Financial Management Theory And Practice

In the present business scenario, characterized by globalization, deregulation and fierce competition, finance functions have, of late, assumed great importance. The fluctuating exchange rates, and volatile rates of interest, have made the fund-raising exercise and ensuring their effective utilization, as the major factors affecting corporate growth and development. Thus, all the executives, operating in today’s competitive global economy, are required to effectively manage costs in the entire range of areas, ranging from production and quality control to maintenance and marketing. The growing requirements of financial reporting have placed new demands on both the finance and non-finance executives, alike. The implications of such changed environments must, therefore, be well understood and, more importantly, managed at all the levels, and across all functions in the organization. Further, it has become all the more important for non-finance executives to have at least a working knowledge of finance functions, so as to appreciate the financial implications of their decisions. Accordingly, this book has been designed to provide the concepts and techniques in the major areas of finance, to enable the executives to objectively evaluate the alternative courses of action, and to take optimal decisions in all the areas, fully appreciating and weighing the financial implications.

It is very much imperative and deligatory on the part of all companies in India that they must have an appropriate financial recording and reporting system. These financial recordings are done through Financial Statements. So, it is extremely important to maintain proper Balance Sheets; Profit and Loss Account; Income Statements; and Sources and Application of Funds which all happen to be the Financial Statements and the most authentic sources to draw realistic conclusions about the true financial position of a company.

In this Chapter, we will first discuss the various items of liabilities and assets, as they appear in the Balance Sheet, one by one.

As against the Balance Sheet, no standard format as such has been prescribed for the presentation of the Profit and Loss Account under the Companies Act, 1956. The Act, however, requires as per Schedule IV, that all the companies must incorporate the relevant information in an adequate measure, under the various heads/ parameters (given hereunder), so as to represent a ‘true and fair’ view of the operations and performance of the company, during the year under report.

This chapter aims at developing the knowledge and understanding of Reclassification of Assets and liabilities, as to why such reclassifications are necessary. It gives a detailed description of the conditions and criteria for the reclassification of the various items of the Balance Sheets. This chapter also tells us about the procedure of compution of various Ratios like Liquidity Ration; Productivity Ratios; the financial structure Ratios and so on by also giving an analysis for each of them.

Now we are ready to analyze and interpret the various ratios and comment upon their implications, ramifications, impact and influence, on the financial management and the overall working, profitability and prospects of the company. As you may well agree, this can be done more effectively with the help of an actual Balance Sheet, and Profit and Loss Account of a live company, of course, with a disguised name. Accordingly, the Balance Sheets, and the Profit and Loss Accounts of (i) Light Motor Vehicles Limited (LMVL) and (ii) Videsh Vyapar Nigam Limited (VVNL) have been given hereafter, by way of case studies.

This chapter gives a detailed knowledge about the Sources and Applications of funds, with the help of various case studies and their suggested approaches. We will also learn about the reasons to exclude cash and the various components in relation to sources and application of funds. The detailed case studies have been mentioned here to make the students understand the concepts belter.

This chapter tells us about the meaning and importance of Working Capital Management, the operating cycle approach, how working capital requirements are assessed and working capital policies are formulated. It tells us about the sources of working capital finances; how credit risks are managed; how effectively we can supervise the follow up of advances and soon.

Working Capital Management is the theme with which this chapter goes on. This chapter encroaches in great detail with analysing every specific factor that correlates to working capital, like components that comprize the current assets and current liabilities; How to manage them; Managing the short term cash inflows within the operating cycle of a company. Working Capital Management is greatly concerned with the working, coordination, co-operation and maintaining a good team synergy so as to reap the benifits of an economy. Factors that impact the working cap requirements are a matter of great concern. The quantum of working capital is totally dependent on the levels of inventories of raw materials and finished products so as to be safe enough to avoid stock outs and loss in Business Sources of financing the current assests definitely relate to the computation of the optimal mix of long term and short-term funds. This chapter also focuses on how different Working Capital Management is from Project Management Conceptualizing a project at its pre-implementation stage to have a gainful proposition is what is project management.

This chapter tells us about Operating Cycle Analysis, weighted operating cycle analysis and working capitial leverage. How much time does each component of working capital take in the manufacturing process; the various steps of calculating weighted operating cycle; what are its applications and soon.

