UNIVERSITY OF SAN JOSE RECOLETOS

Financial Managent

DBA

By
Mojgan Mashayekhi

June 2011
 I. Introduction:

Companies do not work in a vacuum, isolated from everything else. It interacts

and transacts with the other entities present in the economic environment. These

entities include Government, Suppliers, Lenders, Banks, Customers,

Shareholders, etc. who deal with the organisation in several ways. Most of these

dealings result in either money flowing in or flowing out from the company. This

flow of money (or funds) has to be managed so as to result in maximum gains to

the company. Managing this flow of funds efficiently is the purview of finance. So

we can define finance as the study of the methods which help us plan, raise and

use funds in an efficient manner to achieve corporate objectives. Finance grew

out of economics as a special discipline to deal with a special set of common

problems.

The corporate financial objectives could be to:

1. Provide the link between the business and the other entities in the

environment; and

2. Investment and financial decision making.

Let us first look at what we mean by investment and financial decision making.

1. Investment Decision: The investment decision, also referred to as the

capital budgeting decision, simply means the decisions to acquire assets

or to invest in a project. Assets are defined as economic resources that

are expected to generate future benefits.

 2. Financing Decision: The second financial decision is the financing

decision, which basically addresses two questions:

a. How much capital should be raised to fund the firm's operations

(both existing & proposed)

b. What is the best mix of financing these assets?

Financing could be through two ways: debt (loans from various sources like

banks, financial institutions, public, etc.) and equity (capital put in by the investors

who are also known as owners/ shareholders). Shareholders are owners

because the shares represent the ownership in the company.

II. COST OF CAPITAL

The cost of capital is a term used in the field of financial investment to refer to

the cost of a company's funds (both debt and equity), or, from an investor's point

of view "the shareholder's required return on a portfolio of all the company's

existing securities. It is used to evaluate new projects of a company as it is the

minimum return that investors expect for providing capital to the company, thus

setting a benchmark that a new project has to meet.

The Cost of Capital

 Sources of capital

 Component costs

 WACC

 Adjusting for flotation costs

  Adjusting for risk

Why is the cost of retained earnings cheaper than the cost of issuing new

common stock?

 When a company issues new common stock they also have to pay

flotation costs to the underwriter.

 Issuing new common stock may send a negative signal to the capital

markets, which may depress the stock price.

III. CAPITAL BUDGETING

Capital budgeting is a required managerial tool. One duty of a financial manager

is to choose investments with satisfactory cash flows and rates of return.

Therefore, a financial manager must be able to decide whether an investment is

worth undertaking and be able to choose intelligently between two or more

alternatives. To do this, a sound procedure to evaluate, compare, and select

projects is needed. This procedure is called capital budgeting.

CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a

limit to the volume of credit that the banking system can create in the economy.

Commercial banks and other lending institutions have limited deposits from
which they can lend money to individuals, corporations, and governments. In

addition, the Federal Reserve System requires each bank to maintain part of its

deposits as reserves. Having limited resources to lend, lending institutions are

selective in extending loans to their customers. But even if a bank were to

extend unlimited loans to a company, the management of that company would

need to consider the impact that increasing loans would have on the overall cost

of financing.

In reality, any firm has limited borrowing resources that should be allocated

among the best investment alternatives. One might argue that a company can

issue an almost unlimited amount of common stock to raise capital. Increasing

the number of shares of company stock, however, will serve only to distribute the

same amount of equity among a greater number of shareholders. In other

words, as the number of shares of a company increases, the company ownership

of the individual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital,

whether debt or equity (short-term or long-term, common stock) or retained

earnings, accounts payable or notes payable, and so on. Even the best-known

firm in an industry or a community can increase its borrowing up to a certain limit.

Once this point has been reached, the firm will either be denied more credit or be

charged a higher interest rate, making borrowing a less desirable way to raise

capital.
 Faced with limited sources of capital, management should carefully decide

whether a particular project is economically acceptable. In the case of more than

one project, management must identify the projects that will contribute most to

profits and, consequently, to the value (or wealth) of the firm. This, in essence, is

the basis of capital budgeting.

