National Institute of Business Management

Chennai - 020

FIRST SEMESTER EMBA/ MBA

Subject : Financial Management

Attend any 4 questions. Each question carries 25 marks

(Each answer should be of minimum 2 pages / of 300 words)

1. Explain the objectives of financial management, interphase between

finance and other functions.

2. Explain the Indian Financial Systems.

3. Explain debentures as instruments for raising long-term debt capital.

4. What are Inventories? Explain.

5. Explain the different sources of cash.

6. What is cash budget and proforma balance sheet? Explain.

1 Explain the objectives of financial management,
interphase between finance and other functions.

Answer

Objective of Finance Management

The basic objective of Financial Management is to maximise shareholders’ wealth.
Earning of sufficient profit is the prerequisite for achieving the above objective. One
of the ways of improving the profit is by increasing the sales. However, due to the
business/ market conditions all sales do not get immediately converted into cash.
There will be some time-gap before the raw materials get converted into finished
goods, the finished goods into sales, the sales on credit into cash etc. In order to
sustain the sales activity, working capital is required during this period.

The following are the objective of Finance management:

 Profit maximization
 Wealth maximization
 Proper estimation of total financial requirements
 Proper mobilization
 Proper utilization of finance
 Maintaining proper cash flow
 Survival of company
 Creating reserves
 Proper coordination
 Create goodwill
 Increase efficiency
 Financial discipline
 Reduce cost of capital
 Reduce operating risks
 Prepare capital structure

Interface between finance and other functions

Finance is the study of money management, the acquiring of funds (cash) and the
directing of these funds to meet particular objectives. Good financial
management helps businesses to maximize returns while simultaneously minimizing
risks. Finance is the lifeblood of business organizations, without finance the
formation, establishment, production, functioning or operating of big, medium or
small business enterprise is not possible.
Financial management is an integral part of overall management and not merely a
staff function. It is not only confined to fund raising operations but extends beyond it
to cover utilization of funds and monitoring its uses. These functions influence the
operations of other crucial functional areas of the firm such as production, marketing
and human resources. Hence, decisions in regard to financial matters must be taken
after giving thoughtful consideration to interests of various business activities.
Finance manager has to see things as a part of a whole and make financial
decisions within the framework of overall corporate objectives and policies.

Finance may be defined as the art and science of managing money. The major areas
of finance are:
1) Financial services and
2) Financial management
Financial Services is concerned with the design and delivery of products to
individuals, business and government within the areas of financial institutions,
personal financial planning, investments, real estate, and so on.
Financial management is concerned with the duties of the financial managers in the
business firm.

Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a
significant location, etc. In all these matters assessment of financial implications is
inescapable impact on the profitability of the firm. For example, he should have a
clear understanding of the impact the credit extended to the customers is going to
have on the profits of the company. Otherwise in his eagerness to meet the sales
targets he is liable to extend liberal terms of credit, which is likely to put the profit
plans out of gear. Similarly, he should weigh the benefits of keeping a large inventory
of finished goods in anticipation of sales against the costs of maintaining that
inventory. Other key decisions of the Marketing Manager, which have financial
implications, are:
 Pricing
 Product promotion and advertisement
 Choice of product mix
  Distribution policy.

Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major
part of the investment in the form of equipment, materials and men. He should so
organize his department that the equipments under his control are used most
productively, the inventory of work-in-process or unfinished goods and stores and
spares is optimized and the idle time and work stoppages are minimized. If the
production manager can achieve this, he would be holding the cost of the output
under control and thereby help in maximizing profits. He has to appreciate the fact
that whereas the price at which the output can be sold is largely determined by
factors external to the firm like competition, government regulations, etc. the cost of
production is more amenable to his control. Similarly, he would have to make
decisions regarding make or buy, buy or lease etc. for which he has to evaluate the
financial implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm’s long-term goals
are met, finds it convenient to use the financial statements as a means for keeping
itself informed of the overall effectiveness of the organization. We have so far briefly
reviewed the interface of finance with the non-finance functional disciplines like
production, marketing etc. Besides these, the finance function also has a strong
linkage with the functions of the top management. Strategic
planning and management control are two important functions of the top
management. Finance function provides the basic inputs needed for undertaking
these activities.

