Finance Concepts

Management Accounting

Accounting is an information and measurement system that identifies, records, and communicates
relevant, reliable, and comparable information about an organization’s business activities

Accounting Equation : Assets = Liabilities + Equityi

Assets  Resources a company owns or controls (Receivable)

Liabilities  Creditors’ claims on assets (Payable)

Equity  Owner’s claim on assets

Common stock  part of contributed capital reflects inflows of resources such as cash from
stakeholders in exchange for stock (Amount stockholders invest in the company)

Retained earnings  Accumulated revenues – (Expenses + Dividends)

Hence, Assets = Liabilities + Contributed Capital + Retained Earnings = Liabilities + Common Stock –
Dividends + Revenues – Expenses

Income Statement  Describes company’s revenues and expenses along with resulting net income
or loss over a period of time

Balance Sheet  Company’s financial position at a point of time

Statement of Cash Flows  Cash inflows (receipts) and cash outflows (payments) over a period of
time

Building blocks of Financial statement analysis : Liquidity (ability to meet short term obligations and
generate revenues), Solvency (ability to generate future revenues and meet long-term obligations),
profitability (Ability to provide financial rewards sufficient to attract and retain financing), Market
Prospects (Ability to generate positive market expectations)

Liquidity : Current Ration (Current Assets/Current Liabilities)

Solvency : Debt Ration (Total Liabilities/Total Assets)

Profitability : Profit Margin (Net Income/Net Sales)

Market Prospects : Price-to-earnings (Price per share/Earnings per share)

Asset Accounts – Cash, Accounts receivable (Credit Sales), Note Receivable (promissory note),
Prepaid Accounts (Payments of future expenses), Supplies Account (Assets until they are used),
Equipments Accounts (When an equipment is used and gets worn down, its cost is gradually
reported as an expense  Depreciation), Building Accounts, Land

Liability Accounts – Accounts Payable (oral or implied promise to pay later), Note payable, Unearned
Revenue (Liability which is settled in the future when company delivers its products or services),
Accrued Liabilities (wages payables, taxes payable, interest payable)

Equity Accounts – Owner Investments (in exchange of common stock), Owner distribution
(Dividends), Revenue Accounts (Sales, Commission, Professional Fees), Expense Accounts

T Account – Ledger account or tool used to depict effects of one or more transactions
Double Entry Accounting – Accounting equation remain in balance (For each transaction two
accounts are involved  Debit and Credit, The total amount debited = amount credited)

Assets = Debit (+), Credit (-), Liabilities = Debit (-), Credit (+), Equity = Debit (-), Credit (+)

Accrual Basis vs Cash Basis  Revenues are recognized when services and products are delivered
and expenses when incurred (matched with revenues) : Accrual Basis, Cash basis : Revenues when
cash is received and records expenses when cash is paid

Revenue Recognition Principle : Revenue to be recorded when a company provides services and
products to customers

Expense Recognition Principle : recording expenses in the same accounting period as the revenues
that are recognized as a result of those expenses

Classified Balance Sheet

Current Assets : cash and other resources which are expected to be sold, collected, or used within
one year or the company’s operating cycle e.g. cash, short-term investments, accounts receivables,
short term notes receivables, goods for sales, prepaid expenses

Long-Term Investments : Notes receivables, investments in stocks and bonds, expected to be held
more than the longer of one year or the operating cycle

Plant Assets : Tangible Assets  ling lived and used to produce or sell products and services e.g.
Equipments, machinery, building etc.

Intangible Assets : long-term resources that benefit business operations and lack physical form e.g.
Patents, Trademarks, Copyrights, Franchises, Goodwill

Current Liabilities : Obligations due to be paid o r settled within one year or operating cycle e.g.
Account payable, Notes payable, wages, Taxes, interest, Unearned revenue

Long-Term Liabilities : Obligations not due within one year or operating cycle e,g, Notes payable,
mortgages payable, bonds payable

Equity : Owner’s claim on assets  Common stock

or retained earnings

Operating cycle for a Merchandiser  Purchasing

merchandise till collecting cash

Inventory systems - Products a company owns and

expects to sell in its normal operations

Beginning Inventory + Net Purchases =

Merchandise available for Sale = Ending Inventory
+ Cost of goods sold
Perpetual inventory system : Continually updates accounting records for merchandising transactions

Periodic Inventory system : updates the accounting records for merchandise transactions only at the
end of a period

Acid Test Ratio = (Cash and cash equivalents + Short Term investments + Current receivables)/
Current liabilities

To measure merchandiser’s ability to pay its current liabilities

Inventory Cost Flow Assumptions

FIFO – Costs flow in the order incurred (orders are sold in the order acquired)

LIFO – Costs flow in reverse order incurred (Most recent purchases are sold first)