Basic Steps of Capital Budgeting

1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or

payback < policy

Evaluation Techniques

A. Payback period

B. Net present value (NPV)

C. Internal rate of return (IRR)

D. Modified internal rate of return (MIRR)

E. Profitability index
 IV. OPERATING AND FINANCIAL LEVERAGE

One of the most important of the various financial decisions is how much

leverage a firm should employ. A fundamental decision made by any business is

the degree to which it incurs fixed costs. A fixed cost is one that remains the

same regardless of the level of operations. As sales increase, fixed costs don't

increase in the same proportion. Some fixed costs do not increase at all till a

particular point. As a result, profits can rise faster during good times. On the

other hand, during bad times fixed costs don't decline, so profits fall more rapidly

than sales do. The degree to which a firm locks itself into fixed costs is referred

to as its leverage position. The more highly leveraged a firm, the riskier it is

because of the obligations related to fixed costs that must be met whether the

firm is having a good year or not. At the same time, the more highly leveraged

the greater the profits during good times. This presents a classic problem of

making a decision where there is a trade-off between risk and return.

There are two major types of leverage - financial and operating. Financial

leverage is specifically the extent to which a firm gets its cash resources from

borrowing (debt) as opposed to issuance of additional shares of (equity). The

greater the debt compared to equity, the more highly leveraged the firm because

debt legally obligates the firm to interest payments. These interest payments

represent a fixed cost. Operating leverage is concerned with the extent to which

a firm commits itself to high levels of fixed costs other than interest payments. A
firm that rents property using cancellable leases has less leverage than a firm

that commits itself to a long-term noncancellable lease does. A firm that has

substantial vertical integration has created a highly leveraged situation. Consider

what happens if a company vertically integrates by acquiring its raw materials'

supplier. Raw materials will now cost the company less, because it doesn't have

to buy them from an outside firm. But when times are bad, the firm will have to

bear the fixed costs associated with the supplier subsidiary. Had there still been

two separate companies, the big company could have simply slowed its

purchases of raw materials from supplier without having to bear its fixed costs.

In the cases of both financial and operating leverage, the crucial question is how

much everage is appropriate. We can't answer that question in absolute terms,

but we will help you understand the topic. This understanding should make it

simpler to make appropriate choices or to understand what went into making the

choices your firm has already made.

Operating Leverage

While decisions about financial leverage is strictly the domain of the firm's

highest levels of management, operating leverage is an issue that directly affects

the line managers of the firm. The level of operating leverage a firm selects

should not be made without input from the managers directly involved in the

production process. For example, one of the most significant operating leverage

issues is the choice of technology levels. Selection of the highest level of

technology available is not always in the best interests of the business. Suppose
that we are opening a chain of copy centres. Each centre will provide a full

service operation. Customers can drop work off in the morning and pick it up later

in the day or the week. The employees will do the actual photocopying. We are

faced with the choice of renting a relatively slow copy machine, or the newest

technology machine, which is considerably faster. The faster machine is also

considerably more expensive to lease. It will generally be the case that newer

technology has a higher fixed cost and lower variable cost than the older

technology. Variable costs are those that vary directly with volume. If we double

the number of copies made, we double the amount of paper, printing ink toner,

and labour time needed for making the copies. One of the principle functions of

new technology is to reduce the variable costs of production. It may turn out that

a machine that can reduce the variable costs is more expensive to make, and

thus has a higher purchase or lease price than the older generation machine.

However, even if it doesn't cost more to make, its manufacturer will charge more

for the new machine than for the older machine. Intuitively, if the new machine is

in some respect better than the old machine (that is, it lowers the variable cost

without reducing quality), and doesn't cost more to buy, then no one will buy the

older machine. Thus, anytime we see two technologies being sold side by side,

such as slow and fast copy machines, we can expect the faster machine to have

a higher rental fee or purchase price, and therefore a higher fixed cost.
 V. RAISING CAPITAL

Raising capital for small business expenses is not the easiest step of starting a

small business but it is necessary. One major reason why small businesses fail is

because the owner lacked necessary funds. Money is needed for equipment,

property and more essentials for your small business. You may wonder how you

can raise the money needed to start your small business.

There are two major sources of funding you can seek for your business: Equity

VS Debt Financing. Below there are listed various methods of raising capital for a

small business including forms of equity and debt financing. Analyze each option

below and determine which method/ methods is better suited for your particular

small business.

