FINANCIAL MANAGEMENT THEORY AND PRACTICE

Financial Management and Control: An Overview 3–12 Introduction ...4 Facets of Financial Management ...4 Historical Perspective ...5 Deep Depression of the 1930s...6 Financial Management

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FINANCIAL MANAGEMENT

Theory and Practice

SATISH B MATHUR

Ph.D (Business Management), CAIIB.

Mentor, Mathur Management Consultants, (MMC), Lucknow

Former Professor of Finance and Accounting

Indian Institute of Management, Lucknow, (IIML), Administrative Staff College of India, (ASCI), Hyderabad, and

State Bank Staff College, (SBSC), Hyderabad, India

With a Foreword by

DR C RANGARAJAN

Chairman, Economic Advisory Council to the Prime Minister

Government of India, New Delhi, (India) Former Governor, Reserve Bank of India, Mumbai, and

Governor, Andhra Pradesh, Hyderabad

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and Kartika Mathur for their sustained support

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Financial Management is critical to the succes of any organization It is all the more so in the case of business organizations, since almost all decisions taken have financial implications It becomes, therefore, imperative for all executives in a business organization to acquire a fairly good knowledge of the fundamental principles

of financial management and control

Several books by Indian and foreign authors on the subject are available in the market However, not all

of them are reader-friendly Dr Satish B Mathur’s ‘Financial Management : Theory and Practice’ is

an exception It is written in a conversational style The narrative is lucid Difficult and complex topics like analysis and interpretation of financial statements, management and control of working capital, classification and control of costs and cost-volume-profit analysis are presented in a manner that readers may go through them with ease and sustained interest In writing the book, the author has brought to bear on it his personal experience as a senior executive with the State Bank of India for almost three decades As a senior faculty at the Indian Institute of Management, Lucknow, he knows what the requirements of students are

I congratulate Dr Mathur on his endeavour to produce a book covering the basic and essential aspects of financial management and control I am sure that the book will be widely used by students and faculty in academic institutions as well as practising executives in industry and financial institutions

(C Rangarajan)

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My friends, colleagues and well-wishers, in banks, industries and academia, and the top and senior executives

of banks and industries, participating in my Management Development Programmes (MDPs), and the PGP students at the Indian Institute of Management, Lucknow, have been persuading me, to venture into writing

a comprehensive book on ‘Financial Management’, in the Indian context and conditions, citing suitable

illustrative live cases and examples, drawn from Indian experiences They were, perhaps, thinking that, with

my vast and varied experience as a professional banker with the State Bank of India for around three decades,

in several senior positions, I may be able to do full justice to the subject

In fact, their such a high opinion of, and expectation from me, had been more a deterrent, rather than

a facilitating factor, in my daring to take up such a demanding endeavour on my part Besides, my varied experience and widespread knowledge in the area had made me feel that the task was rather too stupendous, difficult and demanding, even to make a humble beginning in this direction But then, it took me long precious time to realise that howsoever long and difficult a journey may be, it can be completed only after taking the first step; that is, when a small beginning is made Thus, the hard and hefty, concerted and concentrated efforts, made in the right direction, and in right earnest, have made it possible for me to place the book, my humble work, before you

A book, like one’s own baby, is invariably the most beloved and beautiful one to its author But then, the real judges are, definitely and decidedly, the readers themselves And, if they would think that the book has presented the difficult and dull subject like ‘Financial Management’ in a quite easy-to-understand, interesting and entertaining manner, I would think that my sincere endeavour was worth the effort And, if the readers, the students (of B.Com and M.Com., MBA and PGP, degrees and diplomas), the Chartered Accountants, the professional and practising bankers and industrialists, experience that, while reading the book, they tend

to feel as if the author had personally been talking to them, instead, on a one-to-one basis, I would sincerely thank them all, and think that my sincere and strenuous efforts have been amply rewarded I sincerely feel that even the practising professionals of commercial banks and industries may find the book quite relevant for reference and refreshing purposes

A summary, containing the essence of each Chapter at its end, may be found very useful and handy for the students at the time of their examination Even the Professors, teaching the subject, may find the synopsis immensely useful for preparing the required transparencies or slides on Power-Point Software, for use in their lecture sessions I earnestly solicit valuable suggestions from my worthy readers, for bringing in further improvements in the next edition of the book

Satish B Mathur

PREFACE

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At the very outset, I must thank my friends and colleagues in banks and academia, and the top and senior executives of industries and banks, who participated in my Management Development Programmes (MDPs), and the PGP students at the Indian Institute of Management, Lucknow, for their persistent persuasion and encouragement, which made it possible for me to write the book on the subject.

