MBA management

Financial Management Topics:

Profit Maximization as a Decision Criterion


Profit maximization is considered as the goal of financial management. In this approach, actions that Increase profits should be undertaken and the actions that decrease the profits are avoided. Thus, the Investment, financing and dividend also be noted that the term objective provides a normative framework decisions should be oriented to the maximization of profits. The term 'profit' is used in two senses. In one sense it is used as an owneroriented.

In this concept it refers to the amount and share of national Income that is paid to the owners of business. The second way is an operational concept i.e. profitability. This concept signifies economic efficiency. It means profitability refers to a situation where output exceeds Input. It means, the value created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used I.e. select asset, projects and decisions that are profitable and reject those which are not profitable.

The profit maximization criterion is criticized on several grounds. Firstly, the reasons for the opposition that are based on misapprehensions about the workability and fairness of the private enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this criterion in the actual real world situations. The term 'objective' refers to an explicit operational guide for the internal investment and financing of a firm and not the overall business operations. We shall now discuss the limitations of profit maximization objective of financial management.

1) Ambiguity:
The term 'profit maximization' as a criterion for financial decision is vague and ambiguous concept. It lacks precise connotation. The term 'profit' is amenable to different interpretations by different people. For example, profit may be long-term or short-term. It may be total profit or rate of profit. It may be net profit before tax or net profit after tax. It may be return on total capital employed or total assets or shareholders equity and so on.

2) Timing of Benefits:
Another technical objection to the profit maximization criterion is that It Ignores the differences in the time pattern of the benefits received from Investment proposals or courses of action. When the profitability is worked out the bigger the better principle is adopted as the decision is based on the total benefits received over the working life of the asset, Irrespective of when they were received. The following table can be considered to explain this limitation.

3) Quality of Benefits:
Another Important technical limitation of profit maximization criterion is that it ignores the quality aspects of benefits which are associated with the financial course of action. The term 'quality' means the degree of certainty associated with which benefits can be expected. Therefore, the more certain the expected return, the higher the quality of benefits. As against this, the more uncertain or fluctuating the expected benefits, the lower the quality of benefits.

The profit maximization criterion is not appropriate and suitable as an operational objective. It is unsuitable and inappropriate as an operational objective of Investment financing and dividend decisions of a firm. It is vague and ambiguous. It ignores important dimensions of financial analysis viz. risk and time value of money.

An appropiate operational decision criterion for financial management should possess the following quality.
a) It should be precise and exact. b) It should be based on bigger the better principle.
c) It should consider both quantity and quality dimensions of benefits.
d) It should recognize time value of money.

Wealth Maximization Decision Criterion


Wealth maximization decision criterion is also known as Value Maximization or Net Present-Worth maximization. In the current academic literature value maximization is widely accepted as an appropriate operational decision criterion for financial management decision. It removes the technical limitations of the profit maximization criterion. It posses the three requirements of a suitable operational objective of financial courses of action. These three features are exactness, quality of benefits and the time value of money.

i) Exactness : The value of an asset should be determined In terms of returns it can produce. Thus, the worth of a course of action should be valued In terms of the returns less the cost of undertaking the particular course of action. Important element in computing the value of a financial course of action is the exactness in computing the benefits associated with the course of action. The wealth maximization criterion is based on cash flows generated and not on accounting profit. The computation of cash inflows and cash outflows is precise. As against this the computation of accounting is not exact.

ii) Quality and Quantity and Benefit and Time Value of Money: The second feature of wealth maximization criterion is that. It considers both the quality and quantity dimensions of benefits. Moreover, it also incorporates the time value of money. As stated earlier the quality of benefits refers to certainty with which benefits are received In future.

The more certain the expected cash in flows the better the quality of benefits and higher the value. On the contrary the less certain the flows the lower the quality and hence, value of benefits. It should also be noted that money has time value. It should also be noted that benefits received in earlier years should be valued highly than benefits received later.

The operational implication of the uncertainty and timing dimensions of the benefits associated with a financial decision is that adjustments need to be made in the cash flow pattern. It should be made to incorporate risk and to make an allowance for differences in the timing of benefits. Net present value maximization is superior to the profit maximization as an operational objective.

It involves a comparison of value of cost. The action that has a discounted value reflecting both time and risk that exceeds cost is said to create value. Such actions are to be undertaken. Contrary to this actions with less value than cost, reduce wealth should be rejected. It is for these reasons that the Net Present Value Maximization is superior to the profit maximization as an operational objective.