Accounting – Finance Interface

The firm’s finance (treasurer) and accounting (controller) activities are typically within
the control of the financial vice president (CFO). These functions are closely related
and generally overlap; indeed, managerial finance and accounting are often not
easily distinguishable. In small firms the controller often carries out the finance
function, and in large firms many accountants are closely involved in various finance
activities. However, there are two basic differences between finance and accounting;
one relates to the emphasis on cash flows and the other to decision making.
Business finance is required for the establishment of every business organization.
With the growth in activities, financial needs also grow. Funds are required for the
purchase of land and building, machinery and other fixed assets. Besides this,
money is also needed to meet day-to- day expenses e.g. purchase of raw material,
payment of wages and salaries, electricity bills, telephone bills etc. We are aware
that production continues in anticipation of demand. Expenses continue to be
incurred until the goods are sold and money is recovered. Money is required to
bridge the time gap between production and sales. Besides producers, may be
necessary to change the office set up in order to install computers. Renovation of
facilities can be taken up only when adequate funds are available.

To meet contingencies Funds are always required to meet the ups and downs of
business and unforeseen problems. Suppose, some manufacturer anticipates
shortage of raw materials after a period. Obviously he would like to stock raw
materials. But he will be able to do so only when money would be available.

To promote sales in this era of competition, lot of money is required to be spent on

activities for promoting sales like advertisement, personal selling, home delivery of
goods etc.

To avail of business opportunities Funds are also required to avail of business

opportunities. Suppose a company wants to submit a tender but some minimum
amount is required to be deposited along with the application. In the case of non-
availability of funds it would not be possible for the company to apply.
The decision function of financial management can be broken down into three major
areas: the investment, financing, and asset management decisions.

Investment Decision
The investment decision is the most important of the firm's three major decisions
when it comes to the value creation. Investment decision relates to the determination
of total amount of assets to be held in the firm, the composition of these assets like
the amount of fixed assets, current assets and the extent of business risk involved by
the investors. The investment decisions can be classified in to two groups: (1) Long-
term investment decision or capital budgeting and (2) Short-term decision or Working
capital decision.
Financing Decision
Financing decision follows the Investment decision. The Finance manager now has
to decide how much of finance is required to meet the long-term and short-term
investment decisions, what are the sources of financing these investment decisions,
what is the composition of these finance and what should be the financial mix and so
on.

Asset Management Decision

The third important decision of the firm is the asset management decision. Once
assets have been acquired and appropriate financing provided, these assets must
still be managed efficiently. The finance manager has more responsibility in
managing the current assets than fixed assets. A large share of the responsibility of
managing the fixed assets would reside in the hands of operating managers of the
company.

2. Explain the Indian Financial Systems.

Answer

INDIAN FINANCIAL SYSTEM

Economic growth and development of any country depends upon a well-knit financial
system. Financial system comprises, a set of sub-systems of financial institutions
financial markets, financial instruments and services which help in the formation of
capital. Thus a financial system provides a mechanism by which savings are
transformed into investments and it can be said that financial system play an
significant role in economic growth of the country by mobilizing surplus funds and
utilizing them effectively for productive purpose.

The financial system is characterized by the presence of integrated, organized and

regulated financial markets, and institutions that meet the short term and long term
financial needs of both the household and corporate sector. Both financial markets
and financial institutions play an important role in the financial system by rendering
various financial services to the community. They operate in close combination with
each other. The financial system facilitates the transformation of savings into
investment and consumption.

The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy. The financial system is concerned about
money, credit and finance-the three terms are intimately related yet are somewhat
different from each other. Indian financial system consists of financial market,
financial instruments and financial intermediation.

Role/Functions of Financial System: A financial system performs the following

functions:

* It serves as a link between savers and investors. It helps in utilizing the mobilized
savings of scattered savers in more efficient and effective manner. It channelises the
flow of saving into productive investment.
* It assists in the selection of the projects to be financed and also reviews the
performance of such projects periodically.
* It provides payment mechanism for exchange of goods and services.