I am immensely grateful to Meera Mathur, my wife, for her self-less sacrifice and support, and valuable

views, from time to time My hearty gratitude is due to my lovely dear daughters – Archana Mathur and Kartika Mathur, for their free and frank opinion, and constructive suggestions, which have gone a long way

in making the book so very reader-friendly, lucid and easy-to-understand, even by non-experts and non-finance executives, in the business and industry I am greatful to the publisher for timely publication this book

Satish B Mathur

ACKNOWLEDGEMENTS

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Foreword by Dr C Rangarajan vii

Preface .ix

Acknowledgements xi

Part I: FINANCIAL ANALYSIS 1 Financial Management and Control: An Overview 3–12 Introduction 4

Facets of Financial Management 4

Historical Perspective 5

Deep Depression of the 1930s 6

Financial Management as a Distinct Discipline 6

Vital Functions of Financial Management 7

Roles and Responsibilities of Internal Auditors 8

Summary 10

Review Questions 11

2 Financial Statements 13–26 Introduction 14

Components of Financial Statements 14

Basic Concepts and Conventions 16

Basic Concepts Pertaining to ‘Balance Sheet’ 16

Basic Concepts Pertaining to ‘Profit and Loss Account’ or ‘Income Statement’ .18

Format of Balance Sheet 20

Interpretation of Balance Sheet .21

Summary 23

3 Balance Sheet 27–58 Introduction .28

Liabilities (Sources of Funds) .28

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Share Capital 28

Equity Share (Ordinary Share) Capital 28

Some Terminologies 28

Some Other Terminologies 31

Issuing of Shares 33

Preference Share Capital 34

Types of Preference Shares 35

Reserves and Surplus 37

Secured Loans 39

Types of Secured Loans 40

Equitable Mortgage 45

Unsecured Loans 46

Current Liabilities and Provisions 47

Fixed Assets 48

Investments 48

Current Assets 49

Miscellaneous Expenses and Losses 51

Summary 51

Practise Problems 57

4 Profit and Loss Account 59–74 Introduction 60

Items Reported in Profit and Loss Account 60

Profit and Loss Appropriation Account 64

Cash Profit 65

Summary 66

Appendix 4.1: Economic Value Added (EVA) 68

5 Evaluation of Financial Performance through Ratio Analysis Techniques 75–82 Introduction 76

Reclassification of Assets and Liabilities 76

Computation of Ratios 78

Analysis and Interpretation of the Ratios 79

6 Evaluation of Financial Performance through Ratio Analysis Techniques: Case Studies with Suggested Approaches 83–108 Introduction 84

Case Study—I: Light Motor Vehicles Limited 85

Case Study—II: Videsh Vyapar Nigam Limited 98

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CONTENTS xv

Introduction 110

Components of Sources and Application of Funds 110

Rationale behind Excluding Cash 111

Case Studies with Suggested Approaches 112

Case Study I: Rashtriya Chemicals Limited (RCL) 113

Case Study II: Reliable Automobiles Ltd (RAL) 119

Case Study III: Puja Paints Ltd (PPL) 122

Summary 125

Part II: FUND-BASED WORKING CAPITAL MANAGEMENT AND CONTROL 8 Working Capital Management and Control: An Overview 131–138 Introduction 132

Working Capital Management 132

Operating Cycle Approach 132

Importance of Working Capital Management 132

Assessment of Working Capital Requirements and Formulation of Working Capital Policies 133

Sources of Working Capital Financing (Short-Term and Long-Term Sources of Funds) 134

Working Capital Financing by Banks 134

Management of Credit Risks 134

Effective Supervision and Follow-Up of Advances 134

Non-Fund Based Working Capital Finance 135

Conclusion 135

Summary 135

9 Working Capital Policy 139–154 Introduction 140

Components of Working Capital Management 140

Working Capital Management vs Project Management 141

Special Features of Current Assets 141

Synergy of Team Spirit 142

Factors Affecting Working Capital Requirements 143

Optimal Level of Current Assets 145

Working Capital Financing Policy 146

Operating Cycle and Cash Cycle 149

Time-Series Analysis vs Cross-Section Analysis 150

Summary 151

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10 Working Capital Management and Control: Operating Cycle Approach 155–166

Introduction 156

Operating Cycle Analysis 156

Weighted Operating Cycle Analysis 159

Working Capital Leverage 162

Summary 164

11 Cash Management 167–204 Introduction 168

Cash Budgeting 168

A Suggested Approach to Overcome Cash Shortages 170

Long-Term Cash Forecasting 172

Periodical Reports and Statements for Control of Cash 173

Effective Management and Control of Sundry Debtors 173

Current Account vs Cash Credit Account 175

Depositing Margin Money in Cash Credit Account 176

Management and Control of Payments 176

Playing the Float 178

Investment of Surplus Funds 179

Units of the Unit Trust of India: 1964 Scheme 180

Models of Cash Management 185

Case Study–I: TDR is not the Best 190

Case Study–II: Turns Tricky 192

Case Study–III: Investing Surplus Funds: Where and Why? 194

Summary 197

12 Credit Management 205–235 Introduction 206

Credit Policy 206

Steps and Strategies for Keeping Sundry Debtors Low 207

A General Pattern of Follow-up Measures 208

Streamlined Enquiry Systems 209

Phone Yourself to Find Yourself 210

Main Causes of High Sundry Debtors 210

Ramifications of High Sundry Debtors 212

Formulation of Credit Policy 212

Cash Discount 213

Management Control System (MCS) and Sundry Debtors 214

Decision-Making 217

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CONTENTS xvii

Parameters of Credit Policy 220

Decision-Making for Granting Credit 227

Management of Sundry Debtors (Bills Receivable or Accounts Receivable) in India 229