Functions of The Financial Manager


The important function of the financial manager in a modern business consists of the following:

1. Provision of capital: To establish and execute programmes for the provision of capital required by the business.
2. Investor relations: to establish and maintain an adequate market for the company securities and to maintain adequate liaison with investment bankers, financial analysis and share holders.
3. Short term financing: To maintain adequate sources for company’s current borrowing from commercial banks and other lending institutions.
4. Banking and Custody: To maintain banking arrangement, to receive, has custody of accounts.
5. Credit and collections: to direct the granting of credit and the collection of accounts due to the company including the supervision of required arrangements for financing sales such as time payment and leasing plans.
6. Investments: to achieve the company’s funds as required and to establish and co-ordinate policies for investment in pension and other similar trusts.
7. Insurance: to provide insurance coverage as required.
8. Planning for control: To establish, co-ordinate and administer an adequate plan for the control of operations.
9. Reporting and interpreting: To compare information with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of the business.
10. Evaluating and consulting: To consult with all the segments of management responsible for policy or action concerning any phase of the operation of the business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures.
11. Tax administration: to establish and administer tax policies and procedures.
12. Government reporting: To supervise or co-ordinate the preparation of reports to government agencies.
13. Protection of assets: To ensure protection of assets for the business through internal control, internal auditing and proper insurance coverage.

Debentures


The issue of debentures by public limited companies is regulated by Companies Act 1956. Debenture is a document, which either creates a debt or acknowledges it. Debentures are issued through a prospectus. A debenture is issued by a company and is usually in the form of a certificate, which is an acknowledgement of indebtedness. They are issued under the company's seal. Debentures are one of a series issued to a number of lenders.

The date of repayment is invariably specified in the debenture. Generally debentures are issued against a charge on the assets of the company. Debentures may, however, be issued without any such charge. Debenture holders have no right to vote in the meetings of the company.

Kinds of Debentures


1. Bearer Debentures: They are registered and are payable to its bearer .They are negotiable instruments and are transferable by delivery.

2. Registered Debentures: They are payable to the registered holder whose name appears both on debenture and in the register of debenture holders maintained by the company. Registered debentures can be transferred but have to be registered again. Registered debentures are not negotiable instruments. PI registered debenture contains a commitment to pay the principal sum and interest. It also has a description of the charge and a statement that it is issued subject to the conditions endorsed therein.

3. Secured Debentures: Debentures which create a charge on the assets of the company, which may be fixed or floating, are known as secured debentures.

4. Unsecured or Naked Debentures: Debentures, which are issued without any charge on assets, are unsecured or naked debentures, The holders are like unsecured creditors and may sue the company for recovery of debt.

5. Redeemable Debentures: Normally debentures are issued on the condition that they shall be redeemed after a certain period. They can, however, be reissued after redemption under Section 121 of Companies Act 1956.

6. erpetual Debentures: When debentures are irredeemable they are called Perpetual.

7. Convertible Debentures: If an option is given to convert debentures into equity shares at stated rate of exchange after a specified period they are called convertible debentures. In our country the convertible debentures are very popular. On conversion, the holders cease to be lenders and become owners. Debentures are usually issued in a series with a pari passu (at the same rate) clause which entitles them to be discharged rate ably though issued at different times. New series of debentures cannot rank pari passu with old series unless the old series provides so.

8. New debt instruments issued by public limited companies are participating debentures, convertible debentures with options, third party convertible debentures, and convertible debentures redeemable at premium, debt equity swaps and zero coupon convertible notes.

9. Participating Debentures: They are unsecured corporate debt securities, which participate in the profits of the company. They might find investors if issued by existing dividend paying companies.

10. Convertible Debentures with Options: They are a derivative of convertible debentures with an embedded option, providing flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue.

11. Third Party convertible Debentures: They are debt with a warrant allowing the investor to subscribe to the equity of a third firm at a preferential vis-à-vis the market price. Interest rate on third party convertible debentures is lower than pure debt on account of the conversion option.

12. Convertible Debentures Redeemable at a premium: Convertible debentures are issued at face value with an option entitling investors to later sell the bond to the issuer at a premium. They are basically similar to convertible debentures but embody less risk.

Balance Sheet


The balance sheet is a significant financial statement of the firm. In fact, it is called the fundamental accounting report. Other terms to describe this financial statement are the statement of financial position or the position statement. As the name suggests, the balance sheet provides information about the financial standing / position of a firm at a particular point of time, say as on March 31. It can be visualized as a snap shot of the financial status of a company. The position of the firm on the preceding or the following day is bound to be different. The financial position of a firm as disclosed by the balance sheet refers to its resources and obligations, and the interest of its owners in the business. In operational terms, the balance sheet contains information regarding the assets, liabilities and shareholder’s equity. The balance sheet can be present in either of the two forms: Report form or Account form.

Contents of the balance sheets:
1) Assets
2) Liabilities


Assets:


Assets may be described as valuable resources owned by a business which have been acquired at a measurable money cost. As an economics resource, they satisfy three requirements. In the first place, the resource must be valuable. A resource is valuable if it is in cash or convertible into cash or it can provide future benefits to the operations of the firm. Secondly, the resources must be owned in the legal sense of the term.

Finally, the resource must be acquired at a measurable money cost. In case where an asset is not acquired with cash or promise to pay cash, the criterion is, what the asset would have cost, had cash been paid for it.

