Finance for non finance executives

1
Finance for non finance executives

• By
• M. K. BANSAL

2
Business

• Business as an economic entity
• Trading activity
• Manufacturing activity
• Servicing activities

Selling
Buying
Selling
Processing
Buying
Servicing
3
Business

• Purpose of an economic entity
• Wealth creation
• Wealth management, and
• Wealth distribution
• Objective To lead the revolution and create the
  
• best possible values and share them in the
• equitable manner among all the stakeholders.

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Business

• Stakeholders in the Business
• Investors
• Equity holders
• Debt holders including banks and financial
  institutions
• Suppliers
• Distributors and retailers
• Employees
• Customers
• Community

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Business

• Proprietary business
• Single owner of the business.
• No difference between the obligations of the
  business and the obligations of the individual.
• Partnership firm
• Two or more owners of the business.
• No difference between the obligations of the
  business and the obligations of the individuals.

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Business

• Company Is an artificial person, created by law
  and has the perpetual existence. Obligations of
  the company are separate from those of promoters
  and management.
• Private limited company
• Not more than 50 members
• Shares are not freely transferable.
• No invitation to public for subscription.
• Public limited company
• Closely held public limited company
• Publicly held public limited company

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Business

• Closely held public limited company
• Not a listed company.
• No invitation to public for subscription.
• Publicly held public limited company
• A listed company.
• Held by large number of shareholders.
• Shareholder have limited liability in Ltd.
  Companies.
• What about the companies with unlimited
  liabilities on
• shareholders.

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Structure of the businesses
Business
Partnership
Company
Proprietary
Public Ltd.
Private Ltd.
Closely held
Publicly held
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Sources of funds

• Long term funds
• Equity
• Long term Debts
• Short term funds
• Short term Debts
• Other short term borrowings
• Portfolio mix of the long term and short term
  funds is called the Capital Structure of the
  company. This forms the left hand side of the
  Balance Sheet.

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Uses of funds

• Fixed Assets
• Land and building
• Plant and Machinery
• Others
• Working Capital
• Raw Material
• Work in progress
• Finished goods
• Cash
• Investments
• Various avenues of investment

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Sources and uses of funds

• Match between the uses of funds and the
• sources of funds
• Long term investments must always be with long
  term funds. Financing long term assets with the
  short term funds creates risks mainly the
  refinancing one.
• Short term investments may be financed with long
  term or short term funds. It depends on the
  attitude of the business managers.

Long term investments
Long term funds
Long term funds
Short term investments
Short term funds
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Funds management
Management of the funds
Mobilization of the funds
Utilization of the funds
Quantum Source Cost time
Fixed assets Work. Cap. Investments
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A typical balance sheet

• Liabilities
• Authorized Capital
• Issued capital
• Paid up capital
• Preference share capital
• Long term Debts
• Other short term borrowings
• Reserves and surplus
• Current liabilities

• Assets
• Fixed Assets
• Land and building
• Machinery
• Others
• Working Capital
• Raw Material
• Work in progress
• Finished goods
• Cash
• Investments
• Deferred revenue expenses
• Intangible assets like goodwill, human resources,
  brands etc.
• Accumulated losses

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Balance sheet

• Assets would always be equal to the liabilities.
  Balance sheet would always match (Result of
  double accounting rule).
• It provides readers with the static picture of
  the business on a specific day.
• Is it possible to engineer balance sheet to
  present misleading picture of the state of
  affairs of business.

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Some Balance Sheet items

• Accumulated losses
• Intangibles like Goodwill, value of Human
  Resources and brands etc.
• For intangibles, equal values are added to the
  Liability side, in the form of Capital Reserves,
  to match both the sides of the balance sheet.

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Sources of funds - Equity

• Equity capital is the risk capital, which
  facilitates the wider dissemination of the risk
  and rewards of the business.
• Can voting rights be different for the different
  share holders.
• Why the equity capital is shown as a liability in
  the books of the company.