Some Suggestions for Improvement 230

Summary 231

Appendix 12.1 236

Appendix 12.2 237

Appendix 12.3 238

Appendix 12.4 240

Appendix 12.5 241

13 Inventory Management 243–280 Introduction 244

Components and Importance of Inventories 244

Economic order Quantity (EOQ) 244

Basic Economic Order Quantity (EOQ) Model 246

EOQ Formula vs Trial and Error Method 246

Derivation of EOQ Formula 250

Economic Order Quantity (EOQ) and Optimal Order Quantity (OOQ) 251

Economic Order Quantity (EOQ) and Inflation 255

Components of Inventory-Carrying Costs 256

Lead Time 257

Order Point 257

Safety Stock 258

Other Variable Factors Affecting EOQ 259

ABC Analysis (or VED Analysis) 260

Categorization of Items for ABC Analysis 262

Rationale Behind Some Other Alternative Categorization 265

Inventory Control through Ratio Analysis 266

Just-in-Time (JIT) System vs Just-in-Case (JIC) System 267

Towards Evolving an Effective System for Inventory Management, Monitoring and Control 268

Strategies to Achieve Success in Inventory Management and Control 269

Rationality 269

Flexibility 270

Inventory Management in India 270

Room for Improvement – Some Suggestions 271

Summary 272

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14 Financing of Working Capital Requirements 281–302

Introduction 282

Short-Term Sources of Funds 282

Accruals 282

Trade Credits 282

Short-Term Loans from Financial Institutions 284

Rights Debentures 285

Factoring 285

Long-Term Sources of Funds 288

Retained Earnings 289

Term Loans 289

Case Study–I: Down the Shutter 292

Case Study–II: An Innocent Victim 296

Summary 297

Part III: WORKING CAPITAL FINANCE BY BANKS 15 Working Capital Finance by Banks 305–334 Historical Perspective 306

Assessment of Working Capital Requirements by Banks 306

Assessment of Working Capital Finance to Non-SSI Sector 307

Financial Follow-up Reports (FFRs) for Working Capital Finance 308

Some Modifications in the Categorization of the Current Assets (CAs) and Current Liabilities (CLs) 308

Commitment Charges 309

Verification of the Levels of Inventories, Receivables and Sundry Creditors 309

Bifurcation of Working Capital (WC) Limit 310

Rationale Behind Bifurcation of Working Capital Limit into Cash Credit Component (CCC) and Working Capital Demand Loan (WCDL) 313

Bifurcation of Approved Bank Finance (ABF) of ` 2 Crore and above but below Rupees 10 Crore 313

Assessment of Working Capital Requirements of SSI Sector (As Per Nayak Committee, W.E.F June 1993) 315

Summary 318

Appendix 15.1 322

Appendix 15.2 324

Appendix 15.3 325

Appendix 15.4 327

Appendix 15.5 328

Appendix 15.6 330

Appendix 15.7 332

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CONTENTS xix

Introduction 336

Historical Perspective 336

Credit Risk Assessment (CRA) System 338

Concept of Credit Risk Assessment (CRA) 339

Credit Risk Assessment (CRA) Model 339

Financial Risks Assessment 339

Overall Financial Risks Assessment 340

Industrial Risks 342

Managerial Risks 342

Overall Credit Risks Assessment (CRA) 343

Overall Score (A Suggested Pattern) 344

Pricing Mechanism of Advances 344

Minimum Cut-Off Point 345

Summary 345

Appendix 16.1 349

Appendix 16.2 353

17 Disbursement and Follow-up of Working Capital Finance by Banks 357–370 Introduction 358

Project Appraisal 358

Assessment of Working Capital Requirements 359

Phased Disbursement of Loans 361

Supervision and Follow-up of Advances and Performance Monitoring of Units 362

Case Study–I 362

Case Study–II 363

Case Study–III 363

Case Study–IV 364

Case Study–V 364

Summary 368

Part IV: NON-FUND BASED WORKING CAPITAL FINANCING 18 Letters of Credit 373–398 Introduction 374

Why Non-Fund Based Financing? 374

Why Letters of Credit? 374

What is Letter of Credit (L/C)? 375

How are Letters of Credit Issued? 375

Amendments to the L/C 375

Payment Under Reserve 376

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Case Study–I: Japson International vs State Bank of India 376

Exhibit 18.1 382

Calculation of Due Date of a Bill of Exchange made Payable after the Specified Number of Days or Months 385

Presentation of Time Bills for Acceptance and Payment 387

Mode of Acceptance of the Time Bill 387

Types of Letters of Credit 387

Case Study–II: Beware, Be Wary 390

Summary 394

19 Bank Guarantees 399–432 Introduction 400

What is a Bank Guarantee? 400

Purposes of Financial Bank Guarantees 400

Performance Bank Guarantees 402

Restrictions Imposed by The Reserve Bank of India (RBI) on Issuance of Performance Bank Guarantees 403

