Introduction to
Financial Management & Accounting
Financial Management
• Financial management involves taking decisions which
will impact the financial results of the firm.
– How much money do we need?
Investments in the form of short term and long term
– How do we mobilise the money?
Sources in the form of debt or equity
How Much Money Do We Need?
• Capital Expenses (Capex) – Capital Budgeting
– Money for capital investment
• Examples: Equipment, Building
• Operating Expenses (Opex) – Working Capital
– Permanent Working Capital for operating the business
• Level of permanent WC grows as business grows
– Temporary Working Capital
• To meet seasonal or peak periods
Sensitivity to Risk:
Fixed Cost vs. Variable Cost
• Reduce Fixed Cost component as much as possible!
• Look into every expense and be sure of the NEED for
Fixed Cost
– i.e. Is there a Variable Cost option?
• Capex – e.g. Buy or lease machinery, office space
• Opex – e.g. Salary – Permanent vs. temporary contract
Capital Budgeting
• Money for investment in Fixed assets/Capacity/ infrastructure
the benefits of which are received over period of time
• They are generally:
– Irreversible
– Non-flexible
– Expensive
– Affect profitability of the concern
• Methods used to evaluate proposals:
– Pay back period
– NPV
Working Capital Management
• Working Capital (WC) is so called because it is
required to make the fixed assets work
• The amount of WC is determined by:
– the nature of the business, size of the fixed
assets,
– the complexity of the production process
• WC should be adequate (neither too much
nor too little) to meet day-to-day operational
needs of the business
Working Capital management is best understood as a cyclic
Working Capital Management
• The working capital cycle should be free of
blocks to allow free flow of cash within the
cycle.
• For example:
– Obsolete, non-moving or defective items in
the raw material stock / work in progress
(WIP) / finished goods inventory
– Customers who delay payments
(receivables/debtors) or don’t pay at all
(bad debts)!
How do we mobilise the money?
• Types of finance
– Equity:
• The owners’ (shareholders’) investment
– Share capital
• Accumulated income, year after year
– Retained Earnings
– Debt:
• borrowed funds – debentures, loans
Types of Finance: Equity
• Inside equity:
– founders, friends, family
• Angel Investors
• Venture Capital
• Public Offering:
– The ultimate in wealth creation
Risk Aware - Equity
• Any increase of equity beyond inside equity will often
lead to dilution, or a lowering of the percentage of
ownership in the company.
• Investors may ask for seats on the board of directors, and
other controls before investing.
Types of Finance: Debt
• Debt is typically cheaper
• Debt offers a tax shield: interest is deducted from
earnings, before taxes
• So, why wouldn’t we always use debt financing?
Risk Aware - Debt
• Debt requires regular repayment…
…or default (and bankruptcy, or loss of collateralized
asset).
• Lenders tend to be more conservative and require
collateral…
…or, as is frequently the case for new ventures,
traditional lending institutions (e.g. banks) might not
lend at all
Important issues to consider
Equity
Cash Flow
Dividend
Collateral
Not required
Ownership
Dilution
Loss of control
Debt
Interest,
Principal
Repayment ,
Tax Shield
Required –
assets are
collaterized
Not affected
Two important Capital Structure decisions
1. Should the business have ‘borrowed’ capital? If so, how
much?
2. What is the correct mix of ‘Long term’ and ‘Short term’
funds?