Finance is the most important and essential ingredient for starting and running any business organization. It can almost be compared to blood, which is so vital for the sustenance of the human organic body. As blood should be running in our body in sufficient quantity and with optimal pressure (neither high nor low), finance should as well be available in any business organization in the optimal quantity, and must be invested and put to use in an efficient manner, so as to result in an optimal profit. The profit, in turn, should be ploughed back into the business, in an appropriate measure, on a continuing basis. As we all know, the unit which fails to generate sufficient internal cash surplus out of its operation and business activity and, consequently, depends on frequent infusion of funds (like the periodical blood transfusion in a blood cancer patient) from outside sources (external borrowings), tends to fall terminally sick and ultimately dies out and closes down. All things considered, the most effective and gainful employment and investment of finance is of immense importance and significance for the success and prospects of any company. Since the hard cash in hand or in the bank’s current account (which is in the nature of a non-interest bearing account) amounts to the loss of interest and/or involves some opportunity cost, it will be the most desirable business sense to keep the quantum of cash at the minimal level. That is why, most of the companies keep it only up to one per cent to three per cent of their total assets, so as to meet their day-to-day expenses, on a continuous basis.

In a competitive economy, most of the companies, especially those who operate in the buyer’s market (and not in the seller’s market) have to sell a large portion of their products on credit. The terms and conditions of the credit sales, however, depend upon the market conditions and the trade practices, prevaling at the material time, in a particular industry and/or the segment of the business activities. Further, as the amount of the credit sales gets blocked for the period of one to two months, or even more, depending upon the terms of the credit, the seller company stands to lose a substantial amount by way of interest on the blocked funds. But then, they have to offer a matching credit term to withstand the market pressure. Thus, it will augur well for the company to streamline and strengthen its system of collection of its bills, on or around the due dates, so as to realize the funds on time and thereby avert the risk of loss due to bad debts. It is all the more important, as the amount invested in sundry debtors usually happens to be significantly high, inasmuch as it happens to be a close third item of assets, only after the levels of investments in the fixed assets and inventories

This Chapter gives a detailed description about the components and importance of inventories and the factors involved in their management and their further advantages. It tells us about the Basic Economic Order Quantity Model also about their Trial and Error Method, the ABC Analysis and the various categorizations and the rationale behind them and their further alternatives and so on. It discusses inventory management through Ratio Analysis it gives the steps to Evolve an Effective system of Inventory management and control. It tells us about the inventory management practices prevailing in India and where all is the attention desirable and discusses about some common arguments related to this. What are the circumstances where we observe that there is a vast scope of improvement. What are the strategies related to this matter.

As we have already discussed in Chapter 9 on ‘Working Capital Policy’, the working capital requirements should be financed not from the short-term sources alone, but by way of a suitable and optimal mix of both, viz. the (i) Short-term sources of funds (ii) Long-term sources of funds

In the recent past, commercial banks granted only short-term loans to meet the working capital requirements of the industries and business. Financial institutions like the ICICI, IDBI and IFCI exclusively sanctioned term loans. However, as a recent development, the term-lending institutions have also ventured into the financing of the working capital requirements of their borrowers. Soon enough, the commercial banks have also followed suit and have started meeting the entire credit requirements of their borrowers, including term loans. Commercial banks had to adopt such strategies because, after the process of disintermediation had stabilized, the banks, as also the financial institutions, had been flush with funds. In a way, this condition had some other ancillary advantages, too, as the borrowers were saved of the avoidable botheration and problems emanating from the lack of coordination between the commercial banks and the term-lending institutions. Long back, well before the process of disintermediation had set in, there was a great demand for the bank finance, far above the banks’ credit supply position. Dahejia Committee, way back in the year 1968, had observed that the banks’ working capital loan was the ‘longest term loan’, as the borrowers’ working capital limits were increased with their steady progress and prosperity. Then came the Tandon Committee Report in the year 1975, which had laid down the inventory norms, and the three methods of lending, so as to ration and rationalize the assessment of working capital requirements of industries. The inventory norms, and the three methods of lending, appear in Appendices 15.6 and 15.7, respectively, at the end of the Chapter. Later, the Chore Committee recommended, inter alia, that all the industrial units, enjoying working capital limits of ` 10 lakh and above, must adhere to the Tandon Committee’s Second Method of lending, whereby the minimum current ratio required invariably came to 1.33 : 1.00. But then, the Reserve Bank of India (RBI), in its Monetary and Credit Policy, for the second half of the year 1997-98, decided to withdraw the then prevailing norms for the assessment of the working capital finance, based on the concept of the Maximum Permissible Bank Finance (MPBF), mainly based on the Tandon Committee Recommendations, regarding ‘Inventory Carrying Norms’ and the ‘Second Method of Lending’. RBI had, however, counselled all the banks to evolve their own appropriate and scientific systems to facilitate the rational assessment of the working capital needs of the borrowers, as also to provide some suitable guidelines for dispensation of credits, pertaining to different categories of economic activities. In doing so, the banks had preferred to retain the essence and spirit of the Tandon Committee Recommendations, as these were also based on some sound principles of lending that had evolved over a period of time. The only difference, however, had been that these guidelines were no longer obligatory to be compulsorily followed by the banks. Instead, the banks were now given some freedom and relaxation to evolve their own respective norms in regard to the following: (i) For the assessment and disbursement of the working capital loans; and (ii) For the post-disbursement supervision and follow-up of advances.