Validity Period of Bank Guarantees 404

Legal Implications/Ramifications of Performance Bank Guarantees 405

Case Studies 407

Case Study–I: Carpets and Crafts Commission 407

Exhibit 19.1 409

Enclosure to Exhibit 19.1 410

Exhibit 19.2 411

Exhibit 19.3 412

Exhibit 19.4 414

Exhibit 19.5 415

Exhibit 19.6 417

A Simplified Version of Case Study-I 422

Exhibit 19.7 424

Exhibit 19.8 425

Exhibit 19.9 426

Case Study–II 427

Summary 429

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CONTENTS xxi

Part V: SOME OTHER SHORT-TERM FINANCING

Introduction 436

What is Export Financing? 436Assessment of Financial Requirements of Export Finance 436Shipment Stage 438Post-Shipment Finance 438How is Pre-Shipment Finance Repaid? 439Advance Against Export Bills Sent for Collection 439Export Finance in Foreign Currency 440Advance Against Duty Drawback and Cash Subsidy 440Export Credit Guarantee Corporation (ECGC) 441

Exhibit 20.1 441

Exhibit 20.2 442

Summary 442

21 Short-Term (Working Capital) Financing of Information Technology (IT)

Introduction 446

Salient Features of Software Industries 446Indian Advantages and Disadvantages 447Critical Success Factors in Software Industry 447Key Risk Factors 448Facilitating Factors for Fresh Exposures 449Working Capital Finance for Information Technology and

Software Industries [Reserve Bank of India (RBI) Guidelines] 450Operational Guidelines for Extending Working

Capital Finance to IT and Software Industries 451

Summary 453

Part VI: PROFITABILITY AND COST CONTROL

22 Contribution Analysis and Break-Even Point (BEP) or

Introduction 458

Fixed Costs and Variable Costs 458Algebraic Presentation of Break-Even-Point 458Arithmetical Presentation of BEP 460Various Expressions of BEP 461Some Other Uses of Contribution Analysis 465

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Summary 477

Part VII: PLANNING, BUDGETING AND CONTROL

Introduction 484

Long Range Plan (LRP) vs Short Range Plan (SRP) 484Performance Budgeting 484Steps and Stages Involved in the Performance Budgeting Exercise 484Budgeting in a Manufacturing Company 485Per Cent of Sales Method 486Combination Method 487Pro Forma Balance Sheet 488Budgeting Process in a Manufacturing Company 490Incremental Budgeting vs Zero Base Budgeting (ZBB) 495Inter-Departmental Coordination 495Performance Monitoring and Review 496

Summary 498

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CONTENTS xxiii

Part VIII: INVESTMENT ANALYSIS

Introduction 506

Time Value of Money 506Net Present Value (NPV) 508Future Value of an Annuity 509Present Value of an Annuity 510Compounding for Less than One Year Period 512Discounting for Less than One Year Period 513Continuous Compounding and Discounting 513

Summary 530

Introduction to leasing 536Payment Schedule of Lease Rentals 536Types of Lease 536Rationale behind Leasing 541Some Unreal Rationale of Leasing 542Legal Aspects of Leasing 542Responsibilities of the Lessee 543Brief Contents of a Lease Agreement 543Provisions of Sales Tax Pertaining to Lease 544Some Relevant Provisions of Income Tax 544Accounting Aspects of Leasing in India 544Hire Purchase 546Salient Features of Hire Purchase 547Leasing and Hire Purchase – A Comparison 549Instalment Sale and Hire Purchase – A Comparison 549

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Project Financing 550Salient Features of Project Financing 550Project Financing Mechanisms 551Managing Financial Risks and their Allocations 552

Summary 553

Part IX: DIVIDEND POLICY AND DECISION

Introduction 564

Models in Which Investment and Dividend Decisions are Related 564Traditional Position 567Miller and Modigliani (MM) Position: ‘Dividend Irrelevance’ Theorem 568Radical Position 574Concluding Remarks 574

Summary 603

Solved Problems 615

Part X: MERGERS, ACQUISITIONS AND RESTRUCTURING

30 Mergers, Acquisitions and Restructuring 621–644

Introduction 622

Rationale Behind Mergers 622

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CONTENTS xxv

Some Reasonable Reasons for Mergers 623Some Unreasonable Reasons for Mergers 624Steps and Procedures of Merger 626 Takeovers 628

Guidelines Stipulated by Securities and Exchange Board of India (SEBI) 630Anti-Takeover Defences in India 630Role of Financial Institutions 631Joint Ventures 631Portfolio Restructuring 632Financial Restructuring 633Concentrated Equity with Debt Components (Also Known as Leveraged Buyout) 633Organisational Restructuring 635Financial Evaluation of Divestiture 636Guidelines for Managing Divestments 637 Demergers 638

Tax Benefits of Demergers 639

Summary 639

Part XI: INTERNATIONAL FINANCIAL MANAGEMENT

Introduction 648

World Monetary System 648Foreign Exchange Markets and Rates 650International Parity Relationships 654Hedging of Foreign Exchange Risks 662Raising Foreign Currency Finance 663Export Financing 667

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7 Sources and Applications (Uses) of Funds Statements

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Financial Management and Control:

An Overview

The value of idea lies in the using of it.

