Finance for non finance executives

Business
 Business as an economic entity
– Trading activity

Buying Selling
– Manufacturing activity

– Servicing activities Processing

Buying Selling

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

Proprietary Company Partnership

Private Ltd. Public Ltd.

Closely held 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
Long term funds
investments

Long term funds

Short term
Short term funds investments
 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.
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