* It provides a mechanism for the transfer of resources across geographic

boundaries.
* It provides a mechanism for managing and controlling the risk involved in
mobilizing savings and allocating credit.
* It promotes the process of capital formation by bringing together the supply of
saving and the demand for investible funds.
* It helps in lowering the cost of transaction and increase returns. Reduce cost
motives people to save more.
* It provides you detailed information to the operators/ players in the market such as
individuals, business houses, Governments etc.

Components/ Constituents of Indian Financial system:

The following are the four main components of Indian Financial system

1. Financial institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities
4. Financial Services.

Financial institutions:

Financial institutions are the intermediaries who facilitates smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of
the surplus units and allocate them in productive activities promising a better rate of
return. Financial institutions also provide services to entities seeking advises on
various issues ranging from restructuring to diversification plans. They provide whole
range of services to the entities who want to raise funds from the markets elsewhere.
Financial institutions act as financial intermediaries because they act as middlemen
between savers and borrowers. Were these financial institutions may be of Banking
or Non-Banking institutions.

Financial Markets:

Finance is a prerequisite for modern business and financial institutions play a vital
role in economic system. It's through financial markets the financial system of an
economy works. The main functions of financial markets are:

1. to facilitate creation and allocation of credit and liquidity;

2. to serve as intermediaries for mobilization of savings;
3. to assist process of balanced economic growth;
4. to provide financial convenience

Financial Instruments

Another important constituent of financial system is financial instruments. They

represent a claim against the future income and wealth of others. It will be a claim
against a person or an institutions, for the payment of the some of the money at a
specified future date.

Financial Services:

Efficiency of emerging financial system largely depends upon the quality and variety
of financial services provided by financial intermediaries. The term financial services
can be defined as "activites, benefits and satisfaction connected with sale of money,
that offers to users and customers, financial related value".
In any financial system the flow of money for business may be represented by the
following chart:

The flow of money from investor is in the form of deposit, debt or

shares and is represented by deposit receipts, debt instruments or share
certificates which are called financial assets. Most of the money in the financial
system flows through the financial intermediaries, whose activities are controlled by
Reserve Bank of India, the Central Bank of the country. RBI is the authority
responsible for laying down the monetary policy. The financial intermediaries in India
can be categorised as under:

1. Commercial Banks grouped as under:

a) State Bank of India and its subsidiaries
b) Nationalised Banks (Public Sector Banks)
c) Private Sector Banks

2. Term Lending Institutions:

a) All India Financial Institutions like IFCI, IDBI, ICICI, SIDBI etc.
b) State-level institutions

3. Agricultural Financial Institutions:

a) National Bank for Agriculture and Rural Development (NABARD)
b) National Companies-operative Development Corporation (NCDC)

4. Insurance Companies and funds

a) LIC of India
b) General Insurance Corporation and its subsidiaries

5. Mutual Funds:
a) Unit Trust of India (UTI)
b) Public Sector Mutual Funds
c) Private Sector Mutual Funds
6. Non-Banking Finance Companies (NBFCs)
7. Others like Post Office Savings Bank, Chit Funds and Nidhi Companies.

4. What are Inventories? Explain

Answer
Inventories:
The term inventories include stock of raw material, work-in-progress and finished
goods. Inventory, often called merchandise, refers to goods and materials that a
business holds for sale to customers in the near future.

a) Raw materials stock

Raw material inventory represents the items of basic input for processing. The
quantity of raw materials required for production and the average time taken in
obtaining fresh delivery - the combination of the above two factors decide the
quantity of raw materials required to be kept in stock. Suppose the total quantity of
raw materials required in a year is 2,400 kg and one month is taken in obtaining a
fresh delivery. Then a minimum stock of 200 kg of raw materials must be kept in
stock (i.e., 2,400 kg / 12). Marginal increases have to be made over this quantity on
the basis of likely delays and other considerations. The quantity of stock multiplied by
the price per unit will give the amount of working capital required for holding stock of
raw materials.

b) Work-in-process
Work-in-process covers all items, which are at various stages of production process.
This is an intermediary item between raw materials and finished goods. i.e., these
items have ceased to be raw material but have not developed into final products and
are at various stages of semi-finished levels. For calculation of the amount of work-
in-process, the time period for which the goods are in the production process is to be
found out. The cost of WIP includes raw materials, wages and overheads.

c) Finished goods
Finished goods are completed products awaiting sale. They are final output of the
production process in a manufacturing firm. The period for which the finished
products have to remain in the warehouse before sale determines the amount locked
up in finished goods.