– Thomas A Edison

Managers have traditionally developed the skills

in finance, planning, marketing and production

techniques Too often their relationship with their

people have been assigned a secondary role This

is too important a subject not to receive first line

attention.

– William Hewlett

LEARNING OBJECTIVES

After reading this chapter you should be able to understand

• The gradual evolution of Financial Management as a distinct discipline

• The various facets of Financial Management, viz man, money, materials, marketing and moments (time) –

referred to as the Six Ms

• The three vital functions of financial management, viz.

(i) Investment decisions

(ii) Financing decisions

(iii) Divided decisions

• The roles and responsibilities of internal auditors

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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

FACETS OF FINANCIAL MANAGEMENT

Financial management primarily aims at maximizing the shareholders’ wealth, by way of maximizing the market value of a company’s equity shares in the stock markets This can be achieved through efficient and effective handling of the various facets of management, which are referred to as the Six Ms of Financial Management, discussed hereafter:

Men (Managing Men and Women)

If we trifurcate the term ‘management’, we may get manage – men – t (‘t’ standing for techniques) Thus, the

essence of management in all the ventures would essentially boil down to the various techniques of managing men and women As we all know, we work through and with people in all the activities Thus, men and women are invariably at work or behind it, in all the business activities Accordingly, managing people seems to be

the most ticklish task, involving, inter alia, motivating and leading people to do their best and beyond This

is so because, only such people who do things well beyond their assigned tasks, roles and requirements, get noticed and achieve recognition

Further, managing machines and materials is more technical in nature than emotional, and hence, far too easier and simpler But then, inasmuch as people have feelings and emotions, you may force them to work, but you can never force them to work well They can, instead, be motivated and led well to work well, so that they may prefer to work, and work well at that, not because they ‘have to’, but because they ‘love to’ Therefore, it will augur well if both the finance and non-finance executives learn the art and skill of managing, motivating and leading their people to give in better than their best That is why, in my considered opinion, based upon

my personal experience as a senior executive with the State Bank of India for over twenty-seven years, the first ‘M’ (Managing People) is undoubtedly of utmost and foremost importance.*

*For a detailed discussion on the art and skill, tact and techniques, of managing people, please refer to Dr Satish B Mathur’s,

The A to Z of Strategic Sutras , Rupa & Co., New Delhi, 2006; Mentoring Mantras for Indian Managers, Matrix Publishers, New Delhi, 2010; and Principles of Effective Management – The Indian Experience, Himalaya Publishing House, Mumbai,

2010.

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FINANCIAL MANAGEMENT AND CONTROL: AN OVERVIEW 5

Money (Managing Cash)

Right from commencing upon and for running any business venture, we require funds and financial resources

to acquire materials and machines for the onset and continuity of manufacturing activities Besides raising funds (both short-term and long-term) at the cheapest possible rates, it is imperative to allocate them to the various business activities in the most judicious and prudent manner, so as to achieve optimal results, and to maximize profit With this end in view, such allocations have to be reviewed periodically, so as to reallocate these funds from some not-so-economical activities to some more profitable ones These aspects have been examined in detail in Chapter 11 on ‘Cash Management’

Machines (Managing Fixed Assets)

After raising funds, the manufacturing company will require to purchase plants and machinery, furniture and fixtures and such other items of fixed assets These aspects have been discussed in Chapter 29 on Capital Budgeting (Capital Investment Decisions)

Materials (Managing Inventories)

After the installation of plant and machinery and other requisites, the manufacturer has to procure raw materials and other inputs for the commencement of the manufacturing activities, culminating in the production of finished

goods, ready for sale The management of inventories (i.e raw materials, work-in-progress and finished goods)

has been discussed in Chapter 13 on ‘Inventory Management’

Marketing (Managing Sundry Debtors)

After production of the finished goods, which are now ready for sale, it is time for the actual sale, and that too, mostly on credit terms This transaction is based on the terms and conditions matching with the market trend prevailing at the material time, unless, of course, the company is fortunate enough to remain in the seller’s market But then, the value of the goods sold on credit has got to be realized – sooner the better – so

as to generate resources quickly and keep the incidence of bad debts at the minimal level These aspects have been discussed in Chapter 12 on ‘Credit Management’ (also known as Sundry Debtors or Bills Receivable or Accounts Receivable)

Moments (Managing Time)

The adage ‘Time is Money’ is more relevant in finance-related matters In the area of project management, timely completion is of essence, as time overruns also involve cost overruns, as also upward revision of cost estimates therewith Similarly, stocking of raw materials in significantly larger quantity than the optimal level

of consumption per day, involves avoidable inventory carrying costs

The same is the case with sundry debtors, i.e unless the collection machinery and monitoring system of

sundry debtors are streamlined and strengthened, faster realization of the sale proceeds of the credit sales cannot be ensured, whereby a substantial sum of money may remain blocked in sundry debtors, involving loss

of interest and opportunity cost

HISTORICAL PERSPECTIVE

In the good old days, finance was not treated as a separate and independent branch of study It was, instead,

an integral part of the faculty of economics But then, with the advent of the industrial revolution and the emergence of organizations like limited liability companies, enabling huge investments in the installation of the required plant and machinery for mass production, as also the much needed higher level of stocks of inventories