The assets in the balance sheet are listed either in the order of liquiditypromptness with which they are expected to be converted into cash- or in reverse order, that is, fixity or listing of the least liquid asset first, followed by others. All assets are grouped into categories, that is, assets with similar characteristics are put into one category. The assets included in one category are different from those in other categories. The standard classification of assets divides them into:

1) Fixed assets/ long term assets
2) Current assets
3) Investments
4) Other assets

Liabilities:


The second major content of the balance sheet is liabilities of the firm. Liabilities may be defined as the claims of outsiders against the firm. Alternatively, they represent the amount that the firm owes to outsiders that is, other than owners. The assets have to be financed by different sources. One source of funds is borrowing- long term as well as short term. The firms can borrow on a long term basis from financial institutions/ banks or through bonds/ mortgages/ debentures.

The short term borrowing may be in the form of purchase of goods and services on credit. These outside sources from which a firm can borrow are termed as liabilities. Since they finance the assets, they are, in a sense, claims against the assets. The amount shown against the liability items is on the basis of the amount owed, not the amount payable.

Depending upon the periodicity of the funds, liabilities can be classified into
1) Long-term liabilities
2) Current liabilities

Ratio Analysis


Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as:
1) Fraction
2) Percentages
3) Proportion of numbers

These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

ADVANTAGES OF RATIO ANALYSIS


· Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.

· Ratios avoid distortions that may result the study of absolute data or figures.

· Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.

· Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.

· Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.

· Ratios are increasingly used in trend analysis.

· Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.

· Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.

· Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.

LIMITATIONS OF RATIO ANALYSIS:


An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks. Some of them are listed below:

1. Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from which they are computed and the financial position of the business at other times of the year. A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1

2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.

3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.

4. Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios are also rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.

5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.

6. Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet.

7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.

8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.

While the ratios indicate what happened in the past Art outside analyst has to rely on the past ratios which may not necessarily reflect the firm’s financial position and performance in future.

Fund Flow Statement


Fund flow statement also referred to as statement of “source and application of funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital. The information required for the preparation of funds flow statement is drawn from the basic financial statements such as the Balance Sheet and Profit and loss account. “Funds Flow Statement” can be prepared on total resource basis, working capital basis and cash basis. The most commonly accepted form of fund flow is the one prepared on working capital basis.

CASH FLOW VS FUND FLOW


CASH FLOW - A Cash Flow Statement is a statement which shows inflows and outflows of cash and cash equivalents of an enterprise during a particular period. It provides information about cash flows, associated with the period’s operations and also about the entity’s investing and financing activities during the period.

FUND FLOWFund Flow Statement also referred to as the statement of “Source and Application of Funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital.,

A fund flow statement is different from cash flow statement in the following ways –

i). Funds flow statement is based on the concept of working capital while cash flow statement is based on cash which is only one of the element of working capital. Thus cash flow statement provides the details of funds movements.

ii). Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement records inflows or outflows of cash, the difference of total inflows and outflows is the net increase or decrease in cash and cash equivalents.

iii). Funds Flow statement does not contain any opening and closing balance whereas in cash flow statement opening as well as closing balances of cash and cash equivalents are given.

iv). Funds Flow statement is more relevant in estimating the firm’s ability to meet its long-term liabilities, however, cash flow statement is more relevant in estimating the firms short-term phenomena affecting the liquidity of the business.

v). The Cash Flow statement considers only the actual movement of cash whereas the funds flow statement considers the movement of funds on accrual basis.

vi). In cash flow statement cash from the operations are calculated after adjusting the increases and decreases in current assets and liabilities. In funds flow statement such changes in current items are adjusted in the changes of working capital.

vii). Cash flow statement is generally used as a tool of financial analysis which is utilized by the management for short- term financial analysis and cash planning purposes, whereas funds flow statement is useful in planning intermediate and long-term financing.

Advantages of Fund Flow Statements:


Advantages of fund flow are as follows:

 Management of various companies are able to review their cash budget with the aid of fund flow statements.

 Helps in the evaluation of alternative finance and investments plan.

 Investors are able to measure as to how the company has utilized the funds supplied by them and its financial strengths with the aid of funds statements.

 It serves as an effective tool to the management of economic analysis.

 It explains the relationship between the changes in the working capital and net profits.

 Help in the planning process of a company.

 It is an effective tool in the allocation of resources.

 Helps provide explicit answers to the questions regarding liquid and solvency position of the company, distribution of dividend and whether the working capital is effectively used or not.

 Helps the management of companies to forecast in advance the requirements of additional capital and plan its capital issue accordingly.

 Helps in determining how the profits of a company have been invested: whether invested in fixed assets or in inventories or ploughed back.



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Review Questions
  • 1. WHat is Weighted Average Cost of Capital?
  • 2. What is operating cycle for working capital?
  • 3. What is preference share capital?
  • 4. What is trend analysis?
  • 5. What is commercial paper?
  • 6. As a creditor or investor or finance manager suggest any 3 ratios to be used for analysis with reasons.
  • 7. What are the precautions to be taken during trend analysis?
  • 8. Give any three objectives of financial analysis?
  • 9. State any 3 uses of common size statement, comparative statement, trend analysis and ratio analysis?
  • 10. Difference between fund flow and cash flow statement.
  • 11. What are inter- corporate deposits?
  • 12. What is cash operating cycle?
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