The levels of raw materials, work-in-process and finished goods differ depending
upon the nature of the business. Inventories form a link between production and sale
of a product. The money blocked in inventories is substantial, and
monitoring the movement of this asset requires considerable attention
from the finance manager. Good inventory management is good
finance management. A company should maintain adequate stock of
materials of right quality at minimum cost so that they are issued to
production when needed in order to have uninterrupted flow of
production. Inadequate inventories will disturb the production line and
result in loss of sales.

BENEFITS OF HOLDING INVENTORIES

The specific benefits of holding inventories are:
1. Avoiding losses of sales: Without required goods on hand, which are ready
to be sold, most firms would lose business. i.e., if the firm maintains adequate
inventories, it can avoid losses on account of losing the customers for non-
supply of goods in time. Shelf stock is items that are stored by the business
and sold to the customers, with little or no modification, such as automobile.
Customers may specify minor variations, but the basic item from the factory
now available on stock is sold as a standard item.
 2. Quantity discounts: Suppliers offer reduction in price for making bulk
purchases to their customers. Maintenance of large inventories in selected
product lines enables the firm to make bulk purchase of goods at large
discounts.

3. Reducing Ordering cost: Each time a firm places an order, it incurs certain
expenses. The variable costs associated with individual orders, such as
typing, checking, approving and mailing the order etc., can be reduced if a
firm places a few large orders rather than numerous small orders.

4. Achieving efficient production runs: Each time a firm sets up workers and
machines to produce an item, startup costs are incurred. Maintenance of
large inventories helps a firm in reducing the set up costs associated with
each production run.

5. Reducing risk of production shortages: If any critical component for the

production is not available when required, the entire production operation will
be halted, with consequential heavy losses.

RISKS OF HOLDING INVENTORIES

The following are the risks associated with holding inventories:
1. Reduction/decline in market price: This is dependent upon the market
supply of the product, introduction of a new competitive product and price-
cutting by the competitors etc.

2. Deterioration of product: Product deterioration may be caused due to

holding a product for too long a period or improper storage conditions.

3. Obsolescence of product: The changes in customers’ tastes, introduction of

new production techniques, improvements in the product design,
specifications etc., may lead to obsolescence of the product.

COST OF HOLDING INVENTORIES

The costs associated with holding of inventories can be broadly classified into two
i.e. direct costs and indirect costs

The direct costs of holding inventories are as follows:

(a) Materials cost: These are the costs of purchasing the goods including
transportation and handling charges less any discount allowed by the supplier of
goods.

(b) Ordering cost: It refers to the variable costs associated with placing an order for
the goods. The fewer the orders, the lower will be the total ordering cost for the firm.
The ordering cost per order remains more or less constant irrespective of the size of
the order although transportation and inspection costs may vary to a certain extent
depending upon order size i.e. ordering costs are invariant to the order size. The
total ordering costs can be reduced by increasing the size of the orders.

(c) Carrying cost: This refers to the expenses for storing the goods. It comprises
storage costs, insurance costs, rent and depreciation of warehouse, salaries of
storekeeper, security personnel, spoilage costs, taxes, cost of funds tied up in
inventories etc.

The indirect costs of holding inventory are:

(a) Cost of funds tied up in with inventory: This is an opportunity cost, in the sense
that the firm has lost the use of funds for other purposes. Whenever a firm commits
its resources to inventory, it is using funds that otherwise might be available for other
purposes.
(b) Cost of running out of stocks: This is also known as stock-out cost. These are
costs associated with the inability to provide materials to the production department
and inability to provide finished goods to the marketing department as the required
quantity of inventories are not available.