(i.e raw materials, work-in-progress and finished goods), the study of financial management became increasingly

intense and complex, necessitating refined and improved tools and techniques, with a view to ensuring optimal results and the productivity and the financial gains that go therewith

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Since those times, and due to such growing needs, the faculty and discipline of finance has been ever growing and ever broadening, both intensively and extensively It is naturally so, inasmuch as finance is the most essential and important requirement for any economic and business activity, for production and profitability, and, above all, for organizational development and growth, all round, and in all ways Therefore, the imperative need of an efficient and effective management and control of finance, and accordingly, the basic knowledge of the essentials of financial management, along with an overview of finance functions, can hardly be overemphasized.During the entire process of the evolution and emergence of the role and responsibility of the finance functions and the finance functionaries, there has been a marked shift from involving just the ‘routine jobs’ to the ‘real roles’ There has been a paradigm shift in the dimension and direction of the finance people, from the role of a record keeper of the various items of income and expenditure, dues and realizations, to the more important mantle of management and control of the corporate finance, ranging from raising of funds to computing an optimal mix thereof; from planning and budgeting to monitoring and control; of current assets as also of current liabilities;

of fixed assets as also of long-term sources of funds; from capital budgeting to the allocation and reallocation of funds; from less economic to more productive and profitable avenues; and so on All factors considered, we can assert that the finance functions and the functionaries have ever since been undergoing a sea change – from

an ‘Accountant’ to a full-fledged ‘Finance Manager and Controller’, in a wider and broader sense of the term

DEEP DEPRESSION OF THE 1930s

Besides the technological development and industrial growth that require more and more funds and, accordingly, effective management and control thereof, the deep economic depression of the 1930s has made the role and responsibility of the finance managers even more enormous and onerous, all comprehensive and all encompassing The governments of the various countries across the globe could not afford to be silent spectators any more, as the economic instability could, in effect, snowball into political instability and the resultant chaos and failure

of all the systems of the respective governments

Accordingly, governments enacted suitable laws and rules, making the management and control of finance functions even more strict and streamlined Besides, it had now become all the more imperative and crucial even for the survival of the industrial units to manage their individual affairs in a much more professional and proficient manner, so as to reinforce and restore the fading and falling confidence and faith of the present shareholders and the prospective investors In a crisis situation of the depression in the economy, it had become

a question of life and death for all the surviving industrial units – a virtual struggle for life and the survival

of the fittest

Effective financial management and control has, thus, become all the more significant for any future growth and development, inasmuch as no one would like to invest any fund in the shares of a sagging and decaying organization Therefore, all the companies have begun to work hard in the direction of evolving better financial tools and techniques, and streamlining the systems and procedures of monitoring and follow-up plan, corrective steps and remedial actions

FINANCIAL MANAGEMENT AS A DISTINCT DISCIPLINE

With the felt need for effective financial management and control by all the companies, coupled with the government regulation and control, with a view to restoring the much-needed confidence in the national economy, financial management gradually evolved as a distinct discipline As a natural step forward, the various aspects and segments, pertaining to the area of financial management, became independent and started

attracting even more focused attention, leading to the evolution of different tools and techniques, viz analysis

and interpretation of financial statements, simple and discounted cash flow/funds flow statements, planning and budgeting, performance monitoring and control, capital budgeting and Cost-Volume-Profit (CVP) analysis, coupled with Time Value of Money, Project Management through Critical Path Method (CPM), Performance Evaluation and Review Technique (PERT) chart, and so on

With the fast changing and developing Information Technology (IT) and all-round computerization, the tools and techniques of financial management, too, have become even better fine-tuned and systematic, faster and smarter

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VITAL FUNCTIONS OF FINANCIAL MANAGEMENT

For the commencement of any business, a manufacturing company will require land and building, plant and machinery, furniture and fixtures, and other such items of fixed assets Accordingly, some vital decisions may have to be taken by the management, in regard to the financing of these items of the fixed assets Such decisions are generally known as Investment Decisions

Soon after the required fixed assets are in place, the requirement is for the stocks of raw materials to feed the machinery and commence production activities (involving the resultant work-in-process and stocks of finished

goods) The decision pertaining to the financing of the inventories (i.e the stocks of raw materials,

work-in-process and finished goods, taken together) is generally referred to as the financing decisions pertaining to meeting the working capital requirements