Weighted Average – Costs flow at an average of the costs available

Specific Identification – Each item in inventory can be identified with specific purchase and invoice

FIFO assign lowest amount to cost of goods sold  Yield highest profit and net income

LIFO assigns highest amount to cost of goods sold  Lowest gross profit (Tax advantages)

Debit card purchase  reduces buyer’s cash account balance

Credit card reflects authorization by the card company of a line of credit for the buyer with preset
interest rates and payment terms

Valuing Accounts Receivable – Direct Write-Off Method : for bad debts  records the loss from an
uncollectible account receivable (Bad debts expenses often not matched with sales)

Materiality Constraints  An amount can be ignored if its effect on the financial statements is
unimportant to users’ business decision

Allowance Method 
Matches the estimated loss
from uncollectible
accounts receivable
against the sales they
helped to produce

Percent of sales Method 

(Income Statement
Method) Given percent of a
company’s credit sales for
the period is
uncollectible

Percent of Receivables
Method  (Balance sheet
Method) Allowance for
doubtful accounts balance equal to portion of accounts receivable that is estimated to be
uncollectible  Given percent of company’s receivables are uncollectible

Aging of receivables  Uses past and current information to estimate allowance amount : Longer
the amount past due date, more likely it is uncollectible

Depreciation – Process of allocating the cost of a plant asset to expense in the accounting period
benefitting from its use (only recorded when the asset is actually in service)

Factors in computing Depreciation : Cost, Salvage Value (Residual value, asset’s value at the end of
its benefit period), Useful Life (Length of time an asset is productively used)

Depreciation Methods –

Straight line Method  Same amount of expense to each period of the asset’s useful life

(Cost – Salvage Value)/Useful life in periods

Units-of-production Method  When use of equipment varies from period to period, units-of-
production depreciation method : Depreciation per unit = (Cost – salvage value)/Total units of
production, Depreciation expense = Depreciation per unit * Units produced in period

Declining-Balance Method  Larger depreciation expenses in the early years of an asset’s life and
less depreciation in later years

Natural resources are reported under either plant assets or their own separate category

Depletion  Process of allocating cost of a natural resource to the period when it is consumed

Types of intangibles :

Patents – exclusive right granted to its owner to manufacture and sell a patented item

Copyright – Gives owner the exclusive right to publish and sell a musical, literary or artistic work
during the life or the creator plus 70 years

Franchises and Licenses – Rights that a company or government grants an entity to deliver a product
or service

Trademarks or Trade Names – Symbol, name, phrase or jingle identified with company, product or
service

Goodwill – Amount by which a company’s value exceeds the value of its individual assets and
liabilities

Leaseholders – Property is rented under lease, property owner lessor, secures the right lessess

Warranty – Seller’s obligation to replace or correct a product that fails to perform as expected within
a specified period

Contingent liability is potential obligation that depends on the likelihood that a future event arising
from a past transaction or event
Bond Financing  Projects that demand large amounts of money are funded from bond issuances.

Bond  Issuer’s written promise to pay an amount identified as the par value of the bond with
interest  Par value (Face value) is paid a specified future date knowns as bond’s maturity date

Corporation is an entity created by law that is separate from its owners  Owners are called
stockholders  Can be privately held (that does not offer its stock for public sale and usually has a
few stockholders)

Capital stock  Any shares issued to obtain capital

Authorized Stock  Number of shares that corporation’s charter allows it to sell

Selling Stock  Can sell directly (Advertisement) or indirectly (Brokerage)

Market Value of Stock  Price at which stock is bought or sold

Stockholder’s equity  Paid in capital + Retained Earnings

Dividends  Cash dividends or stock dividends

Important Dates for Dividends : Declaration, Record and payment\

Stock Splits  distribution of additional shares to stockholders according to their percent ownership

Preferred Stock  has special rights that give it priority over common stock  Preference in
receiving dividends, distribution of assets

Treasury stock  Corporations acquires shares of their own stock

Retiring Stock  Reduces number of issued shares

Price-earning ratio = Market value (price) per share/ Earning per share

Dividend Yield = Annual cash

dividends per share/ Market
value per share

Purpose of the Statement of Cash

Flows

To report cash receipts and cash

payments during a period

Classification:

Operating Activities –
transactions and events that
determine net income 
Production and purchase of
inventory, sale of goods and
services to customer
Investing Activities – Transactions and events that affect long-term assets

Financing Activities  Transactions and Events that affect long term liabilities and equity

Ratio Analysis:

Liquidity : Availability of resources to meet short-term requirements

Current Assets – Current Liabilities = Working Capital

Current Ratio = Current Assets/Current Liabilities (High  High liquidity)

