Fast Track Notes on Financial management and control

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  • 1. Financial Management And Control Corporate planning :- Corporate planning is a systematic approach to clarifying corporate objectives, strategic decision making and checking progress toward objectives. A corporate plan is a set of instructions to managers of an organization describing what role each department is expected to fulfill in the achievement of organization's objectives. Corporate planning defines the strategies that the employees will take to meet the business’ goals and missions. This type of planning, also known as strategic planning, focuses on staff responsibilities and procedures. As with business planning, strategic planning requires a close look at the company’s missions, strengths and weaknesses. However, corporate planning identifies the step-by-step process of the business, such as the actual steps the staff will take to counteract challenges, train employees and achieve accomplishments. Corporate planning also provides specific, measurable goals with realistic time lines.It is the process of drawing up detailed action plans to achieve an organization's goals and objectives, taking into account the resources of the organization and the environment within which it operates. Inventory Management:- The overseeing and controlling of the ordering, storage and use of components that a company will use in the production of the items it will sell as well as the overseeing and controlling of quantities of finished products for sale. A business's inventory is one of its major assets and represents an investment that is tied up until the item is sold or used in the production of an item that is sold. It also costs money to store, track and insure inventory. Inventories that are mismanaged can create significant financial problems for a business, whether the mismanagement results in an inventory glut or an inventory shortage. Capitalisation of Profit :- Converting a company's retained earnings, which represent the profits held in the business over time, to capital. The capitalization of profits process involves issuing a stock dividend, or bonus shares, to existing shareholders. This allocation is done on the basis of their existing share holdings, similar to a rights issue. For the purpose of Issue of Bonus Shares, a seperate provision for Capitalisation of Profits is required in the Articles of Association or Regulation 96 of Table A of the Companies Act, 1956 can be generally applied for the purpose if the Articles of the Company say that Table A is applicable to the Company. Under-Capitalisation:- When a company does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. If a company can't generate capital over time, it increases its chance of going bankrupt as it loses the ability to service its debts. Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term credit, over lower-cost forms such as equity or long-term debt. There may be a number of causes of under-capitalization. However, the main causes of under-capitalization are - (i) Under-estimation of earnings; (ii) Under-estimation of capital requirement; (iii) Promotion of company during the period of depression; (iv) Unforeseen increase in earnings, such as, during boom period, the company will find itself under-capitalized when its earnings exceed the increase in the amount of capital employed; (v) Conservative dividend policy of the company; (vi) Sound financial management with high efficiency; (vii) Tight conditions in the money market. Ownership Securities:- In order to raise long-term finance through public ownerships, a company issues shares which are nothing but an acknowledgement of ownership. Shareholders are the real owners of the company and are entitled to dividends and voting rights. A financial instrument that represents: an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer. A simple definition of a security is any proof of ownership or debt that has been assigned a value and may be sold. (Today, evidence of ownership is likely to be a computer file, while once it was a written piece of paper.) For the holder, a security represents an investment as an owner, creditor or rights to ownership on which the person hopes to gain profit. Examples are stocks, bonds and options. For example, the issuer of a bond issue may be a municipal government raising funds for a particular project. Investors of securities may be retail investors - those who buy and sell securities on their own
  • 2. behalf and not for an organization - and wholesale investors - financial institutions acting on behalf of clients or acting on their own account. Institutional investors include investment banks, pension funds, managed funds and insurance companies. Gearing of Capital:- Capital gearing refers to the total value of long-term borrowed funds, short- term loans and overdrafts divided by the value of the total shareholders' funds. This is usually a key measure of a company's long term liquidity and hence its ability to survive and grow in future. The degree to which a company acquires assets or to which it funds its ongoing operations with long- or short- term debt. Capital gearing will differ between companies and industries, and will often change over time. Capital gearing is also known as "financial leverage". Capital structure:- A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. Right Issue:- An issue of rights to a company's existing shareholders that entitles them to buy additional shares directly from the company in proportion to their existing holdings, within a fixed time period. In a rights offering, the subscription price at which each share may be purchased in generally at a discount to the current market price. Rights are often transferable, allowing the holder to sell them on the open market. Receivable Management:- Money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or used, but not yet paid for. Receivables usually come in the form of operating lines of credit and are usually due within a relatively short time period, ranging from a few days to a year.On a public company's balance sheet, accounts receivable is often recorded as an asset because this represents a legal obligation for the customer to remit cash for its short-term debts Creditorship securites:- In order to raise long-term finance through public borrowings, a company issues debentures and bonds which are nothing but an acknowledgement of debt. Debenture and bond holders are the creditors of the company and are entitled to a fixed rate of interest. Financial Forecasting:- Financial Forecasting describes the process by which firms think about and prepare for the future. The forecasting process provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assists the firm in identifying the asset requirements and needs for external financing. A financial forecast is simply a financial plan or budget for your business. It is an estimate of two essential future financial outcomes for a business – your projected income and expenses. Create a cashflow forecast by adding income and expenses as they are due. You will then know exactly how much you need to make every month for a profitable business. Trading on Equity:- Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity. Trading on equity is when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost
  • 3. of the debt.If a company generates a profit through this financing technique then its shareholders earn a greater return on their investments. In this case, trading on equity is successful. If, on the other hand, the company earns less from the acquired assets than the cost of the debt, then its shareholders earn a reduced return because of this activity. Over capitalisation :- When a company has issued more debt and equity than its assets are worth. An overcapitalized company might be paying more than it needs to in interest and dividends. If a business has more money than it can work with, it will be burdened with high interest charges and/or dividend payments. Reducing debt, buying back shares and restructuring the company are possible solutions to this problem. Control of Capital:- Any measure taken by a government, central bank or other regulatory body to limit the flow of foreign capital in and out of the domestic economy. This includes taxes, tariffs, outright legislation and volume restrictions, as well as market-based forces. Capital controls can affect many asset classes such as equities, bonds and foreign exchange trades.Tight capital controls are most often found in developing economies, where the capital reserves are lower and more susceptible to volatility. Valuation of corporate securities:- After you have evaluated the credit worthiness of a particular issuer, the next step is deciding upon an appropriate valuation for that bond. There are three good ways to do this. The first method is to look at where the bond has previously traded. This can be done by looking at trade history information on Bloomberg, which is collected from the TRACE reporting system. Typing <TDH> into your terminal will provide a listing of recent trade dates, times, and prices for a particular bond. Keep in mind that pricing can vary greatly from day to day and also by size of trade, so it is best to treat this historical pricing as indicative only. We introduce a dynamic fundamental market model for corporate securities valuation. A balance sheet process is adopted to model the book value dynamics for firm assets, liabilities, and equity. Specified with observable corporate financials, the balance sheet process evolves under stationary constraints on firm's capital structure, with inherent dynamic leverage, investing and funding liquidity risks, and default risk. Defaults, corporate debt and equity prices are largely predictable using fundamental data only. Fundamental analysis and implied pricing are unified in this framework. Long-Range Financial Planning:- The objective of the long-range financial planning process is to plan for and monitor the financial resources that will enable the University to achieve its mission. The plan links the enrollment, academic, staffing, facilities planning, and capital improvements programs with the mission, direction, and strategic priorities of the University in order to determine the financial impact of these programmatic needs for the future. The long-range plan tracks and projects financial and operational data of key operational aspects of the University such as: student enrollments, tuition pricing, housing, dining services, fund-raising, auxiliary operations, salaries and fringe benefits, staffing needs, utility costs, depreciation expenses, other revenues and expenses by natural classification, capital expense cash flows, long-term investments, and debt service. The plan also tracks and projects data on key strategic initiatives to ensure the financial feasibility of such initiatives. This detailed information is linked to a summarized pro forma income statement and balance sheet to enable the financial management of the University to review the impact of ongoing and future changes on the institution’s operating cash, other assets, liabilities, and fund balances. The long-range financial plan also monitors the impact of changes in future financial plans on the key financial ratios that the University is required to maintain for debt covenant and current debt-rating purposes.
  • 4. Long Answers Corporate Finance - Factors that Influence a Company's Capital-Structure Decision The primary factors that influence a company's capital-structure decision are: 1. Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad. 2. Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes. 3. Financial Flexibility This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has. The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top. 4. Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS). 5. Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise. 6. Market Conditions Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
  • 5. Meaning and Definition of Over-Capitalization Meaning and Definition: Generally over-capitalization implies that the capital of the company exceeds its requirements. A company is overcapitalized when its earning capacity does not justify the amount of capitalization. In other words, a company is said to be overcapitalized when its actual profits are not sufficient to pay interest (on debentures and borrowings) and dividends (on share capital) at fair rates. In the words of Beacham, "Overcapitalization occurs when securities in the company are issued in excess of its capitalized earning power." In the words of Hoagland, "Whenever the aggregate of the par value of its of stocks and bonds outstanding exceeds the true value of its assets, the corporation company is said to be overcapitalized.". In the words of Charles W. Gerslenberg, "A corporation (company) is overcapitalized when its earnings are not enough to yield a fair return on the amounts of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of the assets." Reasons: The main causes of over-capitalization are (i) Promotion of company with overvalued assets, (ii) Purchase of assets during boom period, i.e., at higher prices; (iii) High promotional expenses; (iv) Raising excessive capital, i.e., more capital than what it can profitably use; (v) Borrowing money at high rates of interest; (vi) Overestimation of earnings: (vii) Under provision of depreciation; (viii) High rate taxation; (ix) Lack of reserves; (x) Liberal dividend policy etc. Merits/Advantages: The main advantages or merits of overcapitalization are:  Increase in the competitive power of the company.  Easy expansion of the company's activities.  Morale of the management is raised.  Risk-taking capacity is increased.  No fear of shortage of capital.  Power to face depression period is increased. Demerits/ Disadvantages: Form Company's Point View: (i) It reduces the earning capacity of the company; (ii) Reputation and goodwill of the company is adversely affected, i.e., reduced; (iii) Company takes resort to unfair practices; (iv) Manipulation of accounts etc. by the company; (v) Feeling of instability is developed; (vi) Fear of winding up of a company; (vii) Borrowings on higher rate of interest. From Investor's or Shareholder's Point of View: (i) Loss in the value of investment (shares); (ii) Loss of easy marketability; (iii) Irregular, uncertain and lower earnings on the investment (dividend on shares); (iv) Speculation is encouraged; (v) Reduction in the liquidity of investment; (vi) Shares cannot be mortgaged easily as their utility as collateral security is reduced; (vii) Loss due to reorganization and liquidation etc. From the Point of view of the Society: (i) Increase in prices or reduction in quality of goods; (ii) Wage cuts or retrenchment of workers; (iii) Increase in unemployment; (iv) Encouragement to reckless speculation; (v) Mis utilization and wastage of resources; (vi) Reduced efficiency of the management; (vii) Loss of public confidence in investment etc.