The art and skill of managing credit risks is of utmost importance and interest to the commercial banks and financial institutions. With this end in view, some of the premier banks and financial institutions have, of late, evolved some scientific and mathematical tools to ascertain and assess the credit risks (creditworthiness) of the borrowers (both present and prospective). These tools are primarily based upon the rich experiences and excellent expertise of the bank officers.

The main factors that must be taken care of by the commercial banks and financial institutions in regard to the management of credit risks comprize the realistic assessment of the credit needs, sanction and phased disbursement of the loans, and effective post-disbursement supervision and follow up of advances. Thus, the efficiency and effectiveness of the credit risks management largely depends on the following seven factors: 1. Prompt and realistic appraisal of the projects on receipt of the loan applications along with the project reports. 2. Prompt and realistic assessment of the credit requirements, both short-term (working capital) and longterm (term loan). 3. Phased disbursement of loans to ensure proper end-use of funds. 4. Effective supervision and followup of advances and periodical performance monitoring of the companies through intelligent scrutiny of their books of accounts, stock statements and financial statements, coupled with personal dialogues with the owners and/or managers of the companies. 5. Timely detection of early symptoms of any sickness at the incipient stage itself, and prompt and effective implementation of suitable remedial measures to put the companies back to health. 6. Effective supervision and control of irregularities in advances by the bank’s branches as also by the controlling office. 7. Prompt decision and action in regard to the rehabilitation of viable sick units or calling up of the advances of non-viable sick units. In this exercise they must, inter alia, consider the following four facets connected with the issue, namely: (i) The objectives (rationale) behind each of the instructions/systems and procedures laid down by the banks; (ii) The actual practices obtaining at most of the branches of the banks; and (iii) The main reasons for flaws/gaps, if any, between the banks’ instructions/laid down systems and procedures, and the actual practices being followed at most of the branches of the banks, and (iv) The strategic steps that could be taken with a view to bridging such gaps, if any, effectively and fruitfully

Non-fund based working capital financing comprises: (i) Letters of Credit (L/Cs); and (ii) Bank Guarantees (B/Gs).

Bank Guarantee (B/G), like Letter of Credit (L/C), is yet another form of non-fund based financing by banks

This chapter tells you about Export Financing. How to assess the financial requirements of export Finance. It tells us about shipment stage the post shipment Finance; how a person can repay pre-ship-ment finance. It discusses many other topics related to it, with the help of specimen’s of Bills of Exchange.

The software industry has always been the driving force in the Information Technology (IT) industry, especially so in India. It has, therefore, been rightly termed as the ‘growth sector of the millennium’. This sector requires highly skilled manpower, and it is heartening to note that in India, the sector has grown almost 50 per cent during the short span of just five years, i.e. from the year 1992 to 1997. The government and the Reserve Bank of India are, therefore, earnestly endeavouring to encourage and facilitate easy and adequate financing of the software activities, as this sector inter alia will make a major contribution in the export earnings of the country, both in the short and medium terms.

This chapter discusses the components of fixed and variable costs; Break-even profit (BEP) and its algebraic, Arithmetical presentations and its Expressions. Contribution Analysis ant its other uses.

Total cost management and control, like the quality control, is of great importance and essence in the area of strategic financial management and control. It would, therefore, augur well for all the business organizations to understand and appreciate the various steps and strategies involved in the effective and efficient total cost management and control.

This chapter tells us about long range planning and short range planning, performance budgeting, its quantitative and qualitiative aspects, the steps and strategies involved in it, the various methods of budgeting and so on.

This chapter tells us about the timevalue of money, net present value of money, future and present values of annuity and various other discounting methods.

