilization of

Funds

Fixed Assets

InvestmentCurrent Assets

Role of a CFO

Finance

Accounting

Audit

Treasurer

Controller

Finance Manager

Decisions made by CFO

Investment Decisions Long-Term Decisions

Financing Decisions Capital Structure Decisions

Dividend Decisions Profit Distribution Decisions

Liquidity Decisions

Working Capital or Short-Term Decisions

Financial Management Objectives

Profit Maximization

Profit After Tax Maximization

Earning Per Share Maximization

Sales Maximization

Market Share Maximization

Firm’s Wealth MaximizationShareholder’s Wealth or Value Maximization

Basic Axioms of Financial Management

Money has time value/opportunity cost

Every Financial Decision involves a trade-off between Risk and Return

Financial Markets are Efficient

Accounting Profits are not relevant for financial decisions. Profits based on Cash Flows are more relevant

Options have a value

Return Risk

Remember that each Financial Decisions are evaluated in terms of

Looking into the brighter side

Looking into the darker side

Relationship between Risk and Return Can we say that a person who has taken high risk

will get higher return?

Should a person go for higher risk if he/she has to earn higher return?

Should a person be compensated by higher return for taking higher risk?

Is it High Risk, High Return?

Or, Is it High Return, High Risk?

Financial Management - Derivatives A derivative is a financial contract which derives its

value from the performance of another entity such as an asset, index, or interest rate, called the "underlying".

Futures Forwards Options

Put Option Call Option

Swaps Interest Rate Swaps Currency Swaps Commodity Swaps Credit Default Swaps

Q & A

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