9 Ways of Raising Capital

1. Saving up your own money- When starting a small business you may not

have all the money needed for start up costs; however you should have some

money saved up for the purpose of starting your business. Bank lenders in

particular are more suspicious of entrepreneurs who don’t invest in their own

business. As a result they can decline a loan because of your lack of investment.

2. Borrow from Friends and Family- I know raising capital for small business

expenses by asking friends and family for money isn’t fun, but hopefully you can
win them over with your great business idea. To avoid complications in the future

make sure to have a written agreement stating terms and details of the loan. You

wouldn’t want to fight with loved ones over money. Be sure to present your

proposition in a professional manner. Show them your business plan, explain to

them why they should invest in you, and answer all their questions. If someone is

giving you money for your business as a gift, be sure you obtain a letter from

them stating the amount of money and that it was a gift. This is precaution to

avoid future complications and misunderstandings.

3. Getting a small business loan- When raising capital for small business

expenses many entrepreneurs go this route. However before attaining a loan you

should be aware that there are many factors associated with business loans such

as interest rates, late charges and collateral. Local community banks are often a

great place to obtain a business loan. Click here for SME Loans and other Fund

sources here.

4. Find a business partner and use their funds- Another way of raising capital

for small business expenses is to develop a business partnership with someone

who can invest in your business. Make sure to present them with a persuasive

explanation for why they should join forces with you.

5. Incorporating your small business- Many entrepreneurs decide to

incorporate their businesses for the purpose of raising capital for small business

expenses. When you incorporate your small business, you will be able to sell

shares of stocks. However when you sell shares of stocks you will also be selling
a percentage of the ownership over the business. So if you sell 50% of your

corporation’s shares of stocks you are selling 50% of the business ownership.

6. Finding a venture capitalist- Venture Capitalists are professionals who invest

in businesses that show a high growth potential. Not only do venture capitalists

provide funding for their clients by investing in their business but they also

provide valuable business advice and strategies. If a venture capitalist decides to

invest in your business it demonstrates to others that they viewed your chances

of success to be favorable. However once a venture capitalist decides to invest in

your business they often have a say on how it should be run. Since venture

capitalists invest in businesses that demonstrate very high and fast growth rates,

many small businesses do not meet the criteria.

7. Small Business Investment Companies- Small Business investment

companies are venture capitalists targeted for small businesses. They are

partnered with the government and provide small businesses with funding in

exchange for a percentage of ownership in the business.

8. Angel investors- Finding an angel investor is another way of raising capital

for small business expenses. Angel investors are simply private investors who

invest money in your business with the belief and hope that in a couple of years

they will see a higher return on their investment. After a 5 year period an angel

investor may expect a return of at least double their initial investment. Of course

starting a small business is risky business so the angel investor may not see any

return if your small business fails. Naturally an angel investor will want
guaranteed exit provisions in the case that your small business fails. You can find

an angel investor by networking with other business owners and small business

professionals. You can also subscribe to angel network firms that can match you

with an angel investor.

9. Credit Cards – Many small businesses have turned to credit cards in order to

pay their small business expenses. Credit Cards may seem like a quick fix but

make sure the terms and interest rates are reasonable.

Wait Before you go…

Before raising capital for small business expenses it is important that you first

determine how much capital you need for your small business. Create a business

budget. Take in consideration that entrepreneurs often underestimate how much

money is needed to run a small business and fail to expect the unexpected. For

example what if your equipment gets damaged and you need replacements…do

you have a back up plan? That is why it is a good idea to always have extra

money put aside just in case.

 VI. CREDIT AND INVENTORY MANAGEMENT

Inventory management is primarily about specifying the size and placement of

stocked goods. Inventory management is required at different locations within a

facility or within multiple locations of a supply network to protect the regular and

planned course of production against the random disturbance of running out of

materials or goods. The scope of inventory management also concerns the fine

lines between replenishment lead time, carrying costs of inventory, asset

management, inventory forecasting, inventory valuation, inventory visibility, future

inventory price forecasting, physical inventory, available physical space for

inventory, quality management, replenishment, returns and defective goods and

demand forecasting

Other definitions of inventory management from across the web:

• Involves a retailer seeking to acquire and maintain a proper merchandise

assortment while ordering, shipping, handling, and related costs are kept

in check.