The company finally sells its finished goods at a reasonably higher price than the cost of production, which,

in turn, results in the profit margin The amount of profit, after paying the taxes, i.e the Profit After Tax (PAT)

belongs entirely to the shareholders of the company But then, a going concern will not prefer to distribute the entire net profit to the shareholders by way of dividend A prudent and pragmatic management, with some vision and a long-term approach, may prefer to retain a substantial portion of the earnings and plough it back into the business, so as to expand its production activities, and its profitability and prospects therewith But then, the shareholders would naturally like to receive some amount by way of dividend as a direct and visible return on their investment in the company (though, in essence, the entire amount of the PAT, including the entire portion of the earnings, retained and ploughed back into the business, belongs to the equity shareholders only) This fact, naturally, calls for a prudent financial decision as to what should be the optimal percentage

of appropriation of the amount of the PAT into the quantum of dividend and retained earning This decision is usually referred to as the Dividend Decision

We can broadly classify the subject matter of the Financial Management into the following three main and vital functions:

Allocation of Funds

The investment decision also involves optimal allocation of funds to various projects, commensurate with their need and importance, profitability and prospects Accordingly, the finance managers are required to be ever alert so as to be able to reallocate the funds from some not-so-economical and profitable assets and avenues to some more profitable and economic ventures and assets

The investment proposals, however, do yield profit, but only in the future As the future is most uncertain and cannot be predicted with precision, the decision whether to go ahead with the instant proposal or not, definitely involves some inherent financial risks Apropos to the saying ‘no pain, no gain’, the companies also

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have to take some fair business risk With a view to keeping the element of risk (of loss) at the minimal level,

a lot of thinking and planning, computation and compilation of various facts and figures, have got to go into it This is due to the fact that once the project has been undertaken and some funds have been invested therein,

it may often become too difficult to go back on it, without incurring some substantial losses

Besides the project management (involving the management of fixed assets), the finance functions also involve management of working capital of a company In fact, a major portion of the time of the finance manager and the finance people is devoted to the management of working capital, inasmuch as it involves taking managerial decisions on a day-to-day basis, as against the one-time-decision, as in the case of a project

Thus, finance functions involve the management of assets, both current assets (pertaining to the working capital management) and fixed assets (pertaining to Capital Budgeting and Project Appraisal) as also their financing, monitoring and timely completion

Leasing, Hire-Purchase, Mergers and Acquisitions

The decision regarding ‘leasing’, ‘hire-purchase’, and ‘mergers and acquisitions’ also pertains to the investment decision area

Financing Decisions

Financial management, regarding financing decisions, pertains to locating the cheapest source and mode of

financing (i.e by way of shares or debentures, and/or loans and advances) It also involves decisions to finance

the working capital mostly out of the term sources of funds or through an optimal mix of both the term and long-term sources of funds The fixed assets, however, have to be financed invariably and exclusively through long-term sources of funds, so as to avoid being termed as the ‘culprit’ of diversion of short-term sources

short-of funds for long-term uses, which is viewed with great disfavour by the banks and the other short-term lenders

Disintermediation

Here, a mention about the recent process of ‘disintermediation’ seems to be quite relevant This process means that while, in the past, the banks were being approached by the companies for high-value loans and advances (as the banks had the huge accumulation of small savings from the general public, pooled together), now, as

a recent phenomenon, the companies are approaching the members of the public (the small investors) direct, through public issues of shares and/or debentures Thus, a developed capital market (stock exchange) can very well set in motion the process of ‘disintermediation’, whereby, instead of using the banks as a major source of finance, the companies may skip and overlook the intermediary (bank), for raising the required funds

Dividend Decisions

This segment of financial management pertains to the vital decisions on the appropriation of net profit (Profit After Tax) by way of payment of dividend to the shareholders, and ploughing back the balance amount into the business

It may be mentioned here that higher the amount ploughed back into the business, the better, inasmuch as

it is indicative of the fact that the company intends to remain in the business for a long time, and does not have

a short-term perspective to close down in the event of the initial setbacks or occasional adverse circumstances This enforces the confidence and trust among the banks and the other creditors of the company Besides, it

is indicative of the fact that the company is far more interested in the maximization and optimization of the shareholders’ wealth, rather than increasing the shareholders’ current income on their investment by way of dividend But then, the shareholders will be mostly interested in the amount of dividend, too It is under such circumstances that the balancing acts and skills of the finance manager comes into play, as to how much should

be the proportion between the dividend paid and the retained earnings ploughed back into the business

ROLES AND RESPONSIBILITIES OF INTERNAL AUDITORS

In most organizations, the internal audit also forms an integral part of the roles and responsibilities of the finance executives Internal auditors are essentially expected to perform as the in-house consultants to the

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organization They are, in fact, supposed to inspect and audit, and check and scrutinize, the various vouchers and the books of accounts of the company on a continuous basis, and thereby prepare the company well to face the external statutory auditors, so that no adverse remarks may be made by them in their report, which may adversely affect the reputation of the company

It will augur well if the internal auditors appreciate and assume their real role and responsibilities to function

as ‘a part of’ the departments and sections, and ‘not apart from’ them They must always be keen to extend their helping hands in the process of rectification of the irregularities and streamlining of the systems and procedures,

so as to arrest and mitigate the recurrence thereof Unfortunately, in most of the organizations, the internal

Moments (time)

OUT

Dividend

paid

Profit retained in business Money (cash

and funds)

Profit after tax

(PAT)

Marketing (cash and credit sales)

Materials inventories

Machines (fixed assets)

Dividend

decisions

Investment decisions (long-term finance)

Financing decisions (short-term finance)

Men (people)

* Fig 1.1 attempts to exhibit the following salient features of financial management:

(i) The circle at the top, representing ‘moment’ (time), suggests that time management is of top importance and essence

in all aspects of financial management, specially so in project management.