Capital Budgeting (Capital Investment Decisions)

The term ‘leasing’ has been quite familiar with us, as it has commonly been used in connection with land (being leasehold or free-hold), and building (being leased, i.e. given out on rent, by execution of a lease deed). Similarly, the leasing of the items of machinery and the other fixed assets, like cars and computers, has also become very common. It, however, is quite a recent development, especially so in the Indian context, by way of an alternative means of financing of the fixed assets, and capital goods, in addition to the term loans, debentures, and such other long-term sources of finance. Thus, the act of leasing, and the execution of lease deed in connection therewith, is an agreement and a contractual arrangement, under which the right to use the asset (usually fixed assets like the industrial equipments), has been granted by a person or company to another person or company, in consideration of the return by way of periodical payments of the lease rent. The person who so gives the asset on lease is known as the ‘lessor’, and the person, to whom it has been given, with the right to use the same, is called the ‘lessee’.

The decision taken by the management, as to what portion of the earnings of the company, i.e. its profit after tax (PAT), should be paid to its shareholders by way of dividends, and what portion of its earnings (PAT) must be retained and ploughed back in its business, for reinvestment purposes, is referred to as the ‘Dividend Policy’. In case the capital budgeting decision of a company is independent of its dividend policy, a higher dividend paid by the company will involve a greater dependence on external borrowings, involving higher pay our by way of interest on the borrowed funds. Thus, the dividend policy has a direct effect on the choice of the sources of financing. However, here we should not forget that the amount of interest paid on the external borrowings is taxdeductible, whereas the portion of the earnings (PAT) retained and ploughed back by the company in its business, for reinvestment purposes, is not tax-deductible. Further, equity shared, issued at a substantial premium, costs much less to the company. For example, if the State Bank of India (SBI) pays 50 per cent dividend on its shares of ` 10 face value, issued at a premium of ` 90 (issue price being ` 100), it costs SBI only 5 per cent (on the shares of ` 10 face value, issued at a price of ` 100). As against this, in case the capital budgeting decision of a company is dependent on its dividend policy and decision, a higher dividend paid by the company will involve contraction (reduction, tightening) of its capital budget, and vice versa. Thus, in such cases, the dividend policy has a direct effect (bearing) on the company’s capital budgeting decision.

In the previous chapter we have observed that, in the real world situations of imperfections and uncertainty, prevailing in actual market place, no company can usually afford to treat its dividend policy as being irrelevant. While deliberating on its dividend policy, it has to carefully appraise and evaluate its own position and the circumstances at the material time, as also the environment prevailing in the market, in which it has to operate. In fact, in actual practice, usually almost all the companies have been found to be attaching very high priority and importance to their dividend decisions. The dividend policy, and more importantly the bonus policy, are debated and deliberated upon in greater detail, and at a great length, in this chapter. However, sometimes, some companies have been observed to have made some minor shift in their dividend policy. In fact, one of the commentators has observed that the ‘shareholders bother a great deal about the dividend policy, financial economists consider the dividend policy as irrelevant, and corporate managements treat the dividend policy merely as an after thought’. All said and done, the dividend policy assumes very high importance and significance in the area of corporate financial management. We will now discuss the key dimensions of the dividend policy, and the factors and considerations that are relevant for the purpose of formulating the dividend policy (as also the policy pertaining to the issue of bonus shares and splitting of shares). We will also deliberate upon the behaviour of the corporate management, pertaining to the issue of declaration of dividends. The legal and procedural aspects of dividends, as also the issue connected with the buy back of the company’s own shares, will also be discussed in this chapter.

Merger, acquisition and restructuring have, of late, become the major financial strategy and economic force, a dominant global business theme. The weapon of ‘take over’ (to use the word of David Sinclair) seems to be the most popular and frequently used mechanism in the business world, all over the world; and India is no exception. Corporate restructuring has been resorted to in many top business firms like Tata Motors, L&T, SBI and NOCIL, to name just a few. Mergers and acquisitions involve various types of transactions, like merger itself, or the purchase of a division, or take overs, or joint ventures, and so on. Corporate restructuring, however, comprises portfolio restructuring, financial restructuring, and organizational restructuring.

The basic principles of financial management are one and the same in both the national (domestic) and international companies (or even in the multinational companies, for that matter). But then, the very fact that the international and multinational companies have significant operations in different foreign countries, too, they have to take into account the following additional factors, which, of course, are not involved in the financial management in the domestic companies, which operate within one country