Finance for non finance executives

By:

M. K. BANSAL

Business

Business as an economic entity – Trading activity

– Manufacturing activity

– Servicing activities

Buying Selling

SellingProcessingBuying

Servicing

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.

Business

Stakeholders in the Business– Investors

Equity holders Debt holders including banks and financial institutions

– Suppliers– Distributors and retailers– Employees– Customers– Community

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.

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

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.

Structure of the businesses

Business

Partnership

Closely held

CompanyProprietary

Public Ltd.Private Ltd.

Publicly held

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.

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

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 fundsShort term investments

Long term funds

Short term funds

Funds management

Management of the funds

Mobilization of the funds Utilization of the funds

Quantum Source Cost time

Fixed assets Work. Cap. Investments

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

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.

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.

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.

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

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.

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.

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.

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.

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

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

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.

Major providers of debt finance

Individual investors Banks Financial institutions Specialized institutions

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.

Main items of the revenues

Sales revenue Other income

– Dividends and interest– Sales of the assets

Lease charges

Main items of the expenses

Cost of goods sold. Salary Other expenses

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)

Items from profit and loss account

Depreciation– Straight line method– Discounted value method– (Change in depreciation methodology to inflate/deflate profits)

Deferred revenue expenditure– R&D expenses– Advertisement expenses– Product promotion expenses

(expenses are charged as capital expenses and amortized over the period of time)

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.

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

Cost concepts

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

A view of profit and loss account

Cash expenses– Raw material, salary and other administrative

expenses Non cash expenses

– Depreciation

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

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.

Annual Reports

Auditors’ report – Profit and loss account– Balance sheet– Cash flow statement– Qualification of auditors

Directors’ report

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.

Corporate actions

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

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).

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).

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).

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 ?

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).

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.

Risks in the business

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

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.

Management of the risks

Management of the risk requires the knowledge of the specialized instruments called derivatives.

Major products are :– Forward – Futures, and – Options