3 Factors  Type of business , Composition of current assets, Turnover Rate of Assets

Acid Test Ratio = (Cash + Short Term investments + Current Receivables)/ Current Liabilities

Accounts Receivables Turnover = Net Sales/Average Accounts Receivable (How frequently a

company converts its receivables into cash)

Inventory Turnover = Cost of goods sold/Average Inventory (How long company holds inventory
before selling it  Affects working capital requirements)

Days’ sales uncollected = (Accounts Receivables/Net Sales)*365 (How frequently company collects
its accounts)

Days’ Sales in Inventory = (Ending Inventory/Cost of Goods sold)*365 ( inventory’s liquidity)

Total Asset Turnover = Net Sales/Average Total Sales (Company’s ability to use its asset to generate
sales)

Solvency: Company’s long run financial viability

Debt-to-Equity Ratio = Total liabilities/Total Equity (High  less opportunity to expand)

Profit Margin = Net Income/Net Sales (Operating Efficiency and profitability)

Return on Total Asset = Net Income/Average total assets

Profit Margin * Total Asset Turnover = Return on total assets

Corporate Finance

Capital Budgeting  Process of making and managing expenditures on long-lived assets

Capital Structure  Represents the proportions of the proportions of firm’s financing from current
and long-term debt and equity

Net working capital  Current Assets – Current Liabilities

The Corporate Firm :

The Sole poprietorship  Business owned by one person

The Partnership  General (all partners agree to provide some fraction of work and cash and to
share profits and losses) or limited (At least one general partner, limited partners do not participate
in managing business)

The Corporation  Distinct legal entity, Three sets of interest : Shareholders, Directors, Corporation
officers (Top Management)

LLC  Hybrid of partnership and Corporation, Goal is to operate and taxed like partnership but
retain limited liability for owners

Goal of financial management is to maximize the current value per share of the existing stock

Agency Problem  Relationship between stockholders and management : Agency relationship

Possibility of conflict between the principal and the agent  Agency problem

Summary

Corporate Finance has three major areas of concern  corporate budgeting (What long-term
investments should the firm take), Capital Strucutre (Where will firm get long-term financing,
mixture of debt and equity to fund operations?), Working capital management (How should the firm
manage its everyday financial activities)

Goal of financial management  for-profit business is to make decisions that increase the value of
the stock, or more generally, increase the value of equity

Corporate form of organization is superior to other forms when it comes to raising mony and
transferring ownership interests, but it has signaficant disadvantage of double taxation

Possibility of conflicats between stockholders and management in large corporation  Agency

problems

Advantage of corporate form are enhanced by existence of financial markets

Financial Statements and Cash Flow Summary

Cash flow is generated by the firm and is paid to creditors and shareholders  Cash flow from
operations, Cash flow from changes in fixed assets, Cash flow from changes in working capital

Accounting value  Book value

Price at which willing buyers and sellers would trade the assets  Market Value
Compound value or Future value  value of sum after investing over one or more periods

Present Value = C/(1+r) …. C is cash flow at a date, r is rate of return or discount rate

NPV = -Cost + PV (Present Value)

Process of leaving the money in the financial market and lending it for another year 
Compounding

Future value (FV) = C0 x (1+r)…….C is cash to be invested at Date 0, r is interest rate per period, T
number of periods

The process of calculating the present value of a cash flow  Discounting

Perpetuity  Constant stream of cash flows without end (PV = c/r)

Growing Perpetuity  g is rate of growth PV = c/(r-g)

Annuity  Level stream of regular payments that lasts for a fixed number of periods

Basic Investment rule 

Accept a project if NPV > 0, Reject a project if NPV < 0 …. NPV Rule

NPV Rule : Uses cash flows, uses all cash flows of the project, discounts the cash flows properly

Payback Period Rule  Particular cutoff date is selected, All investment projects that have payback
periods equal to less than that date are selected  Better version is discounted payback period
method

Internal Rate of Return  Rate which causes NPV of the project to be zero

Accept the project if IRR is greater than the discount rate, Reject if the IRR is less than discount rate

Profitability Index  PV of cash flows subsequent to initial investment/ Initial Investment

Accept independent project if PI > 1

For mutually exclusive projects  Capital rationing : Not enough capital to fund all positive NPV
projects

IRR always reaches same decision as NPV in the normal case where the initial outflows of an
independendent projects

Sunk costs  cost that has already incurred

Opportunity costs  an asset is used for a project, potential revenues from alternative uses are lost

Proper calculation of cash flow is essential for capital budgeting

Approach  Top down approach : Start at the top of income statement and work down to cash flow
by subtracting costs, taxes and other expenses

Bottom up approach : Start with bottom line (net income) and add back any noncash deductions
(like depreciation)
The Tax-shield approach : Two parts of OCF  Calculating project costs with no depreciation, then
depreciation deduction multiplied by tax rate (Depreciation is non-cash expense, and it only reduces
taxes)  Depreciation tax shield