OBJECTIVES OF INVENTORY MANAGEMENT

The main objectives of inventory management are:
a) To ensure that the materials are available for use in production as and when
required, facilitating uninterrupted production,
b) To maintain sufficient stock of raw materials in periods of short supply,
c) To ensure that inventory of finished goods is adequate to fulfil the customers’
orders as per committed delivery schedules,
d) To optimise the investment in inventories and
e) To protect the inventory from deterioration and obsolescence by providing for
proper warehousing and insurance.

5. Explain the different sources of cash.

Answer
A Sources schedule gives a summary of where capital will come from. Sources of
cash can be both internal as well as external.

Internal Sources:
The main internal source of cash is cash from operations. To find cash from
operations, the profit available as per the Profit & Loss account is to be adjusted for
non-cash items, such as depreciation, amortization of intangible assets, loss on sale
of fixed assets and creation of reserves etc. This is computed just like computation of
‘funds’ from operations as explained under Funds Flow Analysis. However, to find out
the real cash from operations, adjustments will have to be made for ‘changes’ in
current assets and current liabilities arising on account of operations

When all transactions are cash transactions, then Cash from operations = Net Profit.
When all transactions are not cash transactions, then, it involves the following two
steps:
1. Computation of funds (i.e., working capital) from operations as in Funds Flow
Analysis.
2. Adjustments in the funds so calculated for changes in the current assets
(excluding cash) and current liabilities.

External Sources of Cash:

Some of the sources of external cash are as follows

 Issue of new shares
 Raising of long-term loans
 Purchase of plant and machinery on deferred payment terms
  Short-term borrowings from banks
 Sale of fixed assets, investments etc.

Another way of approaching this problem is a basic understanding the three sources
and uses of cash - Operating, Investing, and Financing.

1. Operating Activities- This includes, very basically, all our business's day-to-
day activities, including receivables, payable, credit cards, lines of crest, etc.
This does not include loan principal payments and purchases of depreciable
assets. Generally, this category is a source of cash (provides cash) when we
collect on our receivables and show a profit (earn more than you spend). It is
a use of cash (depletes cash) when we don't collect receivables and/or aren't
profitable (spend more than you earn).

2. Investing Activities - Investing includes all the purchases of depreciable

assets (Vehicles, Equipment, etc.) that we make. It can also include some of
the funds received when those assets are sold. It is a use of cash when we
buy an asset, and can provide cash when we sell them. When buying assets
we must consider first how we will pay for it. If we pay for it with cash that
cash comes out of Operating Activities (so we'd better be collecting those
receivables). If we take out a loan, the money comes from Financing Activities
- the next category.
3. Financing Activities - In a small business, a major source of cash from
financing activities is the money received from a long term loan, which is used
to buy an asset. If we don’t have enough funds available from Operating
Activities, we can finance the purchase and pay the money back over time.
One of the main uses of cash in this category, then, includes paying back the
principal on those loans. The other is paying distributions, or draws, to
owners.

Understanding these 3 categories and how each is either providing or taking

cash from your account, will help us make sense of why our checking account
is going up or down. Armed with that knowledge, we can make better long
term decisions and reach our Summit.

To sum up the above points Companies obtain cash through borrowing,

owners' investments, management operations, and by converting other
resources. Each of these sources of cash is examined below.
Borrowing cash: Companies borrow cash primarily through short-term bank
loans and by issuing long-term notes and bonds. For example, assume that
on June 16, a company borrows Rs 8,00,000 for 90 days. It shows the effects
of borrowing on the company's resources and sources of resources.

Obtaining cash from owners: As evidence of their investments in

corporations, owners most often receive shares of common stock. For
example, if owners invest Rs 5,00,000 in a corporation on June 10, I show the
effects on the company's resources and sources of resources.

Cash generated by management: Management generates cash mainly by

servicing customers. For example, if managers provide services to customers
on June 11, and receive Rs 1,50,000 cash, it shows the effects on the
company's resources and sources of resources.

Obtaining cash by converting other resources into cash: Companies

often receive cash by converting other resources, usually accounts
receivable, into cash. For example, if managers collect Rs. 80,000 on June
18, from customers for services provided to them in May, it shows the effects
on the company's resources and sources of resources.