(ii) The circle at the centre, representing ‘men’ (people), which also inherits in itself a segment of each of the four circles, representing the different finance functions, goes to suggest that people are involved in all the functional areas of financial management.

(iii) The special feature of the presentation that all the four circles, representing different finance functions, are interconnected suggests their interdependence with each other, and stress the imperative need of their working as a well-knit team.

(iv) The larger and smaller segments of a circle (as if being the two portions of the same circle), represent the usual dividend policy, whereby a larger portion of the net profit (PAT) is retained in the business, and only a smaller portion is paid out as dividend.

(v) Finally, the circles representing ‘financing decisions’ and ‘investment decisions’ represent the optimal raising and application of short-term and long-term sources of funds, respectively The circle representing ‘dividend decisions’ represents such decisions as are stated in item (iv) above.

Figure 1.1 Schematic Presentation

of the Salient Features of Financial Management*

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auditors seem to act as if they are not a part of the auditees, but a separate identity They usually prefer to enlist the irregularities rather than to rectify them and thereby streamline the systems and procedures, with a view to ensuring their meticulous and spontaneous compliance Such counterproductive attitudes, if any, must change into proactive and positive approaches and actions – the sooner the better.

The internal auditors must, instead, serve as the eyes and ears of the management, and the friendly guides and helpers to the (auditee) departments in the organization It will augur well for the organization if they (auditors) would adopt a proactive attitude of mutual trust and confidence with the auditees, which may, invariably, end

in a ‘win-win’ situation Internal auditors should, at all times, bear in mind that their attitude should always be

of ‘problem solving’ rather than of ‘fault finding’; rectification of the irregularities rather than just enlistment thereof Besides, their yardstick should always be the adequacy and reasonability of the observance of the laid down rules and regulations, systems and procedures, and not meticulous perfection They should look for the observance of the rules in their spirit rather than in words alone, in the strictest sense of the term

The salient features of financial management can well be summarized by way of the schematic presentation

• Great economic depression of the 1930s, necessitated governmental interventions and vigil to streamline the financial management of the companies to restore the declining confidence in the national economies

of various countries

• Rapid developments in the technology and IT areas, automation and computerization of the making processes, have made the roles and responsibilities of the finance managers even more trying and testing

decision-The three broad functional areas of Financial Management are as follows:

• Investment decisions [i.e raising cheap funds and their optimal allocation to various projects (fixed

assets)]

• Financing decisions [i.e raising funds for short-term (working capital) purposes, in an optimal mix

of short-term and long-term sources of funds and their effective utilization]

• Dividend decisions (i.e taking policy decision as to how much percentage of the net profit must be

paid off as dividend, and how much balance amount of the earning should be retained and ploughed back into the business) However, the higher the amount ploughed back into the business the better

The Six Ms of Financial Management:

• Men (Managing people)

• Money (Raising of cheap funds and their optimal allocation)

• Machines (Acquiring the required fixed assets, and putting them to optimal productive use)

• Materials (Keeping inventories at the minimal level, minimizing inventory carrying costs, without the risk of stock outs)

• Marketing (Ensuring high sales and timely realization of the credit sales)

• Moments (Ensuring timely completion of projects, to avoid cost overruns)

Roles and responsibilities of Internal Auditors

Internal auditors are essentially the in-house consultants of the organization; the eyes and ears of the management; the friendly guides and helpers to the (auditees) departments in the organization

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REVIEW QUESTIONS

1 Financial management primarily aims at maximizing the shareholders’ wealth, which can well be achieved through efficient and effective handling of the various facets of management, referred to as the Six Ms of Financial Management Discuss

2 Explain the various events and developments that have facilitated the evolution of financial management as

a distinct discipline

3 Financial Management comprises the following three main and vital functions:

(i) Investment Decisions

(ii) Financing Decisions

(iii) Dividend Decisions

Explain, by citing suitable illustrative examples in each case

4. Internal auditors should discharge their roles and responsibilities by functioning as ‘a part of’ the departments

and sections, and ‘not apart from’ them Discuss

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Financial Statements

Success is neither magical nor mysterious

Success is the natural consequence of consistently

applying the basic fundamentals.

– Jim Rohn

LEARNING OBJECTIVES

After reading this chapter you should be able to understand

• The three components of Financial Statements, viz.

(i) Balance Sheet

(ii) Profit and Loss Account

(iii) Sources and Application (Uses) of Funds Statement

• Basic Concepts and Conventions pertaining to ‘Balance Sheet’, and ‘Profit and Loss Account’ or ‘Income Statement’

• Format of Balance Sheet, as provided in the Indian Companies Act

• An overview of the inherent purpose of interpretation of Balance Sheet:

(i) Intra-Firm Comparison

(ii) Inter-Firm Comparison

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