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Important terms linked to equity

• Market value per share and Market capitalization
• Book value per share Net worth/ number of
  outstanding shares. New worth is equal to the
  share capital reserves and surplus other than
  the Capital Reserves.
• Earning per share (EPS) Profit after tax /
  number of outstanding shares.
• Dividend per share (DPS)
• Price earning ratio (P-E ratio) Market price/
  EPS

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Sources of funds - Preference shares

• Preference shares are called quasi equity. They
  behave partly like shares and partly like debt
  instruments.
• Preference share holders have
• Dividend, which is fixed and paid before anything
  is paid to equity holders.
• Capital appreciation, if any.
• Voting right No voting right originally. But
  acquire the voting rights in certain
  circumstances.

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Important terms linked to preference shares

• Claim over the residual assets, at the time of
  liquidation of the company, before the equity
  holders and after the debt holders.
• They behave like debt instruments because they
  carry fixed dividend rates.
• They behave like equity instruments because they
  offer the dividend to the share holders without
  any obligation on the company.

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Sources of funds - Debt

• Debt provides the business with the capital
  bearing the fixed cost.
• Debt owners have
• Fixed Interest Payment of interest is an
  obligation on the company.
• No voting right
• Claim over the assets of the company before the
  equity holders.

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Sources of funds - Debt

• Both long and short term loans can be secured or
  unsecured.
• Different debt owners would have different
  priority claims on the assets of the company at
  the time of liquidation.
• Can we have perpetual debt.

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Important terms linked to debt instruments

• Face value/ Par value
• Issue price (at face value or at discount to the
  face value)
• Redemption value (at face value or premium to the
  face value)
• Terms of the redemption
• Rate of interest (Coupon)
• Maturity of the instrument

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Important terms lined to debt instruments

• Convertible debts
• To be convertible into shares of the company.
• Fixed or the floating prices.
• Compulsory or optionally convertible.
• Timings of the conversion may vary a lot.
• Fully convertible debentures (FCDs)
• Partly convertible debentures (PCDs)
• Preference shares can also be convertibles like
  debt instruments.
• Bank financing

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Short term financing instruments

• Short term bank loans
• Commercial papers
• Issued at discount
• Unsecured in nature
• Public deposits
• Generally issued at par
• Unsecured in nature
• Inter-corporate deposits
• Bill discounting Financing against the
  commercial bills.
• Factoring Sell of the commercial bills.
• Forfaiting Sell of the export bills.

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Major providers of debt finance

• Individual investors
• Banks
• Financial institutions
• Specialized institutions

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Reserves and Surplus

• General reserves Created out of retained
  profits.
• Share premium reserve premium on allocation of
  securities is credited to this account.
• Capital reserves Also called the revaluation
  reserves.
• Sinking fund account to meet the specific
  requirements/obligations of the business.

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Main items of the revenues

• Sales revenue
• Other income
• Dividends and interest
• Sales of the assets
• Lease charges

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Main items of the expenses

• Cost of goods sold.
• Salary
• Other expenses

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A typical profit and loss account

• Revenues from the business
• Less Cost of goods sold and other expenses
• Less Depreciation
• Earning before interest and taxes (EBIT)
• Less Interest payment
• Earning before taxes (EBT)
• Less Taxes
• Earning after the tax (EAT/PAT)

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Items from profit and loss account

• Depreciation
• Straight line method
• Discounted value method
• (Change in depreciation methodology to
  inflate/deflate profits)
• Deferred revenue expenditure
• RD expenses
• Advertisement expenses
• Product promotion expenses
• (expenses are charged as capital expenses and
  amortized over the period of time)

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Cost concepts

• Cost of goods sold
• Direct material
• Direct labor
• Direct manufacturing overheads
• Administrative costs
• Office rent
• Salaries
• Postage and Telegram
• Other costs
• Selling and distribution costs
• Salaries of sales staff
• Commissions, promotional expenses
• Advertisement expenses etc.