• Systems and processes that identify inventory requirements, set targets,

provide replenishment techniques and report actual and projected

inventory status.

• Handles all functions related to the tracking and management of material.

This would include the monitoring of material moved into and out of

stockroom locations and the reconciling of the inventory balances. Also

may include ABC analysis, lot tracking, cycle counting support etc.
 • Management of the inventories, with the primary objective of

determining.controlling stock levels within the physical distribution function

to balance the need for product availability against the need for minimizing

stock holding and handling costs.

• In business management, inventory consists of a list of goods and

materials held available in stock.

• An inventory can also be a self examination, a moral inventory.

Credit Management: Key Issues

• Granting credit increases sales

• Costs of granting credit

• Chance that customers won’t pay

• Financing receivables

• Credit management examines the trade-off between increased sales and

the costs of granting credit.

Components of Credit Policy

• Terms of sale

= Credit period

= Cash discount and discount period

= Type of credit instrument

 • Credit analysis – distinguishing between “good” customers that will pay

and “bad” customers that will default

• Collection policy – effort expended on collecting receivables

Credit Policy Effects

• Revenue Effects

• Delay in receiving cash from sales

• May be able to increase price

• May increase total sales

• Cost Effects

• Cost of the sale is still incurred even though the cash from the sale has

not been received

• Cost of debt – must finance receivables

• Probability of nonpayment – some percentage of customers will not pay

for products purchased

• Cash discount – some customers will pay early and pay less than the full

sales price

Five Cs of Credit

• Character – willingness to meet financial obligations

• Capacity – ability to meet financial obligations out of operating cash flows

• Capital – financial reserves

• Collateral – assets pledged as security

• Conditions – general economic conditions related to customer’s business

Types of Inventory

• Manufacturing firm

• Raw material – starting point in production process

• Work-in-progress

• Finished goods – products ready to ship or sell

• Remember that one firm’s “raw material” may be another firm’s “finished

good”

• Different types of inventory can vary dramatically in terms of liquidity

 VII. FORMS OF CORPORATE RESTRUCTURING

Corporate restructuring changes the way a company approaches finances,

technology or its business focus.Corporate restructuring is a general term used

to describe major changes within a company. These changes usually affect basic

business practices, redetermining who makes the major decisions in a company

or how certain parts of its business plan are approached. The type of

restructuring depends on the elements of the business being affected and the

reasons that the restructuring is occurring.

Internal Restructuring

Corporate restructuring occurs based on the needs of the company. Internal

restructuring typically occurs as a result of business analysis that shows a need

for greater efficiency in the way business departments communicate and

complete tasks. Sometimes a particular segment of the business will start to fail,

and the company will need to reallocate resources in order to support it.

Sometimes a business may have expanded to much, and needs to refocus on its

core abilities. At other times a business may need to restructure its financial

position in order to continue making profits. Often, restructuring plans are

necessary simply to meet the constantly change demands of technology that

competitors are embracing. Not all reasons for restructuring are negative, and

many benefit employees as well as executives in the company.

Financial Restructuring

Financial restructuring deals with all changes the businesses makes to its debts

and equity, including mergers, acquisitions, joint ventures and other deals.

Generally these occur when a company joins or is bought by another company.

Ownerships of the company, or at least some interest in the company, is

transferred to another organization or group of investors. Actual business

practices may remain unchanged.

Technological Restructuring

Technological restructuring occurs when a new technology has been developed

that changes the way an industry operates. This type of restructuring usually

affects employees, and tends to lead to new training initiatives, along with some

layoffs as the company improves efficiency. This type of restructuring also

involves alliances with third parties that have technical knowledge or resources.

Restructuring Methods

Restructuring methods are typically divided into expansion, refocusing, corporate

control, and ownership structure. The last two, corporate control and ownership

structure, apply mostly to financial changes and affect ownership. Corporate

control, for instance, is a method where the company buys back enough shares

to be able to make its own decisions again. Expansion occurs with acquisition,

mergers, or joint ventures. Refocusing can take many forms, including business

splits, sell offs of certain ventures, and general consolidation practices.

 VIII. COMPARATIVE ANALYSIS

Comparative financial statements are ones, which have been prepared in a

systematic manner and provides statistical information about a particular event

(financial transaction) or aspect, taking place on different dates or during different

periods.