• It is good to have a good mix of Debt and Equity
• But the composition of the mix depends on various
factors including the risk and rewards
Finance and Accounting
• Accounting is the foundation for Finance
• Understanding Finance requires the understanding of the
basics of Accounting
• Accounting is the art of recording, classifying and
summarising the transactions of financial nature and
interpreting the results to know about the health of the
organisation
Financial Statements
Financial Statements consist of:
• the Balance Sheet which is a snap shot of the financial
position of the business as on a particular date
• the Income Statement ( Profit & Loss Account) which
shows the results of the operations during a period
• the Cash Flow Statement which shows the receipts and
payments of cash/money during a period
Financial Statements - Overview
Physical appearance
Balance Sheet
Income statement
Metabolic system
Cash flow statement
Circulatory system
Accounting Concepts & Conventions
Accounting Concepts are the
“generally accepted accounting principles”…
•
•
•
•
•
Legal Entity concept
Dual Aspect concept
Money measurement concept
Going concern concept
Accounting period concept
Accounting Concepts & Conventions
Accounting Conventions are the
“generally followed accounting practices”…
• Conservatism (eg: ‘useful life’ and ‘fair value’)
• Materiality (‘true and fair’ instead of ‘true and correct’)
• Disclosure (eg: Contingent Liabilities)
Accounting Concepts & Conventions
The Balance Sheet ….why it is called so…
Liabilities
What it ‘owes’
=
Assets
=
What it ‘owns’
Balance Sheet
Sources/Liabilities
Application/Assets
Shareholders’ Funds
(Owner’s Capital)
Paid up capital
Reserves & Surplus
(Profits retained)
Fixed Assets
Gross Block
Less: Depreciation
Net Block
Loan Funds
Secured/Unsecured Loans
Current Assets
Inventories/Stocks,
Debtors/
Receivables, Cash & Bank
Balances,
Loans & Advances
Less: Current Liabilities
Creditors/Payables
Total liabilities
=
Net Current Assets
Total Assets
Format of Income Statement
Income statement for the year ending ………
A. Income
Sale of goods / services
Financial income
Interest / Dividend received
Profit on sale of Investment
Misc. receipts (scrap sales etc)
B. Expenditure
Cost of goods sold
Employee expenses
Bought-out services
Depreciation
Operating expenses
Financial expenses (eg: Int pai
Provision for expenses/losses
(eg: Bad Debts, Obsolete good
Amortization of expenses
C. Profit Before Tax (PBT) (A
Less :Tax provision
=
D. Profit After Tax ( PAT)
Less: Transfer to Reserves
=
E. Profit for Distribution
Income Statement
• It is incorrect to use the terms Profit and Income
interchangeably.
– Income relates to Sales/Revenue
– Profit relates to ‘Results’
(net of Sales minus Expenditure )
Cash Flow Statement
• A cash flow statement shows the sources and uses
of cash in the business:
– operating activities
– financing activities
– investing activities
The acid test of any
business is its ability to
pay the financial
obligations
(eg: employees salary,
supplier payments, loan
repayment etc) as and
when they fall due
Format of Cash Flow Statement
Cash flow from Operations
Profit After Tax + Depreciation
Add/Less: Changes in working capital;
Increase/Decrease in
Stocks/inventories, sundry debtors, advances,
current liabilities
Net flow from operations
Cash flow from Investing Activities
Purchase of Fixed assets
Purchase of other non-current assets
Less : Sale of fixed assets/other non-current
assets
Net flow from Investing activity
Cash from Financing Activities
Long term Loans availed
Less: Dividend payment, Loan repayments
Net flow from Financing activity
Net Increase/ Decrease in cash and bank balances for
the period
Interpreting a Cash Flow Statement
Cash Flow
Start
up
Excellen
t
Poor
Operational
activities
-100
+500
-600
Financing
activities
+600
-200
+400
Investing
activities
-500
-300
+200
Creative Accounting
• While Balance Sheet and Income statement can be
manipulated, Cash flow statement cannot be tampered
with / manipulated
“Profit is an opinion, but cash is a fact”
- Mr. Narayanamurthy (Infosys)
Linking Finance & Accounting
Liabilities
Shareholders Equity
8000
(Own)
Long term loan
2000
(Debt)
Total
10,000
Capital Structure
Assets
Fixed Assets
6000
(Capital Budgeting)
Investment decisions
Current Assets less Current 4000
liabilities (Working Capital)
Total
(Working Capital)
10,000
All materials used in this session are available in
the NEN CD Kick-Starting the Entrepreneurial
Campus under Inside the Classroom –
section “Entrepreneurship Concepts”,
subsection “Finance and Fundraising”