Real Interest Rate = Nominal Interest Rate – Inflation Rate

Short-Term Finance and Planning

Net working capital + Fixed assets = Long-term debt + Equity

Net working capital = (Cash + Other current assets) – Current liabilities

Cash = Long term debt + Equity + Current liabilities – current assets ither than cash – Fixed Assets

Operating cycle  length of time it takes to acquire inventory, sell it and collect for it : Inventory
period (Acquire and sell inventory) and Account Receivable period (Time it takes to collect on the
sale)

Cash cycle  Number of days that pass before we collect cash from a sale, measured from when we
actually pay for inventory

Cash Cycle = Operating Cycle – Accounting Payable period

How to calculate operating and cash cycles:

Operating cycle  Inventory turnover (COGS/Avg. Inventory), Inventory Period = 365 days/Inventory
turnover

Receivables turnover  Credit Sales/Average accounts receivable, Receivables period = 365 days/
Receivables turnover

Operating Cycle = Inventory period + Receivables period

Cash cycle  Calculate Payables period : Payables turnover (COGS/Avg. Payables)  365/Payables
turnover

Longer the cash cycle  More financing required

Lengthening of cycle  Trouble in moving inventory or collecting receivables

Costs that rise with increase in level of investment in current assets  Carrying cost

Costs that fall with increase in level of current assets  Shortage costs

Reasons for Holding cash:

Speculative Motive  need to hold cash in order to be take adavantage of

Precautionary Motive  Need for a safety supply to act as a financial reserve

Transaction Motive  Need to have cash on hand to pay bills

Costs of Holding cash  Opportunity cost of excess cash

Cash balance that firm shows on its books  Book, ledger balance

Balance shown in bank account as available to spend  Available Balance

Difference is called float  Reflects the fact that some chekcs have not cleared and are uncollected
 Manager must work with book balance

The firm can make use of variety of procedures to manage the collection and disbursement of cash
in such a way as to speed up the collection of cash and slow down payments  Lockboxes,
concentration banking, wire transfers

Becasuse of seasonal and cyclical activities, to help finance planned expenditures, or as a

contingency reserve, firms temporarily hold a cash surplus  Parking the idle cash

Components of Credit Policy

Terms of sales : Establishes how the firm proposes to sell its goods and services  Cash or extend
credit

Credit analysis : How much effort to expend trying to distinguish between customers who will pay
and customers who will not pay

Collection Policy : To solve problem of collecting cash

Inventory Management Techniques:

ABC Approach  Divide inventory into three (or more) groups  small portion of inventory in terms
of quantity might represent a large portion in terms of inventory value

Economiv Order Quantity Model  Costs associated with holding an inventory vs inventory levels

Total costs = Carrying cost + Restocking cost

Safety Stock  Minimum level of inventory that a firm keeps on hand

Reorder points  Times at which the firm will actually place its inventory orders

Materials Requirement Planning  Once finished goods inventory levels are set, it is possible to
determine what levels of work-in-progress inventories must exist to meet the need for finished good

Just-In-Time Inventory  Minimize inventories and maximise turnover : only have enough inventory
on hand to meet immediate production needs
Types of Banks in India :

Broad classification  Scheduled and Non-scheduled banks, Non-Banking Finance Companies

Scheduled banks  Can either be commercial or corporative banks, Regulated by RBI, can borrow
money from RBI

Non-scheduled Banks  Have to comply with certain provisions of RBI. Not entitled to borrow
money from RBI

NBFCs  Engaged in business of loans, advances and acquisition of securities, should get at least
50% of their revenues from financial activities, do not form part of payment and settlement system

Public Sector Banks or nationalized banks : SBI, Bank of India, IDBI Bank, Bank of Baroda etc. Total 21

Private Sector Banks : Private shareholders hold majority stakes in private sector banks e.g. HDFC,
ICICI Banks, AXIS bank etc.

Foreign Banks : Banks acting as private entity but having headquarters in foreign country e.g CITI
Bank, HSBC Bank

Regional Rural Banks : These banks were established mainly to support the weaker and lesser
fortunate section of the society like marginal farmers, laborers, small enterprises etc. they mainly
operate at regional levels at different states and may have branches in urban areas as well. Their
main features are:
1. Supporting rural and semi-urban region financially
2. Pension distribution and Wage disbursement of MGNREGA workers
3. Added banking facilities like locker, cards-debit, and credit

Small Finance Banks : These banks cater to a niche segment in the society and help with financial
inclusion of sections which are not taken care of by other leading banks.

Cooperative Banks : These are no-profit, no-loss banks and mainly serve entrepreneurs, industries,
small businesses, and self-employment