The comparative financial statements are chalked out in a columnar form (in

majority of the cases). One is also able to view comparative accounts of different

companies.

Comparative financial statements, like all other financial statements have the

following types of financial statements:

• Income statements

• Cash flow statements

• Balance Sheet

Income statements:

Also known as profit and loss financial statement, these types of comparative

financial statements suggest profit amount earned by a company as well as

amount of money lost by a company. Loss or profit may not always mean, loss or

profit of money, it may also include any asset or stock, which has an economic

value. Income statements also include expenditure incurred for conducting

activities, related to operations. This type of a financial statements is referred to

as an operating financial statement.

An income statement can be of two types:

• Single step income statements

• Multi step income statements

It is suggested that, in the preparation of a financial statement, the income

statement, is first worked on. This is generally followed by the statements of cash

flow and balance sheet. In the preparation of a balance sheet, information from

the cash flow statement as well as income statement is often required.

Balance sheet:

Information pertaining to expenses and profit earned by a company are recorded

in the balance sheet.

Statement of cash flow:

Records information about movement of cash within and outside the company.

Usefulness of comparative financial statements: The comparative financial

statements are very helpful in carrying out company analysis. This type of

financial statement is also helpful in observing trends. The auditor traces the

various trends pertaining to a particular financial activity of a company. The

auditor may suggest measures to improve the financial health of the company.
 IX. FINANCIAL RATIOS

Financial ratios are useful indicators of a firm's performance and financial

situation. Most ratios can be calculated from information provided by the financial

statements. Financial ratios can be used to analyze trends and to compare the

firm's financials to those of other firms. In some cases, ratio analysis can predict

future bankruptcy.

Financial ratios can be classified according to the information they provide. The

following types of ratios frequently are used:

• Liquidity ratios

• Asset turnover ratios

• Financial leverage ratios

• Profitability ratios

• Dividend policy ratios

Liquidity Ratios

Liquidity ratios provide information about a firm's ability to meet its short-term

financial obligations. They are of particular interest to those extending short-term

credit to the firm. Two frequently-used liquidity ratios are the current ratio (or

working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio =
Current Liabilities

Short-term creditors prefer a high current ratio since it reduces their risk.

Shareholders may prefer a lower current ratio so that more of the firm's assets

are working to grow the business. Typical values for the current ratio vary by firm

and industry. For example, firms in cyclical industries may maintain a higher

current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that
are difficult to liquidate quickly and that have uncertain liquidation values. The
quick ratio is an alternative measure of liquidity that does not include inventory in
the current assets. The quick ratio is defined as follows:

Current Assets - Inventory

Quick Ratio =
Current Liabilities

The current assets used in the quick ratio are cash, accounts receivable, and

notes receivable. These assets essentially are current assets less inventory. The

quick ratio often is referred to as the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all
current assets except the most liquid: cash and cash equivalents. The cash ratio
is defined as follows:

Cash + Marketable Securities

Cash Ratio =
Current Liabilities

The cash ratio is an indication of the firm's ability to pay off its current liabilities if

for some reason immediate payment were demanded.

Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They

sometimes are referred to as efficiency ratios, asset utilization ratios, or asset

management ratios. Two commonly used asset turnover ratios are receivables

turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts
receivables and is defined as follows:

Annual Credit Sales

Receivables Turnover =
Accounts Receivable

The receivables turnover often is reported in terms of the number of days that
credit sales remain in accounts receivable before they are collected. This number
is known as the collection period. It is the accounts receivable balance divided by
the average daily credit sales, calculated as follows:

Accounts Receivable
Average Collection Period =
Annual Credit Sales / 365

The collection period also can be written as:

365
Average Collection Period =
Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods
sold in a time period divided by the average inventory level during that period:

Cost of Goods Sold

Inventory Turnover =
Average Inventory

The inventory turnover often is reported as the inventory period, which is the
number of days worth of inventory on hand, calculated by dividing the inventory
by the average daily cost of goods sold:

Average Inventory
Inventory Period =
Annual Cost of Goods Sold / 365
The inventory period also can be written as:

365
Inventory Period =
Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Financial Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the

firm. Unlike liquidity ratios that are concerned with short-term assets and

liabilities, financial leverage ratios measure the extent to which the firm is using

long term debt.