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Cost concepts

• Fixed costs
• Salary and wages, lease rentals etc.
• Variable costs
• Raw material and other related costs
• Semi-variable cost
• Total cost
• Average cost
• Opportunity cost

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Cost concepts

• Replacement costs
• Direct cost
• Indirect cost
• Sunk cost
• Estimated cost
• Actual cost

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A view of profit and loss account

• Cash expenses
• Raw material, salary and other administrative
  expenses
• Non cash expenses
• Depreciation

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A view of profit and loss account

• Break even point Is the point of no profit and
  no loss.
• Throughput/productivity output/input
• Ways to improve the throughput/productivity
• Economies of scale and scope

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A view of profit and loss account

• Cost leadership
• Price leadership
• Market leadership
• Offer a better product at a competitive price.
• Offer a competitive product at a better price.

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Annual Reports

• Auditors report
• Profit and loss account
• Balance sheet
• Cash flow statement
• Qualification of auditors
• Directors report

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Corporate actions

• PAT money is available for the equity holders.
  Following three things can be done with this
  money
• Distribute to the equity holders as dividend.
• Retain the whole money and channelize that
  towards the business, if opportunities exist.
• Distribute part of the money and retain part of
  the money.

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Corporate actions

• Dividend decision
• Need of the fresh funds in the company.
• Long term plans of the company.
• Expectations of the shareholders.
• Management philosophy

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Corporate actions

• Bonus shares
• This is another form of paying dividend and so
  bonus shares are also called the stock dividend.
• Some fresh shares are given for the existing
  shares for no extra charges.
• Stock market prices fall down after the bonus
  shares.
• In the books of company, general reserves become
  the share capital (Capitalizing reserves).

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Corporate actions

• Split of shares
• Shares are split in more number of shares.
• Par value per share goes down.
• Stock market prices fall down immediately to
  adjust for the increased number of shares.
• In the books of company, there is no impact other
  than the change in the outstanding number of
  shares (become more).

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Corporate actions

• Consolidation of shares
• This is exactly opposite to the split of shares.
• Shares are consolidated and existing shares are
  exchanged for the lesser number of shares.
• Par value per share goes up.
• Stock market prices go up immediately.
• In the books of company, there is no impact other
  than the change in the outstanding number of
  shares (become less).

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Corporate actions

• Right shares
• At the time of raising further capital, first
  offer is made to the existing share holders by
  the company.
• Additional shares are offered to the existing
  share holders on priority basis to ensure that
  their shareholding does not get diluted.
• Shares are generally offered at a discount to the
  market value of the share.
• Stock market prices fall down after the offer.
• In the books of company, capital changes.
• What about trading of rights on the exchange
  platforms ?

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Corporate actions

• Buyback of shares
• For treasury operations.
• For extinction - If the company wants to reduce
  the share capital, it can do that by buying the
  shares back.
• Fixed price buy back.
• Proportionate right is offered to the investors
  to sell the shares back to the company.
• Buy back of shares is done generally at a price
  higher than the market price.
• Book built buy back
• Put options approach to fixed price buy back
  offers.
• In the books of company, capital changes (it goes
  down).

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Cost of capital

• Cost of equity
• Cost of debt
• Total cost of funds Weighted Average Cost of
  Capital (WACC).
• Rate of return has got to be higher than the WACC
  for economic business proposition.

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Risks in the business

• Business Risk
• Financial Risk
• Default risk
• Interest rate risk
• Currency risk
• Refinancing and reinvestment risks.

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Leverage impact

• More debt creates the financial risk.
• Companies with the high business risk may not
  take high financial risk.
• What about the zero debt companies.

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Management of the risks

• Management of the risk requires the knowledge of
  the specialized instruments called derivatives.
• Major products are
• Forward
• Futures, and
• Options