The debt ratio is defined as total debt divided by total assets:

Total Debt
Debt Ratio =
Total Assets

The debt-to-equity ratio is total debt divided by total equity:

Total Debt
Debt-to-Equity Ratio =
Total Equity

Debt ratios depend on the classification of long-term leases and on the

classification of some items as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover
the interest payments on its debt. This ratio also is known as the interest
coverage and is calculated as follows:

EBIT
Interest Coverage =
Interest Charges

where EBIT = Earnings Before Interest and Taxes

Profitability Ratios

Profitability ratios offer several different measures of the success of the firm at

generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The
gross profit margin considers the firm's cost of goods sold, but does not include
other costs. It is defined as follows:

Sales - Cost of Goods Sold

Gross Profit Margin =
Sales

Return on assets is a measure of how effectively the firm's assets are being used
to generate profits. It is defined as:

Net Income
Return on Assets =
Total Assets

Return on equity is the bottom line measure for the shareholders, measuring the

profits earned for each dollar invested in the firm's stock. Return on equity is

defined as follows:

Net Income
Return on Equity =
Shareholder Equity

Dividend Policy Ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the

prospects for future growth. Two commonly used ratios are the dividend yield

and payout ratio.

The dividend yield is defined as follows:

 Dividends Per Share
Dividend Yield =
Share Price

A high dividend yield does not necessarily translate into a high future rate of
return. It is important to consider the prospects for continuing and increasing the
dividend in the future. The dividend payout ratio is helpful in this regard, and is
defined as follows:

Dividends Per Share

Payout Ratio =
Earnings Per Share

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

• A reference point is needed. To to be meaningful, most ratios must be

compared to historical values of the same firm, the firm's forecasts, or

ratios of similar firms.

• Most ratios by themselves are not highly meaningful. They should be

viewed as indicators, with several of them combined to paint a picture of

the firm's situation.

• Year-end values may not be representative. Certain account balances that

are used to calculate ratios may increase or decrease at the end of the

accounting period because of seasonal factors. Such changes may distort

the value of the ratio. Average values should be used when they are

available.

• Ratios are subject to the limitations of accounting methods. Different

accounting choices may result in significantly different ratio values.

 X. FINANCIAL RISK MANAGEMENT

Financial risk management is a process to deal with the uncertainties resulting

from financial markets. It involves assessing the financial risks facing an

organization and developing management strategies consistent with internal

priorities and policies. Addressing financial risks proactively may provide an

organization with a competitive advantage. It also ensures that management,

operational staff, stakeholders, and the board of directors are in agreement on

key issues of risk. Managing financial risk necessitates making organizational

decisions about risks that are acceptable versus those that are not. The passive

strategy of taking no action is the acceptance of all risks by default. rganizations

manage financial risk using a variety of strategies and products. It is important to

understand how these products and strategies work to reduce risk within the

context of the organization’s risk tolerance and objectives.Strategies for risk

management often involve derivatives. Derivatives are traded widely among

financial institutions and on organized exchanges. The value of derivatives

ontracts, such as futures, forwards, options, and swaps, is derived from the price

f the underlying asset. Derivatives trade on interest rates, exchange rates,

commodities, equity and fixed income securities, credit, and even weather. The

products and strategies used by market participants to manage financial risk are

the same ones used by speculators to increase leverage and risk. Although it can

be argued that widespread use of derivatives increases risk, the existence of

derivatives enables those who wish to reduce risk to pass it along to those who

seek risk and its associated opportunities. The ability to estimate the likelihood of

a financial loss is highly desirable. However, standard theories of probability

often fail in the analysis of financial markets. Risks usually do not exist in

isolation, and the interactions of several exposures may have to be considered in

developing an understanding of how financial risk arises. Sometimes, these

interactions are difficult to forecast, since they ultimately depend on human

behavior. The process of financial risk management is an ongoing one.Strategies

need to be implemented and refined as the market and requirements change.

Refinements may reflect changing expectations about market rates, changes to

the business environment, or changing international political conditions, for

example. In general, the process can be summarized as follows:

Identify and prioritize key financial risks.

• Determine an appropriate level of risk tolerance.

• Implement risk management strategy in accordance with policy.

• Measure, report, monitor, and refine as needed.

Risk Management Process

The process of financial risk management comprises strategies that enable an

organization to manage the risks associated with financial markets. Risk

management is a dynamic process that should evolve with an organization and

its business. It involves and impacts many parts of an organization including

treasury, sales, marketing, legal, tax, commodity, and corporate finance. The risk

management process involves both internal and external analysis. The first part

of the process involves identifying and prioritizing the financial risks facing an

organization and understanding their relevance. It may be necessary to examine

the organization and its products, management, customers, suppliers,

competitors, pricing, industry trends, balance sheet structure, and position in the

industry. It is also necessary to consider stakeholders and their objectives and

tolerance for risk. Once a clear understanding of the risks emerges, appropriate

strategies can be implemented in conjunction with risk management policy. For

example, it might be possible to change where and how business is done,

thereby reducing the organization’s exposure and risk. Alternatively, existing

exposures may be managed with derivatives. Another strategy for managing risk

is to accept all risks and the possibility of losses. There are three broad

alternatives for managing risk:

1. Do nothing and actively, or passively by default, accept all risks.

2. Hedge a portion of exposures by determining which exposures can and should

be hedged.

3. Hedge all exposures possible.

Measurement and reporting of risks provides decision makers with information to

execute decisions and monitor outcomes, both before and after strategies are

taken to mitigate them. Since the risk management process is ongoing, reporting

and feedback can be used to refine the system by modifying or improving

strategies. An active decision-making process is an important component of risk

management. Decisions about potential loss and risk reduction provide a forum

for discussion of important issues and the varying perspectives of stakeholders.

XI. TYPES OF SHORT TERM BARROWINGS

A loan can be a big financial commitment. By taking one out, you will be required

to give up a portion of your salary every month until the loan is paid off, and

ailing to do so could result in serious consequences. There are two main types of

loan: secured and unsecured. Each have their advantages and disadvantages,

depending on a) your financial health and b) how much you want to borrow.

Secured loan

If a loan is ‘secured’, it means it is secured against something you own (an

‘asset’) – and failing to repay the loan could result in the lender taking possession

of that asset, and selling it to cover their losses.

The asset in a secured loan will normally be your home, but it can also be your
car or another item of a high value.

Advantages of a secured loan

• It’s usually possible to borrow more than with an unsecured loan. It’s also

possible to spread payments over a longer period of time. Since the lender

knows they have your asset as backup, there is much less uncertainty

about whether they are going to get all their money back.

• For the same reason, interest rates are often lower.

• Even if you have a bad credit history, you may be able to get a secured

loan. Your secured asset will reassure lenders that they are able to get all

their money back. However, if you currently have other debt problems,

taking out further loans of any type could be a bad idea.

Unsecured loan

An unsecured loan does not require you to secure anything against the loan –

the lender relies on your contractual obligation to pay it back.

Because there is no security and the risk they are taking is therefore greater, the

amount you can borrow tends to be less, and the repayment period is usually

shorter.

The lending criteria also tend to be tighter: lenders generally charge a higher

interest rate which is determined mainly by your credit history and level of

income.

Advantages of an unsecured loan

 • Preserves the equity in your property and avoid the risk of losing your

home or assets. Lenders are not entitled to repossess your belongings if

you struggle to make your payments – although they can attempt to

pursue this in court if necessary.

• You don’t need a property or any other expensive assets to take out an

unsecured loan.

• It’s cheaper than credit/store cards for smaller purchases. Credit and store

cards usually have very high interest rates, so if you’re planning on

repaying over a few months, you can save a lot of money by taking out an

unsecured loan to fund your purchase.

XII. WORKING CAPITAL MANAGEMENT

Working capital management is the device of finance. It is related to manage of

current assets and current liabilities. After learning working capital management,

commerce students can use this tool for fund flow analysis. Working capital is

very significant for paying day to day expenses and long term liabilities.

Meaning and Concept of Working Capital and its management

Working capital is that part of company’s capital which is used for purchasing raw

material and involve in sundry debtors. We all know that current assets are very

important for proper working of fixed assets. Suppose, if you have invested your

money to purchase machines of company and if you have not any more money
to buy raw material, then your machinery will no use for any production without

raw material. From this example, you can understand that working capital is very

useful for operating any business organization. We can also take one more liquid

item of current assets that is cash. If you have not cash in hand, then you can not

pay for different expenses of company, and at that time, your many business

works may delay for not paying certain expenses. If we define working capital in

very simple form, then we can say that working capital is the excess of current

assets over current liabilities.

Types of Working Capital

1. Gross working capital

Total or gross working capital is that working capital which is used for all the

current assets. Total value of current assets will equal to gross working capital.

2. Net Working Capital

Net working capital is the excess of current assets over current liabilities.

Net Working Capital = Total Current Assets – Total Current Liabilities

This amount shows that if we deduct total current liabilities from total current

assets, then balance amount can be used for repayment of long term debts at

any time.
3. Permanent Working Capital

Permanent working capital is that amount of capital which must be in cash or

current assets for continuing the activities of business.

4. Temporary Working Capital

Sometime, it may possible that we have to pay fixed liabilities, at that time we

need working capital which is more than permanent working capital, then this

excess amount will be temporary working capital. In normal working of business,

we don’t need such capital.

In working capital management, we analyze following three points

Ist Point

What is the need for working capital?

After study the nature of production, we can estimate the need for working

capital. If company produces products at large scale and continues producing

goods, then company needs high amount of working capital.

2nd Point

What is optimum level of Working capital in business?

Have you achieved the optimum level of working capital which has invested in

current assets? Because high amount of working capital will decrease the return

on investment and low amount of working capital will increase the risk of
business. So, it is very important decision to get optimum level of working capital

where both profitability and risk will be balanced. For achieving optimum level of

working capital, finance manager should also study the factors which affects the

requirement of working capital and different elements of current assets. If he will

manage cash, debtor and inventory, then working capital will automatically

optimize.

3rd Point

What are main Working capital policies of businesses?

Policies are the guidelines which are helpful to direct business. Finance manager

can also make working capital policies.

1st Working capital policy

Liquidity policy

Under this policy, finance manager will increase the amount of liquidity for

reducing the risk of business. If business has high volume of cash and bank

balance, then business can easily pays his dues at maturity. But finance manger

should not forget that the excess cash will not produce and earning and return on

investment will decrease. So liquidity policy should be optimized.

2nd Working Capital Policy

Profitability policy

Under this policy, finance manger will keep low amount of cash in business and

try to invest maximum amount of cash and bank balance. It will sure that profit of

business will increase due to increasing of investment in proper way but risk of
business will also increase because liquidity of business will decrease and it can

create bankruptcy position of business. So, profitability policy should make after

seeing liquidity policy and after this both policies will helpful for proper

management of working capital.

XIII. TYPES OF FINANCIAL STATEMENTS

Financial statements can be referred to as representation of the financial status

of a company in a systematically documented form.

There are different types of financial statements. Financial statements, are

required to be audited by authentic, efficient audit firms to avoid manipulation of

numbers. Statements are usually audited by the accounting firms after a

thorough study of the company records. The accounting and the audit firms make

sure that the company is obeying and operating as per norms laid down by the

Generally Accepted Accounting Principles or GAAP.

Basically, there are four different types of financial statements. The different
types of financial statements indicate the different activities occurring in a

particular business house.

• Balance Sheet

• Income statement

• Statement of retained earnings

• Statement of cash flow or Cash flow statement

Balance sheet:

The balance sheet provides an insight into the financial status of a company at a

particular time. The balance sheet, type of financial statement is different in

comparison to the other types of financial statements. Other financial statements

are prepared by taking into account the financial health of the company over a

considerable span of time.

Income statements:

Also known as the P&L statement or the Profit And Loss Statement. This

statement, ascertains the profit and loss of any business. This can be again of

two types:

• Single Step Income Statement

• Multi Step Income Statement

Statements Of Retained earnings:

This financial statement denotes alterations in the title rights of equities, in any

business.
Cash flow statement:

This statement highlights flow of cash over a period of time. The cash flow may

be from investment activities, operations or financing activities.

XIV. CONCLUSION

The Financial Management SMF describes the principal processes in managing

the financial aspect of the IT organization, addresses financial risk as part of

these processes, and discusses the means to measure the value realized from IT

solutions.

The major financial management processes described by the Financial

Management SMF are:

• Establish service requirements and plan budget.

• Manage finances.

• Perform IT accounting and reporting.